Bulgaria and the IMF
Press Release: IMF Executive Board Approves Stand-By Arrangement for Bulgaria
August 6, 2004
Country's Policy Intentions Documents
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|Bulgaria—Letter of Intent and Memorandum of Economic and Financial Policies
Sofia, Bulgaria, July 21, 2004
Mr. Rodrigo de Rato
1. The Bulgarian authorities have prepared an economic and financial program for 2004-06 that aims at maintaining macroeconomic stability and strengthening the foundations for sustained high rates of economic growth in the runup to membership in the European Union, which we expect to obtain at the start of 2007. To achieve these objectives in light of risks posed by the external position, the program relies on fiscal adjustment, a tight incomes policy in the public sector, measures to reduce bank liquidity, and structural reform (including further privatization) in the context of the currency board arrangement. In support of our program, we herewith request a stand-by arrangement from the International Monetary Fund in an amount of SDR 100 million (15.62 percent of quota) to be made available over a 25-month period ending in September 2006.
2. The implementation of our program, which is described in the attached Memorandum of Economic and Financial Policies (MEFP), will be monitored through quantitative performance criteria and indicative targets in the fiscal and external sectors. In this regard, the MEFP proposes indicative targets for end-June 2004 and performance criteria for end-September 2004 and end-December 2004. Program implementation for the remainder of 2004 will also be monitored through 5 structural performance criteria and 10 structural benchmarks, all of which are listed in Annex I of the MEFP. The quantitative performance criteria are described in greater detail in Annexes II-IV.
3. The Government believes that the policies set forth in the MEFP are adequate to attain the objectives of its program, but it will take any further measures that may become appropriate for this purpose. Bulgaria will consult with the Fund on the adoption of these measures, and in advance of any revisions to the policies contained in the MEFP, in accordance with the Fund's policies on such consultation. We will provide the Fund with such information as it requests on policy implementation and achievement of program objectives. In any event, there will be four reviews during the period of the requested arrangement, scheduled to take place by March 15, 2005, September 15, 2005, March 15, 2006, and September 15, 2006 in order to assess progress in implementing the program and reach understandings on any additional measures that may be needed to achieve its objectives. In addition, (i) the first review will focus on the economic program for 2005 and set the performance criteria and structural benchmarks for the first half of 2005, (ii) the second review will set the performance criteria and structural benchmarks for the second half of 2005, and (iii) the third review will focus on the economic program for 2006 and set the performance criteria and structural benchmarks for the first half of 2006.
4. In view of Bulgaria's comfortable international reserves position and easy access to international capital markets, we intend to treat the requested arrangement as precautionary (i.e., we do not intend to make the purchases under the requested arrangement that will become available upon its approval and after observance of its performance criteria and completion of its reviews). We reaffirm our intention to make all outstanding repurchases to the Fund on the expectations schedule.
I. Recent Economic Developments and Policy Implementation
1. Economic developments in 2003 were broadly satisfactory. Led by private domestic demand and exports, real GDP grew by 4.3 percent, with an accelerating trend in the fourth quarter. A decline of agricultural output due to a severe drought was more than offset by large output gains in industry (especially manufacturing) and services (especially communications and tourism). In the context of this economic expansion, the unemployment rate dropped by more than 6 percentage points to 13½ percent, reflecting in equal measure active labor market policies and private sector job creation. Consumer price inflation declined to 2¼ percent on average, but its twelve-month rate rose to 5½ percent at end-2003 mainly due to rising food prices in the wake of the drought.
2. Economic activity has remained strong in early 2004, but inflation has so far failed to decline. Driven by investment and exports, real GDP growth accelerated to 5¼ percent year on year in the first quarter, and the growth momentum appears to have continued in the second quarter. Reflecting higher oil prices and a less rapid than expected decline in food prices, twelve-month consumer price inflation rose to 6¾ percent in May. Mainly for seasonal reasons, the registered unemployment rate declined to 12½ percent in May, while real wages were nearly unchanged year on year in the first quarter.
3. The economic expansion has been accompanied by the emergence of macroeconomic imbalances which we have begun to address by policy adjustments. A credit boom has contributed to a surge in domestic demand that has led to a deterioration of the external current account deficit, which widened to 8½ percent of GDP in 2003. As more than 80 percent of the 2003 current account deficit was covered by foreign direct investment, the external debt ratio still declined to 58¾ percent of GDP and international reserves remained close to 5 months of imports at end-2003. The rate of growth of banking system claims on the nongovernment sector accelerated again to more than 50 percent year on year in the first months of 2004. In response to these developments, the Bulgarian National Bank (BNB) took measures to strengthen its supervision and reduce banking system liquidity, and the government tightened fiscal policy by saving one half of its revenue overperformance in 2003, posting a deficit of ½ percent of GDP (with capital transfers treated as expenditure). The most recent data for the twelve-month rates of the current account and nongovernment claims show reductions to 8¼ percent of GDP in April and some 47 percent in June, respectively. Reflecting rapid growth in revenue, the general government recorded a cash surplus of almost 2 percent of annual GDP in the first five months of 2004.
II. The Economic Program for 2004-06
4. Our economic program for 2004-06 aims at reducing external and financial sector vulnerabilities to maintain macroeconomic stability and achieve sustainable high rates of growth in the runup to EU membership in early 2007. The program relies on fiscal adjustment, tight incomes policies in the public sector, strengthened banking supervision, measures to reduce bank liquidity, and structural reforms (including privatization) in the context of the currency board arrangement. The latter has served us well as a disciplining device and will be maintained until the adoption of the euro later this decade. The development of unit labor costs in manufacturing and the rising share of our exports in the EU suggest that competitiveness remains broadly adequate, and the policies under our economic program are designed to bolster it.
5. We expect to achieve real GDP growth of some 5¼ percent a year during 2004-06. Our program contains the measures necessary to raise productivity, employment, and investment. Domestic saving is expected to catch up with levels observed in other EU accession countries in response to higher per capita income, rising enterprise profits, fiscal consolidation, financial deepening, and other structural reforms, including measures to improve governance and the business climate. But, with the investment-to-GDP ratio also rising, reliance on external saving is forecast to decline only modestly to 7½ percent of GDP in 2006. Together with expected high foreign investment (boosted by privatization inflows), this would help reduce the external debt ratio to 50½ percent of GDP at end-2006. After a temporary increase in 2004, average consumer price inflation is projected to abate to 3½ percent in 2005-06, reflecting tight fiscal and incomes policies and structural reform.
6. With monetary policy constrained by the currency board arrangement and an open capital account, macroeconomic policy will rely heavily on fiscal policy. Our program aims at achieving at least general government balance in 2004, withdrawing the fiscal stimulus that was originally planned in 2004. The fiscal stance will be eased in 2005-06 only if credit expansion declines as envisaged in our program and the external current account deficit ceases to give grounds for concern. While NATO and EU related spending and unfavorable demographics make it difficult to reduce further the size of government in the economy, we intend to (i) use EU accession related increases in excise taxes to reduce direct taxes and (ii) improve the quality of expenditure by reducing subsidies and targeting social spending, thereby creating room for priority spending on investment, operations, and maintenance. An unchanged fiscal stance, the realization of privatization receipts and the sparing use of government guarantees will allow the public debt ratio to fall to 37¾ percent of GDP by end-2006.
7. We have begun to implement a step-by-step strategy to reduce bank liquidity, to levels that will still allow banks to maintain an adequate level of lending. Within the limits imposed by an open capital account, we have started to reduce bank liquidity by transferring government deposits with commercial banks to the BNB and tightening reserve requirements, and will monitor closely the effects of these measures on the pace of credit expansion. We stand ready to resort to additional measures, including minimum liquidity requirements and increased government domestic borrowing if needed to achieve our objectives, but we do not envisage the need for restricting capital inflows to make our strategy effective. We have tightened prudential requirements in the banking sector and will intensify our supervisory activity as well as strengthen nonbank supervision during the program period to reduce financial sector vulnerability.
8. To elicit the requisite supply response and reduce vulnerabilities, our program relies heavily on structural reforms. We intend to essentially complete privatization during 2004-06. Apart from the privatization deals already in progress, this requires preparing for the sale of electricity generation and several transportation companies. Measures will be taken to make the labor market more flexible by facilitating entry to and exit from employment and to cut red tape, reduce corruption, and strengthen the enforcement of property rights. As part of our fiscal adjustment program, we will take measures to improve revenue collection and expenditure management and strengthen the pension and health care systems.
9. Fiscal policy needs to remain tight and flexible during 2004-06 to address possible exogenous shocks and program slippages, achieve the targeted improvement in the external current account, and deal with the fiscal impact of EU membership in 2007. EU contributions and cofinancing requirements of EU financed projects are expected to burden the budget by some 2 percent of GDP in 2007 and by some 1½ percent of GDP thereafter. We do not consider it prudent to enter ERM2 with a deficit of this size and therefore will take the appropriate measures to ensure fiscal balance in 2007 and beyond. This objective will be facilitated by the exceptional budgetary support (to be disbursed in 2007) we obtained from the EU at the conclusion of our negotiations of the accession chapters in June 2004.
III. The Program for the Remainder of 2004
10. Our objectives for 2004 are an acceleration of economic growth to just over 5 percent, a reduction of consumer price inflation to 3½ percent at yearend, and to contain the external current account deficit to 8¾ percent of GDP. The acceleration of growth is expected to result from a reduction in the negative external sector contribution, which more than offsets a modest slowdown in the growth of domestic demand. From the supply side, output growth should benefit from a recovery in agriculture, recent investment in capacity, and a good tourist season. While average inflation will be high at 6¼ percent, its twelve-month rate should—despite corrective price increases for electricity and heating—fall rapidly with the arrival of the new harvest. Despite the expected slowdown of credit expansion to 30-35 percent year on year by end 2004 and of domestic demand, the external current account is expected to worsen slightly with respect to 2003 due to recent increases in oil and other commodity prices. With the expected inflow of foreign direct investment and the pending prepayment of external debt, and in spite of a further buildup of gross international reserves, the gross external debt ratio is projected to fall to 56 percent of GDP.
A. Fiscal Policy and Reform
11. We have decided to tighten fiscal policy and aim at overall general government balance (redefined to treat capital transfers as expenditure) on an adjusted accrual basis in 2004 (performance criterion). In view of the further current account deterioration and a weakening private sector saving performance, we have come to the conclusion that the expansionary fiscal stance of the 2004 budget is no longer appropriate. We have therefore decided to achieve, as a minimum, fiscal balance in 2004. In addition, we have also decided to limit general government expenditure (performance criterion), so as to ensure that any revenue overperformance resulting from the more buoyant demand situation than envisaged at the time of budget preparation will be saved. Beyond these commitments, fiscal policy needs to remain flexible and we will consider additional measures to tighten fiscal policy further in consultation with the Fund staff if the current account deficit does not develop as envisaged. To convert our fiscal cash data to an accrual concept, we have begun monitoring the stock of general government arrears on a quarterly basis, and will treat the net accumulation of arrears as expenditure. All central government arrears will be eliminated by end-September 2004 (performance criterion).
12. In the interest of greater transparency, our program for 2004 is based on more realistic revenue projections. This has resulted in an upward revision of revenue by some 2 percent of GDP as revenue losses associated with lower personal and corporate income tax rates are more than offset by improved tax administration, increased excise taxes, and the more realistic reflection of the macroeconomic assumptions made at the time of budget preparation. All revenue categories have experienced upward revisions, most notably, however, value added, personal income and corporate income taxes. Our revised projections were also boosted by higher profits, both realized and still expected, from the BNB and the recently privatized telecommunications company and other nontax revenue. Following the shift to greater reliance on indirect taxes at the start of the year, we will keep our tax system unchanged during the remainder of 2004.
13. In line with the need to increase the program's transparency, and consistently with the goal of achieving at least fiscal balance in 2004, we have raised our budget expenditure by around 1 percent of GDP. This, and a more realistic estimate of interest expenditure, has allowed us to make room for previously unbudgeted priority expenditure for healthcare and road maintenance and to meet late-year expenditure pressures such as wage and pension bonuses. Despite these revisions, the expenditure-to-GDP ratio remains almost 1 percentage point of GDP lower than in 2003. Nevertheless, capital expenditure has been raised somewhat in relation to 2003. As we are determined not to allow expenditure to exceed its revised level in 2004, we will continue to cap all discretionary central government spending at 93 percent, and budget transfers to local governments (except taxes) related to state mandates at 90 percent, of its revised budgeted level until the fourth quarter. These limits have been incorporated in the controls of the Treasury Single Account (TSA). The amount of spending deferred in this manner during the first three quarters is estimated at somewhat less than 1 percent of GDP and will be available for spending in the fourth quarter up to the overall expenditure ceiling. Plans to transfer funds to a new road construction enterprise have been postponed in view of the macroeconomic situation and the need to clearly determine the scheme for building motorways.
14. We will take measures to strengthen the sustainability of the pension and public health insurance systems. To remove discretion, the formula (the annual increases in the average consumer price index and the average insurable income, with weights of 75 percent and 25 percent, respectively) determining the annual adjustment of pensions will be enshrined in the social security code by end-2004 (benchmark). To contain spending on disability pensions the National Social Security Institute (NSSI) will (i) appoint representatives to the regional and national medical expert commissions, and (ii) be given authority from January 1, 2005 to have its own medical experts verify and re-certify any disability certification issued before January 1, 2005 and be required to reconfirm all the commissions' certifications of eligibility for disability pensions issued from January 1, 2005 by end-December 2004 (performance criterion). In addition, the government will pass a decree by end-September 2004 limiting retroactive payments to newly certified individuals eligible for disability pensions to the six months before issuance of the certificate of disability. For 2005, the government will review NSSI benefit expenditures to ensure that the NSSI deficit does not lead to an increase in the transfer from the central government by more than the projected average CPI inflation. Despite the failure to sign a national framework agreement (NFA) for 2004, the National Health Insurance Fund (NHIF) and the Ministry of Health will reimburse hospital financing exclusively on a fee-for-service basis (clinical paths and price per diagnosis). Discussions for the 2005 NFA will be conducted within the terms of the budget procedure for that year, and we intend to broaden the scope for patient co-payments for medicines and other health services.
15. The prevailing excess demand pressure requires continued fiscal prudence. We will set the 2005 budget targets at the same level as projected for 2004. However, we may ease the fiscal stance somewhat, if, at the time of the budget preparation (i.e., in September 2004 for the 2005 budget), private sector credit growth does decelerate as projected and current account trends do not give reason for concern. The detailed policies of the 2005 budget are still being developed. We are examining the feasibility of further lowering the corporate income tax rate from 19½ percent to 15 percent and the personal income tax by reducing its rates and introducing child tax credits. The associated revenue shortfall would be largely offset by raising excise taxes selectively toward minimum EU levels and by the expected further improvement in tax collection. On the expenditure side, better targeted social spending and outlays related to EU accession and for improving infrastructure remain priorities. Following a 8.5 percent wage increase in mid-2004 and employment increases related to judicial and education reform and EU accession, the mid-year increase in the wage bill in the budget sphere will not exceed the projected average CPI inflation for 2005. Subsidies will be further reduced, particularly with the elimination of those to the district heating companies. An agreement on public service obligations of the railways is expected to be signed by end-September 2004. In pursuing plans to construct a new nuclear power plant, we will be guided by the need to enhance the efficiency of public expenditures and maintain fiscal space for priority public investment, and we will minimize (i) recourse to public expenditure and guarantees, and (ii) interference with our plans to privatize existing electricity generation companies.
16. A number of structural reforms will additionally strengthen fiscal performance.
B. Incomes and Labor Market Policies
17. Wage restraint is important to maintain competitiveness. To provide guidance to private sector wage bargaining, we are pursuing a restrained wage policy in the public sector. Along with the restraint on the government wage bill discussed above, the increase in the aggregate wage bill of the 58 largest public enterprises that are monopolies, received government subsidies, or made losses in the third quarter of 2003 will be limited to 4 percent in 2004 (performance criterion). In collaboration with the World Bank, we intend to amend our labor regulations with a view to making entry to and exit from work more flexible. As a minimum, we will (i) eliminate the portability of the seniority bonus to improve the re-employability of older workers and (ii) facilitate work outside regular hours. A decree satisfying the first requirement will be issued by end-December 2004 and a draft law satisfying the second requirement will be sent to parliament by end-December 2004 (benchmark). We are currently considering our minimum wage policy for 2005 and beyond with a view to finding a solution that strikes an appropriate balance between social considerations and the need to preserve competitiveness and promote employment in the formal economy. We will consult on our proposals with the Fund staff in September and the adoption of a satisfactory minimum wage policy will be a focus of the first program review.
C. Financial Sector and Public Asset and Liability Management Policy
18. While we view the expansion of bank credit as an overdue catchup process that will eventually run its course, we are concerned that its rapid pace increases external vulnerability. To mitigate this risk, we have taken and will take a number of measures to strengthen bank supervision and drain liquidity as appropriate.
19. Under a stepwise strategy adopted in mid-2003, the BNB has already considerably intensified its supervisory activity. On-site inspections and targeted reviews of aggressive lenders are conducted more frequently. From April 1, 2004, provisioning requirements on distressed loans were tightened by reclassifying loans as nonperforming with a 100 percent provisioning requirement after 90 days instead of 120 days previously, and by raising the requirement for loans overdue by 61-90 days from 30 percent to 50 percent. In June 2004, banks were required to treat their current profits for the calculation of own capital more restrictively in line with EU banking directives. From July 1, 2004 the BGN 10,000 minimum for loans to be reported to the BNB's credit register was eliminated, thus providing banks important information for their retail lending decisions. As also indicated by macroprudential soundness indicators, we consider the banking system financially sound but, if needed, are prepared to step up our supervision and adopt additional prudential regulations to ensure that banks' balance sheets remain of high quality.
20. In an effort to restrain credit growth, however, we recognize the need to adopt additional measures to reduce banks' liquidity.
21. The government has announced the early redemption of its outstanding Brady discount bonds at the next call date on July 28, 2004. This transaction will reduce the external and public debt ratios by 2.9 percent of GDP and release some 1.2 percent of GDP in collateral, thus reducing net international reserves by only 1.7 percent of GDP as a result of this transaction. We may buy back or prepay some of our other external obligations, subject to maintaining an adequate level of international reserves. To strengthen external sustainability, the government has established ceilings on the contracting and guaranteeing of external public debt (performance criteria). The government's ongoing strategy of shifting from external to domestic borrowing will also help absorb bank liquidity, provide assets to the private pension funds, and develop the domestic capital market.
22. We will strengthen the supervisory and regulatory framework of the nonbank financial sector. The creation of the Financial Supervision Commission (FSC) has been an important step forward, but more effort is needed to strengthen its supervisory capacity, regulatory framework, and enforcement powers, with a particular focus on the insurance sector. By end-2004, we intend to:
D. Other Structural Reforms
23. We realize that an improved business climate is essential in order to stimulate investment and generate a supply response to sustain higher rates of growth. To that end, we are in the process of reforming company registration regulations, dispute resolution procedures, judgment enforcement, collateral law, and corporate governance. Specifically,
As part of our efforts to improve the quality of administrative services, we will extend one-stop shops, which are already functioning in the majority of public administrations, to all such administrations at the central, regional, and municipal levels by end-2004. We intend to provide concrete plans to unify these one-stop shops across administrations for discussion during the first program review. To further improve incentives for entrepreneurial activities, we have already submitted to parliament laws on investment promotion and on small and medium enterprises development. These laws, which simplify investment procedures as well as provide nonfinancial assistance to potential investors, are expected to be passed by end-September 2004.
24. While surveys have shown a decline in recent years, and relevant indicators place us favorably among other countries in the region, we are determined to further reduce the incidence of corruption and improve governance. We are fully committed to the national strategy to counteract corruption outlined in 2001, and intend to improve coordination among ministries and other administrative bodies to reach our goals. We will implement commitments made in closing the judiciary chapter of the EU accession negotiations and further improve accountability of the judiciary. We expect to have a comprehensive code of ethics for public servants approved by the Council of Ministers for application by end-September 2004. In addition, we intend to continue actively prosecuting civil servants engaged in corrupt activities. We had to increase the threshold level for competitive tendering in the public procurement law due to EU requirements, but as the threshold remains high relative to Bulgaria's per capita income, we plan to introduce simple and transparent procedures to tackle petty corruption in low-value procurements by end-2004. To combat corruption related to organized crime, we submitted to parliament a law on asset forfeiture in March 2004, which we expect to be approved by end-2004.
25. Further reforms in the railway and energy sectors, and completion of privatizations remain critical to our medium-term fiscal and external financing strategies and to remove impediments to sustained higher growth. We are working with the World Bank to make the railway sector sustainable, including through cuts of redundant staff and tariff increases. Household electricity and district heating prices have been increased by 10 percent on average, with effect from July 1, 2004. With these adjustments, cost recovery for these utilities has been achieved and the need for subsidies has been reduced. With the adoption of the energy law, we are now addressing restructuring and privatization of the electricity and district heating companies. The heightened external vulnerability during the program period has added to the need to accelerate privatization. A new privatization law, which is currently under discussion in the Council of Ministers, will involve line ministries under tight deadlines in the preparation of privatization deals, with the aim of attracting strategic investors. Specifically:
All quarterly limits in this Annex are cumulative.
The general government accounts are defined to comprise the consolidated budget (including the republican budget, the budgets of ministries and local governments, and the social security funds NSSI and NHIF) as well as all extrabudgetary funds and accounts at the central and local government levels. The central government is defined as the general government minus the sum of the local government budgets and the extrabudgetary funds and accounts at the local government level.
For program monitoring purposes, the arrears of the central government are all overdue obligations on the payment for central and general government expenditure. The stock of central government arrears as of December 31, 2003 amounted to BGN 54.8 million.
For program monitoring purposes, the cumulative general government cash expenditure will be increased/decreased, and the surplus decreased/increased, at the end of each quarter by the cumulative increase/decrease in general government arrears (excluding the increase/decrease of arrears on the amortization of principal) until the end of the quarter concerned.
For program monitoring purposes, the fiscal balance (surplus/deficit) will be defined as the difference between general government revenue (taxes, nontaxes, and grants) and general government expenditure, including net capital transfers (net acquisition of shares and net lending). The cash expenditure data will be adjusted by the cumulative variation of the stock of general government arrears, as described in the preceding paragraph.
Reporting on the fiscal balance will be cross checked from the financing side as the sum of net credit from the domestic banking system to the general government, general government deposits and accounts abroad, net domestic nonbank credit to the general government, privatization receipts of the budget, receipts from external loans for project implementation and direct budgetary support minus amortization due, net disbursement/repayment of loans whose final payee is an entity outside the general government consolidation (onlending operations), and the net increase/decrease of general government arrears, including those on the amortization of principal. For calculating the performance against this ceiling, all privatization receipts, including dividends of the Bank Consolidation Company (BCC) distributed to the general government and taxes and other proceeds from the BCC related to bank privatization, and any revenues from release of Brady bond collateral, are treated as financing items. External flows will be converted into leva at the BNB daily exchange rate. Valuation changes in deposits and accounts that are denominated in foreign currencies will be recorded daily and reported by the BNB and the Ministry of Finance at the end of each quarter, and such changes will be netted out.
All data in this Annex will be reported quarterly by the Ministry of Finance (and by the BNB for some of the financing items in the preceding paragraph) within 60 days of the end of each calendar quarter.
The ceiling on the aggregate wage bill of the 58 state-owned enterprises closely monitored for their large losses or arrears, for receiving subsidies, or for being monopolies, is 4 percent above the level of their aggregate wage bill in the third quarter of 2003. The wage bill is defined to include wages and payroll taxes paid by the employer but does not include additional compensation under Article 12 of the 2004 Incomes Ordinance.
Those enterprises that have been privatized or ceased operations will be excluded from the list for the respective test dates. Those enterprises that register profits in each of the first two quarters of 2004 will also exit the list in the second half of 2004 unless they are monopolies, have arrears, or receive state subsidies. If an enterprise is excluded from the list, the wage bill ceiling for each subsequent quarter will be adjusted down by the amount of that enterprise's wage bill in the third quarter of 2003 plus 4 percent times the number of quarters it has been excluded from the list. The 58 enterprises monitored (enterprises number 1 to 16 are considered monopolies):