Convergence Report 2014

Member States

BG Bulgaria CZ Czech Republic

HR Croatia

LT Lithuania

HU Hungary

PL Poland

RO Romania

SE Sweden

EA Euro area

EA-18 Euro area, 18 Member States

EA-17 Euro area, 17 Member States before 2014

EU-28 European Union, 28 Member States

EU-27 European Union, 27 Member States before July 2013 (i.e. EU-28 excl. HR)

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

HRK Croatian kuna

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)

HNB Hrvatska narodna banka (Croatian National Bank – central bank of Croatia)

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

BSE Budapest Stock Exchange

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

FGS Funding for Growth Scheme

FSA Financial Supervisory Authority

FSAP Financial Sector Action Plan

GDP Gross domestic product

HICP Harmonised index of consumer prices

HFSA Hungarian Financial Supervisory Authority

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 Najwyższa 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

ZSE Zagreb Stock Exchange

Convergence Report 2014 1

Convergence Report 2014 - Technical annex 3

1. Introduction 5

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 13

1.2.5. Long-term interest rates 13

1.2.6. Additional factors 13

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 18

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. Recent fiscal developments 22

2.3.2. Medium-term prospects 23

2.4. EXCHANGE RATE STABILITY 24

2.5. LONG-TERM INTEREST RATEs 24

2.6. ADDITIONAL FACTORS 25

2.6.1. Developments of the balance of payments 25

2.6.2. 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 31

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 39

3.6.1. Developments of the balance of payments 40

3.6.2. Market integration 41

3.6.3. Financial market integration 43

4. Croatia 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 45

4.1.4. Integration in the ESCB 45

4.1.5. Assessment of compatibility 45

4.2. PRICE STABILITY 45

4.2.1. Respect of the reference value 45

4.2.2. Recent inflation developments 46

4.2.3. Underlying factors and sustainability of inflation 46

4.3. public finances 48

4.3.1. The excessive deficit procedure for Croatia 48

4.3.2. Recent fiscal developments 49

4.3.3. Medium-term prospects 50

4.4. EXCHANGE RATE STABILITY 51

4.5. LONG-TERM INTEREST RATEs 52

4.6. additional factors 53

4.6.1. Developments of the balance of payments 53

4.6.2. Market integration 54

4.6.3. Financial market integration 56

5. Lithuania 59

5.1. LEGAL COMPATIBILITY 59

5.1.1. Introduction 59

5.1.2. Central bank independence 59

5.1.3. Prohibition of monetary financing and privileged access 59

5.1.4. Integration in the ESCB 59

5.1.5. Assessment of compatibility 60

5.2. PRICE STABILITY 60

5.2.1. Respect of the reference value 60

5.2.2. Recent inflation developments 60

5.2.3. Underlying factors and sustainability of inflation 61

5.3. PUBLIC FINANCES 63

5.3.1. Recent fiscal developments 63

5.3.2. Medium-term prospects 64

5.4. EXCHANGE RATE STABILITY 65

5.5. LONG-TERM INTEREST RATES 66

5.6. ADDITIONAL FACTORS 67

5.6.1. Developments of the balance of payments 67

5.6.2. Market integration 68

5.6.3. Financial market integration 70

5.7. Sustainability of convergence 71

6. Hungary 77

6.1. LEGAL COMPATIBILITY 77

6.1.1. Introduction 77

6.1.2. Central Bank independence 77

6.1.3. Prohibition of monetary financing and privileged access 77

6.1.4. Integration in the ESCB 78

6.1.5. Assessment of compatibility 79

6.2. PRICE STABILITY 79

6.2.1. Respect of the reference value 79

6.2.2. Recent inflation developments 79

6.2.3. Underlying factors and sustainability of inflation 80

6.3. PUBLIC FINANCES 83

6.3.1. Recent fiscal developments 83

6.3.2. Medium-term prospects 84

6.4. EXCHANGE RATE STABILITY 85

6.5. LONG-TERM INTEREST RATEs 86

6.6. ADDITIONAL FACTORS 86

6.6.1. Developments of the balance of payments 87

6.6.2. Market integration 88

6.6.3. Financial market integration 90

7. Poland 93

7.1. LEGAL COMPATIBILITY 93

7.1.1. Introduction 93

7.1.2. Central bank independence 93

7.1.3. Prohibition of monetary financing and privileged access 94

7.1.4. Integration in the ESCB 94

7.1.5. Assessment of compatibility 94

7.2. PRICE STABILITY 94

7.2.1. Respect of the reference value 94

7.2.2. Recent inflation developments 95

7.2.3. Underlying factors and sustainability of inflation 96

7.3. PUBLIC FINANCES 98

7.3.1. The excessive deficit procedure for Poland 98

7.3.2. Recent fiscal developments 98

7.3.3. Medium-term prospects 99

7.4. EXCHANGE RATE STABILITY 100

7.5. LONG-TERM INTEREST RATEs 100

7.6. ADDITIONAL FACTORS 101

7.6.1. Developments of the balance of payments 101

7.6.2. Market integration 103

7.6.3. Financial market integration 104

8. Romania 107

8.1. Legal compatibility 107

8.1.1. Introduction 107

8.1.2. Central Bank independence 107

8.1.3. Prohibition of monetary financing and privileged access 108

8.1.4. Integration in the ESCB 109

8.1.5. Assessment of compatibility 109

8.2. PRICE STABILITY 109

8.2.1. Respect of the reference value 109

8.2.2. Recent inflation developments 110

8.2.3. Underlying factors and sustainability of inflation 111

8.3. PUBLIC FINANCES 113

8.3.1. Recent fiscal developments 113

8.3.2. Medium-term prospects 114

8.4. EXCHANGE RATE STABILITY 115

8.5. LONG-TERM INTEREST RATEs 116

8.6. ADDITIONAL FACTORS 117

8.6.1. Developments of the balance of payments 117

8.6.2. Market integration 119

8.6.3. Financial market integration 120

9. Sweden 123

9.1. LEGAL COMPATIBILITY 123

9.1.1. Introduction 123

9.1.2. Central Bank Independence 123

9.1.3. Prohibition of monetary financing and privileged access 123

9.1.4. Integration in the ESCB 124

9.1.5. Assessment of compatibility 125

9.2. Price stability 125

9.2.1. Respect of the reference value 125

9.2.2. Recent inflation developments 125

9.2.1. Underlying factors and sustainability of inflation 125

9.3. Public finances 128

9.3.1. Recent fiscal developments 128

9.3.2. Medium-term prospects 128

9.4. Exchange rate stability 129

9.5. Long-term interest rates 130

9.6. Additional factors 131

9.6.1. Developments of the balance of payments 131

9.6.2. Market integration 133

9.6.3. Financial market integration 134

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 26

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. Croatia - Components of inflation 48

4.2. Croatia - Other inflation and cost indicators 49

4.3. Croatia - Budgetary developments and projections 50

4.4. Croatia - Balance of payments 54

4.5. Croatia - Product market integration 55

5.1. Lithuania - Components of inflation 60

5.2. Lithuania - Other inflation and cost indicators 62

5.3. Lithuania - Budgetary developments and projections 64

5.4. Lithuania - Balance of payments 68

5.5. Lithuania - Product market integration 69

6.1. Hungary - Components of inflation 80

6.2. Hungary - Other inflation and cost indicators 81

6.3. Hungary - Budgetary developments and projections 83

6.4. Hungary - Balance of payments 87

6.5. Hungary - Product market integration 89

7.1. Poland - Components of inflation 95

7.2. Poland - Other inflation and cost indicators 96

7.3. Poland - Budgetary developments and projections 98

7.4. Poland - Balance of payments 102

7.5. Poland - Product market integration 103

8.1. Romania - Components of inflation 110

8.2. Romania - Other inflation and cost indicators 112

8.3. Romania - Budgetary developments and projections 114

8.4. Romania - Balance of payments 118

8.5. Romania - Product market integration 119

9.1. Sweden - Components of inflation 126

9.2. Sweden - Other inflation and cost indicators 127

9.3. Sweden - Budgetary developments and projections 129

9.4. Sweden - Balance of payments 132

9.5. Sweden - Product market integration 133

LIST OF Graphs

2.1. Bulgaria - Inflation criterion since 2008 19

2.2. Bulgaria - HICP inflation 19

2.3. Bulgaria - Inflation, productivity and wage trends 21

2.4. Exchange rates - BGN/EUR 24

2.5. Bulgaria - 3-M Sofibor spread to 3-M Euribor 24

2.6. Bulgaria - Long-term interest rate criterion 25

2.7. Bulgaria - Long-term interest rates 25

2.8. Bulgaria - Saving and investment 26

2.9. Bulgaria - Effective exchange rates 26

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

2.11. Bulgaria - selected banking sector soundness indicators 29

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

3.1. Czech Republic - Inflation criterion since 2008 33

3.2. Czech Republic - HICP inflation 33

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

3.4. Exchange rates - CZK/EUR 38

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 39

3.8. Czech Republic - Saving and investment 40

3.9. Czech Republic - Effective exchange rates 40

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

3.11. Czech Republic - selected banking sector soundness indicators 43

3.12. Czech Republic - Recent development of the financial system relative to the euro area 43

4.1. Croatia - Inflation criterion since 2008 46

4.2. Croatia - HICP inflation 46

4.3. Croatia - Inflation, productivity and wage trends 47

4.4. Exchange rates - HRK/EUR 51

4.5. Croatia - 3-M Zibor spread to 3-M Euribor 52

4.6. Croatia - Long-term interest rate criterion 52

4.7. Croatia - Long-term interest rates 52

4.8. Croatia - Saving and investment 53

4.9. Croatia - Effective exchange rates 54

4.10. Croatia - Foreign ownership and concentration in the banking sector 56

4.11. Croatia - selected banking sector soundness indicators 57

4.12. Croatia - Recent development of the financial system relative to the euro area 57

5.1. Lithuania - Inflation criterion since 2008 60

5.2. Lithuania - HICP inflation 61

5.3. Lithuania - Inflation, productivity and wage trends 62

5.4. LTL - Spread vs central rate 65

5.5. Exchange rates - LTL/EUR 65

5.6. Lithuania - 3-M Vilibor spread to 3-M Euribor 66

5.7. Lithuania - Long-term interest rate criterion 66

5.8. Lithuania - Long-term interest rates 66

5.9. Lithuania - Saving and investment 67

5.10. Lithuania - Effective exchange rates 68

5.11. Lithuania - Foreign ownership and concentration in the banking sector 70

5.12. Lithuania - selected banking sector soundness indicators 71

5.13. Lithuania - Recent development of the financial system relative to the euro area 71

6.1. Hungary - Inflation criterion since 2008 79

6.2. Hungary - HICP inflation 79

6.3. Hungary - Inflation, productivity and wage trends 81

6.4. Exchange rates - HUF/EUR 85

6.5. Hungary - 3-M Bubor spread to 3-M Euribor 86

6.6. Hungary - Long-term interest rate criterion 86

6.7. Hungary - Long-term interest rates 86

6.8. Hungary - Saving and investment 88

6.9. Hungary - Effective exchange rates 88

6.10. Hungary - Foreign ownership and concentration in the banking sector 90

6.11. Hungary - selected banking sector soundness indicators 91

6.12. Hungary - Recent development of the financial system relative to the euro area 91

7.1. Poland - Inflation criterion since 2008 95

7.2. Poland - HICP inflation 95

7.3. Poland - Inflation, productivity and wage trends 97

7.4. Exchange rates - PLN/EUR 100

7.5. Poland - 3-M Wibor spread to 3-M Euribor 100

7.6. Poland - Long-term interest rate criterion 101

7.7. Poland - Long-term interest rates 101

7.8. Poland - Saving and investment 102

7.9. Poland - Effective exchange rates 102

7.10. Poland - Foreign ownership and concentration in the banking sector 105

7.11. Poland - selected banking sector soundness indicators 105

7.12. Poland - Recent development of the financial system relative to the euro area 106

8.1. Romania - Inflation criterion since 2008 110

8.2. Romania - HICP inflation 110

8.3. Romania - Inflation, productivity and wage trends 111

8.4. Exchange rates - RON/EUR 115

8.5. Romania - 3-M Robor spread to 3-M Euribor 116

8.6. Romania - Long-term interest rate criterion 116

8.7. Romania - Long-term interest rates 117

8.8. Romania - Saving and investment 117

8.9. Romania - Effective exchange rates 118

8.10. Romania - Foreign ownership and concentration in the banking sector 121

8.11. Romania - selected banking sector soundness indicators 121

8.12. Romania - Recent development of the financial system relative to the euro area 121

9.1. Sweden - Inflation criterion since 2008 125

9.2. Sweden - HICP inflation 125

9.3. Sweden - Inflation, productivity and wage trends 126

9.4. Exchange rates - SEK/EUR 130

9.5. Sweden - 3-M Stibor spread to 3-M Euribor 130

9.6. Sweden - Long-term interest rate criterion 130

9.7. Sweden - Long-term interest rates 131

9.8. Sweden - Saving and investment 131

9.9. Sweden - Effective exchange rates 132

9.10. Sweden - Foreign ownership and concentration in the banking sector 135

9.11. Sweden - selected banking sector soundness indicators 135

9.12. Sweden - Recent development of the financial system relative to the euro area 135

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 14

1.5. The Macroeconomic Imbalance Procedure (MIP) 15

LIST OF Maps

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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), Estonia (2011) and Latvia (2014) have adopted 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 for 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 adopt the euro, they are not the subject of an assessment as to whether they fulfil the necessary conditions.

In 2012, the Commission and the ECB adopted their latest regular Convergence Reports ([7]). At that time, none of the Member States assessed was deemed to meet the necessary conditions for adopting the euro.

On 5 March 2013, Latvia submitted a request for a convergence assessment. Following the Convergence Report 2013 on Latvia and on the basis of a proposal by the Commission, the Ecofin Council decided in July 2013 that Latvia fulfilled the necessary conditions for adopting the euro as of 1 January 2014 ([8]).

In 2014, two years will have elapsed since the last regular reports were prepared. 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, Croatia, Lithuania, Hungary, Poland, Romania and Sweden. This Commission Staff Working Document is a Technical Annex to the Convergence Report 2014 and includes a detailed assessment of the progress with convergence.

The financial and economic crisis, along with the recent euro-area sovereign debt crisis, has exposed gaps in the current economic governance system of the Economic and Monetary Union (EMU) and showed that its existing instruments need to be used more comprehensively. With the aim of ensuring a sustainable functioning of EMU, an overall strengthening of economic governance in the Union has been undertaken. 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 sub-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 in which they appear in Article 140(1) (see Box 1.1). The cut-off date for the statistical data included in this Convergence Report was 15 May 2014.

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 130 and 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. The national provisions on the tasks of the national central bank are assessed against the relevant rules 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”.

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 provided the basis for a change of the HICP index

(Continued on the next page)

Box (continued)

base reference period from 1996=100 to 2005=100 ([10]).

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. Accordingly, the reference value is currently 1.7%, based on the data of Latvia (0.1%), Portugal (0.3%) and Ireland (0.3%) over the 12-month period covering May 2013-April 2014. Greece, Bulgaria and Cyprus were identified as outliers, as their inflation rates deviated by a wide margin from the euro area average reflecting country-specific economic circumstances (see Box 1.2)

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 cyclical or temporary factors. Therefore, this Technical Annex also takes account of the role of the macroeconomic situation and cyclical position 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

(Continued on the next page)

Box (continued)

(Continued on the next page)

Box (continued)

developments have impacted on domestic inflation. Similarly, the impact of administered prices and indirect taxes on headline inflation is also considered.

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 details of the excessive deficit procedure are defined in Regulation 1467/97 as amended in 2005 and 2011 (most recently under the "Six-Pack") which sets out the way in which government deficit and debt levels are assessed to determine whether an excessive deficit exists, under article 126 of TFEU. The convergence assessment in the budgetary area is therefore judged by whether the Member State is subject to a Council decision under 126(6) on the existence of an excessive deficit ([12]).

Long-term sustainability of public finances deserves particular attention at a time when the financial crisis has significantly impacted on the fiscal positions and debt levels in many Member States. In response to this, economic governance in the EMU was substantially strengthened in 2011, which 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.

A number of Member States have benefited from balance-of-payments assistance programmes since 2008. In order to determine whether international financial assistance constitutes evidence that a country has faced severe tensions in its exchange rate, the Commission examines the role played by official external financing during the assessment period on a case by case basis.

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 16 May 2012 to 15 May 2014.

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).

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. The reference value for April 2014 is calculated as the simple average of the average long-term interest rates in Latvia (3.3%), Portugal (5.8%) and Ireland (3.5%), plus 2 percentage points, yielding a reference value of 6.2%.

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, product and labour 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 section on price stability.

The assessment of additional factors gives an important indication of a Member State's ability to integrate into the euro area without difficulties. As regards the balance of payments, the focus is on

the situation and development of the external balance ([16]). Market integration 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.

Starting with the 2012 Convergence Report, the convergence assessment is aligned with the broader "European Semester" approach which takes an integrated and upstream look at the economic policy challenges facing 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 Macroeconomic Imbalance Procedure, which was adopted in December 2011 as one of the key elements of the legislative package (the "Six-Pack") to enhance the governance structures in EMU, and integrates its results into the assessment ([17]).

2.1. Legal compatibility

2.1.1. Introduction

The legal basis for the Bulgarska narodna banka (BNB – central bank of Bulgaria), the Law on the Bulgarian National Bank (the BNB Law) of 1997, has not been amended since the 2012 Convergence Report. Therefore, the comments provided in the 2012 Convergence Report are largely repeated in this year's assessment.

2.1.2. Central Bank independence

Article 14(1) of the BNB Law Bank does not accurately mirror the grounds for dismissal of the Governor set out exhaustively in Article 14.2 of the ESCB/ECB Statute.

Pursuant to Article 14(1) of the BNB Law, a member of the BNB Governing Council, including the Governor, may be relieved from office (1) "if he no longer fulfils the conditions required for the performance of his duties under Article 11(4)", (2) "if he is in practical inability to perform his duties for more than six months" or (3) "if he has been guilty of serious professional misconduct".

Whereas the second ground for dismissal is not provided in Article 14.2 of the ESCB/ECB Statute, the third dismissal ground provided in Article 14(1) of the BNB Law narrows down the concept of "serious misconduct" of Article 14.2 of the ESCB/ECB Statute to "serious professional misconduct". In order to remove these imperfections and limit interpretation problems, Article 14(1) of the BNB Law should be amended.

Furthermore, the ground for dismissal provided in the Conflict of Interest Prevention and Ascertainment Act of 2008 which has been applicable to the BNB Governor, Deputy Governors and the members of the BNB Managing Board since December 2010 has to be brought in line with Article 14.2 of the ESCB/ECB Statute. Article 33(1) in conjunction with Article 3(13) of the Conflict of Interest Prevention and Ascertainment Act provides that the breach of its provisions and the existence of a conflict of interest are grounds for dismissal. This incompatibility should be removed by specifying that a dismissal of the Governor is only admissible if, as set out in Article 14.2 of the ESCB/ECB Statute, the breach of the duty is a lack of fulfilment of the conditions required for the performance of the Governor's duties or is a serious misconduct of which the Governor has been guilty.

Pursuant to Article 12(1) of the BNB Law, the Governor shall be elected by the National Assembly. The National Assembly has taken the view that it has the power to annul or amend its decisions, including decisions under Article 12(1) of the BNB Law. The National Assembly has substantiated this assertion by stating that pursuant to a Constitutional Court decision of 26 February 1993, the Bulgarian Constitution does not explicitly prohibit the National Assembly from amending or annulling its decisions. Such understanding would allow the dismissal of the Governor under conditions other than those mentioned in Article 14.2 of the ESCB/ECB Statute. It should be ensured that the Governor, when properly elected or appointed, may not be dismissed under conditions other than those mentioned in Article 14.2 of the ESCB/ECB Statute.

Article 14(2) of the BNB Law Bank should be amended. Article 14(2) of the BNB Law Bank stipulates that "where the duties of a Governing Council member cease before the term of office has expired, another person shall be elected/appointed for the outstanding period of the term of office". As regards the Governor, this is not in line with Article 14.2 of the ESCB/ECB Statute, pursuant to which the term of office of a Governor shall be no less than five years.

Article 44 of the BNB Law should be amended with a view to achieving compatibility with Article 130 of the TFEU and Article 7 of the ESCB/ECB Statute. Pursuant to Article 44 of the BNB Law, 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. It should be clarified that this encompasses national, foreign and EU institutions or bodies.

2.1.3. Prohibition of monetary financing and privileged access

Article 45(1) and (2) of the BNB Law are not fully consistent with Article 123 of the TFEU and Article 21.1 of the ESCB/ECB Statute and thus should be amended.

Article 45(1) of the BNB Law 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. Article 45(1) of the BNB Law should be amended with a view to including all entities mentioned in Article 123(1) of the TFEU and Article 21.1 of the ESCB/ECB Statute. Furthermore, while the prohibition of monetary financing does not allow the direct purchase of public sector debt, purchases on the secondary market are not prohibited unless they qualify as a circumvention of the objective of Article 123 of the TFEU. For this reason, the word ‘direct’ should be inserted in Article 45(1) of the BNB Law.

Pursuant to Article 45(2) in conjunction with Article 33(2) of the BNB Law, Article 45(1) of the BNB Law 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. The scope of this exemption should be amended to be fully consistent with the wording of Article 123(2) of the TFEU and Article 21.3 of the ESCB/ECB Statute.

2.1.4. Integration in the ESCB

Objectives

The objectives of the BNB are compatible with the Treaty on the Functioning of the European Union.

Tasks

The incompatibilities in the BNB Law 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 and 5), 28, 30, 31, 32, 33, 35, 38, 41 and 61 of the BNB Law);

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

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

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

· ECB's right to impose sanctions (Article 61, 62 of the BNB Law).

There are also numerous imperfections regarding:

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

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

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

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

2.1.5. Assessment of compatibility

The BNB Law and the Conflict of Interest Prevention and Ascertainment Act are not fully compatible with Article 131 of the TFEU as regards central bank independence, the prohibition of monetary financing and the integration in the ESCB at the time of euro adoption.

2.2. PRICE STABILITY

2.2.1. Respect of the reference value

The 12-month average inflation rate, which is used for the convergence assessment, was below the reference value at the time of the last convergence assessment of Bulgaria in 2012. Average annual inflation hovered around 2.5% between mid-2012 and mid-2013, before declining to 0.4% by end-2013. In April 2014, the reference value was 1.7%, calculated as the average of the 12-month average inflation rates in Latvia, Portugal and Ireland plus 1.5 percentage points. The average inflation rate in Bulgaria during the 12 months to April 2014 was -0.8%, i.e. well below the reference value. It is projected to remain well below the reference value in the months ahead.

2.2.2. Recent inflation developments

The inflation rate in Bulgaria has fallen significantly over the past two years, turning negative in the second half of 2013 and first months of 2014. The fall in inflation has been broad-based, but largely driven by declining import prices as well as the appreciation of Bulgaria's euro-fixed currency against its main trading partners in the Balkans, decreases in administratively set energy prices, a good agricultural harvest that led to lower food prices and weak domestic demand. The decline in inflation over the past few years has not followed a smooth trend, as a temporary increase in inflation above the euro area average was recorded in the second half of 2012. This was mainly reflecting the volatility in global commodity prices. However, in addition to import price trends, the sharp fluctuations in energy prices over 2012-13 were amplified by domestic factors. Several administratively set energy price components recorded an increase in 2012, at that time coinciding with an upturn in global energy prices. In contrast, the network charge on electricity was lowered by the government in 2013 in response to public protests against high energy bills. By chance, this measure coincided with a period of global energy price decline.

Core inflation (measured as HICP inflation excluding energy and unprocessed food) declined steadily from somewhat above 1% recorded in 2012 to -0.4% by the end of 2013 and -1.0% in April 2014. Headline inflation was above core inflation till mid-2013, when it abruptly fell due to temporary factors affecting both unprocessed food and energy. The components of core inflation have trended downwards over the past few years, but especially from early 2013. This was likely a reflection of both lower import prices passing through to domestic prices and weak domestic demand, as consumers have remained cautious in spending, in spite of strong growth in real wages over the past years. Inflation of non-energy industrial goods continued to fall, reaching a historically low level of -2.3% in early-2014. Services inflation fell from over 3% in August 2012 to below -1% by early 2014, partly due to the pass-through of lower import prices. Negative producer price inflation confirmed the lack of cost pressures in 2013 and in the first months of 2014.

2.2.3. Underlying factors and sustainability of inflation

Macroeconomic policy-mix and cyclical stance

The economic recovery has so far been weak in Bulgaria, with exports rebounding, but domestic demand still sluggish. GDP growth reached 1.8% in 2011, but has slowed to 0.6% in 2012 before picking up slightly to 0.9% in 2013. According to the Commission services' 2014 Spring Forecast, Bulgaria's GDP growth is expected to be more broad-based over 2014-15, with domestic demand forecast to reinforce the export-driven growth momentum. The purchasing power of households has been buoyed by growth in real wages in a low-inflation environment and consumer confidence appears to be gradually firming. GDP growth is forecast to reach 1.7% in 2014 and 2% in 2015. This relatively modest growth momentum would, however, imply a further slight widening of the already negative output gap.

The fiscal stance, as measured by changes in the structural balance, has shifted over recent years, but was overall rather neutral for inflation. Following three years of strong consolidation, the fiscal stance has been slightly expansionary in 2013, with some discretionary expenditure increases after the parliamentary elections. According to the Commission services' 2014 Spring Forecast, the structural balance is projected to weaken slightly further in 2014, but to tighten marginally in 2015.

In the context of its currency board arrangement to the euro, most standard monetary policy instruments are not available to Bulgaria. In response to these limitations, the BNB has taken a conservative approach towards bank regulation. Credit flow to the economy has remained overall slightly positive, with modest growth in corporate credit compensating for a slight decline in household credit. However, the second half of 2013 and the first months of 2014 have been marked by a deceleration of credit growth. Both deposit and lending interest rates have continued on a downward trend, implying a gradual improvement in lending conditions and credit availability. Nevertheless, credit availability may be limited for those sectors most affected by the financial crisis as well as some corporate segments with higher perceived risk, including start-up companies and SMEs. The subdued lending activity and a risk-averse stance of households, confirmed by the rising deposit stock, support the present low-inflation environment.

Wages and labour costs

The economic crisis has led to an extended period of labour market distress, with the first signs of labour market stabilisation visible only in the second half of 2013. Employment fell by about 2.5% in 2012 and was overall broadly flat in 2013. The unemployment rate peaked at around 13% in 2013, while the working-age population has also declined due to ageing and emigration. Despite these factors and wage restraint in the public sector over 2010-12, nominal wage growth in the private sector remained relatively high especially over 2009-2011, but has since then strongly decelerated. The rapid wage growth in the initial crisis years was partly a reflection of composition effects, continued wage convergence pressures, skills shortages in some sectors and administrative increases of sectoral and occupational wage floors.

Labour productivity grew relatively strongly between 2010 and 2012, as large cuts in employment boosted output per employee, while output growth itself was sluggish. This phenomenon ended in 2013 with the stabilization of the labour market. Labour productivity is projected to increase by around 1.5% in 2014 and 2015. The growth in nominal unit labour cost (ULC) declined between 2009-2012, but it picked up again in 2013. ULC growth is projected to stabilise at around 2% in 2014-2015, with upward pressure resulting from expected wage convergence.

External factors

Given the high openness of the Bulgarian economy, developments in import prices play an important role in domestic price formation. Global energy and food prices are the most relevant for inflation, given their relatively large share in the consumer basket and the high energy intensity of the Bulgarian economy. Import prices (measured by the imports of goods deflator), have been volatile over the past few years. Rebounding from 2009 lows, import prices increased markedly in 2010 and 2011. A somewhat lower increase of about 4% was recorded in 2012, followed by a decline of similar magnitude in 2013, reflecting lower global energy, food and some raw material prices. Import prices are expected to continue declining also in 2014 given i.a. that energy prices are forecast to moderate further over the year. This is also expected to pass through to lower energy-related inflation. It should be noted that Bulgaria depends on a single source of gas supply and negotiates gas prices bilaterally, occasionally diverging from global price trends.

The nominal effective exchange rate of the lev (measured against a group of 36 trading partners) remained relatively stable from early 2009 until late 2012. From November 2012, a noteworthy appreciation trend can be observed, as some currencies of major trading partners depreciated against the euro (Turkish Lira, Russian Rouble, Romanian Leu), which contributed to lower import prices.

Administered prices and taxes

Administered prices ([18]) substantially influenced the consumer price inflation rate in Bulgaria over the past few years, but indirect tax changes less so. The share of administered prices in the HICP basket is relatively high in Bulgaria at around 17%, compared to 13% in the euro area on average. The annual change of administered prices turned from a 4.9% increase in 2012 to a decline of -1.1% in 2013 on average, with higher decline in the second half of 2013. The increase in administered prices in 2012 was most notably related to electricity prices and to a lesser extent to hospital services. In contrast, responding to public protests in early 2013 against high energy bills, the government strongly lowered the administratively set electricity price in several steps in 2013 and the latest decrease took effect on 1 January 2014. Administratively-set prices of healthcare were lowered, as well. Overall, administered prices raised headline inflation in 2012 by about 0.5 percentage points, but lowered it in 2013 by about 0.3 percentage points, albeit more strongly towards the end of the year.

Indirect tax changes had on aggregate only a minor effect on inflation over 2012-13. In 2012, a rise in excise duties on diesel slightly increased energy prices, but on the other hand changes to VAT legislation applicable to the tourism sector reduced services inflation by about the same amount. In 2013, excise duties on diesel fuels were raised again, but were lowered for natural gas used for heating, resulting in an overall small negative effect on inflation. During the assessment period, annual constant-tax HICP was on average at the same level as headline inflation.

Medium-term prospects

With the fading of base effects from energy and food prices, inflation is forecast to slowly rebound over the second half of 2014 to positive territory. The Commission services' 2014 Spring Forecast expects annual average inflation to reach -0.8% in 2014 and to increase to 1.2% in 2015, in line with the projected recovery in domestic demand and the on-going convergence of prices towards the euro area average.

Risks to the inflation outlook appear broadly balanced, with the most significant risks related to global energy and food price developments, given also their relatively large share in the Bulgarian consumer basket. As a specific inflation risk factor, the administratively lowered electricity network charges might not be sustainable in the longer term. However, presently no change in policy has been announced by the Bulgarian authorities.

The level of consumer prices in Bulgaria was at 47% of the euro area average in 2012. 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 44% of the euro area average in PPS terms in 2012).

Medium-term inflation prospects will depend on wage and productivity developments, as well as on global commodity price trends. A prudent fiscal stance is expected to help contain inflationary pressures. Tax policy is expected to have only a limited impact on inflation, as the harmonisation of excise duties on liquid fuels has been finalised and the excise rate harmonisation for tobacco is scheduled to be spread over several years.

2.3. public finances

2.3.1. Recent fiscal developments

On 22 June 2012, the Council decided to abrogate the decision on the existence of an excessive deficit according to Article 126 (12) TFEU, thereby closing the excessive deficit procedure for Bulgaria ([19]). The financial crisis impacted severely on public finances, leading to a budget deficit of 4.3% of GDP in 2009. This was followed by a period of strong fiscal consolidation over 2010-12, when the general government deficit declined from 3.1% of GDP to 0.8% of GDP. The improvement in the fiscal balance was largely due to tight expenditure controls, as reflected in the fall of the expenditure-to-GDP ratio to below 36% of GDP by 2012. In 2013, the deficit has returned to 1.5% of GDP.

This was a weaker outcome than that projected by the Bulgarian authorities in their previous convergence programme submitted in April 2013, which targeted a deficit of 1.3% of GDP. The underperformance was due to a combination of lower-than-expected tax revenues and some expenditure increases. Additional spending was for specific social programmes and for increasing pensions and wages of some public service occupations.

Previously, pensions and the aggregate public sector wage bill were frozen over several years. The above trends in nominal fiscal deficit are similarly reflected in the estimate of the structural balance. In structural terms, the deficit is estimated to have deteriorated by around 0.5 pp. of GDP in 2013, indicating an expansionary fiscal stance in that year after several years of contraction.

Bulgaria's public debt is one of the lowest among the EU Member States and financing conditions have remained favourable. However, since public finances have been running a deficit since the 2009 economic crisis, the debt-to-GDP ratio has steadily increased from 16.2% in 2010 to 18.9% of GDP in 2013.

2.3.2. Medium-term prospects

The 2014 Budget Law was adopted by Parliament on 9 December 2013. The budget targets a general government deficit of 1.8% of GDP in 2014, which would be higher than the outcome in 2013. There are no major tax rate changes foreseen in the Budget, but the government expects to boost revenue collection through improving tax collection. The increase of the deficit is largely explained by a boost to public investment and some additional expenditure for pensions and social measures.

The Commission services' 2014 Spring Forecast projects the general government deficit at 1.9% of GDP in 2014, improving marginally to 1.8% of GDP in 2015. In structural terms, the deficit is estimated to weaken slightly in 2014, but a consolidation would be under way in 2015, based on a no-policy change assumption. The general government gross debt is forecast to increase from 18.9% in 2013 to about 23% of GDP in 2015.

The 2014 Convergence Programme was submitted on 17 April 2014. The programme aims at reducing the headline general government deficit to 0.9% of GDP by the end of the programme period (2017). The official targets for the general government budget balance have been marginally revised down compared to the previous years' update, now targeting -1.8% of GDP in 2014 and -1.5% of GDP in 2015. The small deviation of the targets for 2014-2015 compared with the Commission services' 2014 Spring Forecast is mainly due and an assumption of much stronger VAT and personal income tax collection in 2014, which is, however, partly balanced by also assuming much stronger investment expenditure growth in the same year.

Further details on the assessment of the 2014 Convergence Programme for Bulgaria can be found in the Commission Staff Working Document, which accompanies the Commission Recommendation for a Council Recommendation on the 2014 National Reform Programme of Bulgaria and delivering a Council Opinion on the 2014 Convergence Programme of Bulgaria.

In March 2012, Bulgaria signed the Treaty on Stability, Coordination and Governance in the EMU and declared its intension to comply with the Title III Fiscal Compact already now. This implies an additional commitment to conduct a stability-oriented and sustainable fiscal policy. The TSCG will apply to Bulgaria in its entirety upon lifting its derogation from participation in the single currency.

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.

Over the past two years, the CBA operated in a challenging environment, characterized by weak economic growth, weak credit flow and contagion risks in the banking sector from Greece. However, growing exports, strong public finances, an improving external funding position of the banking sector and sizable reserve buffers have underpinned the resilience of the CBA.

Bulgaria's international reserves (around EUR 14 billion) covered around 163% of the monetary base, about 100% of short-term debt ([20]), 42% of broad money (M3) and about 35% of GDP as of end-2013. 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 rather stable over the past two years and its fluctuation broadly followed the development of the government's fiscal reserves and changes in the price of gold.

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 continued to decrease over the past two years. The 3-month spread declined gradually from around 200 basis points in spring 2012 to well below 100 basis points by early 2014. On the other hand, Bulgarian overnight interbank rates were below those of the euro area.

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 below the reference value at the 2012 convergence assessment. It declined from above 5% in early 2012 to around 3.5% by mid-2013. In April 2014, the latest month for which data are available, the reference value, given by the average of long-term interest rates in Latvia, Portugal and Ireland plus 2 percentage points, stood at 6.2%. In that month, the twelve-month moving average of the yield on the Bulgarian benchmark bond stood at 3.5%, i.e. about 2.7 percentage points below the reference value.

The long-term interest rate of Bulgaria has been on a gradually declining trend since 2009. Bulgarian benchmark bond yields fell significantly in the second half of 2012, with the calming of financial tensions in the euro area, and in Greece in particular. However, 2013 was characterized by some increase in the long-term interest rate, related to political uncertainty around the elections in that year and an expected monetary tightening in the USA.

Spreads to the Bund declined by almost 200 basis points in the second half of 2012 and fluctuated around 190 basis points in 2013, as the rise in Bulgaria's long-term interest rate broadly followed that of Germany. The spread to the German benchmark bond was at around 200 basis points in April 2014 ([21]).

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, labour and financial market integration – gives an important indication of a Member State's ability to integrate into the euro area without difficulties.

In November 2013, the Commission published its third Alert Mechanism Report (AMR 2014) ([22]) under the Macroeconomic Imbalance Procedure (MIP - see also Box 1.5). The AMR 2014 scoreboard showed that Bulgaria exceeded the indicative threshold in two out of eleven indicators, one in the area of external imbalances (i.e. the net international investment position) and one in the area of internal imbalances (i.e. the unemployment rate). In line with the conclusion of the AMR 2014, Bulgaria was subject to an in-depth review, which found that Bulgaria continues to experience macroeconomic imbalances, which require monitoring and policy action.

2.6.1. Developments of the balance of payments

Bulgaria's external balance (i.e. the combined current and capital account) adjusted from high pre-crisis deficits to close to balance by 2010 and reached a surplus of around 3% of GDP in 2013. Both goods and services trade performed well, with the traditionally negative goods balance being partly counterbalanced by the surplus on services. The income account also improved in 2012, reflecting lower profits on FDI, but this slightly reversed in 2013. The strongest improvement relative to 2011 came from current transfers, reflecting an increasing absorption of EU funds and remittances from Bulgarians working abroad.

Mirroring the trends of the current account, the savings-investment gap hovered close to balance from 2010 and rose to about 2% of GDP in 2013. Gross national savings remained high by historical standards, as companies continued to undergo balance-sheet adjustments and households remained cautious in their spending, in spite of increasing incomes. At the same time, gross fixed capital formation remained subdued as firms and households have not recovered confidence amid a weak economic recovery. Capacity utilisation in industry remains below the pre-crisis peak levels.

Competitiveness indicators showed a mixed picture in the past two years. The ULC-deflated real-effective exchange rate has appreciated significantly since mid-2012, largely due to the rising NEER. On the other hand, HICP- and manufacturing sector ULC-based REERs remained more stable (given that manufacturing sector records lower wage growth than in the services sector while productivity growth is higher). Bulgaria has had an improving market performance since the 2008 crisis. After a temporary dip in 2012, this trend resumed in 2013.

Moderate financial account outflows have continued since 2010. Net FDI inflows have remained positive, but rather subdued by historical standards since 2009. New investments went mainly to productive sectors, including automotive and metals manufacturing and energy. The slump in real estate activity was reflected by a sharp drop in FDI in this sector. The banking sector has continued to reduce its foreign liabilities and increased its assets abroad. Net portfolio outflows declined to close to zero in 2013. Gross external debt declined significantly from around 108% of GDP at end-2009 to about 94% by end-2013, supported by repayment of foreign debt by the banking sector and non-financial corporate deleveraging. Similarly, the improvement in the international investment position was reflected in a reduction in net external debt, while the FDI stock has remained relatively stable.

According to the Commission services’ 2014 Spring Forecast, the external surplus is projected to abate to around 2% of GDP in 2014 and 2015, as a pick-up in domestic demand is expected to drive imports while export growth remains overall robust.

2.6.2. Market integration

The Bulgarian economy is well integrated to the euro area through trade and investment linkages. As a small open economy, Bulgaria is characterised by a high ratio of trade openness. During the global crisis, however, Bulgaria recorded a contraction of trade openness, as external demand faltered, and both imports and exports contracted in real terms. In recent years, due to the rebound of global trade, the declining trend in openness to trade reversed, increasing from a low of 52% in 2009 to some 68% in 2012.

Bulgaria's export specialisation is focused on intermediate technology products. A breakdown of exported goods by product category shows a predominance of labour and raw-material-intensive, low- and medium-technology goods over high-technology goods. Mineral products (19%), base metals (18%), and machinery and electrical equipment (14%) are the largest export sectors in Bulgaria. Despite an increase in the share of high technology products in exports until 2009 (reaching 4.6% of GDP), the trend seems to have reversed in recent years, contributing to a high-tech trade deficit (i.e. trade deficit in high-tech) of -3.8% in 2012.

Bulgaria experienced significant FDI inflows during the pre-crisis period on account of low labour costs, an excellent tourism potential and a lower risk perception associated with the perspective of the country's EU accession. The main recipient sectors of FDI were services (real estate and business activities, and financial intermediation), construction and to a lesser extent manufacturing. FDI inflows reached a high of 29% of GDP in 2007, but dried up considerably during the global economic downturn, with just 3.7 % of GDP in 2012. However, in particular due to the high accumulation rate experienced in the years before the crisis, the FDI stock in Bulgaria is higher than the average for the other non-euro area Member States.

After the pre-crisis boom that ended in 2008, house prices in Bulgaria have been declining. The cumulated correction between 2008 and 2012 reached 42% but the speed of the adjustment has declined over time. In 2012, the real house price index fell by 7% (compared to 10% in 2011). Building permits fell sharply from 2007 to 2012, accumulating a huge 83% decline. The latest available figures signal a trend reversal and the number of authorisations to start building projects increased by 16% in 2013. Employment and value added in the construction sector have decreased steadily since 2009.

Concerning the business environment, Bulgaria performs in general worse than most euro area Member States in international rankings ([23]). Based on the World Bank Doing Business indicators, the performance of Bulgaria deteriorated in 2013 in the areas of starting a business, dealing with construction permits and registering property, accessing electricity and protecting investors and managing insolvency. On the other hand, there was a marked improvement in the indicator related to trading across borders. Public administration as a whole scores relatively poorly according to the World Bank's Worldwide Governance Indicators ([24]). According to the November 2013 Internal Market Scoreboard, Bulgaria had a transposition deficit (0.6%) close to the 0.5 % target as proposed by the European Commission in the Single Market Act (2011).

The experience of 2008-13 shows that the Bulgarian labour market adjusts to economic shocks by shedding labour rather than by lowering wages ([25]). This tendency is not entirely explained by institutional factors. Wage setting appears relatively flexible in Bulgaria according to most labour market institutional features (wage bargaining largely at firm level, relatively low coverage of collective wage agreements, low union density, short duration of wage bargaining contracts, limited wage indexation). While most institutional features do not therefore seem to significantly limit labour market adjustment, an exception appears to be a unique Bulgarian system of minimum social security thresholds, which set a multitude of wage floors by industry and occupation, potentially limiting downward wage flexibility in a crisis.

While the Bulgarian labour market demonstrated some flexibility during the downturn through shedding labour, it appears less efficient in post-crisis reallocation and re-employment of labour. In Bulgaria, active labour market and retraining policies to facilitate the upgrading of the skills of the unemployed and their transition to new employment are less developed. The Bulgarian labour market is also characterised by persistent emigration. According to the National Statistics Office data, net emigration was especially high during 2009-10, coinciding with the period of the labour market crisis. However, while emigration was less pronounced in other periods, it exceeded immigration flows also during the boom years 2007-08 and since 2011 (last data is available from 2012). This suggests that emigration is fundamentally driven by the large income gap with the other EU Member States and domestic labour market cycles only affect the strength of net emigration. Therefore, it cannot be expected that in Bulgaria cross-border labour movements would symmetrically facilitate labour market adjustments both over up- and downturns of the economic cycle.

2.6.3. Financial market integration

Bulgaria's financial sector is well integrated with the EU financial sector, in particular through a high level of foreign ownership in its banking system. The share of foreign-owned institutions in total bank assets has, however, declined during the crisis, reaching 73% in 2012, as local banks were more active in the new environment. Bank concentration, as measured by the market share of the five largest credit institutions in total assets, has converged to the euro area average since EU accession.

Financial intermediation in Bulgaria is mainly indirect, with domestic bank credit steadily around 70% of GDP since 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. The banking sector managed to substantially reduce its reliance on external funding. Credit to the economy by the domestic banking sector has been flat since mid-2012. The share of foreign-currency loans (predominantly in euro) in total declined somewhat during the past two years and stood around 72% for non-financial corporations and 39% for households at the end of 2013. Private sector debt of 132% of GDP in 2012 is somewhat below the euro area average (145% of GDP) ([26]).

The Bulgarian financial system has proved resilient to the international financial crisis. No banking system rescue measure had to be taken by the government. Confidence in the currency board arrangement is strong and international reserves remained at high level. The banking system is fairly liquid and well capitalized, with a capital adequacy ratio of 16.9% at the end of 2013. The quality of the loan portfolio is, however, still deteriorating, with the share of non-performing loans reaching 16.9% at end-2013, as domestic recovery has been weak. Profitability of the domestic banking sector has remained positive since EU accession.

The non-banking financial sector remains underdeveloped relative to the euro area with a relatively small insurance sector. The financial deepening of capital markets, which progressed considerably during the economic boom, came to a halt since the financial crisis. The capitalization of the stock market declined markedly since its highs of 2007 and was down to less than 13% of GDP in 2013. 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.

Regulation and supervision of 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 strongly with the BNB, as well as with international partners, especially from the neighbouring countries. Bulgaria has a good track record of implementing EU financial services directives.

3.1. legal compatibility

3.1.1. Introduction

Česká národní banka (ČNB – Czech national bank) was established on January 1, 1993. Its main legal basis is the Czech National Council Act No. 6/1993 Coll. on the Czech National Bank, adopted on 17 December 1992 (the ČNB Law).

Following the Convergence Report 2012, the ČNB Law was amended by Law No. 227/2013 Coll. which was adopted on 20 June 2013. However, since there have been only limited amendments as regards the incompatibilities highlighted in the Commission's 2012 Convergence Report, the comments made in the latter are largely repeated in this year's assessment.

3.1.2. Independence

Article 9(1) of the ČNB Law prohibits the 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.

However, according to Article 3 of the ČNB Law, the ČNB shall submit a report on monetary developments to the Chamber of Deputies of the Parliament for review at least twice per year. 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 power of the Parliament to ask for amendments and, thus, to influence the content of the ČNB's report on monetary developments 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 ČNB Law needs to be adapted to fully reflect the provisions of Article 130 of the TFEU and Article 7 of the Statute and consequently expressly prohibit third parties from giving instructions to the ČNB and its Board members who are involved in ESCB-related tasks.

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

Pursuant to Article 11(1) of the ČNB Law, 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. Article 11(2) entitles 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) of the ČNB Law, 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 give to the Government the opportunity to influence the central bank when taking its key decisions. Therefore, Article 11(1) of the ČNB Law 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

Article 34a(1) first half-sentence of the ČNB Law prohibits the ČNB from providing overdraft facilities or any other type of credit facility to the bodies, institutions or other entities of the European Union, central governments, regional or local authorities or other bodies governed by public law, other entities governed by public law or public undertakings of the Member States of the European Union. The list of entities does not fully mirror the one in Article 123(1) of the TFEU and, therefore, has to be amended.

Moreover, the footnote in Article 34a(1) ČNB Law should refer to Article 123(2) of the TFEU instead of globally to Article 123 of the TFEU.

3.1.4. Integration in the ESCB

Objectives

Pursuant to Article 2(1) of the ČNB Law, "in addition" to the ČNB's primary objective of maintaining price stability, the ČNB shall work to ensure financial stability and the safety and sound operation of the financial system and – without prejudice to its primary objective – support the general economic policies of the Government and the European Union. Article 2(1) of the ČNB Law needs to be amended with a view to achieving compatibility with Article 127 TFEU and Article 2 of the ESCB/ECB Statute. Compatibility with the ESCB's objectives requires a clear supremacy of the primary objective over any other objective.

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 26, 28, 29, 32, 33 of the ČNB Law);

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

· holding and management of foreign reserves (Articles 35(c), 36 and 47a of the ČNB Law);

· 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 of the ČNB Law);

· ECB's right to impose sanctions (Article 46a of the ČNB Law).

There are also some imperfections regarding:

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

· non-recognition of the role of the ECB in the functioning of the payment systems (Article 38 and 38a of the ČNB Law);

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

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

· non-recognition of the role of the ECB in the field of international cooperation (Article 2(3) of the ČNB Law).

3.1.5. Assessment of compatibility

As regards the independence of the central bank, the prohibition of monetary financing and the integration of the central bank in the ESCB at the time of euro adoption, the ČNB Law 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, which is used for the convergence evaluation, was below the reference value at the time of the last convergence assessment of the Czech Republic in 2012. Following an upward trend since mid-2010, it peaked at above 3.5% in late 2012, before declining gradually close to 1% in early 2014. In April 2014, the reference value was 1.7%, calculated as the average of the 12-month average inflation rates in Latvia, Portugal and Ireland plus 1.5 percentage points. The corresponding inflation rate in the Czech Republic was 0.9%, i.e. 0.8 percentage points below the reference value. The 12-month average inflation rate is projected to fall well below the reference value in the months ahead.

3.2.2. Recent inflation developments

Annual HICP inflation in the Czech Republic moved broadly in line with the euro-area average in the period between 2009 and 2011. It increased above the euro-area inflation in 2012, largely due to an increase in the lower VAT rate while higher energy and food prices in global commodity markets were also passed through into consumer prices. Despite another VAT increase in January 2013, price growth significantly moderated throughout 2013 as pressures stemming from energy prices gradually eased off and growth in prices of services became subdued. Price developments in the services sector reflected a sharp fall in prices of communication services and lower increases in administered prices as compared to previous years. Lack of demand pressures, reflecting the economic downturn, also contributed to the moderate price growth. Annual HICP inflation hovered close to 0.3% in early 2014.

Core inflation (measured as HICP inflation excluding energy and unprocessed food), averaged 1.7% in 2012-2013, reflecting weak underlying price pressures in the real economy. Higher costs of key intermediate inputs – energy and food commodities – together with changes in VAT were the main drivers of price growth in processed food, and in 2012 also in services. Prices of non-energy industrial goods have followed a declining trend since 2002 on the back of intensifying competition on final markets and sustained effectiveness gains on the part of producers of imported goods. In 2012-2013, their negative contribution to core inflation was mitigated by the above-mentioned increases in indirect taxes and a weaker koruna. In 2012, headline inflation exceeded core inflation by a wide margin as the hikes in imported food and energy prices were not fully passed through into core inflation. Producer price inflation for total industry decreased to 0.8% in 2013, confirming the moderation of cost pressures on the supply side.

3.2.3. Underlying factors and sustainability of inflation

Macroeconomic policy-mix and cyclical stance

Following a moderate recovery in 2010-2011, real GDP declined again in both 2012 and 2013 largely on account of falling domestic demand. While private consumption expenditure was negatively affected by declines in real disposable income of households, gross capital formation fell due to recurrent cuts in public investment and decreased risk tolerance on the part of businesses. As these factors gradually eased off, economic growth resumed in the second quarter of 2013, albeit initially at a modest pace. According to the Commission services' 2014 Spring Forecast, economic activity, supported by a brightening outlook for the global economy, is expected to strengthen, resulting in real GDP growth of 2% in 2014 and 2.4% in 2015. The Czech economy is estimated to have operated well below its potential since 2009 and the output gap is projected to remain negative even in 2015.

The fiscal stance, as measured by changes in the structural balance, has been restrictive since 2010. The headline deficit decreased in 2010 and 2011 on account of improvements in both the cyclical and structural components. The structural balance continued to improve in 2012 as further consolidation was pursued, although the headline deficit was temporarily pushed up by sizeable one-off expenditure measures (in particular related to the adoption of the law on financial compensations to churches). Fiscal adjustment in both 2012 and 2013 relied heavily on cuts in public investment and increases in indirect taxes, which is likely to have accentuated the economic downturn. Looking ahead, the fiscal stance is expected to loosen in both 2014 and 2015.

Monetary policy, conducted within an inflation targeting framework ([27]), was further loosened in 2012 in view of the subdued inflation outlook and faltering recovery. The ČNB cut its main policy rate (the 2-week repo rate) by a cumulative 70 basis points to its technical 'zero bound' (0.05%) between June and November 2012. Despite the accommodative monetary policy stance, credit growth and the inflation outlook remained subdued. Having fully exploited the interest rate channel, the ČNB began using the exchange rate as an additional instrument for easing monetary conditions in November 2013, which is likely to stoke up inflation in 2014.

Wages and labour costs

The labour market showed substantial flexibility in accommodating lower labour demand during the economic downturn of 2012 and 2013. Specifically, the rise in unemployment was limited by the willingness of firms to cut working hours rather than jobs and by a persistent shift from regular to self-employment. The unemployment rate peaked at 7% in 2012 and started to decline (in seasonally adjusted terms) in the second half of 2013. Despite the unfavourable economic situation, the number of employed persons continued to expand at a modest pace, supported by a growing supply of part-time jobs and rising participation of older workers. Real wages fell in both 2012 and 2013 as a consequence of modest nominal wage increases in this period. The Czech population of working age is projected to continue shrinking in coming years, which is set to weigh on employment growth going forward.

The labour hoarding behaviour on the part of employers contributed to negative growth in productivity per worker in 2012 and 2013. As nominal compensation per employee continued to rise in 2012, nominal unit labour costs (ULC) increased. ULC broadly stabilised in 2013 due to the decline in nominal compensation per employee. This was to a large extent related to the introduction of a second personal income tax bracket, in anticipation of which part of compensations was paid out in the fourth quarter of 2012, before the tax became effective. Labour productivity is expected to increase again along with the firming economic recovery, thus dampening nominal ULC growth in 2014 and 2015.

External factors

Given the size and openness of the Czech economy, import prices have a sizeable effect on domestic price formation. Import prices (measured by the imports of goods deflator) increased considerably in 2012, largely on account of higher prices of internationally-traded commodities, but their growth significantly decelerated in 2013. As a result, energy and food prices increased significantly in 2012 before moderating by late 2013. The joint contribution of energy prices and unprocessed food prices to HICP inflation averaged 1.2 percentage points in 2012 and 2013, accounting for about half of the average HICP increase in this period. The key factor behind the projected increase in import prices in 2014 is a weaker nominal effective exchange rate of the koruna.

Inflationary impulses from the exchange rate have been moderate up to late 2013. The koruna's nominal effective exchange rate (measured against a group of 36 trading partners) depreciated by less than 2% between the first quarter of 2012 and the third quarter of 2013. However, following the ČNB's decision to intervene on the foreign exchange market, the NEER dropped by about 6% in late 2013 and then remained broadly stable in early 2014.

Administered prices and taxes

Changes in administered prices and indirect taxes have played a significant role in determining headline inflation in recent years. At the same time, the share of administered prices in the HICP basket has declined in recent years to below 11% by 2014 ([28]), compared to 13% in the euro area.

Changes in administered prices were a sizeable driver of inflation in 2012, but their growth moderated in 2013. Developments in 2012 were affected by the ongoing deregulation of rents, hikes in heat energy prices and changes in most administrative charges – in particular in health care – on account of the increase in the lower VAT rate (see below) and higher input prices of materials.

Similarly, the contribution of indirect taxes to headline inflation was stronger in 2012 than in 2013 as it was significantly influenced by changes in the value added tax in both years. While the lower VAT rate was increased from 10% to 14% in 2012, affecting about a third of the consumption basket, both VAT rates were raised by 1 pp. to 15% (the reduced rate) and 21% (the basic rate) respectively in 2013. Another significant tax change that affected both years concerned the excise duty on tobacco, the rates of which were harmonised with the minimum rates imposed by the EU Single Market rules. Constant tax inflation was thus substantially lower than headline inflation in 2012 and 2013. HICP inflation is not expected to be significantly affected by further changes in indirect taxes in 2014.

Medium-term prospects

The fading out of past increases in indirect taxes together with the large fall in regulated prices of electricity are expected to keep inflation subdued in 2014. However, inflation is projected to pick up in the second half of 2014 on account of the significant weakening of the koruna in late 2013. Stronger domestic demand is then expected to stoke up inflation in 2015. On this basis, the Commission services' 2014 Spring forecast projects annual HICP inflation to average 0.8% in 2014 and 1.8% in 2015.

Risks to this inflation outlook are broadly balanced. The main downside risk stems from weaker-than-expected economic activity on account of a slower recovery in the euro area and other key trading partners. On the upside, a stronger-than-expected recovery in domestic demand would bolster nominal wages, and re-ignite demand pressures.

The level of consumer prices in the Czech Republic was at some 71% of the euro-area average in 2012, with the relative price gap widest for services. This suggests potential for further price level convergence in the long term. Income convergence has effectively stalled in the post-crisis period as the income level reached 75% of the euro-area average in PPS in 2012, compared to 76% in 2007.

Medium-term inflation prospects will continue to be affected by productivity and wage developments as well as by the functioning of product markets (e.g. energy and telecommunication prices). Given the openness of the Czech economy and its limited resource base, commodity prices and other external price shocks will continue to exercise significant influence on domestic inflation.

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 ([29]). As the headline general government deficit was well below the 3% of GDP threshold in 2013 and the Commission services' 2014 Spring Forecast confirmed the durability of the correction, the European Commission is recommending that the Council abrogate the decision on the existence of an excessive deficit in the Czech Republic.

3.3.2. Recent fiscal developments

The severe economic downturn experienced by the country in 2009 had a negative effect on public finances and caused the general government deficit to widen from 2.2% of GDP in 2008 to 5.8% of GDP in 2009. The subsequent period has been marked by continuous efforts to correct the excessive deficit and to bring public finances back on a more sustainable path. The cumulative fiscal effort (measured by the change in the structural balance) in the period from 2010 until 2013 amounted to about 5.5% of GDP.

While the composition of the consolidation packages varied from one year to another, two main budgetary items appear to have driven the overall budgetary adjustment, namely indirect taxes and public investment. Within the category of indirect taxes, both excise duties and VAT were increased several times with an estimated cumulative fiscal impact of almost 1.8% of GDP in the period 2010-2013. VAT rates increased from 5% and 19% in 2010 to the current 15% and 21%. The sharp drop in public investment averaged more than 13% annually over the period 2010-2013. The consolidation effort affected also other expenditure and revenue categories, such as social benefits, the public sector wage bill, intermediate consumption and the social security contributions, albeit to a lesser degree.

The general government deficit in 2013 reached 1.5% of GDP. This outcome was underpinned by consolidation measures of 0.7 pp. of GDP, of which about two thirds fall on the revenue side. The main measures included increases in both the reduced and standard VAT rate by 1 pp. and a lower indexation of pensions. A public investment retrenchment of 12% year-on-year as well as higher property income reflecting strong performance of some state-controlled companies were also important factors contributing to the reduction of the headline deficit. The revenue-to-GDP ratio increased by 0.6 pp. to 40.9% of GDP while the expenditure-to-GDP ratio fell by 2.1 pp. to 42.4 % of GDP.

While still well below the 60% of GDP threshold, the debt ratio increased from 38.4% of GDP in 2010 to 46% of GDP in 2013, mainly on account of high government deficits.

3.3.3. Medium-term prospects

The budget for 2014 was adopted by the Parliament on 19 December 2013. According to the Commission services' 2014 Spring Forecast, the general government deficit is expected to increase to 1.9% of GDP in 2014 in an environment of improving macroeconomic conditions. Government consumption is set to exhibit a relatively strong growth on account of the planned increase in the public sector wage bill and in intermediate consumption (total fiscal impact of approximately 0.2% of GDP). The forecast also factors in a sharp increase in public investment as a strong rebound is expected in EU-financed investment projects. The main deficit-reducing measures include an increase in excise duties and one-off revenue from the sale of newly released frequency ranges. Overall, total government expenditure will remain broadly in line with nominal GDP growth. The revenue-to-GDP ratio is projected to drop by 0.3 pp. to 40.6%. The structural balance is forecast to deteriorate by about 1.1 pp. of GDP in the context of a narrowing output gap.

On unchanged policies, the headline deficit is expected to widen to 2.4% of GDP in 2015 and the structural deficit is forecast to deteriorate further to 1.9% of GDP. The debt-to-GDP ratio is projected to remain broadly stable over the forecast horizon reaching 45.8% in 2015.

The 2014 Convergence Programme, covering the period 2014-2017, was submitted by the Czech authorities on 28 April 2014. The main goal of the programme´s budgetary strategy is to keep the general government deficit below the 3% of GDP reference value in 2014-2017. The recalculated structural balance is expected to reach -1% of GDP in 2014 according to the programme, implying that the Czech Republic should reach its MTO this year. Following an overall assessment of the Czech Republic's budgetary plans, with the structural balance as a reference, including an analysis of expenditure net of discretionary revenue measures, there is a risk that the structural deficit will exceed the MTO in 2015.

Further details on the assessment of the 2014 Convergence Programme for the Czech Republic can be found in the Commission Staff Working Document, which accompanies the Commission Recommendation for a Council Recommendation on the 2014 National Reform Programme of the Czech Republic and delivering a Council Opinion on the 2014 Convergence Programme of the Czech Republic.

The Czech Republic has not signed the Treaty on Stability, Coordination and Governance in the EMU by the time of this assessment.

3.4. EXCHANGE RATE STABILITY

The Czech koruna does not participate in ERM II. Since the late 1990's, the ČNB has been operating under an explicit inflation targeting framework combined with a floating exchange rate regime, allowing for foreign exchange market interventions by the central bank.

The exchange rate of the koruna against the euro experienced a prolonged nominal appreciation in the period following EU accession, amid significant capital inflows that supported a sustained economic catching-up. After reaching an all-time-high against the euro in mid-2008, the koruna's exchange rate weakened considerably during the global financial crisis in late 2008 and early 2009. The koruna recovered partly during 2009 and then remained