By Levon Kameryan, Associate Director, Sovereign Ratings

The outcome of the election is as much a test for the country’s leading political parties as it is for the EU in confronting the impact of Russia’s divisive energy policies for the region.

Bulgaria (rated BBB+/Stable) is not only a stark example of the energy-related political and economic challenges facing Europe but also a special case because of the country’s historical ties with Russia and scale of its reliance on Russian energy. Russia supplied almost all the country’s gas before Gazprom halted deliveries in April after the government in Sofia refused to pay in rouble.

The country’s particular relationship with Russia was highlighted in the vote on 2 October – the fourth in under two years – with a rise of support for far-right and pro-Russian political groups. The pro-Russian Revival party more than doubled its share of the vote compared with the previous election, to come in fourth with 10.2%.

Former prime minister Boyko Borisov’s centre-right GERB-UDF coalition, despite a serious of corruption scandals, received 25.3% of the vote, ahead of its rival We Continue the Change movement (20.2%) that led the last government before losing a vote of no confidence in June.

Political fragmentation, irreconcilable differences over Russia cloud outlook

One risk is that parties will again fail to yield a stable new government and reforms could take a backseat, with possibility that only another early election could break the deadlock, extending political instability into next year.

Another is that the prospect of negotiations with Russia for resumed gas deliveries to secure supplies for the winter will become the dividing line between parties, making it harder to agree around institutional reforms Bulgaria needs to ensure smooth adoption of the euro in the medium term and the goodwill of other EU member states.

Helping Bulgaria wean itself off Russian energy exports is far from an insurmountable problem for the EU given the country’s modest energy needs (annual gas consumption of only 3bcm) compared with those of bigger economies in central and eastern Europe and given recent opening of a new gas pipeline between Greece and Bulgaria.

What is crucial is that the EU is providing ample financial support for Bulgaria, which has access to EUR 6.3bn in grant monies (nearly 10% of GDP) under the EU Recovery and Resilience Facility, subject to reform implementation.

The catch is Bulgaria’s weak track record in putting EU funds to work given institutional constraints and political instability. Bulgaria’s absorption rate of 2014-2020 European Structural and Investment Funds was 65% as of June 2022, below an average of 70% for central and eastern European EU member states.

Reforms vital for improving growth potential, securing euro-area membership

This underscores the importance of having a stable, reform-minded government in place in Sofia given increasingly difficult economic conditions, notwithstanding the country’s robust budgetary room to provide support for households and business in the future.

We forecast Bulgaria’s economy will grow 2.9% in 2022, compared with our estimate of medium-run potential growth of 2.5%-3%, the latter held back by supply-side bottlenecks, among them a working-age population projected to decline around 1% annually this decade. We see inflation averaging above 11% this year.

The outgoing government of Kiril Petkov’s We Continue the Change party initiated reforms to improve economic planning and the rule of law, supporting Bulgaria’s euro-area accession deadline of 2024.

Joining the euro area would enhance several rating-relevant areas for Bulgaria – take our recent upgrade of Croatia’s credit ratings as an example – by enabling Bulgaria to issue debt in a reserve currency that is also its national currency, curtailing foreign-currency risk and bolstering institutional capacities.

The challenge now is to form a stable new government with a clear mandate to act on those commitments and to meet common EU objectives including reform of the judiciary, tackling of corruption, diversification of energy sources and advancement of green transition. Failure to do so could materially delay the relevant timetable for euro-area accession with potential negative repercussions for Bulgaria’s macroeconomic outlook.