# _2. Why Fiscal Vulnerability_

What will be the government's capacity to respond to the realization of fiscal risks in the future? Building on Hemming (1999), in this section we briefly sketch Bulgaria's fiscal position, its sensitivity to risks, and sources of risks.

# _Current fiscal position appears good_

Bulgaria's _current fiscal position_ has been held in check following the introduction of a currency board arrangement in 19973. General government budget deficit dropped from 12 percent of GDP in 1996 to 2.5 percent in 1997. In 1998, the budget registered a surplus of 0.9 percent of GDP and in 1999, despite the slow-down of growth due to the Kosovo crisis, deficit is expected to stay below 1.5 percent of GDP.

Recent revenue performance has been strong and resilient to the economic shocks that have marked the 1998-99 period (the Russian and Kosovo crises). General government revenues increased from 31.7 percent of GDP in 1997 to 36.8 percent of GDP in 1998 and an estimated 38 percent of GDP in 1999. General government expenditures, however, are also on the rise. For 1999, they are projected to reach 39.5 percent of GDP, up from 35.8 percent in 1998, recovering from their collapse during the 1996-97 crisis. Leading this trend, social expenditures have increased by 1.8 percentage point, while wages and contingency to pay for the cost of structural reforms by 0.8 and 0.7 percentage points, respectively.

Beyond general government budgets, Bulgaria's fiscal position does not suffer from any imminent major pressures either. The Currency Board Arrangement (CBA)<sup>4</sup> precludes the National Bank from engaging in quasi-fiscal activities. The number of extrabudgetary funds declined from over 1000 in 1998 to 28 in 1999. We limit our analysis here to the largest ones, the Pension Fund, Health Fund and Agricultural Fund. Though these funds are rife with fiscal risks, which we will discuss in the following section, their positions appear balanced so far.

- 3 Annex I presents Bulgaria's fiscal framework for 1997-2002, including the main revenue and expenditure itemis as well as the projected deficit and its financing.

- 4 Introduced after a spell of large deficits and hyperinflation in July 1997, the currency board arrangement came as a response to several unsuccessful money-based stabilization attempts and to widespread lack of financial discipline of large state-owned enterprises and financial institutions as well as budgetary agencies. CBA was meant to stop a vicious circle of government subsidies and soft commercial bank financing, that have kept loss-making enterprises afloat. The arrangement has fixed the domestic currency, lev (BGL), to the German mark, and prescribed full coverage of the monetary base with foreign reserves. Furthermore, it cut off central bank credit to both the government and the banking sector. Since January 1, 1999, the lev is fixed to the Euro at the same rate as the DM peg to the Euro. In addition, the original rate BGLIOOO/DM was changed on July 5, 1999 when three zeros were removed, the denomination became BGN, and the peg IBGN per IDM. Under the June 1997 law, the Bulgarian National Bank is not allowed to extend credit to the State or any state agency except against purchase of special drawing rights from the IMF. Similarly, the Bulgarian National Bank (BNB) is forbidden to extend credit to banks, except under very strict conditions in its narrowly defined role of lender of last resort.

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