Author: Kristofor Pavlov, chief economist of UniCredit Bulbank

Economic Growth

The expected GDP growth rate slowed down to only 0.5% in 2013, reporting a record low for the past three years. Political instability we have seen during the better part of 2013 is one of the decisive factors which weigh on the recovery of economic activity and hiring decisions. On the other hand, the regime of too strict fiscal economy in 2012 had a negative impact on the recovery of the domestic demand in the first months of 2013. After that we gradually saw a turn to a less restrictive fiscal policy, which had an effect on the GDP in the second half of 2013, though with a slight delay.

Next year the slow recovery of the economy is expected to continue with the actual GDP growth rate increasing to 1.5%. However, there are not any significant growth prospects in the short-term since the recovery process will continue to rely almost completely on the increased demand of Bulgarian products by the country's key trading partners.

Export

The recovery in exports seen so far this year will carry over into 2014 when economic growth in 18 out of the 20 most important export destinations of the Bulgarian economy is expected to rise. This will also be the first year since the beginning of the global fiscal and economic crisis in which the three most developed economies, i.e. the USA, EU and Japan will report an economic growth at the same time. This will contribute to a boost in world trade, consolidation and expansion on the basis of global economy growth, which in the past three years relied mostly on the growth of the economies of the developing countries. We expect adequate EU funds absorption will continue to provide some stimulus for investment in 2014.

During the past years Bulgaria was not part of the developing markets which derived major benefits from quantitative easing followed by the central banks of the highly developed countries. In this way Bulgaria will be affected less by the increased capital outflows when the central banks of the developed world begin to withdraw liquidity from the markets and normalize their interest policy. In Bulgaria the price and access to loans will continue to be dependent rather on specific domestic factors. Interest rates are expected to continue flagging in 2014.

Investment and stronger private consumption will lag behind, as ongoing political instability adds to uncertainty and prolongs the time in which companies will abstain from starting major new projects and hiring more staff.

The condition of the labour market and real property continues to create uncertainty among households which makes them avoid making expensive purchases and use a large part of their income for new savings or debt repayment. Loans remain restricted to export-oriented businesses and loans related to EU funds utilization. After the budget deficit was increased to 2% of GDP in 2013, fiscal space available to support further economic activity is now smaller. More importantly, the problem about the quality of fiscal expenses remains unsolved, which further narrows the chances of seeing any significant stimuli for GDP growth in 2014.

Labour market

In 2013 labor market data in Bulgaria has been mixed. In line with the discouraging headline unemployment number, both youth unemployment and long-term unemployment remained dangerously elevated. At the same time employment showed signs of certain though faltering stabilization, whereas activity coefficient which measures the share of the population which is employed or is seeking employment keeps improving. Real household disposable income continued to rise and contributed to the good news although it is difficult to explain the two-digit salary income, and more specifically, the so-called additional income.

These data seem to suggest that the worst is over and employment will begin gradually to regain the ground lost in the crisis years. Nevertheless, any convincing labor market recovery will be a very slow process. This is not only because a non-negligible part of the reason for the labor market weakness is structural (which is reflected in sky-high youth and long-term unemployment), but mostly because any meaningful acceleration of GDP growth is not yet in sight. The ongoing political tension is another setback for the labor market recovery in the short-run, as it makes business wary which, in turn, weighs on hiring decisions. It seems that all this is confirmed by the expectations of the business and household about employment, which despite their certain improvement in 2013 they are far behind reporting a stable employment growth.

External environment and external position of Bulgarian economy

Bulgaria’s external position has seen a marked improvement in 2013. This was led by the merchandise exports, which marked about an 8% increase per year in the first nine months of the year as well as an increase in EU funds utilization (an increase of 36% if the incoming current public sector transfers are taken into account), which helped to shift the CA to its strongest surplus ever in the first nine months of the year (3.4% of GDP) since the beginning of the transition period in 1989. Merchandise exports have drawn support from a double digit increase in the export of raw materials for the food industry, medicine and cosmetics, refined petroleum products, and investment goods. This strengthened the external position which put at 92.4% of GDP in September 2013. The stronger external position was also reflected in the improvement of the country’s debt sustainability indicators, including debt-to-exports and debt service payments-to-exports ratios, which are now far from the dangerous area where they were in 2008, and particularly in 2009.

The considerable improvement of the external position shows that the balance of the economy has been almost completely restored. There has been a solid improvement in the competitiveness of the Bulgarian economy, but also that there is now a cushion in case of further shocks, which hasn’t been the case in the past.

Our forecast suggests that the healing process will continue into 2014. We also believe that the prospects for the external environment next year are the best we've seen since the beginning of the crisis. Trade balance will continue to improve (from an expected deficit of 5.3% of GDP in 2013 to an expected deficit of 4.6% in 2014) since merchandise exports (5.7%) will be higher than merchandise imports (4.2%). It is expected that the current account will report a positive balance for a second consecutive year (2.6% of GDP in 2013 and 2.2% in 2014 respectively), although it will be considerably more modest than the expected balance at the end of 2013. In our opinion the financial account will have a negative balance again since the process of reducing external indebtedness of the corporate sector has not been complete. At the same time the financial account deficit will shrink only to 0.4 % of GDP in 2014 in comparison to 4% of GDP in 2013. The final balance of the payment balance in 2014 is expected to be positive and add an amount which is equal to 3% of GDP to the reserves (a minimum decrease of 0.1% of GDP is expected in 2013). In this way the liquidity of Bulgarian economy will continue to improve which in other circumstances would lead to further decrease of interest rates, deposits and loans in 2014.

Inflation

Deflation concerns eased in October after mom CPI increased for a second consecutive month, underpinned by a seasonal uptick in food and clothing prices. Thus, year-to-date deflation moved to 1.7% in October from a record low of -2.2% in August 2013. We see deflation as negative news as it raises the real value of debt and reduces already weak stimuli for consumption. Moreover, if inflation expectations remain anchored in negative territory for too long, the risk of a self-perpetuating deflationary spiral is likely to rise. Deflation is driven by the significant slack in the economy, which continues to operate far below its full potential for a fifth consecutive year. There are a number of one-off factors, such as weak import prices and a politically motivated 5% cut in household electricity prices in August which also brought about deflation we've seen in the first eight months of the year. Against this backdrop, we expect a 1.2% drop in consumer prices at the end of the year and 1% average annual inflation in 2013.

But the outlook is more favorable and we are not particularly worried that Bulgaria will plunge into a classic self-perpetuating deflationary spiral that derails the economic recovery. There are several factors which might contribute to it. For a start, the one-off factors which have contributed to the fall in CPI so far this year are gradually fading. Perhaps even more importantly, inflation expectations have begun to tick up recently for both CPI and PPI, after the independent regulator announced that it doesn’t see room for further cuts in electricity and heating costs in 2014. Even if internationally determined prices of foods and primary energy resources remain broadly flat next year, a tad stronger domestic demand recovery should also help to bring the negative price dynamics to an end.

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