EUROPEAN COMMISSION Brussels, 23.5.2018 SWD(2018) 350 final COMMISSION STAFF WORKING DOCUMENT Convergence Report 2018 Accompanying the document REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL CONVERGENCE REPORT 2018



(prepared in accordance with Article 140(1) of the Treaty on the Functioning of the European Union) {COM(2018) 370 final}



European Commission Directorate-General for Economic and Financial Affairs Convergence Report 2018 EUROPEAN ECONOMY x/2018 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 CZK Czech koruna HRK Croatian kuna HUF Hungarian forint PLN Polish zloty RON Romanian leu (ROL until 30 June 2005) SEK Swedish krona USD United States dollar 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 CEE Central and Eastern Europe 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 GDP Gross domestic product HICP Harmonised index of consumer prices HFSA Hungarian Financial Supervisory Authority IDR In-Depth Review 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 REER Real effective exchange rate TFEU Treaty on the Functioning of the European Union

ULC Unit labour costs VAT Value added tax The Convergence Report and its Technical Annex were prepared in the Directorate-General for Economic and Financial Affairs. The main contributors were Maja Ferjančič, Balázs Forgó, Anton Jevčák and Matteo Salto. Other contributors were Wojciech Balcerowicz, Laura Bardone, Cristiana Belu Manescu, Nicolae-Dragoș Bîea, Stefan Ciobanu, Karl Croonenborghs, Iván Csaba, Patrick D'Souza, Mateja Gabrijelčič, Juan González Fernández, Julien Hartley, Michal Havlát, László Jankovics, Isabelle Justo, Robert Kuenzel, Ivan Kusen, Wojciech Paczynski, Mona Papadakou, Gábor Pellényi, Leonardo Pérez-Aranda, Arian Perić, Mario Pletikosa, Marc Puig, Diana Radu, Maximilian Reßing, Ralph Schmitt-Nelson, Outi Slotboom, Michael Stierle, Márton Szili, Maja Šamanović, Geert Vermeulen, Bartlomiej Wiczewski, Rafał Wielądek, Ana Xavier and Marcin Zogala. Statistical assistance was provided by Eric Mc Coy, Gerda Symens and André Verbanck, administrative assistance by Erdemia Malagrida and Sien Vangompel. The report was coordinated by Balázs Forgó under the supervision of Eric Ruscher, 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 20181 Convergence Report 2018 - Technical annex3 1.Introduction5 1.1.Role of the report5 1.2.Application of the criteria6 1.2.1.Compatibility of legislation7 1.2.2.Price stability7 1.2.3.Public finances10 1.2.4.Exchange rate stability10 1.2.5.Long-term interest rates13 1.2.6.Additional factors13

2.Bulgaria17 2.1.LEGAL COMPATIBILITY17 2.1.1.Introduction17 2.1.2.Central Bank independence17 2.1.3.Prohibition of monetary financing and privileged access18 2.1.4.Assessment of compatibility18 2.2.Price stability19 2.2.1.Respect of the reference value19 2.2.2.Recent inflation developments19 2.2.3.Underlying factors and sustainability of inflation20 2.3.Public finances22 2.3.1.Recent fiscal developments22 2.3.2.Medium-term prospects23 2.4.Exchange rate stability24 2.5.Long-term interest rates25 2.6.Additional factors25 2.6.1.Developments of the balance of payments26 2.6.2.Market integration27 3.Czech Republic31 3.1.Legal compatibility31

3.1.1.Introduction31 3.1.2.Central Bank independence31 3.1.3.Prohibition of monetary financing and privileged access31 3.1.4.Integration in the ESCB32 3.1.5.Assessment of compatibility32 3.2.Price stability32 3.2.1.Respect of the reference value32 3.2.2.Recent inflation developments33 3.2.3.Underlying factors and sustainability of inflation33 3.3.Public finances36 3.3.1.Recent fiscal developments36 3.3.2.Medium-term prospects36 3.4.Exchange rate stability37 3.5.Long-term interest rates37 3.6.Additional factors38 3.6.1.Developments of the balance of payments38 3.6.2.Market integration40 4.Croatia43 4.1.Legal compatibility43 4.1.1.Introduction43

4.1.2.Central Bank independence43 4.1.3.Prohibition of monetary financing and privileged access43 4.1.4.Integration in the ESCB43 4.1.5.Assessment of compatibility43 4.2.Price stability43 4.2.1.Respect of the reference value43 4.2.2.Recent inflation developments44 4.2.3.Underlying factors and sustainability of inflation44 4.3.Public finances46 4.3.1.Recent fiscal developments46 4.3.2.Medium-term prospects47 4.4.Exchange rate stability48 4.5.Long-term interest rates48 4.6.Additional factors49 4.6.1.Developments of the balance of payments49 4.6.2.Market integration51 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 ESCB56 5.1.5.Assessment of compatibility56 5.2.Price stability56 5.2.1.Respect of the reference value56 5.2.2.Recent inflation developments57 5.2.3.Underlying factors and sustainability of inflation57 5.3.Public finances60 5.3.1.Recent fiscal developments60 5.3.2.Medium-term prospects61 5.4.Exchange rate stability62 5.5.Long-term interest rates63 5.6.Additional factors63 5.6.1.Developments of the balance of payments64 5.6.2.Market integration65 6.Poland69 6.1.Legal compatibility69 6.1.1.Introduction69 6.1.2.Central Bank independence69 6.1.3.Prohibition of monetary financing and privileged access70

6.1.4.Integration in the ESCB70 6.1.5.Assessment of compatibility71 6.2.Price stability71 6.2.1.Respect of the reference value71 6.2.2.Recent inflation developments71 6.2.3.Underlying factors and sustainability of inflation73 6.3.Public finances74 6.3.1.Recent fiscal developments74 6.3.2.Medium-term prospects75 6.4.Exchange rate stability76 6.5.Long-term interest rates76 6.6.Additional factors77 6.6.1.Developments of the balance of payments78 6.6.2.Market integration79 7.Romania83 7.1.Legal compatibility83 7.1.1.Introduction83 7.1.2.Central Bank independence83 7.1.3.Prohibition of monetary financing and privileged access84 7.1.4.Integration in the ESCB85

7.1.5.Assessment of compatibility85 7.2.Price stability85 7.2.1.Respect of the reference value85 7.2.2.Recent inflation developments86 7.2.3.Underlying factors and sustainability of inflation86 7.3.Public finances89 7.3.1.Recent fiscal developments89 7.3.2.Medium-term prospects90 7.4.Exchange rate stability90 7.5.Long-term interest rates91 7.6.Additional factors92 7.6.1.Developments of the balance of payments92 7.6.2.Market integration94 8.Sweden97 8.1.Legal compatibility97 8.1.1.Introduction97 8.1.2.Central Bank independence97 8.1.3.Prohibition of monetary financing and privileged access98 8.1.4.Integration in the ESCB98 8.1.5.Assessment of compatibility99

8.2.Price stability99 8.2.1.Respect of the reference value99 8.2.2.Recent inflation developments99 8.2.3.Underlying factors and sustainability of inflation100 8.3.Public finances102 8.3.1.Recent fiscal developments102 8.3.2.Medium-term prospects103 8.4.Exchange rate stability104 8.5.Long-term interest rates105 8.6.Additional factors105 8.6.1.Developments of the balance of payments106 8.6.2.Market integration107 LIST OF Tables 2.1.Bulgaria - Components of inflation20 2.2.Bulgaria - Other inflation and cost indicators22 2.3.Bulgaria - Budgetary developments and projections22 2.4.Bulgaria - Balance of payments26 2.5.Bulgaria - Market integration28 3.1.Czech Republic - Components of inflation33

3.2.Czech Republic - Other inflation and cost indicators34 3.3.Czech Republic - Budgetary developments and projections35 3.4.Czech Republic - Balance of payments38 3.5.Czech Republic - Market integration40 4.1.Croatia - Components of inflation43 4.2.Croatia - Other inflation and cost indicators44 4.3.Croatia - Budgetary developments and projections47 4.4.Croatia - Balance of payments50 4.5.Croatia - Market integration52 5.1.Hungary - Components of inflation57 5.2.Hungary - Other inflation and cost indicators57 5.3.Hungary - Budgetary developments and projections61 5.4.Hungary - Balance of payments64 5.5.Hungary - Market integration64 6.1.Poland - Components of inflation70 6.2.Poland - Other inflation and cost indicators71 6.3.Poland - Budgetary developments and projections75 6.4.Poland - Balance of payments77 6.5.Poland - Market integration79 7.1.Romania - Components of inflation85

7.2.Romania - Other inflation and cost indicators86 7.3.Romania - Budgetary developments and projections88 7.4.Romania - Balance of payments92 7.5.Romania - Market integration93 8.1.Sweden - Components of inflation100 8.2.Sweden - Other inflation and cost indicators100 8.3.Sweden - Budgetary developments and projections103 8.4.Sweden - Balance of payments106 8.5.Sweden - Market integration106 LIST OF Graphs 2.1.Bulgaria - Inflation criterion19 2.2.Bulgaria - HICP inflation19 2.3.Bulgaria - Inflation, productivity and wage trends21 2.4.Bulgaria - BGN/EUR exchange rate24 2.5.Bulgaria - 3-M Sofibor spread to 3-M Euribor24 2.6.Bulgaria - Long-term interest rate criterion25 2.7.Bulgaria - Long-term interest rates25 2.8.Bulgaria - Saving and investment27 2.9.Bulgaria - Effective exchange rates27

2.10.Bulgaria - Foreign ownership and concentration in the banking sector29 2.11.Bulgaria - Selected banking sector soundness indicators29 2.12.Bulgaria - Recent development of the financial system relative to the euro area29 3.1.Czech Republic - Inflation criterion33 3.2.Czech Republic - HICP inflation33 3.3.Czech Rep. - Inflation, productivity and wage trends34 3.4.Czech Republic - CZK/EUR exchange rate37 3.5.Czech Republic - 3-M Pribor spread to 3-M Euribor37 3.6.Czech Republic - Long-term interest rate criterion38 3.7.Czech Republic - Long-term interest rates38 3.8.Czech Republic - Saving and investment39 3.9.Czech Republic - Effective exchange rates39 3.10.Czech Republic - Foreign ownership and concentration in the banking sector40 3.11.Czech Republic - Selected banking sector soundness indicators41 3.12.Czech Republic - Recent development of the financial system relative to the euro area41 4.1.Croatia - Inflation criterion44 4.2.Croatia - HICP inflation44 4.3.Croatia - Inflation, productivity and wage trends46 4.4.Croatia - HRK/EUR exchange rate48 4.5.Croatia - 3-M Zibor spread to 3-M Euribor48

4.6.Croatia - Long-term interest rate criterion49 4.7.Croatia - Long-term interest rates49 4.8.Croatia - Saving and investment50 4.9.Croatia - Effective exchange rates50 4.10.Croatia - Foreign ownership and concentration in the banking sector51 4.11.Croatia - Selected banking sector soundness indicators52 4.12.Croatia - Recent development of the financial system relative to the euro area52 5.1.Hungary - Inflation criterion57 5.2.Hungary - HICP inflation57 5.3.Hungary - Inflation, productivity and wage trends59 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 investment65 5.9.Hungary - Effective exchange rates65 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 area67 6.1.Poland - Inflation criterion71

6.2.Poland - HICP inflation72 6.3.Poland - Inflation, productivity and wage trends73 6.4.Poland - PLN/EUR exchange rate76 6.5.Poland - 3-M Wibor spread to 3-M Euribor76 6.6.Poland - Long-term interest rate criterion76 6.7.Poland - Long-term interest rates77 6.8.Poland - Saving and investment78 6.9.Poland - Effective exchange rates78 6.10.Poland - Foreign ownership and concentration in the banking sector80 6.11.Poland - Selected banking sector soundness indicators80 6.12.Poland - Recent development of the financial system relative to the euro area80 7.1.Romania - Inflation criterion85 7.2.Romania - HICP inflation86 7.3.Romania - Inflation, productivity and wage trends88 7.4.Romania - RON/EUR exchange rate91 7.5.Romania - 3-M Robor spread to 3-M Euribor91 7.6.Romania - Long-term interest rate criterion91 7.7.Romania - Long-term interest rates92 7.8.Romania - Saving and investment92 7.9.Romania - Effective exchange rates94

7.10.Romania - Foreign ownership and concentration in the banking sector95 7.11.Romania - Selected banking sector soundness indicators95 7.12.Romania - Recent development of the financial system relative to the euro area95 8.1.Sweden - Inflation criterion99 8.2.Sweden - HICP inflation99 8.3.Sweden - Inflation, productivity and wage trends101 8.4.Sweden - SEK/EUR exchange rate104 8.5.Sweden - 3-M Stibor spread to 3-M Euribor104 8.6.Sweden - Long-term interest rate criterion105 8.7.Sweden - Long-term interest rates105 8.8.Sweden - Saving and investment107 8.9.Sweden - Effective exchange rates107 8.10.Sweden - Foreign ownership and concentration in the banking sector108 8.11.Sweden - Selected banking sector soundness indicators109 8.12.Sweden - Recent development of the financial system relative to the euro area109 LIST OF Boxes 1.1.Article 140 of the Treaty5 1.2.Assessment of price stability and the reference value8 1.3.Excessive deficit procedure11

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 2016, the Commission and the ECB adopted their latest regular Convergence Reports (). None of the Member States assessed in those reports was deemed to meet the necessary conditions for adopting the euro. In 2018, 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 2018 and includes a detailed assessment of the progress with convergence, as required by Article 140(1) of the Treaty. 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.). President Juncker said in his 2017 State of the Union address: "The euro is meant to be the single currency of the European Union as a whole. All but two of our Member States are required and entitled to join the euro once they fulfil all conditions. Member States that want to join the euro must be able to do so." The Commission proposed in its 6 December 2017 "EMU Package" to set up a dedicated work stream (as part of its technical assistance activities) to offer targeted support to Member States on their way to joining the euro (). The technical support will be offered upon request and will cover all policies that can help achieve a high degree of convergence, such as support for reforms in the areas of public financial management, the business environment, the financial sector, labour and product markets, and the public administration. This technical support will be funded through the Structural Reform Support Programme. The Commission also announced that for the period post-2020, it will propose a dedicated convergence facility, as part of the follow-up to the Structural Reform Support Programme, in order to support Member States in their concrete preparation for a smooth participation in the euro area. This is however irrespective of the formal process towards euro adoption, which is part of a specific monitoring process through the Convergence Reports.

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, the 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 23 April 2018. 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 (see Box 1.2). (Continued on the next page) Box (continued) Accordingly, the reference value is currently 1.9%, based on the data of Cyprus (0.2%), Ireland (0.3%), and Finland (0.8%) over the 12-month period covering April 2017-March 2018. 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, 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 which sets out the way in which government deficit and debt levels are assessed to determine whether an excessive deficit exists, under article 126 of TFEU. The convergence assessment in the budgetary area is therefore judged by whether the Member State is subject to a Council decision under 126(6) on the existence of an excessive deficit (). 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. (Continued on the next page) Box (continued) 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 24 April 2016 to 23 April 2018. 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 March 2018 is calculated as the simple average of the average long-term interest rates in Cyprus (2.2%), Ireland (0.8%) and Finland (0.6%), plus 2 percentage points, yielding a reference value of 3.2%. 1.2.6.Additional factors The Treaty in Article 140 also calls for an examination of other factors relevant to economic integration and convergence. These additional factors include financial, product and labour market integration and the development of the balance of payments. The examination of the development of unit labour costs and other price indices, which is also prescribed by Article 140 of the Treaty, is covered in the section on price stability.

The assessment of additional factors gives an important indication of a Member State's ability to integrate into the euro area without difficulties. As regards the balance of payments, the focus is on the situation and development of the external balance (). Market integration is assessed through trade, foreign direct investment and a smooth functioning of the internal market. Moreover, progress in financial integration is examined, together with the main characteristics, structures and trends of the financial sector. Given that Member States which adopt the euro also participate in the banking union, developments in national banking sectors are specifically looked at as well. 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 2016 Convergence Report. However, no amendments have been made as regards the incompatibilities highlighted in the Commission's 2016 Convergence Report. Therefore, the comments provided in the latter 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. The Conflict of Interest Prevention and Ascertainment Act of 2008, which regarding the possibility to dismiss the Governor of the BNB had to be brought in line with Article 14.2 of the ESCB/ECB Statute, was fully repealed and replaced by the Act on Corruption Counteraction and Eviction of Illegally Acquired Property of 2018 (). However, similar to the repealed Act, Article 80(1) in conjunction with Article 6(1)(12) of the new Act provides that the ascertainment of a conflict of interest is a ground for dismissal of the Governor of the BNB. Thus, an incompatibility remains and 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 ascertainment of a conflict of interest corresponds to a lack of fulfilment of the conditions required for the performance of the Governor's duties or 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. Objectives The objectives of the BNB (Article 2(2) of the BNB Law) 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, 29, 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, 29, 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 (Article 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). 2.1.4.Assessment of compatibility The BNB Law and the Act on Corruption Counteraction and Eviction of Illegally Acquired Property 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. The Commission has understood that the Bulgarian authorities have the intention to amend the BNB Law in the course of 2018. In this context, Bulgarian authorities are invited to consult the ECB on the draft law amending the BNB Law and other related laws, as provided for by Articles 127(4) and 282(5) of the TFEU and to remedy the abovementioned incompatibilities. 2.2.Price stability 2.2.1.Respect of the reference value

The 12-month average inflation rate, which is used for the convergence assessment, was below the reference value at the time of the last convergence assessment of Bulgaria in 2016. It started to increase steadily soon after, moved into positive territory in June 2017 and has been further increasing afterwards, reaching 1.2% in December 2017. In March 2018, the reference value was 1.9%, calculated as the average of the 12-month average inflation rates in Cyprus, Ireland and Finland plus 1.5 percentage points. The corresponding inflation rate in Bulgaria was 1.4%, i.e. 0.5 percentage points below the reference value. The 12-month average inflation rate is projected to remain below the reference value in the months ahead. 2.2.2.Recent inflation developments The annual HICP inflation rate in Bulgaria was negative between mid-2013 and early-2017 due to a combination of several factors, including declining imported commodity prices, subdued domestic demand and reductions in administered prices. With the reversal of these trends, the inflation rate started to gradually increase again in the second half of 2016, after having reached its trough at -2.5% in May. It entered positive territory at the beginning of 2017 and maintained a predominantly growing trajectory since then, reaching 1.2% for the year despite slight downwards fluctuations between April and July. In 2018, inflation continued picking up reaching 1.9% in March. In October 2017, the inflation rate surpassed that of the euro area by 0.12 percentage points and it has remained above it since then. Core inflation (measured as HICP inflation excluding energy and unprocessed food) fell from 0.4% in October 2015 to -0.8% in May 2016. After that, it started to gradually pick up, entering positive figures in the second half of 2017 and reaching 1.0% by December 2017. This trend continued in 2018, with core inflation standing at 1.9% in March. Services and processed food inflation were the main contributors to this increase. Core inflation was above headline inflation during 2015 and most of 2016, highlighting the effect of plunging energy and unprocessed food prices. As prices in these two categories started to increase rapidly in the final months of 2016, the headline inflation increased above the core inflation in December 2016. The components of core inflation have been mostly negative in 2016. Processed food inflation, which was the first to turn around already the year before, partly due to rising unprocessed food prices, continued trending up throughout 2016. Despite some fluctuations over the year, it reached 2.5% in December 2017 and fell slightly to 2.3% in March 2018. Services inflation has been pretty volatile over the last years. After starting 2016 in the positive territory, it fell to 1.1% in May 2016. It had recovered by August 2016, only to be falling again until March 2017, when it bottomed at -1.3%. It resumed growth in the ensuing months reaching 1.2% in December 2017 and peaking at 3.7% in March 2018. This increase is in line with the wage increases and positive developments in the labour market that are strengthening domestic demand. Non-energy industrial goods inflation was deeply negative in 2016 reflecting both lower import prices and weak domestic demand for a long time. Non-energy industrial goods inflation started to recover only in 2017 fuelled by stronger domestic demand and higher import prices, but it remained in negative territory, reaching -0.5% in December 2017 and -0.4% in March 2018. The producer price index rose by 4.1% in December 2017 compared to the same month of 2016, mostly as a result of price increases in the electricity, gas, steam and air conditioning supply and the mining and quarrying industry. 2.2.3.Underlying factors and sustainability of inflation Macroeconomic policy mix and cyclical stance Bulgaria’s economy is growing steadily, with the drivers of growth having shifted from the external sector to domestic demand in 2017. Real GDP growth was estimated at 3.6% in 2017, 0.3 percentage points lower than in 2016. Increases in wages and improved household expectations had a positive impact on private consumption over the course of 2017. Public consumption growth was also stronger than in previous years, reflecting mainly increasing public wages and higher spending on intermediate consumption. Investment is slowly recovering from its drop in 2016, as confidence is improving in the business sector. However, the public investment decreased further in 2017 mainly because the implementation of EU funded projects has been slower than expected. Following a very strong performance in 2016, net exports' contribution to GDP growth turned negative, as imports driven by strong domestic demand grew faster in 2017 and export growth slowed down. The GDP growth rate is expected to remain robust with projections of 3.8% for 2018 and 3.7% for 2019. The output gap turned positive in 2017 and it is set to remain positive in 2018 and 2019. The fiscal stance, as measured by the change in the structural balance, remains tight. The fiscal adjustment which started in 2015, continued in the recent years and the structural fiscal surplus already achieved in 2016 has widened further in 2017. According to the Commission services' Spring 2018 Forecast, the structural surplus is projected to be slightly reduced in 2018 and 2019, indicating a small fiscal expansion owed mostly to a projected higher public investment. In the context of its currency board arrangement with lev (BGN) pegged to the euro, the most standard monetary policy instruments are not available to Bulgaria. In response to these limitations, the BNB has kept relatively conservative liquidity and capital requirements on the banking sector. Bank interest rates have decreased further over the past two years in line with monetary policy developments in the euro area. Lending to the private sector has been on the recovery path since mid-2016. However, it has remained subdued due to an ongoing corporate deleveraging. The domestic banking crisis which erupted in 2014 has been largely quickly overcome, financial sector soundness has improved and contagion risks have abated. Nevertheless vulnerabilities remain as non-financial corporations' debt, and non-performing loans are still higher than in peer countries, albeit decreasing. The action plan drawn to deal with identified shortcomings in banks' management practices and supervision is being implemented. The collateral valuation practices need to be enhanced in line with EU standards. Wages and labour costs The labour market continued to improve over 2016-17. Activity and employment rates increased substantially in this period which, combined with the improved economic outlook, further reduced the unemployment rate from 7.6% in 2016 to 6.2% in 2017. Nominal compensation per employee increased by 5.8% in 2016 and 7.5% in 2017, merely as a response to wage convergence pressures, and skills shortages and mismatches. Labour productivity growth continued to increase, but it is estimated to have flattened from 3.4% in 2016 to 1.7% in 2017. Over 2018-2019, labour productivity is forecast to continue growing as a result of the improvements in the labour market and the ongoing recovery of investment. Nominal unit labour cost (ULC) growth remained at 2.3% in 2016, but exhibited a strong growth of 5.7% in 2017, which is in line with the tightening of the labour market in the private sector and increases in public sector wages. According to the Commission services' Spring 2018 Forecast, ULC growth is expected to continue to be strong in 2018. For 2019, ULC growth is forecast to slow down in line with the evolution of nominal compensation per employee, while remaining well above ULC growth in the euro area. 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 due to 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 until recently, bottoming out at -6% in 2016. This reflected mainly lower international oil prices and the stronger nominal effective exchange rate of the lev. However, this trend was reversed in 2017 with import prices increasing by 3%. This growth in import prices is assumed to continue in 2018, mainly due to the expected movements of global oil prices, pushing upwards energy prices, though at a declining rate.

The nominal effective exchange rate of the lev (measured against a group of 36 trading partners) has appreciated by over 5% since the start of 2016 as the currencies of Bulgaria's major trading partners depreciated against the euro (the US dollar, the pound sterling, the Swiss franc, the Turkish lira, the Russian rouble, the Romanian leu, the Chinese yuan). Almost half of this appreciation was realized in the second half of 2017. While stronger nominal effective exchange rate also contributed to lower import prices over the assessment period, the appreciation of the euro (and hence of the lev) against the US dollar also cushioned somewhat the inflationary pressures of higher oil prices. Administered prices and taxes The growth rate of administered prices () was above headline consumer price inflation over the past two years. The share of administered prices in the HICP basket is relatively high at around 16%, compared to 13% in the euro area. The annual change of a growth rate of administered prices increased from 0.1% in 2016 to 1.7% in 2017. Overall, the contribution of administered prices to headline inflation was neutral in 2016 and about 0.3 percentage points in 2017 (or 22.4% of total HICP growth). Indirect tax changes had an insignificant effect on inflation over 2016-2017 despite tobacco excise tax increases since 2016. Annual constant-tax HICP was broadly at the same level as headline inflation during the assessment period. Medium-term prospects Annual HICP inflation is expected to rise further in 2018 and 2019. Core inflation is set to continue to rise in 2018 as growth in household disposable incomes, fuelled by positive labour market developments, boosts private demand. At the same time, global oil prices are expected to continue pushing energy prices upwards. Accordingly, the Commission services' Spring 2018 Forecast projects HICP inflation to average 1.8% in 2018 and 2019. Risks to the inflation outlook appear broadly balanced. The most significant risks are related to global energy and food price developments, given their relatively large share in the consumer basket. Additional inflation risk factors are supported also by domestic developments, including administered prices changes and higher wage growth. In 2016, the level of consumer prices in Bulgaria was about 47% of the euro area average and the GDP per capita was about 46% of the euro area average in PPS terms. In line with the catching-up of the Bulgarian economy, further price level convergence is expected. Medium-term inflation prospects will depend on wage and productivity developments, as well as on global commodity price trends. The tax policy is expected to have only a limited impact on inflation. 2.3.Public finances 2.3.1.Recent fiscal developments The general government budget registered surpluses in 2016 and 2017. The expenditure-to-GDP ratio decreased by 5.5 percentage points between 2015 and 2017, to 35.2%. The reduction in expenditure reflects the lower spending in investment and other expenditure related to the implementation of EU funded programmes. The transition between the two financing periods of EU structural and investment funds had also an impact on the revenue side. Between 2015 and 2017, total revenues decreased by 2.9 percentage points to 36.1% of GDP. This decrease can almost entirely be attributed to lower transfers from EU funds. However, the negative developments on the side of transfers was partly moderated by higher tax revenue, which increased by 1 percentage point of GDP between 2015 and 2017. The general government balance in 2017 overshot the target of -0.6% of GDP in the 2017 Convergence Programme. The better outcome is mainly owed to a significantly lower public investment relative to the initial target and a better performance on the revenue side. In structural terms, the adjustment achieved since 2015 is 2 percentage points of GDP. The structural surplus improved further from 0.3% of GDP in 2016 to 0.9% in 2017, while the output gap almost closed in 2017, after being in a negative territory for years. The general government gross debt peaked in 2016 at the level of 29% of GDP. The positive primary budget balance and the repayment of debt of around 1.5 percentage points of GDP out of accumulated fiscal reserves together with high nominal growth led to a reduction by more than 4 percentage points of GDP in 2017, to 25.4%. 2.3.2.Medium-term prospects The 2018 budget was adopted by Parliament in December 2017. It aims at a general government deficit of 1% of GDP in cash terms, corresponding to a balanced budget in ESA terms. On the revenues' side, the main measures planned include a further increase of the excise duty on cigarettes in order to reach the EU minimum level, an increase of social security contributions by 1 percentage point, adjustments of the minimum income for which contributions have to be paid and an adjustment of the minimum wage, which is expected to have a positive impact also on direct taxes. On the expenditures' side, the government has decided to increase wages for some categories of teaching staff and security personnel. The medium term plan of the government budget in cash terms provides for reductions of the deficit by 0.5 percentage points per annum until 2020, when it is planned to be balanced. In ESA terms, the surplus that has been achieved already since 2016 is forecast by the government to get to zero in 2018 and again return and remain positive in the medium term. Given the over-achievement of the consolidation targets in the last few years, the Commission services updated their forecast of the budget balance upwards. The Commission services forecast the general government budget in ESA terms to remain in a surplus of 0.6% of GDP in both 2018 and 2019. Taking into account estimated positive output gap from 2018 onwards, the structural surplus is projected to be slightly lower than the headline one at 0.5% of GDP in both 2018 and 2019. The public-debt-to-GDP ratio is forecast to continue to decrease to 23.3% in 2018 and 21.4% in 2019. The 2018 Convergence Programme was submitted by the Bulgarian authorities on 19 April 2018. It plans to reduce the headline surplus to zero in 2018 and return to surpluses in 2019 remaining in positive balance until 2021. In structural terms, the government plan targets at balanced to positive budgetary outcomes, well above the medium-term objective for the entire period 2018-2021.

The various components of the Bulgarian fiscal framework have gradually been strengthened over the last few years. Bulgaria is bound by the Fiscal Compact () based on its own declaration of intention and has transposed its provisions into the national legal order. The most recent steps of this reform drive were adopted in autumn 2017 with, inter alia, improvements in the design of rules governing expenditure developments and as well as in multi-annual budget planning through the legislated systematic use of no-policy-change scenarios. The Fiscal Council became operational in the first half of 2016, and has started to roll out its activities. However, it faces significant challenges in performing its relatively wide remit, mainly due to the limited analytical resources and financial autonomy. In February 2018, the Parliament decided to increase the size of the Fiscal Council's support staff from three to five experts. 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 operated in an environment of strong nominal GDP growth and solid labour market recovery, with improving soundness of the financial sector, recovering credit flows and the abating of the contagion risks in the banking sector which had been observed in the previous years. Furthermore, strong exports, a favourable (mainly deposit driven) 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 20.2 billion to over EUR 23.5 billion between end-2015 and end-2017. International reserves were boosted by some EUR 4 billion due to the issuance of long-term, foreign-currency government debt, inflows of EU funds and an increase of the BNB liabilities towards commercial banks in 2016. International reserves covered around 155% of the monetary base, 55% of broad money (M3) and 47% of GDP at the end-2017. 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 45 basis points by the end-2016 and further declined to 33 basis points in March 2018. 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 around 9 years. The Bulgarian 12-month moving average long-term interest rate relevant for the assessment of the Treaty criterion was below the reference value in the 2016 convergence assessment of Bulgaria. It further declined from around 2.5% in mid-2016 to around 1.6% by the end-2017. In March 2018, the latest month for which data are available, the reference value, given by the average of long-term interest rates in Cyprus, Ireland and Finland plus 2 percentage points, stood at 3.2%. In that month, the 12-month moving average of the yield on the Bulgarian benchmark bond stood at 1.4%, i.e. 1.8 percentage points below the reference value. The long-term interest rate of Bulgaria has been on a decreasing path since early 2016, going from 2.44% in January 2016 to 0.90% in January 2018. These developments partly reflect the efforts in implementing measures to strengthen the financial system, but also re-balancing of their asset portfolios towards government long-term bonds by domestic banks, due to low inflation risk and lack of alternative profitable investment. Bulgarian benchmark bond yields continued to fall throughout 2016-17 mainly due to internal, but also due to external factors. Primarily, they were supported by developments on the secondary market characterised by continuing strong demand for government securities while their supply remained subdued. Falling long-term interest rates were supported also by external forces, i.e. expectations of loose monetary policy in the euro area for an extended period of time. Spreads to the Bund increased by some 50 basis points in the first half of 2016, reaching about 250 basis points at the peak in July 2016, but has been on decreasing path since then. At the end of 2017, the spread has reached 72 basis points, and it has been further decreasing to about 40 basis points in early 2018. 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, as well as 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 2017, the Commission published its seventh Alert Mechanism Report (AMR 2018) under the Macroeconomic Imbalance Procedure (MIP – see also Box 1.5), which concluded that an in-depth review (IDR) was warranted for Bulgaria. In March 2018, the Commission published its annual country report on Bulgaria (), including an IDR. The analysis concluded that Bulgaria was experiencing macroeconomic imbalances, linked to vulnerabilities in the financial sector coupled with high indebtedness and non-performing loans in the corporate sector. The authorities have made progress in implementing the recommendations addressed after the asset quality and balance sheet reviews, but the legacy issues linked to weak governance, asset quality and supervision have not yet been fully dealt with. The robust growth has supported continuous private-sector deleveraging and further decreases in non-performing loan ratios, but stocks are still high, especially in the corporate sector. Labour market improvement has continued despite persistent structural issues. Some measures have been taken to tackle the main sources of imbalances, but further progress is needed to address remaining vulnerabilities in the financial sector and completing the reform of the insolvency framework.

2.6.1.Developments of the balance of payments Bulgaria's external balance (i.e. the combined current and capital account) has further improved over the last two years. The external surplus further expanded to 4.5% in 2016 and 5.5% of GDP in 2017, mainly on acconut of improved primary income balance. The trade balance of goods as a percentage of GDP remained negative but improved by almost 4 percentage points in 2016 before worsening again by about 2 percentage points in 2017. The trade balance in services remained about 6.0% of GDP in both years owing to stable growth in tourism, transportation and business process outsourcing sectors. The capital account surplus decreased in the last couple of years, from 3.1% of GDP in 2015 to 1.0% of GDP in 2017, mainly due to the fluctuations of inflow of EU funds. The negative primary income balance, has improved in 2017 reflecting a less negative net international investment position due to dividends payments. There were no significant changes in the secondary income balance. The saving-investment gap of the Bulgarian economy has increased over the last two years. Investment has decreased by 2 percentage points in 2016 and increased by 1.7 percentage points to 20.9% in 2017. Savings were 24.5% of GDP in 2016 and decreased to 23.9% of GDP in 2017. This dynamics of the saving-investment gap was mostly driven by the public sector. On average, the public sector contributed 1.9 percentage points of GDP to the fall of investment and 2.2 percentage points to the rise in savings between 2015 and 2017. Public investment decreased sharply in 2016 and it continued decreasing in 2017 due to slow uptake of the implementation of the EU structural and investment funds. These developments led to the accumulation of the advanced payments on the saving side. The movement in the private sector was the opposite, but of a smaller magnitude. The positive macroeconomic environment accompanied by low interest rate underpinned confidence and increased investment in 2016, a trend that continued in 2017 but at a slower pace. Competitiveness seems to have been preserved in the past two years, although relevant indicators continue to show a somewhat mixed picture. The real effective exchange rate, deflated by ULC, stabilized in 2016. This period of stabilization helped external competitiveness, which was reflected in stronger exports' growth. In 2017, a significant real appreciation worsened the cost competitiveness of Bulgaria but the pressures induced by the real exchange rate movements were partly offset by non-cost related improvements (such as quality). The real effective exchange rate, deflated by HICP, on the contrary, depreciated in 2016 and started to slowly appreciate in 2017. The price competitiveness of Bulgarian exporters remains high, although their relative advantage has been gradually reduced by narrowing differences in inflation with trading partners. Robust financial account outflows have continued since 2015. Net FDI inflows have remained at low levels by pre-crisis standards, reaching around 0.7% of GDP in 2016 and 1.4% of GDP in 2017. In 2015 and 2016, there was a net inflow of portfolio investment, mainly due to government borrowing. This was reversed in 2017 due to government and corporate deleveraging and the build-up of foreign assets by both financial and non-financial institutions. At the same time, the maturity structure of debt securities has changed from short to long term, indicating lower uncertainty in the borrowing markets. Although still high, gross external debt has improved further in the past two years, from about 80% of GDP in 2016 to around 74% of GDP in 2017. This reduction, accompanied by current account surpluses and lower level of investment inflows, improved also the net international investment position, from around 46% of GDP in 2016 to around 40% of GDP in 2017. According to the Commission services’ Spring 2018 Forecast, the external surplus is projected at 3.2% of GDP in 2018 and at 2.7% of GDP in 2019. 2.6.2.Market integration The 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 stood at around 65% and 69% of GDP in 2016 and 2017, respectively. Trade with the euro area was about 31% of total trade in 2017. Outside the EU, Bulgaria's main trading partners are Russia and China (especially for imports). FDI inflows decreased from about 3% of GDP in 2013 to 1.4% of GDP in 2017. The stock of FDI amounted to some 78% of GDP in 2016 and around 75% in 2017, with FDI mainly coming from the Netherlands, Austria, Germany, Italy and Greece. Half of all FDI is directed to manufacturing and information and communications technology (ICT), with another 25% going into trade, transport and tourism. Concerning the business environment, Bulgaria performs relatively worse than most euro-area Member States in international rankings (WEF's Global Competitiveness Index, the World Bank's Ease of Doing Business). The major challenges relate to the institutional framework, including fighting corruption, improving the functioning of the judicial system, reducing the administrative burden on corporations, and improving the quality of public services. Public administration as a whole scores relatively poorly according to the World Bank's Worldwide Governance Indicators. Bulgaria's transposition deficit of EU Directives, on the other hand, was 1.7% in 2016, above the EU average (1.5%) and the target (0.5%) proposed by the European Commission in the Single Market Act (2011), according to the December 2016 Internal Market Scoreboard. The 4th Anti-Money Laundering Directive imposed transposition by 26 June 2017. Bulgaria communicated to the Commission the measures it adopted to transpose the directive on 3 April 2018, only after a reasoned opinion was addressed by the Commission to Bulgaria on 8 December 2017 due to an absence of an appropriate response to the letter of formal notice from 19 July 2017. The Commission is analysing the communicated measures to assess their completeness and conformity with the directive. 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. Activity and employment rates returned to the pre-crisis level (close to 70%) only in 2017. The positive cyclical factors also largely explain the fall of unemployment below 7% in 2017. In a context of economic growth and declining working age population, the unemployment rate is expected to continue to decrease. Structural weaknesses that continue to hinder the labour market include the high share of long-term unemployment in total unemployment, the shrinking working population, the high inactivity rate especially from discouraged workers, skills and qualifications mismatches, and wide disparities between urban and rural areas and between regions. At the same time, in a context of worsening demographics, the labour force is suffering from high emigration and brain drain. Widespread low skills and relatively high social exclusion remain worrisome. The impact of the ongoing positive labour market developments is not equally spread through the population. The loss of jobs during the crisis was concentrated in specific groups, in particular the low skilled, young, those on pre-retirement and older women. Those without a job for more than a year, inactive youth, Roma, and those living in rural areas continue to face significant difficulties in entering employment. The labour market structural challenges described above have an impact on income inequality and poverty levels which are among the highest in the EU, while the redistribution mechanisms are very limited. 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 increased slightly to 73.8% in 2016. Bank concentration, as measured by the market share of the five largest credit institutions in total assets, increased to 58%, some 10 percentage points above the euro area average in 2016 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 slightly above 22% in the second quarter of 2017 compared to almost 18% in the euro area. The ratio of NPLs to the loan portfolio held by the banking sector has fallen substantially over the last two years, but at 10.6% in the second quarter of 2017, was still well above the euro-area average of 4.3%. The profitability of the domestic banking sector remained above the euro-area level, with an average return on equity (RoE) close to 6% in the second quarter of 2017.

The 2016 asset quality review and stress tests in the banking sector showed robust results on aggregate but pockets of vulnerabilities were identified. The independent reviews in the insurance and pension fund sectors also showed that these sectors are overall stable but some capital shortfalls were identified, as well as instances of unsound business practices. A substantial effort has been made to improve banking and non-banking supervision, however, vulnerabilities remain. The implementation of an action plan for banking supervision and the implementation of the action plan for the non-banking sector adopted in September 2017 are still to be completed. A somewhat tighter risk management of related-party exposures in the banking sector and a broader definition of ‘related parties’ in the non-banking sector in line with international standards have been adopted. Other actions are still due to address remaining vulnerabilities in the financial sector. These include the way both the banking and the non-banking sectors deal with exposures to hard-to-value assets, as well as the treatment of specific reinsurance contracts and inadequate group level supervision in the insurance sector. In the pension funds sector, the concentration of assets on the relatively illiquid traded and non-traded domestic market, and complex ownership and cross-ownership structures require further monitoring. After the pre-2009 boom, real house prices in Bulgaria had been falling till 2012. Thereafter, the recovery was initially slow, but has accelerated in the last few years. House prices increased by 15.7% in real terms between June 2015 and June 2017 and by 7.2% in the second quarter of 2017 alone. Residential investment reached 2.7% of GDP in 2016 and is estimated at the same level in 2017. The stock of loans for house purchases increased in 2016-2017 by 8.7%. Relative to GDP, the financial system is smaller in Bulgaria than in the euro area. Domestic bank credit stood at around 52% of GDP in 2016 compared to almost 90% of GDP in the euro area. The capitalization of the stock market fell to 8.7% of GDP in 2016, well below the euro-area average of 61.5%. The debt securities market remains small in comparison with the euro area average (28.3% vs. 154.2% of GDP). The consolidated stock of private sector debt at 104.9% of GDP in 2016 was below the euro-area average of 137.2%. 3.1.Legal compatibility 3.1.1.Introduction The 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 2016, the ČNB Law was only slightly amended (). However, since there have been no amendments as regards the incompatibilities highlighted in the Commission's 2016 Convergence Report, the comments made in the latter report 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. 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 Court of Justice of the European Union, 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, in 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(2) 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 partial absence of reference to 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. The Czech authorities are invited to remedy the abovementioned incompatibilities. 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 2016. It declined to 0.2% in mid-2016 and then increased gradually over the next 18 months to 2.4% by end-2017. In March 2018, the reference value was 1.9%, calculated as the average of the 12-month average inflation rates in Cyprus, Ireland and Finland plus 1.5 percentage points. The corresponding inflation rate in the Czech Republic was 2.2%, i.e. 0.3 percentage points above the reference value. The 12-month average inflation rate is projected to decline below the reference value in the months ahead.

3.2.2.Recent inflation developments The annual HICP inflation rate dropped from 0.5% in early 2016 to -0.1% in June 2016 before increasing to above 2% by end-2016. It then floated between 2 and 3% during 2017. The annual HICP inflation rate thus averaged 0.6% in 2016 and 2.4% in 2017. The pick-up in annual inflation in 2017 reflected larger inflation contributions from energy and food prices as well as higher price increases in the service sector. The annual HICP inflation rate dropped to 1.7% in the first quarter of 2018, amid strong base effects and decelerating food prices. Core inflation (measured as HICP inflation excluding energy and unprocessed food) has mostly exceeded headline inflation since early 2014. This was mainly the result of muted energy price developments which made a negative contribution to HICP inflation in 2014-2016 and only a modestly positive contribution in 2017. Core inflation accelerated in tandem with headline inflation in the second half of 2016, increasing from below 1% in June 2016 to above 2% in late 2016. It then oscillated around 2.6% in 2017 as prices of processed food and services increased at their highest rates since 2012. Domestic industrial producer prices increased in 2017 after having declined for three years. 3.2.3.Underlying factors and sustainability of inflation Macroeconomic policy mix and cyclical stance The Czech Republic is experiencing an economic upswing. Real GDP expanded by 4.4% in 2017, considerably faster than in 2016 (2.6%). Private consumption was again the main driver of GDP growth in 2017, supported by falling unemployment as well as vigorous wage growth. Following a strong decline in 2016, gross fixed capital formation made a large positive contribution to GDP growth in 2017 owing to revived private investment and increasing support from EU funds. According to the Commission services' Spring 2018 Forecast, domestic demand growth should keep GDP growth at above 3% in both 2018 and 2019. The Czech economy is estimated to have been operating above its potential since early 2017 amid increasingly tight labour market conditions. The positive output gap is estimated to widen slightly in 2018 and 2019. The fiscal stance, as measured by the change in the structural balance, tightened considerably in 2016 and then remained broadly unchanged in 2017. Specifically, the structural balance recorded a surplus of 1% and 1.2% of GDP in 2016 and 2017 respectively. It is expected to moderate over the forecast period to around 0.2% of GDP in 2019. The ČNB conducts monetary policy within an inflation targeting framework. In November 2013 it started using the exchange rate as an additional instrument for easing monetary conditions given that its key policy rate (i.e. the 2-week repo rate), set at 0.05%, was considered to be at its effective lower bound. The use of the exchange rate as an additional monetary policy instrument was discontinued in April 2017. The decision was supported by macroeconomic data and forecasting scenarios indicating a sustainable fulfilment of the 2% inflation target over the forecast horizon. Subsequently, the ČNB started in August 2017 to gradually hike its main policy rate as annual inflation remained above its 2% inflation target. Its 2-week repo rate was raised in three steps to 0.75% in February 2018. Wages and labour costs The labour market has performed well since the economy emerged from recession in late 2013. The unemployment rate declined from 4.0% in 2016 to 2.9% in 2017, i.e. the lowest level in the EU. At the same time, the number of employed persons increased by 1.3% in 2016 and by 1.6% in 2017 despite the decline in working-age population. Nominal wage growth accelerated sharply in 2016 and 2017, reaching 4.6% and 6.7% respectively. Labour productivity accelerated significantly in 2017 following more muted growth in 2016. However, with compensation per employee outstripping productivity growth in both years, and indeed recording the highest growth rates since 2010, nominal unit labour costs rose by 3.3% in 2016 and by 3.8% in 2017. Nominal unit labour costs are expected to continue to increase markedly in 2018 and in 2019. External factors Given the size and openness of the Czech economy, import prices have a sizeable effect on domestic price formation. After having fallen in 2015 and 2016, mainly thanks to a decline in primary commodity prices, the imports of goods deflator stabilised in 2017. Overall, the appreciation of the koruna since April 2017 has tempered import price growth. After having remained broadly stable throughout 2016 and in early 2017, the nominal effective exchange rate (measured against a group of 36 trading partners) appreciated by about 7% between March and December 2017. As a result, Czech import prices remained broadly unchanged in 2017 despite the recovery in primary commodity prices. Administered prices and taxes The share of administered prices in the HICP basket has stabilised at around 10-11% since 2011, after a sharp decline over the course of the previous decade. With a weight of 10.3% in 2017, administered prices in the Czech Republic () accounted for a smaller share of the HICP basket than in the euro area (13.4%). Changes in administered prices were a significant driver of inflation in 2016 as they increased by 1.4%, i.e. more than double of the headline HICP inflation rate. The situation reverted in 2017 when administered prices increased by 1.1%, i.e. around half of the headline inflation rate. Declines in prices for household heating contributed to weak growth in administered prices in 2017 while other categories such as dental services increased noticeably. HICP at constant tax rates was somewhat lower than headline inflation in 2016 and somewhat higher in 2017.

Medium-term prospects Annual HICP inflation is expected to decline in 2018, mainly because the inflation contribution of food prices (both processed and unprocessed food) should decrease. At the same time, prices of energy and services are expected to exert a stronger inflation contribution than in previous years. According to the Commission services' Spring 2018 Forecast, annual HICP inflation is thus projected to average 2.1% in 2018 and 1.8% in 2019. 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 higher inflationary pressures. The level of consumer prices in the Czech Republic increased to about 64% of the euro-area average in 2016, with the relative price gap widest for services. This suggests that there is potential for further price level convergence in the long term. After having stagnated at around 78% between 2008 until 2013, Czech GDP per capita in purchasing power standards gradually increased to almost 83% of the euro-area average by 2016. 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 The Council decided to abrogate the decision on the existence of an excessive deficit according to Article 126 (12) TFEU in 2014, thereby closing the excessive deficit procedure for the Czech Republic (). Since then, the general government balance improved substantially, from -2.1% of GDP in 2014 to a surplus of 1.6% of GDP in 2017. In terms of expenditure and revenues shares, the total expenditure-to-GDP ratio stood at 38.8% and the revenue-to-GDP ratio at 40.4% in 2017. Public investment levels surged to 5.1% of GDP in 2015 due to the EU funds cycle then dropped sharply in 2016 to 3.3% of GDP and grew in line with nominal GDP in 2017. The 2017 general government surplus of 1.6% of GDP was significantly better than the 0.4% of GDP surplus target in the 2017 Convergence Programme. This reflected tax-rich growth on the back of strong labour market boosting direct taxes and social security contributions. At the same time, investment growth fell short of previous expectations. Other notable developments were the marked increase of wage scales for public employees and falling debt service payments. The structural balance remained in surplus at around 1.2% of GDP in 2017 as the output gap is estimated to have turned positive. The general government debt declined to 34.6% of GDP in 2017, remaining well below the 60% threshold. 3.3.2.Medium-term prospects The 2018 Budget was adopted by the Parliament on 19 December 2017. A headline surplus of 1.3% of GDP was envisaged for 2018 at that time. Revised fiscal data for 2017 indicate a higher surplus for 2018. The budget includes increased social expenditure, reflecting measures such as higher pension indexation and higher outlays on family policies. The wage bill is set to increase by 10% for public employees. On the revenue side, additional discretionary revenues, particularly from reducing tax evasion, have a lower revenue-yielding effect than in previous years. Public investment is forecast to grow appreciably, in part due to the maturing of the current EU funds programming period. Interest payments are forecast to stabilise after three consecutive years of decline. According to the Commission services' Spring 2018 Forecast, the headline general government balance is projected to decline slightly to 1.4% of GDP in 2018, largely as a result of revived public investment activity and a minor slowdown in tax revenue growth. The revenue-to-GDP ratio is expected to decline slightly to 40.3% while the expenditure-to-GDP ratio is forecast to increase marginally to 38.9%. Based on the no-policy-change assumption, the headline balance is expected to worsen to 0.8% of GDP in 2019. The structural surplus is set to continue shrinking to around 0.2% of GDP by 2019. The debt-to-GDP ratio is expected to decline below 32% of GDP in 2019. This implies a reduction of around 13 percentage points from its peak in 2013. Better liquidity management, favourable financing conditions and fiscal surpluses in recent years played a key role in the favourable debt dynamics. Important measures to strengthen the Czech national fiscal framework have been taken since mid-2016, but their effectiveness will depend on the implementation of the new rules. In particular, the Fiscal Responsibility Law adopted in early 2017 introduced two numerical rules for the general government, namely an expenditure ceiling set on the basis of cyclically-adjusted revenue projections and a public debt rule. Moreover, local authorities are subject to more stringent rules on debt management. The National Budgetary Council, tasked with monitoring compliance with fiscal rules, has been set up and its members appointed in early 2018. The Committee on Budgetary Forecast assessing the macroeconomic and fiscal projections produced by the Ministry of Finance is expected to be established in the course of 2018. Finally, a draft law on independent audits aims to address the outstanding full transposition of the Council Directive 2011/85/EU on requirements for national budgetary frameworks. 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. Between November 2013 and April 2017, the ČNB used 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. The koruna traded marginally above 27 CZK/EUR throughout 2016 and in early 2017 as foreign exchange market interventions by the ČNB precluded further exchange rate appreciation. Following the expiry of the ČNB's exchange rate commitment in April 2017, the koruna followed a gradual appreciation trend against the euro, strengthening from above 27 CZK/EUR in early April 2017 to below 25.5 CZK/EUR in early 2018.

International reserves held by the ČNB increased from below EUR 60 billion by end-2015 to above EUR 120 billion (64% of GDP) in the first quarter of 2017, largely as a result of its foreign exchange market interventions. They then remained broadly stable up to early 2018. The 3-month interest rate differential vis-à-vis the euro area remained close to 60 basis points between mid-2016 and mid-2017 as the ČNB and the ECB kept their policy rates unchanged. It then widened over the second half of 2017 and in early 2018 as a result of policy rate hikes by the ČNB. It thus exceeded 120 basis points in early 2018. 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 the average residual maturity of close to, but below, 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 in 2016. It declined to 0.4% in late 2016 and then followed a gradual upward trend throughout 2017. It exceeded 1% in early 2018. In March 2018, the latest month for which data are available, the reference value, given by the average of long-term interest rates in Cyprus, Ireland and Finland plus 2 percentage points, stood at 3.2%. In that month, the 12-month moving average of the yield on the Czech benchmark bond stood at 1.3%, i.e. 1.9 percentage points below the reference value. The long-term interest rate of the Czech Republic oscillated around 0.4% in 2016. It then slowly increased to about 1.5% by end-2017 as the ČNB gradually tightened its monetary policy stance. Consequently, the spread against the German long-term benchmark bond () widened to some 120 basis points. In early 2018, the long-term interest rate increased to about 1.8% with the spread vis-à-vis the German benchmark bond fluctuating around 120 basis points. 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 2017, the Commission published its seventh Alert Mechanism Report (AMR 2018) under the Macroeconomic Imbalance Procedure (MIP - see also Box 1.5), which concluded that since issues related to possible internal risks remained contained, no In-Depth Review (IDR) was warranted for the Czech Republic. Risks relate to the increase in nominal unit labour costs, largely driven by strong wage growth which is projected to accelerate further in the context of a tightening labour market, and to the acceleration in real house price growth. The feedback spiral between house prices and mortgage volumes accelerated while the private sector debt level slightly increased in 2016, but remains at a moderate level. 3.6.1.Developments of the balance of payments According to balance of payments data, the Czech Republic's external balance (i.e. the combined current and capital account) has remained in surplus since 2013. It, nevertheless, declined to 2% of GDP in 2017 from 2.7% of GDP in 2016, largely as a result of a lower current account surplus. This reflected both a somewhat lower trade surplus as well as a more negative income balance. The capital account balance remained in surplus for the 13th consecutive year at close to 1% of GDP in 2017 as a result of the drawdown of funds from the EU budget. According to national accounts data, the savings-investment balance was negative in the Czech Republic up to 2016. Investment by the general government and the non-financial corporate sectors tend to exceed their savings, while the household and financial corporate sectors tend to save more than they invest. The strong decline of public investment in 2016 shrank the savings-investment gap to -0.1% of GDP. The savings-investment gap then turned positive in 2017 as the gross national saving rate picked up. Measured by the export market share, the trade performance improved just marginally in 2016 and 2017. External price and cost competitiveness, as measured by ULC- and HICP-deflated real effective exchange rates, remained roughly unchanged in 2016 but clearly worsened in 2017. The deterioration was largely induced by the nominal effective exchange rate appreciation.

The financial account balance of the Czech Republic remained positive in 2016 and 2017. It was mostly affected by rising official reserves since the pace of external asset accumulation by the ČNB further accelerated in the second half of 2016. The increase in official reserves was, however, to a large extent offset by increasing net external