Bulgaria - 2008 Article IV Consultation, Concluding Statement of IMF Mission

December 15, 2008

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, December 15, 2008

1. Since 2004, when agreement was reached on EU accession, Bulgaria has 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 a strong fiscal policy. By 2008, these inflows had increased to about 30 percent of GDP. Boosted by capital inflows, credit to the private sector rose rapidly, and the credit-to-GDP ratio climbed from 36 percent in 2004 to 67 percent in 2007.

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

  • 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 6¼ 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 over 24 percent of GDP in 2008. The widening of the current account deficit was further stimulated by the concentration of GDP growth in construction, real estate, and financial services.
  • As unemployment dropped and the labor market tightened, wage growth accelerated to 24 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.

3. The surge in capital inflows is now expected to abate. 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.

4. At the same time, shrinking foreign demand and declining commodity prices might lead to a drop in Bulgarian exports and a decline in tourism. The IMF's latest projections show a contraction of over ½ a percent in G-7 GDP, which would affect Eastern Europe's growth and exports. 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.

Economic outlook

5. GDP growth is likely to slow to about 2 percent in 2009. With slower growth, the current account deficit is projected to shrink to 15 percent of GDP, while inflation is forecasted to decline to 4½ percent at the end of 2009, helped by a sharp drop in global commodity prices.

6. 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 could lead to a faster drop in exports. And capital inflows could drop by more than we expect-as our projection of 15 percent of GDP could still prove to be overly optimistic-with similar adverse effects.

7. Fortunately, Bulgaria starts 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.

8. Nevertheless, Bulgaria faces this slowdown with considerable private sector vulnerabilities.

  • The gap between private investment and private saving in 2008 is 27 percent of GDP. If capital flows drop sharply, the private sector will be forced to adjust saving and investment accordingly.
  • Private external debt has increased to 94 percent of GDP.
  • The non-financial corporate sector has borrowed considerable amounts in euros, and its foreign currency denominated debt has increased to 70 percent of GDP.

Policy Recommendations

9. In this setting, 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; and confidence in the currency board boosts the financial system.

10. Fiscal policy should aim at maintaining large 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. In this context, we welcome the government having targeted a 3½ percent of GDP fiscal surplus for 2008.

11. Maintaining surpluses will require a significant slowing of expenditure growth. As revenue growth slows with the expected economic downturn, expenditure plans will need to be adjusted accordingly. However, neither revenue nor expenditure plans in the current budget reflect the expected decline in GDP growth.

12. We understand that the government has decided to contain expenditure growth by restricting spending to 90 percent of the 2009 budgeted amount, rather than by revising the proposed budget. The remaining 10 percent would be released depending on macroeconomic and budget developments. While we appreciate this was a pragmatic solution, it is not transparent. Indeed, foreign observers are probably not fully aware of the 10 percent rule, and just see a budget based on unrealistic revenues.

13. It will also be essential that mechanisms to implement the 10 percent rule are clearly understood by ministries and the general public. Some plans and programs may need to be postponed to future years, and ministries should signal early on what their spending priorities are. These intentions also need to be communicated transparently to the public.

14. Strict budget execution is essential, because even with the 10 percent rule the 2009 budget is by no means tight. Implementation of the 10 percent rule would only slow the growth rate of current spending from 17 percent in the proposed budget to 11 percent-6 percent in real terms. Indeed, if GDP growth is in line with the mission's projections, the fiscal surplus is likely to fall to 2 percent of GDP.

15. Lower expenditure growth may be necessary not only in 2009, but also in later years. As the current account adjusts, both domestic demand and tax revenues will grow by less than GDP. With less room for expenditure increases, spending will need to be prioritized; while across-the-board cuts can be a useful temporary fix, they are not a desirable tool in the longer run.

16. Fiscal and structural reforms need to be accelerated, notwithstanding the election cycle. Problems regarding the disbursement of EU funds underscore the need to further upgrade control systems. We note several changes to social security contributions and social policy. 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. As regards structural areas, completing education reform and advancing health reform, raising public sector efficiency, and improving the business climate remain essential for accelerating convergence.

Wages and competitiveness

17. The high growth rate of wages cannot be sustained. 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. Moreover, as experience in other countries has demonstrated, there is a trade-off between unemployment and wage growth-the faster wages grow, the more unemployment is likely to increase in the downturn.

18. Moderation in unit labor cost increases is essential given that resources will need to be shifted to external trade-oriented sectors. As growth in the non-tradable sector slows, GDP growth can only be kept strong if the tradable sector takes over the slack. Therefore, both export-oriented and import-competing branches need to remain sufficiently competitive. Whether the current level of competitiveness has become a problem has no easy answer. Although our counterparts are confident about corporate profitability, we are less certain about the size of existing profit buffers. Our unease was not dispelled by the scant available data on current profit margins.

Financial sector

19. Strong policies will also help the financial sector. The financial system is currently well capitalized and profitable. In the period ahead, 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.

20. The Bulgarian National Bank's (BNB's) framework for financial sector supervision and regulation have 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 Financial Sector Assessment Program (FSAP) Update. These preparations are welcome, especially in light of the current challenging economic and financial environment.


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


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