VZCZCXRO5785
RR RUEHAG RUEHAST RUEHDA RUEHDBU RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA
RUEHLN RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHSF #0828/01 1861439
ZNR UUUUU ZZH ZDF ALL SECTS DUE TO MULT SVCS
R 051439Z JUL 07
FM AMEMBASSY SOFIA
TO RUEHC/SECSTATE WASHDC 3950
INFO RUEHZL/EUROPEAN POLITICAL COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC

UNCLAS SECTION 01 OF 03 SOFIA 000828 
 
SIPDIS 
 
DEPT FOR EUR/NCE MNORDBERG 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PGOV EINV BU
SUBJECT: BULGARIA - OVERHEATING ECONOMY OR JUST GETTING WARMED UP? 
 
 
¶1. (U) SUMMARY:  Strong domestic consumption in Bulgaria has sparked 
a large trade deficit and led to a current-account (CA) deficit of 
15.8% in 2006.  International analysts have warned that Bulgaria's 
growing external deficits render its economy vulnerable to exogenous 
shocks.  While booming domestic credit has supplied money for an 
under-capitalized economy, it also has heated up certain sectors of 
the economy, such as the real estate market, while at the same time 
increasing debt levels.  In the absence of effective monetary 
authority given Bulgaria's currency-board arrangement, tight fiscal 
policies remain the principal working instrument to control public 
wages, inflation and further deterioration of the external sector. 
END OF SUMMARY 
 
INTERNATIONAL ANALYSTS RING THE BELL 
 
2 (U) According to a recent World Bank report, in some 
countries--most notably Latvia but also the other Baltic countries, 
Bulgaria, and Romania--booming domestic demand is leading to 
overheating and current growth rates are unlikely to be sustainable. 
 Danske Bank earlier said it is expecting a less optimistic outlook 
of the Bulgarian and Romanian economies by international credit 
agencies due to a lack of progress in EU-related reforms and 
"continued rise in the external imbalances."  The IMF has similarly 
drawn attention to Bulgaria's rising external debt, which reached 
around 80 percent of GDP last year. 
 
EU-PHORIA DRIVES HIGH GROWTH AND CURRENT ACCOUNT DEFICIT 
 
¶3. (U) Euphoria related to Bulgaria's EU accession has led to high 
and steady economic growth--over 5 percent on average in the last 7 
years--driven by buoyant consumption and investment activity.  While 
the strong domestic demand reflected expectations for deeper EU 
integration and rising incomes, it also caused a large expansion of 
trade and current account (CA) gaps.  The CA deficit tripled over 
the last three years to 15.8 percent of GDP in 2006, while the trade 
gap rose to 21.5 percent of GDP.  The first quarter of 2007 
reconfirmed this negative trend with CA deficit growth of 5.6 
percent of GDP.  The deficit in April grew even further to 8 percent 
of GDP for the quarter.  Government officials and some analysts 
argue that a new EU requirement has led to a notable underreporting 
of exports. 
 
CA DEFICIT PROJECTED TO GROW 
 
¶4. (U) The IMF projected further growth of the CA deficit to 16.6 
percent of GDP this year, slowing to 16.2 percent in 2008.  Finance 
Minister Oresharski was less optimistic, saying the deficit this 
year might grow to 18 percent of GDP.  Local media speculated that 
Oresharski, who is known for his conservative fiscal positions, 
might have intentionally over-stated the figure in an effort to stem 
some ministers' demands for increased budget spending. 
 
LARGE DEFICITS FED BY MORE FOREIGN INVESTMENT 
 
¶5. (U) As is typical for an open and undercapitalized economy, 
Bulgaria's growing CA deficits have been increasingly financed by 
outside money and capital.  This has been facilitated by a 
liberalized investment regime and higher investor confidence in the 
run-up to EU membership.  Foreign direct investments (FDI) grew to a 
record high in 2006, adding to a strong financial account that 
managed to cover last year's CA deficit (103.2 percent).  The 
growing foreign investments help build up a stock of investment 
goods--a third of last year's imports--which while exacerbating the 
trade balance, is helping the higher capitalization and more 
sustainable growth of the economy.  According to analysts from the 
Institute for International Finances, based in Washington, D.C., new 
capital growth has been too strong in recent years--over 18 percent 
on average in the last three years--and the need for some "cooling" 
has already arrived. 
 
OVERHEATING OF REAL ESTATE - QUITE STRONG AND RISING 
 
¶6. (U) The level of corporate and household credit reached 39.6 
percent annual growth in April.  This concerns the central bank, 
which removed administrative barriers to credit growth at the 
beginning of this year and has no intention to re-impose them.  The 
increased money supply created more liquidity and strong 
inflationary potential in some sectors of the economy, most notably 
real estate.  While consumer prices saw an average annual increase 
of 7.3% in 2006, housing prices rose 14.7 percent.  Prices in the 
real estate market are likely to surge as demand for housing remains 
stable, while there is ample room for mortgage loans to grow.  This 
could lead to the accumulation of new household debt, which has 
grown 40.1 percent year-on-year in the first quarter of 2007.  The 
level of corporate debt is also raising concern, as it increased to 
49.1 percent year-on-year in May reflecting local firms' increased 
needs for financing their investment activities. 
 
SOFIA 00000828  002.2 OF 003 
 
 
HIGHER EXPORT COMPETITIVENESS WOULD HELP EXTERNAL POSITION 
 
¶7. (SBU) Bulgaria's high CA deficit reflects a loss of 
competitiveness on the export side.  With investment and consumption 
needs likely to remain high over the mid-term, the Bulgarian economy 
needs to advance its export capacity to become less vulnerable to 
external shocks.  But a fixed exchange rate--with the Bulgarian Lev 
currently anchored to the Euro under the currency board 
regime--makes export-led growth more difficult.  Some financial 
analysts believe the Bulgarian currency is overvalued and impeding 
any export-led momentum.  Neither government officials nor 
international financial analysts we spoke to support a devaluation 
of the Lev in order to stimulate export growth.  But all agreed that 
the economy was becoming too dependent on foreign money and capital 
to cover its external deficits. 
 
BUFFERS SAFEGUARD CURRENCY BOARD 
 
¶8. (U) A number of strong buffers currently shelter the currency 
board against external risks.  The GOB's prudent fiscal policies 
have helped build up large fiscal reserves (5.8 billion leva or USD 
4 billion at end-2006) after three consecutive years of surplus 
budgets.  The government has promised to hold the line--targeting a 
2 percent surplus this year--and will not spend the last 10 percent 
of its budget this year if the CA deficit target of 11.8 percent of 
GDP is not met.  Foreign exchange reserves at the central bank 
continued to grow, reaching 17.5 billion leva (USD 12 billion) at 
end-2006, and covering almost 170 percent of the domestic money base 
and over 5 months of last year's imports.  Additionally, further 
economic and financial convergence with the EU will provide the most 
effective protection against external pressures on the local 
currency in the run-up to Euro-zone membership. 
 
"HOT MONEY" CLOSE, BUT NOT YET FULLY IN BULGARIA 
 
¶9. (U) "Hot money" or currency speculators, who come in and out of 
the market quickly, have not yet been attracted to Bulgaria.  But 
equity funds are now aggressively building up portfolios of high 
risk capital, ready to sell it for quick and high premiums.  A 
recent shake up in China's capital markets resonated slightly in 
Bulgaria, with both domestic market indices registering a slump. 
Due to their large loan portfolio and tight capital adequacy, local 
banks have little free cash to be able to make short-term loans with 
high-risk premiums, which should reduce the exposure of the banking 
system to the risks of speculation.  Foreign banks own 80 percent of 
the banking system, which is another liquidity buffer against a 
systematic run.  Banks have joined efforts with portfolio capital to 
develop mutual funds for financing new high-risk ventures.  In an 
effort to the test the resilience of the local banking system, the 
EU plans to implement an EU-wide project by year's end that will 
gauge how monetary authorities react to an individual bank failure. 
 
 
NO "LANDING" ON HORIZON 
 
¶10. (SBU) The local economy is expected to grow over the next couple 
of years, led by an upsurge in domestic consumption and investment. 
A 6.2 percent GDP growth in the first quarter of 2007 is leading 
economists to argue that the overall growth for the year will reach 
beyond 6 percent.  Strong domestic demand will keep pressure on 
prices, but inflation is projected to decline to an average of 4.4 
percent this year from 7.3 percent in 2006, as output expands and no 
one-off administrative price spikes are anticipated in 2007. 
Government officials told us this projection will be revised upwards 
to include a 7.5 percent increase in electricity prices as of July. 
 
 
PAY AS YOU GROW 
 
¶11. (SBU) Booming consumption points at much higher wage growth in 
2006 than the officially announced 9.6 percent.  Currently, the 
government is facing pressure for wage increases from some 
public-sector servants, such as teachers, medical and social 
workers.  The GOB must continue to adhere to prudent fiscal policies 
and ensure that any future wage increases go hand-in-hand with at 
least equal gains in labor productivity--now at a third of the 
EU-average.  If it does hold down public sector wages, the gap 
between public and private-sector wages will continue to grow, 
increasing the likelihood of labor unrest in the public sector, 
signs of which began to appear in recent months.  The current 
Socialist-led government is well aware that such unrest sparked the 
downfall of the previous Socialist government in 1996-97. 
 
COMMENT 
 
¶12. (SBU) The GOB has taken advantage of its improved public 
finances to ease inflationary pressures and avoid any external 
shocks.  It should now closely track a few potential bad apples that 
 
SOFIA 00000828  003.2 OF 003 
 
 
could quickly spoil the country's strong economic growth. 
Persistent consumption (rather than export)-driven growth, real 
estate price bubbles, and inflation--the only unmet Maastricht 
criterion for Euro-zone membership--should remain on the 
government's watch-list.  Despite the strong pace of capitalization, 
the Bulgarian economy is not able to sustain its growth based solely 
or mainly on new debt and outside money, which often is seeking 
quick profits.  Bulgaria must guard against abrupt changes in 
investor sentiment while ensuring continued strong growth.  At the 
same time, the government must keep looking over its shoulder at 
increasingly restless teachers, healthcare, transport, and other 
public sector workers.  END OF COMMENT 
BEYRLE