Recent Economic Developments and Statistical Appendix

This paper reviews economic developments in Bulgaria during 1990–97. Bulgaria’s macroeconomic performance during 1990–97 was weaker than in most transition countries in the region. With economic activity declining significantly during most years, the cumulative fall in real output over this period amounted to 37 percent. Although Bulgaria’s difficult initial conditions and adverse external shocks played a role, the weak performance mainly reflected the stop-and-go nature of stabilization policies and the slow pace of structural reform.


This paper reviews economic developments in Bulgaria during 1990–97. Bulgaria’s macroeconomic performance during 1990–97 was weaker than in most transition countries in the region. With economic activity declining significantly during most years, the cumulative fall in real output over this period amounted to 37 percent. Although Bulgaria’s difficult initial conditions and adverse external shocks played a role, the weak performance mainly reflected the stop-and-go nature of stabilization policies and the slow pace of structural reform.

Bulgaria: Basic Data

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I. Introduction

1. Bulgaria’s macroeconomic performance during 1990-97 was weaker than in most transition countries in the region (Figures 1 and 2 and Tables 17 and 18). With economic activity declining significantly during most years, the cumulative fall in real output over this period amounted to 37 percent. As a result, Bulgaria’s per capita GDP remains far behind that of most of its peers in central and eastern Europe. The inflation outcomes have been equally disappointing as the 12-month CPI increase was in high double or triple digits virtually throughout the period.

Figure 1.
Figure 1.

Bulgaria: Selected Economic Indicators

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Sources: Bulgarian authorities; and staff estimates.1/ Excluding deferrals of Interest due to the London Club.

2. Although Bulgaria’s difficult initial conditions and adverse external shocks played a role, the weak performance mainly reflected the stop-and-go nature of stabilization policies and the slow pace of structural reform. Already in the second half of the 1980s, Bulgaria had been living beyond its means, financed by massive external borrowing from official and private sources. Throughout most of the 1990s, dealing with the ensuing debt burden, the disruption associated with the start of the transition, the collapse of CMEA markets, and the effects of the Gulf and Yugoslav crises proved too much for a succession of fractured and half-heartedly reform-minded governments. To be sure, there were fitful attempts at stabilization, but these were unsuccessful owing to lack of persistence with structural reform. In particular, the failure to establish market-oriented discipline at the microeconomic level fostered a soft-budget constraint, rent-seeking culture that repeatedly fed back onto the public finances and destabilized the situation further. Meanwhile, time was bought on the external side through a debt moratorium and rescheduling, and on the internal side through the continued depletion of the country’s capital stock as the assets and profits of state-owned enterprises and banks were being stripped by vested interest groups and, in some cases, criminal elements.

3. Bulgaria’s economic problems culminated in a severe banking and foreign exchange crisis in 1996 and early 1997. A last-ditch attempt at stabilization and reform was made in the summer of 1996. As before, a money-based approach was chosen because Bulgaria’s official reserves were deemed insufficient and its banking sector too weak to support the exchange rate as a nominal anchor. The country’s poor track record in policy implementation also made significant up-front external financing unavailable. In the event, the adjustment program aimed at stabilization and jumpstarting structural reforms was derailed in a few months owing to delays in the implementation of enterprise restructuring and a loss of confidence in the banking system. The ensuing sharp increase in interest rates proved fiscally unsustainable and could not halt the collapse of money demand and rapid capital flight. Increasing social tensions led to the fall of the government in December 1996. In the subsequent political stalemate a full-blown economic crisis erupted, culminating in February 1997 with a collapse of output, a rapidly depreciating lev, and a monthly inflation rate of 240 percent, which wiped out the savings of a significant proportion of the population.

Figure 2.
Figure 2.

Bulgaria: International Comparisons, 1997

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source: World Economic Outlook.Note: BGR, Bulgaria; CZE, Czech Republic; EST, Estonia; HUN, Hungary; LVA, Latvia; LTU, Lithuania; POL, Poland; ROM, Romania; SVK, Slovak Republic; and SVN, Slovenia.1/ Debt service for Hungary excludes prepayment of principal.

4. Since mid-1997, Bulgaria has implemented a stabilization strategy based on a currency board arrangement (CBA), so far with considerable success. Because of its severity, the 1996-97 crisis made the bankruptcy of past approaches to reform evident to all, and opened a window of opportunity for radical reforms. A complete regime change centered on a CBA was deemed necessary to restore confidence in public institutions and bestow credibility on monetary and fiscal policies and the commitment to deep-seated reform. With IMF support, a reformist government that emerged following the crisis put in place a CBA with effect from July 1, 1997, and started to implement a strategy that includes a cautious fiscal stance and accelerated structural reforms. The initial results were remarkable: confidence was restored quickly, real interest rates fell sharply, reducing the fiscal deficit to sustainable levels, and inflation declined dramatically. The low-inflation environment has continued through 1998, with the CPI increasing by just 1 percent during the year. As for economic activity, continued fiscal prudence and strong structural measures have by now firmly established the private sector as the main engine of growth. Although annual GDP continued to fall in 1997, by 7 percent, economic activity and incomes have been on an upward trend since mid-1997, and a significantly positive GDP growth rate is expected to be recorded in 1998, despite the adverse effects of the global crises. Thus, Bulgaria should be well placed for sustained rapid growth provided prudent fiscal policy continues to be coupled with forceful structural reforms.

5. This report covers the period since 1995, focussing on the main sectoral developments and policy initiatives. Developments through the mid-1990s were covered in Bulgaria: Recent Economic Developments (SM/95/306, December 11, 1995). The main topics discussed in this report are: developments in economic activity, labor markets, and inflation; progress in enterprise reform; fiscal issues and developments; social protection and other social sector issues; monetary developments; financial sector reform; and external sector developments.

II. Real Sector Developments

A. Overview

6. Since the mid-1990s, Bulgaria’s economic activity has been on a roller coaster. Following a period of relative macroeconomic stability in 1995, the economy slid into a devastating foreign exchange and banking crisis culminating in a collapse of output and hyperinflation in early 1997, before a still-continuing period of growth and low inflation started in mid-1997. Specifically, real GDP declined by 10.9 percent in 1996 and by about 18 percent (year on year) in the first half of 1997. A recovery started subsequently, but annual GDP fell by 6.9 percent nevertheless. The recovery continued in 1998, although the 12 percent growth rate in the first half of 1998 compared to the same period of 1997 was in part due to the low base. Throughout the period since 1995, agriculture has fared much better than industry and services, and growth in the emerging private sector has been more rapid than in the public sector. On the aggregate demand side, investment was particularly hard hit by the crisis. The income accounts show a significant but temporary decline in the share of labor compensation during the crisis, and substantial gains in the private sector’s share of total income generation from 1997 owing to the accelerated pace of privatization.

B. Components of GDP

Sectoral developments

7. A sharp fall in total industrial output between 1995 and 1998 masks a massive decline in the state-owned sector offset in part by a more than doubling of industrial output by the private sector. Real value added in industry declined by a cumulative 27 percent in 1995-97, with practically all branches of industry adversely affected (Tables 19 and 20). This was followed by a sharp recovery in the first half of 1998. The share of state-owned enterprises (SOEs) in industrial output has declined from 81 percent in 1994 to 60 percent in mid-1998, reflecting in part privatization and in part faster growth in private sector companies than in the SOEs. Overall, industry now accounts for less than 30 percent of GDP, down from about 40 percent at the beginning of the decade.

8. The performance of the services sector has been mixed (Tables 21 and 22). Communications and transportation have generally been growth sectors, while the crisis in 1996-97 seems to have caused a sharp decline in both retail and wholesale trade.1 The private sector has become dominant in trade and other services (including education, health, and financial services), but its share in communications has remained below 20 percent. As in industry, the private sector has generally outperformed the public sector. The first half of 1998 brought a strong increase in both gross output and value added, which, if sustained throughout the year would bring back GDP produced in the services sector to approximately the level of 1994. Total services now account for about half of GDP.

9. Output in agriculture has grown rapidly except for 1996 when excessive government intervention and bad weather caused a temporary setback (Tables 23-25). Both gross output and value added registered double-digit increases in 1995 and 1997. In contrast, agricultural output fell by percent in 1996 when excessive and misguided government micro management of agricultural demand and supply through price controls and large state interventions compounded the effect of adverse weather conditions (Box 1). Throughout 1995-98, private and public agriculture fared about equally well, reflecting important common determinants including the weather, the extent of government intervention in the price and trade systems, a market structure dominated by monopolies, the degree of trade protection, and lingering uncertainties related to land restitution. The share of agriculture in the economy is presently about 13 percent.

Expenditures, savings, and incomes

10. The severe downturn in output during 1996-97 mainly affected government consumption and investment (Table 17). Poor macroeconomic policies and the large external debt burden contributed to weak foreign investor interest, exacerbating the adverse effect on corporate investment of the increasingly inadequate levels of depreciation allowances.2 Under these circumstances, the observed negative real interest rates failed to spur investment activity. Household consumption held up relatively well during 1995-96 but fell sharply in 1997, followed by a rapid recovery in the first half of 1998. The decline in government consumption on the other hand was more pronounced in the first two years, leaving the share of total consumption in GDP remarkably stable at around 85 percent throughout 1995-98. Net exports remained positive after 1995 despite a 10 percent decline in export volume in 1996 owing to financing constraints and a massive, exchange rate-driven import compression in the first quarter of 1997. Export growth in 1997-98 was hampered by restrictive trade practices, and a lack of high quality export products owing to slow progress in enterprise restructuring.


By all indications, Bulgaria should have a strong comparative advantage in agriculture, but this potential has so far not been fully exploited. In 1995-97, agriculture continued to suffer from sluggish privatization and land restitution, and from a maze of government-imposed barriers to efficient resource allocation, including export taxes, high and selective import tariffs, an extensive ex ante licensing system inhibiting trade, price margin controls, and regulatory and institutional impediments to a functioning land market. A concentrated market structure with several large monopolies controlling the sectors upstream (for example, those providing seeds and fertilizers) and downstream (for example, grain storage and certain food processing industries) contributed to the poor performance. Structural reforms proceeded sluggishly owing to concerns about food security and opposition from vested interests. Thus, while the previous agricultural system based on large mechanized state-owned or cooperative units was largely eliminated, the way was not cleared for the emergence of efficient private production units. In 1996, government manipulation of the restrictive trade regime and of pervasive “monitored prices” coupled with regional droughts resulted in grossly distorted incentives, especially in grain production, leading to shortages. The government’s response to the shortage was to devise centrally controlled barter transactions involving Neftochim, the country’s largest refinery, but this only led to further distortions and severe losses for Neftochim. Through 1997, the agriculture sector continued to require large implicit subsidies, and to this day has not been able to attract substantial foreign investment.

The deep crisis of 1996-97 and the change of government had a salutary effect on agricultural reforms. The pace of privatization picked up, and by mid-1998 all 63 wine and brewing enterprises, and most SOEs in the canning, edible oil, and sugar sectors were privatized, as was 48 percent of state grain milling capacity and 43 percent of feed mill capacity. By end-1998, only about a third of grain storage capacity remained state property. In addition, the schedule for land restitution was accelerated, agricultural prices were largely liberalized, and export taxes were lowered. Finally, in order to provide an impetus to the emergence of a functioning market in land and enhance the role played by banks in rural finance, the legal framework for collateral was upgraded, and a focussed effort was launched to improve the process of land registration, set up a land cadastre, and put in place essential elements of a warehouse receipts system.

11. The relative stability !of domestic savings during 1995-1998 masked substantial movements in government and nongovernment savings (Table 1). The modest level of domestic savings (averaging 14 percent of GDP) reflected a lack of confidence in the banking system, low real income levels, and adverse demographic dynamics. The relative shares of government and nongovernment savings were affected by the increased profitability of SOEs during the high inflation period, sharp changes in real interest rates, and precautionary savings by the private sector in light of the crisis situation. The wide swings in budgetary interest expenditures also played an important role, since the non-government sector tended to save the inflationary component of ballooning interest payments, then dissaved as this component was eliminated following the CBA. A less than full, but substantial offset is in line with observations from a wide range of countries, lowering but not eliminating the effect of higher public savings on total savings.

Table 1.

Bulgaria: Government and Nongovernment Savings

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12. The growing weight of the private sector and large swings in the share of labor compensation have dominated recent developments in the income accounts (Table 27). The share of the private sector in gross value added has grown fourfold since 1991, and doubled since 1994. Following a sharp drop in 1996, the state sector’s share of employee compensation in gross value added has returned to historic highs at the expense of the gross operating surplus. Comparison with the share of private sector employee compensation in value added is complicated by a significant downward bias in wage statistics stemming from the widespread practice of private enterprises reporting only payment of compensation at the legally allowed minimum level.

C. Wages, Employment, and Labor Market

13. The relentless decline in real wages until 1997 serves as a stark example of the costs of delayed macroeconomic adjustment and reform. State sector real wages declined every year from 1993 through 1997, at double digit rates in most years.3 Despite a sizable increase in 1998, real wages in mid-1998 still remained almost 30 percent below the 1994 level (Table 28). The decline was broad based, the only exception being public utilities, where a massive increase granted by the government in 1997 restored the real wage to its 1994 level. Reliable wage data for the private sector are not available, but indirect evidence suggests that the economy-wide drop in real wages may have been smaller than suggested by public sector wage statistics. It should also be borne in mind that there were mitigating factors even in the case of state-sector workers, including substantial in-kind benefits, such as free or subsidized housing, heating, other utilities, and day care; social assistance; and unemployment benefits. In addition, an NSI survey on the hidden economy found that in 1996-97 unobserved economic activity accounted for supplementary income ranging from 40 to 80 percent of earned wages for employees in various sectors of the formal economy.

14. In contrast to the behavior of real wages, employment has been relatively stable since the mid-1990 (Table 29). Total employment increased marginally in 1995-96 following a strong downward trend in the first half of the 1990s, then declined by 4 percent in 1997. Employment in the public sector has been on a sharply declining trend, and in 1997 its share for the first time fell below that of the private sector. Reflecting the stability of employment, the unemployment rate has not fluctuated as much as might have been expected on the basis of the marked changes in output—since 1995 it has generally been in the 11-14 percent range, and ended 1998 at 12 percent.

15. These wage and employment developments were strongly influenced by institutional and structural factors. Bulgaria’s labor market is segmented into three distinct sectors. First, in the budgetary sector wages and employment are determined as part of the annual budget process. In recent years, efforts to contain the wage bill have been focussed primarily on keeping the nominal wage increases moderate rather than reducing employment, even though budgetary employment was cut by some 10 percent between 1996 and 1998. Second, the nonbudgetary public sector (SOEs) has throughout 1995-98 been subjected to a formal incomes policy, with a view to imposing financial discipline and harder budget constraints on SOEs (Box 2). While incomes policy has been only partially successful in fulfilling its objectives, it (together with control over budgetary sector wages through the annual budgets) has contributed to containing wage pressures and, from mid-1997, to avoiding an accumulation of large quasi-fiscal losses that could have undermined the CBA. Privatization has reduced employment in the SOEs significantly (this process has involved mainly medium- and small-scale enterprises, and by mid-1998 has yet to reach the most important flagships of Bulgarian industry; see section III.B), but many of the remaining SOEs have still been able to operate under rather soft budget constraints.4 Reflecting this, and given the various rigidities thwarting the reallocation of labor, output losses in these companies have seldom resulted in corresponding cuts in employment. Finally, there is an emerging private and hidden sector with highly flexible labor practices. This sector has absorbed much of the released labor, albeit at lower wages and with a loss of job security.

Incomes Policy for SOEs

Incomes policy has been aimed at addressing the lack of SOE financial discipline, a key problem in the Bulgarian economy during 1995-98. Without the discipline, loss making SOEs tend not to reduce their wage bills, opting for decapitalization and a buildup of arrears instead. Recognizing this, during much of the 1990s the government, representatives of SOEs, and trade unions have negotiated tripartite incomes policy agreements designed to maintain competitiveness while limiting real wage erosion by managing increases in the wage bill.

Recent incomes policy agreements have taken the form of constraints on the total wage bill. Focussing on the wage bill, rather than average wages has allowed SOEs to be flexible in setting their wage and employment levels, and trade off lower wages against changes in employment in periods when they incurred losses. Wage bill ceilings have been adjusted according to inflation, with explicit backward looking inflation indexation in 1995 and 1996 (reducing indexation to 70 percent in 1996). In 1997, adjustments were made based on inflation expectations, and indexation was completely abandoned in 1998. Instead, wage bill increases were tied to profitability and increases in productivity (defined as real sales per employee), encouraging better financial performance. In addition, SOEs performing well according to other criteria, for example not having arrears or reducing losses, could use a higher coefficient to increase their wage bills per percentage point increase in productivity. Poor-performing SOEs faced tighter limits, strengthening their budget constraints. In fact, the 1998 incomes policy precluded loss making SOEs that had reduced productivity from increasing their wage bills.

Incomes policy has so far been only partially successful, because a large share of SOEs have remained unconstrained, and weak performers often have not complied with the regulations. SOEs that had reported profits and were current on their payments obligations—some 40 percent of all the SOEs covered by the incomes policy in the first three quarters of 1998—were free to set their wage and employment levels. Enforcement was lax for the remaining SOEs, and various loopholes remained in the regulations including asymmetric adjustment coefficients with a bias against wage bill reduction, categorization based on quarterly (unaudited) enterprise accounts, and the lack of enforcement action on SOEs that had been privatized. Ministry of Labor incomes policy implementation data show that in the third quarter of 1998 SOEs that had diminishing losses (12.8 percent of all SOEs) were supposed to decrease their total wage bill on average around 3 percent during the quarter, but increased it by over 4 percent instead; and three SOEs accounting for a tenth of the total wage bill increased their wage bills by 6 percent despite a prescribed wage bill freeze. The government tightened enforcement and raised penalties on SOEs violating incomes policy regulations from mid-1998. Measures included firing 18 enterprise directors, improved monitoring of compliance and tighter control by tax administration. However, wage bill increases exceeding allowable limits that had already taken place were generally not reversed.

D. Inflation

16. Bulgaria’s poor growth performance through 1997 coincided with high and variable rates of inflation. 12-month CPI inflation had reached a transition-era trough of 33 percent in 1995, but then accelerated to 310 and 580 percent in the subsequent two years, peaking at 2,040 percent in March 1997 (Table 32). Despite the massive increase in the price level, some relative price distortions remain, owing to the monopoly position of large SOEs in energy, agriculture, heavy manufacturing, and other sectors; the remaining restrictive features of the foreign trade regime; and a sizable, albeit decreasing set of administered prices. The following prices remain regulated by the government from January 1, 1999: electricity, central heating, telephone services, postal services, cigarettes, coal, briquettes, and gas. The share of these items in the CPI is 13 percent.

17. The introduction of the CBA from July 1, 1997 quickly stopped inflation on its tracks. Remarkably, while the CPI increased close to 500 percent in the first half of 1997, the increase was limited to only 16 percent in the second half (Table 2). To be sure, average monthly inflation remained at 4 percent in the quarter immediately following the introduction of the currency board (driven by nominal depreciation against the U.S. dollar in July and August 1997, the lagged effects of earlier large increases in administered prices of energy, transport and telecommunications, and some, albeit rapidly declining, inertia in inflationary expectations), but it fell to under 1 percent in the fourth quarter of 1997. In 1998, end-period inflation came to a mere 1 percent, despite sharp administered price adjustments in September when coal and district heating prices were raised significantly, contributing to a monthly CPI increase of 3 percent. The factors contributing to the low inflation outcome included: an abundant harvest (which is important given that food items have more than a 50 percent weight in the CPI); appropriately tight fiscal policy; a drop in inflationary expectations5 owing to the currency peg; a decline in world commodity prices; and the reduced monopoly power of large SOEs owing to trade and price liberalization.6

Table 2.

Bulgaria: CPI During Six Months Preceding and Subsequent to the CBA

(End-period change in percent)

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18. Disaggregated and higher frequency data reveal important patterns. While inflation rates for the food, non-food, and services components of the CPI have shared the same underlying trend, the price of services has tended to grow at a faster pace during non-inflationary periods (Table 3). Turning to monthly data, inflation during 1995-97 in the service sector was characterized by sharp step increases owing to the large role played by administered prices which were adjusted in a discrete manner. During the crisis, administered prices failed to keep up with market prices, magnifying the pre-existing relative price misalignment while food and non-food inflation have been consistently lower than inflation in services since September 1997, reflecting a realignment of relative prices in part owing to the liberalization of administered prices.7 There was also a tendency for food and non-food inflation to move together, although food prices were more volatile since they were heavily influenced by seasonal factors and the abundance of the agricultural harvest. Owing to the high weight of foods in the CPI, the overall index also has displayed significant seasonality.

Table 3.

Bulgaria: Monthly Average Changes in the Main Components of CPI in Percent

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III. Enterprise Reform

19. Enterprise restructuring and the attainment of a competitive enterprise sector remain pivotal components of Bulgaria’s economic reforms. The period leading up to the crisis in 1996-97 was characterized by an inconsistent approach to reforms in the enterprise sector resulting from the lack of political commitment. Meager progress was thus made in economic restructuring, which was a key reason for the lackluster growth performance. Since the crisis, significant progress has been made, in particular in privatizing small- and medium-size enterprises. However, much remains to be done before financial discipline has been imposed on all economic agents. By end-1998, the privatization of large SOEs had hardly started, and the Isolation Program, the first systematic effort to impose financial discipline on SOEs, was still to be completed. Also, serious restructuring of the important energy sector was only in the initial stages.

A. Privatization

20. Until late 1996, progress in Bulgaria’s privatization was extremely slow. This phase included only short-lived bursts of increased activity, such as the one following the agreement with London Club creditors in late 1994, when for a short period debt-equity swaps at very advantageous terms for foreign buyers became possible. Several institutions were jointly designated to manage parts of the privatization process, including the Privatization Agency (PA), the Center for Mass Privatization (CMP), and the branch ministries. However, practically no progress was made in privatizing large enterprises in heavy industry, manufacturing, or infrastructure, although small-scale privatization proceeded, particularly in trade, tourism, and food processing. Apart from the lack of political will, the process was poorly coordinated, and there was little interest from foreign strategic investors, owing to the unstable macroeconomic situation and an inadequate legal framework (for example, legal issues related to restitution of property and SOE debt remained unresolved).

21. Increased awareness of the costs of slow privatization prompted the authorities to adopt a strengthened ownership transformation strategy from late 1996 onward. By this time, policymakers had recognized that delays in privatization were leading to a rapid loss in the value of state assets and contributed to growing subsidy needs. In addition, the worsening fiscal situation in 1996 had elevated the importance of increasing cash privatization receipts. In response, in the second half of 1996 the government reoriented its efforts toward privatizing large enterprises for cash. Following several large deals concluded through direct negotiations (including the Pirdop copper refinery, the Devnya cement plant, and Sodi Devnya, Bulgaria’s largets producer of soda ash), the government decided on a more systematic approach. The main channels for privatization were to be the sale of major enterprises to strategic buyers with the assistance of privatization consultants (the PATA program), 1 the sale of groups of large enterprises with similar profiles (pools),2 the sale of smaller enterprises through auctions organized by supervising ministries, and from September 1997, with the reopening of the Bulgaria Stock Exchange Sofia (BSE), the sale of packets of shares on the BSE. Potential buyers included Bulgarian and foreign entities, including local pension funds and manager-employee buyout (MEBO) teams. In each case, the PA or the branch ministry determined the portion of the enterprise—typically less than 100 percent—to be sold through the various channels.

22. Under the new strategy, progress in removing enterprises from the public sector has been uneven. A number of large transactions were completed in 1997, lifting privatization proceeds to the budget to some US$340 million, and ministries began a steady flow of small SOE divestitures through the sale of enterprises, individual assets and in selected cases through entering enterprises into liquidation proceedings. Measured by the number of transactions concluded, 1998 saw a further acceleration. However, few large deals were closed in 1998, and privatization receipts to the budget fell to about US$150 million. The somewhat disappointing outcome reflected legal obstacles, reduced foreign investor interest in the wake of the Asian and Russian crises, and the difficulty of privatizing large chemical and steel plants against the background of falling commodity prices on the world market. Also, contrary to expectations, none of the PATAs completed the privatization process for their respective SOEs during 1998. The reasons included frictions with the Privatization Agency (which preferred a meticulous hands-on approach), incentive problems stemming from early PATA contracts specifying a stream of payments throughout the process, and legal red tape.3 Moreover, the BSE did not play a significant role in privatization.

23. The encouraging number of transactions notwithstanding, the quality of privatization leaves something to be desired. The authorities have so far seen privatization more as a source of budget financing and an instrument to garner political support (mass privatization) than as a means of improving corporate governance. This attitude has been evident in the proliferation of MEBOs which have typically had little positive impact on corporate governance (Box 3). The quality of privatization has also suffered because of the large number of intermediaries and weaknesses in the coordination of their activities which have led to segmentation of the privatization process. Also, the decision to sell only partial stakes in most SOEs has resulted in fragmented ownership of many privatized enterprises, with adverse consequences for corporate governance. Finally, foreign participation in privatization has been hampered by the lack of a stable policy environment and of a fair, transparent legislative framework. To improve the quality of privatization, the authorities during 1998 clarified the legal framework, and have taken measures to eliminate conflicts of competence and incompatibility of incentives among the various bodies responsible for privatization.

Definition and Legal Aspects of Privatization

What consitutes privatization? Privatization refers to the transfer of ownership from the state to the private sector, implying a transfer of the right to make strategic decisions, including to downsize or liquidate the enterprise, or to issue additional shares. However, most sales of SOEs in Bulgaria so far involved the transfer of only a part of the shares to a private entity, raising the issue of the proper threshold to use in defining privatization. While the Privatization Agency considers the sale of 51 percent of an enterprises as privatization, (the definition underlying Table 38), the World Bank counts an enterprise privatized only if over two thirds of its shares have been divested because under Bulgarian corporate law, the owner of 33 percent of the shares can block decisions concerning the enterprise. Thus, the state can block strategic decisions in an enterprise that the Privatization Agency considers privatized if it held on to more than a third of its shares.

Legal framework and MEBOs. The 1992 Transformation and Privatization of State-Owned and Municipal-Owned Enterprises Act (TPSMEA), which underwent its 15th round of amendments in January 1999, lays out the legal framework for privatization. The main principle is that the privatization of small and medium-sized SOEs is the responsibility of branch ministries; the Privatization Agency deals with the privatization of large SOEs and with coordinating the overall process, while municipalities privatize municipal enterprises, most of which are small or medium size. Since late 1994, the TPSMEA allowed for preferential terms for MEBOs, including allowing MEBOs to pay only 10 percent of the purchase price upfront with payment of the remainder in installments over 10 years, and the comparison of competing bids at face value. MEBOs were frequently able to outbid other buyers because of these advantages, but many have subsequently not been able to improve their financial positions because they lacked the technological know-how and the financial capacity to make much-needed investments, and failed to deliver improvements in corporate governance. In addition, most were not able to receive bank credit due to the lack of collateral or a credible financial program. In some instances, sales to MEBO teams have led to serious asset stripping. The most recent round of amendments to the TPSMEA has helped to level the playing field in privatization by appropriately discounting the value of installment payments. Parliament has also adopted a list of major enterprises for which deferred payments are not allowed.

24. On balance, while much remains to be done, privatization has made significant headway, with the state sector losing its dominance in terms of its share in GDP and employment (Table 33). Wine production, brewing, the cement industry, and a large portion of the sugar industry have been privatized. Privatization is well under way in non-ferrous metallurgy, pharmaceuticals, and 50 percent of tourist facilities are in private hands. Around 150 of Bulgaria’s biggest enterprises accounting for 25 percent of Bulgaria’s output have been put up for sale in 1998, including the Bulgarian Telecommunications Company, Kremikovtsi, Neftochim, Petrol, and 25 military plants, and preparatory work has been largely completed for a second wave of mass privatization (Box 4).

Mass Privatization

The first wave of mass privatization was largely successful. This wave, modeled on the voucher privatization program in the Czech Republic, was conducted from late 1996 to mid-1997. It was not originally intended as the channel for privatizing the bulk of SOEs as there was a pressing need for budgetary cash receipts and external debt reduction through debt-equity swaps. There were also concerns about post-privatization enterprise governance in enterprises with diffuse ownership. Nevertheless, the first wave of mass privatization constitutes the single most important form of transferring ownership to the private sector to date, and played an important role in securing political support for continued structural reforms. It mainly achieved the transfer of ownership in small enterprises or of small stakes in large ones.

How was the first wave conducted? During the first half of 1996, about 3 million people—approximately half of all those eligible—applied for vouchers, resulting in the issue of about leva 75 billion of vouchers, the bulk of which was invested in 81 privatization funds participating in centralized auctions organized to sell approximately a sixth of long-term fixed assets (LTFA) owned by the government. Privatization funds were eligible to buy up to a third of the shares in a single company, empowering them to block strategic decisions in the enterprise. In centralized Dutch auctions bidders—including individuals—submitted bids for a specified number of shares at a price exceeding the minimum price set by the Auction Commission. The price was dropped in three successive rounds if needed, until all shares were allocated. By mid-1997, over 10 percent of LTFA had been transferred to the private sector through mass privatization. In the event, while this method accounted for half of all LTFA privatized through December 1998, the benefits in terms of improved corporate governance were limited; and by transferring partial ownership in large enterprises potentially attractive to strategic investors, mass privatization may have actually complicated the task of attracting such investors, who typically prefer full control of acquired enterprises.

Preparations have now been completed for the launching of the second wave of mass privatization in early 1999. This wave has been designed to be a complementary channel of privatization with a clearly defined list of assets to be made available. The government, wishing to concentrate on cash privatization of large enterprises, intends to use the second wave to sell a large number of small- and medium-sized enterprises and to dispose of residual shares owned by the state. The second wave will also be used to launch private pension funds, and the knock-on effect on the fledgling BSE may be significant, since traders expect lively secondary trading of shares newly acquired in such auctions owing to the rule that the trade of vouchers is prohibited prior to their use in centralized auctions. However, the impact on the pace of privatization is not yet quantifiable because the total supply of assets for mass privatization remains uncertain, the take-up rate by eligible citizens is not known in advance, and vouchers are also issued in conjunction with land or commercial property restitution.

B. Financial Discipline

25. Despite some recent improvement, poor governance and soft budget constraints have remained a pervasive problem in the SOE sector, as reflected in the weak financial performance of SOEs throughout the 1995-98 period. To be sure, the SOE sector recorded significant book profits in 1996 and 1997, following two years of small losses (Table 34). However, the profits were achieved in large part by making use of shortcomings in Bulgarian accounting practices on the valuation of assets and the calculation of profits and losses (see paragraph 27 below); in 1996 exchange rate gains and in 1997 a good export performance also contributed. But there were also signs of somewhat improved financial discipline. An important sign was the fall in SOE liabilities to banks from 62 percent of GDP at end-1996 to just 7 percent at end-1997, owing to a write-off of liabilities, mainly to closed banks, and a very limited increase in credit to SOEs during the year (Table 35). Preliminary data for the first half of 1998 indicate deteriorating financial performance, reflecting the phasing in of higher depreciation costs, continued significant increases in the wage bill, sharply declining sales, and the tendency of recent privatizations to include relatively more profitable enterprises. Throughout 1995-98, over 60 percent of SOEs were unable to meet cash costs from revenues, although the share has been drifting downward from 78 percent in 1995 (Table 36); and the largest 100 lossmakers accounted for between a fifth and a third of total SOE revenues and expenditures (Table 37).

26. Throughout the period, but decreasingly so, financial discipline has been undermined by asset stripping. Over the years, a significant transfer of income and assets has occurred from SOEs to managers and related private enterprises acting as suppliers or buyers of the enterprise’s products. This transfer has been effected through various means, including transfer pricing and running up payment arrears to SOEs. The asset stripping was greatly facilitated by the flow of large direct and indirect state subsidies to the SOE sector. These subsidies (measured on a GFS basis) amounted to 6.7 percent of GDP in 1996 and 2.0 percent of GDP in 1997, and they took the form of recurring large budgetary write-offs of arrears as well as budgetary and extrabudgetary subsidies needed to cover losses. In addition, part of essential repairs or investment at SOEs were also financed from the budget. The large-scale asset stripping created a strong constituency against rapid and transparent privatization of SOEs, contributing to the slow pace of ownership transformation through late 1996.

27. The remaining key obstacles to improved financial discipline include inadequate exit policy and shortcomings in accounting practices. Although some 60 SOEs were liquidated in a World Bank-sponsored program undertaken during 1996-97, many large- and medium-size SOEs continue to operate at sharply reduced levels of production in increasingly difficult financial circumstances. End-1998 estimates put the number of such SOEs and of those that have effectively ceased operations and thus were obvious candidates for liquidation at around 350, even though some remain solvent under Bulgarian accounting standards. Legislation on bankruptcy and insolvency has been improved in recent years but its application remained largely ineffective, mainly owing to judicial and procedural constraints (Box 5). Enterprise financial discipline is also compromised by shortcomings in Bulgarian accounting practices on the valuation of assets and the calculation of profits and losses. In the latter case, a significant source of soft budget constraints has been that revaluation coefficients for fixed assets increasingly failed to reflect inflationary developments since end-1993, the last time fixed assets had been revalued. Consequently, many SOEs were able to show profits by decapitalizing themselves through grossly insufficient depreciation charges based on the limited increase in the book value of fixed assets. A revaluation in 1998 alleviated, but did not eliminate, the problem: a number of SOEs decided to apply a revaluation coefficient below the allowed maximum, and even the maximum revaluation appears to have been insufficient for certain types of fixed assets, especially buildings. Another problem complicating the assessment of true financial results arises from the remaining significant price distortions for a number of SOEs stemming from administered input or output prices, primarily in the energy sector (see section III.C).

Legal Aspects of Enterprise Bankruptcy, Liquidation, and Collateral

Bankruptcy and liquidation procedures. Bulgarian Law distinguishes the liquidation of solvent enterprises—whose assets exceed liabilities as calculated under Bulgarian accounting standards—and the bankruptcy of insolvent enterprises. For the former group, the process is guided by Chapter 17 of the Commercial Code and the provisions of Article 1(3) 2 and Chapter 6 of the Act on the Transformation and Privatization of State-Owned and Municipal Enterprises. For the latter group, the process is defined in the 1994 Bankruptcy Law contained in Part IV of the Commercial Code. Since liquidation proceedings for solvent SOEs do not need to involve the courts, supervising ministries as representatives of the owner, the state, can initiate and implement liquidation procedures. Bankruptcy procedures on the other hand have to be initiated by courts and implemented under their supervision.

Poor record of implementation. Progress in implementing these laws has been hampered by the unreliability of the balance sheet test of solvency in the absence of uniform, internationally accepted accounting, asset valuation and appraisal standards; ambiguities in the wording of legislation and a lack of experience in its application; legal constraints on writing off SOEs’ Zunk-related liabilities; and, at times, the large tax liabilities on debt written off. A lack of trained bankruptcy judges and incentive problems of court-appointed liquidators who receive a fixed salary as long as the bankruptcy proceedings are underway further complicate the process. As a result, only a limited number of liquidations of solvent enterprises, and no successful case of a SOE stabilization or reorganization, let alone a completed SOE liquidation, had been achieved through November 1998.

Problems with collateral. The related regime for secured lending is adequate for personal property, but not for real estate serving as collateral. A modern Law on Registered Pledges following Article 9 of the U.S. Uniform Commercial Code has been enacted in 1998, and a Registry of Secured Interests in Personal Property has been established within the Ministry of Justice. However, through end-1998, land and related mortgage registrations remained highly decentralized, with records unautomated and not based on plot descriptions following cadastral surveying, resulting in an extremely slow and burdensome process of foreclosing on real estate collateral.

28. The ongoing Isolation Program gives promise of major further improvements in financial discipline. This program aimed at addressing the largest loss-making SOEs was launched in 1996. The Isolation Program (IP) was designed to cut off 30 state-owned utilities (Group A) and 41 large state-owned commercial enterprises (Group B) from bank credit, thereby forcing a fundamental restructuring of their operations, with a view to achieving eventual financial solvency of Group A enterprises, and privatization or liquidation of Group B enterprises. The isolated enterprises accounted for approximately 50 percent of SOE sector losses in 1995. The original deadline for completing the program was end-1998. However, delays in implementing the reorganization plans of SOEs under the IP, the lack of resolve in forcing liquidations of major SOEs in Group B that could not be privatized, adverse changes in the external environment resulting in lower interest of foreign strategic buyers in Group B enterprises, and the modalities of enterprise privatization through the PATA and Pool programs have made it unavoidable to extend the program through mid-1999. Nevertheless, although implementation fell short of the original goals, significant progress has already been made under the Isolation Program. In Group A, the program led to a reexamination of the massive redistribution of funds through the Energy Resource Fund (see section III.C) and eventually its closure at end-1998; a gradual raising of district heating prices in order to phase out subsidies to district heating companies (DHCs); the implementation of a far-reaching restructuring plan for the state railways and preparing the ground for one involving the Sofia Transport Company; and the launch of a program to close loss-making coal mines. Twenty-two enterprises have already exited from Group B by end-July 1998, and the need to liquidate major SOEs which are losing hope for being privatized has been accepted.

C. Energy Sector

29. Energy is a key sector in Bulgaria’s highly energy-intensive economy and one which has epitomized the difficulties highlighted in the previous section. Barely touched by the restructuring efforts prior to 1998, the enrgy sector had deep-rooted problems in several sub-sectors: large, uncontested vertically integrated monopolies in electricity (NEK) and gas (Bulgargas); high levels of protection and centralization in oil refining; an inefficient and extremely costly district heating system; and a heavy losses in coal mining. The key causes of this situation were the reluctance to give up state control in this crucial sector to private operators and the failure to liberalize key energy prices or at least keep them at proximate market levels. Policymakers tended to view private operators as unable or unwilling to reliably and efficiently cater to the needs of industry and the household sector at an acceptable price. Moreover, they wanted to keep energy prices low to avoid further worsening. SOEs’ already precarious financial position, and to protect the socially vulnerable parts of the population.

30. In early 1998 the authorities made the first serious efforts at addressing the main problems. They developed a comprehensive medium-term strategy for the energy sector and began to implement it in September 1998. The strategy focusses on electricity, coal, and district heating, and it contains the essential elements necessary to improve the overall efficiency of the energy sector. Although it will take several years to implement some strategically important measures, including large-scale privatization, and the strategy does not cover the gas sector, it was a significant and promising start. The strategy envisages the phasing out of energy subsidies over a period of three years, which was begun in September 1998. It also prepares the ground for breaking up NEK into separate corporate entities dealing with generation, transmission and dispatch, and distribution in the electricity subsector, and launches an effort to restructure coal mining and to confront the deep-seated structural problems related to district heating (Box 6), A key component of the strategy is the preparation and submission to parliament of a modern Energy Law providing the legal and regulatory framework for the market-based development of the energy sector and for an independent regulatory agency for the remaining monopolies.

31. Pervasive government intervention in the energy sector has maintained an inefficient and centralized market structure. Through end-1998, the profit taxes paid by NEK and the bulk of its profits—extracted by the state as dividends—were channeled through the Energy Resource Fund (ERF), an extrabudgetary fund, to district heating companies and coal mines in a large government-operated cross-subsidization scheme. The ERF—together with the implicit subsidy provided to DHCs in the form of free deliveries of gas through 1998 related to the Yamburg agreement4 —avoided a breakdown of district heating and thus averted major social problems. However, it achieved this at the cost of compressing NEK’s maintenance and investment expenditures and contributed to complacency about the need to raise administered prices for district heating as revenues lagged further and further behind costs.

District Heating

Operations. As of 1998, Bulgaria had 22 independent district heating companies (DHCs), supplying about 19 percent of the population—exclusively in large cities—with heat, mainly using imported natural gas as their primary fuel. Until end-1998, all were owned by the central government with the exception of the Sofia DHC, which accounted for over half of the total heating capacity and was owned by the Municipality of Sofia. About two thirds of sales were to households, a fifth to industry (including 12 percent delivered as steam) and the rest to budgetary organizations. Nine of the 22 systems also had the capacity to produce electricity jointly, with Sofia accounting for half of the total.

Performance problems. Estimated heat losses in the district heating systems are about 17 percent of the heat in generation and an additional 20 percent in transmission and distribution, compared with 13 and 8 percent, respectively, in Finland where district heating is also extensively used. With little metering of consumption, and a dilapidated control system for heat transmission and distribution, losses may be substantially underestimated. DHCs charge costs plus 7 percent for industrial users and a low administered price for households. Since 1995, revenues have increasingly failed to cover costs, leading to large financial losses and consequent subsidy needs in excess of one percent of GDP annually, mainly through the Energy Resource Fund.

Planned solutions. The authorities have decided to raise district heating prices, separate heat generation and delivery activities where feasible, put in place a regulatory framework, and eliminate DHC subsidy needs by 2001. Heating prices for households could not be raised immediately to full cost recovery levels owing to the low level of household incomes, the lack of metering and control devices, and the relatively high estimated elasticity of demand for district heating. Also, a sharp drop in demand for district heating could have exacerbated the financial situation of DHCs which operate with very high fixed costs, and the scope for continuing large cross-subsidies was limited by the ability of industrial customers to produce their own heat. The strategy also envisages conveying ownership of DHCs from the central government to municipalities; using World Bank financing to install metering and control devices and to rehabilitate many large DHCs; fostering a reduction of demand through better insulation and other energy saving measures; and allowing regional pricing of district heating services. As a first step, district heating prices were increased by 30 percent in September 1998, covering the fuel component in costs.

32. The National Electric Company maintains a virtual monopoly over the electricity subsector. It controls power generation (including substantial nuclear capacities) with the exception of co-generation capacity, all transmission and dispatch operations, and distribution. Following disastrous losses stemming from the November 1996 freezing of public utility tariffs, administered electricity prices were raised and maintained at close to marginal cost from mid-1997, allowing NEK—which was included in Group A of the Isolation Program—to generate significant profits, albeit in part owing to artificially low depreciation charges. NEK’s position was further bolstered by relatively tight management which led to a low level of unpaid receivables, and its role as a significant exporter of electricity. As of end-1998, NEK had an ambitious investment program aimed at rehabilitating coal based power generation, further enhancing the safety of its nuclear operations, and developing its role as a major exporter. NEK concluded a major international joint venture agreement in October 1998,5 and made progress in accounting separation of its various activities. The restructuring program for NEK includes raising the average tariff for electricity on January 1, 1999 by 14 percent for households and 7 percent for non-households, further increases in subsequent years to cover long-run costs, and the creation of separate corporate entities for the generation, transmission, and distribution of electricity, with a view to privatizing larger hydro and thermal power generation plants, retail services, and power distribution from 1999.

33. With price liberalization, the coal sector should be viable. Much of coal mining—the open-pit mines supplying input to electricity generation—operates with low costs, and thus would be economically viable at fully liberalized prices. However, low administered prices on domestic coal and briquettes, and the threat of acute social problems caused by closing loss-making mines in towns where they are among the most important employers, have severely limited progress in restructuring and led to continuing losses and decaying physical equipment. As a first step in implementing the energy strategy, coal and briquette prices for households were raised by 30 percent in September 1998, several hundred employees were dismissed, and decisions were made to detach auxiliary activities from mining SOEs in preparation for their privatization and to close down severely loss-making deep-pit mines. The medium-term objective is to allow coal mines to survive or fail without government intervention.

IV. Public Finance

34. In part because of structural weakness but principally as the result of quasi-fiscal deficits and general lack of confidence in government policies, fiscal policy lost effectiveness during 1996-97, but fiscal consolidation was achieved rapidly after the CBA-centered adjustment program was launched. Despite a decline in revenues during 1995-early 1997 stemming from incoherent tax policy and tax administration measures and the severe economic recession, primary surpluses rose sharply in an attempt to limit the adverse impact on the deficit of ballooning interest expenditure. The sharp compression of non-interest expenditure, brought about by galloping inflation, proved socially unacceptable and economically unsustainable. Quasi-fiscal deficits had contributed to a large build-up in public debt, raising doubts about the government’s ability to service its debt. Following the crisis of early 1997, the adoption of a comprehensive package of reforms restored confidence, brought interest rates down, and allowed non-interest expenditures to return to acceptable levels. At the same time, reforms to address weaknesses in tax administration and public expenditure management systems were initiated. The results of these measures were, inter alia, reflected in the overall budget surplus recorded in 1998. Further reforms to enhance fiscal transparency and ensure medium-term fiscal sustainability were initiated with the 1999 budget.

A. Structure of the Public Sector and Transparency of Fiscal Operations

35. The public sector comprises the state and municipally owned enterprises,1 and the general government which encompasses three functional sectors: the central government; the social security system; and local governments (Box 7). It also includes a large number of extrabudgetary funds (EBFs), largely financed by earmarked revenues.

36. The structure of the state budget is characterized by an excessive degree of fragmentation and by the presence of some 150 first-tier spending units, of which only 14 are line ministries.2 The state budget incorporates the budgets of the general state or republican budget, and the budgets of other state institutions (i.e., ministries and other central institutions, regional administrations, and the National Audit Office). The budgets of the judicial authorities, universities and the Bulgarian Academy of Science, social security institutions, and municipalities are excluded from the State budget.

37. The republican budget consists of government revenues (VAT, income taxes, customs and excise), interest payments, and transfers to municipalities and extrabudgetary funds, while the budgets of other state institutions consist of appropriations to the state authorities for administrative purposes and capital expenditures. The social security system includes the Social Security Fund—administered through the National Institute for Social Security (NSSI)—and the Unemployment and Retraining Fund. Social security is financed by social security contributions and by transfers from the state budget (see chapter IV).

38. Local governments consist of 258 municipalities, 3,881 settlements and nine regions, although these last ones have no autonomous budget and retain limited functions.3 Since 1992, municipalities have their own budgets. Local governments have major responsibility in health and education, and for funding social assistance cash transfers and services, housing, utilities (including water, sanitation, electricity and heating), road maintenance and local administration. Accordingly, education and health comprise the largest share of municipal budgets, followed by housing and communal services, social assistance services, and local administration. Municipality councils allocate their budgets within the framework of centrally set guidelines. Their deficits, which cannot exceed 10 percent of their revenue, can be financed by issuing securities and bonds or by borrowing from financial institutions. Upon a resolution of municipal councils, temporary revenue shortfalls can be covered by short-term loans from commercial banks, the central government budget, or other municipalities. Interest-free loans from the republican budget can be provided under exceptional circumstances and according to conditions determined by the Minister of Finance.

39. More than half of municipalities’ budgets is financed by sharing revenues from the profit and personal income taxes. In addition to a 10 percent municipal tax levied on companies’ accounting profits (adjusted for tax purposes), the 30 percent standard profit tax rate is levied on all state enterprises under local jurisdiction, i.e., with more than 50 percent municipal ownership. Municipalities’ share of the individual income tax—determined every year in the budget law—was reduced from 70 percent to 50 percent in 1996. Within local taxes, property taxes have always played a relatively minor role, mostly because until 1996 municipalities did not have direct control over rates and assessments, which were valued at historical costs. Since 1998, assessment are based on market-related values. Transfers from the central government, 80 percent of which are for general purposes, account for more than a third of municipalities’ revenue and are determined in annual budgets for each municipality according to a formula taking into account local needs and redistributive mechanisms.

40. Prior to the 1999 budget, there were more than one hundred extra budgetary funds. About 25 funds were under the control of the Ministry of Finance (MoF); the balances of their accounts, which had to be deposited at the central bank, could be used by the MoF, provided that the funds were repaid within the year. Another 30 to 35 funds were specified in individual laws, which prevented the MoF from accessing their balances. Some 50 minor funds were under the control of individual ministries, while a few others were part of the system of social security.

41. Many extrabudgetary funds were financed by earmarking tax revenues and privatization receipts. The Energy Resource Fund (ERF), for instance, was financed by diverting profit tax liabilities of the National Electricity Company (NEK) from the state budget to the ERF. Twenty percent of receipts from fully divested enterprises were earmarked for a mutual fund used to finance pension payments; the remaining 80 percent was earmarked as follows: 7 percent to cover operating costs of the privatization agency; 26 percent to the Agriculture Fund; 4 percent to the Tobacco Fund; 5 percent to an Ecology Fund; and 58 percent to the State Fund for Reconstruction and Development (SFRD).4 In case of partial privatization, 20 percent of receipts went to the mutual fund, while 80 percent would be retained by the enterprise.

42. As large state-owned enterprises encountered increasing difficulties in meeting tax payments in 1996 and 1997, tax administration allowed the offsetting of revenues and debts of government and third parties.5 As funds ultimately do not change hands between the taxpayer and the tax administration under such arrangements, the government’s net cash position is no better than if the offset had not taken place, with the result that tax administration’s collection enforcement powers are effectively compromised.

43. General government banking arrangements still reflect the structure inherited from centrally-planned economies. The government bank accounts—estimated at several tens of thousands and held at the BNB and twelve correspondent banks—are excessive in number and complexity. Each of thousands of spending units has a minimum of three, often five, and sometimes more accounts, including transit accounts, separate accounts for lev- and foreign exchange-denominated transactions, and a number of off-budget accounts, including suspense accounts. All account categories, except a few term deposits and those in foreign currency, are kept in pairs—one for debit and one for credit—and balances are maintained cumulatively through the year. As a result of these banking arrangements, substantial unremunerated cash resources are deposited in the commercial banking system on any given day, adding to the government’s costs and borrowing needs, while subsidizing the banking sector in a non transparent manner.

44. The 1999 budget marks a departure from past practices and a decisive step toward enhancing transparency of government operations. The number of first level spending units has been reduced from 150 to 33. All but 28 extrabudgetary funds and accounts have been closed. All extrabudgetary accounts for second and third level spending units have been closed and their balances transferred to the responsible first level spending unit accounts held at the BNB. Only first level spending units are now allowed to hold bank accounts in foreign currency. A Treasury Single Account (TSA) has been introduced for all first level spending units and the number of correspondent banks has been reduced from 12 to 6. The earmarking of tax revenue and privatization receipts has been eliminated. The possibility of offsetting revenues and debts of government and third parties has been discontinued. The government has also taken action to monitor in a transparent manner government guarantees—the primary form of contingent liabilities.6 In July 1998, a public registry of all government guaranteed loans was established and a decree was issued stating specific criteria for determining the reasonableness of the loan and the required government guarantee. The 1999 budget also sets annual limits on issuing debt guarantees, both external and domestic, and on the outstanding amount of guarantees.7

B. Fiscal Policy

45. Fiscal balances deteriorated progressively through the financial crisis of late 1996-early 1997, but recovered rapidly once the CBA was adopted, and posted a surplus in 1998. The root causes of fiscal deterioration were a secular decline in revenue and rising debt service costs (Figure 3). While the former was a common feature of many transition economies, the latter had its origin in the quasi-fiscal nature of Bulgaria’s public debt as the government repeatedly assumed nonperforming credits contracted by state-owned banks. Declining revenue and rising interest cost forced the government to curtail non-interest expenditure. However, despite running very large primary surpluses, the overall deficit widened while public debt became rapidly unsustainable. The fiscal crisis was resolved when the policy package centered on the adoption of a CBA provided a credible nominal anchor and rapidly reduced interest costs. It was followed by sound fiscal policies which ensured fiscal consolidation.

Figure 3.
Figure 3.

Bulgaria: Fiscal Developments, 1992-98 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source: Bulgaria Ministry of Finance.1/ Consolidated central government, excluding extrabudgetary funds.

The emergence of the fiscal crisis

46. In spite of a significant improvement in the 1994 and 1995 fiscal accounts, the seeds of the looming fiscal crisis were already evident. Although the secular decline in revenue started at the outset of the transition had been temporarily reversed in 1994—largely reflecting the successful introduction of a value added tax (VAT) and the return of revenues from profit taxes to more normal levels after companies fixed assets had been revalued at end-1992—revenue collections of the consolidated government declined by 4 percentage points of GDP in 1995, despite the favorable macroeconomic developments. Restrained non-interest spending more than offset substantial increases in interest payments (Tables 39 and 40). The VAT performed significantly below budgetary expectations, largely as a result of difficulties in administering the tax (see below) and nontax collections also fell, largely owing to a sharp decline in profit transfers from the BNB, reflecting its need to provision for losses in the banking system and its support to ailing banks.

47. The 1996 budget aimed at a further reduction of the overall deficit predicated on substantial savings on interest expenditures. All areas of non-interest spending, except subsidies, were budgeted to increase, to partly compensate cutbacks in previous years. On the revenue side, the budget forecast improvements in VAT and excise tax collections and social insurance contributions, offset by a decline in profit taxes, income taxes, and customs duties. Nontax revenues were expected to decline, largely as a result of a decline in profit transfers from the BNB. Several measures were proposed to improve tax structure and raise revenues, including doubling specific excises on gambling, increasing the excise duties on fuel, and expanding the base to which excises on fuel and alcohol would apply. In the course of the year, Parliament approved changes in the personal income tax aimed at strengthening the ability to collect taxes from sole proprietors and civil contractors.8 The tax treatment of public and private enterprises was unified; companies were allowed to deduct interest payments on bank loans; and tax holidays were granted to privatized companies.9

48. Declining revenue and rising debt service costs came to a critical conjuncture in 1996. Although the government adopted in the middle of the year a number of measures aimed at preventing a further decline in revenue collections, the macroeconomic situation deteriorated and the budget became untenable.10 In spite of a primary surplus that reached 10 percent of GDP, the overall deficit widened to 14 percent of GDP in the last quarter of the year. (The unsustainable nature of the fiscal stance was evident by observing the operational balance, as discussed in Box 8.) At the same time, the contraction of non-interest expenditures no longer became economically feasible and socially acceptable, with the immediate consequence that arrears emerged. Increases in administered prices for energy, utilities, and transportation helped contain subsidies within budgeted levels. In December 1996, parliament approved a supplementary bill, mainly to raise budgetary ceilings on interest payments. However, delays in passing the budget impeded the BNB from further extending credit to the government. Coupled with the government’s inability to place maturing issues in the primary market, this led to the effective default on government debt held by the BNB on December 18. The amount owed was paid on December 19 when the government began borrowing from the SFRD.

The Operational Balance

In presence of high inflation it is often argued that the operational balance can shed light on the sustainability of the real change in public sector indebtedness. The operational budget eliminates the inflationary components of interest payments from the overall balance as this inflation-induced part of the nominal interest bill is in effect an amortization payment compensating bondholders for the erosion of the real value of the stock of debt. In practice, negative real interest rates increase the measure of the operational surplus for they amount to an implicit tax on domestic debt holdings. However, when inflation is high and volatile and real interest rates are a function of expected inflation, unanticipated inflationary shocks can lead to large negative ex-post real interest. In that case, the operational balance would tend to overestimate a fiscal policy tightening and/or its sustainability, to the extent that its usefulness both as a basis for policy assessment and as a guide for policy prescription would be much reduced.

Figure 4 below summarizes how the operational balance differed from the conventional balance during the 1995-98 period in which inflation accelerated and the real interest rate became negative. The real interest rate has been calculated by deflating the simple (annualized) yield on 3-month government securities with the end-of-period CPI. Because of the high degree of volatility of inflation and real interest rates, quarterly flows have been added together to produce more accurate annual figures rather than using annual summary figures. As inflation accelerated in 1996, accompanied by currency devaluation, and real interest rates became negative the operational balance moved from a 3 percent deficit in 1995 into an 11 percent surplus in 1996. In the first quarter of 1997 the operational surplus reached 21 percent of GDP. As inflation eased following the introduction of the currency board arrangement, the operational surplus declined to 1 percent, on average, in the remaining quarters of 1997 and was virtually equal to the overall balance in 1998.

Figure 4.
Figure 4.

Bulgaria: Operational and Overall Balances, 1994-98

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source: Staff calculations.

50. The government’s resignation on December 21, 1996, led to a period of extreme uncertainty and at the turn of the year, an interim 1997 budget automatically went into effect. Expenditures were set by rules that severely constrained non-interest expenditures and allowable deficit financing. As revenue collection fell below 20 percent of GDP in the first quarter of 1997, non-interest expenditures were compressed even further (Table 41). Monthly wages of government employees fell in dollar terms from an average of US$52 in 1996 to US$25 by end-March, below what was considered to be a subsistence wage; the average pension fell from US$23 to US$11 during the same period, leaving most pensioners destitute. This led many embassies to open soup kitchens while the EU promptly released an ECU 20 million grant to provide social assistance to about 500,000 households. The low level of non-interest expenditures resulted in the accumulation of some arrears which, in turn, had some bearing on the accumulation of tax arrears and on the proliferation of offsetting operations. In the first quarter of 1997 the accumulation of tax arrears jumped from 3 to 5 percent of the quarterly GDP. Mainly because of a reduced burden of domestic debt service, the primary surplus remained high (8 percent of GDP) while the overall deficit eased to 10 percent of GDP from 14 percent in the last quarter of 1996.

Fiscal recovery and consolidation under the currency board arrangement

51. The caretaker government that was formed in February decided to adopt a currency board arrangement in order to stabilize the economy. Along with the decision to hold early elections in April, the anticipation of a currency board helped restore confidence: the exchange rate appreciated, and inflation and interest rates declined rapidly. The 1997 budget which passed in April did not rely on bank financing but rather assumed a buildup of balances in the banking system, largely owing to the receipt of privatization revenues and foreign financing. The budget, which envisaged a sharp reduction in the primary surplus and in the overall deficit, focused on short-term tax administration measures aimed at preventing a further revenue decline. Such measures included restricting the use of temporary importation zones and abolishing the temporary importation of alcohol and tobacco; establishing a large taxpayer’s unit; raising the VAT threshold, and deregistering taxpayers below that threshold to reduce fraudulent refund claims. On the expenditure side, the key measure was a reduction of public sector employment by 58,000 workers in 1997, which implied overall savings despite World Bank-financed severance payments. In an effort to enhance the transparency of government operations, the budget also included an expenditure contingency, of 0.7 percent for possible increases in subsidies to utilities under the isolation program and for financial operations of quasi-fiscal origin.

52. The elected government that came into power in May submitted a budget for the remainder of 1997 to further support the currency board arrangement. The new 1997 budget—passed at end-June—aimed at increasing the real level of disposable incomes by cutting personal income taxes, via an increase of the exempt threshold, and by raising pensions and wages. Although poor VAT collections in the first few months of the year had been partly offset by continuing buoyant revenues from the profit tax, tax revenues were revised downward compared with the April budget, leading to a postponement of an overdue revaluation of fixed assets and inventories—not revalued since 1992. To protect the level of revenues, the government raised all penalties, fines, fees, patents, and charges expressed in the legislation in nominal terms to fully reflect inflationary developments both at the state and municipality levels; introduced an excise duty on all licensed gambling equipment; and strengthened the collection of outstanding tax liabilities by allowing tax administration to seize receivables or bank accounts of delinquent taxpayers. On the expenditure side, higher pensions and wages would be offset by cuts in maintenance and operations and, to a lesser extent, defense.

53. In the event, the 1997 fiscal outcome was better than budgeted reflecting a rebound in revenues and a sharp decline in domestic interest payments—a result of the erosion of the real value of lev-denominated debt and lower nominal interest rates. This permitted a recovery of non-interest expenditures (wages, pensions, and social assistance) to more adequate levels, partly offset by the largely unspent contingency allocation. Revenue over performed reflecting higher-than-envisaged wage levels and larger nontax revenues (including a transfer of profits from the BNB). After falling by 9 percentage points of GDP in the second quarter of 1997, the overall balance remained virtually in balance for the remaining three quarters of the year so that by year-end the deficit was down to 2.5 percent of GDP (Table 42). The primary effort remained initially at 9 percent and then subsided at just above 5 percent on average. Despite the good performance, the protracted crisis had exacerbated weaknesses in the tax system and its administration, and in the public expenditure management system, to the point that reforms could no longer be delayed.

54. In the middle of 1997, the attention of the government shifted to tax reform, which became the focus of the 1998 budget. Because the reforms entailed a broadening of the tax base by eliminating most tax holidays and incentives, the government argued that tax cuts were instrumental in making the whole tax reform package acceptable to parliament and to the public at large (the 1998 tax reform is discussed in detail in the next section). However, the government was also concerned about the revenue implications of the reform, in particular about revaluing enterprises’ long-term fixed assets. In addition, social spending, which had been excessively compressed in 1997, had to be restored to more appropriate levels. Despite an earlier announcement of a balanced budget and an expected sharp decline in interest expenses, the budget entailed an overall deficit of 1.6 percent of GDP (2 percent for the consolidated budget), implying a reduction of more than a point of GDP in the primary effort. The budget incorporated a 1.3 percent contingency allocation to reflect the cost of quasi-fiscal operation, including likely privatization costs for the national airline and other costs related to the operations of state-owned enterprises in the energy sector.

55. As in 1997, the fiscal performance was better than expected and the budget (excluding the contingency allocation) recorded a surplus—the first one since the beginning of the transition. The fiscal stance in the first half of 1998 was particularly strong, with the overall balance recording a surplus of 5 percent (on an annual basis), sustained by unexpectedly high revenues—although one-off factors accounted for about one half of the higher-than-programmed tax revenues11—while expenditures were kept in line with the budget. Despite the unwinding of one-off factors, revenue remained buoyant in the second half of the year, spurred by collections from property taxes and local fees, and the new patent regime that had been delayed until the third quarter because of technical and constitutional problems. Larger expenditures in the last month of the year reflected a one-off increase due to an extra month of budgetary wages and pensions as a way of mitigating the effects of substantial adjustments to administered prices.

C. Revenue Developments, Tax Reform, and Tax Administration

56. Revenue developments in Bulgaria have been influenced by an excessive emphasis on tax policy measures unaccompanied by parallel reform of tax administration. Similar to other countries in the region, Bulgaria’s secular revenue decline had its origins in the transition from a centrally planned system to a market oriented economy (Box 9). The persistence of high inflation in particular triggered a real loss in revenues reflecting collection lags, the inadequacy of the tax system and its administration in dealing with high inflation rates, and deterioration in compliance. From the tax administration viewpoint, the erosion of the real value of exempt minimum thresholds for the individual income tax and for VAT dramatically increased the number of taxpayers required to register and file returns, with a consequent additional burden on tax administration. In this regard, delays in adapting the tax system and its administration to the changed economic environment were very costly, as illustrated by the difficulties encountered in administering the VAT.

Revenue Decline in Transition Economies

In most Eastern European transition economies, the share of tax revenue in GDP has declined over the 1990-1997 period (Figure 5). Albania suffered the most severe erosion over this period, with tax revenues dropping from 47 percent of GDP in 1990 to 17 percent in 1997. Bulgaria and Romania experienced a similar decline, although the decline in Romania appears to have bottomed out in the past few years. Despite its relative stability at the start of the transition, the tax share continues to erode in Hungary and in the Czech and Slovak Republics. Poland experienced a sharp decline from 1990 to 1991 and since then has increased the tax share, though it is still lower than in 1990.

Figure 5.
Figure 5.

Revenue Collections in Selected Eastern European Countries

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

The causes for such decline have been insufficient progress in reducing tax exemptions and moving to a more market-oriented tax system with broader tax bases and lower rates; a shift of economic activity from traditionally highly taxed state-owned enterprises to hard-to-tax private sector activities; and weak tax administration, with excessive tolerance of tax arrears and offsetting operations that lead to widespread tax evasion.

To counter this revenue decline, the standard IMF advice has been to broaden the tax bases of VAT, income and profit taxes by removing exemptions and unwarranted preferences. Countries that have fared relatively well are those that saw a substantial shift toward a western-type tax structure, coupled with efforts aimed at strengthening tax administration. The Czech Republic and Hungary certainly fall in that category.

Rise, fall, and recovery of the VAT

57. In April 1994, a VAT was introduced at a single 18 percent tax-inclusive rate. The registration threshold below which taxpayers were obliged to register was set at leva 1.5 million (US$ 30,000). The VAT structure was relatively simple and straightforward. Exports were zero rated—the legislation classified as exporters, businesses who consistently export more than 50 percent of their total turnover. Exemptions were limited compared to other countries in the region. Besides the EU standard exemptions—postal services, medical care, dental care, charitable work, education, noncommercial activities of nonprofit organizations, cultural services, radio and TV broadcasting, insurance and reinsurance, lotteries and gambling, letting of immovable property, supply of land and buildings, and financial services—basic food items were initially exempted for a five-year period.

58. Despite a good start—collections from turnover taxes and VAT doubled as a share of GDP in 1994—tax administration faced increasing difficulties in administering the VAT as the economic situation deteriorated. There were three main reasons: (a) the registration threshold declined rapidly in real terms, forcing an increasing number of small taxpayers to register; (b) a lack of appropriate methods for dealing with VAT refund claims; and (c) clear weaknesses in the VAT audit program. In mid-1996, as VAT collections began to fall, the threshold—which had been eroded in dollar terms to below US$10,000—was raised to lev 7.5 million (US$ 32,000), and the rate was increased to 22 percent (Figure 6). These measures, however, did not have much of an impact. Collections fell from 7.1 percent of GDP in 1995 to 6.8 percent of GDP in 1996, mainly reflecting increasing problems in controlling the VAT refunds.

Figure 6.
Figure 6.

Bulgaria: VAT Developments, 1994-98

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source: Bulgaria Ministry of Finance.

59. The erosion of the exempt threshold in real terms and the processing of refunds were eventually addressed in July 1997. In order to reduce the number of taxpayers, the threshold—which in dollar terms had declined to about US$4,000 during the first half of 1997, the lowest in the region—was raised to lev 75 million (US$41,000). Taxpayers whose turnovers were below the threshold were allowed to deregister on a voluntary basis by end-1997, and on an ex-officio basis starting January 1998. The period for processing exporters’ refund claims was extended from 15 to 45 days and nonexporters were required to carry forward their VAT credits for a period of six months before submitting a refund claim. Along with macroeconomic stabilization, these measures reduced the number of registered VAT taxpayers from more than 100,000 in June 1997 to the current 50,000 and greatly facilitated the control of VAT refunds: during the first half of 1998, the amount of refund claims decreased from 51.7 percent of the gross VAT collection in 1997 to 43.3 percent, and the amount of pending refund claims (claims to be processed) doubled in leva terms. Progress in implementing a modern audit strategy has not been as tangible. Although the VAT law has been amended to eliminate the obligation for the tax administration to verify all refund claims, in practice, these audits are still extended to all VAT liabilities—80 percent of these audits are performed in the taxpayers’ premises.

Inflation and collection lags

60. The persistence of high inflation was among the main causes of the revenue decline in Bulgaria. Since the Bulgarian tax systems was—and still is—set according to nominal values, the presence of high inflation complicated considerably the correct measurement of taxable incomes and exacerbated losses of real revenues because of collection lags (Box 10). Although it is difficult to disentangle the revenue loss associated with high inflation from losses associated with the deteriorating macroeconomic situation, undoubtedly delays in amending tax legislation exacerbated tax administration problems, including delays in revising the levels of monetary penalties and interest charges. Measures introduced in 1994 and 1995 initially helped the Bulgarian tax system absorb part of the negative impact of inflation. Most excise duties were replaced by a VAT in April 1994, with the remaining ones—mostly on energy products—replaced with ad valorem rates in 1995. Toward the end of 1994, the government introduced a system of advanced income tax payments on civil contract wages which strengthened the existing pay-as-you-earn (PAYE) system, therefore minimizing collections lags. Nonetheless, subsequent delays in adjusting the personal income tax schedule pushed taxpayers into higher tax brackets while the erosion of the tax exempt threshold excessively increased the number of taxpayers required to file.

Revenue Loss, Collections Lags, and Inflation

Inflation affects tax systems mainly in three ways: (i) it erodes the tax bases in real terms; (ii) it distorts resource allocations; and (iii) it introduces inequities. While revenue losses are generally associated with indirect, property and personal income taxes, the impact of inflation on collections from the corporate sector is less clear cut. In the presence of high inflation, monetary penalties and interest charges can quickly lose their effectiveness, with adverse consequences for tax compliance. Similarly, long appeal procedures that must be followed before overdue tax liabilities can be collected will also undermine compliance.

Taxes levied at specific rates become rapidly irrelevant if not frequently adjusted. The typical recommendation would be to replace them with ad valorem rates. As to VAT, long collection lags between purchase of inputs and sales of products tend to inflate value added. Property taxes decline rapidly as property values are generally assessed at historic costs. Inflation distorts personal income tax brackets and tax-exempt thresholds. As taxpayers move up into higher tax brackets (bracket creep), during period of high inflation revenues from wage earners often account for an unusually large share of income revenues. Declining tax-exempt thresholds in real terms excessively increase the number of taxpayers required to file.

As corporate tax liabilities are generally based on a measure of profits derived from historic cost accounts, inflation usually increases tax liabilities. Profits tend to be over reported because: (i) the real value of depreciation allowances and other deductible expenses declines; (ii) the real value of loss carry forward provisions is reduced; (iii) under FIFO accounting, increases in the value of stock inventories are treated as income, with no allowance for that part of the increased value due to inflation (the opposite is true under LIFO); and, (iv) since asset are valued at the beginning of the assessment period at historic costs, capital gains are also over reported.

Deductibility of nominal interest payments and taxation of nominal interest receipts— Overall, this effect tends to produce a fall in revenue as nominal interest payments are fully deductible whereas interest payments received typically by small savers in the form of interest on bank accounts tend to be taxed at withholding taxes whose rates are typically lower than the corporate tax rate. The full deducibility of nominal interest costs implicitly allows firms to deduct part of principal repayment, over and above the real cost of debt financing, leading firms toward activities that minimize their tax liabilities rather than optimize resource allocation by encouraging debt rather than equity financing, and favoring short-term assets as opposed to those with a longer useful life.

Frequency of payments, payment periods and advance payments— The loss of real revenue (also known as the Olivera-Tanzi effect) is larger, the higher the inflation rate, the lower the frequency of provisional payments, and the longer the assessment period. For any given collection lag, the revenue loss induced by inflation can be approximated by multiplying the tax unit by: 1/(1 + p)n, where p is the monthly rate of inflation and n is the collection lag, expressed in months. If we assume that unitary tax elasticity prevails, the effect of inflation on tax revenue calculated as a share of GDP can be deduced from:


where T0 is the ratio of tax revenue to GDP in the absence of inflation, Tx is that ratio when the annual rate of inflation is x, and n is the collection lag. By inverting the above formula, it is possible to calculate the underlying tax ratio in the absence of inflation. Figure 7 presents the result of the exercise. The average collection lag in Bulgaria has been estimated at one month per quarter. Not surprisingly, the revenue losses sharply increased during the 1996-97 crisis, reaching close to 15 percent of the quarterly GDP in the first quarter of 1997. By adding up the quarters, estimated revenue loss was 4 percent of GDP in 1996 and somewhat less than 2 percent of GD Pin 1997.

Figure 7.
Figure 7.

Bulgaria: Revenue Losses due to Collection Lags, 1992-98

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source: Staff calculations.

The 1998 tax reforms

61.The 1998 tax reforms tried to address some of the inflation-induced distortions by simplifying and broadening the tax base while reducing marginal rates and allowing enterprises to revalue their long-term tangible assets—still on their books at 1992 prices. The combined corporate tax rate (profits and municipal tax rates) was reduced from 40.2 percent to 37 percent.12 The new profits tax act provided accelerated depreciation for new machinery and equipment and eliminated double taxation of foreign source income by adopting foreign tax credits. The taxation of gains and losses on foreign exchange assets and liabilities was shifted from cash to accrual basis. The tax base was broadened by repealing tax holidays—via a sunset provision; taxing employees’ fringe benefits at a 20 percent rate;13 limiting the deductibility of interest expense via substantially simplified thin capitalization rules; tightening transfer pricing provisions; and limiting the deductibility of banks’ reserves for bad loans to 70 percent.

62. Amendments to the personal income tax act represented a major step toward a global income tax. Employment and nonemployment incomes were combined under a unified rate schedule. The number of income brackets was reduced from eight to four and deductions for social expenses based on minimum wages were eliminated. To partly offset these changes the basic exemption was raised from lev 50,000 to lev 60,000 while the bottom and top marginal rates were kept at 20 and 40 percent, respectively. The existing system of taxing employees under a final monthly withholding system was retained, but employees who also have nonemployment income are now required to file a return to account for all their income. The act also introduced a key provision to presume business expenses for small enterprises (30 percent of gross income), and adopted an expanded patent regime for taxing small enterprises and a number of occupations on a presumptive basis. While this regime does not pretend to account for income perfectly, it does represent a substantial simplification for the large majority of personal-service providers.

63. Amendments to the VAT legislation refined the definition of taxable operations, extended the period for processing refunds from one to three months (from 15 to 45 days for exporters), and improved auditing procedures. A grace period for registering under the VAT was also introduced to reduce the frequency of businesses operating near the turnover threshold having to deregister and re-register. The customs code was brought in line with the EU model, and coordination between customs and VAT administrations was also improved.

64. Tax reforms also tightened tax administration, and hence enforcement, for VAT, customs, and small business, by substantially simplifying reporting and filing requirements under both the profits and personal income tax acts. The profits tax act incorporates a much simplified system for calculating advance payments based on a fixed coefficient rather than on incomes from previous tax periods. Since April 1, 1998, advance payments are no longer based on the financial result reported for the previous quarter but on the basis of 1/12 of the annual taxable profits for the previous fiscal year adjusted with a fixed coefficient identified each year in the State Budget Law. For the first quarter of 1998, the corporate law established a transitory regime whereby the first quarter of 1997 was the base in determining the amount of the advance payment for the first quarter of 1998.

65. Despite the elimination of tax holidays and incentives from the profits tax act, the Foreign Investment Act—passed in late 1997—introduced VAT exemptions and partial tax holidays for priority investment projects. In particular, capital contributions made by foreign partners were granted VAT, duty, and charges exemption. Companies registered in Bulgaria whose objective was the realization of priority investment projects, were allowed to deduct 50 percent of the amount of the profit tax due to the Republican budget for 10 consecutive years. Priority investment projects were defined as those meeting at least one of the following requirements: amount of investment exceeding US$5 million; creating at least one hundred (100) new jobs; and investment in regions with levels of unemployment exceeding the country’s average unemployment rate.

Tax measures for 1999

66. Tax measures introduced in 1999 carried on the reforms introduced in 1998 by further broadening the tax base and lowering of marginal tax rates. Tax holidays and incentives were removed from the Foreign Investment Act and partially offset by a 10 percent regional tax investment credit under the profits tax act. The combined corporate tax rate (inclusive of the 10 percent municipal rate) was reduced from 37 percent to 34¼ percent. Thin capitalization rules were streamlined by adopting a safe harbor provision and the definition of repair expenses was rationalized. The VAT rate was reduced from 22 percent to 20 percent and exemptions for basic foods were eliminated. Exporters are now defined as those whose export activities account for 30 percent—earlier was 50 percent—of their turnovers. As part of the first phase of health care reforms (see next chapter), a 6 percent payroll tax has been introduced—effective July 1, 1999—to finance the National Health Insurance Fund (NHIF); its impact on the tax on labor will be broadly offset by a reduction in social security and unemployment fund contribution rates and by raising the personal income tax-exempt threshold.

Tax administration reform

67. Although tax administration reform has been at the forefront of the reform agenda since 1990, progress has been lacking and tax administration has fallen behind the tax reforms introduced in recent years, rasing doubts about their successful implementation. The reform was initially concentrated on consolidating the administration of all taxes in one organization, the General Tax Administration Department (GTAD). Emphasis was initially devoted at recruiting, training, and allocating staff—GTAD staff more than doubled from approximately 4,000 to 10,000 between 1991 and 1995,—and at developing computer-based systems to support basic tax administration processes and procedures. The reorganization strategy followed a bottom-up approach in which priority was given to restructuring the tax offices and bureaus. However, this approach has left headquarters with only 1 percent of staff positions allocated to headquarters, far below international norms (about 5 percent), while the vacancy rate (17 percent) has reached alarming levels. Key functions, such as audit and collection of arrears, are fragmented across various departments.

68. Prior to 1999, tax administration was organized by types of taxes, resulting in duplication of activities and misuse of resources, poor exchange of information between tax offices, and increased compliance costs for taxpayers. Although with substantial delay, tax offices were recently reorganized into units based on administrative functions,14 and their number substantially reduced. Nonetheless, tax administration structure remains excessively complex with too many tax offices, distributed across a network of 28 territorial directorates, 118 tax offices (including five large taxpayer offices), and 100 tax bureaus. The tax offices administer some 683,000 registered businesses (140,000 legal entities and 543,000 sole proprietors), whereas the tax bureaus are responsible for managing about 6,200,000 individuals who are subject to property taxes, and other fees and licenses. In addition, effective systems for selecting taxpayers for audits are still missing, while the notion of 100 percent audit coverage persists.

69. In the last two years, two measures have been key in modernizing tax administration: establishing large taxpayer offices and adopting a unique identification number. In July 1997, the authorities established five large taxpayer offices (LTOs). The successful operation of the LTOs was, however, seriously impeded initially by the excessive number of enterprises selected as large taxpayers; the maintaining of a double line of reporting; and the lack of appropriate accommodations, equipment (including computers and basic communication facilities), staffing, and budget. Large taxpayers were initially identified as those with a turnover above lev 1 billion. This amount, however, proved to be too low. Indeed, instead of the recommended 500-600 large taxpayers, 1,215 enterprises were identified as large taxpayers: 644 of them directly monitored by the LTOs in the major regions, whereas the remaining 571 large taxpayers were temporarily covered by “satellite” offices spread among the 23 other regions.15 As of May 1998, the large taxpayers controlled by the five LTOs accounted for 58.6 percent of the total amount of taxes collected by the tax administration; those controlled by the satellites accounted for an additional 15.7 percent. To improve the effectiveness of the LTOs and facilitate the extension of their jurisdictions to other regions, in August 1998 GTAD decided to modify these criteria and reduce the number of enterprises classified as large taxpayers and to disband the satellite offices, granting therefore the existing five LTOs appropriate tax jurisdiction.16

70. The adoption of a unique identification number (UIN) by all Bulgarian businesses has been actively discussed within the government for the last three years. Several business identification codes are currently in use by various government agencies: (i) the GTAD uses its own tax identification number (TIN) as a primary identifier but also records the National Statistical Institute (NSI) Bulstat number in its files; (ii) the social security administration uses the Bulstat number and also records the TIN in its files; (iii) the NSI uses its Bulstat number; and (iv) the customs administration processes three numbers (the TIN, the NSI Bulstat number, and the customs importer number, with the latter used as the primary identifier). In July 1998, a Council of Ministers’ decree gave a mandate to the NSI to develop a UIN. The NSI, who would own the UIN register and its associated number, developed an implementation plan and the UIN was officially adopted in January 1999.

D. Expenditure Policies and Management

71. As mentioned earlier, the most striking feature of the expenditure side of the state budget was the growing burden of interest expenditures. Interest expenses increased from 11 percent of GDP in 1995 to 20 percent in 1996, wholly on account of domestic interest expenses which rose from 11 percent of GDP to 17 percent of GDP over the same period. Non-interest expenditures declined by 5 percentage points of GDP in 1996. As the fiscal problems intensified, municipalities’ support from central transfers declined progressively, reaching 36 percent in 1997. A positive development was the reduction in subsidies to state enterprises. Subsidies from the general government fell from over 15 percent at the beginning of the transition to below 2 percent in 1996. Their rebound in 1997 reflected the severe financial problems faced by energy companies because of the sharp devaluation of the currency.

72. The crowding out of non-interest expenditure became acute at the peak of the financial crisis when needs for social protection sharply increased. Although this pattern was common to most expenditure items, it was more accentuated for social spending—social security and welfare, health, and education—which declined from 19 percent of GDP in 1995 to 16 percent in 1996-97 (Table 4). Average pensions in real terms, which had fallen by a cumulative 105 percent between end-1990 and end-1995, declined by an additional 47 percent in 1996. Wages and salaries in the government sector fared a bit better. Between 1993 and 1996 wages in the budgetary sector almost halved in real terms; by February 1997, the average wage was worth US$5 dollar against averages of US$50 dollars in 1996 and US$96 in 1993. Despite the loss in the real value of wages, employment in the budgetary sphere remained fairly stable at around 550,000, including the elimination of about 58,000 positions, including 20,000 employees, in 1997.

Table 4.

Bulgaria: Social Expenditure Structure, 1991-97

(In percent of GDP)

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Sources: Bulgaria Ministry of Finance; health and expenditure data from Government Finance Statistics.

Public expenditure management

73. Although significant progress had been made in improving budget execution since the start of the transition, the 1996-97 crisis brought to light weaknesses in public expenditure management. Many of the established procedures deteriorated under the pressures of the economic crisis and, for the first time, substantial expenditure arrears emerged. This was due to three main reasons. First, the MoF’s oversight of budget execution was principally focused on the state budget and directed at securing control at a first-tier spending unit level. Second, the expenditure control system relied entirely on cash limits, with no financial control over expenditure commitments (i.e., contracts or other agreements that will lead to later cash expenditures) being incurred by spending agencies. In such an environment, ministries were not required to contain expenditure commitments so as to be consistent either with these monthly allocations or even the annual appropriations. Third, the division of responsibilities for budget execution between spending units, line ministries, commercial banks and the MoF was—and remains—inappropriate, with the government banking arrangements (described in section A) remaining a feature inherited directly from the old central planning system.

74. The preparatory phases prior to the introduction of the currency board were utilized—with assistance from the Fund—to overcome the crisis and to lay down a strategy aimed at strengthening budget execution and the existing treasury functions. The remarkable expertise developed in cash management by the MoF was essential in maintaining expenditure under control during the first half of 1997. One of the main purposes of the daily cash flow forecast was—and still is—to guide the release of transfers and subsidies from the MoF to other budgetary institutions included under the republican budget. Nonetheless, expenditure arrears emerged, although in most cases they were a consequence of high unanticipated inflation and unexpected depreciation rather than a diversion by spending agencies of available cash resources to non-priority items.17 Expenditure control mechanisms introduced with the 1997 budget—and replicated in the 1998 budget—limited the transfers of appropriations to first-level spending units in an effort to limit expenditure commitments. The 1999 budget has strengthened these mechanisms by extending their applicability to the Ministries of Defense, Internal Affairs, and Health (Box 11).

Expenditure Control Mechanisms

The 1998 State Budget Law limits subsidies to state bodies, ministries and agencies (Art. 5 (2)), state universities (Art. 7 (2)), regional government administration (Art. 9 (2)), and local governments (Art. 11 (2)) to the amount of 90 percent of the sums allocated. The balance of 10 percent would be provided only in case the budget deficit is not exceeded. The above limitations did not apply to the Ministries of Defense, Internal Affairs, and Health. The 1999 budget eliminated these exceptions.

In addition, Art. 13 of the 1998 State Budget Law establishes that:

(1) the expenditures from the general government will not exceed the amount of the revenues on the accounts held in the bank;

(2) the Ministry of Finance periodically allocates the revenues observing the following priorities: government debt; transfers for social security and municipalities; subsidies for the judicial power budget; payments for ministries, agencies, and other spending authorities; and subsidies for production stimulation;

(3) the ministries, agencies, and other bodies in spending their budget funds will give priorities to medicines, wages, scholarships, pensions, social allowances and assistance, food, heat, electricity and other costs associated with running the social, health care, and education entities.

Art. 14 (2) also limits municipalities’ capacity to finance expenditures for acquisition of fixed assets outside the budgeted allocations to 10 percent of their own resources.

E. Public Debt and Economic Growth

75. Bulgaria’s public debt-to-GDP ratio has fluctuated considerably during the 1990s and concerns about the country’s ability to service its public and external debt have dominated a large part of its transition history thus far.18 Much of Bulgaria’s external debt was inherited from pre-transition days. It fell significantly as a result of Paris and London Club reschedulings and has remained fairly constant in dollar terms since 1995. Since the hyperinflation of early 1997 wiped out most of the domestic debt related to deficit financing, the bulk of the existing stock of domestic debt represents the recognition of quasifiscal losses. The macroeconomic stabilization and structural reform program initiated in 1997 established fiscal discipline and is addressing the causes of quasi-fiscal losses. Debt dynamics have become favorable but continued financial discipline will be needed to ensure debt sustainability and relatively high external debt service is likely to constrain economic growth.

Public debt: recent developments and structure

76. The dynamics of Bulgaria’s public debt-to-GDP ratio were influenced mainly by the sharp contraction of GDP following the transition, wide fluctuations in the real exchange rate, a significant number of debt operations (reschedulings, bank recapitalization, deposit guarantees), sizeable primary fiscal surpluses after 1993, and more recently, privatization proceeds. Shortly after the beginning of the transition, Bulgaria’s public debt-to-GDP ratio soared to unprecedented heights as a result of the sharp contraction of GDP, real exchange rate depreciation, and bank recapitalization operations. At end-1993, total debt amounted to about 150 percent of GDP, of which 115 percentage points were accounted for by external debt (Table 43). Despite the London Club rescheduling which cut some 33 points off the debt-to-GDP ratio in 1994, total debt remained at about the same level (Table 5), owing to further bank recapitalization operations—adding about 19 percentage points to the ratio—and unfavorable macroeconomic conditions reflected in a large excess of the effective interest rate over GDP growth (measured in U.S. dollars) (Box 12). In 1995, a sizeable primary surplus and the sharp, if unsustainable, real appreciation of the exchange rate significantly reduced the public debt ratio: external debt fell from 107 percent of GDP at end-1994 to 69 percent at end-1995 and domestic debt fell by 5 percentage points of GDP. In 1996, the impact on public debt of the recapitalization of the banking sector and depositor protection was more than offset by the inflation induced erosion of domestic currency denominated debt. The domestic debt- to-GDP ratio fell to 22 percent, but with the real exchange rate depreciating, external debt rose to 90 percent of GDP. In 1997, inflation continued to erode leva denominated debt, but significant privatization proceeds (in cash and debt instruments and a sizeable primary surplus contributed to a decline in the debt ratio. While these factors continued to play a similar, but smaller role during the first nine months of 1998, the improvement in macroeconomic conditions made a larger contribution to the decline in the debt-to-GDP ratio which reached 76 percent.

Table 5.

Bulgaria: Contributions to Changes in the Public Debt/GDP Ratio, 1992-98

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Source: Staff calculations.

Paris Club, CMEA, and BNB restructuring in 1997.

Impact of economic growth and interest rates, calculated as residual.

77. At various moments in Bulgaria’s recent transition history public debt dynamics were unsustainable. Equation 4 in Box 12 implies that for the debt-to-GDP ratio to stabilize the primary surplus as a share of GDP has to be larger than (i-g)dt-1(1+g), assuming no contribution from non-deficit related factors. Applying this methodology, it can be seen that the actual primary surplus was less than the required primary surplus in 1994 and 1996, an indication of a rising and thus ultimately unsustainable debt-to-GDP ratio (Table 6). In 1997, the actual primary surplus rose above the required surplus, thus contributing to a declining debt burden, while in 1998 macroeconomic developments were very favorable and a primary surplus would not have been required to stabilize the debt-to-GDP ratio.

Table 6.

Bulgaria: Debt Sustainability, 1994-98

article image
Source: Staff estimates.

Determinants of Public Debt Dynamics

The change in debt can be expressed as follows:


where I is interest payments, P the primary surplus, and A other items besides the budget deficit that affect the public sector’s indebtedness, for example, issuance of recapitalization bonds, the coverage of deposit guarantees, privatization receipts, and valuation changes. Time subscripts for current period variables have been omitted.

To facilitate the analysis of debt dynamics and debt sustainability it is useful to rewrite this equation in terms of ratios to GDP (Y). Define


where I is the nominal interest rate and g is the growth rate of nominal GDP. The change in the debt as a ratio to GDP can be written as:


or, with d=D/Y, p=P/Y, and a=A/Y:


The changes in the debt-to-GDP ratio are seen to depend on the primary surplus as a share of GDP; a term summarizing macroeconomic developments reflecting the difference between the nominal effective interest rate on debt and the nominal growth rate of GDP, the level of debt in the previous period, and the growth rate of GDP; and other factors.

Table 5 uses this equation to analyze the various factors contributing to changes in Bulgaria’s public debt-to-GDP ratio, breaking down the residual (a) in a number of components given its relative importance. Highly volatile exchange rates, inflation, and interest rates throughout the period under review made it very difficult to compute a meaningful macroeconomic term (i-g)dt-1/(1+g). To address this problem, at least partially, the analysis was done after converting all aggregates to US dollars ( flows at the period average exchange rate and stocks at the end-of-period rate) and by calculating the macroeconomic term as a residual. This approach yields consistent results except in 1997 (the year with the largest nominal changes) where the magnitudes of the effective interest rate and nominal growth rate indicate a positive contribution of macroeconomic effects to the debt-to-GDP ratio whereas the calculated residual is negative. Intra period changes in key variables affecting the calculated effective interest rate are the likely culprit.

78. At present, the structure of Bulgaria’s debt is fairly rigid, with most of the debt foreign currency denominated, at long maturities and variable interest rates, but with a low effective interest cost. Aside from domestic deficit financing bills and bonds which constitute less than 5 percent of total debt, all debt is of medium and long-term maturity. However, new issues in the domestic market are still concentrated at the shorter maturities (up to 12 months) and international private market access has not yet been restored. The effective interest rate on public debt is relatively low—an estimated 5.5 percent in 1998: most of the debt is at variable rates linked to Libor and part of the Brady bonds (FLIRBs) and the debt to official creditors are at lower interest rates. Even so, interest payments make up 13 percent of total budgetary expenditure in 1998. The amortization profile of external debt over the next few years is uneven: it is projected to jump from 2.5 percent of GDP in 1999-2000 to 4.3 percent in 2001 and stay at around 3 percent of GDP in the two subsequent years.

79. Even though public debt appears very high, two attenuating factors must be observed which contribute to a lower net debt and net foreign liability position of the public sector. First, successful implementation of the government’s reform program over the past 20 months has permitted a significant buildup in official reserves of the budget: they reached US$1.1 billion at end-September 1998. Second, the principal of discount Brady bonds is fully collateralized. Taking these factors into account, net public debt amounted to about 60 percent of GDP at end-September 1998 and net external public debt to 42 percent of GDP. Against these favorable factors, there are still contingent liabilities which are difficult to quantify and mostly related to foreign debt of state owned enterprises to multilateral institutions and deposit guarantees of the State Savings Bank.

External debt and economic growth

80. While successful transition economies have been able to rely on significant foreign financial inflows, Bulgaria remained broadly in financial autarky since the beginning of its transition and the significant resource transfer abroad associated with external debt service reduced resources available for investment. As confirmed by the moratorium on external public debt declared at the outset of the transition, foreign creditors did not expect that Bulgaria would be in a position to service its external debt.19 Even after the London club rescheduling in 1994, doubts lingered and Bulgaria remained cut off from international financial markets. Only official lending continued intermittently, permitting Bulgaria to service its external debt at times at the expense of severe expenditure compression. External debt service was quite onerous, averaging nearly 10 percent of GDP per annum during 1995-98. As a result, public investment all but disappeared and in the absence of inflation adjustment of depreciation allowances enterprise earnings were largely siphoned off to the budget. Reflecting the external borrowing constraint and the resource transfer abroad, Bulgaria’s external current account has been in surplus on average during 1995-98 while the non-interest current account surplus averaged about 4.3 percent of GDP per year. Consequently, the decline in domestic savings—typical for transition economies—resulted in the case of Bulgaria in a sharp fall in investment to levels too low to replace the obsolescent capital stock, jeopardizing medium-term economic growth.

81. Bulgaria’s external debt remains high compared to most transition countries. Despite favorable macroeconomic developments and prudent fiscal policies over the past 18 months, Bulgaria’s gross external debt remains the highest of the central and eastern European transition economies: at about 80 percent of GDP it is more than twice the group average of 35.9 percent.20 Only Hungary and the Slovak Republic have ratios in excess of 50 percent of GDP. Mainly owing to a longer maturity profile of its external debt, Bulgaria’s debt service is lower than that of Hungary and the Czech Republic but at least twice as high as the other transition economies.

82. Despite significant inflows of foreign direct investment, including related to privatization, Bulgaria has been a net investor abroad during 1996 to mid-1998 as good domestic investment opportunities remained scarce, awaiting further progress in structural reforms. During 1996, the net outflows were caused by capital flight associated with the banking crisis while during 1997 and the first half of 1998 they reflected mostly the build up of official reserves and to a lesser extent increases in domestic banks’ net foreign assets.

V. The Social Protection System, Health, and Educ.

83. The challenges of economic reform have placed extraordinary demands on Bulgaria’s social assistance system. The pre-transition social protection system—based on universal coverage, generous family allowances and early retirement options for laid-off workers, and free provisions of health and education—has remained virtually intact, with the exception of unemployment insurance and welfare programs introduced to help households cope with transition-related shocks. However, broad coverage and overlapping authority on the part of the main arms of social protection have resulted in a set of duplicate and poorly targeted programs that provide a limited level of transfers to those in genuine need. As a result, Bulgaria’s social protection system has not been able to protect the most vulnerable. The weakening link between contributions and benefits has also led to a deterioration in contribution compliance for social insurance, exacerbating the fiscal position of the social insurance system.

84. The incidence of poverty increased between 1995 and 1997. The World Bank has calculated that the share of population below the poverty line (head count ratio) increased from 2.9 percent in 1995 to 20.2 percent in 1997.1 Of this increase, about two thirds can be attributed to a contraction in household consumption—a direct consequence of the fall in real output—while the remaining one third was due to rising inequality as suggested by the increase in the Gini coefficient from 27.1 in 1995 to 31.4 in 1997. This increase in poverty and inequality was not unusual compared to other transition economies. Poverty rates are estimated to have increased in most transition economies, with the increase greater in the Balkans, the Baltics, and the Former Soviet Union.2 Household budget surveys indicate that the average income Gini coefficient rose from 24 in the pre-transition period to 33 in the post-transition period, approaching income disparity levels found in western Europe.

Demographic Trends

Population is aging rapidly in Bulgaria. The population’s natural rate of growth has been declining since the late 1980s and this trend has accelerated in recent years. In 1997, the birth rate was among the lowest in the region. As a result, Bulgaria’s elderly dependency ratio—the share of the population 60 years of age and older to the working age population of age 18-59—is among the highest of all transition economies, including the FSU. In 1995 this ratio was 34.0 in Bulgaria while the weighted regional average was 28. The policy implications are evident: increasingly fewer individuals are contributing to the social insurance system while more are receiving benefits. Similarly, aging population is putting pressure on health expenditure while the declining number of births results in a shrinking number of new school entrants, with implications for the size of the school system.

Bulgaria: Selected Demographic Indicators, 1989-96

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Source: National Statistical Institute.

A. Social Security

85. Public pensions in Bulgaria are provided via a traditional defined-benefit pay-as-you-go (PAYG) system. The NSSI, established in 1995, is responsible for administering the Social Security Fund. The PAYG system covers all employees in the public and private sector as well as self-employed. Retirement age is 60 for men and 55 for women but early retirement with full pensions of up to ten years is quite common for those working in certain occupations. These are known as category I and II, where category I contains workers in the most strenuous jobs and category II workers in somewhat less strenuous jobs. Category III workers include everyone else. In 1997, categories I and II represented 16 percent of pensioners and 22 percent of pensions paid. In order to qualify for an old-age benefit, workers must satisfy age and length-of-service requirements that depend on worker’s category and gender.3

86. The NSSI is financed mainly via payroll taxes. Transfers from the republican budget cover social assistance programs carried out by the NSSI on behalf of the government. In addition, the NSSI relies on its own resources, mainly interest, on government subsidies, and on loans from commercial banks. The contribution rates are 52, 47, and 37 percent of gross wages, depending on workers’ categories, on the employers;4 employees pay a 2 percent tax which is deductible from the personal income tax. Self-employed pay a 32 percent tax on their taxable income—comprised between one and eight times the minimum wage—to cover all insurance risks, and 22 percent for old age pensions. In 1998, the weighted average pension contribution rate was 42 percent, which is high compared with other countries in the region and to European standards.

87. High contribution rates and a weak link between contribution and benefits provide limited incentive to comply, so that under reporting is pervasive, particularly in the emerging private sector. Self-employed account for only 6 percent of contributors and more than 90 percent of them contribute 22 percent of the minimum wage. In spite of increased compliance since a new data base on individuals’ wages was established in late 1997, social security contributions’ arrears remain high; at end-June 1998, they amounted to leva 145 billion (about 0.6 percent of GDP), concentrated in state-owned enterprises. Tax administration is responsible for enforcing collection on behalf of the NSSI. However, despite penalties and interest for late payments that are regularly applied, enforcement remains poor.

88. Since April 1996, old age pension benefits are calculated by multiplying an individual coefficient, a length-of-service factor, and the average wage in the economy over the preceding three years.5 Individual coefficients are determined as the ratio of the individual’s actual wage divided by the average wage in the economy. The averaging period is the highest wage in the three years prior to 1997 plus every nonzero month after 1996, so that eventually individual coefficients would be based on a career average. However, since the benefit levels resulting from the formula were greater than could have been afforded during the 1996-97 crisis, the formula was temporarily abandoned in 1997 and 1998. Social pensions are paid from the general fund at the rate of 65 percent of the minimum wage to individuals above age 70 who do not have any other pension. Benefits are subject to a retirement test. Workers, who earn above the minimum wage, have their pensions reduced by. 35 lev for each lev of gross earnings. The minimum pension is 90 percent of the social pension and the maximum is three times the social pension. Survivors’ benefits are available to widows if they were dependent on the worker and over age 50, disabled, or caring for a child under age 16. Widowers are eligible for benefits if they were dependent on the worker and either disabled or over 60. Children are eligible for survivors’ benefits. Survivors’ pensions are calculated as a percent of old-age pension—50 percent for one survivor, 75 percent for two survivors, and 100 percent for three or more.

89. Similar to other countries in the region, Bulgaria saw a deterioration of its pension system at the beginning of the transition. Besides the normal increase of retirees during the early phases of the transition, the number of pensioners rose because of the government’s policy of offering generous early retirement to those laid off by restructuring firms.6 As a result, the system dependency ratio—pensioners over contributors—rapidly increased from 55 percent in 1990 to 82 percent in 1994, while the PAYG notional cash balance—the difference between actual collections of pension contributions and payments of pension benefits—moved into deficit. Restricting eligibility criteria along with a rapid decline in the unemployment rate reduced the system dependency ratio to 74 percent by 1998 (still well above the 55 percent ratio recorded at the beginning of the decade) and helped restore the PAYG notional cash surplus. However, the single factor explaining the turnaround in the financial balance of the social security system was a drastic reduction of pension benefit levels, as discussed in the previous section. Measures were taken in 1997 to clear up arrears to the social security fund, introduce individual accounts, and eliminate non-insurance related programs such as the provision of special dietary food supplements.

90. Over the past two years, the government has been actively pursuing a comprehensive pension reform plan aimed at reestablishing a close link between pension benefits and contributions and at substantially reducing contribution rates. Efforts have initially been concentrated on restructuring the existing PAYG by reducing the size of early retirement categories, progressively raising retirement age, and modifying the indexation formula.7 While workers will be reclassified, effective January 2000, decisions regarding increasing the statutory retirement age and the indexation formula are expected by June 1999. Pension contribution rates are planned to be reduced over the next year to offset the introduction of a new payroll tax to finance the health insurance fund (see below). Privately managed pension funds are already operating in Bulgaria. A law providing an adequate framework has been submitted to parliament. The government is also actively considering the opportunity of introducing a second mandatory pillar.

91. Unemployment benefits are administered through the Unemployed and Retraining Fund (UFR). Established in 1989, the UFR receives funds from two main sources: an earmarked payroll tax, and transfers from the budget. The unemployment contribution rate is now set at 4½ percent, split on the basis of a 1:5 ratio between employees and employers.8 Budgetary transfers reimburse the UFR for unemployment benefit payments for those in the budgetary sector and for the non-insurance benefits (see below). Benefits are equal to 60 percent of the unemployed’s average earnings over the last six months, with a maximum of 150 percent of the minimum wage and a minimum of 90 percent of the minimum wage. The length of payment period is determined by length of service and age, ranging from six months for those with less than six months of service to twelve months for those with twenty years of service or more who are more than 56 years of age (51 for women). An unemployed person has the right to receive all benefits in a lump sum if a proposal for starting a business is presented to the Labor office.

92. The UFR also pays a number of social benefits which are not, strictly speaking, insurance benefits. School graduates receive a “social benefit” equal to the minimum wage for three to six months. UFR covers child allowances for households where there is no working parent but unemployment assistance is being received. UFR also finances programs to help the unemployed such as labor exchange services, counseling, and training programs. The UFR also manages severance payments. Between 1997 and 1998 about leva 15 billion were disbursed by the UFR for severance payments. These payments amounted to US$250 up to March 1998. Since then, the amount has been raised to leva 1 million (about US$550). Employees dismissed because of liquidation or financial rehabilitation may opt to withdraw a one-time payment or to receive the standard unemployment allowances.

B. Social Assistance and Welfare

93. Social assistance in Bulgaria consists of a large number of programs, each of them managed by various institutions, poorly targeted, and rather generous by international standard. The fragmentary nature of social assistance means that only a small portion of households benefit from individual programs although 81 percent of the population receives some sort of social benefit, including pensions and unemployment. Many of these programs, which include family benefits, such as child allowances and maternity benefits, and cash and in-kind assistance, such as maternity grants and energy vouchers stem from the 1968 State Decree for Birth Promotion, whose aim was to stimulate higher birth rates in face of Bulgaria’s unfavorable demographics. Since 1993, most of the social assistance programs are administered by municipalities and financed through block grants from the central government.

94. Bulgaria’s main poverty alleviation program is a monthly income support. It reaches less than 5 percent of the population in the non-winter months, increasing to 15 percent in the winter during the last two winters, through an energy voucher scheme for low-income households funded by the EU Emergency Social Aid Program. Expenditures on these two programs amounted to approximately 0.2-0.3 percent of GDP in the last two years.

95. Child allowance is the largest family benefit program, amounting to about 0.6 percent of GDP. It provides universal coverage and is managed by three different agencies: the NSSI pays monthly child allowances, on behalf of the central government, through the social insurance system; the Ministry of Labor and Social Protection (MOLSP) provides child allowances to about 201,000 families through social assistance channels; and the Ministry of Education pays allowances to low income students. Child allowances in 1998 amounted to leva 3,885 per month per child (slightly above US$2) and are paid for all children of 16 years of age and younger (18 years if the child is a student). All families receive lump sum birth grants, paid through the social insurance system for the insured, and the MOLSP for the uninsured.

96. The existing scheme for maternity benefits exceeds international standards. Mothers are entitled to three years of leave with a reemployment guarantee. From 45 days before birth to 180 days after, mothers are eligible to receive 100 percent of prior earnings. Afterwards, maternity leave is initially paid at the minimum wage and later entitled to leave without pay. Uninsured mothers are also eligible for maternity leave, for up to two years at the minimum wage, and a smaller allowance in the third year. For those who are insured, maternity benefits are paid from the Social Security Fund; for those who are not insured, the program is financed by the social assistance budget. About a quarter of mothers in the existing program are in better-off households. In 1996 expenditures on maternity leave for the uninsured amounted to more than twice what was spent on the monthly income support program. Maternity grants are paid by the MOLSP in case of uninsured mothers, or by the social security fund for insured mothers.

97. Programs providing assistance to the disabled overlap between the Ministry of Labor and the NSSI. The 1995 Act for Protection, Rehabilitation and Social Integration of the Disabled introduced a range of new cash transfers and in-kind benefits for the disabled, including subsidies for transportation, communication, and medical services. Expenditures on these new programs far exceeded what was spent on regular social assistance. In addition, until 1997 the NSSI supported programs providing benefits in-kind for the disabled, including durable medical equipment and special dietary meals.

98. The fiscal recovery and consolidation have provided the government an opportunity to streamline and rationalize social assistance programs. The objective is the creation of a single, well-targeted, poverty alleviation program for low-income households. The new Social Assistance regulations, which became effective in November 1997, consolidate the eligibility criteria for the monthly income support program and the energy supplement program creating a single, better targeted, income guarantee scheme. Under the new arrangements, benefits are paid based upon two separate income levels with unified eligibility criteria. The Social Welfare Act, approved in March 1998, recognizes separate criteria and functions for social assistance and social care; clearly defines central and local governments’ roles in providing social assistance; and envisages an increased role for NGOs. In order to further consolidate the monthly income support program as the minimum survival benefit, in-kind fuel benefits have been converted to a cash equivalent. With the approval of the 1999 budget, the Government has also eliminated duplicative child allowance payments from the Professional Qualification and Unemployment Fund and has shifted the administration and financing of universal child allowances—which have been frozen in nominal terms since May 1997—and birth grants from the social insurance to the social assistance system, thus freeing the NSSI of non-insurance based benefits. Also, beginning in 1999, various benefits are no longer linked to the minimum wage. Instead they are linked to the basic guaranteed minimum income (BGMI) which is established by the Council of Ministers. For 1999, the BGMI has been set at leva 37,300 per month.

C. Public Health9

99. Bulgaria’s health system closely resembles that of neighboring transition economies. Under the socialist system, Bulgaria established an extensive state health care system, and few structural changes were introduced during the transition. The 1991 constitution establishes universal access to health care and guarantees access to free care as a right for all citizens. Health care centers are largely run by local governments, although there are a number of national hospitals and other health services, including spas and medical colleges, which are run by the Ministry of Health (MoH) together with the Ministry of Finance. Health expenditures declined steadily between 1992 and 1996, capital expenditures in particular, and despite a rebound in 1997, they remain are among the lowest in the region.10

Table 7.

Bulgaria: Public Expenditures on Health in Selected Eastern and Central European Countries, 1991-97

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Source: Ringold(1998).

100. Bulgaria’s health system remains one of the most inefficient in the region. The emphasis on hospital care translates into high rates of doctors and inpatient beds per 1,000 population, and a high average length of stay in comparison with other countries in the region. Occupancy rates of inpatient beds—59 percent in 1997—are also extremely low in comparison with other countries in the region.

Table 8.

Bulgaria: Health Services in Selected Eastern and Central European Countries, 1996

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Source: Ringold(1998).

101. More than half of total health expenditure is carried out by local governments, with the rest being distributed among a number of central government ministries.11 Personnel costs absorb the largest share of health expenditures, followed by pharmaceuticals and administrative expenses. The sharp decline in the share of personnel spending since 1995 reflected the reduction in real wages rather than a reduction in employment. After falling to 2.3 percent of total health spending, the share of capital expenditures rose to nearly 7 percent of total health expenditures, higher than any previous year. In contrast to the rapid downturn in investments and personnel expenses, pharmaceutical expenditures increased during the 1996-97, due to the rise in the cost of medicines most of which have to imported from abroad.

102. Plans for health sector reform are centered around three laws: the National Health Insurance Fund (NHIF) Law, the Health Care Facilities Act, and the Doctors and Dentists Professional Qualifications Act. The NHIF Law was passed in June 1998; the other two bills are still pending. The NHIF Law establishes an independent health insurance fund with 28 regional branches which will contract with public health care providers for a specified package of health services. The NHIF will be financed, effective July 1999, by of a new 6 percent payroll tax, equally shared by employers and employees. To offset this new payroll tax and maintain the overall payroll tax constant over the medium term, other social security contribution rates will be reduced. Personal income taxes have also been reduced—by raising the tax exempt threshold—in order to offset the employees’ share. The Health Care Facilities Act, and the Doctors and Dentists Professional Qualifications Act would develop an accreditation process of health care facilities and health care professionals based upon their activities, functions, and equipment, which should reduce overcapacity and overlapping delivery.12 Significant numbers of health professionals are entering private practice.

D. Education

103. At the outset of transition, Bulgaria inherited a fully developed education system and a highly educated population. The 1992 census showed that 47 percent of the population had completed secondary education or above. Since then, there have been no major structural changes to the education system. In 1991, parliament passed an Education Law, which stated the government’s commitment to providing equality of access to education, compulsory education for ages 7-14, and the right to continue on to secondary school. After compulsory education, students have the option of continuing on general academic courses, or to enroll in specialized gymnasiums for foreign languages or mathematics, or in vocational secondary schools. Tertiary education in Bulgaria includes university courses which grant bachelors (four years) and masters (five years) degrees.

104. Aggregate enrollment figures indicate a decline of approximately 5 percent for basic education between 1989 and 1996.13 Recent studies suggest that the decline was due to the increase in costs to families of sending children to school. A number of regulatory measures are in place to encourage school attendance, but none are particularly effective. Municipalities can impose fines for nonattendance, but inflation has eroded the fine to less than 10 percent of the minimum wage, discouraging collection. Although school attendance is an eligibility criterion for receipt of child allowances for children at the secondary level, the real value of child allowances is so low that they are unlikely to have any affect on attendance. School services, earlier freely provided, are now being charged to families. By contrast, enrollment rates at the tertiary level nearly doubled between 1989 and 1996.

105. Municipalities finance nearly all schools through the secondary level. Personnel costs as a share of education expenditures declined sharply in 1996-97 (Table 9). Regardless a steady increases in the number of teachers since 1991, Bulgaria’s student teacher ratio for basic school is among the lowest in the region and by Western European standards.14 Similar to health, trends in education expenditures reveal a shift away from capital investments, although capital expenditures did rebound significantly in 1997.15 As in the health system, expenditures on utilities have increased in recent years, due to rising energy prices, to the point that the Ministry of Education closed a number of schools for two months during the 1996/97 winter.

Table 9.

Bulgaria: Current and Capital Expenditures on Education, 1991-97

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Source: Ringold (1998).

VI. Monetary Developments and Policy

106. The failure of discretionary monetary policy to prevent accelerating inflation during 1995-97 led to the adoption of a CBA in mid-1997, which legally constrained monetary policy and successfully helped restore confidence. After a brief episode of relative tranquility during the first half of 1995, the onset of the banking crisis placed the BNB before the classic dilemma: weakening confidence in the lev could not be countered with interest rate increases which would further harm an already weak banking system and put pressure on the budget. At the same time liquidity had to be provided to ailing and solvent banks facing withdrawals in an attempt to prevent the crisis from becoming systemic. However, even within this constraint, monetary policy was flawed and ultimately aggravated the inflationary consequences of the banking crisis. The BNB’s attempt to use the exchange rate as a nominal anchor while providing large amounts of uncollateralized refinancing to insolvent banks—rather than to solvent banks—caused an irreversible depletion of official reserves. Once this carefully watched indicator fell below a certain threshold, the banking crisis turned into a general confidence crisis and belated attempts—in September 1996—to use the interest rate to stabilize money demand failed—even as drastic action against the banking crisis was taken. In the ensuing political turmoil, monetary control remained elusive as increasingly large portions of the budget’s financing needs had to be met from central bank credit, culminating in the hyperinflation of February 1997. This removed the remaining liquidity overhang and together with the decision to adopt a CBA and sound macroeconomic policies rapidly restored stability and drastically lowered inflation and interest rates during the remainder of 1997.

A. Loss of Monetary Control

107. After a crisis-ridden 1994, stability returned to financial markets during the first half of 1995(Figures 8 and 9). Confidence in the lev was restored following the elections in December 1994 on expectation that sounder macroeconomic policies would be implemented. Official reserves increased and the lev stabilized until mid-1995 (see SM/95/306). Meanwhile, inflation, which was around 120 percent end-1994, slowed down to 60 percent, and the basic interest rate was reduced gradually from 101 percent in December 1994 to 66½ percent by mid-1995. Concurrently, currency outside banks increased more than 5 percent in real terms, real lev deposits increased more than 12 percent, helped by the favorable uncovered interest differentials, while foreign currency deposits remained stable in U.S. dollar terms. As a result, the ratio of broad money to GDP reached 57 percent at mid-1995 (Tables 44 and 45).

Figure 8.
Figure 8.

Bulgaria: Inflation, the Exchange Rate, and the Interest Rates, 1992-1998

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Sources: The BNB, and staff calculations.
Figure 9.
Figure 9.

Bulgaria: Monetary Indicators, 1992-1998

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Sources: The BNB, and staff calculations.

108. While the increase in monetary aggregates was partially due to the recovery of real money demand, the BNB’s policy was a significant source of monetary expansion. The BNB resisted nominal appreciation pressures that appeared in the first half of 1995 and intervened heavily in the foreign exchange market. The official reserves rose from US$1 billion at end-1994 to US$1.5 billion by mid-1995 (Table 46). Another source of money creation was the refinancing of two ailing banks by the BNB: in the first half of 1995, the BNB injected US$0.3 billion into these two banks. The BNB tried unsuccessfully to curb the resulting liquidity expansion through sterilization and increases in the minimum reserve requirement. However, the portfolio of securities used in sterilization operations was quickly exhausted and the subsequent stepwise increases in the reserve requirement ratio in March and April from 10 percent to 12 percent had limited effect. Consequently, net domestic assets of the BNB increased by 20 percent within the first half of 1995 (Table 47).

109. The refinancing needs of the banking system intensified in the second half of 1995. Most banks were continuing the lax credit policies toward the state and private enterprises that were incurring losses. The lack of financial discipline and the resulting bank losses decreased the confidence in the financial system. Finally, a rumor that the leading private bank was insolvent triggered a run on that bank. This run was elongated for more than 6 months, as the BNB provided substantial refinancing. However, runs on smaller banks also emerged within a short period, requiring the BNB to inject further resources into the banking system. By December 1995, total net lev credit had increased more than 50 percent over December 1994 (Figure 10).

Figure 10.
Figure 10.

Bulgaria: Components of Total Net Credit, 1995-1998

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Sources: The BNB and the staff calculations.

110. The fragility of the banking system led to a large credit expansion and prevented the BNB from raising the interest rates, which would also have imposed large costs on the budget. Instead, the basic interest rate was kept constant, and with increasing inflation, the real interest rates approached zero in the last quarter of 1995 (Tables 48 and 49). By November, the BNB admitted that the direct refinancing of the commercial banks caused “difficulties in curbing money supply growth;” money increased more than 30 percent in 1995 (Figure 11). The steep climb of the gross reserves of the BNB ended, signaling a deterioration of confidence in the lev, and reserves started to decline rapidly at the end of 1995.

Figure 11.
Figure 11.

Bulgaria: Composition of Broad Money, 1995-1998

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Sources: The BNB, and staff calculations.

B. Loss of Confidence—Early 1996

111. Scepticism about the ability of the government to meet its obligations, especially its debt service, and growing awareness of general insolvency of the banking system,1 developed into fears that foreign exchange deposits would be blocked. These conditions further fueled speculation against the lev. Queues of depositors seeking to withdraw their foreign exchange deposits developed outside most banks and even solvent banks had to ration withdrawals to allow them sufficient time to liquidate foreign exchange assets and physically ship in currency. Doubts about the banks’ ability to honor their foreign exchange deposit liabilities were grounded in the fact that banks had reduced their positions in liquid foreign exchange denominated assets relative to their liabilities in 1995 when interest conditions favored leva-denominated assets and foreign exchange denominated loans became nonperforming.

112. The demand for real money and its components, which was stable throughout 1995 started to decline rapidly in 1996. Within the first half of the year, currency outside banks declined more than 20 percent in real terms, real lev deposits declined more than 30 percent, and the foreign currency deposits declined more than 25 percent in U.S. dollar terms. During the same period, the reserves halved to US$573.4 million (5½ weeks of imports of GNFS).

113. With a full-blown banking crisis developing, the BNB was unable to respond appropriately to shore up lev money demand. Faced with bank runs, the BNB continuously extended unsecured loans to the ailing banks. Concurrently, to bring some stability to the lev, this liquidity was partially retracted through open market operations and foreign exchange market interventions. The open market operations pushed interest rates upward, but not enough to alleviate the pressure on the lev. Higher interest rates increased ailing banks’ costs, as the expensive BNB refinancing replaced the cheaper deposits, leading to chronic losses. In turn these losses required further liquidity injections, which completed the vicious circle.

C. Towards Hyperinflation: Mid-1996-Early 1997

114. As official reserves declined to a critical point in May, the BNB stopped intervening in the forex market and initiated a series of different monetary policy actions aimed at restoring confidence in the lev. In May and June, the BNB tried to tighten monetary policy via interest rate and reserve requirement ratio hikes. In May it almost doubled the basic interest rate to 108 percent. However, with surging inflation, the real rate became negative. The one-month nominal and real deposit rates followed a similar pattern. In June, the minimum reserve requirement was raised by 1.5 percentage points. Even with the conservatorship proceedings initiated against five banks to tackle the underlying banking crisis, these measures were not sufficient to change market sentiment and stop the speculation against the lev, which depreciated sharply by close to 35 percent in May only, and 55 percent in the May-July period. Real money demand continued to decline at the same rate as before May.

115. In July, the adoption of a stabilization program brought temporary stability to the markets. Official reserves temporarily increased in August, with the funding from the European Community under a loan agreement. The depreciation of the lev slowed down considerably in August, and foreign currency deposits stopped declining. But this stability turned out to be short-lived, as it became clear that the stabilization program was not being implemented as envisaged. In early September, foreign exchange reserves of the BNB dipped below US$500 million for the second time in three months while the lev depreciated by more than 10 percent.

116. In late September, the BNB unsuccessfully tried to restore confidence in the lev and the banking system with the announcement of a package that included conservatorship for several nonviable banks, increases of interest rates to reach positive real rate, and support for viable banks. In addition, for this package to be effective in bringing confidence back to the financial system, the government was to initiate rapid privatization of banks and restore access to official foreign financing. The increase in the basic interest rate to 300 percent stabilized the lev in October, but the government’s commitment to structural reforms faltered. Finally, as foreign financing did not resume, the lev plummeted in the second half of November, at which point the BNB stood by passively.

117. The resignation of the government in December and the supplementary budget law requiring the BNB to fill in the budget financing gap removed any prospect of stabilizing the value of the lev in the near term, leading to hyper-inflation. The size of the budget gap was much larger than the limit of the short-term loans that the Law on the Bulgarian National Bank allowed the BNB to extend to the government. Nevertheless, the amendments to the State Budget Law provided for securitizing these loans through issues of government securities, and let the government obtain a long-term loan to the budget amounting leva 115 billion by end-1996. With the addition of securitized short-term loans at the same time, these direct net financing of the budget summed up to more than 9 percent of GDP. The news that the fiscal deficit would be monetized fueled the erosion of confidence in the lev and the financial system, triggering hyper-inflation. From December 1996 to February 1997, demand for real lev currency, as well as real lev deposits, shrunk by more than 60 percent, and velocity of money skyrocketed (Figure 11). The drop in money demand was simultaneous with the net lev credit increase to the government, showing the importance of expectations in money demand formation. At the peak of the crisis, the ratio of broad money to GDP had fallen to about one third of its pre-crisis level.

D. Switch in Monetary Regime

118. During the fall of 1996, it had become clear that, in order to restore confidence in lev, a dramatic shift in policy was inevitable. With the obvious failure of money-based stabilization policies in mind, discussions began on the setup of a currency board, which would guarantee to redeem on demand base money for foreign currency at a fixed exchange rate. It was argued that a currency board would restore confidence in the monetary system for several reasons. First, it would guarantee convertibility. Second, it would instill macroeconomic discipline by eliminating any central bank financing of fiscal or quasi-fiscal deficits. Third, it would be a break from the past, because the exchange rate would be the anchor, a sensible choice for an open, small economy like Bulgaria. Finally, it was thought that the interest rates would respond favorably much quicker to a currency board setup, thus minimizing the required fiscal adjustment. Alternatives required a large-scale write-down of government debt, which was not acceptable to the government, and bank deposits, which would diminish further confidence in the banking system.

119. In April 1997, the caretaker government started to implement a macroeconomic stabilization program centered on the adoption of a currency board and signs of a revival of confidence started to emerge already before the CBA became operational. One important start-up requirement for the currency board was sufficient reserves to back the monetary base. Generally, it is difficult to satisfy this requirement because most countries witness a substantial drop in their reserves during financial crises. This was not a major impediment to setting up the currency board in Bulgaria, because, similar to the case in Argentina, during the crisis, real money demand had dwindled to 20 percent of the level prevailing before the crisis. Moreover, the policy package had been positively received by economic agents and confidence in the lev returned. The real demand for lev currency started to rebound, and made up for the drop in the first quarter of 1997 by end-July. The lev stabilized below the 1,000 mark against the DM, and even appreciated somewhat in April. This allowed the BNB to purchase foreign exchange in the second quarter of 1998 without depreciating the exchange rate. By end-June, net international reserves doubled to more than US$1.6 billion. Interest rates declined sharply; in particular, the base rate dropped from 18 percent per month in March to 3 percent in June. Similar patterns were observed in lending rates and government security yields.

E. Modalities and Set-up of Bulgaria’s CBA

120. Bulgaria’s CBA was put in place as a key element of a macroeconomic stabilization program characterized by a move to a transparent, rule based approach to policy making. As a result, the CBA and all of its relevant parameters were determined in the new Law on the Bulgarian National Bank, which entered into force on June 10, 1997, and effectively established the CBA on July 1, 1997. The law determined, inter alia, the rate at which the lev was fixed to the peg currency—leva 1,000 per deutsche mark—and the restrictions on the financial relations between the BNB and the State and state agencies and the BNB and the banking system.

121. Bulgaria’s CBA is a narrow currency board that ensures full cover of the monetary base (currency and settlement accounts) as stipulated in the law (Article 28):

“The aggregate amount of monetary liabilities of the BNB shall not exceed the lev equivalent of the gross international foreign exchange reserves and the lev equivalent shall be determined on the basis of the official exchange rate against the DM.”

This effectively prevents the BNB from extending credit, except on the basis of any excess of international foreign exchange reserves over the amount required to cover the monetary base. However, even this opportunity is tightly regulated by law which explicitly states that the BNB shall not extend credit to banks, except in a narrowly defined role as lender of last resort, or to the state or to any state agency, except against purchases of special drawing rights from the IMF. Consistent with this setup, the BNB had ceased open-market operations and eliminated the repurchase facility on June 13, 1997.

122. The conduct of monetary policy is severely limited under the CBA. The only instruments left at the discretion of the BNB are the level of and conditions for access to the minimum required reserves. Since the start of the CBA banks have been required to continue to hold 11 percent of their deposit base on settlement accounts at the BNB. The conditions for access to the minimum required reserves were eased in early April 1998 when daily averaging was introduced, allowing banks access to 100 percent of required reserves on any given day, up from 15 percent when the CBA was established.

123. The operation of the currency board is also enshrined in the law, which states that on demand, the BNB shall be bound to purchase and sell any amount of deutsche marks against leva in the territory of the country on the basis of spot exchange rates that shall not depart from the official exchange rate by more than 0.5 percent, inclusive of any fees, commissions, and other charges to the customer. In practice the BNB purchases and sells respectively, at leva 995 and leva 1,000 per DM.

124. Since one of the key objectives of the CBA was to contribute to the transparency of the policy regime, it was decided to create two principal financial departments within the BNB following the Bank of England model2 and to organize the BNB’s balance sheet accordingly (Table 10):

  • The Issue Department holds all the BNB’s monetary liabilities, comprising banknotes and coins, deposits of banks and other nongovernmental depositors, government deposits—the majority of which comprise the fiscal reserve account—and the deposit of the Banking Department.3 These must be covered at all times by foreign exchange assets and gold4 and redeemed for the peg currency at the official exchange rate on demand and without limit. The monetary liabilities are themselves interchangeable (thus banknotes are interchangeable with deposits, and vice versa). The Issue Department invests the BNB’s foreign assets subject to restrictions in terms of quality and liquidity explicitly stated in the law on the BNB. The Issue Department has no other functions. Its balance sheet is published weekly.

  • The Banking Department has at its disposal a deposit with the Issue Department, for the purpose of collateralized lending to commercial banks in circumstances where the banking system as a whole is at systemic risk. To safeguard confidence in the CBA, these loans are to be limited to the amounts deemed necessary and deployed only in exceptional circumstances.5 The BNB can lend only to solvent banks levdenominated credits with maturity of up to three months, provided that they are fully collateralized by gold, foreign currency or other such highly liquid assets. The Banking Department is also responsible for enforcing reserve requirements, monitoring financial markets and the payment system, with a view to minimizing the risk of liquidity problems, and holds all other BNB assets, including claims on banks and government, as well as long-term liabilities. These claims and liabilities (except those related to the Fund and to the lender of last resort functions described above) cannot be added to under the current BNB law.

Table 10.

Bulgaria: Structure of Bulgarian National Bank Accounts Under the Currency Board Arrangement

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125. Even though most foreign exchange transactions in Bulgaria are denominated in U.S. dollars, the deutsche mark was chosen as peg currency to reinforce the political objective of EU accession, and taking into account the preponderance of Western Europe in Bulgaria’s trade. The Law on the Bulgarian National Bank anticipated the advent of the euro and explicitly provided for the switch of the peg currency to the Euro when the latter became legal tender in Germany. In accordance with the law, the new parity has been determined by the official exchange rate of conversion of the deutsche mark to the Euro.

126. The choice of the level of the peg—leva 1,000 per DM—reconciled the objectives of consolidating the gains on inflation and preserving external competitiveness while ensuring full cover of the CBA’s monetary liabilities. On balance, the real exchange rate was not considered to be misaligned in mid-1997 and Bulgaria’s economic crisis of 1996/97 did not find its roots in a lack of cost competitiveness. Thus a rate close to the market rate prevailing prior to the adoption of the CBA (leva 927 per DM during March-May 1997) rounded to a simple figure was a logical choice. At this rate some excess cover was available to support the banking system should the need arise.

127. The resources available for the lender of last resort role of the BNB are equivalent to the deposit of the Banking Department with the Issue Department. At the start of the CBA, these resources amounted to somewhat above US$300 million, an amount that covered about 51 percent of the deposits in the banking system and all of the deposits at the State Savings Bank, thus contributing to confidence in the banking system. Coverage of total deposits including foreign exchange denominated accounts, net of banks reserves at the BNB, was about 18 percent, but besides their reserves at the BNB, commercial banks held significant liquid foreign exchange assets. Cover ratios declined during the six months following the adoption of the CBA since the increase in the deposit of the Banking Department—reflecting net income of the BNB—could not keep pace with the strong remonetization.6 Concerns about this decline prompted the BNB to retain in August 1998 one of the purchases from the Fund made under the 1997 stand-by. Together with net income, this boosted the Banking Department deposit to US$459 million at end-September 1998, restoring coverage to 18 percent of total deposits net of settlement accounts, while commercial banks slightly increased their foreign assets.

128. The financial soundness of the BNB had to be ensured before adopting a CBA. The existing BNB claims on the government were restructured prior to July 1, 1997 to match the non-monetary liabilities of the BNB, so that it could service these liabilities, including repurchases to the Fund, without undermining its liquidity or CBA cover. Essentially, the MoF agreed to service the liabilities of the BNB to the Fund in lieu of its outstanding domestic liabilities to the BNB and took over Brady bond collateral held by the BNB to complete the separation of BNB and State accounts.

129. The BNB continues to act as fiscal agent for the Ministry of Finance through a specially created Fiscal Services Department(FSD). The MoF maintains most of its reserves on accounts at the BNB where they are a liability of the Issue Department that must be fully and continuously covered by foreign assets.7 The FSD is also responsible for organizing government security auctions and providing other financial management services to the government. The Banking Department in its role as fiscal agent for Bulgaria with the Fund, registers outstanding purchases from the Fund as a liability and may on-lend these purchases to the government (in SDRs), or deposit them with the Issue Department.

130. The annual budget of the BNB is subject to approval by parliament. Three quarters of any net income of the BNB is to be transferred to the government, and one quarter is to be added to the reserve fund of the BNB.

F. Developments Since Adoption of the CBA

131. Once the currency board became operational, it took about six months for the initial remonetization to be complete but monetary aggregates never returned to precrisis level, except for lev currency. The demand for deposits remained weak as the financial disintermediation intensified with the banks becoming very cautious after the banking crisis. Lending opportunities were perceived to be limited. At the same time, private financial savings were lower, because real consumption had revived and real taxation was heavier.

132. After the initial rapid return of confidence, and the ensuing adjustments, markets have remained stable. Real money demand followed a moderate upward trend in 1998, besides the seasonal fluctuations, consistent with real activity and interest rates. In fact, as inflation and interest rates remained low, the ratio of foreign exchange deposits to GDP that had peaked at the beginning of 1998, started a slow decline. Even the global financial turmoil triggered by the Russian crisis had no discernable impact on the public’s relative holdings of lev and foreign currency denominated deposits, confirming the confidence in the currency board. The banks remained liquid, and the yield on short-term treasury bills, which had declined sharply at the beginning of the currency board to around 6 percent, declined further marginally to its current level of just above 5 percent.

133. Banks have been cautious in lending. Credit to non-government sector has grown only moderately in 1998 after it recovered rapidly in the second half of 1997, and nonfinancial state enterprises have witnessed a continuous decline, partially owing to privatization. The notable exception has been the rapid credit expansion to households by the State Savings Bank.

134. Against this background of stability of the financial system and high liquidity of banks, no monetary policy actions have been undertaken since the start of the CBA, except for an easing of conditions for access to the minimum reserve requirement. Other than improving bank profitability at the margin by allowing better liquidity management, this action was inconsequential.

VII. Financial Sector

135. Bulgaria’s financial system, dominated by the banking sector throughout the transition period, was at the heart of the severe economic crisis that gripped the country in 1996 and early 1997. Years of misuse of credit, lack of appropriate supervision, and delays in structural reform culminated in the banking crisis of 1996 when runs on banks exposed the general insolvency of the banking system. Through a combination of closures, recapitalization, privatization, strengthened supervision, and the adoption of sound macroeconomic policies confidence in the banking system was restored. These reforms had a significant impact on the sector: the banking system is now solvent and compliance with supervisory regulations has improved markedly; privatization and consolidation are under way; a limited self-financing deposit insurance system will soon be in place; and the stage has been set for the development of sound financial intermediation. Still some further consolidation of the banking sector would be beneficial and, with limited new lending activity, core profitability of most operating banks is low. Domestic financial markets for government securities, interbank money, and foreign exchange were disrupted by the banking crisis, but resumed normal operation following the stabilization in 1997. Stock markets have so far failed to play a meaningful role in the economy, but as progress in structural reform continues, prospects are favorable. A properly regulated unified Bulgarian stock exchange (BSE) began operating in early 1998.

A. Structure of the Financial Sector

136. The banking system consist of a relatively large number of banks but a handful of state-owned banks dominate, even though recent progress in bank privatization is increasing the role of private banks. As in other transition economies, Bulgaria’s mono-banking system was broken up into a two-tiered system at the beginning of the transition, consisting of a central bank and largely specialized sectoral banks. But a liberal licensing regime contributed to the proliferation of mostly small private banks. By the end of 1994, 10 state banks, 23 private banks, 2 foreign banks and 3 branches of foreign banks were operating. Bank closures in the aftermath of the 1996 banking crisis, privatization of two state-owned banks, and some private sector consolidation, reduced the number of state-owned banks to 6 and domestically owned private banks to 19 by end-1998.1 Two foreign banks continue to operate, while the number of branches of foreign banks has risen to 7. At end-September 1998, state and municipally owned and controlled banks (excluding Postbank whose privatization was finalized in November 1998) held 59.5 percent of banking system assets, down from 82 percent at end-1994.

137. The banking system is highly concentrated and relatively specialized. Seven former and currently state-owned banks, including the State Savings Bank (SSB) and the privatized Postbank and United Bulgarian Bank (UBB), held 73 percent of banking system assets and 76 percent of deposits at end-September 1998. In this group, Bulbank—the former foreign trade bank—is nearly three times as large as the second largest bank and accounts for about 33 percent of banking assets. Bulbank has a small lending portfolio, however, and is mostly invested in government securities and assets abroad. The SSB—the former monopoly in household deposit taking—is the second largest bank with 12 percent of assets and is now being transformed into a commercial bank. So far, it could take only leva denominated deposits and lend to households and small enterprises. UBB and Postbank, the third and fourth largest banks, respectively, are retail banks that have begun diversifying their lending operations. The three other banks in this group are more specialized lenders, either sectorally or regionally. Domestic private banks serve narrow interests and account for 19 percent and 16 percent of assets and deposits, respectively. Foreign banks and branches hold 8 percent of each, and deal mainly with foreign direct and portfolio investors.

138. The development of the non-bank financial sector was hampered by erratic and insufficient progress in structural reform during most of the 1990s, but recently the foundation has been put in place for the sustainable and sound development of the sector. Following the liberalization of the foreign exchange market in 1991, foreign exchange bureaus were the most important non-bank financial institutions until the adoption of the currency board in July 1997, after which their number and activity declined substantially. In the context of the first wave of mass privatization, which started in 1996, privatization funds emerged which were subsequently converted into investment funds and are in the process of being listed on the stock exchange. Voluntary pension funds have been in existence for a while but have been acting mainly as mutual funds and are of insignificant size. The recently adopted new pension law clarifies their role and supervisory regime—and the reform of the pension system which is about to begin are likely to boost the importance of pension funds over the next few years. Financial brokerage houses flourished in the early 1990s with the proliferation of stock exchanges but the 1996 economic crisis and the closure of most stock exchanges shifted their role towards the marketing of domestic government securities to portfolio investors, including from abroad, and issues targeted to the public.

B. Banking Crisis of 1996

139. The Bulgarian banking crisis of 1996 resulted from a combination of the weaknesses in governance in banks and enterprises which allowed asset stripping and the establishment of private banks to engage in insider lending; the general economic instability during the transition period; and ineffective recapitalization. The misuse of credit—to finance consumption, income transfers, price subsidies, and inefficient production—was endemic during 1990-96. Unsound and unsustainable lending practices and led in 1996 to a system-wide crisis and shake out in the banking sector. The crisis was resolved through a combination of bank closures, recapitalization of some banks, bank privatization, and the strengthening of supervision. These measures came too late, however, to prevent a complete loss of confidence in the banking system and a significant reduction in financial intermediation from which the system still has not recovered.

140. Non-performing loans inherited from central planning and extended in the first half of the 1990s were at the heart of Bulgaria’s banking crisis. Following a limited transformation of bank claims on SOEs into public debt in 1991, all loans extended to SOEs prior to December 31, 1990 and in arrears of more than 180 days, were replaced with government securities beginning in late 1993. Claims on SOEs were transferred to the MoF and restructured through negotiation, thus reducing the moral hazard implications of the operation by not providing full debt forgiveness.2 However, commercial banks continued to hold regionally and sectorally concentrated portfolios and did not develop adequate banking skills. Without significant structural reforms in the enterprise sector, many enterprises continued to be unable to service their debts and most state-owned banks continued to roll over outstanding credits to these SOEs, while capitalizing interest payments.

141. Private banks were established in the early 1990s under a lax supervisory regime. Banks were licensed with less than the required minimum capital actually paid-in. Profits were to increase capital over time, but banks were allowed pay out dividends up to 50 percent or more of profits before paying in the minimum capital requirement. Many private banks invested lavishly in fixed assets and vehicles. Management was closely connected with their debtors, mainly private companies and individuals economically related to the shareholders of the bank. As a result, the share of non-performing loans in private banks rose rapidly and with acquiescence of the political establishment and supervisory authorities, a class of “credit millionaires” was created at the expense of depositors and ultimately the taxpayer.

142. The absence of an effective regulatory and legal environment and market discipline was one of the key factors contributing to the banking crisis. Banks had been explicitly excluded from the insolvency law of July 1994 (as were insurance companies and state-owned monopolies). Instead, it was believed that for state-owned banks, the state-owner would be able to close the bank if necessary and that for other banks the withdrawal of the license by the BNB would be sufficient to do so and to make the court appoint a liquidator. Legislation in effect prior to the banking crisis gave the banking supervision department of the BNB only limited tools to implement regulations. However, a more important problem was that banking supervision had not developed and implemented procedures for a rapid and predictable response to violations of prudential regulations. Consequently supervisory discipline was weak and prudential regulations were flouted extensively, systematically, and with impunity. Moreover, in the absence of uniform accounting standards and disclosure requirements, market discipline remained elusive. As a result, at the end of 1995, 70 percent of bank loans in Bulgaria were classified.

143. A few state-owned banks displayed sustained liquidity problems in 1994 and early 1995, receiving significant refinancing from the BNB and the SSB. The difficulties of these banks were public knowledge, at least by early 1995, when the BNB proposed a recapitalization operation. However, the new government, elected in late 1994, did not accept the proposal and delayed implementation until May 1995. At that time, Zunk bonds in the portfolios of Mineral bank and Economic Bank were converted at face value into short-term government lev-denominated securities at market interest rates and used to extinguish the debts of these two banks to the BNB and the SSB. The total nominal face value of Zunk bonds exchanged amounted to US$ 824.3 million, effecting a recapitalization of about US$80 million.3

144. Without changes in underlying fundamentals, however, the recapitalization failed to inspire confidence and soon insolvency turned into illiquidity. By late 1995 many public and private banks were ailing and the BNB proposal to institute a deposit protection scheme backfired as it raised the prospect that banks could be closed and that deposits would not be fully covered. While providing banks with liquidity to meet the ensuing deposit withdrawals, the BNB depleted its reserves in an attempt to maintain a stable exchange rate. Once reserves fell below a threshold, runs on banks took on a more systemic nature induced by fears of a freeze of foreign currency deposits; these deposits—which had been increasing until end-1995—fell by one fourth by end-May 1996. Interbank payment difficulties occurred, but other than revoking the licenses of two small banks on March 7, the BNB felt obliged to continue to provide liquidity. Between September 1995 and May 1996 liquidity equivalent to 5.8 percent of GDP was injected, a clearly unsustainable development.

145. In response, the BNB placed five banks in conservatorship on May 17,1996, including the largest private bank, a smaller state-owned bank, and three smaller private banks, and applied to the courts to institute bankruptcy proceedings against these banks. This action was made possible by the rushed passage earlier in May 1996 of amendments to the law on banks and credit activity, establishing conservatorship and bankruptcy procedures for banks. It was accompanied by the establishment of a depositor protection scheme and measures to strengthen the remaining state-owned banks and increase supervision over the banking system. Under an ad hoc scheme, the government fully guaranteed household deposits and half of enterprise deposits. The guarantee also covered foreign exchange deposits which were to be made available over a two year period in equal semi-annual installments.

146. Seven state-owned banks were recapitalized to bring them to non-negative capital adequacy. The scheme consisted of a purchase at a 55 percent discount of Zunk bonds with face value of US$400 million from Bulbank by the State Fund for Reconstruction and Development (SFRD); the placement by Bulbank of most of the proceeds from this sale (US$180 million) on deposit at the BNB to prevent depletion of official reserves; and the transfer without quid pro quo of the Zunks from the SFRD to the Bank Consolidation Company (BCC) which in turn transferred them to individual state-owned banks to increase their capital as needed. All of the recapitalized banks and seven private banks with negative capital adequacy were required to sign special Memoranda of Understanding with the BNB detailing their business plan to achieve 4 percent capital adequacy by end-1996. These memoranda, inter alia, set limits on lending and targets for loan collection and were monitored on a monthly basis.

147. Four months later, it became clear that the loss of confidence in the banking system was more far-reaching than had been hoped. Contributing factors were the slow resolution of banks placed in conservatorship in May and the realization that recapitalization resources had been spread too thinly. Monetary control could not be regained: between end-May and September 20, 1996 BNB net refinancing amounted to 2 percent of GDP. In addition, the BNB made outright purchases of Zunk bonds to provide liquidity to banks in difficulty. To turn the tide, a second wave of conservatorship proceedings was initiated for another 9 banks on September 23,1996, including three more state-owned banks. Negative capital and insufficient liquidity to withstand a run on deposits were the criteria used to select these banks. A significant feature of the September actions was that they were seen as sufficiently bold to address the problem and thus provided the foundation for the restoration of confidence in banks that remained open. However, with the failure to implement supporting measures (bank privatization and closure of loss-making enterprises), the return of confidence did not happen until the resolution of the general financial crisis in early 1997. Two systemically insignificant private banks were closed in early 1997 and the weakest surviving state-owned bank was recapitalized in April 1997 at a cost to the budget of US$50 million.

148. The banking crisis imposed a significant cost on the Bulgarian economy. While its impact is difficult to disentangle from the effects of lack of reform in other areas, the crisis contributed to the sharp fall in GDP—by the first quarter of 1997 real GDP had fallen by 23 percent from its 1995 level and it is still 13 percent below that level; a dramatic redistribution of wealth—the negative real return on leva deposits reduced their value by almost 90 percent; and a significant permanent decline in the size of the financial system—the ratio of deposits to GDP fell from 54 percent at end-1995 to 16 percent and recovered to only 21 percent by end-September 1998. In addition, bank recapitalization and deposit guarantees contributed 35 percentage points to the public-debt to GDP ratio since the start of the transition.4

C. Establishing a Viable Banking Sector

149. Following the banking crisis, the authorities adopted a comprehensive strategy to revitalize the banking sector cast against the currency board framework. Its main components were: swift privatization of state-owned banks to strategic investors so as to attract additional capital and assist the development of proper risk evaluation and prudent lending skills; strengthening supervision; establishing a new deposit protection scheme; and the transformation of the SSB into a commercial bank in preparation for privatization. Somewhat paradoxically, the financial crisis had created favourable starting conditions to implement this strategy as banks had net long foreign exchange positions and the real value of their lev-denominated liabilities was vastly reduced by the high inflation in the first quarter of 1997. Recognizing that the improvement in the balance sheet of the consolidated banking system was largely the result of one-off factors, great emphasis was placed on avoiding a recurrence of the conditions that had lead to the crisis. The currency board framework contributed by effectively outlawing more than exceptional and temporary reliance on BNB credit.


150. Two of the seven state-owned banks have been privatized so far, for two others agents have been appointed to assist in privatization, for a fifth marketing has begun and for the remaining two restructuring in preparation for ultimate privatization is getting under way. UBB—the third largest bank—was privatized in July 1997 to a consortium consisting of the EBRD, a foreign strategic partner, and Bulbank. Postbank’s privatization to a private foreign investor was completed in November 1998. Foreign agents were appointed to mediate the sale of Expressbank (August 1998)—after a failed attempt to sell it during late 1997—and Bulbank (November 1998). The BCC began the marketing of Hebrosbank in the fall of 1998. Biochim was involved in a twinning arrangement with a foreign bank since the summer of 1997 and placed under a restrictive memorandum of understanding agreed with the BNB Bank Supervision Department. Different foreign agents are set to take over the management of the bank in early 1999 in preparation for its privatization over the next two years. The SSB is to be transformed into a conventional commercial bank under an EU-PHARE financed project that will place foreign experts in key management roles over the next two years.

Strengthening banking supervision

151. The program to improve bank supervision had several elements. The first was the issuance of the new Law on the BNB and the Law on Banks that clarified and strengthened the BNB’s role in bank supervision. Later came a series of implementing regulations to detail the new principles enshrined in the law. Concurrently, a large commitment to technical assistance was made on behalf of the Fund, USAID, and the EU under the PHARE program, including the provision of resident foreign experts to train staff in on and off-site supervision. This was viewed as essential since previous Bulgarian experience had shown that lack of effective enforcement and a passive supervision—more than inadequate legislation and regulation—had allowed the banking crisis to develop into a systemic problem.

152. The new Law on Banks and BNB law (July 1997), introducing the currency board, contained several essential elements designed to raise the effectiveness of banking supervision. These included a requirement that the BNB revoke the license of any bank deemed insolvent; a tight regime on large exposures with very limited exceptions; strengthened capacity to control the issuance of new licenses through provisions in the law; a reduction in the rights to appeal decisions of the BNB Board; and a ten fold increase in the minimum capital requirement (effective end-June 1998).

153. The BNB issued two key regulations o July 15,1997 governing capital adequacy and loan classification and provisioning. The capital adequacy regulation established a risk-based measure of required minimum capital in line with the Basle Committee recommendations. The minimum capital ratio was set at 8 percent, to rise to 10 percent at end-1998 and 12 percent at end-1999 with at least half of the capital being classified as “primary”. The regulation on provisioning established an aggressive timetable for the categorization and provisioning against problem loans. This replaced a system whereby banks were restricted to provisioning only up to their profits as shown in the profit and loss statement which had led to under provisioning throughout most of 1997. The new regulation calls for exposures to be classified as “watch”, with 25 percent provisioning after a delay in servicing of 31 days and, after intermediate steps, full provisioning as “loss” after a passage of 180 days. These elapsed periods are maximums as other conditions could call for an earlier classification and larger provisioning. Furthermore, the BNB has the right to require changes to classifications and provisioning if it disagrees with the bank’s internal classification. The regulation also introduced mark-to-market pricing for securities holdings with provisions to be made against the difference between cost and market value.

154. Subsequent regulations included those on liquidity management (December 1997), open foreign exchange positions (January 1998), and establishing a central credit registry for banks (August 1998). Regulations currently under revision include those on bank licensing, large exposures, and internal control while new regulations on consolidated bank supervision and insider lending are in the development stage.

155. MAE technical assistance missions visited Bulgaria regularly during the period 1996-97 (seven missions), complemented by several independent expert visits. A Fund resident bank supervision coordination advisor took up his post in September 1997 with the intent to act as a bridge between the USAID financed on-site supervision team and the EU financed program to enhance off-site supervision. In the event, the arrival of the off-site advisors was delayed until August/September 1998 and, as a consequence, the Fund advisor attempted to fill the gap in off-site supervision as well as providing advice on general policy issues.

156. The on-site supervision project began in October 1997. The objectives were to assist the BNB to undertake an annual schedule of bank examinations, develop a formal training program and training materials for on-site examinations, train a core group of BNB examiners to undertake examinations according to the existing prudential regulations, and develop a basic on-site examination manual based upon the CAMELS criteria. Results accomplished after the first year of the project reflected a relatively greater emphasis on hands-on training in actual inspections that was largely a function of the authorities’ request to have enhanced inspections of several banks of systemic importance. These were the SSB, in order to devise a restrictive supervisory Memorandum of Understanding that will guide its development into a commercial bank; and Biochim and Hebros bank, with a view toward assessing their suitability for either a foreign management contract and/or privatization. In all, the advisors participated in 11 bank inspections during the year and developed a detailed structure for the examination process. As a result, the BNB was able to undertake 18 full supervisory inspections during 1998, of which 13 have been completed; 11 banks received CAMELS ratings.

157. Despite the delay in the arrival of the off-site advisors, an Early Warning System was established to enable early identification of problem banks. The first priorities of the new team are to assist in the process of moving all banks to compliance with international accounting standards (for end-1998 accounts) and assessing the completeness and suitability of the existing regulatory returns. They are also to assist the BNB to fulfill its role under the new Law on Money Laundering.

Deposit insurance

158. The authorities also put in place a new deposit insurance law, to become effective on January 1,1999, with the intent to reduce the potential fiscal cost of bank failure but also, importantly, to place more of the onus of monitoring bank soundness on the depositor and thereby limiting the moral hazard associated with all insurance schemes. Under the scheme, deposits for up to leva 2 million (DM 2000) are guaranteed for 95 percent while deposits between leva 2 million and leva 5 million are guaranteed for 80 percent. A deposit insurance fund will be funded from initiation fees paid by banks, annual premia contributed by the banks, calculated on the total deposit base, investment income, and the fund’s share of closed banks’ assets in case of subrogation. The deposit insurance fund has been set up as a separate legal entity with the possibility to borrow in the event that claims exceed resources. The terms and conditions of obligations issued by the fund are to be determined by regulation of the BNB.

Transforming the State Savings Bank

159. The SSB—formerly the monopoly in household deposit taking and still the largest bank in terms of staff, branches, and clients—held about 30 percent of total deposits at the end of 1994, of which about half were invested in government securities and the other half in interbank deposits. The banking crisis of 1996 made the bulk of these interbank deposits non-performing, causing significant losses for the SSB. Since it could not take foreign exchange deposits, the crisis significantly reduced the SSB’s relative and absolute importance: at end-March 1997, the SSB held only 13 percent of total deposits (Table 11). Since then, its share has risen to 18 percent. More importantly the SSB has become very active in the market for household credits: its loans to households rose rapidly from virtually nothing in June 1997 to leva 440 billion at end-September 1998. Most loans are very small, below leva 1 million and are collateralized by the wages of the main borrower and four signatories which the SSB has the right to garnish. In line with restrictions on its activities (see next paragraph), the SSB has limited credits to small and medium-scale enterprises.5 Even so, by end-September 1998 the SSB’s total loans had grown to almost 54 percent of its total assets—significantly above the sector average of 27 percent. Since October 1998, the expansion of credit to households has stopped.

Table 11.

Bulgaria: State Savings Bank Summary Indicators

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Source: State Savings Bank

160. In April 1998, the law initiating the transformation of the State Savings Bank into a commercial bank became effective. The SSB will be registered as a joint-stock company, fully owned by the state, with a capital of leva 70 billion. In August 1998, agreement was reached between the BNB and the SSB on restrictions on the SSB’s activities until it has the capacity to conduct all normal commercial bank operations and its state guarantee on deposits is lifted.6 For a transitional period which lasts until May 2000, lev deposits at the SSB will—as in the past—continue to benefit from a full government guarantee. The SSB has until the end of 1998 to comply with all prudential banking regulations. The transformation of the SSB is supported under an EU-PHARE project that will place foreign experts in key management roles over the next two years.

D. Current Health of the Banking System

161. Following completion of the process of closing insolvent banks, recapitalization of a number of large state banks that remained open (primarily through devaluation and capital gains on dollar denominated government bonds), institution of a C BA at the beginning of July, and promulgation of a strengthened new banking law, confidence in the banking system returned in the second half of 1997. Banks are now adequately capitalized, highly liquid, and complying with prudential standards (summarized in Table 12), except for some violations of regulations on open foreign exchange positions and individual large loan exposures, but they are facing the challenges of restructuring balance sheets containing high levels of problem loans, developing sustainable sources of earnings, and implementing cost reduction measures.

Table 12.

Bulgaria: Summary of Main Prudential Standards as of December 1998

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Source: Bulgarian National Bank.

Risk adjusted assets, as defined as EC Directive 89/647.

Large exposures defined as those which exceed 10 percent of bank capital.

162. All banks have met the required increase to 10 billion leva in their minimum capital (effective June), albeit 3 only after a delay of 2 months, and are currently in compliance with the end-1998 floor on the capital to risk-based assets ratio (10 percent) (Table 50). Banks as a whole have been able to increase their capital adequacy ratios since mid-1997 as a result of overall positive earnings as well as through shifts in their asset portfolios away from high risk-weighted assets towards low ones, mainly government securities.7 Banks, especially large state-owned banks, tended to remain long in foreign currency throughout 1997, in part because of significant stocks of dollar-denominated Zunk bonds on which they realized substantial revaluation gains resulting from the huge depreciation of the lev in early 1997 and the significant increase in the market price of Zunk bonds.8 A substantial portion of these valuation gains were offset by heavy loan loss provisioning, forced in part by more rigorous supervisory requirements. Even so, capital adequacy ratios improved and reached 32 percent as of end-September 1998, a sizeable increase from the 11 percent observed one year earlier. Given the prominent role of revaluation gains (in excess of provisioning), most of the increase was reflected in tier 2 capital.

163. The system is highly liquid with banks appearing to take a fairly cautious attitude toward the extension of new credits (Table 51). However, a considerable increase in lending, over a depressed base at the beginning of 1998 has occurred. Loans to the non-financial sector (net of provisions) have increased by almost 28 percent through end-September for an annualized rate of growth of almost 39 percent. Approximately 40 percent of the increase in credit has been in the portfolio of the SSB with the bulk of the latter lending being consumer credit or small business credit taking the form of consumer, i.e. personal, credit.

164. While growth of credit at this pace would clearly be a source of concern were they to continue in the current low inflation environment, the financial sector would not be viable without a significant growth over the medium term in high quality lending to develop a sustainable source of earnings and cost reduction measures. Indeed, the authorities are well aware that the capital improvement in the sector as a whole largely resulted from one-time revaluation gains made during 1997 which were capitalized in 1998 following the end of the financial year (Table 52). Bulgarian banks remain, in general, poorly structured and organized; burdened by excessive staff, branches and other overhead; possessed of inadequate risk management systems; and in need of significant investment in new information technology. Privatization to foreign strategic investors is expected to play a key role in dealing with these issues.

165. For the first time since the introduction of the currency board, all banks are observing the aggregate limit on large loans in relation to capital, with this measure of overall exposure concentration falling considerably and steadily. The higher year end capital reduced loan concentrations relative to capital, thus facilitating compliance with this regulation. However, 16 banks are out of compliance with the limit on credit exposure to single borrowers (regulations 9) which is particularly troublesome in light of the difficulties having surfaced with certain large enterprises facing privatization/liquidation. This represents little improvement over the situation one year earlier when 17 banks were out of compliance. Regulation number 9, which regulates loan classification and provisioning treats exposures net of “highly liquid collateral”. Among assets eligible for this type of collateral are those properties secured with a first mortgage (albeit at half its value). The problem is that such assets are very difficult to value in Bulgaria and can be considered liquid only in limited circumstances. The risk is that banks may be holding claims on enterprises with significant negative net worth that might be forced into liquidation or—if the balance sheet items were assessed at real market value—bankruptcy. In such cases banks could find themselves without adequate provisions if they are unable to sell the collateral at current valuations.

166. Compliance with the regulation on foreign exchange open positions improved considerably in the past year, but nine banks—down from 23—remain out of compliance. Given the wide open positions following the 1997 crisis, a transitional arrangement is in place which allows banks to achieve compliance gradually by end-1998. While all of the noncomplying banks had reduced their level of exposure during the second quarter of 1998 (with the exception of two branches of large well-reputed foreign banks), the situation did not improve during the third quarter. As of end-September, the same 9 banks out of compliance at end-June remained out of compliance and 6 had increased their exposure.

167. Provisioning overall appears to be adequate, although there remain concerns about the quality of the underlying data reported to the BNB as well as the accuracy of banks’ exposure classification. The BNB has had to require reclassifications in a number of cases. Theoretical provisions while lower than actual provisions (for the system as a whole) at end-1997 have been somewhat below actual provisions during 1998 (Table 13).

Table 13.

Bulgaria: Actual and Theoretical Provisions in the Banking Sector

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Source: BNB and staff calculations.

Based on 4 percent for standard, 25 percent for watch, 50 percent for substandard, 75 percent for doubtful, and 100 percent for loss.

168. Non-performing loans as a percent of total loans stand at 10 percent at end-September 1998 a reduction from approximately 15 percent at end-December 1997. Loans rated as standard rose to almost 85 percent from slightly below 80 percent over the same time period (Table 53). Interpretation of these statistics must take into account the rapid rise in new exposures over the period and the fact that new exposures are less likely, on average, to be classified as non-performing than are older exposures. Consequently, such “positive” trends are likely to be observed whatever the underlying quality of the new credits vis-a-vis the old credits.

169. The vulnerability of the banking system to external shocks was tested at the time of the Russian crisis in August 1998. The crisis had mainly an indirect impact on the banking system, associated with the fall in the market value of bank holdings of Bulgarian government debt. Banks were quick to mark-to-market their holdings and made provisions to cover the decline in market value. As a result, the system’s capital adequacy fell from 34 percent at end-June 1998 to 32 percent at end-September. Losses in income were estimated at leva 130 billion, leading to a quarterly loss of about leva 75 billion which roughly offset profits accumulated during the first half of 1998. However, the decline in the market value of Bulgarian debt was temporary and it is expected that banks will be able to reverse a sizeable portion of the charges to income taken in the third quarter. One bank had significant direct exposure to Russia and suffered significant losses. The authorities have withdrawn the bank’s license and placed the bank in conservatorship.

E. Domestic Financial Markets

170. The development of domestic financial markets since the beginning of Bulgaria’s transition was strongly affected by repeated bouts of macroeconomic instability and associated foreign exchange crises, the deficit financing needs of the budget, the banking crisis of 1996, and the hesitant approach to structural reform. While there were no operational breakdowns of financial markets during the period under review, the 1996/97 crisis severely diminished their economic significance. The crisis caused a dramatic shortening of the maturities of newly issued government securities; a substantial drop in the volumes in the interbank money and foreign exchange markets; and a switch from deposits to fully collateralized repos in the interbank market which ceased to operate altogether at the peak of the crisis. The successful macroeconomic stabilization program launched in April 1997 initiated the recovery of all of these markets. However, secondary market transactions in government securities have remained insignificant while lack of direction and progress in structural reform marginalized the role of the stock exchange, kept institutional and foreign investors away, and prevented the development of a market for corporate debt.

Government securities market

171. Institutional arrangements for the operation of the primary and secondary markets for government securities were put in place in the early nineties. Auctions are conducted by the BNB on behalf of the MoF. Starting from April 1996, a system of primary dealers was introduced to encourage further the development of the primary and secondary markets in terms of volumes, depth, transparency, and liquidity. Primary dealers are licensed for a period of three months and can be banks or non-bank financial institutions. Since the middle of 1997 auctions are held on a regular weekly basis for t-bills: every auction includes 3-month bills while 6-month and 12-month bills alternate. The auction calendar with the amounts on offer is announced for a period of three months ahead. In addition, occasional auctions of longer-maturity bonds are held.

172. Since its inception in 1992, the primary securities market expanded rapidly reflecting the soaring credit needs of the government as the result of a widening budget deficit. The share of the deficit financed directly in the market rose to 77 percent in 1994, with the residual financed directly by the BNB. In 1995, the BNB suspended the extension of direct credit to the government thus forcing the entire deficit to be financed in the market. However, the onset of the financial crisis of 1996 marked a reversal: banks’ liquidity evaporated and market participants reluctance to participate in primary auctions drove up debt servicing costs and forced the budget to rely again on BNB credit. The further erosion of confidence led, inter alia, to a dramatic shrinking of the maturity of new issues of securities: in January 1997 7-day and 4-week t-bills had to be introduced and the average maturity of outstanding leva-denominated deficit financing securities fell from 8.9 months at the end-December 1996 to 3.4 months by end-March 1997 (Figure 12). Subsequently, the successful macroeconomic stabilization in the context of the adoption of the CBA restored confidence in the government: by June 1997 the shortest maturity of new issues was 3 months and by September 1998 the average maturity of outstanding deficit financing issues exceeded 15½ months. Under the CBA, the BNB no longer extends credit to the budget (other than onlending of Fund purchases).

Figure 12.
Figure 12.

Bulgaria: Average Maturity of Domestic Debt Financing Securities

(December 1996-September 1998)

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source: Bulgarian National Bank.

173. In 1995, the MoF began selling the so-called target issues to households at a yield slightly above the yield at primary auctions, but the volume of these issues has remained relatively insignificant. Their share in total outstanding deficit financing debt fell from 3 percent at end-1995 to less than 1 percent during the first half of 1997 before surging to 5.6 percent at end-1997. Since then relatively low returns reduced interest and the outstanding stock fell by more than half by end-September 1998. Briefly, in late 1996, some of these issues were indexed to the cost of living to attract demand in the face of rising inflation.

174. Secondary market transactions in government securities have been relatively unimportant, but domestic securities have been used actively as collateral for interbank transactions and Zunk bonds have recently gained importance in privatization deals. The former development reflected the BNB’s increasing resort to open market operations in 1995 and rising systemic risk during 1996 when lack of confidence induced banks to switch from uncollateralized interbank deposits and credits to collateralized repos. The latter became possible after the government lifted price restrictions on Zunk bonds in early 1997, increasing interest because of higher yields and the option of using these bonds at face value in privatization transactions. In early 1997, banks also traded Zunks to redistribute liquidity.

Interbank money market

175. Developments in the interbank money market were closely linked to those in the market of government securities and strongly affected by the banking crisis. The very active interbank market during 1991-1995 fizzled with the emergence of bank insolvencies. In the middle of 1995 interbank deposits fell because of the forced conversion of SSB interbank claims on Economic Bank and Mineral Bank into long-term securities. In early 1996, deteriorating bank liquidity and the shaken confidence among banks triggered a downward trend in the use of interbank deposits (Figure 13a). Ten banks were unable to raise funds in the interbank market (up from 4 in 1995) and the spread of interbank yields over the basic interest rate rose from 3 to 3.5 percent in 1995 to 4.6 percent by May 1996 (Figure 13a). More than half of interbank deposits were frozen in banks that were put into conservatorship by the BNB, inflicting significant losses on several other banks, especially the SSB. Towards the end of 1996 when it became clear that no further bank closures were imminent, trade among banks resumed and yields on interbank deposits briefly dipped below the basic interest rate. However, doubts about the government’s ability to service its domestic debt in early 1997 ground the interbank money market to a complete halt: only bilateral transactions between banks and the BNB took place. In preparations for the CBA, the BNB stopped open market operations on June 13, 1997.

176. Financial stabilization following the introduction of the CBA fostered the reemergence of the interbank money market and the peg to the DM initiated a trend towards integration of Bulgaria’s interbank market with European financial markets. Initially, increased bank liquidity and uncertainties as to the implications of the new monetary regime for bank operations kept volumes relatively low. Banks held large amounts of unremunerated excess reserves on settlement accounts with the BNB and interbank yields fell to an all-time low (Figure 14b). However, as liquidity management improved banks began placing resources abroad. This trend was reinforced when DM positions were excluded from open foreign exchange position limitations, effective January 13, 1998, and further when, effective April 1, 1998, conditions for access to minimum required reserves were eased. Consequently, money market interest rates moved closer to rates prevailing in the international DM money market.

Foreign exchange market

177. Given the relatively open character of the Bulgarian economy, the large share of deposits held in foreign exchange, and anecdotal evidence on extensive holdings of foreign exchange cash by the broad public, the foreign exchange market plays an important role for the Bulgarian economy. In addition to the formal interbank market, foreign exchange bureaus dominated the street scenes in all major cities prior to the adoption of the CBA and many banks had long-standing relationships with customers engaged in foreign trade. After soaring to record levels in 1995 when the economy grew moderately for the second year in a row, activity in the interbank foreign exchange market suffered a dramatic drop at the onset of the banking crisis: total volume fell by more than one third (Figure 13b). Following the implementation of the macroeconomic stabilization program and CBA in 1997, activity returned to pre-crisis levels and the BNB assumed a passive role. While the bulk of the transactions in the foreign exchange market are still in U.S. dollars, the peg to the DM has begun a gradual increase in the use of DM and other European currencies.

Stock market

178. The Bulgarian Securities Exchange-Sofia (BSES)—now the only stock exchange in Bulgaria—is still embryonic but expected to gain in importance. Following the consolidation in 1997 of several stock exchanges that proliferated in early 1990s, the BSES was established. It is segmented into official and free markets, with stringent listing requirements for the official market. While few companies are listed and market capitalization is small, it has facilitated the consolidation of ownership process that followed privatization, typical for transition economies. Its role in the economy is expected to gain importance with the second wave of privatization and rising investor confidence.

Figure 13.
Figure 13.

Bulgaria: Interbank Money and Foreign Exchange Markets January 1994-September 1998

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source; Bulgarian National Bank.
Figure 14.
Figure 14.

Bulgaria: Money Market Interest Rates

Citation: IMF Staff Country Reports 1999, 026; 10.5089/9781451804331.002.A001

Source: Bulgarian National Bank.

179. Soon after the first organized trading of securities started in November 1991 when the First Bulgarian Stock Exchange was officially registered a proliferation of Stock exchanges began. Four months later the Sofia stock exchange was established, followed a year later by the Danube Free stock exchange. In 1994, 20 stock exchanges and stock exchange subdivisions were operating, but with minor economic significance (Table 14).

Table 14.

Bulgaria: Indicators of the Early Stock Markets

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Source: BSES.

180. With the adoption of the law on securities, stock exchanges, and investment companies in July 1995—the first serious attempt to regulate capital markets—a process of consolidation began. Five regional stock exchanges merged into the First Bulgarian Stock Exchange and its name was changed to Bulgarian Stock Exchange in (BSE) December 1995. It took another year, however, before two key market institutions were established: the securities and stock exchange commission (SSEC) and the central depository. The SSEC introduced the requirement that all listed stocks must have their prospectuses approved by the SSEC in order to trade on the BSE. Since no company complied, trading was effectively suspended on October 23, 1996. The economic and financial crisis of late 1996/early 1997 prevented any further development of Bulgaria’s capital markets. In July 1997, the government decided to set up a national stock exchange and forced the Bulgarian Stock Exchange and the Sofia Stock Exchange to merge. As a result, the Bulgarian Stock Exchange-Sofia (BSES) started operation on October 21, 1997.

181. The BSES consists of a tightly regulated official market and a less regulated free market. The official market is divided into Segments A, B (Parallel), C (Provisional), and the bond market. The listing requirements get less stringent going from Segment A to Segment C, but all the companies in the official market are required to have prospectuses approved by the SSEC and to be registered with the Central Depository (Table 15). For the free market, the requirements are limited to a prospectus and free negotiability of shares.9 Every transaction in these markets has to be done through an investment intermediary that is a member of the BSES. As of October 1998, around 80 privatization funds and 80 brokers, and several foreign investors participated in the market. Initially, separate from these two markets, block trading was also allowed within the BSES. These transactions consisted of transfers of blocks of shares acquired in mass privatization among privatization funds and other participants, and formed the only significant trade in the first three months of the BSES. As of May 18, 1998 trades of this type have been prohibited, on the grounds that they do not allow a realistic price determination since the trades are negotiated and public information about the companies traded is not usually available.

Table 15.

Bulgaria: Listing Requirements for Stock Exchange

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Source: BSES.