Bulgaria—September 2009 Staff Visit, Concluding Statement
September 30, 2009
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. The impact of the global economic and financial crisis on the Bulgarian economy has been severe. Domestic demand has been hit by a sharp drop in capital inflows, which has led to a near-halt of credit growth, while exports have been affected by the recession in Bulgaria’s trading partners. As a result, the economy is now in a recession. Real gross domestic product in the second quarter of 2009 was 4.9 percent lower than a year ago. Exports and manufacturing production have declined sharply, but imports have dropped even more, and the current account deficit has halved. Inflation has declined from almost 15 percent in June 2008, to 1.3 percent in August.
2. The mission projects that real GDP will decline by 6½ percent this year and by 2½ percent in 2010. Upside and downside risks to this projection appear broadly balanced. On the one hand, as the world economy has started to recover, exports could be stronger than we currently expect, which would boost GDP growth. On the other hand, the rebound in domestic demand may be more delayed than we now think.
3. Bulgaria started the downturn with considerable public sector buffers. Foreign exchange reserves were high, there was a large fiscal surplus, and there were sizeable reserves in the fiscal reserve account. These buffers in the public sector were important because Bulgaria entered this recession with considerable private sector vulnerabilities. After years of rapid credit growth and large capital inflows, private sector external debt had increased to around 100 percent of GDP at the end of 2008.
4. Before the downturn, Bulgaria could combine fiscal surpluses with high expenditure growth, as revenue grew very rapidly—the result of the capital-inflows financed domestic demand boom. This revenue boom is now over. If expenditure were to continue expanding at the rates of the boom years, the fiscal surplus could soon turn into a large deficit.
5. Until the middle of this year, however, fiscal policy had not adjusted to the new economic environment. During the first seven months of 2009, revenue declined 10 percent from a year earlier, but spending was 24 percent higher. As a result, the 6.3 percent fiscal surplus of the first seven months of 2008 turned into a small deficit (0.6 percent of GDP). Without corrective measures and given the central macroeconomic scenario outlined above, the 2009 fiscal deficit could have increased to more than 3½ percent of GDP. And under unchanged policies, it would have widened even further in 2010, when revenue is expected to continue to decline.
6. The new government is committed to address these emerging fiscal imbalances, and aims to balance the budgets in both 2009 and 2010 through a package consisting of both revenue and expenditure measures:
• On the revenue side, the government aims to raise tax compliance, by tighter onsite controls, the linking of the information systems of the National Revenue Agency and the customs agency, and the restructuring of both agencies. Other measures under discussion include an increase in the minimum threshold for social security contributions, and increases in excises on tobacco, electricity, and fuel for 2010 and 2011. These revenue gains will be partly offset by the 2 percentage points reduction in the social security contribution rate, which would result in direct revenue losses of about ½ percent of GDP, and by further reductions in later years.
• On the expenditure side, for the remainder of the year, the government aims at compressing maintenance and capital spending. For 2010, it plans to cut further slack in the provision of public services, downsize and optimize the public administration, freeze public wages, contain pension growth (depending on economic developments), reduce nationally financed public investment, and shift financing of public investment towards a higher absorption of EU funds. These expenditure savings will be partially offset by an increase in pensions, particularly for widowers and those over 75 years, which will raise the annual pension bill by 0.5 percent of GDP.
7. The renewed focus on fiscal discipline is necessary, even though it comes at a difficult economic time. But given its large private sector vulnerabilities, and the constraints imposed by the currency board, Bulgaria can ill afford to run large fiscal deficits.
8. In this difficult economic climate, balancing the budget will be very challenging, and we see risks on both the revenue and expenditure side.
• On the revenue side, the main risk is that the projected revenues from improved tax compliance may fall short. This is not only because the projected gains are high, but also because the current economic situation may further complicate efforts to boost tax compliance: during recessions compliance tends to fall. Falling profit margins, including in the financial sector, could also lead to shortfalls in profit tax.
• On the expenditure side, the envisaged cuts will require strong spending discipline. The wage bill reduction of 3.6 percent is ambitious, given the obligations from severance payments and accumulated leave. The increase in health care spending is envisaged to come out of the contingency component, which would leave the latter at a low level. Much of the expenditure reduction relies on across the board cuts, which could affect the effective delivery of public services and be reversed in the future (particularly maintenance and capital spending).
9. Thus, it is well possible that small fiscal gaps will emerge in 2009-10. Based on the implementation of the government’s current plans and accounting for several risk factors (a smaller improvement in tax compliance, an unchanged nominal wage bill rather than one with a reduction, and a higher contingency buffer including for health care spending), a small fiscal deficit in 2009 and a deficit of 2 percent of GDP in 2010 could emerge, and higher deficits are possible if the economy were to contract more than expected.
10. While in order to avoid such risks materializing the planned measures should be implemented with vigor, it is key that the fiscal adjustment proves to be both sustainable and predictable. Sustainable adjustment means a permanent expenditure reduction—not merely a postponement or reversal soon thereafter. This could best be achieved by targeted cuts rather than across-the-board spending reductions. Predictability is based on transparent and stable government budget plans and execution (including within the year). In that respect, a further increase of the role of the government’s medium-term budgetary framework is welcome.
11. The tight revenue envelope calls also for further reforms of the public sector. Enhanced administrative capacity will help in creating an appropriate environment for businesses and boost potential growth while raising the absorption of EU funds. Plans to cut the social security contribution rate in 2010 and over the medium term should be considered only within the framework of a comprehensive pension reform, aiming at ensuring the sustainability of the pension system in light of rising age-related expenditure pressures. Reform of the health sector is needed not only to rebalance the public finances of the National Health Insurance Fund but also to deliver more effective and efficient health care services.
12. The continued health of the financial sector is key to an economic recovery. The capital adequacy ratio of the banking system is high (17.6 percent as of end-June 2009). Published statistics indicate that the banking sector remained profitable on average during the first half of 2009, despite the rise in provisioning for non-performing loans. Active renegotiation of loans has provided some relief to existing borrowers and helped maintain their good credit rating. Recent Bulgarian National Bank stress tests suggest that banks' currently strong capital buffers would cushion the system against significant further deterioration in asset quality. Moreover, the largest foreign-owned banks have reiterated their commitment to maintain their exposure to Bulgaria at the level reached at end-May 2009 and to ensure that their local subsidiaries remain well-capitalized. As the decline in economic activity typically hits loan performance and banking sector's profits with a lag, these capital buffers and funding commitments will be key to maintaining a healthy banking system throughout the recession. Strengthening the corporate insolvency regime would also help improve the recovery value of collateral.
13. When the Bulgarian economy emerges from the recession, it will need to shift to a new growth pattern, which will be based less on the main drivers of growth during the boom years (real estate, financial intermediation, construction) and more on other sectors, including exports. Swift implementation of an economic reform package aiming at raising productivity and enhancing human capital will facilitate the economy's shift to a more sustainable growth pattern. Wage growth will also need to be moderated to preserve competitiveness. According to official statistics, public sector wages in the second quarter were 17 percent higher than a year ago, and private sector wages 14.3 percent.
14. In sum, the global economic crisis has hit Bulgaria hard. The difficult economic situation points to the main policy challenges. In the near term, fiscal discipline needs to be restored in a difficult economic environment, and, in the longer term, structural reforms are vital for steering the economy towards a more sustainable growth pattern. We welcome the commitments of the new government, and wish the authorities all the best in their endeavors.
We wish to thank the authorities for their hospitability, and for the friendly and fruitful discussions we have had in the past week.