Sofia, Bulgaria
January 29, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

Economic developments in Bulgaria continue to be favorable and macroeconomic stability has been maintained despite the international financial crisis and the further deterioration of the external economic environment since the original program was framed. So far, the impact has adversely affected performance of commodity exporting enterprises, reduced investor interest, and precluded access to private international financial markets. The anticipated slowdown in global economic activity is likely to have adverse effects on the Bulgarian economy in 1999.

Against this background, the Government has modified its near-term economic objectives and adopted policies that are expected to safeguard the medium-term objectives of its three-year program of macroeconomic and structural adjustment supported by the EFF. The attached Memorandum on Economic Policies of the Government of Bulgaria updates and revises the Memorandum of September 9, 1998, and describes the policies for 1999. The Government is committed to ensuring macroeconomic stability while sustaining the drive to establish a competitive, predominantly private market economy. On the basis of performance under the arrangement thus far and the policies described in this letter, we request the completion of the first review under the arrangement.

The Government of Bulgaria believes that the policies and measures described in the attached Memorandum are adequate to achieve the modified objectives of its economic program, but it stands ready to take any additional measures as necessary to keep the program on track. The Government will remain in close consultation with the Fund in accordance with the Fund's policies on such consultations.

Attachment: Supplementary Memorandum on Economic Policies of the Government of Bulgaria

1. Macroeconomic developments have been favorable in 1998: real GDP is likely to increase by at least 5 percent, as targeted, while twelve-month inflation is expected to reach 5.9 percent, significantly below the program target of 9 percent. A substantial number of new jobs has been created in the private sector whose share in GDP is likely to reach about 65 percent of GDP by end-1998. Developments in the current account are broadly as anticipated, but official reserves will fall short of the original target, mainly owing to the postponement of the Eurobond issue and possibly lower privatization proceeds. Nevertheless, ample resources remain in the fiscal reserve account (FRA)-about U$1 billion at end-September-and the external debt ratio is estimated to fall to 81 percent of GDP at end-1998, as intended.

2. These favorable developments are the result of prudent implementation of fiscal policy, continuing structural reform, and the beneficial effects of Bulgaria's reorientation towards Western European markets which have grown strongly in 1998. Fiscal revenues have performed better than expected while pressures for excessive expenditure increases were resisted. Part of the excess revenues has been allocated to an additional investment program to help remove infrastructure bottlenecks. Even so, partly owing to lower than programmed use of the expenditure contingency provided to cover the costs of structural reform, we expect a budget surplus in 1998 compared to the balanced budget envisaged under the three-year program.

3. Because of the international financial crisis, which intensified after our three-year program was adopted, and the expected slowdown in the international economy, the outlook for 1999 is now less favorable and more uncertain. The impact of the crisis is being felt mostly through lower foreign demand and prices for key exports, less investor interest in Bulgaria, and higher risk premia on Bulgaria's external debt. We recognize the need to scale back some of our macroeconomic targets and to adopt policies that are adequate to deal with the changes in the external environment.

4. We are maintaining our medium-term objective of achieving 4-5 percent of real GDP growth per year, but for 1999 we have trimmed our growth objective from the envisaged 4.5 percent to 3.7 percent in recognition of the anticipated slowdown in global economic activity. Largely owing to lower international prices, inflation is now expected to reach 6.3 percent, down from the initial projection of 7.4 percent. Compared to the initial program, we anticipate that the global slowdown will reduce export growth and could have a dampening effect on private sector investment, including by foreigners. On the basis of cautious fiscal policy, we expect to be able to contain the current account deficit to about3.1 percent of GDP compared to the original program deficit of 2.7 percent. This remains consistent with favorable external and public debt dynamics. Access to private financial markets is now virtually precluded and inward portfolio flows have all but disappeared. As a result, we have postponed the Eurobond issue until international financial conditions improve and assumed that there will be no net non-bank financing for the budget in 1999. This has lowered the projected level of the FRA, but it is expected to remain at about US$1 billion in 1999. Total official reserves are expected to reach 6.1 months of imports of GNFS by end-1999, in line with the original program target.

5. In response to the crisis, we are implementing prudent fiscal policies geared at maintaining economic stability and with ample room for flexibility. While the currency board arrangement and limited access of the private sector to international capital markets should induce adjustment to external real shocks, we plan to monitor closely developments in the current account and stand ready to tighten the fiscal stance if the external current account deficit increases more than programmed. We will not allow structural reforms to slow down, and we are emphasizing implementation of measures to ensure continued financial discipline in the banking and enterprise sectors (Attachment I).

6. Taking into account the conservative macroeconomic and financing assumptions included in the original program and the stronger than expected fiscal stance in 1998, the revised economic outlook does not require a significant change in fiscal policies. Thus we plan to achieve a primary fiscal surplus of 3 percent of GDP (excluding the amount provided to cover the costs of structural reform), slightly above the original program target. However, in light of the greater uncertainty associated with the economic outlook we plan a cautious and flexible implementation of fiscal policies and have included significant safety margins in the budget. The fiscal stance will be tightened if developments in the current account indicate that the deficit for 1999 is likely to exceed the programmed level, for example through a deceleration of the public investment program or a reduction in other discretionary spending. Conversely, if the current account remained stronger than programmed, there could be room for an acceleration of the public investment program. Regarding expenditure management, the same mechanisms that have proven to be effective in containing expenditures in the past are also included in the proposed 1999 budget; the most important one is that only 90 percent of budget allocations for discretionary expenditures will be released, while the remaining 10 percent is only to be released late in the year if revenue performance and the fiscal balance are in line with the program. Additional flexibility will stem from the possibility to vary the implementation of the public investment program and other discretionary spending as needed. As before, if interest expenditures--which have been projected with adequate margins--turn out to be lower than planned, any favorable deviation will be saved.

7. With the stronger than expected revenue performance in 1998, we are confident that we can proceed with the planned reforms of the tax system; i.e. an effective broadening of the tax base and a reduction in marginal rates. As envisaged under the program, we are reducing the VAT rate from 22 percent to 20 percent, effective January 1, 1999, while eliminating existing exemptions. The five-year VAT exemption for basic food products, expiring on April 1, 1999, will not be renewed. In the context of removing tax preferences, holidays, and exemptions from the Foreign Investment Act and other legislation, the corporate tax rate will be lowered from 37 to 34¼ percent, and a regional investment tax credit of 10 percent will be introduced. The introduction of a 6 percent payroll tax for health insurance, effective July 1, will be offset by a reduction in social security and unemployment fund contribution rates and by revising the personal income tax brackets. On balance, these changes will have beneficial effects owing to the reduction in distortions and opportunities for rent-seeking, while their modest cost in terms of revenue losses will be offset by the effective broadening of the tax base. With the revised economic outlook and following the unwinding of one time factors favorably affecting the 1998 revenue performance, we now project total revenues to reach about 33 percent of GDP, down from an expected 36 percent of GDP in 1998.

8. Non-interest expenditures are expected to increase slightly in terms of GDP from an estimated 30.4 percent of GDP in 1998 to 31.1 percent of GDP in 1999. This is the result of a significant increase in social expenditures from 10.7 percent of GDP to 11.9 percent of GDP, while most other categories of expenditure are being reduced as a share of GDP. These additional social expenditures are necessary for direct assistance to low-income households affected by increases in administered prices for energy and transportation, and to cover the additional cost of health care services whose quality is being improved. Pension reform will start on January 1, 2000 in line with agreements reached with the World Bank to ensure that we are fully prepared for such reforms and that they are socially and fiscally sustainable.

9. A significant amount of the expenditure contingency for structural reform costs budgeted for 1998 has remained unspent and we plan to transfer most of this allocation to the 1999 budget where the amount provided will be raised from 0.4 to 1 percent of GDP, within the overall amount allocated for non-interest expenditures. These resources will be used mainly to cover the costs of structural reforms in the context of liquidation and privatization of state-owned enterprises and will be used only following consultation with Fund staff. The timing and modalities of any use of these resources will be judged in terms of the program's macroeconomic and structural objectives.

10. The success of tax reforms and the measures envisaged for 1999 depend crucially on continuing efforts aimed at strengthening tax administration, which are already yielding results. In this regard, together with the reorganization of tax administration along functional lines and with the long-delayed adoption of a register based on a Unique Identification Number (UIN), a more constructive dialogue will be established with taxpayers. In order to enhance voluntary compliance, we intend to intensify the training of tax officials and the taxpayers' education campaign, and strengthen the advance ruling service at the central level. The systematic cross-checking of all VAT invoices--which is proving to be too costly--will be terminated in the next few months and replaced by an audit strategy based on selective criteria. Tax and social security contribution evasion will no longer be tolerated.

11. To maintain confidence in our program, we plan to keep sufficient resources in the FRA. We have made considerable progress in settling official external debt issues. We willcontinue to work towards resolution of all bilateral debt issues and are committed to ensuring timely implementation of structural reforms so that associated official financing will allow us to maintain an adequate level of reserves in the FRA while meeting our external obligations. Considerable uncertainty remains about the level and timing of access to international financial markets. We have tentatively included the Eurobond issue in the budget for the second half of the year, since it requires parliamentary approval, but if it does not take place in 1999, we will plan to absorb this through a lower balance of the FRA. Privatization revenues continue to be projected conservatively and could be higher than planned depending on the outcome of some large privatization deals (telecommunications, Bulbank, and tobacco) that are currently in the pipeline. Excess privatization proceeds could be used to reduce Bulgaria's large external debt, provided adequate liquidity is maintained in the FRA.

12. Even though bank intermediation has improved, the Bulgarian banking system remains vulnerable as reflected in the decline in profitability in recent months owing to the international financial crisis. In response, we continue to strengthen banking supervision and we will enforce supervisory sanctions on banks that are not in compliance with regulations, in particular on open foreign exchange positions, which have been a source of losses recently. We are committed to introducing institutional and legal arrangements to ensure adequate supervision over non-bank financial institutions. We will appoint a director of the Deposit Insurance Fund and make sure the Fund is functioning effectively by end-1998.

13. Privatization to strategic investors is key to establishment of a sound banking system, but we recognize that the current financial environment is not propitious for swift bank privatization. While two state-owned banks are locked irreversibly into the privatization process, only one tender is likely to be issued by end-March 1999. In part the delay is for administrative reasons related to donor involvement in the financing of privatization agents. However, we expect to be in a position to issue the tender for the other bank during the first half of 1999.

14. Re-establishing control over the liquidation of closed banks continues to be a difficult challenge. The Bulgarian National Bank (BNB) has used all available means to urge the liquidators to proceed as quickly as possible but the court system is thus far unresponsive. Nevertheless, the BNB has been able to sell a significant proportion of the collateral from refinancing credits on which the closed banks had defaulted. The Ministry of Finance has invoked the State Financial Control Law in order to begin conducting special inspections (together with the supervision department of the BNB) in closed banks to establish whether any laws or regulations have been violated. Results will be available in early 1999. The government is exploring alternative means to resolve this issue and is studying the possibility of using amendments to legislation for this purpose. It is expected that a proposal will be ready for implementation during the first quarter of 1999.

15. We plan to underline our long-term commitment to the currency board arrangement through a redenomination of the lev, effective July 1, 1999: one new lev will equal onethousand old leva. Preparations are also being made, including through a public information campaign, for the introduction of the Euro on January 1, 1999.

16. The government is concerned about the adverse effects on enterprise performance of the deterioration in the external environment, especially as regards the remaining state-owned enterprises. The most affected enterprises are in the isolation program which we are determined to complete as planned by end-June 1999. For these and other state-owned enterprises, swift privatization remains our preferred solution, but we do not hesitate to begin bankruptcy procedures for clearly unviable enterprises. As a result, some 80 smaller enterprises have been entered into liquidation so far during 1998. Looking ahead, we are committed to maintaining the momentum of privatization, even if in the current environment this implies that we need to accept lower revenues.

17. Preliminary information on inter-enterprise arrears indicates that more than 80 percent of the arrears (which in total amount to 5 percent of GDP) are concentrated in 100 enterprises and that 10 enterprises are responsible for about half of these arrears. The restructuring of the energy sector that is currently underway, including the increase in tariffs and the explicit provision of budget subsidies, is expected to address a significant portion of this problem in the energy sector. For some enterprises, mainly in the chemical, fuel, and steel sectors, we are facing the difficult decision of coping with the global downturn in commodity markets through closure of these enterprises or through the explicit provision of financial assistance from fiscal resources (paragraph 9), provided in a way that avoids ongoing quasi-fiscal losses such as in the context of finalization of privatization. Discussions are being held with social partners and regional authorities to find a resolution for these problem enterprises. In some cases, workers have already agreed to labor retrenchment and significant, albeit temporary, cuts in wages.

18. The government has initiated discussions with social partners on an appropriate incomes policy for state-owned enterprises for 1999. While our review of the current policy found that the implementation of the incomes policy has been only partially effective, we are taking steps to strengthen compliance and we plan to extend the existing policy to 1999. We believe that the lack of effectiveness is mostly the result of implementation difficulties rather than fundamental flaws in the design of the policy. Although there were significant violations, the policy has contributed to declines in the wage bill in some loss-making enterprises and a freeze of the wage bill in two large, highly visible, state-owned enterprises--the refinery and the railways. We have taken measures to improve implementation: during May and June, 18 managers were dismissed because of failure to comply with the policy, and representatives of the state on the managing boards of enterprises will now be held personally accountable for ensuring compliance with the policy. We are also strengthening the monitoring of inter-enterprise arrears which will help detect violations of the incomes policy early on.

19. In the energy sector, the draft Energy Law was submitted to Parliament but we are committed to submit further changes in line with understandings reached with the World Bank. As a result, while most components of the sector's restructuring program are being implemented as envisaged, the accounting separation of National Electrical Company's generation, transmission, and distribution components is now expected to be completed in the first quarter of 1999 rather than by end-1998.

20. Progress is also continuing on agricultural reform: grain storage capacity is being privatized, legally binding titles to 18 percent of restituted land will be issued by end-1998, and three pilot programs for the use of warehouse receipts have been launched. We reiterate our commitment to limit subsidies, lending, and guarantees of the State Agricultural Fund in line with agreements reached with the World Bank.

21. We have made good progress towards implementing our program of trade liberalization and we intend to continue our efforts to address obstacles to domestic competition, if any. We are concerned about the potential for proliferation of red-tape and bureaucracy and intend to conduct a review, to be completed by end-March 1999, of existing domestic licensing, permit, and other regulatory requirements to see whether any exist that might be inhibiting the growth of the private sector.

22. Recognizing the pressing need to improve macroeconomic statistics to guide policy formulation, we plan to increase resources devoted to the compilation and publication of statistics by the National Statistical Institute and the BNB. This will allow the publication of a monthly industrial production index by March 1999 and identification of the methodology and technical assistance needs for a financial sector survey by mid-1999.

23. Reflecting the importance of maintaining the momentum of structural reforms, some of the structural benchmarks have been converted into structural performance criteria. Quantitative performance criteria for end-March and end-June 1999 and quarterly indicative targets for the remainder of 1999 have been set on the ceiling of the deficit of the general government, the floor on the balance of the fiscal reserve account, the floor on the deposits of the Banking Department, the ceilings on tax arrears, and the ceilings on contracting and guaranteeing of external debt of 1 year and under, over 1 year, and 1-5 years. Quarterly indicative targets have been set on revenues of the general government and net credit from the banking system to the general government. Other performance criteria--applicable on a continuous basis--remain as defined in the Memorandum of September 9, 1998.