Bulgaria: Second Review Under the Stand-By Arrangement and Requests for Waiver of Performance Criteria and for Postponement of Third Review

The staff report for the Second Review Under the Stand-By Arrangement and Requests for Waiver of Performance Criteria highlights Bulgaria’s economic growth, fiscal policy, and reforms. The economic program for 2006 relies on fiscal and credit restraint to rein in demand and strengthen the balance sheets of government and banks, and on structural reforms to stimulate supply. Quarterly credit growth limits and higher penalties for exceeding them are expected to help ensure achievement of this target. Measures to slow down household credit should additionally contribute to current account adjustment.


The staff report for the Second Review Under the Stand-By Arrangement and Requests for Waiver of Performance Criteria highlights Bulgaria’s economic growth, fiscal policy, and reforms. The economic program for 2006 relies on fiscal and credit restraint to rein in demand and strengthen the balance sheets of government and banks, and on structural reforms to stimulate supply. Quarterly credit growth limits and higher penalties for exceeding them are expected to help ensure achievement of this target. Measures to slow down household credit should additionally contribute to current account adjustment.

I. introduction

1. A staff team1 visited Sofia during October 13–26, 2005 and January 19–26, 2006 to conduct discussions on the second review under the stand-by arrangement. The 25-month arrangement in the amount of SDR 100 million (15.62 percent of quota) was approved on August 6, 2004 and its first review was completed on May 18, 2005 (IMF Country Reports No. 2004/267 and 2005/169). The authorities continue to treat the arrangement as precautionary. They made early repayments to the Fund in December 2005 and February 2006 and intend to make all remaining repurchases on the expectations schedule (Table 1). The second review has been delayed because of the election and the time required to reach agreement with the new government on the fiscal parameters of the program.

2. EU accession with an unchanged peg of the lev to the euro under the currency board arrangement (CBA) remains the authorities’ overarching objective. Following parliamentary elections in June 2005, the socialist party, the party of ex-king Simeon, and the Turkish minority party formed a new government in August. As the government is seeking to accede to the EU on January 1, 2007, required legislation—including judicial reform—is likely to be adopted under fast-track procedures before the EC publishes its recommendation in mid-May 2006. Macroeconomic policy is aimed at observing all Maastricht criteria in time for euro adoption in 2009–10.

3. Macroeconomic policy implementation was broadly in line with commitments and economic growth was strong, but the external current account deficit widened sharply, heightening external vulnerability (Text Table 1). The current account deterioration to nearly 15 percent of GDP, relative to 7½ percent of GDP projected at the time of the first review, resulted from an unanticipated increase in domestic demand pressures which were aggravated by supply shocks (¶5 and 6). Because of the large external slippage, the review discussions focused on ways to reduce the external vulnerabilities and on meeting the broader objectives of the original program.

Text Table 1.

Bulgaria: Selected Economic Indicators, 2004–05

(percent of GDP unless otherwise indicated)

Sources: Bulgarian authorities.

4. All quantitative performance criteria for end-June and end-September 2005 and indicative targets for end-December 2005 were observed but the pace of structural reforms was slower than envisaged under the program (Table 2). Two structural performance criteria—the adoption of the National Revenue Agency (NRA) procedural code and the incorporation of the judicial accounts in the budgetary payments system—were implemented with delays. A third performance criterion was only partially implemented: winning bids were selected for two out of three electricity generation companies, but the highest offer for the third one was rejected as unsatisfactory. The authorities request waivers for the nonobservance of these performance criteria (LOI, ¶2). Two structural benchmarks that did not require legislative action were observed on time. However, benchmarks that required governmental or parliamentary action were missed and in some instances implemented with delay.

II. Recent Developments

5. The 2005 current account deficit is estimated to have been nearly 15 percent of GDP, or nearly double the first-review projection, mainly due to booming domestic demand. Domestic demand expanded almost twice as fast as projected, but GDP growth was in line with projections as this expansion was offset by lower net exports (Table 6). The domestic demand expansion explains most of the current account deterioration, the remainder being due to higher net income payments and lower transfers. The rapid growth in domestic demand led to a sharp fall in private saving that was only partially offset by an increase in public saving (Text Table 2). With banks aggressively providing household credit, private consumption surged, possibly reflecting rising expectations of real income convergence in the context of approaching EU membership. Higher investment was driven by greenfield foreign investment, but gross private foreign debt was 10 percentage points of GDP above projection. Available national accounts data, however, do not permit a precise breakdown of the relative contribution of households and corporations to the deterioration of the saving-investment balance. In the second half of the year, domestic demand pressures also pushed up core inflation (Figure 1).

Text Table 2.

Bulgaria: National Accounting Indicators, 2005

Sources: Bulgarian authorities; and Fund staff estimates.

Inward FDI excluding mergers and acquisitions, privatization and reinvested earnings.

6. The slowdown in export volume growth appears to be primarily due to temporary factors rather than competitiveness problems (Box 1). Export volume growth slowed as a result of the summer floods, the lifting of EU quotas on textile imports2, and restructuring in the metals sector (Table 8 and Text Table 3). Competitiveness indicators (such as relative unit labor costs and export market shares) though are satisfactory (Figure 3), and Bulgaria remained an attractive destination for foreign investment.3 However, the buoyancy of trade prices is expected to have an adverse effect on the trade balance for some time. Apart from the widening of the negative net income balance, which resulted from higher profits of foreign-owned enterprises, the reasons for the deterioration of the invisibles accounts are less clear: tourism was less buoyant than expected, possibly due to the floods; the sharp deterioration of other services may have been related to the surge in investment; and the lower than expected private transfer receipts could reflect a switch to other channels of payment.4

Text Table 3.

Bulgaria: External Current Account, 2005

(percent of GDP)

Sources: Bulgarian authorities; and Fund staff estimates.

Current Account Developments, 2004–06

The current account deficit widened to nearly 15 percent of GDP in 2005, up sharply from 8½ percent in 2004. The bulk of the deterioration occurred in the trade account, but the services balance also weakened.

The trade balance was affected by exogenous shocks and high domestic demand. The program’s demand management policies, the partial unwinding of the shocks, and substantial export-oriented investment previously undertaken should aid a recovery in 2006. The buoyancy of both export and import prices is exacerbating the effect on the balance, because of the larger share of imports.

  • Real export growth in 2005 was depressed by several temporary factors. The summer floods damaged crops and infrastructure, affecting exports of agricultural raw materials and processed goods. The major steel producer in the country, currently engaged in a substantial expansion of capacity, shut down part of its plant, and the impact of the expiration of the Multi-Fiber Agreement was larger than anticipated. Together, these factors affected nearly 35 percent of merchandise exports. However, in other areas—especially manufactured investment goods, but also consumer goods excluding textiles—export growth was robust. This, together with indicators such as a decline in relative unit labor costs and rising export market shares, suggests that lack of competitiveness is not the root cause of the slowdown in export growth (Figure 3). Accordingly, reimposition of quotas on Chinese textile exports to the EU in the second half of 2005, substantial additions to capacity at the steel plant, high recent investment more broadly, and the recovery from the floods should help export growth return to its previous trend in 2006.

  • Real import growth remained high in 2005, notwithstanding a sharp increase in import prices. However, the composition of imports shifted markedly to investment goods, while the growth rate of consumption imports moderated. In 2006, the programmed tightening of policies should further ease consumption demand, but the demand for investment imports is expected to remain high.

  • Higher export and import prices, which both increased by nearly 14 percent in 2005, also contributed to the deterioration of the trade balance. The price increase, which is in excess of the rise in the GDP deflator, resulted in both exports and imports rising as a share of GDP, with the impact on the trade balance being greater for imports because of their larger relative size (Box Figure 1). In 2006, continued high growth of prices will again drive the increase of both exports and imports relative to GDP, with the trade deficit projected to decline in relation to GDP because of the pick-up in export volume growth.

Box Figure 1.
Box Figure 1.

Bulgaria: Exports and Imports as Share of GDP, 2002–06

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

The deterioration in the services balance is harder to explain. Some of the deterioration resulted from higher transportation costs, and the growth of tourism exports may have been affected by the floods. The marked deterioration in the “Other services” balance, however, is not well understood. The spike in the imports of such services could reflect the services part of large investment projects, while the export developments may, in part, reflect a natural slowdown following very rapid growth in 2004. Anecdotal evidence does not, however, suggest competitiveness problems. Indeed, there appears to be substantial interest by foreign investors, including by multinationals, in business process outsourcing.

7. Large current account deficits are not unusual in the region, but the magnitude and the speed of the slippage in Bulgaria were a surprise (Figure 6). A number of EU accession countries have experienced large investment inflows because of capital scarcity high risk-adjusted rates of return. These capital inflows have contributed to growth and convergence. Compared to Bulgaria, however, the Baltic countries have experienced higher growth and a slower deterioration in their net international investment position.

8. In response to the rising external vulnerabilities, and as envisaged in the program, a cautious stance on fiscal policy was pursued (Text Table 4). Rapidly rising indirect taxes (especially VAT) boosted revenue above projections. This overperformance was largely saved in accordance with the program.5 Expenditure was 0.8 percentage point of GDP above projection as a result of unbudgeted spending on flood relief and the partial clearance of hospital arrears. With other expenditure also running ahead of budgeted amounts, the new government curtailed customary year-end spending; pension bonuses were about half their 2004 level, and no funds were released for bonuses for government workers.

Text Table 4.

Bulgaria: Fiscal Operations, 2004–05

(percent of GDP, unless otherwise indicated)

Sources: Bulgarian Ministry of Finance; and Fund staff estimates.

9. Policies to restrain bank lending were continued, but nonbank financial intermediation grew rapidly (Text Table 5 and ¶13). As the bank credit flow exceeded 12 percent of GDP in 2004, the BNB set quantitative limits on bank lending to address the emerging macroeconomic imbalances and prudential risks. These measures were broadly observed, although end-year window dressing led to a 0.6 percent of GDP lending spike (reversed in early 2006) that pushed the credit flow to 11 percent of GDP, 0.8 percentage points more than projected. Household credit rose as a share of total bank lending, and firms increasingly financed themselves through bonds and leasing. On the whole, financial flows to the private sector were little changed year on year. Despite the surge in lending, the banking sector (including the balance sheets of all major banks) appears sound, with overdue loans well provisioned and a high capital adequacy ratio.6 The constraints on bank lending contributed to development of the small but rapidly growing nonbank financial sector.

Text Table 5.

Bulgaria: Domestic Financial Flows, 2004–05

(percent of GDP)

Sources: Bulgarian authorities and Fund staff estimates.

Staff estimate.

Excluding intercompany and government guaranteed debt.

Including intercompany debt.

10. After languishing in 2005, structural reforms have picked up in recent months. Structural reforms had slowed before and after the election, but in December 2005 the NRA procedural code was approved by parliament and on January 1, 2006 the long-planned NRA was launched. Health care reform accelerated as political pressure built up in the wake of hospital arrears accumulation. An EU-consistent insurance law was adopted in December, modernizing the supervisory regime. However, there was only limited progress with privatization and labor market reforms. Key privatization transactions were challenged in the courts. The new government required time for consultations with the social partners regarding its labor market policies.

III. The 2006 Program

11. Discussions focused on measures to contain rising external vulnerabilities and on policies to boost growth. The authorities agreed that the widening current account deficit and rising foreign debt had increased Bulgaria’s vulnerability to exogenous shocks. To address the saving-investment imbalance, policies were needed to reduce consumption growth and improve the trade balance by boosting competitiveness, while providing room for investment. Staff and authorities concurred that financial sector vulnerability—while rising after three years of rapid credit growth—remains contained, but measures were nonetheless agreed to strengthen bank balance sheets and nonbank supervision. To reduce excess demand, the demand management measures are complemented by supply enhancing structural reforms.

A. Outlook and Risks

12. The policies outlined in the SSMEFP are designed to sustain economic growth while bringing the current account deficit and inflation under control. Baseline projections assume EU accession in 2007 and respect the 40 percent expenditure-to-GDP limit under the coalition agreement (¶7).

  • Real GDP growth is projected to remain at 5½ percent in 2006, while the current account deficit should narrow from 14.9 to 12.9 percent of GDP. In response to tighter macroeconomic policies, domestic demand growth is projected to slow. In contrast to 2005, net exports are expected to make a small positive contribution to growth. Reflecting the rapidly expanding capital stock and the expected impact of structural reforms on total factor productivity growth, GDP growth is projected to exceed 6 percent over the medium term.

  • Inflation is projected to peak in Q1 before abating to 5.7 percent by year end. On top of the price increases in late 2005, the authorities brought forward EU-required increases in excise taxes on alcoholic beverages and tobacco products to January 2006, raising the projection of average inflation by 2.3 percentage points. Later in the year, food prices are projected to decline as the impact of last year’s floods dissipates (Text Figure 1). Inflation is targeted to decline to 2.5 percent in 2008, consistent with the government’s goal of euro adoption in 2009–10.

    Text Figure 1.
    Text Figure 1.

    Bulgaria: Year-on-year Inflation, 2005–06

    (In percent)

    Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

  • Private domestic saving is projected to recover to 4.6 percent of GDP in 2006, an improvement of 2 percentage points. Private consumption growth is projected to slow to slightly more than half its 2005 rate in response to the large price increases in late 2005 and early 2006, tight incomes policies, and a slowdown in household credit in the wake of recent measures. Over the medium term, saving is projected to continue to increase faster than investment on the strength of a continued slowdown in private consumption growth as actual income approaches expected permanent income (Figure 7).

  • The external outlook hinges significantly on rapid export growth (Text Figure 2; see also Box 1). Export volume growth is projected to revert to trend following the expansion of industrial capacity, a recovery of agricultural production, and higher EU growth. Competitiveness will be further improved by continued wage restraint and the recent and prospective reductions in nonwage labor costs. Import growth is projected to moderate but will likely remain high due to rising imports of investment goods and raw materials for export processing (Table 7 and Figure 2). At 9.4 percent of GDP, FDI inflows are projected to finance over 70 percent of the current account deficit. Half of the projected increase in foreign reserves has been pledged as a security deposit for future imports of military hardware, reducing the reserve cover ratios (Table 7 and ¶15). The current account deficit is projected to narrow to 7 percent of GDP in 2011, when foreign debt is expected to fall below 60 percent of GDP (Table 12). Projected debt ratios are sensitive to noninterest current account shocks but less so to interest rate or GDP shocks (Figure 8).

Text Figure 2.
Text Figure 2.

Bulgaria: Current Account Deficit and Trade Volume Growth, 2005–06

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

13. While the program is designed to contain Bulgaria’s vulnerabilities, risks remain. The measures in the proposed program aim to arrest the recent current account deterioration and gradually reduce the current account deficit, while some of the one-off factors that contributed to the deterioration should unwind automatically. However, the current account deficit may remain uncomfortably high over the next few years as Bulgaria remains an attractive destination for foreign investment and if domestic savings stay low. The program for 2006 will strengthen the position of reform and stability minded policymakers and avoid significantly weaker fiscal, credit, and structural policies—a point persuasively made in the 2004 EPA paper (IMF Country Report No. 04/176).

B. Fiscal Policy and Reforms

14. The 2006 fiscal program aims for a surplus of 3 percent of GDP, compared with a surplus of 0.5 percent envisaged at the first review and a balanced budget approved by parliament (Text Table 6).7 Although the fiscal position is solid, a modest further tightening relative to 2005 was deemed necessary in view of the recent sharp deterioration of the private saving-investment balance to buttress investor confidence that the authorities remain committed to sound policies and medium-term sustainability in the context of the CBA.

Text Table 6.

Bulgaria: Fiscal Position, 2004–06

(Percent of GDP)

Sources: Bulgarian authorities; and Fund staff estimates.
  • Revenue is projected at 39.9 percent of GDP, or 2¼ percentage points higher than in the approved budget. Relative to the 2005 outcome, the revenue-to-GDP ratio will decline by 1 percentage point, principally reflecting a drop of 1.4 percentage points due to a 6 percentage point reduction in social security contributions but also the effect of income and profit tax reductions (¶6). These revenue losses will be mitigated by higher excise and property taxes, some broadening of indirect tax bases, and improving compliance. Nontax revenue is projected to decline in relation to GDP following a rise in 2005 due to one-off factors. Under an adjustor the authorities will save 50 percent of any revenue overperformance (¶4).

  • Expenditure is projected to decline to 36.9 percent of GDP. However, real expenditure is still projected to increase by 0.9 percent, following a jump of 8.8 percent in 2005. Expenditure plans aim to limit discretionary spending to 93 percent of the budgeted amounts, providing savings of ¾ percent of GDP. The release of the remaining 7 percent is conditional upon a significant reduction of the current account deficit (¶4).

15. The fiscal program is subject to significant risks, and the authorities are committed to take compensatory measures if these materialize. The implementation of major tax administration reforms creates short-term revenue risks. The NRA was launched shortly after the procedural code was approved by parliament, and before all supplementary VAT, CIT, and PIT legislation was in place. Excise taxes will be collected by the customs administration from July 2006. Measures are being taken to reduce revenue losses from duty free sales (¶9). Success of the expenditure program requires progress with structural reforms. The health sector is being reformed to prevent a recurrence of expenditure overruns. Plans for reforming the education sector would free up resources for teacher salaries but will require strong political commitment to implement. A planned employment cut in the central administration may also be difficult to implement. Further, there may be pressure to raise spending related to EU accession and defense beyond the amounts budgeted. To guard against fiscal slippage, the authorities are prepared to implement additional expenditure cuts (especially for non-road maintenance and operations) or revenue measures (¶4).

C. Incomes and Labor Market Policies

16. Incomes and labor market policies under the program aim to bolster competitiveness and economic growth (¶12). The public sector will continue to signal wage restraint through tight budgetary and SOE wage bills, and the minimum wage will remain unchanged in the remainder of 2006. By end-March 2006, the authorities expect to reach agreement with the social partners to abolish the portability of seniority bonuses—a major hindrance to job mobility and employment creation—and increase work time flexibility. However, difficult discussions with the social partners suggest that this deadline is likely to slip at least in the case of the seniority bonuses. These measures will contribute to lowering unemployment and bolstering competitiveness.

D. Financial Sector Policies

17. The program aims at a further slowdown in bank credit growth for macroeconomic and prudential reasons. As the CBA precludes the adoption of orthodox measures to slow credit growth, the BNB has extended the quarterly credit expansion limits introduced last year until the end of 2006.8 At the same time, it sharply raised the penalty deposits for banks exceeding the limits (¶13). As the limits allow a constant nominal growth of credit per quarter, annual credit expansion is expected to decline from 32.3 percent (equivalent to 11 percent of GDP in flow terms) in 2005 to 17.5 percent (7 percent of GDP) in 2006. It is recognized that the measure restricts competition, risks being circumvented, and encourages disintermediation, but staff and authorities view steps to curb credit expansion as preferable to direct controls on capital inflows. A strategy for phasing out these measures in the context of EU accession will be discussed during the upcoming mission to conduct the third review and the Article IV consultation.

18. The program contains additional measures to mitigate the risks related to the rapid growth of credit to households. In response to the recent increase in overdue household loans, the BNB raised provisioning requirements for such loans, increased capital adequacy requirements for mortgages, and asked banks not to extend additional loans to households that do not meet the requirement of a minimum amount of income after taxes and debt service (¶13). These market-based measures are expected to make room under the credit growth limits for corporate borrowers, who are more easily able to find alternative sources of financing. Furthermore, in view of the observed correlation between household credit and consumer goods imports (Text Figure 3), these measures have macroeconomic advantages as well.

Text Figure 3.
Text Figure 3.

Bulgaria: Household Credit and Imports of Consumer Goods, 2002–05 (Euro, Million)

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

19. Recognizing that the bank credit limits encourage nonbank lending, the authorities intend to improve nonbank supervision (¶14). The new insurance law and an amendment to the pension law aim to modernize the risk management practices of the nonbank financial sector. The amendment to the pension law also removes the requirement that pension funds invest a portion of their assets in government securities. Staff would have preferred to delay the lifting of this requirement until EU accession, but accepted that the macroeconomic benefit of such a delay would be modest. Leasing companies have started reporting their activities to the BNB. Bank-owned leasing companies are indirectly supervised because banks are supervised on a consolidated basis. The same will apply to companies owned by financial conglomerates following adoption of the financial conglomerates law.

20. The authorities intend to continue reducing external public debt and to deepen domestic securities markets (¶16). They have reduced external public debt through regular amortization and the early redemption of IMF and World Bank loans, but future such operations will be subject to reserve adequacy considerations. The program contains ceilings on the contracting and guaranteeing of external public debt (performance criterion). Notwithstanding a domestic financing surplus, the authorities intend to issue domestic government debt. Such borrowing supports development of the domestic securities market, while helping to absorb bank and pension fund liquidity.

E. Other Structural Reforms

21. The program’s structural reforms aim at improving the business climate by lowering the cost of doing business, reducing corruption, and boosting competitiveness. Although the election delayed implementation of certain reforms, and the new government took time to formulate its priorities, reform momentum has recently picked up (¶16). A law on business registration is expected to be approved soon by parliament (prior action). Its early implementation is a performance criterion. Consistent with an EU requirement, constitutional amendments are likely to be approved soon to reform the judiciary and make it more accountable to parliament. The improved regulatory environment in the energy and water sectors paves the way for future privatizations and/or public-private partnerships. A number of companies are to be privatized in 2006, including three electricity generation companies that could not be sold by the previous government. Planned concessions for the operation of ports and airports will stimulate tourism and merchandise trade. Together, these reforms are expected to stimulate supply, but their precise impact is difficult to assess. Over time, they should help improve the current account. The impact of these reforms in the short run, however, is likely to be negative because the new investment encouraged by the improved business environment will be accompanied by capital goods imports.

F. Program Conditionality and Waiver Requests

22. As in 2005, the program includes four quantitative performance criteria. Three of these deal with the fiscal sector—a floor for the fiscal surplus, and ceilings on arrears and on contracting or guaranteeing non-concessional external debt. In addition, a ceiling has been set on the wage bill of selected state-owned enterprises.

23. Structural conditionality consists of one prior action, six performance criteria, and eleven benchmarks (Text ). As for the program relevance of the prior action and performance criteria:

  • Approval by parliament and operationalization of the business registration legislation will help boost economic growth and reduce corruption.

  • The new VAT law is crucial for revenue administration.

  • Tax rates and bases need to be maintained to safeguard revenues.

  • Preventing an increase in the monthly minimum wage limit is key to competitiveness and current account sustainability.

  • Completion of the privatization deals contributes to economic growth and strengthens the fiscal position.

Text Table 7.

Bulgaria: Structural Conditionality Under the SBA, 2006

Except for those described in ¶6 of the SSMEFP.

24. It is proposed to change the conditionality of the first review in the following respects:

  • To convert the missed structural performance criterion for the privatization of three electricity generation companies into a performance criterion to select winning bidders for two companies while the court case of the third company is pending.

  • To split the benchmark for parliamentary approval of new PIT, CIT and VAT laws into a performance criterion for the VAT law and a benchmark for the PIT and CIT laws.

  • To reschedule the benchmarks dealing with labor market reform, consistent with the new government’s consensual approach to labor relations.

  • The authorities remain committed to enacting the constitutional amendment to allow municipalities to set their own tax rates, but could not commit to a time schedule in view of the broad political support required for such an amendment.

  • Because of the delay in completing the second review, the authorities are requesting to combine the third and fourth reviews and to complete the combined review by September 5, 2006. On current plans, this review could be brought to the Executive Board in early August 2006, together with the 2006 Article IV consultation.

G. Data Issues

25. Data provision and quality are generally sufficient for program monitoring, but the authorities are committed to further improve the quality of statistics (¶17 and Appendix III). The analysis of the rapid deterioration of the current account would have benefited from more up-to-date and detailed national accounts and balance sheet data. The authorities intend to address these gaps and may request technical assistance in statistics.

IV. Staff Appraisal

26. Policy implementation under the 2005 program has once again been strong on the macroeconomic side, and mixed on the structural front. The authorities’ efforts to meet their commitments in the fiscal area by maintaining a cautious fiscal stance in response to higher than expected tax collections have been commendable. The authorities have also been successful in slowing credit expansion in line with the program, although the end-year target was missed due to a temporary credit spike. By contrast, implementation of structural reforms was again delayed—in part due to the elections and preoccupation with EU accession—and several structural performance criteria and benchmarks were breached. On a positive note, however, the parliamentary approval of its procedural code allowed the long planned launching of the NRA at the start of 2006.

27. Notwithstanding satisfactory macroeconomic policy implementation, a sharp widening of the private saving-investment imbalance caused the external current account deficit and inflation to be much higher than envisaged. Exogenous factors such as severe floods, higher oil and administered prices, and restructuring in the metals sector contributed to this outcome. However, based on available indicators, competitiveness appears to have been maintained, but will need to be watched carefully. Imports of investment goods financed by foreign direct investment were higher than projected, suggesting the prospect of higher growth ahead. Economic growth in 2005 remained strong, and would have been higher in the absence of the exogenous factors.

28. Rising excess private demand and exogenous shocks have increased external vulnerabilities beyond the levels envisaged under the 2005 economic program. Although some of the adverse shocks are likely to be temporary, the authorities face the challenge of adjusting their policies to reduce the external current account deficit and stabilize, and eventually reduce, the external debt ratio and build cushions against possible future contingencies. An appropriate policy mix would therefore include measures to restrain demand, bolster competitiveness, and expand supply.

29. The limited effectiveness of the credit measures implemented thus far and the risks of continued rapid credit growth magnify the policy challenges facing Bulgaria. The open capital account has permitted qualified businesses to access credit abroad while allowing domestic banks to redirect their credit to households. At the same time, while increased financial intermediation is welcome from a structural perspective, the recent rate of credit expansion has been uncomfortably high on macroeconomic and prudential grounds.

30. The authorities’ policies for 2006 provide an appropriate response to this challenge. The measures to further tighten the fiscal stance will contribute to reducing excess domestic demand, as should the credit measures that have been strengthened and redirected to households, which have less access to foreign capital markets. In addition, the measures are helpful to strengthen banks’ balance sheets. The restrained incomes policy and the reduction of nonwage labor costs are apt to strengthen further competitiveness in the currency board environment. Equally important for easing the excess demand pressures, however, is the authorities’ commitment to structural reforms aimed at increasing the productive capacity of the economy.

31. The proposed fiscal effort is commendable. It is an appropriate response to the widening private saving-investment gap and sends a clear signal of the authorities’ commitment to prudent macroeconomic policies in the context of the currency board arrangement. It is important now for the authorities to make every effort to reach their revenue target by ensuring that the ongoing restructuring of revenue administration does not result in collection losses and by introducing limits on duty free sales. In this regard, the closure of duty free outlets, especially those outside border areas, should also be a priority. Even more important are efforts to restrain expenditure to the agreed level by enforcing the cuts of discretionary spending, reducing central administration employment as envisaged, resisting pressure for higher defense spending, and implementing reforms to health and education in an expenditure neutral fashion. The targeted fiscal surplus, privatization receipts, and the most recent advance repurchase to the Fund should contribute to a further significant reduction in the public debt ratio. Future debt reduction operations should, however, be mindful of the need for maintaining an adequate international reserve cover. The authorities’ commitment to strengthen fiscal policy further if the current account deficit does not improve as projected during 2006 is important and welcome.

32. Looking ahead, there is a need for greater fiscal transparency. The 2007 budget should be prepared on the basis of a realistic revenue estimate, with a transparent accounting of expected receipts of EU funds and their spending and without within-year caps on discretionary expenditure.

33. Notwithstanding their well-known drawbacks, the extension of the bank credit expansion limits should contribute to current account adjustment. As households have limited alternatives to bank financing in the short term, the emphasis on prudential measures to dampen household credit should give greater traction than in the past in slowing aggregate private sector borrowing. Additionally, these measures should strengthen banks’ balance sheets. However, the currency board arrangement and an open capital account circumscribe the effectiveness of the measures taken beyond the near term. These measures have contributed to the rapid growth of partially unsupervised nonbank intermediation and foreign borrowing. Moreover, under the “single passport” EU banks will obtain unrestricted access to the domestic credit market upon EU accession. To give domestic banks a level playing field and remove the distortions resulting from these measures, the latter will need to be phased out after this year. As the measures stimulate nonbank lending, the authorities’ recent steps to improve reporting and the regulatory framework of nonbank financial intermediaries are welcome. However, the authorities should consider further steps to strengthen nonbank supervision.

34. The program relies appropriately on structural reforms to enhance supply and competitiveness. The adoption of the business register law needs to be followed up by its early implementation to speed up registration, lower its cost and reduce corruption. The reduction in nonwage labor costs is a welcome boost to competitiveness which should be followed up by the planned annual reductions in the employers’ share in social contributions during 2007–09. To further enhance the business climate, the planned measures to improve the functioning of the labor market need to be adopted. The ongoing judicial reform should provide better protection of property rights and speedier contract enforcement while reducing corruption. Finally, privatization of state assets and concessioning of ports and airports should improve efficiency and ease infrastructure bottlenecks.

35. Bulgaria’s increased reliance on capital imports is likely to help achieve more rapid real income convergence with the EU. This prospect is welcome, but it also creates risks. Credit financed consumption smoothing in the expectation of higher future incomes and investment opportunities offering high rates of return underlie the structurally weak current account position and have raised external debt. While the resulting vulnerability indicators lie beyond the conventional comfort zones and are a source of concern, there are also a number of mitigating factors in Bulgaria’s case: a high reserve cover of maturing short-term liabilities and prospective imports, a low net external debt ratio, a solid fiscal position, a well capitalized and highly provisioned banking system, strengthened prudential regulations and supervision, much increased transparency, approaching EU accession, and continued market confidence as expressed in a low sovereign risk spread. In addition, the large imports of investment goods and the prospect of a reversal of at least some of the exogenous shocks augur well for higher growth and a lower current account deficit in the future.

36. Accordingly, staff proposes completion of the second review on the basis of the policies proposed by the authorities. Staff also supports granting the three requested waivers—in two instances because the promised action has since been taken, and, in the case of the partially implemented privatization criterion, because the delay was beyond the control of the authorities, who have proposed an alternative course of action to observe the performance criterion. Finally, staff supports the authorities’ request to combine the third and fourth reviews. This is justified by the delay in completing the present review and will not lead to less monitoring by the Fund. It is planned to complete the combined review in early August 2006.

Figure 1.
Figure 1.

Bulgaria: Real Sector Developments, 2003–05

(In percent, unless otherwise noted)

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: Bulgarian authorities; and Fund staff estimates.
Figure 2.
Figure 2.

Bulgaria: Balance of Payments Developments

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: Bulgarian authorities; and Fund staff estimates.
Figure 3.
Figure 3.

Bulgaria: Competitiveness

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: Bulgarian authorities; and Fund staff estimates.
Figure 4.
Figure 4.

Bulgaria: Fiscal Sector Developments

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: Bulgarian authorities; and Fund staff estimates.
Figure 5.
Figure 5.

Bulgaria: Financial Sector Indicators

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: Bulgarian authorities; and Fund staff estimates.
Figure 6.
Figure 6.

Bulgaria and Comparator Countries, Selected Macroeconomic Indicators, 2004 and 2005

(in percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: WEO and country authorities, various years.
Figure 7.
Figure 7.

Bulgaria: Baseline Medium-Term Projections, 2001–2011 1/

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: Bulgarian authorities; and Fund staff estimates and projections.1/ 2006 onward; projections.2/ Projections include assumptions on disbursements related to debt not already contracted.
Figure 8.
Figure 8.

Bulgaria: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2006.
Figure 9.
Figure 9.

Bulgaria: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2006, 131; 10.5089/9781451804539.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Table 1.

Bulgaria: Proposed New Schedule of Purchases Under the Stand-By Arrangement

Source: Fund staff calculations.

Assuming maximum proposed access. The authorities plan to treat the arrangement as precautionary and do not intend to make any purchases.

Includes access originally proposed to be available on meeting the end-March performance criteria. These performance criteria were to be set at the time of the first review, earlier envisaged to be completed before end-March 2005.

Brought forward to include within the program period.

Table 2.

Bulgaria: Observance of Structural Conditionality Under the Stand-By Arrangement in 2005 1/

Details of the performance criteria and benchmarks are included in the Annexes to the Supplementary Memorandum of Economic and Financial Policies, EBS/05/68.

SPC denotes structural performance criterion, SB denotes structural benchmark, and PA denotes prior action.

Table 3.

Bulgaria: Quantitative Performance Criteria and Indicative Targets Under the Stand-By Arrangement 1/

(In millions of leva, unless otherwise indicated)

Definitions of the performance criteria are included in the Annexes to the Memorandum of Economic and Financial Policies, August 2004 and the Supplementary Memorandum of Economic and Financial Policies, March 2005.

Indicative limit or target.

The targets will be raised by 69 percent of the cumulative tax revenue (excluding personal income tax) overperformance in 2005.

Cumulative change from January 1, 2004 for 2004 performance criteria and from January 1, 2005 for 2005 performance criteria. For central government arrears, 2005 targets are stocks.

Includes change in net central government arrears.

Targets have changed compared to EBS/04/107 due to the privatization of BTC in Q2 2004 and Balkan Mine 2000, Open coal mine, and Brikel SOEs in Q3 2004, and of Mina Zdravec EAD and Eood Central Base-Pernik in Q4 2004. Targets for 2005 have changed compared to EBS/05/68 due to staff layoffs in Terem EAD in Q1 and closures of Balkancar Zaria, Elektrostomana, Dunarid AD, and Balkancar 6th September in Q2 2005.

In millions of euro. Cumulative change from December 31, 2004 for 2004 performance criteria and December 31, 2005 for 2005 performance criteria.

Table 4.

Bulgaria: Selected Economic Indicators, 2001–06

Sources: Bulgarian authorities, Fund staff estimates, and World Development Indicators database.

Starting in 2002, a new format was adopted for monetary data resulting in revisions to historical series.

Includes only foreign currency deposits in M3.

Includes trade credits.

November 2005.

2001 figure for gross primary enrollment, income/consumption distribution, poverty rate. 2003 figure for per capita GNI, urban population, life expectancy, infant mortality, and total population.

Table 5.

Bulgaria: Selected Vulnerability Indicators, 2002–06

Sources: Bulgarian authorities; and Fund staff estimates.

For 2005, staff estimates or latest available observations as indicated in the last column. For 2006, staff projection.

Current account deficit plus amortization of external debt.

Public sector covers central government, autonomous budgets, social security funds, municipal budgets, and extra budgetary funds.

Based on averages for the last five years for the relevant variables (i.e., growth, interest rates).

Overall balance plus debt amortization.

Amorization on domestic and external debt (excluding external debt to official creditors) in 2005 divided by 2004 total debt stock.

Debt in foreign currency or linked to the exchange rate, domestic and external. Does not exclude external debt on concessional terms.

Total debt at variable interest rate (domestic and external).

Public sector gross debt minus balance of the fiscal reserve account.

Financial sector covers banking sector only excluding insurance, pension funds and capital market institutions.

Loans overdue by more than 30 days.

Sum of on- and off-balance sheet exposure.

Table 6.

Bulgaria: Real GDP by expenditure category, 2001–06

Sources: National Statistical Institute for actuals; Agency for Economic Forecasting and Analysis, Bulgarian National Bank, and staff estimates.

Private and public sector decomposition based on staff calculations and not officially reported by the NSI.

Sum of contributions to real GDP growth may not add up to total growth due to statistical discrepancy in the official data.