Eurobank EFG in Athens -

In 2007, we expect real GDP growth to remain at its current levels of 6.3% given that consumption growth will remain at its current levels and investment growth will cancel out any deterioration of net exports.

• Inflation exceeded government's projections in 2006, but is expected to moderate mildly to 5% by end-2007.

• The current account deficit poses a real threat to the economic stability, as it will decline only marginally to 15% during 2007.

• In 2006, Bulgaria's budget recorded a surplus equal to 3.7% of GDP. For 2007, the government's target is for a surplus of 2% of GDP.

• FDI inflows reached 16.6% of GDP in 2006, up from 10.8% in 2005 and are expected to remain at high levels in 2007.

• Credit developments are getting increasingly difficult to monitor as lending is diverted into non-regulated channels in order to circumvent BNB regulatory restrictions.

Business, not consumer, optimism

Since January, Bulgaria has become a fully-fledged member of the European Union. Bulgaria's entry constitutes a milestone not only in the transition of the former socialist country to a fully functioning market economy, but also in the history of Southeast Europe, which becomes more integrated to Central Europe. Yet a paradox is emerging: optimism for the Bulgarian economy is being reflected only in the business climate sentiment indicator, which has improved substantially over the past few months, but it has not affected households, given that the consumer sentiment indicator has been stagnant over a relatively long period of time.

Real GDP continued to record an impressive growth throughout 2006 and we now expect to exceed our previous forecast of 6%. In the first nine months, total growth has averaged 6.3% on year, with domestic demand contribution reaching 11 percentage points (total consumption contributing 5.5 percentage points and gross fixed capital formation 5.7 percentage points). This comes as a result of the growth rate of household consumption which grew 6.7% on year in Q3-2006 and of gross fix capital formation which recorded another consecutive quarter of robust growth expanding by 15.9% on year in Q3-2006, albeit below its recent growth rates of 24.0% in Q3-2005 and 20.3% in Q2-2006. Finally, net exports were the only negative component of GDP growth as they contributed a negative of 4.6 percentage points, a lower negative contribution compared to 2005.

On the other hand, the fiscal surplus continues to provide a cushion against the current account imbalances and support to the currency board. The government budget recorded a surplus equal to 3.7% of GDP in 2006, up from 3.2% of GDP in 2005. Expenditures containment, (expenditures recorded a cumulative growth of 9.7% on year against an 11.3% growth in revenues), led to the realization of a strong primary surplus of 5.1% of GDP, compared with 4.8% in 2005. According to the agreement with the IMF (which is going to expire in March 2007), the government has agreed to target a fiscal surplus of at least 2% of GDP in 2007, and be prepared to increase this surplus should the current account deficit widen significantly. The challenges for the budget outlook for 2007 stem from the reduction in the corporate income tax rate, from 15% to 10%, and the sharp increase in government spending due to EU accession related outlays.

There has been a significant deterioration in the current account deficit in Q4-2006. The current account deficit has now approached 16% of GDP compared with 14.7% in Q3-2006 and 11.4% at end-2005. A closer look at the current account dynamics reveals that this deterioration can be attributed to both the widening of the trade balance and to the decline of the positive balance in services, income and net transfers. The trade balance deficit deteriorated from 20.2% of GDP in 2005 to 21.8% in 2006, despite the fact that exports have been growing faster (26% on year in 2006) than imports (25% on year in 2005). Exports growth has been fuelled by exports diversification at the neighbouring countries, while the increase in imports is primarily due to the increase of imported raw materials which increased by 28% on year in 2006. The surplus in services declined by 1.4 percentage points (reduced tourism related revenues), the income surplus by 1.1 percentage points (investment earnings increase for maturing FDI inflows) and the current transfers surplus by 1.3 percentage points.

More FDI flows

On the other hand, foreign direct investment inflows hit record-breaking levels, driven primarily by investments in real estate by non-residents. FDI in Bulgaria grew by 43% in 2006 to €4.015bn (16.6% of GDP), against €2.809bn (10.8% of GDP) attracted in 2005. Receipts from real estate sales to non-residents amounted to €987.9m, up from €464m in 2005. According to our expectations, Bulgaria will continue to attract FDI inflows during 2007. Our optimism is based on the assumption that Bulgaria will continue to capitalise on its EU membership and take advantage of its low unit labour cost and very favourable corporate tax regime. Yet, it would be more natural to conclude that the FDI inflows structure will be re-oriented towards non-real estate activities.

Despite the substantial inflows of foreign capital, a large part of Bulgaria's economic expansion has been debt financed. During the first 9 months of 2006, Bulgaria's gross external debt has increased by 9 percentage points to 75.2% of GDP. A closer look at the decomposition of external debt shows that this increase is due to higher private sector borrowing, which accounts for 75% of total external debt, up from 70% in the beginning of 2006. Furthermore, the maturity structure of the debt is changing with short-term debt increasing its share to 29% of total debt, up from 25% at end-2005. Nevertheless, the external debt service has been trending downwards from 23% of GDP in 2005 to 13.5% of GDP in 2006.

Strong demand from both domestic and external sectors of the economy led to higher than expected inflation throughout 2006. Specifically, average inflation came in at 7.3%, above government's projections of 5.5%. The main reason for inflation overshooting its projections was the acceleration of prices during the last quarter of the year, from 5.6% in September to 6.5% in December. Almost half of the inflation increase throughout the year can be attributed to the excise tax hikes on tobacco and alcohol products. These tax hikes passed through to non-food prices, which recorded an increase of 11.3% on year, and contributed 3.3 percentage points to inflation. Based on the assumption that the adverse base effects of these tax hikes will fade away during 2007, the government projects an inflation rate of 3.1% at end-2007 (or 4.4% yearly average).

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