Bulgaria – coping with the implications of the global financial turmoil

1. Bulgaria – coping with the implications of the global financial turmoil Kristofor Pavlov, Chief Economist of UniCredit Bulbank September 2008, Sofia

2. GDP will bottom out to 4.2% in 2009 and stabilize closer to its potential thereafter. Growth rate of GDP demand side components in % (2006-2011) Source: NSI and UniCredit Group forecasts In IH 2008 Bulgaria reported the third strongest economic growth in the EU. With global financial crisis adding pressure on the price and availability of external liquidity, deceleration in capital inflows is anticipated. Our central scenario envisages GDP growth to start slowing in the last months of 2008 and further in 2009. However, the slowdown will neither be sudden nor dramatic and will have positive implications for the economy as it will allow large macroeconomic imbalances to decrease toward more sustainable levels.

3. Economic expansion since 2006 was led by construction, real estate and financial intermediation sectors Contribution to GVA growth FDI growth Construction, real estate and financial intermediation heavily rely on the inflow of foreign capital to finance its expansion. Recently FDI channelled to these sectors lost momentum. On the positive side, slowing FDI was compensated by an increase in the debt creating financing.

4. Nevertheless Bulgaria remains attractive for international investors as it is the lowest cost provider in the EU. It has well educated labour force, favourable taxation, and is viewed as a gateway to the countries from the Black Sea and Western Balkans regions. 1) 2005, Percentage of the population aged 20 to 24 having completed at least upper secondary education; 2) 2004, Tertiary graduates in science and technology per 1 000 of population aged 20-29 years; 3) In 2008 4) Estonia do not tax corporate income, except on the distribution of corporate income such as dividends and fringe benefits

5. So far credit growth in Bulgaria was little unaffected by the global financial turmoil … Total customer loans (% yoy growth)1 Source: CB; UniCredit Bulbank

6. In September 2008 repricing of risk in emerging markets (including Bulgaria) seems not over… Increase in the cost of risk at the country level (5Y Credit Default Swaps USD, bps) The spread above the benchmark rate for Bulgaria increased to 253 following the recent surge in recession fears. Source: UniCredit New Europe Research Network, Bloomberg Credit default swaps: the CDS are derivative contracts that can be used to hedge against credit events. The owner of a bond can protect himself from default risk by purchasing a CDS, paying a fee to a protection seller in exchange for a (contingent) payment by the seller upon the default event. An increase in the CDS spread for a specific country can be considred as an indirect indicator of an increase in the cost of risk of the country – which also means an increase in the cost of funding

7. Money market rates in Bulgaria and in the Euro zone decoupled after the start of the crisis LEONIA vs. EONIA (2006 – 2007) Source: Central Bank and Reuters

8. The balance of risks for inflation remains skewed on the upside HICP Euro area and Bulgaria Headline inflation ranking in EU based on HICP (August 2008) 11.8% 11.1% 3.8% Source: Eurostat • In August twelve month HICP (harmonized index of consumer prices) retreated to 11.8%. Still, Bulgaria is the country with the third highest inflation among all EU member states. • Recent drops in oil prices suggests certain moderation of external pressure. However, excessive domestic demand and elevated wages growth continues to pose risks for the price stability.

9. Rapidly growing domestic demand exercises pressure on imports and drives CA to a large deficit Source: NSI and UniCredit Group forecasts * Minus sign denotes increase in BNB’s foreign reserves. • In Jan-July the CA gap widened by 47.3% yoy. Deterioration was mostly attributable to expanding mismatch in foreign trade where import growth outpaced export growth for a fourth month in a row. • We are cautiously optimistic for the CA outlook in the medium run. Production capacity expansion in manufacturing sectors and moderation of domestic demand will allow CA gap to ease gradually in 2009 and going forward.

10. Evolution in the baseline macroeconomic scenario for 2008 - 2010 Source: Central Bank, NSI, UniCredit Bulbank estimates • With its small and very open economy and given its degree of integration into the international financial system Bulgaria will be affected by the global financial crisis. • Economic growth will moderate. However the slowdown will neither be dramatic not sudden. On the positive side it will help the country to drive its large macroeconomic imbalances toward more sustainable levels. • Despite growth moderation economy remains attractive for international investors. Foreign capital inflows will gradually change their direction toward larger relevance of the manufacturing and agriculture sectors.

11. Thank you for your attention! If you want to know more about Bulgarian economy refer to the publications of UniCredit Bulbank research office which are available on http://bulbank.bg/index.jsp?id=1.7.1