Bulgaria -- April 2009 Staff Visit, Concluding Statement of IMF Mission

April 27, 2009

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Sofia, April 22, 2009

1. The global financial and economic crisis has turned out to be more severe than we expected during our last visit in December. The stress in the financial sector in many advanced countries and the drop in the stock market have shaken confidence of the private sector, and global demand and trade flows have declined sharply. Global GDP is now projected to contract by almost 1 percent this year, the first decline in at least sixty years.

2. As a result of the global turmoil, capital flows to Eastern Europe have declined, and demand for Eastern Europe’s exports has dropped.

• Capital flows to the region have declined, as a result of global deleveraging and an increase in global risk aversion. Western European banks are no longer providing new funding to their local subsidiaries, and private sector credit growth has slowed, in many countries to near zero. Consequently, domestic demand growth has slowed, and in many countries become negative.

• Demand for Eastern Europe’s exports has shrunk, as its principal trading partners are in recession. GDP of the European Union is projected to decline by 4 percent this year; Germany by 5.6 percent.

3. With both domestic demand and exports declining, real GDP in Eastern Europe is likely to contract by 3¾ percent in 2009—a stark difference from the strong growth of previous years.

4. Thanks to larger cushions and prudent policies, Bulgaria has been shielded from some of the problems associated with the global financial crisis.

• The banking system has remained stable, and capital has been increased further. While in some other countries governments have had to step in to provide new capital to banks, in Bulgaria the new capital has been provided by the banks, which have used their 2008 profits to increase capital rather than pay out dividends.

• The sharp exchange rate depreciations and associated private sector balance sheet pressures experienced by countries in the region with flexible exchange rate have been absent in Bulgaria.

• The public finances have been in surplus so far, and the difficulties experienced by some other countries in the region in financing their deficit have not been an issue here.

5. Nevertheless, balance of payments data confirm that Bulgaria is experiencing a severe shock.

• In the five months since October, net capital inflows amounted to only €800 million, from €6.1 billion in the previous five months and €5.6 billion in the same period a year ago. The reduction was in part due to the BNB’s decision in late 2008 to lower the required reserves ratio.

• Exports in the first two months of 2009 were 27 percent lower than in the first two months of 2008.

• The drop in imports was even sharper (32 percent), suggesting that domestic demand has contracted rapidly. As a result, the current account deficit declined from an annualized rate of 25.8 percent of GDP in the first two months of 2008 to 11.6 percent of GDP in the first two months of 2009.

6. Indeed, high frequency indicators of economic activity suggest the economy may already be contracting. Retail trade is shrinking: retail trade turnover in February was 4.7 percent lower in volume terms than in February 2008. Car sales haves slumped: new car sales in the first quarter were 51 percent lower than a year earlier. Manufacturing production is declining: in February it was 23 percent lower than a year earlier. Orders have declined even more: industrial new orders in March 2009 were 35 percent lower than in March 2008.

Economic Outlook

7. We expect net capital inflows to decline from 33½ percent of GDP in 2008 to 9¼ percent of GDP in 2009, and export volumes to shrink by 12 percent, and import volumes by 25 percent. The main component of capital inflows would be FDI: net FDI inflows are projected at 7.2 percent of GDP—58 percent lower than in 2008 and 75 percent lower than in 2007. In 2009 net FDI inflows will cover about 57 percent of the current account deficit.

8. As a result of these shocks, we expect the Bulgarian economy to contract by around 3½ percent this year and 1 percent next year. This projection is subject to a large degree of uncertainty, as economic developments in Bulgaria critically depend on developments in global economic and financial markets—which have been unusually volatile. The projection is a downward revision of our projection in the forthcoming April 2009 World Economic Outlook (-2 percent in 2009), which was prepared several weeks ago.

9. The contraction of domestic demand and GDP will contribute to a welcome correction of internal and external imbalances. Inflation, which less than a year ago had increased to over 15 percent, is coming down rapidly, and by the end of the year may be only 1.5 percent. Wage growth, which last year exceeded 20 percent will decline sharply as well. And the current account deficit will decline from 25 percent in 2008 to around 12 percent of GDP this year.

10. The adjustment will be painful, however, and 2009 and 2010 will be challenging years. The non-financial corporate sector, whose domestic and external debt has increased rapidly in recent years, will come under stress now that sales are shrinking, domestic credit has dried up and external financing is no longer readily available. Many firms will need to restructure and reduce their labor force. Some firms could experience difficulties servicing their debt. NPLs are likely to increase, but strong capital buffers of the banking system are currently in place.

Policy recommendations

11. Bulgaria enters the current downturn with strong buffers—the result of prudent policies during the boom years. The public finances are in surplus, the balance sheets of the central bank and the government are strong, with considerable foreign reserves, and substantial buffers accumulated in the fiscal reserve account. The banking system has benefited from the cushions created by regulation put in place in previous years to contain rapid credit growth, and entered the recession with a high capital adequacy ratio and still positive profitability.

12. It is important that policy makers adjust policies to the worsened reality in a timely manner. There is a fine line in managing expectations of the private sector. Being upbeat may help boost confidence. Being too upbeat may undermine the awareness that corrective action is needed and could undermine credibility when overly optimistic expectations do not materialize. Strong policies have supported the currency board arrangement, which has and should continue to anchor economic policies.

13. As a result of the economic downturn, fiscal revenues are likely to disappoint. So far, this has been most visible in VAT receipts, which have been hurt by the sharp drop in imports. But other categories are likely to be affected as well, and total tax revenues may well decline in nominal terms.

14. The original budget, which envisaged 16 percent tax revenue growth, was too optimistic. But even with the decision made in December to limit spending to 90 percent of the budgeted amount (the 90 percent rule), spending plans are not sufficiently tight. Our current revenue projections suggest that such a spending level would result in a deficit of about 1 percent of GDP. To avoid fiscal deficits and a rapid erosion of fiscal buffers, expenditure will need to be cut further.

15. Ideally, the budget should be adjusted to reflect the new revenue realities. We understand that the political cycle is making it difficult to reach consensus on a revision of the budget. In practice, spending will therefore need to be contained by keeping it even further below the budgeted amounts.

16. It is desirable and should be feasible to maintain a small surplus in 2009. There is room to cut expenditure further, including by lowering the growth of spending on maintenance and operation costs and government subsidies, contain the public wage bill, or streamline public investment. Keeping fiscal surpluses is important to prevent an erosion of the fiscal reserve account—an important component of international reserves—and maintain confidence in the currency board.

17. Keeping the public finances in surplus next year will be even more difficult—nominal expenditure may need to decline. Nominal revenues are likely to decline and nominal expenditure will need to be reduced accordingly. It may be prudent to build in significant buffers in the budget. While revenues often grow much faster than expected during boom times, they tend to surprise on the downside during recessions.

18. To sustain a future recovery, private sector resources will need to be shifted to export-oriented sectors. The sectors that have contributed the bulk of the growth in recent years (financial sector, real estate, construction) were dependent on large capital inflows. With a prolonged drop in capital inflows, these sectors are likely to decline in the near future and may see little, if any, growth thereafter. A market driven reorientation toward the tradable sectors is needed. This will only be possible if the rapid rise in unit labor costs of recent years comes to an end. Anecdotal evidence suggests that wages are indeed slowing rapidly, but it will be important that wage moderation is sustained.

19. As the health of the corporate sector can deteriorate considerably during a downturn, it is important to have strong legal and institutional frameworks in place that support corporate workouts, restructuring and bankruptcy procedures. We welcome the intention of the authorities to request a Report on the Observance of Standards and Codes (ROSC) on Insolvency and Creditor Rights Systems prepared by the World Bank, as a means to identify potential areas for improvement in Bulgaria’s insolvency and credit system as well as reform options to strengthen its in- and out-of-court legal and institutional frameworks.

20. Supervisors will need to continue to be vigilant to address any emerging problem in the financial sector promptly and in a forward looking manner. In line with EU commitments, the authorities have strengthened their crisis preparedness. The Bulgarian National Bank (BNB) is regularly conducting stress tests to gauge the potential need for additional capital under alternative shocks; and we welcome the forthcoming comprehensive stress testing exercise in cooperation with banks. The transposition of the EU directive on deposit insurance to facilitate earlier pay-outs, as well as the intention to clarify the coverage are also commendable.

21. EU funds can play an important role in Bulgaria’s development, and it is important that available resources be utilized. This is not only because in the current environment they are one of the few remaining external financing sources, but also because high utilization would boost confidence of foreign investors.

22. In sum, strong policies can help steer Bulgaria through the current downturn. The capital inflows-driven boom has come to an end, and the adjustment will be painful. Difficult policy choices will have to be made to ensure a smooth transition to a sustainable growth path. We wish the authorities all the best in their endeavors.


We wish to thank the authorities for their hospitability, and for the friendly and fruitful discussions we have had in the past week.


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