by Andrew Macdowall*

Economy performing well but government must balance the books

Bulgaria's economy has continued to grow steadily so far this year, with analysts and the International Monetary Fund (IMF) predicting Gross Domestic Product (GDP) growth of over six percent by the end of the year. Foreign Direct Investment (FDI) continues to be a key driver of economic growth, unemployment continues to fall and inflation is under control. However, Bulgaria's current account deficit is still growing and the IMF warned that the government must continue to keep a firm hold on the fiscal reins to avoid driving it up.

According to the National Statistical Institute (NSI), GDP grew by 6.2 percent in real terms year-on-year in the first quarter, exceeding expectations and the 5.5 percent growth of the same period last year. First quarter GDP reached 5.872 billion euros.

Bulgaria's GDP grew 6.1 percent last year, from 6.2 percent in 2005 and 6.6 percent in 2004. The government expects that growth will average over six percent in coming years.

Earlier this month, John Lipksy, the IMF first deputy managing director, concluded his visit to Bulgaria, and in a statement in Sofia, confirmed that the IMF expected growth to match government expectations and disinflation (falling inflation) to continue. Indeed, the organisation forecasts six percent growth for 2007, and for inflation to fall from 7.4 percent in 2006 to 4.6 percent this year.

However, Lipsky's upbeat statement came with the caveat that strong growth has increased the current account deficit due to boosted demand. Bulgaria's currency board arrangement with the euro means that it forfeits monetary policy, thereby losing a key tool for reducing the deficit.

The IMF adjusted its forecast for this year's current account deficit to 16.6 percent from 15.7 percent after export growth failed to meet the increase in imports. Exports grew 4.1 percent in the first two months of 2007, while imports grew 15.9 percent.

“The large current account deficit, projected to increase further this year, poses risks,” warned Lipsky. “While the widening of the deficit reflects confidence in Bulgaria's future, it also implies an increase in the country's vulnerability to external shocks. I urge the government to maintain the prudent stance of fiscal policy that has served the country well.”

This could be seen as a shot across the bows of the government, which is led and dominated by the Bulgarian Socialist Party (BSP). In May's elections to the European Parliament, the BSP came second, narrowly beaten by a dynamic new force in Bulgarian politics, Citizens for the European Development of Bulgaria (GERB). The party, led by the popular and fervently anti-BSP Sofia Mayor Boyko Borisov, is expected to fare well in local elections later this year.

The IMF has in the past been critical of the government's decision to cut the corporate tax rate to 10 percent, the lowest in the EU (along with that of Cyprus).

As IMF European director Michael Deppler told OBG: “Low marginal tax rates are of course important (in ensuring economic competitiveness). However, this year was perhaps not the best time to cut corporate taxes. First, with the 2007 budget buffeted by EU-related forces, private sector demand buoyant and the former 15 percent rate already relatively attractive to investors, the cut could have been postponed, with little harm. Second, corporate taxes tend to be less important to investors than many other factors, some of which require public spending, which in turn requires tax revenues.”

Deppler cautioned that, while most markets in Central and Eastern Europe run a current account deficit, Bulgaria's present deficit - at more than 16 percent - is particularly worrying.

However, the market seems fairly relaxed about the tax cut and business people who spoke to OBG were almost universally supportive of it. Last year, the current account deficit was partly offset by the 4.1 billion euros of FDI the country received. Analysts expect the figure to be at least that high this year.

Yarkin Cebeci, emerging markets analyst at JP Morgan, told local press that “high investment appetite” would continue, with the new corporate tax giving “additional impetus” by encouraging parts of the “grey” economy to come into the open, now that it is cheaper to do so.

In order to combat the current account deficit, the government is running a cautious fiscal policy that targets a small budget surplus that usually yields more than anticipated. This year will be no exception. The government is aiming for a 0.8 percent budget surplus, but Finance Minister Plamen Oresharski said that two percent was a more realistic year-end surplus target.

*Andrew MacDowall,Oxford Business Group analyst;


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