Bulgaria is preparing to join the European Union (EU) on January 1 2007 and it looks like the country will manage it. The next hope for Bulgaria is to become a member of another club - the eurozone. According to Bulgarian National Bank (BNB), this country will be able to adopt the euro in 2009. Recent reports and statements, however, show that Bulgaria may not be ready for the pan-European currency before 2010. The main obstacle most probably will be inflation.

The chief challenge standing on Bulgaria’s way to the fast introduction of the euro is inflation. This is shown in the most recent report, entitled Central and Eastern Europe (CEE) Commentary, by Bank Austria Creditanstalt (BA-CA).

The bank is the CEE region’s arm of the German HVB Group, and after the purchase of HVB by the Italian UniCredito, it became part of the newly formed UniCredit Group.

BA-CA’s analysts point out that Bulgaria has almost completely covered the Maastricht criteria and the only thing the country still has to handle is inflation. The Maastricht convergence criteria envisages that inflation should be no more than 1.5 per cent above the average inflation rate of the three lowest-inflation countries in the EU. For 2005, the criteria average was 2.5 per cent.

Transport, healthcare, alcoholic beverages and tobacco are among the groups of goods and services whose prices, according to Eurostat (the EU’s statistical arm providing data about European countries), marked the highest deviation from the EU average. They are also the goods and services that had the highest price growth in Bulgaria last year - transport with 14.9 per cent year-on-year (y/y), healthcare with 11.4 per cent y/y, alcohol and tobacco with 10.6 per cent y/y.

Naturally, this leads to the conclusion that the pre-accession harmonisation of prices in Bulgaria has been the main factor behind the inflation in the country.

An important matter related to inflation in Bulgaria is also contained in the components of the consumer price index (CPI), where foods, tobacco and alcohol have non-proportionally high levels. (See the attached table for the CPI components in countries of CEE.)

As food prices are increasing faster, the result is overestimated when compared to other price indexes internationally. Such re-balancing, however, will support Bulgaria’s push for the early adoption of the euro, for which meeting inflation criteria remains the major challenge.

In January 2006, annualised inflation was 6.6 per cent in Bulgaria, while the monthly rate was 0.84 per cent. The full impact from higher 2006 excise duties on tobacco and spirits was not transferred to January figures, as retailers still had stock acquired under the old prices. The higher monthly inflation came in February and is expected to continue through March, with the overall effect on CPI from excise duties estimated at about two per cent.

Dimitar Mitev, chief economist of HVB Bank Biochim (owned by BA-CA in Bulgaria), who contributed to the report, wrote that higher energy prices were another contributor to the current bulge in inflation in this country.

Inventory build-up before and initial price level adjustments immediately after EU entry will limit the deceleration of price growth during the second half of this year and in early 2007. BA-CA’s forecast for Bulgaria’s annual average inflation in 2006 is six per cent, which means that the country will again be far away from covering this important convergence criterion.

It appears that Bulgaria’s trouble with inflation is not solitary, as long as neighbouring Romania, which should join the EU together with Bulgaria, also struggles to overcome the problem. The difference, however, is that Romania is not preparing to join the eurozone before 2012, so it will have more time for handling the inflationary pressure.

The strong price pressure observed in Romania in the closing months of 2005, according to BA-CA, continued also at the beginning of 2006. Consumer price inflation even accelerated in January, posting figures of one per cent month-on-month and 8.9 per cent y/y due mainly to adjustments in administered prices (gas: +17.2 per cent, energy: +1.9 per cent).

In order to protect its inflation target of five per cent with a fluctuation range of plus/minus one per cent as of year-end 2006, the National of Bank Romanian (NBR) responded by pulling in the monetary reins: after a cycle of interest rate cuts lasting almost two years, the policy rate was raised for the first time again on February 8 2006 by 100 basis points to 8.5 per cent.

Moreover, the NBR announced it would stick to its practice of using open market transactions to sterilise the surplus liquidity. In order to enhance the efficiency of the interest rate instrument and dampen the strong expansion in foreign currency lending further, the NBR will also raise the minimum reserve requirement for banks’ foreign currency liabilities from 35 to 40 per cent as of March 24 2006.

Following the latest interest rate step, the dilemma of the NBR regarding the need to continue with the process of disinflation while also avoiding the emergence of destabilising speculative capital inflows is likely to mount. As a result of the interest hike the NBR could see a more intense inflow of capital.

Although this would facilitate the fight against inflation by means of the associated pick up in appreciation of the national currency, the Romanian lei, it could also adversely affect the country’s international competitiveness.

Therefore, the greatest challenge for Romania and its central bank this year will be to create a balanced mix of monetary and exchange rate policies, which take account of both the need to curb inflation and the importance of maintaining the country’s competitiveness.

BA-CA found that in 2005, the Central and Eastern Europe region achieved a high degree of price stability. On average for the previous year, consumer prices throughout the new European Union member states rose by 2.5 per cent, which was precisely the upper limit of the EU inflation criteria for euro adoption for 2005. (The rate of inflation must be smaller than the average of the three countries with the most stable prices + 1.5 percentage points.) Consumer price growth amounted to 3.4 per cent on average throughout the wider CEE region (the new EU members plus the candidates Bulgaria, Romania, and eventually Croatia).

The country in the region with the most stable prices in 2005 proved to be the Czech Republic, followed by Poland and Slovenia. By contrast, the countries afflicted the most by inflation were Latvia and Romania.

Looking more closely at the changes in inflation rates, three comparatively homogenous groups of countries emerge. On one hand, there are the five leaders - the Czech Republic, Hungary, Poland, Slovakia and Slovenia - who, subsequent to the price hikes induced by EU accession, quickly found their way back onto declining inflation trajectories. On the other hand, in the Baltic states - Estonia, Latvia and Lithuania - inflation since EU accession has more or less remained at the same high level.

And finally, here are the three candidates - Bulgaria, Romania and Croatia - confronted with accelerated price inflation (e.g., Croatia) or slowly declining rates (e.g., Romania) because of the robust internal demand that is being driven by lending.

Despite the varying paths inflation follows, the factors driving prices were similar throughout the region. Above all, it was adjustments made to regulated prices (principally as a consequence of price and tax harmonisation measures before and after EU accession) that, depending on their weight in the basket of goods, resulted in inflationary pressures of varying sizes.

The soaring price of oil, which characterised 2005, was also a major factor in driving up prices across the region (principally in the sectors of transport and housing), particularly in countries with high import demands, like Bulgaria, and high energy intensities, BA-CA says.

And finally, in some of the countries, like Latvia and Romania, there were signs of demand-induced inflationary pressure owing to the high growth in domestic demand.

The powerful consumption and investment activity were accompanied by a record lending boom, particularly in Bulgaria and Romania. But the rise in appeal of foreign currency loans, which has its roots in interest and exchange rate movements, also led to stimulating the lending business in the other countries, causing some of the central banks to implement restrictive monetary policy measures.

The development of exchange rates dampened prices the most across the region. In the course of 2005, nearly all of the CEE currencies gained substantially in value (except for Bulgaria, where the lev is pegged to the euro under a currency board arrangement) thanks to the persistently strong inflow of capital to the region (both direct and portfolio investments).

Marked gains in excess of 10 per cent against the euro were recorded on an annual average basis in Poland and Romania, in particular. Nevertheless, there were also tax policy measures that facilitated efforts to moderate the burgeoning inflationary pressure driven by energy prices.

For example, Hungary moved forward its planned reduction in value added tax for fuels from January 1 2006 to October 1 2005. The Polish government, for its part, reduced the tax on mineral oils by 16 per cent as of September 15 2005. Above and beyond this, the broadly favourable development in food prices, which are accorded a high weight in the basket of goods in most countries, made its own contribution to improving the inflationary environment - be it for trade policy reasons (like in Poland) or competition reasons (like in Hungary).

Bulgaria is the only exception, as it exhibited substantial inflationary pressures in this area as a result of its agricultural sector being heavily hit by the floods. Last but not least, falling textile prices made an additional and positive contribution to inflationary developments as a consequence of the expired multi-fibre agreement and the concomitant strong import competition from China.

In 2006, BA-CA expects that the region will be able to reinforce the price stability it achieved in the previous year. Inflation for the year is expected to decline in the new EU member states to an average of 2.1 per cent, while the average for the old eurozone members is anticipated to fall just below the three per cent mark.

Acceleration in inflation is only conceivable this year in Bulgaria, the Czech Republic and Slovakia.

The major influencing factors during 2006 remain the strength of the respective national currencies and the price of oil, as well as adjustments to regulated prices and taxes.

The short- to medium-term inflation outlook will take on particular importance, primarily owing to the monetary integration of the region into the European Union.

Inflation will be a key issue from now on in Estonia, Lithuania and Slovenia, who have been members of the EU’s exchange rate mechanism since June 2004 and are planning to join the eurozone in 2007.

While consumer price developments constitute no danger for Slovenia in terms of fulfilling the inflation criterion, the two euro candidates in the Baltic states currently have to fight against more or less high rates of inflation, which threaten to undermine their euro roadmap. The euro train seems to be pulling away also from Latvia - which in January 2006 posted the highest rate of inflation within the EU at 7.5 per cent - owing to the lack of extensive and anti-inflationary measures taken in the field of monetary and fiscal policy in the 2006 election year. The government appears to accord more priority to maintaining the high rate of growth with a view to more rapid EU convergence than enhancing price stability.

Of the countries that are planning on introducing the euro at a later date (2009-2014), only the Czech Republic and Poland met the inflationary target set by the EU in 2005.
One of the positive developments registered in Bulgaria, and only here of the analysed countries, was the record budget surplus in 2005, BA-CA said.

The general government budget generated a surplus of 504 million euro or 2.3 per cent of the forecasted GDP in 2005 (while in 2004 the surplus was 1.7 per cent of GDP).

The positive development in budgetary revenue played an instrumental role here, coming in 12.6 per cent higher than anticipated.

The robust domestic economy meant that revenue from value added (+13.3 per cent) and excise duties (+12.4 per cent) as well as customs duties (+54.8 per cent) was far higher than originally expected. By contrast, expenditure fell somewhat short of its budgeted figure.

The 2006 budget envisages balanced public finances for the current year. In light of the continued need to persist with its policy of fiscal discipline due to the high current account deficit and the strong inflationary pressure, the Bulgarian Cabinet announced after consultations with the International Monetary Fund that the budget surplus target for 2006 was three per cent of GDP, whereby, depending on the success achieved in reducing the current account, deficit it may be possible to loosen fiscal policy slightly.

The sound budget enabled the government to reduce its external debt in the course of 2005. Thanks to the early debt repayments, external government debt fell from 6.6 billion euro (33.8 per cent of GDP) in 2004 to 5.4 billion euro (25.5 per cent of GDP) at the end of 2005.

Yet, despite the massive repayments, fiscal reserves at 2005 year-end totalled 2.3 billion euro and were, therefore, only just under the level recorded at the end of 2004 (2.5 billion euro). This offered the Government the chance in January and February 2006 to make some additional early debt repayments, first of all to the World Bank (191.7 million euro) and then to the IMF (151.4 million euro).

The bad news for Bulgaria came from the widening current account deficit. In 2005, the current account gap reached 3.16 billion euro or 14.7 per cent of the forecast GDP, and thus almost doubled in size in comparison to the previous year, when it was 1.65 billion euro or 8.5 per cent of GDP.

This negative development has been caused by a deterioration of the trade balance.

While exports of goods over the reported period displayed growth of 18.3 per cent (nominal, in euro terms), goods imports increased over the same timeframe by 26.4 per cent, thanks to the strong demand for capital goods as well as price effects generated by energy imports.

In 2005, the income balance remained essentially unchanged from 2004, posting a deficit of roughly 550 million euro. The lower surplus in the balance of services is counterbalanced by higher current transfers.

The inflow of net foreign direct investment (FDI) reached about 1.6 billion euro and thus covered only half of the current account deficit.

Nevertheless, on a more positive note, practically all of the inward FDI fell into the category of greenfield investment.

Despite administrative monetary measures taken by Bulgaria’s central bank to curb the rapid growth in lending and the more restrictive fiscal policy, in 2006 the current account deficit is likely to remain at a similarly high level. This will be driven principally by the persistently strong price effects of crude oil imports and one-off effects boosting imports of consumer and capital goods before the customs laws of the EU in comparison with third countries are adopted when Bulgaria joins the EU in 2007.

The Maastricht criteria
On January 1 1999, 11 countries joined a European monetary union and created a single currency - the euro.

The euro became legal tender in these countries on January 1 2002. For a single currency to succeed, the economies need to follow similar patterns of growth and similar policies - they need to converge. The Maastricht Treaty, therefore, set a series of convergence criteria.

The convergence criteria were the five conditions fixed that countries had to meet if they wanted to take part in full economic and monetary union. They were:

- Inflation - no more than 1.5 per cent above the average inflation rate of the lowest three inflation countries in the EU

- Interest rates - the long-term rate should be no more than two per cent above the average of the three countries with the lowest inflation rates

- Budget deficit - no more than three per cent of GDP

- National debt - no more than 60 per cent of GDP

- Exchange rates - currency within the normal bands of the exchange rate mechanism with no re-alignments for at least two years.