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

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### Staff appraisal and executive summary
- Pre-crisis large capital inflows generated a domestic demand boom with strong GDP and employment growth but also:
  - very high current account deficits, overheating, high wage growth and double-digit inflation.
- Boom ended in Q4 2008; capital inflows sharply adjusted and exports fell, leading to GDP contraction of 5.0 percent in 2009.
- Adjustment needs with lower capital inflows:
  - Private sector: reallocate resources from non-tradable to tradable sectors; wage growth must slow considerably in 2010 and remain moderate over the medium term.
  - Public sector: adjust spending growth to the end of the domestic demand-driven revenue boom; sustain built-up public buffers because private sector vulnerabilities remain considerable.
- Key vulnerability indicators:
  - Private sector external debt is 106 percent of GDP.
  - Foreign currency debt of the non-financial private sector amounts to 80 percent of GDP.
- Policy priorities:
  - Maintain fiscal discipline and deepen structural policies to support the currency board and prepare for eventual euro adoption.
  - Meet government’s cash deficit target of 0.7 percent of GDP in 2010 is challenging; staff projects a cash deficit of 1.8 percent of GDP for 2010.
  - For 2011 and beyond: focus on the overall spending envelope within a medium-term budgetary framework and target real spending growth in line with cautious estimates of potential GDP growth.
  - Use revenue windfalls to build fiscal buffers; compensate tax rate reductions with further expenditure reductions.
  - Rationalize public administration, improve absorption of EU funds, contain public wage growth (public wage freeze in 2010), and align wage increases with productivity.
  - Urgent pension system reforms and health care financing reforms recommended.
  - Financial stability: absorb increases in NPLs; enforce cautious dividend policies; contingency planning and creation of a financial stability unit at the BNB welcomed.

### The boom of 2003–08: features and imbalances
- Drivers: expectations of rapid EU convergence, confidence in the currency board, and strong fiscal policy.
- Net inflows rose to about 34 percent of GDP by 2008.
- Credit expansion:
  - Credit-to-GDP ratio rose from 35 percent in 2004 to 73 percent in 2008.
- Macroeconomic outcomes and imbalances:
  - Real GDP grew by more than 6 percent annually.
  - Current account deficit widened from 5.5 percent of GDP in 2003 to 24 percent of GDP in 2008.
  - Wage growth peaked at 25 percent in June 2008.
  - Inflation peaked at 14.7 percent in June 2008.
  - ULC-based REER appreciated by 26 percent between Q3 2006 and Q3 2008; CPI-based REER appreciated by about 16 percent.
  - Growth concentrated in non-tradable sectors; construction and real estate contributed more than half of GVA growth between 2004 and 2008H1, raising their GVA share from 20.7 percent to 24.5 percent.
  - Average housing prices increased by more than 150 percent over that period.
- Private sector balance sheet vulnerabilities:
  - Foreign currency mismatches largely in euros.
  - Foreign currency debt: non-financial corporate sector 80 percent of GDP; households 10 percent of GDP.
  - External debt increased to 111 percent of GDP by end-2009; about 60 percent of external debt is intercompany debt and debt owed by banks.
  - Net international investment position deteriorated to minus 112 percent of GDP as of end-September 2009.
- Public sector buffers built up:
  - Fiscal surplus averaged 2.8 percent of GDP between 2004 and 2008.
  - Public debt-to-GDP ratio declined from 48 percent at end-2003 to 16 percent by end-2009.
  - Fiscal reserve account held 12 percent of GDP at end-2009.

### Crisis impact and 2009 outcomes
- GDP declined by 5 percent in 2009.
- Capital flows and external funding:
  - Flows to banks declined from +10 percent of GDP in 2008 to -2½ percent in 2009.
  - FDI decreased from 18¼ percent of GDP in 2008 to 9¾ percent in 2009; FDI in the real estate sector fell by 75 percent in 2009.
  - Overall capital inflows declined from 34.2 percent of GDP in 2008 to 7.8 percent in 2009.
- Domestic demand and asset prices:
  - Domestic demand contracted by 15 percent in 2009 (investment plunged by 28.5 percent).
  - Housing prices slumped by 29 percent from their peak in Q3 2008.
  - Exports declined by 22½ percent (10 percent in volumes) in 2009.
- Inflation and labor market:
  - Inflation dropped to 1 percent—from 15 percent in mid-2008.
  - Unemployment estimated at 7.8 percent in 2009.
- Correction of imbalances:
  - Current account deficit narrowed from 24 percent in 2008 to an estimated 9½ percent of GDP in 2009.
  - Stock imbalances remained high.
- Fiscal developments in 2009:
  - First seven months: expenditure grew by 24.5 percent y/y while revenue dropped by 11 percent.
  - Pensions up by 17 percent; capital spending rose by 66 percent in first seven months of 2009 y/y.
  - Social security contribution rates reduced by 2.4 percentage points.
  - After July 2009 new government implemented sharp across-the-board spending cuts; most end-year and other bonus payments scrapped.
  - Overall cash spending growth in 2009 contained to less than 1 percent.
  - Government contained the cash deficit to 0.8 percent of GDP; accrual-based deficit widened to around 1.9 percent (ESA-95).
  - Arrears build-up (largely to construction sector) artificially lowered the cash deficit.

### Banking sector and financial stability
- End-2009 aggregate CAR was 17 percent (BNB minimum 12 percent; EU minimum 8 percent).
- Tier I ratio increased to 14 due to conversion of Tier II capital.
- Asset quality deteriorated since Q3 2008, but:
  - Banks generated enough profits to cover impairment costs.
  - Coverage ratio of NPLs by provisions was 80 percent.
- Heterogeneity across banks: a few banks had CAR just above 13 percent; several domestic banks provisioned less than peers.
- Most banks limited NPL increases via renegotiations; banks most expansionary before the peak face more significant challenges.
- Foreign parent banks broadly maintained funding; BNB unlikely to ask for commitment letters from parents of systemic banks as it did last year.
- Expected NPL ratio increase: from 6½ percent at end-2009 to 10–10½ percent in 2010 under the baseline scenario.
- BNB actions:
  - Aligned risk-weights to less conservative EU standards in March 2010, adding about 1 percentage point to aggregate CAR.
  - Asked banks to fully retain 2009 earnings and allowed inclusion of previous year’s audited earnings in own funds calculation prior to shareholder decision.
- Liquidity and parent-funding risks noted; BNB tools include liquidity monitoring, regular exchanges with parent supervisors, minimum reserve requirements, and a 15 percent coverage ratio requirement of deposits by liquid assets.
- Emergency liquidity and fiscal backstops:
  - BNB may extend loans to solvent banks in acute need, not exceeding the currency board limit.
  - Government could use part of the fiscal reserve account (3.9 bn euros at end-February 2010) if needed.
  - BNB and BDIF analyzing purchase-and-assumption modalities in bank resolution framework.
- Prudential treatment: BNB considers treating euro and leva exposures similarly given a completely euroized real estate market.

### Banking sector structure (select end-Q4 2009 figures preserved exactly)
- Total banking system total assets: 70.9 (in billion leva) and asset market share: 133 (in percent).
- Largest banks (controlling shareholder nationality — total assets (in billion leva) — asset market share (in percent) — loan-to-deposit ratio (in percent)):
  - Unicredit — Italy/Austria — 11.5 — 16.3 — 147
  - DSK 1 — Hungary — 8.7 — 12.3 — 126
  - United Bulgarian Bank 2 — Greece — 8.2 — 11.5 — 156
  - Raiffeisen — Austria — 6.6 — 9.4 — 124
  - Eurobank — Greece — 6.0 — 8.5 — 112
  - First Investment Bank — Bulgaria — 4.1 — 5.8 — 97
  - Piraeus — Greece — 3.6 — 5.1 — 261
  - Other Greek banks:
    - Alpha 3 — Greece — 2.2 — 3.2 — 235
    - Emporiki — Greece — 0.5 — 0.7 — 319
- Notes: 1/ Controlling shareholder is OTP. 2/ Controlling shareholder is National Bank of Greece. 3/ Branch (not subsidiary). 4/ Excludes deposits of financial corporations.

### Reserve coverage and external positions (key statistics preserved exactly)
- At end 2009, official reserves equal to 36 percent of GDP.
- Official reserves covered 182 percent of base money.
- Reserve coverage of broad money: 49½ percent.
- Median reserve coverage: 34 percent for emerging economies and 32 percent among emerging markets pegged regimes.
- Reserve coverage of short-term debt on a residual maturity basis: 75 percent.
- Large part of short-term debt is from Bulgarian subsidiaries to their parent banks, reducing roll-over risk.
- Net international investment position: minus 112 percent of GDP as of end-September 2009.
- External debt: 111 percent of GDP by end-2009; about 60 percent intercompany and bank debt.

### Competitiveness (CGER findings and context)
- CGER macro balance approach: real exchange rate undervalued by 6.5 percent (compared to an overvaluation of 7.4 percent in last year’s report).
- External sustainability approach: REER undervalued by 4 percent (compared to estimated overvaluation of 16.1 percent last year).
- Even targeting stabilization of the IIP at 60 percent of GDP would yield only a 5.6 percent overvaluation.
- CPI-based REER continued to appreciate in 2009, rising by 2.2 percent between 2008Q4 and 2009Q4.
- Other indicators: over a longer period Bulgaria’s real exchange rate appreciation smaller than most other new EU member states; market share continued to increase; wages remain the lowest in the EU.

### Fiscal policy challenges, medium-term framework and specific measures
- Short-term (2010) fiscal challenge: meeting government’s cash deficit target of 0.7 percent of GDP is difficult given revenue shortfalls in H2 2009 and a 2 percentage point cut in social security contribution rate.
- Recent measures and 2010 budget elements:
  - Revenue measures: restructuring National Revenue and Customs Agencies (projected yield about 0.6 percent of GDP); raised excises and taxes (estimated yield of ½ percent of GDP); sales of emissions under Kyoto protocol (0.7 percent of GDP in later package); introduction/increase in lottery, gambling, and luxury taxes; rent and sale of state land.
  - Expenditure measures: wages and general pensions frozen in 2010; no end-year bonuses; civil servants to be reduced by 3 percent (ministries about 15 percent); delay of pension increases to widowers and those over 75 from January 1 to July 1, 2010 (saving of 0.2 percent of GDP); capital spending and subsidies budgeted to rise contingent on higher EU fund absorption.
  - Social security contribution rate reductions: initial cut of 2.4 percentage points in 2009; further cuts would widen pension financing gap.
- Staff projection and concerns:
  - Staff projected a cash deficit of 1.8 percent of GDP for 2010 (versus government 0.7 percent target).
  - After new measures, government expects to contain cash deficit to 2½ percent of GDP; deficit on an accrual basis would be about 2.0 percent of GDP.
  - Staff judged reaching the new target with current measures may be challenging; risks include optimistic yield assumptions, implementation delays, repayment of arrears adding pressure, and weaker underlying revenues.
  - Possible additional measures: raise VAT by 2 percentage points on July 1 (could yield about 0.7 percent of GDP in 2010), increase social security contribution rates, further expenditure restraint.
  - Recommendation: closely adhere to budgeted spending limits and swiftly pursue repayment of arrears to prevent cascading arrears.

### Medium-term fiscal strategy (2011 and beyond) and structural fiscal reforms
- Shift from ad hoc measures to a medium-term strategy focusing on overall spending envelope within a medium-term budgetary framework rather than headline balances.
- Target real spending growth in line with cautious estimates of potential GDP growth to make public spending more predictable and prioritize spending.
- Use revenue windfalls to build fiscal buffers; any tax rate reductions must be compensated by further expenditure cuts.
- High-priority fiscal reforms:
  - Pension system sustainability:
    - Government transfers averaged about 3 percent of GDP until 2008, surged to 5.2 percent in 2009, and expected to rise to 6.2 percent in 2010 due to carry-over of the 2009 pension increase.
    - Possible measures: slow pension increases (after freeze in 2010), adjust retirement age or minimum years of contribution, address underreporting of insurable income, revise inefficient parameters, and address weaknesses in disability pension management.
  - Health care reform:
    - 122 new hospitals created since 2004 (about a 40 percent increase); mispricing and distorted incentives created financing pressures.
    - Recommended swift broad-based reform: rationalize in-patient care, develop quality standards, conduct cost analysis, review medication pricing.
  - Public administration rationalization and improved absorption of EU funds to free fiscal space for infrastructure, education and training.
  - Contain public wage growth; align future increases with productivity.
  - Renewed privatization to enlarge private sector role and replenish fiscal reserve account.

### Structural reforms and convergence of the Bulgarian economy
- Core reform areas identified:
  - Public administration reform: optimize administrative structures, close duplicated units, develop e-government, improve EU funds absorption and revenue collection.
  - Education reforms: improve quality of learning, promote life-long learning, ensure equal access.
  - Business environment reform: reduce administrative burden (government aim to reduce burden by 20 percent by 2012), modernize insolvency framework, streamline construction permits, improve contract enforcement, reduce costs of trading across borders.
  - Other areas: structural reforms in energy and agriculture; public investment to address infrastructure and environmental challenges; strengthen municipal administrative capacity and use public-private partnerships.
- World Bank prepared Box 4 on these reforms (prepared by World Bank staff).

### IMF–World Bank collaboration, programmatic actions and data/statistical issues
- Division of lead roles:
  - World Bank: lead on core structural aspects.
  - IMF: lead on macroeconomic aspects, fiscal and financial sector policies.
- Shared responsibilities: financial sector, public expenditure management and budgeting, and tax administration.
- Joint actions:
  - FSAP (late 2001) and follow-ups (2004, June 2008).
  - Revenue Administration Reform Project (€31.9 million); new National Revenue Agency operational January 1, 2006.
  - Public expenditure reviews and technical assistance to MOF.
- World Bank activity and portfolio (select figures preserved exactly):
  - CPS discussed June 13, 2006; CPS FY07-09 roadmap; CPS for FY10-13 under discussion.
  - Active Bank portfolio: 7 operations totaling US$ 369.6 equivalent.
  - Total historic assistance: 46 IBRD operations with original commitment US$3,003 million equivalent.
  - IFC commitments over US$ 660 million (30 projects as of March 1, 2010).
- Statistical issues and data quality:
  - Bulgaria participates in SDDS since 2003.
  - NSI compiles national accounts consistent with SNA 1993 and ESA 1995; quarterly financial accounts since 2006.
  - Preliminary flash GDP estimates produced 45 days after reference period; quarterly updates 70 days after quarter end; final figures after approximately 5 quarters.
  - Remaining data problems: coverage of private sector activities, constant price estimates of capital formation and external trade, export and import deflators.
  - Price data: CPI begins 1995; HICP 2005; work on owner-occupied housing inclusion underway.
  - Improvements in customs data flow and INTRASTAT since EU accession January 2007.
  - Money and banking statistics reported by BNB based on ECB framework; quarterly BOP statistics timely.

### New information since the Staff Report and fiscal revisions
- 2009 accrual-basis fiscal deficit revised from 1.9 to 3.9 percent of GDP.
  - Upward revision largely reflected previously unidentified payment commitments for capital, maintenance and hospital spending (1.3 percent of GDP) and exclusion of revenue of some cash dividends received in 2009.
- 2009 cash-basis deficit changed marginally from 0.8 to 0.9 percent of GDP.
- Preliminary cash deficit in first three months of 2010 amounted to 2.4 percent of GDP.
  - Partly reflects temporary factors: partial settlement of arrears and payments built up in 2009; VAT receipts affected by closure of refinery in February; repayment of VAT refunds accumulated in Q4 2009.
  - Underlying revenues weaker than expected; deficit largely financed by draw-down of fiscal reserves.
- Government adopted new fiscal package estimated to yield about 2.4 percent of GDP (sales of emissions under Kyoto 0.7 percent of GDP; other revenue and expenditure measures).
- Government expects to contain cash deficit to 2½ percent of GDP (original target 0.7 percent; staff projection 1.8 percent).
  - Deficit on accrual basis would be slightly lower (2.0 percent of GDP).
  - Financing plans include additional privatization proceeds (0.4 percent of GDP) and issuing euro-denominated securities on the domestic market.
- Staff judgment: meeting the new deficit target with current measures may be challenging; more measures likely needed (e.g., VAT increase by 2 percentage points on July 1 could yield about 0.7 percent of GDP in 2010).
- ERM-II application put on hold after deficit revision; European Commission launched a procedure to identify whether an excessive deficit exists (report tentatively scheduled for mid-May).
- Market reaction muted: CDS spreads remained in the 200 basis points range; recent increase to 236 basis points noted.

### Executive Board assessment and recommendations (summarized)
- Directors commended authorities for prudent macroeconomic policies through global crisis.
- Noted economy poised to recover but large private external debt and regional spillover risks pose downside risks.
- Emphasized wage moderation, structural reforms to raise productivity and reorient toward tradable sector, and containing public spending growth.
- Fiscal 2010: supported government package and readiness to take further steps, including tax measures.
- Medium-term advice: focus on overall spending envelope within a medium-term budgetary framework; save windfalls and compensate tax cuts with expenditure cuts.
- Financial sector: welcome prudent regulation and capital buffers; remain vigilant on rising NPLs and parent-funding reversal risks; monitor liquidity, cooperate with parent supervisors, enforce cautious dividend policy, and undertake contingency planning.
- Welcome creation of a financial stability unit at the central bank and improvements to bank resolution framework.

### Key quantitative indicators (values preserved exactly as reported)
- Real GDP: 2005 6.2; 2006 6.3; 2007 6.2; 2008 6.0; 2009 -5.0; 2010 0.2
- Consumer price index (average): 2005 6.0; 2006 7.4; 2007 7.6; 2008 12.0; 2009 2.5; 2010 2.2
- Consumer price index (end of period): 2005 7.4; 2006 6.1; 2007 11.6; 2008 7.2; 2009 1.6; 2010 2.7
- Employment (annual change): 2005 1.9; 2006 4.3; 2007 3.5; 2008 2.8; 2009 -4.0; 2010 -2.2
- General government overall balance (percent of GDP): 2005 2.4; 2006 3.5; 2007 3.5; 2008 3.0; 2009 -0.9; 2010 -2.5
- Gross public debt (percent of GDP): 2005 31.3; 2006 24.6; 2007 19.8; 2008 16.1; 2009 16.1; 2010 16.2
- Financial net worth (percent of GDP): 2005 6.0; 2006 9.9; 2007 10.2; 2008 11.5; 2009 10.8; 2010 8.9
- Broad money (M3) (annual percent change): 2005 23.9; 2006 26.9; 2007 31.2; 2008 8.8; 2009 4.3; 2010 0.3
- Credit claims on non-government sector (annual percent change): 2005 32.4; 2006 24.6; 2007 62.5; 2008 31.6; 2009 3.8; 2010 1.6
- Merchandise trade balance (percent of GDP): 2005 -20.2; 2006 -22.0; 2007 -25.1; 2008 -25.2; 2009 -12.1; 2010 -9.9
- Current account balance (percent of GDP): 2005 -12.4; 2006 -18.4; 2007 -26.8; 2008 -24.0; 2009 -9.4; 2010 -6.2
- Gross international reserves: 2005 33.7; 2006 35.4; 2007 41.3; 2008 37.3; 2009 37.8; 2010 37.8
- Exchange rate regime: Currency board arrangement; Leva per euro Lev 1.95583 per Euro

*Source: IMF staff report chapter “1. Bulgaria’s Reactions to Past IMF Advice” (extracted content).*

### 1. Bulgaria’s Reactions to Past IMF Advice ......................................................................6

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

### Staff appraisal and executive summary
- Pre-crisis large capital inflows generated a domestic demand boom, strong GDP and employment growth, but also very high current account deficits, overheating, high wage growth and double-digit inflation.
- The boom ended in Q4 2008 after the global crisis; capital inflows sharply adjusted and exports fell, leading to GDP contraction of 5.0 percent in 2009.
- With capital inflows unlikely to re-reach pre-crisis levels, both private and public sectors need to adjust:
  - Private sector: reallocate resources from non-tradable to tradable sectors; wage growth must slow considerably in 2010 and remain moderate over the medium term.
  - Public sector: adjust spending growth to the end of the domestic demand-driven revenue boom; sustain built-up public buffers because private sector vulnerabilities remain considerable.
- Key vulnerability indicators cited by staff:
  - Private sector external debt is 106 percent of GDP.
  - Foreign currency debt of the non-financial private sector amounts to 80 percent of GDP.
- Policy priorities highlighted:
  - Maintain fiscal discipline and deepen structural policies to support the currency board and prepare for eventual euro adoption.
  - Meet government’s cash deficit target of 0.7 percent of GDP in 2010 is challenging; staff projects a cash deficit of 1.8 percent of GDP for 2010.
  - For 2011 and beyond, focus on the overall spending envelope within a medium-term budgetary framework and target real spending growth in line with cautious estimates of potential GDP growth.
  - Use revenue windfalls to build fiscal buffers; compensate tax rate reductions with further expenditure reductions.
  - Rationalize public administration, improve absorption of EU funds, contain public wage growth (public wage freeze in 2010), and align wage increases with productivity to support competitiveness.
  - Urgent pension system reforms are needed due to widening gaps between contributions and expenditures; health care financing pressures and misaligned incentives require reform.
  - Financial stability: absorb increases in non-performing loans; enforce cautious dividend policies for banks; contingency planning and the creation of a financial stability unit at the BNB are welcome.

### Introduction and context
- Article IV Consultation focus: how Bulgaria can adjust to the end of the capital-inflows boom.
- Previous fears of a balance of payments or banking crisis have not materialized; flow imbalances corrected but stock imbalances and vulnerabilities remain high.
- Experience cited: after capital inflows-driven booms end, capital inflows tend to remain depressed for a considerable time.

### The boom of 2003–08: features and imbalances
- Drivers of the boom (2004–08): expectations of rapid EU convergence, confidence in the currency board, and strong fiscal policy.
- Net inflows increased to about 34 percent of GDP by 2008—one of the highest among emerging market economies.
- Credit expansion:
  - Credit-to-GDP ratio rose from 35 percent in 2004 to 73 percent in 2008.
- Macroeconomic outcomes and imbalances:
  - Real GDP grew by more than 6 percent annually.
  - Current account deficit widened from 5.5 percent of GDP in 2003 to 24 percent of GDP in 2008.
  - Wage growth accelerated to a peak of 25 percent in June 2008.
  - Inflation peaked at 14.7 percent in June 2008.
  - Unit labor cost (ULC)-based real effective exchange rate appreciated by 26 percent between Q3 2006 and Q3 2008; CPI-based REER appreciated by about 16 percent.
  - Growth concentrated in non-tradable sectors—financial services, real estate and construction.
    - Construction and real estate contributed more than half of gross value added growth between 2004 and 2008H1, raising their share in GVA from 20.7 percent to 24.5 percent.
    - Average housing prices increased by more than 150 percent over that period, with faster rises in Sofia and resort areas.
- Private sector balance sheet vulnerabilities:
  - Foreign currency mismatches largely in euros.
  - Foreign currency debt: non-financial corporate sector 80 percent of GDP; households 10 percent of GDP.
  - External debt, mostly private, increased to 111 percent of GDP by end-2009; sixty percent of external debt is intercompany debt and debt owed by banks.
  - Net international investment position deteriorated to minus 112 percent of GDP as of end-September 2009.
- Public sector buffers built up during the boom:
  - Fiscal surplus averaged 2.8 percent of GDP between 2004 and 2008 (highest among EU new member states).
  - Public debt-to-GDP ratio declined from 48 percent at end-2003 to 16 percent by end-2009.
  - Fiscal reserve account held 12 percent of GDP at end-2009.

### Fiscal policy challenges and medium-term framework
- Short-term (2010) fiscal challenge: meeting the government’s cash deficit target of 0.7 percent of GDP is difficult given revenue shortfalls in H2 2009 and a 2 percentage point cut in the social security contribution rate.
- Recent measures: increases in excise duties and reforms to improve tax compliance; a tight expenditure envelope including a public wage and general pension freeze in 2010; streamlining public administration and stricter controls on health care spending.
- Repayment of arrears from 2009 will add to cash deficit pressures but should be pursued to prevent cascading arrears in the private sector.
- Staff projection: cash deficit of 1.8 percent of GDP for 2010.
- Recommended medium-term approach:
  - Focus on overall spending envelope rather than headline balances.
  - Target real spending growth consistent with cautious potential GDP growth estimates.
  - Prioritize spending, contain intra-year adjustments, and use windfalls to rebuild buffers.
  - Shift expenditure toward growth-enhancing areas (e.g., infrastructure) by improving public administration efficiency and EU funds absorption.
  - Contain public wage growth to support competitiveness.

### Financial sector stability and supervision
- Main banking challenge: absorb increases in non-performing loans.
- Banking system entered the crisis with substantial buffers due to prudent regulation during boom years.
- Supervisory recommendations: maintain cautious dividend policies and continue contingency planning.
- Institutional development: creation of a financial stability unit at the BNB noted positively.

### Implementation of IMF advice and governance
- Bulgaria maintained excellent relations with the IMF and successfully completed a series of Stand-By Arrangements.
- Government largely heeded IMF advice in mid-2009 by reversing large spending increases from early 2009.
- Many recommendations from the 2008 FSAP update mission and FAD TA missions on tax administration are being implemented.

### Other procedural note
- Staff proposes that the next Article IV consultation be held on the standard 12-month cycle.

*Source: IMF staff report chapter “1. Bulgaria’s Reactions to Past IMF Advice” (extracted content).*

### 16.      In the fall of 2008, the boom came to an end. In the global crisis that followed the

### _cr10160 - 16.      In the fall of 2008, the boom came to an end. In the global crisis that followed the

### Crisis impact and 2009 outcomes
- GDP declined by 5 percent in 2009—the first decline since the crisis of 1996/97.
- Capital flows and external funding:
  - Flows to banks declined from +10 percent of GDP in 2008 to -2½ percent in 2009.
  - FDI decreased from 18¼ percent of GDP in 2008 to 9¾ percent in 2009; FDI in the real estate sector fell by 75 percent in 2009.
  - Overall capital inflows declined from 34.2 percent of GDP in 2008 to 7.8 percent in 2009.
- Domestic demand and asset prices:
  - Domestic demand contracted by 15 percent in 2009 (investment plunged by 28.5 percent).
  - Housing prices slumped by 29 percent from their peak in Q3 2008.
  - Exports declined by 22½ percent (10 percent in volumes) in 2009.
- Inflation and labor market:
  - Inflation dropped to 1 percent—from 15 percent in mid-2008.
  - Unemployment estimated at 7.8 percent in 2009.

### Correction of imbalances and fiscal response
- External and macro imbalances:
  - Current account deficit narrowed from 24 percent in 2008 to an estimated 9½ percent of GDP in 2009.
  - Stock imbalances, however, remained high.
- Fiscal developments in 2009:
  - In the first seven months, expenditure grew by 24.5 percent y/y while revenue dropped by 11 percent.
  - Pension increases contributed (pensions up by 17 percent); capital spending rose by 66 percent in the first seven months of 2009 y/y.
  - Social security contribution rates were reduced by 2.4 percentage points, exacerbating revenue shortfalls.
  - After July 2009 the new government implemented sharp across-the-board spending cuts; most end-year and other bonus payments in the public sector were scrapped.
  - Overall cash spending growth in 2009 contained to less than 1 percent.
  - Government contained the cash deficit to 0.8 percent of GDP; accrual-based deficit widened to around 1.9 percent (in ESA-95 terms).
  - Arrears build-up (largely to the construction sector) artificially lowered the cash deficit.

### Banking sector and financial stability
- End-2009 aggregate Capital Adequacy Ratio (CAR) was 17 percent (BNB minimum 12 percent; EU minimum 8 percent).
- Tier I ratio increased to 14 due to conversion of Tier II capital.
- Asset quality deteriorated since Q3 2008, but:
  - Banks generated enough profits to cover impairment costs.
  - Coverage ratio of non-performing loans (NPLs) by provisions was 80 percent.
- Heterogeneity across banks:
  - A few banks had CAR just above 13 percent.
  - Several domestic banks maintained positive profitability but provisioned less than peers.
  - Most banks limited NPL increases by renegotiating with borrowers.
  - Banks most expansionary before the peak face more significant challenges.
- Foreign parent banks broadly maintained funding of local subsidiaries; BNB unlikely to ask for commitment letters from parents of systemic banks as it did last year.

### Outlook for 2010 and risks
- Staff projection for 2010:
  - Real GDP projected to increase by 0.2 percent.
  - Current account deficit projected to narrow from 9½ percent in 2009 to 6¼ percent of GDP in 2010.
  - Inflation projected to be about 2.2 percent (almost half of which is the effect of higher excise duties).
  - Unemployment expected to increase from an estimated 7.8 percent in 2009 to 9.2 percent in 2010.
- Expected demand composition:
  - Exports expected to lead recovery; domestic demand expected to decline further.
  - Investment likely to drop further due to unwinding investment boom and tightened credit.
  - Private consumption expected to suffer from decline in employment.
- Risks:
  - Upside: stronger-than-expected global recovery boosting exports and growth.
  - Downside: reversal of parent funding to Bulgarian subsidiaries, exacerbated by renewed global financial turmoil and concerns about sovereign debt sustainability in euro area countries.

### Policy challenges and recommended directions
- Exchange rate and euro adoption:
  - Currency board remains the appropriate exchange rate regime; euro area membership is the authorities’ declared policy goal.
  - Government aims to apply for ERM-II membership in the spring after its Convergence Report assessment.
  - To strengthen ERM-II prospects: maintain fiscal discipline and deepen structural reforms.
- Shifting growth to tradable sector:
  - Growth must shift from domestic demand to exports because boom years concentrated growth in the non-tradable sector.
  - Wage moderation necessary: average wage growth rose from 6 percent in 2004 to 22.7 percent in 2008; in 2009Q4 official wage growth was still 10½ percent y/y.
  - Authorities noted labor market flexibility, reductions in under-the-table payments, and composition effects that overstated official wage growth.
  - Structural reforms to support tradable-sector growth:
    - Cut red tape and reduce regulatory costs.
    - Tackle informal economy and corruption.
    - Strengthen corporate workouts, restructuring, and bankruptcy frameworks; authorities plan to assess and amend the corporate insolvency framework.
- Fiscal policy and 2010 budget:
  - 2010 budget sets a cash deficit of 0.7 percent of GDP through revenue and expenditure measures.
  - Revenue measures:
    - Restructuring National Revenue and Customs Agencies and intensified inspections (projected yield about 0.6 percent of GDP).
    - Raised excises on cigarettes and electricity, and taxes on gambling and real estate (estimated yield of ½ percent of GDP).
    - These gains partly offset by reduction in social security contributions rate by 2 percentage points.
  - Expenditure measures:
    - Wages and general pensions frozen in 2010; no end-year bonuses.
    - Civil servants to be reduced by 3 percent (ministries about 15 percent).
    - Planned increase of pensions to widowers and those over 75 delayed from January 1 to July 1, 2010 (saving of 0.2 percent of GDP).
    - Capital spending and subsidies budgeted to rise but contingent on higher absorption of EU funds.
  - Staff concern and projection:
    - Staff projected a cash deficit of 1.8 percent of GDP (versus government 0.7 percent target).
    - Risks to meeting cash deficit: optimistic revenue yield assumptions, short-term insufficiency of compliance measures, repayment of arrears built up in 2009 adding pressure, uncertainty of projected savings on health care and social spending.
    - Recommendation: closely adhere to budgeted spending limits and swiftly pursue repayment of arrears to prevent cascading arrears in the private sector.

*Source: BNB and IMF Staff calculations.*

### 33.      The authorities acknowledged the risks, but noted that they were committed to

### _cr10160 - 33.      The authorities acknowledged the risks, but noted that they were committed to

### Fiscal stance and objectives
- Authorities committed to not letting the deficit exceed 2 percent of GDP.
- Overarching objective: contain the fiscal deficit to support the currency board arrangement and prepare the way for ERM-II and euro area membership.
- Authorities stood ready to take additional measures on both the expenditure and revenue side.

### Medium-term fiscal strategy (2011 and beyond)
- Mission recommendation: shift from ad hoc measures to a medium-term strategy focusing on the overall spending envelope within a medium-term budgetary framework rather than headline balances.
- Rationale:
  - Focusing on headline balances had produced pro-cyclical fiscal policy.
  - Targeting real spending growth in line with cautious estimates of potential GDP growth would:
    - Make public spending more predictable.
    - Help prioritize spending and avoid across-the-board cuts.
    - Contain large intra-year adjustments.
- Revenue windfalls should be used to build fiscal buffers to draw down when revenues fall short.
- Authorities agreed on desirability of greater medium-term orientation, particularly given lower revenues.

### Tax policy and fiscal constraints
- Any tax rate reductions within a medium-term framework must be compensated by further expenditure cuts.
- Authorities aware that lowering social security contribution rates further (announced element of policy to reduce labor cost) would widen the financing gap of the social security system and require larger government transfers, jeopardizing medium-term balanced budget targets and pension system sustainability.
- Staff advised against a cut of VAT rates because the budget relied heavily on this income source; Bulgaria has the highest share of indirect taxes in the EU at 55 percent of total revenue.
- Authorities noted there might not be space for further tax rate reductions and would only cut tax rates further if there was fiscal space.

### Fiscal structural reforms and priority spending areas
- Staff recommended creating room for growth-enhancing expenditure shifts while containing the overall spending envelope; priority areas included:
  - Pension system sustainability:
    - Combination of large pension increases and reductions in social security contribution rates widened the gap between pension contributions and pension expenditures.
    - Government transfers averaged about 3 percent of GDP until 2008, surged to 5.2 percent in 2009, and are expected to rise further to 6.2 percent in 2010 due to carry-over of the sharp pension increase in 2009.
    - Possible measures: slow pension increases (after the freeze in 2010), adjust pension system parameters (including increase in retirement age or minimum years of contribution), address underreporting of insurable income, revise parameters creating inefficiencies, and address weaknesses in management of disability pensions.
  - Health care reform:
    - Mispricing and distorted incentives led to proliferation of hospitals: 122 new hospitals had been created since 2004; about a 40 percent increase.
    - Distortions created financing pressures for the public health insurance fund.
    - Swift completion of a broad-based health care reform—including rationalizing in-patient care, developing quality standards, conducting cost analysis, and reviewing medication pricing—was deemed crucial.
  - Public administration rationalization and improved absorption of EU funds to free fiscal space for infrastructure and productivity-raising measures (education and training).
  - Containing public wage growth via the announced public wage freeze in 2010 and future increases aligned with productivity.
  - Renewed privatization to enlarge private sector role and yield resources to replenish the fiscal reserve account.

### Authorities’ implementation stance
- Authorities broadly agreed on the need for fiscal structural reforms.
- Health care reforms underway: tightening eligibility criteria for National Health Insurance Fund funds, anticipated closures of many hospitals, development of quality standards, cost analysis, and medication pricing review.
- Pension reform: an advisory council of experts set up to develop reform proposals.
- Improving absorption of EU funds prioritized, reflected in nomination of a Deputy Prime Minister in charge of this issue.

### Financial sector stability: risks and buffers
- Capital buffers and countercyclical macro-prudential measures expected to allow the banking system to absorb increases in NPLs and associated provisions.
- Both BNB and mission expect a further increase of the NPL ratio from 6½ percent at end-2009 to 10–10½ percent in 2010 under the baseline scenario.
- BNB actions and capital buffers:
  - BNB aligned risk-weights to less conservative EU standards in March 2010, adding about 1 percentage point to the aggregate CAR.
  - BNB asked banks to fully retain 2009 earnings and allowed inclusion of previous year’s audited earnings in own funds calculation prior to shareholder decision.
- Liquidity and parent-funding risk:
  - Many subsidiaries operate with loan-to-deposit ratios well above 100; system depends on parent funding for credit extension.
  - Persistent financial tensions in parent banks’ countries of origin could spill over.
  - BNB tools: liquidity monitoring, regular exchanges with parent bank supervisors, minimum reserve requirements, and requirement of a 15 percent coverage ratio of deposits from credit institutions, households and retail customers by liquid assets.
- Emergency liquidity and fiscal backstops:
  - BNB may extend loans to solvent banks in acute need of liquidity that cannot be provided from other sources, not exceeding the currency board limit.
  - Government could use part of the fiscal reserve account (3.9 bn euros at end-February 2010) if needed.
  - BNB and BDIF analyzing modalities of purchase and assumption transactions in bank resolution framework.
- Prudential treatment of euro and leva exposures:
  - BNB considers it appropriate to give same prudential treatment to euro and leva exposures; Bulgarian real estate market is completely euroized, so collateral for euro-denominated loans is also euro-denominated despite borrowers’ income in domestic currency.

### Banking sector structure (as of end-Q4 2009) — select figures preserved exactly
- Total banking system total assets: 70.9 (in billion leva) and asset market share: 133 (in percent).
- Largest banks (controlling shareholder nationality, total assets (in billion leva), asset market share (in percent), loan-to-deposit ratio (in percent)):
  - Unicredit — Italy/Austria — 11.5 — 16.3 — 147
  - DSK 1 — Hungary — 8.7 — 12.3 — 126
  - United Bulgarian Bank 2 — Greece — 8.2 — 11.5 — 156
  - Raiffeisen — Austria — 6.6 — 9.4 — 124
  - Eurobank — Greece — 6.0 — 8.5 — 112
  - First Investment Bank — Bulgaria — 4.1 — 5.8 — 97
  - Piraeus — Greece — 3.6 — 5.1 — 261
  - Other Greek banks:
    - Alpha 3 — Greece — 2.2 — 3.2 — 235
    - Emporiki — Greece — 0.5 — 0.7 — 319
- Notes in table: 1/ Controlling shareholder is OTP. 2/ Controlling shareholder is National Bank of Greece. 3/ Branch (not subsidiary). 4/ Excludes deposits of financial corporations.

### Financial stability framework enhancements
- Creation of a Financial Stability Unit at the BNB reporting directly to the Governor; will produce an annual financial stability report and serve as BNB secretariat for the Domestic Standing Group for Financial Stability.
- Expected increase of deposit insurance coverage from EUR 50,000 to EUR 100,000 by end-2010.
- Inclusion of preferential deposits in insured deposits during 2011 in line with an EU directive in the making.
- As of end-March 2010, before the increase in coverage, resources of the deposit insurance fund covered 2.6 percent of insurable deposits.

### Reserve coverage (Box 2) — key statistics preserved exactly
- At end 2009, official reserves equal to 36 percent of GDP.
- Official reserves covered 182 percent of base money.
- Reserve coverage of broad money: 49½ percent.
- Median reserve coverage: 34 percent for emerging economies and 32 percent among emerging markets pegged regimes.
- Reserve coverage of short-term debt on a residual maturity basis: 75 percent.
- Large part of short-term debt is from Bulgarian subsidiaries to their parent banks, reducing roll-over risk.

### Competitiveness (Box 3) — CGER findings and context
- CGER macro balance approach: real exchange rate is now undervalued by 6.5 percent (compared to an overvaluation of 7.4 percent in last year’s report).
- External sustainability approach: REER undervalued by 4 percent (compared to an estimated overvaluation of 16.1 percent last year).
- Even targeting stabilization of the IIP at 60 percent of GDP would yield only a 5.6 percent overvaluation.
- Note: CGER-type methods may be less appropriate for Bulgaria given large swings in the current account deficit driven by capital inflows and domestic demand rather than REER changes.
- Despite a reduced current account deficit in 2009, CPI-based REER continued to appreciate in 2009, rising by 2.2 percent between 2008Q4 and 2009Q4.
- Other indicators: over a longer period Bulgaria’s real exchange rate appreciation has been smaller than most other new EU member states; market share continued to increase; wages remain the lowest in the EU.

*Source: IMF staff report (excerpts from _cr10160 PDF).*

### Box 4. Structural Reforms and Convergence of the Bulgarian Economy

### Box 4. Structural Reforms and Convergence of the Bulgarian Economy

### Role of structural reforms
- Structural reforms can help accelerate the convergence of Bulgaria’s income levels with those in Western Europe.
- In addition to pension and health care reforms (discussed in the main text), the following reforms are identified as most essential.

### Public administration reform
- Central objective: achieve higher levels of efficiency and effectiveness of public spending, improve administrative capacity to use EU funds, and further improvements in revenue collection.
- Optimization of administrative structures includes reorganization of units, including closing down of unnecessary or duplicated units and restructuring of staff.
- Development of e-government may enhance transparency, improve timely delivery of services, and minimize conditions for corruption.

### Education reforms
- Build on past achievement with a focus on enhancing the quality of student learning.
- Specific aims: improving quality of education, promoting life-long learning, and providing equal access to education.

### Business environment reform
- Reducing the administrative burden on businesses and enhancing entry/exit of firms is key to improving competitiveness and productivity, and to developing a knowledge-based economy.
- Government aim: reduce the administrative burden for businesses by 20 percent by 2012.
- Progress noted (e.g., reduction of start-up capital for firms), but further reforms needed to:
  - modernize the insolvency framework,
  - extend regulatory reform to the municipal level,
  - streamline the construction permits regime,
  - improve contract enforcement,
  - reduce costs of trading across borders.

### Other areas and instruments
- Structural reforms in energy and agriculture would also be helpful.
- Public investment has a critical role in addressing infrastructure and environmental challenges in the medium term.
- Government expects to make better use of EU funds to finance public investments.
- Strengthening administrative capacity to absorb EU funds including at the municipal level together with public-private partnerships can be main instruments for regional development, rural development, and environmental protection.

*Prepared by World Bank staff.*

### 1. The World Bank has been leading the policy dialogue in structural and institutional

### _cr10160 - 1. The World Bank has been leading the policy dialogue in structural and institutional

### World Bank role and CPS priorities
- The Bank led policy dialogue on structural and institutional reforms aimed at Bulgaria’s EU integration and convergence.
- Country Partnership Strategy (CPS) discussed by the Bank’s Board on June 13, 2006 outlined the roadmap for FY07-09 and focused on: (i) productivity and employment; (ii) fiscal sustainability and absorption of EU funds; and (iii) social inclusion.
- CPS included a three-year program of three development policy loans (DPLs), totaling US$500 million equivalent, supporting institutional reforms in the social sectors.
- CPS program also included investment lending in road, trade and transport facilitation for South East Europe, social inclusion, and municipal infrastructure.
- The Bank continues diagnostics to support policy dialogue, design, and implementation of lending operations and is discussing a CPS for FY10-13 with the Government.

### IMF–World Bank collaboration: roles and shared responsibilities
- Division of lead roles:
  - World Bank: lead on core structural aspects of reforms.
  - IMF: lead on macroeconomic aspects, particularly fiscal and financial sector policies.
- Shared responsibilities: financial sector, public expenditure management and budgeting, and tax administration.
- IMF contributions: macroeconomic stability, fiscal, income, external sector policies; IMF analyses serve as inputs into World Bank policy formulation and advice.

### Areas of shared responsibility — Key programmatic actions and findings
- Financial Sector:
  - Joint IMF–World Bank FSAP for Bulgaria in late 2001 provided a shared development perspective and prioritization/sequencing of financial sector reforms.
  - FSAP findings used as conditionalities under both the SBA and the PAL program.
  - Follow-up undertaken in the 2004 Article IV Consultation (March–April 2004); most recent update completed in June 2008.
- Revenue Administration:
  - Joint efforts led to the Revenue Administration Reform Project (€31.9 million), approved by the Bank’s Board in 2003.
  - New National Revenue Agency became operational on January 1, 2006, integrating collection of tax and social security revenues.
- Public Expenditure Management:
  - Bank led dialogue via: Public Expenditure and Institutional Review (2002); Public Finance Policy Review (2006); Judicial Public Expenditure Review (2008).
  - In FY08-09, Bank provided technical assistance to the Ministry of Finance to strengthen performance based budgeting and public investment budgeting and management.
  - A public expenditure review of the agriculture sector is currently being finalized.

### Areas where the World Bank leads and inputs into IMF policy advice
- Education:
  - Three DPLs approved in March 2007, November 2008, and May 2009 supported deepening education reforms: strengthening institutional capacity of the Ministry of Education and Science to assess quality, and improving school governance and financing.
  - Public Finance Policy Review (2007) outlined reform options with special focus on vocational education and training and tertiary education quality and access.
- Health:
  - Bank supported the government through two investment operations and the DPL program focusing on financial sustainability of the national health insurance system and efficiency of public spending on hospitals and pharmaceuticals.
- Social Protection Programs:
  - DPL program supported an employment promotion program addressing labor supply and demand incentives.
  - Government changed eligibility criteria of some social assistance programs to create incentives for job searching and reduce reliance on welfare.
  - November 2008: Bank completed a policy note on policies to raise employment and address labor and skills mismatches.
  - Multi-year poverty monitoring program launched; first poverty monitoring report provides feedback for policy adjustments.
  - November 2008: Bank’s Board approved a Social Inclusion Loan aimed at addressing longer term constraints to social inclusion and facilitating absorption of European Social Fund grants.

### World Bank Group strategy and lending operations — portfolio and IFC activity
- CPS recap: June 13, 2006 CPS focus reiterated: (i) productivity and employment, (ii) fiscal sustainability and EU funds absorption, (iii) social inclusion. A CPS for FY10-13 to be presented in latter half of FY10.
- Active Bank portfolio in Bulgaria:
  - 7 operations at the total amount of US$ 369.6 equivalent (active portfolio).
  - Total historic assistance: 46 IBRD operations with a total original commitment of US$3,003 million equivalent, consisting of:
    - 15 adjustment loans (US$1,725.8 million)
    - 24 investment projects (US$1123 million)
    - 1 debt reduction loan (US$125 million)
    - 4 Bank-managed Global Environmental Fund (GEF) grants
    - 2 Bank-managed Prototype Carbon Fund (PCF) operations
  - Of the 46 operations, 39 have been completed, of which 13 have been fully or partially cancelled during implementation, and 7 operations are currently under implementation.
- Table of active operations (listed amounts and board dates):
  - District Heating Project (PCF) — US$ 5.0 million — 2003
  - Wood Residue to Energy (PCF) — US$ 1.6 million — 2003
  - Energy Efficiency (GEF Grant) — US$ 10.0 million — 2005
  - Second Trade and Transport Facilitation in Southeast Europe (TTFSE 2) — US$ 52.8 million — 2007
  - Road Infrastructure Rehabilitation Project — US$ 122.5 million — 2007
  - Social Inclusion Project — US$ 59.0 million — 2008
  - Municipal Infrastructure Development Project — US$ 118.7 million — 2009 (pending effectiveness)
- Economic and Sector Work:
  - Country diagnostics focus on transparency and accountability of public spending in the judiciary, institutions and governance in forestry, and policies to increase labor skills and productivity.
  - Ongoing public expenditure review of the agriculture sector.
  - Work on private sector development: Investment Climate Assessment, review of state fees regimes, Review of Consumer Protection and Financial Capability.
  - Updated assessment of corporate governance and auditing and accounting standards under ROSC program.
- IFC activity as of March 1, 2010:
  - IFC has 30 projects (completed and ongoing) in Bulgaria with total commitments of over US$ 660 million.
  - Largest IFC investment: loan for construction of the largest wind park in Bulgaria (renewable energy).
  - IFC involvement: development of the Galata gas field; support for agricultural land investment and land consolidation; support for two specialized SME banks; establishment of Bulgaria’s first micro-lending bank; investment in a venture fund targeting SMEs.
  - Industrial projects include modernization/expansion of an electronics producer, a large steel mill, and two glass processing plants. Some projects include GHG reduction or emissions-monitoring components.

### Statistical issues — data provision and quality
- General:
  - Data provision generally adequate for surveillance purposes.
  - Bulgaria participates in the SDDS since 2003.
- Real sector (NSI responsibilities and practices):
  - NSI compiles national accounts consistent with SNA 1993 and ESA 1995; GDP by activity and expenditure reconciled in an annual supply and use framework.
  - Government output and final consumption are estimated on a cash basis.
  - Published national accounts include current and capital accounts for five main domestic sectors; financial accounts and balance sheets by institutional sectors compiled annually since 2006; quarterly financial accounts and balance sheets prepared by BNB.
  - Quarterly GDP estimates by production and expenditure approaches in current and constant prices compiled since 1994.
  - Preliminary flash GDP estimates produced 45 days after the reference period; quarterly updates disseminated 70 days after quarter end; final figures disseminated after approximately 5 quarters. Annual data disseminated about 5 quarters after reference year.
  - Constant price estimates use chain-linked indices.
  - Remaining problems: coverage of private sector activities and constant price estimates of capital formation and external trade; progress on export and import deflators.
- Price data:
  - NSI produces CPI, HICP (Eurostat methods), and PPI monthly.
  - CPI series begins in 1995; PPI in 2000; HICP in 2005 (earlier years set equal to CPI).
  - CPIs exclude some sectors (owner-occupied housing, health and life insurance); financial services included since 2004.
  - Work started on inclusion of owner-occupied housing in CPI within a Eurostat project.
  - Geographical coverage restricted to 27 urban areas accounting for an estimated 65 percent of sales.
- External trade and customs:
  - Customs data flow improved; new system for processing customs records near completion.
  - Development of export and import unit value indices progressing; additional Eurostat support expected.
  - NSI Import and Export Division meets monthly with BNB to ensure consistency between NSI trade data and BOP data.
- Employment and wages:
  - National account employment and hours compiled from Labor Force Survey and adjusted per ESA’95; monthly estimates from a quarterly establishments survey (excludes establishments with less than five employees; sample included 14,500 private employers out of approximately 142,000 qualifying private enterprises).
  - Household labor force survey conducted four times a year; improvements needed for consistency with establishment survey, especially agricultural employment.
  - Wage data compiled; shortcomings: (i) under-reporting of private sector wages; (ii) reporting of average gross earnings only, not wages for time worked and wages by occupation.
  - Since 2002, an earnings survey every four years provides average monthly and hourly earnings by activity, occupation, gender, and education.
  - NSSI administrative data used to estimate wages by occupation and age, number of self-employed, and employment in small firms. Household budget survey could be an alternative source for private sector wages.
- Census:
  - Population Census conducted in early 2001 supports redesign of household surveys (household budget and labor force surveys).
- Government finance:
  - Progress on implementing accrual accounting for government, budgetary and statistical systems following combined STA/FAD mission recommendations and EU accession fiscal reporting requirements.
  - Consolidated cash-basis data for general and central government operations routinely reported for GFS Yearbook/IFS.
  - Quarterly accrual GFS data reported for publication in IFS through Eurostat.
  - Since September 2008, MOF submits SDDS indicators for central government finances in IMF’s GFSM 2001 format; indicators published on MOF website monthly and quarterly.
  - MOF prepares monthly execution data of consolidated government budget in national presentation (not according to GFS standards); aggregate revenue, expenditure, balance and financing published monthly and posted on MOF website.
  - Progress in disaggregated data presentation, including expenditure by functional classification and full economic classification of expenditure available annually back to 1998.
- Money and banking statistics:
  - BNB reports monetary data for IFS publication based on ECB framework.
- Balance of payments:
  - Bulgaria provides quarterly BOP statistics for dissemination in IFS on a timely basis; yearly BOP data disseminated in BOP Statistics Yearbook up to 2008.
  - BNB derives other sectors investment income data on reinvested earnings (debit) from annual direct investment surveys of NSI and surveys of largest foreign-owned enterprises.
  - Since 2002, freight data series revised under a new methodology introduced jointly by BNB and NSI.
  - Since EU accession in January 2007, trade data with EU countries collected via INTRASTAT; trade with non-EU states and movement of goods within EU still recorded through customs declarations.

*Source: INTERNATIONAL MONETARY FUND — BULGARIA: Staff Report for the Article IV Consultation—Supplementary Information, Approved April 27, 2010.*

### 1.      New information has become available since the Staff Report was issued. The

### _cr10160 - 1.      New information has become available since the Staff Report was issued. The

### Major new information and overall implication
- New information does not change the thrust of the staff report but reinforces staff’s concerns in para 5 that fiscal policy in 2010 will be challenging, and raises the likely fiscal cash deficit for 2010.

### Fiscal policy: revisions, recent developments, and government response
- 2009 fiscal deficit on an accrual basis (EU concept) revised from 1.9 to 3.9 percent of GDP.
- Upward revision largely reflected previously unidentified payment commitments for capital, maintenance and hospital spending (1.3 percent of GDP) and exclusion of revenue of some cash dividends received in 2009.
- 2009 deficit on a cash basis changed marginally, from 0.8 to 0.9 percent of GDP.
- Preliminary data: cash deficit in the first three months of 2010 amounted to 2.4 percent of GDP.
  - Deficit partly reflects temporary factors: partial settlement of arrears and payment commitments built up in 2009; VAT receipts affected by temporary closure of the refinery in February reducing oil imports; repayment of VAT refunds accumulated in Q4 2009.
  - Underlying revenues appear weaker than expected.
  - The deficit has been largely financed by a draw-down of fiscal reserves.
- Government adopted a package of new fiscal measures estimated to yield about 2.4 percent of GDP.
  - Revenue measures include: sales of emissions under the Kyoto protocol (0.7 percent of GDP); introduction/increase in lottery, gambling, and luxury taxes; rent and sale of state-owned land.
  - Expenditure measures include: across-the-board cuts in current spending (0.7 percent of GDP); postponement in increases of special pensions; reduction in social spending; subsidies to the poor to be raised somewhat.
- Government expects to contain the cash deficit to 2½ percent of GDP (original target 0.7 percent of GDP; staff projection 1.8 percent of GDP in the staff report).
  - Deficit on an accrual basis would be slightly lower (2.0 percent of GDP).
  - Financing plans include additional privatization proceeds (0.4 percent of GDP) and issuing euro-denominated securities on the domestic market.
- Staff judgment: reaching the new deficit target with current measures alone may be challenging and more will likely be needed.
  - Risks: estimated overall impact of measures appears optimistic; risk of implementation delays.
  - Possible additional measures: increase in the VAT rate (raising VAT by 2 percentage points on July 1—option under consideration—could yield about 0.7 percent of GDP in 2010); increase in social security contribution rates; additional expenditure restraint (in particular, maintenance and subsidies).
  - The large and unexpected amount of 2009 payment commitments and arrears highlights the importance of timely and adequate fiscal reporting on an accrual basis.

### Economic outlook and macro projections
- Staff’s macro-economic projections remain broadly unchanged.
- Export recovery continuing: in the first two months of 2010, exports were 10 percent higher than a year earlier.
- Domestic demand and capital inflows remain weak.
- Government considering raising its GDP growth projection for 2010 to 1.0 percent; staff projections remain unchanged at 0.2 percent.

### ERM-II application and market reaction
- Following the revision of the 2009 deficit, the government has put its ERM—II application on hold.
  - Whether it will pursue the application this year depends on whether the EU commission will start an excessive deficit procedure for the 2009 deficit.
  - The European Commission has launched a procedure and will produce a report identifying whether an excessive deficit exists, tentatively scheduled for mid-May.
- Market reaction to the postponement muted:
  - CDS spreads changed little after the announcement, remaining in the 200 basis points range reached in weeks prior to the announcement—well below highs of over 650 basis points from a year ago.
  - In the last week, CDS spreads increased by 30 basis points, to 236, as contagion from Greece led to increases in Emerging Europe.
  - Stock market prices remained stable.
  - Ratings agencies have not changed outlook on Bulgaria; Moody’s announced a ratings upgrade is still possible in the next 12-18 months despite fiscal revisions.

### Executive Board assessment and recommendations
- Directors commended authorities for maintaining prudent macroeconomic policies through the global financial crisis.
- Directors noted:
  - Economy poised to recover after a sharp contraction; large private external debt and regional spillover risks pose downside risks.
  - Capital inflows likely to remain low; domestic demand expected to decline further, requiring adjustments by private and public sectors.
  - Wage moderation and structural reforms to increase productivity needed to reorient the economy toward the tradable sector.
  - Containing growth of public spending necessary given end of revenue boom.
- Fiscal policy 2010: Directors recognized challenges from revenue shortfalls and higher-than-expected payables and arrears; they endorsed government’s plan to implement package of measures, notably further cuts in current spending, and welcomed readiness to take further steps including tax measures.
- Medium-term fiscal advice for 2011 and beyond:
  - Larger role for fiscal policy in stabilizing the economy by focusing, within a medium-term budgetary framework, on the overall spending envelope rather than headline balances.
  - Encourage saving revenue windfalls and compensating any tax rate reductions by further expenditure cuts.
  - High-priority fiscal reforms: close gap between pension contributions and pension expenditures; improve efficiency and quality of the health care system.
- Financial sector:
  - Continued stability welcomed, underpinned by prudent regulation and adequate capital buffers.
  - Risks: rising non-performing loans and risk of reversal of parent funding to subsidiaries in Bulgaria.
  - Recommendations: remain vigilant, monitor liquidity closely, continue cooperation with parent bank supervisors, enforce cautious dividend policy, undertake contingency planning.
  - Welcome creation of a financial stability unit at the central bank and further improvements to the bank resolution framework.

### Key quantitative indicators (as reported in table "Bulgaria: Selected Economic Indicators")
- Real GDP: 2005 6.2; 2006 6.3; 2007 6.2; 2008 6.0; 2009 -5.0; 2010 0.2
- Consumer price index (average): 2005 6.0; 2006 7.4; 2007 7.6; 2008 12.0; 2009 2.5; 2010 2.2
- Consumer price index (end of period): 2005 7.4; 2006 6.1; 2007 11.6; 2008 7.2; 2009 1.6; 2010 2.7
- Employment (annual change): 2005 1.9; 2006 4.3; 2007 3.5; 2008 2.8; 2009 -4.0; 2010 -2.2
- General government overall balance (percent of GDP): 2005 2.4; 2006 3.5; 2007 3.5; 2008 3.0; 2009 -0.9; 2010 -2.5
- Gross public debt (percent of GDP): 2005 31.3; 2006 24.6; 2007 19.8; 2008 16.1; 2009 16.1; 2010 16.2
- Financial net worth (percent of GDP): 2005 6.0; 2006 9.9; 2007 10.2; 2008 11.5; 2009 10.8; 2010 8.9
- Broad money (M3) (annual percent change): 2005 23.9; 2006 26.9; 2007 31.2; 2008 8.8; 2009 4.3; 2010 0.3
- Credit claims on non-government sector (annual percent change): 2005 32.4; 2006 24.6; 2007 62.5; 2008 31.6; 2009 3.8; 2010 1.6
- Merchandise trade balance (percent of GDP): 2005 -20.2; 2006 -22.0; 2007 -25.1; 2008 -25.2; 2009 -12.1; 2010 -9.9
- Current account balance (percent of GDP): 2005 -12.4; 2006 -18.4; 2007 -26.8; 2008 -24.0; 2009 -9.4; 2010 -6.2
- Gross international reserves: 2005 33.7; 2006 35.4; 2007 41.3; 2008 37.3; 2009 37.8; 2010 37.8
- Exchange rate regime: Currency board arrangement; Leva per euro Lev 1.95583 per Euro

*Source: IMF staff report and Public Information Notice (PIN) for the 2010 Article IV Consultation with Bulgaria.*

### 2002. The level of public debt, however, remained low (about 16 percent of GDP) and is not

### _cr10160 - 2002. The level of public debt, however, remained low (about 16 percent of GDP) and is not

### Fiscal position and budgetary outcomes
- Public debt remained low at about 16 percent of GDP and is not projected to rise.
- Cash deficit was contained to just 0.9 percent of GDP following across-the-board spending cuts.
- Accrual-basis deficit is currently estimated at about 3.9 percent of GDP; the upward revision reflects:
  - accumulation of arrears due to previously unidentified payment commitments for capital, maintenance and healthcare spending;
  - exclusion of revenue of some cash dividends received in 2009.
- Accumulated arrears largely stem from ongoing revisions of annexes to contracts signed by various ministries before the elections; repayment has begun where revisions are finalized.
- For the 2010 budget:
  - The overall fiscal deficit of 0.7 percent of GDP budgeted for 2010 is judged hardly achievable.
  - The authorities estimate additional revenue measures to yield about 2.4 percent of GDP.
  - Resulting overall fiscal deficit for 2010 (on cash basis) is now estimated to reach about 2.5 percent of GDP and about 2 percent on accrual basis.
- Specific 2010 fiscal measures announced or under consideration:
  - Restructuring National Revenue and Customs Agencies to improve tax compliance.
  - Raised excises on cigarettes and taxes on real estate.
  - Freeze of wages and general pensions in 2010; no end-year bonuses to be paid.
  - Reduction in the number of civil servants by 3 percent.
  - Delay of the planned increase of pensions to widowers and those over 75 years old.
  - Capital spending and subsidies budgeted to rise contingent on higher absorption of EU funds.
  - Revenue-side measures under preparation: sales of emissions under the Kyoto protocol, introduction/increase in lottery, gambling, and luxury taxes, rent and sale of state-owned land.
  - Authorities stand ready to take further measures (including by raising the VAT rate) to preserve fiscal sustainability.
- Policy guidance agreed with staff:
  - Shift from ad hoc fiscal measures to a medium-term strategy of fiscal policy from 2011 and beyond.
  - Focus within a medium-term budgetary framework on the overall spending envelope rather than on headline balances.
  - Targeting real spending growth in line with cautious estimates of potential GDP growth to make public spending more predictable and prioritize spending.
  - Use revenue windfalls to build fiscal buffers.

### Financial system stability and central bank actions
- Financial system, dominated by the banking sector, remained stable.
- Following the global financial turmoil that started in 2007 and intensified after September 2008:
  - Foreign funding declined, resulting in strong competition for deposits and a sharp reduction in credit growth.
  - The interbank market was affected but calmed down after targeted steps taken by the central bank; subsequently volumes resumed and interest rates moderated.
- The BNB and banking-sector measures:
  - Banking system had built up substantial buffers due to prudent regulation in pre-crisis years.
  - Existing capital buffers together with countercyclical macro-prudential measures should allow the banking system to absorb increases in NPLs and associated provisions.
  - BNB asked banks to fully retain earnings to add to capital buffers.
  - BNB implemented additional countercyclical measures including:
    - alignment of its risk-weights on the EU standards (noted as less conservative);
    - inclusion of current and previous year earnings in the calculation of own funds.
  - Central bank intensified liquidity monitoring and initiated regular exchanges of information with parent bank supervisors in relation to developments in neighboring countries.

### Policy response to the crisis and fiscal consolidation
- The crisis effects were exacerbated by the political cycle and large spending increases in the run up to the July 2009 parliamentary elections.
- The new government reversed the trend with across-the-board spending cuts, especially maintenance and capital spending, containing the cash deficit.
- Authorities are implementing both revenue-enhancing and expenditure-containment measures to preserve fiscal sustainability amid possible further revenue slumps.
- Planned combination of measures (about 2.4 percent of GDP of revenue measures plus across-the-board cuts) intended to offset VAT shortfalls and higher payment obligations.

### Challenges ahead and strategic priorities
- End of the capital-inflow driven boom creates significant policy challenges and requires a swift change in policy priorities from convergence and raising living standards to preserving macroeconomic stability.
- Primary policy objective: prevent a confidence crisis by maintaining confidence in the currency board arrangement and the financial system.
- Fiscal policy is regarded as the key instrument given the currency board arrangement.
- Important policy challenge: shift to a medium-term fiscal strategy that controls overall spending envelopes and builds buffers for revenue shortfalls.
- The downturn led to a correction of previously built-up flow imbalances rather than a balance of payments or banking crisis; concerns that financial assistance would be required did not materialize.
- Need to provide a business-friendly environment to support recovery as capital inflows recover over time.

### ERM II, exchange rate, and commitment to euro entry
- Authorities maintain their long-stated position to seek joining ERM II at the earliest possible date.
- The ongoing global financial crisis may delay the process somewhat but has not changed authorities’ determination.
- Authorities have started talks with European partners and are ready to provide firm and detailed policy commitments.
- Plan is to uphold the currency board arrangement at the existing exchange rate until Bulgaria joins the euro area.
- The Bulgarian government and the central bank have committed to unilaterally maintaining a zero deviation of the exchange rate after Bulgaria joins the ERM II.

*Source: _cr10160 - 2002. The level of public debt, however, remained low (about 16 percent of GDP) and is not*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10160.pdf_