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.

Bulgaria - 2006 Article IV Consultation Discussions
Concluding Remarks

May 17, 2006


1. Bulgaria's macroeconomic performance in recent years has been good. Growth has been strong, buoyed by rapid investment growth, and unemployment has fallen. These developments have been supported by a strong and stable macroeconomic policy framework centered on the currency board arrangement and tight fiscal policy. Inflation has been moderate, but has risen recently, mainly because of temporary factors, but also reflecting demand pressure. Wage pressure has remained under control.

2. However, external vulnerability has increased. The confidence inspired by Bulgaria's economic performance, and expectations for convergence with the EU, have been reflected in strong growth of domestic demand, fueled by bank credit and investment flows from abroad. The resulting rapid import growth has led to a severe deterioration in Bulgaria's external current account deficit, although the recovery of exports and sound competitiveness indicators are reassuring. Following many years of decline, and notwithstanding a substantial reduction in government debt, the gross external debt ratio has started to rise again, and remains at a high level.

3. The authorities have pursued prudent macroeconomic policies to contain this vulnerability. Substantial fiscal surpluses have acted to alleviate strong private sector demand. Absent traditional monetary policy instruments under the currency board, the central bank tightened prudential regulations substantially and introduced administrative controls on bank credit growth to address the prudential and macroeconomic risks arising from the lending boom. On the structural front, initiatives such as the reform of the business register and the launch of the National Revenue Agency will help improve the business environment.

4. EU accession presents tremendous opportunities for Bulgaria, but also requires policy adaptations. The harmonization of Bulgarian legislation and practices with EU standards brings wide-ranging benefits to the economy, as does the improved access to EU markets. Bulgaria also stands to benefit from substantial project financing from the EU. These projects can add greatly to Bulgaria's productive capacity, but only if they are planned carefully and managed properly, which will require a significant improvement in administrative capacity. Financial flows from the EU and revenue losses associated with accession will also complicate fiscal policy because they will add to demand pressures, and thus require offsetting savings to maintain a restrictive budget stance.

5. The authorities' plans to retain the currency board at the present parity through to euro adoption remain valid. However, entry into ERM2 will not diminish the need for the currency board to be supported by prudent macroeconomic policies, close financial sector supervision, and structural reform. As euro adoption is likely to reduce external vulnerabilities and also accelerate the process of integration with the EU, and as the lev is already pegged rigidly to the euro, Bulgaria only stands to gain by joining EMU at the earliest feasible date.

Macroeconomic outlook

6. Good macroeconomic performance is projected to continue in coming years, under an assumption of strong policy implementation. Growth is projected to accelerate slightly to around 6 percent a year over the medium term, as capacity is expanded by EU-financed investment projects. Inflation is expected to fall significantly over the next two years, and to remain one or two percentage points above eurozone levels on average in the medium term, as the process of nominal convergence to the EU continues. The external current account deficit is projected to remain high but on a slowly declining trend, as domestic demand and import growth slow and export growth accelerates. These projections assume the continuation of cautious macroeconomic policies and determined implementation of structural reforms to improve the business environment. Absent these conditions a less benign outlook would be expected.

Medium-Term Fiscal Strategy

7. With external vulnerabilities likely to unwind slowly in coming years, there will be scope for only a gradual loosening of the fiscal stance. The government's commitment to a fiscal surplus of at least 3 percent of GDP in 2006 is appropriate. Declines in the surplus in 2007 and beyond should be strictly limited, by identifying offsetting expenditure savings and substitution to compensate for the budgetary impact of EU-related flows. In this connection the budget should aim to achieve a surplus of about 2 percent of GDP in 2007. The government's proposals for cuts in direct tax rates need to await clear evidence that they can be afforded.

8. Tax policy and administration should focus on reducing distortions and incentives to operate in the grey economy. Despite the significant reduction in social security contribution rates in 2006, taxes on labor remain very high, tending to discourage investment and encourage firms to keep labor in the hidden economy. Thus to the extent that further tax cuts can be afforded they should be directed towards payroll taxes. There is still much scope for improvements in tax administration, particularly by ensuring that tax and social security collections are fully integrated within the National Revenue Agency as early as possible.

9. Bulgaria needs to move towards standards of fiscal transparency consistent with its prospective status as an EU member state. The practice of underbudgeting revenue distorts spending decisions and undermines parliamentary scrutiny of government activities. Improvements in public procurement processes and expenditure management are needed, especially in light of the forthcoming increase in project funds from the EU. It will also be important to strengthen internal controls and improve accounting, auditing and reporting of budget execution.

Financial System Stability

10. The banking system is well-capitalized and profitable. However, there are inherent risks in an environment of rapid credit growth, and supervisors need to monitor closely developments in non-performing loans and also ensure the adequacy of banks' risk-management frameworks. The credit limits introduced by the BNB, with the support of the IMF, helped reduce excessive growth in bank lending. But their effectiveness has diminished over time as banks have increasingly developed means of circumvention. The BNB's plan to phase out the administrative credit measures is appropriate. Nevertheless it will be important to maintain the existing tight prudential framework.

11. The insurance and pension sectors are growing rapidly and require close supervision. Parallel to the Article IV mission, the IMF has provided technical assistance to the insurance supervisor to further strengthen the capacity of the Financial Supervision Commission. Although the systemic risk posed by the non-bank financial sector remains small at this stage, reputation risks to the wider financial sector may exist.

Structural Reform Priorities

12. A revitalization of structural reforms is needed to improve medium-term growth prospects and help address external vulnerabilities. A more flexible and dynamic economy will yield stronger growth and better export performance, and will be more resilient to shocks. However, following a period of profound economic restructuring in the years after the introduction of the currency board, the momentum of structural reform has slowed over time. Although the legislative framework has been strengthened in a number of areas, implementation on the ground remains the weak link. A stronger commitment to structural reform will be required if Bulgaria is to realize its ambitions for faster convergence of living standards towards EU levels, and to have the agility to function successfully within the monetary union. Particular areas requiring attention include:

· Efforts to improve the business environment and encourage foreign and domestic investment need to be accelerated. The judicial system does not yet deliver the needed standards of legal certainty, the burden of regulation remains onerous, and public administration remains slow and unresponsive to the needs of businesses. As well as completing the reform of business registration and improving tax administration, licensing and regulatory regimes should be streamlined, procedures for contract enforcement and bankruptcy simplified, and the institutional infrastructure for attracting foreign investors strengthened.

· Many privatizations and concession arrangements have become bogged down in lengthy court proceedings. The government needs to build on the recent agreement on the sale of the Varna thermal power plant to reestablish momentum in this area.

· Public infrastructure needs to be modernized and renovated. Project financing from the EU will be helpful in shifting the public spending priorities towards capital expenditures.

· Bulgaria's adverse demographics highlight the need to increase labor market participation. Social assistance programs, including for sick leave, need careful review to ensure that disincentives to labor market activity are minimized. Release of excess staff from the public sector would also contribute to improved labor supply to the private sector. The government needs to work with its social partners to ensure implementation of its initiatives to improve labor market flexibility. The government should refrain from interference in wage-setting negotiations, which are best conducted between employers and employees at the firm level.

· Reversing the decline in Bulgaria's education standards will be critical to the long-term success of the economy. The sharp fall in the school-age population needs to be reflected in school consolidation and reduced staff numbers, with savings channeled to better quality of teaching, materials and equipment. Health budgets will come under increasing pressure from cost increases and an aging population, reinforcing the need to ensure that the reforms of health financing are supported by hard budget constraints at the hospital level. The government needs to build a political consensus behind its plans for hospital consolidation, which will enable a much higher standard of healthcare provision to the population. The assistance of the World Bank in developing reform programs in both education and health will be valuable.

· There is evidence that the declining trend in corruption reported since the late 1990s has come to an end. Implementation of the government's anti-corruption strategy has fallen short of its objectives. Improvements to public procurement procedures would help in this regard, as will legislative initiatives such as the new duty-free trade law. But results in the fight against corruption will depend ultimately on the political will of the government, parliament and other institutions.


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