Annual inflation in Bulgaria for May 2023 (10.1%) is still almost double the euro area average (6.1%), despite the fixed exchange rate of the Bulgarian lev against the euro. Key factors include insufficient stimulus packages, labour market dynamics, rising house prices, energy and food prices and changes in the global supply chain in recent years. Continued inflationary pressures make it unlikely that inflation will return to pre-pandemic levels and it is likely to stabilize around 5%. In the short term, high inflation is undoubtedly a major obstacle to euro adoption.
In May 2023, the monthly inflation rate is 0.1% compared to the previous month and the annual inflation rate is 10.1% compared to April 2022. Inflation is expected to continue declining, but to remain [close to] double the euro area average on an annual basis. In September 2022, the consumer price index in Bulgaria peaked at 18.7% y-o-y - around the same time as in other CEE countries.
Since then, a gradual decline has started to take place, but given persistent inflationary pressures, inflation is unlikely to return to the pre-Covid pandemic levels of 2-4%. "At iBanFirst, we believe that the Harmonised Index of Consumer Prices (HICP) used for comparison in Europe will reach around 8% in 2023 (8.6% in May 2023). Although inflation is clearly on a downward trend, mostly due to base effects, we think the 2024 market forecast of 4.4% is unlikely to be achieved. Inflation is likely to remain higher for longer, with much greater volatility than before the Covid-19 pandemic," says Mr. Bekyarov.
This is not the first time that Bulgaria is going through a high inflation regime. That already happened in the 1990s. At that time, variation in the exchange rate (balance of payment approach) played a significant role in explaining high inflation. This is not the case anymore. Since 1997, the currency board arrangement has successfully managed to peg the Bulgarian lev to the euro at a fixed FX rate of 1.95583 BGN/EUR. This has remained unchanged since then and we have strong confidence that it can be preserved in the medium term until the country is able to adopt the euro currency. Major changes in the rate of growth of the money supply in the economy are often blamed for large swings in inflation (this is the common monetarist view). But this appears to be insignificant, as it was already the case in the 1990s.
Inflationary versus disinflationary forces
The current high inflation regime and the higher levels reached compared to the euro area are mostly explained by five factors:
· Countries which managed to mitigate the post-lockdown and energy crisis inflation, such as Malta and France, which are both EU countries with the lowest inflation figures, implemented in very early stages large stimulus packages aimed at consumers and/or companies to lower the effect of high inflation. The first package, followed by two others of similar scale, was presented in September 2021 in France, for instance. The ability to react quickly and with a sufficient financial package is the main differentiating factor between EU countries that have succeeded in limiting the rise in inflation and those where inflation has simply exploded. On that specific point, Bulgaria was quite late to the party with stimulus measures that were comparatively too weak and too late, partly due to political instability. In our view, this largely explains why inflation has been out of control in the country since 2021.
· Other factors play a role, of course. The labor market dynamics favor higher wages (second-round effect inflation). Bulgaria’s labor market is one of the most unbalanced in the CEE region with a fast-shrinking workforce due to population ageing, a low birth rate, high mortality (this is a differential factor) and emigration. This is one example of unbalances among many others: the employment rate is over 90% among workers with tertiary education but it is only at 42% among those with only lower secondary education. All of this created a perfect cocktail for robust wage growth – thus resulting in more entrenched inflation than in Western Europe where wage inflation has remained rather limited.
· Housing prices are booming. This is a factor common to several EU countries (the Netherlands are an extreme example of that). In Bulgaria, national housing prices have steadily increased since the Global Financial Crisis (in 2009, prices dropped 26%!). It was up 13.3% in Q4 2022 after a cycle peak at 15.6 % in Q3 2022 (latest data available). This is a bold call to say we are facing a speculative bubble. Probably not. But we certainly have reached pain-level and this is also fueling substantial inflation and second-round effect.
· Without surprise, Bulgaria has also been hit by the global surge in energy and food prices. But sometimes in larger proportions than other EU countries. The current energy mix is one of the weakest points of the country. Nuclear power produces 36% of the country’s power – this is very positive. But all the remaining is produced from fossil fuels (coal, oil and gas) which are basically all imported since there is no domestic supply. While fossil fuels have been in a free fall since the beginning of the year (Brent crude -39%, Gasoline -42%, WTI crude -42%, heating oil -45%, natural gas -75%), they played a major role in the first phase of the inflation crisis in 2021-22.
· Global supply chain disruptions, especially higher freight rates which played a major role as the country is a net importer of many goods and merchandise. During the period 2021-22, freight rates exploded globally. Due to overcapacity and lower global demand, they are now falling sharply. Freight rates between China and Europe are down almost 80 % year-on-year. What was an inflationary factor one year ago has become a disinflationary factor. But we are not back to pre-Covid levels, however. On average, freight rates are still 20 % higher than in 2019, mostly due to higher operating costs.
Higher average inflation than before the Covid crisis
“The path is clear, though no eyes can see”. These are lyrics from the song “Firth of Fifth” of the English rock band Genesis (1973). According to Mr Bekyarov, these words sum up well the current situation on the inflation front. “We know that inflation is receding (there are several disinflationary forces like freight rates, lower global demand, China exporting deflation and energy prices collapse). But we don’t know the speed of the disinflation process.” he says. Inflation data are expected to remain unusually volatile for a long time. It is currently unclear at what levels inflation will stabilise. Central banks maintain their view that inflation will eventually return to target levels, but this may prove to be an overly optimistic view. The iBanFirst expectation is that inflation is likely to stabilise around 4% in the US, 3% in the euro area and around 5% in Bulgaria. This will have serious implications in the long run, especially in terms of a gradual loss of purchasing power. This means that we will have to adapt to 5% annual inflation, which is no easy task. In the short term, high inflation is undoubtedly a major obstacle to the adoption of the euro.