Full Text* of the Bulgarian Section of the Autumn Economic Forecast for 2011-2013 of the European Commission. The forecast was unveiled by EU Commission Vice-President for Economic and Monetary Affairs Olli Rehn on Thursday, November 9, 2011, in Brussels.

Bulgaria - Moderate Growth amid Rising Uncertainty

Growth slowing, inflation following suit

The recovery in Bulgaria has been slow so far and is lagging behind the rebound in most EU emerging economies. The necessary correction of large domestic and external imbalances accumulated during the boom years continues at a fast pace. While exports strongly picked up above pre-crisis levels, domestic demand components have not stabilised yet and real GDP remains almost 5% down from the peak.

Although average wages continued to outpace inflation and consumer confidence gradually recovered from the record lows in 2010, consumer demand was constrained by a continued decline in employment, rising consumer prices and building of precautionary savings.

Fading net FDI over the past year in a context of still high private-sector indebtedness, conservative bank lending policies and lingering uncertainties on demand expectations greatly restrained the resumption in investment activity.

After initially strong growth in Q4-2010, momentum is slowing in 2011. At 2.0% y-o-y (0.3% q-o-q), GDP surprised on the downside in Q2-2011, compared with 3.4% y-o-y (0.5% q-o-q) in Q1-2011. On the supply side, agriculture and construction continued to contribute negatively, but the decline of the latter narrowed significantly in the second quarter.

Industrial sales were supported by continued strength in exports and surpassed pre-crisis levels. Despite continuing adjustment in household balance sheets and rising inflation, tentative signs of a mild recovery in private consumption are more visible in the second quarter.

Final consumption inched up by 1.4% y-o-y in Q2-2011, arguably reflecting sustained real growth in wages. With the slowdown having only just been overcome, businesses are cautious to newly hire, increase leverage or invest again.

Gross fixed capital formation is exceptionally weak and is set to post the largest negative contribution to growth for the third consecutive year, with both construction and investment in equipment dropping in the first half of 2011.

As in previous quarters, exports remained the key driver of economic growth, but the initial strong momentum is levelling off in line with decelerating demand in EU. Export growth halved to 12.2% y-o-y in Q2-2011, but as exports have significant import content, import growth also moderated to 7.5%.

Reflecting a consistently improving trade balance, stronger services and current transfer balance, the current account turned positive in both the first and the second quarter and reached an unprecedented surplus of 2.6% of GDP for the 12-month-period ending in August 2011.

A deceleration in exports is unlikely to lead to a sharp widening in the trade balance in 2011, as both private consumption and investment are still weak and unlikely to recover substantially during the second half.

Overall, the standstill in domestic demand persisted in 2011 and growth has remained largely reliant on external demand. The strong export performance has not yet fed through to domestic demand, with unemployment remaining stubbornly high at 11.2% in Q2-2011.

Unemployment and NPLs are lagging the economic recovery and seem to have reached double-digit highs, from which it is still difficult to come off. Employment contracted by a cumulative 12% over the last three years, but there are a few indications that it could start to grow again.

In spite of high unemployment, nominal wage growth has continued to remain sticky at over 9% y-o-y in the first half of 2011, but the spike in inflation partly limited real wage dynamics in Q2-2011.

Soft growth with employment lagging behind

The second quarter of 2011 is illustrative for the soft growth outturns anticipated for the remainder of the year. Growth expectations for the last two quarters of 2011 remain positive in view of higher revenue from tourism and a very good harvest in agriculture, which would boost consumption and somewhat offset a slowdown in export and the continued slump in construction/investment.

Tight credit conditions, worsening consumer and business sentiment and a weak global backdrop imply that growth will be fairly limited. Overall investment is likely to drop in 2011. However, a turnaround is expected in the second half of the year thanks to increased public capital spending. All in all, real GDP is projected to expand by 2.2% in 2011 and a similar 2.3% in 2012.

Expectations for a recovery in domestic demand rely mainly on government support for important infrastructure projects and real wage dynamics in 2012. As food accounts for a high share of the consumer price basket, the easing of pressures from global food and energy prices as well as a weak growth profile will lead to lower inflation in the near term.

These encouraging price developments are envisaged to gradually strengthen private consumption in 2012 from its current low base. Although lower inflation will sustain households' real disposable income from late 2011 on, the fragility of the labour market and the lack of consumer credit will restrain consumption growth.

Negative wealth effects from a protracted slump in housing and equity prices may also weigh on consumer optimism. Against this background, private consumption is expected to expand less than GDP in 2012 and pick up to 3.0% in 2013 as job creation resumes.

While manufacturing activity may hold up relatively well in the coming quarters, investment growth is likely to remain subdued in the first part of 2012 in light of the worsening of investment sentiment.

Moreover, jitters over the global economy could lead to further delays in rebuilding inventories. As the absorption of EU funds improves further and capacity utilisation reaches pre-crisis levels later in 2012, investment is expected to slowly increase from a very low level.

Weaker export growth will prevent notable progress in investment and employment until the second half of 2012. The cyclical slowdown in Europe will be reflected in a lacklustre labour market with unemployment remaining high in 2012. Entrenched high unemployment and prevailing uncertainty as well as the higher provisioning costs on overdue loans are expected to deter banks from increasing lending.

Hence, the economy is likely to operate below potential for an extended period, which in turn should partly contain inflationary pressures. In this context, further disinflation is expected along the way, but inflation below 3% is unlikely to be reached before 2013, as wage rigidities and increases in regulated prices will feed inflationary pressures over the horizon.

Current account turns positive

The contribution to growth from net exports has been fading away since Q2-2011 and exports are expected to cool down in line with sluggish external demand ahead. Export and import growth rates should converge later in 2011, given the higher base for exports in H2-2010, and come even closer in 2012. Net exports are, however, expected to continue to contribute to growth in 2012 thanks to relatively strong demand from non-EU trade partners.

An expected decline in the trade deficit and a lower services surplus, together with persistent investment income outflows, are expected to bring the current account into a monthly deficit for the remainder of 2011. However, it is projected to end 2011 with an annual surplus of 1.6% of GDP and to remain slightly positive over the forecast horizon, helping to further reduce the external debt-to-GDP ratio.

Risks tilted to the downside

The forecast baseline scenario is subject to particularly significant risks at the current juncture. The outlook for exports is clouded by uncertainty, particularly in the euro area. Moreover, prolonged stress in financial markets worldwide over fiscal and debt sustainability concerns, as well as continued adverse spillovers from Greece, have the potential to delay the recovery in consumption and investment.

Although the capitalisation of banks has remained at reassuring levels, the further deterioration in asset quality and the subsequent erosion of banks' capital buffers is likely to put additional pressure on banks' solvency and lending capacity.

The current forecast already assumes a tightening in credit, low foreign capital inflows and further deleveraging in the economy. While balance-sheet corrections might prove to be protracted, the extent to which investment recovers following the massive contraction over 2009-11 will largely depend on improving the absorption of EU funds.

Uncertainty regarding the consumption behaviour of households remains one of the major risks to the outlook, both on the upside and on the downside. Should households lower their currently high precautionary saving rate, this could support stronger consumption growth even under a declining employment scenario.

Fiscal consolidation continues over 2011-13

Fiscal consolidation resulted in a narrowing of the budget deficit from 4.3% of GDP in 2009 to 3.1% in 2010, i.e. below the revised budget target of 3.8% of GDP. In 2011 the government has maintained the freeze in pensions and public-sector wages and has made cuts in discretionary spending to restrain primary expenditure growth.

This is in line with the government's intention to pursue an expenditure-based fiscal consolidation. The latest budget execution data (September 2011, on a cash basis) reveals an improved fiscal performance against both the previous year budget execution and the 2011 budget targets.

Although fiscal consolidation is expected to lose some ground in line with higher capital outlays during the remainder of the year, Bulgaria is on track to meet the accruals-based fiscal target of 2.5% of GDP in 2011, based on a no-policy-change assumption.

Despite the expected slowdown in the global economy and the outlook for Bulgaria, the government has maintained its strong commitment to fiscal consolidation over 2012-13.

The gradual fiscal adjustment is expected to be achieved by a cyclical improvement in revenue as well as a containment of public expenditure. Spending items such as public sector wages and pensions are to remain frozen in 2012, while some other current non-interest expenditure are expected to be cut. Under a no-policy-change assumption, the budget deficit gradually declines to around 1.7% and 1.3% of GDP in 2012 and 2013 respectively.

This implies a cumulated structural effort of ?% over 2011-13. Under the assumption of zero stock-flow adjustments, general government gross debt is envisaged to increase only marginally from around 17?% of GDP in 2011 to 18?% of GDP in 2013, in line with the budget deficits developments over the forecast period.

*Also available on the EC website HERE

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