A WORLD BANK COUJNTRY STUDY rsl ~~~~~~~22540 May 2001 Bulgaria The Dual Challenge of Transition andAccession I45 A WORLD BANK COUNTRY STUDY Bulgaria The Dual Challenge of Transition and Accession The World Bank Washington, D.C. Copyright i 2001 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing May 2001 1 23404030201 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. The World Bank encourages dissemination of its work and will normally grant permission promptly. Permission to photocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational dassroom use, is granted by the World Bank provided that the appropriate fee is paid directly to Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, U.S.A., telephone 978-750-8400, fax 978-7504470. Please contact Copyright Clearance Center prior to photocopying items. For permission to reprint individual articles or chapters, please fax your request with complete information to the Republication Department, Copyright Clearance Center, fax 978-7504470. All other queries on rights and licenses should be addressed to the World Bank at the address above, or fax no. 202-522-2422. ISBN: 0-8213-4962-7 ISSN: 0253-2123 Cover photo: Alexander Nevski Cathedral, Sofia, from the CD "A View of Bulgaria,"Digital Image. © Ministry of Trade and Tourism, 1997; produced with the assistance of the European Union Phare Program. Library of Congress Cataloging-in-Publication Data has been applied for. CONTENTS ABSTRACT ........................................................................... VI ABBREVIATIONS AND ACRONYMS ........................................................................... VII EXECUTIVE SUMMARY ........................................................................... IX CHAPTER I: MACROECONOMIC STABILITY ........................................................................... 1 INTRODUCTION ............................................................................1 MACROECONOMIC DEVELOPMENTS ........................................................................... I FISCAL SUSTAINABILITY ............................................................................ 4 ECONOMIC INTEGRATION AND GROWTH ........................................................................... 15 CHAPTER II: PUBLIC-PRIVATE INTERFACE ........................................................................... 20 INTRODUCTION ........................................................................... 20 MAKING BUSINESS ACTIVITY PRIVATE ........................................................................... 20 LAWS ...... ..................................................................... 22 REGULATIONS AND ADMINISTRATIVE PROCEDURES ........................................................................... 23 MAKING IT WORK ....... .................................................................... 25 MAKING IT WORK ........................................................................... 26 SUMMARY OF NEXT STEPS (SHORT TO MEDIUM TERM) ........................................................................... 30 CHAPTER III: PUBLIC ADMINISTRATION ........................................................................... 32 INTRODUCTION ........................................................................... 32 CHALLENGES FACING THE PUBLIC ADMINISTRATION IN BULGARIA ....................................................................... 32 EU accession requirements in the area ofpublic administration ...................................................................... 33 ASSE SSME NT OF PROGRESS IN MEETING THE REFORM AGENDA ........................................................................... 36 Statistical analysis .......................................................................... 36 Public sector management and human resource management ......................................................................... 38 Center of government decision-making ......................................................................... 42 Public expenditure management ........................................................................ 44 STRUCTURAL FUNDS ........ ................................................................... 47 ANTI-CORRUPTION ........................................................................... 52 Accelerating the development of a world class public administration in Bulgaria ............... ............................ 54 CHAPTER IV: DEVELOPING STABLE AND COMPETITIVE FINANCIAL MARKETS ......................... 55 INTRODUCTION ........................................................................... 55 MONETARY AGGREGATES AND FINANCIAL INTERMEDIATION ........................................................................... 56 POST-CRISIS FINANCIAL SECTOR DEVELOPMENTS ........................................................................... 60 EU ACCESSION: KEY ITEMS ON THE AGENDA ........................................................................... 66 CHAPTER V: LABOR MARKET AND SOCIAL POLICY ........................................................................... 74 INTRODUCTION .....................................7................................................................ 74 THE ADJUSTMENT PROCESS IN THE LABOR MARKET ................... 75 THE LEGACY: A DEPRESSED LABOR MARKET ................... 80 THE CHALLENGE OF SOCIAL PROTECTION REFORM ................... 83 COMPLIANCE WITH THE ACQUIS COMMUNA UTAIRE ................. 9 1 THE REFORM AGENDA ................... 93 Short run .. . . . . . . . . . . . . . . . . . 93 Medium to long run .................. 95 CHAPTER VI: EXTERNAL TRADE AND CONTESTABILITY OF DOMESTIC MARKETS .97 INTRODUCTION.97 iv CONTESTABILITY OF DOMESTIC MARKETS ........................................................................... 97 Foreign trade policy ........................................................................ 97 Post-1997 shift towards greater stability and liberal trade regime ................................................................... 98 Liberalization through regional trade agreements ........................... ............................................. 99 Distortions generated by tariff structure: reverse discrimination ................................................................... 100 Distortions generated by other trade policy measures ........................................................................ 102 Competition policies ........................................................................ 103 Subsidies (state aid) ........................................................................ 104 External access to government procurement ........................................................................ 104 The right of establishment and services ........................................................................ 105 RE-ORIENTATION OF FOREIGN TRADE TOWARD MARKET-DRIVEN PATTERNS ..................... ............................... 106 INTEGRATION INTO EU MARKETS ........................................................................... 106 Imports from the EU ........................................................................ 107 Export dynamics: two phases ........................................................................ 107 Export basket ........................................................................ 108 Change in competitiveness in EU markets ........................................................................ 109 Factor intensities of EU-oriented exports: unskilled labor intensive products rise again ............................... 109 Changes in the level ofprocessing: the move towards intermediate stage products ....................................... 110 Pollution-intensive sectors in exports to the EU .........................................................................111 INTEGRATION INTO EU-BASED NETWORKS OF PRODUCTION AND MARKETING .................. ................................ 112 Intra-product trade with the EU ........................................................................ 112 Foreign direct investment ........................................................................ 113 CONCLUSIONS AND POLICY RECOMMENDATIONS 113 CHAPTER VII: THE AGRICULTURE AND FOOD SECTOR ....................................................................... 116 INTRODUCTION ........ ...................................................................... 116 AGRICULTURE IN THE ECONOMY AND SECTORAL PERFORMANCE ................................................................. ...... 116 STATUS OF SECTORAL REFORMS ............................................................................. 119 MARKET CONFORMING POLICY FRAMEWORK WITH LIMITED GOVERNMENT INTERVENTION ........... ................... 120 Pricing and trade policy .......................................................................... 120 Remaining interventions .......................................................................... 124 INCOMPLETE TRANSITION IN THE FARMING SECTOR .................................... ......................................... 126 LARGELY PRIVATIZED, BUT INTERNATIONALLY NON-COMPETITIVE AGROPROCESSING INDUSTRIES ......... ......... 128 AGENDA FOR CONTINUING SECTORAL REFORMS: CRITICAL ISSUES FOR EU ACCESSION ............. ....................... 130 Proper response to the evolving CAP .......................................................................... 130 TRADE AND PRICING POLICY .............................................................................. 135 Improvements in ruralfinancial policies .......................................................................... 135 Improvement in irrigation policy .......................................................................... 136 Food security and cereals marketing .......................................................................... 137 Completion of land reform and land market development .......................................................................... 137 Accelerated technical and technological development of agro-processing ..................................................... 139 Establishment of new standards forfood and agricultural products ............................................................... 139 The institutional challenge of EU membership in agriculture ......................................................................... 140 Defining a national rural development program and effective SAPARD implementation ............................... 142 PRIORITIZING THE REFORMS .............................................................................. 143 CHAPTER VIII: REGULATORY AND STRUCTURAL ISSUES IN THE NETWORK UTILITIES ........ 146 INTRODUCTION ............................................................................. 146 BACKGROUND AND ACHIEVEMENTS ............................................................................. 147 The energy sector .......................................................................... 147 The electricity supply industry .......................................................................... 149 Natural gas .......................................................................... 150 District heating .......................................................................... 152 The transportation sectors .......................................................................... 153 Road infrastructure .......................................................................... 153 Road transport .......................................................................... 154 v Railways ................................................................. 154 Ports and shipping ................................................................ 156 Airports and airlines ................................................................ 156 CHALLENGES IN THE TRANSITION PROCESS ................................................................ 157 Sector priorities and choice of industry structure ................................................................ 159 Development of effective regulation ................................................................ 167 Rules governing access to bottleneck infrastructuralfacilities ................................................................ 171 Economically efficient pricing policies ................................................................. 172 Competitively neutral mechanisms forfunding universal service ................................................................ 1 174 CHAPTER IX: COMPLYING WITH THE EU ENVIRONMENTAL DIRECTIVES ................................... 176 INTRODUCTION ................................................................. 176 BACKGROUND AND COMPLIANCE COSTS ................................................................. 176 European union environmental legislation ................................................................ 176 Environmental protection in Bulgaria ................................................................. 177 Compliance costs ................................................................. 178 Implications for the public sector at the central and local levels ................................................................ 181 Financing of environmental investments ................................................................. 182 PUBTJC SECTOR INVESTMENTS ................................................................ 182 PRIVATE SECTOR INVESTMENTS ................................................................ 184 The internal market ................................................................ 184 Industrial pollution control ................................................................ 185 Air pollution ................................................................ 186 MIXED PUBLIC AND PRIVATE INVESTMENTS ................................................................ 189 Water resources ................................................................ 189 Drinking water supply ................................................................ 190 Wastewater collection and treatment ................................................................ 191 Nitrates ................................................................. 193 Waste management ................................................................ 193 IMPLICATIONS ON HOUSEHOLDS BUDGET ................................................................ 194 RECOMMENDATIONS FOR AN IMPLEMENTATION STRATEGY ................................................................ 197 vi ABSTRACT The objective of this country study is to assess Bulgaria's progress in its transition from plan to market and preparing for membership to the European Union. The study analyses economic developments during the 1990's with special emphasis on the 1997-1999 period. It describes the structural and institutional reforms implemented during the period, their impact and the road ahead on the Accession to the European Union agenda. This country study is based on the work of several World Bank missions that visited Bulgaria between November 1999 and May 2000. The team that prepared the report wishes to thank the Government of Bulgaria for the excellent cooperation received from senior officials during the different missions and at the Government Discussions, and Mariella Nenova, Bulgaria's coordinator of the CEM exercise, for her organizational and substantive support. The report was prepared by Leila Zlaoui, based on the following background papers prepared by World Bank staff, and Bulgarian and international experts: "Managing Fiscal Risk in Bulgaria" by Hana Polackova Brixi, Sergei Shatalov and Leila Zlaoui, "From Transition to Accession: Developing Stable and Competitive Financial Markets in Bulgaria" by Esen Ulgenerk and Leila Zlaoui, "The Bulgarian Labor Market: An Overview" by Lubimor Dimitrov, Pietro Garibaldi and Gabriella Stoyanova, "Foreign Trade Performance and Contestability of Markets" by Bartek Kaminski, "Industrial Restructuring and Export Orientation in Bulgaria" by Rossen Rossenov and Andrey Vassilev, "The Challenges Facing the Public Administration in Bulgaria" by Neil Parison and Alexey Proskuryakov, "Implementation of the EU Grants in Bulgaria" by Stanislas Pottier and Luis Madureira Pires, "Food and Agriculture in Bulgaria" by Csaba Csaki, Achim Fock, Holger Kray and John Nash, "Environment Sector in Bulgaria: The Challenge of Preparing for EU Accession" by Julia Bucknall, Rita Cestti and Adriana Damianova. Rossana Polastri is the author of the section on "Income Convergence," Barbara Lee and Frank Sader are the authors of Chapter II "Public Private Interface," Dena Ringold is the author of the section on "Social Protection," Neil Parison and Stanislas Pottier are the authors of Chapter III "Public Administration," and loannis Kessides and Salman Zaheer are the authors of Chapter VIII "Regulatory and Structural Issues in the Network Utilities." Stella Ilieva provided research assistance and Anita Correa was responsible for processing the report. The report and background papers benefited from comments received from colleagues within the Bank, and Bulgarian and intemational experts, in particular, Arvil Van Adams, Pedro Alba, Tito Boeri, Lubomir Christov, Constantijn Claessens, Balazs Horvath, Kathie Krumm, Mariella Nenova, Kyle Peters, John Nash and Thomas O'Brien. John Wilton was the peer reviewer for the comprehensive report. The report was prepared under the guidance of Mr. Marcelo Selowsky, Chief Economist; Mr. Andrew Vorkink, Country Director; Mr. Pradeep Mitra, Sector Director; and Mr. Kyle Peters, Sector Leader. vii ABBREVIATIONS AND ACRONYMS ACAA Ambient Clean Air Act AIG American Intemational Group ALMPS Active Labor Market Policies BNB Bulgarian National Bank BSE Bulgarian Stock Exchange BTC Bulgarian Telecommunications Company CAMEL Capital Assets Management Earnings Liquidity CAP Common Agricultural Policies CBA Currency Board Arrangement CEEC Central and Eastern European Countries CEFTA Central European Free Trade Agreement CFCU Central Finance and Contracts Unit CHP Combined Heat and Power CMEA Council for Mutual Economic Assistance COM Council of Ministers COMECON Council for Mutual Economic Aid CPC Commission for the Protection of Competition DH District Heating DHC District Heating Company DIF Deposit Insurance Fund EA European Agreement EAGGF European Agriculture Guidance and Guarantee Fund EC European Commission EEEA Energy and Energy Efficiency Act EFTA European Free Trade Agreement ERDF European Regional Development Fund ESI Export Specialization Index EU European Union FGD Flue-gas Desulfurization FIAS Foreign International Advisory Service FRA Fiscal Reserves Account FTA Free Trade Agreement GATT General Agreement on Trade and Tariff GEF Global Environmental Facility GDP Gross Domestic Product GLI General Labor Inspectorate GMI Guaranteed Minimum Income GMO Genetically Modified Organism HIF Health Insurance Fund IAS International Accounting Standards IPPC Integrated Pollution Prevention and Control ISPA Instrument for Structural Policy for Pre-Accession LIBOR London Interbank Offered Rate LOUFL Law on Ownership and Use of Farm Land LPC Law on Protection of Competition viii LSSEIC Law on Securities, Stock Exchanges and Investment Companies LTA Long term Assets MEPF Municipal Environment Protection Fund MFN Most Favored Nation MLC Municipal Land Commissions MNC Multi-National Corporation MRA Main Road Administration NARDP National Agriculture and Rural Development Plan NEK National Electricity Company NEPF National Environment Protection Fund NES National Employment Service NMB Navigation Maritime Bulgare NPAA National Plan for the Adoption of the Acquis NPED National Plan for Economic Development NPP Nuclear Power Plant NPRD National Plan for Regional Development NSI National Statistical Institute NSSI National Social Security Institute NTM Non-tariff Measures OECD Organization for Economic Cooperation and Development OTE Off-the Exchange PAYG Pay As You Go PIP Public Investment Plan PPA Power Purchase Agreements PPL Public Procurement Law REER Real Effective Exchange Rate REI Regional Environmental Inspectorates RRI Republican Railways Infrastructure RTGS Real Time Gross Settlement System SAC Supreme Administrative Court SAEER State Agency of Energy and Energy Resources SAPARD Special Accession Program for Agriculture and Rural Development SBM Single Buyer Model SEEA State Energy Efficiency Agency SERC State Energy Regulatory Commission SFA State Fund Agriculture SIC Social Insurance Code SJC Supreme Judicial Council SOE State-owned Enterprises SSC State Securities Commission SSEC Securities and Stock Exchange Commission TB Treasury Bill TPES Total Primary Energy Supply TPP Thermal Power Plant UNFCCC UN Framework Convention on the Changes of the Climate UWWTD Urban Wastewater Treatment Directive WTO World Trade Organization WUO Water Users' Organization ix EXECUTIVE SUMMARY During the first half of the 1990s, Bulgaria experienced a series of stop and go stabilization policies, and a slow pace of structural reforms. The economic policies followed by the socialist government delayed the transition by nearly a decade, leading to the collapse of the Bulgarian economy in 1996-97. The general elections of April 1997 and the ensuing change in leadership put an end to the long period of economic instability and political uncertainty. With the introduction in July 1997 of a Currency Board Arrangement and the subsequent implementation of sound macroeconomic policies and a comprehensive program of structural reforms, Bulgaria's economic performance witnessed a remarkable turnaround. Thus, when Bulgaria was invited in December 1999' to start negotiations towards EU membership, its economy was largely stabilized and despite a difficult external environment, growth had resumed and been sustained over two consecutive years. The legacy of heavy indebtedness, however, will continue to be an important factor as the country faces the dual challenge of transition and EU accession. The recent output recovery (3 percent real average GDP growth per year in 1998-99) has been accompanied by a stabilization of inflation in the single digit level and the maintenance of a broadly balanced Government budget. However, external imbalances have been growing. Driven by a sharp fall in exports, the current account deficit widened to 5.5 percent of GDP in 1999-2000, reflecting temporary factors such as the impact of the Russian crisis and Kosovo war, rising international oil prices as well as the ongoing restructuring of the manufacturing sector. Evidence from price and wage indicators do not suggest an exchange rate misalignment. However Bulgaria's competitiveness will hinge critically upon the pace of enterprise restructuring and sustained foreign direct investment. Although the share of gross domestic investment in GDP doubled between 1996 and 2000, reaching 16 percent of GDP, it is still far below the level underpinning the growth performance of the fastest-growing economies (such as Malaysia and Chile 25 percent of GDP or Ireland 20 percent of GDP). In order to boost private investment, Bulgaria has to maintain macroeconomic stability, substantially improve its investment climate, further accelerate and deepen structural reforms, especially in infrastructure, and undertake the public investments in human capital, administrative restructuring and infrastructure development that will crowd in foreign and domestic private investment. I In December 1997, The European Council discussed the enlargement of the EU, more specifically the application for membership to the EU by the ten CEECs of Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic and Slovenia. In March 1998, the EU formally launched the enlargement process (including all 10 CEECs), and the EC decided to open accession negotiations with the Czech Republic, Estonia, Hungary, Poland and Slovenia. These five countries were seen as capable of satisfying the conditions of membership in the medium-term, provided that they continued their efforts to approximate their legislation to those of the EU. On December 10, 1999, during the European Council's Helsinki meetings, the EC extended invitations to begin accession negotiations for EU membership with the other five CEECs: Bulgaria, Latvia, Lithuania, Romania and the Slovak Republic. x Executive Summary Chapter I identifies the major challenges Bulgaria faces in sustaining macroeconomic stability and accelerating growth. Maintaining fiscal stability while ensuring adequate public investment and gradually reducing the public debt will be a difficult balancing act and will require building sophisticated fiscal risk and debt management skills. While Bulgaria's current fiscal position appears strong, pressures could arise from higher international interest rates driving up debt servicing costs, or from contingent liabilities associated with securing private investment in infrastructure, or implementation problems with the pension and health care reforms. Given Bulgaria's heavy burden of debt, the room for accommodating fiscal shocks is limited: the fiscal pressure is high, the structure of government expenditure is rigid, and deficit financing options limited under the currency board arrangement. Most importantly, public investment required to meet the dual challenge of completing the transition and joining the EU are significant. First, substantial investment is needed in strengthening the central administration, local governments and the judicial system in order to implement the accession agenda, meet EU standards, create a favorable environment for investors and improve the interface with private citizens. Second, although the need for direct Government investment in infrastructure is reduced by possibilities to mobilize private financing, there remain areas where public investment is a pre-condition to attracting private investors, and areas where private investors will require public guarantees to cover selected risks. Third, remedial investments required to meet EU environmental standards, even if spread over a long period, are tremendous. While, assuming a 20 years implementation period, other accession countries would have to spend annually 2-8 percent of 1997-98 GDP in environmental compliance costs, Bulgaria's expenditures could be in the range of 11-16 percent of 1998 GDP. Finally, both the transition and accession agenda involve social costs which will need to be mitigated, through public investment programs among other instruments, to alleviate their detrimental impact on the poorest and most vulnerable segments of the Bulgarian population and maintain social stability. The Government has followed a policy of keeping its budget deficit low and has developed its public expenditure management tools to support a prudent fiscal stance. This is important as under its currency board arrangement, Bulgaria's main options for deficit financing boil down to privatization proceeds and borrowing. Privatization of the largest enterprises should be completed by 2003, leaving debt as the main deficit financing instrument afterwards. Given that public debt is already high, Bulgaria faces a difficult dilemma: adhere to a very conservative stance towards debt and fiscal risk at the expense of investment and growth, or accept a slower pace of debt reduction to guarantee the resources needed for economic restructuring, mitigating the impact of transition on the poor and vulnerable, and meeting the requirements for EU membership. In order to address successfully this dilemma, Bulgaria will need to continue strengthening its fiscal risk management framework and debt management strategies and adopt a better mix of risk mitigation, debt management and fiscal reserves policies. The goal of EU membership requires Bulgaria to adopt EU standards and norms, the Acquis Communautaire and meet the Copenhagen economic criteria: "the existence of a functioning market economy and the capacity to cope with competitive pressure and market forces within the Union". Macroeconomic stability and growth in the years ahead will also be a key factor. As discussed in Chapter I, the experience of Ireland, Greece, Spain and Portugal Executive Summary xi indicate that growth performance, the sustainability of growth as well as the speed of convergence to average per capita income levels in the European Union are all a function of the level and efficiency of investment and the pace and depth of structural reforms. The Government's remarkable reform program of the last three years has radically transformed the economy. Bulgaria has now established the necessary conditions for high and sustained growth. Thanks to the CBA, the fiscal and monetary stance are sound and the banking sector has also been put on a sound footing. First generation reforms, including price and trade liberalization, have largely been implemented and the privatization/liquidation program has eliminated the value-subtracting activities. Yet, unemployment is growing and the standards of living of large segments of the population have declined significantly. In order to boost private investment, achieve high and sustained growth and reduce unemployment, Bulgaria needs to implement its second generation reform agenda and establish the institutional foundations of a well-functioning market economy. Hence, in the following chapters, we will review progress in meeting EU requirements and establishing the institutional foundations for a well functioning market economy. The reform agenda focus on ensuring a sound interface between the public and private sectors (Chapter II), completing the restructuring of the public administration from a command to a market economy type (Chapter III), establishing well functioning factor markets - financial (Chapter IV) and labor (Chapter V), and ensuring openness and contestability of domestic markets (Chapter VI). Chapters VII and VIII assess the remaining structural reforms in the agriculture and infrastructure sectors respectively, while Chapter IX reviews the agenda and costs of complying with EU environmental directives. There are four critical steps in changing the Public-Private Interface, necessary for an economy in transition from a centrally-planned system to a market-oriented one: (i) creating stability and predictability in the macro and policy environment; (ii) removing assets from state ownership and eliminating direct intervention; (iii) building up the public framework (laws, regulations and administrative procedures) to guide private sector behavior; and (iv) making the framework function by improving the capacity, integrity and oversight of the civil service, and its credibility vis-a-vis the general public. Recently, the government has made tremendous progress in achieving stability and predictability in the macroeconomic and policy environment. Although more work needs to be done, progress in removing assets from state ownership and direct intervention has been substantial. Privatization, which lay dormant for most of the 1990s, picked up substantially in the past few years. Similarly, immense progress was achieved in building up the public framework by drafting and enacting market-oriented primary legislation. It is now crucial to ensure quality, appropriate scope and consistency across legislation, but most important to complete the secondary legislation/supporting regulations. The next step will be to undertake continual impact assessments of regulations to determine if they are of appropriate scope and achieve the originally intended purpose, and further streamline and harmonize them based on the assessment findings. xii Executive Summary The major remaining challenge facing the Government is how to make the "framework work". For that, administrative procedures need to be overhauled to become more market friendly and promote rather than obstruct private sector activity. Business establishment and registration procedures need to be further streamlined. Administrative and judicial capacity needs to be substantially strengthened and special emphasis given to improving enforcement, ethics and accountability. More generally, with corruption a matter of public concern, a whole range of actions are required to improve overall governance in Bulgaria. The Government of Bulgaria and the National Assembly have already adopted a range of anticorruption measures and laws, following on the 1998 National Strategy for combating corruption. The comparative success of this program is reflected in major improvements in Bulgaria's rating by international observers and agencies. In addition to the ongoing program to strengthen the public administration and the legal and judicial systems, and to reduce opportunities for corruption through regulatory reforms, the government should intensify its efforts to develop and enforce impartial, timely and painful sanctions against all forms of grand and petty corruption. Reforming the public administration. Bulgaria's public administration faces a number of extremely complex challenges. Clearly the most visible and pressing is the challenge of meeting the requirements for EU accession for both the negotiation period and EU membership. In addition, achieving and sustaining high level of economic growth requires a public administration oriented towards providing an attractive and competitive investment climate. Finally, while significant progress has been achieved, Bulgaria is still completing the transition of the public administration from a command economy state service to a market-oriented, client- oriented public and civil service to meet the growing demands of citizens and service users for high quality public services. The composition of Bulgaria's public sector is more of a problem than its overall size. Bulgaria's central and local government administrations are small compared to OECD country levels, while its education and health sectors are comparatively large. There are also problems of overstaffing in some areas of central government together with areas of understaffing and skills mismatches. The central civil service appears fragmented. The human resource management function throughout the public administration and the civil service is underdeveloped and the depth of political appointments within the public administration is an area of concern. The shortage of adequately skilled human resources and the low levels of remuneration represent a major constraint on Bulgaria's ability to develop its administration to EU member state standards. In response to this situation, the Government has developed a major and wide-ranging public administration reform strategy. The roles, functions and associated organizational structures and staffing levels of all ministries were reviewed, redefined and restructuring proposals formulated. The restructuring process provided the opportunity for significant staffing reduction stemming from the elimination of unnecessary or duplicating functions and associated units. The new system is based on a common classifier of all posts and standardized organizational structures. A number of next steps are planned to improve salary structure and incentives, and raise transparency and accountability in the civil service. The recently enacted Executive Summary xiii Law on Administrative Services to Individuals and Physical Entities provides a very solid base for the ambitious re-launching of the public service as a client-oriented and service-oriented public service. At individual agency level, the Tax General Directorate has undertaken a major restructuring of its work, structure, and working practices designed to give it a strong client orientation and to minimize opportunities for corrupt practices. Notwithstanding this impressive beginning, reforms need to be accelerated and the reform program could benefit from more breadth and depth. In particular more emphasis should be put on introducing formal accountability mechanisms of the public administration and the civil service to citizens and for civil service annual reporting to Parliament. Similarly further attention needs to be paid to applying the merit principles in recruitment, promotion, transfer and rotation, and overall staff development and career management. The importance and complexity of the public administration reform agenda also demands a special emphasis on soliciting and taking into account the views of civil servants and their unions, NGOs, the private sector, and citizen services users. While the formal decision-making processes at the center of government are working reasonably well, there is a clear need to strengthen the Administration of the Council of Ministers over the short to medium term to enhance analytical scrutiny over individual ministerial agendas and to strengthen its strategic and coordination capabilities. As for public expenditure management, the basis for effective macro fiscal management is in place and the Government is successful in ensuring that budget outcomes remain within approved limits. There are however two concerns relating to allocative efficiency. First, pressure to limit the budget deficit in recent years has resulted in inappropriate and excessive postponement of infrastructure spending as opposed to forcing reductions in potentially less productive areas of recurrent spending (such as excess staff and infrastructure in health and education). Second, a problem of allocative efficiency of budget processes arises from the lack of performance information on programs funded by the budget and the absence of a process to ensure the justification of new spending bids by ministries in terms of clearly identified expected outcomes. In the medium term achieving allocative efficiency requires broadening budgeting performance criteria to include not only financial compliance but also outcomes and achievement of objectives. Pre-accession grant transfers from the EU to Bulgaria may represent annually more than 2 percent of GDP (equivalent to about half its 1999 PIP). Upon accession, the Structural Funds could provide grants to support capital and human investment up to 4 percent of GDP every year. For this to happen, however, Bulgaria will have to respect the four basic requirements essential for the utilization of Structural Funds: concentration (where development problems are most serious), programming (elaboration of a strategic plan and multi-annual development programs), additionality (funds from Brussels should complement rather than replace indigenous spending), and partnership (the receiving state, and where appropriate, lower tiers of govermment as well as civil society, share responsibility for the elaboration, selection, management and audit of projects with the European Commission). xiv Executive Summary These requirements raise absorptive capacity issues. They all come to financial and institutional capacity challenges in staffing the appropriate administrative services with enough personnel and with adequate skills, setting the adequate institutional structure and arrangements, securing counterpart funding, ensuring coordination between all stakeholders, and putting in place appropriate controls. A key challenge will be to adapt the municipal finance system and give more control to municipalities over spending and monitoring as well as establishing more accountability. Developing stable and competitive financial markets. Since 1997, banking sector soundness has improved drastically, thanks to the sector consolidation and the tightening of regulation and supervision which followed the introduction of the CBA. Bulgaria's banking sector is now liquid and profitable, and is gradually gaining credibility. The ongoing privatization of the largest state-owned banks has already changed radically the sector's ownership structure. As a result, however of past trauma, financial intermediation remains low as both depositors and lenders were burned by the collapse of the banking system in 1996-97 and behave with extreme caution. In contrast with the banking system, the rest of the financial sector is underdeveloped. Although the regulatory and supervisory foundations are now largely in place, capital markets are still inactive or nontransparent. State involvement in the insurance sector has not yet been fully eliminated. Further strengthening of the regulatory framework and supervisory bodies for the non-bank financial sector is necessary; and implementation and enforcement need to be enhanced. Privatization of state-owned banks, although very advanced, is not yet fully completed. Bulgaria's financial infrastructure is evolving to catch up with technological improvements. Diversification of payment instruments is underway. The efficiency of liquidity management will be enhanced with the conversion to the real-time, gross settlement system. The requirements of external auditing have been introduced, Bulgaria's accounting principles are evolving to meet EU requirements and the adoption of the LAS (International Accounting Standards) "chart of accounts" is underway. Assimilation of the new standards by the banks and the enterprises will probably take some time, however. Bulgaria needs to focus vigilantly on the maintenance of the hard-won stability of the financial system. Most of the regulatory and legal framework enhancements to harmonize with EU Financial Sector Directives have been made. The established institutional infrastructure needs to be strengthened to effectively implement the legislative and regulatory framework created for EU compliance. This in turn requires enhancing the skills and capability of the supervisory and judicial bodies as well as the financial institutions operating in these markets. Establishing a flexible labor market and a fair and sustainable social protection system. Bulgaria's labor market was deeply scarred by delays in restructuring the old industrial sector and tackling fundamental structural problems. Labor shedding was one of the steepest among transition economies of Central and Eastern Europe, but unlike other CEE transition economies, it was not associated with the typical process of job reallocation from industry and agriculture towards the service sector. The slow pace of structural reforms and the unfriendly Executive Summary xv climate for the private sector resulted in agriculture playing a buffer role for employment reductions as workers shed by industry returned to the rural areas to grow crops for their own consumption. Existing labor market policies and institutions, with the exception of high payroll taxes and a somewhat strict employment legislation, do not create widespread labor market rigidities: unemployment schemes are not overly generous, the minimum wage is not high and industrial relations do not appear to prevent an efficient wage dispersion across sectors. Notwithstanding these positive features, labor market flexibility can be enhanced in a number of areas. For example, procedures for implementing collective redundancies are quite rigid, require a difficult coordination with trade unions, and represent an obstacle to firm level restructuring. Employment termination for individual contracts is hampered by a jurisdictional bias in favor of labor. Furthermore, recently proposed changes to the Labor Code could increase rigidities, especially draft regulations which limit the use of fixed-term contracts. In an economy in transition, which suffers from high unemployment, and is attempting to mobilize foreign and domestic investment, and develop a vibrant job-generating small and medium enterprises sector, it is crucial that the required measures be taken to increase labor market flexibility, improve the structure of labor costs and gradually reduce payroll taxes. In terms of compliance with the Acquis Communautaire, Bulgaria's labor legislation appears consistent with most of the EU requirements. Significant progress has been made in harmonizing Bulgarian legislation with the Acquis Communautaire in the area of health and safety at work. The actual standardization of working conditions, which will require substantial investments (with a significant impact on the structure of labor costs) and a strengthening of the administrative capacity to implement EU legislation, should be sequenced carefully so as not to stifle the development of small and medium enterprises or inflate the informal economy. Given Bulgaria's demographic trends, and in order to lessen the social costs of economic restructuring, the establishment of an integrated, effective and fiscally sustainable social protection system is a major challenge. In many respects, the inherited social insurance and social assistance systems have proven ill-suited to the market environment and have been poorly positioned to address growing poverty and unemployment. Ensuring the fiscal viability of the pension system has been a priority issue. Due to sharply declining fertility and extensive use of early retirement pensions, Bulgaria faces the highest system dependency ratios in the region. The government has taken important steps to reform the pay-as-you-go pension system, through a reduction in early retirements, measures to improve contribution compliance, and tightening of the linkages between contributions and benefits. Substantial progress has also been made toward the introduction of a diversified multi- pillar pension system which will gradually shift a share of contributions into a second pillar and private pension funds. The legislative framework for the new system is nearly complete and the government is addressing institutional and technical issues to manage the transition process. In the short run, a financing plan for the deficits arising from the collection of the contribution rate from 32 percent to 29 percent starting from January 2001, and from the shift of contributions to the second pillar needs to be prepared and information systems need to be adapted to create xvi Executive Summary individual retirement accounts. In the medium run, it is important to ensure equity in contributions between private sector workers, civil servants and military and security staff which have a privileged benefit regime. Also, the recently established regulatory body, Social Insurance Supervisory Authority should be enhanced to ensure sound management of private pension funds. Reforms have also been undertaken to ensure the provision of an effective and comprehensive social safety net for the poorest households. Social assistance and family benefit programs have been consolidated to reduce gaps in coverage, and administration and financing of some benefits have been centralized to ensure equity in benefit delivery. Despite these improvements, there are significant pending issues. The main social assistance program, the Guaranteed Minimum Income (GMI) program, needs to be strengthened through improvements in targeting and benefit adequacy. Financing arrangements also need to be addressed, as many municipalities - frequently the poorest - lack resources to pay benefits. Family benefits policy is also at a crossroad. Because of fiscal constraints, the real value of child allowances has been frozen since 1997. The government is considering raising benefit levels. However, important questions remain regarding whether benefits should be targeted, and how levels should be raised. Further in-depth analysis of targeting and benefit adequacy should be undertaken to assess the trade-offs between various options and the balance between social assistance and family benefits. Enhancing external trade and contestability of domestic markets. Import competition and the openness of the economy to foreign investment are keys to the contestability of domestic markets. Higher levels of contestability usually generate higher rates of economic growth and better export performance. Since 1997, Bulgaria's trade policies have shifted towards establishing liberal and stable trade regime. Regional free trade agreements have largely contributed to the liberalization process. These agreements have also generated distortions in the tariff structure and resulted in a reverse discrimination towards non- FTA (free trade agreements) partners. With its new Law on Protection of Competition, Bulgaria's competition policy framework and rules have gone a long way towards harmonization with the EU. The process of bringing domestic government procurement regulations in line with the European Agreement and GATT has begun with the enactment of a new procurement law. Procedures, contracting authorities as well as the contracts falling under the purview of the law have been defined in line with EU directives and the law applies to all companies providing public services, including utilities. Although the legal framework governing the right of establishment and services seems to be overall in compliance with international standards, it contains provisions unfriendly towards foreign investors such as restrictions on the number of residence permits available to directors of stock companies, burdensome and non-transparent process for work permits, and restrictions on the recourse to international arbitration in case of a dispute. Subsidies, or state aids, distort competition. They give those who receive them an unfair advantage in competing with other firms, domestic or foreign. EU's rules prohibit governments from providing state aids to industrial enterprises and the Accession partnership calls for Bulgaria to introduce a coherent legal framnework on state aids and to establish a single agency to Executive Summary xvii administer and monitor them. Now Bulgaria has established a legal framework in line with EU regulations for the application of provisions of state aids. The scope and depth of a country's integration into EU markets for goods offer important insights about the ability of its firms to compete in a Single Market. With the share of the EU in its trade turnover amounting to around 50 percent, Bulgaria is still below the average ratio of inter EU trade to external trade (62 percent in 1990-98). Also, integration into EU markets so far seems to have confined Bulgaria to the status of a supplier of low value-added, labor and natural resources products. But there are encouraging signs pointing to a shift from primary stage products to intermediate and final stage products in commodity chains as well as towards skilled labor intensive products. Exports of these products significantly increased in 1999 and 2000. The 1997-99 period witnessed dramatic improvements in access to Bulgarian markets as tariff reducing provisions of bilateral free trade agreements kicked in and remaining non-tariff measures affecting trade were removed. The challenge ahead is the acceleration of measures to enhance the institutional framework for competition and economic efficiency, and attract foreign investment. Key measures required to improve conditions in access to market for goods include alignment of MFN tariffs on industrial products with those levied on EU products, opening public procurement to foreign companies, adopting EU type market surveillance techniques, and re-engineering the entire customs procedures. Other measures needed to enhance Bulgaria's attractiveness to FDI include simplifying administrative procedures for site development, land registration and titling; reducing the number of audits and inspections, further streamlining the labor code and the legal framework to remove clauses (such as for advertising and arbitration) unfriendly to investors, domestic and foreign alike. Continuing the reform of the agriculture and food sector. The importance of the agriculture sector in the overall economy has remained high throughout the transition. Its share in total employment and in GDP grew during the last decade and food and agriculture are essential components of Bulgaria's foreign trade. The process of reform and transition to a market-based agriculture has been, however, difficult and painful. Until 1997, the sector was burdened by regulation, export controls, and heavy implicit taxation. Due to the privatization and land restitution procedures that were followed, the economic instability until 1997 and the crisis in the Russian market, Bulgaria's farming sector suffered more disruptions than has occurred in other Central and Eastern European countries and agriculture production declined both in terms of yields and total output value. In 1997, the new government introduced a sweeping program of reforms aimed at the creation of an incentive system for producers, processors and traders consistent with a market- based food and agriculture system. The program envisaged the privatization of the major means of production in primary agricultural production, agro-processing and input supply as well as changes in institutions and regulations to enhance the functioning of markets. This program has made great progress in many ways, but with fragmented parcels and significant areas uncultivated because these small parcels are economically non-viable, the sector is still far from having completed its restructuring. xviii Executive Summary Bulgaria opted for physical restitution of expropriated assets including agricultural land, as well as distribution of collective farms assets among members. The outcome of this process has been a very fragmented structure of land ownership with a mixed and still evolving farming structure dominated by a large number of small private family farms and the successors of former collective enterprises. While almost all land has now been restituted and nominally titled, much work remains to establish a well-functioning land market and to encourage restructuring of the farming sector. Hence, several important components of land reform and farm restructuring must be completed to achieve a viable farming structure under EU conditions. These include full land privatization and establishing the conditions for farm restructuring and consolidation, in particular cadastre institutions and real-estate information systems. Compared to most other CEEC economies, Bulgaria has a very limited intervention program in agriculture. There are, however, two direct and one indirect government interventions that impede the transition to a competitive market economy. One is its direct involvement in the tobacco sector by setting prices and controlling quantities through a state body, and organizing processing marketing and handling through a state-owned company. The second is the subsidized short and long-term credit programs of the State Fund Agriculture which, combined with the large state grain reserves fund, have distortionary effects on the agricultural product markets and impede the development of rural financial markets. While its policies are improving, the SFA is still struggling to target its interventions in a way that does not prevent the emergence of private sector credit providers. In view of the characteristics of farm size and ownership structure, rural finance policy should follow a two-track approach: ensure that there are no barriers to the emergence of a commercial credit sector based on commercial banking, while at the same time, putting in place an appropriate legal framework for cooperatives to service small-scale farmers. Although it is not a direct intervention, the activities of the State Reserves sometimes destabilize grain markets and discourage private sector development in this critical sub-sector. State Reserves operating rules need to be limited and more clearly defined to minimize this problem. Bulgaria had inherited from the central planning period a sizeable agro-processing industry characterized by inefficiencies in processing and marketing resulting in high costs, and which now operates at only 30-40 percent of its technical capacity. Following the privatization of most of the facilities over the last three years, with the exception of a relatively small number of domestic and foreign-owned companies, the agro-processing industry shows signs of serious operational difficulties after privatization. Initial privatization commitments to maintain or expand employment and production hamper the ability of the companies to respond to market conditions and should be revised as needed to enhance management flexibility. Streamlining licensing and inspection procedures will also help the agro-processing industry by eliminating unnecessary costs for businesses. At the same time, strictly enforcing bankruptcy legislation is needed to support consolidation of the newly established private sector. The quality of food products represents one of the major obstacles to increasing exports to western and other markets. Bulgarian state standards and technical specifications have not yet been harmonized with internationally accepted standards and will require extensive revision. Progress was made in adjusting the whole set of laws concerning food quality, standards, etc., but enterprises have not benefited from the information, training and assistance to adjust to the Executive Summary xix new concept of quality management. Hence, a substantial educational effort is required for the effective implementation of the new legal framework. In addition, investments -- both public and private - are urgently needed to introduce new technologies related to quality enhancement and environmental protection. Bulgaria must further adjust its agricultural policy to conform to the EU common agricultural policies (CAP) at the time of its accession, but the transition strategy for this must be one that also maximizes the benefit to the agricultural sector and the economy as a whole. There still exist considerable uncertainties regarding the time of accession as well as the features of the CAP at that time. Moreover, many CAP policies are very costly both financially and for consumers, in particular, the poor. This implies that adjustment of trade and pricing policy to harmonize with the CAP should be deferred as long as possible. Another element of accession preparation is implementation of the investment program under the EU's Special Accession Program for Agriculture and Rural Development (SAPARD). It will be important to design and implement the program in ways that allow market forces to decide the directions in which the rural economy evolves, rather than having the government "pick winners" through an excessive focus of support on sectors or economic actors that are selected ex-ante. Resolving regulatory and structural issues in the network utilities. Significant policy attention needs to be paid to the market and governance structures of the infrastructure sectors to ensure that they are aligned to promote Bulgaria's objectives of economic competitiveness and social welfare. In view of the country's fiscal constraints, the many competing priorities for scarce public funds, and the weak condition of the domestic capital markets, it is imperative that policies are pursued to strengthen the private sector and attract foreign investment on reasonable terms for the economy. The infrastructure sectors, if they were to be properly restructured and placed under credible regulation, offer a significant opportunity for attracting sustained large- scale foreign investment. Moreover, the infrastructure sectors provide services that are critical inputs in manufacturing, transportation and commerce. They also provide services that are essential to boosting economic activity and increasing competition through the expansion of product lines and geographic spheres of distribution. Therefore, continuing inefficiencies in the supply of basic infrastructural services will severely limit the growth and export potential of the Bulgarian economy. Restructuring the network utilities and designing appropriate regulatory frameworks to attract large-scale private investments, pose unique and challenging problems. There is very limited regulatory expertise in Bulgaria, in large part because regulation was intricately intertwined with state ownership and policymaking, and because there has been no regulation until recently by which to develop expertise. Policy makers will very rapidly be confronted with "second generation" issues that arise after privatization, particularly when combined with unbundling. The resolution of these "second generation" issues has proven exceedingly challenging even in countries like the United States and the United Kingdom which have had considerable experience with "first generation" problems of regulated franchise monopolies. The development of regulatory principles, the development of solutions to the current and forthcoming problems and, most importantly, the development of regulatory expertise and capacity are key to the future of network utilities. xx Executive Summary Bulgaria faces severe challenges in the energy sector. The delay in restructuring has been costly in lost industrial output and consumer welfare, and a loss in confidence that existing infrastructure and services can be made cost-effective and affordable. Bulgaria is energy- intensive but lacks economic domestic energy resources. Bulgarian coal is of poor quality, the country lacks significant indigenous petroleum resources, and is completely reliant upon imports from Russia for gas, the one fuel that is environmentally friendly, cost-effective for heating and power generation, and most helpful to liberalizing energy markets. Based on their assessment of the safety of the VVER 440/230 type of nuclear reactors, the European Commission (EC) and the G-7 have put pressure on Bulgaria to retire its four VVER 440/230 reactors, supplying about 20 percent of total demand, before the end of their economic life. On the positive side, Bulgaria is on a critical crossroad in Europe, providing transit routes for Russian gas to the south and linking both Greece and Turkey to the European electricity grid. If, at some future date, gas pipelines are brought from the Caucasus through Turkey (or the Black Sea) into Bulgaria and west to Central Europe, Bulgaria will cease to be solely dependent upon Russian gas, and would provide an alternative east-west corridor for diversifying West Europe's dependence on imported gas. The current government is committed to restructuring the energy sector and opening it up to competition. Privatization, after lengthy delays, is now back on the agenda and the Government has privatized some small hydropower plants, is at the point of privatizing a large thermal power station to a strategic investor and finalizing the contractual framework for a strategic private investor to build, own and operate a new power plant, and intends to formulate a privatization strategy for the rest of the sector during 2001 and implement it over the first few years. Other impressive achievements in the energy sector since 1998 include sustained phase-down of price subsidies (with targeted protection of vulnerable people), passage of an Energy and Energy Efficiency Act in July 1999 suitable for the transition to a more competitive and less centrally-planned sector, creation of an autonomous State Energy Regulatory Commission, "unbundling" of the vertically-integrated National Electricity Company (NEK), financial stabilization and initiation of restructuring the gas sector, and some restructuring of the coal mining sector. Much has been achieved in the transportation sectors in Bulgaria, particularly in the field of harmonizing its laws with those of the European Union. In addition, success has been achieved in privatization and liberalization of the road haulage industry, and in dealing with the difficult problems faced by the airline sector. However, Bulgaria's transport sector faces the difficult task of contributing to transforming the economy and increasing Bulgaria GDP, both in the immediate future, and in ensuring the long-term ability of the economy to compete in international markets and, in particular, in the European market. This is why further market liberalization and regulatory reform in the transport sectors of Bulgaria will be of critical importance. Bulgaria has a potential for substantial economic gains from competitive restructuring, privatization, and regulatory reform in the infrastructure sectors. In the energy sector, the key challenge for the Government over the next few years is to properly sequence reforms and investments in a manner which ensures that higher-cost investments are undertaken only after market structures, regulations and appropriate energy prices are in place. While the Government has rightly sought to maximize private investment in the sector, the early establishment of a clear policy and regulatory framework would allow investors to take the market risks and rewards Executive Summary xxi associated with their investments, while also ensuring that consumers are adequately protected from unfair tariffs or poor quality of supply. Indeed, if the Government contracts improperly sequenced and costly private investments at this stage of the transition, characterized by uncertain demand forecasts, high risk premiums required by private capital, and the need for investors to enter into inflexible long-term contracts with state-owned enterprises, it exposes Bulgaria to risks which could erode its competitiveness, worsen the social conditions of its population, and exacerbate demands on the state budget. In the transportation sector, it is clear today that a combination of further market liberalization and an integrated investment program is needed for the sector to contribute best to the Bulgarian economy and to avoid becoming a significant impediment to growth. Moreover, for operational efficiency reasons, fiscal considerations, and in view of the many competing social priorities, the government will need to aggressively pursue all private participation options, including divestiture of key infrastructural facilities. Complying with the EU environmental directives. Environmental protection is a high priority for the Union. The EU legislation environmental directives touch all sectors of the economy. However candidate countries will not have to implement all of the environmental Acquis prior to accession, but rather establish national priorities and explicitly recognize that transition periods will be necessary. Implementation of the Acquis presents a particular challenge because: (i) the scale and scope of EU environmental legislation is broad and requires substantial investments in several sectors of the economy; (ii) compliance costs will affect each Bulgarian household while benefits are spread overtime and geographically (Bulgaria and neighboring countries); (iii) although the requirements of the EU environmental directives have been identified, the challenge will be to identify priority actions with domestic and trans- boundary benefits and be clear about trade-offs; and (iv) the environmental investment program could contribute to regional disparities in income and employment if programs are not designed carefully. Bulgaria has already made considerable efforts in harmonizing its environmental laws with those of the EU. The government has updated the state environmental policy to include full transposition of the framework directives dealing with air, water, waste, nature protection, and chemicals, and to fill the gaps in sectoral legislation. In terms of implementation, Bulgaria has made some progress during the 1990s. Since 1992, environmental expenditures have been relatively stable ranging between 0.9 and 1.3 percent of GDP (of which over 60 percent allocated to cover recurrent costs). During the past three years, environmental expenditures have been reported at 1.0 percent of GDP in 1997, 1.3 percent in 1998, and 2.0 percent in 1999. Expenditure required for EU compliance are of a much higher order of magnitude. Assuming a 20 years implementation period, we estimate that overall expenditures for environmental compliance could range between 11-16 percent of 1998 GDP, or 4.9 to 6.7 percent of GDP at the end of the implementation period (assuming a 5 percent GDP annual growth), of which over 50 percent would have to be assumed by the public sector. It should be mentioned that per capita environmental compliance cost to be borne by Bulgaria is in line with comparable estimates made for other accession countries. While these cost estimates are tentative and should be read with caution, an environmental investment program of this order of magnitude would crowd out other investments, represent an enormous cost for the economy and the people and would be xxii Executive Summary administratively unmanageable. This only underscores the importance of designing a suitable environmental accession strategy which uses all the flexibility offered by the EU directives to distribute the costs over a transition period long enough to avoid crowding-out of other key investments, keep the overall public investment program fiscally sustainable and allow the emerging private sector to adjust to the required capacity and costs of compliance. In conclusion, Bulgaria has made significant progress in recent years in establishing macro-stability and advancing long-delayed structural reforms. The decision by the EU to begin negotiations signifies this progress. Nevertheless, significant challenges remain. Determined progress along the directions outlined in this report would not only advance considerably the prospects for EU accession, but also will result in sustained progress in improving the conditions of all of Bulgaria's population. CHAPTER I: MACROECONOMIC STABILITY INTRODUCTION Until 1997, Bulgaria was one of the poorest performing economies of Central and Eastern Europe. The reforns implemented over the last three years represent a leap forward on the transition path and have allowed the country to catch-up substantially with the time lost during the last decade. The sound macroeconomic policies and the speedy implementation of the first generation of reforms needed for the transition from plan to market have already shown tangible results in terms of macroeconomic stability and growth. This chapter is devoted to the macroeconomic dimensions of the dual challenge of transition and accession to the European union. Section A reviews the macroeconomic developments since 1997. Section B discusses fiscal sustainability, a central requirement under a currency board and in the case of Bulgaria a complex balancing act in view of the high level of debt and the significant investment needed for completing the transition and meeting the requirements of accession. Section C outlines the policy agenda for sustained and high growth and discusses the growth effects of economic integration based on the experience of countries who joined the EU earlier. MACROECONOMIC DEVELOPMENTS The 1996-97 Crisis. Massive external borrowing from official and private sources during the last half of the 1 980s, stop and go stabilization policies and a slow pace of structural reforms during most of the 1990s have delayed Bulgaria's economic transition from plan to market by over a decade. During that period, also marked with disruptions associated with the collapse of the Council for Mutual Economic Assistance (CMEA) markets and the adverse external shocks of the Gulf and Yugoslav crisis, Bulgaria's macroeconomic performance was weaker than most transition countries in the region. Actually, fueled by a failure to establish market discipline at the macro-economic level, the prevalence of soft budget constraints and widespread rent- seeking, Bulgaria's problems culminated in a severe banking and foreign exchange crisis in 1996 and early 1997. The banking sector was plagued with non-performing loans to state-owned enterprises, weaknesses in governance, and unsound credit policies to finance consumption, income transfers, and price subsidies. Out of the ten state-owned banks accounting for more than 80 percent of banking sector assets, nine had negative capital in 1996. About half of the private banks were technically bankrupt. Early palliative attempts to restructure the sector included bank closures or recapitalization, signing of Memorandum of Understandings, and limited changes in regulatory and legal framework. These measures proved insufficient to restore confidence. Indeed, the credibility of the package, of which the conservatorships imposed by Bulgarian National Bank (BNB) in May and September 1996 were a major element, was undermined by the absence of an adequate regulatory framework, and the failure to implement key supportive policies such as privatizing state-owned banks and enterprises and closing loss making enterprises. The banking crisis toll amounted to the closing of 17 banks (or about one 2 Chapter I: Macroeconomic Stability third of the banking system). The fiscal expenditures due to the banking crisis consolidated over the 1991-98 period amounted to the equivalent of 22 percent of GDP.2 As the banking crisis unfolded, liquidity injections from the Bulgarian National Bank (BNB) to support the weakening banking sector increased. Concurrently the BNB attempted to sterilize liquidity through open market operations, and in a vain attempt to support the exchange rate, conducted interventions on the foreign exchange market. The open market operations resulted in interest rate hikes which aggravated the servicing of the domestic debt, while the foreign exchange interventions further depleted the scarce foreign exchange reserves. The escalating political turmoil and rising budget deficit made monetary control impossible. In the face of escalating debt service costs, and in order to avoid default on the domestic debt, the growing budget financing needs were met by central bank credit. The monetization of the deficit, a rapidly depreciating currency and growing political unrest stimulated inflationary expectations, and by March 1997, inflation had soared to an annualized rate of over 2000 percent. Under these circumstances, a consensus developed that another money-based stabilization attempt would be equally unsuccessful and that stabilization would need simple disciplinary rules and a fixed exchange rate. In late 1996, discussions began on the adoption of a Currency Board as a cure to the problems of soft budget constraints and commercial bank financing that kept loss-making enterprises afloat, and the lack of fiscal discipline that led to hyperinflation. The cumulative fall in real output between 1990 and 1997 reached 34 percent. Inflation had reached hyperinflationary levels wiping out the savings of a significant proportion of the population. The social and political tensions caused by the collapse of the economy led to a change of leadership and a radically new approach to economic policies. A currency board arrangement was adopted in July 1997 as a cure to the problems of soft budget constraints and commercial bank financing that kept loss-making enterprises afloat, and the lack of financial discipline that led to hyperinflation. Macroeconomic developments in 1997-2000. The introduction of the CBA in July 1997 and the subsequent implementation of sound macroeconomic and structural policies succeeded in restoring growth, abating inflation and improving public and investors' confidence. The CBA has been underpinned by a conservative fiscal policy and a sharp acceleration of structural reforms. The wide-ranging structural reforms program encompassed agriculture, energy, privatization, completing price and trade liberalization, reform of the social sectors and restructuring and financial discipline in the enterprise sector. Sound macroeconomic management and the acceleration of structural reforms yielded positive results. Although output continued to decline in 1997, shortly after the CBA introduction interest rates dropped sharply, inflation declined dramatically and the fiscal deficit was reduced to far more sustainable levels. Real output recovered in 1998 recording a 3.5 percent positive growth rate and continued in 1999 with 2.5 percent growth despite a difficult external environment marked by turmoil in international markets, unfavorable commodity price developments and the 2 See Resolving Banking Crisis in Transition Countries: Fiscal Costs and Related Issues (Tang, Zoli and Klytchnikova, World Bank, Draft, April 2000). Chapter I. Macroeconomic Stability 3 trade disruptions associated with the Kosovo crisis. Driven by higher external demand and continuing restructuring of the economy, output marked a 5 percent growth in 2000. The Government budget remained broadly balanced registering a surplus of 1.0 percent of GDP in 1998 and a deficit of the same order of magnitude in the following two years. Inflation was contained at single digit levels in 1988-99 (Table 1.1). Due to pressures from international oil prices and depreciation of the Euro, inflation grew by 1 1 percent in 2000. Gross domestic investment bottomed at 8.4 percent of GDP during the crisis in 1996. Although it has doubled since then, it is still far below the level underpinning the growth of the fastest growing economies (such as Malaysia, Chile 25 percent of GDP or Ireland 20 percent of GDP). In order to boost private investment to the levels required for fast and sustained growth, Bulgaria has to maintain macroeconomic stability, substantially improve its investment climate, further accelerate and deepen structural reforms, especially in infrastructure, and undertake the public investments in human capital, administrative restructuring and infrastructure development that will crowd in foreign and domestic private investment. Table 1.1: Selected Economic Indicators 1995 1996 1997 1998 1999 2000 __________ ~~~~~(preliminary) Real GDP Growth (percent change) 2.1 -10.9 -6.9 3.5 2.4 5.0 CPI (End of Period, percent change) 32.9 310.8 578.5 1.0 6.2 11.4 Primary Balance ( percent of GDP) 8.3 6.4 5.7 5.54 2.6 2.7 Interest Payments ( percent of GDP) 14.6 20.3 8.4 4.4 3.9 4.3 Overall Balance (percent of GDP) -6.3 -12.7 -2.5 1.0 -1.0 -1.0 Interest Rates (BNB basic rate) 2.8 435 7.0 5.2 4.6 4.7 Gross Domestic investment (percent of 15.7 8.4 11.4 14.7 19.0 15.7 GDP) 1.1 0.7 1.0 3.8 4.7 3.7 (of which public investment) Current Account Balance ( percent of GDP) -0.6 0.2 4.4 -0.5 -5.5 -5.5 Gross Official Reserves (US$ millions) 1,546 793 2,468 3,056 3,222 3,460 (in months of imports) 3.1 1.6 5.3 6.1 5.9 5.4 External Debt (in percent of GDP) 77.4 96.8 95.9 81.8 79.7 83.4 Exchange Rate (Leva per US$) 0.071 0.487 1.777 1.675 1.947 2.102 ( percent change, + means depreciation) 7.1 589.3 264.5 -5.7 16.2 8.0 Real Effective Exchange Rate (REER-CPI) 8.1 -38.9 85.5 4.2 -0.9 ... ( percent change, + means appreciation) Source: IMF, MoF and WB The recent recovery was associated with a widening current account deficit. Driven by a sharp fall in exports, Bulgaria's current account balance has moved from a surplus equivalent to 4.4 percent of GDP in 1997 to a deficit of 0.5 percent of GDP in 1998 and 5.5 percent of GDP in 1999. While exports recovered substantially in 2000, the current account deficit remained high due to a sharp increase in imports induced by higher international oil prices. Despite a sharp REER appreciation in 1998, evidence from price and wage indicators does not suggest an exchange rate misalignment. Bulgarian wages are among the lowest in the region and its labor markets quite flexible. The pattern of productivity-based dollar wages3 indicate that while 3See "The Bulgarian Labor Market: An Overview" Garibaldi, Dimitrov and Stoyanova (Paper commissioned by the World Bank, 2001) 4 Chapter I: Macroeconomic Stability Bulgaria is undergoing a productivity driven appreciation4, there still exists a sizable difference between the actual and the estimated equilibrium wage, implying that competitiveness is not at risk (see Chapter V). The deteriorating export performance in 1999 was attributable to a number of internal and external shocks. The ongoing enterprise privatization and restructuring caused a number of inefficient enterprises to phase out or overhaul their operations, temporarily reducing activity and exports. In addition, a weak international environment marked by a global financial crisis and low commodity prices lowered significantly the external demand for Bulgaria's products. Finally, the Kosovo conflict blocked transit routes to Western Europe, raising transport costs and causing losses in export markets. Driven by higher demand from the Euro area, more favorable prices for raw materials and a depreciating Euro, exports registered a 10 percent volume growth in 2000. Notwithstanding the strong signs of recovery of exports, a sustained improvement in the trade balance will require an intensification of the restructuring of the enterprise sector and major improvements in the overall investment climate. In meeting its external financing requirements, Bulgaria is highly dependent on FDI inflows (44 percent in 1999) and loans for balance of payment support from International Financial Institutions (33 percent in 1999). FDI flows equivalent to 4.4 percent of GDP in 1998 and over 6 percent of GDP in 1999 and 2000, helped finance the current account imbalance, which therefore did not pose a threat to external sustainability. Nevertheless, in the years ahead, external sustainability will hinge upon the pace of enterprise restructuring, continuing recovery of exports and sustained direct foreign investment. The composition of FDI is also likely to be a key determinant for external balance. In 1997-98, FDI flows were largely privatization-related. With privatization of the largest enterprises, including in infrastructure, likely to be completed by 2003, Bulgaria needs to attract substantial FDI in new export producing facilities to finance future current account deficits. Actually, in the absence of a strong export rebound, large volumes of debt and investment-related capital inflows could disproportionally leak out to finance imports of investment goods and debt service and further worsen external imbalance. FISCAL SUSTAINABILITY Bulgaria's current fiscal position appears solid. Recent revenue performance has been strong and resilient to the economic shocks that have marked the 1998-99 period (the Russian crisis and Kosovo war). General government revenues increased from 31.7 percent of GDP in 1997 to 39.5 percent of GDP in 1998 and exceeded 40 percent of GDP in 1999, providing adequate coverage for rising expenditures.5 Room to accommodate fiscal risks is, however, limited. First, while the CBA is effective in achieving fiscal stability, it does by definition reduce the range of options otherwise available for deficit financing, and therefore the scope for fiscal expansion or for accommodating sudden expenditure hikes due to the materialization of 4This is known as the "Balassa-Samuelson effect": With nominal exchange rate rigidity, productivity growth in the tradable sector, when higher than abroad, results in wage increases that are transmitted to the non-tradable sector. If productivity in the non-tradable sector grows less rapidly, wage increases cause non-tradable prices to increase. 5In 1999 Govermnent expenditures reached 41.3 percent of GDP, up from 38.4 percent in 1998. Leading this trend, social expenditures increased by 3.4 percentage points since 1997, while wages and contingency to pay for the cost of structural reforms increased by 1.7 and 1.2 percentage points, respectively. Chapter I: Macroeconomic Stability 5 unaccounted for fiscal risks. Traditionally, there are four Chart 1: General Government Overall sources for financing public Balance audits Financing sector deficits:' printing money, running down foreign reserves, 8 and foreign and domestic governiment borrowing. The 3- financial discipline inherent to the E El * CBA rules out printing money l and associates running down -7 - reserves with an automatic -12 monetary tightening and 1996 1997 1998 1999 contraction of output. Foreign and domestic borrowing, along *-Overal balance EINet external O Domestic OPrivatization with exceptional proceeds such as privatization revenues, thus Source: Ministry of Finance remain the only means of deficit financing and of raising money to face sudden shocks. Following the CBA adoption, the main source of deficit financing shifted from the domestic banking system (on a net basis) to privatization revenues7 (chart 1), followed by external borrowing from official creditors. As the privatization process comes close to an end, revenues from the sale of state-owned enterprises will fall. The largest and most profitable state- owned enterprises have already been or are now being privatized. Further sizeable revenues could be expected from the privatization of BTC (Bulgarian Telecommunications Company), Bulgartabac (tobacco company), and several power distribution companies in 2000-038 after which the scope for raising revenues from privatization will shrink substantially. Second, in responding to shocks, the government faces a constraint on both the revenue and expenditure side. With revenues at about 40 percent of GDP in 1999 and already high payroll taxation, further increases in tax rates would likely damage investment and growth. Actually, the main fiscal policy objective is now to broaden the tax base and strengthen collection in order to lower tax rates on labor and income.9 The structure of government expenditure is rigid with a large share of non-discretionary expenditures. At 41.3 percent of 6See "The Economics of the Government Budget Constraints" Fisher, Stanley and Easterly, William. The World Bank Research Observer, Vol. 5 (July 1990). 7Privatization receipts are accounted as financing, not revenues. They enter the fiscal reserve account and can be used for debt repayments and investment financing. The privatization receipts of the municipalities can be used for ecological projects, investment debt repayments or writing off non-performing loans of municipality-owned enterprises. 8Privatization of energy companies over the next two to three years could generate significant proceeds if the government revises its current strategy of joint-ventures with strategic investors in favor of cash privatization to strategic investors. 9The government's draft 2001 budget envisages a reduction of the corporate and personal income tax burden to bring them in line with other EU accession countries, and a 3 percentage point reduction in the social contribution rate as a first step towards reducing the high taxation of labor. 6 Chapter I: Macroeconomic Stability GDP in 1999, government expenditures are dominated by social protection programs (12.3 percent of GDP), operation and maintenance (8 percent of GDP), debt service (about 8 percent of GDP), while wages and capital expenditures approximate 5 percent of GDP, each. Against this background, it is important to undertake a systematic assessment of risk exposure. Bulgaria's exposure to fiscal risk. Government exposure to fiscal risk is not negligible. Bulgaria's future fiscal position may suffer from pressures or shocks arising from fiscal risks identified in the Fiscal Risk Matrix, and discussed further in the remainder of this section. Box 1.1: Bulgaria's Fiscal Risk Matrix Sources of Direct (obligation in any Contingent (obligation if a particular event occurs) fiscal risk event) Explicit * Foreign and domestic * Individual state guarantees for non-sovereign sovereign debt (size and borrowing and obligations [L] Govemment structure) [H] * Obligation to recover past environment damages obligation is * Future pension assumed in enterprise privatization and other recognized by expenditures required by environment liabilities [M] law or law [M] * Obligations of business promotion bank [L] contract * Health expenditures * Obligations of export insurance agency (insurance required by law [M] policies to cover political and medium-term commercial risks) [L] * Obligations of state fund for agriculture [L] Implicit * Accumulated and * Environment commitments for still unknown A "moral" expected public damages and nuclear and toxic waste [U] obligation of investment needs to * Clean up of enterprise arrears and liabilities [M] the sustain delivery of * Default of municipalities on own non-guaranteed govemment public services and debt, own guarantees, and/or own obligations to that mainly meet key requirements provide critical public services [M] reflects public for accession to the EU expectations [H] * Support to the banking sector in case of crisis [L] and pressures * Future recurrent costs by interest of public investment groups projects [M] Risk level: H = high; M = medium; L = low; U = unknown Obligations listed above refer to the fiscal authorities, not the central bank. Sovereign Debt. The structure and size of US n Chanl 2. Bukaria's Pubik Debt Bulgaria's sovereign debt are somewhat worrisome. 16,000 i After the 1992-94 successful restructuring, public debt 14.000 declined significantly (Chart 2). At the end of 1999 2, E public debt stood at 86.7 percent of GDP (of which l01l about 14 percent were domestic obligations); total 8.000 external debt (both public and private) was at 81.5 6,000 0 percent of GDP. The fiscal burden of debt servicing 4,0o (external and domestic combined) was relatively light 2,000 1993 1994 1995 1996 1997 1998 1999 Soure: MOF and BNB Chapter I. Macroeconomic Stability 7 at 18 percent of central government revenues (this includes the servicing of a few called guarantees). Bulgaria was rewarded for its prudent debt management policy by the doubling of average domestic T-bill maturity to almost 2 years over 1998-2000. Its foreign debt rating was maintained in 1999 (B2/B+) and the outlook was improved by the rating agencies to positive. Gradual improvement is projected to continue, with external debt service-exports ratio staying at relatively comfortable levels, and peaking at 20.8 percent in 2001 under the baseline scenario.10 Although Bulgaria remains a severely indebted country, its debt stock to GDP is lower than many EU countries. Table 1.2 below, presents government debt for Bulgaria, the EU-15 countries and the Euro zone. Table 1.2: Bulgaria and the EU Government Debt (in percent of GDP) 1996 1997 1998 1999 Italy 122.1 119.8 116.3 114.9 Belgium 128.3 123.0 117.4 114.4 Greece 111.3 108.5 105.4 104.4 Bulgaria 287.8 103.4 78.7 81.9 Sweden 76 75.0 72.4 65.5 Austria 68.3 63.9 63.5 64.9 Netherlands 75.3 70.3 67.0 63.8 Spain 68.0 66.7 64.9 63.5 Germany 59.8 60.9 60.7 61.1 France 57.1 59.0 59.3 58.6 Portugal 63.6 60.3 56.5 56.8 Demnark 65.0 61.3 55.6 52.6 United Kingdom 52.6 50.8 48.4 46.0 Ireland 74.1 65.3 55.6 52.4 Finland 57.1 54.1 49.0 47.1 Luxembourg 6.2 6.0 6.4 6.2 EU-15 72.5 70.9 68.9 68.1 EU-zone 74.4 74 73.4 72.2 Total public debt excluding non-activated guarantees. Source: Bulgaria, MoF and WB calculations. Other sources: EUROSTAT. Although not a requirement for accession, the government aims to reduce its debt stock'1 below the Maastricht criterion of 60 percent of GDP (Box 1.2). While a high debt stock is a cause for concern and all efforts should be made to gradually reduce the debt burden, the key risks to monitor are debt service-related risks, i.e., the currency and interest rate risks, which we discuss further below. There are risks stemming from the rigid structure of Bulgaria's sovereign debt (Chart 3). Refinancing risk as measured by the maturity 10 Total external public and publicly guaranteed debt service to exports of goods and non-factor services. IMF estimates, based on the MOF data. The addition of private non-guaranteed debt and short-term debt increases this key measure of external debt sustainability by about two percentage points; it is projected to peak at 22.7 percent in 2001. l l Government debt as per the Maastricht criteria means the total gross debt at nominal value outstanding at the end of the year of the sector general gover nment. Public sector enterprises debt guaranteed by the government is 'included only when the guarantee is called. If the guarantee is not called, this debt is a liability of the public sector enterprises, and a contingent liability of the general government sector. 8 Chapter I: Macroeconomic Stability structure of public debt and its Chart 3. Structure of Public Debt as of December 31, 1999 volatility appears limited, but so are Total Public Domestic refinancing options. For external debt, G-24anEU the average portfolio maturity is long - World Bank 10M.7% 4.5% over 13 years, which limits refinancing 1.4% risk. However the debt is highly P"slu GL e inflexible, neither restructured Paris and London Club obligations nor the _ dOttt 4.8ated debt to international financial 144% Guarantee (Lana) institutions can be rolled over easily. 4le% Guaranftee (FX) Similarly, long-term FX-denominated 0.8% domestic debt instruments cannot be Londonct Source: MOF and BNB refinanced, while the T-bill market remains small and its average maturity short (around 2 years). CBA, under which the Leva is pegged to the Euro, simplifies the evaluation of currency risk - it boils down to the US dollar/Euro risk (the share of other foreign currencies in the public debt portfolio is under 10 percent). Bulgaria public debt portfolio has a strong natural hedge to currency risk - foreign exchange reserves mainly denominated in the Euro, and net exports, mainly in US dollars. This natural hedge had maintained well over 1998-2000. Box 1.2: The Maastricht Criteria - ARTICLE 104c 1. Member States shall avoid excessive governmental deficits. 2. The Commission shall monitor the development of the budgetary situation and of the stock of government debt in the Member States with a view to identifying gross errors. In particular it shall examine compliance with budgetary discipline on the basis of the following two criteria: (a) whether the ratio of the planned or actual government deficit to gross domestic product exceeds a reference value, unless either the ratio has declined substantially and continuously and reached a level that comes close to the reference value; or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value; (b) whether the ratio of government debt to gross domestic product exceeds a reference value, unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace. The reference values are specified in the Protocol on the excessive deficit procedure annexed to this Treaty. 3. If a Member State does not fulfill the requirements under one or both of these criteria, the Commission shall prepare a report. The report of the Commission shall also take into account whether the government deficit exceeds government investment expenditure and take into account all other relevant factors, including the medium term economic and budgetary position of the Member State. Chapter I: Macroeconomic Stability 9 Interest rate risk is more problematic, as the share of floating rate instruments in the public debt portfolio (external and domestic combined) was at 72 percent at end-1999. Exceptionally low Libor over 1997-1998 worked in Bulgaria's favor. In the future, the widely expected rebound of Libor will likely rise the burden of debt service. Chart 4 presents the results of stress testing the debt service with interest rates increases of 1 percent, 2 percent and 3 percent over the baseline levels.12 Chart 4: Impact of Higher Interest Rates Public debt service to exports GNFS. Public debt service to budget revenues 30% 35% 25% ---- - - - - - - - - - - - - 30% -_--_-- 20% - =- 25% _ X 15% _ - - _ _ 20% _- - ___ 10% 15% 1999 2000 2001 2002 2003 2004 1999 2000 2001 2002 2003 2004 Source sOF andBNB -- - d -baseline dl=1% *dl=2% ,> dl=3% Source: World Bank staff estimates These estimates include the impact of Libor on the domestic interest bill of the central government, which is more volatile than the external one, because domestic capital markets are shallow. Higher interest rates would add from 3.5 to 7.9 percentage points to the total government's debt service ratio in 2000-2004; the fiscal impact is in the range of 3.5 to 9.6 percent of governmmnt revenues. The predominance of debt instruments with floating rates remains risky; in the short run the central government can not do much about it, due to the existing financing constraint. As the prudent policy stance bears fruits in terms of further declines in borrowing costs, the government should seek to contain interest rate risk by contracting new debt at fixed interest rate (for as long as interest rate level is not too high). Eventually, interest-rate benchmarks for both external and domestic components of the debt portfolio should be adopted. Pension and health expenditures. By the late 1990s, the pension and health systems in Bulgaria had become highly inefficient and financially unsustainable. Adverse demographics, generous entitlements, low retirement age, and declining revenues despite high contribution rates have contributed to yield large unfunded pension liabilities. The universal and nominally free health system was characterized by low investment, declining quality of health services and 12 The baseline scenario is based on the MOF assumptions and projects Libor at 5.5 percent (extrapolating the 1999 average). For 2000-2001, interest payments on domestic public debt are projected to be about 1/5 of the total interest bill of the central govermnent; no domestic debt service data are available for later years. 10 Chapter I: Macroeconomic Stability increasing costs to the patients in terms of side payments. Ambitious reforrns to the pension and health systems were initiated in 1999 to restore sustainability and improve efficiency. The pension reform aims to restore the long term viability of the traditional Pay As You Go (PAYG) scheme by reducing entitlements and completing it with fully funded voluntary and compulsory pillars. Under the health reform, a Health Insurance Fund (HIF) created in 1999 will gradually contract out health care provision to competing agencies including a mix of public and private providers. Both reforms increase expenditures in the near and medium terms. Health reform will involve up-front costs to cover institutional capacity building and to rehabilitate gradually the long neglected capital stock. Reflecting the transition problem associated with the introduction of funded components while maintaining a PAYG scheme, the overhaul of the pension system entails up-front revenue losses for the first pillar in 1999-2001 followed by substantially improved financial performance. Chart 5. Projected Deficit of Pillar I with and without the Reform, in percent of GDP Annual Flows Cumulative since 1998 0.5% 2% - 0.0% -8% -0.5% _13% -tO%,0 B% 11111Old system -New system -23% -t5% 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 .Source: NSSI. lone-term nroiection model. Contingent liabilities. Unlike many other ECha r t~~~~~~~~~~~~~~~~~~~~hr 6. Fiscal Impact of Called Guarantees EU accession countries Bulgaria's risk exposure iS 30%/ relatively modest. In response to the macroeconomic 25% crisis of 1996-97, the government has applied 20% prudent limits and regulations for state guarantees. 1.5%- Presently, the government estimates the stock of ,____f___ guarantees at about 17 percent of GDP. Of these obligations, 9 percent of GDP is de facto direct debt owed to the INMF. Governent guarantee for almost 1999 2000 2001 2002 2003 2004 4 percent of GDP of domestic guaranteed debt 1---20% fail 40% fail K 60% fail 8% fa/ifji expired de facto in April 2000 when the deposits of Sources: MOF andBNB the State Saving Bank became subject to the Deposit Insurance Law, which provides for limited coverage under the Deposit Insurance Fund. Calls on the remaining guarantees, which currently amount to about 4 percent of GDP, would cause limited fiscal losses during 2000-2004 (below 3 percent of revenues even assuming a highly unlikely 80 percent default scenario). In addition, for private sector development purposes, the government guarantees obligations of agencies, like the State Fund for Agriculture, the Export Insurance Agency, and Chapter L Macroeconomic Stability 11 the Business Promotion Bank. These are small so far. Pressure on the government to provide guarantees and other forms of off-budget support, through the various existing and new state- guaranteed agencies, is likely to increase as the economy recovers, private participation in infrastructure takes off, commercial banks continue to abstain from providing long-term credit, and foreign creditors fear of uncertainties. Economic restructuring and investment requirements. Bulgaria delayed economic transition from plan to market by over a decade. It is only in 1997 that it embarked on an ambitious and comprehensive program of structural reforms, which once completed will have laid the foundations for a market-based economy. The wide-ranging structural reforms program covers agriculture, energy, privatization, price and trade liberalization, reform of the social sectors and restructuring and financial discipline in the enterprise sector. Transition-related financing needs encompass mitigating the impact of structural reforms on the poor, reforming the social sectors, restructuring infrastructure, and developing a modern administration and judicial system. In addition to the significant investment requirements inherent to the transition process, accession to the European Union requires substantial infrastructure and environmental investment. A major challenge for Bulgarian policy makers will be to maintain an adequate balance between remedial investments to meet EU accession environmental requirements and investments needed to ensure long term growth and poverty reduction. As Table 1.3 indicates Bulgaria has suffered from low public investment levels during most of the 1990s. Table 1.3: Bulgaria: Public Investment13 (in percent of GDP) l1992 1993 1994 1995 1996 1997 1998 1999 l Public Investment 2.8 1.9 1.5 1.1 0.7 1.0 3.8 4.7 Source: Ministry of Finance and IMF Rising capital expenditures in 1998-99 already reflect the transition-related investment agenda. Under its 2000-2004 program, government projects public investment at about 4 percent of GDP. Pressures to meet the investment requirements from transition and accession will intensify further in the future. Total environmental compliance costs to meet EU accession are substantial, in the range of 5.8 to 8.4 billion Euro (in 1998 prices, excluding nuclear safety) of which between 53 and 65 percent from the public sector. Even assuming a 20-year implementation period, remedial environmental investments are far above the current level of the overall public investment program (see Chapter IX). When other environmental costs driven by the single market directives are also included, total environmental costs range between 6.7 and 9.3 billion Euro. Moreover, as illustrated by the Box 1.3 on fiscal risks in the energy sector, although a large share of infrastructure investments is likely to be met through private financing, private sector participation in infrastructure also requires state guarantees and entails substantial fiscal risks. 13 Covers only budgetary investments: Central Government excluding SOE. 12 Chapter 1: Macroeconomic Stability Box 1.3: Bulgaria - Fiscal Risks Associated with the Energy Sector Fiscal risks associated with (a) explicit state guarantees for loans to energy state-owned enterprises and (b) explicit or implicit state guarantees of long-term take-or-pay contracts and other obligations are likely to increase rapidly if investments to modernize energy infrastructure and meet EU Accession requirements are not carefully selected or properly structured. While the Government rightly intends to maximize the use of private capital to minimize fiscal risks, on-going sector restructuring and privatization should ensure that private investors and operators increasingly assume all commercial risks. State guarantees should only be considered for sound projects and where they are needed to secure private financing for projects without which the country's economic growth or social condition would be jeopardized. With regard to (a), in 1999-2000 state guarantees have been provided or are being considered for investment loans of about $850 million to be implemented in the 2000-2004 period. These include investments in nuclear plant safety, waste disposal, and plant upgrade ($380 million), electricity transmission and dispatch ($150 million), district heating ($120 million), and expansion of gas transit capacity to Turkey ($47 million). The implied level of energy-related guarantees approximates the amount of overall investment guarantees at end 1998. With regard to (b), an explicit state guarantee has been provided for the gas supply contract between Bulgargaz and Gazprom, signed in May 1998, which requires Bulgaria to take or pay for pre-deterrnined annual volumes of gas until 2010. The contracted volume for 1999 (4.0 billion cubic meters) is valued at $320 million. A slightly higher volume is contracted for 2000. The continued decline in demand is likely to result in an obligation to pay against the part of the contracted volume that is not taken. Implicit or explicit state guarantees are also being considered for long-term take-or-pay power purchase agreements (PPA) between the state-owned National Electricity Company (NEK) and privatized power producers. The first PPA, to support a $400 million rehabilitation project (840 MW), would impose an obligation on NEK of about $180 million/year for 15 years in electricity off-take and fuel supply upon completion of the project. Similarly, the second PPA, to support a $1.0 billion new plant (600 MW) would impose an obligation on NEK of about $175 million/year for 10-15 years. To the extent possible, these deals should be structured after reforms are more advanced and the investors, not NEK, can take more of the market risk. Source: Brixi, Shatalov, Zlaoui, 2000. Fiscal risk policies and institutional framework. In line with the requirements of a currency board arrangement, Bulgaria has maintained comfortable levels of both external and fiscal reserves. On its Fiscal Reserves Account (FRA), which consists of the balances of all central government budgetary and extra-budgetary accounts in the banking sector (excluding those containing funds held in custody), the government maintains certain floor throughout the fiscal year. This floor which approximated 11 percent of GDP at the end of 1999 is the main contingency instrument to address fiscal risks. The floor on the FRA can be adjusted downwards to accommodate larger than expected structural reform-related contingent expenditures, higher than projected interest payments or shortfall of official financing relative to program Chapter I: Macroeconomic Stability 13 14 projections. Large reserves, however, have an opportunity cost in terms of investment and growth. As we will discuss further in the next section, only major improvements in risk mitigation and risk management capacity could reduce the reserve requirement, opening a way toward a better mix of reserve and hedging strategy and releasing resources for investment. In thefinancial sector, the 1996-97 hyperinflation crisis and subsequent policy actions by the Bulgarian National Bank have effectively cleaned up the banking sector. The ensuing reform has successfully capped both explicit and implicit government obligations for lost deposits and failed banks. Improved bank supervision has also controlled exposure of banks to liquidity and interest rate risks. The quality of bank's loan portfolio and foreign exchange exposure is not a significant fiscal risk so far. Government institutional arrangements for managing fiscal risks are strong in many aspects but not totally reassuring. The government has established a simple framework for dealing with guarantees. Particularly the government has developed a comprehensive register of guarantees and introduced regular reporting of the aggregate amounts of guarantees outstanding along with government debt figures. The register covers all external and domestic guarantees, indicating the beneficiary, creditor, project title, amount, currency, and debt repayment schedule. The government also centralized the issuance of new guarantees and subjected each new guarantee to executive and legislative scrutiny during the regular budget process. In terms of nominal limits, Decree 482 of 1997 set the annual limit on guarantees (face value) issued at 20 percent of expected budget revenues. A recent amendment to this Decree, however, dropped the complementary ceiling of 20 percent of GDP on the total amount of guaranteed debt outstanding (replacing it with a flexible ceiling to be set in the budget process each year). This change significantly expands the legal room for the government to issue new guarantees. Moreover, relatively lax limits on guarantee amounts are accompanied by flexible reserve requirements that are not underpinned by any rules or clear risk assessment practices. So far, however, the government has followed prudent reserve policy. The state budget included reserves in the amount of 50 and 20 percent of the total scheduled guaranteed debt repayment (normally to be paid directly by the debtors) in 1998 and 1999, respectively. Furthermore, under guarantee contracts the govermment always covers all risks, without analyzing their determinants, and the full amnount of debtor's obligation. Official creditors, providing concessional resources for development projects and balance of payment support, dominate the list of creditors and require full risk coverage by the government. If extended to commercial creditors, this practice has negative implications for market behavior, creating moral hazard on the side of debtors and creditors. Finally, for guarantees as for debt management, government lacks capacities to analyze and control risk. The capacities to design private-public risk sharing mechanisms are also to be developed at the MOF. Municipal borrowing is subject to a legal limit of 10 percent of the annual revenues of the respective municipality. Out of this amount, as much as 10 percent of the preceding month's 14 In addition, the government allocates annually resources within the budget for contingent expenditures. Around 1 percent of GDP in 1999 and 1.2 percent of GDP in 2000 were allocated for possible calls on guarantees and implementation problems of pension and health reforns. 14 Chapter I: Macroeconomic Stability revenues can be in the form of a short-term interest-free credit from the central budget. Municipalities are allowed to seek the remaining credit from commercial banks and from other municipalities and request state guarantees for them. Subject to the approval by the Securities and Exchange Commission, municipalities can issue bonds. The City of Sofia had debuted in these markets in 1999, by successfully placing EUR 50 million in Luxembourg. Markets normally perceive municipal bonds as implicitly guaranteed by the central government. Fiscal risk for the central government may also emerge from municipal guarantees and other contingent municipal obligations, which are not currently regulated under any existing law, as well as from the municipal ownership of loss-making and indebted enterprises and financial institutions. Regarding sovereign debt, earlier in the nineties, Bulgaria's debt management strategy appropriately focused on rescheduling the stock of Paris Club and London Club obligations. More recently, the country successfully bought back debts owed to the former COMECON banks at deep discounts, eliminating over US$1 billion of external debt in nominal terms. Nevertheless, the government views its past debt management strategy as passive, and aims to re-invigorate it by enhancing its analytical underpinnings, and by introducing more sophisticated tools to manage risks that lie ahead. A new pro-active debt management strategy, has been prepared. Its main goals are to: minimize the volatility of debt servicing cost, foster the deepening of the domestic capital market and enhance investor confidence by increasing the transparency of government debt management, attain investment grade for sovereign debt instruments and reduce gradually the level of public debt below the Maastricht threshold criteria of 60 percent. To achieve these objectives, the comprehensive program that covers all the main challenges of active debt management envisages to address refinancing, exchange rate and interest risk exposures through quantitative benchmarks (domestic vs. foreign, fixed vs. floating interest rate, special duration benchmark of domestic and foreign debt); establish a special performance benchmark against which debt management capacity is to be evaluated; introduce a quantitative framework ("cost-at-risk") to measure the variability of government debt service, increase the standardization of domestic securities and progressively extend their average duration; develop secondary debt market, including its retail segment; implement a comprehensive debt tracking system in the Ministry of Finance; and develop a risk assessment system for guarantees. Addressing the debt-investment dilemma. Our discussion, so far, reveals a complex and challenging situation. Bulgaria has successfully stabilized its economy following a long period of economic mismanagement and political turmoil, which among other painful legacies has left the country with a severe debt problem. Investment to meet transition and EU accession requirements are significant while fiscal pressures are already high and the structure of government expenditure, rigid. Under its currency board arrangement, Bulgaria can only rely on debt and privatization revenues to finance fiscal deficits and respond to unaccounted for fiscal shocks. Privatization revenues, however, will soon be on the wane, leaving debt as the main financing option. With its already high level of indebtedness, Bulgaria faces a difficult trade-off. Should the country adhere to a very conservative stance towards debt and fiscal risk at the expense of investment and growth or rather accept a slower pace of debt reduction in order to Chapter I. Macroeconomic Stability 15 guarantee the resources needed for economic restructuring and mitigation of the impact on the poor and vulnerable? So far, Bulgaria has relied on high levels of fiscal reserves as a blanket contingency instrument against all risks. Its future investment and development agenda, however, call for a better mix of risk mitigation strategies, fiscal reserves and debt management. The overall framework for fiscal management could be strengthened to better capture fiscal risks across all types of government activities, allow for systematic monitoring and reporting, adjust medium term fiscal strategy to actual risks, create accountability for risk analysis and management, share risks between government and the private sector, and make adequate provisions/reserves based on sound risk assessment methodologies. This would allow a move from a blanket high contingency reserves policy to a still cautious but more grounded fiscal reserve policy, freeing resources for other important uses. In this regard, a new law on Government obligations is currently under preparation and appears to offer the potential of providing the right institutional basis for prudent fiscal risk management in the future. The government is correct in planning to continue to follow a cautious strategy in assuming and structuring new debt and contingent liabilities in order to maintain an affordable debt service and reduce its debt stock in the medium term. In particular, Bulgaria should continue to seize all opportunities to reduce its debt burden whether these are provided by the market, such as buy backs at deep discounts, or by official creditors, such as debt to environment/investment swaps. Without deviating from the prudent stance, more sophisticated tools to tackle risks in the public debt portfolio should be explored. The government can explore various instruments to contain interest risk. While straightforward use of derivatives (e.g. interest rate swaps) may be premature, due to Bulgaria's sub-investment-grade rating, a good preparatory step would be to use the World Bank's new products, that allow the transformation of maturity, exchange rate and interest rate risks.'5 Through some of these instruments, sovereign borrowers could also gain experience that may later be applied in the international derivatives' markets. ECONOMIC INTEGRATION AND GROWTtH In line with its European Union membership goal in the next few years, Bulgaria will face the challenge of developing and implementing a growth strategy that generates high and sustainable growth while avoiding social and macroeconomic imbalances. High and sustainable rates of economic growth will facilitate integration, in particular if efficiency gains and a better 15 Of particular relevance for Bulgaria is the World Bank's new loan product, a fixed-spread loan that has an interest rate based on LIBOR, plus a spread that can be fixed for the life of the loan. The product allows the borrowers to flexibly fix the interest rate on disbursed amounts at any time during the life of the loan; to cap or collar it; to unfix or refix the rate on disbursed amounts; and to change the currency and loan repayment terms, within financial policy limits. It offers an attractive opportunity to increase the flexibility of the government borrowing policy while keeping its low-risk profile. For example, it may consider fixing the maturity of a new loan from the World Bank in such a way that it would smooth the uneven debt servicing profile in the years ahead; or, balance the currency structure of its outstanding obligations with the currency structure of its exports. Sirnilarly, additional opportunities to mitigate risks in asset/liability are provided by the World Bank hedging products such as interest rate swaps, caps and collars; currency swaps; and commodity swaps available to transform the risk structure of Bulgaria's debt portfolio to the World Bank. 16 Chapter : Macroeconomic Stability allocation of resources are the main driving forces of growth. While a high growth scenario will facilitate accession, reducing the already large income gap with EU country members, there are in turn growth benefits from European integration. These economic gains, though, are not automatic but policy contingent as demonstrated by the experience of the less well-off countries which joined the EU. Sustainable growth. The Government remarkable reform program of the last three years has radically transformed Bulgaria's economy and established the necessary conditions for high and sustained growth. Thanks to the CBA, the fiscal and monetary stance are sound and the banking sector has been successfully restructured. The first generation reforms towards a market economy, including price, trade and investment liberalization have been largely implemented and the public enterprise restructuring program has practically eliminated value-subtracting activities. Yet, unemployment is growing and has recently reached an alarming rate of 19 percent and the standard of living of large segments of Bulgaria's population have declined significantly. In order to reduce unemployment, Bulgaria needs to further boost private investment and achieve high growth rates on a sustained basis. This, in turn, requires a swift move towards the second generation reform agenda which will allow to complement the policy framework of the first generation by establishing the institutional foundations of a well- functioning market economy. From its first generation reform program, Bulgaria still needs to complete the state divestiture program in agriculture, network utilities and financial sector. The second generation reform agenda for Bulgaria should aim to ensure that the rule of law, government regulations and property rights support an enabling business environment. Hence, the legal and regulatory framework governing private sector activity, should be complete, clear, coherent, and most importantly well understood and properly implemented by the public administration and the judicial system. Key to a well-functioning market economy are also the institutional underpinnings for efficient and flexible factor markets, i.e., labor and capital. The regulatory framework and institutions governing financial markets activity, in particular capital markets, need to be strengthened to increase intermediation, encourage a more efficient overall allocation of resources, and enhance the public's confidence in the system. In order to boost employment and encourage a shift from the inforrnal to the formal sectors of the economy, the flexibility of labor market regulations should be enhanced while payroll taxation should be reduced. Finally, restructuring and attracting massive investment in the network utilities while developing appropriate regulatory principles and establishing independent and competent regulatory institutions are essential for the competitivity of the Bulgarian economy. This reform agenda if implemented properly will not only stimulate the development of the private sector, but also maximize the benefits to Bulgaria from economic integration. Growth effects of Economic Integration. The two main channels through which economic integration" can affect growth are accumulation of physical capital and knowledge 16R. Baldwin and E. Seghezza (1996) "Growth and European Integration: Towards an Empirical Assessment", Centre for Economic Policy Research, No.1393. Chapter J Macroeconomic Stability 17 creation (technology). Economic integration has the advantage of a potential improvement of the investment climate by reducing the risk premium: for both, domestic and foreign investors, confidence is boosted by many factors. In particular, joining the EU makes the country potentially less risky. EU membership assures well-defined property rights and codifies competition and state-aids policy. It also secures convertibility, open capital markets and right of establishment. On the technology side, integration brings the benefits of international spillovers of knowledge externalities through foreign direct investment, reduces the duplication of innovations and brings efficiency gains by increasing competition. The growth effects of economic integration with the EU can be illustrated with the experience of Ireland, Greece, Portugal and Spain. It is relevant to look at the experience of these four countries for two reasons. First, these countries, when they joined the EU during the 1973, 1981 and 1986 enlargements had lowest per capita income,'7 similar to what will be the case of Bulgaria. Second, enough time has passed since they joined the EU to derive conclusions about the medium-run growth effects of economic integration. Table 1.4 summanzes developments on income per capita and the growth pattem of these four countries. Two stylized facts are worth noting. First, the income gap between the average EU and these countries has substantially narrowed. By 1998 all of them have more than doubled their income per capita level at the time of accession. Second, there is no clear pattem in tenns of pace of convergence and rates of growth and initial income. Ireland's income per capita convergence started right after accession in the early 1970s, slowed in the 1980s but accelerated sharply in the mid-1990, 20 years after entry. Spain and Portugal have been gradually converging at different paces. Greece is a case in which the income gap widened after its entry and it was not until the late 1990s that it started catching up. Table 1.4: Income Convergence of Ireland, Greece, Spain and Portugal 1960 1973 1980 1985 1990 1995 1998 Index 1998 2 GDP per capita EU= I OO I Ireland (1973) 61 59 64 65 71 86 104 177 Greece (1981) 39 57 55 51 47 66 68 117 Spain (1986) 60 79 74 71 75 76 79 III Portugal (1986) 39 56 55 51 56 68 71 140 GDP growth rate Ireland 5.2 6.2 3.1 3.1 7.8 11.8 10.4 Greece 4.4 7.3 1.7 3.1 3.7 2.1 3.5 Spain 2.4 7.8 1.3 2.6 3.7 3.7 3.8 Portugal .. 11.2 4.8 3.0 4.1 2.8 3.9 Notes: 1/ Dates in parenthesis or shaded refer to the year of accession. 2/ The index measures the improvement between the year of accession and 1998 of the respective country vis-a-vis the EU average. Soiurc European Commison Annual Report (1994) for years 1960-93;1998 from EUROSTAT and World Bank 17 By the time Greece, Ireland and Portugal joined the EU their income was 60 percent of the EU average, while Spain's was above 70 percent. 18 Chapter I: Macroeconomic Stability The pattern of income convergence has been sensitive to the policy framework adopted by each country. Clearly, the growth benefits from European integration were not automatic. Rather, gains from economic integration have been contingent on the choices made by policy makers. The commitment and implementation of reforms played an important role in the economic performance of the acceding countries, a reason why Greece lagged behind the others."8 Its unsettled macroeconomic policies and uncompetitive indigenous industries may have reduced its attraction for and benefits from foreign direct investment.'9 Macroeconomic stability, trade liberalization, restructuring of the manufacturing sector and the environment for FDI emerge as key to the extent to which acceding countries benefit from membership. Evidence shows that, except for Greece, the countries experienced investment booms upon accession to the EU. Capital formation was boosted in three of the new "poor" entrants, Ireland, Portugal and Spain, while Greece experienced instead a consumption boom (Figure 1). There is also evidence that, again except for Greece, these countries experienced a stock market boom.20 The investment boom was driven by reduced political risk2' and the restructuring of the capital stock in view of new production patterns and new technologies associate with increased FDI. The opening of the capital account played an important role, as for these countries, entry was generally accompanied by an increase in capital inflows. Upon entry Portugal and Spain experienced an increased inflow of FDI, while Ireland started receiving large inflows only after 1990. Figure 1: Investment to GDP ratios (accession year = 100) 140- 130 t ,H 120 ~- - - 100 ___ 90 - , _____ 7 _ - _ 80 ___ _ _ 60 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 i4--Spain -U- Greece Ireland - Portugal I Source: Baldwin and Portes (1997), "The Costs and Benefits of Eastern Enlargement: the Impact on the EU and Europe". 18 Baldwin and Seghezza (1996) found that for three periods averages (1971-90, 1971-74, 1975-90) European countries experienced higher total factor productivity growth than the sample average that included non-European countries. Another important finding is that European countries that resisted deep integration had systematically worse productivity growth than the EU members. They argue that because European integration has substantially liberalized trade, it has promoted growth. 19 The cases of Greece, Spain, Ireland and Portugal. The single Market review. Volume 2. 20 Baldwin, et. al. (1997) 21Until the mid-1970s Portugal and Spain were under dictatorships. Chapter 1I Macroeconomic Stability 19 In the next section, we will review the current framework for private activity in Bulgaria and highlight the key areas where improvements are needed to promote private investment, and allow to optimize the growth dividends of economic integration. CHAPTER II: PUBLIC-PRIVATE INTERFACE INTRODUCTION There are four critical steps in changing the "public-private interface", necessary for an economy to transition from centrally-planned to market-oriented: (i) creating stability and predictability of the macro and policy environment; (ii) removing assets from state ownership and direct intervention; (iii) building up the public framework (laws, regulations and administrative procedures) to guide private sector behavior; and (iv) making the framework function by improving the capacity, integrity and oversight of the civil service, and its credibility vis-a-vis the general public. Completion of all four of these steps is necessary to provide assurance to the general population and the investment community that a reliable, rules-based system is in place which can serve as the foundation for private investment. These measures also lay the institutional foundations of a well functioning market economy - one of the most important EU Accession requirements. Some of the more advanced transition economies have completed nearly all of these steps and are emerging as full-fledged market economies. Bulgaria is only part way toward completing these four steps. In Bulgaria, superb performance has been demonstrated in achieving stability and predictability of the macro and policy environment. Macroeconomic stability no longer provides a hindrance to the development of the private sector and the Government has held to a steady path of market reforms since 1997. Major progress has been made on reducing state ownership, resulting in a burgeoning private sector share of GDP and a recent surge in FDI, although some problems remain due to continuing Government intervention. Significant progress is visible in the development and streamlining of laws, regulations and administrative procedures, with some fine-tuning still needed. Additional reform and investment are needed to improve the capacity, integrity and oversight of the civil service in order to foster efficiency and credibility. MAKING BUSINESS ACTIVITY PRIVATE Progress in removing assets from state ownership and direct intervention has been substantial. Privatization, which lay dormant for most of the 1990s, picked up substantially in the past few years. In 1997, compared to other transition economies, Bulgaria ranked close to the bottom in terms of privatization of state-owned enterprises (SOEs). With the stabilization program of 1997, the Govermment embarked on an ambitious privatization program that had two phases: (a) the divestiture, originally scheduled to be completed by the end of 1999, of SOEs in sectors other than energy, transport and infrastructure22 accounting for about 63 percent of total long term assets (LTA)23 held by all SOEs; and (b) the privatization, beginning 2000, of most of the SOEs in the energy, transport and infrastructure sectors accounting for about 37 percent of 22 The Bulgarian Telecommunications Company, Balkan Airlines, and some power generation assets have been included in the first phase of the privatization program. 23 The base used is the value of total long term assets of all SOEs at end-1995, estimated at BGN 599 million or about 68 percent of 1995 GDP. Chapter II. Public-Private Interface 21 total LTA. The Government will continue to maintain ownership of certain SOEs and assets in the energy and infrastructure sectors, such as the nuclear power plant and the power transmission company that will be spun off from the National Electricity Company. State ownership of productive assets is being reduced rapidly. Some 70 percent of assets slated for "first phase" privatization have been sold, and another 10 percent have been placed under liquidation or insolvency procedures. In recent months, the Government has also vigorously pursued the completion of the liquidation process: the majority of assets of more than half the enterprises (280 out of 480) that were under liquidation in June 1999 have now been sold. Table 2.1: Bulgaria Privatization Program (as of March, 2000) Category LTA (end-1995) as percent of as percent Number of BGN million 1"t Phase of Total enterprises A. Total Assets 598.9 _ 100 3827 Al. 2nd phase 221.2 36.9 133 A2. Transferred to municipalities 1.1 0.2 50 B. 1st phase 376.6 100 62.9 3644 C. Total Divested 306.3 81.3 51.2 2878 C I. Privatized 247.9 65.8 41.4 2430 C2. In liquidation/solvency 48.2 12.8 8.1 448 C3. Separate parts sold 10,3 2.7 1.7 D. Remaining 70.3 18.7 11.7 766 Dealing with other types of Government involvement in enterprises has been more problematic. A first attempt to address the financial performance of loss-making state enterprises, through an Isolation Program, has had some successes: many large loss makers were privatized or placed under liquidation or insolvency proceedings, but less success was achieved on imposing financial discipline on SOEs. Direct lending from the banking sector to these enterprises has declined in recent years, as have other transfers from the Government to enterprises. But there has been a marked increase in enterprise arrears to the electricity company, the gas company, and the social security agency. As a short-term solution, measures are being imposed to improve collection and decrease arrears. This needs to be coupled with a commitment to make transparent Government support to loss-making enterprises to demonstrate whether they are in compliance with EU "state-aids" requirements. And for the longer term, the Government is gearing up for the "second phase", focusing on the restructuring, regulation and eventual privatization of assets in the areas of energy, transport and infrastructure. As a result of the last three years of steady reform, the private sector share of GDP has risen to about 60 percent (with more rapid growth in recent quarters) and annual FDI flows have soared in the 1997-99 period, averaging more than five times what they were in the 1992-96 period. These are encouraging signs, but there are others which are less positive. While there has been steady growth of new private business in Bulgaria, the informal sector appears to be a sizeable proportion of this activity, which carries with it some benefits (e.g., larger than officially documented private sector and employment), but also significant disadvantages (e.g. unfair tax burdens and unregulated economic activity in some areas which should be regulated in the 22 Chapter II: Public-Private Interface interest of the general public). "Formalizing" the informal sector will be an important step in creating a more stable and legitimate market economy. In addition, commercial bank lending remains very conservative, stifling promising investment opportunities and, although exports have started to recover, their share in GDP is still low (32 percent in 1999). Both of these are indications that the second generation of reform-those in the post-privatized sector-have yet to take hold. In the post-privatized sector, necessary restructuring of most firms has often not been sufficient to revitalize their productivity. Many formerly state-owned enterprises were purchased through MEBOs or sales to a small number of influential domestic purchasers who lacked the funds for the purchase (payment terms can extend up to 10 years), the funds for investments to renew the long-neglected enterprises, and the managerial know-how to restructure them successfully. In addition, the state retains a relationship with many recently privatized enterprises, through privatization contracts which oblige the owner to make certain investments, to maintain levels of employment, and to repay certain debts incurred prior to privatization. New infusions of equity (through the development of capital markets) will be critical to recapitalize the more promising of these firms. A watchful eye needs to be kept on debt servicing of private enterprises (particularly those with repayments to the government), and swift action toward reorganization and bankruptcy should be taken vis-a-vis those unable to meet their financial obligations. The early gains witnessed recently will not be sustainable without attention to these second generation reforms--including releasing private firms from direction by the Government-- and without considerable effort devoted to building the remainder of a market framework. Most importantly, building and implementing the public framework to guide private sector behavior and support a fully functioning market economy remains a crucial item on the Government reform agenda. Progress is ongoing to establish and streamline the laws, regulations and procedures which provide the framework for businesses and citizens to function in a reliable market environment, but securing their consistent, reliable and effective implementation to make the framework function properly will continue to require major attention. These are critical aspects of market reform, and are elaborated below. LAWS Over the last decade, there has been enormous progress in drafting and enacting market- oriented legislation. Primary legislation now exists in the areas of foreign investment, concessioning, privatization, company incorporation and contract law, bankruptcy proceedings and reorganization, public companies and securities transactions, competition law, and corporate taxation. Many of these laws have been redrafted, refined and amended to make them more compatible with international standards. There is still a limited, but not insignificant, agenda which remairns - e nsure quality (including compatibility with international standards), appropriate scope, and consistency across legislation. Some improvements with respect to the protection of interest of minority and portfolio investors could be made in individual pieces of legislation governing corporations, banking and capital markets. Proposals to rectify these shortcomings have been introduced with the integration of modern type rules governing public companies. For example, the widely used option to increase corporate capital at the sole discretion of majority shareholders provided under Chapter II: Public-Private Interface 23 the regulatory mechanism of the Commercial Code is now prohibited for public companies falling within the scope of the Law on Public Offering of Securities. Bankruptcy proceedings are slow and cumbersome, in part due to certain features of the law which result in long procedural delays. But these have been recognized by the Government, which is pursuing reforms. The Code of Civil Procedure will be overhauled; and Part IV of the Commercial Code is being amended to address some of the above problems, as well as others such as incompetent trustees and lack of clarity of the operations and rights of creditors' committees. Both of these measures should help to improve the process of winding down or sale of enterprises through the court system. There are some inconsistencies across the legislation with respect to the recently enacted tax procedure code, the mandatory social security and health insurance laws that will need to be addressed. On the whole, however, the main emphasis on the legislative side should be on finalizing and securing the implementation of secondary legislation/supporting regulations. REGULATIONS AND ADMINISTRATIVE PROCEDURES There has been clear progress in establishing a set of market-based regulations in Bulgaria. This has occurred in an environment which has been particularly challenging: the rapidity with which legislation has been created has placed extreme pressure on the lower levels of government tasked with the responsibility for translating these into implementing regulations, and this has been exacerbated by the absence of systematic analysis or evaluation. The Government has succeeded in dismantling many anti-market rules and practices, has demonstrated its willingness to move toward market friendly and EU-harmonized regulation, and is presently undertaking significant public sector reform and wholesale rewriting of regulations in order to achieve this goal. The regulatory framework is now sufficiently advanced that the impact on enterprises is not considered prohibitive,24 but at the same time it is not always business friendly. This stems primarily from the fact that regulatory officials have not been sufficiently effective in developing regulations, relying heavily on the regulations from the EU countries, sometimes without the design, or even the terminology, being fully understood. Also, not involving consistently the main stakeholders-such as the private sector-of new laws in the drafting process, has created oversights and mistakes which could have been avoided with their involvement. Often, the resulting rules have been of noticeably poor drafting quality and have not been adequately tailored to Bulgaria's problems or implementing capacity. Finally, implementing regulations tend to be passed only with significant delay after new laws have been passed. Consequently, neither the private sector nor the responsible civil servants are clear on the consequences of new laws and how these provisions should be interpreted in practice. A number of initiatives are now underway to address these shortcomings: representatives from the industrial associations participate in the work of the working group which write the 24 This may not be completely applicable to small and micro-enterprises. As in other countries, they may be more adversely affected by regulations/procedures and regulators; this may provide a partial explanation for the size of the informnal sector. As such, studies of these enterprises should be conducted periodically. 24 Chapter II: Public-Private Interface legislation transposing EU directives. Draft laws and regulations are sent to the industrial associations and enterprises for opinion. Special seminars, forums and meetings are organized to present new legislation to industries. A framework agreement for coordination and cooperation between the Bulgarian Industrial Association and the Ministry of Economy is in place and operational. Since Bulgaria has no choice as to which directives to transpose but only how and when to transpose them, the administration works with representatives of the private sector to determine the consequences of new legislation and ask when needed for transition periods. Two specific kinds of problems have plagued the regulatory framework in the early attempts to reform it. First, there was not initially enough selectivity in establishing an appropriate scope of regulation, with clear principles of when and how to regulate explicitly identified. The administration has sometimes erred on the side of excessive regulation, or has left the decision to authorities at lower levels of government which exercise varying levels of intervention.25 Until recently, little attention had been paid to monitoring the impact of regulations to make sure they achieve originally intended purposes and to assess the costs and benefits of regulations. Second, there has not been enough coordination in the development of new regulation, with the result that overlapping and often conflicting requirements are imposed upon firms. An example of this is sanitation permits for commercial entities required by both national and local governnents, or land registration procedures which require duplicate documentation to multiple agencies. The Council of Ministers has limited resources to perform rigorous legal assessments, which would include scrutinizing new regulations for consistency and overlap with existing rules. In addition, the Ministry of Justice has been unable to develop a consistent approach to ensuring that proposals and implementing regulations are harmonized with EU norms and are in accordance with Bulgarian rules. Even language is a problem; the legal terminology is itself still developing, with many terms borrowed from foreign legal instruments and having to be defined and incorporated into Bulgarian legislation. As a result, there are a number of specific regulations and/or procedures, which need to be amended because they contain poor drafting (leaving the regulators uncertain of their intent and open to discretionary application), excessive powers for intervention, or overlap/inconsistency with other rules and regulations. Several such examples have been enumerated in a study by FIAS, in which a series of detailed recommendations were made on how to overcome the various bottlenecks identified by investors at the time of the study. As indicated above, many of these recommendations have now been acted upon. It would, however, be useful for the Government to intermittently evaluate the original purpose of regulations and administrative procedures to examine if they are still required. In addition, regular impact studies from the perspective of actual or prospective investors can provide evidence regarding the efficacy of reform measures in easing constraints for private business activity. 25 An example of this is licensing for road freight transportation, for which municipal govermments can essentially establish their own licensing requirements which vary from minimalist to highly interventionist and costly for the potential entrepreneur. Chapter II: Public-Private Interface 25 Box 2.1: Administrative Issues Identified by Foreign Investors In the FIAS study, investors have indicated that it is not a simple task to establish and operate businesses in Bulgaria; rather, they tend to encounter a number of difficulties at the administrative level. Investors are also concemed about the intrusive nature of audits, inspections and approval procedures, and they perceive that this behavior may be motivated by the desire to control private sector activities. They also indicate that they cannot rely on clear and transparent interpretations of existing laws and regulations. The Government is making progress in recognizing and even rectifying many of these issues. It is, however, worth noting investors' perceptions in an attempt to underscore how these perceptions can negatively affect levels of private investment. Investors have reported two areas where they believe the Govemment has been exercising "undue" amounts of control: license, permit and approval systems as well as their reporting mechanisms, which require substantial amounts of business data; and inspections and audits (particularly those undertaken by the tax and customs administration). In addition, investors have found it difficult to obtain work permits for expatriate staff and they report that contractual arrangements to hire Bulgarian workers lack flexibility. The Labor Code is, however, now being amended which may prove to ease these labor-related constraints. Business registration is an area noted as complex by many investors. The Government is making an effort to streamline the company registration process through the creation of BULSTAT, together with the accelerated computerization of the Tax General Directorate. However, the process is at an early stage. Registration changes also can be quite cumbersome with the Bulgarian court system presently not having the capacity to handle the load of administrative cases it faces. Tax reporting has been rapidly evolving, and thus seen by investors as imposing difficulties. Tax reporting is an area which has been subject to particularly intensive legal reform efforts. Implementing regulations have tended to be missing, while civil servants lack training to implement new policies. This translates into uncertainty among investors, with civil servants unable to provide clear interpretations on requirements, which is a burden as well as a source of increased risk for businesses. Instead inspections and audits seem to be used as the primary tool of enforcing compliance. In addition, the waiting period for VAT reimbursement appears a costly measure to the private sector. It would be worthwhile to investigate the true extent of the private costs of this waiting period, and whether there might be more cost-effective means to obtain similar fraud deterrence and detection results. A Unified Revenue Agency should, in the coming years, improve this situation, which has already benefited from better systems in NSSI. And the VAT refund which is a priority for Government short-term reform measures has been reduced from 6 to 4 months in the 2001 budget. Finally, the tax authorities have instituted several improvements, including risk analysis to better target audits, a. training program intended to improve the professional standards of their staff and the customer service available to taxpayers (including businesses), further development of their website, and a public information campaign to better inform taxpayers about their rights and obligations. Future monitoring and evaluation through client feedback will indicate if these measures have yielded the desired improvements. Physically establishing enterprises in Bulgaria has not been simple. Getting access to land is reported to be problematic, and it is difficult to establish ownership rights over plots. This is partially due to the restitution process, but also because of a complicated and incomplete land registration and titling system. Leasing land does not present an attractive alternative, as lease arrangements are currently very restrictive and reported to be expensive. The entire process of site development - including construction and occupation permits - is similarly complex, with multiple authorities involved, resulting in numerous, and often redundant, approvals and permits. Many of these constraints are beginning to be eased, since land titling is now well-advanced, the new Land Cadastre Law has been passed, work is ongoing on improving Land Registration and a registry of claims is being established. Further work may still be needed to develop a more user-friendly land lease system and to streamline the process for obtaining construction and occupation permits, in order to make it easier for investors to get access to and develop sites. 26 Chapter II: Public-Private Interface MAKING IT WORK The Government has already initiated a number of efforts to tackle these issues, signaling the potential for the evolution of a rule-based public framework, built on an appropriately limited, consistent and coherent set of regulations which gives due consideration to maximizing the benefits to the public at large and the private sector. The medium-term program (Bulgaria 2001) contains a variety of measures to improve the selectivity of government involvement in the economy and enhance the administration of regulations. The Government is making a concerted effort to increase the coordination with regional/local governments to provide a more consistent view on laws, regulations and administrative procedures. Finally, the flagship reforms under the Licensing Optimization Program hold great promise. Under this program, the Government has recently undertaken a comprehensive review of existing licensing and permit requirements, in order to fulfill its commitment to reducing administrative barriers to growth, with a view to eliminate or modify unnecessary requirements. The review has identified areas of violation/excessive regulation; clearly defined and differentiated the concepts of license, permits, etc.; and identified the need for regulatory impact assessments. The challenge for Bulgaria is to limit regulations to those situations where government involvement is essential and to ensure that regulatory obligations are applied in a consistent and rule-based fashion. If the proposals described above are effectively implemented-including appropriate involvement from line ministries, other agencies, and the private sector-this should lead to the retrofitting of existing regulations and tightening up the process for the establishment of new regulation. The end result could be a significantly improved regulatory framework in Bulgaria, and an adjustment in the public-private balance to one more closely resembling a market economy. Another challenge is the capacity of the civil service itself. Bulgaria has set up a framework of institutions at different levels of government (state, municipal, etc.) to administer and enforce compliance with laws and regulations which define and protect private property, enforce contracts, settle disputes and oversee competitive business entities and practices. But to date, most of the institutions charged with administration and enforcement have devoted much of their time to drafting procedures and new regulations. Implementation--that is, administration, enforcement, and adjudication through the court system--has not been a priority. This has left the implementing agencies and the judiciary inadequately equipped for their required roles; civil servants in these entities on the whole do not at present reflect the highest standards of integrity; and there is not appropriate oversight. As a consequence, the general population does not perceive that there is a rule-based system which applies to everyone equally. Administrative and judicial capacity. Overall, regulators in a variety of business-related areas across the Government need more guidance. In general, they have too much discretion and are equipped with too little technical training. Ministries largely have been unable to create transparent procedures for administering regulations, regulators often lack implementing instructions, and they have not been able to generate the type of information and data that is vital to the creation of an effective set of regulatory practices. As a consequence, regulators cannot regulate effectively and businesses get little guidance on how to comply with requirements. The role of judges needs better definition. In the judiciary, judges do not receive pvt) commensurate with the responsibilities, some lack familiarity and experience in modern busii. Rgs and commercial law (require different skills and training) and do not have protection from Chapter II: Public-Private Interface 27 improper influence from other branches of government as well as organized crime. Judges also have to attend too many clerical tasks (hand-writing or typing their own correspondence; conducting their own legal research, answering their phones). Even members of the Supreme Judicial Council are not immune-most of them are also judges on active duty, with caseloads, which undercuts their ability to perform a proper supervisory role. Clerical and administrative court staff are also relatively underpaid, and thus not always motivated to serve as part of a system that resolves disputes. Court administration has suffered serious neglect. There are too many disputes for the courts to handle, chronic and excessive delays in the civil justice process, and no meaningful alternatives to full trial, such as a small claims court. This is exacerbated by the lack of any coordinated system for case management or court administration, and too little computerization or automation (no central set of records through which case numbers, types disposition, length of case are mentioned or reviewed). This is, however, expected to be at least partially remedied through the computerization of the court system which is presently being undertaken. Training programs exist, but they are not sufficient. The Magistrates Training Center presently provides training for judges and magistrates, and is expected to be extended to include court administration. The Institute on Public Administration and European Integration is charged with the mandate of providing professional training for Bulgaria's civil service, specifically to strengthen the professional capacity of current and future civil servants to effectively guide Bulgaria's policy makers in the EU accession process. In addition, training is being provided in specific areas where there are glaring problems. The government is developing a program for upgrading the skills of those involved in bankruptcy and liquidation, including judges, trustees, lawyers, accountants, appraisers, as well as managers of creditor institutions and of debtor enterprises. In the short run, the Council of Ministers has established a unit to set standards for the selection, removal and performance of liquidators for SOEs. This unit will serve as a pilot for a permanent unit that will cover the liquidators of all commercial enterprises. This kind of enclave training is needed, and should be replicated in other areas with serious technical shortcomings. Integrity of civil service. The poor working conditions for regulators and the courts are the most often cited reasons for poor performance. But there is a difference between poor performance--which stems from lack of technical skills, disorganized work environments and work overload--and inappropriate professional conduct. In the judiciary, behavior ranging from minor ethical breaches to blatant corruption has become "not uncommon". Non-judicial support staff are reported to display a low quality of professional conduct. It is commonly cited that clerks are paid small sums to hide files or to move files up on a judge's calendar, and larger sums are paid for a file to be completely "lost". The legal process has been described as "politically controlled"; delays are induced by lawyers, creating a shift in power to those in whose interest it is to suspend the proceedings. Those appointed to be the upholders of justice are by no means above the fray. Anecdotal evidence suggests that case decisions have been resolved through bribery of the judges, prosecutors and investigators. Enforcement of judgments in civil cases is highly ineffective (slow, riddled with procedural requirements, inefficiently run) and thus fertile terrain for corruption. 28 Chapter II. Public-Private Interface On the regulatory side, regulatory practices were found to involve excessive discretionary authority and frequent cases of the misuse of authority were reported. Ministries have operated with a high degree of autonomy in determining how to carry out their regulatory responsibilities, including some egregious examples of licensing and permit requirements being enforced even after they had been revoked. A recent study of the licensing requirements for small businesses in retail food trade, wholesale trade, and road freight transportation reveals that there is enormous variation across cities/regions and even within a given city to procure similar types of licenses, implying that there is significant discretion by administrators on a case-by-case basis. Ministries have also not instilled a sense of accountability for regulatory officials, and there is no method to evaluate the performance of regulators. Most of the problems suggested above are recognized only through anecdotal evidence; there is a clear need to determine how pervasive the problem is. After such an assessment, the Government needs to come to terms with the professional conduct of its regulators and employees in the judiciary and turn its attention to identifying and rooting out those individuals which perpetuate a system of unethical behavior, and do so fairly and transparently. Civil service oversight. There is growing recognition that public institutions require oversight, and some entities have recently been created to perform these functions. But these oversight entities are new and fragile. For instance, the Supreme Judicial Council (SJC) has been given constitutional responsibility and the right to supervise and discipline all judicial branch employees. But the SJC is seriously deficient in performing these functions, primarily because it does not have the administrative capacity to exercise its authority. There is no system through which disciplinary matters are reported and investigated, nor any clear set of guidelines for the conduct of employees, and the SJC does not have expert staff whose responsibility would be to deal with disciplinary actions in judicial. There are also no written standards of conduct for investigators. As a result inappropriate behavior of judiciary employees often goes unpunished. The behavior of regulators also goes largely unchecked. There is no central mechanism to supervise regulatory enforcement. Until the fall of 1999, there was no information system or systematic effort to monitor the activities of regulatory agencies. The Supreme Administrative Court (SAC) has recently been established as an apex of system for contesting rule setting and rule application. It serves as the highest instance for the appeal of decisions of the lower courts on cases disputing the legality of administrative regulations and actions. It has original and exclusive jurisdiction over challenges concerning the legality of actions of government agencies, including those of the Council of Ministers and the individual line ministries. But the SAC has no track record yet, and there are some worrying signs that there is an increasing number of regulations specifically exempting administrative acts from review. There is a need to clearly assign and strengthen supervisory roles for the judiciary and regulators to identify inappropriate behavior. Further, clear rules and responsibilities need to be established for discipline of and punishment for inappropriate behavior. In addition to official/governmental oversight, interest is increasing on the part of non-governmental groups in the probity of the judiciary and the civil service. For instance, the monitoring of official behavior has been enhanced by the activities on non-governmental groups dedicated to stamping out corruption. Government should maintain a dialogue with these groups. Chapter IIT Public-Private Interface 29 Attitude of general public. At present, a vicious circle exists. A large number of disputes are produced due to poor compliance with the law, but the disputes are not promptly resolved due to the inefficiencies of the courts. The result is a lack of faith in the judicial, and many parts of the administrative systems. Since the administrative justice system has had little impact on unethical or unfair official behavior, there is little willingness of individuals to seek recourse in courts for improper/unfair administrative acts. Businesses and private citizens alike experience the poor quality of services from the legal and judicial system. The system is viewed as highly inequitable because no free legal aid exists, which restricts access to justice for a large slice of society. Recent surveys of public opinion26 indicate that these unfortunate developments undermine public commitment to the reform process and damage the construction of a rule-of- law state. There needs to be a change in the perception of the general public that rule of law prevails. A number of first steps can be taken in an attempt to break this cycle. Better disseminating regulatory requirements places regulators and the regulated on an even playing field. Collecting and disseminating performance assessment data of administrative and regulatory practices can highlight problems and bring about improved (more transparent and equitable) service. Providing for a transparent process for citizens to appeal decisions, and in general encouraging participation by citizens to improve legal, judicial, regulatory and administrative systems, would improve the credibility of Government in the eyes of businesses and citizens. 26 Coalition 2000 reports, including Corruption Indexes of Coalition 2000 prepared by Vitosha Research, presented at the February Forum on Transborder Crime and Corruption in Bistritza. 30 Chapter II. Public-Private Interface SUMMARY OF NEXT STEPS (SHORT TO MEDIUM TERM) Second Generation * Complete "first phase" divestiture (particularly residual state ownership of partially privatized entities); Enterprise Reforms: * Continue to improve collection and decrease arrears from all enterprises to key service providers (electricity and gas companies, and social security agency) and commit to make transparent any support to loss-making enterprises; * Initiate government-led bankruptcy proceedings against those privatized enterprises not able to meet debt servicing to government, and facilitate creditor-led proceedings against other potentially insolvent enterprises; * Continue with the "second phase", focusing on restructuring, regulation and eventual privatization of assets in energy, transport and infrastructure; * Take steps to "formalize" the informal sector; and * Develop equity markets to infuse fresh capital into promising enterprises. Legal Reforms: * Follow through on ongoing revisions to bankruptcy legislation, and revise legislation to improve the protection of interest of minority and portfolio investors. Regulations and Build on the work of the Licensing Optimization Program to: Administrative * Assess regulations from the perspectives of overlap/inconsistency and precision, to reduce opportunities for Procedures: discretionary interpretation and application and provide guidance to regulators; * Undertake continual impact assessments of regulations and administrative procedures to determine if they are of appropriate scope and achieve the originally intended purpose, and assess from a cost-benefit perspective; * Streamline and harmonize regulations and administrative procedures, based on the assessments above, in consultation with line ministries, other agencies, and the private sector; * Extend outreach to educate the general population and businesses about regulations (their purposes and what is needed to satisfy requirements) to make procedures clear and easily accessible; and * Consider developing a more user-friendly land lease system and process for obtaining construction and occupation permits. Civil Service Capacity: * Assess the need for enclave training to address immediate technical shortcomings, and broader civil service training to address longer-term needs; * Set rules for the organization of the courts, public prosecutors offices and investigative services, and better define the roles/responsibilities of judges; * Create employment criteria, performance standards and training opportunities for non-judicial court staff; and * Increase computerization of the court system, particularly case management. Chapter II. Public-Private Interface 31 Oversight: Strengthen the mandate of oversight agencies to ensure that they function systemically and transparently, specifically: * Create guidelines for the conduct of employees and a system through which disciplinary matters are reported and investigated; * Establish written standards of conduct for investigators; * Employ expert staff in the SJC, whose responsibility would be to deal with disciplinary actions in the judiciary; and * Ensure that the SAC is fully functioning, and periodically monitor that there are stringent criteria for administrative acts which are exempt from review. Improving Credibility * Collect the essential regulatory data (on the direct costs associated with regulation, the opportunity costs of vis-a-vis the General regulation, the quality of regulatory instruments, and the quality of regulatory management), and publicly share Public: the findings to signal commitment to improving the regulatory environment; * Undertake a serious crackdown on unethical behavior among regulators and in the judiciary, and increase dialogue with groups in civil society working to improve governance; and * Provide a transparent and reliable system for citizens to appeal decisions. CHAPTER III: PUBLIC ADMINISTRATION INTRODUCTION The Government of Bulgaria is actively and successfully pursuing a major and complex program to rebuild the country's public administration at all levels: center, regional, and local. The program is designed to achieve the following objectives: (a) to create an independent, professional and merit-based public administration with a strong client/end user orientation; (b) to deliver substantive results from the country's initiatives in the area of anticorruption; (c) to secure Bulgaria's accession to membership of the European Union. The public administration, and the core civil service within it, cannot function effectively and efficiently unless international best practice processes are in place and operating in key areas such as: policy analysis and evaluation both at the center and in line ministries; performance management; cabinet decision-making; determination of a budget which meets fiscal constraints, and provides for allocation of resources in line with government priorities; technical efficiency in budget execution (including predictability and reliability); together with institutional arrangements for appropriate checks and balances and accountability. These areas fall into three broad categories of public administration development: public sector and human resource management; center of government decision-making; and public expenditure management, particularly the budget process. This chapter identifies the reform agenda for the public administration in Bulgaria, sets out a statement of international best practice in these three areas, assesses Bulgaria's present position against the best practice criteria, and identifies key actions required to meet best practice standards identified. 27 CHALLENGES FACING THE PUBLIC ADMINISTRATION IN BULGARIA The public administration in Bulgaria faces a number of extremely complex challenges. Clearly the most visible and the most pressing is the challenge of meeting the requirements for EU accession for both the negotiation period and subsequent membership. This requires strengthening and developing the policy framework and administrative capacity of Bulgaria's public administration and judicial system so that it is able to implement and enforce the Acquis Communautaire.28 27 Much of the framework for the analysis which follows has been drawn from earlier World Bank work which sought to identify the impact and implications of EU accession on governments in Central and Eastern Europe (including detailed pilot studies of the situation in each of the Czech Republic, Estonia, and Hungary); and to provide a methodological framework for use by other Governments in the region. See in particular Barbara Nunberg, Gary Reid, Jana Orac et al, "Ready for Europe: Public Administration Reform and European Accession in Central and Eastem Europe", World Bank, 2000. 28 Defined as "The entire body of EU law as expressed in the Treaties, the secondary legislation and policies of the Union as well as in the jurisprudence of the European Court of Justice", and consisting of over 100,000 pages of text: see SIGMA Papers No 26, "Sustainable Institutions for European Union Membership", November 1998. Chapter III: Public Administration 33 At the same time, however, Bulgaria will also have to achieve and sustain over at least a medium-term period high levels of economic growth to come within range of overall EU standards of living. This in turn will require a public administration which reflects a role of the state appropriate for a modem market economy, is oriented towards providing an attractive and competitive investment climate which maximizes Bulgaria's attraction of FDI, creates the conditions for significantly increased domestic investment, particularly in export-oriented sectors, and supports the accelerated development of Bulgaria's SME sector. The third challenge facing Bulgaria is to complete the transition of the public administration from a command economy state service to a market economy client-oriented public and civil service in order to meet the growing demands of citizens and service users for high quality public services. EU accession requirements in the area of public administration The EU requirements of member countries in the area of public administration are indirect rather than direct. There is no checklist of "best practice" features or characteristics of EU member state public administrations against which applicant countries are assessed. Nonetheless, these requirements are both significant and onerous. The EU seeks to assess the administrative and judicial capacity of an applicant country to adopt the legal framework of the Acquis Communautaire and to apply the Acquis on a sustainable, timely and predictable basis. The means that a member state uses to discharge these obligations are left to the discretion of that member state (an example of the principle of subsidiarity). The obligations of a member state can be summarized as follows: "Administrative capacity can be seen as having two inter-linked but distinguishable aspects: the capacity to prepare, co-ordinate and carry out the accession process itself; and the capacity to implement the Acquis Communautaire and operate effectively within the Union on an ongoing basis".29 The entire workings of the Union, particularly in areas such as the internal market, internal competitiveness, labor movement and border controls, environmental standards and standards and safety, are only as strong as the performance of the weakest member state in each area. The EU itself has of course no public administration at the member state level; but relies on each member state to perform its membership obligations to the full. The benchmark for a prospective member state for its public administration therefore is that it should be able to function at the same level of competence, efficiency and effectiveness as the public administrations of current member states. A clear summary of these requirements is contained in SIGMA Paper No 26: "The key administrative values which need to be promoted are reliability, transparency, predictability, accountability, adaptability and efficiency. These values must be embedded in institutions and administrative processes at all levels, and they must be defended by independent control bodies (e.g., audit), by systems of justice and judicial enforcement, by Parliamentary scrutiny and by ensuring opportunities for voice and redress to the "clients" of the public administration, namely citizens and firms". The EU summarizes its 29 See SIGMA Paper No 23, "Preparing Public Admninistrations for the European Administrative Space", May 1998, page 19. 34 Chapter III: Public Administration requirements of applicant countries as follows: "a well developed civil service and judiciary is central to the candidate countries being able to assume the obligations of membership".30 In its 1999 Composite Paper, the EU highlighted mixed progress across the region in the area of developing and strengthening public administrations. This mixed progress can be explained by a number of factors. Public administration development involves a large number of different and heterogeneous stakeholder groups; involves significant resource demands at a time of severe fiscal pressures; consists of an extremely complex and inter-related set of activities; and is building in some countries in the region on severely eroded capacity. Despite a number of significant achievements, many public administrations across the region are a long way from being able to meet best practice standards of developed public administration and display the capacity to implement large areas of the Acquis Communautaire. Areas of comparative weakness across the region include the following: lack of a comprehensive long-term strategy for public administration reform and development programs; lack of consensus among stakeholder groups as to the shape, elements, costs, and benefits of such programs; and lack of an effective response to severely deteriorating public administration pay and benefits. Box 3.1 compares the orientation and characteristics of public administrations across the region at the start of the transition period with the benchmark orientation and characteristics of best practice developed public administrations. This highlights the distance which Bulgaria has to travel to be successful in its public administration reform program. 30 See EU "1999 Comnposite Paper: Reports on Progress towards Accession by Each of the Candidate Countries", page 23. Chapter III: Public Administration 35 Box 3.1: Orientations and Characteristics of Public Administrations in Transition: From Support of a Command Economy to Support of a Globally Competitive Market Economy Command Economy Public Administration Globally Competitive Market Economy Public Administration -Party loyalty -Merit & performance -Politicized -Depoliticized & independent -Technocratic -Professional & managerial -Top-down -Top-down and bottom-up -Policy monopoly together with restricted -Policy contestability and unrestricted range of range of policy options options -Reactive -Proactive -Inward looking -Outward looking -Domestic agenda -Domestic & intemational agendas -Narrow competitiveness: self-sufficiency; -Broad competitiveness: investment climate, domestic production facilitating FDI, SMEs -Accountability upwards towards central party -Multiple accountability to different apparatus stakeholders -Concentrated authority -Management decentralization -Centralized authority -Subsidiarity: dispersed authority -Centralized decision-making -Checks & balances, multiple agencies -Leadership (unparticipative) -Partnership -Direction -Service -Scientific management : traditional -International best practice, use of private management systems and structures sector approaches -Stable structures -Fluid, continually changing structures -Elite -Public service ethos -Well staffed -Lean but right mix of numbers & skills -Closed system -Open system -Bureaucratic -Passionate and caring -Untransparent -Transparent -Privileged -Trusted by stakeholder sets -Well-rewarded -Fairly rewarded -Progression by seniority and educational -Progression by demonstrated qualifications performance/merit -Free access to resources -Constrained access to resources -Fragmented (branch management) -Interconnected & inter-dependent -Paper-based -Internet-based 36 Chapter III: Public Administration ASSESSMENT OF PROGRESS IN MEETING THE REFORM AGENDA Statistical analysis The statistical analysis of civilian Figure 3.1 government employment in Bulgaria reveals that while the size of the civil Central and Local Government Administration service in Bulgaria is small in comparison Employment in 1997-1999 with OECD countries, its composition reflects a disproportional share of health 160,OE and education employment. Civilian 1400 government employmnent can be broken 10O down as follows: central government DM (including local - deconcentrated - units of 6000 central government); local government 400O (excluding education and health but 20000 including regional government); 0 19 education; and health. Over the period 1997 19S _999 1997 to 1999, the number of central | PXcen .i L g-.t diistmi,OTo,a,-l --,.n govermnent employees decreased by 9.3 percent from 23,331 to 21,153. Over the Sources:MinistryofFinance,WorldBankstaffcalculations. same period, the number of central government deconcentrated unit Figure 3.2 employees decreased by 15.4 percent from 91,603 to 77,462. Central government Health, Education, Central and Local Government employees including deconcentrated units Employment in 1997-99 decreased by 14.2 percent from 114,934 to 2 I 98,615 (See figure 3.1). Regional 250,000 government employees decreased by 29.6 10: percent from 1,821 to 1,282. Local 150,000 government employees, which excludes 10,000 education and health, increased by 9.3 50,_0m percent. Local government (including 0 HelIh Ed.cioo Cenlt'00G-vet i e G- I regional government) employees increased by 8 percent. The overall decrease in the | 19970 *998 01999 total number of central and local government employees was 7.3 percent. Sources: Ministry of Finance, World Bank staff calculations Figure 3.2 summarizes the changes in the numbers of employees in central and local government, health and education from 1997 to 1999. From 1997 to 1999, the share of education and health public sector employees taken together in the total civilian government employment increased from 69.7 percent to 70.4 percent despite the reduction of the absolute numbers of employees in both sectors. Over this period there has been a decrease of 2.6 percent in public sector education employees, which, as a percentage of population fell from 2.76 percent to 2.72 percent. The corresponding decrease in public sector health employees was 6.7 percent: from 1.87 percent of the population to 1.76 Chapter II.I Public Administration 37 percent. This compares to ratios for the equivalent average number of employees to population of 2.1 percent for education and 1.4 percent for health for OECD countries.3' Figure 3.3 shows Figure 3.3 Bulgaria's general civilian r-- _ government (broken down by General Civilian Government Employee each of central government; (as percentage of population) local government, education and health) as a percentage of 12.0 X population; and compares this 10.0 against the average for a 6 0 sample of 21 OECD countries; 4.0 and against the position in a 2.0 number of individual OECD 0.0 Estonia Hungary Czech Bulgaria Denmark UK Germany OECD countries and a number of other Republic average countries in the region. M Central Govemmerf Local Govemmern EducationO Health Sources: An International Statistical Survey of Government Employment and Wages, World Bank, 1997; Ministry of Finance; World Bank staff calculations. By contrast, Figure 3.4 shows the relative composition of __________________________________________________ general civilian government in InedCviianGovernnentEmyeeCategrnes Bulgaria against the OECD and (as share of respective total) specific country comparators. The composition of Bulgaria's public 9,°% m Er;la r _ sector is more of a problem than 600. n H g iW I its overall size. Bulgaria's central 40% government is somewhat smaller 20% ~~~~~~~~~than the OECD average: 1.4 '% _ _ _ > >:percent of population for Bulgaria Estaia auguy Czeh Bulgia Demmrk UK Genany OECD (of which 80 percent are in Rexbc |ave deconcentrated units) compared M |CentnalCiovenm LGoal CiavenmO FAiamon i O with 1.8 percent for OECD. Local government is very small: 0.6 Sources AnInternaonalstcayvoSGof nemtEtimlqoy'ntand percent of population for Bulgaria Wages, World Bank 1997; NristryofFmance, World Banick aff calculations. compared with 2.5 percent for OECD. Bulgaria's education and health sectors are comparatively large (2.8 percent for Bulgaria compared to 2.1 percent for OECD countries in the area of education; and 1.9 percent for Bulgaria compared to 1.4 percent OECD countries in the area of health).32 31 See Schiavo-Campo et al, 1997, page 39 32 Looking at central government, education and health combined, the 1999 total for Bulgaria is 5.7 percent compared to an average of 5.3 percent for OECD countries; with the comparative `understaffimg"' at central government balanced out by the comparative "overstaffing" in education and health. 38 Chapter III: Public Administration There are of course areas of overstaffing in Bulgaria's present central government administration, some significant; together with a number of areas of understaffing or skills mismatch. There are also a number of areas where efficiency and productivity improvements could be obtained. Further, fiscal constraints may require that Bulgaria continues to operate an extremely lean public administration and civil service, compared to OECD country averages, even perhaps over the medium-term. The challenge therefore is to ensure that these scarce resources are focused on priority objectives and tasks; and that all possible measures are taken to secure optimal efficiency, effectiveness and cost-effectiveness. The shortage of resources in the central government administration however is, and is likely to remain, a major constraint on Bulgaria's ability to develop its public administration to EU member state standards. Public sector management and human resource management Box 3.2 presents a set of benchmarks for best practice public sector management and human resource management against which the performance of Bulgaria is then assessed. The Government has made a strong and successful beginning in public administration reform. Much of the credit for this is due to strong and consistent political leadership for the program; the building of an extremely active public administration reform team; and the subsequent creation of an extremely effective Directorate for State Administration in the Administration of the Council of Ministers. This is particularly noteworthy given the complexity and multiplicity of the challenges which the Government is facing in its efforts in this area. These efforts could best be characterized not so much as a reform of the country's civil service but rather the creation of a modern, professional, independent, merit-based and service-oriented civil service. The central civil service in Bulgaria appears fragmented. The human resource management function throughout the public administration and the civil service is underdeveloped. The depth of political appointments within the public administration and civil service over recent years has gone down to Head of Department level and sometimes further. This militates against the development of an independent, professional and merit-based civil service; lessens the attractiveness for skilled professionals of a job and a career in the civil service; and results in major civil service senior and middle-level management turnover upon a change of government, with consequential loss of institutional memory and stability. Remuneration levels within the public service are extremely low, particularly for professional employees with scarce market-oriented skills. These low levels of remuneration have a major impact on the Government's ability to attract and retain appropriately qualified and skilled staff (particularly in skills areas which are in significant demand in the private sector). The impact is also particularly severe at senior and middle management levels. Chapter IIJ: Public Administration 39 Box 3.2: Public Sector Management and Human Resource Management Best Practice A. Legal & Ethical Framework: -Specific legislation governing the civil service, with subsidiary legislation and/or regulation that elaborates rules/procedures/systems for personnel management in place; -Behavior of civil servants and political appointees is governed by a Code of Conduct; -Merit-based rules for civil service management are established in law and are enforced; -Scope of the civil service is clearly defined; -Civil service political neutrality is provided for and respected in practice; -Civil service operations and policies transparent, and statutory rights of access for outside parties to civil service standards, performance targets, and actual performance. B. Institutional Framework: -Effective, dedicated institutions for civil service policy, management and oversight with clearly established legal status set up and fully operational; -Accountability and recourse mechanisms for citizens, employees, the legislature and the executive in place and operating effectively. C. Employment, Pay Policy and Management: -Numbers of public servants and of civil servants are in line with international and regional best practice and needs; -Civil service wage bill is affordable and contained within overall fiscal framework; -Remuneration is sufficiently competitive to recruit, retain and motivate sufficient qualified staff at all levels; -Compensation system is simple, monetized and transparent, with rule and market-based approaches for determining actual compensation; -Establishment control system in place and linked to computerized payroll and personnel information system to provide adequate budget control of personnel expenditure. D. Human Resource Management: -Planning capacity for reviewing and forecasting current and projected staff resource requirements operational; -Personnel information system in place, integrated with budget, accounts, payroll and establishment management systems; -Recruitment is undertaken on the basis of merit after competitive process; promotion based on open and transparent merit-based procedures; -Performance appraisal system operational with hierarchy of objectives (Ministry to Department to work unit to individual employee), focused on performansce improvements. E. Training and Career Developmentn -Training system provides for systematic identifdcation of training needs; -Training budget deterwined in light of affordability, intesational best practice comparators, and training needs. F. Management Practices and Culture: -Decision-making placed at lowest appropriate level to ensure effective management, service delivery and client responsiveness; -Explicit service delivery standards determined and made available to citizens and reported to legislature, together with assessment of performance against these targets. 40 Chapter I.I Public Administration In response to this situation, the Government has developed and is in the process of implementing a major and wide-ranging public administration reform strategy.33 A number of fundamental pieces of legislation initiated by the Government were passed by the National Assembly over 1999, including the Law on Administration and the Law on the Civil Service. These two laws (together with the secondary legislation/supporting regulations to the Law on the Civil Service now in place) constitute an important step towards building an appropriate legal base for a modem civil service. Further, a draft Code of Ethics for civil servants has been developed and issued for widespread consultation. As provided for by the Law on Administration, the Government over the second half of 1999 completed a process under which the roles, functions, and associated organizational structures and staffing levels of all Ministries and agencies were reviewed and redefined and restructuring proposals put forward for formal approval to the Council of Ministers by each Ministry and agency. The new system is based on a common classifier of all posts in the system and standardized organizational structures at the Directorate level within each Ministry/agency. The restructuring process provided the opportunity for significant staffing reductions to be proposed by Ministries/agencies arising out of the elimination of unnecessary and duplicating functions and associated units. Reduced staffing levels of around 10 percent in the central civil service were incorporated into the draft budget for the year 2000. This process has now also been applied to regional and local governnents. The next steps undertaken by the Government was to develop a salary structure around the new classifier of positions while allowing also for provision of a coefficient to reflect the varying organizational weight of different ministries/agencies. This process was intended to provide a strong basis on which job descriptions for individual employees could be developed; and on which formalized processes for performance management (designed to stimulate increased performance and greater effectiveness) could be developed and introduced at each of the following levels: Ministry/agency; Directorate within Ministry/agency; Department within Directorate; Unit within Department; and individual employees within Units. Such a process should go a considerable way towards raising the levels of transparency and accountability within the civil service; and to increasing morale and motivation among civil servants. A significant amount of effort has gone into supporting the implementation of this process. For example the administrative reform team prepared a sophisticated Internet-based model for Ministries to use when developing their restructuring proposals. This model has the potential to become an integrated Civil Service Management Information System which could in time be developed further to link to personnel expenditures and to budget data and to payroll data. 33 The EU summary of the position in this area is as follows: "The results of the administrative reform process have been so far rather limited but there has been progress with the entry into force of the Law on State Administration and more recently the Civil Service Law. The implementation of these laws is at an early stage so it is premature to judge to what extent the new legal framework will contribute to the establishment of an independent, efficient and professional civil service." See EU Bulgaria Progress Report, page 12. Chapter III: Public Administration 41 Non-confidential data contained on the system is also being made available to all citizens in the country through the Internet. Citizens are then able to identify precise roles and responsibilities of each sub-unit in each Ministry/agency; identify contact persons; and contact numbers, emails, and addresses. This system could also be extended to capture feedback/complaints from citizens. Indeed, the innovative development of Internet-based electronic government could prove to be a real success story for Bulgaria's public administration reform program. While the above assessment shows an impressive beginning and strong progress, there is still a long way to go. Reform needs to be accelerated through making the reform program itself more comprehensive in terms of both breadth and depth. The importance and complexity of the public administration reform agenda demands a special emphasis on soliciting and taking into account the views of all those who will be affected by the changes proposed, including the public servants themselves (and their trades unions), NGOs, the private sector, and citizens/service users. Such an open dialogue can help deepen and broaden consensus behind reform; eliminate perceptions of any hidden agendas; stimulate understanding of and commitment to the reforms; contribute to overcoming resistance and inertia within the system; and thereby significantly facilitate implementation of the reform measures. This partnership in the area of administrative reform also needs to be developed through the introduction of more formal accountability mechanisms of the public administration and of the civil service to citizens, e.g. through setting and publicizing standards for service delivery and actual performance against standards, and for civil service annual reporting to Parliament, with a program also of individual Ministry/agency annual reports. The continuing implementation of the measures of the Law on Administrative Services to Individuals and Physical Entities, including the creation of pilot "one stop shops" for citizens should make a significant and substantive difference to the performance of the public administration in this area. The initiatives of the General Tax Directorate in undertaking a fundamental restructuring to secure client-centered approach across the range of its activities, functions and services are also noteworthy in this respect. Further attention needs to be paid to providing for the application of the merit principle in recruitment, promotion, transfer and rotation, and overall staff development and career management. Open competition needs to be guaranteed for appointment and entry to the civil service at different levels. An appropriate institutional framework to underpin the application of the merit principle and provide the required checks and balances needs to be created. The new State Administrative Commission should over time be able to make a major difference in this area. The new framework for performance management and appraisal needs to be developed and introduced as one of the immediate priority measures for securing improvements in the effectiveness, cost-effectiveness and accountability of the civil service. Effective depoliticization of the civil service remains to be secured. In the area of pay reform, the Government needs to determine an agreed and explicit salary position for the civil service as compared to the private sector; and a realistic time-scale for achieving this target pay position. At the same time, there needs to be quick progress on 42 Chapter III: Public Administration achieving decompression of pay levels for managerial and key professional staff to address recruitment and retention issues. The massive complexity of the public administration reform program is not as yet reflected in the allocation of the human and financial resources required for the objectives of the program to be likely to be attained. This remains a threat to the successful development and sustainable implementation of the program. The challenge of maintaining a strategic reform focus, maintaining momentum while developing and employing a variety of new policy approaches and tools to ensure the success of specific reform measures, while also continuing to build consensus behind the reforms, will require the identification and allocation of significant additional human and financial resources as well as strengthening the institutional arrangements for managing this process both in the center and in the line Ministries, in the next phase, also in the Regional units of administration and in the municipalities. The creation of the State Administrative Commission and the establishment of the Institute for Public Administration and European Integration are both significant moves forward in this respect. Center of government decision-making This section presents a set of benchmarks for best practice in center of government decision-making against which the performance of Bulgaria is then assessed. Box 3.3: Center of Government Decision-making Best Practice A. Functional Arrangements at Center of Government: - Center of Government demonstrates ability to manage the logistics of supporting Cabinet and Cabinet Committees; - Cabinet Office restricts Cabinet agenda to items of strategic significance, and avoids Cabinet agenda getting clogged up with second-order issues, while ensuring that items of strategic significance are not kept from consideration by the Cabinet; - Center of Government contains capacity to subject proposed agenda items for Cabinet to rigorous scrutiny and evaluation; - System in place and operational for monitoring timeliness and substantiveness of implementation of Cabinet decisions by Ministries. B. Institutional Arrangements for Making Decisions at Cabinet Level Binding on all Ministers: - Cabinet decisions are taken in the context of detailed supporting information available on costs and benefits and impact of proposals, including alternative options where appropriate; - Cabinet takes strategic decisions between different policies and spending areas which are in line with overall Government program and reflect Government priorities; - Cabinet takes decisions which can be contained within overall fiscal/resource constraints; - Cabinet Office ensures Ministers have scope for giving real consideration to policy proposals and ensures that full and appropriate consultation is undertaken. C. Appropriate Role for Ministry of Finance: - Ministry of Finance provides full and timely reporting on actual expenditure against planned to Cabinet; - Ministry of Finance able to ensure that allocations required to implement agreed Cabinet decisions are reflected in budget and that allocations in the budget are in fact reliably delivered to spending Ministries; - Ministry of Finance able to provide alternative macro-economic scenarios to Cabinet to illustrate implications of varying policy and fiscal stances and provide context for evaluation of specific policy proposals. Chapter III: Public Administration 43 Strengths of the present system include the following. There is a strong commitment to transparency within the center of government. All major decisions are routed through the Council of Ministers. All major allocative decisions are made by the Council of Ministers. Meetings of the Council of Ministers are able to arrive at decisions which are regarded as binding by all members of the Cabinet. Extensive use is made of informal and ad-hoc meetings before the formal meetings of the Council of Ministers and tied into the cycle of Council of Ministers meetings. This has helped to reduce the duration and frequency of formal meetings of the Council of Ministers over the last two years. However, while present arrangements are sufficient for creating some accountability for policy making on the part of line ministries and for forcing a strengthening in the self-sufficiency of line ministries, the Administration of the Council of Ministers does not itself have the policy- making analytical capability to provide sufficient contestability in the area of policy advice, nor to provide sufficient challenge to the proposals put forward by line ministries. This runs the risk that the overall quality of decisions may be compromised. The linkages between the Legislature and the Executive appear to be working relatively well, with joint planning, shared information, and indeed a shared sense of priorities and objectives. Overall, the decision making system at the center of government is well-managed and appears appropriate. The system is also reasonably balanced. The Administration of the Council of Ministers is neither crowding out line ministries; nor itself being crowded out by line ministries. Strategic planning capability in the Administration of the Council of Ministers needs to be strengthened. Policy analysis capacity and in particular, economic analytical capability and impact analysis should also be developed further, both in the Administration of the Council of Ministers and in line ministries. The recent move to set up political cabinets in each ministry under the Law on State Administration is in part designed to improve the situation in this area; and should indeed, by forcing greater contestability, lead to improvements in the overall quality of decisions made. However, further development is required to support the introduction of more rigorous evaluation techniques (such as program reviews and performance budgeting) than those currently employed. There is also a need to secure improvements in the area of horizontal coordination, both across and within sectors. In this respect, the Administration of the Council of Ministers has a clear role to play in improving arrangements both for inter-sectoral and intra-sectoral coordination. A further area for attention is securing improvements in the arrangements and systems for tracking and monitoring the implementation of decisions taken by the Council of Ministers. The focus here needs to be on substantive compliance with Council of Minister decisions. Improvements in management information systems would make a positive contribution in this area. In conclusion, while the formal decision making processes at the center of government are working reasonably well, there is a clear need to strengthen the Administration of the Council of Ministers over the short to medium term so that it is able both to provide advice to the Council of Ministers based on a broader view (so avoiding the risk that the program of the government 44 Chapter III: Public Administration does not simply become the aggregate of the agendas of the line ministries); and also to subject the proposals of ministries to far fiercer analytical scrutiny than is the case at present. Public expenditure management This section presents a set of best practice benchmarks for public expenditure management against which the perforrnance of Bulgaria in this area is then assessed. Box 3.4: Public Expenditure Management Best Practice A. Ensuring Aggregate Fiscal Discipline: - Budget process set in context of overall Government medium-term policy priorities and objectives; - Budget process respects constraint of clearly determined, realistic and consistently applied macroeconomic scenarios; - Budget process provides for appropriate approval and control of external borrowing, including by sub-national units, and including appropriate treatment of Sovereign guarantees; - Budget process underpinned by timely and real data; - Budget process covers all spending programs, expenditure items and special funds in a single and integrated process; and allows for appropriate integration of implications of capital and recurrent expenditure decisions; - Ministry of Finance cash-flow forecasts for revenues and expenditures are available throughout the year on a timely basis. B. Allocative Efficiency: Allocating Resources in Accordance With Strategic Priorities: - Budget process is underpinned by real data on costs and outcomes of spending programs by Ministry so as to support informed decision-making and prioritization of spending programs and expenditure options within overall affordability constraint; - Budget process adheres to a clearly defined timetable, and one widely accepted as appropnrate by all involved parties; - Budget process provides for responsive, predictable and (within fiscal year) stable allocation of resources in line with provision to spending agencies; - Budget process or capital expenditure is based on rigorous economic and financial appraisal of project proposals including associated recurrent costs); - Budget process provides transparent, stable and accepted framework for intergovernmental finance system and actual transfers; - Budget process provides appropriate framework for managing and for drawing up of coherent and appropriate applications for external funding (including EU structural funds) and is fully in line with external criteria and procedural requirements for such funding. C. Technical Efficiency: Ensuring Efficient & Effective Use of Resources in the Implementation of Strategic Priorities: - Budget process provides resources to support and allow implementation of strategic priorities in consistent and predictable manner within fiscal year and across fiscal years; - Budget process provides for appropriate balance between ex ante and ex post controls; - Budget process is based on timely exchange of information between center and spending agencies and provide for comprehensive and timely treasury management; - Budget process provides for collection, analysis and reporting of data on objectives, costs, outputs and outcomes of expenditure allocations; and supports timely comparisons between budget allocations and actual expenditures; - Appropriate institutional arrangements and checks and balances are in place for monitoring & evaluation and for intemal and extemal reporting; and for intemal and extemal audit, including audit as required by and for legislature. Chapter III. Public Administration 45 Against this background, we will review the Government of Bulgaria's recent budget reform initiatives, and make an assessment of the degree to which: (i) present budget preparation and execution institutions and procedures ensure aggregate fiscal discipline; (ii) the allocation of resources is in accordance with strategic priorities (allocative efficiency); and (iii) the use of resources in the implementation of strategic priorities is efficient and effective (technical efficiency). The Ministry of Finance has built up impressive momentum in its efforts over 1998 and 1999 to begin to reform the budget system and processes. Areas where progress has been achieved include: > modernization and simplification of the budget structure (reduction in the number of first and second level budget units); > review and updating of budget legislation; o strengthening of financial management organization, including preparation of a draft revised chart of accounts for the budgetary sector, which will support both cash and accrual accounting; > improvement of the structure and presentation of annual and monthly budget documents; > introduction of a single account of the Republican budget with the Bulgarian National Bank together with significant moves towards the consolidation of extra budgetary funds; > preparation of a computerized debt and cash balance management system; > introducing a public procurement procedure under the first stage of the development and implementation of the Financial Management Information System for the budgetary sector. The quality of macro fiscal management is determined by the arrangements for budget planning, budget execution and budget coverage. With respect to budget planning, the picture is dominated by the Government of Bulgaria's medium-term overriding commitment to balancing the budget. Annual budgets are prepared within the context of a three-year fiscal planning framework. An aggregate cap on expenditures based on the macroeconomic forecast is established at the outset of the budget process and approved by the Council of Ministers. Effective fiscal control has further been reinforced over the last two or three years through the use of conservative revenue forecasts in planning the expenditure target for the budget. However, this approach is partly itself a response to weaknesses in macro forecasting generally and in forecasting tax revenue in particular. With respect to budget execution, control is ensured through the monthly allotment system. A further approach which helps to ensure effective macro-fiscal management is the 46 Chapter III Public Administration restriction for the first three quarters of the year of the release of budgeted funds to 90 percent of the budget allocation for that quarter, with allocations made available in the last quarter of the budget year only to the extent that release is consistent with the government achieving the overall budgeted surplus/deficit. While this is effective as a control measure, it introduces some difficulties into predictability of funds for line ministries. With respect to budget coverage, a reduction in the number of extra budgetary funds was achieved in 1999. This has the effect of broadening to some degree the extent to which actual public sector claims on resources are brought within the consolidated budget; but much still remains to be done in this area. The basis for effective macro fiscal management is in place. In practice, the Government appears to be reasonably successful in achieving effective macro-fiscal management and thereby ensuring that budget outcomes are within approved limits. There are two potential concerns relating to allocative efficiency. The first relates to the balance between capital and recurrent expenditure. Pressure to limit the budget deficit in recent years has resulted in inappropriate and excessive postponement of infrastructure spending as opposed to forcing reductions in potentially less productive areas of recurrent spending. This has very serious consequences. Delaying investment means also delaying and reducing growth. In this respect, the Government's approach to the Public Investment Program in particular needs to be reconsidered. The second concern relates to the allocative efficiency of budget processes. This arises from the non-availability both of performance information relating to programs currently funded from the budget; and also the absence of a process to ensure the justification of new spending bids by ministries in terms of clearly identified expected outcomes. In general, there is at present little performance information relating to existing programs available, with the budgeting environment being focused on financial compliance rather than outputs or achievement of objectives. In the medium term, achieving allocative efficiency will require a significant refocusing and broadening in the area of budgeting criteria, moving away from financial compliance to performance improvement. A factor which works against technical efficiency is the present high level of detail in budget allocations for operating costs of the first level spending units. However this potential weakness may be ameliorated by liberal virement arrangements during budget execution. While any movement to more flexible financial management for first level spending units (which on balance must be considered desirable over the medium-term) risks a loss of financial control, this risk can be mitigated by putting alongside the new flexibility a strongly increased focus on the outputs and outcomes required to be achieved by those agencies (i.e. a shift from input budgeting to performance budgeting while maintaining an appropriate balance between authority/accountability and appropriate restraint). Areas for further attention include the following: strengthening capability in revenue forecasting; completing the consolidation of all extra-budgetary funds; and securing a re- balancing of recurrent and capital expenditure in favor of the latter. Public investment programs should be strengthened and developed to take account of both the constraints of the overall fiscal position and Bulgaria's present high levels of debt, but also the urgent need to generate growth Chapter III: Public Administration 47 while protecting welfare. For the medium-term, consideration should be given to how to achieve the transition to outcomes-based program budgeting. A first step in this direction would be over the short-term to build a system for collecting performance and outcomes information for existing programs. The system for intergovernmental finance and municipal finance reform requires further development. Spending responsibilities for service delivery and investment needs to be underpinned by appropriate resource allocation and revenue raising systems and processes; and by an appropriate accountability framework. Concerning the government finance system overall, there is a need to create an integrated financial risk management framework. STRUCTURAL FUNDS This section gives a summary assessment of the ability of Bulgaria's institutional system to effectively manage, monitor and control the pre-accession funds and post-accession Structural Funds assistance provided by the European Union. It provides outline recommendations as to how present systems and procedures should be developed by the Government of Bulgaria in order to comply with EU requirements in these areas and proposes technical assistance priorities for the short and medium-term.34 The sums involved are significant. Pre-accession grant transfers from the EU to Bulgaria may represent annually more than 2 percent of GDP (2.2 percent of GDP for 2000, nearly as much as Bulgaria is currently spending on its central government administration, and education and health public sector employees combined). Upon accession, the Structural Funds may provide grants to support capital and human investments in Bulgaria up to a level of 4 percent of GDP each year (applying Structural Funds' regulations in force today). Pre-accession grants will be channeled through three distinct financial instruments, all budgeted for the period 2000-2006: Phare, which already existed but has been reformed, as well as two new instruments, ISPA (Instrument for Structural Policy for Pre-Accession) and SAPARD (Special Action Program for Pre-accession for Agricultural and Rural Development). The main objective of these instruments, beside helping finance the economic development of candidate countries and approximate the Acquis, is to prepare them to use and manage the Structural Funds they will be entitled to receive once they are member of the EU. ISPA is indeed close to the Cohesion Fund, while SAPARD functions more or less like the Guidance section of the EAGGF (European Agriculture Guidance and Guarantee Fund) and the new Phare can be seen as a mix of the ERDF (European Regional Development Fund) and the ESF (European Social Fund). The EU assistance will concentrate on few key sectors. ISPA (about Euro 104 mly) will be dedicated to transport and environment projects; SAPARD (about Euro 52 m/y) will focus on agricultural reforn and rural areas adaptation; and Phare (about 120 m/y) will target the 34 Because of the complexity of EU requirements in these areas, and the associated significance of the levels of funding potentially available to candidate countries and then member states, the World Bank has undertaken a detailed study in this area for the Government of Bulgaria. The detailed results of this study are to be published as "Implementation of the EU Grants in Bulgaria", World Bank, 2000, forthcoming. 48 ChapterIIII: Public Administration approximation of the Acquis and economic and social cohesion through investments (70 percent of the fund) and institutional building (30 percent). Phare should also be restricted, at least for 2000, to two target regions in Bulgaria: the North Western and the South Central. Increase in their availability will also entail great changes in the quality of these funds, which are covered by the implementation of the Structural Funds operating principles. Therefore, Bulgaria will have to prepare itself and respect the four basic requirements of concentration, programming, additionality and partnership, essential for the utilization of Structural Funds. The concentration principle aims at directing support from Structural Funds where it is most needed, where development problems are most serious, and avoiding dilution of funds over too many objectives. This has led to the definition of 3 (originally 6) objectives: objective I (nearly 70 percent of the Funds), targeting the development and structural adjustment of regions lagging behind; objective 2, targeting the economic and social conversion of areas facing structural difficulties; and objective 3, targeting the adaptation and modernization of policies and systems of education, training and employment. The programming approach calls for the elaboration of a strategic plan (Community Support Framework in EU Member States) and multi-annual development programs. In reality, Bulgaria will have to deal with three different grant approaches during the pre-accession period: a project approach in the case of ISPA, where every decision is made on the basis of individual projects; a program approach (similar to the Structural Funds funding model operating today in EU Member States) in the case of SAPARD; and a mixed system in the case of Phare, where annual and multi-annual programs are required, but decisions should still be made on the basis of projects, at least initially. The additional principle is the condition that funds from Brussels should complement rather than replace indigenous spending. This has been concretely understood by Member States as maintaining, in the whole territory concerned, their public investment expenditure at least at the same level as in the previous programming period. This is the way it is applied and enforced by the European Commission. It means concretely that Bulgaria will have to maintain its level of public investment spending, if it wants to get the EU grants. The partnership requirement entails both that the receiving State and, where appropriate, lower tiers of government as well as civil society, share responsibility for the elaboration, selection, management and audit of projects with the EC. This means that consultation and participation mechanisms shall be set up at both national and regional levels to secure involvement of business and employers associations, trade unions, NGOs, etc. The partnership principle also entails co-funding of programs by the receiving State. Today, co-funding rates for receiving EU Member States range, in general, from 20 percent (15 percent in rare exceptional cases) to 50 percent (up to 65 percent when the private sector is involved in a project) of eligible public expenditure. The EC also made it clear that joint financing by the applicant countries will systematically be required for all investment projects. The normal co-funding rate for ISPA, SAPARD and Phare will be 25 percent (and exceptionally 15 percent). Bulgaria will have to secure these matching funds to receive the EU grants, both at central and local level. Chapter III. Public Administration 49 In addition to these four basic requirements, Bulgaria will have to report on the usage of EU grants with adequate accounting record if it wants to obtain all the funds it is entitled to receive. To meet the EC standards, the control system will have to comprise both ex-ante and ex-post controls. These will have to be carried out through both internal (for ex-ante and ex- post) and external controls (usually for ex-post only). The basis for control over EU funds is also operational programs. This means that national control procedures and institutions will have to add to their traditional activities, more geared towards controlling institutions or projects, EU oriented controls based on programs and covering several institutions and projects at once. These series of constraints raise absorptive capacity issues for Bulgaria. In short, they all come to institutional capacity challenges (both in staffing the appropriate services with enough agents and with adequate skills, as well as setting the best institutional organization to deal with the EU funds); securing counterpart funding; ensuring coordination between all the stakeholders; and putting in place the appropriate controls. Bulgaria has already started adjusting in several fields. Priorities and multi-annual perspectives have been set up, as well as mechanisms to define them. The preparations of the NPAA (National Plan for the Adoption of the Acquis), NPRD (National Plan for Regional Development), NPED (National Plan for Economic Development) or NARDP (National Agriculture and Rural Development Plan) have all contributed to build Bulgaria's ability to plan and program more accordingly to EU practices3", though not yet in an enough comprehensive and inclusive way. All these development plans also often overlap, and global strategies and priorities are still lacking or remain unclear. Though not yet tested and fully adapted, some implementing and monitoring bodies have been created: the CFCU (Central Finance and Contracts Unit) in the Ministry of Finance, the SAPARD task force in the Ministry of Agriculture, Forestry and Agrarian Reform, or the ISPA coordination unit in the Ministry of Regional Development and Public Works. Control and audit mechanisms should also be improved soon and the Council of Ministers adopted in June, two draft bills on the Chamber of Accounts and on the Public Internal Financial Control which go in the right direction. Inter ministerial coordination is good. Nevertheless, several important challenges remain, both technical and political Coordination still needs to be improved. There are a large number of agencies with responsibilities in the management of EU pre-accession and Structural Funds. These include, for example, just at central government level: the Administration of the Council of Ministers, the Ministry of Foreign Affairs, the Ministry of Finance, the Ministry of Regional Development and Public Works, the Ministry of Agriculture, Forestry and Agrarian Reform, and the Ministry of Labor and Social Policy. There remains some ambiguity and duplication in the allocation of responsibilities and accountabilities between Ministries, and, sometimes, within a Ministry36. The priority for the Government of Bulgaria, therefore, is to organize and prepare these entities in 35 In particular, strategies and action plans in the areas of institution building, business-related infrastructure, humnan resource development, and support to the productive sectors have been developed and incorporated in the NPED by the relevant ministries to plan, coordinate and justify future PHARE-funded projects. 36 For further development of this and other questions in this section, se "Implementation of the EU Grants in Bulgaria". 50 Chapter III: Public Administration such a way that each Ministry (and each concerned Department within Ministry) has a clear and appropriate set of responsibilities and accountabilities for planning, programming and coordination of the implementation of the EU funds (and, indeed, for public investment finance more generally). During the first semester of 2000 though, some progress has been achieved in setting clearer responsibilities and accountabilities for the various governmental institutions. Also an issue of coherence and coordination, the management of EU grants has to be completely integrated with the Public Investment Plan (PIP), adopted by the Council of Ministers. So far, the PIP only includes projects to be carried out by the central administration and agencies; municipalities projects are not yet included. A more comprehensive PIP and a close connection between the EU funds and the PIP will be crucial. Since EU grants will become a major source of public investment financing, the preparation and management of the PIP will have to take into account the priorities and needs of the operational programs negotiated with Brussels. Since EU transfers also seldom come in time for the projects' needs, a joint management of both national and EU financing sources should be set up. An easy solution is having one ministry in charge of the PIP and the major EU funds (ERDF and Cohesion Fund for the post-accession period). In parallel, Bulgaria will also have to decide on the connection to establish between the national budget and the Structural Funds. Today, pre-accession funds are extra-budget and are added to the resources granted each year by the national budget. Control mechanisms still need improvement. An effective system must be set up, involving different tiers of the administration and all ministries concerned by the EU assistance, through ex-ante and ex-post controls, and clearly coordinated and articulated internal and external controls. There is not one particular model Bulgaria should adopt. It should rather ensure that the model it adopts covers all public expenditure, is able to control operational programs in ministries and also in regions, municipalities, and in any institution, public or private, using public money and EU funds. Bulgaria must also ensure a continuity between its pre-accession institutional arrangements, which are tightly specified by the European Commission and very centralized, and the post-accession institutional arrangements which will be designed by Bulgaria for handling the Structural Funds, and where EU member states have a much greater degree of freedom to choose the appropriate solutions according to their administrative and cultural traditions. Larger amounts of EU grants after accession, many more stakeholders, deeper involvement of regions, and multi-annual programs (not projects any more), will certainly lead Bulgaria to adapt and develop the model set up for implementing the pre-accession funds. As pre-accession instruments involve the main ministries and agencies expected to be in charge of the Structural Funds after accession, their more permanent role once Bulgaria accedes to the EU should be kept in mind, when defining detailed implementation systems. Municipalities and regions should also be trained and involved at the earliest stage possible. Continuity will help maximize efficiency by enabling to concentrate skills and know-how in few services, thus creating centers of expertise, and use those to disseminate knowledge in other departments, regions and municipalities, as the system grows in scale. Continuity could be key in helping Bulgaria build implementation capacity. There are also several political challenges Bulgaria will have to tackle. The most significant will undoubtedly be the reinforcement of regional planning, management and Chapter III: PublicAdministration 51 monitoring of public investment. This will have to be tackled in the medium term, in any case before the accession time and entry into force of the Structural Funds. At local level, the administrative organization of Bulgaria is based on 28 districts and 262 municipalities. The recent preparations of the NDP and NRDP, required by Brussels to set priorities for the allocation of EU funds in the period 2000-2006, used the 28 districts as basic building blocks. However, these territorial areas do not fit with the European Union requirements for planning, programming and managing EU funds. Instead, the EU requires that its assistance be provided in the form of operational programs integrated at "NUTS II Region"37 level. For Bulgaria, this corresponds to the "super-regional" level of the six macro regional groupings, and not the 28 districts; nor the 262 municipalities. Conception, strategy, definition of priorities, management of funds, project selection, monitoring and evaluation are tasks that can only be performed at that "macro-region" level. Appropriate administrative structures should hence be created at that level. A recent Decree of the Council of Ministers, adopted last June, already contains some provisions regarding these issues and creates de-concentrated macro-regional institutions for planning, programming and budgeting purposes. Linked to the last point, Bulgaria will also have to tackle a second political challenge: ensure full participation of local authorities and stakeholders in the absorption of EU grants, and ensure a very large number of beneficiaries, both public and private, have effective access to EU funds, all over the territory. Besides institutional arrangements and cooperation in the planning, programming, monitoring and control processes, this also entails availability of funds for municipalities and local actors. A third political challenge will therefore be to adapt the municipal finance system and give more control to municipalities over spending and monitoring, as well as require more accountability. The actual system, leaving very little budget autonomy to municipalities and mixing tasks delegated by the central government and tasks for which local authorities have been elected, does not provide for transparency, dilutes responsibilities, and does not give any room for rationalization of expenditures. Progressively, investments should become a priority; transfers from central government should obey to accepted, permanent and foreseeable rules and criteria, as well as the breakdown of transfers among municipalities; autonomy of municipalities on investments should be wider, with much less interference from the Ministry of Finance; and municipalities should be allowed clear and substantial own resources as well as ways to finance their investments through credit. Reform of the local budgets funding system must provide transparency and predictability, allowing for effective investment programming at local level. Some priorities for technical assistance can be suggested, drawn from the technical and political challenges Bulgaria is facing as well as their timeframe. The first one would be to reinforce the preparation of central and regional structures of the Ministry of Agriculture and the State Fund for Agriculture, as well as beneficiaries (farmers) for SAPARD, and the Ministries of Transport and Environment for ISPA (training at central level would be sufficient in that case). A second priority would be to adapt the relevant institutions to the "new" Phare, especially in the social sector and in the two Phare target regions (for regional and local authorities concerned). Although Phare has been present in Bulgaria for several years, the shift, 37 The French acronym for "Nomenclature of Territorial Units for Statistics". 52 Chapter III Public Administration from 2000 on, to investment projects and co-financing raises new difficulties. Special effort should be targeted at the Ministry of Labor, with a view to its future responsibilities with the ESF after accession. The recent shift towards nation-wide implementation of the Structural Funds will allow experience and institutional capacity to be built at local level in all - and not only as in the past in two Bulgarian regions. Other technical assistance priorities can be identified for the medium range. Structural Funds interlocutors in Bulgaria will be the main coordination structures and the ones who must be ready to immediately start daily contacts with Brussels after accession, and define domestic rules and procedures to apply to the funds. They will also negotiate with the EC and the other member States all the matters related to the implementation of Structural Funds. They will have to be trained so as to be fully operational at accession. A preparation of the Bulgarian Permanent Representation in Brussels will also be needed. Another medium range priority will be the training of Structural Funds managers and beneficiaries. Beyond the Structural Funds interlocutors, there is a large number of organizations that will be involved in the funds implementation at national, regional and local level. Training actions shall progressively target all public servants who will directly deal with this issue in ministries, agencies, districts and municipalities. The National Association of Municipalities of Bulgaria could play an important role of coordination. Information campaigns on the new opportunities offered by the Structural Funds will also be important. ANTI-CORRUPTION The October 1999 EU Progress Report on Bulgaria in the context of EU accession highlighted the need for urgent measures to make a difference in fighting corruption in Bulgaria: "Corruption remains a very serious problem in Bulgaria. Petty corruption is reportedly widespread in daily life. Surveys show that the sectors most affected are customs, municipalities, medical services, universities, the police, taxation authorities and courts. Despite the measures taken by the Government, considerable further efforts remain necessary to achieve results in the fight against corruption." Grand corruption remains at least as serious a problem as petty corruption. The continuing urgent need for progress in this area was, however, also underpinned on the release by Transparency International in November 1999 of their latest global corruption league table, in which Bulgaria was in 63rd place, behind most of its neighbors (and competitors) both in South East Europe and overall in Central and Eastern Europe. The Government of Bulgaria and the National Assembly have adopted a range of anti- corruption measures and laws, following on the 1998 National Strategy for Combating Corruption. These measures include a strengthening of internal control units in the Ministry of Interior and National Security Service; and a fundamental reorganization of the work, structure, and working practices of the General Tax Directorate (reorganization of the Tax Administration along functional lines so as to reduce opportunities for corruption through weakening direct relationships between individual tax officers and taxpayers, particularly corporates). Within the framework of cooperation with the EU, the General Customs Directorate is implementing the Chapter III: PublicAdministration 53 Fight Against Corruption in the Bulgarian Customs Administration Project with assistance from the French Government. Further reform measures include: approval of a new Public Procurement Law with supporting regulations to ensure transparency and professionalism in all areas of public procurement; an inter-Ministerial review of all regulatory approvals and licenses with a view to either abolishing them, softening or simplifying them, replacing them with a registration regime, or considering self-policing by associations within the private sector; and a Money Laundering Law. Bulgaria ratified the Council of Europe's convention against corruption (criminal aspects) early in 1999. The comparative success of the Government's overall anticorruption program is reflected in the country's move from 63rd pace in 1999 to 52nd place in 2000 in the league table published in September 2000 by Transparency International. There is encouraging micro-level anecdotal feedback from the private sector that the reforms in the areas of tax and customs are beginning to lead to some lessening of the problems previously experienced by the private sector in its dealings with these agencies, together with some positive experience in the Ministry of Interior in identifying and dealing with corruption within the Ministry's structure. Indeed, the program of functional restructuring and strengthening of internal control implemented by the Tax General Administration looks capable of delivering major results over the near-term. However, it is clear that the actual outcomes of all the measures so far taken by the Government and National Assembly are not enough. What is required is impartial, timely, consistent, effective and painful action against all forms of grand and petty corruption (which will also help to reduce appetite); and a step change in terms of reducing opportunity for corruption through accelerating regulatory reform. Further areas where specific interventions should be accelerated include: simplifying interactions between the public administration and SMEs; and removing other administrative barriers to investment. Such measures will need to be supported by legal and judicial reform; developing greater pressure for change through public education, information, awareness programs and debate, including media-led debate, and the strengthening of accountability arrangements between the public administration and the private sector and citizens; development of the institutional framework to allow for significantly increased checks and balances than at present exist; and accelerating progress on developing a merit-based public administration and civil service (and achieving the corresponding reduction in politicization of the civil service and in party capture of the civil service; and tackling conflicts of interest). Clearly though the main success criterion in this area is high-level political will and commitment. In this respect, for Government efforts in this area to be effective in delivering results, extensive senior-level coordination and commitment across Government is essential. This needs to be supplemented by partnerships with the National Assembly; the private sector; and a wide range of civil society and citizens. It could also prove advantageous to mount a public officials survey to provide some objective evidence of areas for priority attention in the fight against corruption. 54 Chapter III: Public Administration Accelerating the development of a world class public administration in Bulgaria Bulgaria has made impressive, significant, and comparatively strong progress in the development of its public administration but some recent initiatives are still at an early stage of implementation. In addition, as highlighted by the EU, capacity building efforts have been hindered by the shortage of human and financial resources. In consequence, the agenda for further change remains complex and challenging. One immediate step which the Government should take is to undertake a comprehensive institutional assessment on which further development of the program would be based. This would be designed to establish the theoretical and the real incentive structures within the system; the formal and the informal rules of the game currently operating; and the espoused and actual operational behavior. The analysis would build a clear picture of winners and losers in different reform areas. It would also support the development of an action plan designed to ensure that reform measures identified address the most important issues, problems and constraints; and that therefore the reform measures proposed are likely to be capable of being successfully and effectively implemented. Acceleration of implementation of the reform program can also be assisted through the formulation and wide dissemination and discussion and reinforcement of a clear vision of the desired end point - what the public administration in Bulgaria will look and feel like at the end of the reform process; and how the general model of a public administration designed to fit the common "European Administrative Space" will reflect Bulgarian traditions, culture, characteristics and preferences. It is also important that the reform program be seen to be underpinned by strong, consistent, clear and coherent political commitment, sustained over the short, medium and long- term. This requires active, direct, strong and senior-level political leadership and involvement of the program (itself a claim on scarce resources), underpinned by strong technocrat managerial leadership and direction of the program. The program needs to be designed to build continually consensus behind the program, and to broaden and deepen this consensus, on the part of both internal and external stakeholders. This in turn requires the development of partnerships with stakeholder groups such as citizens, civil society and NGOs, the private sector, the media, and politicians, as well as among the public servants (and the different interest groups within the public service). The reform program also needs appropriately to balance both the sectoral agenda (EU accession requirements for capability to apply the Acquis in specific sectoral areas) and the systemic agenda (e.g., public administration and civil service management, inter- Ministerial/agency coordination, center of Government decision-making, the budget process). A pragmatic approach should be followed during development and implementation of the program, with, if necessary, specific single issue coalitions formed to secure progress in different areas. Setbacks should be expected and planned for, but a clear, consistent and credible message must be delivered that the reform and development process is irreversible. CHAPTER IV: DEVELOPING STABLE AND COMPETITIVE FINANCIAL MARKETS INTRODUCTION As a candidate country for accession to the European Union (EU), Bulgaria, in the years ahead will need to establish stable, well-regulated and competitive financial markets and institutions. More specifically, this entails adapting its legislative framework and its financial institutional capabilities to the norms and standards of the EU. Since 1997, banking sector soundness has improved drastically, thanks to the sector consolidation and the tightening of regulation and supervision which followed the introduction of the CBA. Although the banking sector is liquid and profitable, and gradually gaining credibility, monetary aggregates as well as credit and deposit indicators suggest that the public's trust in the banks has not been fully restored yet. Similarly, typical of a post-crisis context, the commercial banks conservative stance toward lending demonstrates their high degree of risk aversion and their low capacity for credit risk assessment. These shortcomings are compounded by the intensification of the industrial restructuring process, marked by substantial firm exit and new entry, which makes for an uncertain customer base with short or absent credit history. The rest of the financial sector is underdeveloped. Although the regulatory and supervisory foundations are now largely in place, capital markets are still either inactive or nontransparent. Some financial institutions such as finance companies and investment holdings are still unregulated. Furthermore, noncompetitive state provision of financial services in the insurance sector has not yet been fully eliminated. Further strengthening of the regulatory framework and supervisory bodies is necessary; implementation and enforcement need to be enhanced, and privatization of the provision of financial services needs to be continued. The financial infrastructure is evolving to catch up with technological improvements. Diversification of payment instruments is underway. The efficiency of liquidity management within the banks and system-wide in the payment system is expected to be enhanced with the conversion to the real-time, gross settlement system. The requirements of external auditing have been introduced. Bulgaria's accounting principles are evolving to meet EU requirements and the adoption of the IAS (International Accounting Standards) "chart of accounts" is underway. The assimilation of the standards by the banks and the enterprises will probably take some time, however. Bulgaria needs to complete the privatization of the financial services industry and vigilantly focus on the maintenance of the hard-won stability of the financial system. Still too small in size and equity, the banking sector needs to enhance its credibility, streamline its operational expenses, increase its core banking earnings from lending rather than relying on low- risk government securities and strengthen its managerial and technical capabilities to be able to play fully its intermediation role and effectively contribute to growth. This is also key for EU 56 Chapter IV: Developing Stable and Competitive Financial Markets accession, which requires the presence of stable, competitive, and open markets, as well as the necessary institutions to support them. These requirements are driving the financial sector restructuring agenda. Most of the regulatory and legal framework enhancements to harmonize with EU Financial Sector Directives have been made. The established institutional infrastructure needs to be strengthened to effectively implement the legislative and regulatory framework created for EU compliance. This in tum requires enhancing the skills and capability of the supervisory and judicial bodies as well as the financial institutions operating in these markets. MONETARY AGGREGATES AND FINANCIAL INTERMEDIATION As Figure 4.1 illustrates, monetization and intermediation in Bulgaria are low compared to other transition economies and Germany. These indicators are also below pre-crisis levels.38 Figure 4.1: International Comparison, 1999 (in percent) 140 - 120 - 100 80 60 40 -... ,A 20 M2/GDP Currency/Deposits Total deposit/GDP Bank lending to private sector/GDP | Bulgaria 0 Czech Republic 0 Poland El Romania E3 Slovak o Germany Note: M2 includes currency outside banks and derand deposits (Ml) and quasi-money (time deposits, savings deposits and foreign currency deposits). Data for Bulgaria are as of September 2000. Source: International Financial Statistics Monetization as measured by broad money (M3) as a percent of GDP remains weak compared to its pre-crisis level. Following the banking sector crisis in 1997, the ratio of broad money to GDP fell to 25 percent, less than half its 1995 level. This ratio has stabilized at about 29 percent of GDP, which indicates remaining low confidence in the banking sector. Developments reflect economic agents' preference for cash holdings, perhaps because of the slow recovery of confidence in the banking sector, low deposit rates, and a fairly dynamic informal sector. While initially the crisis affected almost equally Lev and deposit holdings, as both fell sharply, by the end of 1999 Lev currency holdings had recovered close to their pre- crisis level. Time and saving deposits, however, do not show strong signs of recovery. In line with the low level of deposits, the currency to deposit ratio reached 0.34 in September 2000 almost triple its 1995 level, while the money multiplier dropped from 4.5 in 1995 to 3.0 in 38 Pre-crisis levels should, however, be interpreted with caution. Soft budget constraints, politically-driven lending, fraud and weak governance contributed to high intermediation in the past. Chapter IV: Developing Stable and Competitive Financial Markets 57 September 2000 indicating low lending activity. Both depositors and commercial banks are being cautious. As a result, with total assets about 36.3 percent, loans about 23.7 percent and deposits about 27 percent of GDP, size alone limits the potential contribution of the banking sector to economic development. Domestic Credit: The majority of bank assets are in low-risk domestic and foreign securities and placements. Overall, commercial bank loans represent less than one-third of banks' total assets. Indeed, the banking crisis and subsequent developments resulted in a drastic fall in domestic credit which dropped to the equivalent of 18.3 percent of GDP in September 2000 from 67 percent in 1995. A radical change in the composition of credit also took place. First, the share of foreign exchange denominated credit increased from 34 percent of total domestic credit in 1995 to 78 percent in September 2000, with the private sector and the central government holding, respectively, 50 and 41 percent of total foreign exchange-denominated credit. Second, lending to the public sector at Chart 7: Commercial Banks Loan large has sharply dropped. The implementation Portfolio, September 2000 of the reform of the state-owned enterprises resulted in a number of closures of nonviable Loans to state companies, and the isolation program, which iividuals enterprises ended in June 1999, eliminated easy access to 20% 5% commercial bank credit. In addition, under the CBA, which provides only a limited, lender of Loansto last resort facility, commercial banks adopted a Loansto private more conservative stance toward loss-making the budget companies enterprises and state-owned enterprises 0 \3 / 75% undergoing restructuring and privatization. As a result, however, of the sharp fall in lending to the public sector at large, the private-sector Source. Bulgarian National Bank share in the commercial banks' loan portfolio has become dominant (Chart 7). In contrast to the sharp decline in lending to the public sector, the share of banking sector claims on the private sector registered a slight increase from 12.7 percent of GDP in 1995 to about 13.9 percent in September 2000. This level, however, remains by all standards very low. It is attributed to the banks' preference for low-risk liquid assets following the crisis and to the ongoing economic restructuring, which, because of substantial firm exit and new entry, is making for an uncertain customer base with limited or absent credit history. In addition, in view of the high-liquidity requirements in a currency board environment with a limited lender of last resort function and with Bulgaria's shallow short-term money markets, banks may feel obliged to maintain high liquidity as they could face unexpected large claims such as bunching of withdrawals or non-renewal of credit lines by other intermediaries. Other possible factors for these low lending levels include tighter banking regulations and supervision, stricter state guarantee policy for enterprise borrowings that reduce moral hazard, 58 Chapter IVV: Developing Stable and Competitive Financial Markets and a weak legal and judicial environment that reduces the probability of recovering losses in case of default. Box 4.1 further elaborates on private sector credit. Box 4.1: Why is Private Sector Credit so Low In Bulgaria? Bank lending to private sector is low in Bulgaria by any standard. It amounts to only 14 percent of GDP, compared with 17 percent for transition economies, 49 percent in the United States and 120 percent in the United Kingdom. Financial internediation is low even when controlling for Bulgaria's stage of development: based on a cross-country regression, a country with Bulgaria's per capita GDP is expected to have a 17 percentage point higher ratio of credit to the private sector to GDP. This is not due to low bank liquidity: deposit-to-loan ratios are high, but banks tend to hold bonds instead of extending loans. Several factors account for the low level of credit to the private sector: * The banking crisis in 1996-97. As in other countries that went through a banking crisis, banks in Bulgaria became cautious about making loans during and after the crisis. Before the crisis, lending to the private sector had been quite high (20 percent of GDP in 1995), but much of it was based on unsound banking practices and weak supervision. * Economic restructuring. Many old customers have ceased or reduced operations, or have become uncreditworthy under the restructuring that has taken place since the crisis. New customers from the emerging private sector typically do not have a credit history or appropriate collateral, and transparent financial information is often lacking. * Lack of competition in the banking sector, despite a relatively large number (34) of banks. The banking system is dominated by a small number of large banks, all of which were state owned until 1998. Interest margins are high and banking services inefficient, and banks have not felt pressure to cut costs. * An imperfect legal environment. The resolution of financial disputes is often slow, and contract enforcement is weak. Collateral is hard to seize, and bankruptcy and liquidation procedures remain fraught with ambiguity and uncertainty. A legal provision that criminalizes the extension of loans without "proper security," even in the absence of fraudulent intent, acts as a deterrent for bank officials. Source. IMF Interest rates. As could be expected from Chart 8: Interest Rates a successful stabilization, interest rates fell (end of period) sharply following the introduction of the CBA 100 (Chart 8). Interest rates have remained fairly 90- S 80 I B nrouto stable since then. In a pure CBA, interest rates 70- - BAintroduction fluctuate, depending on changes in the money 5 ; supply induced by fluctuations in foreign 40 exchange reserves. In Bulgaria, interbank lending 3 'I and deposit rates continue to follow the base 10 --=-- interest rate, which is determnined by the yield on 0 ,__ the three-month treasury bills issued weekly by r - > r- x°. °, °, the Ministry of Finance (MoF). The supply of : z E z z X E bills 'TB' is limitd because of -4--- Basic interest rate Interbank rate treasury bills (TBs) is limited because of -Short-term credits - Time deposits Source: Bulgarian National Chapter IV: Developing Stable and Competitive Financial Markets 59 government low-financing needs and the high stake in keeping domestic debt-servicing low, while demand is high because of the high liquidity of commercial banks and their cautious attitude toward lending. Hence, interest rate developments are taking place in a shallow and insulated domestic market of government securities, with its idiosyncratic supply and demand characteristics. Reflecting the risks associated with an economy struggling to recover, lending rates were high (11.73 in September 2000); and deposit rates low, at 3.24 percent (3.25 percent in September 2000). The average BGN lending spread (8.2 percent in September 2000), was high by international standards. The high short-term lending spreads are primarily due to the banks' reluctance to lower interest rates to their borrowers. Lack of credible competition, the large provisioning expenses during 1997-98, and a limited borrower base that was highly dependent on the banking sector contributed to the resistance to lowering lending rates to bring them in line with inflation. The banking sector earnings during 1997-99 depended on non-interest income since the high operating expenses added as much as 6 percent to the cost of funds in large state banks, exceeding the net interest income of the sector. Spreads are expected to decline further as competition increases with privatization; reserve requirements were lowered from 11 to 8 percent since July 1, 2000; and, as some of the large banks start to expand their business services and products, especially to the retail-consumer banking areas. What can be done about intermediation? It is important to recognize that Bulgaria may be on for a "long game" here. The devastating effect of hyperinflation and the easy access to a secure home for savings in nearby industrial countries mean that it will take time for depositors to place their savings in Bulgaria and for the privatized banks to become more active in lending to local entrepreneurs. Adverse conditions in former markets of the former Soviet Union and the volatile situation in the neighboring former Yugoslavia mean weak entrepreneurial confidence, which also weakens the demand for credit, thereby limiting the opportunities for banks. Thus, while financial depth is not deteriorating, it has so far shown no great recovery and remains well below that of comparator countries. Cash holdings have been more resilient than deposits in local banks, and the dollarization rate has remained high, with half of the banking sector's assets and liabilities and more than half of the deposit base denominated in foreign currency. Under these circumstances, the broad thrust of policy, that is, sound fiscal policy; the tightening of bank regulations to converge to EU standards; and the privatization of the banks, including to qualified foreign firms, has been correct but it needs to be sustained and deepened. The bank privatization process in particular, through the increase in competition and the diversification of product and services that it is likely to bring, is key to improving the longer- term performance of the sector. In addition to the measures directly targeting the banking sector, a whole range of economic management and business environment-related policies need to be implemented. Enhancing creditors' rights and enforcing contracts; removing obstacles to the use of land as collateral; and, strengthening banks' risk assessment and management skills would go a long way toward changing commercial banks' lending behavior. 60 Chapter IV: Developing Stable and Competitive Financial Markets POST-CRISIs FINANCIAL SECTOR DEVELOPMENTS Banking. At the core of the Bulgarian financial system is the banking sector, comprising of 34 banking institutions, with total assets of about 10 billion in September 2000. In addition, there is a small but growing insurance sector (30 insurance companies), with total financial assets of about 0.3 billion BGN, about 80 finance houses, some investment holding companies (which evolved from voucher privatization funds), a handful of embryonic private pension funds, together with several dozen independent broker-dealers. Overall stock market capitalization is estimated to be about 1.1 billion BGN although the actual figure for the number of non-state shares available for trade at the Bulgaria Stock Exchange (BSE) is estimated to be half of this amount. The sector is largely privately owned. By end 2000, Bulgaria had 34 banking institutions, seven of which are foreign bank branches. Out of the 27 locally incorporated banks, 14 have majority (more than 51 percent) or near-majority foreign ownership. As of October 2000 state-owned banks (State Savings Bank, Biochim, Promotional Bank and Municipal Bank) hold 18.8 percent of the total banking sector assets, Bulgarian national private banks 7.9 percent, and foreign shareholder banks or branches about 73.3 percent. As Table 4.1 indicates, state ownership of banking sector assets which was until recently among the highest in the region, is now at 18.8 percent, second only to Estonia (7.8 percent), Latvia (8.5 percent) and Hungary (11.8 percent). Table 4.1: Privatization in the Banking Sector in Selected Countries in Europe Comparison with Central and Eastern European Countries 1998 Asset share of state- Asset share offoreign- Number of Of which majority owned banks (percent) owned banks (percent)* Banks Foreign-owned Belarus 59.5 2 37 3 Bulgaria 18.8 73 34 22 roatia 37.5 4 60 11 Czech Rep. 18.8 13 45 13 Estonia 7.8 28 6 2 Hungary 11.8 62 40 27 Latvia 8.5 71 27 15 ithuania 45.3 41 10 5 Moldavia 0 14 23 7 Poland 48 16 83 31 Romania 74.6 6 36 16 Russia 42.2 7 1476 29 lovak Rep. 50 19 24 8 Slovenia 41.3 6 34 3 Ukraine Na Na 227 12 Germany* 52 2.4 3392 ... France* 31 570 ... taly* 36 5.3 911 ... Source: Lanoo, European Bank for Reconstruction and Development (1999), European Central Bank (1999), CEPS; and World Bank estimates. Data market with (*) and for the asset share of foreign-owned banks are for 1997. Data for Bulgaria are as of 2000. Chapter IV. Developing Stable and Competitive Financial Markets 61 Since the beginning of 2000, more banks have been privatized as a result of increased Government efforts - Bulbank, Hebros Commercial Bank, and Corporate Bank, previously owned by Bulbank was sold to private owners. By 2001, the Government intends to sell Biochim and State Savings Bank. Bank ownership is highly concentrated. The bulk of the banking system is in the hands of 12 banks,39 two of which are still state-owned. The top 12 banks hold more than 80 percent of banking sector assets, total deposits and total loans. The largest bank, Bulbank, has a dominant position in the market with 27 percent of sector assets. The remaining small and medium-size banks vary widely in size, profitability, and style of business.40 Many have capital and reserves barely meeting the minimum paid-in capital requirement of 10 million BGN. These are not all exclusively private banks, nor are they now all majority Bulgarian-owned. Indeed, of the three largest banks in this group, Sofia municipality has a majority share in the Municipal Bank, three foreign concerns now hold 72.9 percent of First Investment Bank, and the State Agricultural Fund has a 32.7 percent share in the Central Cooperative Bank.4' Post crisis banking sector is gaining credibility. The overall soundness of the banking sector has improved considerably with the closure of unprofitable banks and the substantial strengthening of the regulatory and supervisory functions. Total risk-weighted capital adequacy increased from 10.2 percent in June 1997 to 35.44 percent by September 2000 according to BNB data. The performance of the sector as a whole hides, however, a substantial variance in the performance of individual banks. As of September 2000, 8 banks have recorded losses of varying size according to BNB published data. Given the ongoing restructuring within the sector, it is too early to judge the potential for future profitability and growth of the banking business in Bulgaria. However, in the coming years, as Bulgarian banks increase the mobilization of domestic resources to maintain their market presence and therefore face higher interest expenses, they will need to boost their interest income. They will also need to lower their high operating costs relative to their present income- generating capability. The high interest rate spreads are not helping the recovery, either. The sector is facing here a chicken and egg problem, as the high spreads are needed to cover the bank's operating expenses, given that the scale of their loan portfolio is so low and their business operations are not yet diversified enough to generate stable non-interest income. The preference for very high solvency on a risk-weighted basis also makes banking an expensive business since low-risk, low-return securities clearly do not generate sufficient revenues. Increased competition 39 Bulbank, State Savings Bank, United Bulgarian Bank, Biochim Bank, Bulgarian Post Bank, Expressbank, Hebros Commercial Bank, BNP Dresdner Bank, First Investment Bank, ING Bank, Raiffeisenbank, Economic and Investment Bank (previously BRIB). 40 January 1999 saw the failure of one of the banks formerly in this group-Credit Bank. Already weak, the Russian default dealt this bank a fatal blow, as it had been holding Russian government securities. Its depositors received compensation from the new Deposit Insurance Fund. 41 The government intends to reduce State Fund for Agriculture holdings in Central Cooperative Bank to below 33 percent by end-2000. It is actually reduced to 32.73 percent as of April 28, 2000 (the date of the subscription to the capital increase). However, because of the holding of minority shares of close to 1 percent by the State Insurance Institute, the state still owes a little above 33 percent of the Central Cooperative Bank. 62 Chapter IV: Developing Stable and Competitive Financial Markets from privatization will probably lead bank's management to reassess their risk management and earning strategies. Eventually, long-term profitability will depend on the banks' resource mobilization capability and their ability to generate profit from lending and lending-related core business activities in corporate or retail banking operations. The small size of the Bulgarian economy, a slow recovery in the real sector, or increased competitive pressures42 from foreign banks and branches could raise sooner rather than later the issue that prospective market opportunities are too limited to support some of the existing banks. A self-financing Deposit Insurance Program is in place. From January 1999, the previous blanket deposit insurance, which had been introduced during the 1996-7 crisis, was replaced by a self-financing Deposit Insurance Fund (DIF). The fund collects a levy of 0.5 percent on end-of-year deposits of the banking system and undertakes to cover 95 percent of the first 2,000 BGN of any deposit and 80 percent of the remainder up to a maximum payoff of 5000 BGN for each depositor.43 As of June 1999, DIF has assets of about 33 million BGN.4 It will accumulate funds at a rate approaching 25 million BGN a year at the current insurance levy rate. This rate (already high by international standards) can be increased to 1.5 percent, and if accumulation of funds proves inadequate, DIF's sources can (subject to parliamentary approval) be augmented by borrowing from the government.45 Governed by board representatives of the Government, the BNB and the Association for Banks, the DIF is dependent on the BNB for the information on the banking sector. Experience so far indicates that the DIF's relations with the BNB need to be strengthened. More responsibility should be placed on BNB to supply DIF with information essential for its operations on the distribution of deposits and the state of the banks. Recently, BNB and DIF have submitted to the parliament a "Draft Law on Bank Bankruptcy", which clarifies DIF's powers with respect to the conduct of bank liquidations and bankruptcies. The same draft law also lays the necessary foundation for the speedy resolution of future bank failures. Banking regulations and supervision are considerably strengthened. Following the crisis, both the prudential regulations and the intensity of supervision and enforcement have been strengthened. The Law on the Bulgarian National Bank was issued on June 10, 1997 to support 42 Using bank level data for 80 countries in their study titled "How Does Foreign Entry Affect the Domestic Banking Market?," Claessens and others find that larger foreign ownership share of banks reduces the profitability and the overall expenses of domestically owned banks. Their results suggest that foreign bank entry improves the functioning of national banking markets, with positive welfare implications for banking consumers. 43 No estimate is currently available of what the average percentage payout from the actual distribution of deposits would be, although the figure could be as low as 40 percent or even less. 44 DIF's legislation limits its permissible investments to Bulgarian cash and government investments, and at present invests almost all its resources through reverse repurchase operations. DIF also covers foreign as well as local currency deposits. Although payoff is made on foreign currency deposits in BGN the rate of exchange used is the date of initial payoff, thereby passing exchange risk to the DIF. 45 Another alternative is for the authorities to revert to a fixed lower payout amount. Finally a few countries, for example Canada, authorize the deposit insurance agency to issue "own bonds" to finance liquidity needs. This could increase market discipline over the operation of the fund to the extent that no government guarantees are provided. Chapter IV: Developing Stable and Competitive Financial Markets 63 the CBA which became effective July 1, and replaced the previous law issued in 1991. Adopting a universal banking model, the law clearly defines the permitted activities of the banks, the entry conditions, prudential regulations, and the supervisory authority of the BNB over the banking sector. Various changes are being made to the Law on Banks to strengthen prudential regulations and the supervisory issues related to the BNB. Since the adoption of the new banking law and related prudential requirements, the incidence of violations of major requirements, such as capital adequacy, open foreign currency position and loan concentration to individual borrowers, has been reduced significantly. Further work is ongoing to improve the prudential framework in introducing trading book or market risk capital allocation and requirements; employing consolidated supervision upon the adoption of accounting rules for consolidated bank accounting; and refining the guidelines on loan classification and provisioning. A Central Credit Registry also became operative in August 1998. Parallel to the developments in the legal and regulatory framework, BNB's off-site and on-site supervision capability is improving. In the past, the supervision was of a mechanistic nature, concentrating on compliance to prudential ratios. Qualitative analysis of the banks is being introduced and BNB is in the process of adopting CAMELS46 rating methodology. Some reporting requirements for the off-site supervision have been expanded and an early warning reporting and evaluation system has been developed. The BNB supervision department should now adopt the early warning system and periodically publicize CAMELS' ratings to enhance market-based discipline. However, until the banks completely integrate LAS standards in their reporting, the off-site supervision data collected may not be sufficient to detect the early warning signals. Hence the requirement to have all banks adopt IAS standards should be implemented rapidly and enforced, and their externally audited IAS annual financial statements should be made public. Insurance. The insurance industry is undergoing consolidation under new regulations. Until 1997, the insurance industry consisted of the two state insurance companies (Bulstrad for insuring trade and commodities transactions and the State Insurance Institute [DZI] for domestic insurance) and about 112 unregulated shareholder and mutual insurance companies reporting to the MoF. The Insurance Business Act in force since January 1, 1997, mandated that the insurance companies participate in a licensing process through the newly established Insurance Supervision Directorate. Since then, stricter minimum capital and other prudential requirements have also been imposed. As a result, by the end of 1998, 85 insurance companies were closed, while 27 continued operations. The Directorate of Insurance is liquidating the closed companies. Among the 27 operating insurance companies, the state-owned Bulstrad and DZI still dominate the market. The premium income during 1999 has been about 278 million BGN from general insurance products. Life insurance is a very new product and 1999 premium income was about 32 million BGN. Total assets of the insurance industry are still insignificant. The ratio of Gross Premium to GDP did not exceed 2 percent in 1999, compared to 3.5 to 13 percent of the GDP in 46 The S in CAMELS stands for "systemic"-- evaluating the impact of macroeconomic developments on the banks. CAMEL (Capital Assets Management Earnings Liquidity). 64 Chapter IV: Developing Stable and Competitive Financial Markets the EU. The low level of insurance activity is due to the poor performance of the insurance companies in honoring their obligations in the past, the public's lack of awareness of new insurance products, and the country's low level of income. The insurance industry, however, is increasingly attracting foreign investors. Foreign insurance companies have been entering Bulgaria through acquisitions into offshore small Bulgarian insurance companies. The trend toward acquisition of shares in the largest companies is more recent. The second largest state insurance company, Bulstrad, is now 51 percent owned by TBI, an Israeli-German company, and EBRD. The state is expected to divest from DZI, the largest insurance company, in 2001. Two companies with foreign capital, American International Group (AIG) Life Bulgaria (part of the U.S. based AIG group) and QBE international (an Australian concern) received their licenses in 1999. As a result of privatization and foreign investment, a consolidation of the insurance market is likely to take place in the years ahead. Capital markets. To a large extent they are inactive and nontransparent. Bulgaria's capital market was founded with the first wave of mass privatization completed in June 1997. Shares representing 10 percent of ownership (for large companies) to 90 percent (for small ones) of 1,050 companies were offered at auctions in which individuals participated through pre- assigned voucher books either directly or through privatization investment funds. The privatized companies were given the choice to be listed in various markets of the Bulgaria Stock Exchange (BSE). Although a large number of companies are listed on the BSE-Sofia, many of the small companies have not traded at all. The estimates for total market capitalization for the listed companies are about 1.1 billion BGN. The value of the shares not held by the Government and available for the trading on the BSE is estimated at about half this amount. Despite restrictions, the volume and amount of trading of the listed companies off the exchange exceed the BSE trades by at least 30 percent. The larger volume of off-exchange trading could be due to a number of factors, including a lack of investor knowledge and sophistication, difficult access to the exchange because of the high commissions of the intermediaries or their inaccessibility, and unfavorable tax treatment of capital gains on private securities.47 The preference for off- exchange trading, in which the exchange prices of the shares are not publicly known, raises questions about the transparency of the market pricing. In order to increase the volume of trade on the BSE, plans for listing private and public sector bond issues are underway. The present primary supply of state and municipal bonds is not sufficient to support an active secondary market. The first corporate bond issue was offered to the public in August 1999. The present low level of trading in the BSE is handled by seven or eight intermediaries conducting about 75 percent of the turnover. With such a low turnover, it is difficult to foresee the future viability of many of these intermediaries as well as the BSE. There are also some unregulated yet active financial institutions. Finance companies are involved in diverse activities from leasing to portfolio management and investment advice. As 47 Income from government securities and bank deposits is tax exempt while income from dividends and capital gains on private securities is taxed. Chapter IV. Developing Stable and Competitive Financial Markets 65 of the end of 1998, there were around 40 finance houses with total balance sheet assets of US$62 million. Eight of these finance houses had assets greater than US$1 million or more. The assets of these eight totaled US$57 million, representing 92 percent of the finance house assets. The largest finance house had US$46 million in assets with a 75 percent market share. Investment holding companies are also unregulated. The majority of the privatization funds established under the first mass privatization program converted to investment holding companies whose shares could be traded on the BSE. At present, 76 out of the original 81 privatization funds have been incorporated into investment holding companies. Only two are listed on the BSE. Some of these are also part of the above holding finance companies. Regulatory Framework. However, the regulatory framework for the majority of the non- bank financial institutions and markets is in place. The Law on Securities, Stock Exchanges and Investment Companies (LSSEIC) of 1995 established the Securities and Stock Exchange Commission (now called State Securities Commission (SSC)) to ensure the protection of investors and to speed up the development of the securities market. The new Law on the Public Offering of Securities effective January 31, 2000 has brought the legal framework of Bulgaria's securities markets in line with EU requirements. Also, in line with international practice, the Law on Insurance defines two-tier insurance supervision. In 1998, the supervision of insurance activities had concentrated on re-licensing and eliminating insurance companies, so 1999 will be the first year in which the insurance industry has been operating under the regulations and supervision of the Insurance Directorate. Payment System (Infrastructure). Payment instruments are diversifying. The majority of retail transactions and nearly all salary payments are still conducted in cash48. Non-cash retail payments are routed through the current or demand accounts with the banks. Banks also perform direct debits to customer accounts under instructions to pay for electricity, water, telephone, and heating bills. Check usage is minimal. As of the end of 1998, ten banks were issuing debit cards to their depositors.49 Prepaid (smart) cards are issued by telecommunication companies and gasoline stations. Their use has increased rapidly. The existing public coin telephone network has been largely replaced by a wide network of smart card telephones of Betkom and Bulfon. In addition to telecommunications, Shell and Petrol Bulgaria offer prepaid gas cards. Postal instruments for money transfers are used in the villages without bank branches. Postal instruments are used for payments of pensions, subscriptions, taxes, or transfers to other individuals. BNB estimates the volume of such transfers to be negligible. A few banks are also offering Western Union services. 48 There are no reliable statistical data on the use of cash (local and foreign currency). However, BNB supports this tendency of high use of cash citing the 57.4 percent currency outside the banks in Ml at the end of 1997 and 65.3 percent at the end of 1999 . 49 Several Bulgarian banks are offering VISA, EUROPAY and MasterCard international debit cards, using the clearing system of these international cards over phone lines. Domestic credit cards are not yet common in Bulgaria. 66 Chapter IVV: Developing Stable and Competitive Financial Markets A conversion to real time-gross settlement is planned. The present electronic messaging clearing and settlement system (BISERA) currently is a designated time, gross settlement system operated at "t+1" value date. It also does not recognize "large value" payments. BNB should introduce BISERA 4, the Real Time Gross Settlement System (RTGS). Under this system, the payment orders will be processed periodically with specific cut-off times for batches. Monitoring and the management of the queues of the incoming payments will aim to manage the liquidity in the system and spot illiquidity on a real-time, on-line basis. Each commercial bank will have the possibility of monitoring its position real-time, on-line basis, instead of waiting until the end of the day under the present system. BNB will also have on-line access to the overall functioning of the system, thus overseeing the settlements to minimize systemic risks from illiquidity. Accounting and auditing. The Bulgarian Accounting Principles are evolving to meet EU-IAS requirements. The discipline of external auditing is in place, as all public entities are expected to be externally audited annually by registered and licensed auditors. Bulgarian banks are in the process of adopting IAS chart of accounts and standards. In 1999, they began reporting to BNB under LAS. A sketchy review of their reports indicate that the banks have not yet absorbed the IAS standards. Except perhaps for the foreign joint ventures and banks, the assimilation of the LAS charts and standards is expected to take some time. Eu ACCESSION: KEY ITEMS ON THE AGENDA An overall EU accession strategy in the area of financial services should aim to establish a well-regulated, stable, and competitive system operating under market-based rules, with clear rules for entry and exit. The existence of an independent central bank, supervisory authorities, a regulatory framework and a market infrastructure are crucial for the proper functioning of the financial markets. Despite the progress accomplished in the past two years to improve financial markets operation and institutions, Bulgaria's financial markets are still in the process of developing and are not functioning as efficiently and effectively as needed to support future economic growth. Postponing the restructuring of the real sector for most of the decade was clearly an important impediment to the development of the financial market. Now that the restructuring process is taking hold and the key institutions and rules are established, the authorities need to continuously evaluate their adequacy, and whether there is proper governance, supervision and transparency in and over their operations. The remaining of this section covers the key items in the EU Accession agenda and Table 4.3 in the end presents a matrix summarizing the key financial market development measures. Regulatory harmonization. Regulatory harmonization to the EU Directives is seen as the means to establishing the overall operating rules within the EU common market of financial services. The 1995 EU White paper recommends the sequencing of adoption of EU Directives for the financial sector while distinguishing between first and second stage measures. The key essential conditions for financial markets embodied in these Directives are: (a) free movement of capital, (b) free provision of financial services, and (c) the creation of institutions capable of ensuring the stability of prices and financial markets. Chapter IV: Developing Stable and Competitive Financial Markets 67 Before accession, a country needs to have the EU Directives fully in place or come to an agreement for transition periods during its accession negotiations. As Table 4.2 indicates, Bulgaria is among the most advanced Central and Eastern European Countries in adopting EU Banking Directives. Bulgaria has largely implemented Stage 1 Directives regarding capital movements and banking. Improvements are needed in harmonizing the regulations to the directives in both Stages 1 and 2, especially in annual and consolidated accounts, supervision on a consolidated basis, and capital adequacy (asset classification and provisioning, and market risk capital). The Bulgarian authorities may consider asking for a transition period for increasing the threshold for the coverage of the deposit guarantee. The threshold for deposit guarantee in the EU is at 20,000 Euro against a current threshold of 5,000 DM in Bulgaria. As seen in Table 4.2 below, a similar strategy has been adopted by the other accession countries. The lower deposit guarantee threshold in Bulgaria for a certain time period could be justifiable, given the low real income level of the country and the slower accumulation of the deposit insurance premiums in the newly installed self-financing DIF, due to the slow deposit mobilization of the banks. The Bulgarian legislative framework for capital markets and institutions is broadly in line with the EU Directives following the passage of the new Securities Law effective since January 1, 2000. SSC has to rapidly complete the detailed regulations in line with this law and in particular, clarify minority shareholders' rights. As for the insurance sector, a thorough review of the existing insurance legislature is needed, in particular to make it compatible with the directives listed under Stage 2 for accession. The Bulgarian Insurance Law recognizes some of the EU Directives and correctly separates the activities of the life and non-life insurance institutions. The Directorate for Insurance intends to set up guarantee funds, and also encourage the development of market-based actuarial services. Suitable and effective supervisory bodies. The EU Directives aim at ensuring the stability and reliability of the financial markets and participants. The directives stipulate supervision by competent authorities, but do not give direct guidelines as to the supervisory structure. The EU Law requires that the authorities (public or other) designated with the supervision of the financial markets have all the powers necessary for the performance of their duties. Consequently, different member states have developed different solutions for their supervisory structures. Recently, there is a trend in EU countries toward splitting financial supervision from the central bank and moving toward single supervisory authorities. The increased complexity of financial supervision and growing conglomeration in mature markets may pinpoint the need for a single supervisory structure in the mature EU markets. But in Bulgaria, the present scarcity of resources, the need for institutional capacity building, and the fragility of the financial system may call for more flexibility in the design and evolution of supervisory structures keeping banking and non-banking supervision separate for a while. 68 Chapter IV: Developing Stable and Competitive Financial Markets Table 4.2: Implementation of Bankin Directives in CEEC (as of mid-1999) As of mid-1999 Czech Estonia Hungary Poland Slovenia Lithuania Latvia Bulgaria Romania Slovakia Republic ._ First Banking Partially Fully Fully Fully Fully Fully Fully Fully Almost Partially Directive fully Own Funds Largely Fully Fully Fully Fully Fully Fully Fully Almost Fully Directive (except on I fully item) Solvency Ratio Largely Fully, Fully Fully Fully Fully Fully Fully Almost Fully Directive SR is 10 fully percent Deposit Partially, Transiti Min 4000 Almost fully Fully by Fully. Min Present Present level Present Partially Guarantee min. 14,000 onal Euro, 2001 15,000 level is 800 is 5,000 level is Directive Euro, only period transition Euro by Euro. Euro. 2,300 local to reach will be 2001, Transitional Transition Euro. currency EU needed 20,000 by period to will be Fully by level. 2005. reach EU required 2005 _ _ level. Ann. and Cons. Partially Fully Almost fully Fully Almost Fully Fully Fully Partially Partially Accounts fully Directive I Consolidated Partially, Fully Partially Very Fully by Fully Fully Not yet Partially, No Supervision exp. 2002 partially 2000 by 2000 Directive Large Exposures Fully Fully Almost fully Fully Fully Almost Fully Fully Fully Partially Directive fully Capital Fully (by Almost Not yet, Partially, by Partially Partially Partially Partially Not. By Not. By 2005 Adequacy 2000) fully exp. 1999 2002 from 2000 Directive (CAD I mid- and CAD 11) . 2000 Money Partially Fully Partially Partially Fully Fully Fully Fully Fully Partially Laundering (anonymous (anonymous (anonymous (anonymous Directive accounts) _ accounts) accounts) accounts) BCCI Directive Partially Fully Partially Partially Fully Partially Partially Almost fully No Partially. By 2003. Netting Directive No By end No No, by Possibly No No No Partially. By 1999 accession 2005. Sources: European Conmnission (Karel Lannoo 1999) Bulgaria needs to develop its own proper and suitable supervisory bodies. The supervisory and regulatory structure for financial services is related to the currently evolving institutional structure for the provision of financial services. For example, the present Law on Banks allows for a universal banking structure. However, since the securities market-related regulations are in the process of development, it is not clear whether Bulgarian regulations will separate the capital requirements for securities' businesses from those for banks.50 Furthermore, the present regulations do not give the SSEC sufficient supervisory power over the banks' activities in securities. Because the financial sector is still in its early stages of evolution in Bulgaria, the structure and capabilities of the supervisory bodies need to be tested and assessed. As for 50 The EU banking directives allow the banks to either be involved directly in securities business or through a subsidiary. The Capital Adequacy Directives related to the different approaches are in discussion, however. Chapter IV: Developing Stable and Competitive Financial Markets 69 banking supervision, BNB's supervisory capability is being upgraded. However, c4operation between the BNB supervisory activities and the DIF needs to be enhanced.5' The increasing connection between bank and non-bank ownership indicates that financial services will eventually be provided through either financial holding companies or bank holding companies, or both. The overall size of the local financial markets and the low level of capital accumulation could justify this consolidation of financial services under several groups of related companies for Bulgaria. Such a trend would necessitate the need for closer consolidated supervision with closer cooperation between different supervisory bodies. Establishing different supervisory arrangements for different types of non-bank financial institutions might stretch the capacity of qualified manpower and also increase the costs of operation for these emerging financial institutions. In order to streamline costs and achieve better coordination of information for stronger supervision, careful thought should be given to consolidating non-bank financial institutions' supervisory activities under an umbrella institution. In the short-run, immediate consolidation could be beneficial in the insurance sector where there seems to be overlapping roles for the National Insurance Council and the Insurance Supervision Department of the MoF. In addition, in view of the similarity between life insurance-annuity and private pension instruments, supervision of these activities by a single entity may be warranted. Foreign capital in financial services. The increasing foreign-ownership in all aspects of the financial sector is expected to be supportive of the development of a self-regulated and transparent financial sector with institutional capability to compete in the EU single market. However, there should not be a presumption that foreign ownership automatically means institutional capability or transparency. Hence, care needs to be taken of the quality of the foreign investment, regardless of the home rule and mutual recognition of supervision principles under EU. Privatization in financial services. At present, the state is no longer the major player in the banking and insurance sectors. The presence of the state in the banking services will continue until the privatization of the large banks is completed. Plans to further privatize the large state insurance companies should continue to be implemented. Together with the privatization of the large banks, the state has to formulate an exit strategy from all aspects of financial sector intermediation including divesting all its shares in different banks and insurance companies. State policy and subsidized lending, such as in agriculture need to be made transparent and channeled outside of the banking sector. Consolidation and exit. The key question in the coming years for the Bulgarian banking sector will be how to establish the institutional capability to contribute to growth and gain the credibility to integrate within the EU. This process needs to be closely supervised, given that the banking sector has not yet fully recovered from the shocks of 1996-97. The past two years have been a period of adjustment and consolidation. The banking sector has insufficient expertise and, 51 Whether the banking supervision should be conducted under a central bank or under a separate recognized body-sometimes independent deposit insurance funds or agencies-is an ongoing debate in the financial sector regulatory and supervisory applications in different parts of the world. 70 Chapter IV: Developing Stable and Competitive Financial Markets overall, there is low level of intermediation. The banks need to upgrade their skills and diversify their products and services to become efficient competitive institutions. The entry to EU will also bring more competition and perhaps consolidations and mergers among banks. The exit mechanisms in place are yet to be tested,52 and contingency plans should be formulated to deal with banks that could not be privatized or become problematic, or both. As part of this supervisory effort, the authorities could consider increasing the minimum capital requirements for the different financial institutions operating in Bulgaria. Higher minimum capital requirements, especially in the banking sector would allow for a more orderly and regulated process of mergers or exit of the weakest. Some potential risks. Policymakers need to systematically evaluate the economic and financial market impact of adopting EU regulations. These directives, which reflect minimum conditions for operations in mature financial markets and developed economies, need to be carefully monitored when applied to less than mature markets and economies that are still developing and fragile. One example relates to the nature and magnitude of capital flows, in which large swings can be a source of macroeconomic instability, especially under a CBA. Hence the move toward full capital account liberalization should be gradual and carefully monitored. Similarly, banks' open positions in BGN vs Euro need to be monitored. At present, the system appears to be long in Euro. Although not yet practiced in the market, under the present prudential requirements the Bulgarian banks may find it attractive to borrow in short-term Euro deposits and place in longer-term BGN assets to benefit from interest arbitrage to increase their earnings. Such arbitrage could potentially lead to a worsening of the external position. At this point, the Bulgarian banking sector does not face major risks that could arise from large currency, interest rate, and foreign exchange mismatches. Most of the non-performing loans are expected to have been restructured or provisioned prior to the privatization of the large state banks. Although the sector overall capital adequacy appears robust, some specific institutions may be fragile, as the losses reported from a number of banks indicate. In view of the size of its economy, the exit of the least fit is both desirable and unavoidable. Parallel to this, BNB has already withdrawn the licenses of two banks in 1999 and strengthened the exit mechanism for banks with the proposed Draft Bank Bankruptcy Law. Continuing careful and vigilant supervision is needed to minimize future potential adverse developments from failing banks. Non-bank financial markets and institutions. Unless capital markets develop, Bulgarian enterprises will continue to be dependent on the bank credit market. As the banking sector gets more institutionalized and sophisticated, efforts should be directed toward developing capital markets as well as related areas such as mortgage finance. The promulgation of the Law on Mortgage Bonds in October 2000 was the first step in that direction. 52 The orderly resolution of Credit Bank in early 1999, however, indicates some institutional capability to absorb single bank failures without problems. Chapter IV: Developing Stable and Competitive Financial Markets 71 As for the equities markets, the second wave of mass privatization was expected to increase the supply of securities in the capital markets, but failed to do so. There is no interest toward the sale of residual shares of privatized companies on the stock exchange - what is really expected to boost the capital market is the listing of large attractive companies. The residual government shares from the first wave of privatization could be offered through the BSE to stimulate secondary market activity. Efforts to develop the newly emerging, private bond markets should continue to be encouraged. Following the integration of OTE trading into the new BSE trading system, further efforts need to be deployed to address the present constraints to the development of capital markets, including the undefined role and supervision of banks in their capital market operations, transparency of trading information, weaknesses in company law, and different tax treatment of capital market instruments relative to bank instruments. Improved accounting and auditing. The adjustments to the regulatory framework need the support of an institutional setup that has adequate accounting, auditing, and legal framework. The Bulgarian accounting and auditing standards are not yet fully developed to properly reflect the status of the financial institutions and their borrowers. Further work is needed to enforce external audit discipline as well as meet compliance with new accounting standards and applications in all areas of economic activity. All of the banks and regulated financial institutions are expected to have their annual accounts audited by an external auditor under Bulgarian accounting standards. Several of the banks have also started having their accounts audited under IAS by internationally accepted firms. However, slow progress is being made in the adoption of better accounting standards by enterprises, which makes the quality of banks' portfolios more difficult to assess. As for the non-bank financial institutions, suitable charts of accounts and standards have been prepared, pending applications upon the passage of the necessary regulations. Legal framework to support EU standards. The legal framework for the operations of the financial institutions, especially in terms of property rights protection, Commercial Code, Criminal Code, bankruptcy, and pledge laws should be refined to strengthen contract enforcement. In the banking sector, the liquidation of the closed banks is still ongoing and the procedures are lengthy, notwithstanding the costs. Amendments to the Banking Law 1999 are expected to accelerate the liquidation of these banks. The Draft Bank Bankruptcy Law recently submitted to the parliament is expected to speed up the resolution of future nonviable banks. In connection with the Registered Pledges Law, changes to the bankruptcy and banking laws will be necessary to accelerate the court procedures for the sale of collateral and ensure a normal functioning of the special pledges and loan registry set up in 1999. Furthermore, one feature of the Criminal Code that penalizes the extension of loans without "proper security" needs to be clarified so as not to penalize reasonable lending practices. The capacity and the skills of the judicial system to enforce the laws that lay the foundations of the operations of the market economy is crucial. Key participants in the judiciary process need training to adapt to the changing legal infrastructure for a market economy 72 Chapter IV: Developing Stable and Competitive Financial Markets Table 4.3: A Matrix of Financial Markets Development Measures Short Term Medium to Long Term 2000-1 Banking 0 Complete privatization of state-owned banks. ) BNB issue guidelines on country risk exposure of ) Fine tune regulatory framework to be BASLE-EU Bulgarian banks. compliant. ; Strengthen DIF institutional capacity (training and > Introduce rules and capital charges for market risk and information sharing with BNB). clearer rules for valuation of collateral. > BNB require banks to adopt policies and procedures for > Introduce consolidated reporting of banks and their proper risk management. subsidiaries. 0 Strengthen the role of bankers' associations to develop > Introduce guidelines on loan classification and into a self-regulatory body and complement BNB's provisioning to integrate qualitative risk analysis. CAMELS rating and other supervisory efforts. > Require banks to publish externally IAS-audited > DIF to introduce risk-adjusted deposit insurance premium financial statements. to strengthen market discipline. > BNB to periodically publicly announce comparative > Increase minimum capital requirements to facilitate performance of banks to strengthen market discipline. consolidation and exit. Capital ) Pass legislation to regulate holding companies as > Train judiciary in financial market-related dispute Markets financial institutions. resolution. ' Consider the use of the BSE for government securities' > Enforce external audit under IAS rules for listed trading to stimulate the secondary market for securities. companies registered at CD. > Central Deposit announce ownership and trade > Explore possibility to link electronically BSE with active information on OTE transactions to increase regional EU Country exchanges to stimulate the market. transparency of pricing and encourage a move of OTE ' Introduce euro-clearing and custodianship capability to trading to the BSE. encourage foreign participation in BSE. > Complete implementation of electronic trading in BSE. > Merge the supervisory and regulatory bodies of all non- > Issue SSC regulations supporting the Law on Public Bank Financial Institutions under an umbrella entity (long Offering of Securities, especially on minority term). shareholders' rights. > SSC and BNB clarify and agree on the supervisory arrangements for Bank intermediary activities. Chapter IV: Developing Stable and Competitive Financial Markets 73 Short Term Medium to Long Term 2000-1 0 Offer residual government shares for first wave privatization through the BSE to stimulate secondary market activity. 0 Establish tax neutrality between state and private security instruments for income received. Insurance > Sell state shares in DZI to private parties. > Facilitate development of market-based actuarial services. O Review Stage I and Stage II legislation and compliance. > Streamline and consolidate private pension and insurance > Strengthen enforcement of mandatory car insurance. regulatory and supervisory bodies. CHAPTER V: LABOR MARKET AND SOCIAL POLICY INTRODUCTION The social impact of the transition in Bulgaria has been dramatic. During the past ten years, poverty has grown in both absolute and relative terms and unemployment has increased significantly. 53 Changes in welfare are closely linked to labor market adjustment patterns. This chapter provides an overview of developments in the Bulgarian labor market with a view to understanding the interactions between the performance of the Bulgarian economy and the functioning of its labor market. It also assesses the status of reforms in social insurance, social assistance and labor market measures, with special emphasis on the position of Bulgaria vis-a-vis compliance with the Acquis Communautaire. Finally, it provides a set of key policy recommendations, for strengthening the effectiveness of social protection and labor market institutions with the objective of enhancing Bulgaria's competitiveness. The government has faced a considerable challenge to create an integrated and effective social protection system. Significant progress was made toward establishing the legislative and institutional framework for labor market and social assistance programs. The government moved to improve the fiscal sustainability of social protection through pension reform, by making changes to the existing pay-as-you-go (PAYGO) pension system and laying the groundwork for a diversified multi-pillar system. Reforms of social assistance have also been noteworthy, as the government has consolidated existing benefit programs, reducing duplication and fragmentation in order to create a comprehensive safety net for the poorest households. Labor market policy measures have aimed at improving labor market flexibility, ensuring compatibility with EU norms and enhancing work incentives. Although the Bulgarian labor market resembles a sclerotic market"4 (Box 5.1), not dissimilar from the worst performing European markets, existing labor market policies and institutions, with the exception of excessively high payroll taxes and a somewhat strict employment protection legislation, do not support evidence of widespread labor market rigidity: unemployment support schemes are modest, the minimum wage is not high, and industrial relations do not appear to prevent an efficient wage dispersion across sectors. Thus, the poor performance of Bulgaria is likely to be the result of the delays in restructuring its old industrial sector and tackling fundamental structural problems. In terms of compliance with the Acquis Communautaire, Bulgaria's legislation appears consistent with most of the EU requirements in the labor area. However, the standardization of working conditions require substantial investments, and a strengthening of the administrative capacity to implement EU legislation. 53 The 1997 World Bank poverty assessment found that using a relative poverty line of two-thirds mean per capita income, 37 percent of the population was poor. This represented a marked increase over 1995 when poverty was estimated at 5.5 percent of the population. The sharp rise in poverty was largely due to the fall in consumption and income during the economic crisis of the 1996-97. 54 A sclerotic market refers to a labor market that features high unemployment and it is regulated by a set of very "rigid" labor market policies and institutions. Chapter V. Labor Market and Social Policy 75 BOX 5.1: Bulgarian Labor Market and Eurosclerosis Most of the features of the Bulgarian labor market resemble those of the worst performing European markets, such as France, Gernany and Italy. First, unemployment appears stubbornly stable at double digit level. Second, long term unemployment, measured as the fraction of workers who have been unemployed for more than a year is approximately equal to 50 percent. Third, Bulgaria displays a high incidence of youth unemployment, and up to one- fourth of the pool of those who have been unemployed for at least one year is made up of people aged 24 or less. Fourth, Bulgaria features a dramatic level of "discouraged workers", that is unemployed workers who appear to quit the labor force. An unemployed person is as likely to become employed as he or she is likely to drop out from the labor force. Fifth, unemployment has a regional dimension, with a dispersion in the unemployment rates across regions that is both increasing and persistent. hi the jargon of the unemployment literature, Eurosclerosis refers to an ailing labor market (in the sense that it displays the five features outlined above) regulated by a set of very "rigid" labor market policies and institutions. The set of such "rigid" policies typically include very high payroll taxes, high unemployment benefits, high minimum wages, restrictive protection legislation, and strong unions that do not coordinate their bargaining activities. While Bulgaria's payroll contributions are obviously too high and the labor code needs adjustment, even when compared to the worst performing European countries, the remaining set of labor market policies and institutions do not appear "rigid", at least not when compared to the European experience. Thus, the poor performance of the Bulgarian labor market can only partly be attributed to its labor market institutions, and is likely to be the result of Bulgaria's past inability to restructure its ailing industrial sector, and to tackle fundamental structural problems. THE ADJUSTMENT PROCESS IN THE LABOR MARKET Labor shedding in Bulgaria was one of the steepest among transition economies of Central and Eastern Europe (CEE), and it was not associated with a long-run process of job reallocation from industry and agriculture toward the service sector. Indeed, out of 1.2 million jobs being destroyed over the last ten years, 1 million jobs have been lost in manufacturing, the other loss being concentrated in the service sector. This implies that, in relative terms, agricultural share in total employment grew from 18 to more than 25 percent (Table 5.1). Aggregate real wages in Bulgaria fell by some 40 percent over the 1990s. Political instability, erratic macroeconomic and fiscal policies during the early years of the transitions, combined with the Government's failure to tackle fundamental structural problems are obviously responsible for this outcome. 76 Chapter V: Labor Market and Social Policy There are several concomitant reasons that may rationalize the pace of labor shedding in Bulgarian state enterprises relative to other countries in transition.55 First, output losses were more marked and protracted in Bulgaria than elsewhere. Whereas Poland and other CEE economies in the first group of EU candidates reached the trough of their output loss in 1991-1992, the Bulgarian GDP kept falling until 1993, and cumulative output falls reached 35 percent compared with an average of about 15 percent among the first group of EU applicants. Second, whereas other CEE countries successfully stabilized inflation during the first three years of transition, inflation in Bulgaria accelerated throughout the second half of 1996, and reached hyperinflation levels in 1997. During the same period, a severe banking crisis halted the availability of credit to the emerging private sector. The ratio of employment to output variations (which can be used as a proxy for the employment-output elasticity) over the transitional recession in the 1990-1993 period was in Bulgaria of the order of 88 percent, that is, a one percent decline of GDP was associated with almost a 9 percent decline of employment, compared with 6 percent in other CEE countries. Such a strong responsiveness of employment to output changes can be partly attributed to the virtual absence of stabilizers that elsewhere contributed to reducing the volatility of employment over the cycle. More recently, the Kosovo crisis disrupted transport links and communications, with adverse effect on the aggregate economy and labor market. As shown in Table 5.2, until 1992 employment reductions were sizeable and uniform across sectors, with the sole exception of financial services, whose employment share was, in any event, well below 1 percent at the beginning of transition. In addition to industry -- the sector where employment losses were concentrated in the other CEE economies -- heavy labor shedding took place in construction and in the agricultural sector (including forestry). Protracted employment declines in the construction sector are at odds with developments in other transitional economies, and can be attributed to the longer and more severe recession experienced by Bulgaria, as well as to the fiscal crisis which eroded state funds for maintaining and improving the public infrastructure. The initial large declines of agricultural employment are also in contrast with developments in neighboring Romania, where agricultural employment increased during the first four years of transition, contributing to absorb a large component of labor shed in industry. A possible explanation for the disappointing initial employment performance of the agricultural sector in Bulgaria is in the poor design and slow pace of privatization of collective farms, which maintained for several years significant uncertainty over ownership titles for a large part of arable land. Employment dynamics by sector started getting more diversified in 1993 (Table 5.2). While employment declines in industry and construction continued throughout the decade, job gains were registered in most service sectors and in agriculture. The latter was due to some degree to the progress of the land reform in the country. Thus, agriculture started playing a buffer role for employment reductions as some workers shed by industry returned to the rural areas to grow crops for their own consumption. The evidence, although scant, seems to support 55 State subsidies to state enterprises were cut at the beginning of the transformation. Although there are poor data on subsidies to firns in CEE countries and these offer a poor basis for cross-country comparisons, there is some evidence (Commander and Tolstopiatenko, 1997) that the phasing out of state subsidies was more dramatic in Bulgaria than in the other CEE countries. This could also contribute to explain the larger employment losses that occurred in Bulgaria relative to the other countries in transition. Chapter V. Labor Market and Social Policy 77 this hypothesis. Since agricultural exports decreased and real incomes fell dramatically between 1989 and 1995, additional output must have been consumed by the producers. Thus, agriculture, despite its large initial fall, was eventually able to recover entirely its employment stock, so as to significantly increase its share in total employment (Table 5.1). With respect to industry, a massive restructuring program of loss making state enterprise took place in 1997 and 1998, in concomitance with the introduction of the currency board and the approval of a new economic program aimed at achieving both macroeconomic stability and economic restructuring. Table 5.1: Labor Shedding and Employment Restructuring in Bulgaria 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total Employment (millions) 4.4 4.1 3.6 3.3 3.2 3.2 3.3 3.3 3.2 3.2 Agriculture 0.8 0.8 0.7 0.7 0.7 0.8 0.8 0.8 0.8 0.8 Industry 2.0 1.8 1.5 1.3 1.2 1.1 1.1 1.1 1.0 1.0 Services 1.5 1.5 1.4 1.3 1.3 1.4 1.4 1.4 1.3 1.4 Total EmploymentChanges \ -6.1 -13.0 -8.1 -1.6 0.6 1.3 0.1 -3.9 -0.0 Distribution of Employment by Sector \2 Agriculture 18.7 18.5 19.5 21.2 21.8 23.0 23.9 24.0 24.4 26.2 Industry 46.0 44.8 41.6 38.6 36.0 34.5 33.7 33.1 30.9 30.6 Services 35.3 36.7 38.9 40.2 40.6 41.6 42.6 43.3 41.1 43.2 Gross Job Flows \3 Job Creation .. .. .. .. .. 0.8 3.2 4.1 1.4 Job Destruction .. .. .. .. .. 7.2 3.3 7.0 5.2 Job Reallocation .. .. .. .. .. 8.0 6.5 11.1 6.6 Excess Job Reallocation .. .. .. .. .. 1.7 6.4 8.2 2.9 Memorandum Item Distribution of Employment: First Round Candidates Agriculture .. .. .. 9.70 13.39 12.80 11.94 11.69 11.50 Industry .. .. .. 40.35 38.42 37.73 37.64 37.18 35.83 Services .. .. .. 49.90 48.24 49.62 37.93 51.12 52.63 Distribution of Employment: Second Round Candidates \4 Agriculture .. .. .. .. .. 24.6 22.3 21.3 22.9 Industry .. .. .. .. .. 36.2 32.7 32.8 31.9 Services .. .. .. .. .. 39.2 45.0 45.9 45.2 Gross Job Flows : First Round Candidates \3 Job Creation 3.8 4.9 6.6 5.2 Job Destruction 6.7 6.4 8.2 6.0 Job Reallocation 10.6 11.3 14.7 11.2 Excess Job Reallocation 7.7 9.8 13.1 10.4 \1 In percentage points \2 The Classification of Employment by Sectors was changed in 1997 to the NACE. \3 Gross job creation (destruction) is the sumn of all employment gains (contractions) in expanding (declining) firms in a given year, divided by total enploymnent. Job Reallocation is the sum ofjob creation and destruction. Excess Job Reallocation is defined as the difference between job reallocation and the absolute value of net employment changes. \4 Excluding Bulgania. Source: Bulgarian Authorithies, OECD-CCET Labour Market database for data on EU applicants, and Faggio and Konings (1999) for data on Job Flows Not surprisingly, existing measures of employment reallocation suggest that restructuring in Bulgaria is taking place at a slower speed than in other countries candidates for EU accession (Figure 5.1). While separation rates are very high, the job finding probabilities in Bulgaria are the lowest among countries of Central and Eastern Europe, suggesting that the adverse labor market experience of Bulgaria has been linked not only to fast labor shedding, but also to a chronic inability to create jobs. Nevertheless, in every single year there is a positive value of 78 Chapter V. Labor Market and Social Policy gross job creation, suggesting that jobs were being created at all phase of the transition, but that such heterogeneity was more important in other countries. In Bulgaria, excess job reallocation, a proxy for the size of restructuring, appears to be lower than in other CEE 56 economies. The stop and go nature of the structural reform programs in Bulgaria, and the delays in macroeconomic stabilization have certainly put sands in the wheel of the transformation process. Even though more recent data on employment reallocation are not readily available, important measures aimed at speed up restructuring where undertaken in 1999. As a result, a number of loss-making enterprises have been liquidated and a large-scale privatization program was launched. Fast labor shedding and slow job creation in the private sector involved dramatic declines in the employment rate (employment as a percentage of the working age population). The decline was much faster than in the other CEE countries and was to a large extent driven by the dis-employment of women, whose degree of participation was remarkably higher than that of the other countries at the beginning of transition. Unemploymnent rose at the early stages of transition to more than 20 percent of the labor force and is still significantly larger than for the average of the other CEE economies. The existence of early retirement schemes in Bulgaria also contributed to the fast decline of the employment rate. The other side of the coin of the dramatic decline of employment rates experienced by Bulgaria was the strong increase in the social security burden on the active population. Employment declines were also compounded by widespread avoidance to paying social security contributions, which reduced the number of contributors well beyond what was determined by employment losses. Figure 5.1: Employment Dynamics in Bulgaria and Other CEE Economies 1989=100 --- First Round Candidates - - - Second Round Candidates Bulgaria 100 95 90 8 5 - 80- 7 5- 70 65- 60 1989 1990 1991 1992 1993 1994 1995 1996 1 997 1998 56 Excess job reallocation is defined as the difference between job reallocation and the absolute value of net employment changes (Table5.1, footnote 3). Chapter V. Labor Market and Social Policy 79 The dynamics of the distribution of average productivity of labor across sectors is very heterogeneous (Table 5.3). Whereas some sectors traditionally underrepresented under the command economy, such as telecommunications and transport, experienced marked increases in productivity, the performance of most service sectors was dismal, with cumulative fall in the average productivity of some 60 percent. The marked increased in the dispersion of the average productivity is also confirmed by the continuous and persistent increase in the coefficient of variation, which rose from a level of 0.2 in 1991 to a level of 0.9 in 1999. The time profile of the correlation between the level of real wages and labor productivity shows how market forces have been increasingly at work in Bulgaria. Whereas in 1989, there was almost no correlation between gross wages and the productivity of labor across sectors, such correlation has constantly increased over the decade, and has reached a remarkable level of 0.91 in 1999. This finding represents an important development for the Bulgarian labor market, since it implies that the detennination of real wages is now more synchronized with the productivity of labor, and may sustain, in the long run, a more efficient allocation of labor across sectors. Table 5.2 Bulgaria: Distribution of Employment Growth by Industry: 1989-1996 \1 1990 1991 1992 1993 1994 1995 1996 Total -6.1 -13.0 -8.1 -1.6 0.6 1.3 0.1 Industry -9.0 -17.9 -13.2 -8.3 -3.7 -2.2 -1.2 Construction -6.8 -25.0 -19.1 2.3 -8.1 -2.4 -5.6 Agriculture -6.8 -7.6 -0.3 3.2 5.7 4.3 0.2 Forestry -11.1 -22.0 -0.9 -17.1 -7.0 -0.2 8.9 Transport -2.1 -7.8 -13.3 1.9 -4.3 9.3 -2.0 Conmnunications 2.6 -0.7 -1.8 1.1 0.2 1.8 2.8 Trade -5.4 -8.0 -4.0 0.9 11.1 -3.3 -0.1 Others \2 14.8 -4.9 -1.6 13.4 5.5 6.5 35.3 Public utilities -5.1 -12.6 -15.0 -3.2 14.4 8.0 9.2 Science -6.6 -25.8 -22.0 -30.7 -16.9 -9.7 -8.4 Education -1.5 -1.7 -1.9 -0.1 -3.0 -0.6 1.1 Arts 3.6 -18.6 -10.6 20.8 -0.7 34.0 1.5 Health-care 3.0 -6.3 -1.5 -1.8 -2.6 0.5 2.2 Finance -3.7 10.0 29.8 5.1 19.4 16.0 1.1 Government -10.1 -7.4 2.6 29.7 12.1 1.1 1.5 Others\3 -11.0 -37.1 -31.4 7.4 -28.7 37.9 -26.0 Standard 6.7 9.9 12.3 14.2 9.8 10.3 10.0 CoefficientofVariation 1.1 0.8 1.5 9.0 15.9 8.2 \1 The Classification of Employment by Sectors was changed in 1997 to the NACE. \2 Refers to Restaurants and Hotel \3 Refers to Local Community Source: Bulgarian Authorities 80 Chapter V: Labor Market and Social Policy Table 5.3 Dynamics of Real wages and Productivity 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indeces of Real Wages AgricultureandForestry 100 87 74 57 54 44 40 51 58 Industry 100 122 109 86 84 72 61 69 73 Construction 100 110 95 76 67 56 37 48 52 Transport 100 118 112 89 83 69 58 65 69 Communications 100 112 105 85 76 63 58 72 86 Trade 100 122 11 88 87 53 39 48 60 Other services 100 105 100 76 69 47 38 47 56 Total Labour Productivity at constant prices (1990=100) leva Agriculture and Forestry 100 113 97 66 68 75 68 93 92 Industry 100 96 100 102 113 106 104 83 92 Construction 100 105 146 133 144 151 135 112 136 Transport 100 101 121 129 139 178 178 185 187 Communications 100 94 98 105 106 138 145 150 172 Trade 100 101 85 85 82 87 76 51 53 Other services 100 102 70 69 64 61 50 42 44 Total 100 102 102 103 104 105 96 90 96 Source: Bulgarian Authorities THE LEGACY: A DEPRESSED LABOR MARKET While unemployment rose at the early stages of transition to more than 20 percent of the labor force, it is still around 16 percent (September 2000), and remains significantly higher than that of the average of the other CEE economies. Bulgaria displays a high incidence of youth unemployment, and up to one-fourth of the pool of those who have been unemployed for at least one year is made up of people aged 24 or less (Table 5.4). Older workers, often attached to firms that still need to be restructured, remain a minor component of the unemployment pool. The high incidence of long-term unemployment is linked to a reinforcing vicious circle between the size of the output loss and the delays to implement structural reforms: as the time since the beginning of the transition elapsed, the loss of skills during unemployment reduced the employment prospects of the unemployed workers, which, in any event, were further affected by delays in undertaking structural reforms. The labor market prospects of low educated workers, particularly negative at the early stages of the transition, do not show any sign of improvements. Unemployment in Bulgaria has also a regional dimension, with a dispersion in the unemployment rates across regions that is both increasing and persistent. Regional unemployment unbalances across regions are comparable to that observed in most European countries. More important, however, is the fact that regional unemployment is rising even when total unemployment is falling. Further, such disparities appear also to be persistent, with the standardized ranking of regions being very stable over time (Figure 5.2). Chapter V. Labor Market and Social Policy 81 Figure 5.2: Standardized regional unemployment rates: 1993-1997' 1,5 _ MONT LOVETCH 0,5 -BOURS * ROUSSE * VARNA O *SOFIA-AREA -0,5 1 * PLOVDIV -l /HA ASKOVO -1.5 *s 1 -2_ -2 -1,5 -1 -0,5 0 0,5 1 1,5 2 1993 Standardized regional unemployment rates are obtained by subtracting from each region's unernployment rate the average unemployment rate, and then dividing this value by the standard deviation of regional unemiployment. BOX 5.2: What to do about Unemployment? Unemployment in Bulgaria is significantly higher than that of the average CEE economies. The delays in tackling the challenge of transition and the resulting output losses have made of high youth unemployment and high levels of discouraged workers a persistent feature of Bulgaria's labor markets and the lives of its people. The resumption of positive growth over the last two years has not reversed the unemployment trends as industrial restructuring also started only two years ago and is intensifying. The recent pick-up in private investment only partially compensates for continuing employment losses in the enterprise sector. Tackling the growing unemployment problem will require a two-tier approach with short- term measures to alleviate the most drastic material and psychological pains associated with being unemployed and longer-term measures to boost labor-intensive private investment. In the short term labor-intensive community-based public investment and maintenance schemes can provide a temporary relief to the most vulnerable segment of the labor market, the low-skills and unskilled workers. The only lasting solution to the unemployment problem, however, resides with attracting massive foreign investment in new facilities and developing a vibrant small and medium size enterprise sector that can adapt rapidly to changing domestic and international conditions. Hence, intensifying the implementation of measures (i) to improve the business environment for foreign and domestic investors; (ii) to contain labor costs; and (iii) to enhance the flexibility of labor markets are the employment promotion policies most likely to produce lasting results. 82 Chapter V. Labor Market and Social Policy Table 5.4 Bulgaria. Unemployment Structure by Age, Gender and Skills 1993 1994 1995 1996 1997 1998 1999 Unemployment Rate \1 Official 15.7 13.3 10.7 9.9 14.2 11.4 12.8 ILO definition 21.4 20.0 15.7 13.5 13.7 12.2 14.1 Unemployment Rate by Age 15-24 47.0 42.2 37.8 33.0 27.5 28.4 31.4 2549 17.7 17.2 13.2 11.5 12.1 10.7 12.5 50-64 15.8 14.9 10.8 9.2 9.2 9.2 10.1 Unemployment Rate by Gender male 21.0 20.1 15.7 13.6 14.0 12.7 14.1 female 22.10 19.97 15.80 13.42 13.56 11.84 14.2 Share of Long Term Unemployment total 53.8 59.9 67.0 59.9 61.3 63.7 57.8 youth (15-24) 13.5 13.2 15.0 13.2 12.9 12.4 11.6 other 40.3 46.7 52.0 46.7 48.4 50.6 46.2 Unemployment Rate by Skills Higher education 9.7 7.9 5.6 4.6 5.1 5.4 5.2 Secondary vocational 16.5 15.6 11.6 10.7 12.0 10.4 11.5 Secondary general 22.2 20.0 15.6 13.1 14.6 12.4 14.3 Primary or lower 30.1 29.8 25.1 21.5 20.1 18.4 23.3 Memorandum Items Unemployment Rate First Round Candidates \2 8.3 8.3 8.1 8.1 7.8 7.9 Second Round Candidates \3 7.9 9.4 8.7 7.5 7.4 8.3 Unemployment Rate by Skills First Round Candidates \2 Higher education 3.8 3.4 2.7 2.7 2.7 2.9 Secondaryvocational 11.6 11.2 10.2 9.6 8.7 9.0 Secondary general 8.4 8.1 7.2 6.9 6.8 7.0 Primaryorlower 12.7 13.0 12.6 12.8 12.8 13.9 Second Round Candidates \3 Higher education .. .. 4.8 5.2 4.5 Secondary vocational .. .. 10.2 11.9 10.2 Secondary general .. .. 14.2 15.4 14.4 Primary or lower .. .. 20.6 20.0 16.5 Share of Long Term Unemployment First Round Candidates \4 34.2 37.8 37.3 37.2 43.9 Second Round Candidates \5 31.6 40.2 47.9 56.3 50.4 Unemployment Rate By Age [15-24] First Round Candidates \6 21.1 21.0 19.5 18.6 16.9 [15-24] Second Round Candidates \7 .. .. 25.2 22.6 21.8 \I Data refer to end of June, with the exception of 1993, which refer to end September \2 Includes Czech Republic, Estonia, Hungary, Poland, Slovenia \3 Includes Latvia, Lithuania, Romania and Slovak Republic \4 Includes Czech Republic, Estonia, Hungary, Poland and Slovenia \5 Includes Latvia, Romania and Slovak Republic \6 Includes Czech Republic, Hungary, Poland and Slovenia \7 Includes Latvia, Romania and Slovak Republic Source: Bulgarian Authorithies and OECD-CCET Labour Market database for data on EU applicants Chapter V: Labor Market and Social Policy 83 Bulgaria features a dramatic level of "discouraged workers", that is unemployed workers who appear to quit the labor force. The evidence, based on matched individual records from the Labor Force Surveys, suggests that an unemployed person is as likely to become employed as he or she is likely to drop out from the labor force. This "discouragement" effect is potentially very important, since it may indicate either a huge social waste of potentially productive capacity, or, more likely, a large flow of workers toward the unofficial economy. Indeed, the flow of discouraged workers is estimated to be particularly large among the youth, a phenomenon which provides indirect evidence of substantial flows toward the unofficial economy at aggregate level (Table 5.5). Table 5.5: Transition Probability Matrices. June 1998-June 1999/1 TOTAL Out Of Labour Force Employment Unemployment Total Out Of Labour Force 0.90 0.06 0.03 1.00 Employment 0.09 0.85 0.05 1.00 Unemployment 0.28 0.34 0.37 1.00 1/The labour market state in the first colum refers to the position of the person at time t, and the state in the first row refers to the position at time (t+1). The numbers in each cell refer to the probability of moving from the original to the final position Source:Labour force survey and Authors' calculation The substantial increase in real wages observed in the last few years appears consistent with an estimated "productivity based dollar wage", suggesting that Bulgarian competitiveness is not at risk. Dollar wages in Bulgaria in 1998 were equal to $143, and represent some 70 percent of those in the Baltic countries, and only 50 percent of dollar wages in most CEE countries, including Poland and Hungary.57 However, a low value of dollar wages is not sufficient, by itself, to judge a country's competitiveness, since it does not take into account cross country differences in aggregate productivity. Existing estimates of "productivity based dollar wage" for Bulgaria suggest that there is a sizeable difference between the actual and the productivity based wage, implying that Bulgaria competitiveness is not at risk (Figure 5.3).58 THE CHALLENGE OF SOCIAL PROTECTION REFORM The inherited social protection system proved ill-equipped to deal with the challenges of the new market environment. Social protection programs were largely related to employment, while instruments for assisting poor households were absent. Policy strategies, therefore, involve shifting from a system which implicitly managed risk, through employment guarantees, and price subsidies, to one which explicitly assists households to cope with shocks. Bulgaria 57 Reported dollar wages refer to public sector wages. S8 A methodology for assessing whether real wages in manufacturing in a transition economy should be considered "too high" has been recently proposed by in the literature on transition by Krajmyak and Zettelmeyer (1998). The methodology implies using dollar wages in the manufacturing sector, and then estimate productivity based dollar wages as a function of productivity measures using a short panel of countries. Thus, the productivity based dollar wage represents an estimate of what the country could "afford" based on its stock of human and physical capital. See Kramjak and Zettelmeyr J. (1998), "Competitiveness in Transition Economies: What Scope for Real Appreciation?" IMF STAFF PAPER, Vol. 45, 2. 84 Chapter V. Labor Market and Social Policy faces a common challenge across social protection sectors of maximizing the effectiveness of limited resources available for social protection. The strict fiscal discipline required under the currency board arrangement and the targets set for EU accession have heightened the need for close scrutiny of the efficiency and effectiveness of social protection expenditures, and the need to consider the collective impact of programs and policies on the budget. Figure 5.3. Actual and Productivity-Based Dollar Wages in Manufacturing - Actual Dollar Wage - -Estimated Dollar Wage 400- 350 - . . _ _ .-.-. 300 - . - 250 - - 200 - 150 - 100 . , _ 0 I 1991 1992 1993 1994 1995 1996 1997 1998 Social protection expenditures consume a significant share of GDP and government spending. In 1998 they amounted to 11 percent of GDP and 30 percent of government expenditures, and 12.3 percent of GDP in 1999 (Figure 5.4). Beginning in 1994, spending contracted notably and dropped to a low of 7.8 percent of GDP during the severe crisis of 1997. Real expenditures on social assistance fell steadily, dipping to 53 percent of 1991 levels in 1997 and increasing to 58 in 1998. Trends across sectors have diverged, while expenditures on labor markets have declined steadily throughout the transition, social assistance expenditures increased sharply in 1998 with the immense increase in need following the 1997 crisis. The road ahead entails important challenges to strengthen the targeting and effectiveness of social protection programs to improve their welfare impact. For pensions this involves ensuring the fiscal sustainability of the system in the context of the transition to a multi-pillar system. In social assistance, close attention is needed to ensure that cash benefits, including both social assistance and family allowances, are effectively targeted and that benefit levels are adequate to meet poverty alleviation objectives. For labor markets, reforms include improving assistance for the unemployed through an appropriate balance between active and passive measures and improving labor market flexibility through legislative reforms. Chapter V. Labor Market and Social Policy 85 Figure 5.4: Social Protection Expenditures (percent of GDP)59 18.0 16.0- 14.0 -j 12.0 -_ _ _ _ _ 0 FSamily Benefits (N S W B) 10.0 Sp pPensions protection reform agendaLikeitsnighbos,Bularianheried LaborvMarkets 6.0 0~~~~~~~~~~~~~~~~~ Social Assistance 2.0 0.0 1991 1992 1993 1994 1995 1996 1997 1998 1999 Source: MOLSP; NSSI, and World Bank estimates Pensions. Systemic pension reform is the most challenging item on Bulgaria's social protection reform agenda. Like its neighbors, Bulgaria inherited a Soviet-style PAYGO system characterized by early retirement ages - men at age 60, women at age 55-and much lower for about 17 percent of workers in employment categories which were considered to be hazardous or privileged. The benefit formula is a generous one, with high replacement rates. As a result, contribution rates in Bulgaria are higher than most other countries in the region. The weighted average contribution rate in 1999 was 38.2 percent of gross wages, with workers paying an additional 1.5 percent. The urgency of pension reform is further heightened by Bulgaria's demographic situation. System dependency ratios (the share of population 60 years of age and older to the working age population) are the highest of all transition countries. This implies that social policy revenues have to be collected from a narrow tax base, and hence increasing statutory contribution rates. There is a rather evident negative association across CEE economies between the size of the contribution base and the statutory contribution rates to be paid for by employees as well as employers on the top of the wage bill. The issue is that higher contribution rates are often associated to lower levels of participation, and notably lower employment rates. Not surprisingly, the level of social security contributions in Bulgaria is the highest among that of CEE economies (Table 5.6). 59 To be updated with 1999 data. 86 Chapter V: Labor Market and Social Policy Table 5.6 Non Wage Components of Labor Costs in Selected Countries \1 Social security contributions Health care contnbutions Contributions to unemployment fund Employet's Employee's Total Enployerfs Employee's Total Employer's Employee's Total Bulgaria \2 0.37 0.02 0.39 0.00 0.00 0.00 0.04 0.01 0.05 0.44 Slovak Republic 0.22 0.06 0.28 0.10 0.04 0.14 0.03 0.01 0.04 0.45 Czech Republic 0.20 0.07 0.26 0.09 0.05 0.14 0.03 0.00 0.04 0.43 Hungary 0.22 0.05 0.27 0.11 0.03 0.14 0.00 0.00 0.00 0.41 Poland 0.10 0.10 0.20 0.07 0.09 0.16 0.04 0.00 0.04 0.39 Slovenia 0.09 0.16 0.24 0.06 0.06 0.13 0.00 0.01 0.01 0.38 European Union .. .. 0.24 .. .. .. .. 0.13 0.37 \IContributions are based on the gross salary received by the worker. Data refer to July 1999 . \2 Data refer to the third category of labor. Source: Intemational Monetary Fund, Country Reports (various issues). By looking in further details at the composition and at the magnitude of payroll contributions on labor in Bulgaria, it appears that the sum of social security contributions, health care taxes, and contributions to the unemployment fund reach 50 percent of gross income for most of the workers. The bulk of this burden is clearly linked to the social security contributions, which correspond to 39 percent of gross income for the majority of workers. Health care contributions and contributions to the unemployment fund are still sizeable, but in line with the rest of the OECD countries. The government's long-term strategy for pension reform is to move towards a fiscally sustainable three-pillar system involving the public and private sectors. The passage of the Social Insurance Code (SIC) by Parliament at the beginning of December 1999 represented the most significant step forward to date in laying the groundwork for the reformed system. The first pillar, based upon the existing PAYGO scheme, would remain mandatory, but would be scaled down over time. Beginning in 2002, all young workers will begin to make contributions to a second pillar, comprised of a set of regulated pension schemes. In addition, workers will have the option of making voluntary contributions to a fully capitalized third pillar. As the second and third pillars are built up and contribution compliance increases, contribution rates to the first pillar would decline. Benefit levels from the first pillar would be maintained at the current replacement rate, with an additional amount of benefit coming from the private pillars. More specifically, reform of the first pillar involves a sharp reduction in the occupational categories entitled to early retirement. Those who remain eligible for early retirement will pay a separate contribution. Retirement ages will be raised through increasing the age and years of service required for receiving benefits, and the gradual equalization of retirement ages for women and men. Incentives for contribution compliance will be enhanced by increasing the linkages between benefits and contributions and shifting a greater proportion of the responsibility for the total long-term contribution rate to workers. Protection of widowed pensioners, children and younger surviving spouses of deceased pensioners will be strengthened by allowing for the inheritance of some pension rights. Finally, changes to the benefit formula (including indexing) would allow for the long-term reduction of the payroll tax rate to no more than 30 percent of gross wages. The mandatory second pillar, for younger workers, would be established through the gradual diversion of contributions to funded individual accounts. Workers would be able to choose investment options from a structure of well-regulated and competitive funds. Administrative costs would be kept low, since Bulgaria's high elderly dependency ratio is likely Chapter V. Labor Market and Social Policy 87 to make it fiscally impractical to divert much more than 5 percentage points to the funded pension system. The third pillar will include one or more voluntary earnings-related pension regimes and would be fully capitalized in the long-run. These are expected to include: (a) universally available private pension funds; and (b) other (not just early retirement) "defined benefit" pension schemes. A key initial focus has been strengthening the fiscal viability of the pension system, both through short-term measures intended to improve the balance of the existing PAYGO scheme, and through reforms to address the longer term sustainability of the system. As a first step, past arrears to the social security fund were cleared and future ones were limited, through the passage of laws and regulations requiring employers to pay social insurance debts and limiting wage increases and access to loans for enterprises with payroll tax arrears. Next, compliance was strengthened through changes in contribution reporting and recording and regulatory changes to strengthen the link between contributions and benefits, including gradual lengthening of the earnings/contribution base used to calculate pension benefits. Cost savings were also achieved through the elimination of duplicative, non-insurance related programs, such as provision of special dietary food supplements. The Labor Code was amended to allow individuals to voluntarily retire up to three years later with higher benefits. These measures (as well as the partial indexing of pension benefits) helped the National Social Security Institute (NSSI) achieve a small surplus in 1999. More recently, the government has implemented additional steps to reduce the medium- and longer-run costs of the PAYGO system by reducing or eliminating early retirement privileges for about 75 percent of those previously entitled to these privileges. Labor Market Policies. Over the last years, Bulgaria has put into place a range of passive and active measures designed to meet the needs of the unemployed. Passive measures include unemployment benefits (and related social security contributions), unemployment compensations for workers in part-time jobs and in long term unemployment, as well as contributions to individuals participating in professional qualifications courses and the social security contributions for the unemployed. The expenditure for the Professional Qualification and Unemployment Fund for passive labor market measures comprised 57/5% of total expenditure in 1998. Active labor market programs include training, job clubs, employment subsidies, temporary public works programs and programs aimed at developing entrepreneurial culture. Recent initiatives also include programs to assist vulnerable groups, including Roma and the long-term unemployed. In 1998, the government adopted the Unemployment Security and Employment Incentives Act, which codified the unemployment benefit system, including contribution-based unemployment insurance, and unemployment allowances for workers who remain unemployed following the expiration of unemployment benefits. It established the institutional framework of the system in the National Employment Service (NES). The Law strengthened the financial and administrative basis of the unemployment benefit system by reinforcing the insurance basis of unemployment benefits. The Law excluded non-contributors from receiving benefits (e.g. school-leavers) and introduced contributions for all budget sector workers. 88 Chapter V: Labor Market and Social Policy Table 5.7: Unemployment Benefits Coverage Rates ' 1990 1991 1992 1993 1994 1995 1996 1997 1998 Bulgaria 79 55 39 35 27 23 30 26 29 Estonia - - - 56 46 40 45 54 55 Czech Republic - 64 47 51 47 44 50 51 49 Hungary - 77 74 60 40 36 34 30 - Poland - 79 69 48 47 53 54 - - Slovakia 71 39 35 24 22 26 - Coverage Rates refer to the percentage of unemployment benefits recipients over the total number of unemployed. Source: ETF (2000), various issues for: Bulgaria, Estonia, Czech Republic, Hungary; OECD(1996) for Slovakia and OECD for Poland. The new law improved employment incentives through tightened eligibility for cash benefits - restricting benefits to workers who had paid contributions to the social insurance system - and reducing overly generous benefit levels, from 85 to 80 percent of the minimum wage. This measure strengthened incentives, while ensuring that families with two unemployed parents would not fall below the threshold for social assistance benefits. As a result, unemployment benefits are not generous in terms of the gross replacement rate, coverage or duration in comparison with other countries in the region (Table 5.7)*60 The minimum wage in Bulgaria is not high, as suggested by the ratio between the minimum wage and average wage (Table 5.8). While this ratio in Bulgaria was very high at the beginning of the transition, its level has been cut throughout the decade, and in March 2000 was around 33 percent. In countries such as France and Germany, the fraction of the minimum wage to the average wage is much higher, in the order of 50 percent. Table 5.8: Minimum Wage-Average Gross Wage Ratio. 1990 1991 1992 1993 1994 1995 1996 1997 1998 Bulgaria 43,1 54,2 35,9 38,3 35,7 32,6 29.3 27.1 28 Czech Republic ... 52,4 47,1 37,4 31,6 26,9 27,4 23 ... Slovakia ... 52,4 48,4 40,9 38,9 34 35,9 ... ... Hungary 37,3 37,4 35,9 32,8 31,2 31 32,9 ... ... Poland 21 34 43 41 43 38,6 43,3 ... ... Source: ETF (2000) for Bulgaria and Czech Republic and Vaughan-Whitehead ed., Paying the price, ILO, 1998. Resources have been shifted from passive to active labor policies (Table 5.9). In Bulgaria, Active Labor Market Policies (ALMPs) envisage several policies, such as job search assistance, financial support to the unemployed to start their own business, programs for the unemployment in particularly depressed areas, training and re-training programs for the long term unemployed, etc. While ALMP are more costly, and require high administrative capacity in implementing each program, they should be able to provide better tailored instruments for the re- 60 There are at least three ways to describe the generosity of the unemployment benefit level. The first one is the gross replacement rate, which represents the percentage of the unemployment benefit with respect to the average wage. The second measure is the coverage rate: the percentage of unemployment benefits recipients over the total number of unemployed. A further measure is the duration of benefit, the length of the unemployment spell in which workers can get unemployment benefits. Chapter V: Labor Market and Social Policy 89 employability of the unemployed than simple unemployment compensation schemes. The government's innovative net impact evaluation looking at outcomes of workers who have participated in the five main programs, and analyzing what would have happened had they not participated, indicates positive results. Table 5.9: Breakdown of Labor Market Policies Expenditure in Bulgaria. 1993 1994 1995 1996 1997 1998 Active Labor Market Policies (of which:) 17,3 19,9 27,3 30,8 27,5 31,2 Administration Services 11,5 12,9 15,3 15.0 11,6 14,7 Training and Retraining Courses 1,4 1,3 1,6 1,7 0,6 0,2 Programs for the Youths 0,2 0,2 0,0 0,1 0,1 0,6 Subsidized 4,1 5,4 10,2 13,9 15.0 16,2 Employment Passive Labor Market Policies 82,7 80.0 72,6 69,1 60,1 57,4 Other Expenditure ... ... ... ... 12,1 11,4 Total Expenditure 100 100 100 100 100 100 Source: ETF (2000). Bulgaria is also currently acting to improve labor market flexibility through revision of restrictive provisions in the Labor Code. The present procedures for implementing collective redundancies are quite rigid, require a difficult coordination with the trade unions, and represent an obstacle to firm level restructuring. While employment termination for individual contracts is technically easy, there seems to be a practical difficulty in implementing dismissal, in light of the jurisdictional bias in favor of labor. Some of the proposed changes to the Labor Code could actually increase rather than decrease rigidities, including draft regulations which would limit the use of fixed-term contracts, and mandatory extensions of industry level collective agreements. In other dimensions, however, the labor code suits the needs of a market economy, avoiding some of the most restrictive provisions, including prohibition of part-time and additional work, and unduly onerous standards for terminations which are found in neighboring transition economies. Overall, union membership in Bulgaria is quite strong: existing estimates suggest that union members are 65 percent of workers in state owned enterprises, while this share appears to be only 20 percent in other CEE economies. While there is a general tendency among CEE countries toward a more decentralized bargaining structure, this trend is not apparent in Bulgaria. Industrial relations in Bulgaria are characterized by a high degree of cooperation between unions, and between unions and employer representatives, and there does not seem to be much evidence of excessive wage pressure. However, some fine tuning is required. In particular, improvements are needed towards more de-centralized bargaining at local level to reduce high and persistent regional unemployment differentials. Social Assistance. Reforms of social assistance, including family benefits, are designed to create a safety net to alleviate poverty and address the needs of the poorest households, including the long-term unemployed. As is the case in neighboring transition countries, Bulgaria's inherited social assistance system relied heavily on universal benefits which were connected to employment. Social assistance was narrowly defined to address the needs of 90 Chapter V: Labor Market and Social Policy groups which were unable to work, including the elderly and disabled, and was ill-equipped to address the increasing needs of the population. In 1991, Bulgaria began the social assistance reform process by introducing a monthly cash benefit program, the guaranteed minimum income program (GMI), which provides assistance to poor households below an established income threshold. However, due to rapidly growing need and shrinking budgets, the effectiveness of the program has been limited. Household survey data from 1997, found that coverage was low, with only 10 percent of poor households receiving the benefit. Aggregate expenditures on the program were also exceptionally low, amounting to 0.8 percent of GDP in 1997 and the real value of benefits has dropped dramatically with the periodic economic crises. As a result, the GMI came to be characterized by low coverage and low benefit adequacy. In response, a priority of social assistance reforms has been to target scarce resources to the poor through strengthening of the GMI program. Family benefits are another key component of the safety net. As mentioned above, Bulgaria inherited one of the most generous family benefit systems in the region. A range of family benefits including child allowances, maternity leave and birth grants are provided under the 1968 Birth Promotion Act. Benefits are provided for both insured and uninsured families with two unemployed members. Total spending amounted to about 1 percent of GDP in 1998. In 1998 the government codified its objectives in social assistance through passage of the Social Welfare Act and accompanying regulations. This package of legislation defined the institutional framework for social assistance, separated the distinct functions of cash benefit delivery and social services, and allowed for an increasing role of NGO's in the provision of social services. The new Social Assistance Regulations created a single targeted poverty alleviation program by consolidating two separate income support programs, the GMI and the energy benefit program. In addition, the new regulations provided for improved targeting by increasing the benefit levels for vulnerable groups, including families with many children, elderly over 70 years old and the disabled. The Social Welfare Act improves the institutional framework for benefit delivery by partially re-centralizing the administration and financing of the system. Social assistance, including the GMI and family benefits are delivered by social assistance offices at the municipal level which, until 1997 were under the direction of the mayor of the municipality. This limited the ability of the MOLSP to set standards, ensure quality, and most importantly, monitor the delivery of benefits. As financing was under the discretion of municipal officials, in many cases benefits were not delivered if resources were tight, or if officials diverted funds to other purposes. Reforms strengthened the administrative control of the MOLSP by reinstating regional level social assistance offices, charged with overseeing, monitoring, and giving guidance to the municipal offices. In addition, the Ministry of Finance moved to provide one- half of the financing for social assistance to the municipalities through ear-marked transfers. Despite these reforms, there are still indications that the GMI is not reaching the poor. Preliminary analysis for the first half of 1999 suggests that 86 percent of municipalities were unable to pay the amount required for social assistance benefits, and on average, municipalities Chapter V. Labor Market and Social Policy 91 experienced a 30 percent deficit in funding.61 This is likely due to a number of factors including, (i) a lack of resources at the municipal level; (ii) poor budget planning; (iii) the use of current resources to clear past arrears ; and (iv) the use of resources for other purposes. Penalties for municipalities that fail to meet their expenditure obligations are insignificant and infrequently enforced. COMPLIANCE WITH THE ACQUIS COMMUNA UTAIRE ulgaria is making considerable efforts to align its regulatory framework in the field of labor market with the EU accession requirements, including the adoption of the National Employment Plan for 2000-2001. In the labor area, adoption of the Acquis Communautaire implies the recognition of a certain set of rights to workers in Bulgaria, as well as the standardization of working conditions (health and safety requirements) to those in the EU. More specifically, the process of legal harmonization of labor market-related legislation includes the following four areas: (1) Equal opportunities for Men and Women; (2) Health and Safety at Work; (3) Co-ordination of Social Security Schemes; and (4) Labor Law and Working Conditions (Box 5.3). In principle, most of the worker's rights defined in EU regulations have long been part of Bulgarian labor legislation. However, effective membership in the EU requires not just a harmonized legal basis, but also an economy able to withstand the competitive pressures of the internal market and a flexible environment promoting labor mobility. In particular, compliance with EU labour regulations in the standardisation of working conditions requires substantial investments in infrastructure, and training for the employers, with inevitable impact on the structure of the labour costs. Since there are some risks that such standardisation will harn the developments of the small and medium enterprises, inflate the unofficial economy, and ultimately delay accession, Bulgaria should cautiously consider the costs and benefits of such standardization before proceeding on harmonization. The principle of equality and prohibition of all kinds of discrimination is stipulated in the Constitution of Bulgaria (Art. 6, Para. 2), and all legislative acts related to working activities are based on this principle. Current Bulgarian legislation covers all provisions of the Equal Pay Directive (75/11 7/EEC), equal treatment for men and women as regards access to employment, vocational training, etc. (Equal Treatment Directive 76/207/EEC). The equal treatment of men and women in matters of social security (Social Security Directive 79/7/EEC) is reflected in all social security legislation in Bulgaria, including the newly adopted Social Security Code. The requirements of the occupational social security directive (86/378/EEC) and the directive on equal treatment for self-employed men and women (86/613/EEC) are introduced in national legislation. 61 This is likely an underestimate of the actual shortfall. The deficit represents a ratio of the amount paid by the municipality to the amount required to pay benefits to all applicants approved by the social welfare offices. This measure underestimates the real deficit in meeting social assistance needs, as (i) municipalities may turn away eligible beneficiaries if they anticipate tight budgets and (ii) eligible beneficiaries may not apply for benefits if they perceive that funds are not available. 92 Chapter V: Labor Market and Social Policy BOX 5.3: Acquis Communautaire in the Labor Market Equal Opportunities for Men and Women. Stage I measures require the country to comply with directives 75/117/EEC and 76/202/EEC, which contain provisions regarding: (i) equal pay; and (ii) equal treatment form men and women in access to jobs, promotion, training and working conditions. Stage I1 measures require the country to comply with directives 79/7/EEC and 86/378/EEC, which apply the principle of equal treatment for men and women to statutory and occupational social security schemes. Coordination of Social Security Schemes. The EU's provisions regarding social security legislation are based on four principles: (i) the legislation of only one country can be applicable; (ii) workers from other states receive equal treatment; (iii) workers retain the rights they have acquired; and (iv) penrods of insurance or residence are aggregated. Health and Safety at Work. Measures at Stage I require compliance with Directive 89/391/EEC which stipulates that employers must assess the risks to safety and health at work, ensure that workers receive appropriate safety and health information, and provide workers with adequate safety and health training. Legislation must also include provisions regarding protective and preventive services, health surveillance, and the participation of workers in health and safety issues at work. At Stage II, countries are required to comply with a set of 13 directives that include regulations on maintaining the health and safety of workers in the most critical areas (workplace equipment, safety signs, chemical exposure). Labor Law and Working Conditions. At Stage I countries are required to comply with the contents of four directive that protect workers' rights in the areas of: (i) collective redundancies (ii) undertakings, business, or part of business; (iii) insolvency of employers; and (iv) young people at work. At Stage II, they are required to comply with three additional directives that regulate working conditions, working time and information and consultation with workers. There are no contradictions between Bulgarian social security legislation and the relevant EU regulations. Bulgarian law does not discriminate between foreigners and nationals vis-a-vis social security. There are adequate provisions governing, inter alia, the retention of accrued rights of Bulgarian nationals working abroad. The Health and Safety at Work EU legislation demands to a high extent not just an adequate level of transposition, but an effective enforcement and monitoring mechanism, coordinated through the General Labor Inspectorate. Bulgaria legislation in this area is based on the Act on Health and Safety at Work (1997) and some parts of the Labor Code, which determine the structure and activities of the General Labor Inspectorate (GLI). This legislation also covers important areas like health and safety training requirements, formalized risk assessment, regimes of work and rest, etc. Further alignment of legislation is needed to cover the whole range of specific Health and Safety at Work Directives, especially in relation to the use and protection from hazardous agents, includirt chemical, biological or cancer-organic materials. Admittedly, further efforts will be nev dx. in this direction, especially vis-a-vis small and medium enterprises in the country. In the area of labor law a core legal instrument in Bulgaria is the Labor Code, adopted in 1986 and amended substantially in 1992 and 1995. Despite several revisions since the beginning of the transition, there is an urgent necessity to revise the most restrictive provisions in the Labor code, even though they may not be part of the EU requirements. Current Bulgarian legislation includes most of the provisions of the Labor Law Directives. It is believed that full transposition will be achieved with Amendments to the Labor Code that are to be made in the first half of Chapter V. Labor Market and Social Policy 93 2000. In addition, Framework Directive 89/391/EEC, as well as a set of specific directives on workplace regulation, have been fully transposed in the Bulgarian legislation. The standardization of working conditions to those of the EU requires certain, and in some cases substantial investments which, although desirable, should not necessarily be undertaken immediately. Indeed, an immediate compliance with working conditions in the EU may be too risky, and adversely affect the prospect for EU accession. In the short run, the investments required to align working conditions in the old industrial sector with those prevalent in the EU may increase labor costs, and harm the developments of the small and medium enterprises. This in turn, may inflate the unofficial economy, and ultimately delay EU accession. Indeed, the economic literature on the size, causes, and consequences of the shadow economies find that, other things equal, there is a robust correlation between the regulation of the official economy and the size of the shadow economy THE REFORM AGENDA Short run Pensions Managing the transition. A common challenge of PAYGO reform is managing the transition to the multi-pillar system, and particularly, ensuring that funds are available to pay existing pension obligations. The NSSI has passed the necessary legislation to reduce the share of workers who are eligible for early retirements. This change took effect in January 2000 and is expected to improve the financial viability of the system, however, transitional arrangements are still needed to compensate for the loss of contribution income stemming from the widespread use of early retirement in the past, since the workers in early retirement categories had higher contribution rates. Ensuring fiscal sustainability. Similarly, the NSSI needs to prepare a financing plan for the deficits arising from the loss of contributions to the second pillar and reducing contributions for pensions in the first pillar from January 1, 2000, from 32 percent to 29 percent. In addition, the NSSI's information system needs to be adapted to create individual early retirement accounts. Current actuarial estimates show that the deficit of the pension fund will be critical during 2001 and will decline in following years until 2005 when the fund will be stabilized. Another peak of the deficit could emerge after 2015 as a result of demographic trends. Labor markets Reducing labor costs. The structure of labor cost is characterized by excessively high payroll taxes, whose rate reaches 40 percent of gross labor income for a large size of the employment pool. This structure is a cause of concerns for the job generation prospects of Bulgaria, and substantial cuts in contributions are likely to be beneficial. However, the cuts in social security contributions should not be accompanied by further cuts in the already scarce level of social assistance. Thus, a determined effort on the part of the authorities to increase compliance is vital. 94 Chapter V: Labor Market and Social Policy Reforming labor market legislation. Although the Labor Code has already been amended to better suit the needs of a market economy, further improvements are necessary. These include decentralization of collective bargaining, a simplification of the regulation in the area of collective dismissals, the reduction of requirements with respect to paid education leave and maternity and child leave, reform of sick pay regulations, removing restrictions on the use of fixed term contracts and easier termination for misconduct or economic reasons. These problems areas should be addressed with the amendments of the code currently under discussion. Additional changes to labor market legislation, including amendments to the Unemployment Security and Incentives Act are currently under consideration and will ensure harmonization with the Acquis. Ensuring the effectiveness of active measures. While the shift from passive support to the unemployed to a set of more active measures may enhance employment generation prospects of the unemployed, some shortcomings usually associated to the implementation of such policies should be taken into account; there is evidence, in fact, that Active Labor Market Policies may involve substantial deadweight losses and substitution effects. Thus, the recent decision of the Bulgarian authorities to carry on a rigorous evaluation of the ALMP is welcomed, and future shifts in policies should take into account the results of this evaluation. Social assistance Strengthening social assistance. The government needs to ensure, first and foremost that an effective social assistance program is in place to provide a safety net for the poorest households. Despite the significant improvements mentioned above, there are still indications that social assistance, and particularly the GMI program, is not being fully implemented at the municipal level because of gaps in funding. The MOLSP is currently exploring possible mechanisms for strengthening incentives for municipalities to allocate funds to social assistance. There is an urgent need to resolve this issue, as under the current system it is the poorest municipalities, with the greatest needs, that have the most difficulty financing social assistance. Balancing social assistance and family benefits. Because of the vulnerability of children to poverty in Bulgaria, child allowances can be an important poverty alleviation tool. The government intends to replace the antiquated Birth Promotion Act, with a new law. The current draft, pending in Parliament, makes important changes to the current benefit regime, but does not succeed in focusing limited budget resources on those most in need. The introduction of the new law without allocating additional Budget resources, risks squeezing funding for the essential anti-poverty programs - the GMI program, and the energy benefit supplement, paid during the heating season. Further in-depth analysis of targeting and benefit adequacy is sorely needed to assess the tradeoffs between various options and particularly the balance between social assistance and family benefits. Establishing an effective poverty monitoring system. Improvement of the poverty monitoring capacity of the MOLSP is sorely needed. Current information collected by the MOLSP is inadequate to assess the poverty-alleviation impact of programs, the effectiveness of targeting and the adequacy of benefits. The World Bank supported two LSMS surveys in 1995 and 1997 for the poverty assessment, but it appears that there are no current plans to run another Chapter V: Labor Market and Social Policy 95 survey. The National Statistical Institute (NSI) implements a monthly household budget survey, but the usefulness of the data is limited because it collects data on incomes which has well known limitations for estimating actual consumption. Coordination with the NSI and other information sources is needed to provide a coherent picture of living conditions, poverty and the effectiveness of social assistance programs. Medium to long run Pensions Ensuring equity in contributions. The current situation is characterized by great disparity in contributions. Civil servants do not pay a share of the contribution, all of it is paid by the state budget. Other workers, over time, will pay 50 percent of the contribution. This difference needs to be eliminated to ensure equity within the system. For the military and staff of the Ministry of the Interior, that have a privileged benefit regime, the Treasury should either pay the regular contributions to the NSSI plus a contribution to an Occupational Fund (the preferred option) or will pay contributions to NSSI that are actuarially sound. The central government's liabilities for these staff should not be transferred to the NSSI without adequate and explicit compensation. Current proposals by trade unions and employers' unions suggest phasing in equal contribution rates gradually over the next seven years. Designing and implementing private sector pensions. The government has already taken steps for the introduction of the new system. The Supplementary Voluntary Pension Insurance Law and the Social Insurance Code establish the regulations for the operation and management of private pension funds. The regulatory body -- Social Insurance Supervisory Authority - has been established and is operational. Its authority should be enhanced to ensure sound management of private pension funds and urgent attention should be given to the large number of unlicensed pension funds which are currently operating. Labor markets Decentralizing collective bargaining. While there is evidence that the functioning of the industrial relations system is acceptable, if compared to that of other Central European Countries, some fine tuning is needed. In particular, improvements are needed towards more de- centralized bargaining at local level to reduce high regional unemployment persistence and differentials. Strengthening administrative capacity. In principle, most of the workers' rights defined in EU regulations have long been part of Bulgarian labor legislation. Because of an insufficient compliance, however, substantial gaps with EU requirements remain, even when the legal provisions appear to be in place. Compliance with EU working conditions require resources and administrative capacity that are not yet available in Bulgaria. These have to be gradually put in place and compliance should be sequenced accordingly. Since the costs of complying with EU working conditions may well exceed their short-medium run benefits, it would be necessary to conduct survey-based studies for assessing such costs. Thus, in order to avoid the risks that a too fast compliance inflate the informal economy and ultimately delay EU accession, a carefully designed sequential approach is recommended. 96 Chapter V Labor Market and Social Policy Social assistance Protecting the poor from future price shocks. The energy benefit program, which provides benefits to low-income households during the November-April heating season is fully funded out of a central MOF account. As a result, coverage is significantly higher than the GMI (18 percent of households), and delivery of benefits is secure. However, given that future increases in energy prices are unavoidable to ensure the financial viability of the energy sector (particularly electricity and district heating) the effectiveness of this program needs careful monitoring and possible adjustment. Reducing reliance on institutionalized care for children and others in difficult circumstances. Like other countries in the region, Bulgaria's social assistance system is over reliant on residential care for the elderly who are unable to live on their own, adults with physical and mental disabilities, and children in difficult circumstances due to poverty, ethnicity, disability and other risk factors. The MOLSP recognizes the limitations of this approach, both in adequately assisting groups at need, and efficiently providing services, and is developing a strategy to shift to community-based options. SUENCING OF POLICY RECOMMENDATIONS SHORT RUN MEDIUM RUN LONG RUN Payroll Taxes Cut Social Security Increase compliance by contributions fighting widespread avoidance to pay payroll contributions. Labor Code Simplification of the regulation of collective dismissals; reduction of requirements for paid education leave and matemity leave. Support to the Further resources Unemployed allocated to ALMP should wait for the results of the evaluation of the existing programs. Industrial Relations Move toward a more decentralized bargaining system to reduce high regional unemployment. EU Accession Assess activities of the Perform micro studies Cautious approach vis-a- General Labor for assessing the impact vis the standardization Inspectorate on Labor costs of of working conditions to compliance with EU those prevailing in the working conditions. EU. CHAPTER VI: EXTERNAL TRADE AND CONTESTABILITY OF DOMESTIC MARKETS INTRODUCTION Bulgaria can only prosper if it is an open and outward looking economy. Reforms establishing a modem market-based regime-which simultaneously will help to make progress towards meeting the conditions for accession to the EU-should result in improved economic growth performance. The objective of a pre-accession strategy of a country whose GDP per capita is lower than that of a poorest EU-member should be fast economic growth stemming from removing barriers to efficient allocation of resources and generating healthy competitive pressures on domestic producers. The double legacy of socialist mis-development and stalled economic liberalization until 1996 extracted heavy toll on Bulgaria's economic performance in the 1990s. But Bulgaria appears to have begun to reap benefits of liberal reforms launched in 1997-99. By removing major sources of distortions generated by the foreign trade regime and transferring property rights to private sector, they have led to a significant increase in competition in domestic markets and a dramatic surge in FDI inflows. Although there are also already signs of a strong export recovery, the challenge still remains in complementary reforms. Once these are completed, one may expect a significant improvement in Bulgaria's growth performance and competitiveness in international markets. CONTESTABILITY OF DOMESTIC MARKETS The openness of the economy to foreign investment and import competition determines the contestability of domestic markets. Contestability of domestic markets entails not only issues of market access as embodied in tariffs and narrowly conceived non-tariff barriers. It also entails market access implications of domestic policies and regulations (e.g., standards requirements, phytosanitary measures, and environmental standards) as well as treatment afforded to foreign investment. Higher levels of contestability usually generate higher rates of economic growth and better export performance. Foreign trade policy Dismantling of state monopoly over foreign trade together with its central allocation of convertible currencies represented in 1991 a huge step towards liberalization in market access. However, the incomplete liberalization of prices combined with stalled, if not aborted, institutional reforms including transfer of property rights to private sector was responsible for instability in foreign trade policies and had unavoidably led to the proliferation in state micro- management of foreign trade. These combined with relatively high Most Favored Nation (MFN) tariff rates and frequently introduced import surcharges erected an extra barrier to trade already negatively affected by external developments. In consequence, Bulgarian markets were significantly protected throughout most of the 1990s thus contributing to reducing the country's export potential. 98 Chapter VI: External Trade and Contestability of Domestic Markets Another factor depressing both exports and imports was the instability in Bulgaria's foreign trade policies, which was a major complaint often voiced by Bulgarian businesses.62 The serious effort to remove foreign trade policy-related distortions as well as to reduce instability in Bulgaria's policies began only after the 1996 financial crisis, proceeding initially at a slow pace, but picking up subsequently. Bulgaria has made large strides in opening its economy thanks to overall trade liberalization, large reductions in tariff rates on imports from preferential regional partners and liberalization of foreign investment regime. Post-1997 shift towards greater stability and liberal trade regime Until 1997, Government policies did little to respond to considerably larger challenges than those faced by Central European countries such as Czech Republic, Hungary, Poland and Slovenia which are geographically better located and less dependent on Eastern markets. Although accession to the World Trade Organization (WTO) after negotiations lasting almost a decade potentially offered enormous opportunity to remove an anti-foreign trade bias of the foreign trade regime, Bulgaria did not fully use the WTO accession process as a vehicle to improve conditions in access for foreign goods to local markets. But it did so for services. Since its accession in December 1996, Bulgaria has made significant commitments liberalizing trade in telecommunication and financial services. Although upon accession to the WTO Bulgaria bound 100 percent of its tariff rates, the bound rates63 were generally higher than the rates it then applied particularly on agricultural products. The simple average bound rate was 29 percent in 1999 (55 percent on agricultural products and 25 percent on industrial products). Bulgaria is committed to eventually reduce the bound rates by 2002 to the simple average of 27 percent (46 percent on agricultural products and 24 percent on non-agricultural products. Since this reduction does not bring the bound rates below the currently applied levels, the room exists for significant increases towards MFN suppliers, if a government chooses to do so. The measures taken by the Government so far confirm the policy of trade liberalization and improving access to markets. The use of import surcharge raised the cost of imports and uncertainty among users of imports especially during the first "round" of its operation over 1993-95. The import surcharge (3 percent ad valorem) was first introduced in August 1993. The rate was reduced to 2 percent in 1994 and 1 percent in August 1995 and eliminated on December 31, 1995. With the mounting balance-of-payments pressures, six months later the Government introduced a new schedule of import surcharge with the rate set for the first 12 months at 5 percent ad valorem to be reduced every year by one percentage point. Although these ad valorem charges were not particularly high in comparison to those levied by other Central European economies, their perseverance in the first half of the 1990s set Bulgarian foreign trade policy apart from all of them except Poland. But in contrast to the first 'round' in 1993-95, the second round had a transparent schedule of reductions and the import surcharge was removed a year ahead of schedule on January 1, 1999. Since commitments under preferential trade agreements led to significant reductions in tariff rates, the cost of imports significantly decreased already in 1998. 62 See R. Dobrinsky and 1. Yaneva. 1997. "Impediments to exports in small transition economies: the case of Bulgaria," Moct - Most: Economic Policy in Transitional Economies (Netherlands) No. 2 (33-55). 63 Maximum tariff rates that a WTO member is allowed to impose on imports. Chapter VI. External Trade and Contestability of Domestic Markets 99 Liberalization through regional trade agreements The participation in the EU project of establishing a single European trading bloc in manufactures-which constitutes an important component of Bulgaria's objective to accede to the EU-has shaped Bulgaria's foreign trade policy. After necessary amendments to protocol No 4 to the EA, Bulgaria has applied the rules stipulated in the Pan-European Cumulation of Origin Agreement since its inception on 1 January 1997. The Agreement has established a single territory for rules of origin purposes.'M With the removal of all remaining tariffs on industrial products-as stipulated by respective preferential trade agreements-by 2002, a single European trading bloc for industrial products will then emerge. Bulgaria will thus become part of the largest market for industrial products in the world-both an enormous challenge and great opportunity to Bulgarian firms and consumers. The prospect of the emergence of a pan-European free trade area in industrial products has driven Bulgaria's foreign trade policy vis-a-vis other participants of this arrangement. Beginning with the Europe Agreement (EA), Bulgaria has signed Free Trade Agreements (FTAs) covering industrial products as well as many agricultural product categories with countries with whom the EU already signed or intends to sign preferential trade agreements. The Europe Agreement (EA): The trade component of the EA entered into force on December 31, 1993. As of 1 January 1998, Bulgarian exports of industrial products have tariff- free access to EU markets. The removal of Bulgarian (mainly tariff) barriers proceeds at slower pace and is to be completed by 1 January 2002. Around 85 percent of Bulgaria's industrial imports were not subject to tariffs in 1999. Tariffs on the remaining products stood at 45 percent of respective basic rates.6" They decrease to 30 percent of the basic rate in 2000, 15 percent in 2001 and will be zeroed in 2002. As for agricultural products, the preferential access for some products that Bulgaria had under the unilateral GSP scheme of the EU was retained. Trade in wine was covered by the separate agreement. The EU gave preferential treatment (reduced import duties and/or levies) within tariff quotas for some Bulgarian agricultural products (wines) and without limitation for certain processed agricultural products. Since July 1998, the EC increased tariff quotas by 5 percent annually-as of July 1, 2000 they were 25-28 percent larger than over 1995-97. In 2000, new conditions in access for some agricultural products were negotiated. As of July 1, 2000, tariff rates for some agricultural products were zeroed and new duty-free quotas were established. European Free Trade Association (EFTA): The Agreement with EFTA, signed in 1993, was modeled after the trade component of the EA. Hence, exports of industrial goods originating in what remained of EFTA to Bulgaria face the same tariffs as those from EU 64 See Regular Reportfrom the Commission on Bulgaria's Progress towards Accession, Brussels, 13 October 1999. Full cumulation in 10 EU accession forerunners, Turkey (joined the system on 1 January 1999), European Economic Area (including a non-participant, Switzerland) and EU provides for the cumulation of originating materials and processing operations among all these countries. 65 Basic rate is a Bulgarian MFN rate as applied on December 30, 1993, i.e., on the day before the trade component of the EA went into effect. 100 Chapter VI: External Trade and Contestability of Domestic Markets members and Bulgaria has a duty-free access to EFTA markets. As regards agricultural trade the bilateral agreements with individual EFTA states foresee smaller concessions as compared to the agricultural concessions negotiated with the EU. Central European Free Trade Agreement (CEFTA):66 Bulgaria concluded FTA with some CEFTA members-the Czech and Slovak Customs Union in 1995 and with Slovenia in 1996-even before formally joining the CEFTA as of 1 January 1999. The CEFTA system has both a multilateral component that comprises commonly agreed preferences and a bilateral component not extended to all CEFTA members. Consequently, commitments made under these agreements remained in force, although they were superseded with Bulgaria's accession to CEFTA. In consequence, trade in industrial products with the Czech and Slovak Customs Union (since 1999), Hungary and Slovenia (2000) is not subject to tariff or non-tariff barriers. As for trade with remaining CEFTA countries (Poland and Romania), tariffs on 80 percent of all industrial products were zeroed upon the entry of the CEFTA agreement in force (1999). While the timing of moving to a free trade regime for industrial products varies by countries, all tariff and non-tariff barriers (with some exceptions) will be removed by the end of 2001. As far as agricultural products are concerned, there are reciprocal concessions in terms of zero or reduced duties applicable to specific tariff categories within specified tariff quotas (in some cases to be gradually eliminated) or without tariff quotas. Other FTAs: Bulgaria has FTA with Turkey (in force as of January 1, 1999) envisaging gradual removal of tariffs on industrial trade by January 1, 2002. It also has signed FTA with the Former Yugoslav Republic of Macedonia (January 1, 2000). In accordance with this agreement, around 80 percent of trade in industrial products were freed with the remaining 20 percent by January 1, 2005. Bulgaria is also involved in negotiating FTA with the Baltic States (Estonia, Latvia, and Lithuania), Israel and Morocco-all of these countries have preferential status in EU markets. The pursuit of regional liberalization-clearly the best policy option for Bulgaria-has produced two results: dramatic increase in contestability of domestic markets for industrial products due to the fall in duties on imports from preferential partners and reverse discrimination triggered by preferential tariff margins, i.e., the difference between MFN rates and preferential rate on industrial products. Distortions generated by tariff structure: reverse discrimination Tariff structure can be the source of two types of distortions: those related to dispersion in tariff rates and those caused by differences between MFN applied rates and preferential or zero rates on imports from FTA countries. First, dispersion in tariff rates-measured by the standard deviation-leads to prices that frequently seriously distort production and consumption patterns. Low and uniform tariff rate minimizes the net welfare cost. By this measure, Bulgaria's tariff structure seems to be less distorting than those in several other EU-applicants. The overall standard deviation of Bulgarian MFN rates of 9.3 percent is larger than that in the 66 CEFTA, signed in 1992, provides a framework for bilateral agreements among seven states: Bulgaria (which acceded in 1999), the Czech Republic (1992), Hungary (1992), Poland (1992), Rornania (1997), Slovakia (1992), and Slovenia (1996). Chapter VI: External Trade and Contestability of Domestic Markets 101 EU but lower than in external tariffs of all original founders of the CEFTA, i.e., Czech Republic, Hungary, Poland and Slovakia. Second, the FTAs have resulted in a significant fall in tariff rates especially those on industnral products.67 Maximum tariff rates as well as average weighted and simple tariff rates are highly diversified reflecting differences in baskets of Bulgarian imports from various trading partners as well as differences due to preferential agreements (Table 6.1). These preferences and exemptions from uniform MFN treatment of external suppliers implicit in FTAs are distortionary, as Bulgarian importers will often choose product originating in a preferential country although the same product may be available at a lower cost from a firm facing an MFN rate. Furthermore, an exporter from a preferential area although otherwise competitive in world markets, may boost the price of its products to capture the rent up to a margin below the MFN applied rate. Whatever the case, the loser is ultimately a Bulgarian user of imports. Table 6.1: Simple average tariff rates on industrial imports, standard deviation of tariffs (1999) and the share of pref rential partners in Bulgaria's industrial imports (1997), in percent Share in Bulgaria's Average applied Sutdard Margin over MFN industrial inports, 1997 tariff rate, 1999 deviation,1999 applied rate European Union (15) 59.9 3.6 4.5 9.0 EFTA 9.5 3.6 4.5 9.0 Czech Republic 2.2 0.0 0.0 12.6 Slovak Republic 0.7 0.0 0.0 12.6 Hungary 0.8 2.0 3.0 10.6 Poland 1.3 0.1 1.3 11.5 Rornania 1.4 1.3 2.4 11.3 Slovenia 0.4 0.7 1.1 11.9 Turkey 2.9 3.3 4.7 9.3 Subtotal 79.1 12.6 (MFN) 9.1 (MFN) 0.0 Memorandum: Total imports Average tariff rate Standard deviation Total Imports (in mnillion of 2,754 10.9 9.6 Not applicable US $), average tariff rate and standard deviation Former Republic of 0.6 Macedonia Source: Tariffs calculated from Bulgaria's Tariff Schedule for 1999 and trade data as provided by Bulgaria to UN COMTRADE Database. The scope for trade diversion remains significant. With large tariff margins enjoyed by suppliers from FTA partners as a result of gradual reduction and elimination of tariffs, the level of intensity in reverse discrimination against MFN suppliers has remained high. In 1999, the margins ranged between 9 percent for suppliers from the EU and EFTA and 12.6 percent ad valorem for exporters from the Czech and Slovak Customs Union. The margins are higher when averages are computed on non-zero MFN rates. For instance, the difference between average MFN rates and rates on industrial imports from the EU was 10.4 percent in 1999. This may explain high geographical concentration in Bulgaria's total industrial imports with EU and EFTA 67 The average weighted tariff rate on all imports fell from 9.4 percent in 1998 to 5.9 percent in 1999 and to an estimated tariff rate of 4.5 percent in 2000. The weighted average tariff rate on industrial imports was 5.1 percent. 102 Chapter VI External Trade and Contestability of Domestic Markets exports accounting for 70 percent of the total in 1997. Imports from other preferential partners accounted for around 10 percent of Bulgaria's imports of industrial products. Hence, though as a small country with one of the lowest GDP per capita among candidates to the EU Bulgaria has the most to lose from imposing high tariffs, it uses them rather extensively vis-a-vis non-FTA partners. The increase in the level of reverse discrimination following the implementation of FTAs has also witnessed the increase in preferential partners' share in Bulgarian imports. Their share in total imports increased from 66 percent in 1998 to 68 percent in 1999.68 The increase in 1999 was exclusively due to the increased imports from the EU. It seems that some portion of it might be due to trade diversion that typically accompanies reverse discrimination. Distortions generated by other trade policy measures While not a single non-tariff trade policy measure was a fonnidable barrier to import penetration, taken together they hampered access to markets and thereby their contestability in the 1 990s. However, most of non-tariff measures (NTMs) were either removed over 1997-2000 or will be eliminated soon. NTMs that were removed include: * Export taxes: Export taxes suppress foreign trade and encourage smuggling if the domestic price is lower than that in world markets. Export taxes were widely used by Bulgarian foreign trade policy makers and gradually removed; the last remaining tax on unprocessed wood products was abolished in January 2000. X Licensing procedures: Foreign trade activity is open to all firms registered in Bulgaria. The existing restrictions on trade stem mostly from international commitments (e.g., MFA), national security (arms, dual use products) considerations, protection of historical heritage, etc., and are WTO-compatible. The procedures of issuing licenses have been streamlined and simplified. But still two important barriers remain: * Technical standards: Mandatory technical standards (part of border controls as the proof is required that a product meets Bulgarian mandatory standards) remain an impediment to trade curtailing competition from imports. The present system of comprehensive testing to enforce technical standards continues to diverge rather widely from EU market-type surveillance techniques. The Law on National Standards, which went into effect in September 1999, eliminated 13,000 mandatory standards and the last 1,700 were repealed in September 2000. Once all agencies recognize the CE marking and EU certification without additional sampling and testing, technical standards will cease to be a barrier to trade. 68 The share of EU and EFTA increased 48 percent in 1997 to 51 percent in 1998 and 54 percent in 1999, the share of CEFTA contracted from 4.9 percent to 4.3 percent, and that of Turkey fell from 4.9 percent to 4.3 percent. Chapter VTI: External Trade and Contestability of Domestic Markets 103 * Customs procedures: In 1998-99 Bulgaria approximated its customs regulations to those in the EU and is in full compliance with requirements stipulated in the EA (Article 94). But while the changes in the legal and the procedural framework have been incorporated into the legal framework, it appears that because of the weak institutional capacity, clearance procedures vary from one border point to another. The Government should be commended for having so far successfully resisted the temptation to use a very powerful protectionist vehicle at its disposal-the antidumping legislation. With accession Bulgaria notified the WTO that regulations on antidumping, countervailing duty, and safeguards were effective since December 1996. However, Bulgaria has so far made no recourse to antidumping or countervailing tariff action, and has not initiated a single investigation. Hence, antidumping is not a barrier to trade. Competition policies With its new Law on Protection of Competition (LPC) enacted in May 1998, Bulgaria's competition policy framework, rules and enforcement capacities have gone a long way towards harmonization with those of the EU. The LPC incorporates the EU competition rules and spells out detailed procedural rules for their implementation. It has provisions on substantive rules including definitions of restrictive practices, dominant position, block exemption from prohibition, and merger control. Parties to an agreement that has the potential to distort or restrict competition (as defined in the Law) must notify the Commission for the Protection of Competition (CPC). This requirement does not apply to agreements among parties whose aggregate share in a respective market for goods and services does not exceed five percent of the total. It appears the new Law has already brought about an important change. In comparison to the 1991-97 competition framework, there was already a very significant shift in the composition of petitions. Cases regarding 'unfair' trade practices and contract enforcement-normally decided by courts as involving issues related to enforcement of private contracts and private property-overshadowed cases of anti-competitive behavior in 1991-97.69 But the situation has changed. With the revised Law in place hard core competition cases dominated in 1998. The latter, accounting for 60 percent of all cases, included the abuse of dominant position (33 percent), mergers (18 percent) and restricting agreements (9 percent). The new Law appears to have one major weakness. As OECD report justifiably points out, the articles seem to be completely oblivious to the potentially useful information that advertising can give consumers about products.70 In some instances the wording is vague and opens possibilities for administrative abuse at the expense of competition. 69 B. Hoekman, B. and S. Djankov 1997. "Competition Law in Bulgaria After Central Planning," Policy Research Working Paper, No. 1789. The World Bank, Washington DC. 70 OECD Economic Surveys 1998-99. BULGARIA. Organisation for Economic Co-operation and Development, Paris. (p. 95) 104 Chapter VI. External Trade and Contestability of Domestic Markets Subsidies (state aid) Subsidies, or state aids, distort competition. They give "national champions" an unfair advantage in competing with other firmns, domestic or foreign. The EU rules set the principle of a general ban on aid but provide for a number of exemptions including, among others, regional aid, aid to poor areas. Aid for steel and coal, agriculture and transport are subject to specific provisions. With the expiration of the five-year 'transition' period, the Accession Partnership called for the Government of Bulgaria to introduce a coherent legal framework on state aids and establish a single agency that would administer and monitor state aids. The Association Council Bulgaria - EU completed its work on the establishment of a legal framework for the application of the provisions on state aids. The legislative framework, harmonized with that in the EU, is thus in place. The CPC has been accorded the power to cancel state aid and/or demand that the aid be reimbursed. In assessing state aid proposals, the CPC can make direct reference to the relevant rules of the acquis communautaire. Following the 1996 crisis, most subsidies have been eliminated. The overall level of explicit subsidies in terms of GDP seems to be below the EU average (around 1.7 percent). It appears that subsidies are no longer a sizable impediment to the shift of resources to internationally competitive sectors. External access to government procurement Bulgaria-like other transition economies-has not become part of the Agreement on Government Procurement, which is applicable only to signatories of this component of the Uruguay Round Agreement." By the same token, Government procurement and outsourcing policies do not have to adhere to its disciplines prohibiting preferences for domestic firms and imposing competitive and open tendering to all pre-qualified firms including foreign firms. The normns and provisions of Bulgarian legislation of 1997 were incompatible with the WTO-rules. But under the EA Bulgaria has been committed to extend the national treatment principle to firms from the EU, to government procurement by February 1, 2005. Yet, the process of bringing domestic regulations in line with EA and GATT disciplines has already begun with the enactment of a new public procurement law (PPL) by the Bulgarian Parliament on 9 June 1999. First, procedures, contracting authorities as well as the contracts falling under the purview of the PPL have been defined in line with the EU directives. Procedures are transparent, technical specifications are based on international standards, and tenders for contracts exceeding predetermined thresholds (set below those recommended in the EU directives) are published in the Official Gazette.72 Second, the coverage of the PPL has been extended to cover special budgetary funds, health and pension funds as well as non-profit legal entities. In a nutshell, the PPL applies to all companies providing public services including utilities. 71 The Government is one of 18 countries with observer status and has recently applied to become party to this Agreement. 72 Contracts subject to the PPL are equal or larger than DM 600,000 for construction services, DM 50,000 for supply of goods and DM 30,000 for services. Chapter VI: External Trade and Contestability of Domestic Markets 105 With the PPL in place, Bulgaria has gone ahead the schedule set by the EA in terms of extending the principle of national treatment to EU firms as well as other foreign firms as of 1 January 2000 rather than February 2005. Under the new law bidders from foreign countries enjoy equal treatment with domestic bidders in competing for a tender. There are two caveats. The first caveat that a foreign firm that has won a contract has to register (or set up a company) in Bulgaria. This requirement is temporary-its purpose is to assure that a contract be carried out. The Government justifies it by the existence of a number of foreign companies with financial resources of unclear origins. The second caveat is that the PPL offers two kinds of preferences: to Bulgarian firms employing handicapped and Bulgarian small and medium enterprises. Both provisions unnecessarily introduce loopholes to a framework that is otherwise compatible with the EU laws. These in turn raise the cost of procurement and thus impose extra burden on taxpayers. The right of establishment and services The alternative to providing goods and services from abroad is to establish facilities in a recipient country. In the case of goods, this involves building new production facilities (Greenfield investment) or purchasing controlling equity in an existing enterprise (portfolio or direct investment depending on the percentage of equity acquired). In the case of services, this may simply involve registering a firm, opening offices or purchasing a domestic firm or bank. The legal framework governing the right of establishment in Bulgaria was in the state of flux in the 1990-96 period creating very serious barriers to foreign investment. The current framework (Law on Foreign Investment of October 10, 1997) recognizes the principle of national treatment of investment opening all sectors of the economy to foreign investors. It has also simple procedures for the registration of foreign companies and provides for an unhindered repatriation of profits. There are no limits on foreign equity including investment in financial services. Although the legislative framework seems to be overall in compliance with international standards, it contains provisions unfriendly towards investors, especially those from abroad. These include among others restrictions on the number of residence permits available to directors of stock companies. The process of obtaining work permits is burdensome and non- transparent.73 Moreover, the Bulgarian law also does not allow domestic firms, locally- and foreign-owned alike, to turn to international arbitration bodies in the case of a dispute. While this may not be a problem for a locally owned firm familiar with local regulations and customs, the lack of access to international arbitration may discourage many potential foreign investors. 73 See Bulgaria. Administrative Barriers to Investment. FIAS (Foreign Advisory Service a joint service of the International Finance Corporation and the World Bank), November 1999. 106 Chapter VI. External Trade and Contestability of Domestic Markets RE-ORIENTATION OF FOREIGN TRADE TOWARD MARKET-DRIVEN PATTERNS The collapse of central planning and contraction in import demand in former Council for Mutual Economic Assistance (CMEA) countries shaped Bulgaria's trade pattems during the initial stages of transition. Bulgaria's initial response to the formidable challenge of the loss of markets in what was the CMEA was quite impressive. Following the collapse of import demand in the former Soviet Union, there was a dramatic reorientation in Bulgaria's foreign trade pattems towards the EU.74 Its share in Bulgaria's total trade tumover has been on the increase each year since 1990: it grew from 22 percent in 1989 to 32 percent in 1990 and exceeded 50 percent in 1999. However, the problem was that volatility and contraction in the value of total trade accompanied the expansion of Bulgaria's trade with the EU. The developments in total trade over 1991-98 reveal an unsettling picture of an initially slow growth followed by a sharp contraction in 1994, a surge in 1995, and a steady decline over 1996-98. It fell dramatically in 1998 demonstrating continuing vulnerability of Bulgarian firms to regional, economic and political developments in Russia and Ukraine. The value of total exports has been on the decline since its peak in 1995, despite the growth in EU-oriented exports. But there are signs of export recovery. Although the value of total exports fell around six percent in 1999, this was due to an almost 20 percent contraction in exports during the first seven months.75 The value of exports in August-December over the same period in 1998 was 11 percent higher. Preliminary data for the first ten months of 2000 point to the continued expansion in Bulgarian exports - they increased 20 percent in terms of value over the same period in 1999 according to Bulgaria's balance of payments data. The change in Bulgaria's geographic trade patterns was more significant on the export side than in imports. While the EU supplied 33 percent of Bulgaria's total imports in 1989, it absorbed only 12 percent of Bulgaria's total exports. The growth in exports has driven the dynamics of Bulgaria's trade with the EU with its share doubling in 1990 alone and then again doubling over the next four years by 1995. The average annual rate of export growth of 17 percent over 1990-98 contrasts rather sharply with that for imports of 6 percent. INTEGRATION INTO EU MARKETS The scope and depth of a country's integration into EU markets for goods offer important insights about the ability of its firms to compete in a Single Market. With the share of the EU in its trade tumover amounting to around 50 percent, Bulgaria is less integrated into the EU than most other European candidates for accession to the EU. Note that the ratio of inter-EU trade to 74 Foreign trade data cover all current 15 EU members including years before accession of Austria, Finland and Sweden. 75 While the impact of the Kosovo war on Bulgarian economy was smaller than initially anticipated (see Regular Report from the Commission on Bulgaria's Progress towards Accession, Brussels, 13 October 1999), the war might have delayed the recovery in exports. The value of exports in April-June 1999 stood 14 percent below its level in the same period in 1998 (IMF Direction of trade statistics as reported by Bulgaria). Chapter VI: External Trade and Contestability of Domestic Markets 107 external trade was, on average, 62 percent in 1990-98.76 In addition, the presence of Bulgarian firms in global production and distribution networks of large MNCs have remained limited in spite of signs of growth. An interesting question for the future concerns the ability of Bulgarian firns to withstand competitive pressures from a Single Market. A deeper analysis of Bulgaria's imports as well as export performance in EU markets since the beginning of the transition can offer an answer. Imports from the EU The importance of exports stems from the fact that they generate earnings indispensable to finance imports both for consumption and investment. Although the foreign trade with the EU has been a bright spot in an otherwise difficult Bulgaria's transition to competitive markets and contributed positively to Bulgaria's economic perfornance, imports from the EU increased less between 1989-90 than exports did. The value of the latter doubled over 1989-98, whereas the value of the former tripled over this period. But the share of the EU in Bulgaria's total imports dramatically increased over the last decade mainly at the expense of imports from former Soviet republics. Their share fell from 68 percent in 1990 to 24 percent in 1999 with energy accounting, while the EU accounted for 49 percent of Bulgaria's total imports.77 This share has been significantly higher for manufactures- almost three-fourths of these imports come from the EU. Reorientation of trade to the EU has allowed significant gains to Bulgarian producers and consumers thanks to access to higher quality manufactures embodying new technologies. Two shifts in the composition of imports from the EU can be distinguished over the 1989-98 period. The first was from a basket under central planning in 1988-89 dominated by power generating equipment to a basket (1992-94) with a heavy presence of consumer goods including public 'bads' (e.g., alcoholic beverages and cigarettes) and passenger cars. The second shift in the late 1990s was to a basket retaining passenger cars but including also significant shares of car parts, textiles and clothing, capital equipment and telecommunication equipment.7" The surge in imports of capital equipment in 1998, if sustained, will confirm the revival of investment activity and industrial restructuring. Export dynamics: two phases Following the collapse of central planning and the CMEA Bulgaria's trade with the EU expanded especially on the export side. Two phases can be distinguished: one covering the 1990-95 period and the second phase beginning in 1996. During the first phase the overall 76 Calculations from data in UN COMTRADE database. 77 Data provided by the Bulgarian Ministry of Economy. 78 Clothing and clothing related product groups accounted for more than one-third of the value of imports of the top ten product categories (four-digit SITC. Rev. 1 categories) in 1997-98. It seems that the expansion in exports of clothing over 1996-98 triggered this change, while imports of telecommunication seem to point to the process of modernization of this sector. Although this process probably began in 1994-95, it appears to have gained new momentum with the surge in imports by almost 70 percent in 1998. 108 Chapter VI: External Trade and Contestability of Domestic Markets growth in EU-oriented was impressive even by the demanding standards of CEE-5 economies. Only Czech Republic (25 percent), Estonia (65 percent) and Slovenia (37 percent) experienced faster growth in terms of annual average growth rates (Table 6.2). The second phase witnessed Bulgaria's undistinguished performance. The average annual growth rate of Bulgarian EU-oriented exports of 1.9 percent exceeded only that of Slovenia. It was lower than that of other CE-5 economies. Both external (Kosovo conflict) and internal factors (the legacy of stalled reforms) appear to account for poor export performance. It seems that developments in Bulgarian trade since August 1999 may herald the beginning of a new phase of export expansion. The conundrum of a faster growth in EU-oriented exports in the highly policy-distorted environment during the first phase than over 1996-99 is relatively easy to sort out. First, Bulgaria under-traded with the EU more than former Czechoslovakia, Hungary and Poland. Therefore, its potential for redirection, due to previous very high level of dependence on CMEA markets, was very significant. Second, subsidies and depressed prices of exports artificially maintained exports in 1994-96. With tightening of macroeconomic discipline, this source of export growth was no longer available during the second phase. Third, the price for delayed microeconomic restructuring until 1997, as captured by various indices of Bulgarian export performance over 1990-99, seems to be substantial in terms of postponing welfare and microeconomic efficiency gains. Table 6.2: Bulgarian EU-oriented exports in comparative pers ective, 1989-99 Index 1995 Average growth Index, 1999 Average growth 1989=100 rate, 1990-95 1996=100 rate, 1996-99 Bulgaria 369 21.9 114 1.9 Czech Republic" 408 25.0 146 11.9 Estonia" 382 64.7 146 15.1 Hungary 269 15.5 167 17.3 Poland 295 19.4 122 4.9 Slovenia" 233 37.4 105 0.9 Calculations based on the 1992-99 period. Source: Calculated from data in IMF statistics on direction of foreign trade. Export basket The expansion in commercial ties with the EU had a discernible impact on the composition of exports. First, the expansion of exports has been driven by traditional low processed manufactures: the share of manufactures in Bulgarian EU-oriented exports increased from 52 percent in 1989 to 73 percent in 1998. Second, within manufacturers, clothing and to a lesser extent textiles and yarn have become dominant especially during the second phase (since 1997). The 1996 crisis had no impact on them and the total value of Bulgarian EU-oriented exports slightly increased in 1997 and 1998 solely thanks to the increase in exports of clothing. Total exports without textiles and clothing were flat in 1997 and 1998 and their value was 7 percent below the 1995 level. The value of exports of clothing in 1998 was 65 percent above its level in 1995. Third, in addition to clothing, a rapid increase in the shares of footwear and iron and steel products in EU-oriented exports of manufactures was a trademark of both the 1989-95 phase and Chapter VI External Trade and Contestability of Domestic Markets 109 the 1996-98 phase. The share of footwear (including parts of footwear) remains small albeit increasing-it grew from 1.2 percent in 1989, to 3 percent in 1995 and 4 percent in 1998.79 Exports of steel and iron products displayed huge instability over 1989-98. After the surge in 1990, their share in total exports had been falling each year until 1994-from 21 percent in 1990 to 3 percent in 1993. But it rebounded to 12 percent in 1994 and increased to 19 percent in 1998. Change in competitiveness in EU markets The opening of the economy, combined with increasing globalization of production triggered by reduced costs of transportation and information, usually leads to greater specialization and improved competitiveness. Because of a delayed structural transformation and unfavorable climate for foreign investment over 1991-96, the capacity of Bulgarian firms to compete internationally has only marginally improved. The time profile of shares in EU imports points to shifts in Bulgaria's specialization: from food products to agricultural materials and textile fibers; and from capital equipment to light industries such as clothing, textiles, furniture and footwear but also to metallurgy. Although the share of products made in Bulgaria in EU outside imports (excluding trade among EU members) increased each year (except in 1996 and 1999) since 1989, Bulgarian firms have remained marginal suppliers vulnerable to swings in business cycle. In 1998, there was not a single four-digit SITC product category with the share exceeding 10 percent. Yet there have been signs of progress: the number of product categories with the share in EU external import demand exceeding 2 percent increased from 4 in 1989 to 11 in 1995 and fell to 10 in 1998. Products with the share above one percent and below 2 percent rose from 9 in 1993 and 1995 to 16 in 1998. And so did their share in Bulgaria's exports (from 5 percent in 1989 to 24 percent in 1995 and 25 percent in 1998). Factor intensities of EU-oriented exports: unskilled labor intensive products rise again Considering Bulgaria's large pool of relatively low-cost highly skilled labor and its moderate climate conditions favoring agriculture, one would expect that skilled labor intensive products together with natural resource intensive products would dominate its export basket. The composition of Bulgarian exports points to a continued discord between its pool of skilled labor and factor intensities of exports, albeit the gap appears to have stopped growing over 1996-98. While developments in CEE-5 exports to the EU led to the closure of the gap between unskilled labor intensity of exports and available human capital, Bulgaria's performance has revealed a different profile. The share of unskilled labor intensive products surged again over 1996-98 with the value of these exports to the EU increasing 35 percent over this period. 79 Including parts of footwear (SITC. 6123) the share was 1.2 percent in 1989, 5 percent in 1995 and 6.5 percent in 1998. 110 Chapter VI: External Trade and Contestability of Domestic Markets Table 6.3: Composition of Bulgarian Exports to EU in terms of factor intensities and their share in EU external imports, 1989-98 (in percent) A. Composition of Bulgaria's EU-oriented exports Index Index 1989 1990 1991 1992 1993 1994 1995 1995, 1996 1997 1998 1998, ROW 1989= 1996= ,1997 100 100 Natural Resource Intensive 46.8 44.3 42.2 41.1 41.8 40.1 36.5 78 32.7 32 30.4 93 38.4 Unskilled Labor Intensive 15.5 18.6 24 29.9 31.4 27 23.6 152 28.9 30.2 33.7 117 14.6 Capital Intensive 21.1 19.4 19.3 16.3 18.2 20 19.9 94 22.1 19.8 16.5 75 29.3 Skilled Labor Intensive 13.7 15.6 13.3 11.9 6.9 11.7 18.5 135 15.5 16.8 18.1 117 14.8 All Products (in millions of 657 823 999 1,265 1,210 1,713 2,427 369 2,204 2,410 2,543 115 1,812 US dollars _ B. Share in EU-external imports Natural Resource Intensive 0.08 0.08 0.10 0.12 0.13 0.16 0.18 225 0.14 0.15 0.17 121 Unskilled Labor Intensive 0.07 0.08 0.12 0.17 0.20 0.23 0.25 357 0.27 0.30 0.35 130 Capital Intensive 0.03 0.03 0.04 0.04 0.05 0.06 0.07 233 0.07 0.07 0.05 71 Skilled Labor Intensive 0.03 0.03 0.04 0.04 0.03 0.05 0.10 333 0.07 0.09 0.09 129 All Products 0.05 0.05 0.06 0.08 0.09 0.1I1 0.13 260 0.11 0.12 0.12 109= Source: Own calculations. Data on Bulgaria's exports as reported by the EU to UN COMTRADE database. Skilled labor intensive products account for a significantly lower share of EU-oriented exports than unskilled labor intensive products: their share in EU external imports is also significantly lower (Table 6.3.A). The share of natural resource intensive products was declining through the 1990s: it fell from 47 percent in 1989 to 30 percent in 1998. So did the share of capital intensive products, albeit at a slower pace. Bulgarian suppliers of capital and human capital (skilled labor) intensive products remain, however, at a comparative disadvantage in EU markets. Two developments seem to point to industrial restructuring taking hold. First, the value of exports of capital intensive products, that are also energy intensive, was falling - in 1997, it contracted 2 percent and in 1998, it fell another 12 percent. Second, exports of human capital intensive products grew rather rapidly after the setback in 1996 when their value fell 31 percent. Although their share in EU-external imports was still below its 1996 level, it increased almost 30 percent over 1996. The termination of energy subsidy and hardening of the budget constraint should lead to restructuring and reallocation of resources to more productive use in line with Bulgaria's comparative advantage. Changes in the level of processing: the move towards intermediate stage products Bulgaria's export offer has moved toward labor intensive products, but has it become "higher value-added" in terms of processing of commodities? To examine this question, we use a classification developed by the World Bank for analyzing different levels of processing of commodities. The share of 48 commodity processing chains in Bulgarian exports to the EU increased from 28 percent in 1989 to 34 percent in 1994 and then was falling to 26 percent in 1998 (Table 6.3). During the 1996 crisis, the value of these exports fell from US$ 768 million in 1995 to US$ 565 million in 1996, or 26 percent. Chapter VI: External Trade and Contestability of Domestic Markets 111 In terms of processing, there was a very significant shift to intermediate stage products and to a lesser extent to final stage products. Bulgarian presence in EU markets for commodity chains has increased because of expansion in exports of processed commodities. Primary stage products accounted for less than 10 percent of commodity chains EU-oriented exports in 1998 down from 32 percent in 1989. The share of intermediate stage products rose from 26 percent in 1989 to 51 percent in 1998 mainly as a result of a dramatic increase in exports of semi-processed copper. The shift towards intermediate stage products has resulted in the increase of their share in EU-external imports of these products. The share of final stage products slightly dropped from 42 to 40 percent over this period, but their share in EU external imports stayed at the same level over 1994-98. Pollution-intensive sectors in exports to the EU Environmentally dirty industries tend to concentrate in countries where environmental control measures are less stringently applied. Since these affect costs-more demanding measures impose higher costs of compliance-countries with more lax environmental regulations tend to specialize in "dirty" industries. Since countries acceding to the EU will have to meet EU environmental standards, specialization in "dirty" production implies higher cost in meeting these standards. Contrary to what one might expect, while their share in EU-external imports was growing over 1989-98, the share of environmentally dirty products in Bulgaria's EU exports was falling until 1993. This share increased to 31 and 42 percent in 1994 and 1995, and then fell. The share increased from 21 percent in 1992-93 to 24 percent in 1994-95, but it was falling in both 1996 and 1997 (Table 6.4).8° The environmentally dirty sectors have been at a comparative advantage in the trade of these products in EU markets: the value of Export Specialization Index (ESI) increased between 1992 and 1994 and then steadied at the level of around 1.7. Bulgaria's specialization in EU markets in exports of environmentally dirty products appears to be quite high considering country's geography and potential for development of tourism. Note that the share of dirty products is higher than that in exports of CEE-5 to the EU-Poland had the largest share among them of 30 percent in 1997. Table 6.4: Selected Features of Bulgaria's 'Dirt ' Exports to the EU, 1992-98 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Exports (in million of US dollars) 209 256 257 281 264 523 1,064 767 859 841 Share in EU oriented exports 32 31 26 22 22 31 42 35 36 33 Share in EU "dirty" imports 0.08 0.09 0.09 0.10 0.11 0.19 0.29 0.23 0.26 0.25 Export Specialization Indices 1.4 1.7 1 6 1.4 15 21 28 2.1 2.3 2.4 Source: Own calculations from data in UN COMTRADE database. Since environmental standards are clearly lower than in the EU, Bulgaria may have a long way to go to comply with the EU environmental directives. Considering that investment in 80 Exports of pollution-intensive products remain highly concentrated with the top ten four-digit SITC.(Rev 1) industries accounting for around 50 percent of 'dirty' exports. The most important item have been steel products (accountable for around one-third of 'dirty' exports) followed by copper alloys, lead and zinc alloys. 112 Chapter VI: External Trade and Contestabilitv of Domestic Markets environment will pay off quickly in terms of increased revenues from tourism, a closer examination of the environmental impact of existing resource allocation incentives might be worth pursuing. The perseverance of comparative advantage in "dirty" products should serve as a warning that incentive structures and state policies may need to be adjusted. INTEGRATION INTO EU-BASED NETWORKS OF PRODUCTION AND MARKETING Integration into the production and marketing arrangements of the Multi National Corporations (MNCs) rather than the pursuit of an autarchic national development strategy offers the most efficient way to take advantage of growth opportunities offered by the global economy. Second-tier East Asian tigers (e.g., Malaysia) have pursued vigorously this policy. The possibility of 'dividing up the value chain' of production allows the development of internationalization of the production process on unprecedented scale with deep implications for the global division of labor. Internationalization has been taking place within vertically integrated manufacturing industries and trade in industrial parts and components has been growing much faster than trade in finished manufactures. In consequence, inter-industry division of labor has become increasingly marginalized by a more complex specialization implicit in intra-industry trade presently enriched by intra-product specialization that extends the division of labor to parts and components of products. This trade has several advantages: it is frequently accompanied by transfer of technology and managerial know how; and it offers direct access to larger markets allowing exploiting economies of scale; it boosts exports without firms incurring marketing costs. NINCs have been the force driving this trade. Intra-product trade with the EU While intra-product trade has been the fastest growing component in foreign trade of CEE-5, Bulgaria is yet to tap this new source of economic expansion. The share of parts-which is a good approximate measure of domestic firms' involvement in production fragmentation-in Bulgaria's total exports and imports declined over 1989-98 from 5 percent in 1989 to 2 percent in 1998. Bulgaria and Latvia are the only countries among EU European associates to experience the decline in the share of parts in total imports. The exception has been trade within a furniture network and information revolution network that has shown recently signs of expansion, albeit from very low levels. Exports of furniture parts and final products accounted for 42 percent in 1993, 53 percent in 1997 and 49 percent of total networks' parts and final product exports in 1998. Despite Bulgaria's growing involvement in various stages of the EU-servicing furniture production process, the shares of a furniture network in Bulgarian EU-oriented exports and imports have remained negligible. And so has the share of intra-product trade. The aggregate share of EU-based networks of production in termns of trade turnover in parts and components in total trade turnover of manufactures (excluding chemicals) has remained remarkably stable at 3.2 percent in the 1993- Chapter VI External Trade and Contestability of Domestic Markets 113 98 period. This share is at around one-third of a corresponding share in trade of first-wave countries, i.e., Czech Republic, Estonia, Hungary, Poland, and Slovenia.8" Moving fragments of a production process across borders drives intra-product trade. Bulgaria scores high in terms of infrastructure and availability of skilled labor, though its geographic location is less advantageous than of those countries bordering the EU. It thus seems that unfriendly investment climate to both foreign and domestic investor through most of the 1990s explains the lack of progress in development of intra-product trade. With a very significant increase in FDI inflows beginning in 1997, one may expect expansion in this trade. Foreign direct investment Low levels of intra-product trade usually indicate the lack of FDI inflows, as these are regarded crucial in incorporating domestic firms into global networks of production and marketing run by MNCs. Indeed, FDI inflows had been very low until 1997. The cumulative inflows per capita of US$ 54 over 1990-96 (the same as in Romania) were the lowest among Central European candidates to the European Union. But FDI inflows picked up quite impressively over 1997-99 with the bulk of them going to the industrial sector. The aggregate value of foreign investment of US$ 1.8 billion over these three years amounted to 80 percent of total FDI inflows over 1990-99! Industry has attracted most of the foreign investments (54 percent), with a total of US$ 1.5 billion, followed by trade with the share of 20 percent in the total FDI inflows. The share of investments contributing to the development of an environment facilitating trade has been also on the increase with considerable foreign investment in the banking sector, communications and transport. A significant portion of foreign direct investment (44 percent of the total over 1997-99) was associated with privatization of SOEs. The evidence from other transition economies indicates that the involvement of foreign investors results in improved corporate governance and technological upgrading and restructuring. Since SOEs privatized at this stage of the transition have been large usually bankrupt enterprises and therefore not generating high price, their future impact maybe significantly larger than their mere share in total foreign investment would indicate. CONCLUSIONS AND POLICY RECOMMENDATIONS Integration into EU markets so far seems to have confined Bulgaria to the status of a supplier of low value-added, labor and natural resource-intensive products. Exports of low skilled labor registered the largest growth during both phases of Bulgaria's trade with the EU. Although the share of natural resource intensive products has been on the decline, the aggregate share of unskilled labor and resource intensive products in EU-oriented exports has stayed at roughly the same level of around 62 percent since 1989. 81 B. Kaminski and F. Ng (2000), "Trade and Production Fragmentation: Central European Economies in EU Networks of Production and Marketing," processed, The World Bank, Washington D.C. 114 Chapter VI. External Trade and Contestability of Domestic Markets But signs abound that creative restructuring-much delayed by stalled reforms of the early 1990s-is taking off. There has been a shift from primary stage products to intermediate and final stage products in commodity chains. Exports of skilled labor intensive products sharply increased over 1996-98. Privatization to strategic investors has resulted in the surge of what appears to be mostly high quality FDI inflows. Last but not least, imports expanded with capital equipment significantly increasing its share. The 1997-99 period witnessed significant improvement in access to Bulgarian markets as tariff-reducing provisions of bilateral free trade agreements kicked in as well as most remaining non-tariff measures affecting trade were removed. The challenge for the Government remains the acceleration in implementing measures that would simultaneously improve the institutional framework enhancing growth, competition and economic efficiency and would attract foreign investment. These measures can be grouped into the following: improving conditions in access to markets for goods; and enhancing Bulgaria's attractiveness to FDI. Implementation of these measures would send a crystal clear signal to international investors and domestic firms of unwavering and credible commitment to liberalization of its economic regime. Improving conditions in access to markets for goods. This group includes the following: alignment of MFN tariff rates on industrial products with those levied by the EU; acceleration in opening of public procurement to foreign companies, substitution of EU-type market surveillance techniques for the present system of comprehensive testing to enforce technical standards and recognition of the CE marking and EU certification without additional sampling and testing; and re-engineering of the entire customs procedure based on a risk assessment of inspection activity. The first two recommendations need some elaboration. The growing difference between tariffs levied on industrial imports from MFN and preferential suppliers is a source of distortion. Its undesirable effect is reverse discrimination of MFN suppliers and possible shift to more expensive sources of supply resulting in higher import prices. This is especially true in markets for sophisticated manufactures often dominated by two or three suppliers. If all of these suppliers were in preferential countries, competition among them would be sufficient to keep down the price. More often than not, however, there are also firms from third countries. If only one of them is in the EU, the price paid by a Bulgarian importer is likely to be higher by up to the difference between the MFN rate and preferential rate. In other words, an EU supplier obtains the rent at the expense of Bulgarian users of imports. Since Bulgarian MFN rates are higher than in the EU, their reduction to EU levels would slash the rent to that implied by the level of protection in the EU. Moreover, the alignment of MFN tariff rates with those in the EU would not increase competition from imports as Bulgarian producers are already exposed to fierce competition from preferential partners. Under these circumstances, adopting the EU applied MFN rates on industrial products rather than sticking to the higher Bulgarian MFN rates would benefit Bulgarian producers and consumers. Along similar lines, faster opening of procurement to foreign contractors over the next two years along the lines of the GATT Agreement on Government Procurement would yield at least two important benefits: it would reduce the cost of services provided by the state; and it Chapter VI.- External Trade and Contestability ofDomestic Markets 115 would improve competitiveness of domestic contractors. The latter should allow them to compete for government contracts abroad, especially in EU member countries. Enhancing Bulgaria's attractiveness to FDI. The challenge facing the Government is to create a transparent environment that would eliminate undue pnrvilege and administrative discretion still prevailing in the state administration. A structurally deficient public- administration imposes large cost of regulatory and taxes compliance, which is clearly an impediment not only to badly needed FDI inflows but also to the development of the "local" private sector. All these weaknesses add to the "hassle" cost of doing business in Bulgaria. The measures that might reduce the cost of doing business may include simplification of administrative procedures of site development, land registration and titling system; streamlining of the company registration process; reduction in the number of audits and inspections and scaling down the statistical reporting system and limiting the amount of mandatory reporting; the repeal of clauses in a new Law on Competition on advertising; the repeal of the law denying firms (local persons) access to international commercial arbitration; replacement of work permit procedures for foreigners by a differentiated system of visas offering different permits to work and its length should be extended to two years; and the repeal of the current procedure to obtain the work permit by a firm to employ a foreigner. Matrix of Short and Medium-term Measures SHORT TERM MID TERM Access to Reduction of MFN rates on industrial Adopting EU applied-MFN rates on all markets products that are more than 50 percent industrial imports above EU-applied rates to 50 percent above the EU Recognition of the CE marking and EU Opening of public procurement to foreign certification without additional sampling companies along the lines of the GAIT and testing Agreement on Government Procurement Introduction of EU-consistent surveillance techniques to enforce technical standards Business Repeal of the Law denying access to firms Streamlining of the company registration environment to international commercial arbitration procedures Limiting the amount of mandatory reporting by private firms Introduction of a differentiated system of visas offering different permits to work in Bulgaria with the length extended to 2 years CHAPTER VII: THE AGRICULTURE AND FOOD SECTOR INTRODUCTION Agriculture traditionally played a significant role in the Bulgarian economy. Before this decade, Bulgaria was a major exporter of fresh and processed fruits and vegetables inside the Eastern Block. The process of reforms and transition to a market-based agriculture has been rather difficult for the Bulgarian food and agriculture sector. Due to the specific procedures used to privatize state assets and restitute assets into private ownership, the relative instability of the overall economy until 1997, and the crisis in the Russian market, there has been more disruption in the farming sector in Bulgaria than has occurred in many other Central and Eastern European countries. Since 1997, the government has made rapid progress in implementing a wide-ranging reform program. But because the reform program had made such limited progress before 1997, a number of important components of the transition are still unfinished and Bulgarian food products are not very competitive on the international market. Once the reform agenda is completed and appropriate investments made, it can be anticipated that agriculture will return to its role as an important contributor to export-oriented growth. It is essential that the full completion of the remaining tasks of transition take place before Bulgaria becomes a member of the European Union. The highest priority should be given to actions that will result in a market-driven sectoral restructuring, rather than giving financial support in ways that would perpetuate existing inefficient structures. These policies should support the completion of land reform, the consolidation of farming and agro-processing enterprises, and the development of a market-conforming institutional framework. This will improve the sector's competitiveness, which is a critical prerequisite for accession. Bulgaria must further adjust its agricultural policy to conform to the CAP at the time of its accession, but the transition strategy for this must be one that also maximizes the benefit to the agricultural sector and the economy as a whole. This implies that adjustment of trade and pricing policy to harmonize with the CAP should be deferred as long as possible. AGRICULTURE IN THE ECONOMY AND SECTORAL PERFORMANCE The importance of the Bulgarian agricultural sector in the overall economy has remained high throughout the transition, when compared to other CEECs. It is also important to note that, in contrast to Bulgaria, the share of food and agriculture has declined as a percentage of overall GDP in the most advanced transition countries, such as Hungary, the Czech Republic, and Poland. The sector's share in GDP through the mid-1990s (about 13 percent between 1991 and 1996) has been second only to that of the sector in Romania (20 percent). This climbed sharply in 1997 (26 percent growth) and 1998 (21 percent) (Figure 7.1). By European standards, agricultural employment in Bulgaria is very high, and only ranks behind Romania and Poland in percentage of the workforce employed in agriculture. Another notable phenomenon is that, in comparison to the more advanced CEEC economies, Bulgaria has experienced an increase in the share of agriculture in total employment during the transition. Chapter VII: The Agricultural and Food Sector 117 During the economy-wide decline since 1991, and especially the crisis in 1996-97, the significance of agriculture has increased in two ways. First, while the rest of the economy continued to decline in 1997, agriculture grew, due to a large extent to favorable growing conditions for grains. Second, agriculture has served as a safety net to absorb some of the labor that has been released from other sectors. Thus its share in employment has grown every year between 1991 and the crisis year 1997, when it reached 24.3 percent (Figure 7.1). It is the only sector in Bulgaria in which employment actually grew continuously over this period. In 1998, agriculture employed 24.7 percent of the population directly, and about 32 percent of the population lived in rural areas. Figure 7.1: Share of Agriculture in GDP and in Total Employment, 1991-1998 30 25 - 20- 15 --- 10 1991 1992 1993 1994 1995 1996 1997 1998 Share of agnculture in GDP (%) Share of agnculture in total employment (%) - Log. [share of agriculture in GDP (%)] - - Log. [share of agriculture in total employment (%)] Source: NSI, 1999; European Commission, 1998. Food and agriculture are essential components of Bulgaria's foreign trade. In the early 90s agriculture contributed 20-25 percent to total exports. In 1998 the share of agriculture (including food) in exports was 16.4 percent, which ranked Bulgaria first among the CEE countries. At the same time, agricultural and food products amounted to only 8-10 percent of imports (Figure 7.2). The most important export products are currently wine, tobacco, fresh and processed fruit and vegetables. The CIS is still the predominant destination for Bulgarian exports, but the role of the EU and OECD countries is increasing. On the import side, the OECD countries and the EU supply most of the imported goods to Bulgaria. As a result of changes during transition, although agriculture's share of output and employment was increasing, agricultural production has declined both in terms of output and yields of main products. The main crops are cereals, vegetables, tobacco, and their yields (with the exception of tobacco) declined during the 1990s by 40 percent to 60 percent. Output of the major livestock products (meat, dairy and eggs), declined even more than crop production. In 1997, according to official FAO figures, overall agricultural production was only about 55 percent of its 1989 level. The performance of the food and agricultural sector shows a rather erratic pattern behind the overall declining tendencies. Crop production has fluctuated, 118 Chapter VII: The Agricultural and Food Sector especially when viewed on an annual basis. The relative importance of crop and livestock production has been changing continuously, but in general, the crop sector has maintained its dominance. Figure 7.2: Foreign Trade with Agricultural and Food Products, Balances and Shares, 1993-1998 600 - - 14 500- - - 12 400 - ----- - - --- = 10 E * __ - s X *_ J - 4 100- 2 0 t 0 1993 1994 1995 1996 1997 1998 -100 . . --- - - - -2 Balance of agricultural raw products (mrillion US$) _ Balance of food industry products (million US$) -b- Share of agricultural raw products in total trade (%) r Share of food industry products in total trade (%) Source: NSI, 1998 and 1999; European Commission, 1998. This fall in agricultural production has had a number of causes. As the heavy subsidies to fertilizer were reduced, and the purchasing power of farmers fell, fertilizer use declined precipitously from close to 800,000 tons total in 1989 to less than 200,000 tons in 1996. Mechanization also declined, although not so dramatically. On the livestock side, the effects of subsidy removal were exacerbated by the fact that the privatization process put many animals in the hands of farmers who were ill-equipped to care for them, resulting in a rapid reduction in the herd. The adverse effects of these internally generated supply-side disruptions were magnified by sharp drops in demand for agricultural products. These were due to declines in both domestic and external demand. First, the per capita consumption of major food and agricultural products, especially meat consumption, declined significantly (Figure 7.3) as the purchasing power of the population declined. Chapter VII: The Agricultural and Food Sector 119 Figure 7.3: Change in per capita food consumption: 1989-98 10.0%- 4.7% 0 8% 0.5% 0.0% -8.8% I -2 0 .0 % - -- - - -- - - - - - - - - - - - - - - -- --- - - - - - - -30.0%Y ------- -- ------ -258 8%--- ---- - 25.3% -40.0% -36.9% -38.3% Source: NSI, 1998 and 1999, European Commission, 1998. Second, agricultural exports plummeted at the beginning of the 1990s, as the traditional trading relations within the CMEA disintegrated. As a whole in 1991, exports were about 21 percent of their 1989 value, and exports to the former CMEA markets fell from 79 percent of the total in 1989, to 57 percent of the sharply diminished total in 1991. While exports have begun to recover, the share to formner CMEA economies has continued to decline. Bulgaria has been particularly hard hit by the collapse of the Russian market after the financial crisis. Given the strong ruble devaluation and floating exchange rate regime, which makes imports very expensive in Russia now, it is doubtful that Bulgarian exports will be competitive in this market in the foreseeable future. On the whole, however, Bulgaria has been the only CEEC other than Hungary able to maintain a net agricultural exporting position. The total positive balance of food and agricultural trade amounts to about US$300 to US$400 million annually (Figure 7.2). STATUS OF SECTORAL REFORMS After the collapse of the socialist system in 1989, the new government introduced a sweeping program of economic reform. This program included the transformation of agriculture based on the principles of ownership of land and other agricultural property. The aim was to create a market-oriented and internationally competitive agricultural sector. The reforms have made great progress, although several major tasks remain unfinished. The most important implemented reform measures generally fall into three categories: * the creation of a macro-framework and incentive system for producers, processors, and traders consistent with the requirements of a market-based food and agriculture system; * the privatization of the major means of production, both in primary agricultural production and in agro-processing and input supply; and * the changes in institutions and regulations to enhance the functioning of markets. 120 Chapter VII: The Agricultural and Food Sector MARKET CONFORMING POLICY FRAMEWORK WITH LIMITED GOVERNMENT INTERVENTION Pricing and trade policy Bulgaria's trade regime was characterized by tremendous instability after 1991, when import and export licensing requirements were removed for most products (with significant exceptions, especially in agriculture) and private and state trading organizations were allowed to import and export without special permission. This early liberalization notwithstanding, non- tariff trade policy measures were used intermittently by government until 1998. Unstable policies especially affected grains, oilseeds and their derivative products. From December 1995 to September 1997, basic regulations governing licensing exemptions and bans were changed no fewer than 25 times. This created severe impediments to market entry and investment, with private firms understandably viewing any favorable policy change as temporary. As direct control mechanisms used under central planning were reduced during the 1990s, there was a tendency to use trade policy for very detailed, short-term intervention aimed at micro-managing domestic supplies and prices. Instruments for implementation of this policy included automatic and non-automatic licenses (import and export); export quotas, taxes and bans; minimum import and export prices; and duty free import quotas. Pricing and trade policy during the transition was driven by a preoccupation with providing low-priced domestically produced food for the urban population. The mechanism for implementing this policy-the "material balances" approach-in some important respects resembled that of central planning. Prices of important food products were set by the Government. Domestic consumption was estimated, and at a time when the forthcoming harvest could be forecast, the projected domestic consumption was compared to the quantity to be harvested. Any excess of supply over consumption was considered surplus to be sold abroad. Export licenses could then be issued up to this quantity. If it appeared that there would be a deficit that would need to be met with relatively high-cost imports, the government would sometimes issue licenses for duty-free imports within a quota equal to the size of the projected deficit. Trade controls were reinforced by price controls. While the formal price control apparatus went through a number of changes (in products covered, as well as in mechanics of operation) between 1989 and 1996, the goal was always to keep food prices low, and so agricultural products were always among the products covered. Products which were not expected to be in short supply were monitored through the "automatic licensing" regime, which was less burdensome than the "non-automatic licensing," but which nonetheless served as the means by which the government would collect information to decide if or when products should be transferred back to the non-automatic licensing regime. Producer prices of the major crops were held by this system at levels far below those that could have been received in a liberal trading environment. A World Bank mission conservatively estimated that price and export controls and taxes on wheat alone cost farmers US$457 million in the 3-year period from 1994-96. The large gap between world and domestic prices also generated huge incentives to evade the export controls, and led to extensive corruption and illegal exports. Chapter VII: The Agricultural and Food Sector 121 Since the 1996 crisis, however, the Government has made steady progress in liberalizing trade in agricultural products. All licensing requirements (automatic and non-automatic) for exports and imports of agricultural products and livestock have now been removed82. The Government has also discontinued the practice of allowing duty-free imports within quotas of food items projected by the "material balances" calculations to be in temporary short supply. Elimination of the automatic licensing regime is significant because it lends credibility to the Government's commitment not to undertake ad hoc interventions as in the past. Without the information from the license applications, the Government will not be able to monitor ex ante83 trade in these items. This will in turn reduce the ability-and temptation-to micro-manage. This credible commitment will reassure farmers and traders that they can make decisions based on market fundamentals, without worrying about ad hoc changes in trade policy. The export taxes that were imposed on grains and oilseeds when they were removed from the non-automatic licensing regime have now been phased out. In addition, other long-standing export taxes (wool, hides and skins and live animals) have been removed. Thus, no export taxes remain on agricultural products, consistent with the Government's commitment to develop an open, export-oriented economy. The Government has also abolished the contract pricing system, which was the last vestige of price controls, so prices are now freely determined between buyers and sellers in the market. In addition, the government has taken steps to expand farmers' access to imported inputs. One such step is the reduction of the tariff on fertilizer imports (formerly 40 percent) to 35 percent in 1999. Fertilizer imports, 249,000 tons in 1992, fell to around 33,000 tons in 1995 and 39,000 tons in 1996. While there are inconsistent data on total fertilizer use, it is clear that use has fallen significantly during the 1990s. Fertilizer prices in Bulgaria have been very high. While there are multiple causes of the high price of fertilizer and reductions in its use and imports, the 40 percent tariff-intended to protect domestic manufacturers-has certainly been a contributing factor, so its reduction will provide significant benefits for farmers. The government has implemented a further reduction in the tariff to 25 percent in 2000 and committed to bringing it down to 20 percent by 2002. The government is also expanding farmers' choices of seed varieties by adopting the EU's Common Catalog of Seeds. Any variety approved for use in any EU country is automatically incorporated into Bulgaria's list of varieties allowed to be imported. This action has already been put in place by ministerial decree and will be made permanent by the new seed law, which has been adopted by Parliament. Bulgaria joined the World Trade Organization on January 1, 1997. Its levels of bound tariffs on agricultural products are, in general, rather high relative to those of other CEECs and those of developed countries, including the EU, according to an Organization for Economic Cooperation and Development (OECD) evaluation of bound tariff rates. Applied Bulgarian agricultural tariffs are high in comparison to those on industrial imports, though close to those in the EU. For primary agricultural production, current tariffs on an import weighted basis are 24 percent, or twice the level obtaining for industrial tariffs. (This is higher than the Czech and 82 It makes sense to maintain controls on wood exports as a conservation measure for a natural resource with uncertain ownership rights until clear ownership is established or a stumpage fee system can be put in place. 83 Of course, the Government will still receive the same statistical information on trade flows on these items as it receives for other products from Customs data. 122 Chapter VII: The Agricultural and Food Sector Slovak Republics and Slovenia, though lower than Hungary, Poland, and Romania). This level of customs protection is planned to be reduced gradually down to 22 percent by January 1, 2001 and subsequently down to 20 percent by January 1, 2002. The highest protection among primary products is afforded to meats (especially poultry), vegetables and fruit. Among processed food products, protection is very high for vinegar, dairy products, fernented beverages and alcohol, frozen and preserved vegetables, meat preparation, sugar, chocolate, and vegetable oils. The tariff schedule shows a strong cascading pattern, with higher tariffs on finished and processed products than on primary products. One implication of cascading is the higher protection it affords to domestic processors, relative to primary producers. However, for the most important primary products, the level of import tariffs is not relevant, since Bulgaria is self-sufficient or an exporter. The actual prices producers receive is for most products closely aligned with world market prices, more so than in other transition economies, or the EU. A product-by-product comparison of world prices with domestic prices shows a nominal protection rate of only 2 percent averaged across crops and livestock products, and an average effective rate of protection84 of only 4 percent (Table 7.2 and Figures 7.4 and 7.5). A few products, including milk, show high rates of protection. The computation of rates of protection depends on adjusting prices for quality when comparing domestic and border prices. The computation depends on adjusting prices for quality when comparing domestic and border prices. This adjustment is especially tricky for a product like milk, which is hardly traded in its unprocessed form, and for which the quality of the Bulgarian product, e.g. in terms of germ and bacteria content, is generally considerably below international standards. 84 The nominal rate of protection compares domestic output (product) prices to world prices of the same products. The effective rate of protection compares value-added at domestic prices to what the value-added would be if producers paid world prices for inputs and received world prices for their products. Chapter VII.. The Agricultural and Food Sector 123 Figure 7.4: Comparison of Nominal Protection of Selected Agricultural Outputs Wheat Beef/Cattle Pork Milk 100 - - _-l 25 - - -- ----- o_ t r l _ =r _ ~~~~n ..r_ +L.re1 -25 -50 * Bulgaria U Estonia O Germany 0 Lithuania 0 Poland 0 Romania O Russia 0 Ukraine Note: Results for Bulgaria: 1998, other results: 1997. Source: Valdes (ed.), 1999; Csaki, Valdes and Fock, 1998; Valdes and Kray, 1999; own calculations Figure 7.5: Comparison of Effective Protection of Selected Agricultural Activities Wheat Beef/Cattle Pork Milk 350 - 300 -- - - - - - - - 2 5 0 -- - - - -- - - - - - - - - - - 200 -- - ----- -- 150- I100- 50 I -500 -10 - - --_ _ _ _ _ _ _ ___ i* Bulgaria U Estonia 0 Germany a Lithuania El Poland El Romania a Russia El Ukraine Note: Results for Bulgaria: 1998, other results: 1997. Source: Valdes (ed.), 1999; Csaki, Valdes and Fock, 1998; Valdes and Kray, 1999; own calculations 124 Chapter VII. The Agricultural and Food Sector Remaining interventions Compared to most other CEEC economies, the Government of Bulgaria has a very limited intervention program in agriculture. There are, however, two ways in which the government intervenes that may impede the transition to a competitive market economy. One is its direct involvement in the tobacco sub-sector. Tobacco is a sensitive crop for Bulgaria because of the number of farmers employed in its cultivation (approximately 10 percent of the active population), the tolerance of tobacco for less fertile lands, and the share of tobacco in exports. A State body-the Tobacco Fund-registers all tobacco growers and supports the registered tobacco producers by paying a cash premium and providing tobacco seeds free of charge. The premium is set as a percent of the minimum purchase price. The value of the premium is approved by the Council of Ministers. The aim of the policy of support is to regulate the quantities produced according to the domestic and international demand as well as the implementation of the social policy in the regions where tobacco growing is the main source of income. Production quotas are allocated to growers by municipalities. Tobacco processing and marketing are handled by a state-owned holding company, Bulgartabac (and other smaller registered companies). This company is in the process of privatization. Along with this privatization, the Government needs to develop a plan to withdraw from direct intervention in this subsector, and allow prices and production to be more market-determined. The second type of problematic government intervention is the directed, subsidized credit program of the State Fund Agriculture (SFA). It was established in 1995 based on the Law on Support of Agricultural Producers and began operating in early 1996. SFA is a legal entity with its own budget, which is subject to annual approval by the Council of Ministers of the Republic of Bulgaria upon proposal of the Minister of Agriculture, Forestry and Agrarian Reform. SFA's main activity has been to provide funds directly to farmers, using commercial banks as agents. The amount lent has been substantial (up to 2-4 percent of agricultural GDP). The types of schemes financed vary from year to year, but they have included a seasonal credit facility financing inputs for wheat, maize and sunflower production (with a 50 percent interest subsidy); direct loans per unit area for the same crops; and 70 percent interest subsidies on targeted investment loans approved by a council of experts under the SFA. The SFA budget for 2000 includes BGN 50 million ($27.8 million) for long-term investment loans and BGN 30.0 million ($17.0 million) for short-term credit. Some of these schemes have been distortive not only through their interest subsidies, but also due to other regulations set by the program. For example, wheat producers receiving credit under the input-financing scheme at planting were obliged to sell wheat to mainly state connected companies designated by the SFA, at contract prices negotiated before planting. This requirement limited development of a wheat market still heavily influenced by the marketing agency Zameni Hrani and state millers. A 260 billion leva loan guarantee scheme in 1997 was designed to guarantee loans extended by commercial banks to purchasers of the wheat crop. The state served as ultimate guarantor of loans to purchase from farmers at the official guaranteed price. Along with this scheme, the government also introduced a high official purchase price and an export tax. While a large number of commercial banks were involved in intermediation of the loans to purchase the crop, final borrowers were limited to Zameni Hrani and another twenty state purchasing companies and mills. This allocation pattern was an additional blow to Chapter VII. The Agricultural and Food Sector 125 development of a competitive wheat market, since it effectively excluded the private trade. In the aftermath of this scheme, banks are still reluctant to make any loans for purchase of harvest. The SFA's short-term loans are not in the long-run interest of farmers. First, the regulations and requirements are quite specific. Besides the transaction costs involved in the administration of such scheme, it is also distortive by favoring certain groups of farmers and certain crops over others, supporting the role of existing input suppliers, etc. Moreover, specific regulations also give incentives to farmers to change their production activities in a way that is not in line with improving the sector's overall net income/welfare contribution. Second, the short-term loans are competing with potential credit lines of commercial banks. Banks might generally be interested in short-term lending, which is relatively less risky than long-term credit in unknown markets and for unknown clients. However, they will continue to channel their own money to urban areas or even abroad, as long as they have to compete with subsidized credits. In recognition of these problems, the Government has committed itself to phasing out these short- term credit lines. This is an important step in the reform program. In addition to the short-term credits, the SFA also has a number of longer-term investment credit lines. Recently, another instrument was approved for guarantees to commercial banks for credits extended to agricultural producers for the purchase of land. The maximum amount for such a credit is 100,000 BGN, covering up to 90 percent of the amount of the requested credit over a maximum maturity period of 60 months. This guarantee is the collateral for the commercial bank that gives the loan, while the SFA takes physical collateral in the amount of 130 percent of the guaranteed amount. Evaluation of the net impact of long-term credit on credit access of farmers is more difficult than for short-term credits, since banks are making very few long-term loans, even in sectors where there is no crowding out by state lending. This indicates that the SFA credit is not as likely to crowd out the private sector in this market. Furthermore, some important steps have been undertaken to reform the SFA's investment program (including requiring annual repayments of at least principal, rather than lengthy grace periods) so that the adverse effect on the credit market is minimized. Nonetheless, most SFA programs do not encourage commercial banks to start lending to agriculture. For these reasons, and to bring policy into conformity with the EU, the investment program of SFA also needs to be further reformed. The state should focus on technical assistance to ensure that alternative private financial agents will fill the gap as the SFA's programs are reduced. The Government needs to develop a strategy to promote alternative private financial mechanisms, such as equipment leasing, mortgage credit, and other long-term credit sources common in developed markets. A concrete reform agenda for SFA is suggested below. The agenda in rural financial policy must not exclude the small-holders, which will continue to constitute a substantial part of the rural sector for some time, though their numbers will dwindle as land consolidation proceeds. For these farmers, credit coops appear to be a more feasible source of credit than commercial banks. However, credit coops have their own shortcomings in many countries (having to do, among other things, with incentives to exercise 126 Chapter VII: The Agricultural and Food Sector insufficient caution in lending to members), and the legislative framework needs to be designed with care to avoid these problems in Bulgaria. Thus, the rural finance policy agenda should be a two-track one: ensure that there are no barriers to emergence of a commercial credit sector based on commercial banking, while at the same time putting in place an appropriate legal framework for coops to service the small-scale farmers. This should be supplemented by actions to encourage development of alternative types of credit norrnally available to farmers in developed market economies, including through input suppliers, upstream processors and equipment leasing companies. INCOMPLETE TRANSITION IN THE FARMING SECTOR Bulgaria began the transformation of its agricultural sector early on in the reform process. The country opted for physical restitution of expropriated property, including agricultural land, as well as the distribution of collective farm assets among the members. The initial phase of restitution and restructuring and privatization of large-scale collective and state farms is nearly completed. The outcome of this process has been a very fragmented structure of land ownership with a mixed and still evolving farming structure dominated by a large number of small private family farms, and the successors of former collective enterprises. The period of land reform has been rather difficult and painful for the Bulgarian food and agriculture sector. Due to the specific procedures used to privatize state assets and restitute private ownership, the relative instability of the overall economy, and the crisis in the Russian market, there has been more disruption in the farming sector in Bulgaria than has occurred in many other Central and Eastern European countries. Several important components of land reform and farm restructuring were not fully accomplished by the end of 1999, such as full land privatization and farm restructuring; creation of functioning land and lease markets; and conditions for farm consolidation. These all must be completed to achieve a viable farming structure under EU conditions, and steady progress continues, as described below. The settlement of land ownership issues in Bulgaria was undertaken within the land restitution process and the privatization of the state farms. The process of land restitution started in 1991, and was based on the Law on Ownership and Use of Farm Land (LOUFL). The implementation, which is being managed by the Municipal Land Commissions, operating under MAFAR, started with the registration of claims (including a decision by the MLC regarding the recognition of ownership claims), the re-establishment of ownership based on old boundaries or through agreement on a reallocation plan, and finished with a certification which could be used to register ownership. Restoring former ownership rights to the status of fifty years ago, when neither the corresponding structures of production, nor proper records of the previous boundaries exist, was a costly, labor-intensive, and complicated exercise. Restoration of the old boundaries has been impossible in most cases. The attempt to provide an acceptable replacement for the claimants often ended in a court debate. The task is further complicated by the fact that the original ownership is restituted in the first phase to the initial owner. Most of these owners are deceased and have a variety of heirs, which results in time-consuming inheritance debates. The restitution process has been further complicated and delayed by the frequent amendments to the LOUFL, Chapter VII The Agricultural and Food Sector 127 which has been amended 25 times since its inception. It is not surprising that the restitution of private land ownership, which began in 1991, is still not fully implemented. The current government has put a high priority on the Figure 7.6: Structure of the private agricultural completion of land restitution. enterprises according to the size of their arable land Among other actions, it has increased resources devoted to this l- -0.2 effort and has eliminated the fee for issuance of notarial deeds. It 8.8 has also eliminated all taxes on . ..l land transactions. These steps have paid off in an acceleration of8 the process, so that by the end of 14.41 1999, 95 percent of land subject to restitution was returned to the original owners (almost 100 66.7 percent by the end of 2000), although critical ownership issues, 6 as well as proper titling, are far -5-10ha from resolved. About 39 percent 02-Sha of the land subject to restitution 01-2ha has been titled, either through a ;015-1 ha formal titling process or through a - 0.2-1.5 h decision of the Land Committees, 40% >02ha which (under amendments to the law of 1999) have the power of notary deeds. However, much of this land must still be divided 77 51.5 among heirs before it is titled to individual owners. The completed 20%. restitution will result in a rather 80 fragmented ownership. After the completion of the process, Bulgarian agricultural land will be owned by around 3 million (or by some extreme estimates 5 million) 0% people. Looking retrospectively percentage of land percentage of farms at the process of restitution in cultivated by farms with a size of ... ha Bulgaria, the complicated process of ... ha itself, and the changing political S attitudes toward restitution, Source: NSI resulted in a much lengthier and disruptive land settlement process than occurred in most other Central European countries, which did not try to return land to the original owners but rather used other forms of compensation. 128 Chapter VII: The Agricultural and Food Sector Bulgaria's current farming structure, which is highly dichotomized, requires further restructuring. On the one hand are individual private farms which dominate land use. Inside the category of individual farms there are a large number of small subsistence farms belonging to mostly older people. Over half the farms have a size less than 0.2 ha. (Figure 7.6). On the other hand, there is a smaller, but significant number of commercial farms that are managed by younger and more educated people. Only 4.1 percent of farms are over 5 ha, but these comprise over 70 percent of the arable land area in agriculture. Considered from the point of view of organizational type, about one-third of agricultural land was still used by relatively large-scale, often private, nominally restructured collective farms in 1997. There are a significant number of commercially and non-commercially oriented so-called "private cooperatives" and a few private agricultural companies. On the other hand, hundreds of thousands of small farmers and other private farming organizations cultivate about 45 percent of agricultural land. About 20 percent of agricultural land, mainly pastures, is still in the hands of the state and local municipalities (Table 7.1). Over 94 percent of arable land was in the hands of private farmers and cooperatives, and only 6 percent was in state and municipal government use. By some estimates, about one quarter of the agricultural land has remained uncultivated altogether in the various farming categories. Table 7.1: Farm and Land Use Structures (1997) Farm Type No. of Land Average Share of Arable Pastures* Units Size Size (ha) Agric. Land Land* (percent) ('000 ha) p(percent) (percent) State & municipal 493 1,259.2 2,554.2 20.3 5.7 70.1 Cooperative 3,475 2,158.6 621 34.8 42.4 13.6 Individual & farm companies 1,778,495 2,785.2 1.6 44.9 51.9 16.3 Total 6,203.0 100 100 100 * 1996 figures. Source: NSI. LARGELY PRIVATIZED, BUT INTERNATIONALLY NON-COMPETITIVE AGROPROCESSING INDUSTRIES In the past, state enterprises have dominated Bulgaria's economy. The country has built up a sizable agro-processing industry to transform the surplus of Bulgarian agriculture into products that can be exported. A range of state-owned food plants were established around each of the larger urban centers for processing the local agricultural production. These plants, in addition to satisfying domestic demand, produced goods for export, primarily to the Soviet Union and other markets in the socialist countries. As a result of this policy, a large over- capacity of agro-processing remains compared to the current output of primary agriculture. Lack of investments during the 1980s and 1990s has left most of these plants with outdated equipment; most of which is now in a poor state of repair and ill-equipped to meet the challenges of a competitive market. In many instances, the quality and range of products they are able to offer are poorly suited even for the less demanding Eastern European market. Unit costs of agricultural raw materials appear to be low in comparison with other countries. Notwithstanding these low raw materials prices, inefficiencies in processing and marketing often result in a finished product cost that is relatively high in relation to quality. Consequently, Bulgarian agro- processors have lost most of their markets, even inside the Eastern Bloc. At the same time, Chapter VII: The Agricultural and Food Sector 129 domestic food consumption has also decreased significantly. It is not surprising, therefore, that the utilization of current agro-processing facilities is at the level of 30-40 percent of technical capacity. The privatization of the sector began in the early 1 990s with the sale of the less politically sensitive enterprises. Progress in the government's overall privatization program was very slow until 1997. From 1992 to 1997 only 18 percent of long-term assets were privatized. (A firm is defined as privatized when at least 67 percent of its shares are privately owned). The pace of privatization increased from 1997 onwards. Progress was still hampered by valuation procedures that sometimes led to the setting of unrealistic minimal bids, and by slow procedures for reducing these. Demand for the assets has been low partially because of the generally depressed state of the economy. The result of both these factors was that many agro-industrial assets did not attract bidders when put initially into the privatization program. However, recent privatization policies introduced several changes in legislation and thereby addressed key issues and obstacles to privatization. These include amendments to facilitate writing off the debts of companies, better division of responsibilities between the Privatization Agency and the branch ministries, limitations on the preferences given to management-employee buyouts, and changes in the treatment of investment vouchers. The result is very positive, and at the end of 1999 privatization in agro-processing is close to completion (as of September 30, 1999, 88.9 percent of the assets of the food industry were privatized). Under the privatization process, an open, liberal policy has been applied toward foreign investors. Though there are no significant restrictions on foreign investments and there is a freedom to repatriate profits, the privatization process of agro-processing in Bulgaria has attracted relatively modest foreign investments. Bulgaria is lagging far behind other Central European countries in agri-food FDI (Figure 7.7). Figure 7.7: Cumulative Stocks of Agri-Food FDI in Central and Eastern European Countries in 1997 3.5~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 3.5 - . - 3c15 -- -__'_.,~- -_'--__- C 0 1.5 -- --- ---L---- __ ___ < t ?8 , / +e9 1P' \lb .\l 'lbso Source: OECD. 130 Chapter VII. The Agricultural and Food Sector With the exception of a relatively small number of domestic and foreign owned companies, the agro-processing industry shows signs of serious operational difficulties after privatization. A large number of companies were privatized without appropriate financial consolidation. The new owners, in many cases, lacked financial resources for investments and product improvement. There are significant difficulties with corporate governance, especially in companies owned by employees or investment funds. A significant number of enterprises are near bankruptcy. As a result, the inherited, over-sized, technologically outdated plants work with low level of capacity utilization and efficiency. In this condition, the agro-processing industry is not able to be the engine of the agricultural development in the country. AGENDA FOR CONTINUING SECTORAL REFORMS: CRITICAL ISSUES FOR Eu ACCESSION Proper response to the evolving CAP One critical issue the govermment must decide is when and how to transition to the CAP. The task of evaluating policy options for Bulgaria on its way to EU accession would have been considerably easier if one could anticipate more precisely what EU agricultural policies will be at the time of Bulgaria's accession. A simulation approach was used to analyze the potential costs and benefits of the most relevant policy options for Bulgaria to consider for the pre-accession period. For the twelve activities selected for analysis (wheat, barley, maize, sunflower seeds, tomatoes, potatoes, grapes, milk, beef, pork, poultry, and eggs), the simulation approach identified and quantified the potential impact under each scenario on producers' value-added (farm income), consumers' real income, and on the state budget. Table 7.2 and Figure 7.8 provide a summary overview on selected results. They have been obtained from simulations carried out for four different policy scenarios: Scenario A: Maintenance of the current liberal trade and market policy (this scenario will also be referred to as 'base-period scenario'). Scenario B: (Rapid) Partial adoption of current CAP, without (Scenario B1) or including (Scenario B2) compensatory payments Scenario C: Adoption of CAP Agenda 2000, without (Scenario C,) or including (Scenario C2) compensatory payments. Under this scenario, Bulgaria rapidly adopts the final price levels projected in Agenda 2000 for output levels assumed to be eligible under future CAP regulations. In general, the Agenda 2000 regime includes support prices closer to world market levels. Scenario D: Complete removal of current divergences from world prices. Although abstracts from product specifics, it shows the main results of the analysis. First, it shows that the overall level of distortion in Bulgarian agriculture is currently low. Although the aggregated protection measures of 2 percent (NRP) and 4 percent (ERP) are partly caused by compensating effects of higher product specific rates of protection, they nevertheless indicate a policy and market environment, which is, from the overall welfare point of view, favorable compared to most other CEEC. Hence, a full elimination of all remaining distortions (Scenario D) has only little effects: value-added of producers decreases only marginally from Euro 565 million to Euro 544 million; expenditure on food by households would decrease from Euro 2,105 million to Euro 2,067 million. Chtapter VII. The Agricultural and Food Sector 131 Table 7.2: Summary of Simulation of Effects under Policy Scenarios Scenario A B1 B2 C] C2 D A2000, A2000, Current CAP, excl. CAP, incl. excl. dir. incl. dir. Non- policies dir. paym. dir. paym. paym. paym. intervention EU Agricultural Policy Effects on Agricultural Producers NRP, main products' percent 2.1 38.2 38.2 22.8 22.8 0.0 ERpa,b percent 3.9 31.8 107.0 11.7 100.8 0.0 Gross output valuea M E 1,687 2,242 2,652 2,006 2,491 1,575 VA at domestic prices'a MEI 565 717 1,127 608 1,093 544 VA at border equiv. Pricesa M E 544 544 544 544 544 544 Change in VA at domestic pricesa MIF - 152 561 43 528 -21 EU Agricultural Policy Effects on Households Expenditure on foodc MEI 2,105 2,312 2,210 2,067 Change in food expenditurec MEI - -207 -105 +38 Change in real income percent 0.0 -5.1 -2.7 1.0 EU Agricultural Policy Effects on Taxpayers Change in expenditures M E - -32 -22 Direct payments ME' - - 409 - 484 Other Transfers Structural Funds ME - 1897 Cohesion Fund M E - 372 Bulgaria's contribution to EU budget M E - 110 aaggregate measurement for all analyzed products (incl. direct payments where applicable). baggregate estimate is a weighted average of the product-wise indicators ' including non-alcoholic beverages Source: own calculations. Second, the results reveal that the effects of introducing EU agricultural price and market policies would have considerable effects on all economic agents involved. For the income of producers, the difference between whether direct per hectare and per animal subsidies will be applied to Bulgarian agriculture after EU accession is of greater importance than the difference between current CAP type and Agenda 2000 type policies. Quite interestingly, the most likely option, an adoption of Agenda 2000 policies, has only limited effect on Bulgarian agricultural producers, if no direct subsidies are implemented. Value-added increases only by 8 percent from Euro 564 million to Euro 608 million. However, transfer of direct payments imply an increase by 93 percent to Euro 1,093 million, a value which is even higher than that simulated for the current CAP option without direct subsidies (Scenario B2). In general, cereal producers would benefit most from the introduction of EU type agricultural policies. Producers of milk and most other livestock products, on the other side, still need to invest considerably to improve efficiency and product quality before they can greatly benefit from EU accession. In interpreting the results, it is important to remember that the higher value-added at domestic prices shown under the scenarios B and C are due only to the artificial increases in 132 Chapter VII.. The Agricultural and Food Sector prices from the support policies, which represent transfers from consumers and taxpayers to producers, not actual increase in real production. True value-added (reflecting the value to society as a whole) does not change, and is reflected in Table 7.2 in the row "VA at border equivalent prices." Figure 7.8: Selected Results of Simulations of Alternative Policy Scenarios 2 ,5 0 0-- - - - - - - - - - - - --- - -- - - - --- - - 2,000 - - - x h 1,5 00 -- - - - - -- - - -- - - -- - - 1,000 -------- 500- 0 Scenario A Scenaio BI Scenario B2 Scenario Cl Scenanio C2 Scenario D (ERP 401%) (ERP 32%) (ERP 107%/6) (ERP 12%) (ERP 101%) (ERP 0%) * Aggregate gross output value of analyzed activities (miTfion E) *Aggregate value added under scenario (million ) ' Aggregate household expenditure on food (million Q) Source: own calculations. While agricultural producers would gain from the implementation of EU type agricultural policies, consumers would clearly lose due to increased food prices. In the case of an adoption of the current CAP, households would face a loss in real income through rising food expenditures by 5.1 percent on average. Even under Agenda 2000 Scenario, food expenditure would increase from currently Euro 2,105 million to Euro 2,210 million, corresponding to a loss in real income of 2.7 percent on average. Due to their higher percentage of food expenditure, poor people are hit hardest by the increase of food prices. Table 7.3: Impact of Scenarios on Poverty Share of poverty in population Number ofpoor citizens a [percent] [million] Poverty line I Poverty line 2 Poverty line I Poverty line 2 Current situation cenario A: Base-run 20.0 36.0 1.66 2.98 Inelastic demand response Scenario B: Current CAP 24.8 40.7 2.05 3.37 Scenario C. Agenda 2000 22.3 38.3 1.84 3.17 Scenario D: Non-Intervention 19.6 34.9 1.62 2.89 Elastic demand response Scenario B: Current CAP 23.5 39.4 1.94 3.26 Scenario C: Agenda 2000 21.7 37.7 1.80 3.12 Scenario D: Non-Intervention 10.4 35.2 0.86 2.91 a Total population 1998: 8,283,200. Source: World Bank (1 999b), own calculations. Chapter VII: The Agricultural and Food Sector 133 According to the 1997 higher poverty measure approximately 3 million people of the total population (8.3 million) were assumed to be poor. Our results show that an introduction of CAP-type policies increases the extent of poverty.85 As expected, the increases in relative poverty are more pronounced under the Scenario B (Current CAP) than under Scenario C (Agenda 2000). Applying the higher poverty line, a rapid adoption of current CAP price support schemes would increase the share of poor inhabitants to 40.7 percent (compared to 36.0 percent at current, i.e. base-run, conditions), which corresponds to an absolute increase of 392,000 people. The introduction of Agenda 2000 price schemes would increase poverty by 190,000 people to 38.2 percent. Since consumers will be able to adjust their consumption patterns to the altered food prices over time, we also included the assumption of an elastic demand response to the analysis. As expected, the increase in poverty under this assumption is more moderate but still significant. Under the Current CAP, poverty would rise (by 282,000 people) to 39.4 percent and Agenda 2000 prices would translate to an increase (by 141,000 people) to 37.7 percent poor. Comparing the growth of poverty between the two 'poverty groupings' as established by the two different poverty lines (high and low), it is clear that the increases of poor people falling under the lower poverty line are more pronounced in both CAP-type scenarios. This clearly underlines the more negative impact on the 'very poor' parts of the population by CAP-type pricing policies. A further removal of all distorting market influences (as simulated in Scenario D) would reduce the share of poor people to different degrees. Assuming no demand response, the share of poverty would decline to 34.9 percent, when applying the higher poverty line. Using the lower poverty line, only a marginal decline in poverty would be realized. Under the assumptions of an elastic demand response, which is the more likely case, the share of poor population would decline to 35.2 percent, when applying the higher poverty line. In comparison the results for the lower poverty line are much more striking - here the extent of poverty would be reduced to 10.4 percent (from an initial 20 percent) or by 800,000 people (from an initial 1.7 m people). This result clearly indicates that the very poorest shares of the population would benefit most significantly by a removal of current distortions in the pricing of food products. The third group of economic agents that would be affected by adoption of EU-like policies are taxpayers. First, they would face some additional costs due to reduced tariff revenues and the payment of export subsidies. However, under the baseline assumption the costs are relatively low. More importantly the state would have to pay the direct subsidies to producers - in case they would be implemented in Bulgaria before accession. This amounts to Euro 409 million and Euro 484 million for the current CAP and Agenda 2000 scenario, respectively. After accession, financial solidarity in the EU would transfer the financial burden from the national Bulgarian budget to the EU. The scenarios discussed above are made under assumption that there is no response from producers and consumers in terms of how much to produce or consume, respectively. However, at least in the medium- to long-term, economic agents can and will decide to adjust their behavior according to price changes. This is modeled in sensitivity analyses based on simple assumptions for demand and supply elasticities. Clearly, under such condition, the benefits for 85 The simulation results take into account only the impacts of food price changes, it does not account for further transfers to/from consumers in an EU integration environment. 134 Chapter VII: The Agricultural and Food Sector producers from EU accession are considerably higher, the welfare losses for consumers are lower than those discussed above. The extra burden, e.g. due to increased eligibility for direct subsidies, the additional need for export subsidies, etc., would have to be bome by taxpayers. Second, administrative costs of EU policies are neglected, but can expected to be quite substantial. Moreover, when interpreting the results, it should not be forgotten, that, even if due to financial solidarity, most of the fiscal burden will be paid by the EU, and not by Bulgarian taxpayers, inefficiencies through misallocation of resources caused by price distortion, would decrease overall benefits and increase overall costs to the Bulgarian economy. In addition to the effects due to implementation of EU type agricultural policies, the analysis discusses additional transfers due to Bulgaria's EU accession. shows the estimated gains of Bulgaria from structural and cohesion funds based on the simplifying assumption that criteria similar to those applied for current EU members today would be extended to accession countries. This results in gross benefits of more than Euro 2 billion. However, these results are quite abstract, since Bulgaria, like any other accession country, cannot expect to get transfers above 4 percent of its GDP or roughly Euro 500 million. Bulgaria also would have to contribute to the EU budget. Estimates based on its current GDP and VAT show transfers from Bulgaria to the EU in the amount of Euro 110 million. Bulgaria currently has an aggregate level of support for agricultural production which is quite low compared to the EU and to many of its regional neighbors. While this creates difficulties for farmers, it is part of a sensible macroeconomic policy framework which has been the cornerstone for Bulgaria's economic recovery from the depths of the 1996-97 crisis. In evaluating the effects of this policy, it should also be kept in mind that in the past, some farmers-especially grain producers-were heavily discriminated against, as grain prices were kept artificially low by administered prices and export taxes and controls. These farmers are better off than before. It is also important to recognize that this current low level of support will ease the adjustment to the CAP framework, regardless of what the CAP policies are at the time of accession. Farmers will be able to adjust more easily to higher levels of support-if CAP levels indeed turn out to be higher at accession-than they would be able to adjust to lower levels, if support in Bulgaria were increased now, and then had to be reduced to harmonize with the CAP as it evolves in the pre-accession period. The low support levels will force Bulgarian farmers to try to increase their productive efficiency, but they will be able to do so only if given a proper institutional environment, a well-functioning overall economy, and access to investment resources. But in any case, the high cost to consumers and taxpayers argues against an attempt to rapidly adopt CAP-like policies, as does the uncertainty regarding the CAP's eventual shape. Bulgaria's optimal agricultural policy strategy therefore may be to focus on efforts to: 1) complete the adjustment agenda to develop a functional market economy; 2) implement a second stage of institutional reform; and 3) structure its pre-accession strategy, including investments under the SAPARD program, to ensure that preparation is done properly and expediently, as well as using available funds to best advantage. Chapter VII: The Agricultural and Food Sector 135 TRADE AND PRICING POLICY In a very short period of time, Bulgaria has progressed from one of the worst trade regimes in the region to one of the most open. A few actions are still needed to complete the reform program, including: * Adhere to the announced schedule for reducing fertilizer tariffs to 20 percent by January 2002; * Pass laws to allow for automatic registration for seed varieties in the EU Common Catalogue (currently in Parliament); * Revise sanitary, veterinary, and phyto-sanitary licensing requirements for imports and exports, and the associated fee structure to eliminate unnecessary inspections. It is clear that such requirements must be in place, but it appears that as they currently exist, they may place an unreasonable burden on importers, exporters, and even on some producers for the domestic market. A further review of these areas is needed to identify how the burden can be reduced while still maintaining the necessary inspections; * Initiate reforms in the tobacco sector. This is the only product where the Government still significantly intervenes in ways that are not consistent with efficient private sector development. In the medium term, Bulgaria will have to make decisions in regard to harmonization of its trade policy with that of the EU. In agriculture, this will revolve mainly around the question of when to adopt the trade measures (tariffs and export subsidies) of the CAP. The section of this report with detailed simulations of the results of different options for harmonizing with the CAP shows the costs and benefits to different groups of each option. One clear conclusion from that exercise is that rapid implementation of CAP mechanisms would have very high costs for both Bulgarian consumers and taxpayers. For this and other reasons, it would be difficult for Bulgaria to activate these mechanisms before accession. Instead, Bulgaria could place its emphasis on setting up institutions that will be required for CAP implementation, leaving the trade policy and price support measures until the time of accession. Improvements in rural financial policies Availability of investment capital continues to be a constraint on the ability of agricultural and agro-industrial producers to restructure and improve competitiveness. While anecdotal evidence suggests that there may be some marginal improvements in credit access compared to past years, it is clearly not sufficient. Banks continue to demand high collateral (both because of the very stringent prudential regulations they face and because they view agriculture as a risky sector in which they have little expertise), and farmers continue to be reluctant to mortgage their homes, which is the only kind of collateral they have which banks currently consider acceptable. Rural real estate is not in general attractive to banks as collateral. Investment credit lines of SFA are not used because banks are not willing to make what they consider small, high-risk loans for the small margin on these lines. The government should 136 Chapter VII: The Agricultural and Food Sector focus on getting farmers some liquidity for investment capital, but in a way that will attract, and not crowd out, lending by the commercial banks and other forns of financing. The priority actions should be: * Adhere to announced timetable for phasing out SFA short-term credit lines; * Shift emphasis from direct long-term credit to partial risk guarantees in SFA credit lines, at least on a pilot basis. This should require banks to put up their own capital and bear most of the risk of non-repayment to give them an incentive to carry out a careful assessment of each loan, while modestly reducing their risk exposure. The SFA should not place restrictions on what kind of producers are eligible for these loans - this should be left to the banks (this shift is now underway); * Require that risk evaluation of investment projects supported by SFA be exclusively done by banks; * Pass an appropriate law on Credit Coops; * Consider allowing SFA funds to be channeled through Credit Coops on a pilot basis. This may require revising the supervisory requirements for Coops; * Restructure SFA as the paying agency for SAPARD funds (currently underway); * Consider a pilot program to test payment to banks of a fixed fee for SFA loans to first-time borrowers, the size of which would be the same no matter what the size of the loan. (This would cover their fixed costs and remove the current disincentive to even consider small loans to unknown borrowers). The loans should not have other subsidies (interest rate or guarantee). This would require amending the Banking Law; * Improve legal environment for collateral in secured transactions and mortgages, including creation of appropriate legal instruments and registers to which potential lenders could refer to see if the collateral already has been used for collateral on another loan; * Improve legal environment for equipment and machinery leasing. Improvement in irrigation policy Another important aspect of farmer support in Bulgaria is irrigation policy. The irrigation system has broken down to such an extent that only a small part is still useable. The Government is developing a strategy that relies on the formation of Water Users' Organizations to invest in rehabilitation of the infrastructure. This will require that an appropriate legal framework be put into place, and that the Government then quickly proceed with the transfer of ownership of the on-farm and off-farm infrastructure to the WUOs following the European model. Chapter VII: The Agricultural and Food Sector 137 Food security and cereals marketing Apart from general issues in wholesale and retail marketing, the cereals subsector has some unique problems, which are relics of its previous state-dominated structure. While Zarneni Hrani has been dismantled, the existing State Reserve and Wartime Stockpiles Directorate under the Council of Ministers continues to make quite large purchases and sales. The Government has adopted some operating rules that seek to minimize the degree to which the State Reserves interferes with market development, but some further steps would be useful. What is needed is to: * better define the operating rules for the State Reserves purchasing and sales so as to limit their impact on market prices, and make the impact more predictable; * gradually reduce the overall size of the stocks; * shift some storage to private facilities (thereby improving quality of storage and encouraging private warehouse development); * eliminate in-kind grain loans (already implemented). Completion of land reform and land market development The Government has made great progress in restitution of land and issuing of Land Commission certificates with the legal status of titles, and in amending overly restrictive laws governing leasing and sale. Foreign land ownership is allowed, though only through establishment of a Bulgarian corporation. However, there are still two critical sets of tasks to develop a well-functioning land market. Completion of land privatization, creation of legal and institutional conditions for land markets and leasing. This involves: * the creation of a modern land titling and cadastral system that closely links these two functions in a user-friendly way, based on the Land Cadastre and Registration Law, which has recently passed Parliament; * the speedy settlement of land ownership issues and the provision of proper proof of ownership which can facilitate a land mortgage market; * the sale of remaining state-owned land; * the acceptance of land ownership by individual foreign investors; * focusing on and setting targets for individually titling parcels; and * improving the system for collecting and disseminating information on land market prices and on land market transfer procedures to new landowners. 138 Chapter VII: The Agricultural and Food Sector Conducive framework for farm consolidation. The further consolidation of the farming sector involves two major tasks. * Consolidation of fragmented land ownership and consolidation of smaller farms. The creation of viable farming units can be accomplished by consolidating the current small farms. These objectives should be facilitated by appropriate government policies such as liberal land and leasing market regulations and promotion and support of land consolidation (e.g. by facilitating establishment of real estate service agencies to disseminate land market information). * Further transformation of private cooperative farms. There are many indications that cooperative farms in their current state would not be able to cope with the competitive pressure of the EU environment. Their methods of operation and management and their handling of current resources all need to be adjusted to the principles of a market economy. In the medium term, strict profit motivation and hard budget constraints, as well as financial consolidation are essential. A further transformation involving the restructuring of ownership, management and labor is needed, and in many cases the splitting up and diversification of downstream activities is needed as well. Government policies and legislation should facilitate, rather than obstruct, this process. At the same time, the bail-out of insolvent cooperatives through government support should continue to be avoided. Facilitating the creation of marketing and service cooperatives. In developed market economies, marketing and service activities represent the major framework of cooperation among farmers. Western-type marketing and service cooperatives are very rare in Bulgaria, however, they represent a very important instrument in increasing the efficiency and competitiveness of smaller farms. The creation and functioning of these cooperatives should be supported by appropriate legislation (as it is in the new Cooperative Law) and technical assistance. Privatization of remaining state farms. There are still a number of state owned agricultural enterprises. The privatization of these enterprises needs to be completed as soon as possible. Only the very small amount of farm land attached to research and extension offices should remain in state ownership. Foreign ownership of agricultural land. In principle, membership in the EU would require that agricultural land markets be opened to competitive forces from anywhere within the Union. Although current Bulgarian law allows land ownership by foreign-owned companies registered in Bulgaria (which is a step in the right direction), agricultural land ownership by foreign individuals is a rather sensitive issue, as it is in other EU accession countries (other accession countries are proposing long transition periods before their land markets are opened to foreigners.) It is feared that the opening of agricultural land markets could have a potentially very significant negative impact. Right now, agricultural land prices are much lower in Bulgaria than within the EU, and the fear is that opening the markets would result in large parts of the countryside under foreign ownership. This fact could be recognized and Bulgaria might try to negotiate a grace period for the full liberalization of the agricultural land market, following the Chapter VII: The Agricultural and Food Sector 139 example of Austria. However, it is not clear that this is an appropriate strategy. It is doubtful that there would be a large shift in land ownership to foreigners (this negative conjecture has no basis in economic theory or experience elsewhere), and there are several positive effects that could be expected. While it is clear is that there would be a large jump in the price of land, at the higher price some land would be bought by foreigners, but probably much less than is feared. And this increase in land prices would be of significant benefit to Bulgarians. It would give land sellers much-needed cash; for other land owners, it would increase their wealth. For farmers, this would be especially beneficial by helping provide collateral to alleviate the current lack of liquidity. It could jump-start the land market, and it would be more consistent with the basic meaning of property rights in a free society. Accelerated technical and technological development of agro-processing A working and efficient agro-processing industry capable of producing products for domestic and international markets, and efficient rural services, are critical elements for the improvement of the agricultural sector in Bulgaria. Further actions are needed to create independent and private owners of agro-processing who can efficiently control management and bring in additional investments. Priority should be given to promotion of FDI and rural SME development. To achieve this, the following actions should be taken: - complete privatization of all assets in the privatization programs of MAFAR and the Ministry of Economy (including tobacco company assets), except those involved in court actions that prevent privatization; - post-privatization programs, including the revision of initial commitments regarding production and employment, should facilitate the restructuring and consolidation of ownership in the newly privatized processing companies; o the emergence of secondary markets for ownership of agro-processing enterprises should be promoted and facilitated (by, for example, setting up a brokerage or clearing-house until such time as the shares can be traded on a proper stock exchange) including the promotion of foreign investment; * strictly enforced bankruptcy legislation should be used to consolidate the newly established private sector; * the emergence of rural small and medium agro-processing and service enterprises should be facilitated by improved registration procedures and advice; and . licensing and inspection procedures should be reviewed to eliminate unnecessary costs for businesses (currently being implemented). Establishment of new standards for food and agricultural products The quality of food products represents one of the major obstacles to increasing exports to western, and even eastern, markets. The control of food quality and safety, notwithstanding the significant progress made in recent years in Bulgaria, is still based on regulations originating 140 Chapter VII: The Agricultural and Food Sector in the 1970s and 1980s. While a new Food Law was passed in 1999, and a great effort appears to have been made by the MAF in adjusting the whole set of laws concerning food quality, standards, etc., it appears that the enterprises themselves have not benefited from the information, training and assistance to adjust to this new concept of quality management. A substantial educational effort is required in reference to the implementation of the new legal environment. In addition, the government should place high priority on an investment program to strengthen quality control and new food processing techniques incorporating technologies related to quality enhancement and environmental protection. The program could have two major components that would have to be consistent with each other: one for the private sector (agro-industry was recently made eligible for SFA investment credits, which could be used for this, as could SAPARD funds); and one for the financing of the restructured state agencies in office technology, information networks, laboratory building and equipment, etc., as envisaged in the National Plan for Adoption of the Acquis. The institutional challenge of EU membership in agriculture According to the European Council in Copenhagen in June 1993, EU membership requires the institutional ability to fulfill all the obligations of membership. The new member countries, including Bulgaria, have to be able to implement all the rules and regulations, the Acquis Communitaire, of the Union. The establishment of the Acquis Communitaire requires the legal adoption of primary and secondary EU laws as well as the institutional setting for their execution. At the core of EU legislation are the four freedoms (free movement of goods, services, capital, persons). Bulgaria's liberal price and trade approach will assure no difficulties in adopting EU legislation concerning the abolishment of barriers with the EU. At the same time, Bulgaria will face considerable problems in establishing effective customs control for trade with third countries. Since some of its land borders will become EU borders at the point of accession (Yugoslavia is not an EU association country, Turkey will not participate in the current round of EU negotiations on accession) Bulgaria will have some difficulties in effectively protecting its long borders, especially ensuring adequate veterinary infrastructure to manage livestock inspections and control disease. Some measures have been undertaken to this end. More important, there are many more requirements for the establishment of a common and well functioning market than to abolish internal barriers and protect the market at its borders. A wide range of institution building is necessary to meet the rules on competition and tax measures (competition law, improvement of anti-trust and state aid monitoring authorities), the opening up of public works, supply and service contracts, harmonization of the rules on intellectual property (including the European patent), harmonization of the rules on company law and accountancy, protection of personal data, transfer of proceedings and recognition of judgments. According to the Agenda 2000 assessment of Bulgaria (the Regular Report), the main efforts have to be made in the fields of the process of approximation in the area of public procurement, of meeting all the requirements of the Public Procurement Directive, and in the fields of intellectual and industrial property. In the area of food and agriculture, the most important issue for the free movement of agricultural products is the standardization and conformity assessment, as well as Chapter VII: The Agricultural and Food Sector 141 implementation and enforcement of veterinary and phyto-sanitary requirements, and protection of the EU external borders according to these requirements. In order to comply with these general requirements in the food and agricultural sector, legal harmonization, institutional development, and investments are equally needed. The fragmentation of livestock units and poor farm registration and animal identification systems are serious obstacles, especially because of the threat of the spread of exotic diseases from the Mid-east, via Turkey. Great progress has been made in some areas, including the adoption of appropriate veterinary laws. But while it is implementing an intensive program of harmonization, Bulgaria still has some way to go in reaching full compliance with these requirements. The information system, including the monitoring of developments in the sector, as well as changes in the markets, is another critical component of the institutional framework. The current needs of managing agricultural markets and the EU accession specifically, require a speedy development of a modern, EU-conforming agricultural statistical information system. Some elements of the EU-conforming information system are already in place and a program for adoption of an EU-compliant agro-statistical methodology is now implemented; however, the current situation is far from adequate. The information provided is not fully reliable and not up- to-date, resulting in delayed and inaccurate policy decisions. Immediate improvement is needed and can be achieved by the use of survey methods to get information on evolving farming structures and changes in the supply and demand situation. The implementation of CAP requires an ability to oversee and manage all CAP instruments in a consistent manner and to be able to interact with Brussels to fully obtain all EU funds due to Bulgaria. In order to achieve this, eventually a controlling center, such as an intervention agency, must be established and made operational. It is essential that up-to-date information be available on the operation and status of the farming sector. This requires the establishment of a farm registry which would cover all farms and methods of production to clearly identify the beneficiaries of the various EU support programs. In addition, other information databases like an appropriate land register and cattle identification and registration systems, are also of vital importance to give MAFAR the ability to provide information for Eurostat. All this cannot be achieved without considerable strengthening of the administrative structures. It is important to remember that Bulgaria is still in the first phase of this process. It cannot be overlooked that the administrative costs of implementing EU regulations in the field of agriculture are immense. The EU enlargement will mean a considerable increase in both the number of administrative staff and their education, in particular in the fields of EU legislation. One should also emphasize that a delay in institutional preparation in agriculture would lead, at a minimum, to a delay in obtaining CAP funds, but might also lead to a delay in the overall accession. But, at the same time, it must also be noted that in Bulgaria's current economic situation, there should be no rush to implement CAP-like support programs, particularly since it is very unclear what these programs will be like in the EU at the time of Bulgaria's accession. The focus should be on setting up the administrative infrastructure, rather than to begin implementation. 142 Chapter VII: The Agricultural and Food Sector Defining a national rural development program and effective SAPARD implementation The NARDP has correctly identified priority investments, which are consistent with the areas identified in this report that require such support to mitigate Bulgaria's main problems on its way to complete EU integration. The MAFAR has constructed an impressive rural development program that will serve as the framework for use of SAPARD funds. It is vitally important that these funds be used in the most cost-effective way possible to maximize their benefit in restructuring the sector. SAPARD is a program which is quite flexible. While this flexibility is on balance a positive characteristic of the SAPARD, it also creates the potential that SAPARD could be used for measures that are not optimal or not even conducive to market development. It will be important to design and implement the program in ways that allow market forces to decide the directions in which the rural economy evolves, rather than having the government "pick winners" through excessive focus of support on sectors or economic actors that are selected ex-ante. While the current draft rural development strategy and SAPARD investment plans were clearly drafted with this consideration in mind, and will allow considerable latitude for market forces to work, some consideration should be given to implementing the plans in ways that will set very broad eligibility criteria and allow self- selection of efficient producers and institutions as recipients of grants. For example, the currently uniform self-contribution rate could be set to ration the available funds and ensure that they go to recipients who are more willing to put their own funds at risk, or could persuade a third party to put funds at risk. This would not eliminate the need to have a review process for grant applications, but would reduce frivolous applications. It would also allow more grants to be made. This rate could later be adjusted if it were found that demand for the funds were too low. Alternatively, the grants could be auctioned if demand exceeds supply, with the grants going to those qualified applicants who are willing to provide the greatest self-contribution. Chapter VII: The Agricultural and Food Sector 143 PRIORITIZING THE REFORMS Policy Priorities Short-term actions (2000 - 2001) Medium- to long term actions I (2002 and beyond) Pricing and Trade Policy * Pass law on automatic registration for seed varieties * Adopt EU agricultural pricing and trade in the EU Common Catalogue. institutions without raising level of * Develop reform strategy for the tobacco sector. protection, until time of accession. * Liberalize tobacco sector policies, stop interventions, and compensate with targeted and time-limited direct income transfers. * Further reduce fertilizer tariffs (Jan. 2002). * Revise sanitary, veterinary, and phyto-sanitary licensing requirements for imports and exports, and the associated fee structure to eliminate unnecessary inspections. Improvements in Rural Support and Financial Policies * Continue reduction of SFA short-term credit lines. * Shift emphasis from direct long-term * Require that commercial banks exclusively carry out credit to partial risk guarantees in SFA the risk evaluation of investment projects supported credit lines. by SFA. * Improve legal environment for * Pass and implement Law on Credit Coops, allowing collateral in secured transactions and coops to borrow from commercial banks to on-lend. mortgages. Allow SFA funds to be channeled through Credit * Improve legal environment for Coops, on pilot basis. equipment and machinery leasing. * Pay banks a fixed fee for SFA loans, the size of * Fully restructure SFA as the paying which would be the same no matter what the size of agency for SAPARD funds. the loan, on a pilot basis (requires amending the * Transfer ownership of infrastructure to Banking Law). Water Users' Associations (WUAs). * Pass law on WUAs, facilitating transfer of ownership of on-farm and off-farm irrigation infrastructure. Food Security and Cereals Marketing * Better define the operating rules for the State * Reduce the overall size of the stocks. Reserves purchasing and sales so as to limit their * Shift some storage to private facilities. impact on market prices, and make the impact more predictable. * Eliminate in-kind grain loans (already implemented). 144 Chapter VII: The Agricultural and Food Sector Completion of Land Reform and Land Market Development * Privatize remaining state-owned land. * Consider accepting principle of land * Pass Land Registration and Cadastre Law. ownership by individual foreign * Focus on and set targets for individually titling investors. parcels. * Facilitate speedy settlement of land ownership issues and the provision of proper proof of ownership to develop a land mortgage market. * Create a modem land titling and cadastral system. * Further transform private cooperative farms by strict enforcement of budget constraints and bankruptcy procedures. * Facilitate the creation of marketing and service cooperatives. * Improve system for collecting and disseminating information on land market prices and on land market transfer procedures to new landowners. Accelerated Technical and Technological Development of Agro-Processing * Facilitate the emergence of rural small and * Establish investment program for medium agro-processing and service enterprises private sector and restructured state by improved registration procedures and advice. agencies to strengthen quality control * Revise licensing and inspection procedures to and new food processing techniques eliminate unnecessary costs for businesses incorporating technologies related to (currently under review). quality enhancement and environmental * Complete privatization of all agro-industrial assets protection. in the privatization programs of the MAF and * Carry out substantial education program Ministry of Industry, except those involved in for implementation of the new legal court actions that prevent privatization. environment of standards for food and agricultural products. * Liberally allow revision of initial commitments made during privatization process regarding production and employment to facilitate the restructuring and consolidation of ownership in the newly privatized processing companies. * Promote and facilitate the emergence of secondary markets for ownership of agro-processing enterprises, including the promotion of foreign investment, by supporting establishment of a clearinghouse for trading shares. * Strictly enforce bankruptcy legislation to consolidate the newly established private sector. Chapter VII. The Agricultural and Food Sector 145 Institutional Development for EU Accession * Ensure adequate vetennary infrastructure to manage livestock inspections and control disease. * Strengthen standardization and conformity assessment, as well as implementation and enforcement of veterinary and phyto-sanitary requirements, and protection of the EU external borders according to these requirements. * Further develop a modem, EU- conforming agricultural statistical information system, including establishment of a farm registry and other information databases like an appropriate land register and cattle identification and registration systems. * Strengthen administrative structures. * Strengthen efforts in the area of public procurement fields and intellectual I property. * Use SAPARD funds in the most cost-effective way possible to minimize administrative "picking of winners" and maximize their benefit in restructuring the sector. Prioritization of an action program is difficult for many reasons. All actions are important, and optimal sequencing depends not only on the benefits to be gained from each action, but also their difficulty of implementation. Even reforms with a modest pay-off should get high priority if they are quick and easy, whereas some with higher benefits might be deferred if they are time-consuming and costly in terms of administrative and political capital. This table summarizes the mission's recommendations about sequencing and priorities of reforms, based on judgments of costs, benefits and feasibility. Clearly the Government is in a much better position to judge some of this, especially political feasibility. But this summary may be useful in laying out a short-term and medium-term agenda for consideration. The actions that stretch across the two columns are ongoing actions that should be started immediately, but will not be completed for some time. But the initiation of these should receive high priority. Most actions that involve harmonization with EU standards or approximation of legislation are in the right column, indicating that they are not of the highest priority. This does not indicate that they are not important; clearly they are tasks that must be finished before accession. However, in the short term, they should not be the government's main focus. Rather, the emphasis should be on more basic reforms to improve competitiveness. CHAPTER VIII: REGULATORY AND STRUCTURAL ISSUES IN THE NETWORK UTILITIES INTRODUCTION The primary objective of this section is to examine the market and governance structures of the Bulgarian infrastructure sectors and to propose policies designed to improve their performance. This emphasis on industry structure and regulation is motivated by the emerging international experience that the performance problems in the infrastructure sectors are generally not related to project finance or lack of technical manpower capabilities, but rather to the organization and architecture of the market and governance structures of these sectors; and that achieving public interest goals through privatization requires a commitment to planning and clearly defining the post-privatization governance and industry structures ahead of time. The specific focus on the infrastructure sectors was motivated by several factors. First, it is widely recognized that the efficient functioning of these sectors is vital to sustained economic growth and international competitiveness. The infrastructure sectors provide services that are critical inputs in manufacturing, transportation and commerce. They also provide services that are essential to boosting economic activity and increasing competition through the expansion of product lines and geographic spheres of distribution. Therefore, failure to move in these sectors risks their becoming a serious burden on the economy in general and on the evolution of competitive markets in particular. Second, during the last decade, there has been a major world-wide reassessment of public policy towards the infrastructure sectors and of the proper role of the state in the provision of their services. Governments throughout the world have been actively pursuing institutional, regulatory, and structural reforms aimed at improving operating efficiency and service quality. Countries that have implemented such reforms have realized substantial economic benefits. Third, foreign direct investment in infrastructure could play an important for the Bulgarian economy. The need for policies and mechanisms that can provide credible commitment against political expropriation of private capital and can provide fair and secure financial returns is especially important in infrastructure sectors that require large, up-front investments. The task of restructuring the network utilities in Bulgaria and of designing appropriate regulatory frameworks to attract large-scale private investment, poses unique and challenging problems. There is very limited regulatory expertise in Bulgaria, in large part because regulation was intricately intertwined with state ownership and policy-making, and there has been no regulation until recently by which to develop expertise. The Bulgarian policy makers will very rapidly be confronted with "second generation" issues that arise after privatization, particularly when combined with unbundling. The resolution of these "second generation" issues has proven exceedingly challenging even in countries like the United States and the United Kingdom which have had considerable experience with the "first generation" problems of regulated franchise monopolies. This chapter seeks to provide the needed thrust for the development of regulatory Chapter VIII Regulatory and Structural Issues in the Network Utilities 147 principles, the development of solutions to the current and forthcoming problems, and, most importantly, the development of regulatory expertise and capacity. BACKGROUND AND ACHIEVEMENTS The energy sector Background. Despite its relatively low per capita income, Bulgaria's energy consumption is high (2.5 tons of oil equivalent versus 3.8 average for the EU), reflecting the traditional emphasis in Soviet-type economies of under-pricing energy, concentrating on energy- intensive heavy industry, and paying insufficient attention to energy efficiency. Total primary energy supply (TPES) fell sharply in line with GDP for the first few years of the transition, but since then has fallen less, and substantially less than industrial output. Most of the fall was in oil consumption, rather than coal. At the present level of about 1.8 kg of oil equivalent (kgoe/Euro) of GDP, energy intensity is higher now than at the start of the transition, in sharp contrast to most other transitional countries such as Poland, Hungary and the Czech Republic (0.56-0.77 kgoe/Euro of GDP) and Romania (at 1.32 kgoe/Euro of GDP). The composition of energy consumption in 1998 is summarized below: Table 8.1: End-Use Energy Consumption (1998)a' In million tons of oil equivalent District Solid Natural Oil Electricity Heat Fuels Gas Products Total Industry 1.04 1.76 0.83 1.32 0.47 5.42 Transport 0.04 0.01 0.00 0.00 0.86 0.91 Construction 0.02 0.00 0.00 0.00 0.11 0.13 Agriculture/Forestry 0.02 0.02 0.00 0.02 0.28 0.34 Household 1.06 0.60 1.01 0.08 1.00 3.75 Other 0.19 0.15 0.01 0.00 0.14 0.49 TOTAL 2.37 2.54 1.85 1.42 2.86 11.04 Conversion, transmission and distribution losses (mainly for electricity and district heating) are estimated at about 60 percent of total primary energy consumption. Source: Energoproekt, Fuel-energy balance of Bulgaria. Bulgaria faces severe challenges in the energy sector. The delay in restructuring, particularly in improving supply efficiency and setting economic prices, has been costly in lost industrial output and consumer welfare, and a loss in confidence that existing infrastructure and services can be made cost-effective and affordable. Wars in neighboring countries, disruptions to trade routes and trading partners and the Russian economic crisis have compounded these problems. Bulgaria is energy-intensive but lacks economic domestic energy resources. Bulgarian coal is of poor quality, the country lacks significant indigenous petroleum resources, and is completely reliant upon imports from Russia for gas, the one fuel that is environmentally friendly, cost-effective for heating and power generation, and most helpful to liberalizing energy markets. Based on their assessment of the safety of the VVER 440/230 type of nuclear reactors, the European Commission (EC) and the G-7 have put pressure on Bulgaria to retire its four VVER 440/230 reactors, supplying about 20 percent of total demand, before the end of their economic life. 148 Chapter VIII Regulatory and Structural Issues in the Network Utilities On the positive side, Bulgaria is on a critical crossroad in Europe, providing transit routes for Russian gas to the south and linking both Greece and Turkey to the European electricity grid. If, at some future date, gas pipelines are brought from the Caucasus through Turkey (or the Black Sea) into Bulgaria and west to Central Europe, the country will cease to be solely dependent upon Russian gas, and would provide an alternative east-west corridor for diversifying West Europe's dependence on imported gas. The current government is committed to restructuring the energy sector and opening it up to competition. Privatization, after lengthy delays, is now back on the agenda. The Government has privatized some small hydropower plants, is at the point of privatizing a large thermal power station to a strategic investor and is finalizing the contractual framework for a strategic private investor to build, own and operate a new power plant. It also intends to formulate a privatization strategy for the rest of the sector during 2001 and implement it over the next few years. Other impressive achievements in the energy sector since 1998 include: * sustained phase-down of price subsidies (with targeted protection of vulnerable people); * passage of an Energy and Energy Efficiency Act in July 1999 suitable for the transition to a more competitive and less centrally-planned sector (with further refinements planned for early-2001); * creation of an autonomous State Energy Regulatory Commission under the Council of Ministers; * "unbundling" of the vertically-integrated National Electricity Company (NEK) into independent generation, transmission and distribution companies; * financial stabilization of the national gas company (Bulgargaz), and the accounting separation of its supply, transmission and storage, transit, and distribution functions; and * separation of loss-making coal mines and pits from profitable sections in preparation for the privatization of the profitable sections. Institutional structure. The Energy and Energy Efficiency Act (EEEA) provides for a system of regulation of electricity, district heating and gas with the intention of developing a competitive energy market and attracting private investment into the energy sector. The Act sets up three new bodies concerned with energy; the State Agency of Energy and Energy Resources (SAEER), the State Energy Regulatory Commission (SERC) and the State Energy Efficiency Agency (SEEA). The SAEER (former Committee of Energy) remains the dominant entity in the sector. It is responsible for drawing up energy policy and the strategy for development of the energy sector, and for approving plans for system expansion, restructuring and privatization. It proposes subordinate legislation in areas under its jurisdiction (energy supply policy, strategy and investment requirements), which is then subject to adoption by the Council of Ministers (COM). It also exercises the State's ownership rights in energy companies and is responsible for preparing gislz.sk ve changes to ensure harmonization with the EU Directives for energy. Chapter VIII: Regulatory and Structural Issues in the Network Utilities 149 SERC is required to propose draft ordinances to the COM setting out the conditions and procedures for issuing permits and licenses and specifying the terms of such licenses. Upon approval by the COM, SERC is responsible for issuing, amending, suspending and revoking permits and licenses for generation, transmission and distribution of electricity, heating and natural gas. It must also develop secondary legislation and ordinances for phasing in competition in supply for eligible consumers. SERC also proposes the tariff methodology for regulated prices to the COM and, after approval by the COM, will be responsible for enforcing this methodology after the transitional period which ends on December 31, 2001. The State Energy Efficiency Agency (SEEA) participates in the development of a national strategy of energy and energy efficiency, although this task is also allocated to SAEER. In the past, the two agencies have held radically different views on the appropriate energy strategy, with the SEEA stressing energy efficiency and demand-side measures and the SAEER stressing supply security (through greater reliance on domestic coal and on nuclear energy) to meet demand based on historical consumption pattems. To the extent that the COM is responsible for accepting proposals, neither agency is ultimately responsible for the adoption of a particular strategy, and this apparent conflict may provide a beneficial check on the soundness of any proposed strategy. The SEEA is responsible for promoting energy efficiency and the use of renewables, and for licensing experts for auditing energy efficiency. The electricity supply industry 8.1 The vertically-integrated state-owned Natsionalna Elektricheska Kompania (NEK), established as a joint stock company in 1992, has dominated the Electricity Supply Industry (ESI) until its "un-bundling" in May-July 2000 into legally separate generation, transmission/dispatch and distribution entities. NEK has been converted to a Transmission Company with a Single Buyer division, Transmission System maintenance division, Hydro Power Plants enterprise, and Dispatch Center. Its name is to be changed to Natzionalna Elektroprenosna Kompaniya (National Electrotransportation Company). The 4 large hydro cascades (Belmeken - Sestrimo, Batak - Aleko, Vacha and Arda consisting of 14 plants with total capacity of 1637 MW) and the Pumped Storage Hydro Power Plant at Chaira (with 864 MW generating and 784 MW pumping capacity) will remain in NEK. A key issue in Bulgaria's accession to the EU is the EU requirement for early closure of the four older VVER 440/23086 nuclear power units at Kozloduy, deemed to be intrinsically unsafe in the opinion of the EU based on its assessment of the design of such reactors. To begin Pre-Accession negotiations, the Government agreed to close (before 2003) Units 1 and 2 (commissioned in 1974 and 1975). A definitive agreement has not been reached about Units 3 and 4 (commissioned in 1981 and 1982); however, the EU expects they will be closed before 2006 while the Government would prefer to close them at the end of their economic lives (2010- 2012) and is actively working to modernize and improve their safety to bring it to a level which is acceptable to the relevant international agencies.. In support of an early closure of Units 1-4, 86 The Bulgarian policy makers and energy experts believe that the VVER 440/230 units are safe, low-cost, and environmentally-clean. Their early closure will be costly to the economy in terms of higher electricity prices for replacement capacity, a loss of profitable exports, and greater import dependence at a time of severe balance of payments stress. 150 Chapter VIII: Regulatory and Structural Issues in the Network Utilities the G-7 countries provided a grant of Euro 24 million in 1993/94 under the Nuclear Safety Account to improve their operating safety. The EU has also agreed to grant financing of Euro 200 million over the 2000-06 period to alleviate the social impact of early closure, with the second half of this grant to be confirmed by the EU in 2002 depending on the Government confirming closure of units 3 and 4 by 2006. Additional financing is now being mobilized from Euratom and several bi-lateral and commercial creditors to refurbish and modernize the two newer, VVER 1000 units (commissioned in 1988 and 1993) at a cost of about Euro 400 million. Table 8.2: "Un-bundling" of NEK - Resulting Le Entities Avail. percent Distribution Customers percent of Generation Companies MW Generationa/ Companies (approx.) consumption 1. Maritsa East I TPP 160 2.4 1. Sofia (City) 629,888 15.4 2. Maritsa East 2 TPP 1,340 15.9 2. Sofia (District) 928,072 19.0 3. Maritsa East 3 TPP 800 9.1 3. Pleven 284,292 5.3 4. Mantsa 3 TPP, 120 0.5 4. G. Oryahovitsa 772,727 14.3 5. Vama TPP 1,200 4.8 5. Vama 682,144 16.9 6. Russe 290 0.9 6. Stara Zagora 551,535 13.2 7. Bobov Dol TPP 540 5.7 7. Plovdiv 590,766 15.9 8. Kozloduy NPP -Old 1,680 20.0 Kozloduy NPP - New 1,900 21.2 TOTAL -"Former" NEK 7,850 80.5 TOTAL 4,439,424 100.0 Within NEK Transco (HPP) 2,500 7.5 Other Non-NEK 800 12.0 TOTAL 11,150 100.0 a/ 1999 estimates. Balance generation by industrial, district heating and other non-NEK plants "' Number of customers estimated based on number of meters installed TPP: Thernal Power Plant; NPP: Nuclear Power Plant; HPP: Hydro Power Plant. Source: NEK Natural gas The origins of the gas industry date back to 1963 with the discovery of the gas condensate field at Chiren in the Northwest of the country. Quantities were small and, when the main gas pipeline from the former Soviet Union (Russia-Ukraine via Romania) was completed in 1974, the Chiren gas field was converted to a gas storage facility and connected to the main pipeline ring not far from Sofia. The country has limited confirmed gas resources - the most advanced development (by a private company) is the Galata field in the Black Sea near Varna, with estimated reserves of 1.5 billion cubic meters (bcm). Production is scheduled to begin by 2002 and drawn down over 5 years at 0.3 bcm/year (or about 10 percent of present demand). Apart from the private development of the Galata gas field, the sector is dominated by Bulgargaz (BG), a vertically-integrated, 100 percent state-owned company formed in 1990 and transformed into a joint-stock company in 1993. Gas penetration has been traditionally low in Bulgaria with virtually no low pressure or household supply. Large industries and the cogeneration and heat-only boilers of the district heating companies constitute the main customer groups, with the 28 largest customers accounting for 78 percent of the total consumption and the balance consumed by the remaining 200 customers. Consequently, there is a uniform end-user price in Bulgaria with prices being set by the Council of Ministers until end-2001 after which this function is to be assumed by the SERC. Private investors have expressed interest in Chapter VIII: Regulatory and Structural Issues in the Network Utilities 151 developing the low-pressure market but remain constrained by the absence of a suitable regulatory framework, particularly on differentiated prices for small-volume consumers. Table 8.3: Natural Gas Consumption (BC M Consumer Group 1996 1997 1998 1999 Power (mainly CHPlDistrict Heating) 1.665 1.524 1.379 1.339 Chemicals 2.435 1.719 1.297 0.990 Other Industrial 1.540 1.235 1.000 0.869 Other (Non Industrial) 0.091 0.105 0.115 0.125 Total 5.731 4.583 3.791 3.324 Source: National Statistical Institute The gas network consists of 2200 kilometers of high-pressure pipeline, nine compressor stations (total 190 MW), the Chiren underground gas storage reservoir (lbcm), and 70 gas distribution stations (for automotive purposes). The transmission system is in good physical condition, though it needs system monitoring and management equipment to support the planned development of a low-pressure gas market and the accounting separation of Bulgargaz' supply, transmission, transit, storage and distribution functions. The system has an annual capacity of 16 bcm, maximum daily output 40 million cm (mcm). Bulgaria has served as the transit route for Russian (Gazprom) gas through to Turkey in the south-east since 1989. The transit system has a capacity of 10 bcm and delivers 6 bcm to Turkey. Transit to Greece started in 1996 and in 1998 amounted to 0.9 bcm. Small quantities (22 mcm) have been transited to Macedonia since 1997. In support of Gazprom's plans to double exports to Turkey, Bulgargaz is expanding gas transit capacity to 17 bcm (planned by 2002). The project is absorbing most of Bulgargaz' investment budget (Euro 80 million in 1999, 98 percent of the total). In addition the link to Macedonia and Greece will be strengthened over the next three years to increase capacity along the southern ring which also serves the Sofia region. In addition to transit fees received in the form of gas, in the past Bulgargaz received considerable volumes of gas from Gazprom as payment for investments made by Bulgaria in Russian pipeline projects. The old contract expired on December 31, 1997 and a new contract was signed in April 1998. While the new contract ensures sufficient supply quantities to meet Bulgaria's needs, the following elements of the contract could potentially impose costly obligations on the country if demand continues to decline and oil prices remain high: (i) fixed annual volume ceilings until 2010, set when demand forecasts were more optimistic than actual market absorption, and with a requirement to take-or-pay for a high proportion of the ceiling amount; (ii) the roll-over period for non-taken gas is only five years; (iii) the volumes contracted are over-and-above volumes received from transit fees; (iv) Gazprom does not allow the re- export of volumes contracted by Bulgargaz or volumes received for transit fees; and (v) the contract price is indexed to international oil prices (specifically to gas oil and heavy fuel oil). Fully indexing to a single volatile fuel such as petroleum in an economy based largely on coal and using gas for heavy industrial use involves excessive risk, compared to contracts partly indexed to world coal prices, metal or fertilizer prices. Additional risks are introduced by entering into inflexible, long-term contracts at a time of demand uncertainty. A successful re- negotiation of the terms of the gas supply contract to facilitate a reduction in end-user prices and 152 Chapter VIII: Regulatory and Structural Issues in the Network Utilities introduce greater price predictability will greatly help the development of a low pressure gas market as well as the financial viability of large gas consumers. Greater flexibility in the "take- or-pay" obligation for the volumes contracted will also facilitate the development of Bulgaria's own gas resources. District heating Accounting for about 23 percent of the end-use energy balance in 1998, predominantly gas-based district heating (DH) remains the primary form of space heating in about 21 cities in Bulgaria with a connected load of about 7,700 MW (thermal). Except for the Sofia DH company, which is owned by the municipality and accounts for about 60 percent of the national DH consumption, the remaining DH companies are state owned and governed by the SAEER. The Government initiated a major building-level heat metering program in 1996 as a result of which heat supply to the bulk of consumers (buildings) outside Sofia is now metered and the metering program for Sofia is scheduled to be completed by end-2001. As part of its energy sector restructuring strategy adopted in 1998, the Government also initiated price and organizational reforms in late 1998 with the objective of phasing out operating subsidies by 2001, placing the DH companies under municipal ownership, and relieving fiscal pressures on the state budget. However, the Government's inability to mobilize adequate investment financing to underpin the first phase of the commercialization effort (while the legal and regulatory framework to attract private participation are being put in place), compounded by the sharp increase in fuel prices in 2000, has severely undermined the achievement of the Government's objectives. The key characteristics of the sector include: * A downward spiral driven by declining affordability (as operating subsidies are phased out faster than any increase in consumer incomes), massive disconnection from the DH systems (over 30 percent of consumers have opted to disconnect partially or completely since 1998), and a further worsening of the impact on customers who have not disconnected, the DH companies and the budget; * Out-dated design of supply systems, lack of instrumentation to regulate heat consumption (to within affordability and comfort levels), and the option provided to individual apartments in multi-apartment buildings to partially or completely disconnect without any payment (denying the communal nature of heating in such buildings), has resulted in an increase in supply costs (relative to billed quantities), and an unfair burden sharing between supplier, connected customers, and taxpayers (the budget); * Inadequate legal and regulatory framework governing relations between home owners in multi-apartment buildings for communal services, and technical difficulties to disconnect individual apartments to enforce payment or reduce free-rider problems, has stymied the commercialization of DH services and the development of commercial energy efficiency services. Chapter VIII. Regulatory and Structural Issues in the Network Utilities 153 The transportation sectors Achievements. Since 1997, Bulgaria achieved several major policy reforms in the transportation sector. These include: * Privatization and liberalization in the road haulage industry; * Privatization and liberalization in the airline industry; * A new Railway Act that sets the legal foundation for structural and regulatory reform in the rail sector; * A new "Law of maritime spaces, inland waterways, and ports in the Republic of Bulgaria" separates port infrastructure and operations; * Structural reorganization and rationalization in the rail sector; * Harmonization of the country's transport laws with the EU directives. However, the Bulgarian transport sector faces the difficult task of contributing to transforming the economy and increasing Bulgaria GDP, both in the immediate future, and in ensuring the long-term ability of the economy to compete in international markets and, in particular, in the European market. This is why the effectiveness of transport regulation in Bulgaria will be of critical importance. Road infrastructure The road network in Bulgaria consists of some 90,000 kms of roads, of which 386 kms are highways. The national road network, with a total length of 37,288 kms, is administered by the Main Road Administration (MRA) in the Ministry of Regional Development and Public Works. Roads are divided into four classes, 1st, 2nd, 3rd and local. In March 2000, the new Road Act was adopted by Parliament, which transformed the MRA into the Executive Agency "Roads". The Agency has full responsibility for the 1st, 2nd and 3rd class roads whose total length is 19,054 kms. The local roads are jointly managed by "Roads" and the municipalities. There are extensive investment projects for improving the road network. Current plans envisage a 1,296 km highway network which would include: a west-east component from Sofia to the Black Sea; a link south from Sofia to the Greek border; a link west to FYROM; and a longer south-east link to the border with Turkey. In November 1999, 386 kms of highway were in operation. In addition to the highways already built and in operation, 190 kms are at the working design stage, 500 kms at the pre-feasibility stage, and 33 kms (of the Trakia highway) in suspended construction. "Roads" has at its disposal several sources of finance: Tariff 14, which relates to tariffs charged to foreign haulers and to Bulgarian hauliers with excessive loads, and tariffs charged to petrol stations, hotels and other businesses alongside main roads; and, funds raised under the Road Act from a tax on gasoline and diesel fuel for road vehicles. In addition there is an excise tax on road fuels, revenue from which goes to the state budget. This tax has different rates depending on the fuel type. 154 Chapter VIII: Regulatory and Structural Issues in the Network Utilities Road transport Since 1997 there have been two major developments in the road transport sector: most of the enterprises have been privatized; and two new laws, one on road traffic and the other on road transportation, have set out the legal framework under which the industry operates. In 1997, there were 233 state-owned enterprises providing road transport services, including passenger services. Out of these all but 23 had been privatized by mid-November 1999. Subsequently, the Privatization Agency authorized the Ministry of Transport to privatize 15 additional companies. Out of these, 7 are still awaiting privatization. More than 90 percent of international haulage and 100 percent of passenger operations are in the private sector. Entry into the market is governed by licensing requirements for carriers. The principles of carrier licensing relate to good reputation, financial stability and professional experience. In 1999, 7,754 managers attended training courses to qualify for licenses under a system that is compatible with EU Directives 96/76 and 96/26. In 1999, passenger and freight transportation services were performed by 14,500 automobiles, 12,345 trailers, and 900 busses licensed for international operations. Companies have been updating their fleets in accordance to the higher technical standards set by the EU. Railways Railway services in Bulgaria are currently operated by BDZ. In December 1999, there were 4,290 kms of route, of which 965 kms (22 per cent) were double track, and 2,908 kms (63.1 per cent) electrified. The orientation of the network is west-east rather than north-south. There are three main routes, all of which are electrified, east from Sofia to the Black Sea Coast. In addition, there is a single track electrified route north to the Rumanian border, and a single line non-electrified line to Negru Voda (for the Rumanian port of Constanza). South, there are single track non-electrified routes to the Greek border at Kulata, and to the Greek and Turkish borders near Edirne. There is also an international link west from Sofia to Serbia. Much of the rest of the network consists of single-track non-electrified branch lines. The size of the network has not changed significantly for many years. In 1970, there were 4,196 route kms, 4,267 kms in 1980, 4,299 kms in 1990, and 4,291 kms in 1994. Only 811 kms had been electrified in 1970 (19.3 percent), rising to 1,581 kms in 1980 (37.1 percent), and 2,640 kms (61.4 percent) in 1990. Traffic. Total lifted fell from 77 million tons in 1989 to only 25 million tons in 1998, a fall of nearly 70 percent. Ton-kms fell from 17 billion in 1989 to 6.2 billion by 1998, a fall of 64 percent. In 1999, total lifted declined further to 21 million tons, and ton-kms fell to 5 billion. There has been some relatively small increase in average length of haul over this period. For the first nine months of 1998, 34.0 percent of BDZ freight was either imported or exported by sea. By the first nine months of 1999, this percentage had fallen to 30.3 percent and 11.3 percent respectively. Freight transit traffic declined from 830,000 tons in the first nine months of 1998 to 501,000 tons in the first nine months of 1999. Chapter VIII. Regulatory and Structural Issues in the Network Utilities 155 There have been several factors that contributed to the decline of the railroad's traffic in general and its international traffic in particular: increased competition from road transport; the decline in rail's traditional markets, and the dramatic industrial restructuring that led to some plant closures or the temporary closure of others while they were undergoing privatization; the war in Serbia; the loss of 2.5 to 3 million tons of traffic to a metal works in Skopje in FYROM; the crisis in Russia had led to the loss of over one million tons of ferry traffic; the Far East crisis had affected chemicals traffic, since the Bulgarian chemical industry had a market for its products there; the Kremikovtzi metals works near Sofia had been affected by the crisis in Brazil, and the fall in metals prices; and traffic to Syria via Turkey had been affected by the Turkish earthquake. However, the primary reason for the decline in international traffic is the war in Serbia and the lack of a competitive alternative route through Romania, effectively forcing over 80 percent of the transit traffic to go through the southern routes. Moreover, the decline in the railroad's passenger traffic can be mainly attributed to increased competition from road and air transport. There are published tariffs for freight transportation, but most tariffs can be negotiated with the customers and their terms are confidential. Rationalization program. In July 1999, the Council of Ministers by Decree 147 decided to phase out subsidies from the state budget to BDZ by December 30, 2001. The subsidies for BDZ for 1999 included 60 million leva for PSOs, 17.8 million leva for asset overhauls, and 38.2 million leva for acquisition of fixed assets. The planned PSO support for 2000 is 40 million levas, and for 2001, 30 million levas. There are plans for the rationalization of the network and services offered. As of June 2000, 713 kms of uneconomic routes were abandoned, 8 stations closed, and train-kms were reduced by about 20 percent. However, further rationalization is needed, especially in view of the infrequent passenger services. The new railway law (separation of infrastructure and operations). In 1999, a new Railway Act (Law for the Railway Transport) had been drafted in conformity with EU legislation, was approved by the Council of Ministers, and subsequently submitted to the National Assembly for adoption which is expected to occur soon. The main objectives of the Railway Act are to: provide the legal basis for restructuring the sector; clarify and delineate the respective roles of the state and the railway companies; promote financial stability and safety; and gradually introduce competition in the sector by mandating non-discriminatory access to the infrastructure (track and other bottleneck facilities) for specific categories of services. The Bulgarian State Railway would cease to exist on January 1st 2001. The Council of Ministers must establish a legal successor to the Bulgarian State Railway for the provision of passenger and freight services. The Minister of Transport and Communications and the Ministry of Finance must appoint a Commission to distribute BDZ assets and liabilities between the Republican Railways Infrastructure (RRI) and the railway operators. Vertical separation is a key component of the current reform process. Indeed, the Railway Act, in accordance with the EU directives, mandates vertical (accounting) separation-- the rail system will be separated into an infrastructure organization, which will be a public 156 Chapter VIII: Regulatory and Structural Issues in the Network Utilities company, and a transportation organization that will operate on commercial principles. The law envisages for the Minister of Transport and Communications and the Minister of Finance to appoint a Commission before the Act becomes effective to allocate the BDZ assets and liabilities among its successor legal entities. The initial plan was for the law to become effective from January 1 2000. However, due to the delays of its adoption by Parliament, it is now anticipated that it will come into force by January 1, 2002. The Railway Act is consistent with EU requirements in regard to the separation of infrastructure and operations. However, major issues remain in ensuring that there is free access to the network, and in designing a system of access charges that is consistent with Article 32 but which gives proper incentives to use the network and to invest as appropriate in renewals and, where warranted, in additional capacity. A further important and related issue is that of whether there should be an independent railway regulator rather than, as currently favored by the Ministry of Transport, reliance on the Commission for the Protection of Competition to referee any disputes that arise. Ports and shipping Bulgaria's two main ports are Bourgas and Vama. Together, they handle more than 60 percent of Bulgaria's foreign trade87. The state-owned shipping company, Navigation Maritime Bulgare (NMB), is the biggest Bulgarian shipping company. It is a joint stock company-owned by the Ministry of Transport, and operates more than 1.8 million deadweight tons. In 1998, the Company had revenues of 625 million leva, and expenses of 609 million leva. In recent years, it has bought eight new vessels, and negotiations are in hand to build new oil tankers in Japan to meet new double-bottom requirements. However, the auditors report to the 1998 accounts notes that because of an effective tax rate on profits of 96.39 percent, "the net profit margin reported is negligible, which raises substantial doubt on the Company's abilities to provide additional funds for further development of its operations in the future". The inland waterway is the Danube. Ninety five per cent of the river fleet (about 50/55 vessels) is owned by Bulgarian River Shipping, which is fully state-owned. At present, there are severe difficulties because of the effects of the war in Serbia, since the river is now blocked and about half the fleet is marooned upstream. Airports and airlines Civil aviation in Bulgaria is the responsibility of the Directorate General of Civil Aviation Administration within the Ministry of Transport and Communications. The Directorate General, which includes the State Aeronautical Inspectorate, has oversight in compliance with the Civil Aviation Act of: Air Traffic Services Authority; airport administrations, airport companies and ground handling operators; air carriers and operators; organizations for the technical maintenance and repair of aircraft; aviation training centers; aviation personnel and aviation medical certification. 87 Investments are underway to expand Port of Bourgas capacity, and will be initiated shortly to rehabilitate and modernize the Port of Lom. Chapter VIII. Regulatory and Structural Issues in the Network Utilities 157 Airports. Bulgaria has five international airports: Sofia, Varna, Bourgas, Plovdiv and Goma Orjahovitza (the last mainly handles freight). Sofia's existing terminal is of poor quality. However, there are plans to construct a new terminal building and a second runway. Tenders are currently being carried out for these projects. According to the Civil Aviation Act, airports are property of the state, and they are currently operated by single state-owned entities. However, the airports are subject to the Concession Law. This means that the airports themselves will not be privatized, but the plan is to give concessions for airport operations including some ground handling activities. Such activities were estimated to account for 30-40 percent of current airport revenues. The purpose of introducing external commercial service providers will be to transfer the management of these services to contracted specialized operators for a given period of time and under specified conditions. This is commonplace in the airports sector, reflecting the greater expertise and experience that specialists can bring to these operations. Airlines. Bulgaria's national carrier, Balkan Airlines, has been in serious financial difficulties, but has now been privatized. It has not been an easy process, as there had been four failed attempts since 1993. The other airline, Hemus Air, is still state-owned, but a tender has been issued for its privatization. According to the Ministry, the internal aviation market in Bulgaria is fully liberalized, and any domestic airline can fly, subject only to having appropriate safety certification. Fares can also be freely set. However, the geographic size of Bulgaria and the disrupted state of the country's economy that is undergoing a fundamental transformation, limit considerably the scope for domestic airline services. CHALLENGES IN THE TRANSITION PROCESS Continuing inefficiencies in the supply of basic infrastructure services will severely limit Bulgaria's growth potential and its export performance. While organizational improvements may improve efficiency to some extent, major achievements can only be achieved through appropriate investment. In view of the many competing priorities for scarce public funds, and the relatively low level of domestic savings, it will be necessary for the Government to rely on foreign capital to meet the investment requirements of the infrastructure sectors. The infrastructure sectors, if they are properly restructured and placed under credible regulation, could attract sustained large-scale foreign investment. However, as these investments are likely to impact costs and prices of infrastructure services, a major challenge for the Government over the next few years will be to properly sequence these investments and manage any associated liabilities for the state. Given the imperfections in the market structure of infrastructure services, and the need for substantial strengthening of legal and regulatory institutions, it is appropriate for the Government to exercise caution with respect to the pace of privatization and regulatory decontrol. The challenge facing the Bulgarian policy makers centers around their ability to: establish a framework that promotes undistorted and effective competition; create mechanisms that enforce substantive and procedural restraints on arbitrary administrative intervention and regulatory discretion; put in place pricing structures that provide signals and incentives for 158 Chapter VIT. Regulatory and Structural Issues in the Network Utilities efficient actions by consumers, suppliers of complementary and substitute services, suppliers of inputs, and investors; remove the regulatory impediments to revenue adequacy; establish rules that ensure open, non-discriminatory access to bottleneck infrastructural facilities; and design competitively neutral mechanisms to foster desirable social goals and positive economic externalities. In the energy sector, the key challenge for the Government over the next few years will be to properly sequence reforms and investments in a manner which ensures that higher-cost and more risk-prone investments are undertaken only after market structures, regulations and appropriate energy prices are in place. Clearly, competitiveness of economy and social well- being of the population should be the overriding objectives for the energy sector and these would need to be achieved in a fiscally sustainable manner. The early establishment of a clear policy and regulatory framework would allow investors to take the market risk and rewards associated with their investments, while also ensuring that consumers are adequately protected from unfair tariffs or poor quality of supply. Indeed, if the Government contracts improperly-sequenced and costly private investments at this stage of the transition, characterised by uncertain demand forecasts, high risk premiums required by private capital, and the need for investors to enter into inflexible long-terrn contracts with state-owned enterprises, it exposes Bulgaria to risks which could erode its competitiveness, worsen the social conditions of its population, and exacerbate the demands on the state budget. In this context, the government's immediate focus should be to promote: D Energy efficiency and conservation (given high share of energy expenditures in industry and household budgets), particularly promoting least-cost and environmentally clean home heating options and paving the way for private provision of energy services; 3 Supply-side efficiency and reliability (to ensure competitiveness of the economy), particularly eliminating losses in electricity and heat transmission and distribution, and enhancing the efficiency and economic life of key power and heat production facilities through strategic privatization and relatively low-cost investments. In the transportation sector, it is clear today that a combination of further market liberalisation and an integrated investment program is needed for the sector to contribute best to the Bulgarian economy and to avoid becoming a significant impediment to growth. Moreover, in view of the country's precarious fiscal condition and the many competing social priorities, the government will need to aggressively pursue all private participation options, including divestiture of key infrastructural facilities. The key policy challenges in the transportation sector include: * Setting prices for each service which cover costs while also providing incentives for efficient behavior, and allowing fair competition between different modes of transportation; * Integrating efficient pricing with efficient infrastructure investment; * Further rationalizing and increasing private participation in the rail sector; * Increasing private participation in ports, shipping, and airports; * Developing and implementing an effective regulatory structure in the sector. Chapter VIII. Regulatory and Structural Issues in the Network Utilities 159 Given the necessity to put in place adequate and efficient transportation infrastructure to support economic growth, and given the scarcity of public funds, the government may need to pursue a more aggressive reform agenda than what is required by EU directives to attract significant levels of private investment needed to modemise Bulgaria's infrastructure. Owing to the country's long history of centralised direction and extensive intervention in the economy, there could be some natural reluctance on the part of policy makers to spin transportation activities out of state control, especially in railroads, airports, ports, and shipping. However, continued public ownership and the attendant political interference will inevitably hinder the organisational and institutional restructuring that is necessary to revitalise these transportation activities and improve their performance. Moreover, there has been a historic tendency for public policy to favour specific modes of transport. Such a policy should be abandoned and market forces should be allowed to determine the relative positions of the different modes. Sector priorities and choice of industry structure There are generally several options for restructuring the network utilities. Which of these options is the best choice in a specific country and industry context is a complex policy decision with many important dimensions to consider. Electricity. While acknowledging the Bank's advise to sequence sector reforms and investments in a manner which would allow private investors to assume the bulk of market risks and rewards, the SAEER's strategy is to accelerate private investment in Bulgaria's generating plants and position the country to provide regional stability in the Balkan electricity market. Its strategy (articulated initially in the National Strategy for Development of the Energy Sector till 2010 adopted by Parliament in early 1999), envisages large-scale private investment in power generation with the intention of safely meeting projected domestic demand and capturing an increasing share of regional demand, while also ensuring at least a 20 percent reserve capacity at all times (over and above forecasted peak demand), and minimizing reliance on imported fuels (mainly natural gas). The SAEER's domestic demand projections are reasonable, but it also expects Bulgaria to be in a strong position to capture additional export sales, over and above those already secured under a long-term contract with Turkey and realized through short-term exports to other countries (totaling about 10-15 percent of domestic demand at present). To support this strategy the Government has embarked on an ambitious medium-term (2001-06) investment program which consists of: * Rehabilitation of selected power plants, and transmission assets to improve safety, supply reliability, efficiency, and environmental performance (estimated to cost Euro 1.45 million); * Construction of new lignite and hydro based power generation (Euro 1.25 billion) and possibly transmission capacity to meet projected demand (including from trade); * Ensuring there is sufficient reliable capacity to shut down Units 1 and 2 (880 MW) at the Kozloduy Nuclear Power Plant (NPP) before 2003 and Units 3 and 4 (880 MW) before the end of their economic life, possibly by 2006; 160 Chapter VIII. Regulatory and Structural Issues in the Network Utilities The Government has emphasized that it expects the private investors to finance the bulk of the investment needed in the sector and is in negotiations with strategic investors to rehabilitate, own and operate the Maritsa East 3 plant (840 MW), and build new capacities at Maritsa East 1 (600 MW) and within the Goma-Arda hydro cascade (160 MW). It accepts that private investors will require long-term power purchase agreements with state-owned NEK, the "Single Buyer" under the market model adopted by Bulgaria, but expects to be able to pass any financial obligations under these contracts to end-users in Bulgaria and to its export contracts. In addition to the specific deals being negotiated, by 2002-03, the Government intends to: * Privatize the bulk of non-nuclear power plants, including major CHP plants connected to the district heating (DH) systems, and have strategic investors finance efficiency, reliability and environmental improvements; * Privatize the seven national electricity distribution companies; * Privatize major lignite mines. The "Single Buyer" market model adopted by the Government (and enshrined in the Energy Act), is generally consistent with the EU Electricity Directive (an important exception being NEK's retained monopoly on imports and exports). It could, however, benefit from a greater reliance on market (demand) driven competition rather than state-controlled investment planning to meet projected demand. As described in para. 8.12, the market structure consists of NEK-Transco as a Single Buyer and owner of transmission, dispatch and the regulating plants, and legally separated generation and distribution entities. With the exception of "captive" plants, new capacity can only be added through competitive tendering of pre-determined generation capacities (and fuel sources) identified by NEK-Transco as part of its generation plan which must be approved by the SAEER. While the Energy Act provides for eligible customers to contract supply directly from domestic generators beginning from 2002, with eligibility guidelines to be developed by the SERC, the SAEER has stated this must be done cautiously and gradually. Thus, for the foreseeable future, the only competition envisaged in Bulgaria's market model appears to be the competitive bidding process for developing new capacity. While this model has the attraction of allowing negotiations with private investors to proceed before markets have been created and the regulatory framework has been firmly established and stress tested, developers of large generation projects (rehabilitation or new) will require long-term power purchase agreements (PPAs) with the state-owned NEK-Transco in order to secure project financing. As NEK is unlikely in the short term to be able to offset these long-term PPAs with profitable power sales contracts, they could become stranded costs for NEK if the electricity market (demand quantities and price) develops in a manner which does not allow the contracted volumes and price to be passed through to end-users. Therefore, PPAs should only be considered for investments which are needed in the short-term before the market can be structured to allow investors, and not NEK, to take market risks. If the electricity market is actually opened to competition and eligible customers find cheaper sources of electricity within Bulgaria or from abroad, the single buyer risks losing its most profitable customers and being forced to pass through higher-than-market generation costs to its captive customers (those not Chapter VIII: Regulatory and Structural Issues in the Network Utilities 161 eligible to contract directly) who will experience rapid increases in their prices. Alternatively, NEK-Transco risks large losses if the SERC does not allow regulated prices (for example to households) to rise above reasonable, efficient levels (as revealed through costs of the new contracts signed by the eligible customers). Against this background, the first priority should be to put in place a market structure, regulatory framework and policies before embarking on a costly investment program. as: * There is surplus available capacity in the country (about 11,000 MW versus a winter peak of 7,500 MW including for export), sufficient to meet domestic demand and existing export contracts for the next 4-5 years. Furthermore, demand projections are fraught with uncertainty, particularly during periods of economic transition, and it would be prudent for Bulgaria to seek lower cost options than building new generation capacity to address any risks of blackouts or decline in supply quality if demand grows faster than projected88; * Household energy (electricity, district heating and coal) prices are still being adjusted to their cost-recovery levels and there is significant scope to improve consumption efficiency89; * District heating systems in high population density centers are to be modernized and low-pressure gas systems developed to meet heating needs in other areas; . There is substantial scope to eliminate inefficiencies in existing power supply infrastructure through relatively low-cost investments (for example distribution losses of >20 percent in 1999 and the first four months of 2000 can be reduced by 50 percent through investment and better management). Investment costs associated with the Government program for the 2001-06 period, estimated at Euro 2.8 billion, are large in absolute and relative terms (about 5 percent of cumulative GDP for the period and about 50 percent of cumulative forecasted electricity sales) and could expose the state to large liabilities if demand does not develop as predicted or if adequate market and regulatory structures are not first put into place. It would be more prudent for investments to be prioritized to first eliminate inefficiencies in supply and consumption, including through privatization of existing assets, before embarking on investments in new capacity. Priority policy actions to attract private investors should: * Eliminate cross-subsidies between customer categories (household prices being cross- subsidized by industrial and commercial customers) and replace price subsidies through better targeted mechanisms for supporting low-income customers; * Put in place electricity dispatch rules based on economic, least-cost principles (phasing in preferences for renewable energy as the economy develops); 88 End-user demand in Bulgaria fell for a third successive year in 1999. 89 If cost-recovery principles are adhered, household electricity prices (including VAT) are expected to increase from an average of $34/MWh in 1999 to at least $50/MWh, district heating from $1 8/MWh to $25-30/MWh (depending on gas prices), and coal prices to $8-1 O/MWh once prices are liberalized. 162 Chapter VIII: Regulatory and Structural Issues in the Network Utilities * Put in place transparent tariffs for transmission and system services to enable third-party access to the network on a non-discriminatory basis, including for imports and exports; . Accelerate market reforms by allowing large users of electricity, including distribution companies, to contract supply directly from producers and other suppliers, including from abroad; * Accelerate privatization of distribution companies to strategic investors, providing them with incentives to improve efficiency and the quality of service; . Define a clear policy framework and schedule for enforcing environmental regulations and achieving energy security targets (ensuring that targets are affordable and consistent with the EU Accession schedule); * Let private investors assess demand, secure contracts with eligible end-users (beginning with the largest consumers) and possibly with privatized distribution companies, and proceed with power generation projects within a clear policy and regulatory framework, with the Government authorizing projects (ensuring compliance with national policies), rather than being involved in tendering for capacity based on its assessment of demand. The experience of liberalizing energy markets throughout the world is that the single buyer model (SBM) based on long-term PPAs comes under considerable stress. The reason is that direct PPAs and the SBM transfer all the risk in selecting plant and forecasting demand on to the SB, instead of placing risk where the expertise and the ability to control it lies, namely with the generators making the investment and entry decisions. The planning mechanisms of the previously vertically integrated industries are poorly suited for making commercial decisions in a rapidly evolving competitive electricity market, particularly with competition being driven by economic necessity (the need for Bulgarian products to be competitive in the global marketplace) and Bulgaria's desire to join the EU and its single electricity market. In the United States, where the electricity supply industry was largely in private ownership and was vertically integrated operating the SBM, the forced liberalization has resulted in huge stranded costs in some states and inadequate investment in others, both of which are hampering reform. It is therefore critical to resolve the issue of long-term contracts before the problem escalates to the point at which it becomes a serious financial risk for the state as present owner and probable future guarantor of such contracts. SERC and SAEER as well as the government will have to make very clear the conditions under which new licenses for generation will be granted and future PPAs will be accepted. Ideally, the model contract should allow for a seamless transition to a competitive wholesale market within a relatively short space of time, but would need to take into account the preferences of the international capital markets which are likely to be the main source of investment funds. Recognizing that the existing market structure will require NEK to enter into long-term PPAs, most of which will not be supported by corresponding sales agreements, these should only be considered for essential investments needed to ensure reliable and efficient supply before the market is restructured to alleviate NEK's PPA obligations. To assure private Chapter VIII: Regulatory and Structural Issues in the Network Utilities 163 investors that future wholesale prices will reflect economic reality and will not be unduly constrained by inappropriate regulation, it may become necessary for the Government to quickly create a competitive wholesale electricity market, phase out the Single Buyer Model and replace it with a system of authorization for new capacity, placing the risks upon entrants instead of the captive household customers (or taxpayers, if the GOB accepts the financial liabilities of stranded contracts). Gas. The medium-term priorities in the gas sector are to: * Expand the gas transmission capacity to Bulgaria's neighbors, particularly Turkey; * Develop the nascent low-pressure natural gas market as a means of reducing adverse environmental and health impacts of coal-based heating and providing a competitive alternative to electricity; * Exploit indigenous hydrocarbon deposits (the first gas development project is expected to begin production in 2001). To support these priorities, the focus should be on: * Putting in place transparent tariffs for transmission and storage to enable third-party access to the network on a non-discriminatory basis, including for imports and exports; - Accelerating opening of the gas market by allowing large users to contract supply directly, including from abroad (this may require re-negotiation of the gas supply contract); * Accelerating competitive tendering of licenses for low-pressure gas market development, relying on inter-fuel competition and bench-mark regulation (comparison between gas companies operating in different license areas) to regulate the market; * Positioning Bulgaria as a reliable transit country for future oil and gas transit by putting in place a transparent market structure and regulatory framework. The most important structural issue in the gas sector relates to the appropriate organization for the transmission company - as Single Buyer or operator of a regulated third- party access (TPA) open-access pipeline. The main argument against allowing open-access to the national transmission system is that it would put the country's single supplier, in a position to negotiate directly with each customer and extract whatever market power was available by individual price discrimination. The merchant pipeline option (effectively, a Single Buyer in which the transmission company would take title to the gas at the border and retain ownership and would not be required to provide transport for third parties) allows the transmission company to exercise some monopsony power in negotiating contracts with the single supplier, thus driving down the average price of gas to the benefit of consumers (provided that the transit tariff is carefully regulated to enable the benefits to be passed through to final consumers). 164 Chapter VIII. Regulatory and Structural Issues in the Network Utilities The question is whether the benefits of Bulgargaz' greater bargaining power can be combined with the greater negotiating skill of commercial buyers. The ideal would be a contract between a privatized trading company (inheriting Bulgargaz' existing contracts with both the single supplier and commercial customers) and the single supplier, in which any direct sales by the single supplier, or its affiliates, or traders ultimately buying gas from Russia, could be offset against the minimum take-or-pay obligations of the new trading company. This could then be combined with open access to the national transmission system. Romania has apparently been able to negotiate more flexible contracts (essentially in exchange for hard currency payments on delivery) and the same deal might be negotiated in the case of Bulgaria. Certainly Bulgaria's importance to its supplier is enhanced by its role as a major transit country, and the supplier must also avoid over-enthusiastic exercise of its bargaining power for fear that Bulgaria may negotiate long-term contracts from alternative suppliers, thereby permanently forfeiting a valuable market and transit opportunities. Bulgargaz' Annual Report 1998 shows Bulgaria on the transit route for a prospective "Iran-(Turkmenistan)-Turkey-Europe" pipeline continuing through Romania and Hungary to western Europe, and two other links, one to north Italy via Croatia and Hungary, the other via Greece to southern Italy. If built, these would greatly improve Bulgaria's market position and render regulated third party access (rTPA) more attractive. Bulgargaz clearly wishes to remain a single buyer, thereby preserving its negotiating position vis-a-vis its single supplier. An alternative would be a hybrid solution, in which Bulgargaz retains the ownership of the National Transmission System and the right to contract directly for gas while allowing third party access to eligible customers. Such a compromise represents an uneasy balance, in which the transmission company will have incentives to price discriminate in the downstream market in ways that require an extreme regulatory vigilance to deter. District Heating. Subsidized household electricity tariffs (unfair competition) and the absence of functioning home-owner associations to manage the communal nature of district or building-level heating services, makes commercialization of the DH sub-sector particularly challenging. The Government's medium-term priority should be to rehabilitate and modernize major district heating systems supplying high-population density areas (accounting for about 80 percent of national DH demand) to support their commercialization and privatization. Indeed, if distorted energy prices and lack of a suitable heating strategy for high-population density areas (presently served by district heating) result in a collapse of the major district heating systems (with over 5,000 MW equivalent of connected load), the impact on electricity distribution networks could be damaging and the need for investment in new generation capacity, the costs of which would need to be passed on to consumers, would have a negative effect on the economy. The key objectives and priority actions in the sector should be based on the following findings of work carried out by an inter-ministerial working group supported by the World Bank and EBRD: * In high population density urban areas where the existing district heating infrastructure is already installed, it is the least cost and environmentally cleanest means of space and water heating. Electricity, the only environmentally acceptable readily available alternative, has the advantage of being easy to measure and control, but is more costly when priced at its full cost recovery level and will drive up the Chapter VIII: Regulatory and Structural Issues in the Network Utilities 165 need for investment in expensive new generation and distribution capacity. As there is no gas distribution infrastructure in place and the major DH systems use natural gas as their primary fuel, extending the gas network to households and installing gas- based heating systems at the building or apartment level will require significantly greater investments and will be less cost-effective than modernizing existing DH systems. * DHC governance structures and management must be strengthened to realize the full benefits of any investment program. Measures will include greater involvement of municipal and other stakeholders in the strategic directions of the DHCs, strengthening of management (through better recruitment, incentives and training), and better accountability for achieving specific performance targets covering technical (safety, efficiency and reliability), financial, and customer satisfaction aspects. Residential and public consumers can reduce their average heat consumption by as much as 20-30 percent, without compromising comfort, through cost-effective investments in modem substations, thermostatic valves, and heat cost allocators, which will allow better control and measurement of consumption. - On average, the district heating companies (DHCs) can improve the efficiency of heat production and transmission (and reduce corresponding fuel and operating costs) by as much as 10-20 percent through cost-effective investments in system rehabilitation and modernization. I Improvements in DHC governance and management, and cost-effective investments, will make district heating services more efficient and affordable. However, their full commercialization and long-term sustainability, including through attracting private operation and financing, will require reforms in legal and regulatory framework. Priority reforms would aim to balance the rights and obligations of service providers and consumers by allowing prices to cover reasonable costs, facilitating a fair allocation of costs between consumers living in multi-family dwellings (including through the creation of home-owner associations, better payment mechanisms, etc.), and providing incentives for suppliers to reduce costs and improve service quality (including through competitive procurement of fuel and other inputs, and competition for customers). * Similar legal and regulatory reforms will be necessary to support the commercial provision of any major communal service to inhabitants in multi-family/multi-owner dwellings, including decentralized energy services such as building-level gas boilers and major maintenance or retrofit of buildings. Individual heating services (such as electrical heating) would be significantly more expensive or unhealthy (such as the burning of wood or coal in apartments without adequate ventilation). * Elimination of operating subsidies would need to be supported by an expanded social protection program targeting low income and vulnerable consumers in areas served by district heating. The design of the program would need to mitigate social tensions arising from providing cost-effective communal services to families with a wide 166 Chapter VIII. Regulatory and Structural Issues in the Network Utilities range of incomes living in a common space (apartment building). The creation of home-owner associations and the channeling of consumer subsidies through this association (for the payment of district heating bills) may be an effective means of allowing buildings to avail of relatively low cost heating options. * Costs of a 5-year investment program for Sofia, Pernik and several of the largest DH systems (accounting for 80 percent of the national DH consumption) are estimated at Euro 220 million, excluding investments in combined heat and power (CHP) plants. These investments would allow operating subsidies, estimated at about Euro 50-75 million/year at present (mid-1999) gas prices, to be phased out in 4-5 years. Railroads. In order to develop a transportation system that is responsive to shipper needs and demands, as well as to marketplace opportunities for innovation, it is recommended that the governnent pursues the following policy reforms: * Complete the vertical separation of infrastructure from services and provide a concession for the maintenance and operation of the infrastructure to a private entity; 3 Privatize all the activities of BDZ, and accord the privatized, for-profit railroad, sufficient structural flexibility to rationalize the system; * If the continuation of any uneconomic services is deemed in the public interest, the government should provide an explicit subsidy program to support their provision and adopt a competitive tender process by which the entity requiring the least amount of subsidy is given the right to offer the subsidized services; - Eliminate any remaining statutory restrictions on competitive entry into rail services; a Put-in-place clear framework governing access to the railroad infrastructure by competing private operators and establish the pricing rules for such access; * Establish a simple regime of price regulation towards those elements of railroad activities in which competitive pressures are judged to be inadequate (e.g. service to captive shippers); * To ensure effectiveness, transparency, and accountability in the sector's regulatory process, all regulatory functions should be properly harmonized within a single agency-such an agency should be granted the statutory authority to determine the conditions of access to the rail infrastructure, determine access charges (or at least to intervene in cases in which negotiations between the owner of the infrastructure ands a service operator fail), monitor infrastructure quality, set maximum freight charges, where appropriate, and advise the Ministry and the government on line abandonment policy. The main issue in the rail sector is to implement the separation between infrastructure and operations. The complexity of the practical implementation of this task should not be Chapter VIII. Regulatory and Structural Issues in the Network Utilities 167 underestimated. In addition, the issue of the rationalization of the existing system deserves special attention and needs to be addressed more thoroughly than appears to have been the case so far. Moreover, there are concerns related to the lack of inter-modal competitive neutrality. The option of separating the ownership of facilities from other rail functions such as train operations and marketing has considerable appeal because it seems to mitigate the difficult problems blocking comprehensive rail deregulation that are associated with the roadbed costs that are largely sunk. However, separation is not a panacea. It may create serious coordination problems, loss of economies of scope, and otherwise unnecessary transaction costs. However, these concerns are not unique to Bulgaria and they equally apply to all other European countries that are pursuing separation of infrastructure from services under the EU directives. Roads. Priority actions include: * Adopt efficient highway pricing and investment guidelines-replace the piecemeal and complicated system of taxes with a more structured system; * Take steps to improve highway safety; * Establish and fund independent surveys to assess how well the market is working- the price and quality of road haulage services-and to identify areas that need improvement. Ports. Priority actions include: - Identify options for the structural reorganization of ports and fully exploit all opportunities for private sector participation-in particular the operations of the ports of Bourgas and Varna should be analyzed with the assistance of international experts; - Undertake a review of port charges and services, and propose a mechanism for the future determination of such charges. Airports. Priority actions include: Introduce a price control system for airport services that provides the individual airport administrations incentives to reduce costs and to exploit their land-side commercial opportunities. Development of effective regulation A stable regulatory process that balances the competing interests of consumers and industry participants is key to the success of the transition to privately-owned competitive infrastructure sectors. The regulatory process is critical to the firms' operating environment. Therefore, an indispensable precondition for attracting private investment in the infrastructure sectors and for improving their performance is the establishment of an effective system of regulation. The experience from both developed and developing and transition economies contains several important lessons. These lessons relate to the importance of requiring each 168 Chapter VII: Regulatory and Structural Issues in the Network Utilities regulatory agency to publicly articulate a set of fundamental principles to serve as a transparent basis for their policy analyses and detenninations; and the characteristics of an effective system of regulation--coherency, transparency, independence, and accountability. Guiding principles for public utility regulation. The following are some of the guiding principles that would generate efficient solutions to the wide range of disputes and issues that might arise in the regulated infrastructure sectors of Bulgaria: * Preserve promised investor value by requiring regulators to desist from unilaterally imposing changes in policy or other regulatory directives that would diminish investor value. * Allow competition to function where it can without distortion by mandating that the regulators desist from intervening in activities of the regulated firns that relate to competitive markets, or at least to markets that fail to be identified as protected natural monopolies. - Weigh the costs of rules against the benefits by constraining the regulators from expanding their domain of intervention without demonstrating that the benefits would outweigh the costs. - Assure service quality and price levels that offer consumers no less than the competitive standard of comparison by: requiring regulators to desist from sustaining privatization deals that result in prices higher than financially necessary to support the levels of service quality; allowing consumers to challenge arrangements that charged them more in return for flows of cash to the treasury; mandating the use of price cap mechanisms to control the level of regulated monopoly prices over time; establishing the right of consumers to seek rate adjustments if the quality of service provided falls significantly short of that promised in the privatization agreement. * Assure that prices provide signals and incentives for efficient actions by consumers, suppliers of complementary and substitute services, suppliers of inputs, and investors by: stipulating that such prices be responsive to the relative values of service on the part of consumers, as well as to marginal costs; according the service providers pricing flexibility subject to the constraint that their revenues cover their total costs. * Allow open access to bottleneck infrastructural facilities on terms that reflect competitive parity by requiring infrastructure monopolists to give access to their bottleneck facilities to rivals with access prices that carry the same markups as do the competing end-user services sold by the holders of the bottlenecks. * Pay efficient and competitively neutral attention to social goals pertinent to each infrastructure sector by requiring: any surcharges or taxes collected to affect the prices charged by competing suppliers equally, so as to leave the relationship between the competitors' prices undistorted; subsidies to be granted in as targeted a fashion as Chapter VIII: Regulatory and Structural Issues in the Network Utilities 169 is possible to avoid distorting decisions by those outside the intended ambit of the programs. Characteristics of effective regulation. The statutory framework of each of the regulated sectors should: Mandate coherency in regulatory policy towards each sector * All elements of policy towards each regulated sector fit logically together and are mutually supportive--the underlying laws that establish policies must not be in conflict, and implementing regulations must fit together. * Adherence to the principle of the Rule of Law by requiring respect for precedent and the principle of stare decisions: regulators do not reverse past policy decisions unless considerable evidence has emerged that they have led to significant problems, and cases with the same underlying facts are always decided in the same way. * Within each sector, a single agency should have the primary responsibility for all price regulation, should be given the statutory authority to compel cost and technical information from all firms with any license to operate in the sector, and should be granted discretion to decide whether to regulate. Moreover, this agency should be required to develop and publish its procedures for deciding what to regulate and setting prices, and to justify its pricing decisions on the basis of these principles. Mandate transparency in regulatory procedures and other policy determinations * Clarity of policy from the perspective of regulated firms, unregulated firms that compete at the fringes of regulated services, and users of communications services. a The details of existing policies, the principles for making policy in the future, and the process for making new regulations and resolving disputes should be a matter of public record that is accessible to all citizens. * All decisions in the domain of economic regulation and all entry decisions (licenses and privatization agreements) should be a matter of public record. The regulatory agencies should be mandated to issue public documents, subject to comment from any citizen who wishes to participate, concerning the policies and procedures that will guide regulatory decisions in the future. Mandate the political independence of the regulatory agencies * The regulators should not be subject to informal means of control of formal approval requirements from political and ministry officials, especially on a day-by-day or decision-by-decision basis. 170 Chapter VIII: Regulatory and Structural Issues in the Network Utilities * The head of each regulatory agency should have a fixed term of office and should not be removed from office before the term expires, except for cause and subject to a fornal review. * The government should not over-turn the decisions of the regulatory agencies except through legislative action or appeals of the agencies' decisions to the courts as not complying with existing law. * Decisions about entry (licensing) and pricing should reside in regulatory agencies that have the power to enact and enforce regulations without obtaining the approval of the cabinet, the Prime Minister, or Parliament, but subject to challenge in court or reversal by statute. Mandate accountability in the regulatory process * Citizens and regulated firms should be aware who is responsible for a regulatory decision and regulatory responsibilities and procedures should be clarified for each area of regulation--by technology and by category of activity (e.g., service quality, prices, scope of services offered). * All regulatory agencies should be subject to procedural requirements affording all interested parties an opportunity to be heard on major issues of policy, stipulated deadlines for reaching decisions, and the obligation to supply reasoned justifications of decisions. The energy sector. The most obvious problem with the current institutional structure is that SAEER has assumed most of the responsibilities of a Ministry of Energy, and is in a powerful position, while SERC is still struggling to develop its role, competence and stature, with little support from the Government. Moreover, SERC has little role to play in tariff setting until 2002 and its ability to balance supplier and consumer interests remains questionable so long as the SAEER is responsible for investment and capacity decisions, and in preparing the energy industries for privatization. However, SERC is in the process of being strengthened. Also, the fact that it will play no major role in tariff regulation until 2002 may provide it with the needed time to put in place the basic elements of accounting regulation and to establish the principles that will serve as a transparent basis for its policy and regulatory determinations. The Hungarian experience shows that it is unwise and costly to move quickly on privatization without first creating an effective regulatory structure. The main danger is that without a credible and effective system of market-oriented independent regulation resistant to arbitrary political interference, potential buyers will insist on long-term contractual guarantees for their revenues, as well as possibly high rates of return to offset the perceived political risk. SAEER may be tempted to pursue privatization rapidly in order to be able to negotiate such contracts and hence dramatically restrict the power that SERC will have in setting future tariffs, or in creating a competitive energy market. Chapter VIII. Regulatory and Structural Issues in the Network Utilities 171 8.63. Railways. The main concern relates to the creation of an independent regulatory agency that will be effective in optimizing the performance in the rail industry. The draft Railway Act does call for the creation of an independent Executive Agency "Railways Administration". The "Railways Administration" will monitor compliance with the terms and conditions of licenses, investigate alone or jointly with other authorized bodies railroad accidents, regulate public service obligations, and control access to the infrastructure. However, it is unclear as to whether the "Railways Administration" will be given the statutory authority to regulate the pricing of access to the infrastructure. After all, access pricing is likely to be the single most important determinant of the future competitive developments in the sector. At present, the fees for the use of the infrastructure will be ultimately determined by the Council of Ministers. Moreover, according to the Ministry of Transport, all competition issues could be referred to the Commission for the Protection of Competition (CPC). However, there is a concern that the CPC would not have the specialized expertise to deal with the complex issue of railway access and railway access charges, and of rail freight charges. There is also an added concern the Ministry of Transport would be both judge and jury in the matter of the terms and conditions of access to the railway network. The Ministry will be responsible for Republican Railway Infrastructure (RRI). It will propose (in conjunction with the Ministry of Finance) access charges to the Council of Ministers. It will also be responsible for the train operating components of the former BDZ. It will fund passenger services through the PSO. Through its General Directorate of Railway Administration it will control access to the RRI, and license train operators. In regard to freight rates, it seems likely that BDZ will, at least, in the medium term, continue to operate rail freight services. Hopefully, the reforms would encourage competitors to also offer such services, but this would involve considerable risk for the investors in such services, who would want maximum satisfaction that both access conditions and the charges that they can levy for their own services would be judged fairly. All of the above considerations call for regulatory responsibilities to be coherently and delicately harmonised and be kept within a single agency, and not be counterproductively splintered. It is true that the Railway Act envisages the creation of an independent regulatory agency. However, as noted above, it is not as yet clear that all regulatory responsibilities will be kept within the "Railways Administration". Rules governing access to bottleneck infrastructural facilities The emerging experience from several countries reveals that the allocation of bottleneck input resources and the broad issues of access and interconnection are of critical importance in the deregulation and competitive restructuring of the infrastructure sectors. In the telecommunications industry, the bottleneck is access to the local loop by suppliers of long- distance services; in electricity, rival generators must have access to transmission facilities; in the gas sector, producers require access to transmission pipelines; in railroads, the provision of services is dependent on access to the track. The benefits of liberalizing the potentially competitive segments of these industries will not obtain unless a proper access and interconnection framework is put in place. 172 Chapter VIII: Regulatory and Structural Issues in the Network Utilities One of the primary challenges facing regulators in Bulgaria is to ensure access of competitors to bottleneck facilities, especially when they are controlled by incumbent monopolists, on terms that are consistent with efficient competition--i.e., to set a level and structure of access prices which promote dynamic efficiency through efficient entry and investment decisions while enabling the owner of the respective network to remain financially solvent. Thus, prices should be sufficiently high to be compensatory (at least cover the long-run incremental cost of the use of the network by the entrant), yet not so high as to preclude efficient operations by the entrant. Railroads. One of the primary regulatory challenges in the rail sector is the design of efficient rules governing access to RRI's track and other infrastructural facilities. It would be desirable for the state to set efficient infrastructure access charges. The charges would be based on the marginal cost to the rail infrastructure incurred from transporting passengers and freight. In practice, however, it is quite likely that the state's effort to set charges would be dominated by political forces and that the resulting fees would be far from efficient. A more efficient outcome is likely to result if the fees were determined by private negotiations between carriers and RRI. Intermodal competition from truck would provide competitive discipline on the access charges the infrastructure company could charge rail freight carriers; and competition in the passenger market from bus and car would provide competitive discipline for the access charges the infrastructure company could charge rail passenger carriers. In addition, it is likely that private negotiations would create incentives for carriers to reduce the costs they impose on the infrastructure in return for lower access fees. Economically efficient pricing policies Recognising that efficient pricing policies are necessary for facilitating efficient infrastructure services, the Government has taken bold measures in the energy sector to liberalise (deregulate) coal prices, advance the removal of cross-subsidies for electricity, and raise household district heating prices closer to their cost-recovery levels. Appropriate pricing principles are also enshrined in the Energy Act. However, political constraints and the difficulties in putting in place more efficient social protection systems, still require recourse to a complex system of cross-subsidies within the broad domain of social pricing. In the energy sector, specific additional actions which the Government and SERC will need to take to eliminate energy pricing distortions in the short run include: Accelerating the adjustment of household electricity prices to their full-cost recovery levels with incentives to improve supply efficiency. The cost of supplying electricity to households is substantially higher than to industrial and other large customers, however, household electricity prices are still well below those paid by industrial users. An adjustment in household prices is necessary to prevent a large-scale departure from more cost-effective district heating systems to costly electricity in the short term while DH systems are being restructured and modernized. This measure would need to be supported by strengthening the existing energy subsidy program to alleviate the cost of winter heating for vulnerable consumers; * Articulating a clear policy for taxing environmental emissions, and rewarding use of indigenous and renewable energy resources, and implementing energy efficiency Chapter VIII: Regulatory and Structural Issues in the Network Utilities 173 measures. This policy framework will be essential for private investors, rather than the Govermment, to determine their investment strategy in the sector and to take the market associated risks; * Determining if and when electricity distribution companies will become "eligible customers", free to seek cheaper power including from abroad, and signaling this decision to the market players. This will force NEK-Transco to be more prudent in concluding long-term or risky PPAs with generators; * Designing a low-pressure gas pricing strategy which would allow an accelerated development of the gas market in Bulgaria; * Continuing the increase of household district heating prices to their cost-recovery levels as soon as basic investments have been made to allow consumers to measure and control their consumption (to within affordable levels) and DH suppliers have been put on an efficient and commercial footing. A clear articulation of the above-mentioned policies will be necessary if the Government wants private investors to make sizeable investments in the energy sector without recourse to sovereign guarantees. Electricity. While important pricing policy revisions are underway, the electricity industry still suffers from unbalanced end-user prices and inadequate revenues aggravated by a collapse in demand from industrial consumers which have traditionally paid the highest electricity prices. The obvious political difficulty is that tariff re-balancing requires raising household tariffs. Household tariffs (about US cents 3.5/kWh during the day and US cents 1.8/kWh during the night) are still considerably below the tariff charged to other low voltage (LV) consumers (US cents 5.4/kWh during the day and US cents 2.6/kWh at night)90, which themselves may not yet reflect the full costs of LV distribution. It is expected that household tariffs will increase by 25-50 percent to bring them to a cost-reflective level by the end of 2001 (as is required by the Energy Act). High voltage tariffs to industrial consumers, US cents 4.1/kWh (day) and US cents 1.9/kWh (night), appear reasonable given the presently low average wholesale prices of electricity (which still do not fully reflect the replacement cost of capital). 8.64. The largest electricity customer in Bulgaria, Union Miniere, finds that whereas in the past Bulgaria had relatively cheaper industrial electricity for smelting than its home country, Belgium, this situation has been largely reversed with the liberalization of the European electricity market since the EU Electricity Directive came into effect. Once eligible customers are free to seek cheaper power, NEK-Transco will lose its profitable customer base, and be forced to increase the charges to any captive customers. Gas. The Government and the SERC are already in an advanced stage of developing the methodology of setting regulated tariffs for transmission, transit, storage and distribution of gas. However, as the low-pressure gas distribution system is virtually non-existent and needs to be developed to provide a competitive alternative to electricity, coal briquettes and in some case district heating, there is an urgent need to develop a more market-based approach to setting low- 90 Tariffs are net of VAT and based on an exchange rate of BGN 2.0/$. 174 Chapter VIII: Regulatory and Structural Issues in the Network Utilities pressure gas prices. A possible solution could be through the competitive tendering of properly designed license areas, asking bidders to propose the tariff margin they would need to meet specified service requirements. A more fundamental issue would be to liberalize the import of gas and allow large end-users and developers of low-pressure gas networks the right to negotiate gas purchase prices directly with importers or Bulgargaz, and pass these prices on to their franchise customers together with their regulated distributed margins. Since customers presently are availing of alternate means of heating and cooking, gas would need to compete with these alternate fuels and there may not be the need for extensive price regulation. District Heating. The absence of individual measurement and control devices, and the communal nature of district or building-level heating services, makes adjusting heat prices to their economic levels particularly challenging. As discussed above, any pricing policies would need to take into account the local (city-specific) nature of district heating, the communal nature and positive environmental externalities of this service, and the need to put in place mechanisms to support a fair allocation of costs among consumers. Household Heating and Energy Prices: Given the high share of energy expenditures in household budgets (betWeen 15-20 percent on average), setting prices on an economically rational and predictable basis is urgently needed to promote least-cost and environmentally clean home heating options, and to pave the way for private provision of energy services. Based on household energy data provided by the Energy Efficiency Agency, in 1995-96, households consumed about 22,000 GWh (million kWh) of energy in the form of electricity, district heating and coal briquettes for home heating and hot water. As energy prices approach their economic levels by end-2001 (as is required by the Energy Act), household expenditures on heating would rise by about 15 percent assuming there is no change in consumption patterns, well in excess of average income growth over the same period (see table below). Table 8.4: Household Expenditures on Heating Energy GWh $/MWb (incl. Total Expe diture, m$ Monthly Bill Source (m kWh) July 2000 Mid-2002 2000 2002 (2002 winter Electricity 7,000 34.0 >50.0 238 >350 $75 District Heating 6,000 18.0 25.0 108 140 $37 50b' Solid Fuels 9,000 4.0 8.0 36 56 $32c/ Total 22,000 382 446 Gas potential Minimal 14.0 20-24'_ . A 2 kW heater for 1 room only would consume 1.5 MWh/month if operated 24 hours/day b/ Typical need: 1.5-2.0 MWh/winter month for a standard apartment (70 m2 with present insulation) C/ Based on briquette price of $40/ton in 2002, 50 percent stove efficiency, and 2 MWh (net)/month dI Based on wholesale price of $115/thousand cubic meters ($12/MWh). Additional investment need for furnace/circulation equipment. Source: State Energy Efficiency Agency/World Bank. Competitively neutral mechanisms for funding universal service In Bulgaria, like in most countries around the world, traditional policy towards the network utilities has led to prices reflecting cross-subsidization. Both economic theory and regulatory experience suggest that, with open entry and no remedial policy, maintaining cross- subsidies in the price structure is impossible. Thus, with market liberalization, either new Chapter VIIIT Regulatory and Structural Issues in the Network Utilities 175 sources of subsidy must be found, or rates below incremental costs must be raised to compensatory levels. Deregulation of key sectors of the U.S. economy was based on the promulgation of competitively neutral mechanisms to foster desirable social goals and positive economic externalities. The need to adopt explicit support mechanisms sufficient to advance certain publicly articulated universal service principles, and to assist consumers who would otherwise be disadvantaged, is more pronounced in Bulgaria (relative to the United States) in view of the socioeconomic characteristics of its population. While the U.S. and E.U. experiences are instructive, policies for pursuing universal service goals must be sensitive to an individual country's political and institutional endowment, fiscal condition, consumer incomes and preferences, as well as the industry's economic characteristics. Policy makers must take into account how these factors affect the optimal design of support mechanisms: whether support for universal service should be funded out of general tax revenues, or perhaps out of a broadly-based tax on revenues derived from the industry's products and services; the extent and scope of subsidies; and methods for delivering the subsidy without distorting competition. So far, it is unclear how the issues of universal service will be addressed in the different network utilities. CHAPTER IX: COMPLYING WITH THE EU ENVIRONMENTAL DIRECTIVES INTRODUCTION Bulgaria has already made some considerable efforts to advance the compliance with EU environmental requirements, especially with regard to the adoption of EU requirements and standards on air pollution, waste, water, nature protection and chemicals. Complying with the European Union's environmental directives is a major and urgent challenge because full compliance with the environmental Acquis will require a substantial investment program in environmental infrastructure, namnely, air pollution abatement, waste management, drinking water supply, and wastewater management, and financing the associated operation and maintenance costs. This chapter examines the challenges Bulgaria will face as it adapts and implements the whole body of EU environmental legislation and standards, and outlines some recommendations for developing an implementation strategy. It starts with an overview, including a summary of the compliance costs. It then reviews implementation issues in each of the environmental areas as well as impacts of the required investments on households. The chapter closes with some strategic recommendations." BACKGROUND AND COMPLIANCE COSTS European Union environmental legislation Environmental protection has high priority for the Union. The 1987 Single European Act specifies powers to act on all enviromnental matters. The EU legislation environmental directives touch all sectors of the economy. However, neither Bulgaria nor any of the other candidate countries will have to implement all of the environmental Acquis prior to accession to the Union, but rather explicitly recognizes that transitional periods will be necessary." The implementation of the environmental Acquis presents a particular challenge for several reasons. * The scale and scope of the EU legislation concerning enviromnent is broad and requires substantial investments in several sectors of the economy. Most likely acceding countries would make similar investments at some stage in the future, even without the imperative of EU directives, but accession accelerates the pace of the investment program and reduces the flexibility to adopt different implementation policies and technologies. * Although the implementation of the EU environmental directives will bring benefits, some of these benefits will only be seen in the very long term, and/or in neighboring 9 A background paper for this chapter, "Bulgaria - The Challenges of Complying with EU Environmental Directives," is available. 92 The Commission expects each country to address its own national priorities and problems as well as the economic constraints of accession. Chapter IX: Complying with the FUEnvironmental Directives 177 countries. However, the compliance costs affect each Bulgarian household. All levels of Government will need to engage in systematic consultations with the public and to invest in awareness-raising campaigns. * Although the requirements of the EU environmental directives have been identified as part of the national development program, it is not clear whether they are immediate priorities. The challenge is to identify those actions that will have both domestic and trans-boundary benefits and, and to be clear about trade-offs. * The necessary investment programs could contribute to regional disparities in income and employment. Therefore, the need to examine these programs carefully for their local and regional as well as their financial, economic and social impacts, and to implement appropriates transfer mechanisms where necessary. Environmental protection in Bulgaria Bulgaria's environmental legislation is framed by the Environmental Protection Act adopted in 1991. This Act revises the system of environmental standards, and incorporates the principles of polluter-pays, the right of the public to be informed, and pollution prevention, and calls for the integration of environmental protection in other areas of national policy. In recent years, the country has made considerable progress in harmonizing its environmental laws and regulations with those of the EU, particularly in the areas of air, water, waste, nature protection, and chemicals, and has filled the gaps in sectoral legislation. In terms of implementation, Bulgaria has made some progress during the 1990s. As shown in Figure 9.1, between 1992 and 1998, environmental expenditures93 remained relatively stable at around 1.0 percent of GDP. The level of environmental expenditures allocated for investments averaged only 0.4 percent of GDP94. The National Statistic Institute reports that in 1998, around E142 million or 1.3 percent of GDP were allocated for environment, but 67 percent of the expenditures were allocated for covering recurrent costs95. The economic problems in recent years constrained the ability of key sectors to finance environmental expenditures. Over the same period, Bulgaria has made good progress in improving its environmental quality. Although some of the reduction in air and water pollution has been associated with economic decline, some has been attributed to the investments in pollution control. Despite the progress in air pollution, air quality remains a concern in urban and industrial areas. Air quality monitoring data reveal that over 25 percent of the population live in areas with ambient air 93 Enviromnental expenditures as reported by NSI do not include expenditures on drinking water supply, sewerage system or clean-up of past pollution. In this report, we account for expenditures on drinking water and sewerage when referring to environmental expenditures or costs, except when indicating in the text. 94 This increases to 0.5 percent of GDP when investments in water supply and sewerage are also included. (The Ministry of Regional Development and Construction estimates that about US$ 10 million are invested on an annual basis by the State Budget into the drinking water supply and sanitation sector.) All the calculations in this chapter are done with the following 1998 exchange rates: IUS$=1.76BGN, IE=1.57BGN, and IE=1.12US$. 178 Chapter IX. Complying with the EU Environmental Directives quality below Bulgarian standards. Exposure to some pollutants has fallen in some hot- spots as a result of control measures. Figure 9.1: Overall Expenditures on Environmental Protection 1.4%- 0 Recurrent Costs 1.2% - *Investment Costs 1.0% 0. 0.8% 0 .A 0.6%- 0.4% - 0.2%- 0.0% - - - ___ 1992 1993 1994 1995 1996 1997 1998 Source: Prepared with data provided by the National Statistic Institute (NSI). Data for 1999 was not available at the time of writing this section of the report. Compliance costs We estimate the total investment costs for Bulgaria of complying with the EU environmental legislation at between E5.5 and E8.0 billion (in 1998 prices) regardless of the length of the implementation period. Table 9.1 shows the range of estimates for each sector: drinking water, nitrate, sewerage and wastewater E1.6-3.6 billion; air pollution C3.1-3.3 billion, and waste management 0.9-1.2 billion. Inclusion of other accession-related investments, not necessarily driven by the environmental Acquis but by the single market Acquis, will raise the level of environmental investments to E6. 1-8.6 billion96. The overall annual environmental expenditures have been estimated to range between C1.2-E1.7 billion or E149 and E205 per person (per year) at the end of the investment period. These annual expenditures include three type of costs: first, average annual charge of depreciation of the investment, i.e., investment costs driven by the environmental directives spread over their expected life assumed at 20 years; second, the cost of capital required to finance the investment97; and third, the associated operation and maintenance costs. If year 2015 is assumed as the date of accession, then annual environmental costs in 2015 will represent 4.9 96 This includes investment costs associated with nuclear safety measures in the Kozloduy Nuclear Power Plant (E540 million), and contingent environmental liabilities (E75 million). These are most recent ballpark estimates. 97 For the purpose of estimating the cost of capital, an opportunity cost of capital of 10 percent is used. This is a reasonable bound estimate since UK and US comnpanies involved in the provision of environmental services and investing in relatively low risky environments claim between 6-11 percent as their cost of capital. Some reviewers consider that a lower cost of capital should be used on the basis that Bulgaria will have access to grants and soft loans. Even with a lower cost of capital, i.e., 5 percent, the overall annual environmental cost at the end of the assumed implementation period (i.e., year 2015) is high: 4.1-5.6 percent of 2015 GDP. Chapter IX: Complying with the EUEnvironmental Directives 179 percent to 6.7 percent of forecasted 2015 GDP98. Future expenditures will represent several times more than the current level of expenditures99. A graphic representation of overall annual environmental expenditures between 1998 and 2025 for the minimum and maximum estimates is shown in Figure 9.2. Table 9.1: Environmental Costs of EU Accession Investment Costs Annual Inv. Costsa O&M Costs Total Annualized Sector (E million) (E million) (E million) (f million) Min Max Min Max Min Max Min Max Air pollution - Coal heating 543 752 64 88 95 132 159 220 - TTansportffuel 2,103 2,103 247 247 219 219 466 466 - Existing power plants 405 405 48 48 77 77 125 125 Drinking water 246 1,463 29 172 16 53 45 225 Sewerage 734 1,114 86 131 16 22 102 153 Wastewater treatment 476 850 56 100 49 102 105 202 Waste management 850 1,150 100 135 93 132 193 267 Nitrate 103 155 12 18 - - 12 18 Others b 30 30 3 3 12 12 16 16 Total Compliance Costsc 5,490 8,022 645 942 577 749 1,222 1,691 Total per capita per year (E) 149 205 As percentage of 2015 GDPd 4.9% 6.7% Responsibility lies with: Central Government 1% 1% 1% 1% 4% 3% 2% 2% Municipalities 47% 62% 47% 62% 38% 49% 43% 56% Private Sector 51% 37% 51% 37% 59% 48% 55% 42 % Total Environmental Costse 6,105 8,637 717 1,014 577 749 1,295 1,763 Responsibility lies with: Central Government 11% 8% 11% 8% 4% 3% 8% 6% Municipalities 43% 58% 43% 58% 38% 49% 40% 54% Private Sector 46% 34% 46% 34% 59% 48% 52% 40% Notes: a. Details are presented in Annex 1. Investment costs are annualized over 20 years using a discount rate of 10 percent. The cost recovery factor is estimated as follows: CRF=0.1 17= r(I+r)T/[(lIr)T 1], where r=0. 10 and T=20. b. This includes costs related to strengthening of public administration and subsidies for nature protection. c. Excludes nuclear safety, trade, and clean up of past pollution, and partially includes investments in transport and industry. d. Annual costs are represented as a ratio of forecasted 2015 GDP (E25.1 billion). e. When other environmental costs driven not by the environmental directives but by the single market directives are also included. 98 GDP is assumed to increase at an annual rate of 5 percent. 99 Since past level of environmental expenditures reported in this report do not include expenditures associated with drinking water supply and sewerage, these expenditures have to be excluded from the calculation in order to perform a true comparison. Once these costs are removed, the annual environmental cost will represent 4.3-5.2 percent of 2015 GDP. Nonetheless, the same conclusion holds: Environmental expenditures will have to increase by several folds in the future. 180 ChapterIX. ComplyingwiththeEUEnvironmentalDirectives Figure 9.2: Annual Environmental Expenditures as a Percentage of GDP' Low Cost Estimate 8.0% 8 Ann. hvestrrent cost 7.0%b --- - - - - - - -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- ---- -- - -- -- - -- -- - -- - -- -- - -- -- - -- -- - -- - ighCost-Est e&Mcost ci. 5.0%-- - - - - - -- - - 4.0%-- -- - - - - 3.0% -_ 00% -s i lddddMdiidM 'ote It p asueht199 leve lio eurn ot r ared over le", rest of the period Cpt le an ecret High Cost Estimate 8.0% 7T0% p------------------------------------------------------is - Annu.ivestnt cost 0o&M cost 6.0%P o lan d ------------------------------------------------m--------- cap ital cost 30% assungfrme tat 199er levelofnecurn cot aiifrencarrie novier thenrs ofmheperiod. Capestalends recurren exendioftures inm198fordrnkaiong waerio asupl an sewerae afcuren assume equale tot01herceuntrand 0.2l paern tof Sourcent Worf Bank estimates Thie p her capitaimte o environmental costtmebonpyB lgaianisci line weqith cmarable esimtrpeatesn made forsten orgaftheracsinoutes e.g.,esimtues forentdi thes Cehrepubli wer cl104- complisntanc fnormvrous accessiona coutest includin Bulgaria.nhi figureashows thateem thlowber bumndanaeb. Bulgaria is muchihigher thartatstoa eid for the other counre.Oerao sthtlBlgri drcivs- 4-8 percntfr adis Hungaryt 2-51 percent,isdt Bnulariaz il nheedt investmncot ann ual betee 11-16ies perentof199 GD.1 iNoterpretation,s tan in9lvestm erent prgrm oft the magnitudovrte presete in theeisd reporta will rclrearl rereen anenrmousit additionmnal cost for thbmebulgarganrppuation aind seems tomprble bunmainaeb. Bulga riaimc hisgseekihngo transtoateid for the mte onze Oeraost costhtly lgri drc iv s A uniform adisc unt arat yo 10 5 percentiusdto anulalizeil theedt invetmntc stsi allncuntries. en111 ChapterIX: ComplyingwiththeEUEnvironmentalDirectives 181 landfills directive, drinking water, urban wastewater, etc. Reasonable transitional periods will allow Bulgaria to delay environmental expenditures and to redistribute them in a more manageable and affordable fashion. Two factors accentuating the need to design a suitable environmental accession strategy are the overall fiscal position of Bulgaria (including its present high level of debt), which calls for close scrutiny of the efficiency of environmental expenditures; and the high level of poverty, currently estimated at 36 percent, which calls for the development of appropriate transfer mechanisms. Figure 9.3: Per Capita Cost of Compliance in Accession Countries 300- 250 _ - T- K - . 20 ---- ------ 1i5 0:11----- I - - 0 a. 100 =~ Czech Poland Hungary Slovenia Lithuania Bulgaria Implications for the public sector at the central and local levels The public sector through the central Ministries and agencies as well as municipal government will play a very important role in planning and financing investments driven by the environmental Acquis. The most important areas for public financing will be drinking water supply, sewerage, wastewater treatment, waste disposal, and household heating. In the future, central government should play a bigger role in helping municipalities to identify priority range of services and investment programs, to provide support for fund raising, and to allocate EU grants. The central government is expected to play an important role in the area of strategic planning and coordination. They will help municipalities to: (i) identify the best way to phase investments at the national or regional levels so that those with the highest benefits can be undertaken first; and (ii) cooperate to realize potential economies of scale associated with wastewater treatment and solid waste. Since operation and maintenance costs represent a high share of the overall environmental expenditures, the public sector will have to pay greater attention to the issues of affordability and allocation of subsidies, particularly in the water sector. All present municipalities are accepting water quality protection activities as compulsory costs and burdens and building wastewater treatment plants, but several municipally-owned water companies do 182 Chapter IX: Complying with the EUEnvironmental Directives not want to be responsible for the management of these plants and are refusing to operate and maintain them."'0 Financing of environmental investments Bulgaria will need to generate huge amounts of finance as well as draw from a range of sources of funds to pay for the necessary environmental investments. This will demand careful planning as well as coordination and full mobilization of financial flows. In the past, the state budget and municipal budget"02 financed a large percentage of environmental expenditures. Non-traditional domestic financing sources started to play a key role since 1993. The National Environment Protection Fund (NEPF), which is funded largely from pollution charges and fines, has financed a large portion of environmental investments. In 1998, almost 30 percent of the funds for environmental investment. Although the potential of the NEPF to finance future investment is not known yet, the NEPF has a major role to play in identifying and co-financing priority investments based on economic efficiency and affordability criteria. Other mechanisms are the National Trust Eco Fund and the Municipal Environmental Protection Funds (MEPFs). The privatization process has also been a key factor contributing to addressing poor environmental quality. During the past two years, enterprises using their own resources have funded 77 percent to 83 percent of the environmental expenditures. The restructuring (and privatization) of the energy sector will open new possibilities for increasing industrial investments in environmental protection. The Instrument for Structural Policies for Pre-Accession (ISPA) funds, which will allocate around E50 million per year during the period 2000-2006 for large environmental projects to finance up to 75 percent (and in exceptional cases up to 85 percent) of the project investment cost, represents a tremendous opportunity for Bulgaria to meet its sectoral and environmental priorities and to relieve the burden of these investments on households, particularly on lower income groups. Experience with similar EU funds provides some useful lessons for Bulgaria in planning its investment priorities. Funding for projects with global benefits could be obtained from the Global Environmental Facility (GEF). PUBLIC SECTOR INVESTMENTS Compliance with the EU environmental directives requires changes in three areas that fall exclusively within the state administration or the public sector: (i) harmonization of national legal acts; (ii) institutional improvements, such as adapting institutional structures, changing procedures and increasing management capacity; and (iii) standardizing enforcement, monitoring and reporting procedures with those of the Union. 101 Club Economika (2000). A background paper on the "Powers of Municipal Authorities and Possibilities for Imnplementation of Local Environmental Policy." Sofia, Bulgaria, February. 102 Municipal funds come from various extra-budgetary funds -- the fund of the Environmental Protection Conmmittee, the Forest Development Fund, and the extra-budgetary fund of the Ministry of Finance. It must be noticed that the consolidation of all extra-budgetary funds is underway. ChapterIX: Complyingwith theEUEnvironmentalDirectives 183 Over the past years, Bulgaria has made significant progress in the first area -- harmonizing its environmental legislation, particularly in the areas of air, water, waste, nature protection, and chemicals, with that of the Union. Still, some new legislation (or regulations) needs to be drafted from scratch, or amended from existing legislation. Although it will not be easy to complete the process to obtain a consistent, comprehensive and modem body of law, adapting and strengthening the policy functions of the public institutions poses a far greater challenge. Compliance requires three types of institutional changes. First, Bulgaria may have to create new agencies or departments where legislation requires a fundamentally different approach from that currently operating in the country."03 A preliminary estimate indicates that the central administration will need around 160 additional staff. 104 105 Second, the roles of the public agencies at both the national and local levels will also change. Much of the legislation determines new ways to performn existing functions such as planning, issuing permnits, monitoring pollutants, and reporting results. Although the basic institutional arrangements are established in Bulgaria, there is a need to review procedural aspects related to enforcement, monitoring, and reporting in order to ensure harmonization with EU. Third, improving the capacity of existing agencies at the national, regional and municipal levels will be extremely important. Enforcement of legislation is fundamental, particularly where much of the burden of investment will fall on the private sector. Moreover, enforcement is an important factor in meeting environmental targets and deferring capital expenditures. The new administration will require skilled staff, with authority and clear decentralized decision-making structures, and improved cooperation in the planning, monitoring and control process between relevant agencies and levels of government. The implementation of these changes will be costly - though the costs will be mostly in terms of administrative effort and political will. In financial terms, incremental annual costs on salaries, office space, external expert services, and monitoring equipment associated with the EU environmental approximation have been estimated at £7.2-10 million.'06 These estimates, however, underestimate the true institutional cost of approximation since they do not include expenditures associated with staff training, i.e., staff time when staff are away on training. As the effectiveness of the whole investment program depends on credible and effective institutions, Bulgaria needs to make serious and sustained efforts in this area linking them to the ongoing public administration reform program. 103 In Bulgaria this is likely to apply to directives relating to management of water resources (i.e., creation of Directorates for Water Basin Management and Basin Councils within them), transport emissions, dangerous chemicals, genetically modified organisms, and integrated prevention and control of industrial pollution (i.e., application of eco-labelling and EMAS). 104 It includes 30 new staff for air quality, 40 for water resources management, 25 for waste management, 40 for IPPC, 15 for chemicals, and 8-9 for nuclear safety and radiation protection. [PHARE (1999D)]. 105 No attempts have been made to assess the staffing needs in municipalities, but it is expected they will be large. The administrative structure of municipalities vary widely. No all 262 municipalities have the same administrative structure. Only large municipalities have environmental departments. Municipalities that serve as regional centers have appointed an environmental expert. In small municipalities, either the agriculture department or the urban planning department is responsible for the environment. [Club Economika (2000)]. 06PARE (1999A). 184 ChapterIX: Complying with the EUEnvironmental Directives PRIVATE SECTOR INVESTMENTS'07 The internal market The 1995 EU White Paper on accession identifies the essential measures relevant to the internal market that the accession countries must adopt before they enter the Union. It covers legislation affecting the free movement of goods and services, which in the environment field covers around 40 percent of the whole Acquis. The major enviromnental areas are: * Chemical substances and preparations (administrative procedures, evaluation and control of risks, classification, labeling, packaging, testing, notification, transport, import and export) and genetically modified organisms (contained use and deliberate release); * Waste management (waste oils, PCBs, PCTs, sewage sludge, batteries, packaging materials, incineration, landfills, recycling, and shipment); - Air pollution (lead and benzene content of petrol and sulphur content of diesel fuel and gas oil, VOCs and ozone depleting substances); - Noise from vehicles and machinery; and - Radioactive contamnination of food stuffs and radiation protection. Bulgaria has already adopted significant elements of the White Paper relating to the internal market since the harmonization of legislation and the accession to the internal market is a national priority. However, as mentioned earlier, institutional capacity and enforcement require additional efforts. In the case of the requirements concerning chemicals and genetically modified organisms (GMOs), Bulgaria has already adopted the Chemical Act, which establishes a sound basis for the transposition of EU chemical control legislation. However, existing Bulgarian laws controlling GMOs only cover a small proportion of the issues addressed in the EU legislation. The financial costs to the public sector institutions of implementing these measures have been estimated at about IE2.8 million per year in additional administration costs plus EI7.5 million in additional infrastructure, mainly equipment. Producers and users will bear most of the cost of the changes. These changes will ease access of Bulgarian chemical produces to the EU market, making the investments easier for the more profitable of them to accept. Bulgaria has updated its Waste Management Act in order to bring it into line with EU requirements. The 1997 Act for Reducing the Harmful Environmental Impact of Waste has been 107 The costs of comnpliance for industry is not fully assessed in this report. However, it should be mentioned the existing framework recently established in Bulgaria for addressing past environmental liabilities during privatization and for accelerating the introduction of integrated environmental permits will foster compliance with EU directives by those privatized enterprises. Other industrial enterprises would require some public support to ease the transition period as it has been customary in most OECD countries when new and stricter regulations were introduced. Chapter IX Complying with the EUEnvironmental Directives 185 prepared in the light of the EU requirements. This will require, apart from the establishment of hazardous waste treatment plants, a system for monitoring waste generation, treatment and disposal as well as ensuring that adequate processing and disposal sites are available. The major challenges relate to enforcing this legislation. The single market directives also include several measures relating to fuel quality and vehicle standards designed to improve the quality of urban air. With regard to fuel quality, Bulgaria has almost finished harmonizing its legislation in this area with that of the Union. Implementing it will, again, be costly and politically sensitive. Perhaps the most important from the domestic point of view is the phase out lead in gasoline, which is planned by 2002. This, however, will bring immediate health benefits to the local population. With regard to changes in vehicle standards, the legislation in this area will be more difficult to implement. Individuals will have to bear the brunt of the cost of upgrading the car fleet and fitting catalytic converters, making implementing these requirements difficult and politically sensitive. The total additional investment costs has been estimated at E1.77 billion.'08 Institutional costs, as a result of yearly inspections for both security and environmental legislation, has also been estimated at E186 million per year.'" " This should be considered a long term objective. The measures, once completed, however, should result in significant improvements in the quality of urban air. Industrial pollution control Directive 96/61/EC on Integrated Pollution Prevention and Control (IPPC) gives a general framework for preventing pollution and for controlling it from selected manufacturing technologies that have the most substantial environmental impacts. It sets standards for operating and discharge permits as well as dictating certain procedures for enforcement and reporting. This directive encourages industries to prevent or minimize emissions to all environmental media rather than considering "end of pipe" solutions, and stresses an integrated, cross-media approach to industrial pollution control for emissions to air, land, and water alongside a range of other issues. The big impact on the public sector is the increased demands on agencies responsible for permitting and enforcement of industrial pollution legislation. The IPPC Directive is partially transposed in the Environmental Protection Act and its Amendments, and in Regulation No.4 on Environmental Impact Assessment. Bulgaria will transpose the IPPC Directive in the national legislation by 2002, and will launch a phased issuance of integrated permits for all manufacturing companies falling within its purview. The full implementation of all requirements of the directive is foreseen by 2010-2012. Bulgaria is not expected to fully comply with the IPPC Directive until it becomes a member of the EU. The existing 380-400 plants requiring integrated permits are in the following sectors: waste 26 percent, metallurgy 20 percent, chemical 16 percent, energy 14 percent, and mining 18 percent. There is a wide variation among enterprises in terms of their physical and technical 108 PHARE (1999C). 109 PHARE (I 999C). Security related costs are responsibility of private car-mnaker companies. I I°These are theoretical figures which can be used to assess the cost to deal with vehicle emnissions. In practice, however, retrofitting existing 10-15 year old vehicles is not technically feasible and efficient. 186 Chapter IX.: Complying with the EUEnvironmental Directives lifetime, ranging from 6 to 25 years. The potential for gradual improvement of environmental parameters of individual facilities varies substantially. Most of the existing installations require substantial upgrading to comply with the requirement of the directive. According to the timetable by the end of 2009, BATs to prevent pollution would be adopted in the main industrial sectors. However, some companies may need to be allowed to operate the existing facilities at least until year 2012."' The public sector will have to invest around C4.0 million (or from £67,000 to 227,000 per year) to administer the changes relating to the IPPC directive. This is an underestimate, as it does not include costs of upgrading existing installation to BAT, which will be necessary to develop the necessary administrative and scientific knowledge. Air pollution EU legislation that tackles air pollution takes various forms. One set of directives aims to improve the quality of air in urban areas and to set standards for levels of certain pollutants in the atmosphere. This group of legislation brings the most direct health benefits to the local population. Related to that are regulations that cover the standard of fuels that can be used in vehicle engines or power plants or that set down technical standards for equipment that pollutes the atmosphere. This type of legislation was covered in the section dealing with the single European market. A third group deals with pollution that affects other parts of the country or other countries. This includes emissions from power plants of sulphur dioxide and other substances that cause problems at a regional scale, and pollutants that affect the global atmosphere. Reducing air pollution is a high environmental priority for Bulgaria because of its significant health impacts and its high international visibility."2 According to the results from the continuous assessment of air quality undertaken by the National Monitoring System, the acceptable air quality limit values for these pollutants have been exceeded during the last years within the area of the major Bulgarian cities (of more than 100,000 inhabitants). The violation of acceptable air quality limit values is of special concern within the 14 hot spot areas. In addition to domestic heating and traffic activities, the industry sector is still the largest pollution source despite the decline in production during the last years. Using the Bulgarian classification system, the total emissions in 1998 in "hot spot" areas exceeded admissible limits. In Plovdiv-Assenovgrad daily emissions of lead aerosols, exceeded the admissible limits 29 percent of the days of the year. In Varna -Devnia, daily emissions of SO2 exceeded admissible limits 80 percent of the days in a year."3 I I I According to MOEW's timetable, a transitional period until January 2012 has been suggested for existing facilities. 112 Botcheva, Liliana (1999). Doing is Believing: Participation and Use ofAssessments in the Approximation of EU Environmental Legislation in Eastern Europe. GEA Discussion Paper E-98-13. Available at: http://environment.harvard.edu/gea/pubs/ "3 Ministry of Environmental and Waters (1999). ISPA Strategy Paperfor Environment. Sofia, Bulgaria, November. Chapter IX: Complying with the EUEnvironmental Directives 187 Emissions of air pollutants have decreased significantly since 1990 partly due to contraction of economic activity, and partly due to enviromental improvements. Overall atmospheric emissions of SO2, NO,, VOC, and ammonia have decreased, which has enabled Bulgaria to meet its current international obligations. However, if economic activity is resumed and a new protocol to abate acidification is passed, Bulgaria will have to make significant improvements to meet new obligations. The Ambient Clean Air Act (ACAA) specifies air pollution control and reduction via regulations and economic instruments. The Ambient Clean Air Act and its regulations give the legal basis for full transposition of requirements of Directive 88/609/EEC. The Act defines emission limits on large combustion plants and industries and sets up staged compliance requirements for various harmful substances. The ACAA allows endorsement of temporary standards for working facilities if the type of raw materials and state of equipment used does not allow achievement of standards for period of 1 to 5 years. The ACAA applies to all new facilities and since the beginning of 1996 to existing facilities. Bulgaria has been tightening standards concerning motor vehicle fuels since the early nineties. The new ACAA provides more comprehensive vehicle emissions requirements. A National Program promoting the use of lead free gasoline and phasing out lead gasoline until year 2003 was adopted in 1998. The EC type approval of motor engines is a new practice in Bulgaria regulated by the Road Traffic Act adopted in 1999. It assigns responsibilities of the Ministry of Transport to determine specific conditions of approval. According to the ACAA and the above regulations, municipal authorities within the non- attainment areas are obliged to prepare short-term action plans and long-term programs to reduce pollution from 13 pollutants to certain acceptable levels. The Regional Environmental Inspectorates (REI) within the MOEW are obliged to assist municipal authorities during the preparation of above programs and plans to ensure their compliance with the corresponding provisions of the Framework Directive. Bulgaria has also an obligation to comply with the UN Framework Convention on the Changes of the Climate (UNFCCC) and the Kyoto Protocol. According to the Convention, the main commitment of Bulgaria is that greenhouse gas emissions should not exceed the 1998 level by year 2000. Under the Protocol, Bulgaria is committed to reduce greenhouse gases emissions by 8 percent with respect to the 1988 emissions during the 2008-2012 period. Bulgaria will have no problem in meeting its 2000 commitment. It may, however, be difficult to meet future commitments unless further rehabilitation and renovation of current technology and reduction of energy consumption (by reducing energy subsidies) take place. In order to improve the quality of air in major Bulgarian cities and to deal with long- range pollution, Bulgaria will need to manage pollution from vehicles, fuels, power plants, large industrial and small stationary sources. Managing pollution from vehicles remains significant problem because of the aging car fleet and increasing number of vehicles per thousand inhabitants. Between 1991 and 1997, the vehicle stock increased from 16 to 22 vehicles per hundred inhabitants. As shown earlier, control of transport-related pollutant emissions at the sources could be a very expensive undertaking -- about £1.77 billion in investment costs plus 188 ChapterIXA Complying with the EUEnvironmental Directives El86 million per year in administrative costs."4 However, there are various measures that can help reduce emissions on the margin, including favoring public transportation over individual transportation, switching to lower emission fuel, improving transport system efficiency, etc. Reduction of sulphur content in the fuel could bring substantial improvements in air quality. The amount of sulphur in diesel is about 0.2 percent in comparison with the EU standard of 0.05 percent. Investment costs of the corrective measures in the petroleum industry - - particularly by the national refinery -- have been estimated at £184 million. Similarly, eliminating utilization of leaded fuels and decrease of lead content of unleaded petrol can bring substantial improvement. Investment costs have been estimated at e 80 million."15 Measures to control VOC emissions resulting from storage, loading/unloading and transport of petrol are also necessary. The investment cost of full compliance of gas stations and terminals with the EU requirements has been estimated at £70 million."6 The energy industry is the biggest source of long-range air pollution -- sulphur dioxide (91 percent), nitrogen dioxide (37 percent), carbon dioxide (53 percent), and dust (45 percent). A rough estimate of the environmental control costs for the existing power plants of Bulgaria to comply with their own environmental regulations, as well as the EU regulations, is £362 million."7 A more comprehensive assessment to reduce emissions of SO2, NOx and particular matters in the energy sector is required. Solutions other than end-of-pipe solutions need to be considered. The Energy-Environment Strategy will assess a broader set of alternative solutions to meet international obligations. Centralized district heating systems (predominantly based on natural gas) exist in 22 cities and serve about 20 percent of the households in Bulgaria. A large percent of the population rely on coal, coal briquettes and electricity. To address pollution from burning coal and coal briquettes for heating, Bulgaria will need to undertake some combination of the following abatement options: (i) shifting to the use of cleaner coals; (ii) switching to cleaner fuels such as gas;"8 and (iii) expanding gas-based district heating systems. Investment in power and heat production sources should be undertaken within a clear emission regulations and with investors increasingly assuming demand, price and payment risks. 114 Institutional costs as a result of yearly inspections for both security and environmental legislation has been estimates at £372 per year [PHARE (1999D)]. This study assumes that half of this cost is environmental related. '5 World Bank estimate. 116 PHARE (1999A). It does not include costs of upgrading of petrol stations with Vapour Recovery facilities. 117 This World Bank estimate includes: (i) flue gas desulfurization in Maritsa East I (2x300 MW), Maritsa East 2 (4x215 MW) and Maritsa East 3 (4x215 MW) plants projected to cost £313 million; (ii) low NOx burners in most coal-fired plants and gas reburning at Russe projected to cost £22 million; and (iii) the upgrading of electrostatic precipitators projected to cost £27 million. 118 Natural gas is not piped to households. However, the Govermment plans to promote the development of low pressure gas market in areas presently not served by district heating. This development would enable individual households or localities to install gas boilers. Chapter IX Complying with the EUEnvironmental Directives 189 A rough estimation indicates that the investment cost to deal with particular emissions from coal heating sources in areas of poor air quality could range between E543-752 million, and operation and maintenance costs £95-132 million per year. These estimates assume that 1.76- 2.35 million inhabitants or 0.60-0.79 million households live in areas with particular air pollution problems, that 25 percent to 40 percent of the households heat their houses with solid fuel or coal."9 Overall, we estimate that Bulgaria will have to invest between E3.1-3.3 billion to comply with EU air pollution legislation (including transport-related pollution sources). Overall, annual expenditures for meeting EU requirements in the air sector have been estimated at £750-811 million per year, would represent about 3.0-3.2 percent of projected 2015 GDP. There is a need to adopt a comprehensive planning approach to address air pollution. Environmental investment decisions should be made on the basis of least cost and efficiency criteria. The "National Strategy for Development of Energy Generation and Energy Efficiency up to year 2010", adopted by the Parliament in March 1999, is not least cost and is not efficient.'20 A study has been recently launched to evaluate alternative environmental strategies for meeting the international obligations and local requirements and recommend least-cost compliance strategy. The study will try to explore the flexibility imbedded in the EU legislation with regard to how environmental goals and requirements are met. The recommendations of the study would allow Bulgaria to revise its current National Energy Strategy.'2' MIXED PUBLIC AND PRIVATE INVESTMENTS Water resources The water sector is one of the most regulated areas of EU environmental legislation. Since 1995, the EU water policy has undergone a fundamental review and restructuring process. The proposed Framework Directive on Water Management, COM(97)614, aims to create a comprehensive framework for managing water quality and quantity. It includes measures to standardize river quality monitoring across the Union, and promotes the establishment of appropriate administrative arrangements to ensure coordination within each river basin area. The Government of Bulgaria has prepared a new Water Act to replace the existing legislation on water resources management with the objective of meeting both national and EU requirements. The 1999 Water Act is a framework act that regulates many areas of water 1 9 Average investment cost per household to convert from coal to decentralized natural gas is estimated at US$3,300 per household and to district heating at US$2,000, and average upgrading cost of existing district heating infrastructure at US$600. Electric heating has not been considered as an option because of the difficulty to calculate the cost of electric heat. It is almost impossible to determine the investment cost for the additional power capacities without analyzing the power issues in detail. 120 For example, the national benefit may be greater by: (i) first eliminating coal-based heating before installing flue- gas desulfurization units at the existing lignite-based power plants as envisaged under the Energy Strategy; and (ii) rehabilitation of the Vama power plant to use cleaner imported coal rather than construction of a new 600MW plant at the Maritsa East I domestic lignite-based. 121 World Bank (1999). Bulgaria Energy-Environment Strategy: A Work Plan. 190 Chapter IX. Complying with the EUEnvironmental Directives resources management in accordance with the proposed directive. The Water Act includes the elements on the planning, study and management of the national and river basins levels and the administrations that will be established to carry out these management responsibilities. The implementation of the Water Act will require institutional changes within the various institutions managing water resources. The key institutional requirement of the Act is the establishment of river basin authorities. It has been estimated that the establishment of water basin management and basin councils within them will require about 40 additional new staff per year. This does include the additional staff that will be needed to take account of the increased monitoring requirements of the EU directives.122 Changes or shifts of responsibilities among ministries are also expected as well as the provision of new skills. For example, an early requirement of the Water Act is to prepare river basin plans. Needed skills to carry out modeling and planning work are not yet available within the Regional Environmental Inspectors, and it seems doubtful whether the required expertise can be mobilized by restructuring the inspectorates while maintaining present staff number'23* The institutional changes in water resources management will not impose substantial financial costs, but will require time because of the administrative difficulties associated with their implementation. Drinking water supply Directive 98/83/EC on drinking water quality is designed to safeguard human health by establishing strict standards for the quality of drinking water, whether or not the water is supplied by a public system. It also sets out a system of monitoring, sampling and testing of either tap water or bottled water. The Directive calls for a phased program for addressing the source of pollution, changing the source of supply or treating the water before supplying it to distribution systems. About 99 percent of Bulgaria population have access to piped water supply. A number of small villages (with population less than 200 inhabitants) have no piped water supply systems -- mainly in the mountain areas where few people are left as a result of migration. About 76 percent of the piped water are supplied from surface water, and 24 percent is from groundwater sources. Some of the most pressing problems with drinking water quality are as follows. First, some supplies in rural areas contain high levels of nitrates, which is thought to affect children's health. This applies to 3 percent of the population connected to drinking water supply systems, although the problem has declined recently because of new groundwater protection zones. Second, arsenic contamination has occurred in the Topolnitza River as a result of copper enrichment operations at a plant near Pirdop, which has affected the quality of drinking water in Pazardzik (around 78,000 inhabitants). Third, oil contamination is affecting the Pleven area 122 For purpose of comparison, the Czech Republic will require over 400 man-year staff to implement the water management framework. 123 PHARE (1999C), p. 70. Chapter IX: Complying with the EUEnvironmental Directives 191 (about 120,000 inhabitants). Fourth, water supply to settlements along the lower Maritsa below Plovdiv (about 160,000 inhabitants) and along the Danube (about 340,000 inhabitants) suffer from serious microbiological contamination.'24 Neither monitoring of the surface water intended for abstraction of drinking water nor that of water supply for human consumption is carried out according to EU standards. Authorities need to increase both the number of samples and the frequency they are taken. In Sofia, for example, there are only 16 sampling points to monitoring water supplied to 1.2 million inhabitants. Laboratories are also not equipped to monitor enterococci and fecal coliforms. We have estimated that full compliance with the EU drinking water directive will require expanding the piped water supply system to cover 100 percent of the population or 148,000 inhabitants at a unit cost ranging between E450-625 per capita,'25 replacing the water sources to 243,000 inhabitants experiencing nitrate problems at a unit cost between E135-180 per capita, and undertaking water treatment works and distribution system improvements in the rest of the network at a unit cost between F1 35-160 per capita.'26 Thus, the investment cost to comply with this directive will amount £0.2-1.5 billion. Annual operating and maintenance costs, in turn, have been assessed at E 16-53 million. Wastewater collection and treatment The Urban Wastewater Treatment Directive (UWWTD) directive specifies that all settlements above 2000 population equivalent (p.e.) are connected to the sewerage system and that the sewage collected should be treated to specific levels, depending on the characteristics of the receiving water. This directive gives a timetable for compliance depending on the size of settlements, but the Commission is likely to expect accession countries to negotiate their own timetables for compliance. There are several ambiguities associated with this legislation, which are listed below. The EU UWWTD lays down uniform effluent standards for all wastewater treatment plants serving populations of 2,000 p.e. or more. Article three of the Directive gives dates by which member states must provide sewerage and wastewater treatment for towns of more than 2,000 p.e. It states, however that "where the establishment of a collecting system is not justified either because it would produce no environmental benefit or because it would involve excessive cost, individual systems or other appropriate systems which achieve the same level of environmental protection shall be used". It is unclear for how many of Bulgaria's towns between 2,000 and 10,000 p.e. installing sewers would either produce no environmental benefit or involve excessive cost, but the proportions could be high. The directive also requires member states to identify receiving waters that are sensitive to eutrophication, and discharges into sensitive water 124 PHARE (1999C), p. 61. 125 Range of costs of water supply projects (including source development) funded under the Regional Initiatives Fund of Bulgaria. Although some cities suffer from water shortage, no provisions for additional investments in water treatment facility to restore normal supply of drinking water are made here. 126 Network rehabilitation is assumed here to be driven by the drinking water directive based on the fact that member states that want to comply with the drinking water directive are currently developing detailed investment strategies to improve their drinking water distribution and treatment systems. 192 Chapter IX: Complying with the EU Environmental Directives bodies must receive additional treatment to reduce the concentrations of total nitrogen (TN) and total phosphorus (TP). This makes a big difference to the costs. According to the requirements of the proposed framework Directive, about 60 percent of the waters in Bulgaria can be considered sensitive zones.'27 However, formal designation of sensitive areas has not taken place yet. Treating increased volumes of sewage results in large additional quantities of sewage sludge, disposal of which is constrained by several other directives. In Bulgaria at present, there is not practice of using sewage sludge in agriculture. Sewage sludge is used in the rehabilitation of mines or is dumped into existing landfills. The Landfill Directive eliminates disposal to landfill as an option, which obliges Bulgaria to incinerate a large proportion of its sludge, a far more expensive option. Wastewater management in Bulgaria is regulated by the new Water Act. Amendments are anticipated to harmonize the Water Act with the EU directives. There is a National Program, for priority construction of urban wastewater treatment plants for cities above 10,000 inhabitants and the regulation on sanctions imposed for environmental pollution exceeding the adapted standards. The EU obligation that all agglomerations with populations larger than 2,000 p.e. must be provided with collecting systems for urban wastewater treatment will be transposed in the Territorial and Human Settlement Act. About 67 percent of the population are connected to the public sewerage system. However, part of the sewerage system is not connected to wastewater treatment plants. About 36 percent of the wastewater discharged into the public system is not treated at all. In Bulgaria, only 13 out of the 28 towns with population greater than 50,000 inhabitants have wastewater treatment facilities, and only 26 towns out of the 97 with population greater than 10,000 have wastewater treatment plants (Ministry of Environment and Waters estimates). Our estimates show that the cost of full compliance with UWWTD will add an extra F 1.4-2.2 billion to the capital investment program of the Bulgarian wastewater companies and E73-139 million to their annual operating and maintenance expenditures. The high cost estimate assumes that sewerage and wastewater treatment coverage increases to 78 percent and that 100 percent of Bulgarian territory is considered as a sensitive area, which causes the need for extension of treatment facilities to include nitrogen and phosphorous removal. The low cost estimates, in turn, considers that all communities with 2,000 p.e. plus 50 percent of the population living in settlements with p.e. between 2,000 and 5,000 will be covered with sewerage and wastewater treatment plants, thus increasing coverage to 72 percent, and that the whole territory is a non-sensitive area.'28 Investments in drinking water supply and sewerage/wastewater treatment should be guided by economic and sustainability criteria, and require the participation of the private sector. Because the private sector generally makes better use of existing assets by emphasizing in preventive maintenance and rehabilitation, it is possible to conclude that the private sector could 27 PHARE (1999D), p. 45. 128 Sewerage costs are assumed to range from E360-850 per p.e. Costs associated with sewage sludge disposal are also included. Capital and operating costs are estimated at 20 percent of the total investment cost of wastewater treatment and 40 percent of the annual capital costs, respectively. Municipal sludge disposal investment costs will range between E 64-97 million, while operation and maintenance costs between E 10-15 million per year. Chapter IX: Complying with the EU Environmental Directives 193 be able to reduce the level of investments, together with the level of operating and maintenance costs, and could help reduce the financing gap by its ability to raise capital for investments. Nitrates The EU has strict standards for maximum levels of nitrates in drinking water source and in surface waters that are vulnerable to eutrophication. The requirements are laid down in several directives, particularly, the "nitrates directive" 91/676/EEC on the protection of water against pollution caused by nitrate from agriculture sources. Complying with the nitrates directive will require Bulgaria to develop codes on good agricultural practices and action programs and that all farmers in areas vulnerable to nitrate pollution adopt measures to control run-off. The main problem to be addressed is the proper use of fertilizers. Among other things, large livestock farms will have to construct sealed tanks to store manure for at least six months of the year. The cost for Bulgaria of implementing this directive has been estimated at E104-156 million, based on the assumption that out of the 1.78 million private farms, around 1 percent tol.5 percent are likely to have livestock and will have to comply with the requirements listed above. Waste management The overall EU structure for an effective waste management regime was set out in the 1975 Framework Directive on Waste (75/442/EEC) amended in 1991 by the Hazardous Waste Directive (91/159/EEC). The framework aims at encouraging prevention of waste and ensuring the proper administrative control of waste and the use of clean technologies in its disposal. Two related directives are the Landfill Directive (COM (97) 105), which aims to reduce the adverse effects of existing and new landfills on the environment and to harmonize the technical standards for landfill, and the Packaging and Packaging Waste Directive (94/62/EC), which aims to minimize environmental impacts of packaging waste, and to avoid the erection of barriers to trade within the EU. The Waste framework directive is to a large extent transposed in the Limitation of Harmful Impact of Waste upon Environment Act (or Waste Management Act). Landfill is the most widespread method of waste disposal -- 99 percent of waste is disposed in landfills. In 1996, there were 682 landfills under operation. At present, only 2 of these landfills comply with the law. All landfills under construction are in compliance with the requirements. The total number of planned regional landfills is 56. Currently, there are no incinerators for municipal waste in Bulgaria, but plans are under way to build one in Sofia. This incinerator will run the risk of operating below capacity, because landfill fees will be substantially lower than fees for incineration. Most of the waste-related service activities, such as planning and managing waste collection and disposal operations, are under the responsibility of the municipal governments. The Bulgarian legislation also includes the necessary mechanisms for provision of waste management by municipalities as well as for the recovery of full costs. The level of economic development regionally has been a constraint to introduce full charges on residents. It is also 194 Chapter IX: Complying with the EUEnvironmental Directives unlikely that increased costs due to the requirements of the adopted Landfill Directive can be covered through user charges. According to the latest estimate, investment and operating and maintenance costs associated with the compliance of waste-related directives will range between £850- 1,150 million and £93-132 million, respectively. Derogation of the packing requirements could mean savings of £400 million. IMPLICATIONS ON HOUSEHOLDS BUDGET An investment program of the magnitude outlined above will have impacts on the household budget. The overall cost of compliance will be passed on to consumers through increases in user's services or fees. Although, some Bulgarian utilities and municipalities would have access to EU grants and/or other forms of soft financing, many will finance the investment cost by borrowing on commercial terms. More importantly, environmental investments have high operation and maintenance costs, which are rarely financed from outside sources or central government subsidies. The affordability of tariffs for envirom-nental services is likely to be a constraint on the speed at which Bulgaria complies with EU environmental directives, particularly on the upgrading of its infrastructure. Currently, a large share of the household's budgets goes for food expenditure - on average 37 percent (NSI estimates for 1999), in comparison to other European countries including Central Europe countries.'29 Households in general do not have a lot of spare money to go around. The situation is even worse for the households in the first three deciles. In 1998, they spent between 52 percent-58 percent from their expenditures in food. Bulgaria's average household expenditure for environmental utilities is relatively high. In 1999, water, wastewater, and electricity accounted for 9.2 percent of household expenditure. A similar estimate from 1990 for the United Kingdom (including solid waste, and before investment associated with EU environmental directives had begun to take place, but when infrastructure coverage was significantly higher than currently in Bulgaria) was 3 percent. In Poland, water, electricity and solid waste bills accounted for 4 percent of household consumption in 1996. Prices of environmental services are still below market levels. For example, current average electricity tariff for residential consumers is about US$0.028 per kWh, which is lower than the tariff found elsewhere in Europe (US$0.12 in the United Kingdom, US$0.167 in Germany, US$0.067 in Austria, US$0.06 in the Czech Republic"30). Similarly, the combined price of water, sewerage and wastewater treatment services is on average US$0.5 per m3 (Ministry of Regional Development and Construction estimates), which is lower than those 129 For example, in 1996 households in Denmark and Finland spent 12 percent and 20 percent of their budget in food, respectively. In 1998/99 British's household spent 17 percent on food. In 1999, Polish household spent around 28 percent of their budget in food. 130 International Energy Agency (IEA). 1999. Key World Energy Statistics from the IEA. Chapter IX: Complying with the EU Environmental Directives 195 prices found in Europe (US$1.8 per m 3in Germany, US$1.6 in Denmark, US$1.2 in Belgium, France, and Netherlands, US$1.1 in the United Kingdom, and US$0.73 in Italy'3.). We have analyzed the potential impacts of environmental investments on households, based on the Bulgaria Household Budget Survey conducted in 1999.132 For the analysis, we consider expenditures on "environmental utilities," which here include drinking water supply and wastewater, electricity, gas, solid waste disposal, and household heating.'33 The analysis takes the estimated capital and operation and maintenance costs for the low and high scenarios presented in Table 9. 1, and calculates price increases for environmental utilities on the basis that all cost would be recovered from consumers over the lifetime of the infrastructure, and that investments would be discounted at 10 percent interest over 20 years. The analysis shows that on average, the share of expenditure on "environmental" utilities in the projected 2015 household budget (or expenditures)'34 will rise, under any of the scenarios outlined above. In the low cost scenario, the average share in the urban household budget rises from 14 percent to 17 percent and from 12 percent to 16 percent in the case of the rural household budget. The different investment cost scenarios make a big impact on the household budget. The high cost scenario increases the average share in the urban household budget to 22 percent and in the rural household budget to 24 percent. Grant financing could have some impact on the household budget, but not as large as expected. We have modeled the difference between investments in the water sector where 100 percent of the capital costs were financed by user's charges and where 50 percent came as grant, and found that it made around 25 percent difference to the average increase in the water bill. The main reason for this is that the annual operating and maintenance costs are high. If the price increases resulting from the environmental investments are passed to the consumers directly though utility tariffs, households in the lowest deciles will be impacted the most. Figures 9.4 and 9.5 show the impacts of price increases on household budgets for different income groups in urban and rural areas. In the case of urban households, it seems that both cost scenarios are difficult, especially for poorer urban households. Without any transfer mechanisms in place, the impact will be far larger on poor urban households than on richer ones. In the case of rural households, the low cost scenario seems to be manageable, but will also impose a severe burden on the poorer households. Figure 9.6 presents the impacts of a longer transition period. It is clear that delaying compliance by five year makes the price increase more affordable since it allows for households income to catch up. This analysis points to two clear messages. First, increases in the prices of environmental utilities are inevitable even if significant concessional finance is available. Second, the 131 Global Water Report (1999). Global Water Prices. Published by the Financial Times Energy, Issue 81, October 1, pp. 1-2. 132 The NSI facilitated access to a dataset of the 1999 Household Budget Survey conducted by NSI. 133 Either district heating or heating with electricity, coal or wood. 134 The analysis assumes a 5 percent per year increase in the real household expenditure and a time horizon of 2015 for full adoption and adjustment to the EU environmental directives. 196 ChapterIX: ComplyingwiththeEUEnvironmentalDirectives government will need to pay particular attention to the distributional impacts caused by the environmental investment program, and will need to establish transfer mechanisms to protect vulnerable groups and spread the burden between the different income groups. Figure 9.4: Impacts of EU Accession on Urban Households' Utility Bills C~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 30%- ,R 25% '-, 2 10% . ----- o -----Hi9h Cos 2015 0 5% - ----Low Cost-205 % ------------------------------- - -*- - Current 1999 0% - 1 2 3 4 5 6 7 8 9 10 Poorest Richest Per capita expenditure docile Figure 9.5: Impacts of EU Accession on Rural Households' Utility Bills 30% - 25% _ a. 0 P 5% ---------------------- +High Cost 2015 'U I +Low Cost2015 - -, - Current 1999 0% I l , I 1 2 3 4 5 6 7 8 9 10 Poorest Per capita expenditure decile Richest ChapterIX: Complying with theEUEnvironmental Directives 197 Figure 9.6: Impacts of a Longer Transition Period in the Case of Urban Households 30%- 0 1=% o 10% _ ---- o -4--- | +High Casa by 2020 'IW *s- Low Case by 220 0% - -Current 1999 1 2 3 4 5 6 7 8 9 10 Poorest Richest Per capita expenditure decile RECOMMENDATIONS FOR AN IMPLEMENTATION STRATEGY Bulgaria will have to make substantial investments to comply with the EU environmental directives. Investments requirements between 1998 and 2015 have been estimated at E5.5-8.0 billion. These investments and the associated operating and maintenance costs would represent about 4.9-6.7 percent of GDP per year at the end of the implementation period (assumed year 2015) under a very optimistic assumption of GDP growth of 5 percent per year. These compliance costs can impose a big burden to the population, particularly the urban poor, therefore the need to approach accession with careful planning and negotiation taking into account efficiency and affordability considerations. This section outlines some ideas to help Bulgaria address its EU environmental-related challenges. First, Bulgaria should not shy away from requesting delays or derogation in the implementation of some environmental directives because the level of needed investment seems unfeasible on macroeconomic grounds, given that environmental expenditures during the 1990s has been kept at 1 percent of GDP, and the impacts on households budget seem unaffordable by the urban poor. Second, Bulgaria should consider careful interpretation of the EU rules, since that could bring substantial savings. Clearly all major sources of pollution will have to comply with the EU standards, however, within the legal acts there are some provisions that allow for national circumstances. Some directives explicitly contain clauses that allow exemptions where environmental benefits are negligible or where compliance costs are excessive such as the case of the Urban Wastewater Treatment Directive. Third, Bulgaria's public sector will have to adopt detailed and careful least-cost planning, prioritization and phasing of investments, and to create the necessary incentives to ensure that the investments with the greatest local environmental impacts and the most efficient are implemented first. Not all investments of the same size have the same environmental benefits, and not all investments directly benefit the Bulgarian population. Benefits depend on the conditions in the receiving environment, and on the location of the investment in relation to the 198 ChapterIXY: ComplyingwiththeEUEnvironmentalDirectives watershed or air-shed. Prioritization of investments should be seen within the context of improving sectoral efficiencies. The adoption of least-cost planning, prioritization, and phasing offer an opportunity to direct investments strategically in the interim period towards full compliance that maximize local benefits. Fourth, Bulgaria should use EU subsidies to direct investments towards strategic national priorities during that transition period. This is particularly important for wastewater collection and treatment, air pollution, and municipal solid waste investments, as even EU subsidies will not fully help shield the Bulgarian population from price rises. Even if the investments are financed by EU grants, environmental utilities still have to cover high operation and maintenance cost. Fifth, strengthening capacity of Bulgarian institutions and agencies at all levels is fundamental if the government want to make best use of investment funds and financial assistance. This is essential for developing efficient policies and investment programs across sectoral areas of responsibilities and across different levels of government. Building up capacity to enforce laws or set incentives for improving compliance will also be essential to meeting many of the regulations that affect the private sector and to sustain environmental benefits. Sixth, any accession strategy should take into account the impacts on households. This is needed to establish transfer mechanisms to protect vulnerable groups and spread the burden between the different income groups and to avoid the constant conflict of interest between the price regulators and the environmental regulators. Seventh, government at all levels will need to engage in systematic consultations with the public and to invest in awareness-raising campaigns in order to achieve consensus and gain political support for the implementation of the accession strategy. References: Baldwin, R. and E. Seghezza. 1996 "Growth and European Integration: Towards an Empirical Assessment." Center for Economic Policy Research, No. 1393. Botcheva, Liliana. 1999 "Doing is Believing: Participation and Use of Assessments in the Approximation of EU Environmental Legislation in Eastern Europe." GEA Discussion Paper E-98-13. Club Economika. February 2000 "Powers of Municipal Authorities and Possibilities for Implementation of Local Environment Policy." Sofia, Bulgaria. Dobrinsky, R. and I. Yaneva. 1997 "Impediments to exports in small transition economies: the case of Bulgaria." Netherlands, No. 2 (33-55). Dodgson, John. March 2000 "Transport Regulation in Bulgaria." National Economic Research Associaties. European Commission. "Regular Report: Bulgaria's Progress towards Accession," 1999. European Commission. "Regular Report: Bulgaria's Progress towards Accession," 2000. Fisher, Stanley. Easterly, William. July 1990 "The Economics of the Government Budget Constraints." The World Bank Research Observer, Vol. 5. Garibaldi, Dimitrov and Stoyanova. 2001 "The Bulgarian Labor Market: An Overview." Paper commissioned by the World Bank. Hoekman, B. and S. Djankov. 1997 "Competition Law in Bulgaria after Central Planning." Policy Research Working Paper, No. 1789. The World Bank, Washington DC. Kaminski, K. and F. Ng. 2000 "Trade and Production Fragmentation: Central European Economies in EU Networks of Production and Marketing." The World Bank, Washington DC. Kramjak, and J. Zettelmeyr 1998 "Competitiveness in Transition Economies: What Scope for Real Appreciation." IMF Staff Paper, Vol. 45, 2. Ministry of Environment and Waters. November 1999 "ISPA Strategy paper for Environment." Sofia, Bulgaria. Newbery, David M. February 2000 "The Bulgarian Energy Sector." University of Cambridge. Nunberg, Barbara., Gary Reid, and Jana Orac et al. 2000 "Ready for Europe: Public Administration Reform and European Accession in Central and Eastern Europe." World Bank (forthcoming). PHARE (1999A). BUL-108: "Assistance in the Development of an Environmental Approximation and Training Programme for Bulgaria." Prepared under PHARE Contract No. 96-0863.00. Final Report, Sofia, Bulgaria, January. PHARE (1999B). BUL- 109: "Provision of Technical Assistance in the Approximation of Waste Legislation." Prepared under PHARE Contract No. 96-0863.00. Final Report, Sofia, Bulgaria. PHARE (1999C). BUL- 110: "Provision of Technical Assistance in the Approximation of Water Legislation for Bulgaria." Prepared under PHARE Contract No. 96-0863.00. Final Report, Sofia, Bulgaria, September. PHARE (1 999D). BUL- 111: "Development of the Bulgarian Implementation Programme for Approximation of EU Environment Legislation." Prepared under PHARE Contract No. 96-0863.00. Final Report. Sofia, Bulgaria, July 12. SIGMA Papers No. 26. November 1998 "Sustainable Institutions for European Union Membership." SIGMA Papers No. 23. May 1998 "Preparing Public Administrations for the European Administrative Space." Tang, Zoli and Klytchnikova. November 2000 "Banking Crisis in Transition Economies - Fiscal Costs and Related Issues." Policy Research Working Paper No. 2484. The World Bank, Washington DC. Distributors of World Bank Group Publications PIces and redit terms vary Rot CZECH REPUBLIC INDIA Eulyoo Publishing Co., Ltd. PERU SWEDEN country to country Consult your USIS. NIS Prodejna Allied Publishers Ltd. 46-1, Susong-Dong Editorial Desarrollo SA Wennergren-Williams AB local stribor before placing an Havelkova 22 751 Mount Road Jongro-Gu Apurtado 3824, Ica 242 OF 106 P 0. Box 1305 order. 130 00 Prague 3 Madras - 600 002 seoul Lima 1 S-171 25 Solna Tel: (420 2) 2423 1486 Tel: (91 44) 852-3938 Tel: (82 2) 734-3515 Tel: (51 14) 285380 Tel: (46 8) 705-97-50 ARGENTINA Fax: (420 2) 2423 1114 Fax: (91 44) 852-0649 Fax: (82 2) 732-9154 Fax: (51 14) 286628 Fax: (46 8) 27-00-71 World Publications SA URL: httpJlwww,nis.cz/ INDONESIA LE8ANON PHILIPPINES E-mail: mailWwwi.se 1120 Ciaudo d Boms Aires DENMARK Pt. Indira Limied Librairie du Liban International Booksource Center Inc. SWITZERLAND Tel: (5411) 4815-8156 SamfundsLitteratur Jalan Borobudur 20 P0. Box 11-9232 1127-A Antipolo St Barangay, Libraine Payot Service Inssatutionnel Faa: (5411) 4815-8156 Rosenoerns All 11 P.O. BoX 181 Beirut Venezuela C(trm)tes-de-Montberon 30 Email: wboks@infviacomr DK-1970 Frederiksberg C Jakarta 10320 Tel: (961 9)217944 Makati City 1002 Lausanne E-mail: wPbDoks~ftr`ovIa.com ar Tel: (45 35) 351942 Tel: (62 21) 390-4290 Fax: (9619) 217 434 Tet (63 2) 896 6501: 6505: 6507 Tel: (41 21) 341-3229 AUSTRAUA, FIJI, PAPUA NEW Fax: (45 35) 357822 Fax: (62 21) 390-4289 E-mail: hsayegh@librairie-du- Fax: (63 2) 8961741 Fax: (41 21) 341-3235 GUINEA, SOLOMON ISLANDS, URL: httphIwww.sl.cbs.dk IRAN libancomIb VANUATIJ, AND SAMOAECAOKebSaao.Plihr URL: http://www.Iibrairie-du- POLANDADCVaDire D.A. Information Services Ei,ADOR KetabSara,Co. ubishers International Publishing Service EditionsTechniques 648 Whitehorse Rood Libri Mundi Khaled Eslamboli Ave., 6th Street lbncml Ul. Piektna 31/37 Ch. do Lacuez 41 Micsos 3132. Victoria Libreia Internacional Delafrooz Alley No.8 MALAYSIA 00-677 Warzawa CH1807 Blonay Te(: '61) 3 9210 7777 P.O. Box 17-01-3029 P.O. Box 15745-733 Unisersity of Malaya Cooperative Tel: (46 2) 628-6089 Tel: (41 21) 943 2673 FaxT (61) 3 9210 7788 Juan Leon Mera 851 Tehran 15117 Bookshop, Limited Fax: (48 2) 621-7255 Fax: (41 21) 943 3605 E-mail. servicec@dadirectLcom.a 00 uio Tel: (98 21) 8717818: 8716104 PRO. Boo 1127 E-mail: hooks%ipsO'ikp.otm.com.pI THAILAND EPa:. itpJiwme.dadirecJ.com.au Tel: (593 2) 521-606; (593 2) 544- Fax: (98 21) 8712479 Jalan Pantai Baru URL: Central Books Distribution AUSTRIA . p ¢"W.a Ircs.cm.a 185 E-mail: ketab-sara@neda.net.ir 59700 Kuala Lumpr http://www.ipscg.waw.pVIps/export 306 Silom Road AUSTRIA Fax: (593 2) 504 209 Ko .bPbihr Tel: (60 3) 756-5 000RUALBl k00 Gerold and Co. E-mail: librimul elibrimundi com,oc K xwkab Pubshers Fax: (60 3) 755-4424 Fa(525008o:63 PORTUGAL Ban kok 10500 Weihburgasse 26 E-mail: librimu2tilibrimundr.com.rec P.O. Bo 19575-511 E-mail: umkoop@tm.net.my Apartado 2681, Ruo Do Com Fax: (66 2) 237-8321 Tel:103 lem1247O1n CODEU Tel: (98621) 258-3723 MEXICO 0 70-74 TRINIDAD & TOBAGO FTel (431) 512-47-31-29 Ruiz de Castilla 763, Edif Expocolor Fax: (98 21) 258-3723 INFOTEC 1200 Lisbon AND THE CARRIBBEAN URL: http://wwwgeroId.co1at.online Primer piso, Of. #2 IEADA.SnFrad o 7Tl 1 4-92SseaisSuisLd Q3uito IREoNlA. Sanell F uereana No.37Te: (1) 347-4962 BANGLADESH TeVIFax: (593 2) 507-383, 253 091 Government Supplies Agency Cal. To ieloGr Faa: () 347926 yututine Stopi Center Micro Industries Development E-mail: codeu@impsat.netec -OiBg an tSoludtarr 14050 Mexico, D.F. Eastern Main Road, St. AugustCne Assistance Society (MlIDAS) EYTARBEPBCOF 4-5 Harcourt Road Tel: (52 5) 624-2600 EaTerinia MToleaRood Wst Augusines EGYPT ARABREPLIUC OF Dublin 2 Fax: (52 5) 624-2822 ROMANIA Tiia oao etIde House 5, Road 16 E-mail: infeotec@rtn.net.mnoopn eLbrriBrrs . Tel: (868) 645-8466 tjlanmortdi B/Area At Abram Distribution Agency Tel: (353 1) 601-3111 Copn eLboi uoeoS. Fair: (668) 645-8467 DAssi 1209 nceSo y MIDS) Al Galaa Street Fax (353 1) 475-2670 URL: httpI/rtannet.mx SIr. Lipsca no. 26, sector 3 E-mailx: tubeimtriidnd.net TFe: (88092) 326423 Cairo ISR neL MundiPrensa Mexico SA de CUV) Bucharest Tel: (8802) 32' 1647 Tel: (20 2) 578-6083 YSaE:Le eRio Panaco2 141Colonia Tel: (40 1) 313 9645 UGANDA Fax: (880 2) 811188 Fax: (20 2) S78-6633 P.O.ma InSeratiar Ltd5 Cuau Stemloc Faax (40 1) 312 4000 Gustro Ltd. BELGIUM FINLAD POOv Boa 56055 PO5 Box 9997, MadhO1 ni Building Jean Do Lannoy TeMdoEatOsre3YhaaHaodaStet 050Mac,DFRUSNFDRAINPlot 16/4 Jinja Rd. An. do Pal 202 41, Shelif Street Tel Aviv 61560 Tel:: (52 5) 533-5658 lsdatelstva Kooauo 1060. FessselsCairo Tel: (972 3) 5265-397 Fa: (52 5) 614-6799 9a, Kolpachnx Pereuok I Tel: (32 2 538-5169Tel: (20 2) 393-9732 Faa: (972 3) 5285-397 NEPAL Mocoaxii e: (256 41) 251 467 Tel:ei(32o2) mide,09 TlFaa: (20 2)393-732 Everest Media lntemational Servce Tel: (78 05) 917 87 49Fa(5 4 204 Fax: (32 2) 538-0841 RORL hntemational (I.) Ltd. o Fax: (7 095) 917 92 59 E-mail: gusswiftuganda.cm BRAZIL ~~~~FINLAND PO Bex 13056 GOBx54 imn"lse.uUNITED KINGDOM URacL: T nicsInternacionis AkEatemnineE Kirjakauppa Tel Aviv 61130 GPO Bo 5443 iax(674R icroinfoL Ptablcce TeniasP. Boo 128 Tel: (972 3) 649 9469 Kathmandu SINGAPORE; TAIWAN, CHINA MO.croxef Ltd.g Prkftn Bus Peixoto Gomide. 209 FIN-00101 Helssitki Fao: (972 3) 648 6039 Tot: (977 1) 416 026 MYANMAR; BRUNEI -npshirBo G3,4mg 2Par,Ab CAt409SAoDPAulo,SPTel:358 Editbns Esk: 418J Tel: royi22) tvi6271219 ti Telao: (977 1) 224 431 He-misohre Publication Services Ham 01369 SanPout,ek P Tel: (358OO )121 4418 E-mail: rC nom nasiaSansoni SPA URn 41 Kalr a Puddin Rood 003 England Tel: (6 13) 7459-6644 Fax: (3580) 121-4435 LiRL hDupa/Diwwroyina.col NTHERLANDS dn el Boiing Tel: (441420) 867849 FTe: (55 11) 259-6640 E-mail: akatilaus@stockmann.fi fsbak 5 D a : (44 1420) 88889 Fmaal: (5511) 2566900~ URL-Verltp:ll~w.ag tateominen.com Palestinian 50125FriryfMf ddzeeLest 06 NfWZEALANDeheom/ ionale iTel:g(6r 349318 66 -mail: wbankr2icroinfo.ca.ukk E-otai: postmasterpotuo.br UL hppls Alee n l:nde Information Services Pablicaties b.vg Tel: (E6 71-166 URL: http://lwww.uolub FRANCE P0.s. 19502 Jerusalem PF. Boa 202, 7480 AL Haaksbergen Fax: (65) 742-9356 UgRL: hnitti/wwwamicrainos, co.uk CANADA Edpioos Eska: 0BJ Tel: (972 2) 6271219 Tel: (31 53) 574-0004 E-mail: ashgatePBasianconnect.com The Stationery Office Ronouf Publishing Co. Ltd. 48, rue Gay Luosac Faa: (9722) 6271634 Faa: (31 53) 572-8206 51 Nine Elms Lone 5369 Canatoek Roud 75005 Parts Fax: London SOni nOB SL9VEa d P.Ottawa, Bontax i K82 J 9Tel: (33-1) 55-42-73-08 ITALY, UBERIA E-mail: inoasieacridoninn LENma o u Cfwase Contrporation K or Pro nLicosa Commissionaria Sansoni SPA URL: http:f/wwwoarIdonIino.rnI/-Iin- Gospodarskti vestik Publishing Tel: (44 171) 873-8400 Group Fi 4 7)8384 Tel: (613) 745-2665 Faa: (33-1) 43-29-91-61 Via Duca Di Calabria, 1/1 deboo Dunajska cesta 5 FRL: (44p111ww673-sl242 nry Fax: (613) 745-7660 GERMANY Caslla Postale 552 1EW ZEALAND it000 LhF UBL: tP w tesoie E-mail: CuN-Verlag 50125 Firenzo N Z N Tel: 2)3133 83 47713231230 Uordercdepnmrenoulbooks.cem Poppelsdorter Allee 55 Tel (39 55) 645-415 E6SCO NZ Ltd. 991Fa:(86113800VEZUL URL: hnpcL wwawSrenoufooks.com 53115 Bonn Fncai (39 55) 641-257 Private Mail Bag 99914 Faa: (386 6)30 2EN 4ZUELA Tel:Ap49a228nado9020 E-mail: licosaoftcc.it New Manket E-mail: repanse3Jangvestrik.si Tecni-Ciencia Libras, S.A. CHINA T:4290Ea cCentro Cuidad Comercoal Tomunco China Financial & Economic Fat: (49 228) 211492 URL: h(p-54 wwwi)bcc.itlicosa Auckland SDUTH AFRICA, BOTSWANA Nivel C2. Caracas UDIVR aRL: h1tp:'w w.uno-ver agnde Tel::(64 9) 524-811 F ittales: Publishina House UR:hl:/rmuuvra.o JAMAICA Faa: (64 9) 524-8067 Oxor Uiveirsity Press Southem Tel: (58 2) 959 5547: 5035: 0016 8, Da Fo Si ong JoeE-mail: anoverlag@oo.com Ian Randle Publishers Ltd. Africa Faa: (562) 959 5636 Be ing GHANA 206 Old Hope Read, Kingston 6 Oasis Offiial Vusco Boaeyard, Goodwood ZAMBIA Tel (8610)6401-7365EBooks Services Tel: 876-927-2085 P0. Ben 3627 RO. Boo 12119. Ni City 7463 University Bookahop, University of Fax: (86 10) 6401-7365 P0 Boa 44 Fax: 876-977-0243 Wellington Cape Town Zambia China Book Import Centre TLJC E-mail: irpl@colis.com Tel: (644) 499 1551 T:2 21) 595 4400 Groat LoAut oad Campus PO, Boa 2825 Tot: 2321) 778043 JAPAN Fax: (64 4) 499 1972 Fax: (27 21) 595 4430 P4. Boa 32379 Be*ing T: (361 3 Eastem Book Servico E-mail: oasisCactrix.gen.nz E-mail: oafordmoup.co.za Lusaka Fan: 223 21 779099 3-13 Hon o 3-chome, Benkyon-ka URL: http//wwwoasrsbouks.co.nzt Forsbcito res Tel: (260 1) 252 576. Chinese Corporation tar Promotion G eECE mTo@mailt Fan: (260 1) 253 952 of Humanities Zap@GERWA X2uYo Fangi D u J ong,35,pstfroumr St.Fa:.8 3) 3818-0864 University Press Limited P.O. Boa 41095 ZMAW Xuan Nei Da Jie 35 Stoumara Str. Fax (81 3) 3818-0864Three Crowns Budding Jericho Craighall Academic and Baonbab Beaks (Pvt.) Beijn 106682 Athens E-mail: orderswasvel-ob.co.jp Primate Mail Bag 5095 Johannesburg 2024 Ltd. TeL 8610 60n2g 9 Tel: (30 1) 364-1826 URL: IbdnTot: (27 11) a00-1448 4 Conald Rood. Graniteside Faa: (86610) 660 72 494 Faa: (30 1) 364-8254 http:/Aawwv.bekkkname.or.Jp/-svt- Tel: (234 22) 41-1356 Faa: (27 11) 660-6249 P0, Boo 567 COLOMBIA HAITI eob Faa: (234 22) 41-2056Ema:ssi.z Hre Infoenlace Ltda. Cufture Diffuaion KENYASPITe:234755 Carrera 6 Na. 51-21 5. Rue Capois Africa Book Service (L.A.) Ltd. PAKISTAN Mundi-Prensa Libros. S.A. Fair: 263 4 781913 Apartado Aereo 34270 C.P. 257 Q~~tuaran House, Mtangano Street Minxa Book Agency Castello 37 Santafit do Bogota, D.C. Port-au-Prince P.O. Boa 45245 65, Shahsrah-e-Quaid-e-Azam 28001 Madrid Tel: (57 1) 285-2706 Tel: (509) 23 9260 Nairobi Lahore 54000 Tel: (34 91) 4 363700 Faa: (57 1) 285-2706 Fax: (509) 23 4858 Tel: (254 2) 223 641 Tel: (92 42) 735 3601 Faa: (34 91) 5 753998 COTE DIVOIRE ~~~~~~HONG KONG, CHINA; MACAD Fax: (254 2) 330 272 Faa: (92 42) 576 3714 E-mail: libreriagmwundiprensa.es COTE D'IVIAiaR00ELd. BeksURL: http:/lwwvwmundiprensa.cnm/ Center d'Edition or do Diffusion Asa 00 Ld.LqcyBokse Oxford University Press Mandi-Prensa Barcetona Atricaines (CEDA) 302lesb& irduainDprmn it House Mann1 5 Bangalore Town Conseil do Cent, 391 04 B.P. 541 32SaidHueMzaieISharae Faisal089Bacln Abidjan 04 22-28 Wyadham Street, Central P.O. Ban 68077 PO Boo 13033 08009 Barcelo8n349 tel: (225) 24 6510: 24 6511 Hon(IKuen.Ch'i Nairobi Krci730Fx 3 )4775 Fan: (225) 25 0567 Tel: iRS2) e,530-141). Tel: (254) 2-330853, 221426 aTel i-7521s44607 TEmal: (34 clo3) 468-3492a.e Fao: (852) 2526-1107 Faa: (254) 2-330854, 561654 Tel: (92 21) 45476307Fa(3)4-65 CYPRUS E-mail: salesCmasia2000.com.hk E-mail: Legacy'form-net.com F-ail: (92 pa21)h4547640 r E-maIl LANArcTHEnaMALDIVrnoES Center fun Applied Research URL: htpifvWww asia2000core hk KOREA, REPUBLIC OF Lake House Bookishop 6yr CoIeelteret Enoi HUNGARY Dayang Books Trading Co. Palm Book Corporation 1 00, Sir Chittampalam Gardiner PO.mgenbox eot2 En0 ot Euro Info Service Intemational Division Aziz Chambers 21, Queen's Road Mawathra PD.si Bma208 MaaT?31ue_ti Europa Hiaz 783-20, Psngba Bon-Dong, Lahore Colombo 2 Tel: (357 2) 59-0730 H-i 8 Budapest Socho-ku Tel: (92 42) 636 3222: 636 0685 Tel: (94 1) 32105 Fun: (357 2) 66-2051 Tel: (36 1) 350680 24, 350 80 25 Seoul Fax: (B2 42) 636 2328 Faa: (94 1) 432104 Fax:, (36 1) 350 90 32 Tel: (82 2) 536-9555 E-mail: phcm-bratn.net.pkc E-mail: LHLmPsri.lanka.net E-mail: euroinfoLimail.maotavhu Faa: (82 2) 536-0025 E-mail: seamap@chmollian,net THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433 USA Telephone: 202-477-1234 Facsimile: 202-477-6391 Internet: xvww.worldbank.org E-mail: feedback@Rworldbank.org _ X li I 0-82I3-4962-7 ISBN 0-8213-4962-7