Sofia, Bulgaria, May 28, 1999

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

Dear Mr. Camdessus:

1.  We are pleased to inform you that our adjustment and reform program has for the most part continued to be successful: inflation remains low, fiscal performance has been strong, the liquidation and privatization of loss-making state-owned enterprises is being accelerated, and most end-March 1999 performance criteria under the extended arrangement have been observed. Nevertheless, we have missed three structural performance criteria and one quantitative performance criterion set for end-March 1999. In what follows we describe the outcomes with respect to these performance criteria and outline our response, which in all cases is already underway. Let us assure you that we remain steadfast in our commitment to the overall strategy that we have been following with the Fund's support since early 1997, and will continue to follow despite the Kosovo crisis.

2.  In recognition of the weaker-than-envisaged external environment we have tightened fiscal policy to keep Bulgaria's external position sustainable. Through March, there was a surplus in the general government accounts amounting to 24 billion leva or approximately ½ percent of GDP, and a primary surplus well in excess of that anticipated in the program for end-March. We expect that the primary surplus for the year will be over the program target for 1999 by at least 0.5 percent of GDP, and are prepared to implement additional measures to achieve this outcome. We intend to maintain the tighter fiscal stance largely through continued expenditure restraint as we believe any increase in the tax burden beyond our target could extinguish the fragile economic growth underway. The regional conflict has necessitated humanitarian assistance provided to our neighbors and increased defense expenditures, but we will more than offset these additional expenditures through (i) continuing to release only 90 percent of budgetary allocations for discretionary expenditures, (ii) reassessing the priorities of the investment program, and (iii) achieving savings in the budgeted wage bill (including through larger-than-envisaged cuts in budgetary employment).

3.  While overall revenue performance has been strong, tax arrears remain a problem. Indeed, we missed the end-March 1999 performance criterion on tax arrears of the large monitored taxpayers and enterprises in isolation by a significant margin. To some extent, the arrears reflect structural inadequacies in monopolistic enterprises and the need to strengthen tax administration. We have discussed measures to improve the collection of taxes and social security contributions with a Fund technical assistance mission, and are committed to implementing without delay their key recommendations which include broadening the use of the unique identification number (UIN), unifying the bases for various taxes and required contributions on personal income (especially for those persons claiming a self-employed status), and improving coordination and exchange of information between the tax and social security agencies. More fundamentally, however, the large arrears are the result of serious problems with certain enterprises, particularly Neftochim and Bulgargaz. For the former enterprise we continue to expect that privatization will result in the performance improvements needed to enable it to compete effectively and improve its tax compliance. The more difficult situation is in Bulgargaz as it is an enterprise that will not be privatized in the near term. After much deliberation we have decided that a bold restructuring is needed for this enterprise (see paragraph 5). Furthermore, we are committed to utilizing the structural reform resources in the budget to write off tax arrears in enterprises in the isolation program that are being privatized (see paragraph 6). Nevertheless, recognizing that the various reforms described above will take some time to have their full impact, we request that the tax arrears performance criterion for end-June be modified so that it will more realistically reflect what can be achieved under the current circumstances. Following discussions with IMF staff, we propose setting an end-June 1999 limit of 505 billion leva for the monitored enterprises. Reaching this target assumes that the structural contingency funds in the budget can be used in a manner that ensures a reduction in tax arrears by 70 billion leva. If this proves infeasible, the end-June tax arrears will be correspondingly higher. From end-June, we will ensure that no new tax arrears will be accumulated by Bulgargaz, Neftochim, and BDZ (the enterprises accounting for some 95 percent of total tax arrears), and by end-September, we will ensure a notable reduction in tax arrears as a result of the strategy outlined above.

4.  We continue to implement a tight incomes policy based on market-related principles for state-owned enterprises. As a demonstration of our commitment to the policy we agreed to keep the aggregate wage bill at the Q3 1998 level in nominal terms during the first two quarters of 1999 for the 100 most problematic enterprises. Furthermore, we agreed that no more than 10 of these enterprises would exceed the target. As to the overall level of the wage bill we achieved a remarkable success—a decline of 7.6 percent. Nonetheless, we failed to achieve the goal for individual enterprises, with 14 (representing 8.3 percent of the total wage bill for the 100 companies) missing the target. Of these enterprises, 2 raised the wage bill in the mistaken view that they had been privatized in Q1 but last minute problems led the finalization of the deals to be postponed until April. In 5 others, exceptional factors, such as the unusually harsh winter, led to increased overtime for a large portion of the employees where it would have been impossible to deliver essential public services without exceeding the wage bill limit or where increased orders necessitated additional working hours. For all enterprises in violation of the policy we have written to management for explanations. Undoubtedly we will find cases where there is no justification for the outcome. For such cases we will, as we have in the past, take appropriate action to fine or replace management and tighten our control. We wish to stress that this is the first time such intensive supervision has been placed on so many enterprises and that through learning by doing we are fully confident that this performance criterion will be observed in the second quarter of the year.

5. We continue to make steady progress on energy sector reforms. We have met the performance criterion on the accounting separation of the National Electricity Company, thereby laying the groundwork for the provision of financial data that will serve as the basis for the eventual break up of the company into generation, transmission, and distribution components. We continue to work on the Energy Law with the World Bank. We hope to have the Law passed through a second reading in the National Assembly by the end of June, and believe it lays out the essential prerequisites for a competitive energy market within an appropriate regulatory framework. We have reviewed the rehabilitation plans of the District Heating Companies following the politically difficult decision for dramatic increases in heating prices. We have found that to date 30–40 percent of customers have cut themselves off from district heating, and our aim is to win those customers back with improved service and appropriate monitoring and pricing. We anticipate, with financing from the EBRD and World Bank, to improve the efficiency of heat production, reduce losses from transmission, and install regulators and meters so that those who receive heat pay for it according to their actual consumption. The legal structure of the companies is also being transformed to open them to private sector investment. With respect to Bulgargaz we are at a more preliminary stage but are fully committed to its fundamental restructuring. As the first step, we have already formally requested World Bank assistance for drawing up a financial recovery and restructuring plan, and look forward to working with the Bank's experts to come up with a comprehensive plan by mid-1999, with a speedy timetable for implementation. To demonstrate our commitment, the following measures will be implemented as new structural performance criteria under the extended arrangement: (i) by end-June 1999, the Council of Ministers will approve an action plan for Bulgargaz, including the outline of a comprehensive financial recovery and restructuring program based on recommendations by World Bank experts, and (ii) by end-September 1999, the Council of Ministers will approve a fully elaborated program, with a detailed timetable for implementation. Bulgargaz has already undertaken measures for increasing the collectability of its receivables. It has signed concrete agreements with all debtors recognizing their liabilities and establishing repayment schedules. In general these schedules have been complied with. If these schedules are not complied with, we impose interest penalties, and if the stock of arrears actually increases, gas supplies will be cut. Moreover, we are already arranging for a full international audit of the company. Besides financial rehabilitation, the plan will address a full range of restructuring and regulatory issues. In particular, we intend to restructure the gas sector in a manner which ensures the transparent regulation of Bulgargaz's monopoly functions of transmission and storage, and promotes competition in the sector whenever possible providing that it does not violate the existing contracts for gas supply. Concrete mechanisms to improve the competitiveness of the Bulgarian economy will be included in the action plan and the fully elaborated program to be adopted by the Council of Ministers.

6.  We are moving rapidly to restructure and privatize the remaining state-owned enterprises (SOEs). Several large SOEs, including the Bulgarian Telecommunications Company, have been prepared for sale, and we are determined to complete the privatizations rapidly despite the difficult external situation. We will privatize or liquidate the remaining 11 enterprises in Group B of the isolation program according to the timetable agreed with the Fund and the World Bank. We will also enhance our control over the Group A enterprises as discussed with the World Bank in the context of FESAL II, and will shortly issue a government decree extending the isolation regime for them beyond the mid-1999 expiration date of the isolation law.

7.  We believe we will be able to sell this year all three of the state-owned banks currently on the market. At the beginning of 1999 we solicited indicative competitive offers for Express bank and at end-March formed a short list of preferred potential buyers who are permitted to perform due diligence on the bank. Two potential buyers have already completed this process, and we anticipate that they will all be in a position to make binding offers by the end of June. Despite indications that the current climate for Bulbank is not favorable in light of the regional conflict, we and the agent have not hesitated to move forward with the marketing of the bank, and we fully expect that by end-June we will be in position to call for binding offers, thus meeting the respective performance criterion. We have marketed Hebros Bank directly, thereby saving the time involved with holding international tenders for privatization agents. We are optimistic that this strategy will result in a sale by the end of the year.

8.  With recent efforts, we have found a solution to accelerate the liquidation of 11 already closed banks. The failure of court appointed trustees to accelerate the process had led us to search for an alternative strategy. However, we underestimated the legal complexity of the issue and the time needed to reach a consensus within government on how to deal with this long-standing problem. Although we missed the end-March performance criterion for the submission to the Council of Ministers of the needed legislative amendments, we have subsequently completed the required action by drafting the amendments as part of the package of changes to the Law on Banks that had already passed its first reading in the National Assembly. Thereby we have regained the lost time, and now anticipate the legislation to be finalized in early June and the liquidation procedure itself to be completed within 4 months. The Ministry of Finance stands ready to absorb the remaining assets of the liquidated banks. Hence, we expect to report on the positive conclusion to this process at the time of the next program review. As to the framework for future bank liquidations, we have not yet decided whether a separate law on bank insolvency is needed or whether we can work within the current general commercial code. We intend to reach a consensus on this issue soon which may then lead to a request for rapid technical assistance from the Fund.

9.  The need to analyze the impact of the Kosovo crisis on our economy has reinforced our belief in the importance of a good statistical base. Unfortunately, we were unable to meet the specific performance criterion related to the monthly industrial production index owing in part to a lack of adequate information and methods. Nevertheless, we plan to begin an experimental monthly inventory series and remain fully committed to the publication of a monthly industrial production index from June 1999. We have also requested information and technical assistance from the Fund to assist us to develop this index which was the specific commitment under the performance criterion. We are grateful for the speedy reply we have received on both accounts, and we will endeavor to provide our full support to this project and to the implementation of the technical assistance recommendations. Our overall commitment to improving the quality of statistics is shown by our recent decision to volunteer on a pilot basis for the GDDS.

10.  The current regional crisis is the third major adverse shock in less than two years to affect our economy and the reform program. The record shows that despite these setbacks we have persevered in achieving remarkable fiscal performance, liberalized trade, implemented our commitments to raise domestic energy prices, contained the wage bill in the state-owned enterprises, and advanced our privatization and liquidation programs. We do not underestimate the task ahead, and recognize that the discipline imposed by the currency board has revealed further deep problems with which we are committed to deal. However, we believe that our goals have been ambitious and this, rather than a lack of resolve, is the main reason for our need to request waivers at this time. At this critical juncture we will not hesitate to take decisive action to meet our objectives but also rely on continued Fund support, in particular to assist us in attracting the strategic foreign investors and financing that are needed to transform our economy. As always, we continue to work closely with Fund staff and stand ready to consult with them whenever appropriate during these difficult times. Based on the performance under the arrangement so far and the policies described in this letter, we request waivers for the nonobservance of the above-mentioned four performance criteria for end-March 1999, as well as a modification of the end-June 1999 performance criterion on tax arrears.