Recent developments

The confidence inspired by the good economic performance over the last several years, as well as the recent accession to the EU, has continued to attract substantial amounts of capital inflows, mostly in the form of FDI. As a result, real GDP has accelerated in the first half of 2007 to 6.4 percent, led primarily by fixed capital investment and to a much lesser extent by private consumption. It is widely expected that this trend will hold throughout the year, and the previously expected growth rate of 6 percent for the year as a whole will most likely be exceeded. The current pattern of growth has been repeatedly observed over the last years. The private investment-to-GDP ratio has been surging, while the private consumption-to GDP ratio remains broadly stable, suggesting that consumption has not been the main driver of recent high growth rates. Such a conclusion is also supported by the structure of imports, that shows a growing share of investment goods and a broadly stable share of consumer goods.

Inflation has picked up in 2007, reflecting to a large extent one-off factors caused by a severe summer draught that triggered a significant increase in food prices. This came on top of a more general increase in food prices that has been observed in other countries in the region and elsewhere, prompting a possible price correction. After the summer shock, during which CPI increased by almost 7 percent, conditions are now expected to return to normal, while the disinflationary momentum is expected to gain strength. Nevertheless, headline inflation in 2007 is expected to exceed earlier projections. Core inflation, however, has picked up at a significantly slower pace, reflecting a modest rise in labor cost and only limited overall capacity pressures.

On the back of strong growth, liberalized market conditions, and overall positive expectations, employment has been on an upward trend for the last couple of years. Accordingly, the unemployment rate has fallen (and continues to fall) considerably from about 20 percent in 2000 to less than 7 percent now. As parliament has recently passed amendments to the Labor Code to increase working time flexibility, it is expected that employment, which is still below the average of Bulgaria’s peers, will continue to rise.

Buoyant economic growth, steady capital inflows, and a prudent fiscal policy with sizable surpluses over the last four years, resulted in a significant increase of the Fiscal Reserve Account. Accumulated reserves were used to buy back and retire all outstanding Brady bonds, to make early repurchases to all outstanding loans to the Fund, as well as to prepay a portion of World Bank loans. These prepayments have contributed to significantly lowering the external public debt ratio, which is expected to fall below 15 percent of GDP by the end 2007. Gross external debt, however, has been on the rise since 2003 as the private sector debt has begun to grow rapidly, in line with the investment boom that the country has been experiencing. This trend is expected to reverse in a couple of years, along with an overall moderation of capital inflows. Meanwhile, external debt indicators show that risks are fairly contained as short-term debt is fully covered by reserves. Moreover, a significant part of the private external debt (more than one third) is in fact inter-company debt owned to mother companies.

External Sector

Rapid catch-up economic growth is often, if not always, associated with strong private investment, exceeding - sometimes by far - private savings. Despite continued increase in public savings, the private sector’s saving-investment imbalance has translated into a sizable current account deficit. Exacerbated by high oil and other key commodity prices, in 2007 the external current account deficit may well reach 20 percent of GDP.

The size of the deficit itself is high enough to raise concerns about external stability. While the authorities share the legitimacy of these concerns, there are a lot of uncertainties regarding the nature, the cause, and the implications of the external imbalance. Similar processes can be observed in other countries that recently joined the EU which are equally characterized by real income convergence, substantial amounts of EU grants, financial system deepening, high future income expectations, a declining risk premium, and the overall effects of globalization. The phenomenon of high and persistent current account deficits under such circumstances is a rather unique one, presenting the authorities (and the Fund) with the big challenge of how to react in such cases. The challenge becomes even larger when the authorities, given their monetary framework, have only limited tools to tackle the problem. In particular, this applies to the degree to which external imbalances, emanating from a private saving-investment imbalance, can be counterbalanced by moving and keeping the public finances in large imbalance as well.

Notwithstanding all the difficulties and surrounding uncertainty, Bulgaria has taken up this challenge. The authorities are thankful to staff for the candid and constructive dialogue on the matter during the Article IV mission. They especially appreciate the selected issues paper that provides good quality analyses and recommendations.

Despite high current account deficits, competitiveness does not appear to have been hurt, as evidenced by the continued solid export growth and rising market shares. REER appreciation over the last years has been moderate when benchmarked against conventional relationships between the exchange rate and the current account deficit. As underscored by staff, purchasing power parity and dollar-wage comparisons across countries suggest that Bulgaria’s prices and production costs remain competitive - a suggestion also supported by regression-based estimates of the real equilibrium exchange rate. Moreover, official foreign reserves have been growing in line with the higher imports and the reserve coverage has remained broadly stable over the last couple of years. In general, the authorities and staff share the view that a one-off private investment boom is the main driver of the large current account deficit. Once this boom dissipates, the current account deficit is expected to start approaching its equilibrium levels under present policy settings.

Although the soft-landing scenario is the likely one, the authorities have proved sensitive to external vulnerabilities. They have applied extremely prudent fiscal policies, and taken measures intended to restrain credit growth. When assessing the external imbalance though, 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, while identifying and controlling its potential vulnerabilities.

Fiscal policy

Under a currency board arrangement, fiscal policy remains key to maintaining macroeconomic stability and reducing vulnerabilities. This said, the main challenge for the authorities is to strike the right balance between two competing objectives. On the one hand, maximization of EU funds’ utilization must be given priority, as it provides the country with the unique opportunity to speed-up real convergence, deepen EU integration, and substantially increase living standards in a relatively short period of time. On the other hand, the authorities do acknowledge the need to offset sustained private sector saving-investment imbalances. As the latter objective has become more important over the last years, the fiscal stance has strengthened remarkably and every year marks another record-high surplus. 2007 will be no exception from this trend. By applying this policy, the authorities reaffirm their strong commitment to sound macroeconomic policies, acknowledging the paramount importance of a prudent fiscal stance in the context of the currency board arrangement.

On the back of growing economic activity, increased employment, higher imports, and higher inflation, as well as due to improved tax collection, revenue in 2007 soared significantly above what was budgeted. The revenue windfall from the absorption boom, along with just a modest increase in expenditures, resulted in an unprecedented surplus that, according to the end-November data, was approaching 7 percent of GDP. Given the already strong fiscal position, both social partners and the private sector have expressed objections to such restrictive fiscal policy. There is marked pressure from academic circles, NGOs, and various industry associations for lower tax rates while (on top of that) trade unions are strongly backing rising demands for wage increases.

Against this background, the authorities have decided to use part of the revenue windfall and to step up the investment program in the most needed sectors. The bulk of the supplementary fiscal expenditures is mainly allocated for infrastructural projects like road construction and rehabilitation, and construction of water purification stations and sewerage systems. A big part relates to co-financing of EU-financed projects, and constitutes mostly advance payments for projects under the operational programs in the area of regional development, environment, rural development, and transport. Another significant part is allocated for building-up strategic oil-reserves and oil-storage facilities. Given the recent incidents of massive floods, funds were earmarked for river-bed corrections and preventing landslides. The authorities have taken the necessary steps to ensure the transparency of the extraordinary spending which was given high publicity within the country and was approved by parliament. The most important, however, is the fact that even after this extra spending, the overall budget surplus will again be higher than the 3.5 percent recorded in the previous year, and far beyond the 2 percent of GDP that was initially budgeted.

With regard to the 2008 budget, the authorities are firmly committed to continuing with their prudent fiscal stance. The budget, which is still under consideration in parliament, envisages a surplus of at least 3 percent of GDP which is basically in line with an unchanged fiscal stance. With the new budget the authorities are introducing a flat 10 percent personal income tax along with a 10 percent corporate tax rate that is already in place since the beginning of 2007. In order to minimize the revenue loss, the authorities plan to eliminate most of the existing exemptions, thus broadening the tax base. It is the authorities’ belief that such a step will help shrink the grey economy, while higher excises on tobacco and fuel will compensate to a great extent for the revenue loss.

The 2008 budget has already passed the first reading and is expected to be approved pretty soon. The authorities have undertaken another step in improving fiscal transparency by eliminating the previous practice of across-the-board spending sequestration and introducing a contingency reserve instead. As usual, the authorities are prepared to allow automatic fiscal stabilizers to operate by saving most of a possible revenue overperformance.

Financial Sector

Like in many other countries in the region, a rapid bank credit expansion has been observed over the last years. In many respects this was, and still is, a welcome development as it symbolizes growing financial intermediation. The pace of the bank credit growth, however, remained too high for too long which could be associated with an increase in macroeconomic vulnerabilities. It should be stressed, however, that the rapid bank credit growth is hardly surprising given the extremely low initial base, declining nominal interest rates, rising income expectations, and a stable, well capitalized, and highly profitable banking system. Moreover, in contrast to other countries with a similar pace of growth, the credit expansion in Bulgaria has been financed mostly by a strong increase in deposits instead of relying on foreign borrowing. All this suggests that the currently experienced rapid credit growth is a healthy one, reflecting the overall strong economic performance - a suggestion also supported by the financial soundness indicators showing no signs of deterioration.

No matter the mitigating factors, the authorities are fully cognizant of the macroeconomic and financial stability risks associated with rapid credit growth and are strongly committed to dealing with the situation. They have undertaken various measures in trying to moderate the pace of growth, including by enhancing information; strengthening the prudential and regulatory framework; and lowering liquidity by introducing administrative limits to bank credit growth. Unfortunately, all these measures proved insufficient and credit growth still remains high. In a repeated attempt to moderate the pace, the central bank raised the minimum reserve requirements from 8 to 12 percent in September, and signaled that it would be ready to adopt additional measures, including by further raising the reserve requirements, if needed.

Finally, with regard to the ERM II, the authorities maintain their long stated position that they will seek to joining at the earliest possible date. They have started talks with their European partners and are ready to provide them with firm and detailed policy commitments. The authorities’ plan is to uphold the currency board arrangement at the existing exchange rate until Bulgaria joins the EMU. The Bulgarian government and the central bank have committed to unilaterally maintain a zero deviation of the exchange rate after Bulgaria joins the ERM II.