Executive summary 1

1. Scene setter: economic situation and outlook 3

2. Imbalances and risks 13

2.1. Financial sector 14

2.2. Indebtedness and deleveraging 26

2.3. Labour market and social situation 33

3. Other structural issues 39

3.1. Taxation and fiscal framework 40

3.2. Labour market, education and social implications 45

3.3. Business environment, public administration and judiciary 51

AA. Overview Table 57

AB. Standard Tables 63

LIST OF Tables

1.1. HICP items with the largest difference between BG and EU, 2014 9

1.2. Key economic, financial and social indicators 12

1.3. MIP scoreboard indicators 13

2.1.1. Banking system indicators, Sep 2014 16

2.1.2. Investment restrictions for universal pension funds 27

2.2.1. Corporate debt ratios 29

B.1. Macroeconomic indicators 66

B.2. Financial market indicators 67

B.3. Taxation indicators 67

B.4. Labour market and social indicators 68

B.5. Product market performance and policy indicators 70

B.6. Green Growth 71

LIST OF Graphs

1.1. Real GDP growth by demand components 5

1.2. Components of potential growth 6

1.3. Key labour market data 6

1.4. Export market share 6

1.5. Current account gross components 7

1.6. Decomposition of NIIP 7

1.7. HICP inflation and differential vis à vis euro area 9

1.8. Decomposition of debt by sector (non-consolidated) 10

1.9. Evolution of House Price Index and MFI Loans for House Purchase 11

2.1.1. Financial sector assets, EUR million 16

2.1.2. Evolution of loans and advances 17

2.1.3. Average cost of household deposits and range of values, % 18

2.1.4. Breakdown of growth in corporate loans by bank segment 20

2.1.5. Average credit growth and return on loans to the corporate sector 21

2.1.6. Ratio of watch, non-performing and loss loans to gross loans 21

2.1.7. Change in asset quality categories and impairments, 2010-13* 21

2.1.8. Ratio of total impairments to watch, non-performing and loss loans 22

2.1.9. Pre-tax profit, % of total assets, 2007-14 22

2.1.10.Net interest income, % of total assets 22

2.1.11.Cost of funding and growth for Bulgarian banks 23

2.1.12.Profit and Loss account, DOBs, scenario if the impairments-to-assets ratio was the same as the sector average, everything else kept unchanged, 4-quarter moving sums 24

2.1.13.Net assets of pension funds, EUR mn Sep-14 26

2.1.14.Instruments traded on regulated foreign markets 27

2.2.1. Balance sheet, non-financial corporations 28

2.2.2. Profit margins, non-financial corporations 28

2.2.3. Sustainability risks by sector 29

2.2.4. Sectoral growth of loans and gross value added 29

2.2.5. Credit supply and demand deleveraging pressures 30

2.2.6. Savings and investment, non-financial corporations 30

2.2.7. Saving - investment balance 31

2.2.8. NIIP-stabilising current account balances based on long-term projections 31

2.2.9. NIIP by sector 32

2.2.10.Gross external debt structure 32

2.2.11.Inward FDI stock by economic activity 32

2.2.12.FDI inflows, 2010-2014 33

2.2.13.World market shares for services 33

2.2.14.Geographical and sectoral composition of nominal (USD) rate of change of goods exports 33

2.2.15.Dynamism and competitiveness of goods exports (2012-2013) 34

2.2.16.Unit labour costs by sector 34

2.2.17.Component contributions to change in CA balance 2007-2015 34

2.3.1. Classes of out-of-work population, 2011 35

2.3.2. Unemployment by duration 36

2.3.3. Minimum and average wage (BGN) 36

2.3.4. Number of sectors with minimum wage as the MSST 37

2.3.5. AROPE 38

2.3.6. AROP by employment status 38

2.3.7. In work AROP 39

2.3.8. Labour market policies ( % of total LMP expenditure) 39

3.1.1. Unmet medical needs 43

3.1.2. Developments in health sector financing in Bulgaria (million BGN) 44

3.1.3. Structural indicators in the hospital sector 44

3.1.4. Administrative burden of tax systems for a medium-sized company (2012)* 45

3.1.5. Undisputed tax debt as a percentage of net revenue (2011) 46

3.2.1. Labour market policies 49

3.2.2. Digital Economy and Society Index 51

3.2.3. Education spending and early school leavers 52

3.2.4. Severe material deprivation 53

3.2.5. Reduction in the risk of poverty after social transfers 53

3.3.1. Doing business for EU10 55

3.3.2. Worldwide Governance Index (WGI) and EU Cohesion Policy Funds absorption rates 58

LIST OF Boxes

1.1. Bulgaria depends on Russian energy imports, services exports to Russia are significant, and trade in non-energy goods is negligible 8

2.1.1. Overview of the comprehensive KTB audit 19

2.1.2. Macro-prudential actions 25

Bulgaria’s economic performance has remained subdued during the post-crisis period. After a decline in economic activity in 2009, growth has been fluctuating around 1 % per year, and is forecast to remain so in the short term. Prices stagnated, followed by deflation in the middle of 2013, which is expected to extend through most of 2015. Political instability and banking sector turbulence had a negative impact on confidence in the second half of 2014. Government finances also deteriorated considerably in 2014.

This Country Report assesses Bulgaria's economy against the background of the Commission's Annual Growth Survey which recommends three main pillars for the EU's economic and social policy in 2015: investment, structural reforms, and fiscal responsibility. In line with the Investment Plan for Europe, it also explores ways to maximise the impact of public resources and unlock private investment. Finally, it assesses Bulgaria in the light of the findings of the 2015 Alert Mechanism Report, in which the Commission found it useful to further examine the persistence of imbalances or their unwinding.

The main findings of the in-depth review contained in this Country Report are:

· Banking sector turmoil in the summer of 2014 revealed institutional and supervisory weaknesses. The supervisory body’s failure to detect significant problems in the fourth largest bank in the country, Corporate Commercial Bank (KTB), points to shortcomings in financial sector supervisory practices and in oversight of concentration risk. This has undermined the credibility of banking supervision, in turn also raising doubts concerning the health of other parts of the financial sector.

· Concerns have emerged regarding the reliability of reported financial sector data reports . The liquidity crisis over the summer of 2014 revealed a capital shortfall and led to the revocation of Corporate Commercial Bank’s banking licence. The guaranteed deposits held therein, amounting to some 5 % of GDP, were paid out after a significant delay. Prior to these developments, the bank’s reported asset quality was remarkably high, which the subsequent investigation showed to have been grossly misreported. In addition, shortcomings were discovered with the bank’s collateralisation practices and with its capital adequacy. KTB was an extreme case, but reported figures suggest that there could be shortcomings in other banks as well. Weaknesses may also extend to the non-banking financial sector, particularly in connection to concentration risk and related-party exposures in pension schemes.

· Deleveraging pressures on non-financial corporations, amplified by deflation, could dampen investment and growth in the short and medium term. A large proportion of corporate liabilities, also seen as part of the negative net international investment position, are in the form of cross-border intra-company loans. Nevertheless, deflationary pressures could limit companies’ debt servicing capacity. Furthermore, parts of the economy may face credit constraints during banking sector restructuring after the collapse of KTB. Corporate liabilities in the non-financial sector — including arrears and liabilities towards the government — may also be affected, creating a negative feedback loop for the entire economy.

· As economic growth is still insufficient to support sustainable recovery in employment, the labour market continues to be an area of serious concern. The crisis’ negative effect on employment has not been confined to traditionally vulnerable labour market groups. Unemployment is mostly long-term, underlining its largely structural nature, in the absence of well-targeted and sufficient activation policies for the most vulnerable. School-to-job transition is still problematic. The low quality of education and training systems and their limited relevance to the labour market hampers the supply of a suitably-skilled labour force to the economy. Poverty and social exclusion remain a particular concern for Bulgaria, underpinned by high levels of income inequality.

The country report also analyses other macroeconomic issues and the main findings are:

· Amid weak economic growth and protracted deflation, social pressures and contingent liabilities generated by unreformed sectors pose a threat to fiscal sustainability. Without structural reforms in pensions and healthcare, fiscal sustainability in the medium and long term cannot be ensured. The financial situation of some large state-owned enterprises in the energy and transport sectors remains fragile and may lead to the accumulation of significant contingent liabilities for the government. Tax collection remains inefficient.

· Bulgaria is lagging behind in terms of the quality of several key growth enablers. The country’s growth potential is estimated to be low. Productivity growth is hindered by a number of intertwined weaknesses, ranging from complex regulation and weak administrative capacity, over high compliance costs for businesses, to high energy intensity coupled with low energy efficiency and the poor quality of rail and road transport infrastructure.

· The structural impediments to growth are compounded by a judicial system that lacks effectiveness. A key building block for an investor-friendly business environment is an independent, high-quality and efficient judicial system. As shown by the latest report under the Cooperation and Verification Mechanism, in recent years Bulgaria has made only limited progress in reforming its judiciary and fighting corruption, which is found to be very high in a cross-country perspective.

Overall, Bulgaria has made limited progress in addressing the 2014 country-specific recommendations. During the past year, Bulgaria made some progress on reducing the administrative burden and reforming higher education. However, insufficient action was taken on increasing tax compliance and improving the quality of public sector administration, improving competition and efficiency in the energy sector and enhancing the quality and independence of the judiciary. There was limited progress on extending the coverage and effectiveness of active labour market policies and reaching out to inactive young people. No action was taken on fighting corruption, reforming the pension system or the general education system, or on alleviating poverty and combating social exclusion, including for marginalised populations such as the Roma.

The Country Report reveals a number of policy challenges stemming from the analysis of macroeconomic imbalances, namely:

· Without an in-depth, third-party investigation, the soundness of the financial sector cannot be ensured. Banking sector turmoil during 2014 dented confidence in the financial sector. There are doubts over the reported quality of assets in the system, in particular those in the banking sector. A strong, credible and transparent supervisor is required to reduce the risk of imbalances and correct those that have already accumulated.

· Weak labour market policies and administratively-set wage floors may still price workers out of the labour market, even as conditions for recovery in employment improve. In particular, the lack of targeted education and training practices and active labour market policies may hinder labour market participation and employability of the workforce. The lack of sound mechanisms to set wage floors in line with economic fundamentals may impact employment, especially of unskilled and low-skilled workers.

· A sound and predictable business climate will be important for attracting much needed investment. Red tape in public administration, the low quality of infrastructure, and lack of competition and efficiency in energy diminish the growth potential of the Bulgarian economy. An effective judiciary would also provide a critical degree of predictability in economic relationships, ensuring that citizens, businesses and public officials are all equally accountable under the law.

Other challenges are the concerns over fiscal sustainability, also raised by the incomplete fiscal framework, poor tax compliance and a lack of reforms in key sectors, including pensions, healthcare, energy and transport.

Growth drivers and outlook

Growth is projected to remain low due to subdued domestic demand. Real GDP growth averaged some 5 % per year over 2003-08 but has stalled at around 1 % per year after the contraction of output in 2009 (see Graph 1.1). Weak domestic demand is expected to continue to weigh on growth in 2015-16. Private sector consumption stabilised in 2014 and is expected to be supported by low interest rates and declining oil prices in 2015. However, adverse demographic developments and planned fiscal consolidation are likely to limit the increase in disposable income. Investment in the economy remains low and gross fixed capital formation has stayed broadly flat in real terms since 2009. Private sector investment has been declining since 2008 and is only expected to stabilise in 2016, when uncertainty is expected to decrease, both domestically and abroad. Government investment has been the main driver of gross capital formation post-crisis, mostly linked to the absorption of EU Structural Funds. However, this is expected to slightly lower growth in 2015, as the government phases out an investment programme that was implemented in 2014. A further decline is expected in 2016 as the previous programming period for EU structural funds comes to an end, while the new one will not yet have gathered speed. The inadequate capital stock remains a key impediment to growth.

Potential growth estimates indicate limited convergence towards EU average productivity and income levels in the short term. Potential growth is currently estimated at below 2 % per year (see Graph 1.2). Ageing, emigration and inactivity are becoming a long-term drag on employment and growth. Continued uncertainty, caused by domestic and external factors, is likely to cause companies to focus on productivity gains rather than job creation in 2015-16, in line with the situation in place since 2008.On the domestic side, political instability — resulting in five governments changing office between January 2013 and November 2014 — has weighed on confidence. Financial sector turbulence in 2014 is expected to weigh on credit conditions and company investment plans for several more quarters.

Graph 1.1: Real GDP growth by demand components

Source: European Commission

Employment remains a key issue, as those affected by the crisis continue to struggle in finding jobs (see Graph 1.3). The weak labour market and the social implications of joblessness are discussed in more detail in section 2.3. Other impediments to growth — including structural issues relating to unreformed sectors, the business environment, education and training — are discussed in section 3.

Graph 1.2: Components of potential growth

Source: European Commission

Graph 1.3: Key labour market data

Source: European Commission

External environment

Export-oriented sectors of the economy have recovered faster from the crisis. Bulgaria’s gains in world market shares was sustained in 2013 (see Graph 1.4) and are projected to continue through 2016. Companies seem to have restructured their businesses, optimising costs and increasing productivity. To a certain extent, this has been achieved through labour shedding, as employment in manufacturing has declined each year since 2008.

The current and capital account surplus contribute to improving Bulgaria’s external position. The current-account balance, having corrected swiftly from the very large pre-crisis deficits, is likely to remain positive, at around 1.5 % to 2 % of GDP in 2015-16. Net exports are projected to contribute to growth. The trade balance in non-energy goods turned positive in 2013 thanks to a strong export sector performance (see Graph 1.5). The trade balance in energy remains negative, which is to be expected given the country’s significant dependence on imports for oil and gas (for more details see Box 1.1). The energy-trade deficit has been reduced by more than half since 2008 due to stagnating domestic demand.

Graph 1.4: Export market share

Source: European Commission

Graph 1.5: Current account gross components

Source: European Commission

While Bulgaria’s external position has improved markedly in recent years, the stock of liabilities remains high. The net international investment position has improved by some 25pps. between 2009 and 2014 and stood at around 76 % of GDP at the end of the period (see Graph 1.6). A large proportion of this derives from cross-border intra-company financing. Nevertheless, the stock of liabilities could pose a risk for financing future investments and growth. The deflationary environment and growing government finance needs (both described later in this section) also have a negative impact on the outlook for the external position. Indebtedness and deleveraging are examined in more detail in section 2.2.

Inflation at a historic low

A deflationary trend has prevailed since the middle of 2013 and provides an additional risk for growth and debt stocks. Although consumption may benefit from increased real incomes, its contribution to growth is likely to be offset by the negative impact on businesses. Debt servicing is likely to become more difficult, while profitability could suffer from declining prices, especially if wage growth is not aligned with productivity developments. Since 2009, companies have adjusted to a stagnating economy by reducing costs (including through labour shedding) and limiting new investment. There may, therefore, be limited scope for further cost cutting, leading to an increased risk of delaying repayments and, ultimately, bankruptcies.

Graph 1.6: Decomposition of NIIP

Source: European Commission

In 2014, Bulgaria recorded the strongest average annual deflation in the EU. Bulgaria has the lowest price level in the EU, in absolute terms, and in the past decade has typically recorded inflation rates above the EU average. However, the harmonised index of consumer prices (HICP) decreased sharply over 2013 and fell to -1.6 % in 2014 (see Graph 1.7).

Graph 1.7: HICP inflation and differential vis à vis euro area

Source: European Commission

The strength of deflation is explained by some country-specific price factors in certain product or service categories, most notably regarding healthcare-, telecommunication-, transport- and some specific food-price categories. ([1]) The price changes in these categories are not directly linked with EU-wide price trends or Bulgarian domestic-demand conditions. In the aggregate, they are estimated to explain almost 1 pp. of difference with the 2014 EU average HICP (see Table 1.1).

However, even when taking account of the country-specific factors in the HICP, it is evident that deflation has been significantly stronger in Bulgaria in 2014 than in the EU on average. Some of these country-specific factors are temporary and their effect on the overall price level will fade in 2015. In addition, in 2015, some country-specific factors will lead to price increases, including the 10 % increase in electricity prices as of October 2014. Nevertheless, HICP inflation is not projected to turn positive before the end of 2015, as a result of lower fuel costs and their knock-on effects on other prices. In 2016,

Box: 1.1: Bulgaria depends on Russian energy imports, services exports to Russia are significant, and trade in non-energy goods is negligible This box sets out three aspects of the Bulgarian economy’s exposure to the Russian economy, namely through trade with Russia, energy dependence and foreign direct investment. · Russia accounts for a significant part of Bulgaria’s imports of goods and services, but almost all of this is accounted for by energy products. In 2013, about 20 % of Bulgarian imports of goods came from Russia, with about 95 % of these being energy products. · Russia is a relatively small export destination for Bulgaria. Only about 4 % of Bulgarian exports of goods and services go to Russia. The proportion of goods exports to Russia is particularly small, (2.5 % of total goods exports), while Russia is a larger market for Bulgarian services exports (9 % of total services exports). The main categories for goods exported to Russia are ‘chemicals’ and ‘machinery’ and the main service categories are ‘travel’ and ‘transportation’. · Bulgaria has a relatively high dependency on energy imports from Russia, concentrated in two energy sources: crude oil and gas. Russia provides 100 % of Bulgarian imports of gas and about 80 % of crude oil imports. Bulgaria imports more crude oil than it needs for its own domestic consumption, since a significant proportion of this is processed and re-exported. The largest oil refinery in the Balkan region is located in Bulgaria, owned by a Russian company (Lukoil), and it specialises in refining Russian crude oil. In Bulgaria, the foreign value added content of gross exports is about 35% out of which the Russian share is relatively high at almost 10 pps. This is due to the energy sector (accounted for by the oil refinery) and the transportation services which are also needed to deliver the energy from Russia to Bulgaria. However, Russian value added content shares of Bulgarian manufacturing and knowledge-intensive services exports are small. Graph 1: Imports content share of value added of Bulgarian gross exports in 2011, by sectors

Source: World Input-Output Database, http://www.wiod.org

inflation is projected to turn positive, once the effects of the current oil-price decline disappear. But inflation will remain low compared to past levels, at about 1 %. Overall, the Bulgarian economy may need to operate in a deflationary environment for an extended period of time.

In spite of strong deflation in consumer prices, the GDP deflator, which is a broader economy-wide price measure, is expected to have remained positive in 2014 and to stay positive in 2015. This primarily reflects lower import prices’ positive effect on the GDP deflator. Methodological differences in data collection on different statistical indicators also seem to be significant in Bulgaria. As a result, the decrease in consumer prices has a smaller effect on nominal GDP growth and on the debt stock expressed as a proportion of nominal GDP.

Table 1.1: HICP items with the largest difference between BG and EU, 2014

Data for 12 month cumulative average, latest data reading November 2014. Source: European Commission

In an unexpectedly strong deflationary environment, companies have a weaker ability to service their debt and arrears. The current period of deflation is limiting liquidity in the economy and has contributed to tax revenue shortfalls in the 2014 budget, compared to the government’s projections at the beginning of the year. Arrears in the non-financial corporate sector were already high (see section 2.2. as well as previous in-depth reviews) and stagnating price levels might reduce some companies’ ability to maintain healthy cash flows.

Government finances deteriorate

Fiscal deterioration in 2014 and financing requirements for banking sector measures has resulted in a sharp rise in general government debt, albeit from relatively low levels. The general government deficit deteriorated from 1.2 % of GDP in 2013 to 3.4 % in 2014 and is projected to be about 3 % of GDP in 2015 and 2016. In addition to deficit financing requirements, the debt level has been pushed higher by the additional government debt issued for banking sector measures. As a result, the general government gross debt is expected to increase rapidly from 18.3 % of GDP in 2013 to about 27 % in 2014, and is expected to exceed 30 % of GDP by 2016.

Expenditure on interest servicing government debt is increasing quickly, diminishing the scope to cater for other expenditure needs. Despite the prevailing low interest rate environment, annual expenditure on interest is expected to nearly double in nominal terms between 2014 and 2016. This translates into an increase in expenditure of some 0.5 pp. of GDP, limiting the space for structural expenditure measures. The rising debt burden also implies increased debt servicing costs, once interest rates in the EU and/or in Bulgaria begin to increase.

Further financial sector support measures as well as contingent liabilities coming from state-owned enterprises could add to the rapid increase in government debt. The absence of a lender of last resort under Bulgaria’s currency-board arrangement implies that all potential costs for liquidity and capital provisions to the banking sector have to be borne by the government. So far, the government has been able to successfully issue additional debt in both domestic and international markets to cover the unexpected financing requirements. Given that the domestic saving stock is limited, the increase in general government debt cannot entirely be covered by domestic savings, which implies an increase in foreign funding needs (see section 2.1. for a detailed assessment of the financial sector risks, and section 2.2. for the implications for Bulgaria’s external position). Contingent liabilities, which have been building up in state owned enterprises in sectors like energy and transportation could also be a source of risk for government finances. See section 3. for details.

The banking crisis has also entailed liquidity management challenges for government finances, as the financing requirements related to banking sector measures were unexpected and urgent. Most of the additional funds borrowed for those measures took the form of short-term government bonds and T-bills. The Bulgarian authorities intend to refinance these in 2015 with longer-term government bonds.

Financial sector turbulence in 2014

The banking sector turbulence observed in 2014 revealed significant macroeconomic risks coming from the financial sector. Liquidity pressures in the third and fourth largest banks in the country ([2]) during summer 2014 have led the government to extend liquidity support to the third largest bank and the central bank to place the fourth largest bank under special supervision. The subsequent audit of Corporate Commercial Bank (KTB)’s asset portfolio revealed numerous irregularities in its banking practices. Those had not been detected by auditors or the supervisor up to that point, raising doubts about the quality of reported data in the sector as a whole. Those events also created doubts over whether other banks in the sector could have followed business models similar to that of KTB. Section 2.1. provides a more detailed examination of developments in the financial sector.

Private sector indebtedness remains high

The main risks stemming from private sector debt relate to corporate liabilities. Non-financial corporate debt increased rapidly in the years leading up to the global crisis. The deleveraging observed thereafter came to a stop in 2013, with corporate debt increasing by some 8 pps. to reach 122 % of GDP. In the absence of robust economic growth, this reversal could be a sign of increasing deleveraging pressures and could signal debt servicing difficulties in the future. Household debt is relatively low as a proportion of GDP, at 23.5 %, and has decreased by over 4 pps. since the peak in 2009 (see Graph 1.8).

Graph 1.8: Decomposition of debt by sector (non-consolidated)

Source: European Commission

House prices appear to have stabilised. After a fall of some 40 % since their peak in 2008, house prices have remained broadly flat since mid-2013 (see Graph 1.9). Demand for housing loans has also remained flat, indicating risk aversion on the side of households. Going forward, a boost to demand for housing and prices could come in case people start looking for investment alternatives to bank deposits.

Graph 1.9: Evolution of House Price Index and MFI Loans for House Purchase

Source: European Commission

Box 1.2: Economic surveillance process The Commission’s Annual Growth Survey, adopted in November 2014, started the 2015 European Semester, proposing that the EU pursue an integrated approach to economic policy built around three main pillars: boosting investment, accelerating structural reforms and pursuing responsible growth-friendly fiscal consolidation. The Annual Growth Survey also presented the process of streamlining the European Semester to increase the effectiveness of economic policy coordination at the EU level through greater accountability and by encouraging greater ownership by all actors. In line with streamlining efforts this Country Report includes an In-Depth Review — as per Article 5 of Regulation no. 1176/2011 — to determine whether macroeconomic imbalances still exist, as announced in the Commission’s Alert Mechanism Report published on November 2014. Based on the 2014 IDR for Bulgaria published in March 2014, the Commission concluded that Bulgaria was experiencing macroeconomic imbalances, which require monitoring and policy action. In particular, the protracted adjustment of the labour market warranted policy actions, while the correction of the external position and corporate deleveraging were progressing well. This Country Report includes an assessment of progress towards the implementation of the 2014 Country-Specific Recommendations adopted by the Council in July 2014. The Country-Specific Recommendations for Bulgaria concerned public finances, the pension system, labour market, education, business environment and the energy sector.

Table 1.2: Key economic, financial and social indicators

(1) Domestic banking groups and stand-alone banks (2) Domestic banking groups and stand-alone banks, foreign (EU and non-EU) controlled subsidiaries and foreign (EU and non-EU) controlled branches * Indicates BPM5 and/or ESA95 Source: ECB, European Commission

Table 1.3: MIP scoreboard indicators

Flags: e: estimated. p: provisional. Note: Figures highlighted are the ones falling outside the threshold established by EC Alert Mechanism Report. For REER and ULC, the second threshold concerns non-Euro Area Member States. (1) Figures in italic are according to the old standards (ESA95/BPM5). (2) Export market shares data: the total world export is based on the 5th edition of the Balance of Payments Manual (BPM5). (3) House price indicator: e = NSI estimates. (4) Unemployment rate: i=Eurostat back calculation to include Population Census 2011 results. Source: European Commission

The degree of financial intermediation in Bulgaria is relatively low compared to the EU average, but is in line with that of peer new EU Member States. The total assets of all segments of the financial system add up to around EUR 51.5bn (130 % of GDP), remaining relatively stable over the past several years (see Graph 2.1.1). The system is dominated by the banking sector, which accounts for some 80 % of total assets. This section of the report focuses mainly on the banking and pension sectors, which are likely to be the fastest growing segments of the financial system in the coming years. Both are dominated by large subsidiaries of established international institutions, but there is a non-negligible portion of majority-domestically-owned institutions, which account for about a quarter of the total assets.

Graph 2.1.1: Financial sector assets, EUR million

* excludes the KTB group Source: BNB, FSC, banks’ annual reports

Banking system

The banking system follows a traditional business model and is dominated by foreign institutions, but the composition has changed due to faster growth by Bulgarian-owned banks in recent years. Since the banking crisis of 1996-97, and the setting-up of a currency board arrangement in Bulgaria, the banking sector has been dominated by foreign-owned institutions. The Bulgarian banks are rather conservative, with limited reliance on wholesale funding (less than 5 % of all liabilities for most banks), small inter-bank exposures and an asset side that consists primarily of loans. The 2008 global financial crisis and the subsequent need for parent companies to strengthen their balance sheets, including through deleveraging abroad, decreased the appetite for expansion in the Bulgarian market. Bulgarian-owned banks saw this as an opportunity to gain market shares through quick credit expansion. These new credits were directed primarily to the domestic companies, while funding was ensured through attracting domestic deposits.

Table 2.1.1: Banking system indicators, Sep 2014

For the purposes of this document, the domestically-owned banks include : Investbank, Municipal bank, First Investment Bank, Bulgarian-American Credit Bank, Corporate Commercial Bank, D Commerce Bank, International Asset Bank, Texim bank and Central Cooperative Bank. Source: BNB, European Commission Calculation

While overall credit growth after the 2009 economic downturn has been muted, the domestically-owned segment expanded at very high rates. The average annual growth rate of total loans and advances extended by the Bulgarian banking system between the first quarter of 2010 and the first quarter of 2014 stood at around 3.5 % (see Graph 2.1.2). This modest growth rate, however, masks significant differences between groups of banks. The majority-Greek-owned subsidiaries ([3]) decreased their loan stock by 0.9 % during this period, while the subsidiaries owned by other EU banks ([4]) increased it by 3.7 %. In this context, the average annual expansion of the majority-domestically-owned banks (DOBs) of 17.6 % clearly stands out. This aggressive growth was underpinned by the three biggest DOBs, whose credit portfolios grew by 22.5 % (see Graph 2.1.2). As a result, the DOBs’ share in total loans and advances grew from 14.9 % in March 2010 to 24.8 % in March 2014 (16.8 % in the beginning of 2008). Overall, Corporate Commercial Bank (KTB) exhibited the most buoyant growth rate, at 32.3 % per year. Four DOBs grew by an annual rate in excess of 10 %, while no foreign-owned subsidiary reached this growth rate. DOBs were responsible for over 90 % of the aggregate credit by the banks since 2010.

Graph 2.1.2: Evolution of loans and advances

Source: BNB, European Commission Calculation

Credit expansion took place in the context of low economic growth. Since 2009, nominal GDP grew by 3.3 % per year on average. This is a rather low rate in a catching-up economy like Bulgaria, particularly in comparison with the pre-crisis average of 15 % in 2005-8. This rate of economic growth was far outpaced by the credit growth in DOBs, raising questions about the allocative efficiency of financial intermediation institutions and the quality of the investments they made over this period.

Developments over the summer of 2014

Confidence in Bulgaria’s banking system was seriously dented during the summer of 2014. The banking sector and domestically-owned banks in particular, came under liquidity pressure in late-June 2014. KTB, the fourth-largest bank overall and the second-largest DOB, was placed under special supervision, ([5]) alongside its recently acquired subsidiary Corporate Bank Victoria, after facing a bank run and liquidity pressures. Legal and institutional hurdles prevented the triggering of the deposit insurance scheme within the deadlines required by EU law and depositors were unable to access their funds for more than five months, until 4 December. The central bank eventually revoked KTB’s banking licence in early November after the bank was found to be in a position of deep negative equity (see subsection Audits in KTB for more details), but the insolvency procedure has not yet begun due to legal hurdles. The week after KTB was placed into administration, the largest majority-domestically-owned bank and the third largest bank in the sector, First Investment Bank (FIB), faced a bank run and requested liquidity assistance from the authorities. A credit line of EUR 1.65 billion, approved under State aid rules by the Commission, was made available to all Bulgarian banks. The authorities used it to deposit EUR 0.6 billion into FIB with an initial duration of five months. On 25 November, the European Commission approved the State aid and the restructuring plan for the bank, extending the term of the originally-provided liquidity support by a further 18 months. Retail deposits in five other banks, in addition to KTB and FIB, all of which were DOBs, declined by at least five per cent over the second quarter of 2014. Deposits were generally redistributed within the system and aggregate retail deposits in the system fell by less than 2 % during this period.

After the initial panic, the situation appears to have calmed. The liquidity position of the banking system gradually improved as deposit outflows stopped and inflows eventually resumed. Private sector deposits increased by about EUR 1 billion in July-September and at end-September were 1.2 % higher than at end-May. These deposits, however, mostly went to large foreign-owned banks’ subsidiaries, and some DOBs continued to lose funds during the third quarter of 2014. The liquidity of the system currently seems to be adequate, as evidenced by the declining interest rates for deposits and the low rates on the inter-bank market. The currently stable liquidity position is further supported by the distribution of the guaranteed deposits in KTB, the overwhelming majority of which have remained in the banking system. At the same time, however, some credit institutions — in particular some DOBs — still appear to be under close market scrutiny, as shown by the higher-than-average deposit rates they are paying (see Graph 2.1.3).

Graph 2.1.3: Average cost of household deposits and range of values, %

The sample excludes the branches of foreign banks Source: BNB, European Commission Calculation

Audits in KTB

KTB underwent two third-party audits in the summer of 2014. The audits were requested by the Bulgarian National Bank (BNB) and carried out by Deloitte Bulgaria, Ernst & Young Audit and the domestic company AFA to establish the real situation in the bank as concerns that reported figures may be misleading had emerged. The first audit took ten days in late June and early July, while the second one was much more comprehensive and was carried out between 5 August and 20 October.

The KTB audits raised concerns regarding the asset quality in the sector and the reliability of financial sector data reports. Results of the initial ten-day audit increased doubts about KTB’s banking and reporting practices, and about the adequacy of supervision over the bank as missing documentation did not allow for the proper valuation of over 80% of the loan portfolio. This led the BNB to request a comprehensive audit, (see Box 2.1.1), which confirmed that the reported asset quality and financial results did not accurately reflect the true quality of the loan book. Problems identified in credit-risk management included highly centralised credit management, limited numbers of staff allocated to risk analysis, inadequate control systems given the complexity of the bank’s loan portfolio, and the absence of a specialised unit to deal with non-performing loans . In many cases the credit files did not include a detailed analysis of the financial situation of borrowers, which made valuing the loan portfolios difficult during the ten-day review. The hazards created by these risky lending practices started to materialise around the time of the bank run. At end-May, only 1.6 % of loans were classified outside the category of performing ones, while by end-June 2014 the ratio had increased to 9 %. Moreover, the watch, non-performing and loss exposures amounted to 96 % of the bank’s capital base by end-June 2014.

Box 2.1.1: Overview of the comprehensive KTB audit Results of the administrators’ data collection exercise further increased doubts about lending practices at KTB. The table below summarises the data collection exercise. For reference, at end-June 2014, KTB’s capital amounted to EUR 266.4 million. In addition, 157 of the 166 clients to be audited were asked to submit up-to-date related-party declarations. Table 1: Selected findings from the comprehensive KTB audit || No of clients || Amount borrowed (EUR mn)

137 || 2,702

|| No. || Share || Amount || Share

Sent full documentation || 28 || 20% || 914 || 17%

Sent partial documentation || 80 || 59% || 3,388 || 64%

Sent no documentation || 29 || 21% || 984 || 19%

Source: BNB

Preliminary results from the administrators’ legal review of the available collateral provide evidence of malpractice in KTB’s operations. Based on the analysis of 69 borrowers (around 50% of those reviewed by the auditors), the following problems were identified: (i) unpledged collateral, involving assets that are included in the lending contract but have not been legally pledged; (ii) special claims, which are not legally binding, and (iii) second-lien claims, including 74 claims by KTB and 14 second-lien mortgages.

The administrators’ report on the full audit confirmed the need for significant impairments, placing KTB in a position of negative equity. The auditors completed the valuation of KTB’s assets on 20 October 2014. The information confirmed doubts expressed in previous reports, revealing imprudent lending practices and mismanagement of credit files. The audit also revealed fraudulent practices to misrepresent the actual quality of the loan book, as 42% of the loan servicing payments were found to originate from new loans from the bank itself, wired through a number of accounts in order to disguise the source of the funding. The misconduct in managing lending at KTB revealed in the reports also suggests significant problems in the BNB’s supervision of the bank and raises questions over the quality of bank supervision, as problems with the loan portfolio had not been detected during either on- or off-site inspections. The most recent on-site inspection of KTB took place in mid-2013. The BNB claimed it was misled by the figures reported by KTB, which in turn raises doubts over the quality of audited figures for the rest of the banking system.

Irregularities extend also to KTB’s capital adequacy. The comprehensive audit revealed that a significant portion of the capital increase between October 2011 and March 2014 was financed through loans originating from KTB itself. The BNB pointed out that while the national regulation in force until end-2013 did not forbid this practice, it was deemed imprudent. EU Regulation 575/2013, in force as of the beginning of 2014, however explicitly forbids this practice.

KTB’s losses amount to some two thirds of total assets. According to the final report, the need for further impairments amounts to EUR 2.1bn, ([6]) a significant proportion of KTB’s total assets of EUR 3.3bn. Most additional impairment costs arise from loans to newly-created holding companies. Exposure to these companies was not properly documented or followed up upon, clients refused or were unable to provide the necessary financial information to the auditors to properly evaluate them, some of them have been renegotiated/restructured a number of times and the initially-reported collateral was largely unrealisable. Moreover, these exposures were not properly reported by the bank in its annual audited reports.

(6) The valuation methodology was based on IFRS and ECB best practices and thus differs somewhat from the methodology set by the BNB for the system. Applying the latter would result in loan-loss impairments of EUR 2.4bn. The figures were presented as of 30 September 2014 and did not specify what additional impairments would be required by a worsening of the bank’s asset quality after it was placed under special supervision.

Connected and related-party lending represent a significant risk. ([7]) The comprehensive audit identified significant supervisory shortcomings in the detection of related-party risk. At end-June 2014, KTB’s related-party exposure amounted to 33.5 % of its capital base, a significant increase from the 3.9 % figure reported at end-2013. ([8]) This increase reflected the auditors’ reclassification of a significant exposure to the main shareholder. In addition, the ten-day audit indicated that a large portion of the portfolio is accounted for by exposures to companies connected to the main shareholder. These findings point to significant concentration risk on the books of the bank. The failure of the national banking supervisor (part of the BNB) to detect these irregularities raises doubts over the situation in the rest of the banking system.

Asset quality and supervision concerns

The pricing of loans indicates a higher risk appetite in the DOBs relative to the rest of the system. As Graph 2.1.5 shows, the DOBs have charged, on average, higher interest on the corporate loans they were granting. This profile indicates differences with the rest of the banking system in the average credit quality of borrowers, management standards, credit underwriting practices, the type of collateral and the underlying risk of the portfolio. During the boom years before the 2009 recession, this behaviour could have been justified by the very strong competition for lower-risk clients from the foreign-owned banks, which also accounted for the majority of lending during that period (see Graph 2.1.4). However, this trend continued in the period after 2010 when competition for clients from the other segments of the banking system was much weaker.

Graph 2.1.4: Breakdown of growth in corporate loans by bank segment

Source: BNB, European Commission Calculation

However, the DOBs report better asset quality than the average for the sector. The non-performing loan ratio reported by DOBs is, in aggregate, lower than the sector average (see Graph 2.1.6). This is mainly due to the three largest DOBs, which report relatively low ratios of non-performing loans. At the same time, some smaller DOBs report significantly higher ratios, exceeding 50 % in one case, mainly on account of the negative impact of the bursting real estate bubble after 2008 and overexposure to the property sector. The DOBs accounted for the entire increase in performing loans since end-2010 (see Graph 2.1.7). They also accounted for about 40 % of the increase in bad loans (watch, non-performing and loss categories) and less than 10 % of the increase in loan-loss impairments. These figures show a striking difference in the reported evolution of the assets quality in the two groups of banks. To some extent this can be attributed to different management approaches — while the foreign-owned banks looked to improve their risk profile and clean their balance sheets from incurred losses, also in light of the comprehensive assessment of the European Central Bank in 2014, to which the DOBs were not subjected, the DOBs were still in an expansionary phase. The high proportion of performing loans at the DOBs could also reflect the relatively young age of their portfolios.

Graph 2.1.5: Average credit growth and return on loans to the corporate sector

The size of the bubble represents the relative size of the loan portfolios. Yellow bubbles represent DOBs Source: BNB, European Commission Calculation

Graph 2.1.6: Ratio of watch, non-performing and loss loans to gross loans

Source: BNB, Banks' annual reports, European Commission Calculation

Graph 2.1.7: Change in asset quality categories and impairments, 2010-13*

* excluding foreign branches Source: BNB, Banks’ annual reports, European Commission Calculation

Graph 2.1.8: Ratio of total impairments to watch, non-performing and loss loans

Source: BNB, Banks’ annual reports, European Commission Calculation

The DOBs’ business model could make them more vulnerable in a more subdued macroeconomic environment. The DOBs’ practice of granting loans at higher interest rates than the average for the sector is also a function of the higher cost of funding of these banks. Indeed, interest rates on household deposits held at DOBs have, on average, been more than 1pp higher than the average for the sector as a whole (see Graph 2.1.11). The difference is even more striking when considering the average cost of the total funds attracted. This is due to the unavailability of cheaper intra-group funding in DOBs. The challenging macroeconomic and deflationary environment in Bulgaria, as described in section 1, could make it increasingly difficult for clients to service loans contracted at high interest rates. In turn, this may result in rising non-performing loans and, consequently, increased impairment costs for DOBs.

Reduced reported profitability is an additional concern. While banks operating in Bulgaria have, on the whole, managed to remain profitable throughout the crisis, their profitability was significantly reduced (see Graph 2.1.9). The decline in profitability was bigger in DOBs, mainly owing to a narrowing interest margin (Graph 2.1.10). Unlike the foreign-owned subsidiaries, the profitability of many DOBs declined despite relatively low impairment costs. This suggests that these banks may not be able to generate sufficient profits to absorb losses if asset quality deteriorates. Consequently, even bringing provisioning costs up to the sector average could make them loss-making and start eroding their capital (see Graph 2.1.12). Loan-loss impairments in DOBs represented 2.2 % of total assets (2.8 % when excluding KTB) at end-2013, while the system average stood at 5.9 %.

Graph 2.1.9: Pre-tax profit, % of total assets, 2007-14

2014 figures exclude KTB and reflect the acquisition of MKB Unionbank by FIB Source: BNB, European Commission Calculation

Graph 2.1.10: Net interest income, % of total assets

2014 figures exclude KTB and reflect the acquisition of MKB Unionbank by FIB Source: BNB, European Commission Calculation

Banks’ assets appear well collateralised, but the quality and value of the collateral needs to be re-examined. The audited annual reports of the DOBs indicate high levels of collateral, whose reported value in some cases significantly exceeds that of the assets which they secure. Hence, reported collateral values may not be consistent with accurate and up-to-date market valuations and the enforceability of pledges in some cases is uncertain — KTB’s audit showed that acceptable collateral amounted to only 13 % of the total loans, whereas the audited report for 2013 stated a collateral value of some 170 % of the gross loan book. The collateral in DOBs consists mainly of liquid assets, real estate and ‘other’ collateral, which is a category that includes equity or future receivables from companies. The composition of collateral varies across banks, but in many DOBs ‘other’ collateral represents a significant proportion of the total collateral they hold. In light of this and given the bursting of the real estate bubble after 2009, where housing prices dropped by 40 %, the valuation of collateral is an obvious concern. Accurate collateral valuation is crucial for adequate loan-loss provisioning of banks’ delinquent exposures.

Graph 2.1.11: Cost of funding and growth for Bulgarian banks

Note: The size of the bubble represents the relative size of the portfolios. Yellow bubbles represent DOBs Source: BNB, European Commission Calculation

Resolution framework and deposit insurance

Bulgaria still needs to transpose the Bank Recovery and Resolution Directive in order to have a resolution framework that is fully compliant with the EU resolution rules. Legal provisions have been implemented that allow for burden-sharing with subordinated creditors and shareholders in failed banks. Recent amendments to the Law on Credit Institutions stipulate that bail-in measures should be taken prior to a decision by a competent authority on spending government funds, in compliance with State aid rules. Primary legislation provides that the BNB will issue ordinances on mandatory capital buffers to be held by banks, the terms and conditions for their formation and updating, and ‘conditions for mandatory loss absorption by the shareholders and holders of own funds instruments of the bank before covering losses through other sources’. Full transposition of the Bank Recovery and Resolution Directive is still in progress — the authorities have until end-2015 to implement provisions enabling burden-sharing with senior unsecured creditors and unprotected depositors. This will provide additional protection to taxpayers if cases involving failing banks arise. Other important aspects of the Directive, such as the requirement for banks to develop and regularly update resolution plans in case of failure, have already been transposed, while the BNB also possesses early intervention powers.

Graph 2.1.12: Profit and Loss account, DOBs, scenario if the impairments-to-assets ratio was the same as the sector average, everything else kept unchanged, 4-quarter moving sums

Source: BNB, European Commission Calculation

Despite this seemingly sound resolution framework, the KTB case highlighted shortcomings and inconsistencies with other domestic legislation. The KTB case was not resolved in a quick manner, thus casting doubts over the authorities’ ability to react efficiently in urgent situations. A particular shortcoming in the legal framework that was revealed is that the BNB has the right to put a bank under special supervision, effectively closing it for all operations and freezing its payment obligations, while not revoking its licence, for up to six months. However, the Bulgarian Law on Bank Deposit Insurance uses the withdrawal of a bank’s licence as the only trigger for pay-out of guaranteed deposits. Both the European Commission ([9]) and the European Banking Authority ([10]) have identified this as a breach of the EU Deposit Guarantee Scheme Directive (DGSD). This means that providing deposit insurance compensation in Bulgaria is not a straightforward process, as the KTB case has shown. This, combined with the failure of the central bank to take alternative action citing perceived legal risks (e.g. no legal certainty on prescribed procedures for undertaking a partial pay-out from the available resources of a bank in administration), further complicated the situation and resulted in blocked access to guaranteed deposits for a time period significantly lower than the 20-day period envisaged in the Deposit Guarantee Scheme Directive. This had both negative economic effects and a potential destabilising effect on the entire banking sector. The authorities have submitted a new law on deposit insurance that would address the identified shortcomings to parliament.

Actions by the BNB

After the summer crisis, the authorities announced a number of measures to restore credibility. In the first half of 2014, the BNB initiated macro-prudential measures to conserve the capital buffers accumulated in the system (see Box 2.1.2). Developments over the summer of 2014 revealed supervisory shortcomings, addressing which is crucial for the future stability of the banking system. In particular, weaknesses were noted in the quality, scope and frequency of on-site inspections, particularly for systemic institutions, the supervision of concentration risk, related-party lending and of banks’ collateralisation practices. The authorities announced their intention to enter into close cooperation with the Single Supervisory Mechanism at the European Central Bank, granting the European Central Bank authority over the BNB in a number of areas.([11]) However, no formal steps to achieve this have yet been taken. Moreover, the BNB invited the European Banking Authority to conduct a peer review of its supervisory practices and requested a review by the International Monetary Fund and the World Bank under the Financial Sector Assessment Programme. As a first step towards these reviews, the BNB has launched a process of self-assessment. In addition, the BNB has taken steps to increase the number of on-site inspections and broaden their scope. Finally, a draft law to fully transpose the Bank Recovery and Resolution Directive is expected to be presented to parliament in the second quarter of 2015.

Box 2.1.2: Macro-prudential actions The BNB activated capital buffers during 2014 to address systemic risks stemming from the loosening of prudential requirements on Bulgarian banks as a result of the application of the Capital Requirements Directive (CRD IV). A systemic risk buffer, set at 3% of domestic risk exposures — i.e. for debtors located in Bulgaria, with foreign debtors outside the scope of the measure — was introduced in October with an initial reporting date on 31 December 2014. It applies to all credit institutions authorised in Bulgaria on individual, consolidated or sub-consolidated levels. In accordance with Article 160(6) CRD, the BNB also activated a 2.5% capital conservation buffer, applicable to all credit institutions authorised in Bulgaria as of May 2014. This was earlier than required, as the activation of this buffer was only compulsory from 1 January 2016. Analysis presented by the BNB to the European Systemic Risk Board indicates that the introduction of the CRD IV and the Capital Requirements Regulation package resulted in the weakening of minimum regulatory-capital requirements for Bulgarian banks, as a result of the less conservative requirements in the EU regulatory framework.([12]) Thus, the BNB’s macro-prudential measures have been implemented to prevent the erosion of capital already accumulated in banks and to preserve financial stability in the absence of active monetary policy under a currency-board arrangement, amid deteriorating credit quality and weak profitability in many institutions. However, vigilance on the part of prudential authorities is needed to avoid capital depletion in some banks, given the current calibration of the measures. The main risk stems from the coverage of the systemic risk buffer which targets only domestic exposures, while some institutions have sizeable foreign exposures, including to their parent banks located outside Bulgaria. While the bulk of domestic banks’ credit portfolios is to Bulgarian debtors (about 97%), hence within the scope of the systemic risk buffer, exposures to non-resident credit institutions amount to around EUR 5.23 billion, or 15.6% of total loans and advances for the system as at the end of Q3-2014. It is therefore possible that some foreign-owned banking groups reduce capital in their Bulgarian subsidiaries, while retaining unchanged intra-group exposures (with excess liquidity often posted on deposit with parent banks, also to meet prudential liquidity requirements). While capital levels in the system remain high, weak internal capital generation and deteriorating credit quality in some institutions could result in a gradual capital depletion and erosion of available buffers. In addition, while in aggregate they do not present a material risk, exposures to non-resident credit institutions could need to be brought within the scope of the systemic risk buffer. ([13]) ([1]2) BNB analysis indicates that the introduction of the new EU regulatory framework leads to an improvement in the average capital adequacy ratio of the Bulgarian banking system from 16.9% to 21.7%, with the Tier I capital ratio increasing from 16% to over 19%. Such high capital ratios mitigate somehow the asset quality and collateralisation risks underlined before. ([1]3) All other Member States which have implemented the SRB (CZ, DK, EE, HR, NL and SE) have done so covering all exposures, both domestic and non-resident.

The BNB announced plans for a comprehensive asset-quality review with third-party involvement. Such a review would be a pre-requisite for entering into close cooperation with the Single Supervisory Mechanism. The asset-quality review is planned to cover the entire banking sector, following the methodology applied by the European Central Bank in its comprehensive assessment. Transparency, close cooperation with the international institutions during the entire process and full coverage of the sector, including the foreign branches of Bulgarian banks, will be instrumental in ensuring the credibility of the exercise. The asset-quality review is planned to start in the last quarter of 2015 or the first quarter of 2016.

Pension schemes

The private-pension-fund system has gradually become the largest part of the non-banking financial sector in Bulgaria. As of September 2014, there are nine pension insurance companies operating in Bulgaria. Since 2009, the annual growth rates of the net assets of the pension funds have been 15-17 % for the two market leaders, 22-30 % for the four mid-sized funds and about 25 % for the small funds. According to the Financial Supervision Commission (FSC), the pace of increase in the pension funds’ assets is likely to pick up in the coming years and these are expected to exceed BGN 20 billion (i.e. over a quarter of the size of the Bulgarian economy) by the beginning of the next decade. This would mean a substantial increase in the pension schemes’ importance for the development of capital markets, for financial intermediation and for macroeconomic and financial stability over the coming years. As of October 2014, the largest pension fund is Doverie (subsidiary of the Austrian company Vienna Insurance Group) with net assets exceeding BGN 2 billion (27.6 % market share). The pension insurance market is much more concentrated than the banking or general and life insurance markets. The two market leaders, Doverie and Allianz Bulgaria, account for more than half of the total assets of the sector (Graph 2.1.13).

Private pension funds have developed into an important source of liquidity for Bulgaria’s financial system. They hold about 11 % of the general government debt as of October 2014. While this makes the pension funds an important source of funding for the government, the proportion of funding that they provide is still significantly smaller than that provided the domestic banking system, which holds nearly 70 % of the issued government debt. Moreover, the market value on the funds’ balance sheets of the shares issued by Bulgarian companies represents about 15 % of the market capitalisation of the Bulgarian Stock Exchange.

Graph 2.1.13: Net assets of pension funds, EUR mn Sep-14

* denotes majority-foreign-owned funds Source: Financial Supervision Commission

Direct links between pension funds and the banking system can be significant. Pension funds can invest in bank deposits only in banks that have a credit rating higher than ‘BB’ (according to the scale of Fitch and S&P) or ‘Ba2’ (Moody’s), which significantly restricts the number of banks that funds can deposit in. No DOB meets this criterion. Equity investments in banks are also minor. The most significant exposure between pension funds and the banking system is through the custodian banks that each pension fund is obliged to have (the list of banks that can be custodians is prepared and published by the BNB). Custodian banks hold the pension funds’ cash assets, which in the past have represented up to 20 % of the net assets of individual funds.

Despite being subject to strict supervision, there are vulnerabilities in the sector. The FSC is the authority in charge of supervising pension funds, and the entire non-banking financial sector. The FSC also has some bank supervision responsibilities, but only over the custodian banks of the pension funds. The FSC is headed by a five-person management board that is appointed by parliament for six-year terms and is functionally separate from the BNB. Supervision of the pension funds consists of on-site inspections, review of daily, monthly and quarterly figures for each pension fund and potentially each individual investment they make can be scrutinised. In 2013, the FSC carried out 17 on-site inspections, including cooperating with the BNB on two of the 20 on-site inspections of banks carried out in the same year. The Social Insurance Code limits the instruments that pension funds can invest in (see Table 2.1.2) and sets restrictions on the shareholders (an investor can hold shares in only one pension insurance company) further detailed in a different piece of legislation ([14]) to ensure a competitive and transparent ownership structure. Despite this legislative framework, the ownership structure of the pension insurance companies is not always transparent, which can distort the circle of related parties. This makes identifying related-party exposure to the economic owner of the pension funds and of connected exposures challenging. According to the Social Insurance Code, a pension fund is not allowed to invest in any securities issued by the owner of the pension insurance company that manages it or by companies related to the owner.

Table 2.1.2: Investment restrictions for universal pension funds

* no more than 5 % in a single entity Source: Social Insurance Code

Reviewing and, where necessary, strengthening the supervisory capacity of the FSC is key. The domestically-owned funds are much more focused on the domestic market than their majority-foreign-owned counterparts (see Graph 2.1.14). For some funds, the proportion of investments in foreign instruments is lower than 5 %. The current legislation, while generally sound, has shortcomings in the area of related-party and connected exposures, which involve a significant risk for the profitability of the funds, their clients’ future pensions, and, more broadly, the efficient allocation of resources in the economy. The KTB case showed that related-party exposures can be a significant issue, and uncovering these can be challenging and may necessitate in-depth investigation. The management of credit risk could to some extent impaired by the fact that current legislation does not foresee a role for external asset valuation, apart from real estate properties. Pension funds value their own assets, according to the methodologies prescribed by the FSC in Ordinance 9.

Graph 2.1.14: Instruments traded on regulated foreign markets

Source: Financial Supervision Commission

Private sector deleveraging

Non-financial corporations (NFC) accumulated significant liabilities in the pre-crisis years. While net financial liabilities of NFCs were around 75 % of GDP in 2004, they increased by over 100 percetage points. by 2007. Although this balance sheet expansion led to increased economic output, it also left companies with considerable debt stocks when the crisis hit. Loans are roughly equally distributed between intra-company lending from abroad and domestic bank loans. The share of debt securities is negligible. Since 2008, company liabilities have stabilised. Some variation between the years is visible, mostly due to equity-valuation effects (see Graph 2.2.1).

Graph 2.2.1: Balance sheet, non-financial corporations

Source: European Commission

The high level of corporate indebtedness implies considerable deleveraging needs in the sector. Potential deleveraging needs in the private sector (including households) have been estimated at over 30 % of GDP, most of which is expected to come from the non-financial corporate sector. Balance sheet adjustment could therefore negatively impact investment and growth in the short to medium term. Corporate debt workout could also impact banking sector profitability, especially for credit institutions, which have assumed a higher risk in expanding their credit portfolios in recent years. For more details, see section 2.1.

The prevailing deflationary environment further increases the pressure on corporate balance sheets. In the absence of traditional monetary policy tools under the currency-board arrangement, the performance of companies in Bulgaria depends strongly on external factors, including import and export prices and currency movements of the euro. The deflation observed in the country since mid-2013 has a negative impact on cash flows and profitability, which has been declining since 2009.

Graph 2.2.2: Profit margins, non-financial corporations

Source: European Commission

Firm-level data confirms macroeconomic and financial risks related to the high corporate debt. Looking at firms’ debt leverage and profitability indicates that a significant proportion of companies operate with high debt to capital ratio and low profitability, measured by EBITDA (see Table 2.2.1). ([15]) This suggests that debt financing is not employed productively in those companies and that a significant portion of debt financing is concentrated in the least profitable companies. Such businesses are more susceptible to economic shocks, increasing the risk of them going into bankruptcy. Companies in the hotels and restaurants, construction, real estate and other services sectors face the highest risk in this regard (see Graph 2.2.3). In turn, if those risks materialise, they could increase loan losses and could impact the health of the banking sector. As already noted in section 2.1., KTB’s losses were largely concentrated in loans to companies with high leverage and low or negative profitability.

Table 2.2.1: Corporate debt ratios

Source: ORBIS database, European Commission Calculation

Graph 2.2.3: Sustainability risks by sector

Source: ORBIS database, European Commission Calculation

Deleveraging pressures are more pronounced on the credit demand side. Despite decreasing interest rates, there has been little demand for credit in the post-crisis period. The slow economic recovery, weak domestic demand and the accumulated high debt stocks contribute to this development. Looking at individual sectors, debt stocks in construction and the hotel and restaurant industry have declined since 2009, while export-oriented sectors, including manufacturing and professional services (including an expanding business process outsourcing sector) have maintained their credit demand and have taken on more debt. In some sectors, however, credit developments have been notably more dynamic than the change in gross value added, including in some sectors that face high financial sustainability risks (see Graph 2.2.4). On the credit supply side, the increasing share of non-performing loans and changing risk appetite for some parts of the banking sector, as discussed in section 2.1., may have led to tightening of the lending criteria (see Graph 2.2.5).

Graph 2.2.4: Sectoral growth of loans and gross value added

The size of the balloon indicates the share of the sector in total loans. NACE 2 codes: A – Agriculture, forestry and fishing. F+L – Construction and real estate activities. M-N – Professional, scientific and technical activities; administrative and support service activities. Source: BNB, European Commission, European Commission Calculation

Private investment has declined throughout the post-crisis period. Investment net of depreciation and amortisation has contracted sharply in the aftermath of the crisis in all sectors, most notably in construction and real estate. As foreign capital flows dried up, gross investment contracted and has not been sufficient to maintain the pre-crisis level of accumulated capital. Going forward, investment needs are likely to increase with economic recovery, highlighting the importance of improving the business environment, as discussed in section 3.

An increase in corporate saving could be interpreted as a response to deleveraging pressures. Companies have increased saving and contributed positively to the saving-investment balance of the total economy since 2010 (see Graphs 2.2.6 and 2.2.7). The balance was strongly negative in the pre-crisis years when the deficit was funded by foreign capital inflows. Increased financing needs of the public sector and private investment needs could open up the gap again and would need to be financed from abroad.

Corporate deleveraging pressures could also have impacted the drop in employment. The decrease in employment in the post-crisis period has been higher in Bulgaria than for other countries with a similar drop in output and could also be related the on-going balance sheet repair. ([16])

Policy attention appears warranted, to ensure a smooth deleveraging process with minimum impact on economic growth. Policy avenues to address the problem could include improvements to the insolvency framework (see section 3), coordination of debt workout where possible as well as measures related to the banking sector as discussed in section 2.1.

Graph 2.2.6: Savings and investment, non-financial corporations

Source: European Commission

Graph 2.2.7: Saving - investment balance

Source: European Commission

Sustainability of the external position

The net international investment position (NIIP) appears sustainable based on recent current account (CA) developments and future projections. The external position remains highly negative – NIIP stood at around -76 % of GDP in 2014. An in-house model, used to forecast the development of the NIIP ([17]), combined with the European Commission forecast indicate a likely continued improvement of the external position. Maintaining the same NIIP as a proportion of GDP over the next decade allows for annual average current-account deficits of 2.3 %. At the same time, reducing the NIIP to the scoreboard threshold of -35 % by 2024 would require current-account surpluses of 2.0 % per year. Given the current current-account composition, this would require an average primary current-account (trade balance + current transfers) surplus of 4.5 %. The NIIP improvement is therefore only expected to be gradual in the short term (see Graph 2.2.8).

Graph 2.2.8: NIIP-stabilising current account balances based on long-term projections

Current account as reported in national accounts. Source: European Commission

Sustainability will also depend on perceptions of risk going forward. External liabilities are concentrated in the non-financial private sector (see Graph 2.2.9). Most of them consist of cross-border intra-company lending, as shown in the gross external debt breakdown (see Graph 2.2.10). This type of financing has a relatively low risk profile. Nevertheless, it is not risk-free and could create financing problems if foreign investors change their risk perception of Bulgaria. After a rapid expansion in liabilities, the financial sector repaid most of its foreign debt over the past two years. Government external liabilities have been low, but the increased deficits seen in 2014 and planned for the coming years could increase the importance of government borrowing for the NIIP, as discussed in section 1.

The maturity profile and currency composition of external debt do not suggest immediate risks. Short-term debt decreased to below 30 % of the total, after having peaked at over 35 % in 2008, and is roughly equally distributed between the financial and non-financial corporate sectors. The government’s external debt was entirely long-term until the end of 2014, when it took out a short-term loan. Following the maturing and refinancing in euros of a US-dollar denominated bond in January 2015, over 90 % of Bulgaria’s gross external debt is euro-denominated.

Graph 2.2.9: NIIP by sector

Source: European Commission

Foreign direct investment (FDI) has been an important part of funding growth and shaping the NIIP. Domestic saving is insufficient to finance growth. FDI inflows have benefited the economy as a whole and, in particular, sectors like manufacturing, by raising productivity and improving the country’s export performance. A large proportion of FDI in the pre-crisis period went also into construction and real estate investments (see Graph 2.2.11). Although they benefited the tourism industry, those investments also helped inflate the real estate bubble and contributed to the rapid expansion of the construction sector. As a consequence of the crisis, housing prices have dropped by some 40 % and around 1/3 of construction sector workers have lost their jobs. This emphasises the importance of attracting FDI in sectors of production, to avoid creating imbalances in the economy.

The sectoral composition of FDI inflows has changed in the post-crisis period. Recent FDI flows have been more balanced in their industry composition. Notably, the energy sector, including renewable energy sources, has particularly attracted the investor's attention (see Graph 2.2.12). However, recent problems with pricing the energy produced by those sources indicate potential issues with the profitability of those investments. The FDI stock in energy has doubled over 2010-13. Manufacturing has attracted 21 % of the investment flows, while investment in construction and real estate has slowed down considerably.

Graph 2.2.10: Gross external debt structure

Source: European Commission

Overall, external indebtedness has been reduced post-crisis but risks remain. Those are mostly related to private sector debt servicing in a deflationary environment and the increasing financing needs of the public sector.

Graph 2.2.11: Inward FDI stock by economic activity

* 2014 3rd quarter Source: Bulgarian national bank

Graph 2.2.12: FDI inflows, 2010-2014

Source: Bulgarian national bank

External performance and competitiveness

External indebtedness developments depend on current-account dynamics and thus are strongly linked to the country's export performance. The section below looks at Bulgaria's external performance and competitiveness.

Graph 2.2.13: World market shares for services

Source: WTO, European Commission

Bulgaria appears well-positioned to increase its exports. A detailed look at the geographical and product specialisation of the country shows that for the 2008-13 period it has managed to expand its share both in the products it exports and in the share of imports of its trading partners. Moreover, the main trading partners exhibit positive market dynamism (their markets are growing faster than the world average) and Bulgaria is able to increase its share of this growing market (see Graphs 2.2.14 and 2.2.15).

Graph 2.2.14: Geographical and sectoral composition of nominal (USD) rate of change of goods exports

Decomposition of total (worldwide) nominal export growth (net of the global trade growth) into four components: i) growth due to the growth of destination markets, ii) growth due to the growth in product markets, iii) export growth to destination markets above their growth, iv) export growth in product markets above their growth. Source: COMTRADE date, European Commission Calculation

Cost competitiveness in the industrial sector appears sound, while wage growth is higher than productivity gains in construction and services sectors. Labour cost and unit labour cost (ULC) growth has slowed down and is expected to remain low in the coming years. Labour shedding in the industry sector has continued throughout the post-crisis period, leading to increased productivity. At the same time ULC growth in the sector has remained much lower compared to the rest of the economy (see Graph 2.2.16). Apart from cost competitiveness, non-cost factors have also contributed positively to the country's export performance. ([18])

Graph 2.2.15: Dynamism and competitiveness of goods exports (2012-2013)

The size of the bubbles indicates the weight of this destination on total export of the country at the end of the period. Market dynamism stands for the difference between the annualized growth rates of world imports per market and global world imports. Competitiveness stands for the difference between the annualised growth rates of the selected country exports per market and world imports per market. Source: ORBIS database, European Commission Calculation

Following record-level deficits in the boom years, the current account (CA) balance underwent a mostly non-cyclical correction. A combination of global economic growth, financial-markets deepening and positive confidence effects in the build-up to the country's EU accession resulted in cumulative CA deficits of over 75 % of GDP over 2005-08, or an annual average of around 19 %. FDI inflows financed the deficits, which were to a large extent, driven by the goods and services required by the foreign investments. Non-cyclical factors seem to explain most of the post-crisis correction. The output gap was positive between 2002 and 2008, peaking at 5 % of potential output in the last year and turned negative after that.

Graph 2.2.16: Unit labour costs by sector

Source: European Commission

While the rapid CA correction thereafter does suggest a cyclical element, the CA surpluses observed since 2011, indicate a structural change of the CA composition. The non-cyclical correction observation is also supported by the in-house model for adjusting the CA, taking into account the output gap and real effective exchange rate movements (see Graph 2.2.17).

Graph 2.2.17: Component contributions to change in CA balance 2007-2015

Source: European Commission

Overview

The Bulgarian labour market is weak with low employment and high unemployment rates. The number of people employed in 2014 was about 13 % lower than it was at its peak in 2008. Measured in terms of working-age population (people aged 20-65), the employment rate has fallen from over 70 % in 2008 to 63.5 % in 2013. Bulgaria has therefore fallen behind the EU average of 68.4 %. The working-age population itself has been on a declining path for a number of years. After a trough at below 6 % in 2008, the unemployment rate peaked at 13 % in 2013 and is estimated to have fallen back to 11.7 % in 2014. In spite of early signs of improvement in the labour market in 2014, a large proportion of the population still faces major challenges to participating in the labour market. This exposes them to the risk of poverty. In 2013 the activity rate for people aged 15-64 was 3.5 pps. lower than the EU average, while the rate for those aged 15-24 was 12.5 pps. below the EU average. The recovery in the labour market is forecast to remain modest in 2015-16.

Certain sectors and types of workers have been particularly affected by the crisis. As recognised in previous studies, ([19]) unemployment in Bulgaria has increased the most during the economic crisis for unskilled and low-skilled workers, young people and Roma. Job losses have been largest in the construction and manufacturing sectors. The construction sector suffered the consequences of a bust in the real estate market. Job losses in manufacturing, a mostly export-oriented sector, indicate that companies may have primarily opted for labour shedding to reduce costs and increase competitiveness.

Taking a broader view, the underlying problems in the composition of the labour force lead to low employment and limit the economy’s adjustment capacity in the short term, while restricting growth potential in the medium and long term. The low adaptability to labour market changes shows that the education and training systems (including skills anticipation) could make skills more responsive to labour market needs. The high rate of skills mismatches is made more acute by, on the one hand, the sharp and potentially permanent job destruction in sectors that have been hard hit by the crisis, and, on the other hand, big misalignments between skills supply and demand in the labour market. This leads to structurally low employability for some disadvantaged groups. Moreover, the lack of skills is exacerbated by high levels of emigration. These factors come in addition to overall concerns of an ageing population and add to the challenges for the labour market.

Long-term unemployment increased in the post-crisis period and risks becoming structural. The average duration of unemployment increased between 2009 and 2014. In particular, the proportion of people out of job for more than four years increased from around 1 % of the labour force to over 2.5 % between 2008 and 2014, and currently represents over 20 % of unemployed people (see Graph2.3.2). As noted in the 2014 in-depth review, this increases the risk of unemployment becoming structural, as the skills of those who are unemployed are eroded or become irrelevant with the changing labour market demand. High structural unemployment would lower the economy’s adjustment capacity.

Graph 2.3.2: Unemployment by duration

Source: European Commission

Minimum-wage setting

Bulgaria has a nation-wide statutory minimum wage set by the government. A freeze between 2009 and 2011 has been followed by marked increases and stronger-than-average wage growth. Although in nominal terms the Bulgarian minimum wage is the lowest in the EU, its increases between late-2011 and mid-2015 amount to over 58 % cumulatively, including the already-legislated two-step increases for this year. The government's plans include further increases of some 18 % over 2016-17. As a result, the minimum-to-average-wage ratio has increased and could exceed 50 % by 2017 (see Graph 2.3.3). Going forward, such sharp discretionary shifts in the government's wage setting policy could be distortive for the labour market.

Graph 2.3.3: Minimum and average wage (BGN)

Source: European Commission

Recent minimum wage increases have doubled its coverage and increased its importance for the employability of some workers. According to a report by the Ministry of Finance ([20]) the proportion of workers receiving the minimum wage had decreased from 16 % in 2005 to 6 % in 2011. The increases until 2014 put the coverage at 12.4 % of the employed, ([21]) while no estimations have been made for the legislated increases in 2015 and beyond. According to a study commissioned by the Ministry of Labour, ([22]) the majority of surveyed employers (around 60 %) do not consider the minimum wage as a significant factor for their hiring and firing decisions. However, the general result does not hold for all regions, economic sectors and employee skill levels. For example, over 50 % of the surveyed employers in sectors intensive in low-skilled labour, like extractive industries, hotels and restaurants and energy sectors as well as those in the north-west region of the country consider the minimum wage growth as a factor for decreasing employment.

Minimum wage increases are decided without following a mechanism based on relevant macro-indicators. There are no clear guidelines for minimum wage setting in Bulgaria and there is lack of transparency and effective consultation with social partners. Consequently, the system creates uncertainty as to whether the right balance will be struck between the objectives of supporting employment and competitiveness on the one hand, and safeguarding labour income on the other.

Minimum social security thresholds

The system of minimum social security thresholds (MSST) and their increases in recent years may price the low-skilled out of the labour market and limit the options for labour market adjustment. This system of MSST sets over 700 different minimum social security contribution levels, for about 85 economic sectors and 9 occupation types. Introduced in 2003, the system targeted combating the shadow economy and improving tax collection. MSST growth has broadly followed average wage growth. ([23])

MSST growth for the unskilled and low-skilled has been accelerated through administrative minimum-wage increases. The rapid increases of the minimum wage have made it the MSST for the low-paid workers in most economic sectors (see Graph 2.3.4). Although thresholds are negotiated between social partners, the administrative increases of the minimum wage have replaced and actually invalidated this negotiation process for the lowest-paid workers, which were hardest hit by the rise in unemployment.

Graph 2.3.4: Number of sectors with minimum wage as the MSST

Source: Ministry of labour, European Commission

The current thresholds-setting process implies an element of regressive social taxation. In the case of workers whose actual wages are below the relevant MSST, the burden of social security contributions is higher than the statutory rate for both the employee and the employer. This could de facto lead to a higher tax wedge for lower-paid labour. For instance, the minimum contributory income for agricultural producers was increased by 25% as of 1 January 2015, which will tend to increase the relative cost of social security contributions for lower-paid labour in the agricultural sector.

A study commissioned by the Bulgarian Ministry of Labour and Social Policy recommends that MSST should be kept unchanged in economic sectors with a high concentration of low-skilled employees. The survey was carried out in 2014 in response to the country-specific recommendation to evaluate the influence of MSST on employment, in particular of low-skilled people. It recommends keeping the annual negotiations between social partners on MSST indexation for sectors with high value added but to keep MSST unchanged in those with low-paid labour, as employment would otherwise be negatively impacted. The authorities’ study itself highlights some 'grey' practices in applying MSSTs, including: reassigning employees from positions with a higher MSST to positions with a lower MSST; declaring employees on part-time contracts; employing people on fictitious contracts (e.g. on a lower salary, with undeclared top-ups in cash); and undeclared work from employees without a labour contract.

The Ministry of Finance has completed one study of the MSST system and is working on another. Early results indicate that these thresholds do seem to have an impact on micro firms in two of the sectors examined — retail trade and the hotel and restaurant sector — while no such impact is observed in the third sector examined — transportation.

Progress made in analysing the impact of MSST has not been translated into government policy. Over the past two years, the government kept the unchanged the MSST for those cases when social partners did not reach an agreement. This policy was reversed in 2015, as the government applied administratively the average increase of 4.2 % to all sectors, where no agreement between the social partners could be reached.

Social consequences of unemployment

Joblessness has been identified as a major driver of poverty in Bulgaria (see also the 2014 in-depth review). The proportion of the working-age population (people aged 18-64) at risk of poverty in Bulgaria is nearly twice the EU average (see Graph 2.3.5). However, the proportion of employed people who are at risk of poverty is below the EU average (see Graph 2.3.7), indicating that employment has a large impact on reducing relative poverty in Bulgaria. ([24]) Also, the risk of poverty for the unemployed people is considerably higher than for the retired and other economically inactive persons (see Graph 2.3.6). The creation of quality jobs is therefore of key importance to reduce poverty and social exclusion.

Graph 2.3.5: AROPE

AROPE - People at risk of poverty or social exclusion Source: European Commission

Since the crisis, labour market expenditure has mechanically shifted to passive measures as spending on unemployment benefits increased. Expenditure on active measures was kept nominally flat, despite the increase in job losses and the duration of unemployment periods. In 2011, spending on active measures amounted to less than 0.2 % of GDP. Expenditure on unemployment benefit increased since 2008 and this has acted as an automatic stabiliser following the deterioration of the labour market (see Graph 2.3.8).

Improving the employability of young people not in employment, education or training (NEETs) remains a major challenge. In October 2014, a national agreement was signed between the authorities and relevant stakeholders to ensure the delivery of the Youth Guarantee implementation plan. The authorities are currently financing the recruitment of young NEETs at municipal level to help identify and reach out to non-registered inactive young people, to motivate and support them in finding a job or in taking part in training or education. The government has also recently selected non-profit organisations to set up youth centres providing information and advice. The Employment Agency has taken some steps to reach inactive NEETs: it organised job fairs and ensured the provision of targeted individual support services (e.g. psychological support). As part of implementing the Youth Guarantee, the Employment Agency (EA) published a wide-ranging list of occupations and jobs offered by employers in response to the Youth Guarantee. Activation policies and other possible measures are discussed in more detail in section 3.2.

Graph 2.3.6: AROP by employment status

AROP - People at risk of poverty Source: European Commission

Graph 2.3.7: In work AROP

Source: European Commission

Labour market policies supported by the European Social Fund have continued to play an important role in Bulgaria. Although absorption was low in the first years, reaching only 11 % in 2011, this has since increased, exceeding 75 % at the end of 2014. Labour market policies and the related issues of training and education are discussed further in section 3.

Graph 2.3.8: Labour market policies ( % of total LMP expenditure)

Source: European Commission

Overall, the post-crisis labour-market adjustment is made even more difficult by the lack of adequate wage and social contribution setting systems, which continues to limit job creation and poverty resorption, and poses risks for the country's growth potential.

Amid the deterioration in government finances in 2014, social pressures and contingent liabilities generated by unreformed sectors pose a threat to fiscal sustainability. Structural reforms in key sectors, including pensions and healthcare, are necessary to ensure fiscal sustainability in the long term. In the medium term, several large state-owned enterprises in the energy and transport sectors appear to accumulate significant contingent liabilities for the government. In turn, poor tax compliance and significant tax evasion affect tax revenues. The 2014 country-specific recommendations for Bulgaria set out the need for measures to strengthen tax collection, reinforce the fiscal framework, ensure cost effective provision of healthcare services and implement a long-term strategy for the pension system.

Fiscal sustainability

Bulgaria’s public finances do not appear to face major sustainability risks in the medium term. Government debt (18.3 % of GDP in 2013, expected to rise to 30.3 % in 2016) is currently well below the 60 % of GDP Treaty reference value and is expected to remain below this, even if it continues to rise until 2030. However, based on current pension legislation and abstracting from likely changes due to low adequacy, the budgetary impact of population ageing may pose a challenge to long-term fiscal sustainability. The old-age-dependency ratio, measured as the proportion of people aged over 65 in the population aged 15-64 is expected to rise from 28.9 % in 2013 (EU-28: 27.8 %) to 58.4 % (EU-28: 50.1 %) by 2060 ([25]). It is therefore appropriate for Bulgaria to further contain growth in age-related expenditure to contribute to the long-term sustainability of public finances. Ageing costs comprise long-term projections of public age-related expenditure on pensions, health care, long-term care, education and unemployment benefits.

Bulgaria has made no progress in the area of pension reform. The new government has extended the freeze in the increase in the retirement age in 2015. There are still no plans to link the statutory retirement age to life expectancy in the long term and to equalise the retirement age for men and women. The phasing out of early retirement options has not begun. Similarly, no steps were taken towards tightening eligibility criteria and procedures to allocate invalidity pensions and in the first nine months of 2014, the number of people receiving invalidity pensions increased by 8.4 % compared to the same period in 2013. ([26])

The adequacy and sustainability of the pension system depend on reforms that incentivise and support longer and less interrupted working lives. In 2013, the pensions provided to 1.2 million pensioners were found to be below the national poverty line. ([27]) The rate of people at risk of poverty or social exclusion among people aged over 65 is 57.6 %, the highest in the EU. The at-risk-of-poverty rate contributes significantly to this high level. The key drivers behind low pension entitlements are early retirement and short contributory periods. In 2013, the average age at which people received their pension for the first time was 56.2 years. Increasing the number of years spent in the labour market would help close the gender pension gap of 33 % ([28]) and reduce the high rate of people at risk of poverty and social exclusion among the over-65s. The rapid ageing of Bulgarian society is likely to aggravate the situation in the future.

Health care systems

The Bulgarian healthcare system faces several major challenges, including poor health outcomes, low funding and notable inefficiencies in the use of resources. Life expectancy is considerably below the EU average and life expectancy at birth is among the lowest in the EU. The poor health situation highlights higher needs for healthcare and long-term care in the future. Bulgaria has the lowest public health expenditure per capita (2012, PPS) in the EU and a high share of private in total health expenditure (46 %) with disproportionately high levels of private expenditure for outpatient medical goods. A mapping of infrastructure investments and a clear implementation plan for the National Health Strategy are still lacking and these have not progressed over the last year. According to estimates, between 10 to 20 % of the population are not covered by the National Health Insurance Fund, since they do not pay health-insurance contributions. ([29]) This is also linked to non-participation in the labour market (e.g. for Roma people, among others) and places a large burden on the system.

The healthcare system fails to address the issues of equitable access. Unmet medical needs for cost reasons for the lowest-income quintile of the population in Bulgaria are the second-highest among EU Member States (see Graph 3.1.1). In addition, the incidence of bribery and informal payments in Bulgaria are above the EU average. ([30]) Given that the private cost of healthcare is already a substantial barrier to equitable access, this particularly jeopardises access for the most disadvantaged population groups. Administrative capacity in the healthcare sector needs to be strengthened to enable appropriate strategies to be designed, programmes to be implemented and high-quality projects to be delivered, therefore improving Bulgaria’s ability to obtain results from its investment in healthcare.

The health-insurance fund is accumulating deficits due to non-payment of health contributions and administrative pricing practices in healthcare services. The system continues t