Bulgaria
2010 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Bulgaria
Author:
International Monetary Fund
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Publication Date:
02 Jun 2010
eISBN:
9781455207473
Language:
English
Keywords:
ISCR; CR; government; payment commitment; GDP; deficit; payment; foreign currency; exchange rate; current account; banking system; GDP growth; Wages; Global
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The large capital inflows that generated a domestic demand boom in Bulgaria led to strong employment growth. But a sharp reduction in capital inflows led to a contraction of domestic demand, while the recession in Bulgaria’s trading partners caused a drop in exports. Public policies will also need to attune to the domestic demand-driven revenue boom and adjust spending growth to the new environment. Capital inflows are likely to remain low, and domestic demand is expected to decline further, requiring substantial adjustments by both the private and public sectors.

Abstract

The large capital inflows that generated a domestic demand boom in Bulgaria led to strong employment growth. But a sharp reduction in capital inflows led to a contraction of domestic demand, while the recession in Bulgaria’s trading partners caused a drop in exports. Public policies will also need to attune to the domestic demand-driven revenue boom and adjust spending growth to the new environment. Capital inflows are likely to remain low, and domestic demand is expected to decline further, requiring substantial adjustments by both the private and public sectors.

I. Staff Appraisal and Executive Summary

1. In the years that preceded the global economic and financial crisis, large capital inflows into Bulgaria generated a domestic demand boom. This brought strong GDP and employment growth, but also widened the current account deficit to very high levels, and led to an overheating of the economy, with high wage growth and double-digit inflation.

2. The boom came to an end in the fourth quarter of 2008, amid the global crisis that followed the default of Lehman Brothers. A sharp adjustment in capital inflows led to a contraction of domestic demand, while the recession in Bulgaria’s trading partners caused a drop in exports. As a result, GDP contracted by 5.0 percent in 2009.

3. With capital inflows unlikely to re-reach pre-crisis levels both the private sector and public sector will need to adjust. The private sector will need to shift resources from the non-tradable to the tradable sector. For the shift to the tradable sector to be successful, wage growth will need to slow considerably in 2010 and remain moderate over the medium term. Public policies will also need to attune to the end of the domestic demand-driven revenue boom and adjust spending growth to the new environment. Sustaining the built-up public buffers is important because private sector vulnerabilities remain considerable. Private sector external debt is 106 percent of GDP, while foreign currency debt of the non-financial private sector amounts to 80 percent of GDP.

4. Adjusting public policies would also help prepare the country for eventual euro area membership. The currency board has been a pillar of stability and eventual euro adoption continues to be the only viable exit strategy. Maintaining fiscal discipline and deepening structural policies will strengthen economic fundamentals and the viability of the Bulgarian economy. It will also help make a compelling case that Bulgaria can rapidly adjust its economy within the confines of the currency board, meet all the Maastricht criteria, and prevent the re-emergence of external and internal imbalances.

5. Fiscal policy in 2010 will be challenging—notably meeting the government’s cash deficit target of 0.7 percent of GDP. On the revenue side, projections seem optimistic, in particular given the shortfalls in the second half of 2009. Recent increases in excise duties and a number of reforms to improve tax compliance are important contributions in preventing a further erosion of tax revenues. However, in the short term they may not be sufficient to offset the deterioration in receipts resulting from the macroeconomic situation and the cut in the social security contribution rate by 2 percentage points. On the expenditure side, the budget foresees a tight envelope, including a welcome freezing in public wages and general pensions, streamlining of the public administration, and stricter controlling of health care spending. The repayment of arrears built up in 2009 will further add to pressures on the cash deficit but should be swiftly pursued to prevent cascading of arrears in the private sector. Staff currently projects a cash deficit of 1.8 percent of GDP for 2010. Given the large uncertainties on the revenue side, it will be key that the budgeted spending limits are closely adhered to avoid risking an even larger deficit.

6. For 2011 and beyond, giving fiscal policy a larger role in stabilizing the economy can best be achieved by focusing, within a medium-term budgetary framework, on the overall spending envelope rather than on headline balances. Targeting real spending growth in line with cautious estimates of potential GDP growth would make public spending more predictable, help prioritize spending and contain the large intra-year adjustments that have characterized the past few years. Revenue windfalls should be used to build up fiscal buffers that can be used in times when revenues fall short, while tax rate reductions would need to be compensated by further expenditure reductions.

7. As the Bulgarian economy emerges from the crisis and shifts toward more export-led growth, fiscal policies can lend support to the adjustment also by creating room for growth-enhancing expenditure shifts. By rationalizing the public administration and making it more efficient and effective, including in absorbing EU funds, fiscal space for expenditure in other areas could be created, including accommodating needs for higher infrastructure outlays. Containing public wage growth, through the announced public wage freeze in 2010 and increases in line with productivity over the medium term would not only serve the budget constraint but also help limit economy-wide wage growth and help competitiveness.

8. Ensuring the sustainability of the social pension systems requires urgent reforms. The combination of large pension increases and reductions in social security contribution rates in the past has widened the gap between pension contributions and pension expenditures, and the increases in minimum insurable incomes were insufficient to make up for the revenue losses. At the same time, in the health care system distorted incentives have led to a proliferation of hospitals, mispricing, and rising financing pressures, while satisfaction with the quality of health services remains low.

9. Continued stability of the financial system is key to safeguarding the economic recovery. The main challenge for the banking system will be to absorb the increase in non-performing loans that Bulgaria, like other countries, is currently experiencing. Thanks to prudent regulation, the banking system has built up substantial buffers during the boom years. Nevertheless, supervisors’ enforcement of a cautious dividend policy continues to be appropriate. Contingency planning remains of the essence in Bulgaria as elsewhere, and in that respect the recent creation of a financial stability unit at the BNB is welcome.

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

II. Introduction

11. This year’s Article IV Consultation focused on how Bulgaria can adjust to the end of the capital-inflows boom. Previous concerns that the global crisis might trigger a balance of payments or banking crisis have not materialized, and the downturn has led to a correction of previously built-up flow imbalances, although stock imbalances and vulnerabilities remain high. However, while capital inflows will, over time, recover somewhat from the low levels during the crisis, they will mostly likely remain well below the unsustainable levels experienced before 2009, and both the private sector and public sector will need to adjust to lower capital inflows.1

Bulgaria’s Reactions to Past IMF Advice

Bulgaria and the IMF have maintained excellent relations, as reflected in the successful completion of a series of Stand-By Arrangements. In recent years, the government has maintained, in line with IMF advice, a prudent fiscal policy and built up large fiscal reserves, thus providing strong support to the currency board.

Last year’s staff report noted that with the end of the domestic demand and fiscal revenue boom, expenditure growth would need to slow substantially. The new government that came into office in mid-2009 heeded this advice, and reversed much of the large spending increases that had occurred in the first half of the year. Many of the key recommendations of the 2008 FSAP update mission and the FAD TA missions on tax administrations are being implemented.

III. The Global Crisis and the End of the Capital-Inflows Driven Boom

A. The Boom of 2003–08

12. Between 2004, when agreement was reached on EU accession, and 2008, Bulgaria experienced a surge in capital inflows and a credit boom. 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 34 percent of GDP—one of the highest among emerging market economies. Boosted by capital inflows, credit to the private sector rose rapidly, and the credit-to-GDP ratio climbed from 35 percent in 2004 to 73 percent in 2008.

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

  • Real GDP grew by more than 6 percent annually, leading to a significant narrowing of the income gap with Western Europe.

  • As the increase in domestic demand outpaced GDP growth, the current account deficit widened from 5.5 percent of GDP in 2003 to 24 percent of GDP in 2008.

  • With unemployment dropping and the labor market tightening, 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.

  • The overheating of the labor market resulted in a real exchange rate appreciation. Between the third quarter of 2006 and the third quarter of 2008, the unit labor cost (ULC)-based real effective exchange rate (REER) appreciated by 26 percent, while the CPI-based REER appreciated by about 16 percent.

  • GDP growth was to a large extent been driven by activities in the non-tradable sectors—in particular financial services, real estate and construction.2

14. As a result of the capital inflows boom, private sector balance sheet vulnerabilities became large.

  • Foreign currency mismatches—largely in euros—have become substantial. Foreign currency debt of the non-financial corporate sector stands at 80 percent of GDP; of households 10 percent of GDP.

  • External debt, which is mostly owed by the private sector, increased to 111 percent of GDP by end-2009. Sixty percent of external debt is intercompany debt and debt owed by banks -which is largely debt owed by subsidiaries to their parent banks, which reduces concerns about debt sustainability. Public sector debt, on the other hand, declined rapidly to only 16 percent of GDP (Table 1).

  • The net international investment position deteriorated to minus 112 percent of GDP as of end-September 2009 (Table 2).

Table 1.

Bulgaria: Gross External Debt, 2002–09

(Percent of GDP)

article image
Source: BNB.
Table 2.

Bulgaria: International Investment Position, 2004–09

(Percent of GDP)

article image
Source: Bulgarian National Bank.
uA01fig01

Sectoral Currency Mismatches

(in percent of GDP)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Sources: BNB; Fund staff estimates.

15. With private sector vulnerabilities increasing, the public sector built up significant buffers. Between 2004 and 2008, Bulgaria’s fiscal surplus averaged 2.8 percent of GDP (the highest among EU new member states), which led to a sharp decline in the public debt-to-GDP ratio (from 48 percent at end-2003 to 16 percent by end-2009), and significant reserves in the fiscal reserve account (12 percent of GDP at end-2009).

B. The Global Crisis of 2008–09

16. In the fall of 2008, the boom came to an end. In the global crisis that followed the default of Lehman Brothers, the Bulgarian economy was hit by two shocks: capital inflows declined sharply, which reduced domestic demand, while exports were hit by the recession in Bulgaria’s trading partners (Figure 1). The impact of the shocks was fully felt in 2009, when GDP declined by 5 percent—the first decline since the crisis of 1996/97:

Figure 1.
Figure 1.

Bulgaria: External Shocks and Recession, 2003–09

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Haver; IMF staff estimates.

  • Many advanced countries’ banks which were confronted with liquidity and capital shortages, saw themselves forced to stop new lending or deleverage. In a change of strategy, they advised their subsidiaries that credit growth would henceforth need to be financed from local deposits rather than from parent funding. In addition, the market for syndicated loans froze. As a result, flows to banks declined from +10 percent of GDP in 2008 to -2½ percent in 2009. The decline in foreign funding resulted in strong competition for deposits and rising interest rates, while credit growth came to near-standstill (Figure 1A).

  • FDI and other capital inflows declined as well, although not as sharply. FDI decreased from 18¼ percent of GDP in 2008 to 9¾ percent in 2009 with the sharpest drop in the real estate sector, falling by 75 percent in 2009. Overall, capital inflows declined from 34.2 percent of GDP in 2008 to 7.8 percent in 2009.

  • The reduction in capital inflows and the associated end of the credit boom led to a sharp drop in domestic demand and asset prices (Figure 2). Domestic demand contracted by 15 percent in 2009, as investment plunged by 28.5 percent), and credit stagnated. Housing prices slumped by 29 percent from their peak in Q3 2008, and the stock market corrected sharply.3

  • At the same time, exports were hit by the recession in Bulgaria’s trading partners. Exports declined strongly in the fourth quarter of 2008 and the first quarter of 2009, and stabilized thereafter. For the year as a whole, they declined by 22½ percent (10 percent in volumes).

Figure 2.
Figure 2.

Bulgaria: Capital Inflows and Credit Boom

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Bulgarian National Bank and Haver.
uA01fig02

Interest Rate on New Time Deposits of Households, 2008-10

(Percent)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Bulgariam National Bank.
uA01fig03

FDI by sector

(Billions of euros)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: NSI.
uA01fig04

Bulgaria: Inflation, Wages, and Housing Prices

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: BNB and IMF Staff calculations.

17. The downturn led to a correction of previously built-up private sector flow imbalances (Figure 3). The current account deficit narrowed from 24 percent in 2008 to an estimated 9½ percent of GDP in 2009, and inflation dropped to 1 percent—from 15 percent in mid-2008. Nevertheless, stock imbalances remain high (Figure 4).

Figure 3.
Figure 3.

Bulgaria: Factors Behind the Domestic Demand Bust

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: World Economic Outlook; International Financial Statistics.
Figure 4.
Figure 4.

Bulgaria: Adjustment of Imbalances

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Haver; World Economic Oultook.

18. The decline in domestic demand led to a drop in fiscal revenues, but strong corrective action in the second half of the year ensured that this did not result in a large fiscal deficit (Figure 5).

Figure 5.
Figure 5.

Bulgaria: Stabilization, but High Vulnerabilities

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: World Economic Outlook; Haver.

  • In the first half of the year, in the run-up to the elections, expenditure continued to increase rapidly (growing by 24.5 percent y/y in the first seven months) even though revenue dropped by 11 percent. Most of the expenditure surge came from pension increases (by 17 percent) and higher capital spending (66 percent increase in the first seven month of 2009 y/y). Revenue shortfalls were exacerbated by a reduction in social security contribution rates by 2.4 percentage points.

  • Decisive correction was taken in the second half of the year. The new government that took office in July 2009 implemented sharp across-the-board spending cuts, in particular for maintenance and capital spending. At the same time, most end-year and other bonus payments in the public sector were scrapped, allowing to contain overall cash spending growth in 2009 to less than 1 percent. Overall, the government managed to contain the cash deficit to 0.8 percent of GDP. However, the cash deficit was artificially lowered by the build-up of arrears, largely to the construction sector, and the accrual based deficit widened to around 1.9 percent (in ESA-95 terms).

19. The banking system remained stable (Figure 6). The end-2009 aggregate Capital Adequacy Ratio (CAR) was 17 percent—well above the BNB regulatory minimum of 12 percent and the EU minimum of 8 percent—and the Tier I ratio increased to 14 as a result of conversion of Tier II capital. Asset quality has deteriorated since the third quarter of 2008 but banks have been able to generate enough profits to cover the associated impairment costs, and the coverage ratio of non-performing loans (NPLs) by provisions of 80 percent is comfortable. Contrary to fears expressed by some international market participants 18 months ago, foreign parent banks have broadly maintained their level of funding of their local subsidiaries and the BNB is unlikely to ask for commitment letters from parents of systemic banks as it did last year.

Figure 6.
Figure 6.

Bulgaria: Fiscal Policy

(Year-on-year percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Haver.

20. Nevertheless, aggregate financial soundness indicators mask substantial heterogeneity across institutions. A few banks have a CAR just above 13 percent; several domestic banks maintained positive profitability but provisioned less than their peers; and most banks have limited the increase in NPLs by renegotiating with borrowers facing difficulties. Banks that were the most expansionary just before the peak of economic activity face more significant challenges.

C. Outlook for 2010 and Risks

21. The authorities agreed that an increase in exports will lead to a recovery this year, in line with other countries in the region. Staff projects that real GDP will increase by 0.2 percent. However, domestic demand is expected to decline further, even though financial markets have stabilized (Figure 7). On the back of an unwinding investment boom, tightened credit, and weak economic activity, investment will likely drop further. At the same time, private consumption is forecast to suffer from the decline in employment. As a result, the current account deficit will continue to narrow, from 9½ percent in 2009 to 6¼ percent of GDP in 2010. Inflation is projected to remain moderate, at about 2.2 percent, almost half of which is the effect of higher excise duties; and unemployment is expected to increase from an estimated 7.8 percent in 2009 to 9.2 percent in 2010.

Figure 7.
Figure 7.

Bulgaria: Financial Sector

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Nationa Authorities; Haver, IMF staff estimates.

Real GDP Growth

(Percent)

article image
Sources: IMF WEO database.

22. Risks to the outlook are significant. On the upside, a stronger-than-expected global recovery could boost Bulgarian exports and growth. On the downside, the main risk is a reversal of parent funding to their Bulgarian subsidiaries (Section IV). This risk could be exacerbated by renewed turmoil in global financial markets and concerns about sovereign debt sustainability of euro area countries.

Current Account Balance

(Percent of GDP)

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Sources: IMF WEO database.

IV. Policy Challenges

The currency board remains the appropriate exchange rate regime for Bulgaria, and euro area membership is the only viable exit strategy (section A). Maintaining the fixed exchange rate regime, however, puts restrictions on policies. Growth will need to shift towards the tradable sector (section B); fiscal policy will need to address the challenges arising from the end of the revenue boom and heightened financing pressures in the social security system (section C); while financial sector stability needs to be maintained (section D).

A. ERM-II Membership and Euro Adoption

23. The authorities and the mission agreed that the currency board remains the appropriate exchange rate regime for Bulgaria and euro area membership is the authorities’ declared policy goal. The currency board has contributed to macro-economic stability, not only by providing a nominal anchor, but also by disciplining fiscal policy. To protect the currency board, Bulgaria has run large fiscal surpluses during the boom years, built up significant foreign exchange reserves (Box 2), and these buffers served the country well when the global crisis hit—avoiding the financing difficulties that have affected other countries in the region.

24. The government aims to apply for ERM-II membership in the spring. It would proceed with this after its Convergence Report has been assessed by the European Commission. The authorities felt they had strong arguments to be admitted, as they were one of the few countries in the European Union that met the fiscal Maastricht criteria, the other one being Estonia.

25. Staff argued that the best way for Bulgaria to boost its ERM-II membership prospect would be to maintain fiscal discipline and deepen structural reforms. This would not only strengthen economic fundamentals and the viability of the Bulgarian economy; but also help make a compelling case that Bulgaria can rapidly adjust its economy within the confines of the currency board, meet all the Maastricht criteria, and prevent the re-emergence of external and internal imbalances.

B. Shifting Growth Toward the Tradable Sector

26. With the end of the domestic demand boom, growth will need to shift from domestic demand to exports. During the boom years, growth in Bulgaria was to a large extent driven by capital-inflows that fuelled domestic demand (Figure 8), and GDP growth was concentrated in the non-tradable sector.

Figure 8.
Figure 8.

Bulgaria: Financial Markets

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Bloomberg; Haver.
uA01fig05

Contribution to Average Real GVA Growth, 2003-2008

(Percentage points)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

uA01fig06

Contribution to Average Real GVA Growth, 2009

(Percentage points)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Haver.

27. To facilitate the shift, wage growth, which had accelerated to over 20 percent annually during the boom years, will need to be moderate. Average wage growth of the employed under labor contract increased from 6 percent in 2004, to 22.7 percent in 2008, resulting in a sharp appreciation of the ULC-based REER (37 percent since 2006).4 Wage growth slowed in 2009, but, according to official statistics, in 2009Q4 was still 10½ percent

28. The authorities were confident that this will would happen, arguing that the labor market was flexible. Hiring and firing restrictions are low—also compared to other countries in the region. Average statistics had overstated actual wage growth, as they did not include the sharp reductions in under the table payments. Another composition effect which boosted official wage growth, the authorities pointed out, was that employment had declined most strongly among the lowest paid. Overall, the authorities stressed that labor markets and private sector wages had already started to adjust; the freeze in public sector would also help contain private sector wage growth.

uA01fig07

Compared to other countries in the region, hiring and firing restrictions are low

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Eurostat
uA01fig08

Wages in Bulgaria are low relative to productivity and to other countries in the region, 2008

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: Haver; IMF staff estimates.Average monthly gross wages, in Euro

Hourly Labor Costs, 2008

(Euros)

article image
Source: Eurostat

29. Staff and the authorities agreed that while the real exchange rate had appreciated sharply in recent years, it was not obvious that the real exchange rate level had become a problem (Box 3). Seen over a longer time period, Bulgaria’s real exchange rate appreciation has been smaller than that of most other new member states of the EU (Figure 9). Also, its market share has continued to increase, while wages remain the lowest in the EU. This judgment was further corroborated by interactions of the mission with the private sector, which did not consider the level of wages or the real exchange rate as an issue.

Figure 9.
Figure 9.

Bulgaria: Competitiveness

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: World Economic Outlook; International FinancialStatistics; Haver; Bulgarian National Bank.

30. A sustainable longer-term adjustment of the economy would be further helped by a number of supportive structural reforms (Box 4). The business climate can be strengthened by further cutting red tape and reducing the regulatory costs for doing business, which are still considered burdensome and costly by the private sector, and by decisively tackling the high share of the informal economy and corruption. As the health of the corporate sector has deteriorated during the downturn, it is important to have strong legal and institutional frameworks in place that support corporate workouts, restructuring and bankruptcy procedures. Staff welcomed the authorities’ plan to assess the effectiveness of the corporate insolvency framework and to amend it with a view to making it more supportive of fast resolutions and of trust between creditor and debtor.

C. Fiscal Policy

31. The 2010 budget sets out a cash deficit of 0.7 percent of GDP, to be achieved through a combination of revenue and expenditure measures.

  • On the revenue side, the government has taken several measures. To increase tax compliance, the government has restructured the National Revenue and Customs Agencies, and intensified inspections to tackle particularly contraband activities. It projects that these measures will yield about 0.6 percent of GDP in increased revenue. It has also raised excises on cigarettes and electricity, and taxes on gambling and real estate (with an estimated yield of ½ percent of GDP). These revenue gains, however, will in part be offset by the reduction in social security contributions rate by 2 percentage points.5

  • On the expenditure side, cuts are planned in a number of areas. Wages and general pensions in 2010 will be frozen and no end-year bonuses paid. The number of civil servants will be reduced by 3 percent (with greater cuts at the ministries of about 15 percent) and the originally planned increase of pensions to widowers and those over 75 years old was delayed from January 1 to July 1, 2010 (a saving of 0.2 percent of GDP). Capital spending and subsidies are budgeted to rise; but the increase is contingent on the expected higher absorption of EU funds and could be halted if absorption falls short of targets.

Bulgaria: General Government Operations, 2007–10

(In percent of GDP unless indicated otherwise)

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

Public sector debt (includes guaranteed debt).

Actual fiscal balance adjusted for the automatic effects of internal imbalance (output gap) and external imbalance (absorption gap) on fiscal position. Structural balance (adjusted) = Fiscal balance - 0.4 * output gap - 0.1 * absorption gap (see Country Staff Report 07/390, Chapter III).

Percentage deviation of actual from potential GDP.

32. Staff argued that meeting the government’s cash deficit would be challenging, and projected a cash deficit of 1.8 percent of GDP. While increases in excise duties and reforms to improve tax compliance were important contributions in preventing a further erosion of tax revenues, in the short term they may not be sufficient to offset the deterioration in receipts resulting from the macroeconomic situation and the cut in the social security contribution rate. Moreover, the projected yields from improved tax compliance seemed optimistic, in particular given the shortfalls at end-2009 that highlighted the difficulties to achieve measurable impacts from better tax compliance in difficult economic times. On the spending side the repayment of arrears built up in 2009 would further add to pressures on the cash deficit, but should be swiftly pursued to prevent cascading of arrears in the private sector. Also, the projected savings on health care and social spending were uncertain as they depend on the implementation of reforms. Given the large uncertainties on the revenue side, it would be key that the budgeted spending limits are closely adhered to avoid risking an even larger deficit.

33. The authorities acknowledged the risks, but noted that they were committed to not letting the deficit exceed 2 percent of GDP. Containing the fiscal deficit with a view to supporting the currency board arrangement and preparing the way for ERM-II and euro area membership remained the authorities’ overarching objective and they stood ready to take additional measures on both the expenditure and revenue side.

34. The mission argued it would be important to shift from ad hoc fiscal measures to a medium-term strategy of fiscal policy from 2011 and beyond. Giving fiscal policy a larger role in stabilizing the economy can be achieved by focusing, within a medium-term budgetary framework, on the overall spending envelope rather than on headline balances. Zooming in on headline balances in the past had given fiscal policy a pro-cyclical character. Targeting real spending growth in line with cautious estimates of potential GDP growth would make public spending more predictable, help prioritize spending and avoid across-the-board-cuts, and contain the large intra-year adjustments that have characterized the past few years. Revenue windfalls should be used to build up fiscal buffers that can be drawn down in times when revenues fall short. The authorities agreed with the desirability of a greater medium-term orientation, particularly in the light of lower revenues.

35. Within such a medium-term framework any tax rate reductions would need to be compensated by further expenditure cuts. The authorities are well aware that lowering the social security contributions rates further, an announced element of the government’s fiscal strategy to reduce the cost of labor and support competitiveness, would widen the financing gap of the social security system and require larger government transfers. This would put at risk the government’s medium-term balanced budget targets and the sustainability, in particular of the pension system. Staff also advised against a cut of VAT rates as the budget relied heavily on this source of income6 and with the end of the demand boom shortfalls are expected to be significant for years to come. The authorities agreed that there might not be space for further tax rate reductions, and noted that they would only cut tax rates further, if there was fiscal space.

36. Staff argued that as the Bulgarian economy shifts toward more export-led growth, fiscal policies can lend support to the adjustment process needs in a number of ways. This includes not only containing the overall spending envelope, but also creating room for growth-enhancing expenditure shifts, including accommodating needs for higher infrastructure outlays. Priority should be given to the following areas (see also Box 4):

  • Ensuring the sustainability of the social pension systems requires urgent reforms. The combination of large pension increases and reductions in social security contribution rates in the past has widened the gap between pension contributions and pension expenditures, and the increases in minimum insurable incomes were insufficient to make up for the revenue losses. While government transfers averaged about 3 percent of GDP until 2008, they have surged to 5.2 percent in 2009, and are expected to rise further to 6.2 percent in 2010, as a result of the carry-over of the sharp pension increase in 2009. This gap can be reduced by a combination of the envisaged slowing of pension increases over the next years, after the freeze in 2010, an adjustment of the pension system parameters—including an increase in the retirement age or the minimum years of contribution—addressing the underreporting of insurable income, as well as a revision of those parameters that have created inefficiencies in the system, including weaknesses in management of disability pensions.

  • At the same time, distortions in the health care system need to be addressed. Due to mispricing and other distorted incentives in particular hospitals have proliferated in recent years (122 new hospitals had been created since 2004; about a 40 percent increase) and created financing pressures for the public health insurance fund. A comprehensive health care reform, with a view to improve the efficiency and quality of the health care system is needed.7 The government’s on-going reform efforts aim at mitigating the weaknesses in the health care system, including by rationalizing the in-patient care. Swift completion of a broad-based health care reform will be crucial.

  • By rationalizing the public administration and making it more efficient and effective, including in by raising the poor absorption of EU funds, fiscal space for expenditure in other areas could be created. This is particularly needed to complete the delayed agenda for upgrading Bulgaria’s public infrastructure and avoid it becoming a bottleneck to economic growth as well as through other productivity-raising measures, including in education and training.

  • Containing public wage growth, through the announced public wage freeze in 2010 and increases in line with productivity over the medium term would not only serve the budget constraint but also help limit economy-wide wage growth and help competitiveness.

  • A renewed push for privatization would not only enlarge the role of the private sector, but also yield resources that could be used to replenish the fiscal reserve account.

uA01fig09

Bulgaria: Pension Fund Contributions and Pension Outlays. 2001-10

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Sources: NSSI; and Staff caculations.

37. The authorities broadly agreed on these issues, including the need for fiscal structural reforms. They noted that health care reforms were already underway with the goal of raising the system’s efficiency while improving quality of care. Eligibility criteria to obtain funds from National Health Insurance Fund had been tightened and would soon result in the closure of many hospitals. Moreover, the authorities are in the process of developing quality standards, conducting a cost analysis, and review the pricing policies of medication. On pension reforms, the authorities noted that an advisory council of experts had been set up to develop reform proposals. Improving the absorption of EU funds is a priority of the government as reflected in the recent nomination of a Deputy Prime Minister in charge of this issue.

D. Financial Sector Stability

38. The mission and the BNB agreed that existing capital buffers, together with further countercyclical macro-prudential measures should allow the banking system to absorb the increase in NPLs and associated provisions. Both the BNB and the mission expect a further increase of the NPL ratio from 6½ percent at end-2009 to 10–10½ percent in 2010 under the baseline scenario.8 Even if banking sector earnings could come under greater pressure this year as a result of greater loss recognition and lower collateral values, capital buffers are large. These buffers were further boosted by the BNB’s decision in March 2010 to align its risk-weights to less conservative EU standards. This decision, which is a further step in the BNB’s countercyclical regulatory policy, added about 1 percentage point to the aggregate CAR. In addition, the BNB has asked banks to fully retain 2009 earnings and has decided to allow the inclusion of previous year’s audited earnings in the calculation of own funds prior to a decision taken at the shareholders’ meeting.

39. Another source of risk is a reversal of parent funding to their Bulgarian subsidiaries. With many subsidiaries operating with a loan-to-deposit ratio well above 100, the banking system crucially depends on parent funding for the extension of credit. Although all foreign-owned institutions appear adequately capitalized and sufficiently liquid at the current juncture, persistent financial tensions in a parent bank’s country of origin (which could result from market concerns about sovereign debt sustainability) could spill over to Bulgaria. The authorities emphasized that the BNB had appropriate tools in place for liquidity monitoring and regular exchanges of information with parent bank supervisors. Furthermore, the level of minimum reserve requirements as well as the requirement of a 15 percent coverage ratio of deposits from credit institutions, households and retail customers by liquid assets have created buffers against liquidity risk.

Bulgaria: Banking Sector

(as of end-Q4 2009)

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Sources: BNB; and IMF staff calculations.

Controlling shareholder is OTP.

Controlling shareholder is National Bank of Greece.

Branch (not subsidiary).

Excludes deposits of financial corporations.

40. The financial stability framework has recently been enhanced with the creation of a Financial Stability Unit at the BNB. The mission welcomed the establishment of this new unit, which reports directly to the Governor. It will produce an annual financial stability report and will serve as the BNB’s secretariat in the context of the Domestic Standing Group for Financial Stability. Other expected enhancements to the framework include the increase of the deposit insurance coverage from EUR 50,000 to EUR 100,000 by end-2010 and the inclusion of so-called preferential deposits in the set of insured deposits during 2011, in line with a new EU directive in the making.9

41. The frameworks for emergency liquidity assistance and bank resolution have remained unchanged since the conclusion of the last Article IV consultation. According to the BNB Law and BNB’s Ordinance No. 6, the BNB may extend loans in the event of a liquidity risk affecting the stability of the banking system only to solvent banks experiencing acute need of liquidity that cannot be provided from other sources. Such loans may not exceed the limit fixed by the currency board arrangement. In case of need, the law would also permit the use of part of the fiscal reserve account (3.9 bn euros at end-February 2010) by the government. Following an FSAP Update recommendation, the BNB and the BDIF are currently analyzing the modalities of the introduction of purchase and assumption transactions in the bank resolution framework.

42. The BNB believes it continues to be appropriate to give the same prudential treatment to exposure denominated in euros and in leva. Forthcoming discussions at the EU level will soon address the question of how EU level prudential regulation could help reduce banks’ indirect currency risk in countries with high foreign currency denomination of loans. The BNB explained that the Bulgarian real estate market was completely euroized and that, as a consequence, the collateral value of most euro-denominated loans was also denominated in euros, even if the borrowers’ income was denominated in domestic currency.

Reserve Coverage

Reserve coverage remains relatively comfortable under the staff’s baseline scenario. At end 2009, official reserves (which were equal to 36 percent of GDP) covered 182 percent of base money. Bulgaria’s currency board was designed in a way that foreign currency reserves equal much more than 100 percent of the monetary base, as they also cover the government’s deposit with the central bank and the deposit of the central bank’s Banking Department (the latter being set aside as a safeguard against systematic liquidity problems). As a result, reserve coverage of broad money (49½ percent) is well above the median of 34 percent for emerging economies and 32 percent among emerging markets pegged regimes. Reserve coverage of short-term debt on a residual maturity basis is 75 percent. Large part of short-term debt is from Bulgarian subsidiaries to their parent banks, which reduces the roll-over risk.

uA01fig10

Bulgaria: Reserve Coverage in International Perspective, 2008

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Sources: Haver Analytics; World Economic Outlook; and IMF staff estimates.

Bulgaria: Competitiveness

As a result of the sharp reduction in the current account deficit, CGER estimates of possible overvaluation are well below last year’s estimates. According to the macro balance approach, which compares the underlying current account deficit with the current account “norm”10 the real exchange rate is now undervalued by 6.5 percent (compared to an overvaluation of 7.4 percent in last year’s report). The external sustainability approach—which assesses the REER change needed to stabilize the international asset position at the current level—suggests that the REER is undervalued by 4 percent—compared to an estimate of an overvaluation of 16.1 percent last year. Even with a far more ambitious target (stabilizing the international investment position (IIP) at 60 percent of GDP), the overvaluation would be only 5.6 percent.

However, CGER-type methods, which link the current account balance to the real exchange rate level, may be less appropriate for Bulgaria, given that the large swings in the current account deficit have primarily been the result of the swings in capital inflows and domestic demand, rather than changes in the REER. The current account deficit increased between 2004 and 2007, as capital inflows generated a domestic demand boom, and came down in 2009, when capital inflows declined. Indeed, while the current account deficit came down in 2009, the CPI-based REER has continued to appreciate in 2009, rising by 2.2 percent between 2008Q4 and 2009Q4.

uA01fig11

Domestic demand and Current Account

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

uA01fig12

Private Capital Flows and Domestic Demand

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.A001

Source: WEO.

Other indicators of competitiveness do not suggest that the real exchange rate is overvalued. Seen over a longer time period, Bulgaria’s real exchange rate appreciation has been smaller than that of most other new member states of the EU (Figure 8). Also, its market share has continued to increase, averaging that of other EU transition economies, while wages remain the lowest in the EU.

Structural Reforms and Convergence of the Bulgarian Economy11

Structural reforms can help accelerate the convergence of Bulgaria’s income levels with those in Western Europe. In addition to the need for pension and health care reforms, discussed in the main text, the following reforms are most essential:

  • Public administration reform. This reform is central to achieving higher levels of efficiency and effectiveness of public spending, improving administrative capacity to use EU funds, and further improvements in revenue collection. Optimization of administrative structures includes reorganization of units, including closing down of unnecessary or duplicated units and restructuring of staff. In addition, development of e-government may enhance transparency, improve timely delivery of services, and minimize conditions for corruption.

  • Education reforms: Building on past achievement, education reforms can now focus on enhancing the quality of student learning. Specifically reforms aim at improving quality of education, promoting life-long learning, and providing equal access to education.

  • Business environment reform. Reducing the administrative burden on businesses and enhancing entry/exit of firms is key to improving competitiveness and productivity, and to developing a knowledge-based economy. The government aims at reducing the administrative burden for businesses by 20 percent by 2012. While important improvements in business environment have been undertaken, including reduction of the start-up capital for firms, further reforms are needed to modernize the insolvency framework, extend the regulatory reform to the municipal level, streamline the construction permits regime, contract enforcement, and reduce costs of trading across borders.

Structural reforms in other areas—including energy and agriculture would also be helpful. Public investment has a critical role in addressing infrastructure and environmental challenges in the medium term. The government expects to make better use of EU funds to finance public investments. Strengthening administrative capacity to absorb EU funds including at the municipal level together with public-private partnerships can be main instruments for regional development, rural development, and environmental protection.

Table 3.

Bulgaria: Selected Economic and Social Indicators, 2005–11

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Sources: Bulgarian authorities; IMF staff estimates and projections; and World Development Indicators database.

As percent of labor force.

Table 4:

Bulgaria: Macroeconomic Framework, 2007–15

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Sources: Bulgarian authorities; and IMF staff estimates and projections.

Including deposits of banks.

At original maturity.

Table 5.

Bulgaria: Real GDP Components and Implicit Deflators, 2007–15

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Sources: Bulgaria National Statistical Institute (NSI); IMF staff estimates and projections.

Contributions to GDP growth.

Table 6.

Bulgaria: Balance of Payments, 2007–15

(In millions of euros, unless otherwise indicated)

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Sources: Bulgarian authorities; and Fund staff estimates and projections.
Table 7.

Bulgaria: External Financial Assets and Liabilities, 2008–15

(In millions of euro, unless otherwise indicated)

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Notes:

It includes SDR allocation.

General government. It does not include private sector publicly-guaranteed debt. Sources: BNB; NSI; and Fund staff estimates and projections.

Table 8.

Bulgaria: General Government Operations, 2007–15

(In millions of leva)

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

After the adoption of the budget, a change in the expenditure composition was made with interest spending lowered by BGN 33 million, maintenance lowered by BGN 166 million, and capital spending raised by BGN 199 million. The overall spending envelope remained unchanged.

Public sector debt (includes guaranteed debt).

Actual fiscal balance adjusted for the automatic effects of internal imbalance (output gap) and external imbalance (absorption gap) on fiscal position. Structural balance (adjusted) = Fiscal balance - 0.4 * output gap - 0.1 absorption gap (see Country Staff Report 07/390, Chapter III).

Percentage deviation of actual from potential GDP.

Percentage deviation between actual absorption and the level consistent with external balance.

Table 9.

Bulgaria: Financial Soundness Indicators, 2004–09

(In percent)

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Source: Bulgarian National Bank.

Return on equity is calculated with Tier I as denominator.

Capital to assets is based on Tier I capital.

Table 10.

Bulgaria: External Debt Sustainability Framework, 2005–15

(In percent of GDP, unless otherwise indicated)

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Source: Bulgarian National Bank; and IMF staff estimates and projections.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1 +g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Figure 10.
Figure 10.

Bulgaria: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2010, 160; 10.5089/9781455207473.002.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 2009.
1

Experience in previous EMC-crises suggests that after capital inflows-driven booms have ended, capital inflows tend to remain depressed for a considerable time.

2

Construction and real estate business contributed more than half of gross valued added (GVA) growth between 2004 and 2008H1, raising its share in GVA from 20.7 percent to 24.5 percent. During the same period, average housing prices increased by more than 150 percent, with prices in Sofia and resort areas rising even faster.

3

As of March 15, 2010, the blue chip SOFIX index is still some 78 percent below its peak reached in Q3 2007.

4

The CPI-based REER has appreciated by 20 percent.

5

To partly compensate for this reduction, the minimum insurance income for self-employed and farmers was raised with a view to tackling the problem of underreporting the insurance base.

6

At 55 percent of total revenue, Bulgaria has the highest share of indirect taxes in the EU.

7

Bulgaria has one of the highest numbers of hospitals and an above average number of hospital beds per capita in the EU as well as longer hospital stays, lower bed occupancy rates, and an above average share of non-wage spending.

8

The mission’s and BNB’s methodology were very similar: the mission used an estimated relationship between the NPL ratio and the output gap, while the BNB’s methodology related the NPL ratio to the cumulative GDP loss relative to the pre-crisis GDP growth trend.

9

As of end-March 2010, before the increase in coverage, the resources of the deposit insurance fund covered 2.6 percent of insurable deposits.

10

See Rahman, Jesmin, “Current Account Developments in New Member States of the European Union: Equilibrium, Excess and EU-phoria” IMF Working Paper 08/92, 2008

11

Prepared by World Bank staff.

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Cover IMF Staff Country Reports
Bulgaria: 2010 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Bulgaria
Author:
International Monetary Fund
Volume/Issue:
Volume 2010: Issue 160
Publisher:
International Monetary Fund
ISBN:
9781455207473
ISSN:
1934-7685
Pages:
64
DOI:
https://doi.org/10.5089/9781455207473.002

Sectoral Currency Mismatches

(in percent of GDP)
Figure 1.

Bulgaria: External Shocks and Recession, 2003–09
Figure 2.

Bulgaria: Capital Inflows and Credit Boom

Interest Rate on New Time Deposits of Households, 2008-10

(Percent)

FDI by sector

(Billions of euros)

Bulgaria: Inflation, Wages, and Housing Prices
Figure 3.

Bulgaria: Factors Behind the Domestic Demand Bust

(Percent, unless otherwise indicated)
Figure 4.

Bulgaria: Adjustment of Imbalances
Figure 5.

Bulgaria: Stabilization, but High Vulnerabilities
Figure 6.

Bulgaria: Fiscal Policy

(Year-on-year percent change, unless otherwise indicated)
Figure 7.

Bulgaria: Financial Sector
Figure 8.

Bulgaria: Financial Markets

Contribution to Average Real GVA Growth, 2003-2008

(Percentage points)

Contribution to Average Real GVA Growth, 2009

(Percentage points)

Compared to other countries in the region, hiring and firing restrictions are low

Wages in Bulgaria are low relative to productivity and to other countries in the region, 2008
Figure 9.

Bulgaria: Competitiveness

Bulgaria: Pension Fund Contributions and Pension Outlays. 2001-10

(Percent of GDP)

Bulgaria: Reserve Coverage in International Perspective, 2008

Domestic demand and Current Account

Private Capital Flows and Domestic Demand

(Percent of GDP)
Figure 10.

Bulgaria: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)