The European Commission became the latest addition to the club of institutions forecasting that Bulgaria's economy will contract in 2009. The EC's economic activity forecast, which the institutions releases twice every year, estimated that the Bulgarian economy would shrink by 1.6 per cent this year and a further 0.1 per cent in 2010.

The estimate, which echoes the predictions made by an International Monetary Fund mission in April, will likely add more pressure on Bulgaria's outgoing Cabinet, which has been criticised domestically for not taking the necessary measures to stave off inflation in 2008.

Despite wide-spread warnings from analysts and businesses, the 2009 Budget was built on the assumption of economic growth of at least two per cent. But with tax revenues shrinking, the Government will now have to cut spending or risk missing its Budget surplus target and face a deficit for the first time in nearly a decade.

Despite the expenditure-reducing contingency buffer in the budget, the general Government Budget balance is projected to deteriorate to a deficit of o.5 per cent of gross domestic product (GDP) in 2009, the EC report said. Assuming that there is no Government policy change, the budgetary outcome in 2010 would be a deficit of around 0.25 per cent of GDP.

"There are major downside risks to these projections, associated with a deeper and more protracted economic downturn that would result in higher-than-expected revenue shortfalls. On the expenditure side, discontinuing additional discretionary spending and exercising strict expenditure control would be crucial for the outcome in the context of scarce revenues," the report said.

The projected economic downturn and the resulting weakening of domestic demand, as well as falling global commodity prices and decelerating nominal wage growth, should bring inflation down to 3.9 per cent in 2009 and 3.6 per cent 2010, from an average of 12 per cent in 2008. Future commodity market developments and the corresponding adjustment in administered prices remain crucial to the inflation outlook, the EC said.

Fast growth in recent years, fuelled by foreign cash, has left Bulgaria's economy unbalanced and it was far from certain that the country's industrial sector would be able to contribute to a sustained export-based recovery, thereby helping to achieve more balanced growth, the report said.

With the external imbalances persisting and foreign investment falling, the economy's external position, financed increasingly through accumulation of debt-creating liabilities, is likely to pose an additional risk to the outlook, according to the EC analysts.