General remarks

The Bulgarian authorities wish to express their gratitude to the Fund for its surveillance and assistance. Over the last ten years, Bulgaria has implemented a comprehensive reform agenda and successfully completed several Fund-supported programs that helped the country to stabilize and make progress in the run-up to the EU accession. Prudent macroeconomic policy and well targeted structural reforms eventually paid off and as of January 2007, Bulgaria is a full-fledged member of the EU. This final review marks the end of program-based relationship with the Fund, and provides a good opportunity for some broader reflections.

Comprehensive economic reforms started soon after the political changes of late 1980’s. The initial conditions on the way toward a market-oriented economy were extremely unfavorable. At this early stage of transition, the Fund supported the country by providing financial resources, as well as technical assistance and expertise. However, as happened with other transition countries, instead of allowing front-loaded structural conditionality, the emphasis was mostly on the macro-based conditionality, which proved to be a less effective approach. At the same time, insufficient ownership and hesitant support for reform, coupled with a fragile political situation, were perhaps even stronger barriers to success than the programs design itself. Thus, it is fair to conclude that the major shortcoming during the Fund’s early engagement in Bulgaria was its willingness to support programs that had mixed ownership with respect to a number of key structural reforms.

Things changed dramatically after the implementation of the currency board arrangement (CBA) in mid 1997. While pre-1997 programs failed primarily because there was no pro-reform consensus and the programs were not implemented in their entirety, all the latter programs were successful. Their success reflected the improved ownership, which came as a result of political stabilization. The Fund responded properly by modifying the design of the programs making them more focused, while the conditionality was made much more detailed and front-loaded. These developments, coupled with broad support gained both domestically and internationally, helped securing the accomplishment of the programs, thus changing the image of the country from a failure to a success story.

Performance under the program

Following the conclusions from the ex-post assessment report on longer-term program engagement, the authorities opted in August 2004 for another SBA, designed as a low-access, precautionary arrangement, that would also serve as an explicit exit from Fund program engagement. The program was focused on fiscal adjustment, measures to moderate rapid credit growth, improving the business climate, and making further progress in structural reform. Against the backdrop of worsening external environment, some of the economic problems turned out to be more stubborn than initially envisaged, which warranted the extension of the program by six months at the time of the third review.

The overall performance under the program has been strong and the main program objectives were completed. Sustained economic growth has resulted in significantly higher real per capita growth over the program period, while inflation remained moderate, and unemployment rates declined to single digits for the first time in 15 years. Fiscal stance has strengthened remarkably and the country is now running one of the biggest fiscal surpluses in all of Europe. For a country not endowed with vast natural resources, this is a huge achievement. Financial sector has further matured and rapid credit growth was well managed. External sector imbalance, however, has risen along with a sizable increase in private external debt.

The fourth review is not an exception from what has been already observed during the previous reviews. Quantitative performance criteria were met, but a few structural criteria and benchmarks were delayed or partially met. With regard to the selection of the winning bid for the purchase of a district heating plant, and launching of the business registry, there were some technical reasons, and even circumstances where delays were in fact outside of direct government control. Remedial actions and a realistic timetable have been agreed with the mission and, accordingly, the authorities request a waiver. In any case, the authorities are determined to attain all program objectives and stand ready to take further measures to successfully conclude everything they have committed to under the program.

Fiscal policy

Fiscal policy remains key to maintaining macroeconomic stability and reducing vulnerabilities. Over the last several years, fiscal stance has strengthened remarkably and 2006 ended with a record-high surplus of 3.7 percent of GDP. By achieving this result the authorities have reaffirmed their strong commitment to sound macroeconomic policies, acknowledging the paramount importance of a prudent fiscal stance in the context of the currency board arrangement.

Given the prudent short-term fiscal stance, the authorities and staff are engaged in a dialogue over the policies to be followed after Bulgaria has joined the EU. The issue of the fiscal impact of accession, and hence the policies it entails, remains the most challenging one, as two competing objectives are present. From one hand, maximization of EU funds’ utilization must be given priority, as it provides the country with a unique opportunity to speed up convergence and substantially increase living standards in a relatively short period of time. On the other hand, the authorities do acknowledge the need of fiscal surpluses in order to try to somewhat offset sustained private sector saving-investment imbalances.

In view of the external vulnerabilities and continued strong domestic demand, a broad agreement was reached on the need to avoid large fiscal relaxation in the years to come. Therefore, for 2007 the authorities intend to overshoot the approved surplus of 2 percent of GDP and to pursue at least 2.3 percent by achieving additional net savings. Even though the 2007 fiscal target may look lower than what was achieved in 2006, from an economic point of view it does not correspond to fiscal relaxation in 2007 as it also includes a 1.2 percent of GDP as the country’s first contribution to the EU budget. By definition, these funds have no effect on domestic demand. In addition, the government stands ready to invoke other contingency measures should unambiguous signs of over-heating become evident.

The authorities would like once again to invite staff to take an active position and invest more in looking not only at the macro-side of the catch-up process (and all related issues), but also by digging deeper and helping to identify underlying micro-vulnerabilities, as well as possible policy action directly addressing such vulnerabilities. In particular, this applies to the degree to which external imbalances, emanating from private saving-investment imbalance, could/should be counterbalanced by moving and keeping the public finances in large imbalance as well.

External sector

It has long been observed that 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 are observed in Bulgaria over the last couple of years. Despite continued increase in public saving, the private sector’s saving/investment balance has translated into a sizable current account deficit. Exacerbated by higher oil and other key commodity prices, in 2006 the external current account deficit reached almost 16 percent of GDP. The strong rise in imports relates to growing domestic demand while even stronger FDI inflows (on average for the last nine years, FDIs exceed current account deficits by 35 percent) contribute the most to high import growth. The capital inflows in last years were quite broad-based, going into investment in many sectors of the economy and increasingly into green-field investment.

Despite high current account deficits, competitiveness does not appear to have been a factor in recent foreign trade developments as evidenced by the stable NEER and the real depreciation when using unit-labor costs. Official reserves have grown in line with the higher imports and the reserve coverage remained broadly stable over the last couple of years.

This notwithstanding, the authorities have proved sensitive to external vulnerabilities. They have applied extremely prudent fiscal policies, and taken timely 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 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.

Financial sector

Thanks to the consistent measures taken by the central bank, rapid bank credit growth has slowed. Nevertheless, the main idea of reducing financial flows to the private sector was only partly met as the open capital account allows the corporate sector to access bank credit abroad, while credit from the non-blank financial institutions has continued to grow. Thus, the effectiveness of the bank credit ceilings has much diminished, and, what is worse, started to disrupt the financial sector. Accordingly, the authorities and staff agreed some time ago that temporary credit restraints introduced since early 2005 should be removed, which in fact took place as of the beginning of 2007.

The removal of the restraints coincides with a tightening credit cycle in Europe, the introduction of Basel II, and further liberalization of trade in financial services. There still is a risk of a possible pick-up in bank credit growth although it looks moderate as the pressure may be shifted to non-bank financial institutions. In any case, banks’ portfolio is quite strong and only about 2 percent of loans are reported as overdue. Financial sector vulnerabilities remain contained as banks are well capitalized and profitable. Non-bank financial institutions are well supervised too, as the Financial Supervision Commission has benefited from Fund’s technical assistance and substantially modernized its activity. The authorities look forward for the FSAP update, scheduled for early 2008.

With regard to the ERM II, the authorities maintain their long stated position that they will seek joining it at the earliest possible date. They have already started talks in this direction and it is widely expected to happen by mid-2007. The authorities’ plan is to uphold the currency board arrangement at the existing exchange rate until Bulgaria joins the EMU. Moreover, the Bulgarian government and the central bank have committed to unilaterally maintain a zero deviation of the exchange rate during the stay in the ERM II.

In conclusion, the Bulgarian authorities are committed to achieving high and sustainable economic growth while maintaining a stable and predictable macro-economic environment. With a view to the fulfillment of this objective, the topmost priority of the government will be the maintenance of sustainability of public finances and a level of government and government-guaranteed debt, which allows for a stable compliance with the Maastricht criteria. In the years to come, the government intends to keep running budget surpluses to help curb domestic demand as well as to moderate the external account imbalance.