Program conditionality and recent developments

Performance under the current program has been strong. All quantitative performance criteria and indicative targets for the second review were observed. All structural performance criteria, but one, were also met, with short delays in some cases, due to technical reasons or being outside direct government control. As for the breached structural performance criterion and a few missed structural benchmarks, the non-observance was mainly caused by the time needed to form the new government. Also, the available legislative capacity was stretched given the extensive legislation needed for EU accession. In any case, the authorities are determined to attain the objectives of the program and stand ready to take any further measures to successfully conclude the program. To this end, the authorities request that the third and fourth reviews be combined and completed by September 2006, together with the upcoming Article IV consultation.

Real GDP growth in 2005 was higher than expected under the program and marked the eighth consecutive year with robust economic growth. Private consumption continued to contribute to growth, but private investment was once again its most dynamic component. The GDP growth rate accelerated to 5.8 percent according to the latest estimation, and would have been even higher, but for adverse weather conditions and heavy summer floods causing enormous damage to agriculture.

In the wake of the summer floods, food prices increased faster than anticipated which, along with higher oil prices and subsequent adjustments in the regulated prices of electricity and heating, resulted in a higher than programmed end-year inflation. Core inflation, however, remained low as wage pressures moderated.

Buoyant economic growth, steady capital inflows, and a prudent fiscal policy with significant surpluses over the last two years, resulted in a significant increase of the Fiscal Reserve Account. Accumulated reserves were used to buy back and retire all outstanding Brady bonds, as well as to make early repurchase to the Fund, and prepay a portion of World Bank loans. These prepayments have contributed to lowering the public debt ratio, which is expected to fall well below 30 percent of GDP by the end of this year. Further external debt prepayments remain a policy option. Reflecting these positive developments, and in view of the overall optimistic outlook, major international rating agencies have continued to upgrade both foreign and local currency bonds and deposits, which are now enjoying investment grades.

External sector

Rapid catch-up economic growth is often associated with high investment, exceeding private saving. Like in other countries in the region and worldwide, the same developments can be observed in Bulgaria over the last couple of years. Despite continued increase in public saving, the private sector’s saving/investment balance was negative and this translated into a sizable current account deficit.

While the trend of gradual trade balance deterioration has been long established, and considered mostly benign, the trade balance was seriously affected in 2005 by exogenous shocks. Even though merchandise export proceeds increased by 18 percent, they fell somewhat short of expectations as summer floods damaged crops and infrastructure, negatively affecting exports of agricultural raw materials and processed goods. On top of this, the major steel producer is engaged in reconstruction, while the impact of the expiration of the MFA was larger than anticipated. Notwithstanding such recent developments, the authorities and staff share the view that most of the adverse shocks are of rather temporary nature, and the real exchange rate and competitiveness are not an issue. This is well evidenced by declining relative unit labor costs and constantly rising export market shares.

Reflecting strong economic growth and higher oil prices, merchandise imports increased in 2005 by 26 percent. The composition of imports, however, shifted markedly to investment goods, financed predominantly by foreign direct investment, thus suggesting the prospect of economic expansion ahead. Import growth is expected to moderate in the years to come, although it will most likely remain strong in line with robust GDP growth and rising imports of investment goods and raw materials for export processing.

On to the level of the current account deficit, staff has based its analysis on old data according to which it widened to almost 15 percent of GDP in 2005. For some time it has been known that this overstates the size of the deficit. Revised data show a deficit in 2005 of less than 12 percent of GDP - still large but substantially less so. The risk of exaggerating the current account numbers has been flagged on several occasions, including by this Chair in the Board as early as in 2004. From an economic point of view, the numbers as measured under the old methodology were implausible. The next program review will presumably be based on current data and on an in-depth economic interpretation, so as to avoid any impression of being over-excited prima facie about Bulgaria’s external accounts. The new data should also be properly reflected in the PIN and in the papers for today’s review.

Of course this is not to say that the authorities are insensitive to external vulnerabilities -- to the contrary. They have applied extremely prudent fiscal policies, and taken myriad measures to restrain credit growth. But when assessing the external imbalance, full account must be taken of its context. Bulgaria’s catching-up shows the usual combination of a current account deficit financed by massive capital inflows (in the case of Bulgaria, on average fully FDI). In itself this is precisely desirable, and policy is carefully attuned to keeping the catching-up process stable and to identifying and controlling its potential vulnerabilities. The Fund can have real value-added by looking not only at the macro-side of this, but also by digging deeper and helping to identify underlying micro-vulnerabilities particularly in the functioning of the financial and corporate sectors. Similarly, analyzing more in-depth the composition of the current account may help to better assess its strengths, weaknesses, and sustainability. Looking at the case of Bulgaria, where no imbalances exist in the public finances themselves, there are limits to the degree to which one can counterbalance external imbalances emanating from private saving/investment patterns by moving the public finances into imbalance as well. With a healthy fiscal surplus in place, the discussion should be, in our view, less about a few tenths of a percent more or less for the surplus and more about these underlying issues.

Fiscal policy

In an attempt to counterbalance to the degree possible the external deficit, the authorities have considerably tightened the fiscal stance over the last two years. In 2005, the general government surplus was 2.3 percent of GDP, well above the program target of 1 percent, and even higher than what was called for under the automatic adjustor for tax revenue overperformance. To be clear, this is not a primary surplus but an overall surplus. By achieving this result in an election year, Bulgaria has reaffirmed its strong commitment to sound macroeconomic policies, acknowledging the paramount importance of a prudent fiscal stance in the context of the currency board arrangement.

Should the current account deficit not show improvement in the first half of 2006, the authorities consent to further tightening fiscal policy to achieve a surplus of 3 percent of GDP in 2006. Given the already strong fiscal position and demonstrated fiscal responsibility over the years by different governments, this decision was taken with difficulty, as both social partners and the private sector have expressed objections to such restrictive fiscal policy. There is pressure from academic circles, NGOs, trade unions, and various industry associations for lower tax rates.

Under these challenging circumstances, the authorities remain committed to prudent fiscal policy by making every effort to reach their revenue target. Some tax and nontax revenue reductions were introduced in the 2006 budget by lowering social security contributions and raising the exemption threshold for the personal income tax in line with the increased minimum wage. To offset the revenue loss, the government raised excise taxes by more than initially envisaged in their commitment to comply with EU standards, and brought forward increases for tobacco products and alcoholic beverages that were scheduled to take place in the next two years. By taking these measures at this stage, the authorities also hope to lessen inflationary pressures during the reference period in ERM II. After unifying the legal base for collection of domestic taxes and social security contributions, the National Revenue Agency (NRA) started at the beginning of 2006 and is expected to deliver substantial revenue gains in the near future. Early results are quite encouraging.

Credit growth

After more than three years of rapid credit expansion, 2005 marked an important turnaround as bank credit growth slowed from about 50 percent in 2004 to about 30 percent at the end of 2005, and continued to slow in 2006. In view of low nominal interest rates, rising income expectations, and a stable banking system, rapid credit growth was initially interpreted as a welcome and long awaited development. Similar developments were observed in other European countries before joining the EU, while potential risks were successfully contained. But subsequently the authorities recognized that the pace might be on the high side and, when left unchecked, imply risks to financial stability. Accordingly, as of late 2004, the authorities started implementing a strong and coherent package of measures aimed at reducing credit growth. In 2005, the central bank announced amendments to the minimum reserve requirements and established (on a temporary basis, until the end of March 2006) quarterly credit expansion limits of 6 percent, above which banks are subject to an unremunerated deposit requirement. Later in the year, the BNB extended the quarterly limits to the end of 2006, while penalty deposit rates for bank exceeding the limit were raised. In addition, to make the credit limits more effective, bonds issued to banks by the local nongovernmental sector were brought under the credit limits. With these measures in place, the authorities’ intention now is to further slow bank credit expansion to about 17–18 percent in 2006. By introducing these and other measures, the BNB’s prudential requirements exceed international best practice in many areas.

Notwithstanding results achieved in strengthening prudential regulations and slowing credit growth, important challenges remain as the monetary authorities are fully cognizant of the limited effectiveness of credit restrictions. The open capital account allows the corporate sector to access credit abroad while letting local banks extend credit to households. There are many legal ways to circumvent existing restrictions (albeit at a cost) and some banks are taking advantage of them. In any case, due to the low share of banking assets to GDP, the level of credit to the non-government sector is still lagging substantially behind virtually all the EU countries, including the newcomers, suggesting that credit growth will most likely remain above the EU average for some years to come.