“The impact of the global economic and financial crisis on the Bulgarian economy has been significant. Domestic demand has been hit by a sharp drop in capital inflows, which has led to a near-halt of credit growth, while exports have been affected by the recession in Bulgaria’s trading partners. As a result, the economy is now in a recession. Real GDP in the second quarter of 2009 was 4.9 percent lower than a year ago. Exports and manufacturing production have declined sharply, but imports have dropped even more, and the current account deficit has halved. Inflation has declined from almost 15 percent in June 2008, to 1.3 percent in August. The mission now projects that real GDP will decline by 6½ percent this year and by 2½ percent in 2010.

”Bulgaria started the downturn with considerable public sector buffers, including a large fiscal surplus and sizeable reserves in the fiscal reserve account. These buffers were important given its large private sector vulnerabilities—after year of large capital inflows, private sector external debt had increased to around 100 percent of GDP.

“Before the downturn, Bulgaria could combine fiscal surpluses with high expenditure growth, as revenue grew very rapidly—the result of the capital-inflows financing domestic demand boom. This revenue boom is now over, and if expenditure growth would not slow, the fiscal surplus could soon turn into a large deficit. During the first seven months of 2009, fiscal policy had not adjusted to the new economic environment. Revenue declined 10 percent from a year earlier, but spending was 24 percent higher. As a result, the 6.3 percent fiscal surplus of the first seven months of 2008 turned into a small deficit (0.6 percent of GDP). Without corrective measures, the 2009 fiscal deficit could have increased to more than 3½ percent of GDP.

”The new government is committed to address these emerging fiscal imbalances, and aims to balance the budgets in both 2009 and 2010 through a package consisting of both revenue and expenditure measures. On the revenue side, it plans to raise revenue compliance, by tighter onsite controls, the linking of the information systems of the National Revenue Agency and the customs agency, and the restructuring of both agencies. Other measures under discussion include an increase in the minimum threshold for social security contributions, and increases in excises on tobacco, electricity, and fuel for 2010 and 2011. These revenue gains will be partly offset by a reduction in the social security contribution rate. On the expenditure side, for the remainder of the year, the government aims at compressing maintenance and capital spending. For 2010, it plans to cut further slack in the provision of public services, downsize and optimize the public administration, freeze public wages, contain pension growth depending on economic development, reduce nationally financed public investment, and shift financing of public investment towards higher absorption of EU funds. These expenditure savings will be partially offset by an increase in pensions, particularly for widowers and those over 75 years.

“The renewed focus on fiscal discipline is welcome and necessary. Given its large private sector vulnerabilities, and the constraints imposed by the currency board, Bulgaria can ill afford to run large fiscal deficits. In the current economic climate, balancing the budget will be very challenging. On the revenue side, there are risks that the gains from increased tax compliance may fall short of expectations, while on the expenditure site, the envisaged cuts will require strong spending discipline. Given these risks, it is well possible that a small fiscal deficit could emerge in 2009, and a deficit of 2 percent of GDP in 2010, and higher deficits are possible if the economy were to contract more than expected.

”These risks call for vigorous implementation of the planned measures. To make the fiscal adjustment sustainable, expenditures will need to be reduced permanently. This could best be achieved by targeted cuts rather than across the board spending reductions. Enhanced administrative capacity will help in creating an appropriate environment for businesses and boost potential growth, while raising the absorption of EU funds. Plans to cut the social security contribution rate in 2010 and over the medium term should be considered only within the framework of a comprehensive pension reform, aiming at ensuring the sustainability of the pension system.

“The continued good health of the financial system is critical to an economic recovery. The capital adequacy ratio of the banking system is high (17.6 percent as of end-June 2009). Published statistics indicate that the banking sector on average remained profitable during the first half of 2009, despite the rise in provisioning for non-performing loans. Recent stress tests by the Bulgarian National Bank suggest that banks' currently strong capital buffers would cushion the system against further deterioration in asset quality.

”As the Bulgarian economy emerges from the recession, it will need to shift to a new growth pattern relying more on the tradable sectors. Wage growth will also need to be moderated. According to official statistics, public sector wages in the second quarter were 17 percent higher than a year ago, and private sector wages 14.3 percent higher.

“In sum, the global economic crisis has hit Bulgaria hard. In the near term, fiscal discipline needs to be restored in a difficult economic environment, and in the longer term structural reforms are key to steering the economy towards a more sustainable growth pattern. We welcome the commitments of the new government.”