IMF AND BULGARIA AGREE TO 3 PERCENT BUDGET SURPLUS

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