European Commission

Directorate-General for Economic and Financial Affairs

Convergence Report 2012

EUROPEAN ECONOMY xxx/2012

Member States

BG Bulgaria CZ Czech Republic

LV Latvia

LT Lithuania

HU Hungary

PL Poland

RO Romania

SE Sweden

EA Euro area

EU-27 European Union, 27 Member States

EU-25 European Union, 25 Member States before 2007 (i.e. EU-27 excl. BG and RO)

EU-15 European Union, 15 Member States before 2004

Currencies

EUR Euro

ECU European currency unit

BGN Bulgarian lev

CZK Czech koruna

LVL Latvian lats

LTL Lithuanian litas

HUF Hungarian forint

PLN Polish zloty

RON Romanian leu (ROL until 30 June 2005)

SKK Slovak koruna

SEK Swedish krona

DEM Deutsche Mark

USD US dollar

SDR Special Drawing Rights

Central Banks

BNB Bulgarska narodna banka (Bulgarian National Bank – central bank of Bulgaria)

ČNB Česká národní banka (Czech National Bank – central bank of the Czech Republic)

MNB Magyar Nemzeti Bank (Hungarian National Bank – central bank of Hungary)

NBP Narodowy Bank Polski (National Bank of Poland – central bank of Poland)

BNR Banca Naţională a României (National Bank of Romania – central bank of Romania)

Other abbreviations

AMR Alert Mechanism Report

BoP Balance of Payments

BPO Business process outsourcing

CAR Capital adequacy ratio

CBA Currency board arrangement

CDS Credit Default Swaps

CEE Central and Eastern Europe

CIS Commonwealth of Independent States

CIT Corporate Income Tax

CPI Consumer price index

CR5 Concentration ratio (aggregated market share of five banks with the largest market share)

EC European Community

ECB European Central Bank

EDP Excessive Deficit Procedure

EERP European Economic Recovery Plan

EMI European Monetary Institute

EMS European Monetary System

EMU Economic and monetary union

ERM II Exchange rate mechanism II

ESA 95 European System of Accounts

ESCB European System of Central Banks

EU European Union

Eurostat Statistical Office of the European Union

FESE Federation of European Securities Exchanges

FDI Foreign direct investment

FSA Financial Supervisory Authority

FSAP Financial Sector Action Plan

GDP Gross domestic product

HICP Harmonised index of consumer prices

KNF Komisja Nadzoru Finansowego (Polish Financial Supervision Authority)

MFI Monetary Financial Institution

MIP Macroeconomic Imbalance Procedure

MTO Medium-term objective

NCBs National central banks

NEER Nominal effective exchange rate

NIK Najwyzsza Izba Kontroli (Poland's Supreme Chamber of Control)

NPL Non-performing loans

OJ Official Journal

OJL Official Journal Lex

PIT Personal Income Tax

PPS Purchasing Power Standard

PPP Purchasing Power Percentage

R&D Research and development

REER Real effective exchange rate

SITC Standard International Trade Classification

SKOK Spółdzielcze Kasy Oszczędnościowo-Kredytowe (Credit Union)

TEC Treaty establishing the European Community

TFEU Treaty on the Functioning of the European Union

ULC Unit labour costs

VAT Value added tax

VSE Vilnius Stock Exchange

WSE Warsaw Stock Exchange

The Convergence Report and its Technical Annex were prepared in the Directorate-General for Economic and Financial Affairs. The main contributors were Zdeněk Čech, Balazs Forgo, Anton Jevcak, Sara Tägtström and Ewa Klima.

Other contributors were Benjamin Angel, Piotr Bogumil, Carlos Cuerpo Caballero, Jonas Fischer, Olivia Galgau, Nikolay Gertchev, Gabriele Giudice, Oskar Grevesmuhl, Isabel Grilo, Zoltan Gyenes, Renata Hruzova, Laszlo Jankovics, Barbara Kauffmann, Filip Keereman, Julda Kielyte, Daniel Kosicki, Bozhil Kostov, Joost Kuhlmann, Sven Langedijk, Martin Larch, Karolina Leib, Milan Lisický, Lucia Piana, Bartoz Przywara, Elena Reitano, Stéphanie Riso, Dominique Simonis, Michal Strojwas, Ingrid Toming, Ruediger Voss, Corina Weidinger Sosdean, Markus Wintersteller and Pavlína Žáková.

Statistical assistance was provided by Gerda Symens and André Verbanck, administrative assistance by Maya Philippé.

The report was coordinated by Zdeněk Čech under the supervision of Paul Kutos, Head of Unit and approved by Sean Berrigan, Director, Maarten Verwey, Deputy Director General, and Marco Buti, Director General.

Questions and comments may be referred to Zdeněk Čech (zdenek.cech@ec.europa.eu).

Convergence Report 2012 1

Convergence Report 2012 - Technical annex 3

1.1. ROLE OF THE REPORT 5

1.2. APPLICATION OF THE CRITERIA 6

1.2.1. Compatibility of legislation 7

1.2.2. Price stability 7

1.2.3. Public finances 12

1.2.4. Exchange rate stability 12

1.2.5. Long-term interest rates 14

1.2.6. 15

1.2.7. Additional factors 16

2. Bulgaria 17

2.1. Legal compatibility 17

2.1.1. Introduction 17

2.1.2. Central Bank independence 17

2.1.3. Prohibition of monetary financing and privileged access 17

2.1.4. Integration in the ESCB 18

2.1.5. Assessment of compatibility 18

2.2. PRICE STABILITY 18

2.2.1. Respect of the reference value 18

2.2.2. Recent inflation developments 19

2.2.3. Underlying factors and sustainability of inflation 19

2.3. public finances 22

2.3.1. The excessive deficit procedure for Bulgaria 22

2.3.2. Recent fiscal developments 23

2.3.3. Medium-term prospects 23

2.4. EXCHANGE RATE STABILITY 24

2.5. LONG-TERM INTEREST RATEs 25

2.6. ADDITIONAL FACTORS 26

2.6.1. Developments of the balance of payments 26

2.6.2. Product market integration 27

2.6.3. Financial market integration 29

3. Czech Republic 31

3.1. legal compatibility 31

3.1.1. Introduction 31

3.1.2. Independence 31

3.1.3. Prohibition of monetary financing 32

3.1.4. Integration in the ESCB 32

3.1.5. Assessment of compatibility 32

3.2. PRICE STABILITY 32

3.2.1. Respect of the reference value 32

3.2.2. Recent inflation developments 33

3.2.3. Underlying factors and sustainability of inflation 33

3.3. public finances 36

3.3.1. The excessive deficit procedure for the Czech Republic 36

3.3.2. Recent fiscal developments 36

3.3.3. Medium-term prospects 37

3.4. EXCHANGE RATE STABILITY 38

3.5. LONG-TERM INTEREST RATEs 39

3.6. ADDITIONAL FACTORS 40

3.6.1. Developments of the balance of payments 40

3.6.2. Product market integration 41

3.6.3. Financial market integration 43

4. Latvia 45

4.1. Legal compatibility 45

4.1.1. Introduction 45

4.1.2. Central bank independence 45

4.1.3. Prohibition of monetary financing and privileged access 46

4.1.4. Integration in the ESCB 46

4.1.5. Assessment of compatibility 46

4.2. PRICE STABILITY 46

4.2.1. Respect of the reference value 46

4.2.2. Recent inflation developments 47

4.2.3. Underlying factors and sustainability of inflation 48

4.3. public finances 51

4.3.1. The excessive deficit procedure for Latvia 51

4.3.2. Recent fiscal developments 51

4.3.3. Medium-term prospects 52

4.4. EXCHANGE RATE STABILITY 53

4.5. LONG-TERM INTEREST RATEs 54

4.6. additional factors 55

4.6.1. Developments of the balance of payments 56

4.6.2. Product market integration 57

4.6.3. Financial market integration 59

5. Lithuania 61

5.1. LEGAL COMPATIBILITY 61

5.1.1. Introduction 61

5.1.2. Central bank independence 61

5.1.3. Prohibition of monetary financing and privileged access 61

5.1.4. Integration in the ESCB 61

5.1.5. Assessment of compatibility 61

5.2. PRICE STABILITY 61

5.2.1. Respect of the reference value 61

5.2.2. Recent inflation developments 61

5.2.3. Underlying factors and sustainability of inflation 62

5.3. PUBLIC FINANCES 64

5.3.1. The excessive deficit procedure for Lithuania 64

5.3.2. Recent fiscal developments 65

5.3.3. Medium-term prospects 65

5.4. EXCHANGE RATE STABILITY 67

5.5. LONG-TERM INTEREST RATES 68

5.6. ADDITIONAL FACTORS 68

5.6.1. Developments of the balance of payments 69

5.6.2. Product market integration 70

5.6.3. Financial market integration 71

6. Hungary 75

6.1. LEGAL COMPATIBILITY 75

6.1.1. Introduction 75

6.1.2. Central bank independence 75

6.1.3. Prohibition of monetary financing and privileged access 76

6.1.4. Integration in the ESCB 76

6.1.5. Assessment of compatibility 76

6.2. PRICE STABILITY 77

6.2.1. Respect of the reference value 77

6.2.2. Recent inflation developments 77

6.2.3. Underlying factors and sustainability of inflation 77

6.3. PUBLIC FINANCES 80

6.3.1. The excessive deficit procedure for Hungary 80

6.3.2. Recent fiscal developments 81

6.3.3. Medium-term prospects 82

6.4. EXCHANGE RATE STABILITY 83

6.5. LONG-TERM INTEREST RATEs 84

6.6. ADDITIONAL FACTORS 84

6.6.1. Developments of the balance of payments 85

6.6.2. Product market integration 86

6.6.3. Financial market integration 88

7. Poland 89

7.1. LEGAL COMPATIBILITY 89

7.1.1. Introduction 89

7.1.2. Central bank independence 89

7.1.3. Prohibition of monetary financing and privileged access 89

7.1.4. Integration in the ESCB 90

7.1.5. Assessment of compatibility 90

7.2. PRICE STABILITY 90

7.2.1. Respect of the reference value 90

7.2.2. Recent inflation developments 90

7.2.3. Underlying factors and sustainability of inflation 91

7.3. PUBLIC FINANCES 93

7.3.1. The excessive deficit procedure for Poland 93

7.3.2. Recent fiscal developments 94

7.3.3. Medium-term prospects 94

7.4. EXCHANGE RATE STABILITY 96

7.5. LONG-TERM INTEREST RATEs 96

7.6. ADDITIONAL FACTORS 97

7.6.1. Developments of the balance of payments 97

7.6.2. Product market integration 99

7.6.3. Financial market integration 100

8. Romania 103

8.1. Legal compatibility 103

8.1.1. Introduction 103

8.1.2. Central Bank independence 103

8.1.3. Prohibition of monetary financing and privileged access 104

8.1.4. Integration in the ESCB 105

8.1.5. Assessment of compatibility 106

8.2. PRICE STABILITY 106

8.2.1. Respect of the reference value 106

8.2.2. Recent inflation developments 106

8.2.3. Underlying factors and sustainability of inflations 107

8.3. PUBLIC FINANCES 110

8.3.1. The excessive deficit procedure for Romania 110

8.3.2. Recent fiscal developments 110

8.3.3. Medium-term prospects 111

8.4. EXCHANGE RATE STABILITY 112

8.5. LONG-TERM INTEREST RATEs 113

8.6. ADITIONAL FACTORS 114

8.6.1. Developments of the balance of payments 114

8.6.2. Product market integration 116

8.6.3. Financial market integration 118

9. Sweden 121

9.1. Legal compatitability 121

9.1.1. Introduction 121

9.1.1. Central Bank Independence 121

9.1.2. Prohibition of monetary financing and privileged access 121

9.1.3. Integration in the ESCB 122

9.1.4. Assessment of compatibility 122

9.2. Price stability 123

9.2.1. Respect of the reference value 123

9.2.1. Recent inflation developments 123

9.2.1. Underlying factors and sustainability of inflation 123

9.3. Public finances 126

9.3.1. Recent fiscal developments 126

9.3.1. Medium-term prospects 127

9.4. Exchange rate stability 128

9.5. Long-term interest rates 129

9.6. Additional factors 130

9.6.1. Developments of the balance of payments 130

9.6.1. Product market integration 131

9.6.1. Financial market integration 133

LIST OF Tables

2.1. Bulgaria - Components of inflation 20

2.2. Bulgaria - Other inflation and cost indicators 21

2.3. Bulgaria - Budgetary developments and projections 23

2.4. Bulgaria - Balance of payments 27

2.5. Bulgaria - Product market integration 28

3.1. Czech Republic - Components of inflation 34

3.2. Czech Republic - Other inflation and cost indicators 35

3.3. Czech Republic - Budgetary developments and projections 37

3.4. Czech Republic - Balance of payments 41

3.5. Czech Republic - Product market integration 42

4.1. Latvia - Components of inflation 47

4.2. Latvia - Other inflation and cost indicators 49

4.3. Latvia - Budgetary developments and projections 52

4.4. Latvia - Balance of payments 57

4.5. Latvia - Product market integration 58

5.1. Lithuania - Components of inflation 62

5.2. Lithuania - Other inflation and cost indicators 63

5.3. Lithuania - Budgetary developments and projections 66

5.4. Lithuania - Balance of payments 69

5.5. Lithuania - Product market integration 71

6.1. Hungary - Components of inflation 78

6.2. Hungary - Other inflation and cost indicators 79

6.3. Hungary - Budgetary developments and projections 81

6.4. Hungary - Balance of payments 85

6.5. Hungary - Product market integration 87

7.1. Poland - Components of inflation 91

7.2. Poland - Other inflation and cost indicators 92

7.3. Poland - Budgetary developments and projections 95

7.4. Poland - Balance of payments 98

7.5. Poland - Product market integration 100

8.1. Romania - Components of inflation 107

8.2. Romania - Other inflation and cost indicators 108

8.3. Romania - Budgetary developments and projections 111

8.4. Romania - Balance of payments 116

8.5. Romania - Product market integration 117

9.1. Sweden - Components of inflation 124

9.2. Sweden - Other inflation and cost indicators 125

9.3. Sweden - Budgetary developments and projections 127

9.4. Sweden - Balance of payments 130

9.5. Sweden - Product market integration 132

LIST OF Graphs

2.1. Bulgaria - Inflation criterion since 2006 19

2.2. Bulgaria - HICP inflation 19

2.3. Bulgaria - Inflation, productivity and wage trends 20

2.4. Exchange rates - BGN/EUR 24

2.5. Bulgaria - 3-M Sofibor spread to 3-M Euribor 25

2.6. Bulgaria - Long-term interest rate criterion 25

2.7. Bulgaria - Long-term interest rates 26

2.8. Bulgaria - Saving and investment 26

2.9. Bulgaria - Effective exchange rates 27

2.10. Bulgaria - Foreign ownership and concentration in the banking sector 29

2.11. Bulgaria - selected banking sector soundness indicators relatively to the euro area 30

2.12. Bulgaria - Recent development of the financial system relatively to the euro area 30

3.1. Czech Republic - Inflation criterion since 2006 33

3.2. Czech Republic - HICP inflation 33

3.3. Czech Rep. - Inflation, productivity and wage trends 34

3.4. Exchange rates - CZK/EUR 39

3.5. Czech Republic - 3-M Pribor spread to 3-M Euribor 39

3.6. Czech Republic - Long-term interest rate criterion 39

3.7. Czech Republic - Long-term interest rates 40

3.8. Czech Republic - Saving and investment 40

3.9. Czech Republic - Effective exchange rates 41

3.10. Czech Republic - Foreign ownership and concentration in the banking sector 43

3.11. Czech Republic - selected banking sector soundness indicators relatively to the euro area 44

3.12. Czech Republic - Recent development of the financial system relatively to the euro area 44

4.1. Latvia - Inflation criterion since 2006 47

4.2. Latvia - HICP inflation 47

4.3. Latvia - Inflation, productivity and wage trends 49

4.4. LVL - Spread vs central rate 53

4.5. Exchange rates - LVL/EUR 54

4.6. Latvia - 3-M Rigibor spread to 3-M Euribor 54

4.7. Latvia - Long-term interest rate criterion 55

4.8. Latvia - Long-term interest rates 55

4.9. Latvia - Saving and investment 56

4.10. Latvia - Effective exchange rates 56

4.11. Latvia - Foreign ownership and concentration in the banking sector 59

4.12. Latvia - selected banking sector soundness indicators relatively to the euro area 60

4.13. Latvia - Recent development of the financial system relatively to the euro area 60

5.1. Lithuania - Inflation criterion since 2006 61

5.2. Lithuania - HICP inflation 62

5.3. Lithuania - Inflation, productivity and wage trends 63

5.4. LTL - Spread vs central rate 67

5.5. Exchange rates - LTL/EUR 67

5.6. Lithuania - 3-M Vilibor spread to 3-M Euribor 68

5.7. Lithuania - Long-term interest rate criterion 68

5.8. Lithuania - Long-term interest rates 68

5.9. Lithuania - Saving and investment 69

5.10. Lithuania - Effective exchange rates 70

5.11. Lithuania - Foreign ownership and concentration in the banking sector 72

5.12. Lithuania - selected banking sector soundness indicators relatively to the euro area 72

5.13. Lithuania - Recent development of the financial system relatively to the euro area 73

6.1. Hungary - Inflation criterion since 2006 77

6.2. Hungary - HICP inflation 77

6.3. Hungary - Inflation, productivity and wage trends 79

6.4. Exchange rates - HUF/EUR 83

6.5. Hungary - 3-M Bubor spread to 3-M Euribor 84

6.6. Hungary - Long-term interest rate criterion 84

6.7. Hungary - Long-term interest rates 84

6.8. Hungary - Saving and investment 86

6.9. Hungary - Effective exchange rates 86

6.10. Hungary - Foreign ownership and concentration in the banking sector 88

6.11. Hungary - selected banking sector soundness indicators relatively to the euro area 88

6.12. Hungary - Recent development of the financial system relatively to the euro area 88

7.1. Poland - Inflation criterion since 2006 90

7.2. Poland - HICP inflation 91

7.3. Poland - Inflation, productivity and wage trends 92

7.4. Exchange rates - PLN/EUR 96

7.5. Poland - 3-M Wibor spread to 3-M Euribor 96

7.6. Poland - Long-term interest rate criterion 97

7.7. Poland - Long-term interest rates 97

7.8. Poland - Saving and investment 98

7.9. Poland - Effective exchange rates 98

7.10. Poland - Foreign ownership and concentration in the banking sector 101

7.11. Poland - selected banking sector soundness indicators relatively to the euro area 101

7.12. Poland - Recent development of the financial system relatively to the euro area 101

8.1. Romania - Inflation criterion since 2006 106

8.2. Romania - HICP inflation 106

8.3. Romania - Inflation, productivity and wage trends 108

8.4. Exchange rates - RON/EUR 113

8.5. Romania - 3-M Robor spread to 3-M Euribor 113

8.6. Romania - Long-term interest rate criterion 114

8.7. Romania - Long-term interest rates 114

8.8. Romania - Saving and investment 115

8.9. Romania - Effective exchange rates 115

8.10. Romania - Foreign ownership and concentration in the banking sector 118

8.11. Romania - selected banking sector soundness indicators relatively to the euro area 118

8.12. Romania - Recent development of the financial system relatively to the euro area 119

9.1. Sweden - Inflation criterion since 2006 123

9.2. Sweden - HICP inflation 123

9.3. Sweden - Inflation, productivity and wage trends 125

9.4. Exchange rates - SEK/EUR 128

9.5. Sweden - 3-M Stibor spread to 3-M Euribor 129

9.6. Sweden - Long-term interest rate criterion 129

9.7. Sweden - Long-term interest rates 129

9.8. Sweden - Saving and investment 131

9.9. Sweden - Effective exchange rates 131

9.10. Sweden - Foreign ownership and concentration in the banking sector 133

9.11. Sweden - selected banking sector soundness indicators relatively to the euro area 134

9.12. Sweden - Recent development of the financial system relatively to the euro area 134

LIST OF Boxes

1.1. Article 140 of the Treaty 6

1.2. Assessment of price stability and the reference value 8

1.3. Excessive deficit procedure 10

1.4. Data for the interest rate convergence 13

1.5. The Macroeconomic Imbalance Procedure (MIP) 15

LIST OF Maps

No table of contents entries found.

Report

1.1. ROLE OF THE REPORT

The euro was introduced on 1 January 1999 by eleven Member States. The decision ([1]) by the Council (meeting in the composition of the Heads of State or Government) on 3 May 1998 in Brussels on the eleven Member States deemed ready to participate in the single currency had, in accordance with the Treaty (Article 121(4) TEC) ([2]), been prepared by the Ecofin Council on a recommendation from the Commission. The decision was based on the two Convergence Reports made by the Commission ([3]) and the European Monetary Institute (EMI), respectively ([4]). These reports, prepared in accordance with Article 121(1) TEC ([5]), examined whether the Member States satisfied the convergence criteria and met the legal requirements.

Since then, Greece (2001), Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009) and Estonia (2011) have joined the euro.

Those Member States which are assessed as not fulfilling the necessary conditions for the adoption of the euro are referred to as "Member States with a derogation". Article 140 of the Treaty lays down provisions and procedures for examining the situation of Member States with a derogation (Box 1.1). At least once every two years, or at the request of a Member State with a derogation, the Commission and the European Central Bank (ECB) prepare Convergence Reports on such Member States. Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht Treaty ([6]) and do not participate in the third stage of EMU. Until these Member States indicate that they wish to participate in the third stage and join the euro, they are not the subject of an assessment as to whether they fulfil the necessary conditions.

In 2010, the Commission and the ECB adopted their latest regular Convergence Reports ([7]). Following the Convergence Reports and on the basis of a proposal by the Commission, the Ecofin Council decided in July 2010 that Estonia fulfilled the necessary conditions for adopting the euro as of 1 January 2011 ([8]). None of the other Member States assessed was deemed to meet the necessary conditions for adopting the euro.

In 2012, two years will have elapsed since the last regular reports were made. Denmark and the United Kingdom have not expressed a wish to enter the third stage of EMU. Therefore, this convergence assessment covers Bulgaria, the Czech Republic, Latvia, Lithuania, Hungary, Poland, Romania and Sweden. This Commission Staff Working Document is a Technical Annex to the Convergence Report 2012 and includes a detailed assessment of the progress with convergence.

The financial and economic crisis, along with the recent euro-area debt crisis, has exposed gaps in the current economic governance system of EMU and showed that its existing instruments need to be used more fully. With the aim of ensuring a sustainable functioning of economic and monetary union, an overall strengthening of economic governance in the Union was undertaken over past two years. Accordingly, this Commission Staff Working Document makes references where appropriate to procedures that help to strengthen the assessment of each Member States' convergence process and its sustainability. In particular, it incorporates references to the strengthened surveillance of macroeconomic imbalances (see section 1.2.6.).

The remainder of the first chapter presents the methodology used for the application of the assessment criteria. Chapters 2 to 10 examine, on a country-by-country basis, fulfilment of the convergence criteria and other requirements in the order as they appear in Article 140(1) (see Box 1.1). The cut-off date for the statistical data included in this Convergence Report was 30 April 2012.

1.2. APPLICATION OF THE CRITERIA

In accordance with Article 140(1) of the Treaty, the Convergence Reports shall examine the compatibility of national legislation with Articles 130 and 131 of the Treaty and the Statute of the European System of Central Banks (ESCB) and of the European Central Bank. The reports shall also examine the achievement of a high degree of sustainable convergence by reference to the fulfilment of the four convergence criteria dealing with price stability, public finances, exchange rate stability and long term interest rates as well as some additional factors. The four convergence criteria are developed further in a Protocol annexed to the Treaty (Protocol No 13 on the convergence criteria).

1.2.1. Compatibility of legislation

In accordance with Article 140(1) of the Treaty, the legal examination includes an assessment of compatibility between a Member State’s legislation, including the statute of its national central bank, and Article 131 of the Treaty. This assessment mainly covers three areas.

· First, the independence of the national central bank and of the members of its decision-making bodies, as laid down in Article 130, must be assessed. This assessment covers all issues linked to a national central bank's institutional financial independence and to the personal independence of the members of its decision-making bodies.

· Second, in accordance with Articles 123 and 124 of the Treaty, the compliance of the national legislation is verified against the prohibition of monetary financing and privileged access. The prohibition of monetary financing is laid down in Article 123(1) of the Treaty, which prohibits overdraft facilities or any other type of credit facility with the ECB or the central banks of Member States in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States; and the purchase directly from these public sector entities by the ECB or central banks of debt instruments. As regards the prohibition on privileged access, the central banks, as public authorities, may not take measures granting privileged access by the public sector to financial institutions if such measures are not based on prudential considerations.

· Third, the integration of the national central bank into the ESCB has to be examined, in order to ensure that at the latest by the moment of euro adoption, the objectives of the national central bank are compatible with the objectives of the ESCB as formulated in Article 127 of the Treaty. What is more, the provisions on tasks in national central banks laws are assessed against the relevant provisions of the Treaty and the ESCB/ECB Statute.

1.2.2. Price stability

The price stability criterion is defined in the first indent of Article 140(1) of the Treaty: “the achievement of a high degree of price stability […] will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability” (see Box 1.2).

Article 1 of the Protocol on the convergence criteria further stipulates that “the criterion on price stability […] shall mean that a Member State has a price performance that is sustainable and an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1.5 percentage points that of, at most, the three best performing Member States in terms of price stability. Inflation shall be measured by means of the consumer price index on a comparable basis, taking into account differences in national definitions”.

Since national consumer price indices (CPIs) diverge substantially in terms of concepts, methods and practices, they do not constitute the appropriate means to meet the Treaty requirement that inflation must be measured on a comparable basis. To this end, the Council adopted on 23 October 1995 a framework regulation ([9]) setting the legal basis for the establishment of a harmonised methodology for compiling consumer price indices in the Member States. This process resulted in the production of the Harmonised Indices of Consumer Prices (HICPs), which are used for assessing the fulfilment of the price stability criterion. Until December 2005, HICP series had been based on 1996 as the reference period. A Commission Regulation (EC) No 1708/2005 ([10]) provided the basis for a change of the HICP index base reference period from 1996=100 to 2005=100.

(Continued on the next page)

Box (continued)

As has been the case in past convergence reports, a Member State’s average rate of inflation is measured by the percentage change in the arithmetic average of the last 12 monthly indices relative to the arithmetic average of the 12 monthly indices of the previous period. The reference value is calculated as the arithmetic average of the average rate of inflation of the three best-performing Member States in terms of price stability plus 1.5 percentage points.

Over the 12-month period covering April 2011-March 2012, the three best-performing Member States in terms of price stability were Sweden (1.3%), Ireland (1.4%) and Slovenia (2.1%), yielding a reference value of 3.1%.

The Protocol on the convergence criteria not only requires Member States to have achieved a high degree of price stability but also calls for a price performance that is sustainable. The requirement of sustainability aims at ensuring that the degree of price stability and inflation convergence achieved in previous years will be maintained after adoption of the euro. This deserves particular attention in the current juncture as the financial turmoil exposed unsustainable price developments in many EU Member States, including euro area countries, in the pre-crisis period.

Inflation sustainability implies that the satisfactory inflation performance must essentially be due to the adequate behaviour of input costs and other factors influencing price developments in a structural manner, rather than reflecting the influence of temporary factors. Therefore, this Technical Annex examines also the role of the macroeconomic situation and cyclical stance in inflation performance, developments in unit labour costs as a result of trends in labour productivity and nominal compensation per head, developments in import prices to assess how external price developments have impacted on domestic inflation. Similarly, the impact of administered prices and indirect taxes on headline inflation is also considered.

(Continued on the next page)

Box (continued)

From a forward-looking inflation perspective, the report includes an assessment of medium-term prospects for price developments. The analysis of factors that have an impact on the inflation outlook – cyclical conditions, labour market developments and credit growth – is complemented by a reference to the most recent Commission services' forecast of inflation. That forecast can subsequently be used to assess whether the Member State is likely to meet the reference value also in the months ahead ([11]). Medium-term inflation prospects are also assessed by reference to the economies' key structural characteristics, including the functioning of the labour and product markets.

1.2.3. Public finances

The convergence criterion dealing with the government budgetary position is defined in the second indent of Article 140(1) of the Treaty as “the sustainability of the government financial position: this will be apparent from having achieved a government budgetary position without a deficit that is excessive as determined in accordance with Article 126(6)”. Furthermore, Article 2 of the Protocol on the convergence criteria states that this criterion means that “at the time of the examination the Member State is not the subject of a Council decision under Article 126(6) of the said Treaty that an excessive deficit exists”.

The convergence assessment in the budgetary area is thus directly linked to the excessive deficit procedure which is specified in Article 126 of the Treaty and further clarified in the Stability and Growth Pact (see Box 1.3 for further information on the excessive deficit procedure as strengthened by the 2011 reform of the Stability and Growth Pact). The existence of an excessive deficit is determined in relation to the two criteria for budgetary discipline set in Article 126(2), namely the government deficit and the government debt. Failure by a Member State to fulfil the requirements under either of these criteria can lead to a decision by the Council on the existence of an excessive deficit, in which case the Member State concerned does not comply with the budgetary convergence criterion ([12]).

The issue of sustainability deserves particular attention at a time when the financial crisis has significantly impacted on the fiscal positions in many Member States. Related to this, economic governance in the EMU was substantially strengthened in 2011. This included, inter alia, the operationalisation of the debt criterion in the Excessive Deficit Procedure ([13]).

1.2.4. Exchange rate stability

The Treaty refers to the exchange rate criterion in the third indent of Article 140(1) as “the observance of the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the euro”.

Article 3 of the Protocol on the convergence criteria stipulates: “The criterion on participation in the exchange rate mechanism of the European Monetary System (…) shall mean that a Member State has respected the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System without severe tensions for at least the last two years before the examination. In particular, the Member State shall not have devalued its currency’s bilateral central rate against the euro on its own initiative for the same period” ([14]). Based on the Council Resolution on the establishment of the ERM II ([15]), the European Monetary System has been replaced by the Exchange Rate Mechanism II upon the introduction of the euro, and the euro has become the centre of the mechanism.

In its assessment of the exchange rate stability criterion, the Commission takes into account developments in auxiliary indicators such as foreign reserve developments and short-term interest rates, as well as the role of policy measures, including foreign exchange interventions, in maintaining exchange rate stability.

Some Member States, as was already the case at the time of the 2010 Convergence Report, have received international balance-of-payments assistance during the assessment period for this report. In order to determine whether this constitutes evidence that a country has faced severe tensions in its exchange rate, the Commission examines several factors, including the situation that led to the need for official external financing, the magnitude and financing profile of the assistance programme, the residual financing gap, the policy conditionality attached to it as well as developments in foreign exchange and financial markets.

As in previous reports, the assessment of this criterion verifies the participation in ERM II and examines exchange rate behaviour within the mechanism. The relevant period for assessing exchange rate stability in this Technical Annex is 1 May 2010 to 30 April 2012.

1.2.5. Long-term interest rates

The fourth indent of Article 140(1) of the Treaty requires “the durability of convergence achieved by the Member State with a derogation and of its participation in the exchange rate mechanism being reflected in the long-term interest rate levels”. Article 4 of the Protocol on the convergence criteria further stipulates that “the criterion on the convergence of interest rates (…) shall mean that, observed over a period of one year before the examination, a Member State has had an average nominal long-term interest rate that does not exceed by more than two percentage points that of, at most, the three best performing Member States in terms of price stability. Interest rates shall be measured on the basis of long-term government bonds or comparable securities, taking into account differences in national definitions” (see Box 1.4).

At the current juncture, sovereign bond markets in some Member States are subject to severe distortions. In particular, some Member States face episodes of unusually high nominal long-term interest rates and/or closure of market access. This makes their long-term interest rates not an economically meaningful benchmark for the assessment of convergence and including them would severely affect the reference value and thus the fairness of the criterion. Against this background, the calculation of the reference value excludes Ireland, i.e. one of the three best-performing Member States in terms of price stability ([16]).

For the assessment of the criterion on the convergence of interest rates, yields on benchmark 10-year bonds have been taken, using an average rate over the latest 12 months. Taking into account the current exceptional economic circumstances, in line with Article 4 of the Protocol (referring to 'at most the three best performing Member States'), the reference value for March 2012 is calculated as the simple average of the average long-term interest rates in Sweden (2.2%) and Slovenia (5.4%) plus 2 percentage points, yielding a reference value of 5.8%.

1.2.6. Additional factors

The Treaty in Article 140 also calls for an examination of other factors relevant to economic integration and convergence. These additional factors include financial and product market integration and the development of the balance of payments. The examination of the development of unit labour costs and other price indices, which is also prescribed by Article 140 of the Treaty, is covered in the chapter on price stability.

The assessment of additional factors is equally important indication of whether the integration of a Member State into the euro area would proceed without difficulties. As regards the balance of payments, the focus is on the situation and development of the external balance ([17]). Integration of product markets is assessed through trade, foreign direct investment and a smooth functioning of the internal market. Finally, progress in financial integration is examined, together with the impact of the financial crisis, the main characteristics, structures and trends of the financial sector and compliance with the acquis of the Union in this area.

For the first time, the Convergence Report is aligned with the broader "European semester" approach which takes an integrated and upstream look at the economic policy challenges facing the EMU in ensuring fiscal sustainability, competitiveness, financial market stability and economic growth. The section on additional factors makes reference to the surveillance of macroeconomic imbalances under the Macro-economic imbalance procedure (MIP – see Box 1.5), that was adopted in December 2011 as one of the key elements of the legislative package (the "6-pack") to enhance the governance structures in EMU, and integrates its results into the assessment ([18]).

2.1. Legal compatibility

2.1.1. Introduction

The Law on the Bulgarian National Bank (BNB Law), adopted in 1997, constitutes the legal basis for the Bulgarska narodna banka (BNB – central bank of Bulgaria) and deals with the BNB’s structure and functions. Some amendments were made to it after the 2010 convergence report was published: (1) ) In relation to the conflict of interests, the BNB Law now refers to the Conflict of Interest Prevention and Ascertainment Act; (2) the BNB Law now provides for competences of the BNB in the area of licensing and supervision of payment institutions, payment systems and electronic money institutions.

2.1.2. Central Bank independence

Article 14(1) and (2) of the BNB Law Bank do not accurately mirror the grounds for dismissal of the Governor as laid down in Article 14.2 of the ESCB/ECB Statute. Article 14(1) of the BNB Law provides that a member of the BNB Governing Council amongst others can be relieved from office if "he no longer fulfils the conditions required for the performance of his duties under Article 11(4), if "he is in practical inability to perform his duties for more than six months" or if "he has been guilty of serious professional misconduct". The second dismissal ground mentioned in Article 14(1) is not provided in Article 14.2 of the Statute, whereas the third criterion narrows down the concept of "serious misconduct" of Article 14.2 of the Statute to "serious professional misconduct". In order to remove this imperfection and limit interpretation problems a clear definition of these grounds, in line with Article 14.2 of the Statute, would be required.

In order to be in line with the term duration requirements of Article 14.2 of the Statute, Article 14(2) of the BNB Law should explicitly foresee that a person replacing the Governor whose mandate has ceased as member of the Governing Council should also be elected or appointed for a term of office of at least five years.

Pursuant to Article 33(1) in conjunction with Article 3(13) of the Conflict of Interest Prevention and Ascertainment Act, the breach of conflict of interest prevention and ascertainment duties by the Governor shall be a ground for his dismissal. The Act should remove this incompatibility and specify that the dismissal is only possible if, as per Article 14.2 of the Statute, the breach of the duty is a lack of fulfilment of the conditions required for the performance of the Governor's duty or a serious misconduct of which the Governor has been guilty.

Article 12(1) and (2) of the BNB Law provides for the National Assembly’s powers to elect the Governor and the Deputy Governors of the BNB. The National Assembly has claimed that it has the power to annul or amend its previous decisions, including decisions concerning the election of the Governor and Deputy Governors of the BNB taken under Article 12(1) and (2) of the Law. The National Assembly has justified its claim on the basis of a Constitutional Court decision of February 26, 1993 stating that the Constitution does not contain an express provision prohibiting the National Assembly from annulling or amending its acts. The Law should remove this incompatibility and ensure that the Governor, when elected or appointed, shall not be dismissed under conditions other than those mentioned in Article 14.2 of the ESCB/ECB Statute, even if he has not yet taken up his duties.

Article 44 of the BNB law provides that the members of the Governing Council, in the performance of their tasks, shall be independent and shall not seek or take any instructions from the Council of Ministers or from any other body or institution. Neither the Council of Ministers nor any other body or institution shall give instructions to the members of the Governing Council. This provision constitutes an imperfection and does not correspond to the wording of the Article 130 of the TFEU and the Article 7 of the ESCB/ECB Statute (e.g. Union institutions are not included) and should therefore be brought into line with it.

2.1.3. Prohibition of monetary financing and privileged access

Article 45(1) provides that the BNB shall not extend credits and guarantees, including through purchase of debt instruments, to the Council of Ministers, municipalities, as well as to other governmental and municipal institutions, organizations and enterprises. Pursuant to Article 45(2) of the Law on BNB, this does not apply to the extension of credits to state-owned and municipal banks in emergency cases of liquidity risk that may affect the stability of the banking system. Article 45(1) should include all entities which are mentioned in Article 123(1) of the TFEU and Article 21.1 ESCB/ECB Statute. The provisions of Article 45(1) and (2) provide for incompatibility with the wording of Article 123 of the TFEU and Article 21.1 of the ESCB/ECB Statute and thus, should be amended. What is more, the prohibition of monetary financing prohibits the direct purchase of public sector debt, but such purchases in the secondary market are allowed as long as such secondary market purchases are not used to circumvent the objective of Article 123 of the TFEU. For this reason the word ‘direct’ should be inserted in Article 45(1) of the Law to remove this imperfection and be fully in line with Article 123 of the TFEU.

2.1.4. Integration in the ESCB

Objectives

The objectives of the BNB are compatible with the TFEU.

Tasks

The incompatibilities in the Law on the BNB are linked to the following ESCB/ECB tasks:

· definition of monetary policy and monetary functions, operations and instruments of the ESCB (Articles 2(1), 3, 16(4-5),28, 30, 31, 32, 33, 35, 38, 41 and 61);

· conduct of foreign exchange operations and the definition of foreign exchange rate policy (Articles 20(1), 28, 28, 31, 32);

· right to authorise the issue of banknotes and the volume of coins (Articles 2(5), 16(9), 24 to 27);

· non-recognition of the role of the ECB in the field of international cooperation (Articles 5, 16(12) and 37(4));

· ECB's right to impose sanctions (Article 61, 62).

There are also numerous imperfections regarding:

· non-recognition of the role of the ECB for the functioning of the payment systems (Articles 2(4) and 40(1));

· non-recognition of the role of the ECB and the EU for the collection of statistics (Article 4(1) and 42);

· non-recognition of the role of the ECB and of the Council for the appointment of the external auditor (Articles 49 (4));

· absence of an obligation to comply with the Eurosystem's regime for the financial reporting of NCB operations (Article 16(11), 46 and 49).

2.1.5. Assessment of compatibility

As regards the central bank integration into the ESCB at the time of euro adoption, the independence of the central bank and the prohibition on monetary financing, the legislation in Bulgaria - in particular, the BNB Law and the Conflict of Interest Prevention and Ascertainment Act - are not fully compatible with the compliance duty under Article 131 of the TFEU.

2.2. PRICE STABILITY

2.2.1. Respect of the reference value

The 12-month average inflation rate for Bulgaria, which is used for the convergence assessment, was above the reference value at each convergence assessment since Bulgaria became an EU Member State in 2007. Average annual inflation rose from 1.6% in April 2010 to 3.8% by June 2010, before declining to 3.4% by end-2011. In March 2012, the reference value was 3.1%, calculated as the average of the 12-month average inflation rates in Sweden, Ireland and Slovenia plus 1.5 percentage points. The average inflation rate in Bulgaria during the 12 months to March 2012 was 2.7%, i.e. below the reference value. It is projected to remain below the reference value in the months ahead.

2.2.2. Recent inflation developments

The inflation rate in Bulgaria has fluctuated over the past two years, reflecting the impact of volatile international commodity prices on energy and food prices. With the turn in the commodity cycle and the strong recession, headline inflation declined to close to zero by late 2009. Strengthening commodity prices, indirect tax increases and still significant wage growth put inflation back on an upward trend in 2010 and it reached a peak of 4.6% in early 2011 before decreasing again with the fading of the impact of the former two factors to 2% by end-2011, well below the euro area average. By March 2012, annual inflation fell further to 1.7%. Indirect taxes contributed positively to inflation in 2010, but their impact was minor from 2011, when fiscal consolidation became even more expenditure-based.

Core inflation (measured as HICP inflation excluding energy and unprocessed food) was by construction more resilient to the import price shocks than headline inflation. The gap between the two measures of inflation varied mainly depending on global commodity price fluctuations, with headline rising above core inflation in early 2010 and reverting to it at end-2011. Core inflation picked up slightly in late 2010 amid rising processed food inflation, but this short-lived trend reversed by mid-2011 as the commodity price pressure on processed food abated. Core inflation fell to 1% by March 2012. Prices of non-energy industrial goods continued to fall, partly due to weak domestic demand. Decreasing producer price inflation confirmed the easing of cost pressures in 2011, but its year-on-year level remained elevated in early 2012.

2.2.3. Underlying factors and sustainability of inflation

Macroeconomic policy-mix and cyclical stance

Following a long period of dynamic growth, real GDP contracted by more than 5% in 2009, as foreign capital flows dried up and export markets were hit by the effects of the financial crisis. Exports rebounded in 2010 and 2011, but domestic demand remained very sluggish. Output was overall broadly stable in 2010 and increased by around 2% in 2011. The correction of large pre-crisis imbalances started somewhat later in Bulgaria than in other countries of the region. Available indicators for the first quarter of 2012 suggest that domestic demand remains weak. According to the Commission services' Spring 2012 Forecast, Bulgaria's GDP will increase by 0.5% in 2012 and by 1.9% in 2013. The Bulgarian economy is estimated to have operated well below its potential since 2009 and a sizeable negative output gap is projected to remain even in 2013.

The fiscal stance, as measured by changes in the structural balance, has been restrictive since 2010, allowing for a frontloaded correction of the structural deficit that emerged in 2009. The correction of the headline deficit was achieved mainly by structural measures, in particular in 2010, and fiscal consolidation was concentrated on the expenditure side. In view of the good starting budgetary position and the ambitious tackling of the fiscal slippage in 2009, the drag on the economy from fiscal consolidation is expected to be rather moderate, with the fiscal stance projected to be slightly restrictive in 2012 and broadly neutral in 2013.

In the context of its currency board arrangement to the euro, monetary conditions tightened in Bulgaria with the international financial crisis. The

partial relaxation in the local financial regulatory environment, which included the lowering of the reserve requirement by early 2010, could not fully counterbalance the impact of increased risk aversion and reduced funding by foreign parent banks. The uncertain economic outlook, in particular the heightened risk of unemployment and falling real estate prices, lowered credit demand as well. The flow of new credit recovered somewhat during 2011, as the banking sector's reliance on foreign funding declined.

Wages and labour costs

Bulgaria entered the recession with a tight labour market. The initial labour market reaction was a drop in employment of almost 3% in 2009, but the situation turned even more severe in 2010, when the employment loss reached almost 5%, before a further 4% decline in 2011. The unemployment rate rose from below 6% in 2008 to slightly above 11% by 2011, as jobs were lost mainly in the non-tradable sector, but the manufacturing sector also suffered heavily. Despite these factors and wage restraint in the public sector from 2010, nominal wage growth remained high in the private sector. This suggests that skills mismatches impeded labour market flexibility, despite a relatively decentralized wage setting process.

Labour productivity turned negative in 2009, as output fell faster than employment, but it increased strongly in 2010 and 2011 with continuing labour force reductions amid rising exports. Accordingly, the growth in nominal unit labour cost (ULC) remained high in 2009, before moderating to around 5% in 2010 and 1% in 2011 ([19]). Looking ahead, ULC growth is expected to rise, as the growth in nominal compensation per employee is to remain high and productivity growth is likely to decrease with the stabilization of the labour market.

External factors

Given the high openness of the Bulgarian economy, developments in import prices play an important role in domestic price formation. Import prices, as measured by the imports of goods deflator in the national accounts, dropped at a double-digit rate in 2009, but increased markedly in 2010 and 2011. Annual growth in import prices is expected to remain significant in 2012 mainly on account of rising oil prices.

The development of Bulgaria's import prices is closely linked to the fluctuations in international commodity prices. Accordingly, energy and food products were the most relevant channels of imported inflation, in particular when taking into account their relatively large share in the consumer basket. Energy and processed food inflation rose to high levels in early 2010, but moderated by late 2011, reflecting commodity price changes with a time lag. The good local harvest in 2011 helped to keep unprocessed food inflation moderate and non-energy industrial goods prices, another typical channel of import price transmission, declined marginally in the past two years.

The nominal effective exchange rate of the lev (measured against a group of 35 trading partners) was relatively strong from early 2009, after the currencies of some trading partners depreciated to the euro in reaction to the financial crisis. This strength was lost by mid-2010 and then gradually regained by the summer of 2011. From late-2011, the nominal effective exchange rate of the lev depreciated somewhat. Overall, fluctuations in the nominal effective exchange rate do not appear to have had a significant impact on inflation developments.

Administered prices and taxes

Administered prices ([20]) and indirect tax changes played a significant role in determining Bulgarian inflation over the past few years. The share of administered prices in the HICP basket is around 16%. The annual increase of administered prices fell from 3.6% in 2010 to 2.6% in 2011, as pressure to correct the budget deficit abated, but energy prices were increasingly pushing up costs. Overall, administered prices lifted headline inflation in 2010, but lowered it in 2011. The excise tax increase on tobacco in 2010 had a major impact on the price level, but other indirect tax changes were not significant.

The pressing need for fiscal consolidation led to significant increases in administered prices in 2010, mostly in the categories of water supply, sewage collection, pharmaceutical products, education and other services. In 2011, the price of hospital services went up markedly. On the other hand, the price increase of electricity was low over the past two years, while the price of heat energy fluctuated with global energy prices.

In line with tax harmonisation requirements within the EU and the need to increase budget revenues, the excise tax on tobacco was raised sharply in the beginning of 2010. Accordingly, tobacco products contributed by an estimated 1.3 and 0.5 percentage points to average annual inflation in 2010 and 2011, respectively.

Medium-term prospects

After the decline until March 2012, inflation is expected to pick up slightly during the course of 2012, as commodity price increases in the beginning of the year will feed through and high nominal wage growth is set to lift services prices, despite weak domestic demand. Accordingly, the Commission services' 2012 Spring Forecast projects annual average inflation at 2.6% in 2012 and 2.7% in 2013.

Risks to the inflation outlook appear to be broadly balanced. A stronger economic recovery with an even faster private sector wage growth, potentially spreading to the public sector, a recovery in bank lending or a further rise in global commodity prices would raise inflationary pressures. Conversely, a moderation of wage growth due to high unemployment or a reversal of international commodity prices would have disinflationary effects.

The level of consumer prices in Bulgaria was at 49% of the euro area average in 2010. Over the long run, there is significant potential for further price level convergence, in line with the expected catching-up of the Bulgarian economy (Bulgaria's income level was at about 41% of the euro area average in PPS terms in 2010).

Medium-term inflation prospects will depend on the gap between wage and productivity growth, which could widen again, as the allocation of labour market resources does not appear to be efficient and unemployment created during the downturn could become structural. Bulgaria is particularly exposed to rising global commodity prices, due to the high share of commodity-type products in the consumer basket. A prudent fiscal stance is expected to help contain inflationary pressures, but the need to harmonize excise taxes with EU legal requirements on tobacco, natural gas, gas oil and kerosene is expected to add to inflation over the medium-term.

2.3. public finances

2.3.1. The excessive deficit procedure for Bulgaria

On 13 July 2010, the European Council adopted a decision on the existence of an excessive deficit in Bulgaria in accordance with Article 126(6) of TFEU. The decision was based on data notified by the Bulgarian authorities for the general government deficit in 2009, showing that the deficit exceeded the 3% of GDP reference value. The Council issued a set of recommendations to Bulgaria in accordance with Article 126(7) TFEU with a view to bringing an end to the situation of an excessive deficit by 2011. In its recommendations, the Council established a deadline of 13 January 2011 for effective action to be taken and invited the Bulgarian authorities to take necessary measures to avoid deterioration of the 2010 deficit beyond the planned 3.8% of GDP; ensure a fiscal effort of at least ¾% of GDP in 2011; and specify and implement the measures that were necessary to achieve the correction of the excessive deficit by 2011. To limit risks to the adjustment, Bulgaria was recommended to strengthen its fiscal governance and transparency by reinforcing the Ministry of Finance's spending controls, strengthening the binding nature of its medium-term budgetary framework as well as improving the monitoring of the budget execution throughout the year. The Bulgarian authorities were also invited to ensure that budgetary consolidation towards the medium-term objective for the budgetary position was sustained after the excessive deficit has been corrected. Finally, the Bulgarian authorities were encouraged to improve the efficiency of public spending by fully implementing the planned structural reforms in the area of public administration, healthcare, education, and pensions. On 15 February 2011, the Council concluded that Bulgaria had taken effective action representing adequate progress towards correcting its deficit within the time limit set in the recommendations and that no further steps under the excessive deficit procedure were required ([21]).

2.3.2. Recent fiscal developments

Bulgaria has maintained a relatively strong budgetary position prior to the crisis and in the context of a very tax-rich growth structure. The general government budget posted surpluses of above 1.5% of GDP on average in 2006-08 which contributed to the accumulation of sizeable fiscal reserves (above 12% of GDP in 2008). In 2009, however, the crisis impacted severely on public finances and the budget balance turned from a surplus of 1.7% of GDP in 2008 to a deficit of 4.3% of GDP in 2009. In response, the government undertook strict consolidation measures which led to a gradual improvement of the budgetary position over the period of 2010-11. The measures aimed at raising revenue collection while maintaining a tight control on the expenditure side, including through freezing the public sector wage bill and pensions. Thus, the general government deficit narrowed to 3.1% of GDP in 2010 and improved further to 2.1% of GDP in 2011, against an initially set target of 2.5% of GDP in the 2011 Convergence Programme.

The better-than-expected budget outcome in 2011 was mainly due to a further drop in the expenditure-to-GDP ratio, largely on account of lower-than-projected capital spending. Thanks to frontloading of the consolidation measures the structural deficit improved by 1.6 percentage points in 2010 and dropped further by another 0.5 percentage points to -1.0% of GDP in 2011. The fiscal consolidation was facilitated by a gradual recovery of GDP with the growth structure becoming more broad based.

Bulgaria's public debt is one of the lowest among the EU Member States. The debt-to-GDP ratio increased moderately from 14.6% in 2009 to 16.3% in 2010. The ratio stayed unchanged in 2011, thus remaining well below the 60% of GDP reference value. The debt dynamics reflect the negative impact from the development in the headline fiscal balance which is partly compensated by debt-reducing stock-flow adjustments related to drawing down the accumulated fiscal reserves.

2.3.3. Medium-term prospects

The 2012 Budget Law was adopted by parliament on 16 December 2011. The budget targets a general government deficit of 1.5% of GDP (1.3% of GDP in cash terms). There are no major tax policy or rate changes except for increasing the excise taxes on some energy goods to the minimum EU levels in accordance with agreed transition periods and the introduction of natural gas excise tax as of 1 June, 2012. Budget sector wage bill and pensions will be frozen for a third year in row.

In the Commission services' 2012 Spring Forecast the general government balance is projected to improve further to -1.9% and -1.7% of GDP in 2012 and 2013, respectively. The structural deficit is forecast to decline to -0.8% of GDP in 2013, implying a cumulative structural fiscal effort of 0.2 pp. over 2012-13. The general government gross debt is set to increase moderately from 16⅓% of GDP in 2011 to 18½% of GDP in 2013. The debt forecast does not include possible external debt issuance in 2012 to pre-fund the repayment of Eurobonds of around 2% of GDP in January 2013.

The 2012 Convergence Programme was submitted on 12 April 2012. After the expected correction of the excessive deficit in 2011, as recommended by the Council, the programme aims at achieving a close to balanced budget position by the end of the programme period (2015). The official targets for the general government budget balance have been marginally revised to -1.6% of GDP in 2012 and -1.3% of GDP in 2013, while the targets for 2014 and 2015 have been kept unchanged. The small deviation of the targets for 2012-2013 compared with the Commission services' 2012 Spring Forecast is mainly due to a more favourable macroeconomic scenario underlying the programme.

Further details on the assessment of the 2012 Convergence Programme for Bulgaria can be found in the forthcoming Commission Staff Working Document, which accompanies the Commission Recommendation for a Council Recommendation on the 2012 National Reform Programme of Bulgaria and delivering a Council Opinion on the 2012 Convergence Programme of Bulgaria ([22]).

In March 2012, Bulgaria signed the Treaty on Stability, Coordination and Governance in the EMU. This implies an additional commitment to conduct stability-oriented and sustainable fiscal policies. This Treaty will apply to contracting Member States with a derogation which have ratified the Treaty as from the date when the decision abrogating that derogation will come into force unless they declare their intention to be bound at an earlier date by some or all of the provisions on the fiscal compact and on economic policy coordination and convergence.

2.4. EXCHANGE RATE STABILITY

The Bulgarian lev does not participate in ERM II. The BNB pursues its primary objective of price stability through an exchange rate anchor in the context of a currency board arrangement (CBA). Bulgaria introduced its CBA on 1 July 1997, pegging the Bulgarian lev to the German mark and subsequently to the euro (at an exchange rate of 1.95583 BGN/EUR). Under the CBA, the BNB’s monetary liabilities have to be fully covered by its foreign reserves. The BNB is obliged to exchange monetary liabilities and euro at the official exchange rate without any limit. The CBA was instrumental in achieving macroeconomic stabilisation and serves as a key policy anchor.

Since the onset of the financial crisis, the CBA has operated in a difficult and uncertain environment, as capital inflows turned down and the banking sector was challenged by deteriorating asset quality and linkages to Greece. However, the export-driven economic recovery, a relatively strong public finance position and sizable reserve buffers have underpinned the resilience of the CBA.

Bulgaria's international reserves covered around 176% of the monetary base and close to half of broad money (M3) as of end-March 2012. A high reserve coverage was deliberately built into the framework for Bulgaria's CBA, to cater for potential financial sector stress following the 1996-97 crisis. The government keeps the bulk of its fiscal reserve deposited in the BNB. International reserves remained fairly stable over the past two years, as the reduction in government deposits was counterbalanced by other items, namely by increases in cash in circulation, banks' deposits and accumulated profit of the BNB. At end-2011, international reserves covered some 133% of Bulgaria's short-term debt (at original maturity, excluding liabilities related to direct investments).

The BNB does not set monetary policy interest rates. The domestic interest rate environment is directly affected by the monetary policy of the euro area through the operation of Bulgaria's CBA. Short-term interest rate differentials vis-à-vis the euro area spiked in late-2008 with tighter liquidity and heightened risk perception towards new Member States. The 3-month spread declined gradually until July 2011 from its peak of around 490 basis points of March 2009 and stabilized somewhat above 200 basis points since then. Bulgarian overnight interbank rates were however typically below those of the euro area in 2011 and early 2012.

2.5. LONG-TERM INTEREST RATEs

For Bulgaria, the development of long-term interest rates over the current reference period is assessed on the basis of secondary market yields on a single benchmark government bond with a residual maturity of close to, but below 10 years.

The Bulgarian 12-month moving average long-term interest rate relevant for the assessment of the Treaty criterion was above the reference value at the 2010 convergence assessment. It gradually declined from above 7% in early 2010 to somewhat above 5% by end-2011. In March 2012, the latest month for which data are available, the reference value, given by the average of long-term interest rates in Sweden and Slovenia plus 2 percentage points, stood at 5.8%. In that month, the twelve-month moving average of the yield on the Bulgarian benchmark bond stood at 5.3%, i.e. about 0.5 percentage points below the reference value.

The long-term interest rate spread vis-à-vis the euro area rose sharply in 2008, during the turmoil of the international financial crisis. The spread started to decline from autumn 2009, as Bulgarian bond yields fell with the calming of global financial tensions. There was a temporary bout of pressure in mid-2010 linked to the sovereign debt crisis and concerns about the quality of Bulgarian public finance statistics, but the improving trend resumed relatively soon. Long-term government yields of Bulgaria were broadly resilient to international financial tensions in late 2011, as the liquidity position of the local banking system improved by year-end. Spreads to the Bund remained elevated, reaching around 320 basis points in March 2012, as yields of the latter were influenced by safe haven inflows ([23]) .

2.6. ADDITIONAL FACTORS

The Treaty (Article 140 TFEU) calls for an examination of other factors relevant to economic integration and convergence to be taken into account in the assessment. The assessment of the additional factors – including balance of payments developments, product and financial market integration – is an important indication that the integration of a Member State into the euro area would proceed without difficulties.

The section on additional factors makes reference inter alia to the surveillance of macroeconomic imbalances under the Macroeconomic Imbalance Procedure (MIP - see also Box 1.5), embedded in the broader "European semester" approach to enhance the governance structures in EMU. Related to this, following the adoption of the legislation establishing the new procedure for surveillance and correction of macroeconomic imbalances (MIP) ([24]), the Commission published its Alert Mechanism Report (AMR) in February 2012 ([25]). The scoreboard shows that Bulgaria exceeds the indicative threshold in four out of ten indicators, three in the area of external imbalances (namely on the current account balance, net international investment position and nominal ULC growth) and one in the area of internal imbalances (on private sector debt). In line with the conclusion of the AMR which was based on economic analysis and the scoreboard for 2010, Bulgaria was subject to an in-depth review in the context of the MIP.

2.6.1. Developments of the balance of payments

Bulgaria's external balance (i.e. the combined current and capital account) adjusted from very large deficits until 2008 to around balance in 2010 and to a surplus of around 2% of GDP in 2011. The improvement was mostly on account of merchandise trade, as imports fell with lower domestic demand, but exports also grew dynamically in 2010 and 2011. The surpluses on services and current transfers increased, the latter favourably influenced by remittances of Bulgarians working abroad. The income account improved temporarily in 2009, reflecting lower profits on FDI, but it returned close to 2008 levels in 2011. The current transfers and capital account surpluses also reflect sizeable net inflows from EU funds, although EU funds absorption could be improved further.

The large savings-investment gaps of 2006-2008 closed by 2010, as capital flows moderated following the international financial crisis. Gross national savings hovered at a historically high level of around 25% of GDP in 2011, as companies underwent balance sheet adjustment after several years of high credit growth and households were cautious in the context of rising unemployment. Gross fixed capital formation declined both in 2010 and 2011, as firms postponed investment in the uncertain economic environment.

Competitiveness indicators showed a mixed picture in the past years. After some correction in 2009 and early 2010, the ULC-deflated real-effective exchange rate continued its sharp appreciation trend, partly due to the rising NEER and ULC of Bulgaria, while the HICP- and manufacturing sector ULC-based REER remained considerably more stable. Bulgaria’s export market share increased significantly in 2010 and 2011, although the pace of improvement moderated with the slow-down in export growth towards the end of 2011.

Mirroring the improvement in the external balance, the financial account turned into a deficit by 2010. The net FDI balance remained positive, but diminished, as new investments were mainly related to companies already present in Bulgaria. The long-term trend of net outflows of portfolio investment continued, as the government did not issue on the international market and interest in the Bulgarian stock market remained weak. The reduction in net external funding of the banking sector resulted in a significant deficit on net other inflows, especially in 2011. Gross external debt to GDP declined significantly from around 108% at end-2009 to about 92% by end-2011, supported by strong nominal GDP growth and repayment of foreign debt by the banking sector. The improvement was similar in the net international investment position, but its negative balance remained substantial.

According to the Commission services’ Spring 2012 Forecast, the external surplus is projected to remain unchanged in 2012, as domestic demand is expected to stagnate while export growth is to slow somewhat.

2.6.2. Product market integration

The Bulgarian economy is well integrated into the EU economy through trade and investment linkages. As a small open economy, Bulgaria is characterised by a high ratio of trade openness reaching 70% of GDP in the recent years. In 2009, the global crisis resulted in a temporary contraction of trade openness, as external demand faltered and both imports and exports contracted in real terms. The rebound of global trade in 2010 resulted in an increase in openness, both on the export and import side. This trend was maintained in 2011.

Bulgaria shows a pattern of intermediate technology exports. Trade in goods reveals a comparative advantage mainly in the export of textiles, basic metals, fuels and tobacco, registering a combined 60% export share in 2010. A breakdown of exported goods by product category demonstrates a predominance of labour- and raw-material-intensive, low- and medium-quality goods over high technology goods. The share of high value-added goods in exports has increased slightly recently (reaching 4.6% of GDP in 2009), reflecting a gradual, albeit slow, upward shift in the economy's specialisation pattern in the productivity scale while the technological trade deficit almost halved in 2009 (-2%) compared to 2005 (-3.6%). In the medium-to-long term, the economy should move further away from labour-intensive sectors towards a larger reliance on higher value-added sectors and services.

FDI inflows were more than three times higher than the EU 27 average in the period 2005-2010. Bulgaria particularly benefited from lower costs of inputs, especially labour, and a fairly well-trained work force. FDI inflows peaked at around 29% of GDP in 2007 and dried up considerably during the global economic crisis down to 3.4% of GDP in 2010. The FDI stock was 101% of GDP at the end 2009, substantially higher than that in Romania (42%) and the EU 27 average (70%). The EU 27 is the main contributor to FDI inflows, accounting for well over 85% of total FDI stock at the end of 2009 (the most important source countries were the Netherlands, Austria and Greece). The dominant part of the FDI inflows went however to industries serving local needs, including housing construction and trade and did not significantly improve the export capacity of the country. Almost 70% of the total FDI stock at the end of 2009 was in the service sector (real estate and business activities, and financial intermediation), while the share of FDI in manufacturing (food, textile, metal and chemical products) was around 16%.

House prices and residential construction boomed prior to the crisis. The cumulative real house price growth from trough (in the second quarter of 2002) to peak (in the third quarter of 2008) stood at around 230%, with average quarterly year-on-year price growth reaching 23%. Real house prices dropped substantially during the crisis, by close to 40% since the end of 2008. From 2004 until 2008 the share of residential construction in GDP tripled (as it went from about 2% to 6%), and readjusted to about 4% in 2010. The correction in building permits started already in 2008, is still on-going, and has been much sharper than the correction in investment.

Concerning the business environment, Bulgaria scores below the average of euro area Member States in international rankings ([26]). Based on the World Bank Doing Business indicators, the performance of Bulgaria deteriorated in 2011 in the area of starting a business, dealing with construction permits and registering property, and protecting investors and resolving insolvency. In terms of income and corporate tax rates, Bulgaria is still very competitive in the EU. Finally, according to the November 2011 Internal Market Scoreboard, Bulgaria had a transposition deficit below the EU average (0.9% compared to 1.2%) while the share of public procurement tenders announced in the EU Official Journal has been higher than the EU average (average of 47.4% between 2007 and 2010 compared to 17.7% for the EU 27) ([27]) .

2.6.3. Financial market integration

Bulgaria's financial sector is well integrated into the EU financial system, in particular through a high level of foreign ownership in its banking sector. The share of foreign-owned institutions in total credit institution assets remained broadly stable at over 80%. Bank concentration, as measured by the market share of the largest five credit institutions in total assets, decreased somewhat since EU accession, but was still above the euro area average in 2010.

Financial intermediation in Bulgaria is mainly indirect, with domestic bank credit above 70% of GDP at the end of 2011. Rapid credit expansion ended by 2009 as changes in the international financial environment constrained access to foreign funding and the economy started to deleverage. The attractiveness of domestic deposit collection increased and competition among banks led to high deposit rates in some periods. By the end of 2011, the banking sector managed to substantially reduce its reliance on external funding from the 2009 levels and most banks had only small net external positions. Credit to non-financial corporations by the domestic banking sector increased modestly since 2009, partly due to accounting reasons (cross-border transfers of debt owed previously to non-residents). The share of foreign currency loans (predominantly in euro) increased somewhat during the past two years and stood around 77% for non-financial corporations and 40% for households at the end of 2011.

The Bulgarian financial system has proved resilient to the international financial crisis and its consequences. No banking system rescue measure had to be taken by the government. Confidence in the currency board arrangement is strong and international reserves remain at high level, supported by government deposits, which were prudently accumulated earlier. Contagion from Greece has remained limited, despite significant Greek ownership in the Bulgarian banking sector.

Slow mortgage lending and unsold real estate projects contributed to declining house prices in 2011, but profitability of the domestic banking sector remained positive ever since EU accession. The banking system is fairly liquid and well capitalized, with a capital adequacy ratio of 17.5% at the end of 2011. The quality of the loan portfolio is, however, still deteriorating, with the share of non-performing loans reaching 14.9% at end 2011, as domestic demand recovery has been weak.

The non-bank financial sector remains underdeveloped relative to the euro area. Total assets managed by insurance companies, though growing, are still very low at 4.1% of GDP at the end of 2010. Health insurance, in particular, is still characterised by a very low penetration rate in Bulgaria. Pension funds have shown a somewhat more dynamic development since the start of the financial crisis, with total assets increasing from 3.3% of GDP in 2008 to 5.7% of GDP in 2010.

The deepening of capital markets, which progressed considerably during the economic boom, came to a halt with the financial crisis. The capitalization of the stock market declined markedly since its highs of 2007, but it regained more than 15% in 2011. The debt securities market remains small in comparison with the euro area average and is mainly used for financing a part of Bulgaria's relatively low public debt. Private sector debt of 169% of GDP in 2010 is slightly above the euro area average (164.6% of GDP) ([28]).

Regulation and supervision of the monetary financial institutions is conducted by the BNB. Since 1 March 2003, all players in the non-banking financial sector and the capital markets are under the supervision of a single regulator, the Financial Supervision Commission (FSC). The FSC cooperates closely with the BNB, as well as with international partners, especially from the neighbouring countries. While all FSAP directives have been transposed, no notification has been received yet by the European Commission on the transposition of two of the post-FSAP directives.

3.1. legal compatibility

3.1.1. Introduction

Česká národní banka (ČNB – central bank of the Czech Republic) was established on January 1, 1993, following the division of the State Bank of Czechoslovakia. Its creation was based on the Czech National Council Act No. 6/1993, adopted on December 17, 1992.

The Act on ČNB was last amended in 2010 and 2011. The recent amendments did not introduce significant changes which would remove the incompatibilities or imperfections covered by the last Convergence Report.

3.1.2. Independence

Article 9(1) of the ČNB Act in conjunction with Article II(1)(c) of the Law No 442/2000 Coll prohibit ČNB and its Board from taking instructions from the President of the Czech Republic, Parliament, the Government, administrative authorities, European Union institutions, any government of a Member State of the European Union or any other body.

According to Article 3 of the Act on the ČNB, the ČNB shall submit a report on the monetary development to the Chamber of Deputies of the Parliament for review. The Chamber of Deputies may ask for a revised report and in this case, the ČNB will have to submit a revised version complying with the Chamber of Deputies' requirements. This legal possibility for the Parliament to ask for amendments and, thus, to influence the content of the ČNB's report on the monetary development can affect the ČNB's institutional independence. For this reason, Article 3 contradicts Article 9(1) and is considered as incompatible with Article 130 of the TFEU and Article 7 of the ESCB/ECB Statute.

Further, Article 9(1) of the Act and Article II(1)(c) of the Law 442/2000 need to be adapted to fully reflect the provisions of Article 130 of the Treaty and Article 7 of the Statute and consequently to expressly prohibit third parties from giving instructions to the ČNB and its Board members who are involved in ESCB-related tasks.

Articles 7 and 8 of the Law provide for the replacement of the Governor by a Vice-Governor nominated by him in case of absence. To ensure smooth and continuous functioning of the ČNB in case of expiry of the term of office, resignation, dismissal or other cause of termination of office, the Act needs to remove this imperfection and provide for procedures and rules regarding the successor of the Governor in cases of termination of office.

The possibility for the Chamber of Deputies of the Parliament to request modifications (Article 47(5)), to the submitted earlier annual financial report, could also hamper the ČNB’s institutional (and possibly financial) independence. Thus, Article 47(5) constitutes a further incompatibility which should be removed from the Act.

As regards the personal independence of the ČNB's decision making bodies, Article 6(11)-(13) provides for grounds of dismissal, which are not exactly corresponding to those of Article 14.2 of the ESCB/ECB Statute. In order to remove this incompatibility and limit interpretation problems those provisions should be brought in line with Article 14.2 of the ESCB/ECB Statute.

Pursuant to Article 11(1) of the ČNB Act the Minister of Finance or another nominated member of the Government may attend the meetings of the Bank Board in an advisory capacity and may submit motions for discussion. Paragraph (2) of this Article provides for a possibility for the Governor of the ČNB, or a Vice-Governor nominated by him, to attend the meetings of the Government in an advisory capacity. With regard to Article 11(1), although a dialogue between a central bank and third parties is not prohibited as such, it should be ensured that this dialogue is constructed in such a way that the Government should not be in a position to influence the central bank when the latter is adopting decisions for which its independence is protected by the TFEU. The active participation of the Minister, even without voting right, to discussions where monetary policy is set would structurally offer to the Government the possibility to influence the central bank when taking its key decisions. Therefore, Article 11(1) is incompatible with Article 130 of the TFEU, as Member States have to take undertake not to seek to influence the members of the decision-making bodies of the national central bank

3.1.3. Prohibition of monetary financing

According to Article 30(2) of the Act on the ČNB, the ČNB is not allowed to provide returnable funds or any other financial support to the Czech Republic or its bodies or to any other authority and body governed by public law, with the exception of public banks. The wording of this provision constitutes an imperfection. It is rather extensive and does not take fully into account Article 123(2) of the TFEU. It provides de facto a wider exemption than the one foreseen in Article 123(2) of the TFEU, which exempts publicly owned credit institutions only 'in the context of the supply of reserves by central banks'.

In addition, point 1(d) of Section II of Law No 442/2000 Coll. does not cover the prohibition on a direct purchase by the ČNB of debt instruments from public sector entities and thus, it constitutes a further incompatibility with Article 123(1) of the TFEU. For legal certainty reasons, Article 30(2) and point 1(d) of Section II of Law No 442/2000 Coll should be amended to ensure the correct application of the EU law in the field of prohibition of monetary financing.

3.1.4. Integration in the ESCB

Objectives

No incompatibilities with the TFEU exist in this area.

Tasks

The incompatibilities in this area, following the TFEU provisions and ESCB/ECB Statute, include:

· definition of monetary policy and monetary functions, operations and instruments of the ECB/ESCB (Articles 2(2)(a), 5(1) and 23 to 26a, 28, 29, 32, 33);

· conduct of exchange rate operations and the definition of exchange rate policy (Articles 35 and 36);

· holding and management of foreign reserves (Article 1(4) and Articles 35(d) and 36);

· non-recognition of the competences of the ECB and of the Council on the banknotes and coins (Article 2(2)(b), Articles 12 to 22);

· ECB's right to impose sanctions (Article 46b).

There are also some imperfections regarding:

· the absence of reference of the role of the ECB and of the EU for the collection of statistics (Article 41);

· non-recognition of the role of the ECB for the functioning of the payment systems (Article 38);

· non-recognition of the role of the ECB and of the Council for the appointment of the external audit of the ČNB (Article 48(2));

· absence of an obligation to comply with the Eurosystem's regime for the financial reporting of NCB operations (Article 48);

· non-recognition of the role of the ECB in the field of international cooperation (Article 40).

3.1.5. Assessment of compatibility

As regards the independence of the central bank, the prohibition on monetary financing and the central bank integration into the ESCB at the time of euro adoption, the legislation in Czech Republic, in particular the Act on the ČNB, is not fully compatible with the compliance duty under Article 131 of the TFEU.

3.2. PRICE STABILITY

3.2.1. Respect of the reference value

The 12-month average inflation rate for the Czech Republic, which is used for the convergence evaluation, was below the reference value at the time of the last convergence assessment in 2010. Average annual inflation bottomed out at 0.3% in the second quarter 2010, before increasing gradually until early 2012. In March 2012, the reference value was 3.1%, calculated as the average of the 12-month average inflation rates in Sweden, Ireland and Slovenia plus 1.5 percentage points. The corresponding inflation rate in the Czech Republic was 2.7%, i.e. 0.4 percentage points below the reference value. The 12-month average inflation rate is projected to increase above the reference value in the months ahead.

3.2.2. Recent inflation developments

Annual HICP inflation in the Czech Republic moved broadly in sync with euro area levels in the period between 2004 and late 2007. Inflation spiked temporarily, but very sharply, in 2008 amid rising commodity prices and increases in indirect taxes and administered prices. In 2009, when the effects of large negative cost-push factors receded and the Czech economy entered recession, annual inflation fell sharply and briefly became negative. Inflation remained subdued in 2010 and for most of 2011 amid muted domestic demand, while developments in global commodity prices and the koruna's exchange rate were the main factors affecting domestic prices. Headline inflation picked up towards end-2011, and remained at a higher level in early 2012, largely reflecting an increase in the VAT preferential rate with effect from January 2012.

Subdued core inflation (measured as HICP inflation excluding energy and unprocessed food), averaging 1.0% in 2010-2011, suggests that underlying price and cost pressures stemming from the real economy were moderate. Since 2010, headline inflation has been running well above core inflation largely due to sizeable energy price increases. Core inflation was partly pushed down by negative non-energy industrial goods inflation due to the volatile but on the whole appreciating koruna exchange rate since 2009. Conversely, relatively sharp price increases in processed food since around mid-2010, amid rising commodity prices and indirect taxes, drove core inflation higher. Annual average producer price inflation for total industry increased to 5.5% in 2011, indicating elevated cost price pressures related to commodity price increases.

3.2.3. Underlying factors and sustainability of inflation

Macroeconomic policy-mix and cyclical stance

The Czech economy is estimated to have been operating well below its potential during the global economic crisis. Economic growth turned negative in 2009, dragged down by a collapse of external demand. Strong exports lifted annual GDP growth to positive territory in 2010 and 2011 (to an average of 2.2%), but muted domestic demand amid the ongoing fiscal consolidation and weak confidence indicators did not allow for a sustained recovery. GDP growth is projected to remain flat in 2012, affected by economic weakness in the euro area, and to increase to 1.5% in 2013 as external conditions gradually improve, according to the Commission services' Spring 2012 Forecast. The Commission services' estimates suggest a sizeable negative output gap to remain over the medium term.

The fiscal stance, as measured by changes in the structural balance, has been restrictive since 2009. The decline in the headline deficit in 2010 and 2011 reflected an improvement in both the cyclical and structural component, with the latter mirroring the impact of fiscal consolidation measures. The fiscal stance is expected to be tightened further in 2012 and to remain stable in 2013.

Monetary policy, conducted within an inflation targeting framework ([29]), was loosened in 2009 and early 2010 in view of an improved inflation outlook amid the sharp economic downturn. The ČNB lowered the key policy rate by a cumulative 150 basis points to 0.75% between early 2009 and May 2010. In 2011, ex post real interbank interest rates were negative due to an increase in headline inflation. The depreciation of the koruna's exchange rate in the second half 2011 contributed further to an easing of monetary conditions. Credit growth to the private sector slowed down markedly during the crisis amid unfavourable cyclical conditions, though the economy saw some signs of a revival in lending activity in 2011.

Wages and labour costs

The labour market was considerably impacted by the economic downturn. The unemployment rate increased from a low of 4.4% in 2008 to around 7% on average in 2010-2011. Employment fell markedly in 2009-2010, on account of labour shedding in the private sector and cuts in the public sector workforce, and staged only a very modest recovery in 2011. Growth in nominal compensation per employee declined from 3.7% in 2010 to 1.6% in 2011 amid a weakening economy, and an increase of around 2% is expected in 2012 and 2013. Labour productivity growth should remain broadly flat in 2012, but it is projected to regain some momentum in line with a gradual recovery of economic activity in 2013. As a result, growth in nominal unit labour costs (ULC) is projected to remain muted in 2012-2013.

The wage-setting process in the private sector is decentralised, with wage agreements largely at the enterprise level. Wage developments, in particular in the private sector, reacted swiftly to the economic downturn. Public sector wage restraint also contributed to a moderate growth of wage costs for the whole economy in 2010-2011. In line with fiscal consolidation efforts of the Czech government, the budget for 2012 assumes continuation of a freeze in the public sector wage bill. In January 2012, the Czech Republic revised the Employment Act and the Labour Code, which is expected to contribute to flexibility on the labour market.

External factors

Given the high degree of openness of the Czech Republic, developments in import prices play an important role in domestic price formation. Import prices, as measured by the imports of goods deflator in the national accounts, contributed to disinflation during the economic downturn in 2009. The annual increase in import prices is projected to pick up gradually in the period of 2010-2012. The inflationary effect of import prices is expected to diminish in 2013 in line with the assumed path for commodity prices.

Import prices were driven up in 2010-2011 by volatile – but on the whole rising – global commodity prices. The contribution of energy prices to HICP inflation increased from around 0.4 percentage points in 2009 to around 0.8 percentage points on average in 2010-2011. Unprocessed food inflation, after increasing markedly in 2010, became negative in the second half of 2011; this reflected easing global food prices, but also the price-dampening effect of favourable domestic harvest.

Import price dynamics have been significantly influenced by fluctuations of the koruna. Most available estimates suggest that the pass-through of the exchange rate to inflation in the Czech Republic is substantial and fast. The koruna's nominal effective exchange rate (measured against a group of 35 trading partners) strengthened by about 9% between 2009 and mid-2011; this helped to moderate the inflationary impulses emanating from global commodity markets. A weakening impetus set in during the second half of 2011 amid a rise in global risk aversion, when the koruna's nominal effective exchange rate lost about 5%.

Administered prices and taxes

Changes in administered prices and indirect taxes have been an important driver of inflation dynamics in the Czech Republic in recent years. The contribution of indirect taxes to headline inflation was particularly strong in 2008 and 2010, notably mirroring fiscal consolidation efforts of the government. The inflationary impact of changes in administered prices has however been on a declining trend. Administered prices had a weight in the HICP basket of around 11% in 2011, i.e. down by about 8 percentage points compared to 2004 ([30]).

Administered price inflation declined from 5% in 2010 to 2.9% in 2011, while the narrowing gap vis-à-vis headline average inflation remained positive. The administered price increases in 2011 occurred particularly for items with a comparatively low weight in the headline index (rail fares, postal services and highway toll stickers). The indirect tax changes in 2010 included a 1 percentage point increase in both standard and preferential VAT rates and rising excise duties (on tobacco, alcohols and motor fuels). In January 2012, the preferential VAT rate was increased by 4 percentage points to 14% and there was a relatively modest excise duty increase for cigarettes (in line with tax harmonisation requirements within the EU); the first-round effect of these indirect tax changes is estimated to have contributed by around 1 percentage point to annual headline inflation. For 2013, the Czech government plans another 1 percentage point increase in both standard and preferential VAT rates.

Medium-term prospects

Inflation is projected to remain higher in 2012 compared to recent years, in response to the preferential VAT rate increase. Domestic price pressures are, however, expected to remain muted amid a difficult external environment and sluggish domestic demand going forward. Second-round effects from price increases on inflation expectations and wage growth seem unlikely given the weak economy. On this basis, the Commission services' Spring 2012 Forecast projects annual HICP inflation to average 3.3% in 2012 and 2.2% in 2013.

Risks to this inflation outlook are broadly balanced. There are still some downside risks to economic activity, particularly as the weakness in the euro area may affect the highly open economy through the trade channel. Conversely, upside risks are mainly related to a possible further rise in commodity prices. There is also an important two-sided risk to inflation stemming from the koruna's exchange rate.

The level of consumer prices in the Czech Republic was at some 72% of the euro area average in 2010, with the relative price gap widest for services. This suggests potential for further price level convergence in the long term, as income levels (about 74% of the euro area average in PPS in 2010) increase gradually towards the euro area average.

Medium-term inflation prospects will continue to hinge upon productivity and wage developments as well as on the functioning of product markets (e.g. energy and telecommunication prices). Over the longer term, in view of the negative demographic outlook, further measures to increase labour supply and facilitate the effective allocation of labour resources will play a key role in alleviating possible wage pressures.

3.3. public finances

3.3.1. The excessive deficit procedure for the Czech Republic

On 2 December 2009, the Council decided that an excessive deficit existed in the Czech Republic in accordance with Article 126(6) of the Treaty on the Functioning of the European Union (TFEU) and addressed recommendations to the Czech Republic in accordance with Article 126(7) with a view to bringing an end to the situation of an excessive government deficit by 2013. In its recommendations, the Council invited the Czech Republic to ensure an average annual fiscal effort of 1% of GDP over the period 2010-2013. The Council established the deadline of 2 June 2010 for the Czech government to take effective action to implement the deficit reducing measures in 2010 as planned in the draft budget law for 2010 and to outline in some detail the consolidation strategy that will be necessary to progress towards the correction of the excessive deficit. On 13 July 2010 the Council concluded that the Czech authorities had taken effective action to correct the excessive deficit and that no additional steps in the excessive deficit procedure were necessary at that stage ([31]).

3.3.2. Recent fiscal developments

Fiscal policy before the crisis (2006-2008) provided some pro-cyclical stimulus to economic activity as the structural deficit averaged 3.8% of GDP in a relatively high-growth environment. Good economic times were thus not exploited to make progress with fiscal consolidation. Worsening economic conditions during the crisis put a serious strain on public finances. The general government deficit increased from 2.2% of GDP in 2008 to 5.8% of GDP in 2009, mainly as a result of the economic downturn and discretionary measures taken to counter the impact of the crisis. Faced with a severe deterioration of the deficit in 2009, the Czech authorities decided to withdraw temporary stimulus measures and start fiscal consolidation already in 2010. Consolidation measures included increases in indirect and real estate taxes and cuts in social benefits. Revenue shortfalls and expenditure slippages prompted the government to implement additional cuts in government consumption in the course of 2010 amounting to around 0.5% of GDP. Overall, the expenditure-to-GDP ratio declined by 0.8 percentage points to 44.1% while the revenue-to-GDP ratio increased by 0.2 percentage points to 39.3%, resulting in a reduction of the general government deficit to 4.8% of GDP in 2010.

With consolidation efforts continuing also in 2011, the general government deficit dropped further to 3.1% of GDP. This is a significantly lower outcome than the target of 4.2% of GDP announced in the Czech Republic's 2011 Convergence Programme. Higher-than-expected savings were achieved on the expenditure side, in particular in government consumption and debt servicing. By far the