Matthew Youkee, Editorial manager for Bulgaria Oxford Business Group

Bulgaria's government is expecting inflation to drop significantly this year as supply shocks ease, after a worrying rise at the beginning of 2008. Nonetheless, many of the current inflationary pressures will remain and Bulgaria's ability to address them is limited.

Year-end inflation should slow to 6.9 per cent in 2008 after last year's spike to 12.5 per cent, Finance Minister Plamen Oresharski told the local press on April 2, despite hitting 13.2 per cent year-on-year in February.

This was largely due to the rising costs of food and fuel, combined with over-optimism triggered by high growth and the country's EU accession in January 2007, after which wages rose by more than 20 per cent. Oresharski said he expects all these dynamics to lessen this year, with smaller oil price rises, a better harvest and more constrained wage increases.

While fuel and food price growth may slow in 2008, a drop is unlikely. Oil at $100 or more per barrel looks here to stay, with OPEC reluctant to boost output and tensions still high in the Middle East. This year should not see food price inflation hit the highs of last year if Bulgaria's harvest is good, but shifting global climatic conditions and consumption trends may keep supply tight for the medium term at least.

"Inflation in 2008 will depend on many factors, but in general we expect it to moderate to below seven per cent at the end of 2008, driven mostly by deceleration of food prices after their considerable increase last year," Gabriella Stoyanova-Rozenova, research analyst at ING Wholesale Banking in Bulgaria, told OBG.

Tackling inflation has been an ongoing concern in Bulgaria. Due to the currency board, which hard-pegs the Bulgarian lev to the euro, the country has very limited monetary policy tools to constrain prices.

A recent report by Austria's Raiffeisen Bank forecast that inflation in Bulgaria this year might in fact top eight per cent. The report, published at the end of March, cited rising utility costs as a major inflationary pressure. The government has been undertaking liberalisation of the water, gas and electricity sectors, incrementally allowing suppliers more freedom to set their own prices according to the market. Raiffeisen said it expected charges for all three utilities to go up by about 10 per cent later this year.

Commodity prices look likely to remain high as well, as demand from construction booms in China, the Gulf States and elsewhere remains strong. In addition, Bulgaria's labour bottlenecks look unlikely to ease much, as labour shortages continue.

"While it is difficult to comment at the moment, my feeling is that due to the tight labour market, employers have increased the wages, despite the opportunities for some savings due to the introduction of the flat tax," Rozenova told OBG. The government initiated a flat tax of 10 per cent, the lowest in Europe, in January 2008.

The country needs to bring inflation rates down, on a long-term basis, in order to qualify for adoption of the European single currency. Bulgaria has fulfilled all the other "convergence criteria", the requirements for joining the eurozone, but still needs to bring inflation down to no more than 1.5 per cent above the three lowest rates among existing members - currently this means that Bulgaria would have to aim for a rate of about three per cent. Bulgaria has not even been let into the Exchange Rate Mechanism II (ERM II), viewed as the "waiting room for the eurozone", despite expectations that it would enter as early as the first half of 2007. A member state must join ERM II and stay within set limitations of currency fluctuation from the euro for at least two years before joining the eurozone.

While there are no specific requirements for ERM II membership, and Bulgaria's currency stability and fiscal surpluses would seem to make it suitable for joining, analysts believe that high inflation, as well as the ballooning current account deficit, are making the European Central Bank a little wary of letting Bulgaria in.

While Oresharski's forecast of inflation just below seven per cent would still be well off-target for the eurozone requirement, it is generally believed that the country's long-term trend is towards disinflation. The government is pledged to a very tight fiscal stance, and has consistently, and, so far, successfully targeted a surplus. Recent statements by Prime Minister Sergei Stanishev have reiterated the government's commitment to this policy, and his refusal last year to grant a 100 per cent pay rise demanded by teachers, despite a month-and-a-half-long strike and street protests, may indicate the government's resolve.

Furthermore, the introduction of the 10 per cent flat tax rate may have a positive effect. Although critics have said tax cuts are generally inflationary, some analysts have responded that the flat tax will deliver benefits to the more affluent, who will spend the extra cash on investments rather than consumption.

It is worth mentioning that the euro, to which the lev is pegged, is currently fairly strong, thus lowering the cost of some imports. However, as much of Bulgaria's trade is with eurozone member countries, the effects of the strong currency should not be overstated.
Additionally, the global credit crunch is causing a slowdown in big Western European economies and has prompted many banks to reel in their credit lines. There has been some speculation this will help cool the inflationary heat in Central and Eastern Europe. However, many banks in Bulgaria have thus far been relatively underexposed to the crunch, not having invested heavily in subprime-linked products, and, as Bulgaria's economy is not particularly export-oriented, the slowing of demand in Western Europe should not act as too much of a drag.

With interest rate levers unavailable, Bulgaria does not have a great deal of scope to restrain demand. Last year the BNB increased the minimum reserve requirements, a move that constrains banks' lending as a ratio of their deposits, but a further rise is unlikely, as higher requirements have a detrimental impact on small local banks that do not have easy access to credit from abroad.

In this situation, the government has little choice but to keep its fiscal policy tight and hope that pressures ease over the next few years.