Bulgaria
2008 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Bulgaria

This 2008 Article IV Consultation discusses that Bulgaria has been hit by the global financial crisis, with clear signs that the country’s capital inflows-driven boom has come to an end and that the real economy is slowing down. Executive Directors have commended the Bulgarian authorities for their prudent policies that have built strong balance sheets in the public sector. Directors have also welcomed the authorities’ commitment to maintaining prudent fiscal policies, which will provide crucial support for the currency board arrangement.

Abstract

This 2008 Article IV Consultation discusses that Bulgaria has been hit by the global financial crisis, with clear signs that the country’s capital inflows-driven boom has come to an end and that the real economy is slowing down. Executive Directors have commended the Bulgarian authorities for their prudent policies that have built strong balance sheets in the public sector. Directors have also welcomed the authorities’ commitment to maintaining prudent fiscal policies, which will provide crucial support for the currency board arrangement.

I. Staff Appraisal and Executive Summary

1. In 2008, Bulgaria’s economy continued to perform well, helped by strong policies. GDP growth is likely to have reached 6 percent—one of the highest growth rates in Europe. Fiscal policy continued to be prudent, with another surplus of 3 percent of GDP. Banking sector supervision and regulation remained strong, reacting pro-actively to the global financial turmoil.

2. At the same time, external and internal imbalances widened further—at least until recently. Fueled by large private capital inflows, the current account deficit widened to 25 percent of GDP. The labor market overheated, with wage growth exceeding 20 percent, and annual inflation reached 12 percent—although it has come down in recent months.

3. The global financial turmoil has begun to affect Bulgaria, and near-term prospects for Bulgaria could be more difficult than they have been in a long time. Capital inflows are likely to slow, and exports are likely to be hurt by the global slowdown. The current staff’s forecast is that GDP growth will slow to 1 percent in 2009, but there are significant risks that the slowdown could be even sharper.

4. With a high current account deficit, high external private sector debt, and large foreign currency exposures, a key task for policies is to maintain confidence in the currency board and in the financial system. The two are linked: a strong and resilient financial system is needed to sustain the currency board; while the stability of the increasingly Euroized banking system hinges critically on maintaining the CBA. Fortunately, Bulgaria’s cautious policies of recent years have helped generate substantial buffers in the public sector: international reserves are high, public debt is low, and the government has built up considerable reserves in the fiscal reserve account.

5. Fiscal policy should aim at maintaining comfortable surpluses. This is not only because surpluses have been a support pillar for the currency board, but also to preserve balances in the fiscal reserve account—an important shield if problems were to emerge, including in the financial system.

6. In this context, the government’s de facto fiscal target of a 2 percent fiscal surplus in 2009 is appropriate. While the government officially still targets a fiscal surplus of 3 percent of GDP, in practice it realizes that the 4.7 percent GDP growth on which the budget was based is no longer realistic, and has decided to offset part of the revenue shortfall by keeping expenditure 10 percent below the budgeted amount (the “10 percent rule”). If, as the government expects, GDP expands by around 2 percent, this would result in a surplus of 2 percent of GDP.

7. With GDP growth likely to fall short of 2 percent, additional expenditure cuts will be necessary to achieve the 2 percent surplus. If, as staff currently expects, GDP growth slows to 1 percent, the shortfall would amount to around 0.6 percent of GDP. Such expenditure cuts should be feasible, as even with the 10 percent rule the 2009 budget is by no means tight.

8. A significant slowing of expenditure growth will also be necessary in later years. In previous years, domestic demand has grown much faster than GDP, resulting in a surge of indirect tax revenues, but going forward, with the adjustment in the current account, domestic demand and tax revenues will grow by less than GDP. With less room for expenditure increases, spending will need to be prioritized. While the 10 percent rule was a pragmatic solution to reduce expenditure, across-the-board cuts are not a desirable tool in the longer run.

9. The financial system is well capitalized and has so far been very profitable, but now faces a more difficult time. Profitability is likely to decline, as foreign funding has become scarce, strong competition for domestic deposits has raised funding costs, and lending growth is expected to slow. At the same time, the reliance of banks on foreign funding for new lending makes them vulnerable to the current disruption in international financial markets. Nevertheless, banks are well-positioned for a slowdown, and have strong capital and liquidity buffers.

10. The BNB’s framework for financial sector supervision and regulation has been effective in containing risks in the banking system, but with a slowdown of the economy the operation of these arrangements is likely to be tested. The BNB has reviewed its procedures and is—in line with other EU supervisors—preparing for any contingency. It is collaborating closely with pertinent home country supervisors and it is further enhancing its capacity to conduct stress tests, in line with recommendations of the recent IMF-World Bank FSAP Update. These preparations are welcome, especially in light of the current challenging economic and financial environment.

11. The high growth rate of wages threatens external competitiveness. While wages are low compared to Western Europe and can be expected to catch up over time, this will need to be accompanied by similar productivity increases. The current pace of wage growth is far too rapid for Bulgaria’s relatively small productivity growth differential with Western Europe, and needs to slow down. It is a difficult question whether the current level of competitiveness is a cause for concern, but the change in competitiveness certainly is.

12. Moderation in unit labor cost increases is essential given that resources will need to be shifted to the tradable sector. As growth in the non-tradable sector slows, GDP growth can only be kept strong if the tradable sector takes over the slack. Without such a shift, future growth could remain very low, which eventually could put strains on the currency board arrangement. Therefore, both export-oriented and import-competing branches need to remain sufficiently competitive.

13. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

II. Introduction

14. In recent years, a surge in capital inflows has led to increasing external and internal imbalances. The capital inflows, which were driven by expectations of rapid convergence with the EU, led to a boom in domestic demand. This resulted in a high current account deficit, an overheating labor market, deteriorating competitiveness and large balance sheet vulnerabilities (Section III).

15. The interaction of these imbalances with the global financial turmoil was at the core of the 2008 Article IV discussions. With global deleveraging and increased risk aversion, the large capital inflows to Bulgaria are likely to abate. The global financial market turmoil has already started to affect Bulgaria and GDP growth is likely to slow considerably (Section IV). The policy discussions focused on how to react to this slowdown. How can the risks of financial instability be reduced? What is the appropriate fiscal response to the turmoil? How can the real economy adjust to the external environment in a way that is consistent with maintaining the currency board (Section V)?

Bulgaria’s Reactions to Past IMF Advice

Bulgaria and the IMF have had an excellent working relationship. Policies have been generally consistent with IMF recommendations, as reflected in the successful completion of a series of Stand-By Arrangements. In recent years, the government has maintained prudent fiscal policy and built up large fiscal reserves, thus providing strong support to the currency board and a much needed policy advantage against the current global financial turbulences. However, public sector wage policies were lenient in last two years, and structural reforms hardly progressed, reflecting a lack of political consensus.

At the time of the 2007 Article IV Consultations, Executive Directors praised Bulgaria for its strong economic performance and strong policies, but expressed concern about rising imbalances. Directors emphasized that the current account deficit was unsustainable and would need to be reduced significantly over the medium term in order to contain external vulnerabilities. They also noted that, although competitiveness appeared not to have been affected, domestic price pressures were rising, in large part because of region-wide increases in food and energy prices, but also because of accelerating wage increases as the labor market tightened.

III. Macroeconomic Challenges

A. Large Capital Inflows Have Created Internal and External Imbalances

16. Since 2004, when agreement was reached on EU accession, Bulgaria has experienced a surge in capital inflows and a credit boom (Figures 1 and 2). Inflows were driven by expectations of rapid convergence with the EU, and were further boosted by the confidence-enhancing effect of the currency board and strong fiscal policy. By 2008, net inflows had increased to about 27 percent of GDP—one of the highest among EMCs (Figure 3). Boosted by capital inflows, credit to the private sector rose rapidly, and the credit-to-GDP ratio climbed from 36 percent in 2004 to 63 percent in 2007.

Figure 1.
Figure 1.

Bulgaria: Capital Inflows

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Haver Analytics.
Figure 2.
Figure 2.

Bulgaria: Capital Inflows and Credit Boom

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Bulgarian National Bank and Haver.
Figure 3.
Figure 3.

External Vulnerability Indicators

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: WEO September 2008
uA01fig01

GDP growth

(Y-o-y change, 4-quarter moving average)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

17. The surge in inflows generated strong GDP growth, but also a sharp widening of external and internal imbalances.

uA01fig02

GDP growth

(Y-o-y change, 4-quarter moving average)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

  • GDP grew by more than 6 percent annually, leading to a significant narrowing of the income gap with Western Europe. Growth remained strong in 2008—at an estimated 6 percent, Bulgaria was one of the fastest growing countries in Europe.

  • As the growth of domestic demand outpaced GDP growth, the current account deficit widened from 5 percent of GDP in 2003 to an estimated 25 percent of GDP in 2008.

  • As unemployment dropped and the labor market tightened, wage growth accelerated to a peak of 25 percent in June 2008. The overheating of the economy, together with rising food and oil prices, resulted in a surge of inflation, which peaked at 14.7 percent in June 2008. More recently, as oil prices collapsed, food price increases slowed, and the global economy weakened, inflation declined, to 7.2 percent in December.

uA01fig03

Exports and Imports

(4-quarter moving average, percent of GDP)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Haver.
uA01fig04

Bulgaria: Inflation, Wages, and Housing Prices

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: BNB and IMF Staff calculations.

18. Policies to address these imbalances had only limited success. Fiscal policy targeted large and increasing fiscal surpluses, but these surpluses were offset by declining private net savings. Administrative measures to restrain credit growth moderated credit growth in the short-term, but were soon circumvented by firms’ direct borrowing from abroad and had undesirable effects on financial intermediation.

B. Competitiveness is Deteriorating and Growth has been Driven by the Nontradable Sector

19. Initially, when there was sufficient slack in the labor market, the large deterioration of the current account was not accompanied by an appreciation of the real exchange rate, suggesting that the widening of the current account deficit was primarily the result of the large capital inflows1 and the associated credit boom. Between 2003 and 2006, the current account deficit increased by 12 percentage points, but the real exchange rate remained relatively stable.

uA01fig05

Change in CPI-based REER and Change in Current Account Balance, 2002-2007

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

20. Since the middle of 2006, the overheating of the labor market has resulted in a sharp real exchange rate appreciation. Between the third quarter of 2006 and the third quarter of 2008, the ULC-based REER appreciated 26 percent, while the CPI-based REER appreciated about 16 percent.

uA01fig06

Change in Credit to GDP Ratio and Change in Current Account Balance, 2002-2007

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: WEO.

21. At the same time, export performance has deteriorated. Between 2000 and 2006, the export to GDP ratio increased faster than in EMCs on average, but between 2006 and 2008, performance was worse than in most other EMCs, as the export ratio declined somewhat.

uA01fig07

Bulgaria: Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Haver.

Exports of Goods and Services of Selected Emerging Market Countries, 2000-2008

(Percent of GDP)

article image
Source: WEO Oct. 2008 published version.

22. From a saving-investment perspective, the widening of the current account deficit is primarily the reflection of the investment boom. As the investment to GDP ratio increased sharply, the saving to GDP ratio remained flat. The high level of the current account deficit not only reflects high investment but also low saving—not only compared to emerging market countries outside the region, but also compared to other new member states.2

uA01fig08

Bulgaria: Saving and Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

uA01fig09

Saving and capital formation in New Member States, 2008

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: WEO.
uA01fig10

Saving and Investment in Emerging Market Countries, 2008

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

23. GDP growth has to a large extent been driven by the non-tradable sectors—in particular financial services, real estate and construction.3 Capital inflows have in large part gone to the non-tradable sector, which may have been further stimulated by the widening profitability gap between the non-tradable and the tradable sector. Between late 2006 and Q3 2008, the gross operating surplus of manufacturing has declined from 50 to 38 percent, while the gross operating surplus in the non-tradable sectors has shown little change.

uA01fig11

FDI by sector

(Billions of euros)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: NSI.
uA01fig12

Composition of Accumulated Real Gross Value Added Growth, 2004-2008Q3

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Haver.
uA01fig13

Share of Real Estate, Financial Intermediation and Construction in Gross Value Added

(Percent)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Haver.

Gross Operating Surplus and Gross Mixed Income as a share of Gross Value Added

(Percent, 4-quarter moving average)

article image
Source: BNB Staff Calculations.

24. If capital inflows drop and the credit and investment boom ends, it is likely that the current account deficit will decline—but there will also be a sharp drop in growth. With lower capital inflows and an end to the credit boom, the contribution to growth of construction, financial intermediation, real estate and businesses services will likely drop sharply. Experience in other countries suggests that it may well become negative.

C. Balance Sheet and Financing Vulnerabilities are Large

25. Balance sheet vulnerabilities have become large.

  • External debt has increased to 111 percent of GDP. Debt is mostly owed by the private sector; public sector debt has declined rapidly to only 13 percent of GDP (Table 1).4

  • The net international investment position has deteriorated to minus 97 percent of GDP (Table 2). While the central bank and commercial banks have large foreign assets (56 percent of GDP), there are also large non-debt liabilities (equity capital and reinvested FDI earnings)

  • Foreign currency mismatches are very large. The corporate sector has high direct foreign currency exposure; the banking sector has large indirect foreign currency exposure because of high foreign currency lending. The large foreign currency mismatches have in large part been the result of the belief that euro-denominated loans carry no currency risk, as the currency board would be eventually be replaced by the euro.

Table 1.

Bulgaria: Gross External Debt

(Percent of GDP)

article image
Source: Haver.
Table 2.

Bulgaria: International Investment Position

(Percent of GDP)

article image
Source: Haver.

26. The non-financial corporate sector is particularly exposed. It has high debt, high foreign currency exposure, and large short-term debt (Tables 1 and 4).

Table 3.

Domestic Liabilities of Non-Financial Private Sector, November 2008

(Percent of GDP)

article image
Source: BNB and IMF Staff estimates.
Table 4.

Selected Liabilities of Commercial Banks, November 2008

(Percent of GDP)

article image
Source: BNB and IMF Staff estimates.

27. The household sector is relatively less exposed. Household debt is 37 percent of GDP, a third of which is for mortgages (Table 4). Foreign currency loans from banks are only 8 percent of GDP.

Debt of Non-Financial Corporates

(Percent of GDP)

article image
Source: BNB.

28. These vulnerabilities could come to the fore if capital inflows dropped sharply. The gap between private investment and private saving in 2008 was 27 percent of GDP. If capital flows drop sharply, the private sector will be forced to adjust saving and investment accordingly, and with new financing drying up, defaults of debtors may increase sharply, while corporate sector defaults would in turn affect the banks. Indeed, the recent FSAP update suggest that in a scenario with significant macro-economic stress, NPLs could increase sharply, and the banking sector could be become undercapitalized.5

IV. The impact of the Financial Market Turmoil and the Outlook

A. The Impact of the Financial Market Turmoil

29. The global financial market turmoil has had a severe impact on financial asset prices in Bulgaria. The stock market index has declined by 74 percent since end-August, and as of mid-February is 86 percent down from its peak in October 2007. Stock market capitalization has declined from 51 percent of GDP at end-2007 to around 16 percent at end-2008. Sovereign CDS spreads have risen to 590 basis points—from around 30 a little more than a year ago.

uA01fig14

Stock Market Capitalization

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: EMED.

30. As a result of the financial turmoil, foreign parent banks have reduced new financing to their local subsidiaries. The Bulgarian banking system largely consists of subsidiaries of Western European banks—82 percent of bank assets are foreign owned. Western European banks, faced with capital shortages, and worried about the deteriorating economic prospects in Eastern Europe have begun to curtail new financing to their subsidiaries6, which now need to finance loan growth from local deposits.

Bulgaria: Selected Banking Sector Indicators

article image
Sources: BNB and IMF staff estimates.
Figure 4.
Figure 4.

Bulgaria: Financial Markets

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Bloomberg, DataStream, IFS.
uA01fig15

Bank equity prices, 1/1/2007=100

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Datastream.
uA01fig16

5YR Credit Default Swap Spreads

(Basis points)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: DataStream.

31. The decline in foreign funding has resulted in strong competition for deposits and a sharp reduction in credit growth. Interest rates on new time deposits of households rose from 5.9 percent in August to 8.0 percent in December. Banks have become much more cautious, and credit growth to the non-government sector slowed to an annualized rate of 1.2 percent in December from 66.6 percent a year ago.7

32. The reduction of required reserves in November and December has eased the tightness in the money market.8 The overnight money market rate (SOFIBOR) has come down from a peak of 6.4 percent in October to 4.6 percent at end December. However, the reduction in required reserves has also contributed to a reduction of international reserves, which have declined from €14.2 billion at end October to €12.7 billion at end December, falling another 600 million in the first ten days of January.

uA01fig17

Interest Rate on New Time Deposits of Households, 2008

(Percent)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

33. Reported indicators suggest that banks are generally sound. In December, the capital adequacy ratio was 14.9 percent compared to the 12.0 percent mandatory ratio, which exceeds the 8.0 percent EU minimum requirement. The NPL ratio was around 2.4 percent.

34. However, these indicators are backward-looking: like other countries in the region, Bulgaria has experienced tremendous credit growth, and experience in other countries suggests that banking fragilities may emerge only after the credit boom has ended.9 The accompanying FSSA argues that going forward, credit risk stemming from the rapid expansion of the loan portfolio in the past is by far the most important financial stability risk facing the Bulgarian banking system (Box 2).

35. Banks are also exposed to currency induced credit risks, especially in the non-tradable sector. While, as discussed in the FSSA, the euroization of assets and liabilities (about half of bank assets and liabilities are denominated in euros) partly reflects the convergence process and parent bank funding, it leaves the system exposed to currency induced credit risk, and suggests that the solvency of the banking system critically hinges on maintaining the currency board.

36. GDP growth held up well until the third quarter, but in the fourth quarter there were clear signs of slowing, and the authorities’ previously held view that the impact of the global financial crisis on Bulgaria would be limited has changed. Since October, the business climate indicator for all economic sectors has declined rapidly. Orders for non-residential construction have declined sharply, industrial production in December was 8.4 percent lower than a year ago, and exports were15 percent lower, mainly due to a slump in the exports of manufacturing good (-20.6 percent). Reflecting weakening domestic demand, imports fell by 17.4 percent year/year, while unemployment rate rose to 6.3 percent in December, reversing the declining trend during the last few years. Furthermore, the share of bad and restructured household loans has begun to increase, from 2.7 percent at end December 2007 to 3.0 percent in November 2008.

Bank Credit to Private Sector

(In percent of GDP)

article image
Source: IMF and Fitch Ratings.

Brazil data refer to credit of the broad finanacial system. Bank credit in Brazil grew from 25 to 36 percent of GDP between 2002 and 2007.

B. Outlook for 2009 and Risks

37. The surge in capital inflows is expected to abate in 2009. The global financial turmoil is likely to reduce capital flows to Central and Eastern Europe, including Bulgaria. With increasing global risk aversion, FDI would decline, while local subsidiaries would no longer receive large capital transfers from their parent banks to fund credit growth.

38. At the same time, shrinking foreign demand and declining commodity prices might lead to a drop in Bulgarian exports and a decline in tourism. Some of this is already visible in Bulgaria, as export industries have been hit hard in recent months, including by a sharp drop in metal prices.

39. Staff now expects GDP growth to slow to 1 percent in 2009—down from 2 percent projected at the time of the mission, and 6 percent in 2008. The reduction in growth is in large part driven by the sharp decline in net capital inflows, from 27 percent of GDP in 2008 to 10 percent in 2009. The drop in foreign-financed bank credit and the decline in FDI would lead to a contraction in domestic demand by almost 3 percent. GDP growth will remain weak in 2010, and even in later years is likely to stay below the rates experienced during the boom years, as capital inflows are unlikely to recover to previous boom-levels. Inflation is projected to decline sharply, from 12 percent in 2008, to 4.7 percent in 2009, helped also by the sharp decline in global commodity prices.

Bulgaria: Main Macroeconomic Indicators

article image
Sources: NIS and IMF staff projections.

40. These projections are subject to an unusual degree of uncertainty and there are significant risks that growth will slow even more. A deeper-than-expected recession in Bulgaria’s trading partners and the sharp fall in regional floating currencies could lead to a faster drop in exports. Net capital inflows could drop by more than expected, and financial crises in other countries could spill over to Bulgaria. A recession in the construction sector and a fall in real estate prices could lead to a sharp increase of loan defaults and loss given default rates, which would feed back to bank weakness and a further contraction in the supply of credit. In an alternative, illustrative, scenario, in which net capital inflows slow to around 1 percent of GDP, GDP could decline by 3 percent (Box 3).

Figure 5.
Figure 5.

Bulgaria: Recent Economic Activity, 2006M1-08M12 1/

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: National Statistical Institute; BNB; IMF Staff Estimates; Haver Analytics.1/ Data on the last three charts are up to Jan. 2009.

41. During the discussions in mid-December, official forecasters were more optimistic about capital inflows and GDP growth. They argued that the large capital inflows had been the result of Bulgaria being an attractive investment destination, and this attractiveness had not been diminished by the global turmoil. With investment holding up, GDP growth would slow less than projected by the staff. Thus, the BNB’s mid December baseline forecast projected GDP growth of 4.4 percent in 2009—only slightly lower than the mid-September baseline projection of the Agency for Economic Analysis and Forecasting (AEA) of 4.7 percent.

42. Policy makers, however, were more cautious, and recognizing that there were significant risks that growth would be less than expected, were increasingly basing their policies on more pessimistic scenarios. The AEA had developed a worse case scenario, in which GDP grew by 2.1 percent only, and this scenario rather the baseline was used to set fiscal policy (see section VC). 10

Alternative Scenario

In a scenario in which net capital inflows dropped to near zero in 2009, and stayed weaker thereafter, the economic downturn would be much deeper. Domestic demand, and in particular investment would shrink sharply, and while the impact on growth would partly be offset by an improvement of the current account, overall the economy could shrink by 3 percent in 2009 and another 1 percent in 2010.

Such a scenario would be challenging for policy makers, and would require strong corrective measures. The decline in reserves would be more pronounced, while—in the absence of corrective measures—the fiscal surplus would turn into a deficit of around 2½ percent of GDP in 2009, rising further thereafter.

Bulgaria: Main Macroeconomic Indicators

(Alternative Scenario)

article image
Sources: NIS and IMF staff projections.

Assuming the full play of the automatic stabilizers.

V. Policy Discussions

The end of the capital-inflow driven boom poses considerable policy challenges. The most immediate challenge is ensuring that a sharp drop in capital inflows does not trigger a confidence crisis, which would expose the considerable private sector balance sheet vulnerabilities. The next challenge is ensuring that the economy is flexible enough to adjust to the drop in growth in the non-tradable sector by shifting resources to the tradable sector. Without such a shift, future growth could remain very low, which eventually could put strains on the currency board arrangement.

43. In many ways, Bulgaria starts the current slowdown from a strong position. The public finances are in good shape, with one of the highest fiscal surpluses in Europe. In addition, the balance sheets of the central bank and the government are strong, with large foreign reserves and substantial buffers accumulated in the fiscal reserve account.

44. The mission and the authorities agreed that given the large private sector vulnerabilities, a key task for policies is to maintain confidence in the currency board and in the financial system. The two are intrinsically linked: a strong and resilient financial system is needed to sustain the currency board; while the stability of the increasingly Euroized banking system hinges critically on maintaining the CBA.

45. Policy discussions focused on how to maintain confidence and how to shift to a new pattern of growth. Aside from maintaining financial sector stability (section A), a key instrument is keeping comfortably large fiscal surpluses (Section B). This is not only because surpluses have been a support pillar for the currency board, but also because balances in the fiscal reserve account will be an important shield if problems were to emerge, including in the financial system.11 It will also be important that the economy adjusts well to a decline in capital inflows, and that the tradable sector will take over as the growth engine (section C).

Bulgaria: Potential Liquidity Drains and Liquidity Buffers, December 2008

article image
Sources: BNB and Fund staff calculations, estimates and projections.

Debt by original maturity as of November 2008.

Parent banks deposits dominate banks’ short-term liabilities to nonresidents.

A. Financial Sector Stability

46. The BNB has taken several steps to prevent a crisis by improving depositors’ confidence, easing liquidity pressures, and increasing capital cushions.

  • Deposit insurance coverage has been increased, in line with EU commitments. In mid-November coverage was increased12 from €20,000 to €50,000; and in 2009, it will be increased further to €100,000 per depositor per bank. In contrast to some other EU countries, the authorities did not see a need to adopt blanket guarantees. The authorities will also adopt other envisaged amendments to the EU directive to ensure prompt payment of insured deposits.13

  • Reserve requirements have been lowered. While there is room for further easing (reserve requirements are far above the euro area requirement of 2 percent), the authorities are well aware that an easing of reserve requirements also tends to reduce international reserves.

  • The BNB has taken further steps to increase banks’ capital and liquidity cushions. It has persuaded most bank owners not to pay dividends, but instead add 2008 profits to capital. It has also received comfort letters from parent banks to ensure that they provide adequate liquidity and capital.

  • Reporting by leasing companies owned by non-bank and financial companies to the credit register has been improved, which facilitates banks’ credit risk analysis.

47. The authorities have taken steps to improve their ability to manage a potential crisis:

  • The BNB has intensified its monitoring, with special focus on liquidity and credit risks, and taken steps to further strengthen its stress testing capabilities, in line with recommendations of the recent FSAP Update.

  • The BNB has reviewed its current crisis management framework. Both the BNB and the Financial Supervision Commission (FSC) have conducted targeted inspections to ensure that supervised entities have contingency plans in place.

  • The Domestic Standing Group for Financial Stability, which was established in January 2008 as a sub committee for the Financial Stability Advisory Council, has been working on contingency plans.14

48. The mission discussed Lender of Last Resort facilities.15 The BNB has reviewed its processes to ensure fast action, but its scope to function as lender of last resort is constrained by the CBA—as of mid-January, the excess coverage of the CBA amounted to about €1.6 billion (5 percent of GDP). The government could use its fiscal reserves of around 18 percent of GDP to function as the de facto lender of last resort. The legal framework and procedures have been amended to allow prompt action. The authorities acknowledged that in the current environment, even the failure of a small bank could quickly lead to contagion, but they also noted that different approaches would be considered, including closing a bank while giving due consideration to all depositors.

49. The authorities generally felt comfortable with the bank resolution framework.16 The 1997 banking crisis, when several banks were closed, triggered major changes in the bank resolution framework. Furthermore, several current decision makers had crisis management experience from this period. The authorities agreed that in the event government capital injections were necessary, it would be important to ensure that existing shareholders would carry the losses.

B. Fiscal Policy

50. In recent years, Bulgaria has run large fiscal surpluses. Between 2005 and 2008, the fiscal surplus averaged 3 percent of GDP. Bulgaria targeted large surpluses to bolster confidence in the currency board, and to contain the current account deficit in the context of a large private saving-investment gap. As a result of these surpluses, the gross public debt to GDP ratio fell from 77 percent in 2000 to 17 percent in 2008; and fiscal reserves increased to about 12½ percent of GDP in 2008.

51. Yet fiscal policy was not as tight as suggested by these headline numbers. Nominal expenditure grew by 15 percent annually, and tax rates on corporate and personal income were cut. This was, however, more than offset by a surge in indirect tax revenues, the result of a domestic demand boom, which increased the absorption gap from 3¾ percent of GDP in 2005 to 13¾ percent in 2007. Indeed, the augmented structural balance, which takes into account the effects of both the output and the absorption gap, declined from 1.5 to 0.2 percent of GDP during this period.

Bulgaria: General Government Operations, 2005-09

(In percent of GDP)

article image
Source: Ministry of Finance; and Fund staff estimates.

Actual fiscal balance adjusted for the automatic effects of both output gap and absorption gap on fiscal position. see IMF Country Report No. 07/390, Chapter III for details.

52. Cautious fiscal policy continued in 2008, with another large headline surplus of 3 percent of GDP. As in previous years, aggregate spending remained very tight in the first three quarters; by September, the surplus had reached 7 percent of annual GDP. In October, the government stepped up investment spending, increased budget allocations for social spending,17 and overall government spending in November and December reached 10.8 percent of annual GDP. While the headline fiscal surplus remained one of the largest among EMCs, the augmented structural balance deteriorated by 1.4 percent of GDP, reflecting the further widening of the output and the absorption gap

53. The 2009 budget, which was prepared before the financial turmoil of September, and based on real GDP growth of 4.7 percent, officially aims at a surplus of 3 percent of GDP. Based on optimistic tax revenue projections (an increase of 16 percent—higher than the 15 percent increase in 2008), the budget aimed to increase current expenditure by 16.8 percent compared to the 2008 outcome (19.2 percent compared to the 2008 budget), almost sixty percent of which would go to an increase of social benefits (in particular pensions18) and public sector wages. Capital expenditure would increase by 23 percent, to partly make up for the expected slowdown in investment, but this increase would largely be financed by an increase in EU transfers.19

54. In practice, the government expected a surplus of around 2 percent of GDP, with spending buffers partially compensating for expected revenue shortfalls. Recognizing that GDP growth was likely to be well below 4.7 percent, the government has decided to restrict spending to 90 percent of the budgeted amount. The remaining 10 percent would be released depending on macroeconomic and budget developments. The authorities felt that this approach of reducing spending was politically more feasible than revising the budget, as there was insufficient support for reducing budgeted spending (some members of the coalition had proposed additional spending measures, particularly to support the real economy). With GDP growth around 2 percent and expenditure in line with the 90 percent rule, the budget surplus would likely be around 2 percent of GDP.

55. The staff warned that even with the spending buffers, the 2009 budget was by no means tight, and that a sharper slowdown could turn the surplus into a deficit. If the 90 percent is rule is applied, spending will increase by 13 percent—8½ percent higher than currently projected inflation. While the fiscal surplus was currently high, experience in other countries suggested that if the absorption boom came to an end, the fiscal balance was likely to deteriorate significantly.20 Staff’s medium-term fiscal projections suggest that between 2008 and 2012, the tax revenue to GDP ratio could fall by 1½ percentage points, which would require a commensurate decline in the expenditure to GDP ratio.

56. Since the mission, it has become increasingly likely that GDP growth will fall short of 2 percent, and that additional expenditure cuts may be necessary to achieve the 2 percent surplus. If, as staff currently expects, GDP growth slows to 1 percent, the shortfall would amount to around 0.6 percentage points.

57. The authorities agreed on the importance of maintaining sizeable fiscal surpluses. They explained that, as in previous years, expenditure was backloaded, leaving room for further expenditure cuts if the surplus came in below expectations. They were not only skeptical on the usefulness of discretionary fiscal stimulus, but even on the usefulness of letting automatic stabilizers work, as the impact on growth in a small and open economy such as Bulgaria was very small; and the negative impact on confidence might well offset the positive impact on demand.

58. The mission argued that fiscal and structural reforms needed to be accelerated, notwithstanding the election cycle. The problems regarding the disbursement of EU funds underscore the need to further upgrade control systems.21 There have been several changes to social security contributions and social policy (¶52), and it will be essential to cost these changes realistically and ensure fiscal neutrality, paying special attention to the impact on long-term sustainability of the public finances.

C. Flexibility of the Economy and Competitiveness

59. As the capital flow-driven boom in the non-tradable sector ends, will the tradable sector be able to take over? The answer to this question depends in large part on whether the real exchange rate has become overvalued, and, if so, how quickly the misalignment will correct.

uA01fig18

Composition of Real Gross Value Added growth, 2004-2008Q3

(Percentage points)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Haver.

60. CGER-type calculations based on the difference between the underlying current account and the current account norm suggest that the real exchange rate is now overvalued by 7-20 percent (Box 4).22 These calculations have a large degree of uncertainty, which is due to the difficulty of predicting by how much the large capital inflows will come down over the medium-term. The sharper the decline, the more domestic demand will fall, and the more the current account deficit will adjust even without real exchange rate changes.

61. The authorities did not share the mission’s concern that competitiveness may have become a problem. They pointed out that Bulgaria’s market share within the EU had continued to increase. They argued that much of the rapid wage increase had been a convergence phenomenon, and noted that even after the rapid wage increases in recent years, the level of price and wages was still the lowest in the European Union (Figure 6). Competitiveness had been further boosted by the lowering of corporate and income tax rates, which were now the lowest in Europe.

uA01fig19

Labor Cost Increase, 2000-07

(Percent)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Eurostat.
Figure 6.
Figure 6.

Bulgaria: Competitiveness Indicators

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Eurostat.

62. Staff noted that even if the real exchange rate level was not yet a problem, the recent changes had been very rapid, and warned that wage growth needed to slow. While the wage level was indeed low by European standards, so was labor productivity, and rapid wage increases were only sustainable if accompanied by commensurate productivity increases. The authorities reacted that the labor market was very flexible, and that wage growth would slow rapidly, when the economy slows.

63. Staff and the authorities agreed that structural reforms that raise labor productivity and labor participation are needed to speed up convergence of per capita income with the European Union. Recognizing the importance of further increases in employment and labor productivity, Bulgaria has recently introduced significant education and labor reforms (Box 5). Bulgaria has also made considerable progress in reducing the burden of regulation in recent years, ranking among the top 10 reformers in the World Bank’s Doing Business report in 2006/07, mostly on account of improved tax system and administration.

uA01fig20

GDP in Purchasing Power Standards per Person Employed

(EU-27=1000)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Source: Eurostat.

64. The authorities thought there were no impediments to investment in the tradable sector. They argued that an important reason that FDI had gone to the non-tradable sector was that when FDI to Bulgaria started to pick up, foreign investment in the manufacturing sector in Central Europe had already reached saturation levels. The car industry, for example, had already built new car plants in other transition countries. They also argued that the attractiveness of the non-tradable sector came from large capital gains, and these slowed, the tradable sector would become more attractive.

In staff’s view, much of the increase in the current account deficit since 2002 is temporary, boosted by a private capital inflows-driven domestic demand boom. Between 2002 and 2007, net private capital inflows increased from 12 to 33 percent of GDP, raising domestic demand from 108 percent of GDP to 122 percent. If this temporary surge in capital inflows abates, the current account deficit is likely to decline sharply.

Staff’s estimate of the underlying current account deficit is therefore well below the headline current account deficit. Correcting for the “absorption gap”—the temporary surge in domestic demand driven by the capital inflow surge/credit boom, as well as past changes in competitiveness that have not worked through, yields an underlying current account deficit of 12.8 percent of GDP—about half of the headline deficit.

The real exchange rate is likely to be overvalued by 7-20 percent. The underlying saving-investment deficit is about 2.9 percentage points higher than the equilibrium saving-investment balance, suggesting that the real exchange rate is overvalued by 7.5 percent. According to the external sustainability approach, which calculates by how much the saving-investment balance needs come down to stabilize the IIP, the real exchange rate is overvalued by 16 percent. If we compare the current REER level with the average of the past 5 years, the overvaluation is about 20 percent.

uA01fig21

Private Capital Flows and Domestic Demand

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

uA01fig22

Domestic demand and Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 096; 10.5089/9781451804591.002.A001

Bulgaria: Underling Saving-Investment Balance and Norm

(Percent of GDP)

article image

Assumes that domestic demand to GDP ratio reverts back to pre-boom level.

Based on Rahman (2008)

Real Exchange Rate Overvaluation, June 2008

article image

Deviation of REER from five-year average. (Mean of CPI and ULC-based REER).

Bulgaria FSAP Update

A joint IMF-World Bank mission visited Sofia from June 23 to July 4, 2008, to update the findings of the 2002 Financial Sector Assessment Program (FSAP).

The financial sector has changed with the entry of foreign (mainly Eurozone) banks, which now dominate the financial system. Various efforts to contain rapid credit growth resulted in higher intermediation costs and regulatory arbitrage. Banks increasingly offered financial services through unregulated or less strictly regulated financial companies (leasing companies, consumer credit companies, etc.). Some banks were booking loans abroad and selling loans to their parents to be re-packaged. Returns—among the highest in the region—triggered strong competition for market share. Residents were also increasingly borrowing directly from foreign banks, making Bulgaria more susceptible to spill-overs from abroad.

Reported indicators suggest that banks are generally sound, but rapid credit growth and increased dependence on foreign funding have increased the vulnerabilities of the banking sector especially from the upheaval in global financial markets. The BNB adopted conservative prudential policies: 12 percent capital adequacy ratio; Basel Core Principles for Effective Banking System are observed to a large degree; high (12 percent) unremunerated reserve requirements; etc. Capital adequacy ratios range between 14-30 percent, liquidity ratios 22-39 percent, return on equity 18-29 percent, and nonperforming loans 0.2-2.4 percent. About half of banks’ balance sheets are euro denominated, but positions are largely matched. However, indirect credit risk from unhedged borrowers is a risk factor. While the system relies on domestic deposits for funding, parent bank funding has been increasing (loan to deposit ratios range between 50-130 percent). The risks of regional contagion and spillovers are beginning to crystallize. Banks’ exposure to real estate and construction, through lending as wells as collateral increased, which could suffer from a drop in real estate prices.

The core banking system remains resilient under most stress test scenarios, but could under come pressure under a more adverse scenario. Under an adverse macro scenario with a sudden stop in capital inflows and a 30 percent drop in real estate prices, the NPL ratio would increase by about 12 percentage points, and the Capital Adequacy Ratio would decline from 14½ to 2½ percent

The robustness of the banking critically depends on maintaining the currency board arrangement, given large currency imbalances of corporations and households (71 percent of corporate loans and 25 percent of household loans are in euro).

The securities markets, insurance industry, and private pension funds remain relatively small and underdeveloped despite rapid growth. The legal and regulatory framework is consistent with pertinent EU Directives, but enforcement could be further strengthened.

Despite significant progress, further reforms on Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) are needed on several fronts including implementation of preventive measures, supported by additional supervisory resources.1

Key Recommendations

The BNB should: (i) enhance its capacity to stress test, particularly credit and liquidity risks; (ii) draft amendments to include non-bank borrowers in the credit registry, (iii) enhance and update its assessment tools and methodologies; (iii) develop contingency plans, but delay the introduction of risk-based premiums by the Deposit Insurance Fund; (iv) strengthen regional collaboration; and (v) participate in pertinent crisis management exercises (vi) create buffers in the fiscal space for potential solvency support, in case of systemic problems.

The Financial Supervisory Commission should: (i) strengthen its capacity to enforce securities legislation; (ii) prepare an effective oversight program of the stock exchange and settlement system; (iii) tighten the definition of related parties and develop a map of indirect ownership of pension funds; (iv) review the rules related to switching and the automatic assignation rule for undecided participants in pension funds; (v) increase disclosure of risk adjusted performance of pension funds; (vi) overhaul of the pay-out design of pension funds; and (vii) change its skill mix to better enforce insurance legislation during inspections.

1 An AML/CFT ROSC is being prepared based on the assessment report published in 2008 by MONEYVAL (the FATF-style regional body for Europe) and, in accordance with the agreement between the Fund and MONEYVAL, will be sent to the Board for information.

Structural Reforms and Competitiveness of the Bulgarian Economy1

Structural reforms that raise labor productivity and labor participation are needed to speed up convergence of per capita income with the European Union:

  • Current productivity levels are well below the EU average and that of other new Member States, and productivity growth is just 3% per year.

  • Labor market performance has improved substantially in the past decade, but labor force participation remains low. The unemployment rate, which had climbed to 20 percent at the beginning of the decade, is now at record low levels. But while the labor market has become very tight for highly skilled workers, overall labor force participation remains low, particularly among youth and older workers.

Recognizing the importance of further increases in employment and labor productivity, Bulgaria has recently introduced significant education and labor reforms.

  • The government has delegated budgets to schools and now provides a fixed amount per student which has led to a more efficient utilization of funds and which lays the ground for increases in the quality of education. Bulgaria has also launched external student assessments, both national and international, to benchmark and track progress of student performance. Going forward, education reforms need to be completed and consolidated in a new Education Act foreseen for 2009, and should be expanded to include vocational education and training and higher education.

  • In the labor market, reductions in the social insurance burden, and new employment policies focused on activating previously inactive workers (in particular the low-skilled, youth and older workers), should contribute to increases in labor force participation and employment.

The government has also taken measures to maintain fiscal sustainability of the health sector—improving the pharmaceutical policy, introducing an integrated information system for the National Health Insurance Fund, and raising the health contribution rate to 8 percent from 6 percent until 2008. However, further steps are needed to sustainably change the underlying structure of spending from hospitals to primary health care. A continued review of the financing mechanism in the health sector is needed to make the system financially sustainable and lay the ground for improving its quality and restructuring the health facilities network.

Bulgaria has also made considerable progress in reducing the burden of regulation in recent years, ranking among the top 10 reformers in the World Bank’s Doing Business report in 2006/07, mostly on account of improved tax system and administration. Notwithstanding this, regulation remains a serious constraint to enterprise operations and growth. In the World Bank’s 2008 Investment Climate Assessment, senior managers in Bulgaria reported spending 17 percent of their time dealing with requirements imposed by Government regulations such as taxes, customs, labor regulations, licensing and registration. This is very high compared to other middle-income economies. The Better Regulation Programme adopted by the Government for 2008-10, and the broader National Reform Programme (2008-10) charting a course of action based on EC recommendations, are key steps to maintain reform momentum.

1/ Prepared by the World Bank
Table 5.

Bulgaria: Selected Economic and Social Indicators, 2006–10

article image
Sources: Bulgarian authorities; Fund staff estimates and projections; and World Development Indicators database.