Scope Ratings says the 10 July announcement of Bulgaria’s admission to the Exchange Rate Mechanism II (ERM II) and Banking Union is a significant step toward economic and financial system integration with the euro area. Scope, which has assigned a BBB+/Stable rating for Bulgaria since February 2019, has considered that the formalisation of entrance to ERM II and Banking Union would be credit positive, helping to further lower financial-system, external-sector and foreign-exchange risk – the latter given the economy’s significant exposure to the euro.

“In addition, given a minimum two years that Bulgaria will expend in ERM II, with 1 January 2023 being the very earliest entry stage to the euro area, we believe the forthcoming multi-year period in advance of euro entrance will sustain a significant credit-positive policy reform framework that favours economic and institutional stability and convergence,” says Dennis Shen, analyst at Scope. “We would expect the government to maintain the same commitment to reform visible in the years before ERM II entrance, aimed at ensuring income convergence, sustainable fiscal policy, enhancement of external and financial stability, and addressing institutional and governance limitations. However, implementation in specific areas may prove challenging.”

The Bulgarian lev will remain fixed to the euro within 15% either side of the 1.95583 BGN/EUR central rate the currency has stood at for more than a decade. By joining Banking Union, the ECB will assume supervisory responsibilities over significant Bulgarian financial institutions from 1 October, strengthening banking supervision in close cooperation with the Bulgarian National Bank.

“Bulgaria’s admission to ERM II has been a long one and while this represents a significant achievement in the country’s economic history, the next chapter of gaining entrance to the euro area will not be straight-forward, and require close attention to fulfilling the Maastricht convergence as well as other criteria, for example strengthening central bank independence, addressing corruption and the judicial deficit per demonstrations, and enhancing legislative compatibility,” says Shen.

“Of the four Maastricht convergence criteria¹, reducing an elevated 2020 budget deficit, raised by this year’s exceptional public health crisis, is vital as is ensuring that inflation does not exceed reference rates of above that of the three best-performing euro area member economies.”

While consumer price inflation recently eased (to 0.9% YoY in June), high unit labour cost growth pre-crisis had led to a significant inflation deviation: average inflation in the twelve months to March 2020 stood at 2.6% versus a reference value of 1.8%.

“As Bulgaria’s per capita GDP level stood at 50% of the euro area average under purchasing power standards in 2019 (although nonetheless representing a significant advancement on 39% as of 2008), a key while in the Exchange Rate Mechanism will be on the sustaining of continued income convergence while, at the same time, respecting convergence criteria price stability rules.”

Bulgaria’s economic stability over forthcoming years will be anchored by a strong external sector. The economy’s current account surplus widened to 5.1% of GDP in the year to May 2020. Bulgaria has recorded annual current account surpluses since 2016. The country’s net international investment liability position declined to 31% of GDP in Q1 2020, from 98% of GDP in Q2 2010. Foreign exchange reserves stood at EUR 25.1bn in June 2020, equivalent to about 3.1x short-term external debt, well above the USD 15.1bn in January 2015, which was equivalent to just 1.4x short-term external debt. Foreign exchange reserves had averaged under 1.0x short-term external debt between 2008 and 2011.

“Strong reserve levels represent a significant safeguard, raising investor confidence in the Bulgarian currency during the forthcoming ERM II period,” says Shen.

Scope expects general government debt to increase to a still low 26% of GDP in 2020, up from 20% in 2019, with the budget balance to deteriorate to -5.5% of GDP this year from a 2.1% surplus last year as the coronavirus crisis has taken its toll on sturdy public finances. Significant fiscal reserves of 8.5% of GDP as of May 2020 should ensure that public debt net of reserves total, nonetheless, only around 20% of GDP at end-2020.

“We forecast a significant 2020 economic contraction of 7% in 2020 as Bulgaria experiences a significant second wave of coronavirus incidence,” says Shen. “This weighs on fiscal dynamics though Bulgaria’s recent record of fiscal discipline, checks and balances as the economy transitions toward euro adoption, and sturdy growth potential of an estimated 2.5% over the medium run will help reverse 2020’s increase in public debt and ensure a sustainable debt trajectory post-crisis.”

1  The four convergence criteria being: price stability, sound and sustainable public finances, sustainable long-term interest rates and exchange rate stability in ERM II.