Bulgaria - 2007 Article IV Consultation, Concluding Statement of the Mission
October 16, 2007
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.
1. At first sight, Bulgaria's economy is performing well. Since 2003, against a backdrop of increasingly secure EU accession prospects and impressive macroeconomic stability gains, private investment spending has boomed as foreign and domestic investors sought to take advantage of expected lower risk premia and higher returns. The investment boom was financed by a protracted surge in capital inflows, especially foreign direct investment. Despite relaxed credit constraints, consumption spending, by contrast, has been much less exuberant than investment spending, reflecting restrained fiscal and incomes policies. Official data suggest that real GDP growth averaged about 6 percent during
2003-06, while unemployment dropped sharply from 18 percent to about 7 percent.
2. But four disquieting developments raise challenges for policy makers and other social partners responsible for safeguarding macroeconomic stability:
• The widening gap between Bulgaria's aggregate spending and income is mirrored by a ballooning external current account deficit. This large external imbalance will have to be reduced eventually, otherwise the country's external net financial liabilities and payment obligations could increase to unsustainable levels.
• Since July, the external environment has taken a turn for the worse. While credit tensions in mature markets have had so far little effect on Bulgaria, the tensions have highlighted the speed and scope at which financial markets can re-assess risk premia. Emerging market economies running large external deficits, including Bulgaria, are widely viewed as vulnerable to such re-assessments.
• Inflationary pressures are on the rise, partly reflecting one-off shocks, but also steadily accelerating private sector wage increases as labor market conditions have tightened. In this setting, demands for massive wage hikes in the public sector raise concerns that further domestic overheating could trigger a wage-price spiral.
• With the economy booming, difficult structural reforms that require strong political will to implement were put on the backburner, particularly reforms needed to raise the low efficiency of the public sector. As a result, key stakeholders have become increasingly dissatisfied, and the heat of social argument on how to address these grievances could well lead to short-sighted solutions that cast aside the economic realities of a lagging transition economy anchored by a currency board arrangement.
3. The already large current account deficit has continued to widen, but external cost competitiveness remains adequate. In 2007, real domestic spending growth, mainly driven by the ongoing private investment boom, will again outpace real GDP growth by a large margin, and the mission now projects the current account deficit to reach about
20 percent of GDP. However, because trade statistics collection underwent a regime change with EU accession at the beginning of this year, external data for 2007 need to be interpreted with particular caution. Nevertheless, there can be little doubt that the external deficit has reached unsustainable levels, notwithstanding continued large foreign direct investment inflows. Exporters have continued to gain market share, despite the pickup in private wage growth, suggesting that external cost competitiveness remains in line with cost fundamentals.
4. As for the economy's internal balance, inflationary pressures are building up. Despite real GDP growth projected to remain steady at 6½ percent in 2007, underlying inflation pressures are rising. Headline HICP inflation has soared into double digits, in large part reflecting one-off effects from the drought in agriculture, from EU accession on food prices, and from higher global energy prices. But core inflation has also picked up, albeit at a much slower pace than headline inflation, reflecting cost pressures linked to a tightening labor market and rising labor cost trends.
5. Turning to the financial sector, bank credit growth is booming. With the lapse of the largely ineffective administrative credit limits at end-2006, bank credit growth has accelerated, reaching 54 percent in August. In response, the Bulgarian National Bank (BNB) has hiked minimum reserve requirements from 8 to 12 percent. The banking sector seems well-positioned to absorb adverse shocks, but true underlying credit risk is difficult to gauge in a booming economy, and the quality of credit portfolios needs to be carefully monitored.
6. Bulgaria's significant fiscal surpluses reflect an appropriate policy reaction to the economy's imbalances. The underlying fiscal policy stance has been broadly neutral over recent years, and the surpluses largely reflect the revenue windfalls from an economic situation where aggregate spending is rising much faster than aggregate income. As the economy becomes again more balanced, the fiscal position will automatically weaken as the present large gap between spending and income narrows to more sustainable levels. The mission's own conservative calculations suggest that most of the fiscal surplus is accounted for by the large external imbalance. Thus, the government's decision to, by and large, eschew spending the temporary revenue windfalls on permanent spending increases or tax reductions has avoided the type of procyclical fiscal policies seen in several other countries faced with unsustainable run-ups in current account deficits.
7. Implementation of the 2007 budget has been broadly in line with this prudent fiscal policy practice. Although real GDP growth for 2007 is likely to remain close to earlier expectations, domestic demand growth has proven significantly more buoyant than projected, reflected in a significant overperformance of tax revenue. Notwithstanding the recent decisions to raise (effective October 1) pensions by an additional 10 percent and to cut social contribution rates by 3 percentage points, the fiscal surplus in 2007 is likely to reach at least 3 percent of GDP.
8. Tackling key structural reforms has proven difficult given fragile party politics and entrenched special interests. Bulgaria's progress on structural reforms is at par with its peers in areas where EU legislation tends to enforce regulatory homogeneity, including the liberalization of prices, trade, and the capital account. However, in areas where EU accession provides a weaker reform anchor, progress has been slower, including on raising the efficiency of the public sector, particularly in the education and health sectors, enforcing the rule of law, increasing labor market flexibility, and simplifying business licensing.
9. Under current policies, the mission's baseline scenario projects a gradual narrowing of economic imbalances over the next few years. With the external imbalance narrowing to more sustainable levels as investors find the scope for projects that promise high profits increasingly exhausted, the key will be to prevent domestic overheating from appreciating the real exchange rate to excessive levels, and thus undermining external competitiveness. The baseline scenario assumes that the fiscal stance will remain neutral in 2008 and beyond, while the public sector's real wage growth remains broadly tied to productivity trends. Private sector wage growth also moderates in line with labor productivity trends in a setting where the domestic spending boom looses steam. With the effects of recent one-off inflation shocks dissipating, inflation declines in line with moderating labor cost growth and low projected import price inflation, and external cost and price competitiveness over the medium term would remain consistent with a sustainable currency board arrangement.
10. An alternative scenario that assumes a significant loosening of fiscal and incomes policies illustrates the risk of further aggravating economic imbalances. Under the alternative scenario, public sector wages are assumed to be hiked sharply, in turn boosting private sector wages, and, with a lag, pensions, while the fiscal stance turns expansionary. As rising labor cost feed into higher domestic inflation, external cost and price competitiveness deteriorates, undermining the tradeable sector's ability to export and to compete with imports. A consumption-driven boom in nontradable activities could well overcompensate for growing difficulties in the tradeable sector, resulting in temporarily higher GDP growth. However, as the country's external cost and price competitiveness deteriorates, the nominal exchange rate constraint imposed by the currency board could result in a misaligned real exchange rate.
11. Against this backdrop, we consider the following broad policy framework as appropriate:
• Fiscal and incomes policies: These should continue to avoid adding procyclical pressures-including by limiting public wage increases to sustainable levels-that could widen internal and external imbalances, while using the spending and tax levers of the budget to accelerate real convergence and productivity growth, including through the efficient absorption of EU funds.
• Financial sector policies: Safeguarding financial stability requires continued close monitoring of banks' risk management and capacity to absorb adverse shocks.
• Structural reforms: The scope for catching up to living standards and real wages in the EU in a sustainable manner depends ultimately on raising the efficiency of available human and real resources while providing incentives to add to available resources. Thus, structural reforms are essential for accelerating real convergence.
In our view, sticking to this broad policy framework—with the details spelt out below—would provide the basis needed for a sustainable currency board arrangement, and to achieve Bulgaria's ambition for deepening its EU integration, including by eventually adopting the euro.
Fiscal and Incomes Policies
12. The authorities' present fiscal framework rightly stresses the need to avoid procyclical policies and to restructure the budget to accelerate real convergence. Aiming for a broadly balanced fiscal position over the medium term as the economy reaches external and internal balance would strike a balance between the prudent fiscal policy requirements under the currency board arrangement and Bulgaria's unfavorable demographics on the one hand, and the enhanced spending requirements of a lagging transition economy on the other. In this setting, as noted earlier, the present economic imbalances call for aiming at significant budget surpluses to avoid a procyclical stance. We also welcome the authorities' intention to keep the general government's expenditure-GDP ratio below 40 percent of GDP, while shifting spending toward public infrastructure and human capital formation.
13. The 2008 budget will prove the next key test for implementing this framework. With the economic imbalances projected to narrow only gradually, a fiscal surplus target in the range of 3-3½ percent of GDP range seems appropriate. On the revenue side, as the main policy change, the authorities plan to introduce a flat personal income tax rate of 10 percent, while eliminating exemptions to broaden the income tax base. The likely revenue loss from this measure could amount to some ½ percent of GDP, and the authorities need to monitor carefully their presumption that the flat tax will help de-shadow the private sector wage bill. At the same time, about half of the projected revenue loss is expected to be compensated by higher excises on fuel and tobacco. On the spending side, the main challenge will be to maintain prudent incomes policies by keeping increases in public sector wages broadly in line with productivity trends, including by reducing the public sector work force. In line with the fiscal framework, present budget plans also envisage further stepping up capital expenditure by 1 percentage point to about 7 percent of GDP, underpinned by a similar increase in EU grants. However, the mission is concerned that increased public infrastructure spending could add fresh demand impulses to an already overheated construction sector, although the ongoing slowdown in residential construction may free up some capacity.
14. The envisaged steps in the 2008 budget to increase fiscal transparency are welcome. The government's plan to adopt a single fiscal balance target should help clarify fiscal policy intentions and strengthen accountability. We also welcome the planned shift from using an across-the-board spending sequestration rule to establishing a centralized contingency reserve of some ½ percent of GDP, but note that the rules for using this new contingency reserve should be clearly spelt out in advance.
Financial Sector Policies
15. Bulgaria's framework for financial sector supervision and regulation seems strong, but arrangements have yet to be tested by a downturn in the credit cycle.
Basel II capital adequacy standards apply since January and should encourage a shift to more risk-based management. Moreover, with Bulgaria's foreign banks increasingly centralizing their liquidity and risk management functions, cross-border cooperation with other supervisors needs to be strengthened further. Finally, Bulgaria's active participation in efforts to improve the EU's cross-border crisis management arrangements is also welcome. The planned update of the Financial Sector Assessment Program (FSAP) in 2008 should provide a good opportunity to take stock of the strength and vulnerabilities of Bulgaria's financial system.
16. In Bulgaria's particular setting, capital market development, while clearly desirable, faces difficult challenges. Deeper local capital markets would help diversify risks away from the banking system, provide new investment opportunities for private savings, including savings accumulated in the private pensions and health care pillars, and offer market participants new choices to trade off return against risk. However, Bulgaria's investment culture remains nascent, particularly in the stock market, raising the specter of boom-bust cycles in local asset prices. Thus, following the harmonization of capital market legislation with the EU's acquis requirements, it will be important to enforce rules and transparency standards to allow local capital markets to take root and play their valuable economic roles.
17. We see the following structural reform priorities as achievable during the rest of the term of the present government:
• Raising public sector efficiency: With support from the World Bank and other outside advisors, design action plans for reviewing spending and programs in key budget sectors, notably education and health care. Introduce effective systems for monitoring and evaluating policy implementation in the public sector. And streamline and simplify administrative structures and procedures.
• Activating labor supply: Introduce amendments to the Labor Code that provide more flexibility regarding fixed-term contracts and part-time work. As planned, limit duration of social benefits to stimulate work search effort. And phase out mandatory seniority bonuses that risk pricing older workers out of the market and limit intersectoral mobility.
• Improving the business climate: Reform business registration (including by finally starting the electronic commercial register on January 1, 2008), and simplify licensing and permit systems. Implement privatization plans (including of Bulgartabak Holding AD), and enhance market competition (including in energy markets).
A strong effort to improve the quality of statistical data would be desirable. Efforts under way to develop sectoral flow-of-funds accounts for households and the non-financial corporate sector are welcome. Also, following EU accession, the trade data have emerged as a source of uncertainty about the country's external position. Finally, labor market data, particularly on employment and wage growth, are difficult to interpret, in part reflecting the still substantial size of the grey economy.
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We would like to thank the authorities as well as our counterparts outside the government for excellent cooperation, constructive discussions, and the usual warm hospitality.
Sofia, October 16, 2007