Document ofTHE WORLD BANK

Report No. 25374-BUL

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED

PROGRAMMATIC ADJUSTMENT LOAN

IN THE AMOUNT OF US$150.0 MILLION EQUIVALENT

TO

THE REPUBLIC OF BULGARIA

January 23, 2003

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Currency Equivalent(Exchange Rate Effective as of January 10, 2003)

Currency Unit = Bulgarian Lev (BGN)US$ 1.00 = BGN 1.86216

Government Fiscal YearJanuary 1 - December 31

Weirihts and MeasurementsMetric System

Abbreviations and Acronyms

ALMP Active Labor Market Policy GDP Gross Domestic ProductARCS Administrative and Regulatory Cost GMI Guaranteed Minimum Income

SurveyASAL Agriculture Sector Adjustment Loan GEF Global Environment FundBDZ State Railway Company IFI International Financial InstitutionBNB Bulgarian National Bank IMF International Monetary FundBNSC Bulgarian National Securities Commission ISA Insurance Supervision AgencyBoP Balance of Payments IPPC Integrated Pollution Prevention ControlBTC Bulgarian Telecommunications Company MPG Millennium Development GoalsCAP Common Agricultural Policy MEER Ministry of Energy and Energy ResourcesCAS Country Assistance Strategy MES Ministry of Education and SciencesCBA Currency Board Arrangement MoH Ministry of HealthCEE Central and Eastern Europe MoLSP Ministry of Labor and Social PolicyCoM Council of Mmisters NEK National Electricity CompanyCRC Communications Regulatory Commission NHIF National Health Insurance FundDH District Heating NSSI National Social Security InstituteDSK State Savings Bank OECD Organization for Economic Cooperation

and DevelopmentDZI State Insurance Company PA Privatization AgencyEBRD European Bank for Reconstruction and PAL Programmatic Adjustment Loan

DevelopmentECA Europe and Central Asia PSO Public Service ObligationEEEA Energy and Energy Efficiency Act RWC Regional Water CompanyEPSAL Environment Protection Structural SBA Stand By Arrangement

Adjustment LoanEC European Commnission SERC State Energy Regulatory CommissionEU European Union SISA State Insurance Supervision AgencyFESAL Finance and Enterprise Structural SME Small and Medium Enterprise

Adjustment LoanFDI Foreign Direct Investment SOE State Owned EnterpriseFRA Fiscal Reserve Account SPAL Social Protection Adjustment LoanFSAP Financial Sector Assessment Program USAID United States Agency for International

Development

Vice President: Johannes F. LinnCountry Director: Andrew N. Vorkink

Sector Director: Paul SiegelbaumSector Manager: Yasuo Izumi

Team Leader: Albert F. Martinez

TABLE OF CONTENTS

LOAN AND PROGRAM SUMMARY ........................................................ ;i

A. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS ............................................ 1Background ......................................................... 1Medium Term Prospects and Creditworthiness ......................................................... 5Addressing Poverty ......................................................... 9

B. The Reform Program ........................................................ 11Objectives and Strategic Themes ........................................................ 11Pillar 1: Sustaining Structural Reforms .......................... .............................. 14Pillar 2: Establishing a Market-friendly Business Enviromnent ................................... 17Pillar 3: Deepening the Financial System ........................................................ 20Pillar 4: Improving Public Sector Governance ........................................................ 21Pillar 5: Investing in Human Capital and Strengthening Social Programs ................... 22

C. BANK GROUP STRATEGY ........................................................ 24Country Assistance Strategy ........................................................ 24Cooperation with the IMF ........................................................ 25Coordination with Donors ........................................................ 25

D. THE PROPOSED LOAN ........................................................ 26Program Design ........................................................ 26Actions Taken Prior to Board Presentation ........................................... ............. 27Medium Term Actions and Triggers for Future PALs ................................................. 30Implementation and Monitoring ........................................................ 32Loan Administration ........................................................ 33Benefits and Risks ........................................................ 33

TABLES, FIGURES AND BOXES

Table 1: Selected Economic Indicators ......................................................... 2

Figure 1: Real GDP ........................................................ 6Figure 2: CPI Inflation ......................................................... 6Figure 3: Fiscal Balance ........................................................ 6Figure 4: Current Account Balance ........................................................ 6Figure 5: Unemployment ......................................................... 6Figure 6: FDI Flows ......................................................... 6Figure 7: Ownership Structure of Bank Assets ........................................................ 20

Box 1: Recent Poverty Trends and the Poverty Gap . ........................................................ 0Box 2: The Medium Term Program and the Millennium Development Goals ............................. 12Box 3: The Quality of Public Infrastructure: What do Firms Say? ............................................... 15Box 4: Recent Labor Market Developments ........................................................ 19

ANNEXES

Annex 1. Bulgaria at a GlanceAnnex 2. Bulgaria Social IndicatorsAnnex 3. Selected Indicators TableAnnex 4. Key Exposure IndicatorsAnnex 5. Letter of Development PolicyAnnex 6. Performance BenchmarksAnnex 6-A List of Companies Not Included in the Pnvatization ProgramAnnex 6-B Large State-owned Enterprises/Banks to be Privatized or Liquidated

in PAL-2 and PAL-3Annex 6-C District Heating ReformAnnex 6-D Telecommunications Liberalization Implementation CommitmentsAnnex 7. An Update on PovertyAnnex 8 IMF-World Bank Relations

REPUBLIC OF BULGARIAPROGRAMMATIC ADJUSTMENT LOAN

LOAN AND PROGRAM SUMMARY

Borrower: Republic of Bulgana

Amount: US$150 million equivalent to be disbursed in Euro

Terms: Fixed Spread Loan (FSL) in Euro with 16 years maturity including sixyears grace period

Commitment Fee: 0.85% on undisbursed balances for the first four years and 0.75%thereafter

Front end Fee: 1% on principal amount

Objectives and The proposed PAL supports the Government's medium term programDescription: whose main objectives are the achievement of average annual growth

rates of 4.5-5.0% dunng 2002-05, the reduction of the poverty rate byhalf by 2005 compared to 2001, the reduction of the unemployment ratefrom 17.5% in 2001 to 12-14% in 2005, and substantial progresstowards EU accession. The medium term program is designed around atwo pronged strategy of private sector-led growth and empowerment toensure wide participation in growth. The program is built on fivecomplementary pillars:

* Sustaining structural reforms in the enterprise sector with emphasison the restructunng of the energy, railway, telecommunications,and water sectors;

* Establishing a market-friendly business environment, focusmg onentry and exit policies, regulatory costs, delivery of public services,competition, and judicial reform;

* Deepening the financial sector, addressing the constraints toincreased lending by the banking system and the development offinancial markets;

* Improving public sector governance, including implementing theanti-corruption strategy, strengthening local governments, andreforming public administration and the judiciary;

* Investing in human capital and strengthening social programs,focusing on education, health, and pension reforms and socialassistance effectiveness.

A Letter of Development Policy prepared by the authonties descnbesthe medium term program and is attached to this Report.

Benefits: First, the proposed PAL assists a new government define a mediumterm economic program that achieves sustained growth, povertyreduction, and progress towards EU accession. Second, the proposedPAL helps put in place mechanisms and institutional arrangements thatwould ensure successful implementation, coordination, monitonng, and

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evaluation of the medium term program. Third, the proposed PAL laysthe groundwork for future PALs by creating the framework andidentifying future critical actions to be supported by future operations.Fourth, the proposed PAL complements the current and plannedinvestment projects by establishing the enabling policy framework,especially in the social sector. Fifth, the program supported by the loancomplements and reinforces the IMF program.

Risks: First, there is implementationm risk given the current weaknesses ininstitutional capacity which the PALs seek to correct. To addressimplementation risk, the Government activated the Council forStructural Policy to improve coordination, is implementing institutionalstrengthening programs for critical offices and agencies, and isimproving donor coordination to align donor funded technicalassistance with program priorities. In addition, PAL-2 will focus onupgrading public administration, which will address governmentcapacity to design and implement reform. Current and plannedinvestment projects in the health, education, energy, and water sectors,revenue administration, cadastre, and environment complement thePALs by providing implementation support.

Second, politica riisk remains high, with the possibility of poRicyslippages. Coalition building in support of many of the sociallydifficult reforms may run into resistance especially if unemploymentremains high and anti-corruption efforts fail to improve perception.Implementing difficult structural reforms with accompanying improvedtargeting of social programs and well designed communicationsstrategy mitigates the political risk. This was the case when electncityprices were recently increased by 20 percent - the implementation of anaccompanying winter energy support program and a consultationprocess prevented a political backlash. More generally, the socialprotection and assistance pillar of the reform program would alleviatethe adverse impact of the difficult structural reforms while the businessenvironment pillar would expand opportunities for employment. Inaddition, strong support by all political parties for Bulgaria's EUaccession and NATO membership is effectively anchoring the directionof macroeconomic and structural reforms.

Third, there may be shocks coming from the external environment,jeopardizing macroeconomic stability. Bulgaria faces severalsignificant extemal risks. A failure to carry out the envisagedprivatization program or attract sufficient greenfield FDI would put theprojected extemal financing at risk, requiring additional adjustment toensure that debt levels continue to decline. Moreover, Bulgaria'sexternal accounts are more sensitive to three key parameters: anincrease in oil prices, higher interest rates, and a prolonged slowdownin EU economies which are the destination of over fifty percent ofBulgarian exports and the origin of more than half the FDI inflows.However, the achievements to date, the better than expectedperformance in the last several months of 2002, and the active efforts torestructure and reduce extemal debt enabled Bulgaria to manage

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external risks. Continued maintenance of strict discipline inmacroeconomic management, the measures in place to respond topotential risks, and acceleration of structural reforms substantiallymitigate these risks.

Schedule ofDisbursement: US$150 million equivalent in Euro upon loan effectiveness

Poverty Category: Not Applicable

Rate of Return: Not Applicable

Project ID Number: PE-P06705 1

Map:

This operation was prepared by the Bulgaria Country Team which mcludes: Albert Martmez, task manager(ECSPF); Istvan Dobozi, Sudipto Sarkar, Jean-Charles Crochet, Varadarajan Atur (ECSIE); David Satola(LEGPS); Henry Gordon, Adriana Damnianova (ECSSD); Simeon Djankov (PSAIC); Luc Laeven (OPD);Rosalinda Quintanilla, Neil Parison, Joel Helhman (ECSPE); Hadi Abushakra (LEGMS); Sandor Sipos,Hermann von Gersdorff, Jan Rutkowski, Arvo Kuddo, Dena Ringold, Dominic Haazen, Enis Baris, YaelDuthilleul (ECSHD); Esperanza Lasagabaster (SASFP); Daria Goldstein, Irina Kichigina (LEGEC); LadaStrelkova, Doncho Barbalov, Boryana Gotcheva, Galia Kondova, Stella Ilieva, Peter Pojarski, AnnaGeorgieva, Blaga Djourdjin, Onik Karapchian, Maria Kalimerova (Bulgaria Country Office). Peerreviewers were Joseph Saba (MNC02) and Dimitri Vittas (OPD). Oscar de Bruyn Kops (ECCBG), vanRoy Southworth, Nevena Alexieva, Myla Taylor Williams, Marina Burul-Sir, Antonia Koleva (ECCU5)provided support, advice and coordination. Anne John and Manuel Santiago (ECSPF) provided officesupport at Headquarters.

IBRD PROGRAM DOCUMENTON A PROPOSED PROGRAMMATIC ADJUSTMENT LOAN

TO TIE REPUBLIC OF BULGARIA

1. I submit for your approval this Report and Recommendation on a proposed ProgrammaticAdjustment Loan (PAL) to the Republic of Bulgaria for US$150 million equivalent to support theMedium Term Reform Program of the Government of Bulgana (GoB). This loan is the first ofthree programmatic adjustment loans envisaged in the Country Assistance Strategy (CAS)discussed by the Board on May 9, 2002. This document and the accompanying Letter ofDevelopment Policy (LDP) discuss the three-year program.

A. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS

Background

2. The early years of transition were marked by slow and unsustained reform efforts.'Until 1997, Bulgaria was one of the poorest performing economies of Central and Eastem Europe(CEE). The preceding decade was marked by massive external borrowing, stop-go stabilizationpolicies, and a slow pace of structural reforms. Fueled by a failure to establish market discipline,widespread rent-seeking, and the prevalence of soft budget constraints among enterprises, banks,and the Government budget, Bulgaria's problems culminated in a severe economic and financialcnsis m 1996-97, resulting in a cumulative decline of GDP by about 14 percent, a sharp declinein per capita income, and an increase in poverty. After several months of chaos involving ahyperinflation episode, the collapse of the banking sector, and a major foreign exchange crisis,Bulgana adopted in July 1997 a Currency Board Arrangement (CBA).

3. Bulgaria responded aggressively to the 1996-97 crisis. Following the general electionsof April 1997 and the adoption of the CBA, Bulgana began implementing conservative fiscalpolicies and accelerated implementation of structural reforms. The wide-ranging structuralprogram included implementation of reforms in the social, agriculture, enterprise and bankingsectors, and liberalization of prnces and trade. By December 1999 when Bulgana was invited tostart negotiations towards EU membership, its economy was largely stabilized, and growth andper capita income began to recover. This improved performance took place in a difficult externalenvironment marked by turmoil in international markets, unfavorable commodity pricedevelopments, and trade disruptions associated with the Kosovo crisis. The current accountdeficit widened from 0.5 percent of GDP in 1998 to 5 percent in 1999 due to external pressures.At the same time Bulgaria faced a legacy of high indebtedness, low levels of investment, andrising unemployment. To address the combined effects of these challenges, Bulgaria acceleratedimplementation of structural reforms, expanded its social safety net to mitigate the impact of thetransition, and maintained disciplined macroeconomic policies. After five years of soundmacroeconomic management and acceleration of structural reforms, Bulgana soon succeeded inrestoring growth, bringing down inflation, and improving public and investor confidence.

' See Bulgaria: Public Expenditure Issues and Directions for Reforn, The World Bank, 2002 andBulgaria. The Dual Challenge of Transition and Accession, The World Bank, 2001.

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Table 1: Selected Economic Indicators1996 1997 1998 1999 2000 2001 2002P

GNI per capita (Atlas method, 1,210 1,200 1,270 1,450 1,580 1,630 1,760US$)__ _ _ _ _ _

Poverty rate 5.5' 36.0 12.8Unemployment rate (registered) 11.0 14.0 12.4 13.8 18.1 17.5 Th78TReal GDP Growth (% change) -9.4 -5.6 4.0 2.3 5.4 4.0 4.0CPI (e.o.p., % change) 311.6 547.7 1.6 7.0 11.3 4.8 3.8Total revenues and grants'(% of GDP) 32.9 37.5 39.8 40.7 41.4 40.0 40.5Total expenditure and net 43.2 38.6 38.8 41.7 42.4 40.8 41.3lending (% of GDP) 3Overall Fiscal Balance'(% of GDP) -10.3 -1.2 1.0 -0.9 -1.0 -0.9 -0.8Current Account Balance(% of GDP) 1.7 10.1 -0.5 -5.0 -5.6 -6.1 -4.2Extemal Debt (% of GDP) 97.0 100.4 85.5 84.3 88.9 78.3 70.3Interest Payment (% of GDP) 19.5 8.3 4.3 3.8 4.0 3.7 2.2Sources. National Statistical Institute, Bulgarian National Bank, Ministry of Finance, Employment Agency,IMF, and the World Bank.'The estimate is for 1995.2As of November 2002.3 Consolidated general govemment. In contrast to the estimates shown in Annex 3, revenues and expenditure includesocial contnbutions paid by the Govemment on behalf of government employees. For 2002 estimates are on the basisof the annual 2002 Budget Law.

4. The domestic financial sector has improved substantially in line with the resumptionof growth in the real sector and strengthened banking supervision. Following the closure of17 banks, consolidation of a number of banks, and privatization of almost all state-owned banks,mainly to foreign investors, the banking system was put back on solid ground. The recent JointWorld Bank-IMF Financial Sector Assessment Program (FSAP) review2 concluded thatBulgaria's banking system - which is currently the main component of the financial system - isgenerally well supervised, highly capitalized, and profitable. However, the legacy of the deepbanking crisis in 1996-97 has led to a more conservative lending policy by banks; interest ratespreads are high but declining; governance and asset and liability management capacity needfurther strengthening; and the deposit base remains low. As a result, bank intermediation hasremained low compared to other CEE countries, and the non-bank financial sector has continuedto be underdeveloped. However, after four successive years of economic growth, creditexpansion, especially in retail banking, accelerated m 2001 and the first three quarters of 2002driven by higher deposit growth, lower international interest rates on bank deposits abroad, andcompetition among commercial banks.

5. The economic recovery contributed to a reduction in poverty. Living standards haveimproved and overall poverty levels have declined by two-thirds since 1997. The economic crisisin 1997 seriously affected living standards, and poverty escalated to 36 percent of the population,according to the household survey conducted that year.3 Since then, poverty rates have declinedsignificantly, to 12.8 percent in 2001 , as consumption levels have recovered from the shock ofthe cnsis. While the overall magnitude of the decline m poverty rates since 1997 may have been

2 A joint Bank-Fund Financial Sector Assessment Program (FSAP) mission visited Sofia in Novemnber2001. The FSAP report was discussed with the authorities during the Fund Article IV rmission in May2002.3 Bulgarna: Poverty during the Transition, The World Bank, 1999.4 Bulgaria: Poverty Assessment, The World Bank, 2002.

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less than two-thirds due to potential for measurement error in 1997 as a result of high inflationrates, there has been a notable improvement in living standards since the crisis. The depth andseverity of poverty have also improved (see Box 1). These suggest that the penod of sustainedeconomic growth between 1997 and 2001, as well the social safety net, have had an importantimpact on living standards.

6. Private sector development has been central in accelerating growth. The accelerationof privatization and restructuring of existing SOEs, together with the improvements in businessenvironment and gradual decrease in tax burden, have contributed to the expansion of the privatesector to 63 percent of GDP in 2001 compared to 53 percent in 1996. Although the private sectorhas been growing at about eight percent per annum since 1997, its share of GDP remainscomparatively lower than the more advanced CEE countries. Much lower is the share of newenterpnses which could spur growth and help the economy reach its full potential.5

7. But growth has not been sufficiently high to reduce persistently highunemployment. Unemployment has been growing smce 1996, turning Bulgaria into the countrywith the highest registered unemployment rate among the EU accession countries - 18 percent in2000, 17.5 percent in 2001, and a slight decline in 2002. Also, Bulgaria has the highest rate ofyouth and long-term unemployment. Registered job creation in the private sector has beenlagging behind labor shedding, particularly in the enterprise sector. An over-regulated labormarket,6 high payroll taxes, and the heavy burden of social contributions, together with skillmismatches, contribute to registered high unemployment in Bulgaria. While there are nomechanisms to measure directly employment outside the official registry, there is some indirectevidence that to minimize the heavy official costs on the use of labor, employers and workers areincreasingly using mechanisms such as engaging in an employment relationship without laborcontracts, or reporting labor wages at the level of minimum wage.

8. The external position has remained under pressure, although the external currentaccount deficit has improved in 2002 compared to 2001. In 2001, the external current accountdeficit accounted for 6.1 percent of GDP dnven by strong domestic demand for imports, lowerinternational prices, and global slowdown, including in the EU and Turkey, Bulgaria's main tradepartners. FDI inflows of about 5.1 percent of GDP, together with the debut Euro bond issue inlate 2001, provided for the bulk of the financing of the external current account deficit in 2001.Foreign exchange reserves remained at a comfortable level, covering about five months ofimports of goods and services. The external current account deficit is expected to improve byclose to 2 percentage points to about 4.2 percent of GDP in 2002 due to strong export growthdriven by textiles, light manufacturng, and tourism, as well as by a slowdown in imports,especially of oil products. At the same time, external debt has declined by about 30 percentagepoints since 1997, to 68 percent of GDP at end-October 2002.'

9. Sound macroeconomic policies and continued progress on structural reforms areaddressing current account imbalances and improving development prospects. Bulgaria'spolicy framework is centered on the CBA and supported by tight fiscal policy, strict incomes

5 See Transition* The First Ten Years, Analysis and Lessons for Eastern Europe and the Former SovietUnion, The World Bank, Washmngton D.C., 2002.6 Rutkowski, J. , "Why Is Unemployment So High in Bulgana?", Background paper for the BulgariaPoverty Assessment, forthcoming, The World Bank, Washington D.C., 2002.7 External debt to GDP ratio declmned significantly due to a series of debt buybacks, debt exchanges, limitednew borrowing and slow disbursement of projects m pipeline, as well as higher GDP growth and exchangerate adjustments.

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policy and a broad agenda of structural reforms. Macroeconomic performance has been robust:Bulgaria has had a primary surplus of three percent of GDP and a fiscal deficit of one percent ofGDP since 1999; the Fiscal Reserve Account (FRA) has remained at about 100 percent of nextyear's gross public debt service requirements; inflation has remained at single digit levels;mternational reserves have remained at about five months of imports; and growth has beenbetween 4-5 percent per year. Total public debt, external and domestic, has declined substantiallyfrom over 100 percent in 1997 to around 70 percent of GDP in 2001 and the Government hasstated its commitment to meet the Maastricht critenon8 prior to EU accession. As of end-October2002, total public debt to GDP stood at 60.6 percent, of which 54 percent was external and 6.6percent was domestic debt.

10. Provided the Government maintains fiscal discipline, sustains a strict incomespolicy, and accelerates structural reforms, the CBA provides a stable nominal anchor andfacilitates the political economy of reform. Prudent macroeconomic policies andimplementation of structural reforms have contributed to improved economic performance in2002. Bulgaria shows stronger fundamentals in 2002 compared to 2001: despite slow growth inthe EU and other economic partners, Bulgaria's economic growth remains solid, inflation ratedeclined, and the external current account deficit narrowed in 2002 compared to 2001. However,reaching fiscal targets in 2003 are a challenge and external risks remain. To address these risksthe Government has identified and agreed with the Fund under the Stand-By Arrangement (SBA)several measures: (i) efforts to improve revenue collection and collection of arrears are bemgaccelerated; (ii) revenue indicative targets are being monitored on a monthly basis - significantdeviations would trigger consultations with IMF staff on offsetting measures; and (iii)discretionary spending is limited to 88 percent of budgetary allocation for the first three quartersof the year - equivalent to about 1 1/4 percent of GDP through September 2003 of possible fiscaladjustment should risks materialize. 9

11. Summary of recent developments. Per capita income is increasing; the level of povertyis declining; inflation is low; and economic growth is being sustained at 4-5 percent per year.Macroeconomic stability has been maintained and public debt to GDP has declined and isapproaching the Maastricht criterion of 60 percent - debt reduction and fiscal adjustment havecreated savings, enabling the Government to increase spending on social programs. Furthermore,structural reforms are moving forward - the banking sector has been put on sound footing; theprivate sector share in the economy is increasing; a major regulatory reform is underway, andenergy pricing reforms are improving efficiency and reducing fiscal burden. Bulgaria is alsomaking important progress in its EU accession program - the EC has recently assessed Bulgariaas a functioning market economy'0 and Bulgaria has closed 23 of the 30 chapters of the acquis.In addition, preliminary 2002 estimates indicate a marked improvement in economicperformance: growth increased to 4.4 percent year-on-year in the first three quarters of 2002suggesting that the annual growth may be higher than the projected 4 percent; registeredunemployment while still high seems to be leveling off after several years of continuousdeterioration; twelve month inflation in December 2002 declined to 3.8 percent having reached apeak of 9.2 percent in March 2002; the ten month external current account deficit to October

8 This is according to article 104 of the Treaty Establishing the European Community signed in Maastrichtin 1992. The convergence criterion on debt refers to the ratio of gross government debt to GDP, whichmust not exceed 60 percent at the end of the preceding financial year or shall be approaching the referencevalue at a satisfactory pace.9 See IMF Staff Report for the Second Review under the Stand-By Arrangement, IMF, January 2003.10 2002 Regular Report on Bulgaria's Progress towards Accession, Commission of the EuropeanCommunities, October 2002.

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2002 has declined to 1.4 percent of GDP; gross intemational reserves have increased to US$4.4billion or more than five months of imports; and financial intermediation continues to improve.

12. Significant but manageable external risks exist. Bulgaria faces several significantextemal risks. A failure to carry out the envisaged privatization program or attract sufficientgreenfield FDI would put the projected extemal financing at risk, requiring additional adjustmentto ensure that debt levels continue to decline. Moreover, Bulgaria's external accounts aresensitive to three key parameters: an increase in oil prices, higher interest rates, and a prolongedslowdown in EU economies which are the destination of over fifty percent of Bulganan exportsand the origin of more than half the FDI inflows. However, the achievements to date, the betterthan expected performance in 2002, and the measures in place to address fiscal and extemalvulnerabilities mitigate these nsks.

Medium Term Prospects and Creditworthiness

13. The medium term macroeconomic framework centered on the Currency BoardArrangement is expected to support a rapid and sustainable economic growth in the comingyears. The medium term outlook" envisages robust growth of about 5 percent per annum, agradual narrowing of the extemal current account deficit, and a reduction in debt to GDP ratios.Growth would be driven by continuous rise in investment and improved export performance inline with the expected recovery in external demand from EU and increased competitiveness ofBulgarian goods on international markets. Consistent with the planned upgrades in infrastructuresectors and contmued progress towards EU accession, investment is likely to grow at a higherspeed and reach at least 22 percent of GDP in 2005. Despite the continuing slow growth amongBulgaria's main trade partners so far, macroeconomic performance has been good and is expectedto improve further in 2003-05 as EU economies may start their recovery and the cumulativeeffect of structural reforms in Bulgana start to pay off.

14. FDI inflows continue to be the primary source of BoP financing. Despite theirslowdown m 2001 to 5 percent of GDP, FDI inflows amounted to more than US$3 billion in1998-2001, the bulk of which were in the service sector (57 percent) - mainly financial services,trade and tourism. About US$1.3 billion were invested in industry in those years - mainly oil-processing, chemical, food, metal and non-metal mineral products. With the global slowdownnegatively affecting capital flows, and some of the large pnvatization deals delayed, FDI inflowsin Bulgaria eased off further in 2002 but are likely to provide sufficient coverage of the externalcurrent account deficit. Planned privatization in the energy sector, and completion of the deals onsome monopolies such as Bulgartabak and Bulgarian Telecom (BTC), together with additionalinvestments, such as those projected in the energy sector and expected inflows of greenfieldinvestments, are likely to help Bulgaria meet its financing needs. The returns from foreign directinvestment in the country have been growing and a further boost in investments is possible if theremaining structural and institutional impediments are addressed, including weaknesses inbusiness climate, public administration, and legal and judicial systems.

" See Bulgaria 2002 Article IV Consultation and First Review Under the Stand-By Arrangement-StaffReport, The Intemational Monetary Fund, August 2002.

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Figures 1-6: Macroeconomic Indicators

Figure 1. Real GDP Figure 2. CPR Inflation(% change) (% change, annual average)

10- 40 54 40

900 0-

700--5-

-10-

15. International financial markets have responded favorably to the achievements of thereform program. At the end of 2001 and early 2002, Standard and Poor's, Fitch Ratings, andMoody's upgraded Bulgaria's credit rating. In less than a year, Standard and Poor's and FitchRatings did a second upgrade to the country rating m October 2002. Active debt managementpolicies in 2001 and 2002 through debt buybacks and exchanges are reducing debt levels andimproving exchange rate and interest rate risks of debt portfolio. In March 2002, the Governmentof Bulgaria exchanged US$1,319 million Brady Bonds. The exchange resulted in a net presentvalue savings of US$94 million and released a collateral of about US$220 million. In September2002, the Government reduced further the share of Brady Bonds in total debt by exchangingUS$866 million for global bonds, and released another US$140 million of collateral. As a result,the external public debt stock is estimated to decline by US$108 million. The total external debthas fallen significantly since the beginning of 2002 - by end-October 2002, total external debtstood at 68 percent of GDP and is expected to decline further due to the sharp reduction ofexternal public debt.

16. The current course of fiscal policy is basically appropriate to ensure macroeconomicstability, growth and poverty reduction in the medium term. The main fiscal challenge,however, is to work towards an improved allocation of expenditures' 2 to achieve a balancedbudget in the medium-term, while lowering the overall tax burden - especially payroll taxes - toboost investment and employment, and reducing extemal indebtedness. So far fiscal adjustmenthas been made possible by revenue expansion rather than expenditure rationalization. Onlyrecently the revenues have started to decline, reflecting gradual reduction of the tax burden. Tolimit revenue losses from future tax cuts, the tax administration needs to be overhauled and taxcompliance improved. A decade long neglect of investment in basic infrastructure has beenexacerbated by several years of declining capital and maintenance expenditures which have bornethe brunt of expenditure cuts. Going forward, fiscal adjustment will need to rely heavily onexpenditure rationalization which needs to precede reductions in tax burden to safeguard fiscalsustainability. In addition, fiscal strategy will need to adjust to the decline in pnvatizationrevenues, a main source of fiscal financing, as the prnvatization program is soon to be completed.Expenditure rationalization will require implementation of deep structural reforms which willhave to be accompanied by measures protecting the poor from the adverse impact of thesereforms.

17. Meeting the challenge of improving the allocation of public expenditure requirescreating an efficient and transparent expenditure management system with enoughflexibility to adjust quickly and efficiently to macroeconomic shocks. The central keypressure points on the fiscal position emerge from health care, education, social protection system(pension funds, social assistance programs, and labor market policies), and from municipalities.The recently finalized Public Expenditure and Institutional Review for Bulgaria'3 has indicatedthe need to improve allocations to address the issues of overcapacity, especially in health andeducation, and improve the targeting of social protection programs, which constitute about one-third of total public spending. Equally important are policies to improve allocations betweensectors - decreasing subsidies to the energy sector, while protecting the poor through expandedenergy benefit program and gradual increase in energy prices to bring them to full cost recovery

12 For more details see Bulgaria: Public Expenditure Issues and Directions for Reforn, The World Bank,August 2002.'3 Bulgaria: Public Expenditure Issues and Directions for Reform, The World Bank, August 2002.

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in the medium term. In addition, increased efficiency in expenditure management would requirean overhaul of the intergovernmental relations. The Government approval in mid-2002 of theFiscal Decentralization Program for 2002-05 is a step forward in that direction. It aims atreducing the fiscal pressures arising from arrears in municipal finances, and improving theefficiency in service delivery. A fiscal decentralization and service study is currently beingprepared by the Bank to guide the Bank's policy dialogue with the authorities in support of thelocal finance reforn, which will be a focus of a planned second PAL.

18. Independent reviews indicate that issues of governance have improved butimportant challenges remain. Accordmg to a World Bank report'4 Bulgaria is characterized asa country with a high level of state capture and a medium level of administrative corruption. Theproblem is due to both the structure and the functioning of government - in particular, theconcentration of power despite progress toward decentralization - weak legal and regulatoryframework, weak capacity to monitor corruption and enforce laws, a weak judiciary, and weakoverall accountability' 5 and transparency. The areas most affected have been customs, healthservices, tax administration, higher education, and the courts. In recent years, the Governmenthas taken a number of steps to improve governance, in recognition of the problem. TheGovernment has put together comprehensive strategies and action plans for: (i) stateadministration modernization; (ii) judicial reform; and (iii) fighting corruption. TwoCommissions have been set up to combat the corruption - a standing parliamentary committeeand an inter-ministry operational commission. In addition a series of measures have beenundertaken to strengthen control within the Tax Administration, Customs Agency, the Ministry ofthe Interior, and the National Security Service. The framework for addressing administrativecorruption has improved with recent public administration reforms, but capacity weaknesses at alllevels of govemment - central and municipal, managerial and technical - remain formidable.

19. With the external financing provided by the PALs, the structural reforms can bephased in while softening the impact of adjustment, protecting the poor, and safeguardingsocial cohesion. Without the PAL financing, policy dialogue, and support, the momentum foraccelerating structural reforms is unlikely to be sustained or the costs of adjustment would weighheavily on vulnerable segments of the population. While international reserves remain at acomfortable level to support macroeconomic stability in the context of the CBA, Bulgaria willcontinue to rely on official creditors' support to meet its external financing requirements, startaddressing a decade of neglected maintenance of physical assets needed to support private sector-led growth, and soften the impact on vulnerable groups. The expected Bank financing under theproposed series of PALs of US$150 million per year for three years would provide fiscal andbalance of payments support needed to implement a broad reform program.

20. Creditworthiness Indicators. Prudent fiscal policies, implementation of structuralreforms, and an active debt management strategy have resulted in an improvement increditworthiness indicators (see Annex 4). Total debt outstanding and disbursed as a share ofGDP has declined from 100 percent in 1997 to around 70 percent in 2002. This share is expectedto decline to around 60 percent by 2005. Similarly, total debt service as a share of exports ofgoods and services is expected to decline from around 17 to 13 percent. The share of debt serviceto IBRD to total public debt service is expected to increase to around 12 percent in the next threeyears. The share of Bulgaria's portfolio in IBRD's portfolio is expected to remain under 1.2percent. In addition, spreads on Bulgaria's Brady bonds have been narrowing since the June2001 election, reflecting prudent policies and markets' expectation of a more active debt

'4 See Anticorruption in Transition: A Contribution to the Policy Debate, The World Bank, 2000.5 The World Bank is currently preparing a Country Financial Accountability Assessment for Bulgaria.

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management strategy. The collapse of the CBA in Argentina and the difficulties in Turkey havenot had any significant impact on this trend. There have been no discernable contagion effects onBulgaria's domestic financial markets either, and financial fundamentals and indicators ofexternal vulnerability remain comfortable.

21. IBRD exposure will remain manageable in the base case scenario of the CAS. IBRDdebt service is projected to rise from 1.0 to 1.3 percent of exports, and from 6 to 12 percent ofpublic debt service during the CAS period. The ratio of preferred creditor debt service to publicdebt service has remained above 35 percent and increased sharply in 2001. It is projected todecline to about 40 percent in 2004 before nsing again to 47 percent in 2005. These high ratiosare partly the result of debt restructuring in the mid-1990s which stretched out Bulgaria's publicdebt repayments to private creditors over decades with the issuance of Brady bonds, and oflimited commercial bank lending until the strong recovery following the 1997 reforms.Continued substantial adjustment lending as envisioned in the CAS would seriously reduce theBank's headroom in Bulgaria, especially for further adjustment loans beyond FY05. However,since the three proposed PALs - designed to support a robust reform program that has a highprobability to succeed - are the cornerstone of the overall Bank's strategy, high adjustmentlending is justified, but would have to be carefully monitored. The additional triggers' 6 forprocessing PAL-3 identified in the CAS have been adopted to ensure that adjustment lendingwould reach the proposed US$450 million level only if indicators of economic outcomesconfirmed that Bulgaria substantially improved its standing as a result of reforms under the firsttwo PALs, and if the downside risks of overall economic performance at that time were low.

Addressing Poverty'7

22. Despite the improvements since 1997, poverty remains at twice the levels of 1995and deep poverty persists among certain vulnerable groups. The nature of poverty hasevolved, as recent improvements in welfare have not been equally distributed across thepopulation. There are "pockets of poverty" among certain groups, particularly the unemployed,ethnic minorties, most notably Roma, and families with more than four children. Considerablescope remains to obtain further reduction of poverty through the development of targeted povertyintervention (e.g. for the Roma) and improving the targeting of social assistance, particularlysocial assistance to mitigate the impact of restructuring. Moreover, capacity in the Governmentto monitor poverty and assess the impact of policies on vulnerable groups needs to bestrengthened, as demonstrated by the need to contract out the last household budget surveys(HHBS) and the absence of living standard measurement survey (LSMS).

16 The following developments would trigger reconsideration of proceeding with the presentation of PAL-3to the Board: (i) material deviation from the downward trend in the total public debt to GDP ratios asprojected in the CAS; (ii) lack of improvement in the spreads on Bulgaria's sovereign borrowing via-a-viscountries with similar risk rating, or deterioration in its own risk rating; (iii) material deviation from theimproving trend in the fiscal balance projected in the Government's medium term program, reaching fiscalbalance by 2005; (iv) matenal slowdown in the present trend of increasing SMEs' share of totalemployment; and (v) inadequate progress in reducing arrears in tax payments, social msurancecontributions, and energy bill payment as set out in the Government program.7See Annex 7 "Poverty Update" for an extended discussion of poverty in Bulgaria, mcluding its multipledimensions. The recent World Bank report Bulgaria: Poverty Assessment (October 2002) also addressesgender issues, and has a background paper "Gender Aspects of Poverty and Inequality m the Family andthe Labor Market".

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Box 1: Recent Poverty Trends and the Poverty Gap

The 2001 poverty profile for Bulgaria shows a dramatic rebound of living standardssmce the 1997 crisis. Poverty escalated to 36 percent of the population in 1997, according to thehousehold survey for that year. Since then, poverty rates have declined, as consumption levelshave recovered from the crisis. Using poverty lines updated from 1997, poverty fell by nearlytwo-thirds to 12.8 percent, and the depth and seventy of poverty have also improved (see tablebelow).a/ In order to compare trends over time, the relative poverty lines from 1997- two-thirdsof per capita income (high) and one-half per capita income (low) - were fixed in real terms.

Poverty and Inequality Trends

1995 1997 2001

Poverty Estimates High Low High Low High Low

Poverty Rate 5.5 2.9 36.0 20.2 12.8 7.5Poverty Gap 1.7 0.9 11.4 5.9 4.2 2.2Poverty Depth 0.8 0.4 5.3 2.7 1.9 0.9

Gini Coefficient 27.1 31.4 29.6

Source: Poverty Assessment Update, The World Bank, 2002. BIHS 1995, 1997, 2001.Notes: The "poverty rate" refers to the percent of the population that is below the poverty line; the"poverty gap" is the average shortfall from the poverty line; and "poverty seventy" is the average squaredconsumption shortfall as a percentage of the poverty line, and is more sensitive to inequality among thepoor.

Despite the improvements since 1997, the poverty rate remains at twice the levels of1995. In addition, recent improvements in welfare have not been equally distributed across thepopulation. There are "pockets of poverty" among certain groups, particularly the unemployed,ethnic minorities, most notably Roma, and families with more than four children. Poverty alsohas a significant rural dimension. Urban areas have experienced a more significant drop inpoverty levels, from 34 to 6 percent, while in rural areas, poverty rates were less than halved,from 41 percent to 24 percent.

The poverty gap has also fallen since 1997, but it remains more than double 1995 levelsat 4.2 in 2001. In 2001, the poverty gap amounted to BGN 0.2 billion, or 0.7 percent of 2001GDP. This implies that - under conditions of perfect targeting and zero administrative costs -eliminating poverty would cost 0.7 percent of GDP. As these assumptions are unrealistic, thetrue cost is likely to be higher, perhaps as high as 2.1 percent of GDP.

a! The poverty line is set at two-thirds mean 1997 per capita consumption, adjusted to 1995 and 2001prices. In other words, the relative poverty line from 1997 is held constant to function as an absolutepoverty line.

Source: Bulgaria Publhc Expenditure Issues and Directions for Reform, The World Bank, August 2002.

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23. Social protection reforms helped the poor cope with transition shocks, butsignificant issues still remain for further enhancing the effectiveness of the system and itssustainability. The previous govemment implemented reforms to provide a comprehensivesafety net for the poorest households. It strengthened and consolidated means-tested socialbenefits, targeted benefits to the most vulnerable individuals and households, and reducedduplicative benefit programs. Institutional and administrative capacity within the socialassistance system was strengthened. Licensing requirements, contractual and funding transferarrangements and minimum standards for delivery of social care services by NGOs and thepnvate sector were specified. Nonetheless, there is scope for improving the effectiveness ofexisting programs by strengthening the administration of social assistance delivery, tightening theeligibility criteria, reducing leakage, expanding coverage, and improving means-testing. PAL-3,whose preparation work begins this fiscal year, will address these issues.

24. While according to official data Bulgaria is on track meeting the MillenniumDevelopment Goals (see Box 2), gaps in access to both education and health are real forvulnerable groups. Despite the growing enrollment rates, the attendance rates especially forvulnerable households in rural areas and among ethnic minority have declined below 1995 levels,particularly for preschool and secondary education. The household survey data for 1997 and2001 indicate that while enrollments in basic education have increased slightly for the country atlarge, enrollment rates for poor children have fallen ten percentage points from 84 percent in1997 to 74 percent in 2001. In addition to the high costs of education for the poor households,there is evidence that they also face barriers to accessing health care, because of the prevalence offormnal and informal out-of-pocket payments and gaps in health insurance coverage for uninsuredgroups. As in the case with education, Roma are more likely to fall through the cracks of thehealth system than other groups because of lack of necessary identification and registrationpapers, and poor communication with health providers which is compounded by social exclusion.

B. The Reform Program

Objectives and Strategic Themes

25. The new Government which came into power in mid-2001 has articulated twoobjectives: (a) sustaining economic growth and (b) reducing poverty, both key to EUmembership. This is a shift from the objectives of the program of the previous Government,whose agenda was driven by the depth of the economic and financial crisis of 1996-97, the focuson macroeconomic stabilization, the need to accelerate the much delayed privatization program,the establishment of a sound fiscal regime to support the CBA by cutting expenditures andclosing non-viable SOEs, and the reform of system of social protection.'8 The reform program ofthe current Government builds on the gains of the past five years and makes a strategic shift memphasis towards promoting growth and reducing poverty focusing on increasing investment andproductivity and building human capital. The Government has articulated the followingoutcomes of its program: (a) average annual GDP growth rates of 4.5 to 5.0 percent during2002-05; (b) reduction of the poverty rate by half by 2005 compared to the rate in 2001; and (c)reduction of the unemployment rate to 12-14 percent in 2005 compared to 17.5 percent in 2001.The program components that address strengthening of market institutions, modernizing public

18 Since 1997, the Bank has supported the structural reforms with a Cntical Imports Rehabilitation Loan, aSocial Protection Adjustment Loan, two Finance and Enterprise Sector Adjustmnent Loans (FESALs), twoAgriculture Structural Adjustment Loans (ASALs), and an Environmental Protection Structural AdjustmentLoan (EPSAL).

administration, fighting corruption, and reforming the judicial system are critical to the EUaccession agenda.

Box 2: The Government Medium Term Program and the Millennium Development Goals

Goal Recent Data 2005 Target 2015 Target

Eradicate extreme povertyo percent of population below $2.15 per day 7.9 (2001) 3.2 1.5

Achieve universal educationo net enrollment rate - primary school 96 (2001-02) 97-98 100o net enrollment rate - middle school 84 (2001-02) 86-90 100o net enrollment rate - secondary school 68 (2001-02) 75-80 95

Improve maternal healtho maternal mortality rate per 100,000 live 19.1 (2001) 18 16

births

Combat HIV/AIDS, malaria and otherdiseaseso Tuberculosis incidence (new cases per 48 (2001) 40 26

100,000)o Polio immunization rate (percent of 94.4 (2000) 98 100

children under two)

Reduce infant mortalityo Mortality per 1000 live births 14.4 (2001) 13 9

Ensure environmental sustainabilityo GDP per unit of energy use (US$ GDP 568 (1997) 653 751

per kilogram of oil equivalent ofcommercial energy use)

Sources: National Statistical Institute and World Bank

26. The strategy for attaining the sustained growth and poverty reduction objectiveshas two main themes. First, the Government intends to use private initiative as the main engineof growth. For this reason, the government program focuses on creating an investment climatethat encourages private investment and enhances productivity. This requires redefining andupgrading the role and capabilities of the public sector, establishing credible institutions such asthe judiciary, and putting in place a stable legal and regulatory environment. Second, theGovernment is taking steps to ensure that the population is empowered to participate in futuregrowth. The Government is working towards fundamental reforns in the education and healthsectors, not only to improve efficiency of these large sources of public expenditures, but also todevelop human capital capable of adapting to an increasingly dynamic work environment,especially with greater competition expected from EU countries. In addition, there is recognitionthat poverty reduction policies need to be tailored to reach certain groups that have not benefited

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from the recent increase in welfare. The Government realizes that growth alone will not liftcertain groups out of poverty.

27. To implement its growth and poverty-reduction strategy, the Government isbuilding its medium term reform program on five pillars:

* Sustaining structural reforms in the enterpnse sector with emphasis on the restructunng ofthe energy, railway, telecommunications, and water sectors;

* Establishing a market-friendly business environment, focusing on entry and exit policies,regulatory costs, delivery of public services, competition, and judicial reform;

* Deepening thefinancial sector, addressing the constraints to increased lending by the bankingsystem and the development of financial markets;

* Improving public sector governance, including implementing the anti-corruption strategy,strengthening local governments, and reforming public administration and the judiciary;

* Investing in human capital and strengthening social programs, focusing on education, health,pension reform, and social assistance effectiveness.

28. The program pillars complement each other and support the achievement of theGovernment's goals and objectives. The restructunng of the infrastructure sector improves thebusiness environment (Box 3), contnbutes to the sustainability of fiscal stabilization, and areimportant components of public administration reform. The business environment and financialsector pillars encourage the entry of new and the expansion of existing firms to support thegrowth and employment objectives by absorbing labor released from the restructuinng of thepublic sector (Box 4). Social programs protect the vulnerable groups dunng the transition penodand contribute to the reduction of poverty while investments in human capital provide a longerterm capability to respond to the needs of a dynamuc market economy. The restructuring of thepension, health, and education sectors - which are the main components of public expenditureand, in the case of health and education, the major areas of overstaffing in the public sector - alsoimproves the overall efficiency of public administration. The governance pillar - publicadministration modernization, judicial reform, and anti-corruption measures - is cntical to pnvatesector development and progress in EU accession.

29. The proposed PALs support the Government's EU accession agenda, which is themajor driving force for reforms in Bulgaria. More specifically, the PAL programcomplements and supports the Government's efforts in building a functioning market economyand the capacity to cope with the competitive pressures and market forces within the EU in themedium term. Achieving the PAL program objective of building a dynamic and competitiveeconomy through stable macroeconomic performance, deep structural reforms, sustainableprivate sector-led growth, and improved investment climate determines the extent to whichBulgaria could benefit from EU accession. The PAL program also complements EU accessionrelated efforts to strengthen and develop the ability of the public administration and judicialsystem to implement and enforce the acquis communautaire. The PAL process helps theGovernment in formulating the pre-accession economic program and in sequencing economicreforms, including through analytical work based on experience from other EU accessioncountnes.

30. The effectiveness of the above program depends on the maintenance of soundmacroeconomic policies. The Government articulated its macroeconomic program in itsMemorandum of Economic Policies attached to the Letter of Intent to the IMF dated February 12,

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2002 where the Government committed to: (a) maintain the CBA at least until accession to theEU; and (b) implement a cautious and flexible fiscal policy, which is key to safeguarding externalviability under the CBA. The Government is aware of the importance of structural reforms tosustained macroeconomic stabilization.

Pillar 1: Sustaining Structural Reforms

31. The current privatization program19 focuses on infrastructure SOEs. Bulgaria hasdivested more than 90 percent of assets of non-infrastructure SOEs existing as of end-1995 andthe current program calls for the completion of this phase of the privatization by end-2004.20 Thenext phase of privatization has begun, involving the restructuring of the energy, railway,telecommunications, and water sectors with the objective of improving efficiency of servicedelivery through greater private sector investment within a framework of market rules andeffective enforcement. To improve transparency, reduce corruption, and accelerate theprivatization process, the legal and institutional framework for privatization has improved withthe enactment of the new Law on Privatization and Post Privatization Control and therestructuring of the Privatization Agency. By end-2005, the only remaining state enterprises willbe those listed in Annex 6-A. In conjunction with the business environment and publicadministration reforrms, the privatization program should increase the share of the private sectorin GDP to about 70- 75 percent by 2005.

32. The program in the energy sector aims to reduce Bulgaria's energy intensity2i andenable the private sector to assume an increasing share of commercial risks. To achievethese objectives, the sector is being fundamentally overhauled. First, energy prices are beingrationalized to cover costs and eliminate cross-subsidies beginning with a 20 percent electricityprice increase in the second half of 2002, with another 25 percent programmed over the next twoyears.22 Second, the legal and regulatory framework under which energy services will beprovided by the private sector is being improved and the capacity of the State Energy RegulatoryCommission (SERC) is being upgraded. Third, electricity distribution and generation companieshave been spun off from the former monopoly electricity company NEK and will be privatizedover the next two years.23 Fourth, the District Heating Strategy, which calls forcommercialization measures in the short term and privatization in the medium term, is beingimplemented. Finally, the gas sector will be opened to the private sector. The energy reforms areexpected to reduce Bulgaria 's energy intensity - measured by energy consumption to GDP - by 15percent at end-2005 compared to the level at end-2001.

19 Environmental policies put in place as part of the Environmental Protection Structural Adjustment Loan(EPSAL) will be enforced. The preparation of privatization plans of SOEs includes an environmentalsection to define the responsibility for past and future environmental liabilities.20 The remaining SOEs where the Govermment has majority control number 440, of which one quarter areconsidered large, mainly in the utilities and manufacturing sectors. There are another 1,800 non-infrastructure privatized enterprises where the Govermment has minority shares, which will also bedivested.21 Bulgaria has the highest energy intensity ratio in the ECA region.22 The social impact of the increase in electricity prices was reviewed in a PHRD funded study anddiscussed in the recent Poverty Assessment and Public Expenditure and Institutional Review. TheGovernment has put in place an energy subsidy program and structured the electricity tariff increases in away that minimizes the impact on the poor.23 The Ministry of Energy and Energy Resources (MEER) has engaged Paribas as lead privatizationadviser.

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Box 3: The Quality of Public Infrastructure: What do Firms Say?

In a survey of enterprise owners and senior managers in Bulgaria and other transition economies, respondents wereasked about their perception of the quality of infrastructure in their country. The responses for Bulgana are startlingand informative. The figures below compare Bulgaria's performance to four CEE transition countries, which willbe in the first wave of EU accession. The results strongly support the conclusions of the Public Expenditure andInstitutional Review that inadequate public infrastructure is a key impediment to the investment climate andinvestment in infrastructure is a key priority for public expenditure. The main conclusions:

* 78 percent of Bulgarian entrepreneurs surveyed perceived the road network in Bulgaria as bad or verybad, and less than 5 percent of the respondents felt that the road network was good or very good; this canbe compared to the next worst country, Poland, where only 49 percent of the respondents felt the roadswere bad or very bad;

* 15 percent of the respondents felt that the telephone service was bad or very bad; this is almost three timesworse than the next worst country in the sample - Slovak Republic;

* 19 percent of respondents felt the electricity service was bad or very bad; again this is more than doublethe next worst country;

* 18 percent of the respondents also felt the water services were bad or very bad; this is more than threetimes the next worst country - Hungary.

The implications of these entrepreneurs' perceptions of the adequacy of public infrastructure for business areobvious for foreign investment inflows, as well as domestic investment.

Quality and Efficiency of RPblic Services: Roads Quality and Efficiency of PublicServices: Telephone

W- . F 'Y P'rd Rd. BuaWra Czech HungaWry Poland Slovakia

* Good / very good 0 Good I very good* Middle (slightly good s lightly bad) * Middle (slightly good / slightly bad)~IBad I v0erY Dad U Bad I very bad

Quality and Efficiency of Public Services: Quality and Efficiency of PublicElectricity Services: Water

,os ,0_00- -

-~~~~~~ m~~~~~m .sr i £1 x .,_"x .- s , , 'S ^1 4.

0% , , . , , Bulgaria Czech Hungary Poland SlovaklaBulgaria Czech Hungary Poland Slovakia Republic

Republic D Good /very good

OGood/very good * Middle (slightlygood /slightly bad)* Middle (slightly good I slightly bad) @ Bad / very bad* Bad / very bad

Source Bulgaria: Public Expenditure Issues and Directions for Reformn, The World Bank, 2002

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33. In the railway sector, the restructuring program aims to increase efficiency, ensurefinancial sustainability, and improve staff productivity. The Railway Law passed inNovember 2000 provides the legal basis for the implementation of the reform program. A newrailway operating company and a new railway infrastructure State enterprise have been created aspart of the implementation of the program. Market rules are being developed that will enable theentry of private firms and the eventual privatization of the railway operating company, as well asensure fair competition for all land transport operators. The program also includes freedom to settariff for the railway operating company, rationalization of the railway network and services,24

introduction of public service obligation (PSO) contracts with the Government who pays for thenon-commercial services it does not want terminated, and the reduction of the railway labor force.The desired outcomes are: (a) by end-2004, the railway labor force will have been reduced by 20percent compared to the level at end-2001;25 and (b) subsidies (excluding loans and grants) to thesector will have fallen from 0.5 percent of GDP in 2000 to 0.2 percent of GDP in 2005.

34. The telecommunications markets are liberalized starting January 1, 2003 consistentwith the Government's EU accession agreement. The Bulgarian TelecommunicationsCompany (BTC) is expected to be privatized in 2003 without an extension of its monopolies.Amendments to the Telecommunications Law passed in December 2001 provides the legalframework for market liberalization, including the establishment of a new, independentCommunications Regulatory Commission (CRC), whose capacity is being strengthened withtechnical assistance. To ensure a competitive market, BTC will share its infrastructure with andallow indirect access by other market participants. The Government has affirmed its commitmentto implement the time-bound EU accession commitments. The Government goals are to achieveby end-2005 a degree of digitalization of transfer network of 100 percent, of exchanges 82percent, and of subscribers capacity 46 percent. By end-2005, the number of households withtelecommunication services allowing internet access is expected to be 94 percent, and telephoneconnection waiting time will not exceed one month.

35. In the water sector, the modernization program addresses the problems ofinefficiency and lack of investment by inviting private operators to bid for concessioncontracts. The water service providers cover 98.4 percent of the population, so access is not amajor issue. The focus of current reforms is efficiency, and the strategy to achieve this objectiveis to utilize private sector participation. The Water Law passed in September 2000 enablesRegional Water Companies (RWCs) to award concession contracts to private operators.Amendments to the Water Law have been submitted to Parliament to further facilitate theconcession program. The Government is in the process of completing the drafting of theregulations that will govern pnvate sector participation. By end-2003, the Government will haveawarded concession contracts in two RWCs to the private sector. The Government expects areduction in the ratio of operating costs (including depreciation) to revenues of RWCs to 80percent by end-2005.

36. The Government is implementing environmental reforms, supported by the Bank'sEPSAL, and will move into the next phase of reforms to meet the challenges of compliancewith the acquis. Environmental policies are being further improved by harmonizingenvironmental laws and regulations with those of the EU and strengthening the capacity ofenvironmental institutions and agencies to enforce environmental laws and regulations. The

24 The social impact of the termination of loss-making services on the poor will be included m thepreparation of the plan for terminating such services.

The recently approved Social Investment and Employment Promotion project will assist in mitigatmg theimpact on those affected by the restructuring of the railway sector.

16

Parliament recently passed a new Environmental Protection Act which is fully harmonized withEU acquis and which will implement the provisions of the EU Integrated Pollution Preventionand Control (IPPC) Directive. To maintain integrity of the natural environment, the Governmentwill further improve sector policies and regulations to prevent overexploitation and guaranteesustainable resources use. A Natural Resource Management Strategy will be developed whichwill ensure that land, forests and biological resources are used in environmentally sustainableway. The current goal is to issue 225 permits under the IPPC by end-2005 and to issue permitsto all enterprises covered by the IPPC directive by end-2007.

Pillar 2: Establishing a Market-friendly Business Environment

37. While the liquidation of loss-making SOEs and the privatization program haveincreased productivity, future growth will depend on the emergence of dynamic privatesector enterprises. New sources of growth will have to come from increased investment by theprivate sector in both new as well as existing enterprises. To continue attracting foreign directinvestment (FDI) and stimulate small and medium enterprise (SME) activity, the Government isundertaking measures to improve the business environment focusing on reducing entry andregulatory costs, improving public services to the busmess sector, maintaining stable market rulesand regulations, and ensuring a competitive environment. These initiatives complement thereforms in the areas of public administration, judiciary, and financial system. With these reforms,the Government hopes to attract FDI inflows averaging US$ 1.0 billion per year (of whichgreenfield FDI would be at least 50 percent) during 2002-05; increase the share of SMEs26 invalue added and employment to at least 50 percent by 2005; and increase total factorproductivity by 2.5 percent annually during the period 2002-05.

38. The Government is streamlining the regulatory regimes affecting business entry andresulting in additional transaction costs to the private sector. The Inter-ministerial WorkingGroup for the Optimization of Regulatory Regimes headed by the Deputy Prime Minister andMinister of Economy has reviewed all 361 centrally managed regulatory regimes and developed aprogram for eliminating 70 and modifying 118 of these by end-2004. In addition, the companyregistration process will be simplified by integrating the registration procedures that are currentlyperformed by several agencies. To monitor the impact of regulatory reforms, the Government hascompleted a baseline Administrative and Regulatory Cost Survey (ARCS)27 in 2002, and willperforn similar surveys annually and use the results to assess the effectiveness of its regulatoryregime simplification program. By end-2005, at least 50 percent of the current regulatoryregimes will be eliminated or modified thereby significantly reducing the regulatory compliancecosts compared to the 2002 baselinefigure as measured by the recently completed Administrativeand Regulatory Cost Survey (ARCS).

39. The Government plans to institutionalize measures to ensure that the introductionof future regulatory regimes is based on clear rationale, proper cost-benefit analyses, andappropriate consultation with affected parties. To control the development of future licensingregimes, the Government has submitted a draft Law on Administrative Regulation andAdministrative Control of Economic Activities which will codify the principles that underpin thedesign of new licensing and regulatory regimes. The CoM will provide specific guidelinesregarding the design of new regulatory regimes, including the identification and measurement ofcosts and benefits and the establishment of a process by which new regimes evolve from conceptto enactment which will include stakeholder consultation. The proposed law will require that

26 Defined as enterprises with 100 or less employees.27 This initiative was completed with the support and active involvement of FIAS.

17

new regulatory regimes, whether initiated by the central or local government, can be introducedonly by legislation.

40. En parallel, the front line government offices and agencies are undergoing reformsto improve service delivery and cost effectiveness. Institutional development initiatives areongoing in Customs, the Tax Administration Office, the Real Estate Registry Office, the NationalSocial Security Institute (NSSI), and various regulatory agencies such as the SERC and CRC.28

For the regulatory regimes that are considered necessary, the cost of compliance will be reducedby simplifying the administrative processes, a review of which will be initiated in three sectors -construction, tourism, and food processing - that account for about 10 percent of GDP and aresubject to a maze of administrative requirements. The process simplification initiative will beexpanded to other sectors in the future. The Govemment will also pilot a performance standardmonitonng system in offices that deal with the construction and labor services,29 and themonitoring system will be expanded to other offices dealing directly with the pnvate sector.Finally, the Govemment is reviewing and prioritizing information system changes, which willenable the integration of all corporate and government revenue information. By 2005, front lineGovernment offices are expected to achieve a 90 percent performance against standard duringthe year. The Government plans to reform the system of administrative courts to improveaccountability and provide the public with a venue for dispute resolution in the publicadministration area.

41. The Goverrnment is curirently undertaking a review of its competition policies andthe effectveness of the Commission for the Protection of Competition in the context of EUaccession. To strengthen the Commission for the Protection of Competition, the CoM hassubmitted draft amendments to the Law on the Protection of Competition, which in its currentform is already harmonized with EU requirements. The Parliament passed in 2002 the Law onState Aid to ensure consistency of intervention policies with EU directives. In line withcommitments under the Second Agriculture Structural Adjustment Loan (ASAL-2), theGovernment will abstain from establishing an agricultural commodity market stabilizationfacility, except for an intervention agency which is required to implement the EU's CommonAgricultural Policy (CAP) as a condition for EU accession. The Government also commits tomaintaining stability in the agricultural trade regime.

42. Labor marrket refoirm aims to introduce flexibility and reduce long termunempRoyment. The action plan for labor market reform involves: (i) deregulation of laborrelations through changes to the Labor Code; (ii) devolution of responsibility for determining thelabor relations to social partners, which entails adequate and genuine representation of employersand employees in social dialogue; (iii) decentralization of collective bargaining by strengtheningfirm level bargaining. The Labor Code will be overhauled towards reducing the procedural costsof dismissals, encouraging flexible forms of employment and work organization, and enablingwage flexibility. At the same time, the adequacy of the social safety net for displaced workerswill be reviewed and active labor market policies (ALIPs) that would facilitate the transition forold to new jobs are being designed and implemented. By end-2005, with the labor market andbusiness environment reforms, improvements are expected in the labor participation rate, theemployment to population ratio, and the share of long term unemployed in total unemployment.

28 Sumlar initiatives are ongoing in the financial supervision agencies.29 The offices involved are the Directorate for National Building Control at the Ministry of RegionalDevelopment and Public Works and the Labor Inspectorate at the Mmistry of Labor and Social Policy.KPMG has been retained to implement the pilot project.

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Box 4: Recent Labor Market Developments

Unemployment has been high in Bulgaria for a number of years and presently is about17 percent. The most worrisome feature of Bulgarian unemployment is its long duration.More than half of the jobless are long-term unemployed, implying a loss of human capital,erosion of morale, less reemployment chances and eventually large welfare cost to affectedindividuals and society at large.

The pattern of low employment prevailing in Bulgana is similar to that observed inother high unemployment transition economies. Its distinctive features include lowemployment of prime age men, relatively high employment of prime age women, and lowlabor force participation of younger (below 24 years of age) and older workers (55 to 64 yearsof age).

The pnma facie reason behind high unemployment in Bulgaria is high inflows intounemployment coupled with limited outflows, meaning low chances of finding a new job.The high inflows into unemployment, associated with a high rate of job destruction, arecaused by an accelerated enterpnse restructuring which followed the macroeconomic crisis in1997. Intensive enterprise restructuring has also contnbuted to unemployment by giving nseto skill and spatial mismatches, as new jobs that are being created differ in terms of skillcontent and location from the old jobs that are being destroyed.

The insufficient rate of job creatlon and associated limited outflows fromunemployment reflect three major factors: a relatively poor business environment, labormarket rigidities, and low skills of some of the unemployed. The poor business environmentis reflected in a slow rate of firm growth and relatively small share of the new sector -consisting of small pnvate firms - in employment. This points to barriers to entry and vanousobstacles to creation of new firms. Labor market ngidities stem from the Labor Codecontaining provisions which increase finng and hiring costs, limit wage adjustments, andconstrain working time flexibility. Finally, a significant portion of the unemployed has poorand narrow skills, which fall short of those required by the employers. This problem isparticularly pronounced among Roma and Turkish minonties. Accordingly, improvingbusiness environment, enhancing labor market flexibility, and improving access to and qualityof education are key for reducing unemployment.

The inadequate skills of the unemployed, especially of the long term unemployed, arelikely to be an important factor behind relatively limited flows from unemployment to work inBulgaria. Poor skills prevent a substantial fraction of the unemployed to effectively competefor jobs, and can lead to their marginalization in the labor market. The unemployed accountfor only 40 percent of new hires, while the rest is accounted for by persons who change jobsor new entrants to the labor market. The apparent importance of skills mismatch and gapproblems points to the role of the educational and training systems in addressing the problemof low, narrow and inadequate skills.

Source: J. Rutkowskl, "Why Is Unemployment So High in Bulgaria", draft Working Paper,The World Bank, 2002.

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44. To facilitate the exit of non-viable enterprises, the Government has initiatives thataim to accelerate the insolvency resolution process. First, the provisions in Part IV of theCommercial Code are being amended towards simplifying the process, establishing shorter andbinding deadlines, and providing more powers to creditors. Second, there is a programestablishing more stringent criteria for the licensing and dismissal of trustees, and strengtheningtheir monitoring and control by the Ministry of Justice (MoJ) and the courts. Third, institutionalreforns in the judiciary will upgrade the skills of judges and improve the efficiency of courtadministration. Finally, the MoJ is prepanng a program for overhauling the Civil ProcedureCode and creating a system of specialized commercial courts which would be the recipient offocused institution building efforts. The Government goal is to cut the time for processinginsolvency cases. The MoJ is in the process of developing indicators to track progress inreducing processing time for insolvency cases.

Pillar 3: Deepening the Financial System

45. While Bulgaria has achievedsignificant progress in restructuring the September 2002banking system, flnancial Spe er20intermediation remains low and Foreignfliancial markets are undeveloped. 8% PnvateAbout 85 percent of the banking assets are 7%now in private ownership, mainly by ._ foreign financial institutions (Figure 7), asa result of an aggressive privatizationprogram in 1999-2001. However, about

Foreign ~~~~~~State Owned30 percent of banking assets are deposited Subsidianes 15%in foreign banks. Non-bank financial 70%institutions do not constitute a majorcomponent of the financial system, andcapital markets and micro-finance areundeveloped. The Government's objectives in this sector are to increase financial intermediationand stimulate financial markets described below. The Government wants to see an increase inM2/GDP from 42 percent at end-2001 to 50 percent at end-2005, closer to the percentages ofadvanced transition economies.

46. The legal and institutional framework for lending is being improved to encouragefinancial intermediation. Amendments to the foreclosure provisions of the Civil ProcedureCode were recently passed by Parliament to reduce delays in enforcement of valid claims.Amendments to the Law on Registered Pledges have been submitted to Parliament to increasesecured lending. The Accountancy Act and the Independent Financial Audit Act were recentlyenacted to bring the accounting and auditing standards to international standards thus improvingthe quality of financial information. There will be a reform of the taxation of the financial sectorto eliminate distortions and inconsistencies across various financial instruments and institutions.Finally, the Anti-money Laundering Law will be strengthened in line with international standardsand good practices. These reforms are expected to result in major improvements in the lendingenvironment which will help increase private sector loans to GDP from 15 percent at end-2001 to25 percent by end-2005, a ratio closer to those of advanced transition economies.

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47. The restructuring of the banking system is well advanced, and the Government willsustain the implementation of the agenda for banking reform. The sale of the remainingState shares in Central Cooperative Bank and the privatization of Biochim Bank have beencompleted. The privatization process for the State Savings Bank (DSK) has begun with theappointment of J.P. Morgan as the privatization adviser, and is expected to be completed by mid-2003.30 The Bank Bankruptcy Law was recently enacted to improve the exit process for insolventand closed banks. The enactment of amendments to the Banking Law strengthens the supervisionpowers of the Bulgarian National Bank (BNB) to enable BNB to identify and investigate directand indirect owners of banks. The private sector share of banking assets is expected to be about98 percent by mid-2003. BNB is pursuing efforts to ensure that prudential standards aremaintained during 2002-05.

48. The Government is taking steps to stimulate capital markets. The development of thepension fund and insurance sectors will mobilize long term savings which can be invested in longterm financial instruments in the market. Initiatives include the privatization of the dominantState Insurance Company (DZI),3 ' strengthening the governance structures of private pensionfunds, and defining a higher and more stable contribution rate to the mandatory second pillar ofthe pension system. To improve investor confidence, the Commercial Code is being amendedand the Law on Public Offering of Securities has been amended to address deficiencies inminornty shareholder protection and to strengthen corporate governance provisions. TheMortgage Bond Law was also passed to enable the introduction of more financial instruments. Toprotect investors, the supervision capacities of the Bulgarian National Securnties Commission(BNSC), the State Insurance Supervision Agency (SISA), and the Insurance Supervision Agency(ISA) are being upgraded. The Parliament is currently deliberating on a draft law that wouldintegrate the supervision of non-bank financial institutions (NBFIs) in one agency.

49. A separate body of senior officials from all financial services supervisory agencieshas been established to ensure proper coordination and development of a system-wideperspective in assessing and dealing with risk and vulnerability. This body - the FinancialSector Advisory Committee - will serve as an information sharing and policy-oversight organ.Membership of this body includes the heads of supervisory agencies, although the membershipcomposition will be reviewed when the legislation integrating NBFI supervision is passed.Information will be shared among members of the committee to plan and coordinate actions toaddress any major vulnerabilities within the financial sector, and to improve investor confidenceand buoyancy of the market. Through such sharng of information, it is expected that thecoordination of functions of the various supervisory agencies can be improved, especially wheresupervisory functions overlap. This body will also develop an Early Warming System and a set ofindicators to be used in monitoring the vulnerability of the financial system.

Pillar 4: Improving Public Sector Governance

50. The Government plans a comprehensive approach to public administration reform.The Council of Ministers (CoM) recently approved the document Strategy for StateModernization - from Accession to Integration, together with a set of draft amendments to theexisting Civil Servant Law which have been submitted to Parliament. The strategy will makeprovision for improving the functioning of the Institute of Public Administration and EuropeanIntegration; the setting up of a program of functional reviews of different ministries and agencies

30 By mid-2003, only two non-private banks will remain: the Business Promotion Bank and the MunicipalBank owned by the Sofia municipality, which together account for 2.3 percent of bank assets as of end-September 2002.31 The privatization of DZI was recently completed, making the insurance sector 100 percent private.

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to align structures and staffing with program priorities; and the development of a time-boundprogram for the implementation of service delivery and performance standards for ministries,agencies, regional offices, and municipalities. By end-2005, the administrative capacity will besubstantially upgraded and ineffective and overlapping structures closed down.

51. The Government has adopted a National Anti-Corruption Strategy which takes acomprehensive approach to the problem of corruption. The challenge will be to translatesuch an ambitious agenda into a sequence of concrete actions that will allow the Government toachieve demonstrable progress in selected priority areas. In that context, the Government hasprepared an action plan that includes: (a) concrete steps to address issues relating to conflict ofinterest, lobbying regulation, and political financing; (b) the establishment of an inter-ministerialcommission to implement the plan; (c) the creation of a full time secretariat to support the workof the commission; and (d) the design of a monitoring system to track progress in meeting theanti-corruption objectives. The Government has established the Inter-ministerial Committee forImplementing the Anti-corruption Strategy and Action Plan to ensure coordination of effortswithin the Government.

52. The Government has also adopted a program and action plan for judiciaDl reform,including an anti-corruption strategy for the judiciary. The program has four components.First, human capacity will be enhanced by upgradmg legal education; introducing compulsorytraining; improving the magistrate selection, promotion, and demotion process; and establishingand enforcing performance standards. Second, administrative capacity will be upgraded throughimproved planning and resource allocation, better systems support, and implementation of anti-corruption strategy. Third, alternative dispute mechanisms will be established, including thetraining of arbitrators and mediators. Finally, a monitoring system will be established to track theprogress of reforms and how the judiciary is viewed by the lawyer and litigant communities aswell as by the general public. The Government would like to see major improvements by 2005 inthe efficiency of the judicial system using indicators such as by case load per judge, number of

judgments enforced, number ofpending cases, and public perception based on survey feedback.

Pillar 5: Investing in Human Capital and Strengthening Social Programs

53. The Government has begun an education reform initiative designed to improveresource management and quality of teaching and learning while continuing to maintainhigh levels of access. The reforms will strengthen the capacity of the Ministry of Education andScience (MES); introduce new education standards and curriculum and student assessment andevaluation system; train inspectors, school directors and teachers; d