Bulgaria's EU Accession: Building on a Decade of Success, A Commentary by Robert P. Hagemann, Deputy Division Chief, European Department, IMF

May 9, 2007

A Commentary by Robert P. Hagemann
Deputy Division Chief, European Department
International Monetary Fund
Published in Bulgarian in Dnevnik (Bulgaria)
May 9, 2007

Bulgaria has come a long way since the dark days of the 1997 crisis. Back then, the future looked bleak, with inflation raging at over 1,000 percent, unemployment climbing, and output collapsing. But since adoption of the currency board arrangement a decade ago, along with consistent implementation of supporting fiscal policy and structural reforms, growth has been strong, inflation has been kept low, and unemployment has fallen.

Bulgaria's accession to the EU this past January is a landmark, holding the promise of sustained growth and rising living standards. EU-financed projects, if properly prioritized, can help boost economic performance through improved and additional infrastructure. Also, full integration into the common EU trading area should boost trade and competition. Finally, a reduction in Bulgaria's perceived risk should further encourage private investment, helping to raise productivity growth.

But accession alone is no panacea. Satisfactory economic performance will continue to depend on sound macroeconomic policies and sustained structural reforms. Indeed, this was a central theme of a seminar jointly organized by the Bulgarian National Bank and the IMF in Sofia on May 2.1 The seminar brought together government officials, members of parliament, academics, and representatives from think tanks, civil society and the international community to look at the challenges ahead and the policies needed to succeed.

A key challenge will be to maintain a prudent fiscal policy. The government remains committed to the currency board arrangement that has served the country well. But the absence of an independent monetary policy leaves fiscal policy as the only macroeconomic policy lever. Bulgaria's strong fiscal stance has cut public debt in half since 2003, to 25 percent of GDP. This strong performance provides credibility to the fiscal surpluses planned under Bulgaria's Convergence Programme, recently reviewed by the EU. At the same time, however, the budgetary challenge will intensify. With large net EU transfers expected to increase domestic development spending substantially, the government will have to reduce other expenditures to keep overall spending under the government's chosen ceiling of 40 percent of GDP.

Another formidable challenge is reducing the large current account deficit to a sustainable level. At over 16 percent of GDP in 2006, the current account deficit has tripled in three years. Although this external imbalance continues to be largely financed by foreign direct investment, external private debt has also risen substantially. This has taken overall external debt to around 80 percent of GDP. In light of the risks posed by such high debt, Bulgaria should self-insure against unforeseeable shocks. The government should continue to build readily available reserves as insurance against a sudden disruption of capital flows to Bulgaria. The country's defenses are at comforting levels in case of a moderate and temporary shock. But a deeper and more durable stoppage of inflows would be far more consequential for Bulgaria. Asia's financial crisis a decade ago should be a reminder that even countries in generally sound shape are not immune from the impact of crises elsewhere-and the sudden reversals of capital inflows that can result. Bulgaria therefore needs to be prepared for such a contingency. Sustained fiscal surpluses will be required to strengthen the government's Fiscal Reserve Account while also saving for additional spending demands arising from an aging population.

With demand for imports of both investment and consumption goods expected to remain high, as well as outflows for servicing the sizable accumulated external liabilities, reducing the current account deficit will require a much higher level of exports than in recent years. Research presented at the May 2 seminar suggests that even though various indicators indicate that Bulgaria remains competitive, the margin may be falling. With the exchange rate fixed under the currency board, there is no choice but to continually enhance the flexibility of domestic product and labor markets. In this regard, the unfinished structural reform agenda elaborated at the seminar demonstrates the huge challenge ahead.

As required of all EU members, Bulgaria has the responsibility to establish the domestic conditions needed for eventual euro adoption. The government's attention is therefore rightly focused on early ERM-2 participation, which would provide a helpful external anchor for policy. Bulgaria already is in solid shape on 4 of 5 of the Maastricht criteria for participation. But inflation, currently well above the permissible range, needs to come down. As illustrated at the seminar on May 2, some special aspects of acceding countries-such as very strong domestic demand driven by "EU-phoria"-make reducing inflation to very low levels a serious challenge. With commitments already made to maintain a prudent fiscal stance, and in the absence of independent monetary policy, bringing down inflation will also require many reforms to improve the business climate, eliminate obstacles to competition in product markets, and increase the flexibility of labor markets to enhance mobility and ensure that wage growth stays in line with productivity growth.

While EU membership offers countless opportunities, reaping the maximum benefits will be an enormous challenge. Given the required efforts, now is not the moment for policy complacency. The Bulgarian government is well aware of this. Policymakers will hopefully be aided by the domestic consensus that the above framework-so effective since 1997-will yield even better results on the road to euro membership.

1 Presentations made at the seminar can be found at http://www.bnb.bg/bnb/home.nsf/.


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