EUROPEAN COMMISSION Brussels,7.3.2018 SWD(2018) 201 final COMMISSION STAFF WORKING DOCUMENT Country Report Bulgaria 2018

Including an In-Depth Review on the prevention and correction of macroeconomic imbalances

Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2018 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2018) 120 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the Macroeconomic Imbalance Procedure in-depth review 4.Reform priorities 4.1.Public finances 4.2.Financial sector 4.3.Labour market, education and social policies 4.4. Investment and competitiveness 4.5. Sectoral policies Overview TableAnnex A: Macroeconomic Imbalance Procedure ScoreboardAnnex B: Standard TablesAnnex C: References LIST OF Tables Table 1.1:Financial soundness indicators - all banks in Bulgaria Table 1.2:Key economic and financial indicators – Bulgaria

Table 2:Summary table on CSR assessment Table 3.1:Macroeconomic Imbalance Procedure assessment matrix for Bulgaria Table B.1:The MIP scoreboard for Bulgaria (AMR 2018) (1), (2), (3) Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: Real GDP growth by demand components Graph 1.2: GDP growth and GDP per capita Graph 1.3: Potential growth breakdown Graph 1.4: Nominal wage growth in Bulgaria in comparison with wage benchmarks Graph 1.5: Activity, employment and unemployment rates Graph 1.6: Level of income inequality in EU, 2016 Graph 1.7: Current account developments Graph 1.8: Net international investment position Graph 1.9: Domestic credit growth

Graph 1.10: House prices overvaluation gaps Graph 2.1: Overall multiannual implementation of 2011 - 2017 CSRs to date (1), (2), (3) Graph 4.1.1: Tax revenue by main category Graph 4.1.2: Public expenditure by category, average 2011-2015 Graph 4.2.1: NPLs share of total loans and advances, all banks Graph 4.2.2: Private debt breakdown Graph 4.2.3: NFC debt ratio against the fundamental-based benchmark (1) and prudential threshold (2) Graph 4.2.4: NPLs, share of total loans and advances - total, households and NFCs Graph 4.2.5: Share of companies facing financial stress Graph 4.2.6: Determinant of growth for financially and non-financially stressed NFCs Graph 4.3.1: Population projections (2016-2080) Graph 4.3.2: Employment by sector, year-on-year changes Graph 4.3.3: Unemployment rate and potential additional labour force Graph 4.3.4: Expenditure on and participation in activation measures, 2017 Graph 4.3.5: Early school leaving disaggregated by the urban status, Bulgaria and the EU average Graph 4.3.6: Expenditure on health Graph 4.3.7: At-risk-of-poverty or social exclusion rate, components Graph 4.3.8: At-risk-of-poverty or social exclusion rate, age groups Graph 4.4.1: Gross fixed capital formation as % of GDP Graph 4.4.2: FDI in NFCs by economic activity, 2016

Graph 4.4.3: Evolution of export market share Graph 4.4.4: Quality and share of exports by category Graph 4.4.5: Rate of change of ULC, breakdown Graph 4.4.6: Real effective exchange rate based on ULC Graph 4.4.7: Proportion of contract award notices where the negotiated procedures without prior publication were used, 2013-17 Graph 4.5.1: Employment and value added in manufacturing 2009-2015 Graph 4.5.2: Air quality — PM10 concentrations in relation to the daily limit value in 2015 in the EU28 LIST OF Boxes Box 2.1: Tangible results delivered through EU support to structural change in Bulgaria Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 4.4.1: Investment challenges and reforms in Bulgaria Box 4.4.2: Policy highlights Executive summary Bulgaria's strong economic situation could facilitate structural reforms. Strong economic growth and a sound fiscal position represent an opportunity for structural reforms that could accelerate catching up with the rest of the European Union and reduce persistent high levels of poverty and inequality. The economy's cyclical upswing helped a solid labour market recovery, but persistent skills shortages and mismatches require a structural response. The authorities' response to the challenges in banking and non-banking strengthened the financial sector and these reforms need to be completed to consolidate recent progress. ( ) Economic growth remains robust, but catching-up with the rest of the EU is slow. GDP growth is estimated to have been 3.8 % in 2017, slightly lower than 2016. The main engine of growth, however, has changed from the external sector to domestic demand as private consumption grew stronger and investment growth turned positive. In 2018 and 2019, GDP growth is expected to slow down somewhat but to remain strong, still mainly driven by domestic demand. Despite the positive economic outlook, convergence with the EU average income slowed down again in 2017 as growth in the rest of the EU has picked up. Increasing the growth potential of the economy could accelerate the catching-up process, but moderate increases in capital and labour limit the growth potential. Further gains in total factor productivity, the main driver of potential GDP growth since 2015, could be constrained by relatively low investment. Labour market conditions have recently improved. Employment and activity rates have increased, while the unemployment rate has decreased substantially, to 6.3 % in 2017. Based on 2016 data, the compensation of employees was very low relative to the EU average. The strong wage growth in 2017 will improve wages, but if continued and not accompanied by similar productivity developments it could lead to competitiveness losses. Low educational outcomes and inequalities linked to socio-economic background represent major obstacles to human capital improvement, with potential knock-on effects on skill levels and the growth potential. The fiscal performance remains sound creating room to address economic and social challenges. The general government budget remained balanced in 2017 in both nominal and structural terms and public debt decreased. The fiscal outlook remains positive in the medium term with a small surplus projected for 2019 and could be further reinforced by improvements in tax collection, as planned by the authorities. On the expenditure side, while budget planning and execution are overall sound and stable, there is room to improve efficiency and monitoring of public spending to support economic and social development and convergence.

The soundness of the financial sector continued to improve despite remaining vulnerabilities. Capital and liquidity levels have increased and the quality of assets has improved. Profitability remained strong. Households are among the least indebted in the EU but non-financial corporations' debt, and non-performing loans are still higher than in peer countries, albeit decreasing. Still, some vulnerabilities persist despite measures to follow-up the banking and non-banking sector reviews and increased supervisory efforts. Bulgaria has made some progress in addressing the 2017 country-specific recommendations. Some progress was achieved in tax collection and tax compliance, in stepping-up enforcement measures to reduce the informal economy and undeclared work,, in taking follow-up measures on the financial sector reviews and in enhancing banking and non-banking supervision, in facilitating the reduction of non-performing corporate loans, in improving the targeting of active labour market policies and the integration between employment and social services, in improving the coverage and adequacy of the minimum income, and in ensuring efficient implementation of the 2014-2020 National Public Procurement Strategy. Limited progress was made in increasing the provision of quality mainstream education, in particular for Roma, in increasing health insurance coverage, in reducing out-of-pocket payments, in addressing shortages of healthcare professionals, and in establishing a transparent mechanism for setting the minimum wage. Regarding progress in reaching the national targets under the Europe 2020 strategy, Bulgaria appears to be already ahead in reaching its targets for reducing greenhouse gas emissions and increasing the share of renewable energy. Measures have been taken to improve energy efficiency but energy consumption remained above the indicative national targets. Bulgaria has made progress on the employment rate and tertiary education, but the targets are still to be met. The situation has deteriorated regarding the targets on early school leaving, poverty reduction and R&D intensity. Bulgaria faces challenges with regard to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. Whilst the high economic growth has translated into improved employment outcomes, the levels of poverty and income inequality remain very high and active labour market policies are underdeveloped. The education system does not fully equip students with relevant skills and access to quality education remains unequal. Moreover, Bulgarians face difficulties in accessing healthcare and housing. On the positive side, Bulgaria has a low gender employment gap and an increasing gross disposable household income per capita. The main findings of the in-depth review contained in this report and the related policy challenges are as follows: ·The financial sector has been strengthened overall, but vulnerabilities remain. Substantial effort has been made to improve banking and non-banking supervision, with the on-going implementation of the action plan for banking supervision and the adoption of an action plan for non-banking. Legislative amendments introduced a somewhat tighter risk management of related-party exposures in the banking sector and a broader definition of ‘related parties’ in the non-banking sector, in line with international standards. Further measures which remain to be fully implemented include dealing with exposures to hard-to-value assets and in the insurance sector with the treatment of specific reinsurance contracts and the inadequate group level supervision. In the pension funds sector, the concentration of assets on the relatively illiquid traded and non-traded domestic market, and complex ownership and cross-ownership structures require further monitoring. ·Despite the ongoing debt reduction, high private debt is still a concern. High non-financial corporations' debt could hamper medium-term growth prospects. Problems with the valuation of illiquid assets and the lack of a deep secondary market for non-performing loans constrain Bulgaria’s ability to reduce this high corporate indebtedness. ·The reform of the insolvency framework continues. Despite new legislation on business restructuring, some elements of a functioning framework are still missing. In particular, Bulgaria lacks rules for granting a second chance to consumers and entrepreneurs in a reasonable timeframe following a bankruptcy, and an effectiveness analysis of existing and new procedures. Data collection in the field remains a challenge. ·Despite solid labour market recovery structural challenges persist. A shrinking working age population, skills shortages and mismatches, particularly in digital skills, and high inactivity remain major concerns for sustainable growth. Undeclared work continues to distort the labour market. Active labour market policies have low coverage and are mostly focused on direct job creation and employment incentives. The young, the low-skilled, the Roma and the rural population face particular difficulties in entering employment. Measures addressing jobseekers' employability and skills gaps are not sufficiently developed. The minimum wage is still being adjusted without a clear and transparent mechanism, in part due to the current challenges in social dialogue. Other key structural issues analysed in this report, which point to particular challenges for Bulgaria’s economy, are the following: ·The social protection system is insufficient to tackle the significant social issues. The percentage of the population at risk of poverty or social exclusion is among the highest in the EU particularly among the disadvantaged social groups. The adequacy and coverage of social assistance benefits are low and there is no objective mechanism to update the benefits. The flat personal income tax has a small redistributive impact. Inequality of opportunity in education, healthcare and housing remains of concern. The provision of social services is insufficient and their integration with labour market services remains incomplete. ·Recent measures aim to modernise the education system, but challenges remain. Educational outcomes are low and strongly influenced by socioeconomic status. Early school leaving is high and kindergarten fees contribute to an unequal start in education. Integration of Roma remains a major challenge. A mechanism to identify out-of-school children has been established, but measures to improve school attendance and retention are still limited. The insufficient labour market relevance of vocational education and training remains a challenge. Adult participation in learning is insufficient to address the need for upskilling. ·Access to healthcare is limited by low and uneven distribution of resources. Public healthcare expenditure is very low, resulting in a high proportion of non-reimbursed medical expenditure. The number of medical doctors is relatively high and their emigration has decreased. However, district-level differences in the distribution of doctors, and the low number of nurses, remain a problem. Despite improvement in recent years, the number of Bulgarians reporting problems with accessing healthcare is much higher than the EU average. ·Efforts to improve the business environment are ongoing. Businesses remain concerned about corruption, institutional shortcomings and insufficient labour supply. Several multiannual projects reduced barriers to investment but the speed of implementation of the reforms is insufficient to catch up with peer countries. Slow progress with public administration reform, including e-government, has held back the quality of public services. Despite improvements in public procurement, administrative capacity is still weak and the measures included in the National Public Procurement Strategy have not been assessed yet. E-procurement is not yet fully in place and the potential of central purchasing remains untapped. The fight against corruption has been hampered by the fragmented landscape of corruption-prevention institutional structures, and by procedural and legal obstacles to the effective investigation and prosecution of high-level corruption. Recent efforts to address these issues still need to show concrete results. Significant progress has been made towards reinforcing the independence of the judiciary but further follow-up is needed on this as well as on addressing other shortcomings in the judicial system, which weaken the business environment and deter investment. ·The fiscal performance is sound but there is space to improve management and governance. Improving tax compliance and the efficiency of the tax administration remains a key objective for public finances' sustainability and the promotion of a socially fair and growth-friendly economic environment. Fiscal stability is supported by strong political commitment and the currency board arrangement, but checks-and-balances in the fiscal framework are insufficient. Public expenditure management is sound in terms of monitoring and medium-term planning of the main aggregates but is not governed by performance goals or benchmarks. Enhancing the operation of the Fiscal Council remains a challenge. State-owned enterprises are a source of economic and fiscal risks, as their corporate governance structures are rarely subject to professional management or rules that ensure independent and transparent decision making. ·Further challenges exist in specific sectors. Shortcomings in the research, development and innovation system limit its contribution to productivity and growth. Reforms are still needed in the energy sector to ensure a reliable, competitive and sustainable supply of energy to businesses and the society at large. The energy saving potential remains untapped and air quality continues to give cause for serious concern. Shortcomings in infrastructure are reflected in the low effectiveness and performance of the transport sector. 1. Economic situation and outlook GDP growth Bulgaria’s economy is growing steadily, with the drivers of growth shifting from the external sector to domestic demand. Real GDP growth was estimated at 3.8 % for 2017. Increases in wages and improved household expectations had a positive impact on private consumption, Public consumption growth, was also stronger than in previous years reflecting mainly higher spending on wages and intermediate consumption. Investment is slowly recovering from its 6.6 % drop in 2016, as confidence is improving in the business sector and implementation of EU funded projects has re-started. Net exports, which performed very well in 2016, lost momentum in 2017 as export growth slowed and higher domestic demand fuelled a rise in imports. The difference between actual and potential GDP, the output gap, closed in 2017 and is set to turn positive in 2018. Graph 1.1:Real GDP growth by demand components 2017-19: Winter forecast 2018 for real GDP growth, otherwise Autumn forecast 2017 Source: European Commission

Wage increases and faster implementation of EU funds are expected to drive economic growth in the medium term. Investment's contribution to economic growth is set to somewhat increase with faster implementation of EU funds. Public consumption is forecast to grow, mostly driven by the planned increases in public sector wages in 2018. Wages will continue to have a positive impact on private consumption but their growth is expected to slow. Both export and import growth rates are projected to drop and net exports’ contribution to growth is expected to remain close to zero. Convergence Following relatively fast income convergence prior to the crisis, catching up with the rest of the EU has slowed down. The GDP per capita gap with the EU average, measured in purchasing power standards (PPS), closed by almost 13 pp. between 2006 and 2017 (Graph 1.2). The process of convergence slowed after the global crisis, but has revived as growth gained momentum since 2014. Convergence with the EU and the euro area,, however, has been slower than in other Member States with broadly comparable levels of income at the time of accession (e.g. Lithuania, Romania and Poland). For that reason, Bulgaria’s distance in terms of real income from some of its peers has increased. Graph 1.2:GDP growth and GDP per capita Source: European Commission Potential GDP growth has benefited from productivity improvements but is constrained by modest capital and labour increases. Potential GDP is expected to grow at an annual rate of close to 3 % (Graph 1.3). Although above those of many other EU Member-States, this rate is below the potential GDP growth forecast for several regional peers. The contribution of total factor productivity (TFP) to potential GDP growth has increased since 2014 and its importance is growing, in contrast with the shrinking contribution of capital accumulation, which is at its lowest level in 10 years. Private investment did not recover completely after the international financial crisis and experienced a second drop in 2013-2014. Despite the gradual recovery of public investment which started in 2017, the capital stock is not forecast to increase significantly in the medium term due to a number of structural obstacles to business and investment that will take time to eliminate (see Section 4.4). Labour’s contribution, although positive since 2015, remains subdued reflecting the relatively slow increase in the labour force (see Section 4.3). Graph 1.3:Potential growth breakdown 2017-19: Winter forecast 2018 for real GDP growth, otherwise Autumn forecast 2017 Source: European Commission Prices and wages Prices are rising after a long period of deflation. Annual consumer price (HICP) inflation was 1.2 % in 2017 due to strong domestic demand, higher administrative prices for utilities, and recovering energy and commodity prices. Inflation is forecast to gradually increase in 2018 and 2019 to 1.4 % and 1.5 %, respectively. Strong wage increases have not yet created inflationary pressures. Compensation of employees increased by 7.8 % in 2017 and is expected to grow 8.3 % in 2018. Unit labour cost (ULC) in nominal terms increased by 4.6 % in 2017 (against 2.3 % in 2016). Real ULC growth jumped from almost zero in the previous two years to 4% in 2017. Nominal wage growth has been in line with a stable evolution of cost competitiveness (as measured by an unchanged real effective exchange rate), but is faster than developments in labour productivity, prices and the unemployment rate would predict (Graph 1.4) ( ) Moreover, wage increases seem to have had so far no impact on the domestic demand deflator. Graph 1.4:Nominal wage growth in Bulgaria in comparison with wage benchmarks Source: European Commission based on the methodology described by Arpaia and Kiss (2015) Labour market, poverty and social exclusion Unemployment is falling mainly because of the improved economic outlook. The unemployment rate fell from a peak of 13 % at the end of 2013 to just below 7 % in 2016 and 6.3 % in 2017. Activity and employment rates increased substantially in the last few years, recovering from the sharp drop during the crisis period (Graph 1.5). In 2017 the employment rate is expected to have increased further and, for the first time since the crisis, to reach a level close to the 71 % recorded in the pre-crisis period. However, there is still a sizeable potential labour force. Labour market prospects are expected to remain positive but to moderate somewhat in 2018 and 2019 due to limited labour supply. The impact of the positive labour market performance is not evenly spread across the population. In particular, people without a job for more than a year, inactive young people, Roma and those living in poorer regions and rural areas continue to face significant difficulties in obtaining work. The overall rate of young people not in employment, education or training and the proportion of the inactive population within that group are still high. Skills shortages and mismatches remain a challenge. The so-far low participation in active labour market measures and the limited focus on training do not help to improve this situation. Graph 1.5:Activity, employment and unemployment rates Source: European Commission Structural labour market issues may hinder the sustainability of economic growth in the medium term. The shrinking working age population is a long-term drag on the potential of the economy (see above). Skills and qualifications mismatches also hamper the functioning of the labour market, despite a trend toward upskilling (see Section 4.3). The levels of undeclared work remain high (see Section 4.1), which has considerable implications for fiscal revenue, labour conditions and the adequacy of income after retirement. Minimum wage setting is still not based on objective socio-economic criteria. Growth has not been inclusive enough to reduce poverty and economic and social inequalities. Bulgaria has one of the highest levels of poverty and income inequality in the EU (see Graph 1.6 and Box 4.3.1). Close to one quarter of the population have income below the "risk-of-poverty" level. Extreme poverty, as measured by indicators such as severe housing deprivation ( ) for families with dependent children, is decreasing but remains among the highest in the EU. Market income inequality for the working age population is only slightly higher than the EU average. However, the effect of taxes and transfers on reducing inequality is among the weakest in the EU. This is partly due to the relatively small redistribution impact of the flat personal income tax system, as well as the relatively low spending on social protection and the absence of a mechanism to better target and update social transfers to the population in need. Graph 1.6:Level of income inequality in EU, 2016 Source: European Commission Inequality of opportunities is also high. Access to social services is characterised by big discrepancies between rural and urban areas, as well as among regions. Poor education and health of some groups, including Roma, form another important driver of inequality irrespectively of the region. Health inequalities, measured by the gap in unmet needs for medical examination between the highest and lowest income households, have been declining in recent years, but remain above the EU average. Another factor is the strong trans-generational transmission of social and economic conditions. Poverty among children with low-skilled parents is 15 times higher than it is among children with high-skilled parents ( ). Similarly, the socioeconomic background of parents seems to have a strong impact on the educational performance of students. The level of digital skills is overall among the lowest in the EU and is very diverse among different socioeconomic groups, adding to social exclusion and inequality of opportunities. External position The current account balance remains positive, albeit decreasing. The current account balance is estimated at around 3 % of GDP in 2017,significantly lower from its 2016 peak of 5.3 % of GDP. Growing demand from trading partners is being outstripped by strong domestic demand, leading to a higher increase in imports than in exports in 2017. This trend is expected to continue in 2018 and 2019, when the current account surplus is expected to drop.

Graph 1.7:Current account developments Source: European Commission The net international investment position (NIIP) has significantly improved in recent years. From a very negative position of -95 % of GDP in 2009, the NIIP improved to -47.7 %] of GDP in 2017. This improvement is mainly related to an increase in reserve assets, the reduction of bank liabilities to parent companies and higher holdings of foreign assets by domestic companies (mainly pension funds but also banks). Persistent current account surpluses combined with a capital account surplus and nominal economic growth have also contributed to the positive NIIP trend since 2009. Foreign direct investment (FDI) is the NIIP's main source of finance. Graph 1.8:Net international investment position Source: European Commission External sustainability risks are expected to decline further as the negative NIIP is shrinking Based on current trends, by the end of 2018 the NIIP is expected to be below the MIP threshold (-35%), as well as the country-specific prudential threshold for Bulgaria, estimated at -34 % of GDP (see European Commission, 2016a). Taking into account the fundamentals of the economy, to maintain or to improve this NIIP level the current account balance should be above -2.3% of GDP; this is the so-called current account norm. ( ) The projected current account surpluses, well above this norm, are paving the way for further improvement in NIIP. The positive marketable external debt position is an additional positive indicator of the external sustainability. This is due to the high share of net direct investment in NIIP (Graph 1.8), as the high level of reserves (50% of GDP in 2017, the highest level in the EU) offsets corporate foreign debt liabilities. Financial sector Steady expansion of the balance sheet, improved quality of assets and higher capital levels characterise the banking sector. Commercial banks’ total assets grew by 6.2 % at end 2017, compared to 12 months earlier. Banks’ funding has been driven entirely by the significant increase in deposits. Household deposits grew by 4.8. %, while the growth rate of non-financial corporate deposits was 13.1 % (BNB, 2017a). Depositors showed sustained preference for domestic currency. As a result of positive liquidity developments, the loan-to-deposit ratio declined further from 78 % in September 2016 to 74.8 % in September 2017. Banks' profitability remained strong in 2017. There was nonetheless a decrease in pre-tax return on equity from 10.4% in December 2016 to 9.3% in December 2017 This high profitability may be overstated because of accrued interest income, which is not backed by cash inflows. These interest accrual practices on impaired loans are acceptable under International Financial Reporting Standards (IFRS) but they increase the risk that, as legacy assets are worked out, such high profitability levels may not be sustainable. Profits helped to strengthen the banks’ capital positions, with the CET1 ratio increasing from 18.5 % in June 2016 to 20 % in June 2017. Table 1.1:Financial soundness indicators - all banks in Bulgaria Source: ECB The share of non-performing loans continued to decline, but remains high. The ratio of non-performing loans (NPLs), which is at 10.6 % of gross debt as of June 2017 (ECB data), remains much higher than the EU average of 3.5%. It has, nonetheless, declined, from 12.3% in June 2016, due to the falling volume of NPLs and the rising total volume of loans. In addition, the ratio of loans with forbearance measures to total loans was 8 %, above the EU average of 2. 9%. Provision for NPLs went up slightly, to 51.1 %, between September 2016 and September 2017. The vulnerabilities from the level of NPLs is partly mitigated by the higher levels of capital and above average provisioning. Capital buffers are comfortable overall, providing space for a balance-sheet clean-up. However, not all banks benefit equally from robust capital levels (European Commission, 2017). Furthermore, capital adequacy ratios alone will not provide sufficient incentives to reduce NPLs. Other factors, such as a functioning secondary market for loans, adequate legal frameworks for foreclosure and accurate valuation of collateral, are needed to facilitate balance-sheet clean-up. In cases where collateral is overvalued relative to its market price ( ), higher provisioning requirements could encourage banks to work out NPLs. In this context, implementing the IFRS 9 accounting regulation as of January 2018 should help strengthen loan-loss provisioning for some banks. Lending activity picked up, with a shift in favour of loans in leva (BGN). The total stock of private sector loans increased by 7.2 % in November 2017 as compared to a year earlier, driven by a rise of about 15 % in lending in BGN. Lending in euro decreased by about 10 %. Lending to non-financial corporations remained almost flat and was driven by loans in BGN, while those in euros fell. The stock of residential mortgage credit expanded by about 7.8% y-o-y, supported by lending in BGN, while its counterpart in euros declined. The change in currency preference is somewhat counter-intuitive, given the opposite shift in interest rates for both deposits and loans. For all categories of loans, interest rates for new business declined more and to lower levels for loans denominated in euros than for those in BGN. Graph 1.9:Domestic credit growth Source: ECB Asset prices have increased recently, without signs of over-valuation so far. House prices increased by 15.7 % in real terms between June 2015 and June 2017 (23 % in the capital, Sofia) and by 7.2 % in the second quarter of 2017 alone. Rapid growth was also seen in the domestic stock exchange, with the main index, SOFIX, gaining 18 % in one year, as of mid-January 2018. The recovery appears to be supported by fundamental economic improvements, such as an increase in disposable income, an improved labour market and favourable lending conditions. There are no signs yet of over-valuation of real estate. Despite recent growth, house prices appear to be in line with fundamentals (Graph 1.10). Indicators of affordability and the return on investment of owner-occupied houses remain well below their long-term average. In particular, the rapid increase in gross disposable income means that the price-to-income ratio continued to fall in 2016. While the number of building permits has increased rapidly in the first quarters of 2017, it remains much lower than the pre-crisis levels. This suggests that supply constraints may play a role in the increase in house prices and that the economic impact of this increase remains modest so far. However, the recent pace of the increase and the modelling uncertainty affecting the above-mentioned indicators, call for continued close monitoring of house price developments. Public finances Bulgaria has successfully consolidated its public finances and budgetary developments are expected to remain positive. The general government budget remained balanced in 2017. On the expenditure side, public investment started to recover, despite the slower-than-expected progress with implementing EU funded projects and public sector wages increased. On the revenue side, taxes and social security contribution revenue increased and the recovery of transfers from the EU outweighed the rise in expenditure . The structural budget was also balanced in both 2016 and 2017. Graph 1.10:House prices overvaluation gaps Source: European Commission calculations The general government budget is forecast to remain balanced in 2018 and to record a surplus in 2019. A further rise in public sector wages and investment is expected to be offset by strong revenue performance. Higher wages in the private sector and higher social security contribution rates are set to have a positive impact on public revenues. Revenue from indirect taxes is also projected to increase, in line with higher consumption and public investment. The general government debt declined in 2017. The drop to below 26 % of GDP in 2017 is due to the positive impact of the primary surplus and debt repayment (worth around 2 pp. of GDP) out of accumulated fiscal reserves. The primary surpluses and low interest payments projected for 2018 and 2019 are expected to lead to a further reduction in the general government debt. Table 1.2:Key economic and financial indicators – Bulgaria Source: Eurostat and ECB as of 30 Jan 2018, where available; European Commission for forecast figures (Winter forecast 2018 for real GDP and HICP, Autumn forecast 2017 otherwise)

2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Bulgaria in 2017 ( ) has to be seen in a longer term perspective since the introduction of the European Semester in 2011. Looking at the multi-annual assessment of the implementation of the CSRs since these were first adopted, 74% of all the CSRs addressed to Bulgaria have recorded at least 'some progress'. 26% of these CSRs recorded 'limited' or 'no progress' (see Graph 2.1). Since 2011, the successive changes of six governments (two caretaker and four regular ones) further slowed down reform efforts. However, the current government seems committed to follow up on reform priorities and continue reform efforts in key sectors. Measures have been taken in several policy areas subject to CSRs, but further efforts are needed to have more tangible results of reform implementation. The latter also complicates the CSR implementation assessment. Graph 2.1:Overall multiannual implementation of 2011 - 2017 CSRs to date (1), (2), (3) Source: European Commission The most notable progress has been achieved in increasing and equalizing the statutory retirement age by the 2015 pension reform. The authorities are taking sustained efforts in tackling the challenges of the labour market related to the participation of disadvantaged groups, but some important problems persist. The reform of the public employment service is another good example of continuous reform implementation. Combatting poverty and promoting social inclusion remain a big challenge and the measures taken in response to the recommendations fall below the magnitude of the problem. The work on the minimum wage setting mechanism, a CSR for several years, has stalled. The adoption of the Pre-school and School Education Act is another example of successful CSR implementation. The higher education reform accelerated. However, since 2014 Bulgaria has not progressed significantly on improving the provision of quality education for disadvantaged groups, despite some recent measures. Healthcare reforms initiated in 2015-2016 have addressed concerns raised in successive CSRs, but many legislative measures are still under preparation, and implementation of others has stalled, such as selective contracting based on the National Health Map. Recommendations on public procurement, first introduced in 2011, have not significantly changed over the years. A number of measures have been put in place, but the concrete impact on the public procurement landscape remains to be seen. There has been insufficient progress so far in enhancing administrative capacity in public procurement and no specific achievements in e-procurement. Bulgaria made some progress in improving tax collection over the period 2015-2017 and in reducing the informal economy. It did address the recommendation to have a comprehensive strategy, but with a delay. Some progress was achieved over 2015-2017 in reviewing assets and balance sheets in the financial sector and in taking follow-up actions and strengthening supervision . The authorities completed the asset quality review and stress tests in the banking sector, but the degree of independence and the nature of the stress tests did not fully comply with the recommendation. The pension funds and insurance sector reviews were completed with a high degree of independence and transparency. Follow-up actions have been addressed, and their implementation is ongoing. Measures to improve supervision have been taken and remain to be finalised. Some progress was made in reforming the insolvency framework since 2014. A procedure for business restructuring has been adopted, but measures are needed to ensure it fulfils its purpose. Some elements of a functioning framework are still lacking. Overall, Bulgaria has made some progress in addressing the 2017 country-specific recommendations. ( ) Some progress was made in further improving tax collection and tax compliance, and in stepping-up enforcement measures to reduce the informal economy, in particular undeclared work. Some progress was made in taking follow-up measures on the financial sector reviews, in improving banking and non-banking supervision and in facilitating the reduction of non-performing corporate loans.

Some progress was done in improving the targeting of active labour market policies and the integration between employment and social services for disadvantaged groups. Limited progress was made in increasing the provision of quality mainstream education, in particular for Roma and in increasing health insurance coverage, reducing out-of-pocket payments and addressing shortages of healthcare professionals. Limited progress was achieved in establishing a transparent mechanism for setting the minimum wage, while some progress was done in improving the coverage and adequacy of the minimum income. Finally, some progress was done in ensuring efficient implementation of the 2014-2020 National Public Procurement Strategy. Table 2:Summary table on CSR assessment Source: European Commission ESI Funds are pivotal in addressing key challenges to inclusive growth and convergence in Bulgaria. This is done notably by investing in public administration reform, including public procurement, improving the overall business environment and enhancing SME access to finance. ESI Funds are also instrumental in the reform of the higher education system by making the reform a pre-condition for future investments in the area. Obstacles to investment in the education and health sector are being reduced and health care efficiency is enhanced by shifting the system from hospital to ambulatory care. Member States can request from the Commission technical support to prepare, design, and implement growth-enhancing structural reforms. The Structural Reform Support Service (SRSS) provides, in cooperation with the relevant Commission services, tailor-made technical support, which does not require co-financing and is provided at a Member State's request. The support addresses priorities identified in the context of the EU economic governance process (i.e., implementation of country-specific recommendations), but the scope of the SRSS support is wider as it can also cover reforms linked to other Commission priorities, or reforms undertaken at the initiative of Member States. Bulgaria has requested technical support from the SRSS to help implement reforms in various areas, such as revenue administration, small and medium-sized enterprises, education, access to capital markets, judicial reform, energy and environmental sector, financial management and internal audit. In particular, the SRSS has already provided support through an independent analysis of the structural and functional model of the Prosecutors Office, assisted with the set-up of the Fiscal Council and supported the design of a system of disability benefits and services.

Box 2.1: Tangible results delivered through EU support to structural change in Bulgaria Bulgaria is a beneficiary of significant European Structural and Investment Funds (ESI Funds) support and can receive up to EUR 9.8 billion until 2020. This represents around 3 % of GDP annually over the period 2014-2018 and 55% of public investment I . By 31 December 2017, an estimated EUR 5.3 billion (54 % of the total) was allocated to projects on the ground: 3,000 SMEs received grant support, 300 new start-ups were created and 600 unemployed were able to start a new business. In addition, waste recycling capacity will increase by 105,000 tonnes and 220,000 more people will be served by improved water supply and sanitation. Compared to the 2007-2013 period, over EUR 500 million is to be delivered via financial instruments, a two-fold increase. ESI Funds help address structural policy challenges and implement country-specific recommendations. Actions financed cover, among others, measures to improve the overall business environment and general human resource development, including through facilitating access of small and medium enterprises to finance, as well as to reducing obstacles to investment in education, social and health sectors by improving administrative and technical capacities of the local public administration and actions to improve the effectiveness of the justice system. Various reforms were undertaken already as precondition for ESI Funds support II . A Smart Specialisation Strategy was developed to focus research and innovation investments on products with strong market potential. Taking the research and innovation reform further requires very strong commitment of the Bulgarian authorities in order to facilitate involvement of local businesses and improve cooperation between enterprises and public research institutions. The national transport plan has allowed the timely preparation of road and railway projects, implemented not only with support from ESI Funds, but also from the Connecting Europe Facility (CEF), European Investment Bank (EIB) loans and national funding. Reform of public procurement, including e-procurement is increasing the efficiency of public spending. The mapping of health infrastructure needs in the Bulgarian emergency health care system intends to enhance coordination and targeting of investments improving access to healthcare. The higher education system was reformed as a pre-condition for investments in that area. Bulgaria is advancing the take up of the European Fund for Strategic Investments (EFSI). As of December 2017, overall financing volume of operations approved under the EFSI amounted to EUR 349 million, which is expected to trigger total private and public investment of EUR 1.5 billion. More specifically, 3 projects have been approved so far under the Infrastructure and Innovation Window, amounting to EUR 281 million in EIB financing under the EFSI. This is expected to trigger nearly EUR 652 million in investments. Under the SME Window, 9 agreements with financial intermediaries have been approved so far. European Investment Fund financing enabled by the EFSI amounts to EUR 68 million, which is expected to mobilise more than EUR 923 million in total investment. Some 6 000 smaller companies or start-ups will benefit from this support. SMEs rank first in terms of operations and volume approved, followed by RDI. Funding under Horizon 2020, the Connecting Europe Facility and other directly managed EU funds is additional to the ESI Funds. By the end of 2017, Bulgaria has signed agreements for EUR 406 million for projects under the Connecting Europe Facility. 3. Summary of the main findings from the Macro economic Imbalance Procedure in-depth review The in-depth review for the Bulgarian economy is presented in this report. In spring 2017, Bulgaria was identified as having excessive macroeconomic imbalances, in particular relating to pockets of vulnerabilities in the financial sector coupled with a high corporate indebtedness in a context of incomplete labour market adjustment. The 2018 Alert Mechanism Report (European Commission, 2017l) concluded that a new in-depth review should be undertaken for Bulgaria to assess developments relating to identified imbalances. Analyses relevant for the in-depth review can be found in section 4.2 financial sector, including developments in private indebtedness in section 4.2.3. An additional IDR relevant topic through its links to private indebtedness and growth is that of investment, analysed in section 4.4. Labour market related adjustment aspects are dealt with in section 4.3. 3.1.Imbalances and their gravity The overall robustness of the banking sector has further improved despite remaining vulnerabilities. The 2016 asset quality review and stress tests (AQR/ST) showed robust results overall. It also identified pockets of vulnerabilities, including low capital buffers of two banks. Recently the banks' balance sheets expanded, the quality of their assets improved and their capital levels increased. The two banks retored their buffer and work is ongoing to restore their robustness. Some vulnerabilities still warrant attention, including exposure to hard-to-value assets, and related-party transactions. The share of non-performing loans has decreased but remains high. The soundness of the non-banking financial sector has improved but some issues remain. Net assets held by pension funds and insurance companies increased, together with the debt securities market and the capitalisation of the stock market. Two insurers had their licence withdrawn as a result of the independent balance sheet review. Despite increased supervisory efforts, some specific issues remain. These include the treatment of specific reinsurance contracts, the valuation of some non-traded assets and the group level supervision. The negative net international investment position further improved. Bulgaria's net international investment position has increased from - 92% of GDP in 2010 to [- 47.7%] of GDP in 2017 and is expected to further improve in 2018. Although still low, it partly reflects the country's status as a catching-up economy. Moreover, the net international investment position consists mostly of FDI, reserves are high and net external debt is positive. For these reasons, the external position is not considered an imbalance. Despite ongoing deleveraging, private sector debt remains high relative to regional peers. Private sector debt has decreased from 132% of GDP in 2013 to 105% of GDP in 2016. This drop is mainly linked to debt reduction in non-financial corporations, while the debt ratio of households is among the lowest in the EU. The corporate debt burden could negatively affect investment and growth over the medium term. The still-high aggregate NPL ratio confirms that vulnerabilities remain. The labour market has improved, but structural issues still hamper its functioning. Despite the strong drop in the unemployment and the long-term unemployment rates, the share of young people not in employment, education or training remains high. Labour shortages and mismatches negatively impact the functioning of the labour market and the adjustment capacity of the economy.. 3.2.Evolution, prospects and policy responses The positive macroeconomic developments, together with some policy action resulted in unwinding of imbalances. The robustness of the financial sector improved, both in banking and non-banking. The deleveraging process in the private sector continued. The labour market also continued improving. The growth momentum is expected to carry on and support the debt reduction and the labour market. The measures to address vulnerabilities in the financial sector are being taken but are not yet completed. Important steps were made towards reducing potential macro-financial risks stemming from the banking sector. The Bulgarian National Bank (BNB) has addressed follow-up recommendations to banks and their implementation is ongoing. Amendments to the Law on Credit Institutions were adopted, to strengthen the requirements for managing and reporting related-party transactions. Measures to be completed include finalising the revision of the supervisory review and assessment manual, strengthening the resolution framework for banks and approving banks' resolution plans. Implementation of follow-up measures to the independent reviews in the non-banking financial sector continues. The non-bank supervisor took some steps to improve its functioning and others could be finalised soon, but challenges in supervision persist. Amendments to the Law on the FSC aimed at improving supervision were adopted. An action plan to address shortcomings in non-banking supervision has been adopted. Remaining issues in the financial sector include related-party exposures, hard-to-value assets, group-level oversight, treatment of reinsurance contracts and a still high ratio of NPLs. Reduction of the high corporate indebtedness level is hindered by the incomplete insolvency framework reform and the still shallow secondary market for NPLs. The insolvency framework reform is progressing slowly, but some elements of a functioning framework remain missing. Furthermore, a deeper market for NPLs could facilitate disposing of banks' NPL stock and restructuring viable businesses. Persistent challenges make it difficult to match supply and demand of labour effectively, despite some measures. The matching of demand and supply is hindered by persistent structural issues. In spite of there being a methodology in place for monitoring the effectiveness of policy measures, there remains potential to improve the targeting and effectiveness of active labour market policies. Structural issues remain, including a high share of young people not in employment, education or training, and labour shortages and mismatches. In addition, Bulgaria still lacks a transparent mechanism for setting the minimum wage. 3.3.Overall assessment Bulgaria still faces imbalances in the form of remaining fragilities in the financial sector, combined with a relatively high corporate debt. The economy has improved and the external sector does not represent an imbalance. The robustness of the financial sector has increased albeit further progress is needed to complete recent reforms. Private sector debt has decreased due to the better economic conditions, but remains relatively high. The same is true for the share of NPLs, suggesting potential problems with credit allocation and a need for tools to reduce NPLs. The reform of the insolvency framework has advanced, but is still incomplete. The labour market has improved, despite some remaining structural issues. Overall, imbalances have abated but some fragilities in the financial sector and the high corporate debt could constrain economic growth. Table 3.1:Macroeconomic Imbalance Procedure assessment matrix for Bulgaria (Continued on the next page)

Table (continued) Source: European Commission



4. Reform priorities 4.1. Public finances 4.1.1.Tax policy Bulgaria has a relatively low level of taxation and a growth-friendly tax structure. Tax revenue as a percentage of GDP is the lowest in the EU and well below the EU average (Graph 4.1.1). Indirect (mostly consumption) taxes are the main source of revenue. They represent more than 15 % of GDP, against an EU average of around 13 %. Environmental taxes, especially on transport fuels, form a considerable part of tax revenues compared to other Member States ( ). This is despite the low tax rates on the main motor fuels (petrol and diesel), which are just above the minimum EU level and have not been increased since 2011 for petrol and 2013 for diesel. Consumption taxes are less detrimental to economic growth, but are often regressive. Graph 4.1.1:Tax revenue by main category Source: European Commission Despite a simple tax system the administrative burden of paying taxes remains high. Corporate and personal income tax rates are flat — at 10 % — and among the lowest in the EU, with the aim to attract investors. Income tax bases are relatively broad, with little use of tax exemptions. At the same time, the overall administrative burden of complying with the tax system is reported to be high. Paying taxes is more time consuming than in other Member States (PWC, 2017) mainly due to the compliance requirements for labour taxes and social security contributions. The power of the tax system to correct poverty and social disparities is limited. Income inequality, as measured by the Gini coefficient for disposable income (i.e. after taxes and benefits), is the highest in the EU. The ’at-risk-of-poverty’ rate was the second highest in 2016 (see Section 1). The relatively small difference between market and disposable income inequality suggests that the tax and benefit system plays a limited role in combating income inequalities. By design, the flat personal income tax systems are usually characterised by a low (or no) degree of progressivity. The low tax-to-GDP ratio also provides little scope for the supply of public goods and services, which would possibly reduce inequalities and foster social mobility (see section 4.3.4) and economic development. The shadow economy ( ), while slightly decreasing, remains a considerable challenge. The value added tax (VAT) gap remains large, 21 % of the total VAT liability (close to 2.3% of GDP), well above the EU average of 12.8 % (CASE, 2017). Although there are no official measures of the size of the shadow economy, some model-based studies ( ) estimate that the shadow economy is twice as large as the EU average. The Bulgarian Industrial Capital Association estimated the loss of revenue due to the grey economy ( ) at more than 2 % of GDP in 2016. In many of these measures Bulgaria's performance has improved over time, but its ranking within the EU is still very low. Undeclared work continues to distort the labour market and impede fair working conditions. While the introduction of one-day contracts in agriculture has helped to reduce undeclared work in the sector (Industry Watch, 2017), the number of people working without a contract economy-wide is increasing from 37500 in 2012 to 55900 in 2016 (National Statistical Institute, 2013 and 2017). One in seven employees has reported receiving under-declared (‘envelope’) wages (William and Horodnic, 2017) and the national authorities consider 47 % of employers and 58 % of employees at risk of engaging in under-declared employment ( ). Joint inspections between fiscal and labour authorities have been organised, promising future improvements in efficiency and scope. A number of measures are in place to tackle persistent problems with tax collection and to reduce the administrative burden of paying taxes. In 2015, Bulgaria put into effect a comprehensive tax compliance strategy and action plan. The authorities also continued to introduce and adjust a number of control measures. In 2017, the implementation of the strategy was improved, and controls and measures to collect tax debt were intensified. By the end of 2017, more than 60 % of the measures included in the strategy had been launched, but not all of them had been completed. The authorities are considering extending the strategy beyond 2017. Efforts to improve tax compliance are bearing fruit but the impact on revenues is still limited. Tax revenues remained relatively stable as a percentage of GDP between 2013 and 2016 (Graph 4.1.1). The authorities estimate the additional revenue from the measures to improve tax compliance at more than 0.8 % in 2017. In the same year, a number of other policy measures – already adopted and implemented including increases in social contributions and excise duties, were expected to lead to additional revenue of 0.5 % of GDP (Ministry of Finance, 2017). Despite these developments, tax revenues are estimated to have increased by just a fraction of the combined impact of the policy measures. This implies that the tax system is still unable to reach its full potential in tax revenue. 4.1.2.Efficiency of public spending The public budget provides limited resources for the promotion of social and economic development. Average public expenditure was close to 36 % of GDP, against an EU average of 46 % of GDP in 2017. The structure of public spending indicates that pressing social and economic needs receive only limited resources. Budgets for social policies, education and health are much lower as a percentage of GDP than the EU average (Graph 4.1.2). This partly explains the small impact of public policy on reducing poverty and inequality. Similarly, the low level of growth-friendly expenditure, often defined as public expenditure on investment, education and health care, indicates a lack of proper targeting of growth enhancing policy areas. Graph 4.1.2:Public expenditure by category, average 2011-2015 Source: European Commission Depending on the policy area, higher or more efficient public expenditure could make a difference. According to a recent cross-country comparison for the EU, the performance of public expenditure, i.e. policy outcomes measured with a range of indicators, is found to be comparatively low in all expenditure categories. In education, health and public services, where public spending is among the lowest in the EU, policy performance, although low, is at levels similar to or better than Member States with comparable spending patterns, pointing to somewhat higher level of efficiency. The efficiency of public expenditure is relatively low in high-spending areas, such as public order and safety and infrastructure (European Commission, 2016). More recent data broadly confirm the assessment (Cepparulo et al, 2018). Budget planning and implementation are sound, but there is limited monitoring of developments inside expenditure categories. The Ministry of Finance prepares the annual and medium term budget and monitors budget implementation on a monthly basis. However, information affecting major public spending such as pay systems, size of public sector employment and recipients of social benefits remains fragmented. Following a decision by the government in 2016, the World Bank has undertaken a spending review focusing on maintenance and staff expenditure in seven ministries and 21 municipalities, including an in depth assessment of spending on police and fire protection services as well as of waste management systems. The project is expected to be completed by the summer of 2018, and to conclude with a set of recommendations and a manual for future spending reviews. 4.1.3.State owned enterprises

The economic performance of state-owned enterprises (SOEs) is weak compared with countries in the region and the private sector. Measured by return on equity, SOEs profitability in most sectors is significantly lower than that of the private sector (Bower, 2017). Similarly, SOEs in Bulgaria perform worse in terms of capital and labour efficiency than both the private sector and peer countries (Bower, 2017). Energy is the most loss-making sector and its SOEs are the most indebted. In the transport sector, the two railway SOEs account for liabilities worth 2.6 % of GDP. The government intends to use funds from the concession of the management of Sofia airport to help modernise the loss-making and highly indebted state railway operator, BDZ. The performance of state-owned enterprises is a source of uncertainty and risk for public finances. Total liabilities of SOEs’ where the state owns at least 50 % and exerts control amounted in June 2017 to close to 17 % of GDP (Ministry of Finance, 2017). Almost half of these liabilities belong to companies outside the general government, and are thus contingent liabilities which the state often has to guarantee or cover. Corporate governance of SOEs remains a challenge. The SOE governance framework does not fulfil most of the conditions set out in the OECD guidelines on Corporate Governance of SOEs (OECD, 2015). The main challenges are: (i) the unclear rationale for state ownership in many cases and the fragmented supervisory framework, (ii) a lack of financial targeting and accountability, and (iii) management appointments often made without competitive procedures or value-maximising incentives (see also Bower, 2017). The presence and role of the political authority is strong. This often comes at the expense of longer-term vision and coordination, transparency and high-level management standards. 4.1.4.Fiscal framework Bulgaria took further steps towards improving its fiscal framework. The authorities recently amended the Public Finance Act to bring it into full compliance with the EU’s budgetary frameworks requirements (Council Directive 2011/85). The amendments aimed at: (i) improving the transparency of public finances by extending the requirement to systematically compare official projections with the most recent Commission’s forecasts, (ii) increasing the effectiveness of domestic numerical rules by specifying consequences for non-compliance with the two rules governing expenditure developments, and (iii) improving multi-annual budget planning through systematic use of a no-policy-change scenario as a benchmark for different policy scenarios. The Bulgarian Fiscal Council has expanded its activities, but there are number of constraints on its effective functioning. Based on its broad mandate, the Council has started to publish its monitoring reports on the annual and medium-term fiscal plans and on budgetary execution and compliance with the Public Finance Act. However, the Council still faces significant challenges in performing its core tasks, mainly due to the limited resources available. Recent attempts by the Council to increase its financial autonomy did not receive the necessary support from the government and the Parliament. However, in February 2018 the Parliament adopted a legislative amendment that increases the Council's staff from three to five experts 4.2. Financial sector A robust financial sector is an important milestone on the road to joining the euro area. Adopting the euro also means joining the Banking Union. Therefore it is crucial to ensure that the financial sector is robust and well-regulated and supervised, and systemically-significant institutions in particular. 4.2.1.Banking sector Banks have made progress in implementing the recommendations of the Bulgarian National Bank (BNB) following the asset quality review, but some efforts are still needed. The review conducted by the BNB in 2016 (European Commission, 2017) found that two banks needed to replenish their capital buffers, although they still complied with the regulatory minimum capital requirement (BNB, 2016). The banks met the deadline to restore their capital buffers and work is ongoing to restore their robustness. The two banks are working with external advisers to improve risk management practices, in particular regarding their non-performing portfolios, and to de-risk their balance sheets, partly by selling-off repossessed collateral. Mitigating the risks associated with large exposures and improving collateral valuation is key to strengthening balance sheets and boosting the resilience of the banks in general. In addition, the larger of the two banks has tried to raise fresh capital, including by attracting new core investors, but it has been unsuccessful by end-January 2018. The restructuring of the sector was reinforced by the BNB's preliminary approval of the privatisation of a mid-sized bank to an acquirer which, however, is not a banking entity. Banks are working on improving their internal policies and procedures. The BNB recommendation to improve internal policies and procedures was addressed in particular to banks that underperformed in the 2016 stress tests and thus needed to strengthen their resilience to shocks. Banks' followed-up on these recommendations and have also prepared for the introduction of the new International Financial Reporting Standard (IFRS 9), which entered into force in January 2018. The BNB put in place a two-stage review of banks’ level of preparedness. The fact that the new IFRS 9 credit loss provisioning rules could result in higher loan-loss provisions in some banks contributes to the cleaning of banks’ balance sheets and the reduction of the still high level of non-performing loans (NPLs). There has been notable progress in improving bank supervision, but some important measures remain to be fully implemented. The BNB has implemented forcefully its 2015 detailed plan to improve banking supervision. Key measures that remain to be completed include finalising the revision of the supervisory review and assessment manual, strengthening the resolution framework and approving banks’ resolution plans. In addition, the process of upgrading the ICT tools available to the banking supervision department is delayed. In November 2017, the Parliament adopted amendments to several pieces of legislation to strengthen the BNB's decision-making framework and improve the supervisory process. The authorities have taken steps to improve the supervision of risk from related-party exposures. Parliament adopted amendments to Article 45 of the Law on Credit Institutions, which sets limits to related-party exposures. The changes aim to extend the scope of relevant legislation to better capture the risks involved. It remains to be seen how well they can integrate economic interlinkages into the assessment of related-party transactions. Requirements for managing and reporting related-party transactions have also been strengthened. The banking supervisor no longer intends to follow the ECB's approach for non-performing loans. The ECB guidance on non-performing loans (NPLs), published in March 2017, asked euro-area banks, in particularly those with high levels of impaired loans, to establish internal strategies to tackle NPLs on their books (ECB, 2017a). This guidance also applies to the Bulgarian subsidiaries of euro-area banks. Earlier plans by the BNB to extend this guidance to domestically owned banks (European Commission, 2018d) have not been confirmed. The ongoing work of the EBA on this issue may be considered instead. 4.2.2.Non-banking sector Independent reviews examined the balance sheets of insurance companies and the assets of private pension funds. As part of its plan to address excessive macroeconomic imbalances, the government mandated the non-bank supervisor, the Financial Supervision Commission (FSC), to conduct independent reviews of the balance sheets of insurance companies and the assets of private pension funds. Additionally, stress tests of the insurance market were done on the post-review balance sheets, to provide the FSC with more information on potential risks. The reviews were completed in early 2017. In the insurance sector, problems relating to the treatment of reinsurance contracts and group-level supervision persist despite some progress. The reviews/stress tests found shortcomings in terms of solvency requirements in the insurance sector, and issues relating to the treatment of reinsurance contracts ( ) and group-level supervision ( ). Although the insurance sector was found to be well-capitalised overall, a quarter of the reviewed companies and groups did not fully meet the capital requirements.. Most of the companies identified with capital shortfalls took measures to meet the solvency capital requirement and to address some governance deficiencies, as followed-up by the supervisor. Two insurers had their licence withdrawn. Still, further issues remain to be addressed through supervisory measures. Risks to the long-term benefits of pension fund account holders remain a challenge. While the private pension funds’ assets were subject to only minor adjustments, reviewers highlighted important concerns for some of the funds. These include concentration of assets on the traded and non-traded domestic market, low liquidity and trading volumes on the domestic stock exchange and not enough information on exposure to related parties. All these risks could have a significant impact on the funds available to account holders in the pay-out phase, which will start in earnest around 2020. Some funds were found not to have proper tools to identify and monitor related parties. Complex ownership and cross-ownership structures were also identified in some cases. Compliance with the law is respected but may not be enough to ensure the best interest of pension funds' account holders. The FSC took measures towards some pension funds in order to have valuations adjusted to market valuations, for instance on certain investment properties. The FSC issued a series of recommendations, but some issues need to be further addressed. Following the reviews in the pension fund and insurance sectors, the FSC made a series of recommendations both to companies with capital needs and to those with shortcomings in governance. In the insurance sector, a new inspection by external experts with cut-off date of 31 December 2016 was completed upon request by the FSC, following-up on the implementation of the adjustments required. Remaining issues with possibly important implications for some companies’ capital levels include the treatment of specific reinsurance contracts, the valuation of some non-traded assets and group level supervision. The FSC adopted an action plan to address important issues identified by an independent assessment. The asset quality review on pensions and insurance balance sheet review were followed by an independent assessment of supervision performed by the IMF and the World Bank as part of the overall financial sector assessment programme (FSAP). The reviews highlighted important supervisory shortcomings and areas in need of improvement. These include legislation, its implementation and the overall setup and operation of the supervisory institution. The FSC worked with EIOPA to draw up an action plan for the most pressing issues, which has recently been adopted.

Important steps have been taken and further action has been scheduled for the coming years. The Parliament adopted in 2017 significant changes to the law, reinforcing the FSC’s financial independence through direct collection of levies from the industry, higher fines and financial penalties, and the judicial framework. The legislative changes also cover the FSC’s governance structure, legal protections and pay scales. In addition, changes to the Social Insurance Code include a broader definition of ‘related parties’, in line with international standards. Further planned measures include increasing the FSC’s resources in terms of staff numbers and skills, and improving supervisory practices with the support of a proper risk assessment framework. A specific example of better supervision is the car insurance sector. The authorities started in November 2017 to automatically match information from car registration databases with third-party liability motor insurance contracts, to combat fraud in connection with these contracts. The FSC has taken further measures to ensure proper compensation of victims of car accidents, in particular regarding cancelled insurance contracts and the obligation on all Bulgarian insurers to have a network of claims representatives in all EU Member States under the Motor Insurance Directive. As the measures taken are recent, their effectiveness will need to be assessed in the coming months. 4.2.3.Non-performing loans The ratio of NPLs to the loan portfolio held by the banking sector has fallen substantially over the last two years. The banking sector is dominated by subsidiaries of foreign-owned banks, but domestic banks are also relevant players. Trends in NPLs have differed sharply between domestic and foreign-owned institutions over the last two years. Foreign-owned institutions have seen a gradual fall in NPLs, both in absolute terms and as a percentage of their overall portfolios. By contrast, domestic banks’ ratio of NPLs has been rising (Graph 4.2.1). Graph 4.2.1:NPLs share of total loans and advances, all banks Source: ECB Volumes in the secondary market for NPLs remain low. Despite a gradual downward trend, the aggregate NPL ratio remains high, at about 10.6% as of June 2017 (ECB data), representing mainly the legacy of the credit-led boom before the 2009 recession. ( ) This is partially the consequence of a very shallow secondary market for NPLs. It consists almost entirely of deals involving unsecured consumer loans ( ) and is driven mainly by a few subsidiaries of euro area banks. Domestic institutions tend not to participate. Despite the long average period of delinquency of most NPLs, market participants report a large gap between the prices offered in the market and those the banks are willing to accept, given current provisioning levels. Various hard-to-value assets exist, in particular those related to immovable property. Problems with the valuation of collateral reduce the incentive to dispose of NPLs. Some examples include real-estate collateral in the banking sector, receivables and real estate holdings in the insurance sector, and stocks, bonds, real estate and other financial instruments in the pension funds sector. Anecdotal evidence from debt collectors suggests that mismatches between the bank auditor’s valuation ( ) and the market price can be significant. Similar mismatches were found on various occasions for some equity and fixed-income instruments held by pension funds and insurance companies. This is partly due to outdated collateral valuations which,, according to the IMF, is a common problem (IMF, 2017). It follows that the frequency of collateral estimates is not always in line with the relevant EU regulations, which require banks to value commercial immovable property at least once a year and residential real estate at least once every three years. The quality of auditing appears to be uneven relative to international standards. This creates problems with the valuation of illiquid instruments traded on stock exchanges and non-traded assets, including receivables, minority equity stakes and subsidiaries. For real-estate valuations, auditors rely on locally-licensed appraisers. Despite the advantage of local expertise, valuation standards vary greatly and the licensing system does not appear to be sufficiently tight. With the creation of the Chamber of Independent Appraisers of Bulgaria, licensed appraisers were able to obtain a new license upon request. In the absence of mandatory standard methodology, commercial banks have the discretion to use different valuation frameworks, which may create considerable discrepancies In addition, the methodologies for indexed valuations are not reviewed by the BNB (IMF, 2017). 4.2.4.Private indebtedness Private debt is mainly concentrated in non-financial corporations and is high compared to regional peers. Private debt has decreased from 132% of GDP in 2013 to 105% in 2016. Most of the decrease is linked to deleveraging in the non-financial corporation (NFC) sector. The consolidated debt of NFCs stood at 84% of GDP in 2016, significantly higher than in regional peers. NFC debt could negatively affect companies' investment decisions and have a durable impact on potential growth going forward. In contrast, households' indebtedness is among the lowest in the EU at 21% of GDP in 2016. Graph 4.2.2:Private debt breakdown Source: European Commission The deleveraging needs of NFCs have been reduced in the last few years. The debt ratio of NFCs is now just below the prudential benchmark (see graph 4.2.3). The current debt ratio remains above what macroeconomic fundamentals would suggest, albeit converging towards it and thus progressively unwinding the large increase in leverage between 2003 and 2007. Overall, and also in light of the improving macroeconomic conditions and stronger capitalisation in the banking system, the remaining deleveraging needs in the corporate sector have decreased. Graph 4.2.3:NFC debt ratio against the fundamental-based benchmark (1) and prudential threshold (2) Despite lower deleveraging needs, NFCs continue to show high level of NPLs. In the first quarter of 2017, NFCs represented 72% of the banks' NPLs and about 41% of total loans and advances. At 21.2%, their NPL ratio is much higher than the 13.6% recorded for households (Graph 4.2.4). While this ratio has decreased for NFCs since late 2015, the progress is clearly less pronounced than for household. In this context, the improvement in the asset quality of institutions is linked to the decreasing share of loans to NFCs in their portfolio. While loans to NFC are stagnating, banking institutions increase their lending to financial corporations and governments, which have a much lower rate of non-performing loans. Furthermore, restructuring has played only a minor role in the NPL dynamics. The forborne loans represent 7% of total loans in 2017, a relatively stable share, and most of these remain non-performing. Graph 4.2.4:NPLs, share of total loans and advances - total, households and NFCs Source: ECB Graph 4.2.5:Share of companies facing financial stress The large proportion of financially-stressed companies ( ) acts as a drag on growth. As financially constrained companies invest less, grow less and have lower productivity (see Graph 4.2.5), their prevalence hampers productivity at the macroeconomic level. In sectors with a large proportion of distressed companies, the productivity of non-financially stressed firms may also suffer from poor allocative efficiency (McGowan, Andrews and Millot, 2017) (see Graph 4.2.6). About half of the companies in financial stress in 2016 had experienced such stress for the last 3 years. The financial sector does differentiate between financially stressed and non-stressed companies in terms of prices, but volume changes are similar, raising concerns about ‘evergreening’ of non-performing corporate debts. Graph 4.2.6:Determinant of growth for financially and non-financially stressed NFCs Source: Orbis, European Commission calculations

4.2.5.Insolvency framework The insolvency framework presents some weaknesses. The ineffectiveness of the insolvency framework is slowing the reduction in private sector indebtedness and the work-out of NPLs. Procedures are lengthy and the recovery rate is low. Reform of the insolvency framework has advanced but is incomplete. In December 2016, Parliament adopted changes to the Commercial Act and Pledge Registry, introducing new rules on business restructuring. The procedure entered into force on 1 July 2017. Some elements of a functioning framework are still lacking, in particular rules for granting second chance to entrepreneurs and consumers in a reasonable timeframe following a bankruptcy. Measures are needed to ensure the new restructuring procedure fulfils its purpose. The legal amendments provide the basis for streamlining business restructuring. It remains to be seen whether the training given has equipped judges to apply the new procedure effectively. No efforts were made to familiarise the business community with the potential benefits of the new procedure in the consultation phase. The new procedure remains relatively unknown, especially to smaller businesses which stand to benefit most from it. There has been no analysis of the effectiveness of either older or new procedures, including for business restructuring. The lack of data gathering and adequate monitoring tools prevents an assessment. At present, data are not collected on matters such as the number of cases filed and completed under the new procedure or their duration. The lack of data also prevents comparison with the use of alternative procedures that have existed until now. This presents an obstacle to analysing the usefulness of court procedures, estimating the impact of legislative changes and ultimately formulating and implementing sound policies. No plans for improvements in data collection have been communicated by the authorities. 4.3. Labour market, education and social policies 4.3.1.Labour market Strong economic growth has led to solid labour market recovery, but structural challenges persist. The employment rate was 71.9 % in Q3-2017, wages are on the rise and unemployment decreased substantially, to 6.2 % (see Section 1). Bulgaria displays increasing gross household disposable income per capita and low gender employment gap. However, the positive labour market developments are not spreading equally as social safety nets are not effective in reducing the high inequality, poverty and social exclusion. The high level of undeclared work (see section 4.1.1) and low participation in active labour market policies hinder access to the labour market and equal opportunities. The high and rising rate of early school leaving and weak digital skills signal broader problems in the education system and contribute to skills shortages. The population is ageing and shrinking fast. This means fewer workers and a rising old-age dependency ratio ( ). The population is expected to shrink by as much as 22 % by 2050 (Graph 4.3.1) due to net migration, low birth rates and relatively high mortality. This is one of the highest projected drops in the EU (Eurostat, 2017a). Most Bulgarians living abroad are of working age, further exacerbating adverse population change. The high inactivity rate is a further concern. Graph 4.3.1:Population projections (2016-2080) Source: European Commission Disparities between urban and rural areas and between different regions are high. In rural areas,, the rates of unemployment, of young people not in employment, education or training, of risk of poverty and social exclusion and of early school leaving are all well above the EU and national averages, despite the outflows of people in working age.. This is leading to large inequalities of opportunity. The government is seeking to address some of these disparities. The programme "Work", addressing high unemployment in the most underdeveloped Northwest region will be rolled out to other municipalities with the support of the European Social Fund (ESF.. Wages remain relatively low but have substantially increased in recent years. The average compensation of employees per hour worked (EUR 4.6 in 2016) is one fifth of the EU average, mostly explained by productivity differentials. Wage increases in recent years, helped to reduce the gap with the EU average from 34% in 2010 to 43% in 2016 (in purchasing power parity). Nevertheless, the wage gap for the main destination countries remains a major reason for emigration. In the first three quarters of 2017, wage growth was particularly high in the administrative and support services (13.3 %) and manufacturing (9.4 %). Wage sectoral differentials are decreasing and the rapid growth in the private sector is contributing to the closing of the public/private wage gap. Minimum wage increases are being adopted without clear and transparent criteria. The minimum wage has been increased from BGN 460 (EUR 235) to BGN 510 (EUR 261) as of 1 January 2018 and is set to rise to BGN 610 (EUR 312) by 2020. Over 13% of the labour force, some 400 thousand people, earned at the minimum wage at the beginning of 2017 and this number is expected to grow. These changes to the minimum wage level were decided ad-hoc, which may not ensure a proper balance between supporting employment and competitiveness and safeguarding labour income. The government has tabled a proposal for a minimum wage setting mechanism to address this shortcoming but there is still no agreement between the social partners. In 2018, Bulgaria ratified the International Labour Organisation's convention 131 on minimum wage fixing which would be a step in the right direction. Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights The European Pillar of Social Rights, proclaimed on 17 November 2017 by the European Parliament, the Council and the European Commission, sets out 20 principles and rights to benefit citizens in the EU. In light of the legacy of the crisis and changes in our societies driven by population ageing, digitalisation and new ways of working, the Pillar serves as a compass for a renewed process of convergence towards better working and living conditions. Bulgaria faces challenges with regard to a number of indicators of the Social Scoreboard III supporting the European Pillar of Social Rights. Bulgaria has a high rate of poverty and social exclusion as well as income inequality. The rate of young people not in employment, education or training remains very high. Roma and students with lower socio-economic status have difficulties in accessing quality, inclusive education. Individuals' level of digital skills is very low. At the same time, the gender employment gap is low and gross disposable household income per capita is increasing fast. Social transfers have a low impact on reducing poverty and income inequality; spending on social protection is well below the EU average. This contributes to persistently high levels of poverty (see section 4.3.4). To improve equity in education and Roma inclusion, Bulgaria has started implementing an inclusive education reform. To fight early school leaving, integrated teams were set at a local level to support out-of-school children in returning to education. Some recent measures seek to support the participation of Roma in education, including additional language courses for students whose mother-tongue is not Bulgarian, work with parents and further possibilities to finalise compulsory education in the so-called "united schools''. There are also plans lower the compulsory pre-school age to 4. Despite these positive initiatives effective measures to improve school retention have not been developed yet. Job creation has rallied but companies face challenges in finding the right employees. In the first three quarters of 2017, y-o-y employment growth has been generally positive in most of sectors (Graph 4.3.2). In 2017, job creation has spread to a larger part of the country. The ratio of self-employed to employee has decreased to 12.6 % following a more dynamic increase in the number of employees. Labour shortages are increasingly felt, in particular in manufacturing, construction and the digital sector (Manpower, 2017; CEDEFOP, 2017). A declining working age population, migration and unattractive working conditions are the main causes. Macroeconomic skills mismatches have been decreasing but remain among the highest in the EU. The overall level of skills has increased with tertiary education attainment rising. However, growing early school leaving and one of the lowest rates of adult participation in learning (2.2 %. EU average: 10.8 %) further weaken long-term prospects. Graph 4.3.2:Employment by sector, year-on-year changes Source: European Commission The sizeable potential labour force represents an opportunity for the economy. Discouraged workers (those available but not seeking work) were in Q3-2017 equivalent to two thirds of the unemployed (European Commission, 2017k). Involuntary part-time workers, and inactive people seeking work but not available to work were, combined, equivalent to a further one third (Graph 4.3.3). Although more individuals recently entered employment from inactivity than from unemployment, the high proportion of discouraged workers suggests that activation support may be insufficient. With the right mix of active labour market policies and social services, groups such as educated but inactive young people, low-skilled long-term unemployed middle-aged men and long-term unemployed women with caring responsibilities, could be better integrated in the labour market (World Bank, 2018). Graph 4.3.3:Unemployment rate and potential additional labour force Source: European Commission

Long-term unemployment decreased substantially but challenges remain. In Q3-2017, it was 3.3 %, 1.1 pp. less than a year ago, and close to the EU average. However, as a percentage of total unemployment, at 53.4 %, it remains significantly above the EU average of 44.4 % (Q3-2017). Many of the long-term unemployed are Roma, who often face difficulties in finding a job due to low skills and discrimination in recruitment ( ). Young people do not yet fully share the benefits of an improving labour market. Regardless of a slight fall in the rate of young people not in employment, education or training (NEET), to 18.2 % in 2016, it is still among the highest in the EU and significantly above the EU average of 11.6 %. Over half of those not in employment, education or training were low-skilled and the rate of young Roma who report not to be in work or education remains very high (65 %), in particular for girls. Measures have been taken to address the situation of young people, but the coverage of the Youth Guarantee still remains low. Around 80 % of those in the NEET category are deemed as inactive (among the highest rates in the EU) and as such are not covered by the Youth Guarantee. Only 12% of those NEET aged 15-24 were enrolled in the Youth Guarantee at any point during 2016, a decrease from 2014. Only 40.5 % of those leaving the scheme took up an offer within 4 months. Several outreach measures are, however, helping young people to take up work despite the still low individual registration with the public employment service. More active labour market policies are being directed to the low-skilled youth. Job fairs as well as youth and Roma mediators at local level have proven to be among the most effective measures. Participation in active labour market policies (ALMPs) remains limited. Low funding and low participation rates weaken the potential of activation policies ( ). Their efficiency may be also limited by the high fragmentation of policies and programmes, as well as overlapping eligibility criteria for participation (World Bank, 2018). Measures continue to be overwhelmingly focused on direct job creation and employment incentives. Given the large skills mismatches, measures addressing jobseekers' employability and skills gaps, e.g. training and retraining programmes, seem underdeveloped (see Graph 4.3.4). The Employment Agency is undergoing a comprehensive modernisation agenda. The goal is to turn the Agency into a modern and customer-oriented public employment service. The reform covers service provision, planning mechanisms, management, implementation and monitoring at all levels of the organization. Despite progress, customer segmentation and case management remain incomplete, as a fully functional competence-oriented and IT based job matching has yet to be introduced. Graph 4.3.4:Expenditure on and participation in activation measures, 2017 Source: 2017 national data from Public Employment Services The integration of employment and social services has continued, but is not yet complete. Seventy-three Centres for Employment and Social Assistance have been set up, improving the integration of the services provided by the Labour Offices and the Agency for Social Assistance. New services are planned, such as family labour counselling and mobile service. However, for a one-stop-shop approach, considerable investment is required to expand the network of centres and harmonize administrative processes and joint case management, including data collection and sharing (World Bank, 2018). The limited involvement of municipalities, the main providers of social services, is hampering the integration of employment and social services. The social dialogue faces several challenges. Collective bargaining takes place predominantly at company, industry or branch level but has been undermined by the low membership and capacity of social partners ( ), especially at branch level. Bipartite dialogue at national level deteriorated in 2016-2017, as shown by substantial differences between the social partners on issues such as minimum social security thresholds, the so-called 'seniority bonus' and the minimum wage setting mechanism. Trade unions consider the involvement of social partners in the design and implementation of reforms and policies positively but with room for improvement, while employers' views are more critical. 4.3.2.Education and SKILLS Education reform is progressing, but several systemic challenges remain. Investment in education is improving in real terms, but remains below the EU average (in 2015, 4 % of GDP, compared to 4.9 %, and 9.8 % of total government spending, compared to 10.3 %). Almost 50 % of teachers are aged 50 or more. Initial teacher education does not prepare teachers sufficiently in terms of inclusive teaching methods and for working with students from disadvantaged backgrounds. Recent measures seek to improve this situation. New curricula seek to improve currently low educational outcomes. Many 15-year olds are not equipped with the basic skills necessary to solve the kind of problems routinely faced by today's adults in modern societies. 29.6 % of students are low achievers in all three tested subjects in the PISA international education survey (science, reading and mathematics). The percentage of top-performing students is low ( ). The share of population with basic or above basic overall digital skills, at 29%, is among the lowest in the EU. Schools provide trainings on digital skills, with different quality and intensity. Since 2015, a government Ordinance regulates IT training in schools. Implementation is gradually starting, but digital skills among young people (16-24) at 54.3%, remain very low compared to the EU average of 81.9% (Digital Scoreboard 2017). In 2017-18, curriculum reform continued with grades 2, 6 and 8. Low inclusion of Roma in education remains a challenge. Of Roma aged 18-24, 67% are early school leavers, with women disproportionately at risk of dropping-out (77 %, against 57 % for men) (FRA, 2016). Implementation of the ban on class segregation remains a challenge. 48% of Roma students in non-segregated neighbourhoods attend classes where all or most children are Roma. Despite some improvements, the impact of socioeconomic status on performance remains high. Low achievement among disadvantaged students is among the highest in the EU (59 % in science compared to 33.8 %, on average). The gap in underachievement between advantaged and disadvantaged students is also among the highest (42 pp. compared to 26.2 pp, on average). The variation in performance is strongly associated with students' and schools' socioeconomic status. Kindergarten fees are a barrier to full participation in early education and care. Despite the positive impact of the introduction of the two-year compulsory programme for children aged 5-6, participation is not universal mainly due to care-related fees. Less than 15% of municipalities for which data are available offer free-of-charge compulsory preschool education, resulting in low participation of Roma children (66 % in 2016) and an unequal start in education (Amalipe, 2017). Only 9 % of children aged below 3 are in formal childcare, which is significantly below the Barcelona target of 33 % and the EU average. This leads to a poor acquisition of Bulgarian language skills and overall low educational outcomes. The performance gap between students who speak Bulgarian at home and those who do not (8% of the students in PISA 2015) is significant. Despite recent measures, early school leaving remains a challenge for the labour market. Early school leaving was 13.8 % in 2016 (EU average: 10.7 %; see graph 4.3.5), with higher levels for Roma and in rural areas (30.3 %). A new system to identify out-of-school children and bring them back into education was introduced. However, recent additional measures to improve school retention require strengthening. The labour market relevance of vocational education and training (VET) remains limited. The proportion of upper secondary VET students is above the EU average. However, one in three VET students graduate without a professional degree and the employment rate of recent VET graduates (64.2 %) is 10.8 pp. below the EU average. The quality on offer, the attractiveness of VET and links with the labour market remain challenges. The authorities revised the educational standards for VET and are working on connecting supply and demand for skills and qualifications. Recent amendments in the Law on Pre-primary and School Education are related to additional financial stimulus for schools which offer VET specialties that correspond to the labour market needs. These developments aim at labour market relevance of VET provision. Structural VET graduate tracking measures have yet to be developed. Graph 4.3.5:Early school leaving disaggregated by the urban status, Bulgaria and the EU average Source: European Commission Despite recent reforms in tertiary education, addressing skills shortages is a challenge. Tertiary education attainment is improving (33.8 % in 2016. EU: 39.1 %) but graduates' profiles by sector show imbalances. Shortages are expected particularly in ICT, teaching, health and engineering. However, the number of graduates in these fields is rather low, particularly in health ( ).The government is undertaking measures to address the shortage of teachers. Low participation in adult learning remains critical given the skills shortages. Almost one in five adults is low qualified, resulting in poorer employment prospects. However, investment in adult education remains insufficient, evaluation and monitoring is weak and provision is fragmented and unevenly-developed across regions. Adults' participation in learning was only 2.2 % in 2016 (EU average: 10.8 %). In the context of the Upskilling Pathways Council Recommendation, training, including for digital skills, literacy courses and projects to recognise acquired competences, are