Both S&P and Fitch upgraded their outlooks for Bulgaria last Friday from stable to positive. The moves come even as the nation moves closer to being the next member of the Eurozone.
Ten years after joining the EU, Bulgaria is signaling that it wants to adopt the euro as well. Finance Minister Goranov confirmed last week that it would request joining ERM-2, which is a precursor to adopting the euro. While no timetable was given yet, we believe Bulgaria will move quickly since the center-right GERB just won the snap election in March.
Bulgaria is hoping to leave behind a period of extended political uncertainty. Prime Minister Borisov takes the helm of the government for the third time. His center-right GERB party first came to power in 2009. He resigned in February 2013 after anti-austerity protests brought his government down. GERB won the May 2013 elections but fell short of having a majority, which ushers in a technocratic government that lasts for about a year.
October 2014 elections led to a splintered parliament, but Borisov took power for the second time to lead in coalition with the so-called Reformist Bloc. When Socialist candidate Rumen Radev won the presidential election in November 2016, Borisov again resigned as Prime Minister. GERB won snap elections in March 2017 but again fell short of having a majority. It is now ruling in coalition with three nationalist parties.
European officials appear receptive to Bulgaria’s entry into the Eurozone. French President Macron has reportedly told Borisov that he will support any efforts to join the euro once the criteria have been met. European Commission (EC) Vice President Dombrovskis recently trumpeted that “Bulgaria is on its way to the Eurozone.”
This is a break from the past. Back in 2008, the EC suspended aid for failing to act against corruption and organized crime. This may be reading too much into Brexit, but we wonder if European policymakers are keen to show that integration is still moving forward. Indeed, no country has left the Eurozone and it has only gotten bigger since its inception.
The IMF highlights corruption as the biggest obstacle for business in Bulgaria. While Bulgaria scores very well in the World Bank’s Ease of Doing Business rankings (39 out of 190), it does less so in Transparency International’s Corruption Perceptions Index (75 out of 176 and tied with Kuwait, Tunisia, and Turkey). Even Romania comes in better at 57.
EURO ADOPTION PROCESS
Stage 1 is EU accession. Bulgaria and Romania joined the EU on January 1 2007. This requires largely political convergence, such as stable democratic institutions, rule of law, human rights, and protection of minorities. Of the two, Bulgaria is considered further along with regards to euro adoption.
At some point following EU accession, the candidate will join ERM II. The standard fluctuation band is +/- 15% around a central parity. Success requires that the currency remain within its fluctuation band “without severe tensions” for at least 2 years.
The lev has been pegged to the euro at a central parity of 1.95583 since 1999. There are no fluctuation bands. Before that, the lev was pegged to the Deutsche mark at 1000: 1 on July 1 1997, when a severe banking crisis coupled with near-hyperinflation called for drastic measures after several failed attempts at stabilization. However, the decision was not an easy one as the banking crisis added a new element of risk.
A currency board is drastic in the sense that the country gives up all sovereignty with regards to monetary policy. Each unit of domestic currency is backed by an equivalent amount of foreign currency transacted at the pegged exchange rate. This requires that foreign reserves equal the domestic monetary base (M1).
In theory, a pure currency board can never be broken. If there is a run on the domestic currency, shrinking money supply would drive up interest rates and make it more attractive to stay in the domestic currency. Argentina did not run a pure currency board, and so it was eventually broken.
Stage 2 is Eurozone accession. This could be said to require largely legal and economic convergence. The legal criteria ensure that the legal foundations for monetary union are in place, foremost being central bank independence. The economic criteria include, and adheres to the generally recognized notion that countries in a monetary union will require sustainable macroeconomic convergence amongst the countries.
The EU publishes its Convergence Report at least once every two year or at the request of a member state that would like to adopt the euro. The last one was published in June 2016. Of the five Maastricht Criteria, Bulgaria met three: price stability, public finances, and long-term interest rate convergence. Bulgaria fell short by not being in ERM-2 (though it would easily qualify with the peg) and having incompatible laws regarding central bank independence.
We think these two areas will easily be met by the current government. By running a strict currency board, Bulgarian policymakers have already given up discretionary monetary policy. As such, a move to euro adoption wouldn’t entail any drastic changes with regards to the exchange rate.
The economy is growing steadily. GDP growth is forecast by the IMF to decelerate modestly to 2.9% in 2017 from 3.4% in 2016, and slowing further to 2.7% in 2018. GDP rose 3.4% y/y in Q1, and so we believe there are some upside risks to the growth forecasts.
Price pressures bear watching, with CPI inflation accelerating to 2.6% y/y in April from 1.9% in March. That was the highest rate since June 2013, but this is welcome after an extended period of deflation from 2013-2016. Because it runs a currency board, the central bank does not have an independent monetary policy.
Fiscal consolidation is running ahead of schedule. In its last Article IV assessment, the IMF “noted that fiscal consolidation is advancing faster than anticipated, and commended the authorities for their successful efforts in strengthening revenue administration.” The budget was balanced in 2016, but Bloomberg consensus sees a modest deficit equal to -1% of GDP in both 2017 and 2018.
The external accounts remain strong. Despite robust economic growth that has stoked import demand, the current account surplus was about 4% of GDP in 2016. It is expected to narrow slightly to 2% in both 2017 and 2018. The IMF estimates that Bulgaria’s Net International Investment Position improved from -93% of GDP in 2010 to -61% in 2015, and stems from both an increase in reserve assets and a decrease in external liabilities.
Foreign reserves have risen steadily. At $24.2 bln in April, they cover over 9 months of import and are nearly 3 times larger than the stock of short-term external debt. At EUR21 bln, reserves fully cover the monetary base (M1).
Our own sovereign ratings model showed Bulgaria’s implied rating falling a notch this quarter to BBB/Baa2/BBB. This suggests limited upgrade potential for actual ratings of BB+/Baa2/BBB-, though it seems both S&P and Fitch should upgrade to bring Bulgaria into line with us and Moody’s.
With the victory of Macron in France, the forces against greater European integration have hopefully been turned back. While Brexit initially seemed to foster a period of greater fissures in European unity, it now seems to have been an isolated, idiosyncratic event. Besides Macron, Merkel’s fortunes have improved in Germany and elections in the Netherlands and Austria this year have also seemed to favor pro-European candidates. Bulgaria will likely be the next member of the Eurozone, which has yet to lose a member even as it expands into the east.