EU-Report Accession Bulgaria

The existence of a functioning market economy

There has been continued support for the medium-term economic reform programme and for EU accession-related policies. Tight fiscal policies and market-based economic reform are among the main objectives of the new government. There is a broad consensus on the fundamentals of economic policies. Announced policies have mostly been implemented by government, although sometimes delayed or softened for social reasons. In February 2002, the International Monetary Fund approved a two-year stand-by credit and a first review has been successfully concluded in July 2002. Prior to the programme's approval a ``Memorandum on Economic Policies of the Government and the Bulgarian National Bank'' had been submitted which was re-confirmed in the context of the first review. It specifies the economic policy programme based on the currency board arrangement (CBA) at least until accession to the EU, a cautious and flexible fiscal policy aimed at a balanced budget over the medium term and an acceleration of structural reforms to create a fully functioning and competitive market economy. In August 2002, the Bulgarian authorities submitted their latest pre-accession economic programme which had been prepared by the Ministry of Finance, following consultations of social partners, NGOs, academic circles and various government institutions. This programme confirms the government commitment to its reform agenda.

Macroeconomic stability has allowed sustained economic growth at an average of almost 4% since 1998. This was the case in spite of successive adverse external conditions, including the Kosovo crisis, the conflict in the Former Yugoslav Republic of Macedonia, the economic crisis in Turkey and the global economic slowdown. Last year, real GDP growth was 4%, despite a slowdown following more adverse global economic conditions during the year, and real GDP growth in the first quarter of 2002 is estimated at 3.2% (compared with the corresponding period of 2001). It was largely based on buoyant domestic demand, while the external balance continues to be a drag on growth. Investment growth was high at 20% in 2001. Although the investment-to-GDP ratio has increased over the years, it stood at only 17.8% in 2001 which is still relatively low for a sustained process of catching-up.

The high current account deficit continues to reflect the gap between domestic savings and investment, but is exceeded by net inflows of foreign direct investment in most years. Total foreign debt declined to below 80% of GDP and this was further accelerated in March 2002 by a swap of Brady bonds against fixed interest rate bonds denominated in both EUR and USD. Exports of goods remain low and this contributes to a high trade deficit, which is only partly balanced by exports of services, in particular tourism.

Unemployment increased until 2001 due to the high pace of restructuring of the economy and some regional and skills mismatch. The unemployment rate increased steadily from 12.2% in 1998 to 19.9% in 2001 in spite of high economic growth. Registered unemployment in the first half of 2002 was lower than in the corresponding period in 2001 and stood at 17.0% of the labour force in July 2002. However, the amount of employment in the large informal economy as well as in agriculture is difficult to assess. The presence of a large informal economy tends to add some flexibility to a labour market which is formally rather highly regulated and characterised by high non-wage labour costs. An improved functioning of the administrative system, which will reduce the informal sector and tax evasion, should therefore go in parallel with an increased labour market flexibility and lower non-wage labour costs in the formal sector of the economy. Social partners do not yet have sufficient responsibility at a decentralised level for labour relations, including wage bargaining. The proper functioning of the labour market is also hampered by the fairly low regional mobility of the workforce, caused by a combination of mentality, imperfections on the housing market and underlying skills mismatches between regional labour demand and supply.

Bulgaria continues to adhere to the currency board arrangement which was introduced in July 1997 and fixes the Bulgarian lev (BGN) against the euro. Due to higher inflation than anticipated, real short-term interest rates turned negative at the end of 2001. The broad monetary aggregate M3 grew by 18% in nominal terms and by 9% in real terms between March 2001 and March 2002. As, under the currency board, money supply is determined exclusively by economic actors' demand for money, this shows that the economy is being remonetised and that money demand is being re-established after its strong decline in the 1996-97 period of high inflation. The currency board arrangement continues to be well covered by foreign exchange reserves.

The introduction of the currency board arrangement has contributed to containing inflation. Inflation, measured by the harmonised index of consumer prices on annual average, has come down to 7.4% in 2001. Compared to the corresponding month of the previous year, inflation was low at the end of 2001, increased to somewhat higher levels in the first quarter of 2002, following increases in indirect taxes and food prices, and declined again in the second quarter of 2002 due to lower food prices. The overall yearon-year growth of administered prices declined from three-digit rates at the beginning of 1998 to 23.3% in May 2002. Inflation excluding administered prices was fairly volatile with negative rates in 1999, positive rates around 10% in 2000 and 2001 and a rate of 2.7% in May 2002.

Fiscal policy has been tight. The general government deficit has been below 1% of GDP in all years. In 1998 and 1999 there was even a surplus. Low deficits and high nominal GDP growth contributed to a constant reduction of general government debt to a level of below 70% of GDP in 2001. In 2001, the government implemented an income tax reform in order both to gradually shift from direct to indirect taxation and to reduce the revenueto-GDP ratio. Corporate and personal income tax rates were reduced by several percentage points in 2001 and 2002 to maximum 23.5% and 29% respectively, and are now fairly low by international standards. VAT refunding was speeded up by further reducing its legal deadline from 4 to 3 months and was made more resistant to fraud by an obligation to open a VAT bank account. Reforms of the pension and health care systems have been implemented to reduce long-term fiscal risks, but the already high social security contributions require further attention in view of an ageing population. For 2002, the government has kept a budgetary reserve of 0.3% of GDP which will only be spent if there is no deterioration of macroeconomic conditions. Despite the pursuit of fiscal consolidation, general government gross fixed capital formation has varied between 3% and 4% of GDP in all years, except 1997.

The macroeconomic policy mix has been adequate. In the absence of monetary policy instruments and changes to exchange rates, fiscal policy has been the main instrument of macroeconomic stabilisation. The tight fiscal policy pursued was appropriate in order to stabilise the currency board arrangement and to avoid a pro-cyclical stimulus to demand, which, in view of the high growth rates and the still limited capacity of the Bulgarian economy, would have triggered further inflationary pressures and an increase in the already high current account deficit. The current account deficit has so far not been a problem, since it allowed higher investment than domestic savings alone would do and was covered by net inflows of foreign direct investment except in 2001. In order to maintain external competitiveness vis-à-vis the euro area as the main trading partner against which the Bulgarian lev had some real exchange rate appreciation, wage increases in the budgetary sector, which tend to serve also as a benchmark for the private sector, should remain within the limits of real productivity increases in the private sector plus the euro area inflation rate.

Liberalisation of prices has progressed, but further steps need to be taken. The number of goods and services with administered prices has decreased. In 2001 prices for coal were liberalised, but prices for tobacco, water supply, electricity, gas, heating, medicines, postal services and telecommunications are still administered or regulated. Measured by their shares in the consumer price index in 1997, their weight went down from 14.5% in 1997 to 13.2% in 2002. However, due to their increased weight in the consumer price index, in particular because of increased demand for telecommunication services, more than one fifth of inflation is still arising from the adjustment of administered prices. In July 2002, a three-year schedule for an increase of approximately 50% in electricity prices for households was decided.

Private ownership has become predominant in the economy. In 2001, 73.4% of all employees were working in the private sector. The private sector's share of gross value added grew from 63.4% in 1997 to 71.7% in 2001. Houses and land are largely in private hands since land restitution was finalised in 2000. More than 90% of all forest land property has been restituted until April 2002. Between the start of transformation and April 2002, 4821 privatisation deals were concluded so that 79.8% of all assets slated for privatisation (i.e. all assets of enterprises not on a shortlist for definitive public ownership) have actually been privatised and less than 2000 companies remain to be privatised.

New privatisation procedures were set up in 2002. These are intended to accelerate the privatisation of the remaining state-owned assets (chiefly telecommunications, banking, insurance, energy, maritime transport, and tobacco) in a more transparent and efficient way through auctions, tenders and public offering of shares. Management or employee buy-outs, which have created many problems in the past, are no longer treated preferentially. 1500 minority stakes in companies will go to a specific segment of the stock exchange. 360 companies are for direct sale and 100 are provisionally excepted from privatisation either because they are not for sale for reasons of national security or because they need prior restructuring. One of the two remaining state-owned banks (Biochim) was sold to a foreign bank in July 2002 and an 80% share of the last stateowned insurance company, the State Insurance Institute (DZI), was privatised in August 2002. By early September 2002, a buyer for 80% of the national tobacco company (Bulgartabac) was selected, but the finalisation of the procedure was still under preparation, and a short list of bidders for 65% of the telecom monopoly (BTC) was established. Given that post-privatisation commitments of previously privatised companies were often not met because they proved to be too demanding, procedures for post-privatisation control have also been simplified.

Market entry and exit are still not working properly, although the situation is improving. The proportion of new companies (including self-employed) in the business register relative to all existing companies was 11.7% in 2000 and 6.6% in 2001. At the same time, the number of companies eliminated from the business register was 0.8% in 2000 and 0.7% in 2001. While these figures indicate high, though falling, net creation of new firms, they may also reflect both the overall business cycle and a lack of rigour in market exit procedures. Market entry is still hampered by numerous licensing procedures, which slow down start-ups and bind considerable amounts of enterprises' and public administrations' resources. In 2002, a working group at the Ministry of Economy proposed to eliminate 74 of the 360 regimes existing at central level and to simplify 120 of them, for which the government is carrying out the corresponding legislative procedures. Still, administrative obstacles will continue to exist at local level. Reforms of the customs and tax administrations are ongoing in order to enhance the sometimes very poor performance of these institutions. In spite of these improvements, many businesspeople still complain about considerable problems of starting and running a business because of red tape, corruption, slow administrations and courts. Regarding market exit, insolvency procedures remain to be slow. For the year 2001, courts statistics show that 408 insolvency cases were pending from previous years, 457 new cases were initiated, decisions were taken on 433 cases, so that 432 cases were still pending at the end of the year. Domestic legislation currently does not specify a deadline for insolvent debtors to pay outstanding dues to their creditors, so courts have to find evidence of the debtor's inability to pay. In order to speed up insolvency proceedings, the government has presented a draft amendment to the Commercial Code which states that a company which fails to make an outstanding payment within 60 days after the date the payment was due will be considered insolvent. In addition, special legal chambers have been created to deal exclusively with bankruptcy cases. A new bank bankruptcy law has been adopted in September 2002 which should increase transparency and speed up procedures mainly by giving a strong control on the receivers' activities to the Banking Deposits Guarantee Fund. Although progress has been made, a number of firms are still operating at a loss, implicitly subsidised through a toleration of arrears on wages, taxes, social security contributions and bills from state-owned suppliers, without being forced to restructure or close down.

Enforcement of property rights remains difficult in some areas. The slow proceedings of the judicial system often discourage parties from taking cases to court, which contributes to the lack of reliable enforcement. Progress has been made in reducing red tape, but these still impose substantial costs on the private sector. Whilst large foreign companies are sometimes able to bridge these shortcomings in the legal and regulatory environment by turning directly to political decision-makers, this path is not always available to smaller or domestic companies. The enforcement of intellectual property rights legislation is insufficient, and this contributes to widespread software and audio-visual piracy and counterfeiting. Housing property is mostly clearly defined and markets are working properly. However, in spite of the finalisation of land restitution, the number of transactions and the prices of agricultural land are low due to a range of factors such as fragmented land plots with often shared ownership, insufficient documentation of ownership in land registries and slow legal disputes as well as low expectations of making profits in agriculture. This is a serious impediment to increasing productivity in agriculture and it is estimated that currently about 25% of the farmland is idle. Efforts are being made to modernise the land registration system, also with the support of international donors, but this takes time.

Following the crisis in 1996 and 1997, the banking sector has been restructured and is gradually developing. Since the crisis, when 17 banks were closed down, the number of banks has stayed more or less constant (35 at the end of 2001). Following major privatisations in 2000 (Bulbank) and in 2002 (Biochim), 85% of commercial banking in terms of total assets is in private hands of which about 80% is majority foreign-owned. Government still controls the State Savings Bank (DSK), accounting for 12% of total commercial banks' assets, which is scheduled for privatisation in 2003. The Municipal Bank of Sofia and the Encouragement Bank, whose mandate is to support SMEs, account for the remaining 2.5% of banking in state control. Banks have maintained a policy of prudent lending which has contributed to a low rate of banking intermediation. Credit to the private sector is very low, but increased steadily from 10.5% of GDP in 1999 to 14.4% of GDP in 2001. Accordingly, the capital adequacy ratio, although declining over the years, is still high (31% in 2001). This loan restraint also keeps systemic risks to banking within close limits. The situation as regards non-performing loans steadily improved from 21.3% (December 1997) to 6.5% (March 2002). Interest rate spreads in terms of average short-term bank lending and deposit rates have decreased slightly, but remain high at some 10 percentage points, possibly due to a lack of alternatives to banks, but also due to the average risk profile of borrowers in the country.

The non-banking financial sector is still in its early development stage. The stock exchange remains underdeveloped and is largely illiquid with very low turnover despite a high number of companies quoted. The market capitalisation of companies listed on the Bulgarian Stock Exchange was EUR 678 million or 4.5% of GDP in June 2002. The government intends to improve the situation by means of privatisation and by gradually shifting from foreign to domestic sources of financing public debt. The ratio of gross premium income of all insurance companies (including life and non-life insurance) to GDP was still rather low at 1.6% in 2001.

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