UNCLAS SECTION 01 OF 02 SOFIA 000187

SIPDIS

USDOC FOR 4232/ITA/MAC/EUR/OEERIS/SAVICH

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON EINV BU

SUBJECT: IMF AND BULGARIA AGREE TO 3 PERCENT BUDGET SURPLUS
TO REIN IN LARGE CURRENT ACCOUNT DEFECIT

REF: A) 05 SOFIA 1925 B) 05 SOFIA 2120


1. (SBU) SUMMARY: The recent January 19-26 IMF mission to
Bulgaria succeeded in reaching an agreement on economic
policies for this year. The agreement entails radical
fiscal tightening through a three percent budget surplus and
a credit growth rate target of 17.5 percent. The IMF
commended Bulgaria's fiscal performance over the last two
years of maintaining a budget surplus of two percent, and
the Central Bank's efforts to curb the credit growth rate.
However, strong domestic demand has brought an excessively
high current account deficit of 14.6 percent causing the IMF
to push for the stringent measures using the government's
only two available levers. Talks with the IMF have flagged
structural reform delays and the inability of the Socialist-
led government to formulate a sound medium-term economic
policy. This successful review secures continuation of the
existing Precautionary Standby Agreement of USD 146 M, which
expires in late 2006. END SUMMARY.

RADICAL FISCAL TIGHTENING
--------------


2. (SBU) The IMF and the Bulgarian government agreed to
target a three percent budget surplus in 2006 to counter the
country's dramatic widening of the current account deficit.
The IMF resident representative, James Roaf, told us the
government's positive fiscal performance last year - a
budget surplus of 2.4 percent - was slightly higher than the
original target. During recent negotiations, the IMF
initially pushed to have a budget surplus greater than 3
percent in 2006, while the Bulgarian government said 2.8
percent was more realistic. However, in the face of the
higher-than-expected current account deficit, the GOB
finally agreed to a three percent budget surplus this year.
The three percent target could be lowered at the end of the
year depending on whether the current account deficit falls,
but Minister of Finance Plamen Oresharski told Amb. Beyrle
that he did not think that was likely.


3. (SBU) Bulgaria's current account deficit -- in spite of

booming foreign direct investment, tourist revenues and
other transfers -- was 14.4 percent of GDP for January
through November, 2005. The IMF now estimates it at 14.6
percent for all of 2005, well above its earlier projection
of 7.5 percent of GDP for 2005. At the 2005 rate, Bulgaria
is among the countries with dangerous levels of current
account deficits. This causes investors to raise questions,
Roaf said. However, he feels that for now, Foreign Direct
Investment (FDI) is preventing a balance of payments
problem. FDI covers 77.5 percent of the current account
deficit, but the IMF is concerned since export growth has
been outstripped by a more rapid increase in imports. The
concern lies more in the macro situation, i.e., with the
National Accounting Identity.


4. (SBU) The IMF projects the current account deficit to
drop to 12.6 percent in 2006, encouraged by the budget
surplus target and Central Bank resolve to further cut
credit growth. Credit restrictions succeeded in moderating
credit growth, from over 50 percent in 2004 to 32 percent in

2005. The IMF believes that the Central Bank's measures
will further reduce bank credit growth to 17.5 percent,
targeting a slowdown of bank lending to households.
However, commercial banks are still able to circumvent those
measures by setting up special purpose vehicles or leasing
companies, Roaf admitted. The pace of credit expansion has
caused concern at the IMF as it has substantially
contributed to an increase in domestic demand, which led to
the external imbalances. However, there is no serious
deterioration of the banks' portfolio quality, and the
increasingly competitive banking sector is well-regulated,
Roaf said.


5. (SBU) Bulgaria's inflation rate rose to 6.5 percent in
December 2005, and is expected to exceed 8 percent early
this year. This is mainly due to the GOB's tactical
decision to increase excise taxes this year in order to not
suffer a large jump in inflation in 2008 when Bulgaria
should be under evaluation for entry into the Euro-zone.
Under the current and projected future environment, Bulgaria
will have a hard time meeting the Maastricht criteria for
their goal of 2010 entry. Regardless of Euro posturing,
there is a risk if the trend continues of prices getting
ahead of productivity.


SOFIA 00000187 002 OF 002


THE IMF WORRIES ABOUT STRUCTURAL REFORMS
--------------


6. (SBU) Roaf shared with us the IMF's disappointment with
the Socialist's (leader of government coalition) inability
to formulate a well thought-out economic plan to address
structural reforms. He cited several areas of concern about
Bulgaria's medium-term outlook, which the government must
address early in order to sustain its positive macroeconomic
performance. Specifically, the IMF has urged the GOB to
monitor more closely the operations of the duty-free shops
at the land border crossings and those situated inland.
These shops have been facilitating smuggling (primarily of
cigarettes, alcohol and gas), depressing customs revenues by
an estimated 170 million leva (about USD 106 million), and
nurturing political corruption. The IMF recognizes its
limited leverage to push the government to close duty-free
shops, but insists on better state control and hopes EU
entry will force the government to eventually close down the
shops. The IMF has also called for reforms to strengthen
the operation of the business register; restructure and
privatize the energy sector; reform the labor market;
implement tax legislation; and reduce employment in public
administration - all areas where Embassy Sofia has been
active.

THE FUTURE ROLE OF THE IMF
--------------


7. (SBU) The relationship between Bulgaria and the IMF has
been a constructive one, and the IMF remains supportive of
the Socialist-led government. IMF supervision of Bulgaria's
economic policies in the run-up to EU accession is strongly
backed by Minister Oresharski. In fact, he told the
Ambassador that he enjoys pointing to the IMF or EU when
challenging his colleagues on the need for tighter fiscal
practices or legislative changes. The two-year
precautionary stand-by agreement with the IMF expires in
September 2006, but active monitoring will involve only
economic performance through June 2006. Roaf told us that
extension of the current agreement through the end of the
year will assure that the Bulgarian government sticks to the
agreed macroeconomic policy and accelerates structural
reforms. The IMF and the government will resolve this issue
in May.


8. (U) In the meantime, the government has continued to
lessen the debt burden by pre-paying on February 1, a debt
of 151.4 million euro owed to the IMF. The Bulgarian
government carried out the first repayment of its IMF debt
ahead of schedule in December 2005 in the amount of 147.4
million euro. As a result of the two transactions, the
remaining debt to the IMF and government external debt
decreased to 393.7 million euro and 5.39 billion euro (25.5
percent of GDP), respectively.


9. (SBU) COMMENT: In the end, as Roaf told us, no one at
the IMF thinks a small fiscal surplus will be able to fully
tame such a large current account deficit. But because it
is one of the only tools available to Bulgaria - whose
currency is pegged to the Euro - they must use it. This
will also draw attention to the issue and highlight the need
for the Central Bank to further tighten credit. With the
new economic policy in place, the IMF appears positive about
Bulgaria's outlook for 2006. The Socialist-led government,
however, still has a ways to go before Bulgaria bids
farewell to IMF conditionality and reverts to normal member-
country relations with the IMF. In the run-up to EU
accession, IMF supervision should provide the necessary
mechanism for insulating the economic agenda from the
effects of political infighting and assure necessary
structural reforms are being implemented.

BEYRLE