Study on the economic outlook for Bulgaria. Topics cover: growth scenarios for 2009-2010, the immediate challenges faced by the new government, and how Bulgaria (and Central and Eastern Europe in general) will have to reinvent its growth model after the recovery.

1. Bulgaria - Economic Outlook
July 16, 2009

2. Bulgaria is in a midst of a heavy recession, brought about by a severe drop in capital formation and
exports – due to the adverse environment globally, and especially the European Union (EU)
BASE SCENARIO – HARD LANDING
Key issues of adjustment Adjustment of key economic indicators
• The main priority is to keep a healthy GDP growth
level of foreign exchange reserves and %
preserve the stability of the currency 6.3 6.6
6.0 - 9.8%
board until a reasonable exit strategy is
found
• The economy is in a recession, as a
result of a lower rate of capital formation
and plummeting exports due to worse 0.4
conditions globally
• On the positive side, the government’s 2006 2007 2008 2009F 2010F
zero short-term debt provides room to
maneuver. However, falling budget
revenues increase the risk of a budget -3.8
deficit that would undermine the
Gross capital formation Budget surplus
country’s financial system
% of GDP % of GDP
• The current account (CA) deficit is
contracting quickly, as expected – a 38 3.9
more dramatic reduction would
inevitably be accompanied by a severe 25
recession
• The high levels of private sector short- 0.5
term debt increase rollover risk - risk
mitigated by the sound banking sector
2008 2009F 2008 2009F
Source: Oriens analysis, EUROSTAT, BNB 1

3. The new global environment influences Central and Eastern Europe (CEE) and the Bulgarian economy
through two main channels: decreasing external demand and severe shortage of external funding No effect
Significant effect
DIRECT EFFECTS OF THE NEW GLOBAL ENVIRONMENT ON THE CEE ECONOMIES
Consumption
Consumption Investment
Investment Government
Government Net export
Net export
Funding
Squeeze
Decreasing
External
Demand
• The age of cheap funding and growing demand globally is over, with
overwhelming consequences on all growth factors in the economy
• CEE economies, including Bulgaria, have been growing as a result of the
unprecedented growth of money supply in the developed world, and now
are particularly exposed to the changing global environment
Source: Oriens analysis

4. Even after EU-15 countries return to growth, inflow of capital to the region will not happen on a pre-
crisis scale – for the Bulgarian economy, which is highly dependent on FDI, this would mean
diminished growth prospects in the subsequent period
GROWTH IN TIMES OF RESTRICTED FUNDING
Real GDP growth, 2009F
%
Funding squeeze in perspective
20
• Bulgaria’s growth model is strongly FDI/GDP
dependent on the inflow of foreign
funds, thereby making FDI a more 16
important contributor to growth
than exports
• However, finance will be hard to 12
get in the years to come, which
inevitably lowers Bulgaria’s growth 8
prospects
• The likely growth rate of Bulgaria
will be lower than what we 4
experienced in the past decade
0
Source: Oriens analysis

5. The next government in Bulgaria will have to face some immediate and daunting tasks: figure out what
to do with the currency board and handle the budget deficit issue; after that, the country’s long-term
growth model will have to be rethought
KEY POLICY CHALLENGES
Key Challenges For New Government
• Handle the • Find a sensible • Rethink Bulgaria’s
consequences of the strategy to exit the growth model after
recession, currency board, the end of the golden
deteriorating budget having in mind that a years of growth led by
figures, secure help real depreciation the influx of cheap
from international could be necessary to foreign funding
finance institutions restore
competitiveness
A strong and legitimate government is fundamental for Bulgaria’s economic
return to growth
Source: Oriens analysis 4

6. However, the key policy challenge is in the growth model of the country – so far heavily reliant on
inflow of foreign funds, the economy needs to find a way to boost productivity to stay on a path of EU
economic convergence
BULGARIA – LONG-TERM GROWTH MODEL
New growth model
Productivity growth
• Bulgaria can grow through increased
• Boosting productivity by increasing productivity, for which there are several obvious
energy efficiency, better growth reserves (e.g. energy efficiency)
infrastructure, improvements in • However, most of the measures to boost growth
labour productivity would require sufficient capital – a challenge in
• Efficient allocation of capital, an age of scarce funding
increase competition, and support • With strong political will, Bulgaria could achieve
knowledge spillover through a significant effect by preserving stability, and at
dismantling oligopolistic markets the same time improving institutions, crack
down on oligopolies that fetter competition and
knowledge spillover
Attract capital
• A failure to do so would diminish further capital
• Ensure stability flows to the country; even guaranteed sources
• Improve institutional quality of capital, such as EU funds, might have
• Capitalise on real assets adverse consequences on the economy
Source: Oriens analysis 5

7. Bulgaria’s level of labour productivity is the lowest in the whole EU, and its increase has been relatively
modest in the past 5-7 years. Bulgaria was far more successful in bridging the GDP-gap but the
country’s continued growth depends on a substantial increase in productivity
IMPORTANCE OF PRODUCTIVITY GROWTH
Productivity per person employed Labour productivity and GDP in Bulgaria, 2002-2008
EU-27=100 EU-27=100
GDP 40
110 Labour productivity
100 102
37
36
79
74 72 34 34
33
58
48 31
30
36
EU- EU- GR SK HU CZ MK RO BG 2002 2004 2006 2008
27 15
Source: Oriens analysis, EUROSTAT 6

8. Increasing energy efficiency is one example of growth reserves hidden in the economy – bringing down
the energy intensity of the country to levels closer to its peers would save around EUR 1.5 billion.
However, the lack of funding might present a significant obstacle to its realisation
EXAMPLE OF GROWTH RESERVES - ENERGY EFFICIENCY
Gross inland consumption of energy/GDP
kg of oil equivalent per EUR 1,000
1016
• Bulgaria is the least
656 energy-efficient country
553 539 in the EU, far behind its
closest peers
401 400 • The growth reserve
336 307 hidden in increasing
253 251 energy efficiency is to
165 152 182 EUR 1.5-2 billion
• This growth reserve
could be realised in 3-5
years – however, tight
EU- EU- BG RO CZ SK HU PL CR LV SI TR GR funding represents a
27 15 serious bottleneck
EUR 1.5
Estimated growth reserve
billion
Source: Oriens analysis, EUROSTAT 7

9. EU funds are considered an important source of funding that could lift productivity and economic
growth. However, if not allocated wisely, and without the adequate institutional background, they could
actually make things even worse – the so-called ‘Dutch disease’
THE ROLE OF EU FUNDS
Re-allocation of resources
• Inefficient allocation of resources -
investment, labour, raw materials, Effect on real economy
etc. are sucked up by sectors that
benefit from the inflow of funds, at • Despite being touted as an important growth
the expense of those who don’t factor for Bulgaria, EU funds might actually
worsen the country’s competitiveness, the so-
called ‘Dutch disease’
Inflow of funds
• If not spent wisely, EU funds could damage the
Spending increase country’s international competitiveness through
misallocation of resources and deteriorating terms
• In the case of Bulgaria’s fixed
of trade
exchange rate, increasing demand
• Ideally, EU funds would be directed towards
for non-traded goods and services
sectors that increase competitiveness of the
would drive up inflation and
traded sectors
adversely affect the country’s
terms of trade
Source: Oriens analysis 8

10. At the end of the day, Bulgaria’s continued growth is conditional upon its ability to bring about a
discernible change in institutional quality. If the government is unable to improve institutions, the
economy will falter at the level of GDP/capita of around USD 15,000
THE LINK BETWEEN INSTITUTIONAL QUALITY AND GDP GROWTH
GDP/Capita,
PPP
High USD 15,000
GR
• There is a strong correlation
SK CZ between institutional quality
HU and GDP/capita
BG CR • USD 15,000 represents a
RO threshold after which growth
TR becomes even more dependent
SR
on institutional quality
• Bulgaria is close to the point
after which the country would
stagnate unless it gradually
improved institutional quality
Low
Institutional
quality
Low High
Source: Oriens analysis, WBI Worldwide Governance Indicators, IMF 9