By Levon Kameryan, Associate Director, Sovereign and Public Sector

A long series of short-lived administrations has long constrained Bulgaria’s credit rating (BBB+/Stable), hence the concerns over whether another early election – scheduled on April 2 – can break the political deadlock. A government with a working parliamentary majority is vital for implementing growth-enhancing structural reforms to underpin the country’s smooth adoption of the euro.

Acceleration in institutional reforms and reforms of the labour market and infrastructure are key to boost investment and generate the economic growth needed to raise living standards closer to EU levels, particularly given today’s double-digit inflation, tight financial conditions and Bulgaria’s demographic weaknesses.

Adopting the euro would enhance Bulgaria’s credit outlook through the country’s adoption of a global reserve currency, the associated strengthening of institutions and governance, and assurance of more robust monetary policy flexibility.

Political instability has held back reforms that would unlock and put to work EU funding. Bulgaria received the first EUR 1.37bn tranche of grants under its national Recovery and Resilience Plan (a total of EUR 5.7bn in grants) only in December 2022.

Figure 1: Bulgaria faces stiff inflation challenge on path to joining the euro
HICP Inflation, annual rate of change, %

Note: The price-stability criterion stipulates average inflation of not more than 1.5 percentage points above the rate of the three best performing member states for a year before the assessment. Source: Eurostat, Scope Ratings.

The emergence of a functioning coalition in April’s elections, and one prepared to act on popular demands for institutional reform, would boost the confidence of euro-area authorities that Bulgaria remains on course for joining the currency union and potentially provide a degree of flexibility around their future evaluation of convergence criteria.

Such a government would capitalise on progress made by Bulgaria’s previous short-lived government in 2022 led by prime minister Kiril Petkov and his ‘We Continue the Change’ party that got the ball rolling with improvements to economic planning and institutional quality, which were positive for the rating outlook.

High inflation risks complicating euro accession timetable

In the meantime, Bulgaria’s inflation, at 13% as a 12 month-average in December 2022, is running at much more than 1.5 percentage points above the rates in the EU’s three lowest-inflation economies (Figure 1), a disparity which is a core hindrance to euro adoption near term.

Inflation is likely to slow down in the coming months – we forecast an average HICP inflation in Bulgaria at 7.3% in 2023 – but the rate might still be too high to benefit from the European Commission and the ECB’s exclusion of outlier countries as benchmarks in their 2023 convergence assessment, as they did when considering Croatia’s ultimately successful entry to the euro area last year.

Volatile energy and food prices, inflation among Bulgaria’s trading partners, and supply-chain disruptions will continue to determine the outlook for prices for the next months, adding to uncertainty. ECB tightening should contribute to lowering inflation, given Bulgaria’s currency board arrangement to align monetary conditions with those of the euro area, a policy that has helped shield the country from financial-market volatility since the Covid-19 crisis.

Economy is on course for 1% growth in 2023

By other measures, Bulgaria is better placed to fulfil near term other euro-accession criteria, including public finances, interest rates and exchange-rate stability. A new government’s likely commitment to fiscal discipline should help keep debt below 30% of GDP in the medium term.

But the slow absorption of EU funds clouds an otherwise sound fiscal outlook, as the implementation of investment projects funded by the EU and co-funded by the national budget will need to be shifted into 2023 and beyond.

Bulgaria’s economy is on course to grow 1% this year after an estimated growth of 3.4% last year, as high inflation weighs on household income. In 2024, the economy should rebound 3%, which is close to its medium-run growth potential, as inflation eases and investment recovers.