Scope Ratings GmbH has today upgraded the Republic of Bulgaria’s long-term local-currency and foreign-currency issuer ratings to BBB+ and revised the Outlook to Stable. The sovereign’s senior unsecured debt ratings in local and foreign currency have also been upgraded to BBB+, with the Outlook revised to Stable. The short-term issuer ratings have been affirmed at S-2 in both local and foreign currency with a Stable Outlook.

Rating drivers

The upgrade of Bulgaria’s long-term ratings to BBB+ from BBB reflects the following three drivers:

1. The sovereign’s low and declining general government debt ratio, and favourable debt profile;
    
2. A commitment to reform, including the addressing of banking system vulnerabilities, further facilitated by Bulgaria’s application to enter the Exchange Rate Mechanism II (ERM II) and the EU’s Banking Union; and
    
3. Improving external resilience reflected in: the significant boost to reserve coverage ratios in recent years, supporting the nation’s currency board exchange rate regime; and declines in the external debt ratio and improvements in the net international investment position.

The upgrade to BBB+ reflects changes in Scope’s assessments in the ‘public finance risk’, ‘external economic risk’ and ‘institutional and political risk’ categories of its sovereign methodology. Bulgaria’s credit strengths support the sovereign rating upgrade, outweighing challenges stemming from the economy’s vulnerability to shocks as a small, open economy, financial system risks, the restrictions on the Bulgarian National Bank (BNB) in serving as the lender of last resort to banks, and demographic weaknesses.

The first driver underpinning Scope’s decision to upgrade Bulgaria’s sovereign rating is the strength of the country’s public finances. The government’s balance sheet incorporates a low and declining debt ratio, sizeable fiscal reserves and a favourable debt structure. Bulgaria’s gross public debt ratio stood at 23.1% of GDP as of Q3 2018 – comparatively low when viewed against Bulgaria’s ‘bbb’ sovereign peers, after a steady drop from Q1 2016 peaks of 29.7%. Going forward, the IMF projects that the debt ratio will decline slowly to 18.5% of GDP by 2023. Accounting for Bulgaria’s sizeable fiscal reserves, government debt net of fiscal reserves stood at only 13% of GDP as of Q3 2018. In addition, Bulgaria’s debt has a long average residual maturity; there is no large bond redemption (in excess of EUR 1bn) until 2022.

In 2018, Bulgaria recorded a budget balance of 0.1% of GDP on a cash basis, exceeding expectations of a 1% of GDP deficit. While Bulgaria’s fiscal surplus has been reduced since 2016 (when it was 1.6% of GDP), last year’s balanced budget nonetheless represented an improvement on a cash deficit of 3.7% of GDP as of 2014. While the 2019 budget envisions a deficit of 0.5% of GDP, reflecting increased public sector pay alongside higher education, health care and infrastructure spending, the medium-term budget framework sees this reverting back to a balanced position by 2020. Scope views positively the strides forward in improving the budget balance since 2014 but also notes the importance of continued discipline in order to maintain a balanced budget and ensure a degree of counter-cyclicality in budgetary policy.

The second driver of the rating upgrade is Bulgaria’s commitment to reform. Following the 2014 failure of Corporate Commercial Bank, Bulgaria took steps including an Asset Quality Review and stress test on the financial system, the initiation of reforms to the supervision of the central bank, the introduction of a new bank resolution authority and the proactive request and implementation of recommendations from an IMF Financial Sector Assessment Program.

Advancement of reforms has been maintained after approval from the Eurogroup in July 2018 of a series of procedural steps for Bulgaria to enter ERM II and European Banking Union by mid-2019. Here, Bulgaria became the first non-euro area country to apply to enter into close cooperation with the European Central Bank relating to Banking Union entrance, with associated reforms to the regulation of the central bank and credit institutions. The ECB is expected to complete its comprehensive assessment of Bulgaria’s financial sector by July 2019. Bulgaria approved a comprehensive Action Plan of reforms in August 2018. The European Central Bank and European Commission are now monitoring the implementation of six commitments under this Action Plan tied to financial sector supervision, building stronger insolvency and anti-money-laundering frameworks as well as the reform of state-owned enterprise governance. Scope expects Bulgaria to successfully enter ERM II and would consider the formalisation of its entry to be credit positive. Once Bulgaria joins ERM II, reforms must nonetheless be aimed at achieving a high degree of sustainable economic and institutional convergence before any entrance into the euro. As a minimum of two years would be required in ERM II before euro area admission could be attained, the ongoing process to enter the euro enforces a degree of prudence in policymaking linked to pro-growth reform, fiscal discipline and the sustenance of external stability.

The third driver of the upgrade to BBB+ is the increase in foreign-exchange reserve coverage, which bolsters the stability of the nation’s currency board exchange rate regime. Bulgaria’s currency board fix of 1.96 levs to the euro was introduced after a 1996-97 banking crisis, and has lowered inflation and interest rates, as well as prevented further bouts of the hyperinflation experienced in the 1990s. At the same time, it places significant constraints on the central bank. The credibility of the fixed exchange rate is supported by the central bank’s reserve accumulation, with foreign exchange reserves totalling USD 25.2bn as of January 2019, up from USD 15.1bn in January 2015. In combination with the effects of debt deleveraging, foreign-exchange reserve coverage of short-term external debt amounted to approximately 2.6x as of January 2019, almost doubling from 1.4x as of January 2015, and compared to under 1.0x between 2008 and 2011. This is especially important under present uncertain global capital flow conditions.

The upgrade is also supported by improvements in Bulgaria’s external position. Bulgaria's current account balance showed a surplus of 4.6% of GDP in 2018 – lower than the surplus of 6.5% in 2017, owing to some deterioration in the trade in goods deficit, but nonetheless up on a balance of -0.0% of GDP as of 2015. Scope is mindful that Bulgaria’s current account is volatile, and in the long run, Scope expects the current account surplus to revert back towards a balanced position. Nevertheless, Bulgaria has seen improvements in its net international investment position to -36% of GDP as of Q3 2018, from -98% of GDP in Q2 2010. Gross external debt has declined to 62% of GDP as of Q3 2018, from above 100% of GDP in early 2010. These developments strengthen resilience to balance of payment shocks.

Bulgaria’s economy saw real GDP growth of 3.8% and an estimated 3.3% in 2017 and 2018. Scope estimates Bulgaria’s growth in 2019 at about 3% – driven by domestic demand, but with net exports acting as a drag under an EU slowdown and higher imports. This compares with average growth of 1.1% over 2010-14, though it remains below average rates of 6.0% experienced over 2000-08. Scope foresees medium-run potential growth averaging a more modest 2.25% – implying an easing of growth over time compared with the present, as the labour market nears full employment and elevated real wage growth tempers. Lower potential growth reflects supply-side bottlenecks due to a rapidly declining and ageing population. Bulgaria’s working-age population is projected to fall by 1.1% per annum on average between 2019 and 2023.

Despite these credit strengths, Bulgaria’s ratings are constrained by the country’s low GDP per capita (an estimated USD 9,080 in 2018) and small economic size (with nominal GDP of USD 64bn), which, in combination with its economic openness, make Bulgaria vulnerable to idiosyncratic as well as global shocks. In addition, domestic non-financial private debt remains high, at 204% of GDP as of Q3 2018 – although this reflects in significant part high inter-company lending. Non-performing loans remain above the EU average, even though they have dropped to 7.6% of total loans as of end-2018.

According to the currency board, the BNB’s ability to act as a true lender of last resort is restricted. This is a rating constraint, although amendments to the Public Finance Act attempt to remedy this to an extent. The BNB can only provide liquidity support to the banking system to the degree that reserves exceed monetary liabilities. In addition, Bulgaria has middle-range scores on institutional measures, such as the World Bank’s Worldwide Governance Indicators. Bulgaria’s history of unstable governments is a rating constraint as it restricts continuity in reform drives, encourages populism (which weighs on the fiscal balance sheet), reduces the capacity for long-term economic planning, and undermines the business environment and investor confidence. In October 2018, the government survived the third no-confidence motion since entering office. Planning for EU and local elections in 2019 is on the near-term horizon.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative “BBB” (“bbb”) rating range for the Republic of Bulgaria. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.

For Bulgaria, the following relative credit strengths are identified: i) economic policy framework; ii) debt sustainability; iii) market access and funding sources; iv) external debt sustainability; and v) good resilience to short-term external shocks. Relative credit weaknesses are signalled for: i) current account vulnerabilities.

The combined relative credit strengths and weaknesses generate a one-notch upward adjustment and indicate a sovereign rating of BBB+ for Bulgaria.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Bulgaria’s performance on ESG-relevant factors is average but has improved since Scope’s last rating announcement on Bulgaria in April 2018. These ongoing improvements, especially those related to governance reform, have contributed to the decision to upgrade Bulgaria’s long-term ratings to BBB+. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, in which Bulgaria has average scores on a composite index of six World Bank Worldwide Governance Indicators, albeit somewhat higher scores than the median of bbb indicative sovereign peers. Specifically, Bulgaria’s Worldwide Governance Indicators score on political stability & absence of violence/terrorism improved in 2017. Qualitative governance-related assessments include a revision in Scope’s QS evaluation of Bulgaria for ‘recent events and policy decisions’ to ‘neutral’, from ‘poor’ in April 2018. The revision reflects areas of progress being pursued under the European Commission’s Cooperation and Verification Mechanism, in judicial reform and the fight against corruption and organised crime; these reforms are required for entry into ERM II. Recognising progress made, the latest Cooperation and Verification Mechanism report suggested that the mechanism could be concluded in 2019.

Social (“S”) factors are reflected in Scope’s CVS in Bulgaria’s comparatively low GDP per capita, average rates of unemployment, and weak old-age dependency ratios, compared with bbb peers. However, the government’s weak overall score on social factors has also improved since a year before, as high growth since Bulgaria’s accession to the EU (3.2% over 2007-17, compared with an EU average of 0.8% during this time) has supported income convergence and lower levels of unemployment. However, faster convergence towards EU average incomes requires accelerations in areas of reform given significant demographic bottlenecks – this could include action in areas like infrastructure, education and health care as well as to address labour shortages. Income convergence will moreover ease current emigration challenges. Scope anticipates further reforms that enhance income convergence, and reduce poverty and social exclusion, as these are requirements for any medium-run introduction of the euro. Bulgaria’s ‘economic policy framework’ is assessed as ‘good’ in Scope’s QS assessment, in recognition of the anchor provided by the government’s ERM II and euro objectives – ensuring pro-growth policies alongside fiscal discipline.

Bulgaria’s record on environmental issues is average but has improved. Of the EUR 9.9bn in EU structural and investment funds allocated to Bulgaria over 2014-2020, EUR 2.6bn is budgeted for environmental and resource management themes (the single largest category of fund use), with a further EUR 1.4bn allocated to the low-carbon economy. A relatively rapid increase in the share of renewables and the elimination of high carbon-emitting fuel sources have been pursued. Per-capita CO2 emissions are low and energy efficiency is gradually improving. Environmental factors are considered during the rating process, but did not play a direct role in this rating action.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the coming 12 to 18 months.

The ratings/outlooks could be upgraded if: i) Bulgaria keeps to its prudent fiscal policy, maintaining a clear downward trajectory on debt ratios; ii) advances are made in the reduction of risks in the financial system alongside significant reforms to banking supervision, including vis-à-vis entry into Banking Union; iii) successful entry into ERM II provides a clear road towards the introduction of the euro under a medium-run horizon; and/or iv) external stability is retained, including via continued enhancements to reserve coverage ratios and/or the preservation of current account surpluses that exceed expectations.

Alternatively, the ratings/outlooks could be downgraded if: i) there is renewed stress in the banking system or private-sector debt risks return; ii) Bulgaria’s fiscal balance deteriorates significantly, compromising anticipated improvements in the public debt ratio; iii) the current account surplus moderates significantly or measures of external resilience worsen; and/or iv) institutional challenges arise once more.

Rating committee
The main points discussed by the rating committee were: i) government debt dynamics; ii) economic, fiscal and institutional reforms; iii) external accounts and reserves; iv) demographic trends and potential growth outlook; v) banking sector developments; vi) developments with ERM II and Banking Union entry.

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.
The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: IMF, Bulgarian National Bank, Bulgaria’s National Statistical Institute, Ministry of Finance of the Republic of Bulgaria, Eurostat, European Commission, United Nations and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the rating, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst Dennis Shen, Associate Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 27.04.2018.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 27.04.2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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