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Austerity Brings Down Another European Government

By Win Thin

Recent Bulgarian developments are worth discussing.  Austerity just brought down another European government, as Prime Minister Borisov and his cabinet resigned this week amidst rising popular protests against his policies.  But the story goes even deeper than just austerity, with corruption allegations and higher electricity prices added to the mix as well.  In fact, protests against higher electricity prices went hand in hand with power distributor CEZ having its license revoked due to allegations that it routinely broke procurement rules.

The IMF Article IV assessment for Bulgaria in November 2012 noted that “Conservative fiscal and financial supervisory policies have helped maintain macroeconomic and financial stability.  However, the adjustment has resulted in sizeable job losses and a feeble recovery.  The economy remains vulnerable due to linkages with the euro zone, still substantial external debt and rising nonperforming loans.”  We fully concur.

Center-right GERB party has been in power since 2009, but its popularity has dropped steadily.  Parliamentary elections were due this July anyway, but Borisov’s resignation moves up the timetable as fresh elections must now be called within three months.   Press reports suggest late April or early May as the most likely window for elections.  Borisov had hoped to be the first Prime Minister to be re-elected since the fall of communism, but is looking very difficult now.  Polls suggest that the opposition Socialists are just as popular as GERB currently.  However, the Socialists have not yet chosen its candidate for Prime Minister yet and so much can happen in the political arena still.

Protests continued even after Finance Minister/Deputy Prime Minister Djankov fell on his own sword, resigning February 18.  Djankov is a former World Bank economist and kept Borisov on the strictly orthodox policy path.  His exit risks policy slippage if Borisov were to win another term.  A Socialist win could also prove problematic, as some in that party have advocated re-nationalization of the power companies.  Note CEZ is a Czech company, so Bulgaria’s handling of the matter could have a significant impact on foreign investment as well as on bilateral relations with the Czech Republic, as Czech Prime Minister Necas has already expressed concern over the handling of the matter.   Power distribution in Bulgaria is controlled by two Czech firms and one Austrian one. 

Discontent with the ruling party has clearly risen as stagnant wages, rising costs of living, and ongoing economic malaise have taken a toll on the nation.  Real GDP rose only 0.5% in 2012 and follows 1.7% growth in 2011 and 0.4% in 2010.  For 2013, the IMF forecasts 1.5% growth but we think risks are tilted to the downside.  As a small open economy (exports/GDP over 50%), Bulgaria is very vulnerable to the recession in Western Europe.   Export performance has improved in recent months, but are basically back to being stagnant y/y after seeing significant y/y contraction for most of 2012.  Imports slowed too, but not by enough to prevent some modest worsening of the external accounts this past year.  IP has also started to improve modestly.

Inflation troughed near 1.5% y/y back in mid-2012 but has since moved higher to near 4.5% y/y in January 2013.  Wages are rising, but unevenly as private sector wages rose 8% y/y in December while public sector wages rose about 1.5% y/y that same month.  What’s worse, the unemployment rate troughed near 10.5% in September and has risen since to near 12%, the highest April 2005.  Not surprisingly, retail sales have collapsed, dropping nearly -10% y/y in real terms as 2012 closed out.

Bulgaria unemployment

Bulgaria inflation

Bulgaria GDP

Bulgaria exports and industrial production

 

Source:  Bloomberg, IMF

No wonder the populace is turning on the politicians, as the promised benefits of EU entry and eventual euro adoption just haven’t materialized.  Under the currency board, Bulgaria has no discretionary monetary policy tools.  Instead, it has to simply deal with the slowdown with internal devaluation (via disinflation and lower wages) rather than external devaluation.  Other countries running currency boards, like Latvia and Lithuania, have seen a similar adjustment but their recoveries have been stronger than Bulgaria’s.  On the fiscal side, Bulgaria is subject to the -3% of GDP deficit limit under EU rules.  It has maintained budgetary discipline despite the slowdown, with the budget gap limited to about -2% of GDP in 2011 and a forecast -1% of GDP in both 2012 and 2013.

Bulgaria external balance

Bulgaria foreign reserves

Source:  Bloomberg

Bulgaria has maintained that it wants to adopt the euro.   However, it froze its bid for euro adoption last September and is on hold “indefinitely.”  Back in 2010, Borisov had expressed intent to join by 2013, but the appeal of the single currency has fallen as the debt crisis spread and caused collateral damage in Bulgaria.  Bulgaria meets the economic criteria for euro adoption in terms of debt and budget deficits, but still fall short with respect to legal and institutional frameworks.  Still, as Borisov put it so succinctly last September, “Right now, I don’t see any benefits of entering the euro zone, only costs.”  The currency board will be maintained until the euro is adopted, but the timing of that has only been made cloudier by Borisov’s resignation.

Interestingly, markets view Bulgaria (actual ratings of BBB/Baa2/BBB-), Latvia (BBB/Baa3/BBB), and Lithuania (BBB/Baa1/BBB) as very similar credit risks, with 5-year CDS prices currently at 127 bp, 110 bp, and 109 bp, respectively.  Estonia (AA-/A1/A+), the most recent entry into the euro zone back in 2011, currently sees its CDS trading near 63 bp.  Spreads on their euro-denominated bonds also tell a similar story, with Bulgaria 2017 trading near 167 bp, Latvia 2018 near 155 bp, and Lithuania 2016 near 142 bp.  Spreads on their dollar-denominated bonds tell a different story, however, with Bulgaria 2015 trading near 99 bp, Latvia 2017 near 198 bp, and Lithuania 2015 near 141 bp. 

We think the dollar-denominated bonds most closely reflect our own fundamental view.  Our sovereign model rates both Lithuania and Bulgaria as BBB credits (but Lithuania slightly better than Bulgaria), while Latvia is seen as a BBB- credit.  As noted, CDS prices and spreads on euro-denominated debt are treating all three as very similar.  However, we believe that political uncertainty poses a serious risk to Bulgaria and its structural reforms.  Any backsliding on reforms will surely hurt its creditworthiness and would prevent any near-term upgrades for the country.  S&P last downgraded it in October 2008 to BBB and has kept it there, while Moody’s has continued to upgrade it with the last move to the current Baa2 coming in July 2011.  Fitch moved in a similar manner to S&P, downgrading Bulgaria to BBB- back in November 2008 and has kept it there.

CDS spreads

Source:  Bloomberg

Win Thin

About 

Win Thin is the Head of Emerging Markets Currency Strategy at Brown Brothers Harriman. He has a broad international background with a special interest in developing markets. Win received his Ph.D. in economics from Columbia University in 1995, specializing in international and development Economics. He received an MA from Georgetown University in 1985 and a B.A. from Brandeis University 1983.