Sofia
September 9, 1998

Dear Mr. Camdessus:

The Government of Bulgaria successfully stabilized the economy and substantially advanced long-delayed structural reforms under the economic program supported by the stand-by arrangement with the Fund which expired last June. As a result, the economy is recovering from the severe economic crisis of early 1997, inflation is low, and the conditions for growth are favorable. The recovery remains fragile, however, and we are still at an early stage of our goal of transition to a competitive, predominantly private market economy.

In order to consolidate the gains already achieved and to remove the structural impediments to sustainable growth and rising living standards, we have developed a comprehensive three-year macroeconomic and structural adjustment program, covering the period July 1998–June 2001. The main elements of the three-year program and the details of the first-year program thereunder are described in the attached Memorandum on Economic Policies of the Government of Bulgaria (Memorandum). In support of this program, we request on behalf of the Government financial support from the Fund in the form of a three-year extended arrangement in an amount equivalent to SDR 627.62 million (135 percent of quota).

The Government of Bulgaria believes that the policies and measures described in the attached Memorandum are adequate to achieve the objectives established under its 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. In addition, we will complete with the Fund comprehensive reviews of the program as provided for in the Memorandum.

Attachment: Memorandum on Economic Policies of the Government of Bulgaria

2.  The challenge we now face is to build upon this initial success by accelerating and deepening structural reforms aimed at establishing a competitive, predominantly private market economy. Achieving this objective will require aggressive pursuit of a broad array of structural reforms to improve resource allocation and remove the impediments to sustainable economic growth. This will ensure significant improvements in the standard of living of Bulgarian citizens and will prepare Bulgaria for EU accession, one of the main goals established in our program Bulgaria 2001. We believe strongly that the success of our efforts will depend importantly upon support from the international community in terms of financial resources, technical assistance, and access to foreign markets.

4.  To achieve these objectives, we will rely on prudent fiscal and incomes policies, the continuation of the CBA, and the implementation of an ambitious reform agenda aimed at fostering private sector initiative and investment (Attachment I). Our priorities in the structural areas are to complete privatization of the state banks and enterprises; develop and deepen financial markets; improve and restructure social safety net programs; strengthen the tax system and its administration; reform the agricultural and energy sectors; further liberalize the exchange and trade regimes; and develop the administrative, legal, and judicial institutions necessary to underpin a competitive market economy.

5.  We expect that these policies will raise productivity and attract a significant amount of investment (both foreign and domestic) which will sustain higher growth over the medium term. We will rely strongly on investment by the private sector and will put in place policies that will ensure the efficiency of such investment. Investment by the public sector will play a complementary role and will be focused on infrastructure.

6.  Successful implementation of structural reform and liberalization measures will be the key to raising living standards on a sustainable basis. Incomes and wages have the potential to grow significantly over the next three years as comprehensive structural reform measures yield large productivity gains. Such gains are likely to be larger in the tradeable goods sector, allowing wage growth to outpace inflation without jeopardizing competitiveness. In turn, this mechanism will contribute to price increases for non-tradeables which will be the main reason that domestic inflation exceeds EU rates.

8.  The coverage of the budget will be widened to improve transparency, ensure that no hidden fiscal costs or offsetting operations occur, and increase accountability. In July we established a public register of government guarantees to help keep track of contingent liabilities of the budget. We have also established strict criteria for granting government guarantees and a limit on their annual and total amounts. Guarantees will not be given to enterprises with tax arrears or commercial enterprises in isolation. Starting with the 1999 budget we will present in the budget the cost of restructuring and liquidation of enterprises and will consolidate extra-budgetary funds on a gross basis. We plan to eliminate the earmarking of privatization proceeds and budgetary revenues to various extra-budgetary funds and to abolish the two larger funds: the Energy Resource Fund (ERF) and the State Fund for Reconstruction and Development (SFRD). Their activities will be incorporated into the budget so as to provide accurate information on fiscal activity and increase accountability. Over the course of the three-year program, we intend to separate, corporatize, and privatize commercial activities now included in the budget.

9.  In the areas of tax policy and administration, our aim is to maintain sufficient revenues to meet expenditure requirements while achieving a fairer incidence of the tax burden and lower marginal tax rates. At present this burden is high and is being borne mostly by a shrinking public enterprise sector through high marginal tax rates and social security contributions. We are implementing measures to improve the efficiency of the tax system by broadening the tax base and redoubling efforts to capture the growing private sector in the tax net. We are eliminating most tax exemptions and exceptions and reducing existing tax preferences in the 1999 budget. As a matter of priority, we will abolish the preferences granted under the Foreign Investment Act, which have been largely ineffective, and will incorporate any tax incentives for investment (as agreed with Fund staff) in the appropriate tax legislation. We will strengthen tax administration by enhancing enforcement and compliance, while reducing compliance costs. In this regard, a reorganization of tax administration along functional lines is crucial, starting with headquarters. We will not allow any further increase in tax arrears of enterprises in isolation and liquidation and for other enterprises we will ensure that tax liabilities are reduced according to agreed schedules. From the 1999 budget onwards any operations consisting of offsetting arrears to the budget against direct or indirect claims on the budget or public enterprises will be prohibited. Of key importance in strengthening tax administration are the adoption of a unified identification number and further improvements in the functioning of the large taxpayers offices (LTOs). If these policies are successful in raising revenues, over the medium term we would progressively lower marginal tax rates including VAT rates, but we remain committed to a single VAT rate. We also plan to lower social security contribution rates to reduce taxation of labor, but we intend to proceed cautiously in this area, consistent with the needed reforms of the pension and health systems (paragraphs 11 and 12) and progress in strengthening the collection of social security contributions from the private sector.

10.  On the expenditure side of the budget we are facing considerable challenges relating to civil service reform, the reform of the major expenditure systems, in particular social assistance, health and pensions, and the need to support investment in infrastructure. In tune with the changed role of the government we are implementing administrative and civil service reforms with the objective of establishing a streamlined, accountable civil service, insulated from political interference and with more adequate remuneration. We already reduced employment in the budget sphere by 10 percent (58,000 staff and positions) during 1997 and we plan a further 4.5 percent reduction (24,000 staff) during 1999–2001. To establish rights and obligations of the civil service, we will enact a new civil service law by the end of this year, and during 1999 we will adopt regulations establishing qualifications and procedures for obtaining and retaining positions as well as a code of conduct. On social assistance, we are consolidating the existing programs and improving their targeting which, inter alia, will allow us to address the consequences of the phasing out of price subsidies for household energy and public transportation. The most important step has been to increase targeted support for the most vulnerable by raising the level of real income supported under the means-tested Differentiated Basic Minimum Income Program; we are in the process of consolidating this program with our in-kind support scheme for household utility payments.

11.  Despite overcapacity in Bulgaria’s health care system, broad health indicators of the population have been deteriorating. We have started to implement reforms that will reallocate existing resources within the sector through the elimination of overcapacity and overlapping delivery of services and shift them towards improved outpatient care. Over the medium term, health care will require additional resources which will be provided through the establishment of a National Health Insurance Fund (NHIF); legislation for this purpose has already been passed. On July 1, 1999, a 6 percent payroll tax will become effective, but its burden on employment will be broadly offset by other measures (paragraph 40). The contracting of services between the NHIF and doctors and hospitals is to begin in January 2000 and 2001, respectively. The transitory costs of the rehabilitation of remaining health care facilities will be included in the budget of the consolidated government. We are well aware of the need to proceed cautiously with these reforms and to maintain tight controls to avoid an unsustainable escalation of health care costs. To ensure that the necessary reforms take place prior to effectiveness of the NHIF, we have adopted the Doctors and Dentists Professional Organizations Act and we will adopt the Health Facilities Act by end-1998. In addition, each year an annual limit on health care expenditure will be established in the budget and benefits, eligibility, and fees defined within this limit.

12.  In its present form, Bulgaria’s pay-as-you-go pension system is financially unsustainable over the medium term as a result of an aging population, generous early retirement categories, a low statutory retirement age, and low effective contribution rates. To restore actuarial solvency to the pension system, we plan to establish a three-pillar pension system consisting of mandatory pay-as-you-go and fully funded components, and a voluntary component. In the initial stage, we plan to phase in a higher retirement age and reduce eligibility for and contributions to early retirement schemes. The cost of these initial measures is estimated at about 1 percent of GDP per annum but will be offset in due course as a higher retirement age is phased in. We are introducing progressively a well-defined link between contributions and benefits and, at a later stage, we plan to introduce a fully funded mandatory component. By the end of 1998 an appropriate regulatory framework will be in place for the voluntary pension component, or third pillar (paragraph 20).

13.  To complement private investment, the public sector plans to increase its involvement in infrastructure investment. However, direct contributions from the budget are not planned to exceed 2.5 percent of GDP annually over the program period. The remaining state-owned enterprises (SOEs) are also expected to raise their investment, largely financed from internally generated resources. Through concessions, we plan to attract significant risk-sharing private resources for investment in ports, roads, and the energy sector. Our main challenge will be to ensure an adequate rate of return for these projects so that any additional debt contracted or guaranteed for this purpose can be serviced without added burden on the budget and the economy. As a rule, we will not provide any government guarantees for loans except for projects financed or co-financed by international multilateral financial institutions, if required. For investments done through the budget, we will begin implementing a three-year rolling public investment program from 1999 onwards. We will maintain flexibility in the implementation of the public investment program so that it can be used as a tool to help manage aggregate demand in the economy.

14.  As part of the rationalization of financial and debt management we plan to improve the existing treasury function as recommended in the FAD technical assistance report with the aim of establishing a complete treasury function by the end of the EFF period. We plan, inter alia, to reduce substantially the number of first level spending units and bank accounts starting with the 1999 budget.

16.  We have shifted the focus of our bank privatization strategy to selling the best state banks first so as to attract the additional capital and expertise needed to establish a competitive banking system. In August we concluded a stock purchase agreement with a foreign investor for 78 percent of the equity of Postbank, and by end-October we will issue tenders for two other state-owned banks of which the sale is expected to be completed during the first few months of 1999. We anticipate selling a fourth bank later in 1999. The fifth state-owned bank will be placed under a management contract with a foreign manager in the fall of 1998 and will be prepared for privatization. Implementation of this strategy is well underway and is following the procedures agreed with the EU as a condition for technical and financial assistance.

17.  To stimulate sound financial intermediation, we need to strengthen the banks’ capacity to assess the creditworthiness of borrowers and enforce loan recovery, including when necessary the timely recovery of collateral. We plan to review and amend, as needed, the law on registered pledges, the banking law, and the bankruptcy law taking into account technical assistance recommendations. We will streamline court procedures for the realization of loan collateral and ensure proper functioning of the register of pledges and credits. Several other reforms will directly or indirectly enhance bank intermediation, including the improvement in accounting standards for enterprises and the land titling process. To set an example, we will expedite the liquidation of closed banks which has been subject to excessive delays and poor governance. To avoid distortions in bank operations we will phase out government intervention in credit markets through subsidies or guarantees.

18.  The transformation of the State Savings Bank (SSB) into a commercial bank and the initial phase of its preparation for privatization are expected to be accomplished during the EFF period. At present the SSB’s capacity for lending is still limited and restrictions will be placed on its operations to prevent a deterioration of its loan portfolio. Significant expansion of its lending will initially only be allowed in strongly collateralized loans to households. Lending to enterprises will not exceed 75 percent of capital by end-1998 and the 1999 limit will be established by end-1998 taking into account developments in SSB’s loan appraisal capacity. Agricultural credits extended for the 1997 harvest will be collected, if needed through calling on government guarantees that were extended for this purpose. We will ensure that the SSB is in compliance with all banking regulations by the end of the third quarter of 1998. To strengthen the SSB’s loan appraisal and monitoring capacities, a comprehensive technical assistance program will be implemented under the auspices of the EU. As capacity improves, restrictions on the SSB’s operations will be lifted gradually, a process that is expected to be completed in about two years when the transitional full deposit guarantee is planned to be removed.

19.  Effective banking supervision will contribute to a healthier banking system and help avoid quasi-fiscal deficits. We have enforced full compliance with the 8 percent capital adequacy requirement and will raise it further to 12 percent by end-1999. The three small banks that are not yet meeting the increased minimum capital requirement which became effective on July 1, 1998 have been notified that failure to comply by end-August will result in termination of their license. We will review and tighten regulations on open foreign exchange positions and large loan exposures and we will adopt new regulations and guidelines as needed, beginning with the issues of consolidated supervision and interest rate risk. We are continuing to implement a detailed program to develop off-site and on-site banking supervision, including staff training, an internal bank rating system, and an early warning system. We have completed enhanced supervisory audits with foreign assistance of the two weaker state banks and will do so for the SSB by end-August with the objective of formulating a program containing restrictions on operations and actions to strengthen these banks as needed.

20.  Developments in other segments of Bulgaria’s financial markets are picking up pace. We plan to adopt this year an amended securities act that will facilitate the development of the stock market and put in place an appropriate regulatory framework and adequate supervision. We will also strengthen the securities and stock exchange commission through staff training, adoption of appropriate information technology, and reliance on foreign advisors. Voluntary pension funds are expected to play an important role in developing the domestic capital market and in transforming the pension system. It is essential to safeguard the value of these funds through an adequate legal separation of the fund’s assets from the assets of management companies and the imposition of limits on the type of assets in which these funds can invest. No investment will be allowed in unlisted companies and the total value of investments in government securities, cash, and demand deposits in domestic banks by any voluntary pension fund shall not be less than 50 percent of its portfolio initially. Voluntary pension funds will be allowed to invest up to 10 percent of their portfolios in high quality foreign assets. This is an initial step in our strategy of increasing Bulgaria’s integration in the global financial system (paragraph 28). Voluntary pension funds will also be allowed to participate in voucher privatization through separate funds established specifically for this purpose.

22.  We have adopted a flexible approach to privatization, employing a wide variety of methods tailored to the size and nature of the enterprise. For smaller enterprises we have vested the responsibility for privatization in the relevant line ministries and municipalities and we expect that they will be able to sell half of the assets under their purview by the first quarter of 1999. This process relies heavily on auctions and management-employee buyouts (MEBOs) which emphasize speed rather than revenue. To accelerate this process further, we will eliminate the binding reservation price for auctions in which more than one bidder participates. To avoid problems with post-privatization governance we will eliminate the advantage enjoyed by MEBOs by applying an appropriate discount factor for MEBO bids involving deferred payment schemes. For larger enterprises the responsibility for privatization rests with the privatization agency (PA). We are relying on foreign consultants for the privatization of pools of large and medium-sized enterprises. To guard against a loss of momentum in this process we have clarified the responsibilities of these agents and urged them to expedite privatization, a process which we are monitoring through frequent meetings with the agents. We are modifying legislation to facilitate the restructuring of enterprise debts to the state related to earlier recapitalization of banks (Zunks) and to prevent restitution claims from hampering privatization. We plan to reduce the emphasis on secondary objectives such as commitments on investment and employment as criteria for selecting investors but we will continue to favor strategic investors with an established corporate profile and international presence. We have included some large enterprises (telecommunications, tobacco, electricity, and the refinery) in the privatization pipeline and we have begun to implement the second round of mass privatization. To improve the transparency of the voucher privatization process, we will announce prior to the first centralized auction a list of assets that will be made available for voucher purchases. Placement of shares on the Bulgarian Stock Exchange will provide an additional avenue for privatization.

23.  The largest loss-making enterprises have been isolated from the banking system since October 1996 and have been subject to implementation of financial rehabilitation programs. Fourteen of the 41 commercial enterprises in this isolation program have been liquidated or privatized but about 15 are unlikely to be privatized or liquidated by end-1998 as originally targeted. For these enterprises we will continue effective isolation through mid-1999 when all of them are expected to be privatized or liquidated. For utilities and monopolies in the isolation program (especially district heating, railways, and urban transportation) restructuring efforts will be strengthened and accelerated in order to achieve financial viability. We will provide for explicit subsidies in the budget to cover the losses of these companies and will restrict their access to bank credit. We will review the financial performance of state-owned enterprises that have not been subject to isolation to identify loss-makers. If privatization of these enterprises cannot be completed expeditiously, we will implement administrative measures to enforce financial discipline. We are also instituting a monitoring system for inter-enterprise arrears to help detect problem enterprises.

24.  Incomes policy continues to be a useful tool to exert financial discipline on state-owned enterprises and will continue to be implemented until these enterprises are fully subject to market discipline. The incomes policy ordinance adopted by the Council of Ministers in January 1998 will remain applicable for the remainder of 1998. The policy, which applies to SOEs, will continue to be tailored to the performance of the individual enterprises. The wage bill can be increased only when labor productivity increases and only in enterprises that are profitable, are not incurring any new arrears, and are servicing outstanding arrears since end-December 1997 on schedules agreed with their creditors. The effectiveness of the policy will be reviewed regularly. At present we are taking measures to bring enterprises that have violated the provisions of the incomes policy decree back into compliance including by freezing their wage bills. Enterprises under the isolation program will be able to increase their wage bills only after they have demonstrated compliance with the incomes policy ordinance as verified by the relevant line ministry and the isolation unit in the Ministry of Finance. Implementation of incomes policy will be subject to program reviews, and agreement on the 1999 incomes policy will be a condition for completing the first program review.

26.  While the prospects for investment flows to emerging markets have become less favorable, the private sector should be able to obtain adequate external financing given its low indebtedness and the low share of Bulgarian assets in international portfolios. However, meeting the public sector’s sizeable external amortization payments will remain a challenge. Our financing strategy relies on sustained implementation of the structural reform program to attract significant privatization revenues and official external financing on appropriate terms to help cover most of this external debt service. To assist this process, we will continue our efforts to resolve all outstanding bilateral disputes with Paris Club creditors. Our balance of payment projections show financing requirements of around US$1.6 billion over the next three years. We expect to meet these requirements mainly with external support from official creditors (including the IMF, the World Bank, the EU, and bilateral creditors). This assistance will be supplemented by modest access to international capital markets as the source of external financing of the public sector shifts gradually toward private international capital markets. However, given the recent turbulence in international financial markets, there are considerable uncertainties about the timing and modalities of such access and we plan to implement prudent external debt policies consistent with a reduction of the external debt burden.

27.  In order to increase the integration of Bulgaria in the global economy and assist in keeping inflation low under the CBA through external competition, the government attaches great importance to maintaining a liberal and nondistortionary trade system. Building on progress made so far, the government will (i) remove discretionary elements from the trade regime, (ii) permanently eliminate all remaining export taxes, with the temporary exception of that on timber, (iii) progressively reduce the average and maximum level of tariff protection and the number of tariff rates, and (iv) eliminate the import surcharge. In order to pave the way for small and medium-sized enterprises to enter export markets, parliament adopted legislation to promote exports through an export credit insurance agency. However, to limit the risks posed to the budget, the budget laws from 1999 will contain an explicit ceiling on the total amount of exposure that this agency can accumulate under government guarantees.

28.  We will review (i) our foreign exchange system and related regulations with a view to accepting the obligations of Article VIII, sections 2, 3 and 4 of the IMF’s Articles of Agreement by end-1998 and streamlining our foreign exchange approval procedures, and (ii) our regulations on capital account transactions and develop a phased plan for further opening of the capital account in a manner consistent with the continued operation of the CBA during the period of the EFF-supported program. In order to facilitate the inflow of long-term capital we will review and streamline the administrative procedures for foreign investment.

30.  We have adopted a comprehensive reform program for the energy sector to restore its financial viability and ensure efficient allocation of resources. We plan to phase out all subsidies, initiate appropriate pricing mechanisms, and create a regulatory environment that is conducive to private sector participation in the energy sector so that much needed resources for investment can be attracted on commercial terms without incurring excessive budgetary liabilities and risks. Core elements of our medium-term program for the electricity sector are: (i) increasing tariffs progressively to 72 leva/kwh (4 cents/kwh), the estimated long-run average cost, by April 2001 starting with an increase to 62.8 leva on January 1, 1999; (ii) establishment of a sound legal and regulatory framework; (iii) liberalization of the market for electricity generation; (iv) breakup of the national electricity company into separate entities for generation, transmission, and distribution; and (v) privatization of major non-nuclear generation assets.

31.  Around two thirds of the sales of district heating companies (DHCs) are at an average price which covers only about 60 percent of marginal short-run costs, causing financial losses estimated at over 1 percent of GDP per annum in addition to severe decapitalization of these enterprises. District heating losses have also been a source of intransparent quasi-fiscal operations and cross-subsidization through extra-budgetary funds which has contributed to a culture of non-payment in the energy sector. We realize that a long-term solution to this problem is to rehabilitate district heating companies where no economical alternatives are available and to close them in other cases. We will begin by ensuring transparent accounting for the operations of district heating companies. For this, we will eliminate the Energy Resource Fund by end-1998; deal with any arrears of DHCs without further offsetting operations; include a pre-announced, fixed allocation for district heating in the budget each year; and use the contingency funds if ex post cost overruns occur. We will phase out heat subsidies by gradually increasing average district heating prices to cover the fuel component of DHC costs before the 1998–99 heating season, 90 percent of marginal short-run costs by mid-2000, and to cover fully such costs from Q2 2001. Moreover, we will clearly define the regulatory framework for DHCs, put in place measures to raise average collection rates to about 90 percent by 2001, facilitate the installation of metering and control devices at end-users, and allow entry into the market of heat provision by private energy service companies. As regards other areas of the energy sector, we will deregulate the price of domestic coal and briquettes by end-1998 for non-households and by mid-2000 for households; and the price of briquettes by mid-2001, phasing out state subsidies. We will allow concessions for selected coal mines, privatize non-core activities, and close most non-viable sections of coal mines during 1999–2000. We will also create a free retail market in natural gas for households.

32.  We will reduce the role of government in agriculture by phasing out direct financial support for agricultural activities except for the provision of extension services and infrastructure. As a first step, we have decided to refrain from providing government financing or guarantees for the purchase of the 1998 harvest. To create a thriving, market-driven agricultural sector, we will (i) eliminate interventions in the market through automatic and non-automatic licensing and export taxes; (ii) abolish the contract pricing system and any remaining price or profit margin controls; and (iii) complete 80 percent of land restitution by end-1998. To foster the emergence of a functioning land market and provide an impetus to bank lending, we will create a land cadastre and a unified registry of land ownership, and by end-1998, provide final, legally binding titles to 18 percent of arable land and repeal the conveyance tax on land sales and leases. We will also remove restrictions on land leasing by the third quarter of 1998 and finish privatizing all mills and bakeries by end-1998. We have begun rapid privatization of grain warehouses and will develop a warehouse receipts system consistent with commitments under the World Bank ASAL. To foster bank lending for investment in agriculture, we have enabled the State Fund for Agriculture (SFA) to provide loans and interest subsidies. However, the SFA will not provide such subsidies after end-1999, and we have established quantitative ceilings for 1998 on such loans (leva 30 billion) and on the total amount of subsidies outstanding (leva 13 billion).

33.  Given the importance of improving the statistical base for macroeconomic decision making, we attach high priority to the timely availability of quality macroeconomic statistics. We will be working towards adopting the IMF’s General Data Dissemination System (GDDS), facilitated by our continued cooperation with EUROSTAT, and by our future participation in the new Phare program of statistical cooperation aimed at developing our statistical system. We will also follow through on technical assistance recommendations received, and ensure that adequate resources will be allocated for improving the timeliness and quality of high frequency indicators of economic developments, quarterly national accounts, balance of payments, and banking statistics. Finally, we will review the legislative basis for the collection of statistical data and amend it, if necessary, by June 1999.

35.  With economic developments deviating significantly from projections and uncertainty about the impact of tax reforms and asset revaluation on revenue performance, managing fiscal policy proved challenging during the first half of the year. One-time factors contributed to much better than expected revenue performance causing the budget to record a surplus of about 2.5 percent of annual GDP during the first six months. To address pressing needs we intend to spend this surplus during the remainder of 1998, thus achieving a balanced budget for the year. However, we will make sure that these expenditures do not result in permanently higher spending commitments by limiting increased spending to one-time expenditures. Part of the additional expenditures will consist of an extra month of wages in the budgetary sector and an extra month of pensions, to be disbursed in early December. This will mitigate the consequences of the large price increases of coal and heating (30 percent) that will take effect before the start of the 1998/99 heating season and railways (15 percent), and the increase in electricity prices (14 percent for households) on January 1, 1999. Also, some additional capital spending will be used to effect major repairs of schools. The expenditure contingency (about 1¼ percent of GDP) will be used for as yet to be identified transactions that are not expected to have any significant macroeconomic impact (e.g., debt restructuring in the context of privatization). Other expenditures will be in line with the budget.

36.  On the revenue side, underlying performance is expected to weaken somewhat during the remainder of the year mainly as the result of lower than programmed inflation. We are strengthening efforts to collect outstanding tax arrears which we intend to reduce by about half or the equivalent 0.6 percent of GDP by end-1998. This should partially counteract the impact of lower inflation on revenues.

37.  We believe that the fiscal stance of a balanced budget is appropriate and will not cause an undue deterioration of the current account. During the first half of 1998 the current account has recorded a small deficit. Following the usual seasonal current account surplus in the summer, the fiscal impulse which will mostly be felt in the fourth quarter will push the current account into a deficit, projected at about 1 percent of GDP for the year.

38.  With the budget expected to be in balance and our policy of not increasing domestic public debt, our financing needs stem mainly from large external amortization falling due. A significant portion of external amortization is expected to be met through privatization proceeds. However, because of delays in the privatization of larger companies and a reduction in the likely value of assets up for sale, we have revised our estimate of privatization proceeds down from the equivalent of 2.8 percent of GDP to 1.9 percent of GDP. This leaves a financing gap of approximately US$340 million for the second half of 1998, which we expect to fill through official external financing. To re-establish our access to international financial markets, later this year or early next year we expect to issue a Eurobond of modest size if market conditions permit. Overall, our strategy will allow us to continue to maintain significant resources in the FRA.

39.  We expect the economic recovery to slow marginally during 1999 as the brunt of the restructuring effort in the enterprise sector is felt, with real GDP growth projected at 4.5 percent. Further significant administrative price increases will keep inflation above EU rates, at about 7 percent, and a further strong increase in aggregate demand, especially from the expected pickup in investment, is expected to contribute to a widening of the current account deficit to about 3 percent of GDP.

40.  Consistent with the fiscal framework, the 1999 budget will provide for an overall deficit of up to 2 percent of GDP to support the need for higher investment in infrastructure and social assistance to those affected by structural reform. On the expenditure side public investment is planned to increase by 1.5 percent of GDP, while social spending (excluding pensions and health care) will increase by 0.6 percent of GDP mainly reflecting increased assistance to low income families and the unemployed. In the context of civil service reform (paragraph 10), budgetary wages will be increased significantly (by 20 percent) to make up for some of the loss in competitiveness vis-á-vis the private sector. The minimum wage will also be increased significantly (by 25 percent) to restore its level to about one third of the average monthly salary in the public sector. As part of our strategy to ensure a fairer distribution of the tax burden we plan to lower the VAT rate from 22 percent to 20 percent while reducing exemptions to maintain broadly unchanged VAT revenues as a percentage of GDP. From July 1, 1999 a 6 percent payroll tax will be introduced to finance the NHIF. This new tax will be broadly offset by a reduction of unemployment and social contributions by employers and by lower effective personal income tax rates. The deficit is expected to be covered largely by privatization proceeds (projected at US$250 million) so that the budget’s financing needs are approximately equal to external amortization plus a further build up of the FRA. This results in an equivalent financing gap in the balance of payments for 1999 of approximately US$600 million which we expect to fill largely with the official financing associated with our structural reform program.