Mission Concluding Statement 

Bulgaria: Staff Concluding Statement of the 2024 Article IV Mission

March 19, 2024

The Bulgarian economy showed resilience amidst a succession of shocks, and the outlook is that of rebounding growth and further declining inflation. Yet, inflation remains higher than in peers, and significant risks could push growth down and inflation up again. In this context, fiscal policy needs to strike a balance between supporting disinflation and not harming the recovery. This calls for a neutral fiscal stance rather than the expansionary 2024 budget. The banking sector is well capitalized, but rapid credit growth requires vigilance. Reinforcing the macroprudential framework would help reduce risks of asset quality deterioration. Looking ahead, and with the euro adoption in sight, policies need to tackle longstanding, intertwined challenges: poverty and inequality are significant and convergence toward EU average income is lagging peers while low investment and productivity and a shrinking population constrain economic growth. Fiscal reforms should aim at sustainably expanding space to address investment and social needs while structural reforms need to strengthen governance, boost productivity and competitiveness, and accelerate the green transition.

1. Growth slowed to 1.8 percent in 2023 from 3.9 percent in 2022. Strong real wages growth and higher pensions supported private consumption, but investment was hindered by uncertainty from global developments, political uncertainty, and delays in EU funds disbursement. Driven by lower energy prices and slower food price inflation, HICP inflation declined markedly, reaching 3½ percent in February. It remains higher than peers, though, presenting an immediate challenge for euro adoption. Core inflation remained above 4 percent.
2. Growth is expected to accelerate this year, and inflation to continue declining. Supported by the stabilization of the inventory cycle and a boost to public investment, growth is expected to reach about 2¾ percent. Global commodity prices are expected to continue declining, supporting disinflation. The decline in core inflation, however, will be slowed by strong wage and pension growth. Uncertainty is high and risks worsen the outlook. Notably, a stronger slowdown in trading partners’ growth than anticipated would affect growth, while an intensification of conflicts or geopolitical tensions could sharply increase commodity prices and rekindle inflation. Further postponements of euro adoption could negatively affect economic sentiment and investment.

A fiscal stance to balance growth and inflation

3. The budget 2024 is expansionary and, if implemented as is, would add to inflationary pressure. Fiscal policy played an important role in supporting the recovery from the pandemic but contributed to the inflation surge. While the fiscal stance likely helped reduce demand pressures in 2023, the 2024 budget is expansionary and, without adjustment, will add to inflationary pressures.
4. Fiscal policy needs to protect the expected small rebound in growth and let the disinflation process run its course. Reducing the planned 2024 deficit by about 1 percent of GDP would achieve a broadly neutral fiscal stance and balance these two objectives, considering significant downside risks to activity and upside risks to inflation in an environment marked by weak transmission of ECB’s monetary policy tightening. The adjustment would need to focus mostly on measures to permanently increase revenue:

• The 2024 budget appropriately seeks to increase social spending and investment. The planned increase in social spending and public investment (largely owing to EU funds) are needed to foster long-term growth and income convergence with EU peers.
• However, the 2024 budget lacks revenue reforms that would help sustain the increase in spending. Most increases in revenues are ad hoc and will not help sustainably meet expenditure needs. The increase in maximum insurance income is a welcome first step but is insufficient considering the growing fiscal transfers needed to meet pension system deficits. The projected revenue increase from improvement in tax collection is uncertain, and the dividend payments of 100 percent of state-owned companies’ profits risks undermining their financial health and ability to invest.
• Fully reinstating pre-pandemic VAT tax rates, targeting subsidies, eliminating the cap on social contributions, and increasing personal income taxation while making it more progressive would help achieve a more neutral stance and provide sustainably higher revenue. These measures should be introduced within well-designed reforms. It would not be advisable to seek a neutral fiscal stance by cutting investment (often the adjustment variable of first resort in recent years), as this would further weigh on long-term growth.

Fiscal reforms to support economic and social objectives

5. Fiscal reforms and a tight stance remain needed in the medium-term to preserve buffers and create space for large investment and social needs. Several considerations argue for a tighter stance than the planned deficits of 3 percent of GDP annually over 2024–26. First, strengthening public finance management to address the low efficiency of spending is a prerequisite to ensure that any new debt finances investment with high return. Second, buffers remain needed considering the uncertain, shock-prone global environment, and prevailing fiscal risks (e.g., from pensions and state-owned companies). Third, fiscal space should also be preserved for future investment once EU funding gradually recedes. Fourth, recurrent deficits could be perceived as a deviation from hard-won fiscal discipline, potentially widening risk premia and thus borrowing costs.
6. Fiscal reforms are crucial to sustainably raise social spending, invest in infrastructure and human capital, and improve governance. Immediate priorities include:

• Raising spending efficiency. Improving public investment management and governance, including public procurement and fiscal transparency, would help free resources and strengthen the capacity to absorb EU funds. The potential for increased efficiency of social spending (health, education, and social protection) is large and could help improve social protection coverage and boost human capital. A comprehensive review of public wages should inform the public wage policy.
• Reforming the pension system. Improving the financial sustainability of the pension system while improving the adequacy of pensions to reduce old-age poverty requires reforms that increase revenue (e.g., eliminating the cap on social contributions) combined with changes in the benefit formula to increase incentives to contribute. These measures would also help reduce inequalities.
• Reforming the tax system to make it fairer and address rising spending needs. Moving from the low corporate and personal income tax flat rates of 10 percent to higher and, for personal income tax, progressive taxation would help reduce inequalities and raise revenue. A gradual increase in the coverage of carbon taxation would help achieve emission targets and generate revenues for green investment and support to vulnerable households affected by the transition.
• Widening the tax bases. Revenue collection could be improved by ensuring the compliance of large taxpayers and other high-risk sectors, including through strengthened control and auditing processes. The planned merger of the National Revenue Agency and the National Customs Agency should be handled carefully to ensure the quality of core tax and customs functions. More broadly, strengthening governance and reducing corruption will enhance trust in institutions and improve tax compliance.
• Preventing the buildup of contingent liabilities from state-owned enterprises. Although total outstanding state-owned companies’ liabilities are more limited than in many other European countries, fiscal risks exist. State-owned companies are, on average, significantly less profitable than private firms, and several key state-owned companies continuously make losses, face liquidity pressures, or increasingly face difficulties to service their debt. Beyond fiscal considerations, improving state-owned companies’ productivity is also important due to their central role in the economy.

Structural reforms to raise living standards

7. Accelerating structural reforms is necessary to foster productivity, promote income convergence and, eventually, successfully integrate into the euro area. Addressing declining potential growth and slow income convergence requires higher productivity, more domestic and foreign investment, greater competitiveness, and further integration into global and regional value chains. Along with the timely implementation of the Recovery and Resilience Plan, supporting these goals requires:

• Strengthening governance and addressing corruption. Though important legal reforms have been recently enacted, the implementation of some Recovery and Resilience Plan milestones related to anti-corruption and rule-of-law reforms, such as judicial and asset recovery reforms, has been delayed, impacting the delivery of EU funds. Moreover, Bulgaria’s recent inclusion in the Financial Action Task Force (FATF) grey list due to deficiencies in its anti-money laundering/combating the financing of terrorism framework can negatively impact the economy. It will be important to continue efforts to swiftly implement the authorities’ action plan to align the legal, regulatory, and enforcement framework with FATF standards, and effectively implement these measures to mitigate anti-money laundering/combating the financing of terrorism risks.
• Investing in infrastructure and human capital. Priorities include upgrading the transportation and communication networks and reforming the education system through measures to increase life-long training, improve low and declining educational outcomes, reduce skill mismatch, further bridge the digital skill gap, and prepare the workforce for the rapid changes that artificial intelligence is bringing. Improving the quality of and access to health care is also important.
• Bolstering the green transition while preserving energy security. Bulgaria suffers from the highest greenhouse gas emissions intensity in the EU. As energy prices have declined, maintaining incentives for energy savings, investment in renewables, and reduction of coal use through price-based mechanisms and fiscal tools should be considered.

Macroprudential policy to contain financial sector risks

8. The banking system is resilient and systemic risks remain moderate, but vigilance to incipient risks remains needed. Overall, the banking sector is well capitalized, profitable, and liquid. However, real estate lending is rising rapidly, although households’ debt remains low. Exposure to commercial real estate, another potential source of vulnerability, also requires close monitoring. Considering the risks of a possible house prices-mortgage credit spiral and rising credit risks amidst elevated uncertainty, the recent increase in the countercyclical capital buffer was appropriate. Reinforcing the macroprudential framework with borrower-based measures would help preserve asset quality amidst high credit growth, especially ahead of a possible increase in lending market competition when the reduction in the minimum reserve requirement upon joining the euro increases liquidity.

The IMF team thanks the Bulgarian authorities and other stakeholders for their hospitality, candid discussions, and productive collaboration.