This paper analyzes factors for the dynamics of bank loans and non-banking financial companies (NBFCs) in Bulgaria. Following a short introduction, it discusses in length the regulations governing NBFCs and the monetary policy of the country, particularly in relation to the outstanding loans. It further lays down the role of Central Bank of Bulgaria in governing NBFCs. Then, it presents the credit demand factors followed by an analysis of general credit dynamics and of credit supply factors. The paper in the following chapters would provide an overview of the loans granted by the Banks and NBFCs, and the respective terms and conditions along with the limits or restrictions on such loans. In the end, it compares the share of outstanding loans by banks as against NBFCs in light of the financial and legal framework in Bulgaria.
This paper analyzes factors for the dynamics of bank loans and non-banking financial companies (NBFCs) in Bulgaria. Following a short introduction, it discusses in length the regulations governing NBFCs and the monetary policy of the country, particularly in relation to the outstanding loans. It further lays down the role of Central Bank of Bulgaria in governing NBFCs. Then, it presents the credit demand factors followed by an analysis of general credit dynamics and of credit supply factors. The paper in the following chapters would provide an overview of the loans granted by the Banks and NBFCs, and the respective terms and conditions along with the limits or restrictions on such loans. In the end, it compares the share of outstanding loans by banks as against NBFCs in light of the financial and legal framework in Bulgaria.
This paper analyzes factors for the dynamics of bank loans and non-banking financial companies (NBFCs) in Bulgaria. Following a short introduction, it discusses in length the regulations governing NBFCs and the monetary policy of the country, particularly in relation to the outstanding loans. It further lays down the role of Central Bank of Bulgaria in governing NBFCs. Then, it presents the credit demand factors followed by an analysis of general credit dynamics and of credit supply factors. The paper in the following chapters would provide an overview of the loans granted by the Banks and NBFCs, and the respective terms and conditions along with the limits or restrictions on such loans. In the end, it compares the share of outstanding loans by banks as against NBFCs in light of the financial and legal framework in Bulgaria.
THE SHARE OF OUTSTANDING LOANS BY NBFCs VIS-A-VIS THE
OUTSTANDING LOANS BY BANKS IN BULGARIA
Vineet Bhansali Ali Yavar Amerjee Ankita Ankur Arora Ayushi Singh Geetika Singh National Law University, Jodhpur (Batch of 2015), Semester IX Faculty Advisor: Dr. Rituparna Das 1
(Words: 16,130)
Abstract This paper analyzes factors for the dynamics of bank loans and non-banking financial companies (NBFCs) in Bulgaria. Following a short introduction, it discusses in length the regulations governing NBFCs and the monetary policy of the country, particularly in relation to the outstanding loans. It further lays down the role of Central Bank of Bulgaria in governing NBFCs. Then, it presents the credit demand factors followed by an analysis of general credit dynamics and of credit supply factors. The paper in the following chapters would provide an overview of the loans granted by the Banks and NBFCs, and the respective terms and conditions along with the limits or restrictions on such loans. In the end, it compares the share of outstanding loans by banks as against NBFCs in light of the financial and legal framework in Bulgaria.
1 We hereby express our sincerest heartfelt gratitude to our faculty Dr. Rituparna Das for his guidance and supervision. This paper has instilled in us a unique thirst for knowledge in the subject. It could not have achieved completion without the aegis of Dr. Das.
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TABLE OF CONTENTS I. INTRODUCTION ................................................................................................................................... 3 II. BULGARIA: THE DEVELOPMENT OF ITS MONETARY POLICY................................................. 3 III. BACKGROUND: EXTERNAL HEADWINDS HAMPER RECOVERY .............................................. 4 IV. ECONOMIC OUTLOOK AND RISKS .............................................................................................. 5 V. POLICY CHALLENGES: SAFEGUARDING STABILITY AND REVIVING GROWTH ......................... 7 VI. INTERCONNECTEDNESS AND SPILLOVERS FROM THE EURO AREA TO BULGARIA .......... 13 VII. THE PURPOSE OF THE FISCAL RESERVE .................................................................................. 17 VIII. RECENT MACROECONOMIC DEVELOPMENTS AND OUTLOOK ......................................... 21 IX. FISCAL POLICY .............................................................................................................................. 23 X. MONETARY AND MACRO-PRUDENTIAL POLICIES AND FINANCIAL SECTOR DEVELOPMENT ......................................................................................................................................... 24 XI. NATIONAL LEGAL FRAMEWORKS FOR NCB INVOLVEMENT IN BANKING SUPERVISION . 25 XII. NCB INVOLVEMENT IN THE PREPARATION OF LEGISLATION RELATING TO SUPERVISION 27 XIII. JURISDICTIONS WHERE BANKING SUPERVISION IS EXERCISED BY THE NCB .................. 28 XIV. JURISDICTIONS WHERE BANKING SUPERVISION IS EXERCISED BY THE FSA ................... 29 XV. ROLE OF CURRENCY BOARD IN BULGARIAS STABILIZATION ............................................... 30 XVI. BULGARIAN LOAN MARKET ................................................................................................... 33 XVII. GENERAL ECONOMY DYNAMICS OF BULGARIA ................................................................... 33 XVIII. BANK LOANS AND FACTORS OF CREDIT SUPPLY (DYNAMICS) IN BULGARIA .................... 34 XIX. COMPARISON WITH INDIAN MICRO FINANCING MARKET ................................................. 36 XX. CONCLUSION ................................................................................................................................. 43
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I. INTRODUCTION The Bulgarian economy progressed phenomenally in the years prior to the global financial crisis, which hardly hit it. In the five-year period ending in 2008, GDP expanded by a hefty rate of 6% per year in real terms, while financial intermediation deepened with double-digit growth rates yearly. Bank lending was one of the factors for the outpacing economic growth in Bulgaria, as it has been confirmed by Stattev (2009). The outstanding bank loan growth was triggered by foreign capital inflows, aggressive lending of commercial banks, galloping exports and strong internal aggregate demand. However, inflation, current account and external debt ballooned, signaling for an overheating economy and for an internal and external imbalances formation. The global financial crisis revealed this economic weakness in 2009 in the slumping external demand and capital outflows, and in the plummeting the foreign direct investments and increased risk aversion of economic agents. Economic recovery remained modest in the following years to the end of 2012. Deteriorating economic activity led to a rapid growth of non-performing loans. Banks became more demanding on their existing and potential customers, and intensified on accumulating capital and liquidity buffers. 2
Non-banking financial companies, or NBFCs, are financial institutions that provide banking services, but do not hold a banking license. These institutions are not allowed to take deposits from the public. Nonetheless, all operations of these institutions are still covered under banking regulations. The pre-crisis double-digit growth of bank loans extended to the non- financial companies and households was induced by strong external and internal demand and by enormous capital inflows. In the post-2008 period a process of deleveraging took place, a period of modest lending because of the weakness in demand factors. Namely, poor economic recovery was the main driver of the non-performing loans uptrend, which harmed the credit supply process. II. BULGARIA: THE DEVELOPMENT OF ITS MONETARY POLICY Macroeconomic and financial stability has been maintained in recent years. 3 This owes to both the policies pursued before the crisisfiscal surpluses and proactive banking supervisionand steadfast policy implementation since. The framework of European Union
2 PETER PESHEV, Bank Lending Dynamics in Bulgaria, Economic Alternatives, Issue 2, 2014, p.20. 3 Balzs Horvth and Istvn P. Szkely, The Role of Medium-Term Fiscal Frameworks for Transition Countries: The Case of Bulgaria, Emerging Markets Finance & Trade, Vol. 39, No. 1, The Role of Fiscal Reforms in the Transition (Jan. - Feb., 2003), pp. 86-113.
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(EU) membership (from 2007 and anticipated well before) and currency board (since 1997) have provided legal and monetary stability. Growth since the crisis has left unemployment high and income levels relatively low. Per capita GDP growth has been substantial over the last 15 years, but Bulgaria remains the poorest EU member. The real economy has yet to recover from the crisis, reflecting the unwinding of the domestic demand boom and headwinds from the euro zone crisis. Unemployment has continued to rise and emigration and aging undermine potential growth. The policy framework, while solid and resilient to the 2009 crisis, could be tested by further shocks. The economy has shown its ability to adjust rapidly within this framework. Flow imbalances have unwound since the crisis but stock issues linger. 4 Private external debt has fallen but a large share is short-term and needs to be rolled over, and in the banking system, which has significant buffers, nonperforming loans (NPLs) are rising. The currency board imposes constraints on lender of last resort abilities. Large swings in the fiscal deficit may be difficult to finance now that fiscal buffers have been reduced. Trade and financial links to the euro area are strong especially with economies in difficulty 5
III. BACKGROUND: EXTERNAL HEADWINDS HAMPER RECOVERY Growth has been lackluster since the crisis and output remains below pre-crisis levels. Domestic demand has fallen until recently while exports, which rose sharply in 201011, have slowed. GDP growth in the first half of 2012 was positive but weak at 0.9 percent supported by an uptick in domestic demand but with a negative external sector contribution. 6 While many countries are suffering from lower export growth, GDP growth in Bulgaria has weakened more, and is lower, than in most regional peers. Domestic demand has recently shown signs of revival. Investment is benefitting from rising foreign direct investment (FDI) and EU funds absorptionthe latter is projected to be some 40 percent higher in 2012 than in 2011. However, significant corporate (nonfinancial) sector leverageat 138 percent of GDP in 2010 remains a drag. Households have been buffeted by still rising unemployment, declining real estate prices and tensions in the euro zone that undermined confidence. Increases in nonperforming mortgages are evidence of some
4 Ibid 5 Horvath, B. Pension and Health Reforms in Bulgaria: Restoring Sustainability , International Monetary Fund: Selected Issues and Statistical Appendix for the 1999 Article IV Consultation with Bulgaria. Washington, DC: IMF available at www.imf.org/external/ country/B G R/index .htm (accessed on Oct. 15, 2014) 6 Increased indirect tax collection through improved enforcement has added to measured real domestic demand
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financial stress but households on the whole are not in poor financial health. Their bank deposits are rising, banking debt remains low at25 percent of GDP, headline inflation has fallen significantly from pre-crisis highs and real wages have 10 grown rapidly since 2009, factors that have allowed consumption to revive 7 . The rapid correction in the current account deficit since 2009 culminated in a small surplus in 2011. It reverted to deficit in the first half of 2012 with subdued exports and more imports related to FDI. The overall balance of payments, however, improved as inflows in the first half of 2012 were 212 percent of GDP higher than a year earlier due to higher FDI and slowing financial sector outflows. 8 The international investment position has improved in line with the fall in external debt, reflecting in particular capital outflows from the financial sector. The fiscal deficit has continued to decline and public debt is the second lowest in the EU The adjustment, which amounted to a cumulative structural improvement in 201112 of 2 percent of GDP, was largely expenditure- based. Pensions and wages were frozen and a public administration reform reduced public employment by 3 percent since 2010. 9 Meanwhile, domestic arrears fell from 1 percent of GDP at end-2009 to 0.5 percent of GDP at end-2011. 10
Credit growth is weak and deposits are rising. These developments represent two sides of the same coinsubdued domestic demandand increasing domestic deposits allowed banks to reduce their foreign liabilities and improve their liquidity. 11 The local financing of Greek banks also improved (their loan-to-deposit ratio decreased from 151 percent in 2009 to 125 percent in mid-2012) and their share of assets has declined, but the two largest Greek banks still account for just over 15 percent of total system assets. The non-bank financial sector is witnessing moderate growth in the net assets of Supplementary Insurance Pension Funds, uneven developments in the capital market, and still contracting life and non-life insurance segments. IV. ECONOMIC OUTLOOK AND RISKS On a baseline of a tepid euro area recovery, growth is projected to be modest, around 1 112 percent, in the near term driven by EU funds absorption . Headline inflation is expected
7 Horst Brezinski and Johannes Stephan, Capital inflows, Current Accounts, and Exchange Rate Regimes in Central East Europe duringand after the Global Financial Crisis, Review of Economics, Bd. 62, H. 1 (2011),pp. 22-39. 8 Id at Pg 30 9 Id at Pg 25 10 Id 11 Darvas, Z. (2009), The Impact of the Crisis on Budget Policy in Central and Eastern Europe, Institute of Economics, Hungarian Academy of Sciences Discussion papers, No. MT-DP - 2009/24.
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to reach 212 percent on average in 2012 due to higher food and fuel prices and moderate next year in the absence of demand pressures. The current account is projected to be in deficit as importsdriven by rising FDI and EU funds absorptionoutpace exports. Over the medium- term, growth is projected to gradually increase towards 412 percent by 2017 and close the output gap, provided external conditions improve, domestic demand recovers from the sharp contraction witnessed during 200911, and, equally crucially, productivity growth increases. Higher productivity growth will require stronger EU funds absorption to narrow the infrastructure gap, improvements in the business climate, institutions, and product markets to attract foreign investment to bolster innovation, as well as better education, training and active labor market policies to develop skills. 12 Employment is projected to be little changed as the labor force shrinks due to aging and emigration. The authorities agreed that the near term outlook was for modest growth. They did see room for GDP growth to approach 2 percent next year on the assumption that the euro area recovers. The return of the current account to deficit was seen as largely related to FDI developments and thus unproblematic. The authorities recognized that aging constrains future growth and structural reforms were imperative to boost productivity. The authorities also saw external spillovers as the key risk to the recovery. They were confident about the ability of the economy to absorb shocks and maintain stability. 13 They viewed their banking system as replete with buffers and benefitting from close supervision that would act preemptively if needed. 14 They see fiscal policy less as a shock absorber than as a support for the currency board arrangement (CBA). The authorities disagreed that rising NPLs in the near term could limit credit supply because liquidity was ample and credit demand low. Deleveraging posed little risk as it was in their view largely driven by the plentiful domestic liquidity amid low credit demand, and they were also confident that their supervisory powers and on-going collaboration with home supervisors mitigated remaining risk. On structural reforms and building on some recent improvements in international competitiveness rankings, they felt that with improved EU funds absorption, longer-term growth could surprise especially if external uncertainty resolves. They also saw the need for a push after the elections to tackle insolvency, judicial, and health reforms to boost growth.
12 BulgariaStaff Report for the 2011 Article IV Consultation. 13 Kaminsky, G., S. Lizondo, and C. Reinhart (1998), Leading Indicators of Currency Crises, IMF Staff Papers, Vol. 45, No. 1, March. 14 Fabrizio, S., D. Leigh, and A. Mody (2009), The Second Transition: Eastern Europe in Perspec tive, IMF Working Papers, No. 09/43.
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V. POLICY CHALLENGES: SAFEGUARDING STABILITY AND REVIVING GROWTH Needed policies to maintain stability and reduce vulnerabilities, while reviving growth, are twofold. First, fiscal and financial buffers should remain sufficient in view of the downside risks from the euro zone crisis. 15 This precludes space for looser fiscal and credit policies placing the onus firmly on structural reform to revive growth. Second, structural policies need to support growth, investment, and job creation. This includes greater EU funds absorption and changing the composition of fiscal policy, tackling the legacy of NPLs, and reforms to boost productivity. A. The Policy Framework: A Bulwark in Uncertain Times Bulgarias policy framework is three-pronged and proved its worth in recent years. First, the CBA which links the lev to the euro has provided a macroeconomic anchor. Second, prudent fiscal policies generated pre-crisis fiscal surpluses and sizeable fiscal reserves. This did little to dampen the domestic demand boom but did allow the crisis, when it came, to be absorbed with moderate fiscal deficits and public debt. 16 Third, conservative supervisory policies ensured the building of buffers in the financial system in pre-crisis years so that post crisis the system remained sound. Policy credibility is high at present. 17 Domestically, the CBA enjoys unquestioned support. Official reserves, 37 percent of GDP at mid-2012, are well in excess of the minimum required. Internationally, Bulgaria was able to issue a euro bond in July 2012 for 950 million (2 percent of GDP) with an interest rate of 414 percent. Spreads have fallen further since then, placing Bulgaria more in league with the Baltics than its geographic neighbors. Competitiveness has been maintained under the policy framework. The CGER-valuation range suggests that the real exchange rate is broadly in line with fundamentals. Improved export performance and the correction in the current account have occurred despite rising private sector real wages and unit labor costs (ULCs). The latter likely contributed to the sizable reduction in employment, but may not have harmed external competiveness given that wage levels in Bulgaria remain low, with hourly remuneration just one-third of the EU median. More broadly, the comfortable level of international reserves, subdued but increasing capital flows, moderate current account deficit, and improving international investment
15 Darvas, Z. (2009), The Impact of the Crisis on Budget Policy in Central and Eastern Europe, Institute of Economics, Hungarian Academy of Sciences Discussion papers, No. MT-DP - 2009/24. 16 Id 17 Rodrick, D., Why Do More Open Economies Have Bigger Governments? Journal of Political Economy, Vol. 106(5), pp. 997-1032.
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position reinforce the notion that the exchange rate is broadly in line with fundamentals. The CBA remains the appropriate anchor for policies until eventual euro adoption given the strong on-going support provided by fiscal and financial policies. In the current highly uncertain environment, the benefit of the fiscal reserve is enhanced as it complements other crisis management tools and financial system buffers. With the reduction in the fiscal reserve since 2009, a low probability, large impact shock could prove more difficult to absorb. 18
Saving any fiscal over performance, proceeding with budgetary plans of domestic debt issuance, and saving privatization proceeds would strengthen the fiscal reserve. 19 Such measures have the potential to increase the reserve, without recourse to further external borrowing, to about 7 percent of GDP in 2016 prior to the bond repayments falling due in 2017. The recently adopted debt management strategy, which focused on gross debt, should be complemented with a review of how the fiscal reserve is structured and funded to meet its fiscal and financial shock absorption and savings objectives. The authorities saw limited scope to increase the fiscal reserve via further external borrowing particularly ahead of the elections. They agreed that the reserve serves a crucial role in supporting Bulgarias policy framework by providing a backstop, particularly now that euro adoption plans are on hold. 20 They are not letting the fiscal reserve fall further and are setting its legal minimum at end-2013 nominally unchanged from end-2012 at 512 percent of GDP. They emphasized the availability of other tools to resolve any potential liquidity or solvency issues in the banking system. B. Reorienting Fiscal Policy to Better Support Growth Fiscal consolidation continued in 201112. The fiscal deficit is on track to fall to 1.3 percent of GDP in 2012. On the revenue side, the combination of administrative improvements and price developments boosted VAT collections. Furthermore, risks from contingent liabilities in the energy and transport sectors have been reduced by cancelling the construction of a nuclear reactor and reforming the railway system to eliminate public subsidies by 2013. The latter includes privatizing freight, closing unprofitable lines, and laying-off 2,000 workers. The 2013 budget represents a pause in the consolidation effort. Average pensions are to increase by 9.3 percent in April 2013 to compensate for inflation
18 International Monetary Fund (2010), World Economic Outlook: Rebalancing Growth, April 2010, Washington DC, USA. 19 Id. 20 Id
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during the last three years while public wages will remain largely frozen for a fourth year. Interest income will be included in the income tax base and minimum social security contributions thresholds raised by 3.3 percent to counter under-recording of incomes. Reaching the governments 2015 target of a balanced budget will require 0.4 percent of GDP in structural measures. On current projections this would result in structural balance in 2015, a more ambitious target than the EUs Fiscal Compact. A proposed new public finance law incorporates the Fiscal Compacts structural budget balance rule. It also puts forward automatic correction mechanisms in case of non compliance, lists all national and supranational fiscal rules, and introduces monthly general government financial reporting requirements. 21 The financial management of sub-national governments remains weak. However, their budgets are small and broadly balanced, and their debt is low at 1.3 percent of GDP. Moreover, the authorities have established an incentive system to improve performance, monitoring, and transparency at the municipal level. Targeting a balanced budget by 2015 appropriately supports Bulgarias policy framework. A small and declining deficit would keep public debt low, preserve the fiscal reserve, and allow fiscal space to use in the event of potential shocks. The trade-off with short-term growth would be limited because of the small adjustment and modest multipliers. However, if growth were to slow significantly relative to projections, automatic stabilizers should be allowed to operate provided adequate financing is available. A pause in the adjustment next year seems reasonable given the subdued growth outlook and the small structural adjustment remaining till 2015, but it will be necessary to resist pressures for generalized wage increases. 22
The commitment to fiscal discipline should be complemented by improvements in public financial management. 23 The proposed law is an important step but further efforts are needed including reconciling domestic and EU reporting standards and rules, setting up an independent fiscal council to assess fiscal projections, and disclosing contingent liabilities, particularly related to State Owned Enterprises. The authorities are committed to preserving fiscal stability and market credibility. They are skeptical of the counter cyclical effectiveness of fiscal policy in a downside scenario and fear the negative impact on credibility of
21 Marer, P. (2010), The Global Economic Crisis: Impacts on Eastern Europe. Acta Oeconomica, Vol. 60(1), pp. 3-33. 22 Kose, M.A. et al. (2006), Financial Globalization: A Reappraisal, NBER Working Paper No. 12484, also published as: IMF Staff Papers, Palgrave Macmillan Journals, Vol. 56(1), pp. 8-62. 23 Mojon, B., Smets, F., Vermeulen, P.(2002), "Investment and Monetary Policy in the Euro Area", Journal of Banking and Finance, 26, pp.2111-29.
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deviating from their 2015 balance target. They see scope to improve the quality and composition of spending, especially through improved EU funds absorption. C. Financial Sector: Fortifying Resilience The financial system is stable but operating in a challenging low-growth environment. The banking system-wide capital adequacy ratio is high (16.7 percent in June 2012) with all banks meeting the 12 percent regulatory minimum. Strong deposit growth and subdued credit demand boosted liquidity (coverage ratio of 26 percent) and allowed external funding to decline, although the stock of parent funding in some banks remains sizeable. The difficult economic environment has taken a toll on asset quality and profitability. 24 Rising asset impairment could impede the recovery. NPLs were 16.9 percent of total loans in June 2012 and still rising, but there is a high degree of dispersion across the system. Weak growth, high corporate indebtedness, and a depressed real estate market continue to pressure asset quality. A large stock of NPLs may constrain credit availability once the recovery gains traction and savings and related deposit growth ease, and it may also undermine the efficiency of credit intermediation by locking in resources. The institutional framework to discuss financial stability matters is working well. The Financial Stability Advisory Council meets quarterly and provides a platform of cooperation among the BNB, the Ministry of Finance, and the Financial Supervision Commission. The BNB also consults closely with foreign supervisors, but does not participate in the Vienna II Initiative. 25 The Deposit Guarantee Fund has resources equivalent to 4.7 percent of the covered deposits. Continued vigilance through close bank monitoring and strong safety nets remain priorities. The BNB should continue to closely monitor banks and intervene preemptively through targeted requirements to reinforce capital and liquidity buffers in the relatively weaker pockets of the system. Plans to strengthen the BNBs bank resolution framework by introducing purchase and assumption and bridge bank options should proceed quickly in line with the proposed EU directive on bank recovery and resolution and the Financial Stability Boards indications. The authorities consider the banking system, with high buffers and increased domestic
24 Orlowski, L, "Monetary Policy Regimes and Real Exchange Rates in Central Europe's Transition Economies", Economics Systems, 24, pp. 145-66. 25 Nenovsky, N., Rizopoulos(2004), "Extreme Monetary Regimes. Evidence from Currency Board Introduction in Bulgaria", Journal of Economic Issues, 37, pp.909-41.
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funding, well placed to cope with risks. They assess the risks to the recovery posed by NPLs as low since credit demand remains subdued, liquidity high, and buffers adequate. With high deposit growth and a lack of evidence of parent banks forcibly deleveraging, the authorities see existing cooperation with foreign supervisors and EU colleges working well. They see merit in fast-track court approval for corporate reorganizations while they view existing out- of-court debt restructuring as satisfactory. D. I mproving the Environment for Growth Improvements in the predictability of the business environment, workers skills, and quality of infrastructure would help boost growth. These are areas where Bulgaria lags internationally and where improvements could make a real difference. 26 Regarding the business environment, shortcomings exist in the insolvency framework, notably the possibility to backdate the start of insolvency. This backdating of the insolvency date by courts, often years before filing, triggers automatic invalidation of a wide range of transactions, including the validity of collateral and payments made after the insolvency date. It reduces the predictability of private contract enforcement, raises credit and operational risks, creates moral hazard, and discourages lending. Other shortcomings include delays in and costly court processes, lax enforcement of legal provisions on liability for failure to timely file for insolvency, insufficient expertise, and the uncertain and unpredictable process for reorganizing firms outside formal insolvency proceedings. In the labor market, structural mismatches undermine potential growth. The crisis exposed large and rising regional, age, and skills mismatches that have resulted in significantly higher unemployment and a slight increase in poverty and inequality. Average real wage growth in the private sector since the crisis (2009Q1 to 2012Q1) has surpassed productivity gains. 27 This wage growth partly reflects compositional changes in employmentthe disproportionate lay off of less productive, low wage workersbut also likely reflects increases in the minimum thresholds for social security contributions. While labor productivity gains help explain the increase in exports , they have come at the expense of jobs (especially low skilled). The backdating of insolvencies should be disallowed. Proposals,
26 BulgariaStaff Report for the 2011 Article IV Consultation 27 Real wage growth data vary from 6 percent annually since the crisis (National Accounts) to 9 percent (Labor Force Survey) and productivity growth from 1 percent (Labor Force Survey) to 4 percent (National Accounts). Unionization is low and bargaining largely occurs at firm level.
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such as limiting the timeframe for back-dating, while not unknown to other legal systems, would not resolve the problem. A broader review of the existing insolvency framework is also needed to identify weaknesses in insolvency processes and suggest required legislative amendments. In addition, improving the capacity of all parties involved in the process is necessary. Boosting EU funds absorption is critical to improve productivity. Additional reforms to complement those already implemented should focus on improved financial control and capacity building at the municipal level, and the introduction of a framework law to govern procedures and processes for EU funds management. Future wage increases need to be anchored in productivity gains to preserve competitiveness. The upcoming review of the system of minimum social security contribution thresholds should identify the adjustments necessary to alleviate their impact on low-wage workers. Expanded active labor market policies and more targeted education and training would raise productivity and increase employment. The authorities recognize that the insolvency framework needs reform and see the post election period as holding the greatest promise for progress. More broadly, the National Reform Program sets out policies for addressing structural impediments to growth. It also outlines programs on social inclusion and poverty reduction including long-term care, Roma integration, and training for vulnerable groups. 28 Regarding EU funds, the authorities have increased contracts and implementation and are preparing for the next EU program period. The authorities see recent developments in private sector wages as largely reflecting productivity gains and do not consider it a risk for future competiveness. 29 They value the flexibility of the labor market but recognize that structural bottlenecks are keeping unemployment high. They are increasing active labor market programs to reduce skills mismatches and increase productivity. Given regional gaps, they are considering regional minimum wages to complement the review of social security contribution thresholds. 30
28 See Supra note 1 29 Nenovsky, N., Chobanov, P., Mihaylova, G., Koleva, D.(2008), "Efficiency of the Bulgaria Banking System: Traditional Approach and Data Envelopment Analysis", AEAF Working Paper, No. 1/2008. 30 Id
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VI. INTERCONNECTEDNESS AND SPILLOVERS FROM THE EURO AREA TO BULGARIA With significant and increasing trade links with the euro area (EA), the slowdown in EA growth has a strong impact on growth in Bulgaria, particularly as its business cycle has become more synchronized with the core. Increased domestic savings led to rapid domestic deposit growth that allowed banks to reduce external debt substantially. Spillovers to
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sovereign debt spreads have also been limited. 31
31 Id.
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A. Trade Channels Bulgarias trade linkages with the euro area are strong. In 2011, exports to the euro area accounted for 44 percent of Bulgarias total exports and 23 percent of the countrys GDP. Bulgarias market share in the euro area trade has increased steadily for 10 years. Real export growth to the EU15 since 2010 has been faster than during the pre-crisis years, with growth touching a 10 year high 24 percent in 2011 as trade with Germany expanded. Exports to the European Unions New Member States and the Balkans have also grown rapidly. In 2011, Bulgaria exported 63 percent of its total exports to the European Union and 77 percent to the combined European Union and the Balkans. In contrast, Bulgarias share in Asian markets has been relatively flat since 2009. 32
Therefore, Bulgarian growth is very sensitive to developments in the euro area. The elasticity of Bulgarian export growth to euro area GDP growth is high: when the euro area GDP grows by 1 percent, Bulgarian exports grow by 3.5 percent in volume terms. Signs of the effect of the euro area slowdown are already visible as the volume of goods export growth eased to16.4 percent year-on-year by end-2011 from 33.1 percent in the first quarter. In addition, the correlation of the Bulgarian business cycle with the euro areas has increased over 2008/2011 compared to 2001/2007 period with twice as high an elasticity of Bulgarian GDP growth to the euro area growth during the latter period. 33
B. Capital Flows Channel, I ncreased Domestic Savings and Banking Sector Deleveraging The crisis saw a dramatic increase in domestic deposit growth that allowed a rapid decline in banks foreign liabilities while credit growth remained positive. Amid weak credit demand owing to weak sentiment, the impact on credit supply has been muted with credit growth to the non-government non-financial sector reaching 3.9 percent in 2011. The rapid growth in non-financial domestic customer deposits of around 30 percent since 2010, reflected rising savings, and has more than offset the decline in commercial banks foreign liabilities (which are registered as a capital outflow in the BOP). As a result of the crisis and the repayment of banks external funding lines Bulgaria has experienced a dramatic fall in capital inflows. Capital flows shifted from inflows of 44 percent of GDP in 2007 to outflows of 112 percent of GDP in 2011. This reflects the collapse
32 Id 33 International Financial Statistics. 2009. 2009 Yearbook. Washington, DC: International Mon etary Fund.
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in cross-border banking flows by 23 percent of GDP between 2008 and 2011, which in contributed to the private external debt falling from 94 percent of GDP at end-2008 to 81 percent at end-2011. Only FDI remained positive but still substantially below the elevated pre-crisis boom levels, reflecting the collapse in FDI into the financial and real estate sectors. 34
The decline in cross- border banking flows is evident in banks net foreign position that is now closer to balance. Bulgarian banks foreign liabilities have exhibited a clear downward trend since the start of the crisis in 2008, with a level in December 2011 at 36 percent lower compared to the 2008 peak, a decline equivalent to 9 percent of 2011 GDP. During the same period, banks foreign assets grew by 28 percent. After rising by 24 percent of GDP during the boom, foreign liabilities of the banking system have fallen by 12 percent of GDP since 2009. Data from the BIS (Consolidated Banking Statistics, September 2012) show that euro area banks, primarily Greek banks, drove most of the fall during the 201011 period. 35 This contrasts with developments observed after the 2008 Lehman failure when euro area banks, led by Greek banks, maintained their level of exposures to Bulgaria due to their profitable operations there that partly offset their losses in home markets. 36 The asset market share of domestic banks increased from 16 percent in 2009 to 25 percent in 2012Q2 at the expense of particularly Greek banks (their market share fell from about 30 percent in 2009 to 22 percent in 2012Q2). Deeper analysis confirms the limited impact of the decline in foreign liabilities on credit supply. A bank-by-bank panel data regression for Bulgaria shows that funding from credit institutions, the bulk of which is composed of euro area parent funding, had a significant but limited effect on credit growth. Contrasting the pre and post-crisis periods shows that the growth in funding from credit institutions has a significant effect on credit growth during the pre-crisis period only, while non-financial customers deposit growth has a significant effect over the whole period. By contrast, real GDP growth has a significant and very large effect in the post-crisis period only, with a one point GDP growth entailing a 1.83 percentage point increase in credit growth. The results are confirmed by a macro regression using monthly monetary survey data on credit and deposits. The results imply that the decline in foreign liabilities had a cumulative negative effect of 2 percentage points on credit flows during
34 IMF. 2011. Government Finance Statistics Yearbook. Washington, DC: International Monetary Fund. 35 IMF. 2012. Government Finance Statistics Yearbook. Washington, DC: International Monetary Fund. 36 Id
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201011. This assumes banks' wholesale funding is made up exclusively of foreign funding, and uses the average year-on-year growth in attracted funds from credit institutions over 2010/2011 (-18.8 percent) and the regression coefficient . The combined effect of the funding from credit institutions variable and the deposit variable on credit growth is estimated to be equal to 1.4 percentage point each year over 2010/2012, compared to an average annual credit growth of 3.1 percent, with the difference reflecting the autoregressive behavior of credit growth as shown in the econometric results. C. Financial Markets Linkages The widening of spreads on Bulgarian debt has been contained compared to regional peers. The increase in CDS spreads has evolved in line with global risk aversion and regional peers, remaining below Bulgarias March 2009 own crisis high. A correlation analysis shows that the increase in regional risk aversion has impacted Bulgarian bond spreads and CDS less negatively than the stock market, as the latter was largely driven by domestic factors. The correlation between the V2X index (volatility of the Euro Stoxx 50 index) and Sofia stock market volatility has risen dramatically since the onset of the 2008 crisis. By contrast, the correlation of the V2X with Bulgarian sovereign CDS spreads and with 10-year sovereign bond spread declined and even turned negative for bond spreads. A Garch model estimating co-movements in financial variables confirms that Bulgarian indicators have been less vulnerable than others in the region to contagion. VII. THE PURPOSE OF THE FISCAL RESERVE A. Background The fiscal reserve was set up in 1997 at the inception of the Currency Board Arrangement (CBA). It was (and is), however, not a formal requirement of the CBA. The minimum level of the fiscal reserve was initially fixed at the amount of debt payments over the next year (around 1 billion or about 10 percent of GDP). 37 Fund programs included a performance criterion on the minimum balance in the fiscal reserve account (FRA). 38 The fiscal reserve soon exceeded the minima related to debt repayments. Public debt declined rapidly in the 2000s and the FRA was boosted inter alia by privatization revenues and inclusion of the governments cash resources. Budget surpluses in the boom years of the mid
37 Government Debt Management Strategy for the Period 200608. 38 For example, the 2002 Stand-By Arrangement referred to a minimum FRA of 90 percent of next years gross public debt service requirements
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2000s flowed into the FRA, which subsequently helped finance budget deficits resulting from the global crisis that began in 2008.
The FRA includes the State Fund for Guaranteeing the Stability of the State Pension System (Silver Fund). This fund amounted to BGN 2.1 billion (2.7 percent of GDP) at end-August 2012 or just under one-third of the total FRA. It is dedicated to meeting future needs in pillar I of the pension system, which restricts the short-term usability of its resources without legislative changes. The Silver Fund started accumulating resources in 2007, when the fiscal surplus and FRA were rising, to lock in part of the gain. 39 The FRA includes the single treasury account. Use of the FRA has to take into account the operational needs of the government, which may be around 23 months of non-transfer spending (around BGN 2.5 billion or 3 percent of GDP). The single treasury account also holds balances of some organizations with budgets that are not part of the state budget, as well as certain funds. 40 An end-year legal minimum for the FRA is specified in the budget. For end-2012 this is set at BGN 4.5 billion (5.8 percent of 2012 GDP), and the proposed 2013 budget sets the same nominal minimum for end-2013. No legal minimum applies during the year. B. The Fiscal Reserve as a Shock Absorber Bulgarias faces certain vulnerabilities. A key vulnerability is the short-term external debt (25 percent of GDP at mid-2012) which needs to be rolled over within a year. The Risk Assessment Matrix (see main text) summarizes staffs views on the major risks facing Bulgaria, and discusses its trade and financial interconnections with the euro area as possible channels through which shocks can spillover to Bulgaria. More generally, Bulgaria is an emerging economy that is still building credibility: risk premiums have come down but this is a recent development that cannot be taken for granted. In terms of its policy framework, while the currency board is well supported by policies, it limits the policy options to address shocks, including the lender-of-last-resort function. Fiscal policy in the case of a shock may
39 In the case of external borrowing that is placed in the FRA, the effect on international reserves is reduced below one-for-one to the extent that residents finance part of the external borrowing immediately or soon after (with the July 2012 eurobond, residents were not allowed as primary purchasers but secondary market purchases did take place). 40 The 2012 State Budget of the Republic of Bulgaria Act lists these organizations. Funds in the single treasury account include the Nuclear Facilities Decommissioning Fund and the Radioactive Waste Fund (see Safe Use of Nuclear Energy Act).
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be constrained by limited financing room (the domestic market is small and the external market may not necessarily be open when needed), which could force severe short-term budget adjustment. The fiscal reserve is a tool in Bulgarias policy framework that can act as a buffer of last resort to help absorb shocks in two dimensions. They include shocks to the government finances and the financial system that could generate liquidity or financing needs. These are examined in turn. In the two years from 2008 to 2010, the (cash) fiscal balance deteriorated to a deficit of only 3.9 percent of GDP because the starting position was a surplus of 2.9 percent of GDP. As a result, the cumulative financing need was reduced and the fiscal reserve could finance a substantial part of it. Moreover, it allowed fiscal policy to play a more active role in supporting the economy in the downturn. 41 Without the reserve a more abrupt adjustment to curtail the widening of the fiscal deficit would have been required, which would have compounded the economic downturn. The anticipated level of the FRA would likely be insufficient to cope with large shocks to the budget. The FRAs peak-to-trough decline was about 12 percentage points of GDP, whereas the FRA by January 2013 will be just around 6 percent of GDP, and only part of it is usable given the constraints mentioned above. In addition, recent simulations showed a potential funding need for Bulgaria over a 3-year period in worst-case scenarios amounting to 7 to 9 percent of GDP. 42 Both the recent experience and the simulations provide indications of the amount of liquid, available FRA resources that might be needed in an adverse downside scenario that caused a significant shock to growth and the budget balance. In the current international environment, tail risksunrelated to cyclical factors and not necessarily Bulgaria-specificthat could involve a severe fiscal deterioration and high financing requirement cannot be ruled out. The size of the fiscal buffer potentially needed to finance deficits in such an extreme case could be very large and costly to accumulate and maintain. Thus, the cost at this time of building up such self-insurance from borrowing, combined with the low probability of needing it, needs to be weighed against alternatives, including potential bilateral or multilateral support. Bulgaria pursues conservative financial supervisory policies as its main defense against the impact of shocks. The modest size of the
41 The benefit of using the FRA in terms of smoothing GDP over the cycle depends on the multiplier. For example, an estimated revenue multiplier in the downturn of 0.5 and in the upturn of 0.4 (with opposite signs). This implies a small net positive impact on GDP over the cycle from financing a revenue decline in the downturn and clawing it back in the upturn 42 Andritzky, Evaluating Designs for a Fiscal Rule in Bulgaria (IMF, WP/11/272, November 2011)
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financial system in Bulgaria, with total banking system assets at around 75 percent of GDP, helps contain risks. The stability of the banking system in recent years, following the unwinding of the domestic demand boom, attests to the adequate policy framework and its successful implementation. 43 However, given that the currency board strictly circumscribes the BNBs ability to act as lender of last resort by limiting the amount of reserve money to no more than international reserves, strong defenses are appropriate. B. The Fiscal Reserve as a Saving Vehicle The FRA could be used as a tool to save and address the financial consequences of population aging. An aging population puts pressure on government finances which can be prepared for in part by building up assets. To this end, Bulgaria has established pillar II of the pension system along traditional lines, with resources being built up and invested with the aim of generating long-term returns. To complement the state pension system, the Silver Fund (which is part of the FRA) was established to set aside savings. Although designated as a pension fund, it does not operate along these lines as its resources are limited, kept very liquid (only short-term deposits) and, as a consequence of their being liquid, do not generate a return in the current low interest rate environment. 44 More importantly, its structure and legal framework do not conform to those of a pension fund. The role of the FRA and the Silver Fund in saving for aging pressures could be reexamined. A savings fund could be a useful instrument of macro-fiscal management provided fiscal policy generates enough savings and it is fully integrated in the policy framework. That is to say, the accumulation of financial assets in a fund with intergenerational objectives should be derived from the actual fiscal surpluses determined in the policy framework. Significant legal changes would be required for the Silver Fund to play this role, if it is desired. In this context, the asset/debt nexus would also need to be examined. Generating savings when net public debt is positive may seem premature but possibly be defensible if maintaining a gross public debt has other functions, for example underpinning domestic financial market development. C. Fiscal Reserve Comparison Comparisons with other countries are fraught with difficulty because Bulgarias combination of a currency board and fiscal reserve is uncommon. One economy that is
43 id 44 Existing room to invest in other than short-term deposits (for example, foreign shares and investment grade foreign government bonds within limits specified in the law) is not being used (see State Fund for Guaranteeing the Stability of the State Pension System Act, Article 13).
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comparable in these respects, although it differs significantly in many respects including size and level of development, is Hong Kong SAR, which is briefly examined. For Hong Kong SAR, the Asian crisis illustrated the utility of, and way to manage fiscal reserves. They were drawn down to help finance budget deficits, and once budget surpluses returned they were rebuilt. The recent decline in Bulgarias fiscal reserve could similarly be followed by a rebuilding. Hong Kong SARs fiscal reserves are placed with the Hong Kong Monetary Authority (HKMA), which invests them as part of its management of the international reserves. This is similar to the present arrangement in Bulgaria. A difference is that the HKMA is explicitly managing its international reserves partly as a liquid portfolio and partly for the longer term. This reflects the primary role of the international reserves as backing the currency board and also that Hong Kong SAR has decided to dedicate its fiscal reserves for multiple purposes: they are a buffer against the volatile public revenues, function as a potential backstop for the financial system (in addition to the Hong Kong Monetary Authoritys role as lender of last resort), and are a resource for anticipated age-related spending. In Bulgaria, if any changes in the investment of the FRA were to be contemplated, they should be preceded by a re- examination of the purposes of the FRA, including as a saving vehicle for aging. However, the resources available in the FRA for the shock absorption functions with respect to the government finances and financial system, discussed above, would need to be safeguarded. VIII. RECENT MACROECONOMIC DEVELOPMENTS AND OUTLOOK In view of the adverse external developments since the last Article IV consultation, the authorities have made substantial policy efforts to maintain macroeconomic stability and sustainability. They continued with the fiscal consolidation committed under the 2012 Budget Law to further lower the deficit. In July 2012, the authorities took advantage of the temporary window and successfully issued Eurobonds at a favorable rate. This should secure smooth repayment of the existing Eurobond in January 2013. Some important structural reforms were boosted further. The real economy has yet to recover from the pre crisis output level. The most recent flash GDP estimates suggested that during the Q3, economic growth remained moderate at 0.5 percent (seasonally adjusted data) compared to the same quarter of the previous year. The indicator's movement is determined mainly by the increase recorded in the agricultural sector
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(by 6.3 percent) and industry (by 3.5 percent). During 2012, Bulgarias terms of trade deteriorated due to external spillovers. Between January and September 2012, exports grew modestly by 2.2 percent year-on-year, compared to 34.2 percent during the same period last year. As a result, the trade deficit widened and reached EUR 2.7 billion (6.9 percent of GDP) in the first nine months of 2012, against a deficit of EUR 1.3 billion (3.3 percent of GDP) in January September 2011. The competitiveness of the economy has been preserved. Labor productivity continues to grow after the decline in employment and subsequent moderation in wage growth. Sustained faster growth rates of productivity in Bulgaria compared to the EU average attracted foreign investments. However, the seasonal labor market revival decelerated during the second and third quarters, and remained unable to reverse the negative annual trend in unemployment. Expectations for labor market developments in 2013 are related to the stabilization of the main indicators around their 2012 levels. While showing some signs of recovery, domestic demand remains suppressed. According to flash GDP estimates, in Q3 the recovery in final consumption decelerated to 2.9 percent (seasonally adjusted data) compared to the same quarter of the previous year, and down from 3.2 percent in Q2. The still high unemployment rate and uncertainty about future income were also factors that affected consumer demand. Investment activity appears to be stabilizing, supported mainly by public projects and some recovery in FDI, especially in the energy sector. After a slowdown in the rate of decline during the last three quarters, the gross fixed capital formation increased by 1 percent (seasonally adjusted data) in Q3, compared to the same quarter in 2011. For the first nine months of 2012, FDI in Bulgaria totaled EUR 971.8 million (2.5 percent of GDP), against EUR 711.9 million (1.8 percent of GDP) in the same period of 2011. Next year, investment is expected to be initially supported by public sector projects funded by the EU. The pressures from the earlier surge in world energy prices are easing, following the stabilization in international oil prices. Since June 2012, the annual average HICP inflation remained flat at 2.3 percent. In October, the HICP inflation reached 2.7 percent since the beginning of the year.
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IX. FISCAL POLICY The authorities deserve credit for implementing another round of fiscal consolidation 45 , and further lowering the deficit during a slow economy in late 2011 and early 2012 (in seasonally adjusted terms). Bulgaria exited the EUs excessive deficit procedure in mid-2012. Performance up till now suggests that the 2012 deficit target of 1.3 percent of GDP (ESA 95 methodology) will be comfortably met. Bulgaria has now one of the lowest deficits and public debt ratios in the EU, far below the thresholds set by the Treaty, the new EU Fiscal Compact, and national limits. As pointed by staff, reaching the 2015 target for a structurally balanced budget will require only 0.4 percent of GDP in additional structural measures. This provides the government with some degree of flexibility in the next election year. In the current highly uncertain environment, the authorities are well aware that a strong fiscal policy is critical to sustain macroeconomic stability and ensure stable footing for growth. The 201112 restructuring of the tax and customs administration has already provided revenue stabilization, greater efficiency of tax collection, and eradication of financial fraud and tax evasion in key sectors. The tax policy will remain broadly unchanged until 2015, as part of the strategy to provide a stable and predictable environment for businesses. On the expenditure side, the authorities will maintain restrictive medium-term budgetary framework in line with the 2012 Convergence program of the Republic of Bulgaria. In addition, risks from contingent liabilities in the energy and transport sectors have been reduced by cancelling the construction of the Belene nuclear power plant, and the reform of the railway system to eliminate public subsidies by 2013. The authorities fiscal strategy in 2013 is to continue spending optimization in the national budget in order to release the necessary co-financing for accelerated absorption of funds under EU programs, in view of the approaching end of the programming period 20072013. The increase in the national budget balance by 0.7 percent of GDP due to a decrease in administrative expenditure will be offset by higher absorption of the EU funds, which results in a balance deterioration of 0.7 percent of GDP. The overall general government deficit in 2013 will remain almost unchanged from 2012. Among the priorities of the 2013 budget are some social and growth-enhancing policies. Average pensions will be indexed by 9.3 percent in April 2013 to compensate for the inflation of the last three years. Public wages will remain largely frozen for a fourth year. At the same time, interest income from term bank deposits
45 See Supra note 1.
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will be included in the income tax base and the minimum social security contributions thresholds will be raised by 10 percent to counter under-recording of incomes.The authorities welcomed staffs analysis on fiscal multipliers. They agreed that the results should be treated with caution, especially when the model-based policy proposals ought to serve policymakers in such highly uncertain external environment. They also noted that, in general, the Dynamic Stochastic General Equilibrium Models are known as being driven by the pre-analytic belief in validity of a certain model, and subject to a number of calibration problems. The authorities remain open for further discussions on fiscal multipliers based on empirical data research and country experiences. The fiscal reserve has served the authorities well as a liquidity buffer during the crisis. In their view, it remains sufficient to meet the current liquidity needs of the budget. The authorities found staffs analysis on fiscal reserves and its role in the macroeconomic adjustment consistent with their own long-term policy strategy. They plan to rebuild the reserves over time, but do not consider a substantial debt issuance in 2013. It is the authorities view that fiscal reserve could do little as a shock absorber, given the high degree of openness of the Bulgarian economy and the magnitude of external spillovers. In case of a further deterioration of the external environment or of revenue performance, as a first line of defense the authorities will consider compensatory expenditure measures, and faster than initially envisaged optimization in public finance management. X. MONETARY AND MACRO-PRUDENTIAL POLICIES AND FINANCIAL SECTOR DEVELOPMENT The strong commitment of all political players to the Currency Board Arrangement (CBA)supported by a more than adequate reserve level (coverage of imports of above 6 months)is an additional buffer against shocks. The CBA has proved its flexibility and sustainability both during the boom prior to the crisis and in the cyclical downturn. The authorities agreed with staff that CBA remains the appropriate anchor for policies until the eventual euro adoption. It also has continuous support from macroprudential policies during the current economic adjustment. The authorities remain vigilant. They are aware that since the global crisis has erupted, the Bulgarian financial system has operated in a challenging low-growth environment. The BNB continues its policy from the pre-crisis period towards strengthening the accumulated capital
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and liquidity buffers. In return, the financial system, dominated by the banking sector, remains stable, well capitalized and highly liquid, and so are individual banks. The strong and persistent risk-aversion of the supervisory authorities led to a more diversified funding structure with less reliance on foreign funding in the post-crisis period. The majority of the banks remained profitable following the restructuring of their operating expenses, which additionally boosted credibility in the system. The authorities intend to properly address the problems in the existing insolvency framework, in particular those related to the backdating of insolvencies. XI. NATIONAL LEGAL FRAMEWORKS FOR NCB INVOLVEMENT IN BANKING SUPERVISION
A. Historical background and developments The aim of this section is to review the reforms undertaken in the selected CEECs with regard to the organisational structure of financial supervision and draw conclusions about central bank involvement in banking supervision. In Bulgaria, the processes of financial market consolidation and the blurring of boundaries between financial sectors led to the creation of the Financial Supervision Commission (BG-FSA) on 1 March 200312. 46 The BG-FSA unified the supervisory functions that were previously carried out by the former State Securities Commission, State Insurance Supervision Agency and Insurance Supervision Agency. Currently, it has competences with respect to all regulated participants in the non- banking financial markets (investment, insurance and pensions insurance) in the country. 47
Banking supervision remained, however, outside of the competences of the integrated supervisor. As was the case prior to 1 March 2003, banking supervision continues to be exercised by the Bulgarian National Bank (BG-NCB) 48
B. Findings All countries under review apart from Bulgaria adopted an integrated supervisory system during the period from 1999 (Hungary) to 2008 (Poland). The case of Bulgaria
46 Law on the BG-NCB, Darjaven vestnik, issue 46 of 10 June 1997 http://www.bnb.bg/bnb/home.nsf/vPages/Laws_BNB/$FILE/en%20Law%20on%20the%20BNB.pdf. 14 See Article 20(3) of the Law on the BG-NCB. 47 S. Dyankov and the Head of the parliamentary committee for bbudget and finance M. Stoyanova in Capital from 19.12. 2009 and Klassa.bg from 27.12. 2009 accordingly 48 Article 2(6) of the Law on the BG-NCB13
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appears somewhat hybrid, as the supervisory competences for all financial actors, apart from credit institutions and markets were assigned to a single supervisory authority, while the BG- NCB retained its traditional competence in the area of banking supervision. If the announced reform concerning the merger of the two current supervisory bodies proceeds, this hybrid system in Bulgaria will constitute only a transitional step. However, no details about the future supervisory model in Bulgaria are known so far. The historical outline set out above reveals a clear trend towards an integrated supervisory system in the CEECs. The integrated supervisory system is probably so popular in those countries because, apart from Poland, they are all comparatively small and/or have comparatively small financial sectors, and policy makers wished to achieve synergies by reducing the number of supervisory authorities. Notwithstanding the trend towards an integrated supervisory system, a common pattern for the framework of the integrated supervisory authorities cannot be detected, as the objectives, scope of tasks and internal organisation of those bodies differ among the countries. With regard to central bank involvement in banking supervision, one can observe that the tendency towards integrated supervision systems is not linked necessarily to a diminution or suspension of central bank supervisory powers. 49
In five of the seven countries (Bulgaria, the Czech Republic, Estonia, Latvia and Slovakia), the NCB acted as banking supervisor prior to the reform. In three of these countries (Bulgaria, Czech Republic and Slovakia), the NCB retained this function after the reform. In a fourth country, Estonia, the supervisory authority operates as an agency at the central bank, but is established pursuant to law and is independent in the conduct of financial supervision. In one country (Poland), prior to the reform the banking supervisor acted as an independent commission supported by the PLNCBs organisational structure. Thus, reduction of NCB powers is evident only in Latvia and Estonia, and to a large extent in Poland. Two main patterns for central bank involvement in banking supervision have emerged in the countries under review: (i) integrated supervision under the NCBs roof, implemented in the Czech Republic and Slovakia; and (ii) an integrated supervision authority outside of the NCB structure in Estonia, Hungary, Latvia and Poland. The case of Bulgaria, where banking supervision is conducted by the central bank and BG-FSA has supervisory competences with
49 Law on the guarantee fund, State Gazette I 2002, 23, 131 (original title: tagatisfondi seadus), as amended, available at: http://www.tf.ee/files/eng_Regulations/Statutes_ofGFA.PDF.
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regard to all other financial institutions and markets, is a hybrid one. The analysis below is organised according to those categories. 50
XII. NCB INVOLVEMENT IN THE PREPARATION OF LEGISLATION RELATING TO SUPERVISION This section examines whether NCBs have powers to influence the content of supervisory legislation and, where this is the case, how those powers operate. As the law on supervision is usually very technical and adopted both as parliamentary (primary) legislation and as lower level acts (secondary or implementing legislation), this section will explore these two situations separately.
A. Primary legislation In Bulgaria, the Government establishes inter institutional working groups wheredraft laws are discussed and benefit from the expertise of all the public bodies involved. Although legislation does not expressly provide for the BG-NCBs involvement in the process of making primary law governing supervision, in practice, the BG-NCB influences the drafting of the primary law through its participation in inter institutional working groups on the preparation of legal acts to such extent that the BG-NCB may even draft the legislative provisions. 51
B. Secondary legislation In Bulgaria, the BG-NCB has broad regulatory powers in the area of banking supervision. On the basis of Article 60 of the Law on the BG-NCB and paragraph 13 of the Transitional and Final Provisions of the Law on credit institutions, the BGNCB has adopted a number of ordinances amplifying the provisions of banking supervision law. 52
The most important are Ordinance No 2 on the licenses, approvals and permissions granted by the Bulgarian National Bank according to the Law on credit institutions; Ordinance No. 7 on the large exposures of banks; Ordinance No 8 on capital adequacy of credit institutions; Ordinance No 9 on the evaluation and classification of risk exposures of banks and the
50 Constitutional Law No 460/1992 Coll., Zbierka zkonov Slovenskej republiky, (original title: stavn zkon. 460/1992 Zb. stava Slovenskej republiky v znen neskorch predpisov) as amended, available at: http://www.nrsr.sk/Static/en-US/NRSR/Dokumenty/constitution.doc. 51 According to Article 37 of Law No 6/1993 Coll. on the CZ-NCB, as amended, the CZ-NCB shall co-operate with the [CZ]-Ministry of Finance in preparing draft legislation in the areas of the financial market 52 Ordinance No 38 on the capital adequacy of banks.
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allocation of provisions to cover impairment loss; Ordinance No 10 on the internal control in banks; Ordinance No 11 on liquidity management and supervision of banks; Ordinance No 12 on supervision on a consolidated basis; Ordinance No 17 on establishing the amount of bank investment under Article 47 of the Law on credit institutions; Ordinance No 20 on the issuance of approvals under Article 11(3) of the Law on credit institutions; Ordinance No 21 on the minimum required reserves maintained with the Bulgarian National Bank by banks; Ordinance No 22 on the central credit register of banks; Ordinance No 23 on the terms and procedure for payment of insured amounts on depositswith banks with revoked licenses and Ordinance No 38 on the capital adequacy of banks. 53
XIII. JURISDICTIONS WHERE BANKING SUPERVISION IS EXERCISED BY THE NCB In the jurisdictions where performance of the supervisory function was entrusted to the NCB (the Czech Republic and Slovakia), naturally, the NCBs operate as banking supervisors. This is also the case in Bulgaria, where banking supervision is performed by the BG- NCB73.In relation to deposit insurance funds, in the Czech Republic, at least one member of the five members of the Board of Directors (a body managing the Deposit Insurance Fund) is appointed from among the employees of the CZ-NCB and at the proposal of the CZ-NCB. Similarly, in Slovakia, the Governor of the SK-NCB appoints two members of the seven- member Board Directors and two members of the seven-member Supervisory Board of the Deposit Protection Fund, not necessarily employees of the SK-NCB. 54
Two main patterns for central bank involvement in banking supervision have emerged in the countries under review: (i) integrated supervision under the NCBs roof, implemented in the Czech Republic and Slovakia; and (ii) an integrated supervision authority outside of the NCB structure in Estonia, Hungary, Latvia and Poland. The case of Bulgaria where banking supervision is conducted by the central bank and BG-FSA has supervisory competences with regard to all other financial institutions and markets, is a hybrid one. The analysis below is organised according to those categories. 55
53 Under Article 79(3) of the Czech Constitution 54 See Article 16(2) and Article 20(2) of Law No 118/1996 Coll. on deposit protection and includingamendments to certain laws, Zbierka zkonov Slovenskej republiky (original title: zkon Nrodnej rady Slovenskej republiky . 118/1996 Z. z. o ochrane vkladov a o zmene a doplnen niektorch zkonov v znen neskorch predpisov), as amended, available at: http://www.nbs.sk/_img/Documents/LEGA/a1181996.pdf. 55 See Article 16(2) and Article 20(2) of Law No 118/1996 Coll. on deposit protection and including
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XIV. JURISDICTIONS WHERE BANKING SUPERVISION IS EXERCISED BY THE FSA Although in Estonia the ET-FSA is independent in the conduct of financial supervision, it was established as an agency with autonomous competence and a separate budget at the ET- NCB. In addition, the Governor of the ET-NCB is a member of the ET-FSAs supervisory board by virtue of his or her office and proposes two other members of the board. The ET- NCB, ET-Ministry of Finance and ET-FSA have concluded a Cooperation Agreement of 1 November 200275 with the objective of ensuring a sound and stable financial system and to agree arrangements for appropriate financial sector legislation and a Cooperation Agreement of 5 December 2006 on the management of financial crises 56 . The latter agreement provides the only legal definition of financial crisis currently in force. The legal basis for both agreements is the Law on the ET-FSA and the Law on the ET-NCB. 57 The ET-NCB, ET- FSA, ET-Ministry of Finance as well as the Estonian Banking Association are represented on the Supervisory Board of the Guarantee Fund, established on 1 June 2002 on the basis of the Law on the Guarantee Fund79 as an important element in the domestic financial safety network. Links exist at a practical level, too, with the ET-FSA located at the premises of the ET-NCB and benefiting from premises administration and furnishing implemented by the ET-NCB which, in turn, is also the provider of the joint IT infrastructure. 58
NCB involvement in licensing Jurisdictions where banking supervision is exercised by the NCB licence 59 and revoke an existing licence 60 . If a bank wishes to perform investment services and/or activities as well as ancillary services 61 , the BG-NCB must take into account the BG-FSAs written opinion 62 . If that opinion is negative, the BG-NCB must reject the banks application for a licence for investment services and activities and/or ancillary services. 63 Similarly, the BG-NCB must
amendments to certain laws, Zbierka zkonov Slovenskej republiky (original title: zkon Nrodnej rady Slovenskej republiky . 118/1996 Z. z. o ochrane vkladov a o zmene a doplnen niektorch zkonov v znen neskorch predpisov), as amended, available at: http://www.nbs.sk/_img/Documents/LEGA/a1181996.pdf. 56 Cooperation Agreement of 5 December 2006 on the management of financial crises (original title: koostkokkulepe finantskriiside haldamiseks), available at: http://www.eestipank.info/pub/en/yldine/pank/finantskeskkond/keskpanga_roll/lepe1106.pdf?ok=1. 57 That definition is adopted in an amendment, currently pending, to the Law on the State Budget, State Gazette I 1999, 55, 584 (original title: riigieelarve seadus), available at: www.legaltext.ee/text/en/X60037K2.htm. 58 Article 2(5) of the Law on the ET-NCB and Article 50 of the Law on the ET-FSA. 59 Article 13 of the Law on credit institutions. 60 Article 36 of the Law on credit institutions. 61 In the meaning of Article 5(2) and (3) of the Law on the markets in financial instruments. 62 Article 14(2) of the Law on credit institutions. 63 Ibid Article 16(2)
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revoke a banks licence for conducting investment services and activities and/or ancillary services, if the BGFSA has requested this in a reasoned proposal 64 .
NCB involvement in ongoing supervision Jurisdictions where banking supervision is exercised by the NCB In Bulgaria, the BG- NCB is the authority competent to exercise supervision over banks to ensure the observance of law, the sound and safe management of banks and the risks they are or may be exposed to, and the maintenance of own funds adequate to the risks 65 . The BG-NCB is entitled to require information from banks and their shareholders, as well as from parent companies and bank subsidiaries when conducting supervision on a consolidated basis, and carry out on-site inspections 66 .On-site inspections may be carried out jointly with employees of the BG-FSA or other competent authorities 67 . The BG-FSA may ask the BG-NCB to perform target inspections on banks and provide it with the results, subject to the requirements of banking and commercial confidentiality. 68
J urisdictions where banking supervision is exercised by the NCB In Bulgaria, Article 103(2) of the Law on credit institutions lays down a number of supervisory measures that the BG-NCB may apply. If a bank acts as an investment intermediary and/or depository, under certain circumstances, the BG-FSA Deputy Chairperson may propose to the BG-NCB that it should apply those measures 69 .Furthermore, the BG-NCB may also impose pecuniary sanctions on entities and individuals for: (i) breach of the Law on credit institutions and implementing acts and (ii) dissemination of untrue information or facts concerning any bank, detrimental to the reputation and credibility of that bank. 70
XV. ROLE OF CURRENCY BOARD IN BULGARIAS STABILIZATION After several failed stabilization attempts, Bulgaria introduced a currency board on July 1, 1997. Controversial and difficult to implement because of Bulgaria's serious structural
64 Article 103(8) of the Law on credit institutions. 65 Article 79 of the Law on credit institutions. 66 The BG-NCBs competences in the area of ongoing supervision are listed in Article 79 et seq. of the Law on credit institutions. 67 Article 80(5) of the Law on credit institutions and point 9 of Article 17(1) of the Law on the BG-FSA. 68 Article 18(7) of the Law on the BG-FSA. 69 point 5 of Article 15(1) of the Law on the BG-FSA. 70 Article 152 of the Law on credit institutions.
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problems, the currency board has been a crucial factor in the success of the country's latest stabilization program. Combining a traditional, rule-based exchange arrange-ment with legal and structural measures that addressed pressing banking sector and fiscal issues, it was well designed for the task at handcredible but flexible enough to allow Bulgaria to tackle a systemic banking crisis. 71
I nitial conditions In late 1996, Bulgaria was in the midst of a banking crisis and entering a period of hyperinflation. Support for the government was declining and popular protest calling for new elections was widespread. In view of the failure of the country's earlier stabilization programs, a perception was developing that, to be credible, a renewed stabilization attempt would require a visible, rule-based system, such as a currency board. Nevertheless, the economic and financial problems confronting Bulgaria seemed insurmountable at first.
Macroeconomic and structural setting The depth of the macroeconomic crisis was daunting. On an annual basis, inflation had soared to almost 500 percent in January 1997 and surpassed 2,000 percent in March. The causes of the rapid acceleration of inflation included liquidity injections to support the country's weakening banking system, continued central bank financing of the budget deficit, andincreasingly importantfaltering confidence in the Bulgarian lev, which reduced domestic money demand. In an effort to soften the currency's depreciationfrom lev 487 to lev 1,588 per US$1 in the first quarter of 1997the central bank depleted its international reserves; remaining reserves covered less than two months of imports. At the same time, falling output and growing tax evasion caused tax revenues to plummet, from almost 40 percent of GDP (annualized) to 14.7 percent of GDP in February 1997. To finance the fiscal deficit, the government issued treasury bills with successively shorter maturities and higher interest rates. Real output, this had grown in 1994 and 1995, contracted by more than 10 percent during 1996. 72
Structural problems were equally severe. A banking crisis had been smouldering since at least 1995. A 1996 review found that out of 10 state banks, which accounted for more than 80
71 http://www.imf.org/external/pubs/ft/fandd/1999/09/gulde.htm 72 Finance and Development, A quarterly magazine by International Monetory Fund, September 1999, vol 36, No. 3, http://www.imf.org/external/pubs/ft/fandd/1999/09/gulde.htm
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percent of banking sector assets, 9 had negative capital, and more than half of the state banks' portfolios were nonperforming. Half of the private banks, including the country's largest and best known, were also technically bankrupt. Rumours about the state of the banking sector led to several runs on banks. A first round of bank closures in May 1996 was limited to a subset of the institutions known to be weak and was therefore not sufficient to restore confidence in the banking sector. The situation continued to deteriorate, and the Bulgarian National Bank (BNB) placed nine more banks in conservatorship in September 1996. In all, banks accounting for about one-third of Bulgaria's banking system had been shut down. The BNB announced that this second round of closings would be the last and that it would keep remaining banks open. Thus, when banking sector problems intensified, the BNB's hands were tied; it reacted by injecting liquidity through its Lombard window and repurchasing government bondsactions that fuelled inflation. 73
Policy discussions and constraints There was growing awareness that a visible and credible departure from past policies would be necessary to restore any semblance of normality to the economy. In addition, stabilization would require measures to prevent financial indiscipline, reduce the government's overwhelming debt-service burden, and increase the lev's attractiveness, as well as strong official commitment to reforms and widespread public support. In November 1996, an IMF mission initiated the first discussion with the Bulgarian authorities and major interest groupsincluding all political parties and trade unions, foreign donors, journalists, and academicson the merits of a currency board. The idea aroused considerable debate. 74
Critics did not dispute the potential advantages of a currency board arrangement but argued that Bulgaria did not meet the necessary preconditions. Most important, Bulgaria's banking sector was bigger and plagued with more problems than the banking sectors of most other countries that had adopted currency boards, and the need for lender-of-last-resort lending could not be ruled out. In addition, temporary access to central bank overdrafts was thought to be necessary to deal with strong seasonal fluctuations in fiscal revenues and to cover the redemption of bond issues. Finally, international reserves were low and a currency board might require a large up-front devaluation. 75
73 Ibid 74 Annie Marie Gulde,The role of Currency Board in Bulgarian Stabilization, http://www.imf.org/external/pubs/ft/fandd/1999/09/gulde.htm 75 Id
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XVI. BULGARIAN LOAN MARKET The Bulgarian economy progressed phenomenally in the years prior to the global financial crisis, which hardly hit it. In the five-year period ending in 2008, GDP expanded by a hefty rate of 6% per year in real terms, while financial intermediation deepened with double-digit growth rates yearly. Bank lending was one of the factors for the outpacing economic growth in Bulgaria, as it has been confirmed by Stattev (2009). The outstanding bank loan growth was triggered by foreign capital inflows, aggressive lending of commercial banks, galloping exports and strong internal aggregate demand. However, inflation, current account and external debt ballooned, signalling for an overheating economy and for an internal and external imbalances formation. The global financial crisis revealed this economic weakness in 2009 in the slumping external demand and capital outflows, and in the plummeting the foreign direct investments and increased risk aversion of economic agents. Economic recovery remained modest in the following years to the end of 2012. Deteriorating economic activity led to a rapid growth of non-performing loans. Banks became more demanding on their existing and potential customers, and intensified on accumulating capital and liquidity buffers. XVII. GENERAL ECONOMY DYNAMICS OF BULGARIA The open economy of Bulgaria went through a period of impressive economic growth since the beginning of the millennium until the onset of the crisis in late 2008, when the international conjuncture sharply deteriorated. In the 2008-2012 period, the Bulgarian economy viability was put under a tremendous hardship. 76 A complex symbiosis between different factors, that are largely interconnected, contributed to the outstripping pace of economic growth until the beginning of the crisis (4th quarter of 2008). Among the important factors are: 1) the stability of the local currency and that of the financial system, both backed by the currency board arrangement (CBA) and by the conservative monetary and supervisory policies of Bulgarian National Bank; 2) bank privatization and the accompanying transfer of know-how and innovation; 3) the lending activity of commercial banks; 4) the succession of fiscal policy of budget surpluses; 5) foreign direct investments; 6) domestic and foreign aggregate demand; 7) EU membership and the related synchronizing of legislation and
76 Blundell-Wignall, A. and M. Gizycki, 1992. Credit Supply and Demand and the Australian Economy, Research Discussion Paper, No. 9208, Reserve Bank of Australia.
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institutions; 8) favourable international conditions; and other factors. Of course, such rapid development in the pre-crisis period brought about some side effects, such as the formation of internal and external economic imbalances. Growth was accompanied by high inflation, unsustainable large current account deficits and rapidly increasing external and internal indebtedness. As a result of the crisis this tendency changed diametrically, that is to say there was a process of deleverage and imbalances clearance. 77
In the five-year period ending in 2008, growth intensified. GDP grew on average by 6.4 % per year (compound annual growth rate), exceeding considerably the economic growth rate in the developed world. In the subsequent period, from late 2008 to the end of 2012, GDP at constant prices decreased by 0.7% annually. During the worst crisis year for the Bulgarian economy in 2009 GDP shrank by 5.5%. The 2009 slump was experienced by all aggregate expenditures components, but the largest contribution to the economic downturn was the collapse of exports (decreased by 11.2% year on year in real terms) and the fall in gross fixed capital formation (shrinking by 17.6%). The economy recovered by 0.2% in 2010, by 1.8% in 2011, with external demand contributing the most to this overall weak economic revival. In 2012 economic growth dropped to 0.8%, triggered mostly by the pickup in consumption and changes in inventories. 78
In the period between 2004 and 2008, the harmonized index of consumer prices (HICP) rose by 8 % annually (CAGR), and in the 2008-2012 period price increase rates fell to an average rate of 2.8 % per year. However, the decline in domestic demand during the 2008-2012 period reduced inflation. In the second period major contributors to price index increase were the goods and services with administered prices, food and energy products, with HICP converging to the EU average values in the period. XVIII. BANK LOANS AND FACTORS OF CREDIT SUPPLY (DYNAMICS) IN BULGARIA The financial sector, which is dominated by the banking sector in Bulgaria, is in complex relationships with the real economy. Studies with high probability prove that money is not neutral and that the dynamics of the financial sector is at once a consequence of and a factor for economic growth. Empirically verified in the work of Stattev (2009) is that in Bulgaria there is a two-sided causality between the real economy and the financial sector. Rapid
77 Demirguc-Kunt, A. and H. Huizinga, 1998. Determinants of Commercial Bank Interest margins and profitability-Some International Evidence, The World Bank. 78 Tschoegl, A., 2003. Financial Crises and the Presence of Foreign Banks, The Wharton School of the University of Pennsylvania.
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economic growth in the period between 2004 and 2008 was accompanied by even faster growth rate of bank loans to non-financial companies and households. During the period cumulative loans increased on average by 37.7% per year (geometric mean), however, measured as a ratio between bank loans and GDP the growth rate, they amounted to 18.9 % annually. Erdinc has described the rapid credit growth in Bulgaria and Romania in the 1999- 2006 period as a catching-up process. 79 On the other hand, rapid credit growth can be seen as a reason for the formation of imbalances, which at some point materialize and challenge the financial system and the economy as a whole. In this vein is the study of Duenwald et al. (2005), which analyzes the credit boom in Bulgaria, Romania and Ukraine. 80 Using a database of various banking crises, authors conclude that in the five years before the positive trend in the financial sector and the economy abruptly changed the bank loans to GDP increased on average by 5.2 % per year, upon which a fast decline of the rate of change, or even a decline in the ratio started. Rapid credit growth leads to macroeconomic imbalances and further deterioration in credit quality (see ibid.). The loans to GDP ratio in Bulgaria started to decline after 2009, albeit at a paltry pace, on the assumption that the imbalances formed during the catching-up process are in a process of clearance, i.e. a process of deleverage was underway. In the 2008-2012 period bank loans in Bulgaria increased in nominal terms by 2.7% annually, while the ratio between loans and GDP decreased by 0.2% annually, prompted by faster growth of the nominal value of the denominator. Loans in the Bulgarian banking system managed to increase in nominal terms, even in a period which was the most unfavorable for the Bulgarian economy year. Loan growth in 2009, however is due largely to the past net purchase of credits granted by commercial banks, which amounted to BGN 1.5 billion. Over the next three years the net amount of loans increased more slowly because commercial banks sold loans, stripping from their gross loans holding. 81 Microfinance institutions (MFIs) perform a crucial function of facilitating financial inclusion goals in developing countries through the provision of micro- finance services. Micro-finance services include: (a) micro-credit facilities to the extent of 05 lac [or 10lac if so specified by the Reserve Bank of India (RBI)]; (b) the collection of thrift;
79 Erdin, D., 2009. From credit crunch to credit boom: transitional challenges in Bulgarian banking, 1999 2006, PRA Paper 10735, University Library of Munich, Germany 80 Duenwald, C., N. Gueorguiev and A. Schaechter, 2005. Too Much of a Good Thing? Credit Booms in Transition Economies: The Cases of Bulgaria, Romania, and Ukraine, IMF Working Paper, No. 05/128. 81 Duenwald, C., N. Gueorguiev and A. Schaechter, 2005. Too Much of a Good Thing? Credit Booms in Transition Economies: The Cases of Bulgaria, Romania, and Ukraine, IMF Working Paper, No. 05/128.
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(c) pension; (d) insurance services; and (d) the remittance of funds to individuals within India subject to prior approval by the RBI. XIX. COMPARISON WITH INDIAN MICRO FINANCING MARKET MFIs in India have grown tremendously in terms of size, outreach, and financial maturity since their emergence in the 1980s. Recent RBI reports with regard to microfinance activities state that alongside self-help group (SHG)-bank linkage programmes, MFIs, such as non- government organisations (NGOs) and non-banking finance companies (NBFCs) have emerged as important sources of microfinance delivery in India. Consequently, incentives have been provided for penetration of banking into unbanked areas and encouraging MFIs as intermediaries. However, the growth of the MFIs has been geographically disproportionate. The Malegam Committee report noted that distribution of microfinance penetration is more than half of the total MFI portfolio of India in the Southern region while the Eastern region has over one fourth of the total MFI portfolio. This briefing paper presents a picture of the regulatory instruments governing different microfinance entities in the country. Specific features of regulation of NBFC-MFIs, and the current state of the conflict between State Money Lending institution actors and the RBI has been captured. 82
Legal Structure of MFI s A microfinance institution under the Microfinance Institutions (Development and Regulation) Bill, 2012 includes the following entities: (a) a society registered under the Societies Registration Act, 1860; (b) a company registered under section 3 of the Companies Act, 1956; (c) a trust established under any law for the time being in force; (d) a body corporate; or (e) any other organisation, which may be specified by the RBI if the object of the institution is the provision of microfinance services. It does not include a banking company, co-operative societies engaged primarily in agricultural operations or industrial activities or any individual who carries on the activity of money-lending and is registered as a moneylender under the provision of any State law. A MFI in India acquires permission to lend through registration (Table 1 provides details of the registration requirements). MFIs are registered as one of the following five types of entities:
82 Acharya, V.V., 2012. Governments as shadow banks: the looming threat to financial stability. Texas Law Review 90 (7), 17451774.
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1. Non-Government Organisations engaged in microfinance (NGO MFIs), comprising of Societies and Trusts; 2. Cooperatives registered under the conventional state-level cooperative acts, the national level Multi-State Cooperative Societies Act (MSCA 2002), or under the new State-level Mutually Aided Cooperative Societies Act (MACS Act); 3. Section 25 Companies (not-for profit); 4. For-profit NBFCs; and 5. NBFC-MFIs. Contributions by NBFIs and Banks Financial institutions, including banks and non-banks, provide some or all of the following core financial services. These services are often provided in combinations: 1. Some financial institutions provide payments services by issuing claims that have the capacity to be used in settling transactions. To serve as an effective means of payments, a claim must have a highly stable and reliable value, be widely accepted in exchange and must be linked to the arrangements for ultimate settlement of value. 83
2. Liquidity is the ease with which an assets full market value can be realized once a decision to sell has been made. Financial institutions enhance liquidity through specialization and scale. 3. Divisibility - Divisibility is the extent to which an asset can be traded in small denominations. Financial institutions break up large denomination (lumpy) claims and aggregate small denomination claims to meet divisibility preferences of the community. 4. Store of value is the extent to which an asset provides a reliable store of purchasing power over time this is fundamental to satisfying savings preferences. 5. Information is costly to access and process. Providing economies of scale in processing and assessing risks is an important role of financial institutions.
83 Claessens, Stijn, Pozsar, Zoltan, Ratnovski, Lev, Singh, Manmohan, 2013. Shadow Banking: Economics and Policy. Working Paper. International Monetary Fund
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6. Risk pooling is the extent to which an asset spreads the default risk of the underlying promises by pooling. By pooling assets, financial institutions have much more scope to risk pool than do individuals. Banks provide an attractive bundle of most of the core financial services in their deposit product: Ability to write cheques on deposits means that banks offer payments services and liquidity equal to that of currency. Deposits also offer exceptionally high divisibility (at least to the same level as currency). The store of value service is that of a debt promise in that deposits promise repayment at (nominal) face value plus interest. Banks resolve the information conflict faced by borrowers and generally enjoy substantial economies of scale in processing and analyzing information. Finally, banks risk pool borrowers promises into a single promise by the intermediary itself. Bank NBFC linkages in I ndia The RBI classifies the commercial banks in India into five categories: 1) The SBI Group; 2) Nationalized Banks; 3) New Private Banks; 4) Old Private Banks; 5) Foreign Banks. 84
As of 2012 year-end, the size of the total assets of the Indian commercial banks was above 80 Trillion Rupees. The Nationalized Bank Group is the largest bank group by assets (about 50% of total bank assets), followed by the SBI Group (about 21%), New Private Bank Group (about 15%), Foreign Bank Group (about 8%) and Old Private Bank Group (about 5%), in that order. The SBI Groups consists of the State Bank of India (SBI) and its current five
84 For definitions of the NBFC types, for example, see: http://www.rbi.org.in/scripts/FAQView.aspx?Id71
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associates. The Nationalized Bank Group consists of 20 formerly private commercial banks, 14 of which were nationalized during the first bank nationalization of 1969 while the remaining 6 of which were nationalized during the second bank nationalization of 1980. The Old Private Bank Group consists of 14 private banks, which were not nationalized at the time of bank nationalizations of 1969 and 1980, while the New Private Bank Group consists of 7 banks, which were established after the 1993 amendment which followed the 1991 Indian economic liberalization reforms to the Indian Banking Act, which permitted the entry of new private banks into Indian banking sector. Lastly, the Foreign Bank Group currently consists of 36 foreign banks either operating themselves or having their branches in India. Both domestic and foreign banks are subject to priority sector lending requirements, and the priority sector lending requirement is 40% for domestic banks and 32% for foreign banks of their adjusted net credit 85 as of December 2012. One of the important aspects of the 2006 NBFC supervisory framework was the introduced capital adequacy requirement. The systemically important non-deposit taking NBFCs were required to maintain a capital to risk-weighted asset ratio (CRAR) of 10% while the CRAR requirement for the deposit taking NBFCs was left at 12% or 15%, as the case may be, depending on their types by function. This CRAR requirement was later increased to 12% to be effective as of March 2011 and to 15% to be effective as of March 2012. Hence, in terms of capital requirements, unlike the typical shadow banks in other parts of the world, the Indian NBFCs are tightly regulated. This fact alone calls into question, whether it is appropriate to consider the Indian NBFCs as shadow banks or not. Nevertheless, the fact that these NBFCs are non-banks as far as investor perceptions are concerned (for example, concerning the extent of central bank support and government guarantees), but that they borrow heavily from banks makes them interesting for studying what economic purpose are they fulfilling and how shadow banking and banking in emerging markets are potentially intertwined. Difference between Banks and NBFI s in I ndia NBFCs are doing functions akin to that of banks, however there are a few differences: (i) a NBFC cannot accept demand deposits;
85 Adjusted net bank credit is net bank credit plus the investments made by banks in held-to-maturity bonds which are not to meet the RBI liquidity requirements or it is the credit equivalent of off-balance-sheet exposures, whichever is higher
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(ii) it is not a part of the payment and settlement system and as such cannot issue cheques to its customers; and (iii) deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation (DICGC) is not available for NBFC depositors unlike in case of banks. In Southern Technologies limited v. JCIT, 86 on 11th January 2010, the Supreme Court held that the business operations of NBFCs and banks are quite different. NBFCs accept deposits from the public for which transparency is the key; hence, we have RBI directions/norms. On the other hand, for banks, weightage must be placed on liquidity. These two concepts, namely, risk and liquidity brings out the basic difference between NBFCs and banks, the Bench added. 1. Inefficiency of Banks In principle, there is no reason why banks cant provide all services indeed to an extent they do. However they are extremely inefficient in providing some services and even face conflicting incentives in providing all services. In short, the way in which banks provide their core services means that they cannot provide all services equally efficiently. In order to provide certainty of value for payments, bank deposits must be low risk. This limits the range and nature of assets that banks can hold on the asset side of their balance sheets and thereby the extent to which they can offer risk pooling. It also limits their ability to offer a wide range of store of value services, especially equity type stores of value services. More generally, NBFIs play a range of roles that are not suitable to banks: through the enhancement of equity promises (adding liquidity, divisibility, informational efficiencies and risk pooling services), NBFIs broaden the spectrum of risks available to investors; in this way they encourage investment and savings and improve the efficiency of investment and savings; through the provision of contingent promises they foster a risk management culture by encouraging those who are least able to bear risk to sell those risks to those better able to manage them; and
they can enhance the resilience of the financial system to economic shocks NBFIs complement banks by providing services that are not well suited to banks andthey fill the gaps in financial services that otherwise occur in bank-based financial systems. 2. Serve as Competition for Banks Equally important, NBFIs provide competition for banks in the provision of financial services. NBFIs unbundle bank services and compete with them as providers. They specialize in particular sectors and target particular groups. 3. Economic Development There is a growing body of hard evidence to suggest that: The development of financial intermediaries contributes strongly to economic growth; That contribution is increased where intermediation is provided through a balanced combination of NBFIs and banks in particular, there is a strong correlation between the depth and activeness of non-banks and stock markets on the one hand, and economic development on the other. In the first place, banks offer assets (deposits) that claim to be capital certain. If this promise is to be honored, then there must be limits to the range and nature of assets that a bank can reasonably take on to its balance sheets. Notwithstanding the existence of universal banking in many parts of the world (i.e., banks also engaged in securities market activities), this consideration implies that bank-based financial system will tend to have a smaller range of equity-type assets than those with a more broadly based structure including a wide range of NBFIs. More generally, NBFIs play range of roles that are not suitable for banks and through their provision of liquidity, divisibility, informational efficiencies, and risk pooling services, they broaden the spectrum of risks available to investors. In this way, they encourage and improve the efficiency of investment and savings. Through the provision of a broader range of financial instruments, they are able to foster a risk management culture by attracting customers who are least able to bear risks and fill the gaps in financial services that otherwise occur in bank-based financial systems. 4. Financial Stability In a financial sector in which NBFIs are comparatively undeveloped, banks will inevitably be required to assume risks that otherwise might be borne by the stock market, collective
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investment schemes or insurance companies. However, there is basic incompatibility between the kinds of financial contracts offered by the banks and those offered by the financial institutions. Thus, banks are more likely to fail as a result. One way of minimizing financial fragility in the developing economies may be to encourage a diversity of financial markets and institutions, where investors are able to assume a variety of risks outside the banking system itself. Without this diversity, there is a tendency for all risks to be bundled within the balance sheet of the banking system, which may lead to severe financial crises more likely. This point was widely noted by policymakers in their analysis of the lessons of the Asian currency crisis, for instance. As Alan Greenspan (1999) pointed out, the impact of the currency crisis in Thailand might have been significantly less severe if some of the risks borne by the Thai banks had instead been borne by the capital markets. 87
Leasing in Bulgaria According to the Bulgarian law, there are two types of leasing: operating and financial. Any company may act as leasing company (lessor). There are no licensing requirements. According to the Law on Banks, such a company should be registered with the BNB as a non-bank financial institution. In 2001, 25 leasing companies were registered. But, there are also companies operating as leasing companies without being registered with BNB. Their number is difficult to estimate. Currently, there is no legal base for control of the leasing companies activities. The main advantage of leasing is the less complicated appraisal procedures: the time for evaluation of an application and signing the contract takes on average half as long as the completion and approval of loan applications. Usually, the lessee must make a down-payment of 30%, but no additional collateral is required. Leased assets are usually insured against the most common risks such as fire and theft. Banks are avoiding leasing as a form of financing. This is partly due to the unfavourable tax treatment since leasing is VAT taxable. Moreover, important impediments for repossession of the leased item exist in Bulgaria. In case of default, the lessor cannot foreclose on the asset if the lessee does not agree. Repossession in case of default requires action by the local police backed by a court order. Local courts do not
always fully understand the principles of leasing which puts timely repossession at risk. This reduces the incentives for financial institutions to offer leasing. Moreover, supply chain and support structures (repair shops, spare parts, etc.) are not always readily available. This increases the risk of default due to breakdown of leased equipment and of accelerated depreciation due to lack of proper maintenance. Finally, as mentioned above, markets for second-hand machinery are limited. Here the Non Banking financing Institutions come into picture. XX. CONCLUSION Our study indicates that bank loans have a significant positive effect on most performance indicators of micro, small and medium sized enterprises (MSMEs) in the transition economies. In particular, exit rates related to cessation of business are higher for companies that did not benefit from European Bank for Reconstruction and Development (EBRD) loans (even though they may have benefited from non-EBRD loans) than for companies that benefited from EBRD loans. The fiscal reserve is an integral part of Bulgarias policy framework that has served Bulgaria well. In practice, it has a stabilizing backstop financing function which, in uncertain times, may imply actively using its resources. Its size should be increased through the saving of privatization proceeds and fiscal over performance and over the longer-term through fiscal savings as output strengthens. Its purposes, including as a buffer for aging, are somewhat unclear and should be further examined to ensure that the FRA is appropriately structured and financed to meet its multiple objectives. As might be expected, the effect of loans on the performance indicators varies somewhat across countries and further country-specific analyses will be useful. Moreover, we find that many of the effects do not vary with the size of the loan and that some loans may be too big in the sense that they bring about a diminishing return or even decline in performance. This finding deserves further study as it indicates that the absorptive capacity of MSMEs may need to be more carefully taken into account. In terms of determinants of loans, we confirm in the transition economy context that prior credit (loan) history is an important determinant of the ability of firms to obtain subsequent loans from the same provider but not from different providers. The (older) age of the firm, the adoption of international accounting standards and having a male CEO increase the probability of receiving credit from a non-
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EBRD provider. In terms of determinants of the size of EBRD loans what matters is the past credit history and having adopted international accounting standards. The authorities are fully aware that sustainable economic growth requires further structural reforms. They remain committed to provide strong financial footing to the pension, healthcare, education and railroad transportation systems. In compliance with the recommendations from the European Commissions and the IMF to accelerate pension reform, a more comprehensive package of policy measures became effective from January 1, 2012. A procedure to privatize the state railroad cargo company has been re-launched. Progress with other reforms, however, has been limited or is lagging behind due to a combination of factors like unfavorable market conditions, insufficient institutional capacity, and constrained financial resources.