Recent measures have created a healthier financial sector . Under new leadership in the Bulgarian National Bank (BNB), gaps in banking sector supervision and resolution are being addressed: a Plan on Reforms and Development of Banking Supervision was adopted by the BNB in October 2015 and is being implemented, an assessment of the Basel Core Principles for Effective Banking Supervision was undertaken in 2015, an assessment of the banking system—consisting of an asset quality review (AQR) and stress test—was completed in August this year, and a Financial Sector Assessment Program (FSAP) is being undertaken jointly by the International Monetary Fund and the World Bank. In addition, the Financial Supervision Commission is conducting reviews of pension funds’ assets and insurance companies’ balance sheets.

The completion of the AQR and the stress test is a significant step towards strengthening confidence in the banking sector and the BNB’s ability to supervise it . The AQR broadly followed the methodology of the European Central Bank and the stress test that of the European Banking Authority. The exercise covered all 22 banks in the system and the assumptions and scenarios for the AQR and the stress test were generally conservative. The results showed that most of the system remains well-capitalized even after the AQR adjustments. The AQR and stress test should also help banks prepare for the introduction of new international financial reporting standards (IFRS9).

However, the AQR also found that three banks—the largest domestically-owned bank and two small ones—had to restore the coverage of their capital buffers by an aggregate amount of 0.3 percent of GDP; recovery strategies should seek to decisively address the identified weaknesses. One of the two small banks has already raised needed capital. The other two banks have until mid-2017 to reach additional capital buffers required by the BNB. Bringing in new bona fide investors would help improve credibility and governance. If the banks are not able to successfully bring additional capital buffers to the required levels within the announced time frame, it would be important for the authorities to intervene.

Recent reforms to strengthen the institutional framework for financial system oversight are welcome and should continue. As important steps, a new governance structure for bank supervision has been implemented at the BNB and supportive legislation has been adopted to strengthen the powers of the BNB to dismiss senior managers, board members and auditors. The central bank should use the information acquired as part of the AQR and stress test to pursue a more risk-based supervisory review and evaluation process. Also, adequate resources should be secured to facilitate more inspections. Following the Basel Core Principles assessment, there is a need to tighten the legal framework pertaining to ultimate beneficial owners and related party lending, and for the BNB to announce a comprehensive set of indicators for early intervention in banks. Reduction of NPLs, especially in banks with lower capital ratios, would help prepare against adverse shocks. Reinforcing the insolvency framework and monitoring its performance will be important in this regard. The financial safety net needs to be strengthened, including by operationalizing the resolution framework and ensuring adequate funding for the Bulgarian Deposit Insurance and Banking Resolution funds. If public funds are needed, their use should be minimized. Initiatives to strengthen banking supervision and resolution should be informed by the FSAP, which is scheduled to be finalized in the first half of 2017, and will provide a more in-depth assessment of the financial sector.

Structural reforms: Rekindling Bulgaria’s potential

Raising Bulgaria’s potential growth will require acting on various structural fronts:

Significant effort is needed to advance the anti-corruption agenda. As an initial step, a comprehensive anti-corruption law needs to be adopted, free of amendments that compromise its effectiveness. Steadfast implementation will be equally important, including by establishing a single agency with adequate powers and independence, and consolidating the anticorruption work currently being performed by several separate agencies in an uncoordinated manner. It would also be important to advance reforms in the judicial system.

Fiscal policy: Ensuring long-term sustainability

Fiscal consolidation is advancing faster than anticipated . Driven largely by administrative revenue measures and stronger economic activity, the cash fiscal deficit declined by ¾ percent of GDP in 2015 to 2.9 percent of GDP. This was a welcome change in the course of fiscal policy after significant slippage in 2014. Fiscal overperformance has continued so far this year, due to increases in excise rates, sustained administrative efforts, faster-than-expected growth, and under-execution of EU-funded capital spending. The mission projects revenues for 2016 to overperform the budget target by ¾ percent of GDP on current trends.

The mission supports the authorities’ plan to save the revenue overperformance . This is appropriate from a cyclical perspective—as recent consumption growth has been above trend—and will also strengthen fiscal buffers to address any unanticipated needs that could arise from contingent liabilities in the energy, financial, and other sectors. At the same time, execution of EU-funded capital spending should be accelerated. Assuming that the revenue overperformance is saved and EU funds spending is accelerated, the mission projects the cash deficit to be 0.8 percent of GDP for 2016.

The authorities’ medium-term fiscal consolidation plans are appropriate. The 2017 budget should continue the consolidation trend on an accrual basis. The mission supports the authorities’ plan to reach fiscal balance by 2020. The authorities plan to reach this goal through a combination of revenue measures and expenditure restraint. If expenditures savings do not materialize, there is scope to use additional tax measures, such as raising property taxes, to make up for any shortfall. Adhering to the authorities’ medium-term consolidation plan and maintaining a structurally balanced budget thereafter will help reduce government debt gradually to below 25 percent of GDP by 2020. Keeping public debt low is especially important in the context of Bulgaria’s currency board arrangement.

Contingent liabilities should be reduced and their risks internalized in fiscal planning. The main threats to the fiscal accounts are posed by the poor performance of SOEs, the weak finances of subnational governments, and concerns regarding the viability of private pension funds, which could lead to shifts to the public pension system. At a minimum, the potential negative impact from these risks should be estimated and incorporated in fiscal scenarios. The mission welcomes the establishment of the Fiscal Council. Ensuring its operational independence and enhancing its capacity would help support policy credibility.

There are significant long-term fiscal pressures from demographic trends. Over the long run, the projected aging of, and decline in, Bulgaria’s population will have a significant impact on the public pension system and health spending. In the absence of a concerted policy response, such demographic trends will also depress long-term economic growth and accentuate fiscal pressures. In this regard, the 2015 pension reform was important to improve the sustainability of the public pension system in the near and medium terms. At the same time, more needs to be done to address long-term sustainability. Options include introducing additional parametric reforms of the pension system, containing health spending, improving education to boost labor productivity, and raising high-quality public investment. In addition, the review of private pension funds’ assets would help to identify any needed changes in the private pension system.

The mission is grateful to the authorities and other counterparts for their warm hospitality and excellent cooperation.