## 1.     Bulgaria's Reactions to Past IMF Advice

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### Staff appraisal and executive summary
- GDP growth in 2008: 6 percent (likely).
- Fiscal outcome 2008: fiscal surplus of 3 percent of GDP; public sector buffers include high international reserves, low public debt, and considerable reserves in the fiscal reserve account.
- External/internal imbalances in 2008:
  - Current account deficit: 25 percent of GDP (widened).
  - Labor market overheated: wage growth exceeding 20 percent (peak figures below).
  - Annual inflation reached 12 percent (2008 average).
- Near-term outlook and staff forecast:
  - Capital inflows likely to slow; exports hurt by global slowdown.
  - Staff forecast: GDP growth will slow to 1 percent in 2009, with significant downside risks.
- Policy priorities and recommendations:
  - Maintain confidence in the currency board and in the financial system; these are mutually reinforcing.
  - Fiscal policy: maintain comfortable surpluses to support the currency board and preserve the fiscal reserve account.
- Government 2009 fiscal stance:
  - Government de facto fiscal target for 2009: 2 percent fiscal surplus.
  - Official target: 3 percent of GDP surplus.
  - 2009 budget was based on 4.7 percent GDP growth (seen as unrealistic).
  - “10 percent rule”: keep expenditure 10 percent below the budgeted amount to offset part of the revenue shortfall.
  - If GDP expands by around 2 percent (government expectation), outcome would be a surplus of 2 percent of GDP.
  - If GDP grows only 1 percent (staff baseline), additional shortfall of around 0.6 percent of GDP would arise, requiring further expenditure cuts.
- Financial sector assessment:
  - System well capitalized and profitable but facing pressures: foreign funding scarcity, higher domestic funding costs, slowing lending growth—profitability likely to decline.
  - Banks remain well-positioned with strong capital and liquidity buffers; BNB supervisory and regulatory framework effective.
  - BNB preparing for contingencies, collaborating with home country supervisors, enhancing stress-testing capacity per FSAP Update.
- Competitiveness warning:
  - Rapid wage growth threatens external competitiveness; wages should converge only with commensurate productivity increases.
  - Moderation in unit labor cost increases essential to shift resources to tradable sector and sustain the currency board.

### Context, boom dynamics, and macro imbalances
- Capital inflows and credit boom:
  - Net inflows by 2008: about 27 percent of GDP.
  - Credit-to-GDP ratio: 36 percent in 2004; 63 percent in 2007 (other passages cite 67 percent in 2007).
- Growth and external imbalance:
  - GDP growth: more than 6 percent annually; growth in 2008 estimated at 6 percent.
  - Current account deficit widened from 5 percent of GDP in 2003 to an estimated 25 percent of GDP in 2008.
- Labor market, wages, and inflation (exact figures preserved):
  - Wage growth peak: 25 percent in June 2008.
  - Inflation peak: 14.7 percent in June 2008; 7.2 percent in December 2008.
- Policy attempts and limitations:
  - Fiscal policy targeted large surpluses but private net savings declined offsetting public surpluses.
  - Administrative measures to restrain credit growth had limited success and were circumvented by direct foreign borrowing.

### Exchange rate dynamics, tradables vs non-tradables, and competitiveness
- Real exchange rate movements:
  - Between Q3 2006 and Q3 2008: ULC-based REER appreciated 26 percent; CPI-based REER appreciated about 16 percent.
  - CGER-type estimated overvaluation (June 2008 averages): 14.4 percent (components: Macro balance 7.4; External sustainability 16.1; REER deviation 19.7).
- Sectoral composition and export performance:
  - Between 2004 and 2008H1, construction and real estate contributed more than half of GVA growth; their share in GVA rose from 20.7 percent to 24.5 percent.
  - Gross operating surplus of manufacturing declined from 50 to 38 percent between late 2006 and Q3 2008.
  - Between 2006 and 2008, export performance deteriorated and the export ratio declined.
  - Average housing prices increased by more than 150 percent (2004–2008H1), with prices in Sofia and resort areas rising faster.
- Saving-investment balance and current account from national accounts:
  - Household saving (2006): -16.9 percent of GDP.
  - Corporate saving (2006): 21.3 percent of GDP.
  - Reported share of wages: 35 percent of GDP (noted as likely affected by underreporting).
  - Gap between private investment and private saving in 2008: 27 percent of GDP.
- If capital inflows drop and credit/investment boom ends:
  - Likely decline in current account deficit and likely sharp drop in growth; contribution from construction, financial intermediation, real estate and business services likely to fall sharply and may become negative.

### External debt, NIIP, and balance sheet vulnerabilities (selected exact figures)
- External debt and NIIP:
  - Total gross external debt rose to 112.2 percent of GDP (2008 Nov.).
  - Memorandum: Long-term external debt 69.1 percent of GDP; Short-term external debt 43.0 percent of GDP.
  - Public and publicly guaranteed external debt: 12.4 percent of GDP.
  - Private non-guaranteed external debt: 99.8 percent of GDP.
  - International Investment Position, net: -96.9 percent of GDP (2008 Sep).
    - Assets: 68.1 percent of GDP.
    - Liabilities: 165.0 percent of GDP.
    - Reserve assets: 44.7 percent of GDP (2008 Sep).
    - Direct investment in Bulgaria: 91.4 percent of GDP (2008 Sep); equity capital and reinvested earnings 66.7 percent of GDP.
- Non-financial corporate sector exposures (selected figures):
  - Total debt: 97.5 percent of GDP.
  - Domestic debt: 60.7 percent of GDP.
  - External debt: 36.8 percent of GDP.
  - Memorandum: Foreign currency debt 70.1 percent of GDP; Short-term debt 39.7 percent of GDP.
- Household sector liabilities:
  - Household debt: 35.6 percent of GDP (table); 37 percent of GDP noted in text summary; about one-third of household debt is for mortgages.
  - Foreign currency loans from banks to households: 8 percent of GDP.
- Banking sector foreign exposure and ownership:
  - 82 percent of bank assets are foreign owned.
  - All banks total assets: 59.5 billion (89.3 percent of GDP in table).
  - Foreign banks assets: 49.3 billion (74.0 percent of GDP share in table).

### Banking sector soundness, liquidity and stress tests (selected exact figures)
- Reported prudential indicators (December/2008 reporting):
  - Capital adequacy ratio: 14.9 percent (mandatory ratio 12.0 percent; EU minimum 8.0 percent).
  - NPL ratio: around 2.4 percent.
  - BNB prudential policies include a 12 percent capital adequacy ratio and 12 percent unremunerated reserve requirements (historical reference).
  - Capital adequacy ratios range between 14–30 percent; liquidity ratios range between 22–39 percent; Return on equity: 18–29 percent; Nonperforming loans: 0.2–2.4 percent.
- Currency composition and exposure:
  - About half of bank assets and liabilities are denominated in euros.
  - 71 percent of corporate loans and 25 percent of household loans are in euro (FSAP note).
- Banking sector short-term liabilities and potential liquidity drains (December 2008):
  - Potential Liquidity Drains (A+B+C+D+E): 122.9 percent of GDP / 41.7 billions of euros.
    - A. Cash, excluding cash in vault: 12.1 percent of GDP / 4.1 billions of euros.
    - B. Deposits by residents: 59.3 percent of GDP / 20.1 billions of euros.
      - B.1. Domestic currency: 30.4 percent of GDP / 10.3 billions of euros.
      - B.2. Foreign currency: 28.9 percent of GDP / 9.8 billions of euros.
    - C. Commercial banks' short-term foreign liabilities: 27.9 percent of GDP / 9.5 billions of euros.
      - C.1. Currency and Deposits: 18.9 percent of GDP / 6.4 billions of euros.
      - C.2. Other liabilities: 5.2 percent of GDP / 1.8 billions of euros.
    - D. Nonbank short-term external debt 1/: 19.2 percent of GDP / 6.5 billions of euros.
      - D.3. Others: 19.2 percent of GDP / 6.5 billions of euros.
    - E. Amortization of medium and long-term external debt (2009): 4.4 percent of GDP / 1.5 billions of euros.
  - Potential Liquidity Buffers (F+G): 49.0 percent of GDP / 16.6 billions of euros.
    - F. Central bank and central government liquid external assets: 37.5 percent of GDP / 12.7 billions of euros (Reserve assets: 37.5 percent of GDP / 12.7 billions of euros).
    - G. Commercial banks' liquid foreign currency assets: 11.5 percent of GDP / 3.9 billions of euros.
  - Potential Liquidity Shortfall: 73.8 percent of GDP / 25.0 billions of euros.
  - Potential buffers' coverage of potential drains [(F+G)/(A+B+C+D+E)]: 39.9 percent.
- Stress-test scenario (sudden stop in inflows and 30 percent real estate price drop):
  - NPL ratio increase: about 12 percentage points.
  - Capital Adequacy Ratio decline: from 14½ to 2½ percent.

### Impact of global financial turmoil and near-term indicators
- Market and funding developments:
  - Stock market index declined by 74 percent since end-August; as of mid-February down 86 percent from its peak in October 2007.
  - Stock market capitalization declined from 51 percent of GDP at end-2007 to around 16 percent at end-2008.
  - Sovereign CDS spreads rose to 590 basis points (later reported as 634 basis points in a follow-up).
- Funding and deposit/credit reactions:
  - Interest rates on new time deposits of households rose from 5.9 percent in August to 8.0 percent in December.
  - Credit growth to the non-government sector slowed to an annualized rate of 1.2 percent in December from 66.6 percent a year earlier.
  - Reserve requirement reductions eased money market tightness; SOFIBOR came down from a peak of 6.4 percent in October to 4.6 percent at end December.
- Reserve movements:
  - International reserves declined from €14.2 billion at end October to €12.7 billion at end December, falling another €600 million in the first ten days of January.
  - Reserve loss in January: 0.6 billion euros; reserves increased by €0.1 billion in the first three weeks of February.
- Policy measures taken (dates and exact changes preserved):
  - October 21, 2008: BNB allowed 50 percent of commercial banks’ cash on hand to be recognized as reserve assets and eased commercial banks’ access to reserves with the BNB.
  - Effective December 1, 2008: minimum required reserves on all attracted funds reduced from 12 percent to 10 percent.
  - Effective January 1, 2009: minimum required reserves on funds attracted by the banks from abroad decreased from 10 percent to 5 percent; government deposits from state and local government will no longer be subject to reserve requirements.
- Bank behavior:
  - Many banks reduced loan-to-value ratios to 50–65 percent and are using more conservative appraisals.
  - Foreign parent banks reduced new financing to local subsidiaries; subsidiaries need to finance loan growth from local deposits; parents provided comfort letters to maintain liquidity and capital.

### Recent economic developments and Q4 2008 flash estimates
- Q4 2008 GDP preliminary flash estimate: GDP growth slowed to 3.7 percent year/year (from 6.8 percent in Q3 2008).
- Demand-side contributors:
  - Gross fixed capital formation: declined from 22.2 percent to 9.7 percent (contribution/magnitude context).
  - Exports: declined from 3.8 percent to -6.8 percent.
- Net capital inflows in Q4: €701 million, down from €3,416 million in Q3.
  - Decline components: foreign borrowing reduced by €785 million; inbound FDI reduced by €753 million; non-resident deposits reduced by €589 million.
- Private sector credit growth (January):
  - Annualized month/month growth rate: 5 percent (up from 1.6 percent in December).
  - Year/year growth rate: 30.0 percent (down from 31.1 percent in December, and 61.8 percent in January 2008).
- Broad money (M3) and credit claims (selected historical values preserved in tables):
  - Broad money (M3) growth (Selected Economic Indicators): 19.6 (2003), 23.1 (2004), 23.9 (2005), 26.9 (2006), 31.2 (2007), 8.8 (2008).
  - Credit claims on non-government sector (Selected Economic Indicators): 48.3 (2003), 48.6 (2004), 32.4 (2005), 24.6 (2006), 62.5 (2007), 32.0 (2008).
- Labor market and inflation (exact figures):
  - Nominal wage growth: slowed to 18 percent year/year in December (from 25 percent in June).
  - Inflation: declined from 14.7 percent (June 2008) to 7.2 percent (December 2008).
  - Unemployment rate: 6.3 percent in December (6.1 percent in December noted elsewhere; record low 6.0 percent in November).
- Financial market indicators:
  - SOFIX lost another 4 percent since staff report issuance; sovereign CDS reached 634 basis points in a subsequent update.

### Projections, risks, and alternative scenarios
- Staff baseline projection (Selected Macro Indicators):
  - Capital inflows (percent of GDP): 31.8 (2008); 10.9 (2009); 9.4 (2010); 9.1 (2011); 10.0 (2012)...
  - Current account (percent of GDP): -24.8 (2008); -15.3 (2009); -8.4 (2010).
  - Real GDP growth (percent): 6.0 (2008); 1.0 (2009); 1.5 (2010); 3.0 (2011).
  - Real domestic demand growth (percent): 7.6 (2008); -2.9 (2009); -4.7 (2010).
  - Inflation (percent, average): 12.0 (2008); 4.7 (2009); 2.5 (2010).
  - Fiscal balance (percent of GDP): 3.0 (2008); 1.4 (2009); 1.5 (2010).
- Staff projection: GDP growth to slow to 1 percent in 2009 (down from 2 percent projected earlier).
- Net capital inflows projected to fall from 27 percent of GDP in 2008 to 10 percent in 2009.
- Domestic demand contraction: decline by almost 3 percent due to decline in foreign-financed bank credit and FDI.
- Inflation projected to decline from 12 percent in 2008 to 4.7 percent in 2009.
- Significant downside risks identified:
  - Deeper recession among trading partners; sharp fall in regional currencies; faster drop in exports; larger decline in net capital inflows; spillovers from financial crises.
- Illustrative adverse alternative scenario (Box 2 summary):
  - If net capital inflows slow to around 1 percent of GDP, GDP could decline by 3 percent in 2009.
  - Alternative scenario table (selected exact rows):
    - Capital inflows, net (percent of GDP): 26.9 (2008); 0.3 (2009); 1.2 (2010).
    - Real GDP growth (percent): 6.0 (2008); -3.0 (2009); -1.0 (2010).
    - Inflation (percent, average): 12.0 (2008); 3.5 (2009); 0.8 (2010).
    - Fiscal balance (percent of GDP) 1/: 3.0 (2008); -2.4 (2009); -3.1 (2010) (1/ Assuming the full play of the automatic stabilizers).

### Fiscal policy design, 2008–09 outcomes and recommendations
- Fiscal performance and buffers:
  - Fiscal surplus averaged 3 percent of GDP between 2005 and 2008.
  - Gross public debt fell to 17 percent of GDP in 2008 (from 77 percent in 2000).
  - Fiscal reserves increased to about 12½ percent of GDP in 2008.
- 2008 fiscal specifics:
  - Headline fiscal surplus in 2008: 3 percent of GDP.
  - By September 2008, surplus had reached 7 percent of annual GDP; government stepped up investment spending in October; government spending in Nov–Dec reached 10.8 percent of annual GDP.
  - Augmented structural balance deteriorated by 1.4 percent of GDP.
- 2009 budget assumptions and implementation rule:
  - 2009 budget prepared before turmoil, based on real GDP growth of 4.7 percent.
  - Budget tax revenue projection: increase of 16 percent.
  - Current expenditure planned to increase by 16.8 percent compared to 2008 outcome; about 60 percent of current expenditure increase for social benefits and public sector wages.
  - Capital expenditure planned +23 percent, largely financed by EU transfers; 2009 budget includes EU grants of 3 billion leva (4.4 percent of GDP).
  - Authorities implemented a 90 percent spending rule (restrict spending to 90 percent of budgeted amount); remainder to be released depending on macro developments.
  - With GDP growth ~2 percent and 90 percent rule, in-practice surplus likely ~2 percent of GDP.
  - Staff warned the 2009 budget was not tight; if GDP growth slows to 1 percent shortfall ~0.6 percentage points.
- Social spending and pensions (exact measures):
  - April 2009: pensions increased by 10 percent by counting each service year as 1.1 years; replacement ratio increase from 43 percent to 48–49 percent; minimum guaranteed pension set to increase by 10 percent to 120 BGN.
  - July 2009: pensions increased by another 9.7 percent.
- Fiscal medium-term concerns:
  - Staff’s medium-term projections suggest tax revenue to GDP ratio could fall by 1½ percentage points between 2008 and 2012, requiring a commensurate decline in expenditure to GDP ratio.
  - Need to prioritize spending rather than across-the-board cuts; cost social security and social policy changes realistically and ensure fiscal neutrality and long-term sustainability.
- Authorities’ stance:
  - Authorities agreed on the importance of maintaining sizeable fiscal surpluses and were skeptical about the usefulness of discretionary fiscal stimulus and fully allowing automatic stabilizers to work.

### Financial sector measures, contingency planning and lender-of-last-resort capacity
- Deposit insurance:
  - Mid-November 2008: coverage increased from €20,000 to €50,000.
  - In 2009: coverage to be increased to €100,000 per depositor per bank.
  - Authorities did not adopt blanket guarantees.
- Reserve requirement changes (dates preserved above).
- Capital and liquidity support measures:
  - BNB persuaded most bank owners not to pay dividends and to add 2008 profits to capital; comfort letters from parent banks obtained.
  - Reporting by leasing companies to the credit register improved.
  - BNB intensified monitoring, strengthened stress testing, and conducted targeted inspections with FSC.
  - Domestic Standing Group for Financial Stability working on contingency plans.
- Lender of Last Resort considerations:
  - Excess coverage of the CBA amounted to about €1.6 billion (5 percent of GDP) as of mid-January.
  - Government fiscal reserves around 18 percent of GDP could function as a de facto lender of last resort.
  - Legal framework and procedures amended to allow prompt action.
  - Bank resolution framework regarded as generally comfortable; if government capital injections were necessary, existing shareholders should carry the losses.
- FSAP and supervisory recommendations (selected exact actions):
  - BNB to enhance stress-testing capacity, draft amendments to include non-bank borrowers in the credit registry, develop contingency plans, delay introduction of risk-based premiums by Deposit Insurance Fund, strengthen regional collaboration, and participate in crisis management exercises.
  - FSC to strengthen capacity to enforce securities legislation, oversee exchange and settlement system, tighten related-party definitions, map indirect ownership of pension funds, review switching and automatic assignation rules, increase disclosure of risk-adjusted performance, overhaul pay-out design of pension funds, and change skill mix to enforce insurance legislation.

### Structural reforms and competitiveness (Box 5, World Bank prepared)
- Productivity and labor market:
  - Productivity growth: 3% per year.
  - Labor force participation remains low despite improvements; unemployment fell from 20 percent at the beginning of the decade to record low levels.
  - Labor market tight for highly skilled workers; participation low among youth and older workers.
- Education reforms:
  - Budgets delegated to schools; fixed amount per student policy adopted.
  - External student assessments launched nationally and internationally.
  - New Education Act foreseen for 2009 to consolidate reforms.
  - Need to expand reforms to vocational education, training and higher education.
- Labor activation and social insurance:
  - Reductions in social insurance burden and new employment policies to activate inactive workers.
- Health sector measures:
  - Pharmaceutical policy improvements; integrated information system for National Health Insurance Fund; health contribution rate raised to 8 percent from 6 percent until 2008.
  - Further steps needed to shift spending from hospitals to primary care and review financing mechanism.
- Regulatory reform and business climate:
  - Bulgaria ranked among top 10 reformers in Doing Business 2006/07.
  - Regulatory burdens remain significant: senior managers reported spending 17 percent of time on government regulatory requirements (taxes, customs, labor, licensing, registration).
  - Better Regulation Programme 2008-10 and National Reform Programme 2008-10 are key steps to maintain reform momentum.

### Appendix I — Bulgaria’s financial position in the Fund (as of January 31, 2009)
- Membership status: Joined September 25, 1990.
- Quota: 640.20 SDR Million — 100.00% Quota.
- Fund holdings of currency: 606.69 SDR Million — 94.77% Quota.
- Reserve position: 33.53 SDR Million — 5.24% Quota.
- SDR Department holdings: 4.20 SDR Million — N/A % Allocation.
- Outstanding purchases and loans: None.
- Latest financial arrangements (selected exact entries):
  - Stand-By: Date of Arrangement Aug. 6, 2004; Expiration Date Mar. 31, 2007; Amount Approved 100.00 SDR Million; Amount Drawn 0.00 SDR Million.
  - Stand-By: Date of Arrangement Feb. 27, 2002; Expiration Date Mar. 15, 2004; Amount Approved 240.00 SDR Million; Amount Drawn 240.00 SDR Million.
  - EFF: Date of Arrangement Sep. 25, 1998; Expiration Date Sep. 24, 2001; Amount Approved 627.62 SDR Million; Amount Drawn 627.62 SDR Million.
- Projected payments to Fund: None.
- HIPC/MDRI: Not applicable.
- Resident Representative: Mr. Fernandez-Ansola, Senior Regional Resident Representative, based in Bucharest; took up position on September 4, 2006.

_Source: IMF staff report excerpt (2008–2009), _cr0996_.

### 1.     Bulgaria's Reactions to Past IMF Advice..........................................................................

### 1.     Bulgaria's Reactions to Past IMF Advice..........................................................................

### Staff appraisal and executive summary
- In 2008, Bulgaria’s economy continued to perform well, with GDP growth likely to have reached 6 percent.
- Fiscal policy: a fiscal surplus of 3 percent of GDP in 2008; public sector buffers include high international reserves, low public debt, and considerable reserves in the fiscal reserve account.
- External/internal imbalances widened: current account deficit widened to 25 percent of GDP; labor market overheated with wage growth exceeding 20 percent; annual inflation reached 12 percent (later stated more precisely below).
- Global financial turmoil effects and near-term outlook:
  - Capital inflows are likely to slow and exports to be hurt by the global slowdown.
  - Staff forecast: GDP growth will slow to 1 percent in 2009, with significant downside risks.
- Policy priorities:
  - Maintain confidence in the currency board and in the financial system; these are mutually reinforcing.
  - Fiscal policy should aim to maintain comfortable surpluses to support the currency board and preserve the fiscal reserve account.
- Government fiscal stance for 2009:
  - Government’s de facto fiscal target of a 2 percent fiscal surplus in 2009 is judged appropriate.
  - Official target remains a fiscal surplus of 3 percent of GDP, but the 2009 budget was based on 4.7 percent GDP growth, which is now seen as unrealistic.
  - Government adopted the “10 percent rule”: keeping expenditure 10 percent below the budgeted amount to offset part of the revenue shortfall.
  - If GDP expands by around 2 percent (government expectation), the outcome would be a surplus of 2 percent of GDP.
  - If GDP grows only 1 percent (staff baseline), an additional shortfall of around 0.6 percent of GDP would arise, requiring further expenditure cuts; such cuts are judged feasible given the budget is “by no means tight” even with the 10 percent rule.
- Longer-term fiscal guidance:
  - A significant slowing of expenditure growth will be necessary in later years as domestic demand and tax revenues grow by less than GDP; spending will need prioritization rather than across-the-board cuts.
- Financial sector:
  - The financial system is well capitalized and has been profitable, but faces pressures: foreign funding scarcity, higher domestic funding costs, and slowing lending growth—profitability is likely to decline.
  - Banks remain well-positioned for a slowdown with strong capital and liquidity buffers.
  - The BNB’s supervisory and regulatory framework has been effective; the BNB is preparing for contingencies, collaborating with home country supervisors, and enhancing stress-testing capacity in line with the IMF-World Bank FSAP Update recommendations.
- Competitiveness:
  - Rapid wage growth threatens external competitiveness; wages are low relative to Western Europe and should converge only with commensurate productivity increases.
  - Moderation in unit labor cost increases is essential to shift resources to the tradable sector; tradable-sector competitiveness must be maintained to sustain future growth and the currency board.

### Introduction and context
- Since 2004 (EU accession agreement), Bulgaria experienced a surge in capital inflows and a credit boom, driven by expectations of rapid convergence with the EU and reinforced by the currency board and strong fiscal policy.
- The surge led to a boom in domestic demand and widening external/internal imbalances; the interaction of these imbalances with global financial turmoil was central to the 2008 Article IV discussions.
- Policy discussions focused on: reducing risks of financial instability; appropriate fiscal response to the turmoil; and enabling real economy adjustment consistent with maintaining the currency board.

### Box summary: Bulgaria’s reactions to past IMF advice
- Bulgaria and the IMF have had an excellent working relationship; policies have been generally consistent with IMF recommendations and the country completed a series of Stand-By Arrangements.
- Government maintained prudent fiscal policy and built large fiscal reserves, supporting the currency board and providing policy advantages against global financial turbulences.
- Weaknesses noted: lenient public sector wage policies in the last two years and limited progress on structural reforms due to lack of political consensus.
- At the 2007 Article IV Consultations, Directors praised strong performance and policies but warned that the current account deficit was unsustainable and needed significant medium-term reduction; noted rising domestic price pressures driven by food/energy prices and accelerating wage increases.

### Macroeconomic challenges — large capital inflows, credit boom, and imbalances
- Capital inflows and credit:
  - By 2008, net inflows had increased to about 27 percent of GDP.
  - Credit to the private sector rose rapidly: credit-to-GDP ratio climbed from 36 percent in 2004 to 63 percent in 2007.
- Growth and external imbalance:
  - GDP grew by more than 6 percent annually; growth in 2008 estimated at 6 percent.
  - Current account deficit widened from 5 percent of GDP in 2003 to an estimated 25 percent of GDP in 2008.
- Labor market, wages, and inflation:
  - Unemployment declined and the labor market tightened; wage growth accelerated to a peak of 25 percent in June 2008.
  - Inflation peaked at 14.7 percent in June 2008 and declined to 7.2 percent in December 2008.
- Policy attempts:
  - Fiscal policy targeted large and increasing surpluses but private net savings declined, offsetting public surpluses.
  - Administrative measures to restrain credit growth had limited success and were circumvented by firms borrowing directly from abroad; such measures had undesirable effects on financial intermediation.

### Key statistics (preserving original figures)
- GDP growth in 2008: 6 percent (estimated).
- Fiscal surplus in 2008: 3 percent of GDP.
- Current account deficit in 2008: 25 percent of GDP (estimated).
- Wage growth peak: 25 percent in June 2008.
- Inflation peak: 14.7 percent in June 2008; 7.2 percent in December 2008.
- Staff forecast for GDP growth in 2009: 1 percent.
- Government budget basis: 4.7 percent GDP growth assumed originally for 2009.
- Government de facto fiscal target for 2009: 2 percent fiscal surplus.
- Government official fiscal target: 3 percent of GDP surplus.
- Expenditure adjustment: 10 percent below budgeted amount (the “10 percent rule”).
- Net capital inflows by 2008: about 27 percent of GDP.
- Credit-to-GDP ratio: 36 percent in 2004; 63 percent in 2007.
- Shortfall if GDP grows 1 percent vs. target 2 percent: around 0.6 percent of GDP.

_1.     Bulgaria's Reactions to Past IMF Advice.........................................................................._

### 19.      Initially, when there was sufficient slack in the labor market, the large

### _cr0996 - 19.      Initially, when there was sufficient slack in the labor market, the large

### Exchange rate dynamics and current account
- Between 2003 and 2006, the current account deficit increased by 12 percentage points, but the real exchange rate remained relatively stable.
- Between the third quarter of 2006 and the third quarter of 2008:
  - ULC-based REER appreciated 26 percent.
  - CPI-based REER appreciated about 16 percent.
- Initial widening of the current account deficit was primarily the result of large capital inflows and the associated credit boom.
- Capital inflows have been much larger than the current account deficit—suggesting that they have driven the current account deficit rather than the other way around.

### Export performance and tradables vs non-tradables
- Between 2000 and 2006, the export to GDP ratio increased faster than in EMCs on average.
- Between 2006 and 2008, export performance deteriorated and the export ratio declined somewhat, performing worse than in most other EMCs.
- GDP growth has been largely driven by non-tradable sectors: financial services, real estate and construction.
- Between late 2006 and Q3 2008:
  - Gross operating surplus of manufacturing declined from 50 to 38 percent.
  - Gross operating surplus in the non-tradable sectors showed little change.
- Construction and real estate business contributed more than half of gross value added (GVA) growth between 2004 and 2008H1, raising its share in GVA from 20.7 percent to 24.5 percent.
- During the same period, average housing prices increased by more than 150 percent, with prices in Sofia and resort areas rising even faster.

### Saving, investment, and current account from a balance perspective
- Widening of the current account deficit primarily reflects the investment boom: investment to GDP ratio increased sharply while saving to GDP ratio remained flat.
- The high current account deficit reflects both high investment and low saving—low saving not only compared to emerging market countries outside the region, but also compared to other new member states.
- According to National Accounts (2006):
  - Household saving was highly negative at -16.9 percent of GDP.
  - Corporate saving was 21.3 percent of GDP.
  - Reported share of wages is only 35 percent of GDP (noted as likely affected by underreporting of wages).

### Sectoral allocation of capital inflows and risks to growth
- Capital inflows largely financed the non-tradable sector, potentially stimulated by a widening profitability gap between non-tradable and tradable sectors.
- If capital inflows drop and the credit and investment boom ends:
  - Likely decline in the current account deficit.
  - Likely sharp drop in growth.
  - Contribution to growth from construction, financial intermediation, real estate and business services will likely drop sharply and may become negative (experience in other countries).

### Balance sheet and financing vulnerabilities
- External debt increased to 111 percent of GDP; debt is mostly owed by the private sector; public sector debt declined to 13 percent of GDP (Table 1).
- Net international investment position deteriorated to minus 97 percent of GDP (Table 2).
- Central bank and commercial banks have large foreign assets (56 percent of GDP) but there are also large non-debt liabilities (equity capital and reinvested FDI earnings).
- Foreign currency mismatches are very large:
  - Corporate sector has high direct foreign currency exposure.
  - Banking sector has large indirect foreign currency exposure because of high foreign currency lending.
  - Large foreign currency mismatches were in part due to the belief that euro-denominated loans carry no currency risk pending eventual euro adoption.
- Non-financial corporate sector exposures (Table 4):
  - Total debt 97.5 percent of GDP.
  - Domestic debt 60.7 percent of GDP.
  - External debt 36.8 percent of GDP.
  - Memorandum items:
    - Foreign currency debt 70.1 percent of GDP.
    - Short-term debt 39.7 percent of GDP.
- Household sector:
  - Household debt 35.6 percent of GDP (Table 3).
  - Household debt is 37 percent of GDP in text summary; a third of which is for mortgages.
  - Foreign currency loans from banks to households are 8 percent of GDP.
- Large short-term debt and high external indebtedness concentrated in non-financial corporates.
- The gap between private investment and private saving in 2008 was 27 percent of GDP.
- In a scenario with a sudden stop in capital inflows and a 30 percent drop in real estate prices (FSAP update):
  - NPL ratio would increase by about 12 percentage points.
  - Capital Adequacy Ratio would decline from 14½ to 2½ percent.

### External debt and international investment position (selected exact figures from tables)
- Table 1: Total gross external debt rose to 112.2 percent of GDP (2008 Nov.).
  - Memorandum items:
    - Long-term external debt 69.1 percent of GDP.
    - Short-term external debt 43.0 percent of GDP.
    - Public and publicly guaranteed external debt 12.4 percent of GDP.
    - Private non-guaranteed external debt 99.8 percent of GDP.
- Table 2: International Investment Position, net reached -96.9 percent of GDP (2008 Sep).
  - Assets 68.1 percent of GDP.
  - Liabilities 165.0 percent of GDP.
  - Reserve assets 44.7 percent of GDP (2008 Sep).
  - Direct investment in Bulgaria 91.4 percent of GDP (2008 Sep), with equity capital and reinvested earnings 66.7 percent of GDP.

### Banking sector and domestic liabilities (selected exact figures)
- Domestic liabilities of non-financial private sector, November 2008 (Table 3):
  - Non-financial corporations 59.7 percent of GDP.
    - Domestic banks, on balance sheet 47.6 percent of GDP.
      - In euros 33.9 percent of GDP (short-term 10.9; medium and long-term 22.9).
  - Households 35.6 percent of GDP.
    - Domestic banks, on balance sheet 28.0 percent of GDP.
      - In levs 20.0 percent of GDP (mortgages 6.2; other 13.8).
      - In euros 7.7 percent of GDP (mortgages 5.5; other 2.2).
- Selected liabilities of commercial banks, November 2008 (Table 4):
  - Deposits by residents 58.8 percent of GDP (Forex 29.9; Lev 29.0).
  - Forex deposits by non-residents 26.4 percent of GDP.
  - Other foreign borrowing 4.5 percent of GDP.
  - Capital and reserves 12.2 percent of GDP.
- Banking sector ownership and size:
  - 82 percent of bank assets are foreign owned.
  - Foreign banks assets 49.3 billion (74.0 percent of GDP share in table).
  - All banks total assets 59.5 billion (89.3 percent of GDP).

### Impact of the global financial market turmoil and near-term outlook
- Stock market and sovereign risk:
  - Stock market index declined by 74 percent since end-August, and as of mid-February is 86 percent down from its peak in October 2007.
  - Stock market capitalization declined from 51 percent of GDP at end-2007 to around 16 percent at end-2008.
  - Sovereign CDS spreads rose to 590 basis points—from around 30 a little more than a year ago.
- Foreign parent banks reduced new financing to local subsidiaries; subsidiaries now need to finance loan growth from local deposits.
- Deposit and credit market reactions:
  - Interest rates on new time deposits of households rose from 5.9 percent in August to 8.0 percent in December.
  - Credit growth to the non-government sector slowed to an annualized rate of 1.2 percent in December from 66.6 percent a year ago.
- Reserve requirement and reserves:
  - Reduction of required reserves in November and December eased money market tightness.
  - Overnight money market rate (SOFIBOR) came down from a peak of 6.4 percent in October to 4.6 percent at end December.
  - International reserves declined from €14.2 billion at end October to €12.7 billion at end December, falling another 600 million in the first ten days of January.
- Policy measures related to reserves (dates and changes preserved verbatim):
  - On October 21, 2008, the BNB allowed 50 percent of commercial banks’ cash on hand to be recognized as reserve assets and eased commercial banks’ access to reserves with the BNB.
  - Effective December 1 the minimum required reserves on all attracted funds of the banks were reduced from 12 percent to 10 percent.
  - Effective January 1, 2009, the minimum required reserves on funds attracted by the banks from abroad were decreased from 10 percent to 5 percent, while government deposits from state and local and government will no longer be subject to reserve requirements.
- Bank behavior and credit standards:
  - Many banks reduced loan-to-value ratios to 50–65 percent and are using more conservative appraisals.
  - Banks indicated that while their parent banks will not provide new financing, they will maintain their existing exposure.

*Source: IMF staff and data extracts in the provided content unit.*

### 33.      Reported indicators suggest that banks are generally sound. In December, the

### 33.      Reported indicators suggest that banks are generally sound. In December, the

### Banking soundness and immediate risks
- Capital adequacy ratio was 14.9 percent compared to the 12.0 percent mandatory ratio, which exceeds the 8.0 percent EU minimum requirement.
- NPL ratio was around 2.4 percent.
- These indicators are backward-looking; rapid credit growth raises the risk that banking fragilities may emerge only after the credit boom has ended.
- The FSSA identifies credit risk from the rapid past expansion of the loan portfolio as “by far the most important financial stability risk facing the Bulgarian banking system (Box 2).”
- Euroization: about half of bank assets and liabilities are denominated in euros, leaving the system exposed to currency-induced credit risk and making the solvency of the banking system critically dependent on maintaining the currency board.

### Recent economic developments (late 2008)
- Business climate indicator for all economic sectors has declined rapidly since October.
- Orders for non-residential construction have declined sharply.
- Industrial production in December was 8.4 percent lower than a year ago.
- Exports were 15 percent lower year/year, mainly due to a slump in exports of manufacturing goods (-20.6 percent).
- Imports fell by 17.4 percent year/year.
- Unemployment rate rose to 6.3 percent in December.
- Share of bad and restructured household loans increased from 2.7 percent at end December 2007 to 3.0 percent in November 2008.
- Deposit euroization and parent bank funding partially explain the euroization of assets and liabilities.

### Outlook for 2009 and key projections
- Surge in capital inflows expected to abate in 2009.
- FDI would decline; local subsidiaries would no longer receive large capital transfers from parent banks to fund credit growth.
- Shrinking foreign demand and declining commodity prices may reduce exports and tourism; export industries already hit, including by a sharp drop in metal prices.
- Staff projection: GDP growth to slow to 1 percent in 2009—down from 2 percent projected at the time of the mission, and 6 percent in 2008.
- Net capital inflows projected to fall from 27 percent of GDP in 2008 to 10 percent in 2009.
- Decline in foreign-financed bank credit and FDI would lead to a contraction in domestic demand by almost 3 percent.
- Inflation projected to decline from 12 percent in 2008 to 4.7 percent in 2009.

- Bulgaria: Main Macroeconomic Indicators (selected rows, as presented)
  - Capital inflows (percent of GDP): 38.0 31.8 10.9 9.4 9.1 10.0 10.4 10.3 (2007 2008 2009 2010 2011 2012 2013 2014)
  - Current account (percent of GDP): -21.8 -24.8 -15.3 -8.4 -6.4 -7.1 -7.2 -7.2
  - Real GDP growth (percent): 6.2 6.0 1.0 1.5 3.0 4.5 5.0 5.5
  - Real domestic demand growth (percent): 9.4 7.6 -2.9 -4.7 1.3 6.3 5.7 6.0
  - Inflation (percent, average): 7.6 12.0 4.7 2.5 3.0 3.5 3.5 3.4
  - Fiscal balance (percent of GDP): 3.5 3.0 1.4 1.5 1.3 1.2 1.5 1.2
  - Sources: NIS and IMF staff projections.

### Risks and alternative scenarios
- Significant downside risks: deeper recession in trading partners, sharp fall in regional currencies, faster drop in exports, larger decline in net capital inflows, spillovers from financial crises elsewhere.
- Recession in construction and falling real estate prices could sharply increase loan defaults and loss given default rates, feeding back to bank weakness and further credit contraction.
- Illustrative alternative scenario: if net capital inflows slow to around 1 percent of GDP, GDP could decline by 3 percent in 2009 (Box 3).

Box 2 / Alternative scenario (summary of main outcomes)
- If net capital inflows dropped to near zero in 2009 and stayed weaker thereafter, domestic demand and investment would shrink sharply; economy could shrink by 3 percent in 2009 and another 1 percent in 2010.
- In such a scenario, reserves would decline more pronouncedly; absent corrective measures, the fiscal surplus would turn into a deficit of around 2½ percent of GDP in 2009, rising further thereafter.

- Bulgaria: Main Macroeconomic Indicators (Alternative Scenario, selected rows)
  - Capital inflows, net (percent of GDP): 38.0 26.9 0.3 1.2 3.9 5.1 6.5 7.5 (2007 2008 2009 2010 2011 2012 2013 2014)
  - Current account (percent of GDP): -21.8 -24.8 -6.2 -3.9 -3.5 -4.7 -6.2 -7.3
  - Gross International reserves (billions of Euro): 11.9 12.7 10.8 9.9 10.0 10.3 10.5 10.8
  - Real GDP growth (percent): 6.2 6.0 -3.0 -1.0 1.0 4.0 5.0 5.5
  - Real domestic demand growth (percent): 9.4 7.6 -17.7 -2.1 4.2 6.8 7.0 7.2
  - Inflation (percent, average): 7.6 12.0 3.5 0.8 1.5 2.7 3.5 3.5
  - Fiscal balance (percent of GDP) 1/: 3.5 3.0 -2.4 -3.1 -4.5 -5.0 -4.4 -4.0
  - Real GDP (Level, 2008=100): 100 101.0 102.5 105.6 110.3 115.9 122.2
  - Idem, baseline: 100 97.0 96.0 97.0 100.9 105.9 111.7
  - Sources: NIS and IMF staff projections.
  - 1/ Assuming the full play of the automatic stabilizers.

### Policy discussions and recommended policy focus
- Immediate policy challenge: prevent a sharp drop in capital inflows from triggering a confidence crisis that would expose private sector balance sheet vulnerabilities.
- Next challenge: ensure economy adjusts from non-tradable to tradable sector to sustain future growth and protect the currency board arrangement.
- Strengths entering slowdown:
  - Public finances in good shape, with one of the highest fiscal surpluses in Europe.
  - Strong central bank and government balance sheets, large foreign reserves, and substantial buffers in the fiscal reserve account.
- Key policy consensus: maintain confidence in the currency board and the financial system; these are intrinsically linked.
- Policy instruments highlighted:
  - Maintain comfortably large fiscal surpluses to support the currency board and provide buffers via the fiscal reserve account.
  - Use fiscal reserve balances as an important shield if financial problems emerge.

### Financial sector measures undertaken
- Deposit insurance coverage increased: mid-November increase from €20,000 to €50,000; in 2009, to be increased to €100,000 per depositor per bank. Authorities did not adopt blanket guarantees.
- Reserve requirements lowered; room for further easing exists though this reduces international reserves.
- BNB persuaded most bank owners not to pay dividends and to add 2008 profits to capital; received comfort letters from parent banks to provide liquidity and capital.
- Reporting by leasing companies owned by non-bank and financial companies to the credit register improved.
- BNB has intensified monitoring with focus on liquidity and credit risks and strengthened stress testing capabilities per the FSAP Update recommendations.
- BNB and Financial Supervision Commission (FSC) conducted targeted inspections to ensure contingency plans.
- Domestic Standing Group for Financial Stability working on contingency plans.
- Lender of Last Resort considerations:
  - BNB’s scope constrained by the CBA—excess coverage of the CBA amounted to about €1.6 billion (5 percent of GDP) as of mid-January.
  - Government fiscal reserves around 18 percent of GDP could function as a de facto lender of last resort.
  - Legal framework and procedures amended to allow prompt action.
- Bank resolution framework regarded as generally comfortable; experience from the 1997 crisis informed current arrangements. Authorities agreed that if government capital injections were necessary, existing shareholders should carry the losses.

### Liquidity and potential buffers (December 2008, as presented)
- Potential Liquidity Drains (A+B+C+D+E): 122.9 percent of GDP / 41.7 billions of euros
  - A. Cash, excluding cash in vault: 12.1 percent of GDP / 4.1 billions of euros
  - B. Deposits by residents: 59.3 percent of GDP / 20.1 billions of euros
    - B.1. Domestic currency: 30.4 percent of GDP / 10.3 billions of euros
    - B.2. Foreign currency: 28.9 percent of GDP / 9.8 billions of euros
  - C. Commercial banks' short-term foreign liabilities: 27.9 percent of GDP / 9.5 billions of euros
    - C.1. Currency and Deposits: 18.9 percent of GDP / 6.4 billions of euros
    - C.2. Other liabilities: 5.2 percent of GDP / 1.8 billions of euros
  - D. Nonbank short-term external debt 1/: 19.2 percent of GDP / 6.5 billions of euros
    - D.1. General government: 0.0 percent of GDP / 0.0 billions of euros
    - D.2. Monetary authorities: 0.0 percent of GDP / 0.0 billions of euros
    - D.3. Others: 19.2 percent of GDP / 6.5 billions of euros
  - E. Amortization of medium and long-term external debt (2009): 4.4 percent of GDP / 1.5 billions of euros
- Potential Liquidity Buffers (F+G): 49.0 percent of GDP / 16.6 billions of euros
  - F. Central bank and central government liquid external assets: 37.5 percent of GDP / 12.7 billions of euros
    - E.1. Reserve assets: 37.5 percent of GDP / 12.7 billions of euros
    - E.2 Other liquid foreign currency assets: 0.0 percent of GDP / 0.0 billions of euros
  - G. Commercial banks' liquid foreign currency assets: 11.5 percent of GDP / 3.9 billions of euros
- Potential Liquidity Shortfall: 73.8 percent of GDP / 25.0 billions of euros
- Potential buffers' coverage of potential drains [(F+G)/(A+B+C+D+E)]: 39.9 percent
- Note: Parent banks deposits dominate banks' short-term liabilities to nonresidents; nonbank short-term external debt by original maturity as of November 2008.

### Fiscal position summary
- Between 2005 and 2008, fiscal surplus averaged 3 percent of GDP.
- Gross public debt to GDP ratio fell from 77 percent in 2000 to 17 percent in 2008.
- Fiscal reserves increased to about 12½ percent of GDP in 2008.
- However, nominal expenditure grew by 15 percent annually and tax cuts on corporate and personal income occurred; surge in indirect tax revenues from domestic demand masked underlying looseness.
- Absorption gap increased from 3¾ percent of GDP in 2005 to 13¾ percent in 2007.
- Augmented structural balance declined from 1.5 to 0.2 percent of GDP during this period.

- Bulgaria: General Government Operations, selected figures (2005-09 presentation)
  - Revenue (percent of GDP) examples: 39.8 38.8 40.7 42.5 39.7 42.8 41.3 41.3 41.3 (various columns labelled Approved budget, Budget, IMF, etc. as presented)
  - Expenditure (percent of GDP) examples: 37.5 35.3 37.2 39.5 36.7 39.8 41.6 39.3 39.9
  - Fiscal balance (percent of GDP) examples: 2.3 3.5 3.5 3.0 3.0 3.0 -0.3 2.0 1.4
  - Structural balance (percent of GDP) examples: 1/ 1.5 1.6 0.2 -1.1 -1.9 0.5 -0.2
  - Revenue growth (percent): 14.2 12.4 20.1 14.0 14.7 19.3 10.1 10.1 8.3
  - Expenditure growth (percent): 13.4 9.1 21.6 16.0 15.9 20.1 20.1 13.3 13.3
  - HIPC inflation (percent): 6.0 7.4 7.6 12.0 4.7
  - Output gap and absorption gap figures shown in table as presented.
  - Sources: Ministry of Finance; and Fund staff estimates.
  - 1/ Actual fiscal balance adjusted for automatic effects of both output gap and absorption gap on fiscal position.

*Source: _cr0996 - 33.      Reported indicators suggest that banks are generally sound. In December, the*

### 52.      Cautious fiscal policy continued in 2008, with another large headline surplus of

### _cr0996 - 52.      Cautious fiscal policy continued in 2008, with another large headline surplus of

### Fiscal outcomes in 2008
- Headline fiscal surplus in 2008: 3 percent of GDP.
- By September 2008, surplus had reached 7 percent of annual GDP.
- Government stepped up investment spending in October; overall government spending in November and December reached 10.8 percent of annual GDP.
- Augmented structural balance deteriorated by 1.4 percent of GDP, reflecting a further widening of the output and the absorption gap.
- Government raised the 2008 surplus target to 3½ percent of GDP (footnote: due to disappointing revenues in the last few months, the overperformance did not materialize).

### 2009 budget design and assumptions
- 2009 budget prepared before the financial turmoil of September; based on real GDP growth of 4.7 percent.
- Official 2009 budget aim: surplus of 3 percent of GDP.
- Budget tax revenue projection: increase of 16 percent (noted as higher than the 15 percent increase in 2008).
- Budget aimed to increase current expenditure by 16.8 percent compared to the 2008 outcome (19.2 percent compared to the 2008 budget).
  - Almost sixty percent of the current expenditure increase would go to an increase of social benefits (in particular pensions) and public sector wages.
- Capital expenditure planned to increase by 23 percent, largely financed by an increase in EU transfers.
- 2009 budget includes EU grants of 3 billion leva (4.4 percent of GDP), 1.1 billion higher than the 2008 budget, and 1.9 billion more than the amount actually absorbed in 2008.
  - Authorities explained that shortfalls in EU transfers would result in lower capital spending, and thus would not affect the fiscal balance.

### 2009 implementation strategy and staff assessment
- Government expected an in-practice surplus of around 2 percent of GDP, with spending buffers to partially compensate for expected revenue shortfalls.
- Authorities decided to restrict spending to 90 percent of the budgeted amount; remaining 10 percent to be released depending on macroeconomic and budget developments.
  - With GDP growth around 2 percent and expenditure in line with the 90 percent rule, the budget surplus would likely be around 2 percent of GDP.
- Staff warned that even with spending buffers the 2009 budget was not tight; a sharper slowdown could turn the surplus into a deficit.
- If the 90 percent rule is applied, spending will increase by 13 percent—8½ percent higher than currently projected inflation.
- Staff’s medium-term fiscal projections suggest that between 2008 and 2012, the tax revenue to GDP ratio could fall by 1½ percentage points, which would require a commensurate decline in the expenditure to GDP ratio.
- Since the mission, likelihood increased that GDP growth will fall short of 2 percent; additional expenditure cuts may be necessary to achieve the 2 percent surplus.
  - If GDP growth slows to 1 percent (staff expectation), the shortfall would amount to around 0.6 percentage points.

### Social spending and pensions (specific measures noted)
- Footnote on pensions: In April 2009, pensions will be increased by 10 percent.
  - Increase implemented by counting each service year as 1.1 years, increasing the replacement ratio from 43 percent to 48-49 percent.
  - Minimum guaranteed pension set to increase by 10 percent to 120 BGN.
  - In July, pensions will be increased by another 9.7 percent.

### Fiscal stance and authorities’ views on stabilization policy
- Authorities agreed on importance of maintaining sizeable fiscal surpluses.
- Authorities were skeptical about the usefulness of discretionary fiscal stimulus and even about allowing automatic stabilizers to work fully, arguing:
  - Impact on growth in a small and open economy such as Bulgaria was very small.
  - Negative impact on confidence might offset positive impact on demand.
- Mission argued fiscal and structural reforms needed to be accelerated, notwithstanding the election cycle.
- Problems regarding disbursement of EU funds underscore the need to further upgrade control systems.
- Need to cost social security and social policy changes realistically and ensure fiscal neutrality, paying special attention to long-term sustainability.

### Flexibility of the economy and competitiveness
- Key question: as the capital flow-driven boom in the non-tradable sector ends, can the tradable sector take over? Depends on real exchange rate misalignment and speed of correction.
- CGER-type calculations suggest the real exchange rate is now overvalued by 7-20 percent (Box 4); large uncertainty emphasized.
- Between 2007Q2 and 2008Q3, the REER has appreciated by 12 percent—close to the mid-point of the current overvaluation estimate.
- Authorities did not share concern that competitiveness had become a problem; they noted:
  - Bulgaria’s market share within the EU had continued to increase.
  - Rapid wage increases mainly a convergence phenomenon; price and wage levels still the lowest in the European Union.
  - Competitiveness further boosted by lowering of corporate and income tax rates, which were now the lowest in Europe.
- Staff cautioned that recent changes had been very rapid and wage growth needed to slow:
  - Wage level low by European standards, but labor productivity also low; rapid wage increases sustainable only if matched by productivity increases.
- Staff and authorities agreed on need for structural reforms to raise labor productivity and labor participation to speed up convergence of per capita income with the European Union.
  - Bulgaria has recently introduced significant education and labor reforms.
  - Bulgaria ranked among the top 10 reformers in the World Bank’s Doing Business report in 2006/07, mostly due to improved tax system and administration.

### Exchange rate assessment (Box 3 summary and numerical estimates)
- Staff view: much of the increase in the current account deficit since 2002 is temporary, boosted by a private capital inflows-driven domestic demand boom.
  - Between 2002 and 2007, net private capital inflows increased from 12 to 33 percent of GDP, raising domestic demand from 108 percent of GDP to 122 percent.
- Correcting for the “absorption gap” and past changes in competitiveness yields:
  - Underlying current account deficit: 12.8 percent of GDP.
  - Capital transfers: 2.1 (percent of GDP).
  - Underlying Saving-Investment Balance: -10.7 (percent of GDP).
  - Equilibrium Saving-Investment Balance: -7.8 (percent of GDP).
  - Deviation from Equilibrium: -2.9 (percent of GDP).
- Real exchange rate overvaluation, June 2008 (approach assessments):
  - Macro balance: 7.4 (percent).
  - External sustainability: 16.1 (percent).
  - REER (deviation of REER from five-year average): 19.7 (percent).
  - Average: 14.4 (percent).

### Financial sector assessment (Box 4: FSAP Update) — key findings and numerical indicators
- Financial sector changed with entry of foreign (mainly Eurozone) banks, which now dominate the financial system.
- Reported banking indicators:
  - BNB prudential policies include: 12 percent capital adequacy ratio; high (12 percent) unremunerated reserve requirements.
  - Capital adequacy ratios range between 14-30 percent.
  - Liquidity ratios range between 22-39 percent.
  - Return on equity: 18-29 percent.
  - Nonperforming loans: 0.2-2.4 percent.
- About half of banks’ balance sheets are euro denominated; indirect credit risk from unhedged borrowers identified as a risk factor.
- Loan to deposit ratios range between 50-130 percent.
- Banks’ exposure to real estate and construction increased and could suffer from a drop in real estate prices.
- Stress-test finding: under an adverse macro scenario with a sudden stop in capital inflows and a 30 percent drop in real estate prices:
  - NPL ratio would increase by about 12 percentage points.
  - Capital Adequacy Ratio would decline from 14½ to 2½ percent.
- Robustness of banking system critically depends on maintaining the currency board arrangement, given currency imbalances in corporate and household borrowing:
  - 71 percent of corporate loans and 25 percent of household loans are in euro.
- Financial sector development notes: securities markets, insurance industry, and private pension funds remain relatively small and underdeveloped despite rapid growth; legal and regulatory framework consistent with EU Directives but enforcement could be strengthened.
- AML/CFT: despite progress, further reforms needed on several fronts including implementation of preventive measures, supported by additional supervisory resources.

### Key recommendations (FSAP)
- BNB should:
  - Enhance its capacity to stress test, particularly credit and liquidity risks.
  - Draft amendments to include non-bank borrowers in the credit registry.
  - Enhance and update its assessment tools and methodologies.
  - Develop contingency plans, but delay introduction of risk-based premiums by the Deposit Insurance Fund.
  - Strengthen regional collaboration.
  - Participate in pertinent crisis management exercises.
  - Create buffers in the fiscal space for potential solvency support, in case of systemic problems.
- Financial Supervisory Commission should:
  - Strengthen capacity to enforce securities legislation.
  - Prepare an effective oversight program of the stock exchange and settlement system.
  - Tighten the definition of related parties and develop a map of indirect ownership of pension funds.
  - Review rules related to switching and the automatic assignation rule for undecided participants in pension funds.
  - Increase disclosure of risk adjusted performance of pension funds.
  - Overhaul the pay-out design of pension funds.
  - Change its skill mix to better enforce insurance legislation during inspections.

*Source: IMF staff report excerpt (2008–2009), _cr0996_.*

### Box 5. Structural Reforms and Competitiveness of the Bulgarian Economy

### Box 5. Structural Reforms and Competitiveness of the Bulgarian Economy

### Context and need for reforms
- Current productivity levels are well below the EU average and that of other new Member States, and productivity growth is just 3% per year.
- Labor market performance has improved substantially in the past decade, but labor force participation remains low.
- The unemployment rate, which had climbed to 20 percent at the beginning of the decade, is now at record low levels.
- The labor market has become very tight for highly skilled workers, while overall labor force participation remains low, particularly among youth and older workers.

### Education reforms (recent and proposed)
- The government has delegated budgets to schools and now provides a fixed amount per student, which has led to a more efficient utilization of funds and which lays the ground for increases in the quality of education.
- Bulgaria has launched external student assessments, both national and international, to benchmark and track progress of student performance.
- Going forward, education reforms need to be completed and consolidated in a new Education Act foreseen for 2009.
- Education reforms should be expanded to include vocational education and training and higher education.

### Labor market reforms and activation
- Reductions in the social insurance burden and new employment policies focused on activating previously inactive workers (in particular the low-skilled, youth and older workers) are expected to contribute to increases in labor force participation and employment.

### Health sector measures and outstanding challenges
- Measures taken to maintain fiscal sustainability of the health sector include: improving the pharmaceutical policy; introducing an integrated information system for the National Health Insurance Fund; and raising the health contribution rate to 8 percent from 6 percent until 2008.
- Further steps are needed to sustainably change the underlying structure of spending from hospitals to primary health care.
- A continued review of the financing mechanism in the health sector is needed to make the system financially sustainable and lay the ground for improving its quality and restructuring the health facilities network.

### Regulatory reform and business climate
- Bulgaria ranked among the top 10 reformers in the World Bank’s Doing Business report in 2006/07, mostly on account of improved tax system and administration.
- Notwithstanding progress, regulation remains a serious constraint to enterprise operations and growth.
- In the World Bank’s 2008 Investment Climate Assessment, senior managers in Bulgaria reported spending 17 percent of their time dealing with requirements imposed by Government regulations such as taxes, customs, labor regulations, licensing and registration.
- The Better Regulation Programme adopted by the Government for 2008-10, and the broader National Reform Programme (2008-10) charting a course of action based on EC recommendations, are key steps to maintain reform momentum.

*Prepared by the World Bank*

### Appendix I. Bulgaria—Financial Position in the Fund

### Appendix I. Bulgaria—Financial Position in the Fund (as of January 31, 2009)

### I. Membership Status
- Joined September 25, 1990

### II. General Resources Account
- Quota: 640.20 SDR Million — 100.00% Quota
- Fund holdings of currency: 606.69 SDR Million — 94.77% Quota
- Reserve Position: 33.53 SDR Million — 5.24% Quota

### III. SDR Department
- Holdings: 4.20 SDR Million — N/A % Allocation

### IV. Outstanding Purchases and Loans
- None

### V. Latest Financial Arrangements
- Stand-By: Date of Arrangement Aug. 6, 2004; Expiration Date Mar. 31, 2007; Amount Approved 100.00 SDR Million; Amount Drawn 0.00 SDR Million
- Stand-By: Date of Arrangement Feb. 27, 2002; Expiration Date Mar. 15, 2004; Amount Approved 240.00 SDR Million; Amount Drawn 240.00 SDR Million
- EFF: Date of Arrangement Sep. 25, 1998; Expiration Date Sep. 24, 2001; Amount Approved 627.62 SDR Million; Amount Drawn 627.62 SDR Million

### VI. Projected Payments to Fund
- None

### VII. Implementation of HIPC Initiative
- Not Applicable

### VIII. Implementation of Multilateral Debt Relief Initiative (MDRI)
- Not applicable

### IX. Resident Representative
- Mr. Fernandez-Ansola is the Senior Regional Resident Representative, based in Bucharest.
- He took up the position on September 4, 2006.

*Source: Appendix I. Bulgaria—Financial Position in the Fund (as of January 31, 2009).*

### 1. According to preliminary flash estimates, GDP growth slowed to 3.7 percent

### _cr0996 - 1. According to preliminary flash estimates, GDP growth slowed to 3.7 percent

### GDP growth and demand-side drivers
- Preliminary flash estimate: GDP growth slowed to 3.7 percent year/year in Q4, down from 6.8 percent in Q3 2008.
- Staff projection cited: 4.0 percent (flash estimate close to staff’s projection and does not lead to changes in staff’s GDP projections).
- Demand-side contributors to the slowdown:
  - Gross fixed capital formation: declined from 22.2 percent to 9.7 percent.
  - Exports: declined from 3.8 percent to -6.8 percent.

### Balance of payments and reserves
- Net capital inflows in Q4: €701 million, down from €3,416 million in Q3.
- Components of the decline in capital inflows:
  - Foreign borrowing: reduced by €785 million.
  - Inbound FDI: reduced by €753 million.
  - Non-resident deposits: reduced by €589 million.
- Counterpart to decline in private capital inflows: decline in official reserve assets by €2 billion euro.
- Reserve movement in early 2009:
  - Reserve loss in January: 0.6 billion euros.
  - Reserves increased by €0.1 billion in the first three weeks of February.
- Gross international reserves (from Selected Economic Indicators table): 30.5 (2003), 34.5 (2004), 33.7 (2005), 35.4 (2006), 41.3 (2007), 37.4 (2008).

### Credit, money, and banking sector
- Private sector credit growth (January):
  - Annualized month/month growth rate: 5 percent (up from 1.6 percent in December).
  - Year/year growth rate: 30.0 percent (down from 31.1 percent in December, and 61.8 percent in January 2008).
- Broad money (M3) (Selected Economic Indicators): 19.6 (2003), 23.1 (2004), 23.9 (2005), 26.9 (2006), 31.2 (2007), 8.8 (2008).
- Credit claims on non-government sector (Selected Economic Indicators): 48.3 (2003), 48.6 (2004), 32.4 (2005), 24.6 (2006), 62.5 (2007), 32.0 (2008).
- Policy and supervisory actions taken:
  - Deposit insurance coverage increased from €20,000 to €50,000 and will be increased further to €100,000 per depositor per bank in 2009.
  - Reserve requirements lowered: local currency from 12 to 10 percent; foreign currency to 5 percent.
  - Banks persuaded not to pay dividends and to add 2008 profits to capital.
  - Comfort letters obtained from parent banks to provide liquidity and capital.
  - BNB intensified monitoring, focusing on liquidity and credit risks and strengthening stress testing.

### Labor market, wages, and competitiveness
- Nominal wage growth: slowed to 18 percent year/year in December (down from 25 percent in June).
- Inflation movement: slowed from 14.7 percent to 7.2 percent.
- Real wage growth: described as remaining very high.
- Unemployment rate: picked up from a record low of 6.0 percent in November to 6.1 percent in December.
- Staff concern: high wage growth further exacerbates concerns about competitiveness; authorities encouraged to avoid real wage increases exceeding productivity gains.
- Unit labor cost–based real effective exchange rate: appreciated 27 percent in the two years ending in mid-2008 (noted earlier in the report).

### Financial markets and external vulnerability
- Bulgarian stock market index (SOFIX): lost another 4 percent since the staff report was issued.
- Sovereign CDS spreads: reached 634 basis points.
- Context and vulnerabilities:
  - Capital-inflows driven boom had produced large current account deficits and rising private sector debt.
  - Current account deficit widened from 5 percent of GDP in 2003 to an estimated 25 percent of GDP in 2008.
  - Net inflows had increased to about 27 percent of GDP by 2008.
  - Rapid credit growth and a rising credit-to-GDP ratio from 36 percent in 2004 to 67 percent in 2007.

### Fiscal stance, policy recommendations, and authorities’ response
- Authorities’ fiscal intentions and actions:
  - Intention to maintain a fiscal surplus of 2 percent of GDP in 2009 (authorities concurred with maintaining prudent fiscal policies).
  - Authorities applied a rule to restrict spending to 90 percent of the amount budgeted to help achieve targeted surplus.
  - Authorities noted fiscal surplus in 2008 estimated at about 3 percent of GDP.
- Executive Directors’ recommendations and assessments:
  - Currency board arrangement served Bulgaria well as anchor for macroeconomic stability.
  - Advisories to monitor developments closely and adapt policies as warranted, given downside risks.
  - Support for measures to improve depositor confidence, increase capital cushions, secure commitments from parent banks, and intensify monitoring of liquidity and credit risks.
  - Emphasis on prioritization and further spending restraint if growth slows more than expected.
  - Structural reforms (education, labor market, reducing administrative burdens) seen as key to recovery and EU convergence.
- Authorities’ stance on exchange rate regimes:
  - Plan to uphold the currency board arrangement at the existing exchange rate until Bulgaria joins the EMU.
  - Commitment to unilaterally maintain a zero deviation of the exchange rate after joining ERM II.

### Selected economic indicators (excerpt)
- Real GDP growth (Selected Economic Indicators): 5.0 (2003), 6.6 (2004), 6.2 (2005), 6.3 (2006), 6.2 (2007), 6.0 (2008).
- Consumer price index (average): 3.0 (2003), 4.0 (2004), 6.0 (2005), 7.4 (2006), 7.6 (2007), 12.0 (2008).
- Consumer price index (end of period): 5.6 (2003), 4.0 (2004), 7.4 (2005), 6.1 (2006), 11.6 (2007), 7.2 (2008).
- Employment: 3.0 (2003), 2.6 (2004), 2.7 (2005), 2.4 (2006), 2.6 (2007), 3.1 (2008).
- General government overall balance: -0.2 (2003), 1.7 (2004), 2.3 (2005), 3.5 (2006), 3.5 (2007), 3.0 (2008).
- Gross public debt: 48.1 (2003), 40.1 (2004), 31.3 (2005), 24.6 (2006), 19.8 (2007), 16.8 (2008).
- Financial net worth: 8.8 (2003), 9.3 (2004), 11.7 (2005), 13.7 (2007), 14.7 (2008).
- Merchandise trade balance (% of GDP): -13.7 (2003), -14.9 (2004), -20.2 (2005), -22.0 (2006), -25.3 (2007), -29.2 (2008).
- Current account balance (% of GDP): -5.5 (2003), -6.6 (2004), -12.4 (2005), -17.8 (2006), -21.8 (2007), -24.8 (2008).
- Exchange rate regime: Currency board arrangement; Leva per euro: Lev 1.956 per Euro.

*Source: IMF staff report and Public Information Notice (PIN) No. 09/34, March 17, 2009.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0996.pdf_