Bulgaria's general price level, as measured by the CPI, fell 2.6% y/y in February, declining for a seventh month in a row, raising concerns about the effects of deflation on the country's economic recovery.

What prompts deflation fears

The media and local analysts are repeating the textbook Keynesian theory, which says that deflation can be disastrous for the economy by discouraging consumption and investment because consumers, expecting prices to fall further, delay purchases, preferring instead to save and wait for even lower prices. The decrease in demand forces firms to reduce wage rates and/or lay workers off in order to cut costs, which puts additional downward pressure on demand. In other words, a deflationary spiral develops and the economy is left severely damaged.

Entrepreneurs care about price spreads

This theory overlooks the causes behind Bulgaria's deflation and assumes that firms' expenditures remain constant in times of falling consumer prices. Entrepreneurs' anticipation of falling consumer prices make them bid down the prices of the factors of production (and those who fail to do that go bust and free up the resources they were already using, thus pushing their prices down), as a result of which they can continue to work profitably. What matters is the price differentials between selling prices and costs, not the general price level per se. Ultimately, since the factor prices are imputed backwards from those of consumer goods through the various stages, the structure of production adjusts to the new price spreads specific for every business.

It must also be noted that the starting point of the deflationary spiral is also problematic as individuals can not postpone consumption forever (even for non-essential goods like products of the consumer electronics and high-tech industries, where sustained levels of deflation for the past several decades have accompanied increasing profit margins).

Deflation in Bulgaria

Bulgaria's deflation is largely induced by supply side factors*. Much of the drop in consumer prices can be considered growth deflation - the result of more abundant energy resources (mainly due to the shale oil and gas revolution) and larger supplies of food (due to the exceptionally good harvest last year). Energy products cost 2.1% less in January compared to a year earlier, while food costs dropped 1.3% y/y in February, according to latest data by the statistics office.

On the other hand, electricity prices decreased 13.5% y/y in February, however, not due to an increase in supply but because of the three administratively imposed cuts in the price of the resource from the last twelve months (by 7% in March 2013, by 4.3% in August and by 1.3% in January). And while the other two deflation-driving factors have positive effect on the economy, the artificially lower price of electricity jeopardises the stability of the energy sector. By setting price caps below the otherwise relatively market-determined prices the energy regulator (SEWRC) limits the profitability of the industry and even drives the companies in the sector to bankruptcy. The price ceilings additionally discourage potential producers from entering the market and thus increasing competition. Furthermore, the price caps also discourage existing producers from investing profits in adding new capacity.

The distorted price system and the condition of the energy sector

The three foreign-owned power distributors in Bulgaria have stated on numerous occasions in the past year that the regulator's policy to cut end-consumer electricity prices by taking income away from them has severely worsened their financial position, restricted their investment stimuli and forced a process of decapitalisation. SEWRC has severely reduced the distributors recognised expenses and also their margin for recognised technological losses in order to enforce the cut in electricity prices.

In addition, the public power utility NEK - a state-owned company, which buys nearly all of the electricity produced in Bulgaria and then resells it to the distributors - is on the brink of a collapse. The company had a liquidity ratio of 0.38% as of end-September 2013 and BGN 2.15bn (EUR 1.1bn) worth of short-term dues, which NEK has said is a direct result of the regulator's pricing policy. In February, Standard & Poor's lowered its long-term corporate credit rating on NEK to 'B+' from 'BB-'/negative outlook. The downgrade followed the steep deterioration in NEK's credit metrics in 2013, which resulted mainly from the adverse regulatory tariff decisions, the S&P explained.

Meanwhile, the earning before interest and taxes of the Bulgarian Energy Holding (BEH), which groups Bulgaria's largest state energy utilities (NEK included), tumbled 55.3% y/y to BGN 244.8mn in the first nine months of 2013, latest data has shown. BEH itself tapped foreign markets in October 2013 to raise EUR 500mn in a debut eurobond issues in order to cover one of NEK's maturing loans.

* The drop in consumer prices could also be partially a result of a cash-building deflation as Bulgarians decided to reduce their current spending on consumer goods below their income, preferring instead to add the unspent income to their cash balance held in bank deposits. However, it is not clear whether the investment/consumption proportion in the economy has been changed by this since not only did deposits grew (by 7% y/y as of end-January) but also the currency in circulation (by 8.8% y/y as of end-January).