ECR: Bulgaria is next in line for a downgrade

The term ‘bond market vigilantes’ has been used regularly in recent years to describe those investors who inflict high interest rates upon European governments struggling with high levels of public debt.

But while bond markets are up in arms about the contingent liabilities of Greek, Irish and Portuguese sovereigns, high-risk Bulgaria appears to have slipped off their radar.

“Bulgarian sovereigns are our biggest European ‘Sell’,” says Gabriel Sterne, an economist at Exotix, a frontier market brokerage. “Spreads are quite astonishingly narrow.”

Despite the country’s large exposure to Greece’s banking sector, the spread for Bulgaria’s 8.25% 13-year sovereign maturing in February 2015 is less than 200 bps over a US dollar benchmark. By contrast, Greece, Portugal and Ireland have each seen yields on government debt rise to record levels in recent weeks.

Greek banks invested heavily in Bulgaria before the crisis and have a 26% market share. Total claims by Greek banks on Bulgarian assets are equivalent to 37% of 2009 GDP, according to the Bank for International Settlements. Standard & Poor’s, Moody’s and Fitch have all maintained their investment grade ratings of Bulgarian public debt, despite Greece being downgraded to B1 by Moody’s earlier this month. “The Credit rating agencies were way behind the curve on Greece and they are behind it again on Bulgaria,” commented Sterne.

Bulgaria’s low public debt burden (under 20% of GDP) appears to have satisfied both the market and the ratings agencies of its creditworthiness. The country has also made good progress curbing its fiscal deficit (4% of GDP in 2010) since the global financial crisis.

The economy is expected to grow by 2-2.5% in 2011, according to the IMF. Strong macro-prudential policies in the banking sector, (18% capital adequacy, 7% NPL ratio) won praise from the IMF delegation that visited Sofia last October.

But these figures mask some potentially devastating risks within the Bulgarian economy. The country’s indebted private sector borrowed heavily before the crisis. As a result, Bulgaria’s total external debt was over 100% of GDP in 2009. Bulgaria’s bloated banking sector is bigger than the real economy, meaning that the sovereign would have significant contingent liabilities should Bulgarian banks require a bailout. Like Hungary, Bulgarian corporates borrowed heavily in foreign currencies. Foreign currency loans to the private sector have now reached 44% of GDP as a result. Worryingly, Bulgaria has relaxed its bad loan classification markedly (IMF June 2010 country report, page 57) since the crisis began.

“The IMF’s growth forecast is long on baseline, short on risk,” comments Sterne. “It does not take into account the very real threat of a large-scale insolvency crisis in the Greek banking sector, which could put Bulgarian banks under severe pressure.” Bulgaria’s fixed exchange rate with the euro could also come under threat in the event of a banking crisis in the wider region.

Bulgaria’s foreign currency debt is still rated Baa3 by Moody’s, BBB by S&P and BBB- by Fitch. The Republic of Panama has the same rating from each agency, despite lying 17 places above Bulgaria in the official Euromoney Country Risk rankings.

Bulgaria is not the only country in southern Europe with a dubious investment grade rating. Both Croatia and Romania are rated Baa3 by Moody’s, despite Romania’s weak banking sector and Croatia’s heavily indebted private sector. However, Bulgaria’s susceptibility to a Greek financial meltdown means that it in the event of a crisis it may well be first in the firing line of the ratings agencies and, more importantly, the markets.