Branimir Kondov in Sofia -

While the sovereign debt crisis laps at the shores of older and much bigger EU member states like Italy and Spain, and Greece, Ireland and Portugal catch a breath of air thanks to their bailout packages, newcomer Bulgaria has received an upgrade on its sovereign rating in recognition of its fiscal prudence, which the government is currently trying to enshrine into its constitution.

Having learned hard lessons from its own financial crisis in 1996-97 that closed a third of its banks and forced it to seek a bailout from the International Monetary Fund (IMF) and introduce a rigorous monetary policy arrangement to stabilise its currency, this poorest EU member plans to go a step further by trying to make a cap on government spending part of the constitution - the second member of the bloc to do so after Germany, which in 2009 put into its constitution a provision allowing the federal government to increase its annual net borrowing by just 0.35% of the country's GDP after 2016 and banning the federal provinces from increasing their net borrowing after 2020.

In a bid to discourage politicians from spending beyond its means, Bulgaria's ruling centre-right GERB party, whose fiscal prudence won praise from Moody's Investor Service on July 22 when it raised the sovereign rating one notch to 'Baa2', pushed through parliament changes in the budget law in late June limiting the consolidated budget deficit to a maximum 2% of projected GDP and capping government spending at 40% of GDP. Both changes, two pillars of the government's so-called Financial Stability Pact, were adopted by simple majority and are to take effect as of next year.

"We expect the general government financial balance to show a deficit below 3% of GDP in 2011, as evidenced by the results already achieved in the first half of the year," said Moody's in statement accompanying the upgrade. "Moreover, the implementation of the latest pension reforms and the new 'Financial Stability Pact' are likely to help keep the government finances close to balanced over the medium to long term."

Third pillar

It is unclear yet, however, whether the government will muster a qualified majority in parliament to adopt the third pillar of the Financial Stability Pact - an amendment to the constitution that calls for a majority of at least two-thirds in the 240-seat chamber for increasing the budget deficit above the 2% ceiling and for raising direct taxes. An attempt to pass the amendment at the end of July failed due to a lack of quorum. "It's time to make the next step in the right direction - to change direct taxes through two-thirds majority in parliament only. This is the way in which our government and any other government after us will pursue a prudent fiscal policy," Finance Minister Simeon Dyankov told the chamber on July 28.

To amend the constitution, the cabinet will need the support of at least 160 members of parliament in which GERB party has 117 seats, and the nationalist Ataka party, which usually sides with GERB, controls 16 seats. The opposition represented by the Socialists and mainly ethnic Turk DPS party control 75 seats. The right-wing Blue Coalition's 14 deputies and 18 independents hold the balance.

Dubbed locally a "fiscal board" in reference to the restrictive IMF-advised currency board system introduced in Bulgaria in 1997 to rein in triple-digit inflation and win back the trust of international financial institutions and investors, the Financial Stability Pact proposed by Dyankov also aims to back plans for the adoption of the euro in Bulgaria, which joined the EU in 2007. The currency board pegs the Bulgarian lev currency at a fixed exchange rate to the euro, tying the amount of levs in circulation to the level of the Bulgarian National Bank's (BNB) foreign exchange reserves and restricting central bank lending to the government. The fixed exchange rate is enshrined in the BNB Law.

The adopted budget deficit ceiling of 2% of GDP is lower than the 3% cap on the shortfall that is allowed under the Maastricht criteria for the adoption of the euro. Dyankov, however, told international news media in July that joining the euro's waiting room, or ERM-II, currently is not an immediate priority for Bulgaria in view of the debt crisis in the Eurozone.

The government plans to bring down its budget shortfall to 2.5% of GDP this year, or even to cut it to just above 2.0% as Dyankov said in July, from 3.9% in 2010. It reported a preliminary half-year fiscal gap equivalent of 0.9% of the GDP projected for 2011, compared with a budget deficit of 2.2% of GDP in the first half of last year.

Bulgaria's government cut its debt to €5.33bn, or 13.8% of the projected 2011 GDP, at the end of June from some 16% at the end of 2010, which was the second lowest in the EU27 after Estonia. End-June external government debt was equivalent to 8.5% of the projected 2011 GDP, and domestic government debt was 5.3% of GDP, the Finance Ministry reported on its website in August.

Bond bonanza

Confident that the government would honour its debt commitments, investors snapped up several issues of Treasury bonds in July and August, reflecting the perceptions of Bulgarian debt as low risk.

An offer of BGN30m worth of 3.5-year government paper at the end of July was 2.19 times oversubscribed, the highest coverage ratio in the last three auctions for this maturity, the Finance Ministry said. The average weighted annual yield achieved in the auction was 3.53%, below the yields on euro-denominated Eurobonds with similar residual maturity of Lithuania (3.57%), Turkey (3.84%), Croatia (4.01%), Hungary (4.62%) and Romania (4.88%). The spread compared with German federal bonds with similar residual maturity was 1.71 percentage points.

Added the Finance Ministry: "The yield level is below the current value of the index [five-year credit default swaps] of Bulgaria, which takes into account the assessment of international markets on the issuer default risk (about 220 basis points) and shows that market participants have not required any currency risk premium."

Yields on BGN50m of 10.5-year benchmark fixed-rate Treasury bonds fell to 5.31% in August, the lowest level in the five auctions of this maturity held since January 2011, as the amount on offer was 2.7 times oversubscribed. The average weighted annual yield on BGN40 million seven-year government securities also declined to 4.53% in August, the lowest ever since the issue was launched in February of 2010, as the coverage ratio in the auction 1.86.