Recent economic developments

Performance under the program so far has been quite strong and in many areas program targets were exceeded. Nourished by strong growth in investment and a large reduction in the negative contribution of net exports, real GDP grew in 2004 by 5.6 percent – the highest growth rate since the start of the economic transformation. A rebound in agricultural output and record-high tourist receipts have also contributed to growth, while domestic demand remained broadly unchanged, reflecting a tighter than programmed fiscal performance. Robust output growth resulted in a lower unemployment rate, although at 12.7 percent of the labor force it is still high and many jobless are still to benefit from the expansion of the economy.

Even though economic growth in 2004 has exceeded somewhat the estimated potential, and despite surging oil prices, end-year inflation declined from 5.6 percent in 2003 to 4 percent at the end of 2004, being just slightly above the program target. Although inflation is still a bit higher than in most of the main trade partners, international competitiveness has not been significantly damaged. While the REER appreciated modestly, unit labor costs continued to decrease. Over the medium term, inflation is expected to decline further, but is likely to remain above the EU average due to a faster productivity growth and some administrative price adjustments still to be implemented.

There has been an overall strong performance under the program, and most of the program conditionality for the first review was satisfied. The nonobservance of a few performance criteria was rather minor and technical in nature. All prior actions have been implemented. Four out of five prior actions were met well in advance, one prior action – on several tax laws required to make the National Revenue Agency (NRA) operational – was met one day late. In fact, due to some technical reasons and because of several consecutive holidays in early May, after the Council of Ministers promptly approved the laws, they were submitted to Parliament as required, but four instead of five working days before the Board date. Nevertheless, this provided staff with sufficient time to verify the implementation of these measures. In addition, all program objectives remain in place and the missed criteria have been timely addressed as part of the remainder of the program.

Fiscal policy

Fiscal policy has been appropriately tight over the last couple of years and has simultaneously created more room for priority spending. Strong revenue growth and improved tax compliance in 2004 resulted in a sizeable consolidated budget surplus that amounted to 1.8 percent of GDP – twice as high as programmed. On the back of over– performance of VAT, excise and import duties, revenue was about one percentage point of GDP higher than in the previous year despite the cut of corporate tax rate. In nominal terms, expenditure was contained as programmed, but declined somewhat as percentage of GDP because of the higher GDP growth and lower subsidies owing to continued structural reforms. Social assistance and unemployment payments were also lowered in line with reduced unemployment and higher disposable household income.

The economic program for 2005 continues to rely on prudent fiscal policy providing at the same time more flexibility to accommodate those expenditure overruns that are unavoidable. Notwithstanding the approaching parliamentary elections, the authorities are determined not to exceed the programmed expenditure total and to stick to a consolidated budget surplus of at least one percent of GDP. Although it appears a slight fiscal relaxation compared to the 2004 outcome, it is justified in view of the reduced external vulnerability. The authorities have also committed to tighten fiscal policy further if the external current account deficit proved to be weaker than projected. As a way of preventing revenue overperformance from generating correspondingly higher spending, the authorities agreed to save the bulk of any tax revenue overperformance of the general government.

In their medium-term fiscal framework (MTFF), the authorities envisage in principle balanced budgets for the years to come with the possible exception of 2007, which is the expected year of EU accession and as such will be marked with more accession-related spending. Under a currency board arrangement, this framework is seen as the only proper response to the external current account deficits and as an instrument for offsetting the impact of the credit boom. Expenditure restructuring, centered on lowering of current spending, is a key element of the MTFF. The authorities believe that the ongoing institutional strengthening will strongly support the MTFF. In this regard, continued efforts have been put forth to make the NRA operational as of the beginning of the next year.

Credit growth

The last three years were marked by a rapid credit growth to the private sector, with an average pace of increase over the period of about 47 percent annually. The credit expansion has been financed mainly by a strong increase in deposits, and recently by a sharp decrease in banks’ net foreign assets. In view of declining nominal interest rates, rising income expectations, and a stable banking system this development was anticipated. As a share to GDP, however, credit to the non-government sector has still been lagging behind compared to virtually all the EU countries, including the newcomers. In this regard, and given the still low level of capital stocks in the country, a strong credit growth, but at a lower and more healthy pace, is very likely over the next several years. A similar phenomenon has been observed in other European countries before joining the EU and potential risks have been successfully contained.

The authorities are fully cognizant of the macroeconomic and financial stability risks associated with rapid credit growth and are strongly committed to deal with the situation. Early attempts at reducing credit growth by taking measures to lower liquidity in the banking system proved to be insufficient due to the open capital account, combined with the relatively high return on capital in the country, which has been attracting solid capital inflows. In response, the authorities requested and the Fund provided technical assistance on policies and tools to manage rapid credit growth. Following the conclusions of the highly appreciated technical assistance, the authorities adopted measures – on a temporary basis only – to control more directly the credit extension.

In February 2005, the BNB announced some amendments to the regulation on the minimum reserve requirements. The amendments stipulate that banks whose portfolio expands more than 6 percent per quarter will be subject to an unremunerated deposit requirement of twice the excess credit expansion, unless the ratio of their credits to deposits is below 60 percent. However, as the measures became effective as of April 1, a number of banks opted to boost lending prior to that date so as to create a larger base from which to calculate growth rates. This unwelcome development prompted the central bank to undertake an additional set of measures that was announced in late April. These measures include: (i) limiting the base from which credit growth is to be measured to a maximum of 4 percent above banks’ credit stocks at end-February; (ii) moving to measurement of credit growth on the basis of daily average levels over the quarter rather than end-quarter levels; (iii) introducing limits of 5, 12.5 and 17.5 percent cumulative growth compared to the base level in the second, third and fourth quarters of 2005 respectively. The ultimate goal is to lower the annual rate of credit growth to about 30 percent by the end of 2005 and the monetary authorities are firmly committed to succeed in their endeavors.

External sector

On the back of strong growth in services, particularly tourist receipts, as well as a significant increase in current transfers, the external current account deficit improved markedly in 2004. Although at 7.5 percent to GDP the deficit is still considered high and needs to be further addressed, it was 9.2 percent of GDP in 2003 and was projected to decline to 8.8 percent of GDP in the following year. The merchandise trade deficit, however, continued to widen as imports kept on growing faster than exports, reflecting rapidly growing economic activity and surging oil prices. Exports also rose impressively despite a moderate real appreciation. As most of the imports relates to growing domestic demand, partly financed by bank credits, the authorities continue to exert efforts to moderate imports by tempering credit growth.

Financing current account deficits does not seem to pose any problems so far. On the back of high FDI inflows, official foreign reserves have grown in each year since the currency board implementation in 1997. In 2004, gross international reserves rose by 28 percent, covering more than five months of prospective GNFS imports and stood twice as high as the short-term external debt. Although FDI in 2004 was surprisingly low (because of a debt financed merger and acquisition transaction of a big domestic company, followed by a transfer of the realized capital gains abroad), expectations for 2005 and beyond are quite favorable, showing FDI inflows exceeding current account deficits.

The debt burden continues to lessen as the authorities continue their policy aimed at reducing public debt and external borrowing. The reduction of foreign public debt over the last three years has been remarkable – from 66 percent to GDP in 2001 to about 35 percent at the end of 2004. By redeeming US$ 938 million of Brady bonds in January 2005, financed exclusively from resources accumulated in the fiscal reserve account, foreign public debt fell below 30 percent of GDP. Debt sustainability analysis provided by staff shows that in virtually all scenarios external debt-to-GDP ratios decline, meaning the medium-term current account appears sustainable. The authorities’ strategy of shifting from external to domestic borrowing will also help absorb excessive bank liquidity, provide assets to the private pension funds, and strengthen domestic capital markets. Nonetheless, as the public borrowing requirement has been constantly falling, total public debt is expected to decline from 41 percent to GDP in 2004 to less than 20 percent by 2010, while the foreign public debt is expected to fall to just about 13 percent.

In conclusion, while asking for completion of the first review, the authorities wish to express once again their gratitude to the Fund for providing surveillance and assistance, which have been helping Bulgaria to make progress in implementing the needed economic reforms, as well as during the preparation for the EU accession. The authorities are firmly committed to the policy framework under the current program and they believe its successful implementation will make the exit from Fund financial assistance a smooth one.