Is a lot of liquidity a good thing... or not? How is the banking system in Bulgaria doing?

It recently became clear that the country's economy continues to slow down its growth and even contracted by 0.2% in the second quarter on an annual basis due to still suppressed private consumption, a negative contribution from inventories and another contraction in capital formation (investment).[1] However, how this affects the banking sector, why savings are growing and what is the foundation behind the negative trend in profits in the sector is yet to be examined in this text.

The benefits of increasing savings at the macro level are numerous, but in the most general case they are necessary for the cherished investments in an economy to exist. First someone needs to save and then someone needs to invest. The logic is shockingly simple, but strangely enough – often overlooked.

During the boom in most developed economies (for example, the US), investment reached new and new heights, while the saving rate remained suppressed due to record high levels of consumption. The key to this is that the shortage of investment funds has to be filled from “somewhere”, and there are usually two channels – quantitative stimuli through the effect of the multiplication of the monetary base or foreign investment, which is very likely to have swelled through the first channel. Whichever of the two options we choose, the result is clear – a unique boom at some future moment. This system is simply extremely unsustainable, since it is based mainly on positive expectations for the future on the part of economic participants, who, as the last crisis showed, are often misled by low interest rates artificially pushed by central banks.

On the other hand, the full coverage of investment funds by savings, whether domestic or foreign, is a completely sustainable system, which is also embedded in the main function of the financial sector – to act as an intermediary that provides funds from savers to borrowers in a more effective (meaning providing lower transaction costs) and more efficient way (meaning faster and more correctly directing funds to the less risky borrower). Therefore, under these conditions, we can apply a simple rule – the more we save, the more we will invest, increasing the potential growth of the economy in the long run.

And hopefully, but unlikely – the key to this rule is the so-called “ceteris paribus” condition (other things being equal). To achieve such an end effect, the continuous existence of the right incentives through several channels is necessary:

- households' desire to save;

- interest on the part of the financial sector to finance individual investors;

- and finally - the benefit to potential borrowers from the investments in question.

If one of these feathers cracks, the ultimate effect of sustainable investment growth is likely to be lost (or at least slowed) somewhere along the way. The problem in Bulgaria is that the shaky economic environment strongly stimulated the first feather, but seriously shook the other two – the demand and supply of investment funds in the market between banks and borrowers[2]. Let’s look at what exactly happened in recent years.

The recession in Bulgaria, which began in early 2009, triggered a number of curious processes, but the strongly increased propensity to save seemed to stand out among the most significant. Non-bank deposits grew by 43.1% since the end of January 2009, maintaining double-digit annual growth rates for the period June 2011 – July 2012[3]. Even the highly controversial “interest tax” failed to shake the propensity to save in the economy and led to a net redirection to demand deposits, current accounts and, to some extent, investment funds. This entire process significantly improved the liquidity of the banking sector, providing fresh capital ready to flow into investment projects.

Then where is the problem?

The liquidity provided still comes at a price (interest rates, albeit falling), and the lending situation is far bleaker, completely in line with the deteriorating dynamics of the economy. The main part of the banks’ profit, both now and during the initial beginnings of usury, comes from the difference between the interest rates on deposits and those on loans. However, when the growth of deposits significantly outpaces that of the credit base, the situation for banks worsens. Moreover, in parallel with this process, in Bulgaria, bad and restructured loans in the private sector – those in which banks accumulate partial or full losses – began to grow strongly and reached just over 23% of all loans by the end of July 2013.[4] For comparison – their share amounted to nearly 4% at the beginning of 2009. All this led to an increase in expenses and a contraction in interest income – i.e. negative downward trend in net interest income in the banking sector (Chart 1).

Chart 1. Annual rates of change in deposits, loans and net interest income

Source: BNB

The banking system's reports for July showed a slight awakening and a 5.7% growth on an annual basis in loans provided. But let's not rush to positive conclusions. The data were far from confirmed by the BNB's monetary statistics for the same period and we are probably talking about an increase in lending to foreigners. Obviously, the private sector in Bulgaria is still in the process of waiting and cutting costs in the conditions of a stagnant economy. Banks, for their part, will probably continue to tighten their requirements for potential borrowers, limiting their financing strictly to the most promising projects in the short term.

Another blow to the private sector has been the uncertainty among the political elite. The new “triple” coalition is increasingly outlining its policy of “day-to-day” survival, in conditions where declaring long-term goals is starting to look increasingly absurd and unlikely. In fact, the latest Global Competitiveness Index report[5], published in early September this year, ranks for the first time the deteriorating political situation as a major obstacle to business, along with difficult access to financing and corrupt practices in the country.

Is there a way out?

Of course, it is probably much easier to find than most of us would assume. Whether it is achievable in the conditions of an increasingly “socializing” environment in which we currently operate is far more difficult to predict. Like any developing economy, Bulgaria has faced the need for ongoing structural changes, which seemingly emerged out of nowhere at the moment when external interest sank somewhere in the problems of the eurozone, and growth sharply slowed down. These structural difficulties are, for example, the inefficient education and pension systems, the deepening mismatch between skills in demand and supply on the labor market, the subsequent high levels of unemployment, an ineffective institutional environment, etc.

The solutions are more than clear, but they certainly do not go through the planned increase in the minimum wage by the BSP, nor do they include a massive increase in direct social transfers and accumulation of government debt, and even less do they cover postponing reforms in the energy market and maintaining monopoly structures in the country. And as long as the status quo and the lack of common sense among the political elite remain on the agenda, our tendency to save will increase. In turn, the financial system will continue to distort its traditional function as an intermediary to the private sector, orienting itself towards lower-risk, but low-yielding government securities, significantly reducing its profits.

Did you like it? Take a minute to support the EKIP on Patreon!