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Rating action

Scope Ratings GmbH (Scope) has today affirmed the Republic of Bulgaria’s (Bulgaria) long-term local and foreign currency issuer and senior unsecured debt ratings at BBB+ and has revised the Outlook to Positive from Stable. Bulgaria’s short-term issuer ratings have been affirmed at S-2 in local and foreign currency, with Outlooks revised to Positive, from Stable.

Summary and Outlook

The revision of the Outlook on Bulgaria’s BBB+ sovereign credit ratings to Positive from Stable reflects the following rating drivers:

1. Scope’s expectation of progress on Bulgaria’s euro area entry, by 2025 at the earliest, acknowledging uncertainties on specific timing. Euro area entry would have multiple credit-positive effects, most notably via adopting a global reserve currency as local currency, eliminating foreign-exchange risk in euroised public- and private-sector balance sheets and greater monetary policy flexibility through the Eurosystem. Scope expects that most convergence criteria should be met by the upcoming Convergence Report in mid-2024, a precondition for Bulgaria’s accession.
   
   The main obstacle relates to the price stability (inflation) criterion, which Bulgaria does not currently meet. A projected slowdown in headline inflation would improve the likelihood of meeting the criterion by mid-2024. Still, even if a gap to meeting the inflation criterion were to remain, Scope expects the European Commission to adopt a flexible implementation of the reference rate calculation as was the case when Croatia was assessed as meeting the criterion in mid-2022.
    
2. The recent formation of a coalition government comprising the two major political groupings, GERB and Union of Democratic Forces (GERB-SDS) on the one hand, and We Continue the Change and Democratic Bulgaria (PP-DB) on the other, both of which are committed to euro area entry. This could stabilise politics after a turbulent two years, with five elections held since 2021. The two groups agreed on a power-sharing arrangement over the next 18 months, with each group holding the premiership for nine months. A stable government over the coming 18 months with a majority in parliament should be able to pass necessary legislation for euro area entry and ensure that the public finance convergence criterion is met via an updated 2023 budget and associated general government deficit in line with the 3% Maastricht threshold. Finally, Bulgarian authorities recently entered negotiations with the European Commission and the ECB to introduce in parallel euro non-cash payments from 2024, which further highlights the government's commitment to euro area accession in the medium term.
   
   Main risks relate to a recent history of unstable governments and frequent elections, which has delayed crucial policy making and Bulgaria’s euro area entry, originally targeted for January 2024.

The Outlook revision reflects Scope’s updated assessments of Bulgaria under the ‘domestic economic risk’, ’public finance risk’ and ‘external economic risk’ categories of its sovereign methodology.

The Positive Outlook represents Scope’s view that risks to the ratings are tilted to the upside over the next 12 to 18 months.

The ratings could be upgraded if: i) euro area accession were formalised; ii) Bulgaria sustainably raised its economic growth potential, ensuring continued convergence with EU average per-capita income; and/or iii) progress were made in addressing institutional challenges, including the rule of law and the fight against corruption.

Alternatively, the ratings/Outlooks could be downgraded if: i) institutional challenges and/or political instability reoccurred, weakening the macroeconomic outlook and/or delaying Bulgaria’s euro area entry significantly; ii) economic prospects deteriorated considerably; iii) the fiscal outlook worsened significantly; and/or iv) the banking system’s or external-sector resilience weakened.

Rating rationale

The first driver for the Outlook revision on Bulgaria’s BBB+ ratings is Scope’s expectation of Bulgaria’s euro area accession by 2025, latest 2026, acknowledging uncertainties around the specific timetable. The next Convergence Reports by the European Commission and the ECB, due in mid-2024, will assess whether Bulgaria meets the requirements to join the euro area, namely the four nominal convergence criteria (price stability, sound public finances, exchange rate stability and long-term interest rates) as well as whether Bulgarian legislation is fully compatible with the requirements of the Treaty and the Statute of the European System of Central Banks/ECB.

Accession to the euro area would improve multiple rating-relevant areas, including by eliminating foreign-exchange risk in an euroised economy, increasing monetary policy flexibility and strengthening market access. Market access would improve once Bulgaria issues in euro as domestic currency, reducing foreign-exchange risk in Bulgaria’s outstanding primarily euro-denominated public debt portfolio. In addition, this would provide domestic banks with access to loan facilities of the ECB, and sovereign access to the European Stability Mechanism (AAA/Stable), bolstering the country’s financial stability.

First, the process to enter the euro area requires a minimum of two years under the Exchange Rate Mechanism (ERM II), which Bulgaria entered in 2020. Bulgaria has since maintained exchange rate stability and therefore meets the exchange rate criterion. Stable exchange rates have been anchored by the nation’s credible currency board since July 1997, which has been given strong institutional support with the ERM II. The external sector is strengthened by robust foreign exchange reserve coverage. Official reserves totalled EUR 34.8bn as of end-May 2023. In combination with declining external debt, official-reserve coverage of short-term external debt amounted to over 4.3x as of April 2023. Bulgaria’s adequate reserves back the credibility of the exchange rate during participation in the ERM II. Bulgaria’s external position has been strengthening continuously, with its net international investment position improving to -12.7% of GDP as of Q1 2023, from -61.5% in 2015. Gross external debt stood at around 51.6% of GDP in Q1 2023, down substantively from 80.4% in 2015.

Second, Bulgaria should be able to fulfil the criterion on public finances, i.e. not be subject to an excessive deficit procedure by the European Commission. Scope continues to view public finances as an important credit strength for Bulgaria. In its recently-passed budget for 2023, the new government has introduced measures to reduce the expected general government deficit to 3% of GDP this year, after 2.8% of GDP in 2022. The previously expected deficit was 6.1% of GDP as outlined in the Convergence Programme 2023-2026 under the previous caretaker government. At the same time, downside risks remain, such as lower-than-assumed economic growth and associated revenue collection.

Bulgaria’s gross general government debt ratio continues to be very low compared to that of sovereign peers. Scope projects the debt ratio to stand at around 22% of GDP in 2023, from 22.9% in 2022 and 20.0% in 2019. Bulgaria retains the lowest government-debt ratio in the EU-27 with the exception of Estonia. In the medium-term, Scope expects the debt ratio to trend upward but to remain moderate, reaching around 26% of GDP by 2028, significantly below most A-rated European sovereigns. Bulgaria further holds sizeable fiscal reserves, amounting to BGN 11.7bn as of May 2023, or 7% of GDP. Bulgaria’s debt profile is favourable, with a long average residual maturity of around 7.4 years. The 72% of central government debt denominated in euro as of May 2023 represent a foreign-exchange risk, which is however mitigated by the credible currency board framework.

Third, Bulgaria meets the long-term interest rate convergence criterion. As of early July 2023, Bulgaria’s local-currency ten-year government bond yield stood at around 4%, broadly in line with the average of EU countries (plus a margin of 2pp used in the reference rate calculation). Bulgaria had met this criterion in the latest 2022 Convergence Report.

Finally, the fourth nominal convergence criterion (price stability) represents the main risk to Bulgaria meeting all convergence criteria. Bulgaria’s Harmonised Index of Consumer Prices (HICP) inflation rate, while having moderated to a 12-month moving average rate of 13.0% as of June 2023, stood well above the reference rate without any “outliers” of 7.6% (the unweighted average of HICP inflation of the three best performing (lowest inflation) Member States plus 1.5pp). Even though inflation is expected to slow down in the coming months, the Bulgarian National Bank (BNB) forecasts inflation to stand at 5.6% YoY at end-2023 and at 3.4% at end-2024, pointing to substantial risks of not meeting the price stability criterion in the near and medium term. Factors hindering faster convergence of HICP inflation to best performers include, among others, high nominal wage increases, averaging around 16% since H2 2022. Robust nominal wage increases are partly driven by the convergence of the country’s low income and price levels to euro area averages, structurally putting upward pressure on inflation.

At this stage, it thus seems likely that several member states would need to be omitted from the reference rate calculation in the next Convergence Report for Bulgaria to meet the price stability convergence criterion. This flexibility was already used in reference rate calculations in the 2022 Convergence Report, where Croatia was assessed as meeting the criterion. Scope notes that in case the BNB’s inflation forecasts prove accurate, and a few best performers were excluded from the reference rate calculation, Bulgaria could meet the inflation criterion. Scope believes that the current geopolitical environment, together with the exceptional energy-price developments and various adopted anti-inflationary measures across EU member states, would allow the European Commission to exclude several countries as outliers in calculating the price stability reference rate, if needed and desired. In addition, as all euro area member states are part of the Schengen area, Scope also believes that the latest developments, including the European Parliament’s recent call on the European Council to approve Romania’s and Bulgaria’s Schengen applications, also support Bulgaria’s euro adoption progress.

The second driver supporting the Outlook revision is the recent credit-positive formation of a coalition government between GERB-SDS and PP-DB. The two groups agreed on a power-sharing arrangement over the next 18 months, with each political grouping holding the premiership for nine months. A stable government over the coming 18 months with a majority in parliament should be able to pass necessary legislative changes for euro area entry, such as changes to the Law on the BNB, which was assessed as not fully compatible with Article 131 of the Treaty on the Functioning of the European Union regarding central bank independence, the monetary financing prohibition, and legal integration into the Eurosystem in the 2022 Convergence Report. In general, compatibility of Bulgarian laws and addressing challenges in the business environment and institutional bottlenecks relating to corruption, organised crime and government efficiency remain priorities.

The government is committed to ensuring that the public finance convergence criterion can be achieved. Parliament recently passed the updated 2023 budget, which should keep the general government deficit in line with the 3% Maastricht threshold. Moreover, a stable government would help unlock more funds under Bulgaria’s Resilience and Recovery Plan, amounting to a total of EUR 5.7bn, or 8% of 2021 GDP. Political turmoil since 2021 had already led to a postponement of the second payment request for recovery funds to September 2023. A stable, pro-EU government would further be crucial in geopolitical considerations, as the parties that form the current government stand in opposition to parties such as Revival, with a pro-Russian stance, which further opposes euro area entry. In this context, Revival has recently put forward a referendum on keeping the Bulgarian lev as the only currency until 2043. A majority in parliament, comprising the government parties, has rejected the proposal, but the proposal for a referendum could still be brought forward to the Constitutional Court.

At the same time, Bulgaria’s BBB+ ratings also reflect several rating challenges.

First, Bulgaria faces political and institutional challenges. The recent political crisis, with a total of five elections held since 2021, was caused by widespread corruption allegations and highlights longstanding institutional issues in Bulgaria.

The recent episode of unstable governments and frequent and inconclusive elections significantly hampered reform momentum, including on the original target of euro area entry on 1 January 2024. The political crisis was driven by corruption allegations against the GERB party, which had been ruling Bulgaria since 2009, triggering protests in late 2020 and early 2021. Further, a number of former Bulgarian government officials have been sanctioned, most recently in February 2023 by the US Department of the Treasury’s Office of Foreign Assets Control, due to their involvement in corruption and their links to Russia. Bulgaria’s history of political instability is a rating constraint as it restricts continuity in reform, fosters populism, and hinders capacity for long-term economic planning.

Institutional weaknesses, as captured for example by Bulgaria’s relatively weak performance on the World Bank’s Worldwide Governance Indicators, and political instability weigh on the business environment and investment climate. Scope notes weak investment dynamics in the last three quarters up to Q1 2023, with a drop in gross capital formation of around 7.5% YoY on average. The implementation of EU-funded projects has been facing delays, further weighing on the country’s investment outlook. Historically, Bulgaria’s record of absorbing EU funds has been in line with the EU average, with 75% of cohesion funds under the 2014-2020 Multiannual Financial Framework paid out by end-2022.

Second, Bulgaria also faces several longer-term demographic pressures. Adverse demographics weigh on growth and public finances. Bulgaria’s working-age population has been shrinking since 2007, reaching a new record-low of 3.8m people at the end of 2022, from 4.8m in 2007, with the average yearly change at around -1.5%. This was driven by net emigration of an average of 6,000 persons per year over 2007-2019, even though the trend has reversed since 2020, with average net immigration of around 24,000 persons. Ageing further weighs on the working-age population, as highlighted by a rising old-age dependency ratio (the share of persons aged above 64 relative to the working-age population) of 35.0% in 2020, which is expected to increase to 38.5% by the end of the decade. This is well above levels in other countries in Central and Eastern Europe.

A declining working-age population, with an average decline of 0.9% per year in the next five years, weighs on Bulgaria’s potential growth, which Scope estimates at around 2.75% per year. This is still relatively robust compared to euro area and European peers, however, it would need to be improved via productivity gains to enable Bulgaria to converge more rapidly to European and euro area average incomes. Bulgaria’s ageing society will also impact public finances, with total cost of ageing expected to increase to 16.6% of GDP by 2030, from 16.1% in 2019, according to the European Commission’s 2021 Ageing report.

Third, the decarbonisation of Bulgaria’s economy, which remains the most carbon-intensive in the EU, is another key challenge. The country’s energy mix is heavily reliant on fossil fuels (63% of gross inland energy consumption) and electricity generation is mostly powered by solid fossil fuels (36% of the total in 2022), predominantly coal. Given the recent political crisis, reform momentum on reducing emissions, especially in the energy sector, has significantly slowed down. For example, the European Commission decided in January 2023 to refer Bulgaria to the Court of Justice of the European Union with a request to impose financial sanctions in accordance with Article 260(3) TFEU for failing to transpose the EU's Renewable Energy Directive into national legislation. Further, a parliament resolution to approve a path to climate neutrality, based on recommendations of the independent Energy Transition Commission, a key deliverable under the country’s recovery plan, has been significantly delayed. At the same time, Bulgaria has rapidly reduced its dependence on natural gas imports from Russia without supply disruptions. Gas sources have been diversified via the Gas Interconnector Greece–Bulgaria, operational since October 2022, and total gas consumption has been reduced by 24% YoY during August 2022 and January 2023.

Finally, Bulgaria’s ratings are constrained by its vulnerability to shocks as a small, open economy with low wealth. GDP per capita was EUR 12,400 in 2022, the lowest level in the EU-27, or around 59% of the EU-27 average in volume per capita terms, up from 55% in 2020. Bulgaria’s small economy, with a nominal GDP of EUR 85bn in 2022, in combination with high trade openness, makes the economy vulnerable to idiosyncratic and global shocks. This was seen during the Covid-19 crisis, when the Bulgarian economy contracted by around 4%, due partly to the high importance of tourism in economic activity. The Bulgarian economy has rebounded robustly in 2021 and 2022, with growth rates of 7.6% and 3.4% respectively, but Scope expects a slowdown in growth to around 1.6% in 2023.

Core variable scorecard (CVS) and qualitative scorecard (QS)

Scope’s core variable scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative credit rating of ‘bbb+’. The methodology allows the qualitative scorecard (QS) to adjust the indicative ratings by up to three notches, depending on the size of relative credit strengths or weaknesses versus peers based on analysts’ qualitative analysis.

For Bulgaria, the following relative credit strengths have been identified via the QS: i) growth potential of the economy; and ii) external debt structure. The following relative credit weaknesses have been identified in the QS: i) monetary policy framework; ii) social factors; and iii) governance factors.

Combined relative credit strengths and weaknesses identified in the QS result in a positive adjustment of zero rating notches. This indicates a sovereign credit rating of BBB+ for Bulgaria.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues in its ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a significant 25% weighting under the quantitative model (CVS).

On aggregate, Bulgaria’s performance on ESG-relevant factors is relatively weak.

Environmental factors are explicitly considered in the ratings process via the environmental sub-category under the ESG sovereign risk pillar. Here, the CVS considers Bulgaria’s comparatively high level of carbon emissions per unit of GDP and greenhouse gas emissions per capita. However, risk to Bulgaria’s sovereign ratings from exposure to natural disasters is low as evaluated via the United Nations University’s World Risk Index, although climate-change-related weather events such as droughts and floods do pose risks. Finally, Bulgaria has strong scores compared with ratings group peers on the ecological footprint of its consumption compared with available biocapacity. Bulgaria’s economy is the EU’s most energy-intensive, and Bulgaria’s energy mix is relatively reliant on fossil fuels (63%), with nuclear (22%) and renewables (15%) as the main other energy sources. Coal is heavily used in electricity generation, with a key deliverable being a plan to phase-put coal, which would support a reduction in CO2 emissions from the energy sector. In addition to risks captured under the CVS, environmental factors are also considered under the QS, under which Scope has assigned an evaluation of ‘weak’ against Bulgaria’s sovereign peer group.

Socially-related factors are captured under Scope’s sovereign methodology in the CVS via the accounting of Bulgaria’s average labour force participation (73.7% in Q1 2023, recovering from Q1 2020 lows of 71.4%), but comparatively high level of income inequality. Bulgaria’s old-age dependency ratio compares weakly against that of sovereign peers. Robust economic growth since Bulgaria’s 2007 accession to the EU (2.5% over 2007-19, compared with an EU average of 1.0% during the same period) has advanced income convergence and reduced levels of unemployment. However, faster convergence towards EU average incomes requires acceleration in areas of reform given significant demographic bottlenecks – this could include action in priorities such as infrastructure, education and health care as well as addressing labour-market shortages. Social factors are also considered in the QS evaluation with an assessment of ‘weak’ on ‘Social factors’.

Under governance-related factors, Bulgaria has relatively low scores on a composite index of six World Bank Worldwide Governance Indicators. Governance considerations include a high turnover of governments in recent years, with five elections between 2021-23. Frequent government turnover has hampered reform momentum crucial for tackling medium- to long-term challenges and in advancing euro area accession. Scope evaluates ‘Governance factors’ in the QS as ‘weak’ compared with Bulgaria’s indicative sovereign peer group.

Rating committee
The main points discussed by the Rating Committee were: i) euro area accession progress; ii) political developments, iii) economic outlook, iv) fiscal outlook; v) financial sector performance; vi) external sector developments; vii) ESG consideration; and viii) peers.

Methodology
The methodology used for these Credit Ratings and Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and Outlook is (Core Variable Scorecard Model Version 2.1), available in Scope Ratings’ list of models, published under https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Rating(s) if the Credit Rating(s) were to change within the next 12 to 18 months. 

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party participation     NO
With access to internal documents                                  NO
With access to management                                           NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and Outlooks and the principal grounds on which the Credit Ratings and Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Julian Zimmermann, Associate Director
Person responsible for approval of the Credit Ratings: Alvise Lennkh-Yunus, Executive Director
The Credit Ratings/Outlook were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 18 June 2021.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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