Kristofor Pavlov, Chief Economist of UniCredit Bulbank

This year the economy continued to recover from the effects of the real estate bubble burst and the recession of 2009, however, unfortunately, at much lower rate than the one most of us hoped for a few years ago. Actually, after the 2009 bottom of the recession economic growth registered for the third quarter of 2012 reached an average level of slightly over 1% on an annual basis.

This took place in the context of continued decline in employment which was at first concentrated in the domestic demand-oriented sectors having shown the strongest signs of overheating in the boom years. Regrettably, over the recent years the slowdown in export had further negative impact on the labour market and this made it impossible to break the adverse employment trend which had been going on for almost four years.

The decrease in the number of jobs affects most regions and sectors of the economy and only a few sectors - constituting in total one-sixth of the jobs in the economy – registered an increase in employment in 2012. All this indicates that low employment levels are more likely to be the result of a broad-based decline in demand rather than the discrepancy between the skills of people in the sectors in which jobs are lost and those in which new jobs are created. As a result, unemployment remains above the so-called natural rate of unemployment or in other words above the lowest unemployment levels which the economy is able to sustain without overheating.

Why is the economy so slow to recover? The main reason for this seems to be the real estate bubble of 2004-2008. This is also confirmed by the historical experience of other countries which indicates that the recovery process after the real estate bubble burst is painful and long-lasing because economic agents need to go through a long period of time in which they have to spend less than they receive in order to make up for the wealth wiped out as a result of the adjustment in real estate prices. The outcome is that the economy is destined for a prolonged downturn in demand especially in times of limited options for incentive policies and times of global decline in demand which make it impossible for the recovery to rely on export.

Nevertheless, over the following years recovery rates will accelerate since all the impediments to growth in 2012 are about to lose their force, in part. Which are these impediments and why their adverse effect on growth will be felt less in 2013?

Firstly, the sovereign debt crisis in Europe is in the retreat leading to a radical change in the situation on the financial markets. Since the middle of the current year investors’ traditional attitude to risk has started to be restored, unlike the allocation of capital over the preceding two years aimed at protecting investors in case of breakup of the Eurozone. We have witnessed the renewed interest in developing markets which has already led to a decrease in risk premiums and the price of debt issued by the Bulgarian government.

Capital flows reversed and a stable flow is observed following the significant outflow of funds registered in 2011 and driven by the external pressure for the reduction of indebtedness. Practically all the components of the financial account improved considerably in the course of 2012. The most significant development on this front is that capital outflows channeled through the banking sector diminished to only 0.6% of GDP for the period January-October 2012 compared to 4.5% a year ago. This reflects the significant improvement of the banking sector’s external position whereby the dependence on external financing with most banks has been reduced to risk-free levels. Thus, there will only be very few banks which will need to continue to work on reducing their dependence on external financing the following year.

The government has also made a contribution to improving liquidity by addressing already in 2012 the better part of the funding needs for next year. All this will make easier not only the access to new loans but also the renegotiation by debt-laden companies of their maturing liabilities. This is important because unsustainably high levels of debt accumulated in several economic sectors in the boom years are among the major constraints on economic recovery over the past four years.

Secondly, the economy’s natural forces of recovery, of which already John Maynard Keynes wrote, have been triggered. What does this mean? Since the beginning of the crisis private companies’ capital costs nearly halved compared to peak values observed during the boom. At the same time a not insignificant part of the existing production capital went out of use because the existing machinery, equipment, buildings and facilities have become obsolete. This undermines production capacity and in the long run, despite the decline in demand, it is only logical that at one point it will lead to shortage of production capacities.

In response, albeit at a slow pace, the private sector will start increasing its capital costs in certain sectors. Thus, following a decline over four years in a row since the beginning of the crisis and given the ever more clear signs of stabilization in the course of the current year, I expect that for the first time investments will contribute positively to growth in 2013. Of course, in this regard the continued improvement in the absorption of EU funds will be a crucial factor without which the economy would probably still be in recession.

Along with this households which have for a long period of time put purchases on hold are slowly but surely starting to increase their consumer expenditures. In this way individual consumption registers positive growth on a quarterly basis in five out of the six last consecutive quarters. After reducing their total financial liabilities to 26% of GDP in the middle of 2012, against the peak level, reached in the third quarter of 2009, of 31% which is still low for the standards of a developing economy, Bulgarian households will feel more confident to borrow new loans. This will be further facilitated by the fact that bad loans for households have already reached their highest point and their effect has started to wear off, albeit slowly, and at the same time the stabilization of house prices seems to have reached an advanced stage.

Thirdly, inflation will continue to weaken and will also have a negative impact on the purchasing power of income. Inflation temporarily accelerated in the middle of the current year as a result of the one-off increase in electricity and food prices which, I believe, is transitory in nature and its effect will rapidly wear off towards the end of the year and in the beginning of 2013.

As it appears that the economy will continue to function below its long-term potential at least in the following two years, there are practically no inflation risks in the short and medium term. Fears that the injections of liquidity made by the central banks of developed economies might fuel inflationary pressures also seem to be unjustified because the increase in the money supply leads to higher inflation only when accompanied by growth of lending to the real economy.

Finally, the fiscal position of the country in 2013 will not be a burden to growth. This happens for the first time after the fiscal easing of the end of 2008 and the first half of 2009 which was an attempt to mitigate the consequences of the coming crisis. There followed a period of fiscal restraint which in the beginning of 2012 allowed Bulgaria to become the first EU Member State with respect to which an excessive deficit procedure was closed. Fiscal parameters have continued to improve this year too which will allow Bulgaria to have a break from the fiscal consolidation process next year since, at this stage, given the stage of the county’s economy in the economic cycle, there is no need to speed up and undertake further fiscal restraint. Therefore, next year the target will be a deficit of 1.35% of GDP with our estimates being lower for the current year – at around 1% of GDP.

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