S&P Downgrades Bulgaria to BBB-/A-3, Outlook Stable

S&P Downgrades Bulgaria to BBB-/A-3, Outlook Stable

Standard&Poor's Ratings Services (S&P) said on Friday it downgraded Bulgaria's long- and short-term sovereign credit ratings to 'BBB-/A-3' from 'BBB/A-2'.
The outlook is stable, the ratings agency said in a statement.
"Bulgaria's political environment continues to pose a challenge for the implementation of reforms needed to tackle deep-rooted institutional and economic problems, in our view," S&P said. "Absent meaningful reform progress, we expect growth to remain lackluster and unemployment high."
"The stable outlook balances the risks we see from policy complacency against the fiscal flexibility afforded by relatively low government indebtedness," it added.
The ratings agency also said in statement:
"The downgrade reflects our view of the structural impediments facing Bulgaria which constrain institutional effectiveness and impede economic growth. They matter all the more given Bulgaria's weak growth environment and high unemployment.
Bulgaria's structural impediments are related to governance-addressing corruption and strengthening the rule of law--and tackling the adverse demographics of net emigration and an aging population. We view these factors as inhibiting growth and believe that other disruptions--such as the procedure launched by the state energy regulator to revoke the licenses of foreign electricity distribution companies--add to business uncertainty and send strong negative signals to potential investors. Further, apart from their impact on the business environment, inefficiencies in the governance of state-owned energy and railway companies could cause liabilities to crystallize on the government's balance sheet, if unaddressed.
The volatile domestic political environment since early 2013 has complicated the challenges policymakers face in implementing reform. For much of last year, the ruling coalition of the Bulgarian Socialist Party (BSP) and the Movement for Rights and Freedoms (DSP), which does not have a parliamentary majority, was under pressure to resign. Tensions seem to have resurfaced following the result of the May European Parliamentary elections in which the ruling BSP performed poorly. As a result, we expect that the political landscape will remain volatile over the coming months and will likely not be conducive to implementing potentially unpopular reforms.
Bulgaria's economic recovery has failed to gather pace. Real GDP growth averaged less than 1% in 2010-2013 while net exports drove growth (with the exception of 2012) but have not strengthened domestic demand or translated into meaningful reductions in the 13% unemployment rate, materially above the 5.6% rate before 2008.
In our view, signs of a recovery in private consumption in the first quarter of 2014 were likely due to increased social transfers and pension payments. We believe that sustainable growth in domestic demand in Bulgaria will depend on a substantial decline in unemployment, an increase in lending to the corporate sector supported by foreign investment inflows, and a continued recovery in key export markets. However, these factors are constrained by what we view as Bulgaria's unaddressed economic and institutional structural impediments. Bulgaria's pronounced deflationary trend primarily reflects several rate cuts in state-set energy prices and lower imported inflation and, to some extent, weak economic conditions domestically and in the eurozone.
The banking sector's liquidity appears high, supported by deposit growth outstripping lending growth. Banks wound down their external debt positions by $4.8 billion between 2008 and 2013 while also increasing their assets held abroad by $6.6 billion over the same period (as international investment position data shows). Cumulatively, the net outflows from the financial system constitute more than 20% of 2014 GDP. In 2013, these outflows contributed to a financial account deficit of 3.7% of GDP on the balance of payments, which was not fully covered by the small current account surplus (1.9% of GDP) and inflows on the capital account (1.2%). We expect that the financial account will remain in deficit until end-2015 as direct investment inflows and external borrowing by the government and nonbank private sectors will not offset banking sector net outflows.
Despite a slight loosening of the fiscal stance in 2013, the general government deficit and net general government debt remain rating strengths at 1.8% and 14.2% of estimated 2014 GDP. About 70% of Bulgaria's government debt stock is denominated in foreign currencies. While contingent liabilities from the financial sector and outstanding government guarantees are together limited, the loss-making state-owned utilities and railways could also represent additional claims on the government.
The currency board regime and high euroization (62% of loans are in foreign currency) restrict the monetary flexibility of the Bulgarian National Bank and limit its ability to act as a lender of last resort. Bulgarian policymakers have suspended plans to join the European Exchange Rate Mechanism (ERM-II), the precursor to eurozone entry, but remain committed to maintaining the currency board regime. Credit growth, despite a recent pickup, has been anemic, reflecting banks' low risk appetite, poor demand from the corporate sector (which continues to deleverage), high capital adequacy and liquidity requirements, and group-level decisions by foreign parent banks. The resolution of nonperforming loans (NPLs) has been slow; gross NPLs remain high at about 17% of total loans.
The stable outlook balances our view on the risks to growth from policy complacency against the space afforded by relatively low government indebtedness.
We could lower the ratings if contingent liabilities from state-owned enterprises were to crystallize on the government's balance sheet, if we see continued outflows in the financial account of the balance of payments, or if there is a further deterioration in the policy environment that adversely affects private investment flows and the economic recovery.
On the other hand, upward pressure on the ratings could build if supply-side rigidities and governance issues are addressed effectively, boosting Bulgaria's growth potential."

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