EUROPEAN COMMISSION Brussels, 7.6.2016 SWD(2016) 191 final COMMISSION STAFF WORKING DOCUMENT Convergence Report 2016 Accompanying the document REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL CONVERGENCE REPORT 2016



(prepared in accordance with Article 140(1) of the Treaty on the Functioning of the European Union)

{COM(2016) 374 final}



European Commission Directorate-General for Economic and Financial Affairs Convergence Report 2016 EUROPEAN ECONOMY 4/2016 Member States BG Bulgaria

CZ Czech Republic HR Croatia HU Hungary PL Poland RO Romania SE Sweden EA Euro area EA-19 Euro area, 19 Member States EA-18 Euro area, 18 Member States before 2015 EA-17 Euro area, 17 Member States before 2014 EU-28 European Union, 28 Member States EU-27 European Union, 27 Member States before July 2013 (i.e. EU-28 excl. HR)

EU-25 European Union, 25 Member States before 2007 (i.e. EU-27 excl. BG and RO) EU-15 European Union, 15 Member States before 2004 Currencies EUR Euro BGN Bulgarian lev CHF Swiss franc CZK Czech koruna HRK Croatian kuna HUF Hungarian forint PLN Polish zloty RON Romanian leu (ROL until 30 June 2005) SEK Swedish krona Central Banks BNB Bulgarska narodna banka (Bulgarian National Bank – central bank of Bulgaria) ČNB Česká národní banka (Czech National Bank – central bank of the Czech Republic) HNB Hrvatska narodna banka (Croatian National Bank – central bank of Croatia) MNB Magyar Nemzeti Bank (Hungarian National Bank – central bank of Hungary) NBP Narodowy Bank Polski (National Bank of Poland – central bank of Poland)

BNR Banca Naţională a României (National Bank of Romania – central bank of Romania) Other abbreviations AMR Alert Mechanism Report BoP Balance of Payments CAR Capital adequacy ratio CBA Currency board arrangement CDS Credit Default Swaps CEE Central and Eastern Europe CIS Commonwealth of Independent States CIT Corporate Income Tax CPI Consumer price index CR5 Concentration ratio (aggregated market share of five banks with the largest market share) EC European Community ECB European Central Bank EDP Excessive Deficit Procedure EMU Economic and monetary union ERM II Exchange rate mechanism II ESA European System of Accounts ESCB European System of Central Banks

EU European Union Eurostat Statistical Office of the European Union FDI Foreign direct investment FGS Funding for Growth Scheme FSA Financial Supervisory Authority FSAP Financial Sector Action Plan GDP Gross domestic product HICP Harmonised index of consumer prices HFSA Hungarian Financial Supervisory Authority MFI Monetary Financial Institution MIP Macroeconomic Imbalance Procedure MTO Medium-term objective NCBs National central banks NEER Nominal effective exchange rate NIK Najwyższa Izba Kontroli (Poland's Supreme Chamber of Control) NPL Non-performing loans OJ Official Journal OJL Official Journal Lex PIT Personal Income Tax PPS Purchasing Power Standard

PPP Purchasing Power Percentage REER Real effective exchange rate SNB Swiss National Bank TFEU Treaty on the Functioning of the European Union ULC Unit labour costs VAT Value added tax WSE Warsaw Stock Exchange The Convergence Report and its Technical Annex were prepared in the Directorate-General for Economic and Financial Affairs. The main contributors were Balázs Forgó, Anton Jevčák, Julda Kielytė and Erik Sonntag. Other contributors were Hanna Aspegren, Wojciech Balcerowicz, Laura Bardone, Francisco Barros Castro, Eugeniu Colesnic, Karl Croonenborghs, Iván Csaba, Angela D'Elia, Patrick D'Souza, Jari Friebel, Isabel Grilo, Zoltán Gyenes, Julien Hartley, Michal Havlát, Nora Hesse, László Jankovics, Isabelle Justo, Csanád Sándor Kiss, Cvetan Kyulanov, Milan Lisický, Allen Monks, Aurora Mordonu, Kristian Orsini, Wojciech Paczynski, Mona Papadakou, Janka Petőcz, Presiyan Petkov, Ventsislav Petrov, Lucia Piana, Dominik Pripužić, Elena Reitano, Monika Sherwood, Outi Slotboom, Michael Stierle, Caroline Vandierendonck, Bartlomiej Wiczewski and Rafał Wielądek. Statistical assistance was provided by Eric Mc Coy, Gerda Symens and André Verbanck, administrative assistance by Lina Chahrour, Greet De Pauw and Martine Meijer. The report was coordinated by Balázs Forgó under the supervision of Paul Kutos, Head of Unit and approved by Lucio Pench, Director, Servaas Deroose, Deputy Director General, and Marco Buti, Director General. Questions and comments may be referred to Balázs Forgó ( balazs.forgo@ec.europa.eu ). Convergence Report 20161 Convergence Report 2016 - Technical annex3 1.Introduction5 1.1.Role of the report5 1.2.Application of the criteria5 1.2.1.Compatibility of legislation6 1.2.2.Price stability7 1.2.3.Public finances9

1.2.4.Exchange rate stability12 1.2.5.Long-term interest rates12 1.2.6.Additional factors13 2.Bulgaria15 2.1.Legal compatibility15 2.1.1.Introduction15 2.1.2.Central Bank independence15 2.1.3.Prohibition of monetary financing and privileged access16 2.1.4.Integration in the ESCB16 2.1.5.Assessment of compatibility16 2.2.Price stability17 2.2.1.Respect of the reference value17 2.2.2.Recent inflation developments17 2.2.3.Underlying factors and sustainability of inflation17 2.3.Public finances20 2.3.1.Recent fiscal developments20 2.3.2.Medium-term prospects21 2.4.Exchange rate stability22 2.5.Long-term interest rates23 2.6.Additional factors23

2.6.1.Developments of the balance of payments24 2.6.2.Market integration25 3.Czech Republic29 3.1.Legal compatibility29 3.1.1.Introduction29 3.1.2.Central Bank independence29 3.1.3.Prohibition of monetary financing and privileged access30 3.1.4.Integration in the ESCB30 3.1.5.Assessment of compatibility30 3.2.Price stability30 3.2.1.Respect of the reference value30 3.2.2.Recent inflation developments31 3.2.3.Underlying factors and sustainability of inflation31 3.3.Public finances34 3.3.1.Recent fiscal developments34 3.3.2.Medium-term prospects34 3.4.Exchange rate stability35 3.5.Long-term interest rates36 3.6.Additional factors37 3.6.1.Developments of the balance of payments37

3.6.2.Market integration38 4.Croatia41 4.1.Legal compatibility41 4.1.1.Introduction41 4.1.2.Central Bank independence41 4.1.3.Prohibition of monetary financing and privileged access41 4.1.4.Integration in the ESCB41 4.1.5.Assessment of compatibility41 4.2.Price stability41 4.2.1.Respect of the reference value41 4.2.2.Recent inflation developments42 4.2.3.Underlying factors and sustainability of inflation42 4.3.Public finances44 4.3.1.The excessive deficit procedure for Croatia44 4.3.2.Recent fiscal developments45 4.3.3.Medium-term prospects45 4.4.Exchange rate stability46 4.5.Long-term interest rates47 4.6.Additional factors48 4.6.1.Developments of the balance of payments48

4.6.2.Market integration49 5.Hungary53 5.1.Legal compatibility53 5.1.1.Introduction53 5.1.2.Central Bank independence53 5.1.3.Prohibition of monetary financing and privileged access54 5.1.4.Integration in the ESCB55 5.1.5.Assessment of compatibility56 5.2.Price stability56 5.2.1.Respect of the reference value56 5.2.2.Recent inflation developments56 5.2.3.Underlying factors and sustainability of inflation57 5.3.Public finances59 5.3.1.Recent fiscal developments59 5.3.2.Medium-term prospects60 5.4.Exchange rate stability61 5.5.Long-term interest rates62 5.6.Additional factors63 5.6.1.Developments of the balance of payments63 5.6.2.Market integration65

6.Poland67 6.1.Legal compatibility67 6.1.1.Introduction67 6.1.2.Central Bank independence67 6.1.3.Prohibition of monetary financing and privileged access68 6.1.4.Integration in the ESCB68 6.1.5.Assessment of compatibility68 6.2.Price stability69 6.2.1.Respect of the reference value69 6.2.2.Recent inflation developments69 6.2.3.Underlying factors and sustainability of inflation70 6.3.Public finances72 6.3.1.Recent fiscal developments72 6.3.2.Medium-term prospects73 6.4.Exchange rate stability74 6.5.Long-term interest rates74 6.6.Additional factors75 6.6.1.Developments of the balance of payments75 6.6.2.Market integration77 7.Romania81

7.1.Legal compatibility81 7.1.1.Introduction81 7.1.2.Central Bank independence81 7.1.3.Prohibition of monetary financing and privileged access82 7.1.4.Integration in the ESCB83 7.1.5.Assessment of compatibility83 7.2.Price stability83 7.2.1.Respect of the reference value83 7.2.2.Recent inflation developments84 7.2.3.Underlying factors and sustainability of inflation85 7.3.Public finances87 7.3.1.Recent fiscal developments87 7.3.2.Medium-term prospects88 7.4.Exchange rate stability89 7.5.Long-term interest rates90 7.6.Additional factors90 7.6.1.Developments of the balance of payments91 7.6.2.Market integration92 8.Sweden95 8.1.Legal compatibility95

8.1.1.Introduction95 8.1.2.Central Bank independence95 8.1.3.Prohibition of monetary financing and privileged access95 8.1.4.Integration in the ESCB96 8.1.5.Assessment of compatibility97 8.2.Price stability97 8.2.1.Respect of the reference value97 8.2.2.Recent inflation developments97 8.2.3.Underlying factors and sustainability of inflation98 8.3.Public finances100 8.3.1.Recent fiscal developments100 8.3.2.Medium-term prospects101 8.4.Exchange rate stability102 8.5.Long-term interest rates103 8.6.Additional factors104 8.6.1.Developments of the balance of payments104 8.6.2.Market integration105 LIST OF Tables 2.1.Bulgaria - Components of inflation18

2.2.Bulgaria - Other inflation and cost indicators19 2.3.Bulgaria - Budgetary developments and projections21 2.4.Bulgaria - Balance of payments24 2.5.Bulgaria - Market integration25 3.1.Czech Republic - Components of inflation32 3.2.Czech Republic - Other inflation and cost indicators33 3.3.Czech Republic - Budgetary developments and projections35 3.4.Czech Republic - Balance of payments38 3.5.Czech Republic - Market integration39 4.1.Croatia - Components of inflation43 4.2.Croatia - Other inflation and cost indicators44 4.3.Croatia - Budgetary developments and projections45 4.4.Croatia - Balance of payments49 4.5.Croatia - Market integration50 5.1.Hungary - Components of inflation57 5.2.Hungary - Other inflation and cost indicators58 5.3.Hungary - Budgetary developments and projections60 5.4.Hungary - Balance of payments64 5.5.Hungary - Market integration65 6.1.Poland - Components of inflation69

6.2.Poland - Other inflation and cost indicators70 6.3.Poland - Budgetary developments and projections72 6.4.Poland - Balance of payments76 6.5.Poland - Market integration77 7.1.Romania - Components of inflation84 7.2.Romania - Other inflation and cost indicators85 7.3.Romania - Budgetary developments and projections88 7.4.Romania - Balance of payments91 7.5.Romania - Market integration93 8.1.Sweden - Components of inflation98 8.2.Sweden - Other inflation and cost indicators99 8.3.Sweden - Budgetary developments and projections101 8.4.Sweden - Balance of payments105 8.5.Sweden - Market integration106 LIST OF Graphs 2.1.Bulgaria - Inflation criterion since 201017 2.2.Bulgaria - HICP inflation17 2.3.Bulgaria - Inflation, productivity and wage trends18 2.4.Bulgaria - BGN/EUR exchange rate22

2.5.Bulgaria - 3-M Sofibor spread to 3-M Euribor22 2.6.Bulgaria - Long-term interest rate criterion23 2.7.Bulgaria - Long-term interest rates23 2.8.Bulgaria - Saving and investment24 2.9.Bulgaria - Effective exchange rates25 2.10.Bulgaria - Foreign ownership and concentration in the banking sector26 2.11.Bulgaria - Selected banking sector soundness indicators26 2.12.Bulgaria - Recent development of the financial system relative to the euro area27 3.1.Czech Republic - Inflation criterion since 201031 3.2.Czech Republic - HICP inflation31 3.3.Czech Rep. - Inflation, productivity and wage trends32 3.4.Czech Republic - CZK/EUR exchange rate36 3.5.Czech Republic - 3-M Pribor spread to 3-M Euribor36 3.6.Czech Republic - Long-term interest rate criterion36 3.7.Czech Republic - Long-term interest rates37 3.8.Czech Republic - Saving and investment37 3.9.Czech Republic - Effective exchange rates38 3.10.Czech Republic - Foreign ownership and concentration in the banking sector39 3.11.Czech Republic - Selected banking sector soundness indicators40 3.12.Czech Republic - Recent development of the financial system relative to the euro area40

4.1.Croatia - Inflation criterion since 201042 4.2.Croatia - HICP inflation42 4.3.Croatia - Inflation, productivity and wage trends43 4.4.Croatia - HRK/EUR exchange rate46 4.5.Croatia - 3-M Zibor spread to 3-M Euribor47 4.6.Croatia - Long-term interest rate criterion47 4.7.Croatia - Long-term interest rates47 4.8.Croatia - Saving and investment48 4.9.Croatia - Effective exchange rates48 4.10.Croatia - Foreign ownership and concentration in the banking sector50 4.11.Croatia - Selected banking sector soundness indicators50 4.12.Croatia - Recent development of the financial system relative to the euro area51 5.1.Hungary - Inflation criterion since 201056 5.2.Hungary - HICP inflation56 5.3.Hungary - Inflation, productivity and wage trends58 5.4.Hungary - HUF/EUR exchange rate62 5.5.Hungary - 3-M Bubor spread to 3-M Euribor62 5.6.Hungary - Long-term interest rate criterion63 5.7.Hungary - Long-term interest rates63 5.8.Hungary - Saving and investment64

5.9.Hungary - Effective exchange rates64 5.10.Hungary - Foreign ownership and concentration in the banking sector66 5.11.Hungary - Selected banking sector soundness indicators66 5.12.Hungary - Recent development of the financial system relative to the euro area66 6.1.Poland - Inflation criterion since 201069 6.2.Poland - HICP inflation69 6.3.Poland - Inflation, productivity and wage trends71 6.4.Poland - PLN/EUR exchange rate74 6.5.Poland - 3-M Wibor spread to 3-M Euribor74 6.6.Poland - Long-term interest rate criterion75 6.7.Poland - Long-term interest rates75 6.8.Poland - Saving and investment76 6.9.Poland - Effective exchange rates77 6.10.Poland - Foreign ownership and concentration in the banking sector78 6.11.Poland - Selected banking sector soundness indicators78 6.12.Poland - Recent development of the financial system relative to the euro area79 7.1.Romania - Inflation criterion since 201083 7.2.Romania - HICP inflation84 7.3.Romania - Inflation, productivity and wage trends86 7.4.Romania - RON/EUR exchange rate89

7.5.Romania - 3-M Robor spread to 3-M Euribor90 7.6.Romania - Long-term interest rate criterion90 7.7.Romania - Long-term interest rates90 7.8.Romania - Saving and investment92 7.9.Romania - Effective exchange rates92 7.10.Romania - Foreign ownership and concentration in the banking sector93 7.11.Romania - Selected banking sector soundness indicators94 7.12.Romania - Recent development of the financial system relative to the euro area94 8.1.Sweden - Inflation criterion since 201097 8.2.Sweden - HICP inflation97 8.3.Sweden - Inflation, productivity and wage trends99 8.4.Sweden - SEK/EUR exchange rate102 8.5.Sweden - 3-M Stibor spread to 3-M Euribor103 8.6.Sweden - Long-term interest rate criterion103 8.7.Sweden - Long-term interest rates103 8.8.Sweden - Saving and investment104 8.9.Sweden - Effective exchange rates105 8.10.Sweden - Foreign ownership and concentration in the banking sector106 8.11.Sweden - Selected banking sector soundness indicators107 8.12.Sweden - Recent development of the financial system relative to the euro area107

LIST OF Boxes 1.1.Article 140 of the Treaty6 1.2.Assessment of price stability and the reference value8 1.3.Excessive deficit procedure10 1.4.Data for the interest rate convergence13 1.5.The Macroeconomic Imbalance Procedure (MIP)14 1.1.Role of the report The euro was introduced on 1 January 1999 by eleven Member States. Since then, Greece (2001), Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009), Estonia (2011), Latvia (2014) and Lithuania (2015) have adopted the euro. Those Member States which are assessed as not fulfilling the necessary conditions for the adoption of the euro are referred to as "Member States with a derogation". Article 140 of the Treaty lays down provisions and procedures for examining the situation of Member States with a derogation (Box 1.1). At least once every two years, or at the request of a Member State with a derogation, the Commission and the European Central Bank (ECB) prepare Convergence Reports for such Member States. Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht Treaty () and do not participate in the third stage of EMU. Until these Member States indicate that they wish to participate in the third stage and adopt the euro, they are not the subject of an assessment as to whether they fulfil the necessary conditions.

In 2014, the Commission and the ECB adopted their latest regular Convergence Reports (). Following the Convergence Reports and on the basis of a proposal by the Commission, the Council decided in July 2014 that Lithuania fulfilled the necessary conditions for adopting the euro as of 1 January 2015 (). None of the other Member States assessed was deemed to meet the necessary conditions for adopting the euro. In 2016, two years will have elapsed since the last regular reports were prepared. Denmark and the United Kingdom have not expressed a wish to enter the third stage of EMU. Therefore, this convergence assessment covers Bulgaria, the Czech Republic, Croatia, Hungary, Poland, Romania and Sweden. This Commission Staff Working Document is a Technical Annex to the Convergence Report 2016 and includes a detailed assessment of the progress with convergence. The financial and economic crisis, along with the euro-area sovereign debt crisis, has exposed gaps in the economic governance system of the Economic and Monetary Union (EMU) and showed that its instruments need to be used more comprehensively. With the aim of ensuring a sustainable functioning of EMU, an overall strengthening of economic governance in the Union has been undertaken. Accordingly, this Commission Staff Working Document makes references where appropriate to procedures that help to strengthen the assessment of each Member States' convergence process and its sustainability. In particular, it incorporates references to the strengthened surveillance of macroeconomic imbalances (see sub-section 1.2.6.). The remainder of the first chapter presents the methodology used for the application of the assessment criteria. Chapters 2 to 8 examine, on a country-by-country basis, fulfilment of the convergence criteria and other requirements in the order in which they appear in Article 140(1) (see Box 1.1). The cut-off date for the statistical data included in this Convergence Report was 18 May 2016. 1.2.Application of the criteria In accordance with Article 140(1) of the Treaty, the Convergence Reports shall examine the compatibility of national legislation with Articles 130 and 131 of the Treaty and the Statute of the European System of Central Banks (ESCB) and of the European Central Bank. The reports shall also examine the achievement of a high degree of sustainable convergence by reference to the fulfilment of the four convergence criteria dealing with price stability, public finances, exchange rate stability and long term interest rates as well as some additional factors. The four convergence criteria are developed further in a Protocol annexed to the Treaty (Protocol No 13 on the convergence criteria). 1.2.1.Compatibility of legislation In accordance with Article 140(1) of the Treaty, the legal examination includes an assessment of compatibility between a Member State’s legislation, including the statute of its national central bank, and Article 130 and 131 of the Treaty. This assessment mainly covers three areas. First, the independence of the national central bank and of the members of its decision-making bodies, as laid down in Article 130, must be assessed. This assessment covers all issues linked to a national central bank's institutional financial independence and to the personal independence of the members of its decision-making bodies. Second, in accordance with Articles 123 and 124 of the Treaty, the compliance of the national legislation is verified against the prohibition of monetary financing and privileged access. The prohibition of monetary financing is laid down in Article 123(1) of the Treaty, which prohibits overdraft facilities or any other type of credit facility with the ECB or the central banks of Member States in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States; and the purchase directly from these public sector entities by the ECB or central banks of debt instruments. As regards the prohibition on privileged access, the central banks, as public authorities, may not take measures granting privileged access by the public sector to financial institutions if such measures are not based on prudential considerations. Third, the integration of the national central bank into the ESCB has to be examined, in order to ensure that at the latest by the moment of euro adoption, the objectives of the national central bank are compatible with the objectives of the ESCB as formulated in Article 127 of the Treaty. The national provisions on the tasks of the national central bank are assessed against the relevant rules of the Treaty and the ESCB/ECB Statute. 1.2.2.Price stability The price stability criterion is defined in the first indent of Article 140(1) of the Treaty: “the achievement of a high degree of price stability […] will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability”. Article 1 of the Protocol on the convergence criteria further stipulates that “the criterion on price stability […] shall mean that a Member State has a price performance that is sustainable and an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1.5 percentage points that of, at most, the three best performing Member States in terms of price stability. Inflation shall be measured by means of the consumer price index on a comparable basis, taking into account differences in national definitions”. Since national consumer price indices (CPIs) diverge substantially in terms of concepts, methods and practices, they do not constitute the appropriate means to meet the Treaty requirement that inflation must be measured on a comparable basis. To this end, the Council adopted on 23 October 1995 a framework regulation () setting the legal basis for the establishment of a harmonised methodology for compiling consumer price indices in the Member States. This process resulted in the production of the Harmonised Indices of Consumer Prices (HICPs), which are used for assessing the fulfilment of the price stability criterion. As has been the case in past convergence reports, a Member State’s average rate of inflation is measured by the percentage change in the arithmetic average of the last 12 monthly indices relative to the arithmetic average of the 12 monthly indices of the previous period. The reference value is calculated as the arithmetic average of the average rate of inflation of the three 'best-performing Member States in terms of price stability' plus 1.5 percentage points. Accordingly, the reference value is currently 0.7%, based on the data of Bulgaria (-1.0%), Slovenia (-0.8%) and Spain (-0.6%) over the 12-month period covering May 2015-April 2016. Cyprus and Romania were identified as outliers, as their inflation rates deviated by a wide margin from the euro area average reflecting country-specific economic circumstances (see Box 1.2). The Protocol on the convergence criteria not only requires Member States to have achieved a high degree of price stability but also calls for a price performance that is sustainable. The requirement of sustainability aims at ensuring that the degree of price stability and inflation convergence achieved in previous years will be maintained after adoption of the euro. This deserves particular attention as the financial crisis exposed unsustainable price developments in many EU Member States, including euro area countries, in the pre-crisis period. Inflation sustainability implies that the satisfactory inflation performance must essentially be due to the adequate behaviour of input costs and other factors influencing price developments in a structural manner, rather than reflecting the influence of cyclical or temporary factors. Therefore, this Technical Annex also takes account of the role of the macroeconomic situation and cyclical position in inflation performance,

(Continued on the next page) Box (continued) developments in unit labour costs as a result of trends in labour productivity and nominal compensation per head, developments in import prices to assess how external price developments have impacted on domestic inflation. Similarly, the impact of administered prices and indirect taxes on headline inflation is also considered. From a forward-looking inflation perspective, the report includes an assessment of medium-term prospects for price developments. The analysis of factors that have an impact on the inflation outlook – cyclical conditions, labour market developments and credit growth – is complemented by a reference to the most recent Commission services' forecast of inflation. That forecast can subsequently be used to assess whether the Member State is likely to meet the reference value also in the months ahead (). Medium-term inflation prospects are also assessed by reference to the economies' key structural characteristics, including the functioning of the labour and product markets. 1.2.3.Public finances The convergence criterion dealing with the government budgetary position is defined in the second indent of Article 140(1) of the Treaty as “the sustainability of the government financial position: this will be apparent from having achieved a government budgetary position without a deficit that is excessive as determined in accordance with Article 126(6)”. Furthermore, Article 2 of the Protocol on the convergence criteria states that this criterion means that “at the time of the examination the Member State is not the subject of a Council decision under Article 126(6) of the said Treaty that an excessive deficit exists”. The convergence assessment in the budgetary area is thus directly linked to the excessive deficit procedure which is specified in Article 126 of the Treaty and further clarified in the Stability and Growth Pact (see Box 1.3 for further information on the excessive deficit procedure as strengthened by the 2011 reform of the Stability and Growth Pact). The details of the excessive deficit procedure are defined in Regulation 1467/97 as amended in 2005 and 2011 (under the "Six-Pack") which sets out the way in which government deficit and debt levels are assessed to determine (Continued on the next page) Box (continued) whether an excessive deficit exists, under article 126 of TFEU. The convergence assessment in the budgetary area is therefore judged by whether the Member State is subject to a Council decision under 126(6) on the existence of an excessive deficit (). Long-term sustainability of public finances deserves particular attention at a time when the financial crisis has significantly impacted on the fiscal positions and debt levels in many Member States. In response to this, economic governance in the EMU was substantially strengthened in 2011, which included, inter alia, the operationalisation of the debt criterion in the Excessive Deficit Procedure (). 1.2.4.Exchange rate stability The Treaty refers to the exchange rate criterion in the third indent of Article 140(1) as “the observance of the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the euro”. Article 3 of the Protocol on the convergence criteria stipulates: “The criterion on participation in the exchange rate mechanism of the European Monetary System (…) shall mean that a Member State has respected the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System without severe tensions for at least the last two years before the examination. In particular, the Member State shall not have devalued its currency’s bilateral central rate against the euro on its own initiative for the same period” (). Based on the Council Resolution on the establishment of the ERM II (), the European Monetary System has been replaced by the Exchange Rate Mechanism II upon the introduction of the euro, and the euro has become the centre of the mechanism. In its assessment of the exchange rate stability criterion, the Commission takes into account developments in auxiliary indicators such as foreign reserve developments and short-term interest rates, as well as the role of policy measures, including foreign exchange interventions, and international financial assistance wherever relevant, in maintaining exchange rate stability. In principle, the assessment of this criterion verifies the participation in ERM II and examines exchange rate behaviour within the mechanism. As currently none of the Member States assessed in this Convergence Report participates in ERM II, de facto exchange rate stability is reviewed for analytical purposes. The relevant period for assessing exchange rate stability in this Technical Annex is 19 May 2014 to 18 May 2016.

1.2.5.Long-term interest rates The fourth indent of Article 140(1) of the Treaty requires “the durability of convergence achieved by the Member State with a derogation and of its participation in the exchange rate mechanism being reflected in the long-term interest rate levels”. Article 4 of the Protocol on the convergence criteria further stipulates that “the criterion on the convergence of interest rates (…) shall mean that, observed over a period of one year before the examination, a Member State has had an average nominal long-term interest rate that does not exceed by more than two percentage points that of, at most, the three best performing Member States in terms of price stability. Interest rates shall be measured on the basis of long-term government bonds or comparable securities, taking into account differences in national definitions” (see Box 1.4). For the assessment of the criterion on the convergence of interest rates, yields on benchmark long-term bonds have been taken, using an average rate over the latest 12 months. The reference value for April 2016 is calculated as the simple average of the average long-term interest rates in Bulgaria (2.5%), Slovenia (1.8%) and Spain (1.8%), plus 2 percentage points, yielding a reference value of 4.0%. 1.2.6.Additional factors The Treaty in Article 140 also calls for an examination of other factors relevant to economic integration and convergence. These additional factors include financial, product and labour market integration and the development of the balance of payments. The examination of the development of unit labour costs and other price indices, which is also prescribed by Article 140 of the Treaty, is covered in the section on price stability. The assessment of additional factors gives an important indication of a Member State's ability to integrate into the euro area without difficulties. As regards the balance of payments, the focus is on the situation and development of the external balance (). Market integration is assessed through trade, foreign direct investment and a smooth functioning of the internal market. Finally, progress in financial integration is examined, together with the main characteristics, structures and trends of the financial sector. Starting with the 2012 Convergence Report, the convergence assessment is aligned with the broader European Semester approach which takes an integrated look at the economic policy challenges facing EMU in ensuring fiscal sustainability, competitiveness, financial market stability and economic growth. The section on additional factors makes reference to the surveillance of macroeconomic imbalances under the Macroeconomic Imbalance Procedure, which was adopted in December 2011 as one of the key elements of the legislative package (the "Six-Pack") to enhance the governance structures in EMU, and integrates its results into the assessment (see Box 1.5). 2.1.Legal compatibility 2.1.1.Introduction The legal basis for the Bulgarska narodna banka (BNB – central bank of Bulgaria), the Law on the Bulgarian National Bank (the BNB Law) of 1997, has been amended to some degree since the 2014 Convergence Report by repealing Article 14(2) of the BNB Law. The 2014 Convergence Report indicated that as regards the Governor such provision stipulating that "where the duties of a Governing Council member cease before the term of office has expired, another person shall be elected/appointed for the outstanding period of the term of office" was not in line with Article 14.2 of the ESCB/ECB Statute pursuant to which the term of office of a Governor shall be no less than five years. Further comments provided in the 2014 Convergence Report are largely repeated in this year's assessment. 2.1.2.Central Bank independence Article 14(1) of the BNB Law does not accurately mirror the grounds for dismissal of the Governor set out exhaustively in Article 14.2 of the ESCB/ECB Statute. Pursuant to Article 14(1) of the BNB Law, a member of the BNB Governing Council, including the Governor, may be relieved from office (1) "if he no longer fulfils the conditions required for the performance of his duties under Article 11(4)", (2) "if he is in practical inability to perform his duties for more than six months" or (3) "if he has been guilty of serious professional misconduct".

Whereas the second ground for dismissal is not provided in Article 14.2 of the ESCB/ECB Statute, the third dismissal ground provided in Article 14(1) of the BNB Law narrows down the concept of "serious misconduct" of Article 14.2 of the ESCB/ECB Statute to "serious professional misconduct". In order to remove these imperfections and limit interpretation problems, Article 14(1) of the BNB Law should be amended. Furthermore, the ground for dismissal provided in the Conflict of Interest Prevention and Ascertainment Act of 2008 which has been applicable to the BNB Governor, Deputy Governors and the members of the BNB Managing Board since December 2010 has to be brought in line with Article 14.2 of the ESCB/ECB Statute. Article 33(1) in conjunction with Article 3(13) of the Conflict of Interest Prevention and Ascertainment Act provides that the breach of its provisions and the existence of a conflict of interest are grounds for dismissal. This incompatibility should be removed by specifying that a dismissal of the Governor is only admissible if, as set out in Article 14.2 of the ESCB/ECB Statute, the breach of the duty is a lack of fulfilment of the conditions required for the performance of the Governor's duties or is a serious misconduct of which the Governor has been guilty. Pursuant to Article 12(1) of the BNB Law, the Governor shall be elected by the National Assembly. The National Assembly has taken the view that it has the power to annul or amend its decisions, including decisions under Article 12(1) of the BNB Law. The National Assembly has substantiated this assertion by stating that pursuant to a Constitutional Court decision of 26 February 1993, the Bulgarian Constitution does not explicitly prohibit the National Assembly from amending or annulling its decisions. Such understanding would allow the dismissal of the Governor under conditions other than those mentioned in Article 14.2 of the ESCB/ECB Statute. It should be ensured that the Governor, when properly elected or appointed, may not be dismissed under conditions other than those mentioned in Article 14.2 of the ESCB/ECB Statute. Article 44 of the BNB Law should be amended with a view to achieving compatibility with Article 130 of the TFEU and Article 7 of the ESCB/ECB Statute. Pursuant to Article 44 of the BNB Law, the members of the Governing Council, in the performance of their tasks, shall be independent and shall not seek or take any instructions from the Council of Ministers or from any other body or institution. It should be clarified that this encompasses national, foreign and EU institutions or bodies. In this context, it is also noted that Article 3 of the BNB Law provides that "in the formulation of the general outlines of the monetary policy, the BNB and the Council of Ministers shall inform each other". This procedure provides for the opportunity for the government to exert ex ante influence on the monetary policy of the BNB. As from the date of the formal adoption of the euro in Bulgaria or after the currency board agreement has been suspended this might constitute an incompatibility in the area of independence, with Article 130 of the TFEU and Article 7 of the ESCB/ECB. 2.1.3.Prohibition of monetary financing and privileged access Article 45(1) and (2) of the BNB Law are not fully consistent with Article 123 of the TFEU and Article 21.1 of the ESCB/ECB Statute and thus should be amended. Article 45(1) of the BNB Law provides that the BNB shall not extend credits and guarantees, including through purchase of debt instruments, to the Council of Ministers, municipalities, as well as to other governmental and municipal institutions, organizations and enterprises. Article 45(1) of the BNB Law should be amended with a view to including all entities mentioned in Article 123(1) of the TFEU and Article 21.1 of the ESCB/ECB Statute. Furthermore, while the prohibition of monetary financing does not allow the direct purchase of public sector debt, purchases on the secondary market are not prohibited unless they qualify as a circumvention of the objective of Article 123 of the TFEU. For this reason, the word ‘direct’ should be inserted in Article 45(1) of the BNB Law. Pursuant to Article 45(2) in conjunction with Article 33(2) of the BNB Law, Article 45(1) of the BNB Law does not apply to the extension of credits to state-owned and municipal banks in emergency cases of liquidity risk that may affect the stability of the banking system. The scope of this exemption should be amended to be fully consistent with the wording of Article 123(2) of the TFEU and Article 21.3 of the ESCB/ECB Statute. 2.1.4.Integration in the ESCB Objectives The objectives of the BNB are compatible with the Treaty on the Functioning of the European Union. Tasks The incompatibilities in the BNB Law are linked to the following ESCB/ECB tasks: • definition of monetary policy and monetary functions, operations and instruments of the ESCB (Articles 2(1) and (3), 16(4) and (5), 28, 30, 31, 32, 33, 35, 38, 41 and 61 of the BNB Law); • conduct of foreign exchange operations and the definition of foreign exchange rate policy (Articles 20(1), 28, 31, 32 of the BNB Law); • right to authorise the issue of banknotes and the volume of coins (Articles 2(5), 16(9), 24 to 27 of the BNB Law); • non-recognition of the role of the ECB in the field of international cooperation (Articles 5, 16(12) and 37(4) of the BNB Law); • ECB's right to impose sanctions (Article 61, 62 of the BNB Law). There are also numerous imperfections regarding: • non-recognition of the role of the ECB in the functioning of the payment systems (Articles 2(4) and 40(1) of the BNB Law);

• non-recognition of the role of the ECB and the EU in the collection of statistics (Article 4(1) and 42 of the BNB Law); • non-recognition of the role of the ECB and of the Council in the appointment of the external auditor (Articles 49(4) of the BNB Law); • absence of an obligation to comply with the Eurosystem's regime for the financial reporting of NCB operations (Article 16(11), 46 and 49 of the BNB Law). 2.1.5.Assessment of compatibility The BNB Law and the Conflict of Interest Prevention and Ascertainment Act are not fully compatible with Article 131 of the TFEU as regards central bank independence, the prohibition of monetary financing and the integration in the ESCB at the time of euro adoption. 2.2.Price stability 2.2.1.Respect of the reference value The 12-month average inflation rate, which is used for the convergence assessment, was well below the reference value at the time of the last convergence assessment of Bulgaria in 2014. Average annual inflation fell to -1.7% by January 2015, before starting to slowly rise again. In April 2016, the reference value was 0.7%, calculated as the average of the 12-month average inflation rates in Bulgaria, Slovenia and Spain plus 1.5 percentage points. The average inflation rate in Bulgaria during the 12 months to April 2016 was 1.0%, i.e. 1.7 percentage points below the reference value. The 12-month average inflation rate is projected to remain well below the reference value in the months ahead. 2.2.2.Recent inflation developments The annual HICP inflation rate in Bulgaria has been negative since summer 2013. This was initially due to an unusually strong combination of disinflationary factors, i.a. a good harvest, administrative energy price reductions and declining import prices. Weak domestic demand and low inflation in the euro area sustained the disinflationary environment and falling oil commodity prices represented a new downward price shock in 2014 and 2015. The inflation rate reached its trough of -2.4% at the beginning of 2015 and then increased somewhat with the passing or even partial reversal of the above mentioned shocks. Headline inflation was approaching positive territory by early 2016, but it fell back sharply again in March and April, due mainly to unprocessed food and fuel prices. The inflation rate in Bulgaria has remained below that of the euro area throughout the past two years. Core inflation (measured as HICP inflation excluding energy and unprocessed food) stayed above headline inflation during most of 2014 and 2015, highlighting the effect of plunging energy prices on inflation. Core inflation bottomed out at 1.9% in late 2014 and increased to 0.4% by October 2015. It then reversed and turned negative again in early 2016, reaching 0.6% in April 2016. The components of core inflation had trended downwards over the past few years, reaching their lows at different points in 2014 and they demonstrated no clear trend since then. Processed food prices were the first to turn around, partly due to rising unprocessed food prices. After becoming positive again in April 2015, they reached 1.0% at end-2015. Non-energy industrial goods inflation reflected both lower import prices and weak domestic demand, as consumers have remained cautious in spending, despite the strong growth in real wages over the past years. It bottomed in autumn 2014 at -2.4%, but remained deeply negative even in early 2016. Services inflation was the lowest in November 2014 at 2.7%, and after increasing to 1.2% by October 2015, it fell back to 0.5% by April 2016. Negative producer price inflation confirmed the lack of cost pressures in 2014-2015 and reached about -4% in early 2016. 2.2.3.Underlying factors and sustainability of inflation Macroeconomic policy mix and cyclical stance The economic recovery has accelerated in Bulgaria with GDP growth of 1.5% in 2014 and 3% in 2015. Domestic demand had a good year in 2014, but its growth slowed somewhat in 2015, while net exports picked up. According to the Commission services' Spring 2016 Forecast, the main driver of Bulgaria's GDP growth is expected to shift gradually back to domestic demand by 2017. The purchasing power of households has been buoyed by growth in real wages in a low-inflation environment and economic sentiment remains relatively high. Public investment is however expected to decrease in 2016, with the slowdown of the implementation of projects co-financed by the EU. GDP growth is forecast to moderate to 2% in 2016, before picking up to 2.4% in 2017. This relatively modest growth momentum would imply a persistent negative output gap. The fiscal stance, as measured by the change in the structural balance, has shifted over recent years. Following years of consolidation, the fiscal stance was expansionary in 2014 and broadly neutral in 2015. According to the Commission services' Spring 2016 Forecast, the structural balance is projected to remain broadly unchanged in 2016, but to tighten in 2017. In the context of its currency board arrangement to the euro, most standard monetary policy instruments are not available to Bulgaria. In response to these limitations, the BNB has set relatively conservative liquidity and capital requirements on the banking sector. Bank interest rates decreased over the past two years, reflecting monetary easing in the euro area. However, private sector lending continued to stagnate, with new loans merely replacing maturing ones. The domestic banking crisis in 2014 caused disruption in financial intermediation. Overall, weak lending still contributes to the current low-inflation environment.

Wages and labour costs The labour market has started to improve gradually over 2014-15. Employment increased by a moderate 0.4% in 2014 and 2015. This together with a decrease in the labour force, partly due to emigration, helped to reduce the unemployment rate from 13% in 2013 to about 9% in 2015. Nominal wage growth was dampened by negative inflation over the past few years, in particular in 2015, despite continuing wage convergence pressures and skills shortages in some sectors. Labour productivity growth was weak in 2013-2014, as the decline in employment ended, but it picked up in 2015 with higher output growth. Nominal unit labour cost growth slowed down over the past two years, which mainly reflected the rapidly declining growth of nominal compensation per employee. Labour productivity growth is expected to remain moderate over 2016-17, given the gradual stabilisation of the labour market and the lack of sufficient new investment. According to the Commission services' Spring 2016 Forecast, ULC growth is projected to pick up again in 2016 and 2017, in line with the evolution of nominal compensation per employee. External factors Given the high openness of the Bulgarian economy, developments in import prices play an important role in domestic price formation. Global energy and food prices are particularly relevant for inflation, given their relatively large share in the consumer basket and the high energy intensity of the Bulgarian economy. Import prices (measured by the imports of goods deflator) had a strong disinflationary effect over the past three years, falling by nearly -3% per year. This reflects mainly the lower international oil price and the stronger nominal effective exchange rate of the lev. Import prices are expected to continue declining also in 2016. In particular, the fall in the oil price is expected to pass through to lower energy-related inflation. It should be noted that Bulgaria depends on a single source of gas supply and negotiates gas prices bilaterally, occasionally diverging from global price trends. The nominal effective exchange rate of the lev (measured against a group of 36 trading partners) appreciated by about 4% from mid-2013 until early 2014, as some currencies of major trading partners depreciated against the euro (Turkish Lira, Russian Rouble, Romanian Leu). About half of this appreciation had been unwound by early 2016, but the stronger nominal effective exchange rate contributed to lower import prices over the assessment period. On the other hand, the depreciation of the euro (and hence of the lev) against the US dollar in 2014-2015 cushioned somewhat the disinflationary impact of lower oil prices. Administered prices and taxes The growth rate of administered prices () was above headline consumer price inflation in Bulgaria over the past two years, but indirect tax changes played overall a negligible role. The share of administered prices in the HICP basket is relatively high in Bulgaria at around 16% compared to 13% in the euro area. The annual change of administered prices turned from a 1% decline in 2014 to an increase of 1.5% in 2015. In particular, household electricity prices were increased in mid-2014 and in late 2014. Overall, administered prices raised headline inflation in 2014 by about 0.1 percentage points (by decreasing less than the headline) and in 2015 by about 0.5 percentage points. Indirect tax changes had on aggregate an insignificant effect on inflation over 2014-15. During this period, annual constant-tax HICP was on average at the same level as headline inflation. In early 2016, a tobacco excise tax increase took place, but annual constant-tax HICP was on average broadly at the same level as headline inflation during the assessment period. Medium-term prospects Annual HICP inflation is expected to rise gradually as the effect from the decline in commodity prices slowly tapers off; however it is to remain negative throughout the first three quarters of 2016. In the meantime, the weaker euro and the tightening domestic labour market conditions are expected to exert some upward price pressure. Accordingly, the Commission services' Spring 2016 Forecast projects HICP inflation to average 0.7% in 2016 and 0.9% in 2017. Risks to the inflation outlook appear broadly balanced, with the most significant risks related to global energy and food price developments, given their relatively large share in the Bulgarian consumer basket. Additional inflation risk factors are core inflation movements elsewhere in the EU and administered prices changes. The level of consumer prices in Bulgaria was at 47% of the euro area average in 2014. Over the long run, there is significant potential for further price level convergence, in line with the expected catching-up of the Bulgarian economy (Bulgaria's income level was at about 44% of the euro area average in PPS terms in 2014). Medium-term inflation prospects will depend on wage and productivity developments, as well as on global commodity price trends. Tax policy is expected to have only a limited impact on inflation. 2.3.Public finances 2.3.1.Recent fiscal developments On 22 June 2012, the Council decided to abrogate the decision on the existence of an excessive deficit according to Article 126 (12) TFEU, thereby closing the excessive deficit procedure for Bulgaria (). The general government deficit was kept well below the Treaty reference value of 3% of GDP in 2012 and in 2013. Although the general government deficit reached 5.4% of GDP in 2014, the Commission concluded in its November 2015 report in accordance with Art 126(3) of the TFEU that the excess over the reference value could be qualified as exceptional and temporary and also taking into account all relevant factors the opening of an EDP was not suggested (). The expenditure-to-GDP ratio increased by 2.6 pp. between 2013 and 2015 to 40.2%, which was somewhat counterbalanced by an increase in the revenue ratio by 1.0 pp. of GDP to 38.2%. The increase in the expenditure ratio mainly reflects a higher investment ratio, partly stemming from increased absorption of EU funds. The higher revenue ratio reflects both more capital transfers from the EU and more tax revenue partly in light of enhanced tax collection.

The general government deficit in 2015 reached 2.1% of GDP, i.e. below the target of 2.8% of GDP in the 2015 Convergence Programme. The better outcome mainly reflects higher tax revenues, mostly attributable to improved tax administration. Those additional revenues more than offset various expenditure slippages, such as the incomplete implementation of the planned reduction of the public wage bill. In structural terms, the deficit improved by 0.1 pp. in 2015. As the output gap remained broadly unchanged (slight negative) in the period of 2013-2015, the actual growth performance had a neutral impact on the fiscal consolidation. General government gross debt increased from 17.1% of GDP in 2013 to 27% of GDP in 2014. This reflected not only the underlying budget deficit in 2014 but also the pay-out of guaranteed deposits, support to the financial sector via a liquidity scheme and pre-financing for a roll-over of a large bond maturing in January 2015. The gross public debt ratio slightly decreased to 26.7% of GDP in 2015. 2.3.2.Medium-term prospects The 2016 budget was adopted by Parliament on 2 December 2015. It aims at achieving a general government deficit of 1.9% of GDP based on a number of measures both on the revenue and on the expenditure side. First, strengthening of tax compliance in light of exercising fiscal control and forced collection of arrears is expected to increase tax revenues by ¼% of GDP. Increase in excise duty on fuel and cigarettes would imply higher revenues of 0.2% of GDP, which could be partly off-set by the fuel voucher system provided in the agriculture sector. Higher revenues from the hike of road tolls and the concession revenues related to the transport sector as well as the lower national co-financing related to the absorption of the EU-funds are partly counterbalanced by the budgeted higher public investments from own resources. According to the Commission services' Spring 2016 Forecast, the general government deficit is foreseen to be 2% of GDP. In 2017, the Commission forecasts the general government balance to improve and achieve a deficit of 1.6% of GDP in light of some revenue increasing measures and of the economic growth. Taking into account the negative output gap estimated by 2017, the structural deficit is projected to be 1.4% of GDP. The public-debt-to-GDP ratio is forecast to increase from 27% in 2014 to around 29% by 2017. Bulgaria submitted the 2016 update of the Convergence Programme on 15 April 2016. The Programme aims at the gradual improvement of the general government balance from 1.9% of GDP in 2016 to 0.8% of GDP in 2017 and further to 0.2% of GDP in 2019. Also, the Programme targets the achievement of the medium-term objective of a structural deficit of 1% of GDP in 2017. In 2017, compared with the Commission forecast of 1.6% of GDP, the targeted improvement of the deficit is ambitious and specification of further deficit decreasing measures are likely to be needed to be achieved. Based on the assessment of the convergence programme and taking into account the Commission services' Spring 2016 Forecast, the Commission is of the opinion that Bulgaria is expected to broadly comply with the provisions of the Stability and Growth Pact. Further details can be found in the Assessment of the 2016 Convergence Programme for Bulgaria (). As far as the national fiscal framework is concerned – which refers to numerical fiscal rules, medium-term budgetary frameworks, independent fiscal institutions, and budgetary procedures – the Bulgarian system has gradually been strengthened over the last few years, also driven by EU legal requirements. Bulgaria declared its intention to apply the provisions of the Fiscal Compact (). The main milestones of the reform were the introduction of a wide set of numerical rules at the general government level, and an improved medium-term budgetary framework in 2014. Over the course of 2015, the reform process was continued by the stipulation of an automatic correction mechanism in case of a significant divergence from the targeted structural balance position as well as by the establishment of the Fiscal Council, entrusted with a broad mandate including monitoring compliance with national fiscal rules. The Fiscal Council members were appointed by Parliament at the end of 2015, however, the body is not yet fully operational. 2.4.Exchange rate stability The Bulgarian lev does not participate in ERM II. The BNB pursues its primary objective of price stability through an exchange rate anchor in the context of a currency board arrangement (CBA). Bulgaria introduced its CBA on 1 July 1997, pegging the Bulgarian lev to the German mark and subsequently to the euro (at an exchange rate of 1.95583 BGN/EUR). Under the CBA, the BNB’s monetary liabilities have to be fully covered by its foreign reserves. The BNB is obliged to exchange monetary liabilities and euro at the official exchange rate without any limit. The CBA serves as a key macroeconomic policy anchor. Over the past two years, the CBA continued to operate in a challenging environment, with low nominal GDP growth, weak credit flows and contagion risks in the banking sector related both to the failing domestic banks and Greece. However, growing exports, a favourable external funding position of the banking sector and sizable reserve buffers have underpinned the resilience of the CBA. Bulgaria's international reserves increased from around EUR 14 billion to over EUR 20 billion between mid-2014 and end-2015. International reserves were boosted by the issuance of EUR 3.1 billion in long-term, foreign-currency government debt in March 2015 and by BNB macroprudential action to reduce spill-over risks from Greece via the repatriation of banking sector foreign assets. International reserves covered around 144% of the monetary base, about 166% of short-term debt (), 54% of broad money (M3) and about 46% of GDP as of end-2015. A high reserve coverage was deliberately built into the framework for Bulgaria's CBA, to cater for potential financial sector stress following the 1996-97 crisis. The BNB does not set monetary policy interest rates. The domestic interest rate environment is directly affected by the monetary policy of the euro area through the operation of Bulgaria's CBA. Short-term interest rate differentials vis-à-vis the euro area were quite stable over the past two years. The 3-month spread hovered around 55 basis points till end 2015 and declined to around 40 basis points in early 2016. 2.5.Long-term interest rates For Bulgaria, the development of long-term interest rates over the current reference period is assessed on the basis of secondary market yields on a single benchmark government bond with a residual maturity of close to but below 10 years. The Bulgarian 12-month moving average long-term interest rate relevant for the assessment of the Treaty criterion was below the reference value at the 2014 convergence assessment of Bulgaria. It declined from around 3.5% in mid-2014 to around 2.5% by end-2015. In April 2016, the latest month for which data are available, the reference value, given by the average of long-term interest rates in Bulgaria, Slovenia and Spain plus 2 percentage points, stood at 4.0%. In that month, the twelve-month moving average of the yield on the Bulgarian benchmark bond stood at 2.5%, i.e. about 1.5 percentage points below the reference value.

The long-term interest rate of Bulgaria increased somewhat in mid-2014, partly reflecting its domestic banking sector problems. Bulgarian benchmark bond yields started to fall again at end-2014, as the political situation stabilised with the formation of a new government and depositors of KTB were finally able to access their frozen bank deposits. In early 2015, Bulgaria's long-term interest rate fell significantly, supported by strong demand for its government securities, partly due to the spill-over from the ECB's public sector asset purchase programme. Spreads to the Bund increased by almost 100 basis points between mid-2014 and November 2014, partly reflecting Bulgaria's banking problems. Then they started to decline gradually, reaching post-2008 financial crisis lows in mid-2015, before rising again from late 2015, partly linked with the Fed's policy tightening. The spread to the German benchmark bond was at around 230 basis points in April 2016 (). 2.6.Additional factors The Treaty (Article 140 TFEU) calls for an examination of other factors relevant to economic integration and convergence to be taken into account in the assessment. The assessment of the additional factors – including balance of payments developments, product, labour and financial market integration – gives an important indication of a Member State's ability to integrate into the euro area without difficulties. In November 2015, the Commission published its fifth Alert Mechanism Report (AMR 2016) () under the Macroeconomic Imbalance Procedure (MIP - see also Box 1.5). The AMR 2016 scoreboard showed that Bulgaria exceeded the indicative threshold in four out of fourteen indicators, two in the area of external imbalances (i.e. the net international investment position and nominal unit labour cost) and two in the area of internal imbalances (i.e. unemployment and long-term unemployment rate). In line with the conclusion of the AMR 2016 (i.e. that imbalances had been identified for Bulgaria in the previous MIP round), Bulgaria was subject to an in-depth review, which found that Bulgaria continued to experience excessive macroeconomic imbalances. The economy is characterised by remaining fragilities in the financial sector and high corporate indebtedness in a context of limited labour market adjustment. 2.6.1.Developments of the balance of payments Bulgaria's external balance (i.e. the combined current and capital account) has been in surplus since 2011, following a rapid adjustment from deficits above 20% of GDP in 2007-08. The surplus of the external balance reached 3.1% of GDP in 2014 and rose to 4.6% of GDP in 2015, partly due to strong export growth. The latter was also reflected in the trade balance of goods, which although still negative has improved strongly in 2015, by more than two percentage points of GDP. The trade balance in services has remained positive owing to stable growth in the tourism, transportation and business process outsourcing sectors and reached about 6% of GDP both in 2014 and 2015. The capital account surplus also increased in the last couple of years, from 1.1% of GDP in 2013 to over 3% of GDP in 2015, mainly due to an increase in the absorption of EU funds. The primary income balance stayed negative, reflecting the negative net international investment position, but it was counterbalanced by a surplus of secondary income. The large saving-investment gap of the Bulgarian economy observed in 2007-08 closed by 2013. Gross national saving was supported by households and companies, and reached around 23% of GDP both in 2013 and 2015. On the other hand, private investment remained low, as negative inflation, which started in mid-2013, increased the burden of debt-servicing. In addition, the still unsupportive business environment and increased perceived risks from the financial sector turmoil in 2014 influenced the investment climate negatively. Meanwhile, the public sector increased its investment in 2014-2015, thanks mainly to EU funds. Competitiveness seems to have been preserved in the past two years, although relevant indicators show a somewhat mixed picture. The real effective exchange rate, deflated by ULC, appreciated significantly between mid-2012 and early 2014. It then depreciated for about a year and has stabilised since early 2015. After a long period of improvement, Bulgaria's export performance deteriorated in 2014, before it picked up again in 2015. The financial account without official reserves recorded significant net inflows in 2014 and 2015. Net FDI inflows have remained at low levels by pre-crisis standards, reaching around 2% of GDP in 2014 and 3% of GDP in 2015. The net inflow of portfolio investment in 2014 and 2015, reflected i.a. increased government borrowing. The positive balance of net other inflows in 2015 represented mainly the build-up of foreign assets of the banking sector. Although still high, gross external debt has improved further in the past two years, from about 91% of GDP in 2013 to around 83% of GDP in 2015, due to reduced foreign liabilities of the banking sector and some corporate deleveraging. The net international investment position has also improved, from around 73% of GDP in 2013 to around 61% of GDP in 2015. According to the Commission services’ Spring 2016 Forecast, the external surplus is projected at 3.5% of GDP 2016 and at 3.8% of GDP in 2017. 2.6.2.Market integration The Bulgarian economy is well integrated with the euro area through trade and investment linkages. As a small open economy, Bulgaria is characterised by a high ratio of trade openness, which increased from a low post-crisis level of 56% in 2010 to around 69% in 2015. Trade with the euro area expressed in percentage of GDP reached about 31% in 2015. Beyond the euro-area, the main trading partners are Romania, Russia and Turkey. The stock of FDI in Bulgaria amounted to some 80% of GDP in 2014, with FDI mainly originating in the Netherlands, Austria, the UK and Greece. The main recipient sectors of FDI were services (chiefly real estate, renting and business activities, financial intermediation and trade) and to a lesser extent manufacturing (17% of the total) and construction.

Concerning the business environment, Bulgaria performs in general worse than most euro-area Member States in international rankings. The difference to the euro-area average is more pronounced based on the WEF's Global Competitiveness Index than on the World Bank's Ease of Doing Business indicator, but Bulgaria's position deteriorated with the latter in 2015. Public administration as a whole scores relatively poorly according to the World Bank's Worldwide Governance Indicators. According to the May 2015 Internal Market Scoreboard, Bulgaria's transposition deficit of EU Directives was at 0.7% which is above the target (0.5%) proposed by the European Commission in the Single Market Act (2011). The Bulgarian labour market adjusted to the economic shock of 2008-2013 by shedding labour rather than by lowering wages, in a context of generally flexible wage-setting conditions. Following the initial labour shedding, the economy has not been able to absorb the available supply of labour because of structural issues, including the employability effects of long-term unemployment and skills mismatches. The Bulgarian labour market was characterised by persistent emigration, which is fundamentally driven by the large income gap with other EU Member States. Bulgaria's financial sector is well integrated with the EU financial sector, in particular through a high level of foreign ownership in its banking system. The share of foreign-owned institutions in total bank assets reached 76% in 2014. Bank concentration, as measured by the market share of the five largest credit institutions in total assets, remained somewhat above the euro area average in 2014. The banking system came under strong liquidity pressure in June 2014 due to deposit withdrawals by individuals and firms. This led to placing the fourth-largest bank, Corporate Commercial Bank (KTB), and its subsidiary in a regime of special supervision. In addition, the third-biggest bank, First Investment Bank, required state liquidity aid. Guaranteed deposits of KTB became available only in December 2014, more than five months after its banking activities were suspended. Nevertheless, public confidence in banks appears to have recovered and deposit flows have normalised since the summer 2014 liquidity crisis. The deposit-guarantee and bank-resolution frameworks were strengthened with the transposition of the relevant EU directives into national law. Based on the available data, the capital adequacy of the banking sector measured by standard regulatory ratios is somewhat higher than in the euro area. The average capital adequacy ratio stood close to 22% in September 2015. The deterioration of the loan portfolio that started in 2008 has halted, but the share of non-performing loans still reached 13% at end-September 2015, well above the euro-area average. Profitability of the domestic banking sector remained above the euro-area level, with average return on equity (RoE) above 4% in 2014. However, a robust assessment of the soundness of the banking sector can only be made based on the results of the ongoing asset quality review and stress test, which are expected to end in August. Similar reviews are currently being conducted in the insurance and pension fund sectors. After the pre-2009 boom, real house prices in Bulgaria fell till 2012. There has been a slow recovery since then, but the real house price index reached still only 90.3% of its 2010 level in 2015. Residential investment hovered below 2% of GDP in recent years as the stock of loans for house purchases decreased in 2014-2015. The financial system in Bulgaria is smaller relative to GDP than that of the euro area. Domestic bank credit stood at around 56% of GDP in 2015, with the majority of it denominated in foreign-currencies. The capitalization of the stock market reached less than 10% of GDP in 2015, well below the euro-area average of 60%. The debt securities market remains small in comparison with the euro area average (25% vs. 158% of GDP) and is mainly used for financing a part of Bulgaria's relatively low public debt. The consolidated stock of private sector debt at 124% of GDP in 2014 was somewhat below the euro-area average of 138%. 3.1.Legal compatibility 3.1.1.Introduction Česká národní banka (ČNB – Czech national bank) was established on January 1, 1993. Its main legal basis is the Czech National Council Act No. 6/1993 Coll. on the Czech National Bank, adopted on 17 December 1992 (the ČNB Law). Following the Convergence Report 2014, the ČNB Law was amended by several laws. () However, since there have been no amendments as regards the incompatibilities highlighted in the Commission's 2014 Convergence Report, the comments made in the latter are largely repeated in this year's assessment. 3.1.2.Central Bank independence Article 9(1) of the ČNB Law prohibits the ČNB and its Board from taking instructions from the President of the Czech Republic, Parliament, the Government, administrative authorities, European Union institutions, any government of a Member State of the European Union or any other body. Further, Article 9(1) of the ČNB Law needs to be adapted to fully reflect the provisions of Article 130 of the TFEU and Article 7 of the Statute and consequently expressly prohibit third parties from giving instructions to the ČNB and its Board members who are involved in the performance of ESCB-related tasks.

The power for the Chamber of Deputies of the Parliament to impose modifications to the annual financial report which was previously submitted and rejected (Article 47(5) of the ČNB Law) could hamper the ČNB’s institutional independence. Moreover, it is formulated in a very general manner which could create situations where the Parliament requests changes affecting the financial independence of the ČNB. Thus, the current wording of Article 47(5) of the ČNB Law constitutes an incompatibility which should be removed from the Act. Article 6(10) of the ČNB Law provides that members of the Bank Board, which also includes the Governor, may be relieved from office only if they no longer fulfil the conditions required for the performance of their duties or if they have been guilty of serious misconduct. Although article 6(10) of the ČNB Law extends the protection offered by article 14.2 of the ESCB/ECB Statute to Governors against arbitrary dismissal to all Bank Board members of the ČNB, it remains silent on the Governor’s right in case of dismissal to seek a remedy before the Court of Justice of the European Union. However, pursuant to footnote 22, the Commission understands that the possibility to seek legal redress by the Governor before the ECJ, as enshrined in article 14.2 of the ESCB/ECB Statute, would apply. However, the ČNB Law would benefit from a more explicit clarification. . Pursuant to Article 11(1) of the ČNB Law, the Minister of Finance or another nominated member of the Government may attend the meetings of the Bank Board in an advisory capacity and may submit motions for discussion. Article 11(2) entitles the Governor of the ČNB, or a Vice-Governor nominated by him, to attend the meetings of the Government in an advisory capacity. With regard to Article 11(1) of the ČNB Law, although a dialogue between a central bank and third parties is not prohibited as such, it should be ensured that this dialogue is constructed in such a way that the Government should not be in a position to influence the central bank when the latter is adopting decisions for which its independence is protected by the TFEU. The active participation of the Minister, even without voting right, to discussions where monetary policy is set would structurally give to the Government the opportunity to influence the central bank when taking its key decisions. Therefore, Article 11(1) of the ČNB Law is incompatible with Article 130 of the TFEU, as Member States have to undertake not to seek to influence the members of the decision-making bodies of the national central bank. 3.1.3.Prohibition of monetary financing and privileged access Article 34a(1) first half-sentence of the ČNB Law prohibits the ČNB from providing overdraft facilities or any other type of credit facility to the bodies, institutions or other entities of the European Union, central governments, regional or local authorities or other bodies governed by public law, other entities governed by public law or public undertakings of the Member States of the European Union. The list of entities does not fully mirror the one in Article 123(1) of the TFEU and, therefore, has to be amended. Moreover, the footnote in Article 34a(1) of the ČNB Law should refer to Article 123(2) of the TFEU instead of globally to Article 123 of the TFEU. 3.1.4.Integration in the ESCB Objectives Pursuant to Article 2(1) of the ČNB Law, "in addition" to the ČNB's primary objective of maintaining price stability, the ČNB shall work to ensure financial stability and the safety and sound operation of the financial system and – without prejudice to its primary objective – support the general economic policies of the Government and the European Union. Article 2(1) of the ČNB Law needs to be amended with a view to achieving compatibility with Article 127 TFEU and Article 2 of the ESCB/ECB Statute. Compatibility with the ESCB's objectives requires a clear supremacy of the primary objective over any other objective. Tasks The incompatibilities in this area, following the TFEU provisions and ESCB/ECB Statute, include: definition of monetary policy and monetary functions, operations and instruments of the ECB/ESCB (Articles 2(2)(a), 5(1) and 23 to 26, 28, 29, 32, 33 of the ČNB Law); conduct of exchange rate operations and the definition of exchange rate policy (Articles 35 and 36 of the ČNB Law); holding and management of foreign reserves (Articles 35(c), 36 and 47a of the ČNB Law); non-recognition of the competences of the ECB and of the Council on the banknotes and coins (Article 2(2)(b), Articles 12 to 22 of the ČNB Law); ECB's right to impose sanctions (Article 46a of the ČNB Law). the possibility for Parliament to demand amendments to the report of the ČNB on monetary policy developments and to determine the content/scope of the extraordinary report in view of the absence of a specification regarding the non-forward looking nature of the reports (Article 3 of the ČNB Law) There are also some imperfections regarding: the absence of reference of the role of the ECB and of the EU in the collection of statistics (Article 41); non-recognition of the role of the ECB in the functioning of the payment systems (Articles 2.2 c), 38 and 38a of the ČNB Law);

non-recognition of the role of the ECB and of the Council in the appointment of the external audit of the ČNB (Article 48(2) of the ČNB Law); absence of an obligation to comply with the Eurosystem's regime for the financial reporting of NCB operations (Article 48 of the ČNB Law); non-recognition of the role of the ECB in the field of international cooperation (Article 2(3) of the ČNB Law). 3.1.5.Assessment of compatibility As regards the independence of the central bank, the prohibition of monetary financing and the integration of the central bank in the ESCB at the time of euro adoption, the ČNB Law is not fully compatible with the compliance duty under Article 131 of the TFEU. 3.2.Price stability 3.2.1.Respect of the reference value The 12-month average inflation rate, which is used for the convergence assessment, was below the reference value at the time of the last convergence assessment of the Czech Republic in 2014. It declined gradually to below 0.4% in early 2015 and then remained broadly stable up to late 2015 when it fell below 0.3%. In April 2016, the reference value was 0.7%, calculated as the average of the 12-month average inflation rates in Bulgaria, Slovenia and Spain plus 1.5 percentage points. The corresponding inflation rate in the Czech Republic was 0.4%, i.e. 0.3 percentage points below the reference value. The 12-month average inflation rate is projected to remain below the reference value in the months ahead. 3.2.2.Recent inflation developments Price growth moderated significantly in 2014, with the HICP inflation rate slowing to 0.4% from 1.4% in the previous year. This was largely due to a large negative contribution from energy prices, reflecting the pass-through of a sharp decline in oil prices to domestic fuel prices. Falling food prices also contributed to weak price growth in the second half of 2014. Inflation accelerated somewhat during the first half of 2015, as the negative contribution of energy prices moderated while food and administered prices recorded some modest increases. There was a sharp slowdown in the second half of the year, however, amid renewed declines in food and energy prices. The annual HICP inflation rate averaged 0.3% in 2015. It picked up somewhat in early 2016 and stood at 0.5% in April 2016. Core inflation (measured as HICP inflation excluding energy and unprocessed food) averaged about 1% in 2014-2015, reflecting weak underlying price pressures in the economy. Prices of non-energy industrial goods, which had declined every year since 2002, rose moderately in 2014 and 2015, reflecting the koruna's weaker nominal effective exchange rate and strengthening domestic demand. Prices of processed food continued to increase but at a slower rate than in 2011-2013, due to lower contributions from input prices and changes in indirect taxes. These factors also led to slower growth in the price of services in 2014, although growth accelerated in 2015 amid strengthening domestic demand. Core inflation exceeded headline inflation in 2014 and 2015 as a result of the negative contribution of energy prices to the headline rate in these years. Producer price inflation for total industry was negative in both years, falling to -3.2% in 2015, highlighting weak supply-side cost pressures. 3.2.3.Underlying factors and sustainability of inflation Macroeconomic policy mix and cyclical stance The Czech Republic emerged from a 2-year recession in 2014, with domestic demand acting as the main driver of growth. The growth rate of private consumption accelerated in 2014 and 2015, amid falling unemployment and higher real disposable income. Gross fixed capital formation has contributed positively to real GDP growth in the last two years, particularly in 2015, also reflecting a significant increase in public investment co-financed by EU funds. The level of such investment is expected to fall in 2016, however, contributing to slower real GDP growth. According to the Commission services' Spring 2016 Forecast, real GDP growth is expected to slow to 2.1% in 2016, compared to 4.2% in 2015. Growth is then expected to accelerate to 2.6% in 2017 amid renewed growth in investment. While the Czech economy is estimated to have operated below its potential in the period 2009-2014, the output gap is estimated to have closed in 2015 and is projected to be positive in 2016 and 2017. The fiscal stance, as measured by the change in the structural balance, was accommodative in 2014. The structural balance deteriorated from a minor surplus in 2013 to a deficit of about 0.8% of GDP in 2014 before improving again to -0.4% of GDP in 2015. Its evolution largely reflected developments in the headline deficit and fading one-off factors. The structural balance is expected to deteriorate somewhat in 2016 and 2017. Monetary policy, conducted within an inflation targeting framework (), has remained highly accommodative. The ČNB's main policy rate (the 2-week repo rate) has been set at 0.05% since November 2012. Moreover, in view of projected undershooting of the inflation target for a protracted period of time, the ČNB decided in November 2013 to start using the exchange rate as an additional instrument for easing monetary conditions by allowing the koruna exchange rate against the euro to float freely only on the weaker side of the 27 CZK/EUR level. Following its meeting on 5 May 2016, the Bank Board of the ČNB reiterated that it would not discontinue the use of the exchange rate as a monetary policy instrument before 2017. Wages and labour costs

The labour market has performed strongly since the economy emerged from recession at the end of 2013. The unemployment rate, which had peaked at 7% in 2012 and 2013, fell to 6.1% in 2014 and to 5.1% in 2015, one of the lowest in the EU. At the same time, the number of employed persons increased by 0.6% in 2014 and 1.2% in 2015. This occurred despite falls in the population of working age and was made possible by an increase in the participation rate, as more workers were drawn into the labour market. Nominal wage growth has accelerated, reaching 2.4% in 2015, while real wage growth has also turned positive in an environment of low inflation. Labour productivity sharply accelerated in 2014 and 2015 as the number of persons employed grew more moderately than real GDP. With labour productivity growing faster than compensation per employee, nominal unit labour costs fell in 2015, after having remained broadly stable in 2014. As a consequence of lower GDP growth, labour productivity is also expected to increase at a slower rate in 2016 and 2017. At the same time, increasingly tight labour market conditions should give rise to faster growth of compensation per employee. As a result, nominal unit labour costs are expected to increase in 2016 and 2017. External factors Given the size and openness of the Czech economy, import prices have a sizeable effect on domestic price formation. This has particularly been the case in recent years, when there have been significant negative price shocks in global commodity markets. Developments were, however, quite mixed across categories of imported goods with the price of oil falling in koruna terms and contributing to falling energy prices in the domestic economy while prices of other energy goods increased. The exchange rate provided an inflationary impulse to domestic price developments in 2014, with the nominal effective exchange rate (measured against a group of 36 trading partners) weaker by more than 5%. As a result, Czech import prices increased by 1.9% compared to a fall of 2.6% in the euro area. Developments in the exchange rate had only a moderate impact on inflation in 2015 as the koruna's nominal effective exchange rate remained on average close to its 2014 level. Administered prices and taxes The share of administered prices in the HICP basket has been on a generally declining trend in recent years, although there was a slight increase in 2015. It stood at 11% in 2015 (), compared to 13% in the euro area. Changes in administered prices were not a significant driver of inflation in 2014 and 2015, with growth rates broadly in line with those of headline HICP inflation. Falling retail energy prices and the abolition of regulatory fees in the healthcare sector contributed to weak growth in administered prices in these years. Tax changes had a marginally positive impact on HICP inflation in 2014 and 2015. Medium-term prospects Annual HICP inflation is expected to remain subdued in 2016 as the decline in oil and food prices during the second half of 2015 will continue to exert a dampening impact on the year-on-year rate. At the same time, domestic price pressures are expected to become stronger, particularly with regards to services prices. According to the Commission services' Spring 2016 Forecast, annual HICP inflation is expected to average 0.5% in 2016, accelerating in the second half of the year. This acceleration is expected to continue in 2017, with HICP inflation forecasted to average 1.4%. Risks to the inflation outlook are broadly balanced. The main downside risks relate to weaker-than-expected economic activity which could stem from a slowdown in external demand. On the upside, faster-than-expected growth in domestic wages could give rise to inflationary demand pressures. The level of consumer prices in the Czech Republic dropped to below 63% of the euro-area average in 2014, with the relative price gap widest for services. This suggests there is potential for further price level convergence in the long term. After having basically stagnated between 2007 until 2013, Czech GDP per capital in purchasing power standards increased by almost 2 percentage points to above 79% of the euro-area average in 2014. Medium-term inflation prospects will be affected by productivity and wage developments as well as the functioning of product markets. Given the openness of the Czech economy and its limited resource base, commodity prices and other external price shocks will continue to exercise significant influence on domestic inflation. 3.3.Public finances 3.3.1.Recent fiscal developments On 17 June 2014, the Council decided to abrogate the decision on the existence of an excessive deficit according to Article 126 (12) TFEU, thereby closing the excessive deficit procedure for the Czech Republic (). The general government deficit declined substantially from 1.9 % of GDP in 2014 to 0.4% of GDP in 2015. Total revenue-to-GDP ratio increased to 42.2% of GDP in 2015, up from 40.8% in 2014, while total expenditure-to-GDP remained broadly stable at 42.6% of GDP in 2015, compared to 42.8 % in 2014. The 2015 headline deficit outcome is well below the target of 1.9 % of GDP in the 2015 Convergence Programme. This significantly better-than-expected outcome was due to several temporary factors including an exceptionally high absorption rate of EU funds, which boosted GDP growth. The structural balance improved in 2015 on the back of a rapidly closing negative output gap. The debt-to-GDP ratio declined from its peak of 45.1% of GDP in 2013 to 41.1% of GDP in 2015, remaining well below the 60% threshold. The fall was mainly induced by a favourable stock-flow adjustment, reflecting better liquidity management. 3.3.2.Medium-term prospects

According to the Commission services' Spring 2016 Forecast, the headline deficit is projected to increase to 0.7% of GDP in 2016, largely as a result of fading one-off factors and stabilisation of tax revenues in line with lower economic growth. The revenue-to-GDP ratio is expected to drop to 40.7% while the expenditure-to-GDP ratio is set to fall to 41.4%, as co-financing of EU-funded investment should decline due to lower expected drawdown of EU funds in the new programming period. The structural balance is set to deteriorate somewhat in 2016. The headline deficit is expected to decline marginally to 0.6% of GDP in 2017 due to the continued improvement in economic performance. The structural deficit should, however, further worsen to almost 1% of GDP. The debt-to-GDP ratio is projected to fall to 40.9% of GDP in 2017. The 2016 Convergence Programme was submitted by the Czech authorities on 11 May 2016. The authorities expect the headline deficit to decline to 0.6% of GDP in 2016 and then to stabilise at 0.5% of GDP beyond. The Czech Republic over-achieved its medium-term budgetary objective, set as a structural deficit of 1 % of GDP, which continues to be met over the programme horizon. According to the convergence programme, the government debt-to-GDP ratio is expected to remain at 41.1% in 2016 and to fall to 39.3% in 2019. Based on its assessment of the convergence programme and taking into account the Commission services' Spring 2016 Forecast, the Commission is of the opinion that the Czech Republic is expected to comply with the provisions of the Stability and Growth Pact. Further details can be found in the Assessment of the 2016 Convergence Programme for the Czech Republic (). As far as the national fiscal framework is concerned – which refers to numerical fiscal rules, medium-term budgetary frameworks, independent fiscal institutions, and budgetary procedures – the Czech Republic scores low compared to other EU Member States. Medium-term budgetary framework and expenditure ceilings exist but enforcement and monitoring is weak. The draft reform package aimed at strengthening the framework was revamped several times. This package is also meant to complete the transposition of the Directive on national budgetary frameworks () into Czech legislation, which Member States were obliged to carry out by the end of 2013. Its latest version was approved by the government in February 2015 but still awaits adoption by the parliament. 3.4.Exchange rate stability The Czech koruna does not participate in ERM II. Since the late 1990s, the ČNB has been operating an explicit inflation targeting framework combined with a floating exchange rate regime, allowing for foreign exchange market interventions by the central bank. The exchange rate of the koruna against the euro remained broadly stable between early 2010 until late 2013, oscillating between 24 and 26 CZK/EUR. On 7 November 2013, the ČNB began using the exchange rate as an additional instrument for easing monetary conditions in view of projected price developments indicating an undershooting of the inflation target for a protracted period of time. The ČNB announced that it would intervene on the foreign exchange market to weaken the koruna, so that its exchange rate against the euro was close to 27, and clarified that it regarded this commitment as one-sided, allowing the exchange rate to float freely on the weaker side of this level. The announcement and initial market interventions proved to be effective as the koruna swiftly weakened from below 26 CZK/EUR to above 27 CZK/EUR. The koruna traded on average at around 27.5 CZK/EUR throughout 2014 and the first half of 2015, amid low volatility. It strengthened close to 27 CZK/EUR in mid-2015 and then remained near its lower bound set be the ČNB during the second half of 2015 and in early 2016. During the two years before this assessment, the koruna appreciated against the euro by some 1.6%. International reserves held by the ČNB increased by more than EUR 8 billion to above EUR 40 billion (27% of GDP) in late 2013, largely as a result of its foreign exchange market interventions. They continued to increase gradually over the next two years, with the pace of reserve accumulation accelerating considerably in the second half of 2015. As a result, they reached almost EUR 60 billion by end-2015 (36% of GDP). The 3-month interest rate differential vis-à-vis the euro area tightened to below 10 basis points in early 2014 as a result of koruna liquidity injections related to the ČNB's foreign exchange market interventions combined with declining excess liquidity in the euro area. It widened again to above 10 basis points in June 2014 and above 20 basis points in September 2014 following the ECB deposit facility rate cuts. It then continued to widen gradually throughout late 2014 and 2015 as excess liquidity in the euro area increased through ECB asset purchase programmes. The widening trend accelerated in late 2015 and early 2016, following further ECB deposit facility rate cuts. At the cut-off date of this report, the 3-month spread vis-à-vis the euro area was some 54 basis points. 3.5.Long-term interest rates Long-term interest rates in the Czech Republic used for the convergence examination reflect secondary market yields on a basket of government bonds with a residual maturity of about 10 years. The Czech 12-month average long-term interest rate relevant for the assessment of the Treaty criterion was well below the reference value at the time of the last convergence assessment of the Czech Republic in 2014. It remained broadly stable at just above 2% in the first half of 2014 and then declined gradually to below 0.6% by end-2015. In April 2016, the latest month for which data are available, the reference value, given by the average of long-term interest rates in Bulgaria, Slovenia and Spain plus 2 percentage points, stood at 4%. In that month, the 12-month moving average of the yield on the Czech benchmark bond stood at 0.6%, i.e. 3.4 percentage points below the reference value. Long-term interest rates in the Czech Republic followed a downward trend from early 2014 up to April 2015, declining from above 2.4% to below 0.3%, mainly thanks to strong investment demand. As a result, the spread against the German long-term benchmark bond narrowed from some 70 basis points to about 10 basis points over this time period. Long-term interest rates jumped to above 1% in June 2015, largely mirroring the bond market correction in the euro area, but then declined again gradually throughout the second half of 2015. The spread against the German benchmark bond oscillated at around 25 basis points in early 2016 (). 3.6.Additional factors

The Treaty (Article 140 TFEU) calls for an examination of other factors relevant to economic integration and convergence to be taken into account in the assessment. The assessment of the additional factors – including balance of payments developments, product and financial market integration – gives an important indication of a Member State's ability to integrate into the euro area without difficulties. In November 2015, the Commission published its fifth Alert Mechanism Report (AMR 2016) () under the Macroeconomic Imbalance Procedure (MIP - see also Box 1.5). The AMR 2016 scoreboard showed that that the Czech Republic exceeded the indicative threshold in one out of fourteen indicators, i.e. the net international investment position. In line with the conclusions of the AMRs 2012-16, the Czech Republic has not been subject to in-depth reviews in the context of the MIP. 3.6.1.Developments of the balance of payments According to the balance of payments data, the Czech Republic's external balance (i.e. the combined current and capital account) remained in surplus over the last two years, increasing from below 1% of GDP in 2014 to above 3% of GDP in 2015. The improvement reflected higher surpluses in both the current and capital accounts. The current account surplus increased from 0.2% of GDP in 2014 to 0.9% of GDP in 2015, due to an increase in the income balance. The higher capital account surplus largely reflected a substantial drawdown of funds from the EU budget. However, according to the national accounts data, gross capital formation has actually increased at a faster pace than savings since 2013, giving rise to a more negative savings-investment balance. This increase was largely driven by the general government sector as public investment increased significantly in 2014 and 2015. In contrast, gross capital formation by the household and corporate sectors fell over this period and the savings-investment gap of the private sector as a whole improved. Export performance improved significantly in 2014, reflecting a sharp depreciation of the nominal effective exchange rate in late 2013 and stronger external demand as the euro area emerged from recession. Export growth remained buoyant in 2015 but slowed down somewhat compared to the previous year. External price and cost competitiveness, as measured by ULC- and HICP-deflated real effective exchange rates, improved considerably in late 2013 and, to a lesser degree, throughout 2014. The real effective exchange rate then increased somewhat in the course of 2015 as a result of the nominal effective exchange rate appreciation. The financial account balance remained positive in 2014 and 2015, increasing quite sharply in 2015. This increase was largely driven by rising official reserves, as the pace of external asset accumulation by the ČNB accelerated in the second half of 2015. The contribution of net FDI flows also increased while net portfolio investment flows contributed negatively in 2015. Although gross external debt increased gradually to almost 71% of GDP in 2015, the net international investment position continued to improve. According to the Commission services' Spring 2016 Forecast, the trade balance is expected to improve in 2016 and 2017, contributing to further improvement in the current account balance. The risks to this outlook are, however, tilted to the downside, as lower than expected world demand could give rise to a weaker trade performance. 3.6.2.Market integration The Czech economy is highly integrated with the euro area through trade and investment linkages. Trade openness of the Czech Republic remains very high. It has continued to increase in recent years, reaching almost 94% of GDP in 2015. The share of trade with the euro area expressed in percentage of GDP is high and has also been further increasing in recent years, exceeding 57% in 2015 as neighbouring euro-area countries belong to the Czech Republic's largest trade partners. The Czech Republic has attracted a high share of FDI in the tradable sector thanks to its geographical proximity to EU core markets, relatively good infrastructure and highly educated labour force. FDI inflows mainly originate in the euro area, with the Netherlands, Germany, and Austria accounting for more than half of the total stock. As far as the business environment is concerned, the scores received by the Czech Republic in international rankings have improved in recent years, converging close to the euro-area average. At the same time, the Czech Republic's deficit in the transposition of EU directives was just 0,5% in 2015. Protection of permanent employees against collective and individual dismissals is relatively strict (as measured by the 2013 OECD employment protection indicator). Cross-border migration flows have remained relatively subdued although net immigration into the Czech Republic seems to have picked up somewhat recently.

The Czech financial sector remains highly integrated into the EU financial sector. The main channel of integration is through a high degree of foreign ownership of financial intermediaries as about 87% of banking sector's assets was in 2014 held by foreign institutions via local branches and subsidiaries. Bank concentration, as measured by the market share of the largest five credit institutions in total assets, has remained above the euro-area average over the past years at just above 60%. The Czech banking sector is well capitalised with the average capital adequacy ratio of 16.7% in the third quarter of 2015, similar to 16.2% in the euro area. Moreover, its profitability has held up remarkably well in recent years, with the average return on equity (RoE) reaching almost 10% in Q3-2015, compared to about 4% in the euro area. At the same time, the share of non-performing loans has remained broadly stable at around 5½% while it exceeded 6% in the euro area. After having followed a declining trend between end-2008 and end-2013, the real house price index started recovering again in 2014 and it exceeded its 2010 level by end-2015. However, the GDP share of residential investment remained quite stable in recent years even though bank lending to households for house purchase