Document of THE WORLD BANK Report No. 25374-BUL INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED PROGRAMMATIC ADJUSTMENT LOAN IN THE AMOUNT OF US$150.0 MILLION EQUIVALENT TO THE REPUBLIC OF BULGARIA January 23, 2003 Currency Equivalent (Exchange Rate Effective as of January 10, 2003) Currency Unit = Bulgarian Lev (BGN) US$ 1.00 = BGN 1.86216 Government Fiscal Year January 1 - December 31 Weirihts and Measurements Metric System Abbreviations and Acronyms ALMP Active Labor Market Policy GDP Gross Domestic Product ARCS Administrative and Regulatory Cost GMI Guaranteed Minimum Income Survey ASAL Agriculture Sector Adjustment Loan GEF Global Environment Fund BDZ State Railway Company IFI International Financial Institution BNB Bulgarian National Bank IMF International Monetary Fund BNSC Bulgarian National Securities Commission ISA Insurance Supervision Agency BoP Balance of Payments IPPC Integrated Pollution Prevention Control BTC Bulgarian Telecommunications Company MPG Millennium Development Goals CAP Common Agricultural Policy MEER Ministry of Energy and Energy Resources CAS Country Assistance Strategy MES Ministry of Education and Sciences CBA Currency Board Arrangement MoH Ministry of Health CEE Central and Eastern Europe MoLSP Ministry of Labor and Social Policy CoM Council of Mmisters NEK National Electricity Company CRC Communications Regulatory Commission NHIF National Health Insurance Fund DH District Heating NSSI National Social Security Institute DSK State Savings Bank OECD Organization for Economic Cooperation and Development DZI State Insurance Company PA Privatization Agency EBRD European Bank for Reconstruction and PAL Programmatic Adjustment Loan Development ECA Europe and Central Asia PSO Public Service Obligation EEEA Energy and Energy Efficiency Act RWC Regional Water Company EPSAL Environment Protection Structural SBA Stand By Arrangement Adjustment Loan EC European Commnission SERC State Energy Regulatory Commission EU European Union SISA State Insurance Supervision Agency FESAL Finance and Enterprise Structural SME Small and Medium Enterprise Adjustment Loan FDI Foreign Direct Investment SOE State Owned Enterprise FRA Fiscal Reserve Account SPAL Social Protection Adjustment Loan FSAP Financial Sector Assessment Program USAID United States Agency for International Development Vice President: Johannes F. Linn Country Director: Andrew N. Vorkink Sector Director: Paul Siegelbaum Sector Manager: Yasuo Izumi Team Leader: Albert F. Martinez TABLE OF CONTENTS LOAN AND PROGRAM SUMMARY ........................................................;i A. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS ............................................1 Background .........................................................1 Medium Term Prospects and Creditworthiness ......................................................... 5 Addressing Poverty .........................................................9 B. The Reform Program ........................................................ 11 Objectives and Strategic Themes ........................................................ 11 Pillar 1: Sustaining Structural Reforms .......................... .............................. 14 Pillar 2: Establishing a Market-friendly Business Enviromnent ................................... 17 Pillar 3: Deepening the Financial System ........................................................ 20 Pillar 4: Improving Public Sector Governance ........................................................ 21 Pillar 5: Investing in Human Capital and Strengthening Social Programs ................... 22 C. BANK GROUP STRATEGY ........................................................ 24 Country Assistance Strategy ........................................................ 24 Cooperation with the IMF ........................................................ 25 Coordination with Donors ........................................................ 25 D. THE PROPOSED LOAN ........................................................ 26 Program Design ........................................................ 26 Actions Taken Prior to Board Presentation ........................................... ............. 27 Medium Term Actions and Triggers for Future PALs ................................................. 30 Implementation and Monitoring ........................................................ 32 Loan Administration ........................................................ 33 Benefits and Risks ........................................................ 33 TABLES, FIGURES AND BOXES Table 1: Selected Economic Indicators .........................................................2 Figure 1: Real GDP ........................................................6 Figure 2: CPI Inflation .........................................................6 Figure 3: Fiscal Balance ........................................................6 Figure 4: Current Account Balance ........................................................6 Figure 5: Unemployment .........................................................6 Figure 6: FDI Flows .........................................................6 Figure 7: Ownership Structure of Bank Assets ........................................................ 20 Box 1: Recent Poverty Trends and the Poverty Gap . ........................................................ 0 Box 2: The Medium Term Program and the Millennium Development Goals ............................. 12 Box 3: The Quality of Public Infrastructure: What do Firms Say? ............................................... 15 Box 4: Recent Labor Market Developments ........................................................ 19 ANNEXES Annex 1. Bulgaria at a Glance Annex 2. Bulgaria Social Indicators Annex 3. Selected Indicators Table Annex 4. Key Exposure Indicators Annex 5. Letter of Development Policy Annex 6. Performance Benchmarks Annex 6-A List of Companies Not Included in the Pnvatization Program Annex 6-B Large State-owned Enterprises/Banks to be Privatized or Liquidated in PAL-2 and PAL-3 Annex 6-C District Heating Reform Annex 6-D Telecommunications Liberalization Implementation Commitments Annex 7. An Update on Poverty Annex 8 IMF-World Bank Relations REPUBLIC OF BULGARIA PROGRAMMATIC ADJUSTMENT LOAN LOAN AND PROGRAM SUMMARY Borrower: Republic of Bulgana Amount: US$150 million equivalent to be disbursed in Euro Terms: Fixed Spread Loan (FSL) in Euro with 16 years maturity including six years grace period Commitment Fee: 0.85% on undisbursed balances for the first four years and 0.75% thereafter Front end Fee: 1% on principal amount Objectives and The proposed PAL supports the Government's medium term program Description: whose main objectives are the achievement of average annual growth rates of 4.5-5.0% dunng 2002-05, the reduction of the poverty rate by half by 2005 compared to 2001, the reduction of the unemployment rate from 17.5% in 2001 to 12-14% in 2005, and substantial progress towards EU accession. The medium term program is designed around a two pronged strategy of private sector-led growth and empowerment to ensure wide participation in growth. The program is built on five complementary pillars: * Sustaining structural reforms in the enterprise sector with emphasis on the restructunng of the energy, railway, telecommunications, and water sectors; * Establishing a market-friendly business environment, focusmg on entry and exit policies, regulatory costs, delivery of public services, competition, and judicial reform; * Deepening the financial sector, addressing the constraints to increased lending by the banking system and the development of financial markets; * Improving public sector governance, including implementing the anti-corruption strategy, strengthening local governments, and reforming public administration and the judiciary; * Investing in human capital and strengthening social programs, focusing on education, health, and pension reforms and social assistance effectiveness. A Letter of Development Policy prepared by the authonties descnbes the medium term program and is attached to this Report. Benefits: First, the proposed PAL assists a new government define a medium term economic program that achieves sustained growth, poverty reduction, and progress towards EU accession. Second, the proposed PAL helps put in place mechanisms and institutional arrangements that would ensure successful implementation, coordination, monitonng, and i evaluation of the medium term program. Third, the proposed PAL lays the groundwork for future PALs by creating the framework and identifying future critical actions to be supported by future operations. Fourth, the proposed PAL complements the current and planned investment projects by establishing the enabling policy framework, especially in the social sector. Fifth, the program supported by the loan complements and reinforces the IMF program. Risks: First, there is implementationm risk given the current weaknesses in institutional capacity which the PALs seek to correct. To address implementation risk, the Government activated the Council for Structural Policy to improve coordination, is implementing institutional strengthening programs for critical offices and agencies, and is improving donor coordination to align donor funded technical assistance with program priorities. In addition, PAL-2 will focus on upgrading public administration, which will address government capacity to design and implement reform. Current and planned investment projects in the health, education, energy, and water sectors, revenue administration, cadastre, and environment complement the PALs by providing implementation support. Second, politica riisk remains high, with the possibility of poRicy slippages. Coalition building in support of many of the socially difficult reforms may run into resistance especially if unemployment remains high and anti-corruption efforts fail to improve perception. Implementing difficult structural reforms with accompanying improved targeting of social programs and well designed communications strategy mitigates the political risk. This was the case when electncity prices were recently increased by 20 percent - the implementation of an accompanying winter energy support program and a consultation process prevented a political backlash. More generally, the social protection and assistance pillar of the reform program would alleviate the adverse impact of the difficult structural reforms while the business environment pillar would expand opportunities for employment. In addition, strong support by all political parties for Bulgaria's EU accession and NATO membership is effectively anchoring the direction of macroeconomic and structural reforms. Third, there may be shocks coming from the external environment, jeopardizing macroeconomic stability. Bulgaria faces several significant extemal risks. A failure to carry out the envisaged privatization program or attract sufficient greenfield FDI would put the projected extemal financing at risk, requiring additional adjustment to ensure that debt levels continue to decline. Moreover, Bulgaria's external accounts are more sensitive to three key parameters: an increase in oil prices, higher interest rates, and a prolonged slowdown in EU economies which are the destination of over fifty percent of Bulgarian exports and the origin of more than half the FDI inflows. However, the achievements to date, the better than expected performance in the last several months of 2002, and the active efforts to restructure and reduce extemal debt enabled Bulgaria to manage ii external risks. Continued maintenance of strict discipline in macroeconomic management, the measures in place to respond to potential risks, and acceleration of structural reforms substantially mitigate these risks. Schedule of Disbursement: US$150 million equivalent in Euro upon loan effectiveness Poverty Category: Not Applicable Rate of Return: Not Applicable Project ID Number: PE-P06705 1 Map: This operation was prepared by the Bulgaria Country Team which mcludes: Albert Martmez, task manager (ECSPF); Istvan Dobozi, Sudipto Sarkar, Jean-Charles Crochet, Varadarajan Atur (ECSIE); David Satola (LEGPS); Henry Gordon, Adriana Damnianova (ECSSD); Simeon Djankov (PSAIC); Luc Laeven (OPD); Rosalinda Quintanilla, Neil Parison, Joel Helhman (ECSPE); Hadi Abushakra (LEGMS); Sandor Sipos, Hermann von Gersdorff, Jan Rutkowski, Arvo Kuddo, Dena Ringold, Dominic Haazen, Enis Baris, Yael Duthilleul (ECSHD); Esperanza Lasagabaster (SASFP); Daria Goldstein, Irina Kichigina (LEGEC); Lada Strelkova, Doncho Barbalov, Boryana Gotcheva, Galia Kondova, Stella Ilieva, Peter Pojarski, Anna Georgieva, Blaga Djourdjin, Onik Karapchian, Maria Kalimerova (Bulgaria Country Office). Peer reviewers were Joseph Saba (MNC02) and Dimitri Vittas (OPD). Oscar de Bruyn Kops (ECCBG), van Roy Southworth, Nevena Alexieva, Myla Taylor Williams, Marina Burul-Sir, Antonia Koleva (ECCU5) provided support, advice and coordination. Anne John and Manuel Santiago (ECSPF) provided office support at Headquarters. IBRD PROGRAM DOCUMENT ON A PROPOSED PROGRAMMATIC ADJUSTMENT LOAN TO TIE REPUBLIC OF BULGARIA 1. I submit for your approval this Report and Recommendation on a proposed Programmatic Adjustment Loan (PAL) to the Republic of Bulgaria for US$150 million equivalent to support the Medium Term Reform Program of the Government of Bulgana (GoB). This loan is the first of three programmatic adjustment loans envisaged in the Country Assistance Strategy (CAS) discussed by the Board on May 9, 2002. This document and the accompanying Letter of Development Policy (LDP) discuss the three-year program. A. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS Background 2. The early years of transition were marked by slow and unsustained reform efforts.' Until 1997, Bulgaria was one of the poorest performing economies of Central and Eastem Europe (CEE). The preceding decade was marked by massive external borrowing, stop-go stabilization policies, and a slow pace of structural reforms. Fueled by a failure to establish market discipline, widespread rent-seeking, and the prevalence of soft budget constraints among enterprises, banks, and the Government budget, Bulgaria's problems culminated in a severe economic and financial cnsis m 1996-97, resulting in a cumulative decline of GDP by about 14 percent, a sharp decline in per capita income, and an increase in poverty. After several months of chaos involving a hyperinflation episode, the collapse of the banking sector, and a major foreign exchange crisis, Bulgana adopted in July 1997 a Currency Board Arrangement (CBA). 3. Bulgaria responded aggressively to the 1996-97 crisis. Following the general elections of April 1997 and the adoption of the CBA, Bulgana began implementing conservative fiscal policies and accelerated implementation of structural reforms. The wide-ranging structural program included implementation of reforms in the social, agriculture, enterprise and banking sectors, and liberalization of prnces and trade. By December 1999 when Bulgana was invited to start negotiations towards EU membership, its economy was largely stabilized, and growth and per capita income began to recover. This improved performance took place in a difficult external environment marked by turmoil in international markets, unfavorable commodity price developments, and trade disruptions associated with the Kosovo crisis. The current account deficit widened from 0.5 percent of GDP in 1998 to 5 percent in 1999 due to external pressures. At the same time Bulgaria faced a legacy of high indebtedness, low levels of investment, and rising unemployment. To address the combined effects of these challenges, Bulgaria accelerated implementation of structural reforms, expanded its social safety net to mitigate the impact of the transition, and maintained disciplined macroeconomic policies. After five years of sound macroeconomic management and acceleration of structural reforms, Bulgana soon succeeded in restoring growth, bringing down inflation, and improving public and investor confidence. ' See Bulgaria: Public Expenditure Issues and Directions for Reforn, The World Bank, 2002 and Bulgaria. The Dual Challenge of Transition and Accession, The World Bank, 2001. I Table 1: Selected Economic Indicators 1996 1997 1998 1999 2000 2001 2002P GNI per capita (Atlas method, 1,210 1,200 1,270 1,450 1,580 1,630 1,760 US$)__ _ _ _ _ _ Poverty rate 5.5' 36.0 12.8 Unemployment rate (registered) 11.0 14.0 12.4 13.8 18.1 17.5 Th78T Real GDP Growth (% change) -9.4 -5.6 4.0 2.3 5.4 4.0 4.0 CPI (e.o.p., % change) 311.6 547.7 1.6 7.0 11.3 4.8 3.8 Total revenues and grants' (% of GDP) 32.9 37.5 39.8 40.7 41.4 40.0 40.5 Total expenditure and net 43.2 38.6 38.8 41.7 42.4 40.8 41.3 lending (% of GDP) 3 Overall Fiscal Balance' (% of GDP) -10.3 -1.2 1.0 -0.9 -1.0 -0.9 -0.8 Current Account Balance (% of GDP) 1.7 10.1 -0.5 -5.0 -5.6 -6.1 -4.2 Extemal Debt (% of GDP) 97.0 100.4 85.5 84.3 88.9 78.3 70.3 Interest Payment (% of GDP) 19.5 8.3 4.3 3.8 4.0 3.7 2.2 Sources. National Statistical Institute, Bulgarian National Bank, Ministry of Finance, Employment Agency, IMF, and the World Bank. 'The estimate is for 1995. 2As of November 2002. 3Consolidated general govemment. In contrast to the estimates shown in Annex 3, revenues and expenditure include social contnbutions paid by the Govemment on behalf of government employees. For 2002 estimates are on the basis of the annual 2002 Budget Law. 4. The domestic financial sector has improved substantially in line with the resumption of growth in the real sector and strengthened banking supervision. Following the closure of 17 banks, consolidation of a number of banks, and privatization of almost all state-owned banks, mainly to foreign investors, the banking system was put back on solid ground. The recent Joint World Bank-IMF Financial Sector Assessment Program (FSAP) review2 concluded that Bulgaria's banking system - which is currently the main component of the financial system - is generally well supervised, highly capitalized, and profitable. However, the legacy of the deep banking crisis in 1996-97 has led to a more conservative lending policy by banks; interest rate spreads are high but declining; governance and asset and liability management capacity need further strengthening; and the deposit base remains low. As a result, bank intermediation has remained low compared to other CEE countries, and the non-bank financial sector has continued to be underdeveloped. However, after four successive years of economic growth, credit expansion, especially in retail banking, accelerated m 2001 and the first three quarters of 2002 driven by higher deposit growth, lower international interest rates on bank deposits abroad, and competition among commercial banks. 5. The economic recovery contributed to a reduction in poverty. Living standards have improved and overall poverty levels have declined by two-thirds since 1997. The economic crisis in 1997 seriously affected living standards, and poverty escalated to 36 percent of the population, according to the household survey conducted that year.3 Since then, poverty rates have declined significantly, to 12.8 percent in 2001 , as consumption levels have recovered from the shock of the cnsis. While the overall magnitude of the decline m poverty rates since 1997 may have been 2 A joint Bank-Fund Financial Sector Assessment Program (FSAP) mission visited Sofia in Novemnber 2001. The FSAP report was discussed with the authorities during the Fund Article IV rmission in May 2002. 3 Bulgarna: Poverty during the Transition, The World Bank, 1999. 4Bulgaria: Poverty Assessment, The World Bank, 2002. 2 less than two-thirds due to potential for measurement error in 1997 as a result of high inflation rates, there has been a notable improvement in living standards since the crisis. The depth and severity of poverty have also improved (see Box 1). These suggest that the penod of sustained economic growth between 1997 and 2001, as well the social safety net, have had an important impact on living standards. 6. Private sector development has been central in accelerating growth. The acceleration of privatization and restructuring of existing SOEs, together with the improvements in business environment and gradual decrease in tax burden, have contributed to the expansion of the private sector to 63 percent of GDP in 2001 compared to 53 percent in 1996. Although the private sector has been growing at about eight percent per annum since 1997, its share of GDP remains comparatively lower than the more advanced CEE countries. Much lower is the share of new enterpnses which could spur growth and help the economy reach its full potential.5 7. But growth has not been sufficiently high to reduce persistently high unemployment. Unemployment has been growing smce 1996, turning Bulgaria into the country with the highest registered unemployment rate among the EU accession countries - 18 percent in 2000, 17.5 percent in 2001, and a slight decline in 2002. Also, Bulgaria has the highest rate of youth and long-term unemployment. Registered job creation in the private sector has been lagging behind labor shedding, particularly in the enterprise sector. An over-regulated labor market,6 high payroll taxes, and the heavy burden of social contributions, together with skill mismatches, contribute to registered high unemployment in Bulgaria. While there are no mechanisms to measure directly employment outside the official registry, there is some indirect evidence that to minimize the heavy official costs on the use of labor, employers and workers are increasingly using mechanisms such as engaging in an employment relationship without labor contracts, or reporting labor wages at the level of minimum wage. 8. The external position has remained under pressure, although the external current account deficit has improved in 2002 compared to 2001. In 2001, the external current account deficit accounted for 6.1 percent of GDP dnven by strong domestic demand for imports, lower international prices, and global slowdown, including in the EU and Turkey, Bulgaria's main trade partners. FDI inflows of about 5.1 percent of GDP, together with the debut Euro bond issue in late 2001, provided for the bulk of the financing of the external current account deficit in 2001. Foreign exchange reserves remained at a comfortable level, covering about five months of imports of goods and services. The external current account deficit is expected to improve by close to 2 percentage points to about 4.2 percent of GDP in 2002 due to strong export growth driven by textiles, light manufacturng, and tourism, as well as by a slowdown in imports, especially of oil products. At the same time, external debt has declined by about 30 percentage points since 1997, to 68 percent of GDP at end-October 2002.' 9. Sound macroeconomic policies and continued progress on structural reforms are addressing current account imbalances and improving development prospects. Bulgaria's policy framework is centered on the CBA and supported by tight fiscal policy, strict incomes 5 See Transition* The First Ten Years, Analysis and Lessons for Eastern Europe and the Former Soviet Union, The World Bank, Washmngton D.C., 2002. 6 Rutkowski, J. , "Why Is Unemployment So High in Bulgana?", Background paper for the Bulgaria Poverty Assessment, forthcoming, The World Bank, Washington D.C., 2002. 7 External debt to GDP ratio declmned significantly due to a series of debt buybacks, debt exchanges, limited new borrowing and slow disbursement of projects m pipeline, as well as higher GDP growth and exchange rate adjustments. 3 policy and a broad agenda of structural reforms. Macroeconomic performance has been robust: Bulgaria has had a primary surplus of three percent of GDP and a fiscal deficit of one percent of GDP since 1999; the Fiscal Reserve Account (FRA) has remained at about 100 percent of next year's gross public debt service requirements; inflation has remained at single digit levels; mternational reserves have remained at about five months of imports; and growth has been between 4-5 percent per year. Total public debt, external and domestic, has declined substantially from over 100 percent in 1997 to around 70 percent of GDP in 2001 and the Government has stated its commitment to meet the Maastricht critenon8 prior to EU accession. As of end-October 2002, total public debt to GDP stood at 60.6 percent, of which 54 percent was external and 6.6 percent was domestic debt. 10. Provided the Government maintains fiscal discipline, sustains a strict incomes policy, and accelerates structural reforms, the CBA provides a stable nominal anchor and facilitates the political economy of reform. Prudent macroeconomic policies and implementation of structural reforms have contributed to improved economic performance in 2002. Bulgaria shows stronger fundamentals in 2002 compared to 2001: despite slow growth in the EU and other economic partners, Bulgaria's economic growth remains solid, inflation rate declined, and the external current account deficit narrowed in 2002 compared to 2001. However, reaching fiscal targets in 2003 are a challenge and external risks remain. To address these risks the Government has identified and agreed with the Fund under the Stand-By Arrangement (SBA) several measures: (i) efforts to improve revenue collection and collection of arrears are bemg accelerated; (ii) revenue indicative targets are being monitored on a monthly basis - significant deviations would trigger consultations with IMF staff on offsetting measures; and (iii) discretionary spending is limited to 88 percent of budgetary allocation for the first three quarters of the year - equivalent to about 1 1/4 percent of GDP through September 2003 of possible fiscal adjustment should risks materialize.9 11. Summary of recent developments. Per capita income is increasing; the level of poverty is declining; inflation is low; and economic growth is being sustained at 4-5 percent per year. Macroeconomic stability has been maintained and public debt to GDP has declined and is approaching the Maastricht criterion of 60 percent - debt reduction and fiscal adjustment have created savings, enabling the Government to increase spending on social programs. Furthermore, structural reforms are moving forward - the banking sector has been put on sound footing; the private sector share in the economy is increasing; a major regulatory reform is underway, and energy pricing reforms are improving efficiency and reducing fiscal burden. Bulgaria is also making important progress in its EU accession program - the EC has recently assessed Bulgaria as a functioning market economy'0 and Bulgaria has closed 23 of the 30 chapters of the acquis. In addition, preliminary 2002 estimates indicate a marked improvement in economic performance: growth increased to 4.4 percent year-on-year in the first three quarters of 2002 suggesting that the annual growth may be higher than the projected 4 percent; registered unemployment while still high seems to be leveling off after several years of continuous deterioration; twelve month inflation in December 2002 declined to 3.8 percent having reached a peak of 9.2 percent in March 2002; the ten month external current account deficit to October 8 This is according to article 104 of the Treaty Establishing the European Community signed in Maastricht in 1992. The convergence criterion on debt refers to the ratio of gross government debt to GDP, which must not exceed 60 percent at the end of the preceding financial year or shall be approaching the reference value at a satisfactory pace. 9 See IMF Staff Report for the Second Review under the Stand-By Arrangement, IMF, January 2003. 10 2002 Regular Report on Bulgaria's Progress towards Accession, Commission of the European Communities, October 2002. 4 2002 has declined to 1.4 percent of GDP; gross intemational reserves have increased to US$4.4 billion or more than five months of imports; and financial intermediation continues to improve. 12. Significant but manageable external risks exist. Bulgaria faces several significant extemal risks. A failure to carry out the envisaged privatization program or attract sufficient greenfield FDI would put the projected extemal financing at risk, requiring additional adjustment to ensure that debt levels continue to decline. Moreover, Bulgaria's external accounts are sensitive to three key parameters: an increase in oil prices, higher interest rates, and a prolonged slowdown in EU economies which are the destination of over fifty percent of Bulganan exports and the origin of more than half the FDI inflows. However, the achievements to date, the better than expected performance in 2002, and the measures in place to address fiscal and extemal vulnerabilities mitigate these nsks. Medium Term Prospects and Creditworthiness 13. The medium term macroeconomic framework centered on the Currency Board Arrangement is expected to support a rapid and sustainable economic growth in the coming years. The medium term outlook" envisages robust growth of about 5 percent per annum, a gradual narrowing of the extemal current account deficit, and a reduction in debt to GDP ratios. Growth would be driven by continuous rise in investment and improved export performance in line with the expected recovery in external demand from EU and increased competitiveness of Bulgarian goods on international markets. Consistent with the planned upgrades in infrastructure sectors and contmued progress towards EU accession, investment is likely to grow at a higher speed and reach at least 22 percent of GDP in 2005. Despite the continuing slow growth among Bulgaria's main trade partners so far, macroeconomic performance has been good and is expected to improve further in 2003-05 as EU economies may start their recovery and the cumulative effect of structural reforms in Bulgana start to pay off. 14. FDI inflows continue to be the primary source of BoP financing. Despite their slowdown m 2001 to 5 percent of GDP, FDI inflows amounted to more than US$3 billion in 1998-2001, the bulk of which were in the service sector (57 percent) - mainly financial services, trade and tourism. About US$1.3 billion were invested in industry in those years - mainly oil- processing, chemical, food, metal and non-metal mineral products. With the global slowdown negatively affecting capital flows, and some of the large pnvatization deals delayed, FDI inflows in Bulgaria eased off further in 2002 but are likely to provide sufficient coverage of the external current account deficit. Planned privatization in the energy sector, and completion of the deals on some monopolies such as Bulgartabak and Bulgarian Telecom (BTC), together with additional investments, such as those projected in the energy sector and expected inflows of greenfield investments, are likely to help Bulgaria meet its financing needs. The returns from foreign direct investment in the country have been growing and a further boost in investments is possible if the remaining structural and institutional impediments are addressed, including weaknesses in business climate, public administration, and legal and judicial systems. " See Bulgaria 2002 Article IV Consultation and First Review Under the Stand-By Arrangement-Staff Report, The Intemational Monetary Fund, August 2002. 5 Figures 1-6: Macroeconomic Indicators Figure 1. Real GDP Figure 2. CPR Inflation (% change) (% change, annual average) 10- 40 54 40 900 0- 700- -5- -10- <<300- -20 1 30 1995 1996 1997 1998 1999 2000 2001 Vo . -4--GDPgrowth, 1995=1 -F}-GDPannualgrowth -K0 1995 996 997 998 999 2000 2001 Figure 3. Fiscal Balance (% of GDP) Figure 4. Current Account Balance (% of GDP) ~ ~~~~~(% of GDP) 12. 4- 2 8 0 ELDL -4 o-8F -°2 L,-_ n t. , -2 - -8 J a'W'L 995 1996 V97 198 1999 2000 2001 1995 1996 1997 1998 1999 2000 2001 Figure 5. Registered Unemployment Figure 6. FBD Inflows 60. 20 (US$ million) 1200- 9918 1002 0. 16 1000 819 E 406 689 30 - ~~~~~~~~~~~~~~~~~~~~~~~390 400 20 8 ~~~~~~~~~~~~~~~20090 g 109 1995199619971998199920002001Oct-02 1995 1996 1997 1998 1999 2000 2001 Jan-' ~]Unemployment rate (right srale) Oct- --Share of LT unemployed 0 Total *3 From pnivatlzation 2002 Sources: National Statistical Institute, Bulgarian National Bank, Ministry of Finance, Emiployment Agency and World Bank staff estimates 6 15. International financial markets have responded favorably to the achievements of the reform program. At the end of 2001 and early 2002, Standard and Poor's, Fitch Ratings, and Moody's upgraded Bulgaria's credit rating. In less than a year, Standard and Poor's and Fitch Ratings did a second upgrade to the country rating m October 2002. Active debt management policies in 2001 and 2002 through debt buybacks and exchanges are reducing debt levels and improving exchange rate and interest rate risks of debt portfolio. In March 2002, the Government of Bulgaria exchanged US$1,319 million Brady Bonds. The exchange resulted in a net present value savings of US$94 million and released a collateral of about US$220 million. In September 2002, the Government reduced further the share of Brady Bonds in total debt by exchanging US$866 million for global bonds, and released another US$140 million of collateral. As a result, the external public debt stock is estimated to decline by US$108 million. The total external debt has fallen significantly since the beginning of 2002 - by end-October 2002, total external debt stood at 68 percent of GDP and is expected to decline further due to the sharp reduction of external public debt. 16. The current course of fiscal policy is basically appropriate to ensure macroeconomic stability, growth and poverty reduction in the medium term. The main fiscal challenge, however, is to work towards an improved allocation of expenditures'2 to achieve a balanced budget in the medium-term, while lowering the overall tax burden - especially payroll taxes - to boost investment and employment, and reducing extemal indebtedness. So far fiscal adjustment has been made possible by revenue expansion rather than expenditure rationalization. Only recently the revenues have started to decline, reflecting gradual reduction of the tax burden. To limit revenue losses from future tax cuts, the tax administration needs to be overhauled and tax compliance improved. A decade long neglect of investment in basic infrastructure has been exacerbated by several years of declining capital and maintenance expenditures which have borne the brunt of expenditure cuts. Going forward, fiscal adjustment will need to rely heavily on expenditure rationalization which needs to precede reductions in tax burden to safeguard fiscal sustainability. In addition, fiscal strategy will need to adjust to the decline in pnvatization revenues, a main source of fiscal financing, as the prnvatization program is soon to be completed. Expenditure rationalization will require implementation of deep structural reforms which will have to be accompanied by measures protecting the poor from the adverse impact of these reforms. 17. Meeting the challenge of improving the allocation of public expenditure requires creating an efficient and transparent expenditure management system with enough flexibility to adjust quickly and efficiently to macroeconomic shocks. The central key pressure points on the fiscal position emerge from health care, education, social protection system (pension funds, social assistance programs, and labor market policies), and from municipalities. The recently finalized Public Expenditure and Institutional Review for Bulgaria'3 has indicated the need to improve allocations to address the issues of overcapacity, especially in health and education, and improve the targeting of social protection programs, which constitute about one- third of total public spending. Equally important are policies to improve allocations between sectors - decreasing subsidies to the energy sector, while protecting the poor through expanded energy benefit program and gradual increase in energy prices to bring them to full cost recovery 12 For more details see Bulgaria: Public Expenditure Issues and Directions for Reforn, The World Bank, August 2002. '3 Bulgaria: Public Expenditure Issues and Directions for Reform, The World Bank, August 2002. 7 in the medium term. In addition, increased efficiency in expenditure management would require an overhaul of the intergovernmental relations. The Government approval in mid-2002 of the Fiscal Decentralization Program for 2002-05 is a step forward in that direction. It aims at reducing the fiscal pressures arising from arrears in municipal finances, and improving the efficiency in service delivery. A fiscal decentralization and service study is currently being prepared by the Bank to guide the Bank's policy dialogue with the authorities in support of the local finance reforn, which will be a focus of a planned second PAL. 18. Independent reviews indicate that issues of governance have improved but important challenges remain. Accordmg to a World Bank report'4 Bulgaria is characterized as a country with a high level of state capture and a medium level of administrative corruption. The problem is due to both the structure and the functioning of government - in particular, the concentration of power despite progress toward decentralization - weak legal and regulatory framework, weak capacity to monitor corruption and enforce laws, a weak judiciary, and weak overall accountability'5 and transparency. The areas most affected have been customs, health services, tax administration, higher education, and the courts. In recent years, the Government has taken a number of steps to improve governance, in recognition of the problem. The Government has put together comprehensive strategies and action plans for: (i) state administration modernization; (ii) judicial reform; and (iii) fighting corruption. Two Commissions have been set up to combat the corruption - a standing parliamentary committee and an inter-ministry operational commission. In addition a series of measures have been undertaken to strengthen control within the Tax Administration, Customs Agency, the Ministry of the Interior, and the National Security Service. The framework for addressing administrative corruption has improved with recent public administration reforms, but capacity weaknesses at all levels of govemment - central and municipal, managerial and technical - remain formidable. 19. With the external financing provided by the PALs, the structural reforms can be phased in while softening the impact of adjustment, protecting the poor, and safeguarding social cohesion. Without the PAL financing, policy dialogue, and support, the momentum for accelerating structural reforms is unlikely to be sustained or the costs of adjustment would weigh heavily on vulnerable segments of the population. While international reserves remain at a comfortable level to support macroeconomic stability in the context of the CBA, Bulgaria will continue to rely on official creditors' support to meet its external financing requirements, start addressing a decade of neglected maintenance of physical assets needed to support private sector- led growth, and soften the impact on vulnerable groups. The expected Bank financing under the proposed series of PALs of US$150 million per year for three years would provide fiscal and balance of payments support needed to implement a broad reform program. 20. Creditworthiness Indicators. Prudent fiscal policies, implementation of structural reforms, and an active debt management strategy have resulted in an improvement in creditworthiness indicators (see Annex 4). Total debt outstanding and disbursed as a share of GDP has declined from 100 percent in 1997 to around 70 percent in 2002. This share is expected to decline to around 60 percent by 2005. Similarly, total debt service as a share of exports of goods and services is expected to decline from around 17 to 13 percent. The share of debt service to IBRD to total public debt service is expected to increase to around 12 percent in the next three years. The share of Bulgaria's portfolio in IBRD's portfolio is expected to remain under 1.2 percent. In addition, spreads on Bulgaria's Brady bonds have been narrowing since the June 2001 election, reflecting prudent policies and markets' expectation of a more active debt '4 See Anticorruption in Transition: A Contribution to the Policy Debate, The World Bank, 2000. 5 The World Bank is currently preparing a Country Financial Accountability Assessment for Bulgaria. 8 management strategy. The collapse of the CBA in Argentina and the difficulties in Turkey have not had any significant impact on this trend. There have been no discernable contagion effects on Bulgaria's domestic financial markets either, and financial fundamentals and indicators of external vulnerability remain comfortable. 21. IBRD exposure will remain manageable in the base case scenario of the CAS. IBRD debt service is projected to rise from 1.0 to 1.3 percent of exports, and from 6 to 12 percent of public debt service during the CAS period. The ratio of preferred creditor debt service to public debt service has remained above 35 percent and increased sharply in 2001. It is projected to decline to about 40 percent in 2004 before nsing again to 47 percent in 2005. These high ratios are partly the result of debt restructuring in the mid-1990s which stretched out Bulgaria's public debt repayments to private creditors over decades with the issuance of Brady bonds, and of limited commercial bank lending until the strong recovery following the 1997 reforms. Continued substantial adjustment lending as envisioned in the CAS would seriously reduce the Bank's headroom in Bulgaria, especially for further adjustment loans beyond FY05. However, since the three proposed PALs - designed to support a robust reform program that has a high probability to succeed - are the cornerstone of the overall Bank's strategy, high adjustment lending is justified, but would have to be carefully monitored. The additional triggers'6 for processing PAL-3 identified in the CAS have been adopted to ensure that adjustment lending would reach the proposed US$450 million level only if indicators of economic outcomes confirmed that Bulgaria substantially improved its standing as a result of reforms under the first two PALs, and if the downside risks of overall economic performance at that time were low. Addressing Poverty'7 22. Despite the improvements since 1997, poverty remains at twice the levels of 1995 and deep poverty persists among certain vulnerable groups. The nature of poverty has evolved, as recent improvements in welfare have not been equally distributed across the population. There are "pockets of poverty" among certain groups, particularly the unemployed, ethnic minorties, most notably Roma, and families with more than four children. Considerable scope remains to obtain further reduction of poverty through the development of targeted poverty intervention (e.g. for the Roma) and improving the targeting of social assistance, particularly social assistance to mitigate the impact of restructuring. Moreover, capacity in the Government to monitor poverty and assess the impact of policies on vulnerable groups needs to be strengthened, as demonstrated by the need to contract out the last household budget surveys (HHBS) and the absence of living standard measurement survey (LSMS). 16 The following developments would trigger reconsideration of proceeding with the presentation of PAL-3 to the Board: (i) material deviation from the downward trend in the total public debt to GDP ratios as projected in the CAS; (ii) lack of improvement in the spreads on Bulgaria's sovereign borrowing via-a-vis countries with similar risk rating, or deterioration in its own risk rating; (iii) material deviation from the improving trend in the fiscal balance projected in the Government's medium term program, reaching fiscal balance by 2005; (iv) matenal slowdown in the present trend of increasing SMEs' share of total employment; and (v) inadequate progress in reducing arrears in tax payments, social msurance contributions, and energy bill payment as set out in the Government program. 7See Annex 7 "Poverty Update" for an extended discussion of poverty in Bulgaria, mcluding its multiple dimensions. The recent World Bank report Bulgaria: Poverty Assessment (October 2002) also addresses gender issues, and has a background paper "Gender Aspects of Poverty and Inequality m the Family and the Labor Market". 9 Box 1: Recent Poverty Trends and the Poverty Gap The 2001 poverty profile for Bulgaria shows a dramatic rebound of living standards smce the 1997 crisis. Poverty escalated to 36 percent of the population in 1997, according to the household survey for that year. Since then, poverty rates have declined, as consumption levels have recovered from the crisis. Using poverty lines updated from 1997, poverty fell by nearly two-thirds to 12.8 percent, and the depth and seventy of poverty have also improved (see table below).a/ In order to compare trends over time, the relative poverty lines from 1997- two-thirds of per capita income (high) and one-half per capita income (low) - were fixed in real terms. Poverty and Inequality Trends 1995 1997 2001 Poverty Estimates High Low High Low High Low Poverty Rate 5.5 2.9 36.0 20.2 12.8 7.5 Poverty Gap 1.7 0.9 11.4 5.9 4.2 2.2 Poverty Depth 0.8 0.4 5.3 2.7 1.9 0.9 Gini Coefficient 27.1 31.4 29.6 Source: Poverty Assessment Update, The World Bank, 2002. BIHS 1995, 1997, 2001. Notes: The "poverty rate" refers to the percent of the population that is below the poverty line; the "poverty gap" is the average shortfall from the poverty line; and "poverty seventy" is the average squared consumption shortfall as a percentage of the poverty line, and is more sensitive to inequality among the poor. Despite the improvements since 1997, the poverty rate remains at twice the levels of 1995. In addition, recent improvements in welfare have not been equally distributed across the population. There are "pockets of poverty" among certain groups, particularly the unemployed, ethnic minorities, most notably Roma, and families with more than four children. Poverty also has a significant rural dimension. Urban areas have experienced a more significant drop in poverty levels, from 34 to 6 percent, while in rural areas, poverty rates were less than halved, from 41 percent to 24 percent. The poverty gap has also fallen since 1997, but it remains more than double 1995 levels at 4.2 in 2001. In 2001, the poverty gap amounted to BGN 0.2 billion, or 0.7 percent of 2001 GDP. This implies that - under conditions of perfect targeting and zero administrative costs - eliminating poverty would cost 0.7 percent of GDP. As these assumptions are unrealistic, the true cost is likely to be higher, perhaps as high as 2.1 percent of GDP. a! The poverty line is set at two-thirds mean 1997 per capita consumption, adjusted to 1995 and 2001 prices. In other words, the relative poverty line from 1997 is held constant to function as an absolute poverty line. Source: Bulgaria Publhc Expenditure Issues and Directions for Reform, The World Bank, August 2002. 10 23. Social protection reforms helped the poor cope with transition shocks, but significant issues still remain for further enhancing the effectiveness of the system and its sustainability. The previous govemment implemented reforms to provide a comprehensive safety net for the poorest households. It strengthened and consolidated means-tested social benefits, targeted benefits to the most vulnerable individuals and households, and reduced duplicative benefit programs. Institutional and administrative capacity within the social assistance system was strengthened. Licensing requirements, contractual and funding transfer arrangements and minimum standards for delivery of social care services by NGOs and the pnvate sector were specified. Nonetheless, there is scope for improving the effectiveness of existing programs by strengthening the administration of social assistance delivery, tightening the eligibility criteria, reducing leakage, expanding coverage, and improving means-testing. PAL-3, whose preparation work begins this fiscal year, will address these issues. 24. While according to official data Bulgaria is on track meeting the Millennium Development Goals (see Box 2), gaps in access to both education and health are real for vulnerable groups. Despite the growing enrollment rates, the attendance rates especially for vulnerable households in rural areas and among ethnic minority have declined below 1995 levels, particularly for preschool and secondary education. The household survey data for 1997 and 2001 indicate that while enrollments in basic education have increased slightly for the country at large, enrollment rates for poor children have fallen ten percentage points from 84 percent in 1997 to 74 percent in 2001. In addition to the high costs of education for the poor households, there is evidence that they also face barriers to accessing health care, because of the prevalence of formnal and informal out-of-pocket payments and gaps in health insurance coverage for uninsured groups. As in the case with education, Roma are more likely to fall through the cracks of the health system than other groups because of lack of necessary identification and registration papers, and poor communication with health providers which is compounded by social exclusion. B. The Reform Program Objectives and Strategic Themes 25. The new Government which came into power in mid-2001 has articulated two objectives: (a) sustaining economic growth and (b) reducing poverty, both key to EU membership. This is a shift from the objectives of the program of the previous Government, whose agenda was driven by the depth of the economic and financial crisis of 1996-97, the focus on macroeconomic stabilization, the need to accelerate the much delayed privatization program, the establishment of a sound fiscal regime to support the CBA by cutting expenditures and closing non-viable SOEs, and the reform of system of social protection.'8 The reform program of the current Government builds on the gains of the past five years and makes a strategic shift m emphasis towards promoting growth and reducing poverty focusing on increasing investment and productivity and building human capital. The Government has articulated the following outcomes of its program: (a) average annual GDP growth rates of 4.5 to 5.0 percent during 2002-05; (b) reduction of the poverty rate by half by 2005 compared to the rate in 2001; and (c) reduction of the unemployment rate to 12-14 percent in 2005 compared to 17.5 percent in 2001. The program components that address strengthening of market institutions, modernizing public 18 Since 1997, the Bank has supported the structural reforms with a Cntical Imports Rehabilitation Loan, a Social Protection Adjustment Loan, two Finance and Enterprise Sector Adjustmnent Loans (FESALs), two Agriculture Structural Adjustment Loans (ASALs), and an Environmental Protection Structural Adjustment Loan (EPSAL). administration, fighting corruption, and reforming the judicial system are critical to the EU accession agenda. Box 2: The Government Medium Term Program and the Millennium Development Goals Goal Recent Data 2005 Target 2015 Target Eradicate extreme poverty o percent of population below $2.15 per day 7.9 (2001) 3.2 1.5 Achieve universal education o net enrollment rate - primary school 96 (2001-02) 97-98 100 o net enrollment rate - middle school 84 (2001-02) 86-90 100 o net enrollment rate - secondary school 68 (2001-02) 75-80 95 Improve maternal health o maternal mortality rate per 100,000 live 19.1 (2001) 18 16 births Combat HIV/AIDS, malaria and other diseases o Tuberculosis incidence (new cases per 48 (2001) 40 26 100,000) o Polio immunization rate (percent of 94.4 (2000) 98 100 children under two) Reduce infant mortality o Mortality per 1000 live births 14.4 (2001) 13 9 Ensure environmental sustainability o GDP per unit of energy use (US$ GDP 568 (1997) 653 751 per kilogram of oil equivalent of commercial energy use) Sources: National Statistical Institute and World Bank 26. The strategy for attaining the sustained growth and poverty reduction objectives has two main themes. First, the Government intends to use private initiative as the main engine of growth. For this reason, the government program focuses on creating an investment climate that encourages private investment and enhances productivity. This requires redefining and upgrading the role and capabilities of the public sector, establishing credible institutions such as the judiciary, and putting in place a stable legal and regulatory environment. Second, the Government is taking steps to ensure that the population is empowered to participate in future growth. The Government is working towards fundamental reforns in the education and health sectors, not only to improve efficiency of these large sources of public expenditures, but also to develop human capital capable of adapting to an increasingly dynamic work environment, especially with greater competition expected from EU countries. In addition, there is recognition that poverty reduction policies need to be tailored to reach certain groups that have not benefited 12 from the recent increase in welfare. The Government realizes that growth alone will not lift certain groups out of poverty. 27. To implement its growth and poverty-reduction strategy, the Government is building its medium term reform program on five pillars: * Sustaining structural reforms in the enterpnse sector with emphasis on the restructunng of the energy, railway, telecommunications, and water sectors; * Establishing a market-friendly business environment, focusing on entry and exit policies, regulatory costs, delivery of public services, competition, and judicial reform; * Deepening thefinancial sector, addressing the constraints to increased lending by the banking system and the development of financial markets; * Improving public sector governance, including implementing the anti-corruption strategy, strengthening local governments, and reforming public administration and the judiciary; * Investing in human capital and strengthening social programs, focusing on education, health, pension reform, and social assistance effectiveness. 28. The program pillars complement each other and support the achievement of the Government's goals and objectives. The restructunng of the infrastructure sector improves the business environment (Box 3), contnbutes to the sustainability of fiscal stabilization, and are important components of public administration reform. The business environment and financial sector pillars encourage the entry of new and the expansion of existing firms to support the growth and employment objectives by absorbing labor released from the restructuinng of the public sector (Box 4). Social programs protect the vulnerable groups dunng the transition penod and contribute to the reduction of poverty while investments in human capital provide a longer term capability to respond to the needs of a dynamuc market economy. The restructuring of the pension, health, and education sectors - which are the main components of public expenditure and, in the case of health and education, the major areas of overstaffing in the public sector - also improves the overall efficiency of public administration. The governance pillar - public administration modernization, judicial reform, and anti-corruption measures - is cntical to pnvate sector development and progress in EU accession. 29. The proposed PALs support the Government's EU accession agenda, which is the major driving force for reforms in Bulgaria. More specifically, the PAL program complements and supports the Government's efforts in building a functioning market economy and the capacity to cope with the competitive pressures and market forces within the EU in the medium term. Achieving the PAL program objective of building a dynamic and competitive economy through stable macroeconomic performance, deep structural reforms, sustainable private sector-led growth, and improved investment climate determines the extent to which Bulgaria could benefit from EU accession. The PAL program also complements EU accession related efforts to strengthen and develop the ability of the public administration and judicial system to implement and enforce the acquis communautaire. The PAL process helps the Government in formulating the pre-accession economic program and in sequencing economic reforms, including through analytical work based on experience from other EU accession countnes. 30. The effectiveness of the above program depends on the maintenance of sound macroeconomic policies. The Government articulated its macroeconomic program in its Memorandum of Economic Policies attached to the Letter of Intent to the IMF dated February 12, 13 2002 where the Government committed to: (a) maintain the CBA at least until accession to the EU; and (b) implement a cautious and flexible fiscal policy, which is key to safeguarding external viability under the CBA. The Government is aware of the importance of structural reforms to sustained macroeconomic stabilization. Pillar 1: Sustaining Structural Reforms 31. The current privatization program19 focuses on infrastructure SOEs. Bulgaria has divested more than 90 percent of assets of non-infrastructure SOEs existing as of end-1995 and the current program calls for the completion of this phase of the privatization by end-2004.20 The next phase of privatization has begun, involving the restructuring of the energy, railway, telecommunications, and water sectors with the objective of improving efficiency of service delivery through greater private sector investment within a framework of market rules and effective enforcement. To improve transparency, reduce corruption, and accelerate the privatization process, the legal and institutional framework for privatization has improved with the enactment of the new Law on Privatization and Post Privatization Control and the restructuring of the Privatization Agency. By end-2005, the only remaining state enterprises will be those listed in Annex 6-A. In conjunction with the business environment and public administration reforrms, the privatization program should increase the share of the private sector in GDP to about 70- 75 percent by 2005. 32. The program in the energy sector aims to reduce Bulgaria's energy intensity2i and enable the private sector to assume an increasing share of commercial risks. To achieve these objectives, the sector is being fundamentally overhauled. First, energy prices are being rationalized to cover costs and eliminate cross-subsidies beginning with a 20 percent electricity price increase in the second half of 2002, with another 25 percent programmed over the next two years.22 Second, the legal and regulatory framework under which energy services will be provided by the private sector is being improved and the capacity of the State Energy Regulatory Commission (SERC) is being upgraded. Third, electricity distribution and generation companies have been spun off from the former monopoly electricity company NEK and will be privatized over the next two years.23 Fourth, the District Heating Strategy, which calls for commercialization measures in the short term and privatization in the medium term, is being implemented. Finally, the gas sector will be opened to the private sector. The energy reforms are expected to reduce Bulgaria 's energy intensity - measured by energy consumption to GDP - by 15 percent at end-2005 compared to the level at end-2001. 19 Environmental policies put in place as part of the Environmental Protection Structural Adjustment Loan (EPSAL) will be enforced. The preparation of privatization plans of SOEs includes an environmental section to define the responsibility for past and future environmental liabilities. 20 The remaining SOEs where the Govermment has majority control number 440, of which one quarter are considered large, mainly in the utilities and manufacturing sectors. There are another 1,800 non- infrastructure privatized enterprises where the Govermment has minority shares, which will also be divested. 21 Bulgaria has the highest energy intensity ratio in the ECA region. 22 The social impact of the increase in electricity prices was reviewed in a PHRD funded study and discussed in the recent Poverty Assessment and Public Expenditure and Institutional Review. The Government has put in place an energy subsidy program and structured the electricity tariff increases in a way that minimizes the impact on the poor. 23 The Ministry of Energy and Energy Resources (MEER) has engaged Paribas as lead privatization adviser. 14 Box 3: The Quality of Public Infrastructure: What do Firms Say? In a survey of enterprise owners and senior managers in Bulgaria and other transition economies, respondents were asked about their perception of the quality of infrastructure in their country. The responses for Bulgana are startling and informative. The figures below compare Bulgaria's performance to four CEE transition countries, which will be in the first wave of EU accession. The results strongly support the conclusions of the Public Expenditure and Institutional Review that inadequate public infrastructure is a key impediment to the investment climate and investment in infrastructure is a key priority for public expenditure. The main conclusions: * 78 percent of Bulgarian entrepreneurs surveyed perceived the road network in Bulgaria as bad or very bad, and less than 5 percent of the respondents felt that the road network was good or very good; this can be compared to the next worst country, Poland, where only 49 percent of the respondents felt the roads were bad or very bad; * 15 percent of the respondents felt that the telephone service was bad or very bad; this is almost three times worse than the next worst country in the sample - Slovak Republic; * 19 percent of respondents felt the electricity service was bad or very bad; again this is more than double the next worst country; * 18 percent of the respondents also felt the water services were bad or very bad; this is more than three times the next worst country - Hungary. The implications of these entrepreneurs' perceptions of the adequacy of public infrastructure for business are obvious for foreign investment inflows, as well as domestic investment. Quality and Efficiency of RPblic Services: Roads Quality and Efficiency of Public Services: Telephone W- . F 'Y P'rd Rd. BuaWra Czech HungaWry Poland Slovakia * Good / very good 0 Good I very good * Middle (slightly good s lightly bad) * Middle (slightly good / slightly bad) ~IBad I v0erY Dad U Bad I very bad Quality and Efficiency of Public Services: Quality and Efficiency of Public Electricity Services: Water ,os ,0_00- - -~~~~~~ m~~~~~m . sr i £1 x .,_"x .- s , , 'S ^1 4. 0% , , . , , Bulgaria Czech Hungary Poland Slovakla Bulgaria Czech Hungary Poland Slovakia Republic Republic D Good /very good OGood/very good * Middle (slightlygood /slightly bad) * Middle (slightly good I slightly bad) @ Bad / very bad * Bad / very bad Source Bulgaria: Public Expenditure Issues and Directions for Reformn, The World Bank, 2002 15 33. In the railway sector, the restructuring program aims to increase efficiency, ensure financial sustainability, and improve staff productivity. The Railway Law passed in November 2000 provides the legal basis for the implementation of the reform program. A new railway operating company and a new railway infrastructure State enterprise have been created as part of the implementation of the program. Market rules are being developed that will enable the entry of private firms and the eventual privatization of the railway operating company, as well as ensure fair competition for all land transport operators. The program also includes freedom to set tariff for the railway operating company, rationalization of the railway network and services,24 introduction of public service obligation (PSO) contracts with the Government who pays for the non-commercial services it does not want terminated, and the reduction of the railway labor force. The desired outcomes are: (a) by end-2004, the railway labor force will have been reduced by 20 percent compared to the level at end-2001;25 and (b) subsidies (excluding loans and grants) to the sector will have fallen from 0.5 percent of GDP in 2000 to 0.2 percent of GDP in 2005. 34. The telecommunications markets are liberalized starting January 1, 2003 consistent with the Government's EU accession agreement. The Bulgarian Telecommunications Company (BTC) is expected to be privatized in 2003 without an extension of its monopolies. Amendments to the Telecommunications Law passed in December 2001 provides the legal framework for market liberalization, including the establishment of a new, independent Communications Regulatory Commission (CRC), whose capacity is being strengthened with technical assistance. To ensure a competitive market, BTC will share its infrastructure with and allow indirect access by other market participants. The Government has affirmed its commitment to implement the time-bound EU accession commitments. The Government goals are to achieve by end-2005 a degree of digitalization of transfer network of 100 percent, of exchanges 82 percent, and of subscribers capacity 46 percent. By end-2005, the number of households with telecommunication services allowing internet access is expected to be 94 percent, and telephone connection waiting time will not exceed one month. 35. In the water sector, the modernization program addresses the problems of inefficiency and lack of investment by inviting private operators to bid for concession contracts. The water service providers cover 98.4 percent of the population, so access is not a major issue. The focus of current reforms is efficiency, and the strategy to achieve this objective is to utilize private sector participation. The Water Law passed in September 2000 enables Regional Water Companies (RWCs) to award concession contracts to private operators. Amendments to the Water Law have been submitted to Parliament to further facilitate the concession program. The Government is in the process of completing the drafting of the regulations that will govern pnvate sector participation. By end-2003, the Government will have awarded concession contracts in two RWCs to the private sector. The Government expects a reduction in the ratio of operating costs (including depreciation) to revenues of RWCs to 80 percent by end-2005. 36. The Government is implementing environmental reforms, supported by the Bank's EPSAL, and will move into the next phase of reforms to meet the challenges of compliance with the acquis. Environmental policies are being further improved by harmonizing environmental laws and regulations with those of the EU and strengthening the capacity of environmental institutions and agencies to enforce environmental laws and regulations. The 24 The social impact of the termination of loss-making services on the poor will be included m the preparation of the plan for terminating such services. The recently approved Social Investment and Employment Promotion project will assist in mitigatmg the impact on those affected by the restructuring of the railway sector. 16 Parliament recently passed a new Environmental Protection Act which is fully harmonized with EU acquis and which will implement the provisions of the EU Integrated Pollution Prevention and Control (IPPC) Directive. To maintain integrity of the natural environment, the Government will further improve sector policies and regulations to prevent overexploitation and guarantee sustainable resources use. A Natural Resource Management Strategy will be developed which will ensure that land, forests and biological resources are used in environmentally sustainable way. The current goal is to issue 225 permits under the IPPC by end-2005 and to issue permits to all enterprises covered by the IPPC directive by end-2007. Pillar 2: Establishing a Market-friendly Business Environment 37. While the liquidation of loss-making SOEs and the privatization program have increased productivity, future growth will depend on the emergence of dynamic private sector enterprises. New sources of growth will have to come from increased investment by the private sector in both new as well as existing enterprises. To continue attracting foreign direct investment (FDI) and stimulate small and medium enterprise (SME) activity, the Government is undertaking measures to improve the business environment focusing on reducing entry and regulatory costs, improving public services to the busmess sector, maintaining stable market rules and regulations, and ensuring a competitive environment. These initiatives complement the reforms in the areas of public administration, judiciary, and financial system. With these reforms, the Government hopes to attract FDI inflows averaging US$ 1.0 billion per year (of which greenfield FDI would be at least 50 percent) during 2002-05; increase the share of SMEs26 in value added and employment to at least 50 percent by 2005; and increase total factor productivity by 2.5 percent annually during the period 2002-05. 38. The Government is streamlining the regulatory regimes affecting business entry and resulting in additional transaction costs to the private sector. The Inter-ministerial Working Group for the Optimization of Regulatory Regimes headed by the Deputy Prime Minister and Minister of Economy has reviewed all 361 centrally managed regulatory regimes and developed a program for eliminating 70 and modifying 118 of these by end-2004. In addition, the company registration process will be simplified by integrating the registration procedures that are currently performed by several agencies. To monitor the impact of regulatory reforms, the Government has completed a baseline Administrative and Regulatory Cost Survey (ARCS)27 in 2002, and will perforn similar surveys annually and use the results to assess the effectiveness of its regulatory regime simplification program. By end-2005, at least 50 percent of the current regulatory regimes will be eliminated or modified thereby significantly reducing the regulatory compliance costs compared to the 2002 baselinefigure as measured by the recently completed Administrative and Regulatory Cost Survey (ARCS). 39. The Government plans to institutionalize measures to ensure that the introduction of future regulatory regimes is based on clear rationale, proper cost-benefit analyses, and appropriate consultation with affected parties. To control the development of future licensing regimes, the Government has submitted a draft Law on Administrative Regulation and Administrative Control of Economic Activities which will codify the principles that underpin the design of new licensing and regulatory regimes. The CoM will provide specific guidelines regarding the design of new regulatory regimes, including the identification and measurement of costs and benefits and the establishment of a process by which new regimes evolve from concept to enactment which will include stakeholder consultation. The proposed law will require that 26 Defined as enterprises with 100 or less employees. 27 This initiative was completed with the support and active involvement of FIAS. 17 new regulatory regimes, whether initiated by the central or local government, can be introduced only by legislation. 40. En parallel, the front line government offices and agencies are undergoing reforms to improve service delivery and cost effectiveness. Institutional development initiatives are ongoing in Customs, the Tax Administration Office, the Real Estate Registry Office, the National Social Security Institute (NSSI), and various regulatory agencies such as the SERC and CRC.28 For the regulatory regimes that are considered necessary, the cost of compliance will be reduced by simplifying the administrative processes, a review of which will be initiated in three sectors - construction, tourism, and food processing - that account for about 10 percent of GDP and are subject to a maze of administrative requirements. The process simplification initiative will be expanded to other sectors in the future. The Govemment will also pilot a performance standard monitonng system in offices that deal with the construction and labor services,29 and the monitoring system will be expanded to other offices dealing directly with the pnvate sector. Finally, the Govemment is reviewing and prioritizing information system changes, which will enable the integration of all corporate and government revenue information. By 2005, front line Government offices are expected to achieve a 90 percent performance against standard during the year. The Government plans to reform the system of administrative courts to improve accountability and provide the public with a venue for dispute resolution in the public administration area. 41. The Goverrnment is curirently undertaking a review of its competition policies and the effectveness of the Commission for the Protection of Competition in the context of EU accession. To strengthen the Commission for the Protection of Competition, the CoM has submitted draft amendments to the Law on the Protection of Competition, which in its current form is already harmonized with EU requirements. The Parliament passed in 2002 the Law on State Aid to ensure consistency of intervention policies with EU directives. In line with commitments under the Second Agriculture Structural Adjustment Loan (ASAL-2), the Government will abstain from establishing an agricultural commodity market stabilization facility, except for an intervention agency which is required to implement the EU's Common Agricultural Policy (CAP) as a condition for EU accession. The Government also commits to maintaining stability in the agricultural trade regime. 42. Labor marrket refoirm aims to introduce flexibility and reduce long term unempRoyment. The action plan for labor market reform involves: (i) deregulation of labor relations through changes to the Labor Code; (ii) devolution of responsibility for determining the labor relations to social partners, which entails adequate and genuine representation of employers and employees in social dialogue; (iii) decentralization of collective bargaining by strengthening firm level bargaining. The Labor Code will be overhauled towards reducing the procedural costs of dismissals, encouraging flexible forms of employment and work organization, and enabling wage flexibility. At the same time, the adequacy of the social safety net for displaced workers will be reviewed and active labor market policies (ALIPs) that would facilitate the transition for old to new jobs are being designed and implemented. By end-2005, with the labor market and business environment reforms, improvements are expected in the labor participation rate, the employment to population ratio, and the share of long term unemployed in total unemployment. 28 Sumlar initiatives are ongoing in the financial supervision agencies. 29 The offices involved are the Directorate for National Building Control at the Ministry of Regional Development and Public Works and the Labor Inspectorate at the Mmistry of Labor and Social Policy. KPMG has been retained to implement the pilot project. 18 Box 4: Recent Labor Market Developments Unemployment has been high in Bulgaria for a number of years and presently is about 17 percent. The most worrisome feature of Bulgarian unemployment is its long duration. More than half of the jobless are long-term unemployed, implying a loss of human capital, erosion of morale, less reemployment chances and eventually large welfare cost to affected individuals and society at large. The pattern of low employment prevailing in Bulgana is similar to that observed in other high unemployment transition economies. Its distinctive features include low employment of prime age men, relatively high employment of prime age women, and low labor force participation of younger (below 24 years of age) and older workers (55 to 64 years of age). The pnma facie reason behind high unemployment in Bulgaria is high inflows into unemployment coupled with limited outflows, meaning low chances of finding a new job. The high inflows into unemployment, associated with a high rate of job destruction, are caused by an accelerated enterpnse restructuring which followed the macroeconomic crisis in 1997. Intensive enterprise restructuring has also contnbuted to unemployment by giving nse to skill and spatial mismatches, as new jobs that are being created differ in terms of skill content and location from the old jobs that are being destroyed. The insufficient rate of job creatlon and associated limited outflows from unemployment reflect three major factors: a relatively poor business environment, labor market rigidities, and low skills of some of the unemployed. The poor business environment is reflected in a slow rate of firm growth and relatively small share of the new sector - consisting of small pnvate firms - in employment. This points to barriers to entry and vanous obstacles to creation of new firms. Labor market ngidities stem from the Labor Code containing provisions which increase finng and hiring costs, limit wage adjustments, and constrain working time flexibility. Finally, a significant portion of the unemployed has poor and narrow skills, which fall short of those required by the employers. This problem is particularly pronounced among Roma and Turkish minonties. Accordingly, improving business environment, enhancing labor market flexibility, and improving access to and quality of education are key for reducing unemployment. The inadequate skills of the unemployed, especially of the long term unemployed, are likely to be an important factor behind relatively limited flows from unemployment to work in Bulgaria. Poor skills prevent a substantial fraction of the unemployed to effectively compete for jobs, and can lead to their marginalization in the labor market. The unemployed account for only 40 percent of new hires, while the rest is accounted for by persons who change jobs or new entrants to the labor market. The apparent importance of skills mismatch and gap problems points to the role of the educational and training systems in addressing the problem of low, narrow and inadequate skills. Source: J. Rutkowskl, "Why Is Unemployment So High in Bulgaria", draft Working Paper, The World Bank, 2002. 19 44. To facilitate the exit of non-viable enterprises, the Government has initiatives that aim to accelerate the insolvency resolution process. First, the provisions in Part IV of the Commercial Code are being amended towards simplifying the process, establishing shorter and binding deadlines, and providing more powers to creditors. Second, there is a program establishing more stringent criteria for the licensing and dismissal of trustees, and strengthening their monitoring and control by the Ministry of Justice (MoJ) and the courts. Third, institutional reforns in the judiciary will upgrade the skills of judges and improve the efficiency of court administration. Finally, the MoJ is prepanng a program for overhauling the Civil Procedure Code and creating a system of specialized commercial courts which would be the recipient of focused institution building efforts. The Government goal is to cut the time for processing insolvency cases. The MoJ is in the process of developing indicators to track progress in reducing processing time for insolvency cases. Pillar 3: Deepening the Financial System 45. While Bulgaria has achieved significant progress in restructuring the September 2002 banking system, flnancial Spe er20 intermediation remains low and Foreign fliancial markets are undeveloped. 8% Pnvate About 85 percent of the banking assets are 7% now in private ownership, mainly by . _ foreign financial institutions (Figure 7), as a result of an aggressive privatization program in 1999-2001. However, about Foreign ~~~~~~State Owned 30 percent of banking assets are deposited Subsidianes 15% in foreign banks. Non-bank financial 70% institutions do not constitute a major component of the financial system, and capital markets and micro-finance are undeveloped. The Government's objectives in this sector are to increase financial intermediation and stimulate financial markets described below. The Government wants to see an increase in M2/GDP from 42 percent at end-2001 to 50 percent at end-2005, closer to the percentages of advanced transition economies. 46. The legal and institutional framework for lending is being improved to encourage financial intermediation. Amendments to the foreclosure provisions of the Civil Procedure Code were recently passed by Parliament to reduce delays in enforcement of valid claims. Amendments to the Law on Registered Pledges have been submitted to Parliament to increase secured lending. The Accountancy Act and the Independent Financial Audit Act were recently enacted to bring the accounting and auditing standards to international standards thus improving the quality of financial information. There will be a reform of the taxation of the financial sector to eliminate distortions and inconsistencies across various financial instruments and institutions. Finally, the Anti-money Laundering Law will be strengthened in line with international standards and good practices. These reforms are expected to result in major improvements in the lending environment which will help increase private sector loans to GDP from 15 percent at end-2001 to 25 percent by end-2005, a ratio closer to those of advanced transition economies. 20 47. The restructuring of the banking system is well advanced, and the Government will sustain the implementation of the agenda for banking reform. The sale of the remaining State shares in Central Cooperative Bank and the privatization of Biochim Bank have been completed. The privatization process for the State Savings Bank (DSK) has begun with the appointment of J.P. Morgan as the privatization adviser, and is expected to be completed by mid- 2003.30 The Bank Bankruptcy Law was recently enacted to improve the exit process for insolvent and closed banks. The enactment of amendments to the Banking Law strengthens the supervision powers of the Bulgarian National Bank (BNB) to enable BNB to identify and investigate direct and indirect owners of banks. The private sector share of banking assets is expected to be about 98 percent by mid-2003. BNB is pursuing efforts to ensure that prudential standards are maintained during 2002-05. 48. The Government is taking steps to stimulate capital markets. The development of the pension fund and insurance sectors will mobilize long term savings which can be invested in long term financial instruments in the market. Initiatives include the privatization of the dominant State Insurance Company (DZI),3' strengthening the governance structures of private pension funds, and defining a higher and more stable contribution rate to the mandatory second pillar of the pension system. To improve investor confidence, the Commercial Code is being amended and the Law on Public Offering of Securities has been amended to address deficiencies in minornty shareholder protection and to strengthen corporate governance provisions. The Mortgage Bond Law was also passed to enable the introduction of more financial instruments. To protect investors, the supervision capacities of the Bulgarian National Securnties Commission (BNSC), the State Insurance Supervision Agency (SISA), and the Insurance Supervision Agency (ISA) are being upgraded. The Parliament is currently deliberating on a draft law that would integrate the supervision of non-bank financial institutions (NBFIs) in one agency. 49. A separate body of senior officials from all financial services supervisory agencies has been established to ensure proper coordination and development of a system-wide perspective in assessing and dealing with risk and vulnerability. This body - the Financial Sector Advisory Committee - will serve as an information sharing and policy-oversight organ. Membership of this body includes the heads of supervisory agencies, although the membership composition will be reviewed when the legislation integrating NBFI supervision is passed. Information will be shared among members of the committee to plan and coordinate actions to address any major vulnerabilities within the financial sector, and to improve investor confidence and buoyancy of the market. Through such sharng of information, it is expected that the coordination of functions of the various supervisory agencies can be improved, especially where supervisory functions overlap. This body will also develop an Early Warming System and a set of indicators to be used in monitoring the vulnerability of the financial system. Pillar 4: Improving Public Sector Governance 50. The Government plans a comprehensive approach to public administration reform. The Council of Ministers (CoM) recently approved the document Strategy for State Modernization - from Accession to Integration, together with a set of draft amendments to the existing Civil Servant Law which have been submitted to Parliament. The strategy will make provision for improving the functioning of the Institute of Public Administration and European Integration; the setting up of a program of functional reviews of different ministries and agencies 30 By mid-2003, only two non-private banks will remain: the Business Promotion Bank and the Municipal Bank owned by the Sofia municipality, which together account for 2.3 percent of bank assets as of end- September 2002. 31 The privatization of DZI was recently completed, making the insurance sector 100 percent private. 21 to align structures and staffing with program priorities; and the development of a time-bound program for the implementation of service delivery and performance standards for ministries, agencies, regional offices, and municipalities. By end-2005, the administrative capacity will be substantially upgraded and ineffective and overlapping structures closed down. 51. The Government has adopted a National Anti-Corruption Strategy which takes a comprehensive approach to the problem of corruption. The challenge will be to translate such an ambitious agenda into a sequence of concrete actions that will allow the Government to achieve demonstrable progress in selected priority areas. In that context, the Government has prepared an action plan that includes: (a) concrete steps to address issues relating to conflict of interest, lobbying regulation, and political financing; (b) the establishment of an inter-ministerial commission to implement the plan; (c) the creation of a full time secretariat to support the work of the commission; and (d) the design of a monitoring system to track progress in meeting the anti-corruption objectives. The Government has established the Inter-ministerial Committee for Implementing the Anti-corruption Strategy and Action Plan to ensure coordination of efforts within the Government. 52. The Government has also adopted a program and action plan for judiciaDl reform, including an anti-corruption strategy for the judiciary. The program has four components. First, human capacity will be enhanced by upgradmg legal education; introducing compulsory training; improving the magistrate selection, promotion, and demotion process; and establishing and enforcing performance standards. Second, administrative capacity will be upgraded through improved planning and resource allocation, better systems support, and implementation of anti- corruption strategy. Third, alternative dispute mechanisms will be established, including the training of arbitrators and mediators. Finally, a monitoring system will be established to track the progress of reforms and how the judiciary is viewed by the lawyer and litigant communities as well as by the general public. The Government would like to see major improvements by 2005 in the efficiency of the judicial system using indicators such as by case load per judge, number of judgments enforced, number ofpending cases, and public perception based on survey feedback. Pillar 5: Investing in Human Capital and Strengthening Social Programs 53. The Government has begun an education reform initiative designed to improve resource management and quality of teaching and learning while continuing to maintain high levels of access. The reforms will strengthen the capacity of the Ministry of Education and Science (MES); introduce new education standards and curriculum and student assessment and evaluation system; train inspectors, school directors and teachers; develop a methodology to support local efforts to optimize the school network; improve resource allocation in general education through expandmg the delegated budgets system and developing a methodology to support local efforts to optimize the school network; reform the allocation process for resources and seats in the higher education institutions; and establish a modem student loan and stipend program. For the general education, a plan for phased staff reduction and redeployment options will be implemented. Reductions in employment will to the extent possible be carried out through attrition and rationalization in urban areas takng into account the social and demographic factors. In addition, the school network will be gradually optimized by merging schools to reduce the admmistrative and operational costs and improve maintenance and energy efficiency of schools. With these measures, the Government expects to raise the student-teacher ratio towards the average level in OECD countries by end-2005, increase enrollment in primary, middle and secondary schools to 97-98, 86-90 and 75-80 percent respectively, and upgrade the quality of education as measured by surveys. 22 54. The Government has begun a fundamental transformation of the health care system to improve the relatively poor health status indicators and use the available resources more efficiently. The focal point of the reforms is the National Health Insurance Fund (NHIF), which will undertake both risk pooling and medical care purchasing functions on behalf of the population. The parameters of a "steady state" health financing system, including the long-term division of responsibilities and revenue sources between the Ministry of Health (MoH) and the NHIF, are being developed. The Government plans to ensure adequate maintenance of existing capital assets and investment in new equipment and facilities so that the quality of care does not suffer, especially in the hospital sector. It will also develop a plan to address segments of the population who currently have limited or no access to either medical insurance or medical care due to socio-economic status or ethnicity. By end-2005, access is expected to improve by 25 percent compared to 2000 baseline, and administrative costs of NHIF kept to within three percent of revenues with staffing at less than 1,800. The Government would like to see improvements in the health indicators, including an increase in life expectancy, a reduction in incidence of tuberculosis and other infectious diseases, and an increase in immunization coverage which has experienced a sustained decline since 1989. 55. The Government has also begun the reform of the pension system towards a multi- pillar one. The new system comprises three pillars: first, the publicly managed pay-as-you-go system; second, the mandatory supplementary defined contnbution universal32 and occupational33 pension plans; and third, the voluntary supplementary plans. The Government has prepared an action plan which will help ensure successful implementation of the multi-pillar reform and has the following main components. First, the contribution rate that will be allocated to the public and private pillars will be better defined through a legislative amendment. Second, the legal framework concerning private pension plans and their supervision will be amended to improve governance structures and supervision capacity, introduce more flexibility in the investment regime, and eliminate inconsistencies. Third, additional regulations will be issued to complement legislation. Fourth, an institutional development plan has been prepared to transform State Insurance Supervision Agency (SISA) into an effective supervisory agency. Fifth, contnbutions to private pension plans will be transferred promptly and handled in a transparent manner. Sixth, there will be a campaign to improve public understanding of the reform. By end-2007, private pension fund assets are projected to reach 2 percent of GDP and the transfer offunds from NSSI to private pension funds is expected to be no more than 5 days. 56. The Government plans to further improve the efficiency and coverage of social assistance programs. The two main cash benefit programs, the Guaranteed Minimum Income (GMI) and energy benefit programs, have high incidence among the poor. In 2001 the 'extended GMI' program - encompassing cash and in-kind benefits - channeled 68 percent of resources to the poorest 20 percent of the population, while 53 percent of the energy benefit went to the bottom quintile.34 The effectiveness of the GMI program will be improved by elimmating in-kind benefits in favor of cash and strengthening the administration of social assistance delivery. The coverage of the energy benefit program will be extended to large families, the eligibility critena tightened to focus on poor families, and the program reviewed in the light of future tariff increases. The child allowances program will also be improved by reducing leakage, expanding coverage, and utilizing means-testing. A poverty monitoring unit in the MOLSP has been 32 For those born after December 31, 1959. 33 For those working under hazardous conditions. 34 See Chapter 5 of Bulgaria. Poverty Assessment, The World Bank, 2002, for an analysis of the social programs and recommendations for further reformL 23 established to track and assess the impact of government policies and programs on poverty, including the improvement in the efficiency and coverage of the social assistance programs. C. BANIK GROUP STRATEGY Country Assistance Strategy 57. The proposed PAL is fully consistent with the 2002-05 Bank Group Country Assistance Strategy for Bulgaria which was reviewed by the Board of Executive Directors on May 9, 2002. The CAS focused on three main themes: (a) promoting competitive private sector led growth; (b) strengthening public administration and anti-corruption initiatives; and (c) mitigating the social impact of restructuring and delivering social services more effectively. Drawing from the lessons of the previous CAS, the 2002-05 CAS recognized the need for a comprehensive policy reform program to support the wide range of policy and institutional reforms that the transition to market economy market entails. The CAS strategy is for Bank support to be provided over the CAS period through a series of programmatic adjustment loans (PALs), which will enable the Bank to be comprehensive in its approach, at the same time ensuring sustainability of the multi-year nature of the program. 58. Bulgaria has satisfactorily met the CAS conditions to remain in the base case and, more importantly, the proposed PAL assists the Government in maintaining satisfactory progress. The macroeconomic performance improved during the year, portfolio performance remains satisfactory, structural reforms remain on track, measures to further develop the pnvate sector are being implemented, the multi-pillar pension reform is ongoing, an energy subsidy program is in.place to protect the vulnerable groups affected by the substantial electricity price increase in the second half of 2002, and a Country Financial Accountability Assessment (CFAA) mission was conducted in December 2002. Further progress on Country Procurement Assessment Report (CPAR) recommended actions is expected with the decentralization of procurement and formation of a regional procurement unit in Sofia. The CFAA and CPAR will serve as important inputs to PAL-2 which will focus on upgrading public sector governance. The preparation of both PAL-2 and PAL-3 is being initiated this fiscal year which will ensure the sustainability of the Govermment program begun under the first PAL. The identification in the first PAL of the tnggers for future PALs further clarifies the conditions to remain in the CAS base case. Portfolio Quality 59. The total Bank-assisted program in Bulgaria as of end-December 2002 comprised 29 operations for a total original commitment of US$1,600.6 million equivalent. This includes ten adjustment loans (US$900.8 million equivalent), 17 investment projects (US$682.4 million equivalent), and two Bank-managed Global Environmental Fund grants (US$17.4 million equivalent). Of these 29 operations, 21 have been completed, of which two have been restructured and partially cancelled, and eight operations are currently under implementation. The most recent addition to the Bank's portfolio - the Social Investment and Employment Promotion project - was approved by the Bank's Board in December 2002. 60. The current portfolio is comprised of projects with commitments net of cancellations totaling US$230.6 million35 and complements the reform agenda articulated by the Government and supported by PALs. The current portfolio of projects was designed to 35 This includes the Social Investmnent and Employment Promotion project. 24 upgrade education and health services, improve child welfare, support environmental interventions, develop modem registration and cadastre systems, modermize water and transport sectors, and reduce unemployment. The projects under implementation are in the early implementation stages, with only three projects older than two years. Three projects are in an advanced stage of preparation - Revenue Administration Reform, District Heating Rehabilitation, and Forest Development - two of which directly support the implementation of the Government medium term program articulated in the proposed PAL. 61. The Bank also provides a range of analytical and advisory services as part of its activities in Bulgaria, and these will be important inputs to the future PALs. An updated Poverty Assessment and a Public Expenditure and Institutional Review have been completed recently and provide the analytical base of several components of PAL-2 which focuses on public sector governance and PAL-3 where the emphasis will be the social sector agenda. A Pension Note scheduled in FY03 will do a cntical review of the pension reform implementation and provide options and recommendations that will be covered by PAL-3. A Private Sector Assessment planned for FY04 will review the effectiveness of the business environment reforms and will suggest measures to further strengthen the reforms. Numerous grants provided under the Bank's trust fund programs complement the Bank's lending services through financing project preparation and advisory services. 62. The overall performance of the Bulgaria program has been satisfactory since 1997 when a major restructuring of the portfolio took place. The transition to the new Government in 2001 has been difficult, and there are some symptoms of potential deterioration and volatility of the portfolio especially in the social sectors. However, these are being proactively addressed in the process of project supervision and joint portfolio reviews. The Government is fully committed to project implementation and is working intensively with the Bank to address the remainng issues quickly in order to ensure that the ambitious program of reforms is implemented in a timely and efficient manner. The Bank and the Government intend to maintain the increased level of attention to portfolio management through general dialogue, regular project supervision, and the joint portfolio review process. Cooperation with the IMF 63. The IMF Board approved in February 27, 2002 a two year SDR 240 million Stand By Arrangement. The IMF supports the Bulganan authorities' economic program as articulated in the Memorandum of Economic Policies dated February 12, 2002. The ability of the Government to fulfill its commitments under the EMF program depends to a large extent on the structural and institutional reforms to be supported by the PALs. Cooperation between the Fund and the Bank has been strong, including the completion of the joint Bank-Fund Financial Sector Assessment Program for Bulgaria and the joint technical assistance initiative to upgrade the MoF debt management capacity. Annex 8 sets out in more detail the roles of the Bank and the IMF with respect to the Government's economic program. Coordination with Donors 64. The Government has adopted a mechanism for better coordination of donor activities to ensure effective implementation of Government program priorities as articulated in the proposed PAL. In order to make more effective use of donor resources available for reform and development programs, the Government has started developing an enhanced approach to external assistance by taking the lead in donor coordination. The new process seeks to organize donor resources around the Government's major development priorities. Four thematic areas for donor support have been identified: (i) business climate; (n) 25 living standards improvement; (iii) governance and public administration; and (iv) infrastructure and natural resources management. Under the new donor coordination mechanism that was adopted, relevant deputy prime ministers are responsible for these broad prionty areas. Various working groups in each of these thematic areas are established to work at operational level. They are aligned with government priorities and are led by deputy ministers. The Council for Structural Policy plays the overarching policy coordination role, and the Council of Ministers' Directorate for EU Integration and Relations with International Financial Institutions acts as secretariat (coordination unit). D. THE PROPOSED LOAN Program Design 65. The proposed PAL is the first of a series of three adjustment operations envisioned to be implemented during the CAS period. Each PAL operation is to be presented separately to the Board, within a common framework developed and agreed to in the first operation. As articulated in the CAS, the first PAL would advance structural, regulatory, and institutional reforms in the real andfinancial sectors that would move Bulgaria towards a functioning market economy. PAL-2, in addition to sustaining the reforms under the first PAL, would focus on public sector governance, including public administration modernization, judicial reform, and anti-corruption initiatives. PAL-3 would focus on the long term social sector agenda, in addition to ensuring the sustained implementation of the reform program supported by previous PALs. The sequencing of the thematic focus was based in part on the state of preparatory work and the absorptive capacity of the Govemment. Important pieces of Economic and Sector Work either planned or recently completed - including a Poverty Assessment, a Public Expenditure and Institutional Review, and a Pension Note - are important building blocks in the preparation of PAL-2 and PAL-3. 66. The evolution of the design of the proposed PAL was influenced by the Government's own priorities and timetable, which were driven by both EU accession issues and the need to deliver on campaign promises. While the first PAL was initially envisioned to focus on busmess environment, energy and financial sector issues, the Government begun developmg reform strategies on several fronts, including railway, telecommunications, water, anti-corruption, judiciary, health, education, and social assistance which were initially planned to be covered by future PALs. Rather than wait for the preparation of the future PALs to engage the Government on these issues, the first PAL included its program design the development of strategies and action plans in the areas of public sector governance and social sector, and incorporated the railway, telecommunications, and water reforms whose implementation had started. Given that the first PAL was the only adjustment operation under preparation, the PAL was the appropriate vehicle to engage the Government on policy and structural reform issues where the Government was making strategic decisions. 67. The Letter of Development Folicy (Annex 5) describes the Government's medium term program, including those components to be supported by future PALs. It also identifies measurable program outcomes36 and emphasizes coordination and implementation. The process of identifying measurable outcomes has impressed on the different govemment officials the importance of coordmation given the need for inter-ministerial action to achieve many of the outcomes. The monitoring and evaluation of outcomes will guide both the Bank and the 36 Some outcomes, such as those m the public administration and anti-corruption areas, will be identified during the PAL-2 preparation. 26 Government in assessing the effectiveness of the different reform initiatives and institutions. The LDP also contains the agreed triggersfor PAL-2 and PAL-3. 68. The Government has taken several steps to ensure the successful implementation of the program. First, it has activated the Council for Structural Policy within the Council of Ministers which is charged with the coordination function. Second, the Government has received institutional development plans, currently under implementation, from several critical institutions to ensure capacity to deliver on program commitments. Third, the Govemment has reorganized its donor coordination activities to align donor activities with program pnorities, including technical assistance to critical institutions. Fourth, Government has taken greater efforts to ensure the successful implementation of current and future investment projects, such as the recent successful effort at upgrading the unsatisfactory status of the Customs project. Fifth, the Government has improved communications with the public, including establishment of commissions with private sector participation and more generally involving stakeholders early in the design of government reform initiatives. Actions Taken Prior to Board Presentation 69. In addition to developing the foundation of the medium term reform program, the Govemment in the course of preparing the proposed PAL completed several substantial and concrete actions to begin implementation of the program. These actions, including the Board conditions, are identified below. The maintenance of macroeconomic stability, which was discussed in the first section of this memorandum, is a precondition for proceeding with the proposed PAL. As discussed earlier, macroeconomic performance has been robust in 2002. Pillar I: Sustaining Structural Reforms * Enactment of a new Law on Privatization and Post Privatization Control * Privatization of Biochim and DZI [PAL-I Board Condition] * Enactment of amendments to the Energy and Energy Efficiency Act (EEEA) * Establishment of electricity distribution, generation and transmission companies as separate legal entities * Adoption by the CoM of key regulations on electricity pricing and contracting of power by eligible consumers * Implementation of an average price increase of 20 percentfor household electricity prices in the second half of 2002 and approval of an indicative timetableforfuture price increases towards their adjustment to cost-recovery levels [PAL-I Board Condition] * Satisfactory implementation of the district heating (DH) component of the Energy Strategy approved by the CoM on May 11, 2002, including: introduction of two-part tariffs for all customers (a fixed capacity charge for all customers and an energy charge based on measured or estimated consumption); implementation of a 10 percent price adjustment in 2002, approval of an indicative schedule for raising household tariffs to cost-recovery levels and phasing out DH company subsidies; and allowing disconnection of entire buildings under specified conditions (Annex 6-C) * SERC development of a strategy for issuing tenders to develop the low-pressure gas market * Creation of new railway operating company as a joint stock company which has commercial objectives and autonomous decision making 27 * Creation of new railway infrastructure company as an independent public agency required to comply with minimum economic criteria for its expenditures * Issuance by the Ministry of Transport and Communications (MoTC) of regulations that (i) ensure that any willing and competent railway service supplier may be licensed; (ii) provide fair and transparent rules for track access; and (iii) keep transaction costs low for any prospective railway service supplier * Preparation of sound plan of action for rationalization of rail network and operations * Implementation of Chapter 19 (telecommunications) EU accession commitments descrnbed in Annex 6-C * Establishment of an independent, transparent, and accountable regulator for the telecommunications sector - the Communications Regulation Commission (CRC) * Issuance and implementation of a privatization strategy for BTC that ensures no extension of BTC exclusivities [PAL-I Board Condition] * Satisfactory progress in BTC tariff rebalancing * Submission to Parliament of draft New Telecommunications Law * Submission of amendments to the Water Law supporting the restructuring of the Regional Water Companies * Enactment of a new Environment Protection Act [PAL-I Board Condition] * Enactment of Biodiversity Law Pillar H: Establishing a Market-friendly Business Environment * Submission to Parliament of draft Law on Administrative Regulation and Administrative Control on Economic Activities [PAL-I Board Condition] * CoM approval of a program for eliminating and restructuring regulatory regimes * Development by a working group of a plan for the integration of the Bulstat, tax, and social security registration of companies * Completion of a baseline Administrative and Regulatory Cost Survey (ARCS). * Establishment of a Tax Council to include representatives from the private sector * Implementation of Customs reform in three pilot locations * Development of a plan for piloting a system of monitoring service standards in the Directorate for National Building Control at the Ministry of Regional Development and Public Works and the Labor Inspectorate at the Ministry of Labor and Social Policy * CoM decision to establish a National Revenue Agency * Enactment of the Law on State Aid harmonized with EU directives * Submission to Parliament of amendments to the Law on the Protection of Competition to strengthen the enforcement powers of the Commission for the Protection of Competition * Initiation of actions implementing the Social Policy Strategy and Strategic Note on Labor Market Reform37 adopted by the CoM * Development of a set of indicators on labor market flexibility and ALMP impact * Submission to Parliament of proposed amendments to Part IV (insolvency) of the Commercial Code [PAL-I Board Condition] * Approval by the MoJ of a plan to improve the selection and monitoring of bankruptcy trustees 37 PAL-3, whose first mission is being planned this FY, will review implementation of the strategy and recommend measures to further improve on the action plan. 28 Pillar HI.: Deepenint the Financial System * Submission to Parliament of amendments to the Law on Registered Pledges * Enactment of amendments to the foreclosure provisions of the Civil Procedure Code * Enactment of an Accountancy Act and an Independent Financial Audit Act to adopt intemational standards in accounting and auditing * Submission to Parliament of a draft Law on Measures Against Terrorist Financing * Submission to Parliament of draft amendments to the Law on Measures Against Money Laundering * Enactment of Bank Bankruptcy Law * Enactment of amendments to the Banking Law providing broader powers to the BNB to investigate and identify direct and indirect ownership of banks * Issuance of regulations for foreign investments of private pension funds * Adoption of an institutional development plan for the State Insurance Supervisory Agency (SISA) * Adoption of an institutional development plan for Insurance Supervisory Agency (ISA) * Enactment of the Mortgage Bond Law to enable issuance of mortgage backed securities * Enactment of amendments to the Law on Public Offering of Securities to strengthen minority shareholder rights protection * Submission to Parliament of amendments to the Commercial Code to strengthen corporate govemance * Enactment of amendments to the Insurance Act to harmonize with EU directives and strengthen ISA * Elimination of monopolies in certain segments of the insurance market * Establishment of a forum for coordination and review of systemic vulnerabilities Pillar IV: ImDro vig Governance * Approval of Strategyfor State Administration -from Accession to Integration, and program for its implementation agreed with the Bank [PAL-I Condition] * Approval of a national training strategy approved by CoM * Completion of a Pay and Benefits Survey in the public sector * Development of monitoring indicators to track public administration outcomes * Development of an anti-corruption strategy and action plan agreed with the Bank [PAL-i Condition] * Establishment of the Inter-ministerial Committee for Implementing the Anti- corruption Strategy and Action Plan * Approval by CoM of a program and action plan for judicial reform including a National Anti-Corruption Componentfor the Judiciary [PAL-i Condition] * Preparation by the Supreme Judicial Council of uniform standards of service for the administrative staff in the judiciary * Submission to Parliament of amendments to the Judicial Act incorporating adoption of uniform criteria for the selection of magistrates and the evaluation of their performance * Introduction of compulsory training for magistrates 29 Pillar V: Investing in Human Capital and Strengthening Social Protection * Preparation of a plan for phased staff reduction and other efficiency measures m the education system agreed with the Bank o Approval by CoM of a strategy for hospital restructuring, including financing plan * Agreement among the MoF, MoH, and the NHIF on a long term funding approach for hospital services * Introduction of the second pillar of the pension reform with a two percent contribution rate * Adoption of regulations to transfer contributions to private pension funds in a prompt and transparent manner * Initiation of implementation of an action plan to improve and strengthen the pension reform program * Introduction of targeting of child allowances * Adoption of an adjusted energy subsidy program in view of announced tariff increases [PAL-I Condition] * Establishment of a poverty monitoring unit in the MOLSP • Approval by CoM of amendments to the Social Assistance Act opening social services provision for private and NGO providers Medium Term Actions and Triggers for Future PALs 70. The Government has identified time bound actions to sustain the reforms over the next two to three years and agreed to a set of triggers for PAL-2 and PAL-3. As more information becomes available from economic and sector work as well as feedback mechanisms such as surveys, some of these actions may be modified or strengthened. Nonetheless, several actions during the next three years critical to the success to the program have been identified and are included in the LDP and Performance Benchmark Matrix. The triggers for future PALs are listed below. In addition, the continued maintenance of macroeconomic stability is a precondition for future PALs. Furthermore, as discussed in paragraph 21, the CAS has imposed additional triggers for processing PAL-3. Pillar I Sustaiing Structural Reforms By Mid-2003 (PAL-2 Trigger): * Privatization or liquidation of large SOEs listed in Annex 6-B o Enactment of energy legislation consistent with EU Electricity & Gas Directives * Reduction of railway labor force by 10% compared to the level at end of 2001 * Satisfactory implementation of environmental policies on SOEs to be privatized By mid-2004 (PAL-3 Trigger): * Privatization or liquidation of large SOEs listed in Annex 6-B e Privatization or liquidation 80 percent of the remaining small SOEs as of September 30, 2002 * Continued satisfactory implementation of district heating component of the Energy Strategy approved by the CoM on May 11, 2002, including a tariff adjustment program and private sector participation (Annex 6-C) * Cumulative reduction of the railway labor force by 20% compared to the level at end of 2001 30 Pilar H: Establishing a Market-friendly Business Environment By mid-2003 (PAL-2 Trizger): * Elimination of 40 and modification of 50 regulatory regimes per program approved by the CoM on June 7, 2002 * Submission to Parliament of amendments to the Labor Code agreed with Bank By mid-2004 (PAL-3 Trigger): * Implementation of the reform of the administrative court system towards specialization, and of a program for upgrading skills ofjudges Pilar mW1: Deepening the Financial System By mid-2003 (PAL-2 Trig ger): * Enactment of amendments to the Mandatory Social Insurance Code and the Voluntary Pension Code strengthening pension fund govemance and SISA supervision capacity, introducing more flexibility to the investment regime while maintaining a prudent portfolio, and eliminating inconsistencies Pilar IV: Improvin-' Governance By mid-2003 (PAL-2 Tri-gyer) * Satisfactory progress in implementing the State administration modemization program based on the agreed performance benchmarks and assessment of the agreed monitoring/performance indicators * Development and initiation of implementation of a program for improving local administration * Regulatory action establishing a legal framework favorable to a national system of altemative dispute resolution By mid-2004 (PAL-3 Trigger) * Continued satisfactory progress in implementing the State administration modemization program based on the agreed performance benchmarks and assessment of the agreed performance indicators * Continued satisfactory implementation of the anti-corruption action plan * Improved supervisory, budgetary and planning capacity of the SJC based on a plan to be agreed with the Bank Pilar V: Investing in Human Capital and Strengtbening Social Protection By mid-2003 (PAL-2 Trigger): * After a review of the social assistance programs, development and implementation of a plan agreed with the Bank to improve coverage and increase efficiency38 38 This will be performed m the course of PAL-2. The Poverty Assessment has made an analysis of the impact and efficacy of existing programs on the poor and laid out some strategic options for improvement (see para 56). The improvements will need to take into account the work in PAL-2 on the local government and decentralization components of the public administration pillar. Specific outcome indicators on social assistance program reform - such as quantitative targets on percentage of resources going to the poorest quintile of the population - will be defined m PAL-2 and satisfactory progress in implementing the program will be a trigger for PAL-3. 31 By mid-2004 (PAL-3 Trigger) * Continued satisfactory progress in implementation of the action plan to improve and strengthen the pension reform program39 o Implementation of plan agreed with the Bank to improve coverage and increase efficiency of social assistance programs Implementation and Monitoring 71. To improve coordination and management of the program, the Council for Structural Policy was activated, headed by the Deputy Prime Minister and Minister for Economy and includes as members the Deputy Prime Minister and Minister of Labor and Social Policy, the Deputy Prime Minister and Minister of Regional Development and Public Works, the Minister of Finance, four other ministers, two deputy ministers, and the Executive Directors of the Privatization Agency and Foreign Investment Agency. The secretariat function is provided by an eight-member team in the Directorate for EU Integration and Relations with IFIs. A full time adviser will be hired to assist in the functioning of the Council. 72. There are several committees that focus on specific components of the reform program, among them: the Inter-ministerial Working Group for the Optimization of Regulatory Regimes, the Financial Supervision Advisory Council, the Poverty Monitoring Unit at the Ministry of Labor and Social Policy, and Labor Standards Measurement Survey (LSMS) Unit within the National Statistical Institute. 73. To ensure implementation funding and expert support, there are existing Bank projects in the areas of education, health, social assistance, employment promotion, cadastre, and customs. Planned Bank projects cover distnct heating, unification of revenue collection, and rural development. As mentioned earlier, the Government has taken steps to improve coordination of donor activities to ensure better alignment of donor activities with government priorities. 74. The Government has also developed mechanisms for participation by stakeholders in the design and implementation of the reform program. Several forums have been established with both private and public sector memberships to facilitate dialogue on thematic issues, among them, the Council on Economic Growth and the Tax Council. There are regular consultations with established private sector organizations such as the Chamber of Commerce and Industry, the Industnal Association, and the Employers' Association. 75. Finally, the medium term program implementation plan includes several feedback mechanisms to enable the Government to track progress towards the desired outcomes. A baseline Administrative and Regulatory Cost Survey (ARCS) has been completed and will be performed annually. The living standards survey will be done on a regular basis. A joint EBRD/WB enterprise survey has been completed recently and annual enterprise surveys on specific issues are planned. To assess changes in public perception of the judicial system, a survey is being designed to be implemented next year. 39 The Govermnent submitted a seven-point program for strengthening the implementation of the reform of the pension system. The objectives of the program are to increase the contribution rate to the second pillar, irmprove supervision and govemance of pnvate pension funds, increase the efficiency of collection and transfer by NSSI of pension contribution to pension funds, and improve public awareness of the pension reform. Satisfactory progress in the implementation of the program will be a PAL-3 trigger. 32 Loan Administration 76. Borrower and Loan Amount. The proposed PAL will have a loan amount of US$150 million equivalent to be disbursed in Euro to be made to the Government of Bulgarna, represented by the Ministry of Finance. The loan will be a single tranche fixed spread loan with a 16 year matunty including a grace period of 6 years. The proposed PAL is the first of three planned adjustment loans totaling $450 million based on the CAS. 77. Disbursement. In accordance with the February 8, 1996 Operational Directive on the Simplification of Disbursement Rules under Structural Adjustment and Sectoral Adjustment Loans, funds disbursed under the proposed PAL will be released against satisfactory progress in the reforms set forth in the loan. Disbursements will not be linked to specific purchases, thus evidence will not be needed to support disbursements, nor will procurement requirements be necessary. Upon approval of the loan and notification by Bank of loan effectiveness, the Government will submit a withdrawal application. The Ministry of Finance will open and maintain a Deposit Account in the Bulgarian National Bank. IBRD will deposit the proceeds of the loan into this Deposit Account at the request of the Ministry of Finance. Pnor to that, the Bank will withdraw from the Loan Account a front end fee amounting to 1 percent of the loan amount. If after the loan proceeds are deposited in the BNB account, the proceeds are used for ineligible purposes as defined in the loan agreement, IBRD will require the borrower to either: (a) return that amount to the Deposit Account for use for eligible purposes or (b) refund the amount directly to IBRD. 78. Accounts, Auditing and Closing Date. The Govemment will maintain accounts and records, or ensure that such items are maintained, showing that loan disbursements were in accordance with provisions of the Loan Agreement. Such accounts and records will be maintained in a form acceptable to the Bank. The extemal auditor of BNB will conduct an annual review of the deposit account opened by the Govemment in BNB to exclusively hold the loan proceeds. The terms of reference of the review should be acceptable to the Bank. The review will examine and report on the disbursements from the deposit account until such time that all the loan proceeds have been fully utilized. Such reviews will be submitted to the Bank as soon as they are completed. The Bank. may require a more extensive audit of such records by independent auditors. 79. Environmental Impact. The environmental classification is C. The project has addressed environmental issues in the privatization process, energy restructuring, water sector modermization, and introduction of the Integrated Pollution Permit System. 80. Compliance with Bank Policies. The loan complies with all applicable Bank policies. Benefits and Risks 81. Benefits. First, the proposed PAL assists a new govemment define a medium term economic program that achieves sustained growth, poverty reduction, and progress towards EU accession. Second, the proposed PAL helps put in place mechanisms and institutional arrangements that would ensure successful implementation, coordination, monitoring, and evaluation of the medium term program. Third, the proposed PAL lays the groundwork for future PALs by creating the framework and identifying future critical actions to be supported by future operations. Fourth, the proposed PAL complements the current and planned mvestment projects by establishing the enabling policy framework, especially in the social sector. Fifth, the program supported by the loan complements and reinforces the IMF program. 33 82. Risks. First, there is implementation risk given the current weaknesses in institutional capacity which the PALs seek to correct. To address implementation risk, the Government under the proposed PAL activated the Council for Structural Policy, is implementing institutional strengthening programs for critical offices and agencies, and is improving donor coordination to align donor funded technical assistance with program priorities. In addition, PAL-2 will focus on upgrading public administration, which will address government capacity to design and implement reform. Current and planned investment projects in the health, education, energy, and water sectors, revenue administration, cadastre, and environment complement the PALs by providing implementation support. 83. Second, the political risk remains high, with the possibility of policy slippages. Coalition building in support of many of the socially difficult reforms may run into resistance especially if unemployment remains high and anti-corruption efforts fail to improve perception. Implementing difficult structural reforms with accompanying improved targeting of social programs and well designed communications strategy mitigates the political risk. This was the case when electricity prices were recently increased by 20 percent - the implementation of a winter energy support program and a consultation process prevented a political backlash. More generally, the social protection and assistance pillar of the reform program would mitigate the adverse effects of the difficult structural reforms while the business environment pillar would expand opportunities for employment. In addition, strong support by all political parties for Bulgaria's EU accession and NATO membership is effectively anchoring the direction of macroeconomic and structural reforms. 84. Third, there may be shocks coming from the external environment, jeopardizing macroeconomic stability. Bulgana faces several significant extemal risks. A failure to carry out the envisaged privatization program or attract sufficient greenfield FDI would put the projected extemal financing at nsk, requiring additional adjustment to ensure that debt levels continue to decline. Moreover, Bulgaria's extemal accounts are more sensitive to three key parameters: an increase in oil prices, higher interest rates, and a prolonged slowdown in EU economies which are the destination of over fifty percent of Bulgarian exports and the origin of more than half the FDI inflows. However, the achievements to date, the better than expected performance m the last several months of 2002, and the active efforts to restructure and reduce extemal debt enabled Bulgaria to manage extemal risks. Continued maintenance of strict discipline in macroeconomic management, the measures in place to respond to potential risks, and acceleration of structural reforms substantially mitigate these rnsks. 34 Annex 1 Page 1 of 2 Bulgaria at a glance 1903 Europe & Lower- POVERTY and SOCIAL Central middle- Bulgaria Asia Income Development diamond' 2001 Populabon, rrid-year (mIllons) 8 1 475 2,164 Life expectancy GNI per capita (Atlas method, US$) 1.630 1960 1.240 GNI (Altas method, USS bgllons) 13 2 930 2,677 Average annual growth, 1995401 Populalon (%J -0 6 01 10 Labor force (X) -0 5 0 6 12 GNI Gross per pnnmary Most recent eastmate (latest year avalable, 1995-01) capita nient Poverty (% of population below national poverty line) Urban populabon (% of total populatlon) 70 63 46 Ltfe expectancy at birth (years) 72 69 69 Infant mortality (per l,000liveirths) 14 20 33 Child rialnutnton (96 of chidren under 5) 11 Access to improved water source Access to an improved water source (X of population) 98 90 s0 Illiteracy (X ofpopulation age 15+) 2 3 15 Grossprirnlaryenrolrment (X ofschool-agepopulation) 101 102 107 -B ulgana Male 102 103 107 Lower-rniddle-income group Ferrale 99 101 107 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1981 1991 2000 2001 EconomIc ratlos- GDP (US$ bfllions) 201 109 126 136 Gross domesic investmenVGDP 35 5 22 6 18 3 20 4 Exports of goods and servicesGDP 35 6 43 5 55 7 55 7 Trade Gross domeslc savings/GDP 36 6 26 9 12 9 12 9 Gross nabonal savlngs/GDP 17 3 12 7 14 3 Current account balancelGDP 0 6 -0 7 -5 6 -61 omestc Iv. r Interest payments/GDP 0 2 0 8 4 0 3 7 Don t Total debt/GDP 3 9 107.3 88 9 783 gs Total debt servicelexports 0 7 5 4 13 5 17 0 Present value of debt/GDP Present value of debVexports Indebtedness 1981-91 199141 2000 2001 200145 (average annual growth) GDP 2 2 -0 7 5 4 4 0 5 0 Bulgarla GDP per capita 2 4 -0 1 5 9 4 6 5 7 - Lower-middle-income group Exports of goods and servmces -114 7 2 16 6 8 5 8.9 STRUCTURE of the ECONOMY 1981 1991 2000 2001 Growth of Investment and GDP (%) (% of GDP) Agriculture 166 154 123 121 T Industry 51 9 57 8 25 8 25 2 -20 Manufacturing 157 1555o Services 290 184 487 571 -20 98 go OD 01 Pnvate consumption 48 7 54 1 69.2 711 40 General govemment consunmtion 14 7 19 0 17 9 161 GDI GDP lmports of goods and services 34 5 39 2 61 1 63 2 GD- GO 1981-91 199141 2000 2001 Growth of exports and Imports (%) (average annual growth) 3 Agnculture -19 41 -103 05 30 Industry 3 0 -3 2 10 6 4.2 20. Manufacturing Servioes 4 4 -3 5 6 7 4 2 to Private consumprton 15 -0 5 4 6 5 0 Om Generl govemment consumpbon 3 7 -6 0 11 7 2 4 -10 Gross domestc investmanet- -0 1 1 6 154 199 Exports Imports Imports of goods and services -12 9 a 8 18 6 13 0 Note 2001 data are prelirinary esbtrates The diamonds show four key indicators in the country (in bold) compared with its income-group average If data are rrsssing. the diamond will be Incompiete Reters to gross dormestic fixed investment Annex 1 Page 2 of 2 Bulgana PRICES and GOVERNMENT FINANCE 1981 1991 2000 2001 In1bdon (%) DomestSc tprices (% change) |ooS Consumer prices 104 715 _- Implict GDP deflator 226 6 6 7 65 t0 D 485 Govenmet finance __-. (6 of GDP, incudes current grants) o 0 Current revenue 43 6 38 2 37 4 go D7 Oa go oo rn Current budget balance -1 2 3 2 3 3 - GDP delator - CPI Overall surplustdsfiact -4 2 0 3 2 0 TRADE 1981 1991 2000 2001 Export and Import levels (USS mill.) (US$ mlllhons) Total exports (fob) 3,737 4.825 5,107 8.rJc Consumer goods 1,439 1,715 7.0OD Investment goods 552 625 a OC* Manufactures 656 675 5 _OD Totl imports (clf) 4.071 6.507 7.261 4.O * Food 175 198 z9o _ _ Fuel and energy 1,775 1,627 ,o _ )_ _ Capital goods 1,263 1.592 1,816 o Expont price index (1995=100) as85 65 Import prdce index (1995=100) 86 87 D Exports U imports Terms df trade (1995=100) 99 98 BALANCE of PAYMENTS 1981 1991 2000 2001 Current account balanco to GDP (36) (US$ mittlonsJ Exports of goods and servicea 9,338 4,137 7.000 7.532 12 Imports of goods and services 9,046 4,255 7,670 8.555 10 Resource balance 292 -118 -670 -1.023 Net income -261 -28 -321 -304 4 Net current transfers 90 69 290 498 2 PM Current aacount balance 121 -77 -702 -828 -2 Ge 97 Oa Fmnancing Items (net) -490 -4 975 1.272 44 Changes hi net reserves 369 81 -273 44 Memo: Reserves Including gold (US$ milZions) 616 3.460 3,579 Conversion rate (DEC, tocal'JSS) 0 01 2.1 2 2 EXTERNAL DEBT and RESOURCE FLOWS 1981 1991 2000 2001 (US$ miDlions) Composrton of 2001 debt (USS mIll.) Totaldebtoutstandinganddisbursed 773 11,742 11.202 10,616 IBRD 0 61 824 844 IDA 0 0 0 0 G t,210 A S44 Total debt seerve 68 227 990 1,340 IBRD 0 0 76 80 - IDA 0 0 0 0 Composibon of net resource flows _ 797 OfMlidal grants , 19 74 177 r Oftfioal creditors 29 12 -179 - Pnvate creditors 30 107 352 Foreign direct investment 56 1,002 694 Portfolio equity 0 5 -9 F 5,935 World Bank program CommRanents 0 267 135 88 A- 16FD E- Bliateral Disbursements 0 58 71 88 6 - IDA D - Oter multiateral F - Pnvate Principal repayments 0 0 27 32 C - IMF G - Sort-n Net flows 0 58 44 56 Interest payments 0 0 49 48 Net transfers 0 58 -5 8 Development Economics 1/9/03 Annex 2 Page 1 of 1 Bulgaria Social Indicators Latest single year Same region/income group Europe & Lower- Central middle- 1970-75 1980485 1994400 Asia Income POPULATION Total populabon, mid-year (millions) 8 7 8 9 8 2 474 7 2,048 0 Growth rate (% annual average for penod) 05 02 -0 5 0 1 1 0 Urban population (% of population) 57 5 64 5 69 6 66 8 42 4 Total fertility rate (births per woman) 2 2 2 0 1 3 1 6 2 1 POVERTY (% of populabon) National headcount index Urban headcount index Rural headcount index INCOME GNI per capita (US$) 1,980 1,520 2,010 1,140 Consumer pnce index (1995=100) 3,448 192 149 Food pnce index (1995=100) INCOME/CONSUMPTiON DISTRIBUTION - Gini index 26 4 Lowest quinble (% of income or consumption) 10 1 Highest quintile (% of income or consumption) 36 8 SOCIAL INDICATORS Public expenditure Health (% of GDP) 36 43 27 Education (% of GNI) 55 34 51 47 Social secunty and welfare (% of GDP) 11.7 88 Net primary school enrollment rate (% of age group) Total 96 96 93 92 99 Male 96 96 94 93 100 Female 97 96 92 92 99 Access to an Improved water source (% of population) Total 90 80 Urban 95 95 Rural 98 82 69 Immunization rate (% under 12 months) Measles 99 96 97 87 DPT 99 96 97 87 Child malnutnbon (% under 5 years) 11 Life expectancy at birth (years) Total 71 71 72 69 69 Male 69 68 68 64 67 Female 74 75 75 73 72 Mortality Infant (per thousand live births) 23 15 13 21 32 Under 5 (per thousand live births) 32 25 16 26 40 Adult (15-59) Male (per 1,000 population) 172 190 227 289 192 Female (per 1,000 populaton) 106 106 106 127 133 Matemal (per 100,000 live births) 23 Births attended by skilled health staff (%) 99 This table was produced from the CMU LDB system 1ol18/02 Note 0 or 0 0 means zero or less than half the unit shown Net enrollment ratios exceeding 100 indicate discrepancies between the estimates of school-age population and reported enrollment data Annex 3 Page 1 of 2 Bulgaria - Selected Indicators Table Bose-case (most likely) projection Actual Estimate Projection 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Part A: Main Macro Aggregates Annualgrowth rates (%) GDP(mp) percapita -8.9 -5.1 47 2.9 5.9 4.6 4.6 56 6.2 6.2 Total consumption per capita -7.7 -9 1 4.7 9.4 6 3 5.1 4.1 5.1 5 6 5.6 GDP at market pnces -9.4 -5 6 4 0 2.3 5 4 4 0 4.0 5.0 5.5 5 5 Total consumption -8.2 -9.6 4.0 8.8 5 7 4.5 3.5 4 5 4 9 4.9 Private consumption -38 -107 2.7 95 4.6 5.0 3.6 50 5.5 57 Gross domestic investment (GDI) -25.9 -6 7 26.4 5.2 4 7 7 0 4.2 4 8 3.0 2 8 Gross dom. fixed investment (GDFI) -21.2 -20 9 35 2 20 8 15.4 19 9 7 0 8 0 8.5 8.5 Exports (GNFS) 11.8 12.8 -4.7 -5 0 16.6 8 5 5.9 9 9 9 7 9 2 of which Goods -5.6 9 3 -3 8 -4.5 20.4 5 8 4 6 9 4 9 6 9.2 Imports(GNFS) -1.9 10.9 12.1 93 186 130 5.5 95 7.3 66 of which Goods -10.8 3.4 17 1 11.2 17.9 108 4.2 9.1 6.9 7.8 Savings-investment balances, aspercentage of GDP GrossDomestic investment 8 1 99 16 9 17 9 18 3 204 20.7 21 1 21 5 22 0 of which Government investment 1.6 1.0 3 7 45 3 9 3.9 3.2 3 5 3.6 4.0 Foreign savings -1.7 -10.1 0 5 5.0 5.6 6 1 4.2 5 3 4.7 4.4 Grossnationalsavings 98 200 164 12.9 127 14.3 165 15.8 16.8 176 Govemmentsavings -13.7 2.1 48 45 3.2 33 3.1 32 2.9 2.9 Nongovemmentsavings 234 178 11.6 8.4 9.5 11 0 13.4 12.6 13.9 14.7 Gross domestic savings 13.5 14.5 17.1 12.1 12.9 12.9 14.5 14.8 16 1 17.1 Other GDP inflation (%) 120.8 948.5 23 7 3 7 6.7 6.5 5.4 3.3 4.0 3.6 Annual average exchange rate (LCU/US$) 0.18 1 68 1.76 1.84 2.12 2 19 2.09 2.00 1 99 1 98 Index real average exchange rate(YR95=100,%) 81 6 74.2 61 2 63.3 660 .. Terms of trade index (YR95 =100, %) 96.3 94.8 98.6 98.6 98.5 97.9 106.6 106 6 106 6 106 7 Incremental capital-output ratio (GDI based) -3 3 4 6 6.3 13.4 5.9 7 9 8 1 6 5 5 9 5 8 Import elasticity with respect toGDP 114.7 -601 428.3 4870 331.5 270.0 1059 181.3 126.2 142.4 M2growth(%) 117.2 3568 119 13.0 322 26.7 154 155 17.0 17.0 Annex 3 Page 2 of 2 Bulgaria - Selected Indicators Table (Continued) Base-case (most likely) projection Actual Estimate Projection 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Part B: Government Finance Indicators Percentage of GDP a Total revenues, of which a 31 7 30.7 354 386 387 37.7 36.0 35.6 356 35 3 Taxrevenues 264 26 1 298 294 299 28.8 27 3 274 27 1 268 Total expenditures, of which 42 0 32 7 34.5 39 6 39 7 38.6 36.7 36.3 35.9 35 3 Consumption 114 13.3 158 168 160 138 139 129 12.6 124 Deficit(-)/Surplus(+) -10.3 -2 0 09 -0.9 -1.0 -0.9 -0.7 -0 7 -0 3 0 0 Financing 10.3 2.0 -0 9 0.9 1.0 0.9 0 7 0.7 03 0 0 Other Total Debtb/GDPmp (%) 1167 1075 93.0 84.7 805 700 61 7 552 504 459 Total interest payments/Tax revenues (%) 750 303 14.6 128 135 13.0 81 87 11.5 10.9 Part C: Debt & Liquidity Indicators Total DOD and TDS DOD(US$millions) 9603 10414 10893 10915 11202 10616 10933 11416 12080 12829 DOD / GDPmp (%) 97 0 100.4 85.5 84 3 88 9 783 70 3 64 8 62 2 60 1 TDS(US$millions) 1254 817 1090 936 990 1340 1583 1128 1147 1390 TDS/exports(XGS),% 18.5 11 3 17.3 154 13.5 17.0 19.1 12.6 117 129 Total gross reserves (months' imports G&S) 1.4 4 6 5 6 5.5 5 0 4 7 5.8 5 4 5 4 5 5 Part D: External Financing Plan (USS, millions) Official capital grants 65.9 0 0 0 0 -2 4 24 9 -0.1 0.0 0 0 0 0 0 0 Private investment (net) 8.1 639.4 295.8 602 3 824.6 766.8 567 7 648.4 777.8 857.2 Net Long term borrowing excl IMF -275.0 -133 0 114 0 355.0 234.0 60.6 105.2 525.0 670 0 724 7 Adjustments to scheduled debt service 0.0 0.0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 All other capital flows -606 0 -309 6 -16 7 61 9 -108 8 444 6 681 3 -115.4 -45 5 33 5 Financing Requirements (mel IMF) -807.0 196 8 393 0 1016 8 974 8 1271 9 1354.2 1057 9 1402 3 1615 4 of which current account deficit -163 7 -1046 3 61.4 651.7 701 6 828 2 653 5 928 9 910 4 942.4 a General Govemment operations consistent with the IMF Stand-By Arrangement and differ from GFS definitions. b. Includes total public debt-extemal and domestic. Annex 4 Page 1 of 1 Bulgaria - Key Exposure Indicators Actual Estimate Projected Indicator 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total debt outstanding and 9603 10414 10893 10915 11202 10616 10933 11416 12080 12829 disbursed (TDO) (US$m)a Net disbursements (USSm)a -41 131 413 666 492 115 -233 250 460 447 Total debt service (TDS) 1254 817 1090 936 990 1340 1583 1128 1147 1390 (US$m)a Debt and debt service indicators (%) TDO/XGSb 141.4 144 2 173 2 180.1 153.0 134 7 131.8 127.5 123.4 119.3 TDO/GDP 97.0 100.4 85 5 84.3 88.9 78.3 70.3 64.8 62.2 60.1 TDS/XGS 18 5 11.3 17.3 15.4 13.5 17.0 19.1 12.6 11.7 12.9 Concessional/TDO 1.9 1.6 1.6 2.0 3.2 3.2 0.0 0.0 0.0 0 0 IBRD exposure indicators (%) IBRD DS/public DS 3.6 5.9 5.6 7.6 8.4 6.6 5.5 11.2 12.4 119 Preferred creditor DS/public 29.9 45 5 48.9 34.9 40.2 48.8 31.8 41.9 39.8 47.0 DS (%)' IBRD DS/XGS 0.6 0.6 0.9 11 10 1 0 0.9 1.2 1.2 1.3 IBRD TDO (USSm) 453 501 697 829 824 844 891 1028 1159 1288 Of which present value of guarantees (US$m) ShareofIBRDportfolio(%) 0.0 0.0 00 0.7 07 0.7 0.7 0.9 1.0 1.1 IDA TDO (US$m)d 0 0 0 0 0 0 0 0 0 0 IFC (US$m) Loans Equity and quasi-equity /c MIGA MIGA guarantees (US$m) a. includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short- term capital. b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements. d. The current market value of the disbursed and outstanding amount of the loan including the exchange rate adjustment e. Includes equity and quasi-equity types of both loan and equity instruments. Annex 5 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN LETTER OF DEVELOPMENT POLICY December 20, 2002 Mr. James D. Wolfensohn President International Bank for Reconstruction and Development Washington D.C. Dear Mr. Wolfensohn: 1. We appreciate this opportunity to request support from the World Bank for the implementation of our medium term reform strategy which aims to further reduce poverty, sustain economic growth, complete our transformation to a market economy, and move us closer towards EU accession. We have responded to the 1996-97 economic and financial crisis by completing the first generation of economic reforms, which focused on macroeconomic stabilization, price liberalization, and the initial phase of structural reforms. We are moving into a second generation of reforms, where the emphasis is on developing well-functioning markets. This requires a massive effort of building institutions involving the establishment or strengthening of market rules, enforcement capacity, and supporting organizations. In this effort, we seek to redefine and upgrade the role and capability of government. We believe the Programmatic Adjustment Loans (PALs) provide the appropriate vehicle for Bank support in addressing our medium term policy and institutional reform agenda. 2. In the course of preparing the first Programmatic Adjustment Loan (PAL-1), we have defined and begun implementing most of the components of our reform agenda, taking into account sequencing issues. Subsequent PALs will enable us to review and monitor the implementation of these components, and we will take the necessary actions to ensure sustained implementation of policies and successful outcomes of institution building efforts. In addition, we will develop, articulate, and implement the remaining components of our reform agenda during the preparation of future PALs, based on the findings of the Bank's economic and sector work such as the Public Expenditure and Institutional Review and the Pension Note, as well as lessons from the implementation of existing Bank operations such as the Education Modernization Adaptable Program Loan and Health Sector Reform Project. The programmatic approach provides us the flexibility to make sound adjustments in our program and build on new information and additional experience in institutional design and implementation towards the successful achievement of our strategic objectives and program outcomes. 3. The Government and Bank staff have worked together in developing the components of the Government Program to be supported under the PAL series. The Annex 5 Letter of Development Policy Page 2 of31 reform program outcomes and the critical steps to achieve these outcomes are summarized in the accompanying Performance Benchmark Matrix. The reform program, which is described below, contains five pillars which support our strategy: (i) sustaining structural reforms focusing on the infrastructure sector; (ii) establishing a market-friendly business environment; (iii) deepening the financial system; (iv) improving public sector governance; and (v) investing in human capital and strengthening social protection. Program implementation during the year 2002 has already resulted in the completion of critical steps towards achieving the desired outcomes in several program components. It is on the basis of these completed actions, in addition to the reform program itself, that we seek your support under the first PAL operation. 4. We have defined the desired outcomes of our program, and the monitorable indicators to determine whether the outcomes are being achieved. The benchmarks in the attached matrix - defined as a set of actions needed to achieve the outcomes of each program component - reflect our current knowledge and experience of what actions are necessary during the next two years to achieve the desired outcomes at the end of program implementation. We have detailed in the matrix the future actions to be completed as well as monitorable indicators to guide the work of different government teams engaged in this process and to enable us to assess our progress towards achieving the reform outcomes. As we accumulate learning by doing and as we digest the outputs of analytical work and the results from feedback mechanisms, we will refine the benchmarks to ensure the successful attainment of the outcomes. We have nonetheless defined the specific benchmarks that are critical to the program and we have identified these as the triggers for the future PALs. 5. The following section provides the context within which the program was developed. It specifies the set of reform objectives and describes the strategic themes that guide the program design to ensure intemal coherence. Background 6. Following the economic and financial crisis of 1996-97, Bulgaria has achieved macroeconomic stabfity and implemented the first generation of structural reforms. Macroeconomic stabilization has been successfully maintained over the past four years largely due to the Currency Board Arrangement (CBA) and a tight fiscal stance. After a steep decline in 1996-97, output recovered and GDP growth averaged 4.7 percent in 2000-01, with inflation contained to low levels. There have been major structural changes in the economy, with private sector share of GDP reaching 63 percent in 2001 as a result of a major push in privatization in 1998-99. 7. Although Bulgaria's per capita GDQP has recovered since the crisis, it is still one of the lowest among the EU accession mcountries. We intend to raise incomes from the current low levels, which are 31 percent of the European Union (EU) average in per capita terms (based on purchasing power parity). We believe that sustained growth will help us make important progress in reducing unemployment and raising living standards. Annex 5 Letter of Development Policy Page 3 of31 The resumption of growth has been instrumental in reducing the poverty rate, by nearly two-thirds compared to the level in 1997. 8. We also recognize that participation in the benefits from growth over the past four years has been uneven among the population. Economic restructuring, which has been one of the major drivers of growth during the past four years, has been dominated by the exit of many non-viable SOEs and by improvements in efficiency of privatized enterprises, both resulting in labor shedding. As a consequence, our unemployment rate, based on data from our Employment Agency, is one of the highest in the region at 17.3 percent at mid-2002. Moreover, we are concerned about the increasing duration of unemployment, with about half of the unemployed out of work for more than one year. Reducing unemployment is one of the major focus of our economic program. 9. Despite the improvements since 1997, poverty is higher than the rate in 1995. The nature of poverty has evolved, as recent improvements in welfare have not been equally distributed across the population. There are "pockets of poverty" among certain groups, particularly the unemployed, ethnic minorities - most notably Roma - and families with more than four children. Poverty also has a significant rural dimension. Poverty reduction policies need to be tailored to reach these groups to ensure that the benefits of growth are targeted to reduce poverty. In designing our program, we are cognizant of the importance of broader participation in the growth agenda, and the need to improve the efficiency and coverage of social assistance within fiscal constraints. 10. Building on the reforms of the past four years, our program for the medium term aims to sustain economic growth and reduce poverty. More specifically, our targets are to maintain an average annual growth rate of 4.5 to 5.0 percent over the period 2002-05, reduce the poverty rate by 50 percent by end-2005 compared to the level at end- 2001, and bring the unemployment rate to 12-14 percent by end-2005. Our strategy for growth and poverty reduction revolves around two major themes: * creating an investment climate that promotes private sector investment, restructuring, and productivity leading to growth; and * empowering the population, especially the poor, to participate in economic growth. 11. Our strategy uses private sector initiative as the main engine for aggregate growth. The private sector is also potentially the major provider of opportunity to the poor, especially the large number of unemployed. Our strategy during the past few years focused on the divestment of the State's non-infrastructure assets and the enforcement of financial discipline on the remaining SOEs, thereby creating space for the private sector. Our current strategy is to unleash private initiative by establishing an investment climate that will not only increase the level of investment but also improve productivity of IThe poverty rate is defined as the percent of the population below two-thirds the mean 1997 consumption. Annex 5 Letter of Development Policy Page 4 of 31 existing investments. Our strategy focuses on the factors that drive investment and productivity to result in growth, with particular attention to the role of foreign direct investments (FDI) and small and medium enterprises (SME). This requires a massive effort of building credible market institutions, and careful definition of the role of Government which needs to upgrade its capabilities. 12. Empowering the population requires investment in human capital and further strengthening of social protection. Our focus during the past few years was designing and strengthening social protection programs at the time when price liberalization and enterprise restructuring were having an adverse impact on the poor. While we will continue to fine tune the effectiveness of our social protection programs - including the implementation of an ambitious multi-pillar pension reform - we will shift our emphasis to the heath and education agenda and proactive measures to mitigate the adverse impact of the reforms on the poor. We recognize the importance of basic education to participation and productivity. Our program combines structural reforms in health, education, and pension with improvements in social assistance to address the transition needs of the poor. 13. To implement our growth and poverty-reduction strategy, we have built our medium term reform program on five pillars: o Sustaining structural reforms in the enterprise sector focusing on the restructuring of the energy, railway, telecommunications, and water sectors; o Establishing a market-friendly business environment, focusing on entry and exit policies, regulatory costs, delivery of public services, competition, and market institutions; o Deepening the financial system, addressing the constraints to increased lending by the banking system and the development of financial markets; o Improving public sector governance, including implementing the anti- corruption strategy, strengthening local governments, reforming the judiciary, and pursuing administrative reform; o Investing in human capital and strengthening social protection, focusing on education, health, and pension reforms and social assistance effectiveness. 14. Tlhe effectiveness of the above program depends in large part on the maintenance of macroeconomic stability, to which we are fully committed. We will maintain the CBA at least until accession to the EU. The CBA has served Bulgaria well, providing a stable monetary environment, contributing to low inflation, and boosting confidence. We are fully committed to take all necessary steps to support it. We will implement a cautious and flexible fiscal policy, which is key to safeguarding external viability under the CBA. We aim to reach, and then maintain, a broadly balanced fiscal stance in the medium term. The current account deficit, which reached about 6.1 percent of GDP in 2001, has been declining. The economy is becoming more competitive, and investment is increasingly financed by private savings. We expect the external deficit to continue to be mostly financed by FDI, and thus reserve levels to remain comfortable, Annex 5 Letter of Development Policy Page 5 of 31 and the debt-to-GDP ratio to decline rapidly in the medium term. At the same time, inflation is expected to remain low, with price increases relative to our trade partners limited to productivity catch-up and further adjustments in administered prices. The IMF Board approved a two-year Stand By Arrangement (SBA) on February 27, 2002. Pillar I: Sustaining Structural Reforms Implementing the Privatization Program 15. We will continue the momentum of structural reforms which will provide the foundation for sustained growth. We have completed the divestiture of more than 90 percent of non-infrastructure SOEs.2 In addition, about 85 percent of the assets of the banking system and 100 percent of the insurance sector are now in private hands, and with the expected sale of the State Savings Bank (DSK), the banking system will be almost fully private by the mid-2003 . We will accelerate the restructuring initiatives already under way in the energy, telecommunications, railway, and water sectors. We have deternined which enterprises will remain state owned, and our intention is to sell the remainder. As we proceed with the structural reforms, we will review the social impact of these reforms and the adequacy of the social assistance programs. We will also ensure that the reforms are in compliance with the environmental policies. 16. The next phase of the privatization program focuses on infrastructure SOEs. We have begun this phase of privatization which involves the restructuring of the energy, railway, telecommunications, and water sectors with the objective of improving efficiency of service delivery through greater private sector investment within a framework of market rules that ensure fair competition. To improve transparency, reduce corruption, and accelerate the privatization process, the legal and institutional framework for privatization has been improved with the recent enactment of the Law on Privatization and Post Privatization Control and the reorganization of the Privatization Agency. By end-2005, we expect that the only remaining state enterprises will be those listed in Attachment B, reducing the size of the public sector to about 25-30 percent of GDP. Completed Actions * Enactment of a new Law on Privatization and Post Privatization Control * Privatization of Biochim and DZI [PAL-i Board Condition] 2 Pnvatization performance is measured on the basis of long term assets of non-mfrastructure SOEs as of end-1995. 3The two remaining non-pnvate banks - the Business Promotion Bank and the Municipal Bank owned by the Sofia municipality - account for 2.4 percent of bank assets as of mnid-2002. Annex 5 Letter of Development Policy Page 6 of31 Medium Term Actions PAL-2: @ Privatization or liquidation of the large SOEs listed in Attachment C [PAL-2 Trigger] e Privatization or liquidation of 50 percent of the remaining small SOEs as of September 30, 2002 PAL-3: * Privatization or liquidation of the large SOEs listed in Attachment C[PAL-3 Trigger] e Privatization or liquidation of 80 percent of the remaining small SOEs as of September 30, 2002 [PAL-3 Trigger] Restructuring the Energy Sector 17. Our program in the energy sector aims to reduce Bulgaria's energy intensity and enable the private sector to assume an increasing share of commercial risks. To achieve these objectives, we have taken several steps to fundamentally overhaul the sector. First, we have begun the process of rationalizing energy prices to cover costs and eliminate cross-subsidies by raising electricity and heating prices in the second half of 2002. Second, to improve the legal and regulatory framework, we have enacted amendments to the Energy and Energy Efficiency Act, adopted key regulations, and upgraded the institutional capacity of the State Energy Regulatory Commission (SERC). Third, we have spun off from the National Electricity Company (NEK) electricity distribution and generation companies which are in the process of being privatized. Fourth, the District Heating Strategy, which involves commercialization measures in the short term and privatization in the medium term, is being implemented. Finally, the gas sector, which is currently controlled by the state owned Bulgargas, will be opened to the private sector. The energy reforms are expected to reduce Bulgaria's energy consumption to GDP by 15 percent in 2005 compared to the level in 2001. Completed Actions * Enactment of amendments to the Energy and Energy Efficiency Act (EEEA) * Establishment of electricity distribution, generation and transmission companies as separate legal entities o Adoption by the Council of Ministers (CoM) of key regulations on electricity pricing and contracting of power by eligible consumers * Implementation of an average price increase of 20 percent for household electricity prices in the second half of 2002 and approval of an indicative timetable for their adjustment to cost-recovery levels [PAL-I Board Condition] * Satisfactory implementation of the district heating (DH) component of the Energy Strategy approved by the CoM on May 11, 2002 (see Attachment D) Annex 5 Letter of Development Policy Page 7 of 31 * SERC development of a strategy for issuing tenders to develop the low- pressure gas market. Medium Term Actions PAL-2: * Enactment of energy legislation consistent with EU Electricity & Gas Directives [PAL-2 Trigger] * Implementation of electricity market opening targets and timetable * Adoption of additional regulations to support electricity market opening including pricing methodology for access to transmission, dispatch and other system services * Satisfactory implementation of the electricity tariff adjustment program * Continued satisfactory implementation of the district heating component of the Energy Strategy approved by the CoM on May 11, 2002 (see Attachment D) PAL-3: * Continued satisfactory implementation of the electricity tariff adjustment program * Continued satisfactory implementation of district heating component of the Energy Strategy approved by the CoM on May 11, 2002 (see Attachment D) [PAL-3 Trigger] * Opening of gas market in accordance with EU Directive 98/30 for internal market of natural gas and awarding of licenses for developing the low pressure gas market * Maintenance of regulatory -- framework and market structure for the commercial development of the low pressure gas market Restructuring the Railway Sector 18. In the railway sector, our restructuring program aims to increase efficiency, ensure financial sustainability, and improve staff productivity. The Railway Law passed in November 2000 provides the legal basis for the implementation of our program which entails the establishment of a new railway operating company and a new railway infrastructure State enterprise. We will ensure that the new railway operating company can operate independently and is motivated solely by commercial objectives. The new railway infrastructure State enterprise will prioritize its expenditures on the basis of economic criteria and eventually contract out most of its activities. Market rules will be established that will enable the entry of private firms and the eventual privatization of the railway operating company, and ensure fair competition between all land transport operators. The program also includes freedom to set tariff for the railway operating company, rationalization of the railway network and services, introduction of public service obligation (PSO) contracts with the Government to pay for the non-commercial Annex 5 Letter of Development Policy Page 8 of 31 services it does not want terminated, and the reduction of the labor force. By 2004, we expect that the railway companies will reduce losses, improve the condition of the rail network, and partially renew the rolling stock. The railway labor force will be reduced by 20 percent compared to the end-2001 level and the railway operating company will have achieved a financial working ratio of 105 percent (before subsidies and PSO payments). Operating subsidies (excluding loans and grants for investment) will be reducedfrom 0.5 percent of GDP in 2000 to 0.2 percent of GDP in 2004. Completed Actions * Creation of new railway operating company as joint stock company which has commercial objectives and autonomous decision making * Creation of new railway infrastructure company as an independent public agency required to comply with minimum economic criteria for its expenditures * Issuance by the Ministry of Transport and Communications of regulations that (i) ensure that any willing and competent railway service supplier may be licensed; (ii) provide fair and transparent rules for track access; and (iii) keep transaction costs low for any prospective service supplier. * Preparation of sound plan of action for rationalization of rail network and operations Medium Term Actions PAL-2: * Adoption by the railway operating and infrastructure companies of sound medium term business plans including phased reduction of the railway network and service optimization e Adoption of plans for optimization of the structure and labor force of the railway operating and infrastructure companies, including accounting separation between the freight and passenger parts of the railway operating company * Increase in the cost recovery level of intercity passenger services to at least 70% e Adoption by the railway infrastructure company of sound systems and procedures for planning/budgeting expenses * Signing of a framework contract between the Government and the operating company for non-commercial services that will be subject to PSO e Development of preliminary plan for the termination and interim financing of loss making services not subject to PSO. * Termination of 342 kilometers of loss-making services. e Reduction of railway labor force by 10% compared to the level at end of 2001 [PAL-2 Trigger] Annex 5 Letter of Development Policy Page 9 of 31 PAL-3: * Satisfactory implementation of an action plan for the termination and interim financing of all loss making services that will not be subject to PSO * Signing of contracts between the Govermment and the operating company for all non-commercial passenger services that will be subject to PSO * Full accounting separation between the freight and passenger parts of the railway operating company * Preparation of sound plan ensuring conditions for privatization or concession of freight and passenger services * Railway operating company to be given full freedom to set passenger fares and freight tariffs in accordance with sound commercial principles (except in cases of PSO contracts) * Track access charges to be set at full marginal social cost recovery level effective as of January 1, 2004 * Increase in cost recovery level of intercity passenger services to at least 90% including infrastructure charges based on full marginal social cost * Reduction in railway labor force by 20% compared to the level at end of 2001 [PAL-3 Trigger] Liberalizing the Telecommunications Sector 19. In the telecommunications sector, we will completely liberalize markets by January 1, 2003 consistent with our EU accession agreement. We expect to privatize the Bulgarian Telecommunications Company (BTC) in 2003 without extending its exclusive rights. The Telecommunications Law passed in 1998 and amended in December 2001 provides the legal framework for market liberalization, including the establishment of a new independent regulator - the Communications Regulation Commission (CRC). We have submitted to Parliament new telecommunications legislation, consistent with best practice and our EU accession agreement, to reinforce CRC's independence, transparency, and accountability; ensure the liberalization of the telecommunications market; and ensure effective and fair competition. Under the new legislation, all licensing responsibility will be within the competence of CRC. We have a program for the institutional strengthening of the CRC, including ensuring its financial independence. To ensure a competitive market, BTC will share its infrastructure with other market participants. We are committed to implementing the time-bound EU accession commitments. In 2003, we will undertake as a priority an analysis of competition in the market to assess and be a further guide toward, inter alia, implementation of our commitments to the EU, implementation of the New Telecommunications Law, the extent of broadband access and competition, indirect access, and provision of universal access. This analysis will form the basis of an updated sector policy and action plan. By the end of 2005, we will achieve a degree of digitalization of transfer network of 100 percent, of exchanges 82 percent, and of subscribers capacity 46 percent. The number of households with telecommunication services allowing internet access will be 94 percent. Telephone connection waiting time will not exceed one month. Annex 5 Letter of Development Policy Page lOof31 Completed Actions o Implementation of Chapter 19 EU accession commitments described in Attachment E o Establishment of an independent, transparent, and accountable regulator for the telecommunications sector - the Communications Regulation Commission (CRC) o Issuance and implementation of a privatization strategy for BTC that ensures no extension of BTC exclusivities [PAL-I Board condition] o Satisfactory progress in BTC tariff rebalancing o Submission to Parliament of draft New Telecommunications Law Medium Term Actions PAL-2: o Preparation of analysis of competition in the market, including effective broadband access and competition, leased line access, carrier selection, indirect access, and provision of universal service o Satisfactory progress on implementing EU accession commitments described in Attachment E o Enactment of New Telecommunications Law o Adoption and satisfactory implementation of CRC institutional development plan, including its financial independence o Adoption of primary legislation and satisfactory progress in secondary legislation ensuring personal data protection in electronic communications PAL-3: o Continued satisfactory progress on implementing EU accession commitments described in Attachment E o Continued satisfactory implementation of CRC institutional development plan o CoM approval of an updated sector policy and implementation action plan Modernizing the Water Sector 20. In the water sector, our modernization program addresses the problems of ineffilciency, water losses, and lack of investment. We have passed amendments to the Water Law which regulates the awarding of concession contracts to private operators for the Regional Water Companies (RWCs). This will facilitate the proposed concession transaction for Vama and Shumen. We have submitted to Parliament another amendment of the Water Law which will restructure and decentralize the RWCs whereby municipalities are expected to have full control over the assets within their territory. The Government has also made progress in developing the framework for a water regulator to ensure that quality services are provided at affordable prices. Further, a Water Sector Annex 5 Letter of Development Policy Page I Iof31 Strategy has been prepared which is expected to be soon adopted by the Goverrnment. By end-2005, we expect reduction of the operating ratios (the ratio of operating costs including depreciation to total revenues) of Regional Water Companies to 80 percent. Completed Actions * Submission to Parliament of amendments to the Water Law supporting the restructuring and decentralization of the Regional Water Companies Medium Term Actions PAL-2: * CoM approval of a Water Sector Strategy. * Adoption of a regulatory framework for the water sector * Issuance of water concession contracts to private companies in Vama and Shumen. PAL-3: * Issuance of water concession contracts to private companies in three additional Regional Water Companies Managing Environmental Risks 21. We will continue the momentum in environmental reforms to meet the challenges of EU accession compliance to environmental acquis. We will further increase our efforts and improve environmental protection policy by harmonizing environmental laws and regulations with those of the EU and strengthening the capacity of environmental institutions and agencies to enforce environmental laws and regulations. To this end, we have adopted a new Environmental Protection Act which is fully harmonized with EU acquis. We will implement the provisions of the EU Integrated Pollution Prevention and Control (IPPC) Directive, and extend the issuance of integrated permits, currently implemented on a pilot basis. To be able to preserve the integrity of the national environment we will improve our sector and regulations and will prevent overexploitation, and guarantee sustainable utilization of resources. We will develop a Natural Resource Management Strategy which will ensure that land, forests and biological resources are used in environmentally sustainable way. By end-2005, we expect to issue 225 permits under the IPPC directive and by end-2007, we will have issued permits to all enterprises covered by the IPPC directive. Completed Actions * Enactment of a new Environment Protection Act [PAL-I Board condition] * Enactment of Biodiversity Law Annex 5 Letter of Development Policy Page 12 of 31 Medium Term Actions PAL-2: * Satisfactory implementation of environmental policies on SOEs to be privatized [PAL-2 Trigger] * Approval by CoM of a general plan for institutional development and administrative strengthening related to the complete practical application of the EU directives in the field of environment o Development and issuance of regulation on Environmental Impact Assessment * Development of a system of issuance and control of Integrated Pollution Prevention and Control Permits (IPPC) PAL-3: * Continued satisfactory implementation of environmental policies on SOEs to be privatized o Issuance of regulation on Strategic Environment Assessment o Development of a national strategy for sustainable management of land, forests, and biological resources Pillar II: Establishing a Market-friendly Business Environment 22. While the liquidation of loss-making SOEs and the privatization program have increased productivity, future growth will depend on the emergence of dynamic private sector enterprises. Experience in advanced transition economies indicates that gains from further labor shedding and other defensive restructuring measures will taper off over time. New sources of growth will have to come from increased investment by the private sector in both new as well as existing enterprises. We believe that attracting FDI and developing a dynamic SME sector are the best ways to expand private sector activity. To attract FDI and stimulate SME activity, we have begun to undertake measures to improve the business environment focusing on reducing entry barriers and regulatory costs, improving public services to the business sector, and ensuring the stability of market rules and regulations. We have also begun developing plans for comprehensive reforms that would result in improvements in the efficiency of public administration and the judiciary. With these reforms, we hope to attract FDI at an average annual rate of US$ 1.0 billion (of which greenfield FDI would be at least 50 percent) during 2002-05; increase the share of SMEs4 in value added and employment to at least 50 percent by 2005; increase the private sector share of GDP to 70 percent by 2005; and increase total factor productivity by 2.5 percent annually during the period 2002-05. 4 Defined as enterpnses with 100 or less employees. Annex 5 Letter of Development Policy Page 13 of 31 Reducing Entry Constraints and Regulatory Costs 23. We are streamlining the regulatory regimes that increase costs of private sector transactions. The Inter-ministerial Working Group for the Optimization of Regulatory Regimes has reviewed 361 regulatory regimes and approved a program eliminating 70 and modifying 118 of these regimes The company registration procedure will also be simplified, reducing the time for company registration documents processing by integrating the Bulstat, tax, and social security registrations. In addition, the performance of the regional courts in the company registration process will be improved by integrating them in the unified information system. To monitor the impact of these reforms, we will conduct annual surveys on regulatory regimes application costs and will use the results for program evaluation and for further streamlining regimes if necessary. We envisage the streamlining of regulatory regimes as an ongoing objective of public administration reform. A public register of current operative regulatory regimes will be introduced and maintained. By end-2005, we expect at least 50 percent of our current regulatory regimes to be either eliminated or modified thereby significantly reducing the regulatory costs compared to the 2002 baseline figure as measured by the recently completed Administrative and Regulatory Cost Survey (ARCS). 24. We are taking steps to ensure that the introduction of future regulatory regimes is based on clear rationale, an analysis of costs and benefits, and consultation with affected business parties. To control the future development of regulatory regimes, we have submitted to Parliament a draft Law on Administrative Regulation and Administrative Control on Economic Activities which would define the principles that underpin the introduction of new regimes and guide Government actions. The CoM will provide specific guidelines to central administrative bodies regarding the design of proposed new regulatory regimes, including the identification and measurement of costs and benefits and the establishment of a process by which new regimes evolve from concept to implementation. Completed Actions * Submission to Parliament of a draft Law on Administrative Regulation and Administrative Control on Economic Activities [PAL-I Board condition] * CoM approval of a program for eliminating and restructuring regulatory regimes * Development by a working group of a plan for integrating the Bulstat, tax, and social security registration of companies * Completion of the baseline Administrative and Regulatory Cost Survey (ARCS) Annex 5 Letter of Development Policy Page 14 of 31 Medium Term Actions PAL-2: * Enactment of the Law on Administrative Regulation and Administrative Control on Economic Activities * Issuance by the CoM of guidelines to central administrative bodies on the design of proposed new regulatory regimes * Elimination of 40 and modification of 50 regulatory regimes based on program approved by the CoM on June 7, 2002 [PAL-2 Trigger] * Establishment of a comprehensive public registry of regulatory regimes * Completion of second annual ARCS PAL-3: * Elimination of additional 20 and modification of additional 58 regulatory regimes per program approved by the CoM on June 7, 2002 * Introduction of one stop company registration at the Bulstat offices by integrating the Commercial Register with the Bulstat Register. * Completion of third annual ARCS Improving Business Service Delivery of Government Offices 25. In parallel to the regulatory reform efforts, the front line government offices and agencies are undergoing reforms to improve service delivery and cost effectiveness. Institutional development initiatives are ongoing in Customs, the Tax Administration Office, the Real Estate Registry Office, the National Social Security Institute, and various regulatory agencies such as the State Energy Regulatory Commission and the Communications Regulation Commission. For the regulatory regimes that are considered essential, the cost of compliance will be reduced by simplifying the administrative processes, a review of which will be initiated in three sectors - construction, tourism, and food processing - that account for about 10 percent of GDP and are subject to a maze of administrative requirements. The process simplification initiative will be expanded to other sectors in the future. We will also pilot a performance standard monitoring system in Government offices that deal with the construction and labor services, after which we intend to expand the monitoring system to other offices dealing directly with the private sector. Finally, we are reviewing and prioritizing information system changes, which will enable the integration of all corporate and government revenue information. By 2005, we expect the government offices to achieve a 90 percent performance against standard during the year. We will reform the system of administrative courts towards specialization and upgrade the qualifications of judges. Completed Actions * Establishment of a Tax Council to include representatives from the private sector Annex 5 Letter of Development Policy Page 15 of 31 * Implementation of Customs reform in three pilot locations * Development of a plan for piloting a system of monitoring service standards in the Directorate for National Building Control at the Ministry of Regional Development and Public Works and the Labor Inspectorate at the Ministry of Labor and Social Policy * CoM decision to establish a National Revenue Agency Medium Term Actions PAL-2: * Adoption by the Inter-ministerial Working Group for the Optimization of Regulatory Regimes of a program of simplification of administrative procedures for regulatory regimes in the construction, tourism, and food processing sectors * Development of measures by the respective authorities for border and in-the- country control, on national level, which shall replicate the pilot projects at cross border points and clearance terminals, handling a minimum 50% of all - traffic * Implementation of a system of monitoring service standards in the Directorate for National Building Control at the Ministry of Regional Development and Public Works and the Labor Inspectorate at the Ministry of Labor and Social Policy * Adoption by the MoF of a program for improving VAT procedures * Establishment of a National Revenue Agency * Submission by MoJ of a plan for the establishment of specialized commercial courts * Submission by MoJ of a plan for the reform of the administrative court system PAL-3: * Implementation of a program of simplification of administrative procedures for regulatory regimes in the construction, tourism, and food processing sectors * Attainment by property registry of the efficiency level of the average EU property registry system * Expansion of system of monitoring service standards to other Government offices dealing with the private sector * Establishment of a Unified Revenue Information System (URIS) and a Unified Corporate Information System (UCIS) * Implementation of VAT reforms * Implementation of the reform of the administrative court system towards specialization and upgrading skills ofjudges JPAL-3 Trigger] Annex 5 Letter of Development Policy Page 16 of31 Ensuring Competition and Functioning Markers 26. We are committed to creating a level playing field and functioning markets. In the context of EU accession, we are currently undertaking a review of our competition policies. To improve the effectiveness of the Commission for the Protection of Competition (CPC), we have enacted amendments to the Law on the Protection of Competition. We are in the process of developing a plan for the further upgrading of the capacity of the CPC, supported by a technical assistance grant from the EU. We have adopted the Law on State Aid consistent with EU directives. 27. In line with commitments under ASAL II, we will abstain from establishing an agricultural commodity market stabilization facility, except an intervention agency which is specially required to implement the EU's Common Agricultural Policy (CAP) as a condition for EU accession. The Ministry of Agriculture and Forestry (MAF) will give precise definition to these requirements, demonstrating that they are the minimum required, and allowing a clear distinction to be drawn between CAP interventions and non-CAP interventions. Regarding stock rotations, we will minimize their effect on markets by making them more predictable and transparent. To improve market entry in the private grain storage, the government will pass legislation so that only one category of warehouses is licensed and eligible to issue warehouse receipts. 28. In the area of agricultural finance, a level playing field will be promoted by (a) reducing the budget allocation for short term credit by the State Fund Agriculture to zero starting in 2003, and (b) ensuring that total 2003 short term credit extended from funds repaid from previous years' loans will be no more than one-half the total amount of short term credit in 2002 (i.e. BGN 12.5 million, which is one-half of the 2002 allocation of BGN 25 million), and will reduce to zero in 2004 and thereafter. Any long-term credits (those with a maturity of more than one year) will be allocated according to transparent and widely publicized criteria; have well defined beneficiaries; and be minimally distorting. Finally, we will maintain stability in the agricultural trade regime, refraining from temporary import tariffs or exemptions, and from quantitative restrictions. Any import duties applied will be in compliance with commitments with the EU and under GATT. 29. Our action plan for developing a functioning labor market aims to introduce flexibility, reduce unemployment including the share of the long term unemployed, and design appropriate active labor market policies. The plan involves: (i) deregulation of labor relations through changes to the Labor Code; (ii) devolution of responsibility for determining the labor relations to social partners, which entails adequate and genuine representation of employers and employees in social dialogue; (iii) decentralization of collective bargaining by strengthening firm level bargaining. We will begin the public dialogue in the process of overhauling the Labor Code towards reducing the procedural costs of dismissals, encouraging flexible forms of employment and work organization, and enabling wage flexibility. We will review the adequacy of the social safety net for displaced workers and design active labor market policies that would Annex 5 Letter of Development Policy Page 17 of 31 facilitate the transition for old to new jobs. There should be an enhancement of the scope and quality of employment services, such as job search assistance and counseling, by, inter alia, removing regulatory and bureaucratic barriers for private service provision. We will develop a mechanism for monitoring and evaluating the impact of the labor market reforms. Completed Actions * Enactment of the Law on State Aid * Submission to Parliament of amendments to the Law on the Protection of Competition * Initiation of actions implementing the Social Policy Strategy and the Strategic Note on Labor Market Reforms agreed with the Bank * Development of a set of indicators on labor market flexibility and ALMP impact Medium Term Actions PAL-2: * Completion of review of competition policies and their implementation and adoption of program for improving competitive environment * Development and initiation of action plan to upgrade the institutional capacity of the Commission for the Protection of Competition * Submission to Parliament of amendments to the Labor Code agreed with Bank [PAL-2 Trigger] * Elimination of regulatory and bureaucratic barriers to private provision of employment services PAL-3: * Implementation of program for improving competitive environment * Enactment of amendments to the Labor Code * Privatization of grain storage facilities and increase in the share of State Reserves inventories stored in private, licensed warehouses * Enactment of legislation aimed at changing the status of the State Reserves to a public institution, subject to full public disclosure Improving the Efficiency of the Insolvency Regime 30. To facilitate the exit of non-viable enterprises, we have initiatives that aim to accelerate the insolvency process. First, we have submitted to Parliament proposed amendments to Part IV of the Commercial Code which would simplify the insolvency procedure, establish shorter and binding deadlines, and provide more powers to creditors. Second, we plan to overhaul the Civil Procedure Code which will, among others, streamline the cumbersome procedures that cause delay in insolvency proceedings and Annex 5 Letter of Development Policy Page 18 of 31 disposal of assets under liquidation. Third, we have developed a program establishing more stringent criteria for the licensing and dismissal of trustees, and strengthening their monitoring and control by the Ministry of Justice and the courts. Finally, institutional reforms in the judiciary, discussed in Pillar IV, will upgrade the skills of execution judges and improve the efficiency of court administration. We will develop a system of monitoring the efficiency of the insolvency process and we expect a substantial reduction in average processing time by 2005. Completed Actions * Submission to Parliament of proposed amendments to Pat IV of the Commercial Code [PAL-1 Board condition] * Approval by the MoJ of a plan to improve the selection and monitoring of bankruptcy trustees Medium Term Actions PAL-2: * Enactment of amendments to Part IV of the Commercial Code * Preparation by MoJ of a plan to reform the Civil Procedure Code * Implementation of plan to improve selection and monitoring of bankruptcy trustees PAL-3: * Implementation of monitoring system covering insolvency reform Pillar III: Deepening the Financial System 31. While Bulgaria has achieved significant progress in restructuring the banking system, financial intermediation remains low and financial markets are undeveloped. About 85 percent of the banking assets are now in private ownership, mainly by foreign financial institutions, as a result of an aggressive privatization program in 1999-2001. However, about 25 percent of banking assets are deposited in foreign banks. Non-bank financial institutions do not constitute a major component of the financial system, and capital markets and micro-finance are undeveloped. The Govenrnent's objectives in this sector are to increase financial internediation and stimulate financial markets described below. As a benchmark, we would like to see the M2/GDP ratio increase from 42 percent in 2001 to 50 percent by 2005, although the attainment of this ratio is dependent on progress in institutional reforms described in the previous sections and to a certain extent on global economic conditions. Improving the Legal Framework for Leading 32. The legal and institutional framework for lending is being improved to encourage financial intermediation. The foreclosure provisions of the Civil Procedure Annex 5 Letter of Development Policy Page 19 of31 Code have been amended to help reduce delays in enforcement of valid claims. The Accountancy Act and the Independent Financial Audit Act were recently enacted to bring the current standards to intemational standards thus improving the quality of financial information. There will be a reform of the taxation of the financial sector to eliminate distortions and inconsistencies across various financial instruments and institutions. Finally, we have submitted a draft Law on Measures Against Terrorist Financing and draft amendments to the Law on Measures Against Money Laundering in line with international standards and good practices. We expect that these reforms will be major factors in increasing private sector loans to GDP from 15 percent at end-2001 to 25 percent by end-2005, a ratio closer to those of advanced transition economies. Completed Actions * Submission to Parliament of draft amendments to the Law on Registered Pledges * Enactment of amendments to the foreclosure provisions of the Civil Procedure Code * Enactment of the Accountancy Act and the Independent Financial Audit Act * Submission to Parliament of a draft Law on Measures Against Terrorist Financing * Submission to Parliament of draft amendments to the Law on Measures Against Money Laundering Medium Term Actions PAL-2: * Enactment of amendments to the Law on Registered Pledges * Enforcement of the application of international standards in accounting and auditing * Development of a plan for financial sector tax reforms to address tax distortions * Enactment of the Law on Measures Against Terrorist Financing * Enactment of amendments to the Law on Measures Against Money Laundering PAL-3 * Implementation of tax reform in the financial sector Completing Banking Reform 33. We will sustain the implementation of the agenda for banking reform. The privatization of Biochim and the sale of the remaining State shares in the Central Cooperative Bank (CCB) have been completed and the privatization of the State Savings Bank (DSK) will be completed by end-2003. We are reviewing the activities of the state- Annex 5 Letter of Development Policy Page 20 of 31 owned Business Promotion Bank - which was established as a conduit for funds from Kreditanstalt fur Wiederaufbau (KfW) of Germnany to SMEs - to ensure that the bank does not engage in functions that are currently being performed by the private banks. The articles of incorporation of the Business Promotion Bank prohibit the bank from accepting deposits from the population. We will work with the Bank in defining and designing appropriate activities for the Business Promotion Bank. The Bank Bankruptcy Law has been enacted to improve the exit process for insolvent and closed banks. The supervision powers of the BNB has been been strengthened to enable BNB to identify and investigate direct and indirect owners of banks. By end-2003, the private sector share of banking assets is expected to be about 98 percent;5 during 2002-05, we will ensure that the banking system meets the prudential standards; and we will take the necessary actions to ensure that the level of non-performing loans does not deteriorate. Completed Actions * Enactment of Bank Bankruptcy Law * Enactment of amendments to the Banking Law providing broader powers to the BNB to investigate and identify direct and indirect ownership of banks Medium Term Actions PAL-2: e Development and initiation of implementation of strategy and action plan for Business Promotion Bank agreed with the Bank * Establishment of institutional mechanism for mandatory consultation of the BNB and other financial regulatory agencies with regard to drafts of laws and regulations relevant to the financial sector Developing Financial Markets and Improving Supervision Coordination 34. We are taking measures to stimulate capital markets. The development of the pension fund and insurance sectors would mobilize long term savings which could be invested in long term financial instruments in the market. Other capital market initiatives include privatizing the dominant State Insurance Company (DZI), strengthening the governance structures of private pension funds, and legislating a higher and stable contribution rate to the mandatory second pillar of the pension system. To improve investor confidence, the Commercial Code is being amended and the Law on Public Offering of Securities has been amended to address deficiencies in minority shareholder protection and strengthen corporate governance provisions. To protect investors, we are upgrading the supervision capacity of the Bulgarian National Securities Commission, the State Insurance Supervision Agency, and the Insurance Supervision Agency. 5The Municipal Bank (owned by the municipality of Sofia) and the Business Promotion Bank will be the only remaining non-private sector banks, and these two banks accounted for only 2.4% of banking assets as of mid-2002. Annex 5 Letter of Development Policy Page 21 of 31 35. We have established a separate body of senior officials from all financial services supervisory agencies to ensure proper coordination and development of a system-wide perspective in assessing and dealing with risk and vulnerability. This body serves as an information sharing and policy oversight organ. Information is shared among members of the committee to plan and coordinate against any major vulnerabilities within the financial sector, while improving investor confidence and buoyancy of the market. Through such sharing of information, it is expected that the coordination of functions of the various supervisory agencies can be improved, especially where supervisory functions over-lap and where consumer protection and prudential regulation are of prime importance. This body will develop an Early Warning System (EWS) and a set of indicators that will be reviewed to assess the vulnerability of the financial system. Completed Actions * Issuance of regulations for foreign investments of private pension funds * Adoption of an institutional development plan for the State Insurance Supervisory Agency (SISA) * Adoption of an institutional development plan for Insurance Supervisory Agency (ISA) * Enactment of the Mortgage Bond Law * Enactment of amendments to the Law on Public Offering of Securities * Submission to Parliament of amendments to the Commercial Code to strengthen corporate governance * Enactment of amendments to the Insurance Act to harmonize with EU directives and strengthen ISA * Elimination of monopolies in certain segments of the insurance market * Establishment of a Financial Supervision Advisory Council for coordination and review of systemic vulnerabilities Medium Term Actions PAL-2: * Enactment of amendments to the Mandatory Social Insurance Code and the Voluntary Pension Code strengthening pension fund governance and SISA supervision capacity, introducing more flexibility to the investment regime while maintaining a prudent portfolio, and eliminating inconsistencies [PAL-2 Trigger] * Upgrading of regulations covering private pension funds. * Enactment of amendments to the Commercial Code to strengthen corporate governance provisions * Enactment of Law on Financial Supervision Commission Annex 5 Letter of Development Policy Page 22 of 31 o Establishment of an Early Waming System with respect to financial sector vulnerabilities PAL-3: o Unification of supervision of non-bank financial institutions (NBFIs) Pillar IV: Improving Public Sector Governance Reforming Public Administration 36. Our public administration initiatives to date have focused on selective government offices and agencies whose reforms are linked to sectoral strategies and policies. We are restructuring the public institutions in the education and health sectors, which are the main areas of public sector overstaffing. The reforms in district heating, water, and railway deal with the areas of public administration that receive large budgetary subsidies. We have also given priority to the reform of government agencies involved in revenue collection, including the establishment of the National Revenue Agency and the strengthening of Customs Administration. As described in the section on improving market institutions, we are now implementing initiatives to improve the service provision of government offices, including local ones, that deal directly with the private sector. In addition, the supervisory agencies in energy, telecommunications, and the financial sectors are being strengthened. Finally, we are taking steps to improve the efficiency of delivery of social assistance. 37. We now plan to take a comprehensive approach to public administration reform. We have approved a Strategy for State Administrative Modernization - from Accession to Integration, together with a set of amendments to the existing Civil Servant Law. The strategy will make provision also for improving the functioning of the Institute of Public Administration and European Integration, the setting up of a program of functional reviews of different ministries and agencies to align structures and staffing with program priorities, and the development of time-bound program for the implementation of service delivery and performance standards for ministries, agencies, regional offices, and municipalities. By end-2005, we expect to improve the administrative capacity (optimize the number and capability of the civil servants) through implementation of an overall system of human resource management and performance appraisal and closing down ineffective and overlapping structures. Completed Actions • Approval of a Strategy for State Administration, and a program for its implementation agreed with the Bank [PAL-I Board condition] o Approval of a national training strategy approved by Council of Ministers o Completion of a Pay and Benefits Survey in the public sector o Development of monitoring indicators Annex 5 Letter of Development Policy Page 23 of 31 Medium Term Actions PAL-2: * Satisfactory progress in implementing the state administration modernization program based on agreed performance benchmarks and assessment of agreed monitoring and performance indicators [PAL-2 Trigger] * Development and initiation of implementation of a program for improving local administration [PAL-2 Trigger] * Completion and publication of a comprehensive review on the functioning of public administration * Completion of functional reviews of an agreed number of ministries and agencies * Implementation of a monitoring system to track reform outcomes versus target PAL-3: * Continued satisfactory progress in implementing the state administration modernization program based on agreed performance benchmarks and assessment of agreed monitoring and performance indicators [PAL-3 Trigger] * Completion and publication of the second annual report on functioning of public administration * Roll-out of "one stop shops" based on outcomes of pilot exercises * Completion of functional reviews of agreed number of ministries/agencies Reducing Corruption 38. We have adopted a National Anti-Corruption Strategy which takes a comprehensive approach to the problem of corruption. The challenge will be to translate such an ambitious agenda into a sequence of concrete actions that will allow the Government to achieve demonstrable progress in selected priority areas. In that context, we have prepared an action plan that includes: (a) concrete steps to address issues relating to conflict of interest, lobbying regulation, and political financing; (b) the establishment of an inter-ministerial commission to implement the plan; (c) the creation of a full time secretariat to support the work of the commission; and (d) the design of a monitoring system- to track progress in meeting the anti-corruption objectives. There has been improved perception of the public regarding our anti-corruption efforts based on indicators from international surveys. Based on feedback mechanisms to be designed, we expect to see continued improved annual trends in public perception of our reform efforts. Annex 5 Letter of Development Policy Page 24 of 31 Completed Actions e Development of an anti-corruption strategy and action plan agreed with the Bank [PAL-i Board condition] e Establishment of Inter-ministerial Committee for Fighting Corruption Medium Term Actions PAL-2: * Satisfactory implementation of the anti-corruption action plan PAL-3: Continued satisfactory implementation of the anti-corruption action plan [PAL-3 Trigger] Reforming the Judiciary 39. We have adopted a program and action plan for judicial reform, including a judicial anti-corruption component. The program has four components. First, human capacity will be enhanced by upgrading legal education; introducing compulsory training; improving the magistrate selection, promotion, and demotion process; and establishing and enforcing performance standards. Second, administrative capacity will be upgraded through improved planning and resource allocation, better systems support, and implementation of anti-corruption strategy. Third, alternative dispute mechanisms will be established, including the training of arbitrators and mediators. Finally, a monitoring system will be established to track the progress of reforms and the perception of the judiciary by the lawyer and litigant communities as well as by the general public. By end-2005, the efficiency of the judicial system measured by case load perjudge, increase in number ofjudgments enforced, and reduction in pending cases will have improved and the public opinion of thejudicial system based on surveys will have improved. Completed Actions e Approval of a program and action plan for judicial reform including a National Anti-Corruption Component for the Judiciary [PAL-I Board condition] * Preparation by the SJC of uniform standards of service for the administrative staff * Submission to Parliament of amendments to the Judicial Act incorporating adoption of uniform criteria for the selection of magistrates and the evaluation of their performance * Introduction of compulsory training for magistrates Annex 5 Letter of Development Policy Page 25 of 31 Medium Term Actions PAL-2: * Adoption of uniform standards of services for administrative staff of the judiciary * Regulatory action for the selection of magistrates * Regulatory action for the performance appraisal, promotion and demotion of magistrates -~ * Regulatory action establishing a national training system for magistrates in the -areas of international business transactions and European law * Preparation of a diagnostic study assessing the shortcomings of the national legal education * Regulatory action establishing an internal unit within the SJC to address issues of corruption within the judiciary * Regulatory action establishing a legal framework favorable to a national system of alternative dispute resolution [PAL-2 Trigger] * Implementation of a training program for arbitrators and mediators * Preparation of a baseline study on the public perception of the judiciary PAL-3: * Based on the results of the diagnostic study, updating the Unified State Requirements for legal education * Improved supervisory, budgetary and planning capacity of the SJC [PAL-3 Trigger] * Implementation of survey to assess effectiveness and public perception of judicial system * Progress in promoting the using of the national system for alternative dispute resolution PILLAR V: INVESTING IN HUMAN CAPITAL AND STRENGTHENING SOCIAL PROTECTION Improving the Efficiency of the Education and Health Systems 40. We have begun an education reform initiative designed to improve resource management and quality of teaching and learning while continuing to maintain high levels of access. The reforms will strengthen the capacity of the Ministry of Education and Science (MES); introduce new education standards and curriculum and student assessment and evaluation system; train inspectors, school directors and teachers; improve resource allocation in general education; reform the allocation process for resources and seats in the higher education institutions; and establish a modern student loan and stipend program. For the general education we will implement a plan for phased staff reduction and redeployment options. Reductions in employment will to the extent possible be carried out through attrition and rationalization in urban areas taking into account the social and demographic factors. In addition, we will gradually optimize the Annex 5 Letter of Development Policy Page 26 of 31 school network by merging schools to reduce the administrative and operational costs and improve maintenance and energy efficiency of schools. With these measures, we expect to raise the student-teacher ratio towards the average level in OECD countries by end- 2005. 41. While the net enrollment ratios of 96 percent in primary6 schools indicate that access is not a problem, we are concerned about the relatively low ratios ratios in middle7 (84 percent) and secondary8 (68 percent) schools. High unemployment and the perception that secondary education studies are irrelevant are the possible causes of the high drop out rate. But little is known about the causes of the large decline in attendance after primary education. We are conducting in-depth studies of the causes of attrition and we will develop responses to these. Our goal to increase net enrollment rate in primary school to 9 7-98 percent, in middle school to 86-90 percent, and in secondary school to 75-80 percent by 2005. 42. There are signs of a decline in education quality, as measured by the 1995 and 1999 TIMSS international surveys9 in which Bulgaria participated. The decline in assessment results reflects the pressures of a severely strained education system, with lack of investments to maintain the system - let alone improve it. Our real outlays for education fell more precipitously than those in other accession countries during the 1990s, and the share of education expenditures in GDP is lower than OECD and first-tier EU accession countries. We have named education a priority sector in the Budget Acts for 2002 and we intend to implement the policy recommendations contained in the Bank's recent Public Expenditure and Institutional Review. We expect to see improvement in education quality as measured by future TIMSS surveys. Completed Actions o Preparation of a plan for phased staff reduction and other efficiency measures in the education system agreed with the Bank Medium Term Actions PAL-2: o Implementation of agreed measures to improve efficiency of education resource use 6 Grades 1-4 7Grades 5-8 8 Grades 9-12 9The most inclusive source of intemally comparable data on what students leam is the TIMSS intemational science and math assessment which was carried out for a nationally representative sample of eighth grade students in 24 countries in 1995 and 39 countries in 1999. Nme EU accession countnes participated, and while Bulgaria scored above the international average in 1995, its score declined to below average in 1999. Annex 5 Letter of Development Policy Page 27 of 31 PAL-3: * Continued implementation of agreed measures to improve efficiency of education resource use 43. We have begun a fundamental transformation of the health care system to improve the relatively poor health status indicators and use the available resources more efficiently. The focal point of the reforms is the National Health Insurance Fund (NHIF), which undertakes both risk pooling and medical care purchasing functions on behalf of the population. We are developing the parameters of a "steady state" health financing system, including the long-term division of responsibilities and revenue sources between the Ministry of Health and the NHIF. We plan to ensure adequate maintenance of existing capital assets, and investment in new equipment and facilities, so that the quality of care does not suffer, especially in the hospital sector. We will also develop a plan to address segments of the population who currently have limited or no access to either medical insurance or medical care due to socio-economic status or ethnicity. By 2005, administrative costs of NHIF will be less than 3 percent of revenues and staffing less than 1800. With the health reforms, we expect to see improvements in the health indicators, including an increase in life expectancy, a reduction in incidence of tuberculosis and other infectious diseases, and an increase in immunization coverage which has experienced a sustained decline since 1989. Completed Actions * Approval by the CoM of a strategy for hospital restructuring, including a financing plan * Agreement among the MoF, MoH, and the NHIF on a long term funding approach for hospital services Medium Term Actions PAL-2: * Development of an action plan implementing the hospital restructuring strategy * Achievement of balanced operating budget for NHIF * Development of long term approaches for financing capital requirements of the health sector PAL-3: * Implementation of the action plan implementing the hospital restructuring strategy * Implementation of long term approach for financing capital requirements of the health sector Annex 5 Letter of Development Policy Page 28 of 31 Ensuring Successful Implementation of the Pension Reform 44. We have also begun the reform of the pension system towards a multi-pillar one. The new system comprises three pillars: first, the publicly managed pay-as-you-go system; second, the mandatory supplementary defined contribution universal (for those born after Dec. 31, 1959) and occupational (for those working under hazardous conditions) pension plans; and third, the voluntary supplementary plans. We have recently developed an action plan designed to help ensure successful implementation of the multi-pillar reform and which has the following main components. First, the contribution rate that will be allocated to the public and private pillars will be better defined through a legislative amendment. Second, the legal framework concerning private pension plans and their supervision will be amended to improve governance structures and supervision capacity, introduce more flexibility in the investment regime, and eliminate inconsistencies. Third, additional regulations will be issued to complement legislation. Fourth, an institutional development plan has been prepared to transform SISA into an effective supervisory agency. Fifth, contributions to private pension plans will be transferred promptly and handled in a transparent manner. Sixth, there will be a campaign to improve public understanding of the reform. By end-2007, we forecast that pension fund assets will reach two percent of GDP and transfers from NSSI to the private pension funds will take no more than five days. Completed Actions o Introduction of the second pillar of the pension reform with a two percent contribution rate o Adoption of regulations to transfer contributions to private pension funds in a prompt and transparent manner o Initiation of implementation of an action plan to improve and strengthen pension reform program Medium Term Actions PAL-2: o Enactment of amendments to the pension legislation to define the contribution rate that will apply to the second pillar o Satisfactory progress in the implementation of the pension reform action plan PAL-3: o Continued satisfactory progress in the implementation of the pension reform action plan [PAL-3 Trigger] Improving Efficiency and Coverage of Social Assistance Programs 45. We will further improve the efficiency and coverage of social assistance programs. The two main cash benefit programs, the Guaranteed Minimum Income Annex 5 Letter of Development Policy Page 29 of 31 (GMI) and energy benefit programs, have high incidence among the poor. We will improve the effectiveness of the GMI program by limiting in-kind benefits in favor of cash and strengthening the administration of social assistance delivery. The coverage of the energy benefit program will be extended to large families, the eligibility criteria tightened to focus on poor families, and the program reviewed in the light of future tariff increases. The child allowances program will also be improved by reducing leakage, expanding coverage, and utilizing means-testing. Improving delivery of social assistance requires institutional strengthening of municipal social assistance services and local governments, and legislative amendments to allow access of private and non-for-profit providers to social services delivery. We also plan to establish a poverty monitoring unit in the MOLSP to track and assess the impact of government policies and programs on poverty, incomes, and living standards. With these measures, by end-2005 we expect to reduce the poverty rate of 2001 by 50 percent and to reduce the number of people on social assistance by 100,000. Completed Actions * Introduction of targeting of child allowances * Adoption of an adjusted energy subsidy program in view of announced tariff increases [PAL-I Board condition] * Establishment of a poverty monitoring unit in the MOLSP * Approval by CoM of amendments to the Social Assistance Act opening social services provision for private and NGO providers Medium Term Actions PAL-2: * After a review of the social assistance programs, development and implementation of a plan agreed with the Bank to improve coverage and increase efficiency [PAL-2 Trigger] * Development of minimum standards for social services * Building capacity for poverty and living standards analysis PAL-3: * Implementation of a plan to improve coverage and increase efficiency of social assistance programs [PAL-3 Trigger] * Implementation of poverty and living standards surveys Coordination and Monitoring of Medium Term Program 46. Recognizing the importance of implementation to the success of the program, we have developed institutional arrangements to ensure effective coordination and monitoring of the program. The central policy coordination function is performed by the Council for Structural Policy established by Regulation No 58 of the Council of Ministers and chaired by Deputy Prime Minister Nikolay Vassilev. The Council is Annex 5 Letter of Development Policy Page 30 of 31 composed of two deputy prime ministers (the minister of labor and social policy and the minister of regional development and public works); the ministers of finance, transport and communication, agriculture and forestry, state administration, energy and energy resources; the deputy ministers of economy and finance; and the executive directors of the Privatization Agency and the Foreign Investment Agency. The Council formulates the priorities and mechanisms for economic and social reforms, coordinates the policy activities of line ministries and institutions, and supervises the overall implementation of the reform program supported by the PAL. The secretariat function is provided by an eight-member team in the Directorate for EU Integration and Relations with IFIs. The Directorat'e team is playing a key coordination role for all activities under the PAL, both internally among ministries and institutions involved and externally with coordination of donor activities supporting the Government program. In addition, we have established several working groups, among them: the Inter-ministerial Working Group for the Optimization of Regulatory Regimes, the Financial Supervision Advisory Council, the Poverty Monitoring Unit at the Ministry of Labor and Social Policy, and Living Standards Measurement Survey (LSMS) Unit with the National Statistics Institute (NSI). 47. We are also establishing a mechanism for better coordination of donor activities. In order to make more effective use of donor resources available for our reform and development programs, we have started developing an enhanced approach to extemal assistance by taking the lead in donor coordination. The new process seeks to organize donor resources around the Government's major development priorities. Four thematic areas for donor support have been identified. These are (i) Business Climate; (ii) Living Standards Improvement; (iii) Governance and Public Administration; and (iv) Infrastructure and Natural Resources Management. Under the new donor coordination mechanism that was adopted, relevant deputy prime ministers are responsible for these broad priority areas. Various working groups in each of these thematic areas are established to work at operational level. They are aligned with government priorities and are led by deputy ministers. The Council for Structural Policy plays the overarching policy coordination role, and the Council of Ministers' Directorate for EU Integration and Relations with IFIs acts as secretariat (coordination unit). 48. We have developed strategies for participation by stakeholders in the design and implementation of our reform program. We have regular consultations with the business associations with respect to the reforms on the business climate, which have been institutionalized in forums such as the Council on Economic Growth and the Tax Council which have private sector participation. The future amendments to the Labor Code would define institutional arrangements to improve coordination and communication among the Government, labor, and employers. We have set up a data users group to enhance public participation in poverty monitoring, analysis and policy development. We will ensure local participation in the governance of the school system. We will also establish specialized Administrative Courts to ensure more efficient processing of complaints about improper imposition or implementation of administrative acts by the Government. Annex 5 Letter of Development Policy Page 31 of 31 49. We have also developed several feedback mechanisms to enable us to track the progress and effectiveness of our reforms. We have completed the baseline Administrative and Regulatory Cost Survey (ARCS). Future ARCS will provide us with quantitative measurements on the regulatory costs which we will compare to the baseline numbers. We will perform a regular survey of living standards. We will track the impact of our judicial reforms on the level of credibility of the judicial system through periodic surveys of those in the legal profession, businessmen, as well as the public in general. 50. By upgrading our coordination capacity, involving the stakeholders in institutional design and implementation, and establishing timely feedback mechanisms, we are confident of successfully implementing our reform program. We have a mechanism in place to track the progress in each component of our program, and we will make the necessary adjustments to ensure that we meet our goals. We will continue to look to the Bank and the donor community for support in our policy making and institution building efforts. Sincerely yours, ikolay Vassilev Milen Velt Deputy Prime Minister and Minister of Minister of F ance Economy Sofia, Bulgaria December 20. 2002 fASucx U LDP Attachment A Page I of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes PILLAR 1: SUSTAINING STRUCTURAL REFORMS Rationalization of the role of the * Enactment of a new Law on * Privatization or liquidation * Privatization or liquidation By end-2005, the only remaining State by privatizing activities that Privatization and Post of the large SOEs listed in of the large SOEs listed in SOEs would be those listed in can be performed by the private Privatization Control LDPAttachment C** LDPAttachment C*** LDP Attachment B. sector * Privatization of Biochim * Pnvatization or liquidation * Privatization or liquidation and DZI* of 50 percent of remaining of 80 percent of the small SOEs as of September remaining small SOEs as 30, 2002 of September 30, 2002*** Improvement in efficiency of * Enactment of amendments to * Enactment of energy * Continued satisfactory In 2005, energy consumption to energy services and preparing the Energy and Energy legislation consistent witb imnplementation of the GDP would reduce by 15% energy sector for EU accession Efficiency Act (EEEA) EUElectricity & Gas electricity tariff adjustment compared to the level in 2001. Establishment of electricity Directives** program distnbution, generation and * Implementation of electncity * Continued satisfactory transmission compames as market openig targets and implementation of district separate legal entities timetable heating component of the * Adoption by the CoM of key * Adoption of additional Energy Strategy approved regulations on electncity regulations to support by the CoM on May 11, pncing and contracting of electncity market opening 2002 (LDP Attachment power by eligible consumers including pricng D)*** * Implementation of an methodology for access to * Opening of gas market in average price increase of 20 transmission, dispatch and accordance with EU percentfor household other system services directive 98/30 for intemal electricity prices in the * Satisfactory implementation gas market and awarding of second half of 2002 and of the electricity tariff licenses for developing the approval of an indicative adjustment program low pressure gas market timetable for their * Continued satisfactory * Mamtenance of regulatory adjustment to cost-recovery implementation of the framework and market levels* distnct heating component structure for the commercial * Satisfactory inplementation of the Energy Strategy development of the low of the district heating approved by the CoM on pressure gas market component of the Energy May 11, 2002 (LDP Strategy approved by the Attachment D) CoM on May 11, 2002 (LDP Attachment D) * SERC development of a strategy for issuing tenders to develop the low-pressure Note: This annex is the agreed medium term performance matnx and is an attachment to the Government's Letter of Development Policy. * PAL- I Board Condition ** PAL-2 Trigger PAL-3 Trigger Annex 6 LDP Attachment A Page 2 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes gas market. Improving efficiency of the o Creation of new railway o Adoption by the railway o Satisfactory implementation o By 2004, reduction of state railway sector resulting in a operating company as joint operating and infrastructure of an action plan for the railway labor force by 20% decrease in railway subsidies. stock company which has companies of sound medium termination and intenm cornpared to level at end- commercial objectives and term business plans financing of all loss-making 2001 autonomous decision making including phased reduction services that will not be o By 2004, achievement by the o Creation of new railway of the railway network and subject to PSO railway operating company infrastructure company as an service optimization. a Signing of contracts between of a financial working ratio independent public agency o Adoption of plans for the Government and the of 105% (before subsidies required to comply with optimization of the structure operating company for all and PSO payments) minimum economic criteria and labor force of the non-commercial passenger s Decrease in operatng for its expenditures railway operating and services that will be subject subsidies (excludmg loans o Issuance by the Mimstry of infrastructure companies, to PSO and grants for investment) Transport and including accounting a Full accounting separation from 0.5% of GDP in 2000 Communications of separation between the between the freight and to 0.2% of GDP in 2004 regulations that (i) ensure freight and passenger parts passenger parts of the that any willmg and of the railway operating railway operating company. competent railway service company. e Preparation of sound plan supplier may be licensed; (ii) e Increase m the cost recovery ensurng conditions for provide fair and transparent level of intercity passenger privatization or concession rules for track access; and services to at least 70%. of freight and passenger (iii) keep transaction costs o Adoption by the railway services. low for any prospective infrastructure company of o Railway operating company service supplier. sound systems and to be given full freedom to c Preparation of sound plan of procedures for set passenger fares and action for rationalization of planning/budgeting freight tariffs in accordance rail network and operations expenses. with sound commercial o Signing of a framework principles (except in cases of contract between the PSO contracts). Government and the a Track access charges to be operating company for non- set at full marginal social commercial services that cost recovery level effective will be subject to PSO. as of January 1, 2004. o Development of preliminary o Increase in cost recovery plan for the termination and level of intercity passenger interim financing of loss services to at least 90% making services not subject including infrastructure to PSO charges based on full Note: This annex is the agreed medium term performance matrix and is an attachment to the Government's Letter of Development Policy. * PAL-I Board Condition ** PAL-2 Trigger * PAL-3 Trigger Annex 6 LDP Attachment A Page 3 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL,2 PAL-3 Desired Outcomes * Termination of 342 km of charges based on full loss-making services. marginal social cost * Reduction of railway labor * Reduction in railway labor force by 10% compared to force by 20% compared to the level at end of 2001 ** the level at end of 2001 ***. Liberalizing the teleconmium- * Implementation of Chapter * Preparation of analysis of * Continued satisfactory By the end of 2005, the degree of cations market 19 EU accession competition in the market, progress on implementing digitalization of transfer network commitments descnbed m including effective EU accession commitments will be 100%, of exchanges 82% LDP Attachment E broadband access and descnbed in LDP and of subscribers capacity 46%; * Establishment of an competition, leased line Attachment E the number of households with independent, transparent, access, carrier selection, * Contnued satisfactory telecommunication services and accountable regulator indirect access, and imnplementation of CRC allowing internet access will be for the telecommunications provision of universal institutional development 94%; telephone connection sector - the Commumcations service plan waiting time will not exceed one Regulation Commission * Satisfactory progress on * CoM approval of an updated month. (CRC) implementng EU accession sector policy and * Issuance and implemen ta- commitments described in implementation action plan don of a privatization LDP Attachment E strategy for BTC that * Enactment of New ensures no extension of Telecommunications Law BTC exclusivities* * Adoption and satisfactory * Satisfactory progress in BTC unplementation of CRC tariff rebalancing institutional development * Submission to Parliament of plan, including its financial draft New Telecom- mdependence munications Law * Adoption of primary legislation and satisfactory progress in secondary legislation ensuring personal data protection in electronic communications Modernizing the water sector * Submission to Parliament of * CoM approval of a Water * Issuance of water concession Reduction of the operating ratios amendments to the Water Sector Strategy contracts to private (operating costs including Law supporting the * Adoption of a regulatory companmes in three depreciation to total revenues) of restructurng and framework for the water additional Regional Water Regional Water Companies to decentralization of the sector Companies 80% _______________ __ Regional Water Cornpanues * Issuance of water concession Note' This annex is the agreed medium term performance matnx and is an attachment to the Government's Letter of Development Policy. * PAL- I Board Condition ** PAL-2 Trigger PAL-3 Trigger Annex 6 LDP Attachment A Page 4 of 1 2 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes contracts to pnvate companies in Vama and Shumen Mitigatmg environrnental risks o Enactment of a new o Satisfactory implementation o Continued satisfactory o By end-2005, issuance of Environment Protection of environmentalpolicies implementation of 225 mtegrated Act* on StiEs to be privatized environmental policies on environmental permits under o Enactment of Biodiversity o Approval by CoM of a SOEs to be privatized the IPPC dtrective Law general plan for institutional o Issuance of regulation on o By end-2007, issuance of development and Strategic Environment permits to all enterprises administrative strengthening Assessment covered by the IPPC related to the complete o Development of a national directive practical application of the strategy for sustainable EU directives in the field of management of land, environment forests, and biological e Development and issuance resources of regulation on Environmental Impact Assessment e Development of a system of issuance and control of Integrated Pollution and Control Permits (IPPC) PILLAR I1: ESTABLISHING A MARKET-FRIENDLY BusImEss ENVIRONMENT Reducing entry constraints and a Submission to Parliament e Enactment of the Law on * Elimination of an additional e FDI inflows of $ 1.0 billion regulatory costs of a draftLaw on Administrative Regulation 20 and modification of per year during 2002-05 Administrative Regulation and Administrative Control additional 58 regulatory * Increase in share of SMEs in and Administrative Control on Economic Activities regimes per program valued added and on Economic Actifities * e Issuance by the CoM of approved by the CoM on employment to at least 50 * CoM approval of a program guidelines to central June 7, 2002 percent by 2005 for eliminating and administrative bodies on the e Introduction of one stop * Total factor productivity restructuring regulatory design of proposed new company registration at the increase of 2.5 percent regimes regulatory regimes Bulstat offices by mtegrating annually during 2002-05 * Development by a working e Elimination of 40 and the Commercial Register * By 2005, private sector share group of a plan for modification of 50 with the Bulstat Register. of GDP at 70 percent integrating the Bulstat, tax, regulatory regimes based e Completion of third annual * By 2005, elimination or and social security on program approved by ARCS modification of at least 50 registration of companies the CoM on June 7, 2002** percent of regulatory Note: This annex is the agreed medium term performance matrix and is an attachment to the Government's Letter of Development Policy. * PAL-I Board Condition * PAL-2 Trigger *** PAL-3 Trigger Annex 6 LDP Attachment A Page 5 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes * Completion of the baseline * Establishment of a regimes existing at mid-2002 Administrative and comprehensive public resulting m significant Regulatory Cost Survey registry of regulatory reduction of regulatory costs (ARCS) regumes as measured by the annual * Completion of second ARCS _ annual ARCS Improvmg busmess service * Establishment of a Tax * Adoption by the Inter- * Implementation of a By 2005, achievement of delivery of government offices Council to mclude munisterial Working Group program of simplification of performance standards 90 percent representatives from the for Optimization of administrative procedures of the time during the year. pnvate sector Regulatory Regimes of a for regulatory regimes in the * Implementation of Customs program of simplification of construction, tourism, and reform in three pilot administrative procedures food processing sectors locations for regulatory regimes in the * Attainment by property * Development of a plan for construction, tourism, and registry of the efficiency pilotmg a system of food processing sectors level of the average EU monitonng service standards * Development of measures by property registry system in the Directorate for the respective authonties for * Expansion of system of National Building Control at border and rn-the-country monitoring service standards the Mimstry of Regional control, on national level, to other Government offices Development and Public which shall replicate the dealing with the private Works and the Labor pilot projects at cross border sector Inspectorate at the Ministry pomts and clearance * Establishment of a Unified of Labor and Social Policy terminals, handling a Revenue Information System * CoM decision to establish a minimum 50% of all traffic (URIS) and a Unified National Revenue Agency * Implementation of a system Corporate Information of monitoring service System (UCIS) standards m the Directorate * Implementation of VAT for National Building reforms Control at the Ministry of * Implementation of the Regional Development and reform of the administrative Public Works and the Labor court system towards Inspectorate at the Ministry specialization and of Labor and Social Policy upgrading skills of * Adoption by the MoF of a judges*** program for improvmg VAT procedures * Establishment of a National Note. This annex is the agreed medium term performance matnx and is an attachment to the Government's Letter of Development Policy. * PAL- I Board Condition ** PAL-2 Trigger PAL-3 Trigger Annex 6 LDP Attachment A Page 6 of 12 BULGARIA: PRoGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes Revenue Agency * Submission by MoJ of a plan for the establishment of specialized commercial courts e Submission by MoJ of a plan for the reform of the administrative court system Ensuring competition and o Enactment of the Law on o Completion of review of Implementation of program The labor participation rate, the functioning markets State Aid competition policies and for improving competitive employment to population ratio, o Submission of amendments their implementation and environment the unemployment rate, and the to the Law on the Protection adoption of program for o Enactment of amendments to share of long term unemployed to of Competition improving competitive the Labor Code total unemployed will be o Initiation of actions enviromnent e Privatization of grain storage monitored and evaluated implementing the Social o Development and initiation facilities and increase in the periodically. Policy Strategy and Strategic of action plan to upgrade the share of State Reserves Note on Labor Market institutional capacity of the inventories stored in pnvate, Reforms Commission for the licensed warehouses o Development of a set of Protection of Competition o Enactment of legislation indicators on labor market o Submission to Parliament aimed at changing the status flexibility and ALMP impact of amendments to the of the State Reserves to a Labor Code agreed with public institution, subject to Bank** full public disclosure o Elimination of regulatory and bureaucratic barriers to private provision of emnployment services Improving the efficiency of the o Submission to Parliament c Enactment of amendments to o Implementation of To be developed in PAL-2 insolvency regime ofproposed amendments Part IV of the Commercial monitoring system covering to PartIVof the Code insolvency reform Commercial Code* o Preparation by MoJ of a plan e Approval by MoJ of a plan to reform the Civil to improve the selection and Procedure Code monitoring of bankruptcy o Implementation of plan to trustees improve selection and / monitoring of bankruptcy trustees Note: This annex is the agreed medium term performance matnx and is an attachment to the Government's Letter of Development Policy. * PAL-1 Board Condition t PAL-2 Trigger 000PAL-3 Trigger Annex 6 LDP Attachment A Page 7 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL- PAL-2 PAL-3 Desired Outcomes PILLAR ILI: DEEPENING THE FINANCIAL SYSTEM Improving the legal framework * Submission to Parliament of * Enactment of amendrnents to * Implementation of tax Increase in financial for lendmg draft amendments to the Law the Law on Registered reform in the financial sector intermediation to support pnvate on Registered Pledges Pledges sector investment, while * Enactment of amendments to * Enforcement of the maintaining capital adequacy and the foreclosure provisions of application of international liquidity standards. By end- the Civil Procedure Code standards in accounting and 2005, mcrease in M2 to GDP * Enactment of the auditmg from 42% in 2001 to 50% and Accountancy Act and the * Development of a plan for increase in private sector loans to Independent Financial Audit financial sector tax reforms GDP from 15% at end-2001 to Act to address tax distortions 25%, while maintammng * Submission to Parliament of * Enactment of the Law on prudential standards a draft Law on Measures Measures Against Terrorist Against Terrorist Financing Financing * Submission to Parliament of * Enactment of amendments to draft amendments to the Law the Law on Measures on Measures Against Money Against Money Laundering Laundering Completing banking reform * Enactment of Bank * Development and initiation Bankruptcy Law of implementation of * Enactment of amendments to strategy and action plan for the Banking Law providmg Business Promotion Bank broader powers to the BNB agreed with the Bank to investigate and identify * Establishment of direct and indirect ownership institutional mechanism for of banks mandatory consultation of the BNB and other financial regulatory agencies with regard to drafts of laws and regulations relevant to the financial sector Developmg financial markets and * Issuance of regulations for * Enactment of amendments * Unification of supervision of improvmg supervision foreign mvestments of to the Mandatory Social non-bank fmancial coordmation private pension finds Insurance Code and the institutions (NBFIs) * Adoption of an mstitutional Voluntary Pension Code development plan for the strengthening pension fund State Insurance Supervisory governance and SISA Note: Thus annex is the agreed medium term performance matrix and is an attachment to the Government's Letter of Development Policy. * PAL-l Board Condition * * PAL-2 Trigger *** PAL-3 Tngger Annex 6 LDP Attachment A Page 8 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LoAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes Agency (SISA) supervision capacity, * Adoption of an institutional introducing more development plan for flexibility to the investment Insurance Supervisory regime while maintaining a Agency (ISA) prudent portfolio, and * Enactment of the Mortgage eliminating Bond Law inconsistencies"* * Enactment of amendments to * Upgrading regulations the Law on Public Offering covering private pension of Securities funds. * Submission to Parliament of * Enactment of amendments to amendments to the the Commercial Code to Commercial Code to strengthen corporate strengthen corporate governance provisions governance * Enactment of Law on * Enactment of amendments to Financial Supervision the Insurance Act to Commission harmonize with EU * Establishment of an Early directives and strengthen Warning System with ISA respect to financial sector * Elimination of monopolies vulnerabilities in certain segments of the insurance market * Establishment of a Fmancial Supervision Advisory Council for coordination and review of systemic vulnerabilities PILLAR IV: IMPROVING PUBLIC SECTOR GOVERNANCE Improving the efficiency and * Approval of a Strategy for * Satisfactoryprogressin * Continued satisfactory By end-2005, improvements in effectiveness of public State Administration implementing the state progress in implementing the administrative capacity administration Modernization, and a administration the state administration (optimization of the number and program for its modernizadton program modernization program capability of civil servants) implementtion agreed based on agreed based on agreed through implementation of an with the Bank* performance benchmarks performance benchmarks overall system for human * Approval of a national and assessment of agreed and assessment of agreed resource management and training strategy approved monitoring and monitoring and performance appraisal and Note: This annex is the agreed medium term performance matrix and is an attachment to the Govermment's Letter of Development Policy. * PAL-I Board Condition ** PAL-2 Trigger * PAL-3 Trigger Annex 6 LDP Attachment A Page 9 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes by Council of Ministers performance indicators'* performance indicators * closing down the ineffective and * Completion of a Pay and * Development and initiation * Completion and publication overlapping administrative Benefits Survey in the public of implementation of a of the second annual report structures sector program for impro ving on fimctioning of public * Development of momtonng local administration ** admuiistration indicators * Completion and publication * Roll-out of "one stop shops" of a comprehensive review based on outcomes of pilot of the functioning of public exercises administration * Completion of functional * Completion of functional reviews of agreed number of reviews of an agreed number ministnes/agencies of ministries and agencies * Implementation of a momtonng system to track reform outcomes versus target Reducing corruption * Development of an anti- * Satisfactory implementation * Continued satisfactory To be developed m the course of corruption strategy and of the anti-corruption action implementation of the anti- PAL-2 action plan agreed with the plan corruption action plan *** Bank* * Establishment of Inter- ministenal Committee for Implementing the Anti- Corruption Strategy and Action Plan Improving the efficiency, * Approval of a program * Adoption of uniform * Based on the results of the * The outcomes to be effectiveness, and credibility of and action plan for judicial standards of services for diagnostic study, updatng monitored will include: case the judicial system reform including a administrative staff of the the Umfied State load per judge, number of NationalAnti-Corruption judiciary Requirements for legal judgments enforced, number Component for the * Regulatory action for the education of pendmg cases, and Judiciary* selection of magistrates * Improved supervisory, Improvement m the pubhc * Preparation by SJC of * Regulatory action budgetary andplanning perception of the judicial uniform standards of service establishing criteria for the capacity of the SJC*** system based on survey for the administrative staff performance appraisal, * Implementation of survey to results. These outcomes will * Submussion to Parliament of promotion and demotion of assess effectives and public be quantified in the course of amendments to the Judicial magistrates perception of the judicial PAL-2 Act mcorporatmg adoption * Regulatory action system Note This annex is the agreed medium term performance matrix and is an attachment to the Government's Letter of Development Policy. * PAL- I Board Condition ** PAL-2 Tngger "t PAL-3 Trigger AnDex 6 LDP Attachment A Page 10 of 12 BULGARIA: 1PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes of uniform criteria for the establishing a national o Progress in promoting the selection of magistrates and traming system for using of the national system the evaluation of their magistrates in the areas of for alternative dispute performance international business resolution Introduction of compulsory transactions and European traimng for magistrates law o Preparation of a diagnostic study assessing the shortcomings of the national legal education o Regulatory action establishing an internal unit within the SJC to address issues of corruption within the judiciary * Regulatory acton establishing a legal framework favorable to a national system of alternatve dispute resolution"** * Implementation of a training program for arbitrators and mediators * Preparation of a baseline study on the public perception of the judiciary . PILLAR V: INVESTING IN HUMAN CAPITAL AND STRENGTHENING SOCIAL PROTECTION Improving the efficiency and * Preparation of a plan for * Implementation of agreed * Continued implementation * By 2005, improvement in financial sustainability of the phased staff reduction and measures to improve of agreed measures to student-teacher ratio to educational and health systems other efficiency measures in efficiency of education improve efficiency of OECD levels the education system agreed resource use education resource use * By 2005, increase in net with Bank * Development of an action * Implementation of the action enrollment rate in primary * Approval by the CoM of a plan implementing the plan for the hospital school to 97-98%, in middle strategy for hospital hospital restructuring restructuring strategy schools to 86-90% and in restructuring, including strategy * Implementation of long term secondary schools to 75- _ financing plan * Achievement of balanced approach for financing the 80% Note: This annex is the agreed medium term performnance matrix and is an attachment to the Government's Letter of Development Policy. * PAL-I Board Condition ** PAL-2 Trigger * PAL-3 Trigger Annex 6 LDP Attachment A Page 11 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes Agreement among the MoF, operating budget for NHIF capital requirements of the * Improvement m the quality MoH, and the NHIF on a * Development of long term health sector indicators based on surveys long term funding approach approaches for financing the such as TIMSS for hospital services capital requirements of the * By 2005, NHIF administra- health sector tive costs kept at less than 3% of revenues and staffing at less then 1800 * Increase mn life expectancy by 2005 * Decrease in incidence of tuberculosis per 100,000 from 45.5 in 1999 to 40 in 2005 * Increase in proportion of chlldren under 2 immunized against DPT from 68 percent in 2000 to 85 percent in 2005 Ensuring successful implemen- * Introduction of the second * Enactment of amendments to * Continued satisfactory * By end-2007, increase in tation of the pension reform pillar of the pension reform the pension legislation to progress in implementation mandatory contribution to with a two percent define the contribution rate of the action plan to the second pillar to 5 percent contribution rate that will apply to the second improve and strengthen * By end-2005, pension assets * Adoption of regulations to pillar the pension reform managed by private finds transfer contributions to * Satisfactory progress in the program*** would reach 2% of GDP pension funds in a prompt implementation of action * By 2005, transfers from and transparent manner plan descnbed to improve NSSI to private pension * Initiation of implementation and strengthen the pension funds would take no more of an action plan to improve reform program than 5 days. and strengthen the pension reform program Improvmg efficiency and * Introduction of targetmg of * After a review of the social * Implementation of a plan * By end-2005, reduce poverty coverage of social assistance child allowances assistance programs, to improve coverage and rate of 2001 by 50 percent. programs * Adoption of an adjusted development and increase efficiency of social * By end-2005, reduce the energy subsidy program in implementation of a plan assistance progra ms"f* number of people on social view of announced tariff to improve coverage and * Implementation of poverty assistance by 100,000 increases* increase efficiency** and living standards surveys * Establishment of a poverty * Development of minimmum Note. This annex is the agreed medium term performance matrix and is an attachment to the Government's Letter of Development Policy * PAL-I Board Condition * * PAL-2 Trigger PAL-3 Trigger Annex 6 LDP Attachment A Page 12 of 12 BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN PERFORMANCE BENCHMARKS Goals PAL-1 PAL-2 PAL-3 Desired Outcomes monitoring unit in MOLSP standards for social services * Approval by CoM of Building capacity for amendments to the Social poverty and living standards Assistance Act opening analysis social services provision for private and NGO providers. Note: This annex is the agreed medium term performance matrix and is an attachment to the Government's Letter of Development Policy. * PAL-I Board Condition ** PAL-2 Trigger t** DAT -1 T_ Annex 6-A LDP Attachment B Page 1 of 2 List of Companies Not Included in the Privatization Program 4 Bourgas Airport EAD - Bourgas LIST OF COMPANIES WITH MORE THAN 50 PER CENT OF STATE PARTICIPATION IN THE 5 Goma Onahovitsa EAD - Goma Onahovitsa EQUITY OT DETACHED PARTS THEREOF 6 Plovdiv Airport EAD - Plovdiv 7 Stara Zagora Airport EOOD - Stara Zagora I Ministry of Regional and Urban Development 8 Rousse Airport EOOD - Rousse 9 Port Complex Rousse EAD - Rousse I Water Supply and Sewerage EOOD - Blagoevgrad 10 Port Complex Lom EAD - Lom 2 Water Supply and Sewerage EAD - Bougras I Port of Vidin EOOD - Vidin 3 Water Supply and Sewerage OOD - Vama 12 Port of Vama EAD - Vama 4 Water Supply and Sewerage Yovkovtsi OOD - Veliko Tamovo 13 Port of Bourgas EAD - Bourgas 5 Water Supply and Sewerage EOOD - Vidin 14 Lesport EAD - Vama 6 Water Supply and Sewerage OOD - Vratsa 1 Bulganan Posts EAD - Sofia 7 Water Supply and Sewerage OOD - Gabrovo 8 Water Supply and Sewerage EOOD - Dobnch III Ministry of Agriculture and Forestry 9 Water Supply and Sewerage OOD - Karali 10 Water Supply and Sewerage OOD - Kyustendil I Imgation Systems EAD - Sofia 11. Water Supply and Sewerage OOD - Lovech 2 Agrolesproekt EOOD - Sofia 12 Water Supply and Sewerage OOD - Montana 3 St. Ivan Rilski EAD - Sofia 13 Water Supply and Sewerage EOD - Pazardjik 4. Hidromeloiracii - Sevlievo EAD - Sevlievo 14. Water Supply and Sewerage OOD - Pemik 5 Agrogeometer-Sofia EAD - Sofia 15. Water Supply and Sewerage EOD - Pleven 6 Vodproekt EAD - Sofia 16 Water Supply and Sewerage EOOD - Plovdiv 7 Kabijuk EAD - Shumen 17 Water Supply and Sewerage OOD - Ispenh 8. Khan Asparuh KZ EAD - Yasenovets 18. Water Supply Dounav EOOD - Razgrad 9 Stefan Karadja EOOD - Balchik 19 Water Supply and Sewerage OOD - Rousse 10. Vrana EAD - Sofia 20 Water Supply and Sewerage OOD - Silistra 21 Water Supply and Sewerage OOD - Sliven IV Ministry of Defence 22. Water Supply and Sewerage EOOD - Smolyan 23. Water Supply and Sewerage EOOD - Stara Zagora I Terem EAD - Sofia 24 Water Supply and Sewerage OOD - Targovisbte 2. Military Publishing House EOOD - Sofia 25 Water Supply and Sewerage OOD Dimitrovgrad 3 Supply and Commerce MF EOOD - Sofia 26. Water Supply and Sewerage EOOD - Haskovo 4 Tnarnistroymnvest EOOD - Sofia 27 Water Supply and Sewerage OOD - Shoumen 5 PRONO EOOD - Sofia 28 Water Supply and Sewerage OOD - Yambol 29. Water Supply and Sewerage EOOD - Sofia V Ministry of Education and Science 30. Geoprotection EOOD - Vama 31 Geoprotection EOOD - Pemik I Student Canteens and Boarding Houses EAD - Sofia - social functions 32 Geoprotection Pleven EOOD - Pleven 2 Education and Science EAD - Sofia - social functions 33 National regional development Center EAD - Sofia 3 Akademika 2000 - Sofia - social functions 34 Research Construction Institute - NISI - Sofia 4 Allians EOOD 35 Technoexportstroy EAD - Sofia 5 Unique Appliances and Systems EOOD 36 Metal Structures Holding EAD - Sofia 37 Industnal Construction Holding EAD - Sofia VI Ministry of Culture 38 Installations - Sofia 1. Submanne Archaeology Center EOOD - Sozopol 11 Ministry of Transport and Communications VIl Ministry of Health I Bulganan State Railways EAD - Sofia, which, according t the Transition and Final Provisions of the Act on Railway Transport, shall be terminated without liquidation on January 1, 2002, and its I Specialized Rehabilitation Hospitals - National Complex EAD - Sofia successors will be the Railway Infrastructure National Company and a sole-propnetor company that 2 Balneological Center - Kamena EAD - Velingrad shall be established by the Council of ministers by January I, 2002 and shall perform the activity related to railway transport of passengers and cargo 2 Sofia Airport EAD - Sofia V Ministry of Energy and Energy Resources 3 Varna Airport EAD - Vama Annex 6-A LDP Attachment B Page 2 of 2 List of Companies Not Included in the Privatization Program I Kozloduy nuclear power station EAD - Kozloduy 2 Bulgargas EAD - Sofia 3 Ecoingenenng EOOD - Sofia IX Ministry of Economy I L B Bulgancum EAD Sofia 2 Bulgarian Rose State Laboratory EOOD - Sofia 3 Eco Elshitsa EOOD - village of Elshitsa 4 Eco Medet EOOD - village of Panagyurski Kolonil 5 lntemational Economics Staff Training Center EOOD - Sofia 6. Bulganan Agency for Export Insurance AD - Sofia X Ministry of Finance I. Tax Free Zone Bourgas AD - Bourgas 2. Tax Free Zone Vidin AD - Vidin 3 Tax Free Zone Rousse AD - Rousse 4. Tax Free Zone Plovdiv AD - Plovdiv 5 Tax Free Zone Svilengrad AD - Svilengrad 6. Transit Commercial Zone AD - Vama 7 Information Service AD - Sofia 8. Formpnnt AD- Sofia 9 Promotion Bank AD - Sofia 10. Bulgarian Stock Exchange AD - Sofia I Central Depository AD - Sofia 12 Bank Consolidation Company AD - Sofia Xl State Agency for Youth and Sport I National Sports Base EAD - Sofia 2 Olympika EAD - Sofia Annex 6-B LDP Attachment C Large State-Owned Enterprises/Banks to be Privatized or Liquidated in PAL-2 and PAL-3 PAL-2 1. Bulgartabac 2. DSK (State Savings Bank) 3. Bulgarian River Fleet, Rousse 4. Bulgarian Commercial Fleet, Varna 5. Balkancar Holding 6. Twenty out of 35 small Hydro Power Plants PAL-3 1. The seven electricity distribution companies 2. Five district heating companies Annex 6-C LDP Attachment D BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN District Heating Sector Reform Completed actions 0 Satisfactory implementation of the district heating (DH) component of the Energy Strategy approved by the CoM on May 11, 2002, including: introduction of two-part tariffs for all customers (a fixed capacity charge for all customers and an energy charge based on measured or estimated consumption); implementation of a 10 percent price adjustment in 2002; approval of an indicative schedule for raising household tariffs to cost-recovery levels and phasing out DH company subsidies; and allowing disconnection of entire buildings under specified conditions. IPAL-2 o Continued satisfactory implementation of the district heating component of the Energy Strategy approved by the CoM on May 11, 2002 including: implementing tariff and subsidy adjustments; adjustment of the winter energy subsidy program to account for the increase in tariffs; strengthening the management of supply companies; stimulating the formation of Housing Associations in multi-family dwellings (or other mechanisms to enforce the rights and obligations of suppliers and customers); regulation of heat accounting companies; installation of heat allocators and thermostatic valves by domestic consumers, and securing the financing for potentially viable DH companies to improve supply (and consumption) efficiency covering at least 50% of Bulgaria's customer base. 1PAlL-3 o Continued satisfactory implementation of the district heating component of the Energy Strategy approved by the CoM on May 11, 2002 including: implementation of district heating tariff adjustment program and privatization of at least five district heating companies [PAL-3 Trigger] Annex 6-D LDP Attachment E BULGARIA: PROGRAMMATIC ADJUSTMENT LOAN TELECOMMUNICATIONS LIBERALIZATION IMPLEMENTATION COMMITMENTS Completed Actions * CRC Established PAL-2 * Adoption of New Telecommunications Law and satisfactory progress in adoption of secondary legislation under Telecommunications Law * New BTC License issued pursuant to new telecommunications law and including network rollout obligations reflected in plan submitted to the Bank during appraisal * BTC Reference Interconnection Offer Submitted to CRC PAL-3 BTC will: * provide cost-oriented prices for voice services * provide separate accounting and cost-oriented prices for interconnection * implement requirements for leased lines - minimal set, separate accounting, cost orientation Annex 7 Page 1 of 5 An Update on Poverty' 1. The recent poverty profile for 2001 shows a notable decline in poverty since the last survey which was conducted in 1997. For the analysis, relative poverty lines from 1997 - two- thirds mean per capita consumption (high) and one-half mean per capita consumption (low) - were held constant and adjusted to 2001 price levels to document trends.2 The results indicate that poverty in Bulgaria has fallen by nearly two-thirds since 1997, but persists at levels more than double the pre-crisis rates (12.8% vs. 5.5% in 1995) (Table 1). In addition, in 2001, the poor have become less poor compared to 1997, in terms of depth, or severity of poverty (meaning how far below the poverty line, poor people are). Inequality for 2001, as measured by the Gini coefficient, is down from 1997, but higher than it was in 1995 (29.6 versus 31.4 and 27.1 respectively). Table 1: Poverty and Inequality Trends 1995 1997 2001 Poverty estimates High Low High Low High Low Headcount ratio 5.5 2.9 36.0 20.2 12.8 7.5 Gap 1.7 0.9 11.4 5.9 4.2 2.2 Severity 0.8 0.4 5.5 2.7 1.9 0.9 Avg. per capita monthly 117.2 62.6 99.0 consumption (June 1997 BGN) Gini coefficient 27.1 31.4 29.6 Sources: Bulgaria Integrated Household Surveys 95, 97, 01 Note: Poverty rates are based upon per capita consumption. The "high" poverty line (equivalent to $2.76/day) is set at two-thirds mean consumption in 1997, the "low" line (equivalent to $2.07/day) is set at one-half mean consumption. 2. Absolute poverty in Bulgaria in 2001 is comparable with neighboring countries, although it exceeds levels in the high-performing countries of Central and Eastern Europe (Table 2). Using the absolute poverty line of $2.15 (ppp) per day for purposes of international comparison, poverty in Bulgaria was 7.9 percent, slightly higher than that of Romania and Latvia in 1998. This remained significantly higher than poverty in the more advanced EU Accession countries such as Hungary and Poland (1.3 and 1.2 percent respectively at the above mentioned poverty line). The Bank is working with the Govermment on poverty analyses, monitoring and evaluation. For the purposes of the Poverty Assessment Update, the Bank is using the high poverty line, equal to $2.76 per day adjusted for ppp. Table 2: Poverty Rates in Selected Countries of Central and Eastern Europe Country Survey Year at $2.15 ppp/day at $4.30 ppp/day Bulgaria 1995 3.1 18.2 Bulgaria 2001 7.9 31.9 Romania 1998 6.8 44.5 Latvia 1998 6.6 34.8 Ukrame 1999 3 29.4 Hungary 1997 1.3 15.4 Poland 1998 1.2 18.4 Source: Makmng Transition Work for Everyone, The World Bank, 2000. 'For more details see Bulgaria: Poverty Assessment, The World Bank, 2002. The assessment is based upon the Bulgaria Integrated Household Survey which was implemented in Spring 2001. 2 As a result, the relative poverty lines for 1997 function as 'absolute' poverty lines in 2001. Annex 7 Page 2 of 5 3. Despite the rising unemployment associated with the restructuring of the economy, poverty has fallen since the 1997 crisis: growth-oriented structural reforms combined with enhanced safety nets and sharper targeting appear to have helped the poor. The decline in measured poverty rates has taken place within a context of increasing unemployment, suggesting a large role for social protection income, informal employment and remittances in mitigating the impact of the labor shedding in the formal sector. As expected, poverty is highest among unemployed and economically inactive individuals. The share of households whose head is unemployed grew from 7 percent in 1997 to 15 percent in 2001, and individuals in households whose head is unemployed make up almost 40 percent of the poor. 4. In the context of increasing unemployment, the impact of social protection transfers on poverty was sizable. Bulgarian households on average derive 12 percent of their income from social protection benefits and this share jumps up to more than one third among the poor. Pensions play the largest role in protecting consumption. In the absence of social protection benefits, poverty would be 18 percentage points higher. This is largely the result of pension income - other benefits, including unemployment and social assistance, reduce poverty by two percentage points. 5. Improvements in welfare since the 1997 crisis have not been distributed evenly across the population. Preliminary analysis of the poverty profile indicates that poverty rates, which measure the proportion of people below the poverty line, have declined less for some groups than others. For example, urban areas experienced a more significant drop in poverty levels, from 33.5 to 5.9%, while in rural areas, poverty rates were less than halved (from 41.2 to 23.7 percent). Similarly, poverty rates for other high risk groups, including individuals with low education levels and the Roma and Turkish minorties have fallen less than for the population as a whole. This suggests the existence of important 'pockets' of poverty which have not benefited as much as the rest of the country from recent economic improvements. 6. Poverty in Bulgaria still has a significant ethnic dimension. In particular, the Roma minority is over-represented among the poor. The 2001 data indicate that Roma are ten times more likely to be poor than ethnic Bulgarians. Although Roma represent only 8.8 percent of the individuals in the sample, they constitute nearly half of the total poor. The Turkish minority also has consistently higher poverty rates than the total population. In the 2001 survey, poverty rates for Turks are four times higher than those for ethnic Bulgarians. 7. Poverty is most severe among younger people. Although children 10 and below represent only 10 percent of the population, they make up almost 20 percent of the poor. Severe poverty is widespread among both children and teenagers who bear almost 40 percent of the poverty share and one out of every two children under the age of 5 in rural areas lives in poverty. 8. Poverty is not gender neutral. The preliminary profile provides a mixed picture on the relationship between gender and poverty. According to the 2001 survey, there are no significant differences in the poverty rates of individuals in male and female-headed households. However, the national figures conceal significant urban-rural differences: poverty rates are higher among female-headed households in urban areas, as compared to male-headed households, while they areilower in rural areas. Particularly in urban areas other than Sofia, poverty rates among female- headed households are double those for male-headed households (10.0 vs. 5.4%). Complementary analysis confirmed that consumption in households headed by single women was lower than for other two-person and other single-headed households. Annex 7 Page 3 of 5 9. Ongoing research indicates that several categories of women are among the most vulnerable social groups in Bulgaria. Especially vulnerable are women with young children, women with very low levels of education, especially Roma women, and women living in remote rural communities. They are marginalized and practically excluded from formal market structures. 10. The good news is that female access to education has improved. Net enrollment in basic education, which in Bulgaria is slightly higher for girls than boys, increased from 92.31 in 1997 to 93.89 percent in 2001. The gender gap in secondary education has narrowed significantly. Female net enrollment rose sharply from 67 percent in 1997 to 76 percent in 2001, close to the male net enrollment rate of 78 percent. 11. Education matters. Consistent with previous studies, results from the 2001 survey highlight a close inverse relationship between poverty and educational attamment. Education provides the most effective insurance against poverty. Poverty rates for individuals with university or higher education are significantly less, at 3 percent, than those with basic or secondary education, 46 and 26 percent respectively. Poverty rates are also highest among younger, less educated individuals: almost two-thirds of those between 18-21 with primary education or less are poor. 12. There is some evidence of declining educational attainment, particularly among the poor and ethnic minorities. Precisely because education is an effective tool to lift people out of poverty, developments concerning access to education for poor children over the last 4 years are worrisome. The household survey data for 1997 and 2001 indicate that while enrollments in basic education have increased slightly for the country at large, enrollment rates for poor children have fallen ten percentage points from 84 percent in 1997 to 74 percent in 2001. In some Roma neighborhoods, there are reports of children not attending school. The Turkish minonty may also be affected. For example in Kurdjali, a region with a high percentage of ethnic Turks, enrollment rates of 76 percent are substantially lower than the national average of 95.1 percent.3 The trend in secondary education is even worse, with a nation-wide decline of about 26 percentage points in the net enrollment of the poor from 60 percent in 1997 to 34 percent in 2001. 13. Existing evidence suggests that social exclusion, economic hardship - including increasing formal and informal costs of education to households -- unemployment, low quality of schools in poor areas and low demand for education among certain groups are causing an increasing number of children to drop out of schools. These factors also contribute to increase in the number of street children (the exact number is unknown, but is thought to be between 3,000 and 5,000), as well as those who end up in institutions (estimated at some 35,000). 14. Health indicators have shown little improvement and have sometimes deteriorated over the transition period. Life expectancy at birth, which increased in the 1980s has fallen slightly through the last decade to 72 in 1997. The incidence of new cases of tuberculosis increased steadily throughout the decade from 25.9 new cases per 100,000 people in 1990 to 49.9 in 1998. The incidence of hepatitis in Bulgaria, which stands at 95 cases per 100,000 people in 1998, while at similar levels to Eastern European countries, remains four to five times higher than that in Central European transition economies. And immunization coverage4, which was virtually universal at the beginning of the transition, had fallen to 95 percent by 2000. 3 Based on administrative data. 4As measured by the proportion of children under 2 inununized against DPT. Annex 7 Page 4 of 5 15. An active dialogue on poverty issues is ongoing with the objective of mainstreaming poverty reduction into the overall Government economic and social policies. In 2000-01, the previous govemment and its development partners engaged in an active dialogue on poverty reduction. In January 2000 the Bank hosted a high level poverty retreat on "Mainstreaming Social Development and Poverty Reduction" under the leadership of the Pnme Minister. The retreat was attended by much of the cabinet, and key donors mcluding the EMF, EU and UNDP. At the retreat, the government expressed its commitment to building capacity for on-going poverty monitoring, and requested Bank assistance for developing this capacity and updating the analysis of the 1999 poverty assessment. An update of the poverty profile was prepared in 2001 last summer. Its preliminary results were presented to the Council of Mmisters in December 2001, and are at the center of the proposed strategy. 16. Poverty monitoring needs to be strengthened. Despite the increased level of activity related to poverty, actual monitorng capacity in Bulgaria remains weak. The Bank supported the implementation of a third Bulgarian Integrated Household Survey (BIHS) in April-June 2001 to update measures of living standards and poverty. Previous rounds of the survey were conducted in 1995 and 1997, and formed the basis for the 1999 poverty assessment. These surveys are a valuable instrument for analyzing poverty and living standards, and it will be important for the govermment to establish its own capacity for poverty monitoring within the govemment. 17. The National Statistical Institute (NSI) conducts monthly Household Budget Surveys (HBS). While the HBS is currently the only source of updated information on household income and expenditures in the country, and is widely used for poverty estimates, it suffers from a number of methodological flaws. Because the main objective of the HBS is not to measure poverty and inequality, the information it collects is incomplete and insufficient for constructing a full consumption-based welfare aggregate, among other deficiencies. Over the last five years, the HBS proved ineffective in monitoring poverty developments. 18. In order to ensure long-term capacity to monitor poverty within Bulgaria, the Bank and the government are collaborating to institutionalize poverty monitoring capacity through the implementation of regular Living Standards Measurement Surveys (LSMS) and improvements to the HBS methodology. An IDF Grant for Poverty Monitorng, Evaluation and Policy Design (FY02) to support these activities was extended to the Government in December 2001. A central focus of the grant is be to create capacity within the NSI, MOLSP and other relevant government bodies for data collection, poverty analysis and ex ante assessment of government programs and their effects on income distribution, assets and living standards. 19. Steps have been taken to reduce poverty, integrate ethnic minorities into mainstream Bulgarian society, and address the large range of problems poor and vulnerable children face. In 1999 the Government signed a Framework Program for the Integration of Roma in the Bulgarian society and established a National Council on Ethnic and Demographic Issues (NCEDI). The Bank is providing support to the implementation of this program through an IDF Grant for Ethnic Minority Integration which builds the capacity of NCEDI and its regional offices for policy development, monitoring and evaluation; work at community and grass-root level and interaction with the society at large. The Government implemented a Regional Initiatives Fund (RIF) project with assistance from the Bank, UNDP, and USAID which pioneered community- driven development in the poorest municipalities and temporary job creation labor market programs. A large share of the beneficiaries of these programs were representatives of ethnic minorities. A Japan Social Development Fund (JSDF) Grant for Child Development in Disadvantaged Communities is implemented to enhance the access of children from ethnic minority communities to the mainstream educational system and to promote early childhood Annex 7 Page 5 of 5 development in these communities. Another JSDF Grant for Social Capital Building in Disadvantaged Communities facilitates community mobilization and building of trust at community level. Despite this progress, a significant agenda remains to improve integration of minorities within society. 20. In November 2000, the Government announced an important Strategy on Child Welfare. Its implementation, which targets govemment institutions, ethnic minorities, parents as well as the children themselves has gained support from the EC, the UK, the Govemment of Japan and the World Bank. Its goal is to improve the welfare of street children (60 to 80 percent of which are Roma) and institutionalized children, through de-institutionalization, protection of children's rights by developing new institutions and policies, social integration of children in high-risk communities, prevention of child abandonment, promotion of altemative family and community- based altematives to institutional care and decentralization of services to help vulnerable children grow into responsible citizens. A key feature of the strategy is the extensive involvement of the communities in the different programs including attracting ethnic community staff in the social services provision programs. The Govemment has given its full support to the strategy. It has also developed a New Social Policy Strategy which addresses the needs of all categories of people at risk. The Bank will be supporting its implementation through the Social Investment Employment Promotion (SIEP) Project. Annex 8 Page I of 9 Bulgaria: IMF-World Bank Relations A. Partnership in Bulgaria's Development Strategy 1. The Government's economic program has been underpinned by a conservative fiscal and incomes policies and significant acceleration of structural reforms. So far Bulgaria has made substantial progress towards long-term macroeconomic stability-an important step along the way to its ultimate goals of improving living standards and accession to the EU. The wide-ranging reforms in the Government's agenda hinge on the continuing challenge of macroeconomic stability in the context of the Currency Board Arrangement (CBA), sustaining structural reforms and establishing a business environment conducive to growth, together with improved governance, financial system deepening, and investment in human capital and physical infrastructure. 2. The IMF has been leading in supporting Bulgaria's medium-term program in maintaining macroeconomic stability. Building on the achievements of the three-year Extended Fund Facility (EFF) arrangement with Bulgaria, in February 2002 the IMF Board approved a two-year Stand-By Arrangement (SBA). The SBA, with a reduced scope and detail of structural conditionality compared to the EFF, focuses on medium-term fiscal challenges and structural reforms with significant macroeconomic, notably fiscal, implications. 3. The World Bank has been leading the policy dialogue in structural and institutional reforms aiming at (i) promoting competitive private sector-led growth; (ii) strengthening market institutions and improving governance; and (iii) mitigating the social impact of restructuring and delivering social services more effectively. In May 2002, the Board of the Directors discussed the new Country Assistance Strategy (CAS) which outlined the roadmap for the Bank's country support for the period 2002-2004. In addition to the ongoing Bank's lending operations in areas such as education, health, child welfare, water, trade and transport, environment, registration and cadastre, the new CAS includes a three-year programmatic adjustment lending (PAL) program. Moreover, the Bank continues to undertake substantive country diagnostics providing a solid base for policy dialogue and design and implementation of its lending operations in Bulgaria. B. IMF-World Bank Collaboration in Specific Areas 4. There are a number of areas where the IMF leads and its analyses serve as inputs into the World Bank policy formulation and advice, including policies to maintain macroeconomic stability, fiscal policies, income policies and external sector policies. There are other areas in which the Bank and the Fund share responsibility and are coordinating closely their policy advice to the Bulgarian authorities, such as the financial sector, public expenditure management and budgeting, and tax administration. In some areas, the Bank has taken the lead but its analysis, country diagnostic work, and policy recommendations served as inputs into the Fund's policy advice on the fiscal front such as education, health care, pensions, social protection, energy, and railways. In areas such as private sector development, Annex 8 Page 2 of 9 strengthening market institutions (including entry and exit policies, regulatory reform to enhance the business climate, judicial reform, labor market reform), and improving governance the Bank has the lead and there is no conditionality under the Fund program. In addition to having had consultations early in the process on formulating and adjusting each institutions' program with Bulgaria, the Bank and Fund staff teams interact extensively during the review of the progress achieved in the country and coordinate closely their policy advice to the Bulgarian authorities. B.1. Areas where the IMF leads and its analyses serve as inputs into the World Bank policy formulation and advice. 5. To achieve the objectives of its economic program, the Bulgarian authorities are fully committed to maintain sound and flexible macroeconomic policies centered on a CBA and to implement an ambitious reform agenda. In particular, the authorities have reduced the fiscal deficit to below one percent of GDP and aim to eliminate the deficit by 2005, conduct fiscal policy flexibly in the face of shocks, and maintain a high level of fiscal reserve assets. Given the constraints of the CBA, the authorities see labor market policies as another key component of the broad policy strategy. A strict incomes policy for the state enterprise sector is enforced and measures aimed at facilitating the adjustment of labor markets are being implemented. The structural and institutional reforms, which constitute the third pillar of the policy strategy, are focused on creating a fully functioning market economy that is competitive and can flexibly adjust to shocks. 6. In the context of the 24-month Stand-By Arrangement approved on February 27, 2002, the IMF is taking the lead in assisting Bulgaria in safeguarding macroeconomic stability and promoting structural reforms in areas that are macro-critical and fall within the Fund's core expertise. To safeguard the CBA and ensure that it can continue to serve as the macroeconomic policy anchor, the IMF sets ceilings on the size of the overall deficit of the general government and floors on the balance of the fiscal reserve account (FRA), and ceilings on the net outflows from the FRA. To prevent threats to the currency board and macroeconomic stability that could arise from a loss in competitiveness or excessive extemal financing requirements, Fund conditionality also includes ceilings on the wage bill of those state enterprises that have the largest losses and arrears, are monopolies, and receive subsidies, and on the contracting and guaranteeing of public sector external debt. B.2. Areas of shared responsibility. 7. Financial Sector. Recently staff of the two institutions carried out a joint IMF-World Bank Financial Sector Assessment Program (FSAP) for Bulgaria, providing a shared perspective on the development agenda of the country and on the prioritization and sequencing of reforms in the financial sector. Key findings of the FSAP are conditionalities on financial sector policies under both the SBA and the PAL programs. The IMF has emphasized aspects related to the banking sector-mainly on policies under the mandate of the Bulgarian National Bank (BNB) and supervisory agencies-while the World Bank is focusing on policies that affect market performance and development of the financial sector such as improving the legal and institutional framework for lending, restructuring of the Annex 8 Page 3 of 9 banking sector, strengthening creditor rights, corporate insolvency and governance, and non- banking financial sector issues. 8. Since 1997, in the context of two Finance and Enterprise Adjustment Loans (FESALs), the Bank has supported the Government in restructuring of the financial sector. Privatization of commercial banks have been major components of the FESALs, while the Fund had provided support for the institution building efforts of the BNB, its Banking Supervision Department in particular. In the financial sector, the Bank has focused on banking, insurance, pension funds, and capital markets while the Fund has continued its focus on the BNB, banking supervision, and the payments system. 9. Revenue Administration. The IMF and the World Bank have been carrying out a joint effort since 1996 to assist Bulgaria in reforms aimed at the establishment of an efficient revenue collection agency. Diagnostics consistently pointed to revenue collection deficiencies-including weak management, problematic audit and enforcement of collection-which in turn facilitate low compliance. Supporting reform efforts, the World Bank implemented a project to modernize the Social Security Institute, including its revenue collection activities. The IMF has provided a long-term advisor to the Ministry of Finance, and focused advisory services through consulting assignments. Joint World Bank-IMF efforts resulted in a proposal for "Implementing a Modern Revenue Collection Agency" in March 2000, which is now moving forward. The World Bank, with technical assistance of the IMF, is in an advanced stage of preparing an institutional development project to support the establishment of the national revenue agency (NRA). This Agency would seek to maximize the level of taxpayer voluntary compliance, promote effectiveness and efficiency, establish a professional workforce and approach to collection, and help reduce the scope for corruption. 10. Public Expenditure Management. The Bank has taken the lead in the dialogue on the efficiency and effectiveness of public expenditures and the recently completed Public Expenditure and Institutional Review (PEIR)l outlines policy directions, which are going to be further supported by the PAL program. The PEIR notes that notwithstanding progress to date, important challenges remain in: (i) improving management and accountability in the use of public resources; (ii) restructuring and rationalizing intersectoral public expenditure- particularly energy and railways, economic services, defense and security, and general services; (iii) reallocation of intrasectoral priorities-especially in health, education, social protection; and (iv) higher investment requirements in many sectors-infrastructure, environment, education and health-some of which are priorities for EU accession, and some of which should involve the private sector. The PEIR notes that Bulgaria's main fiscal challenges include working towards an improved allocation of expenditures, while gradually reducing the overall level of expenditures over the medium term in tandem with Bulgaria's fiscal targets of easing the overall tax burden, especially payroll taxes. 11. The IMF has provided long-term technical assistance on budgeting and expenditure management. The Government has already initiated a number of public expenditure management reforms. New budget procedures were introduced in early 2002 and have been I The PEIR is entitled Bulgaria. Public Expenditure Issues and Directions for Reform, August 2002, The World Bank, (Report No. 23979-BUL) Annex 8 Page 4 of 9 implemented for the preparation of the 2003 budget. The Government is moving towards preparing of sectoral medium-term budget frameworks (MTBFs) with a view to strengthen budget-policy links. Despite this important progress, the PEIR notes that there is a need to continue and broaden the reform effort, especially in accounting and auditing-internal audit needs to be made operational across all first-level budget units; capital expenditure proposals should be prepared under hard budget constraints and as integral part of the MTBFs; and the financial management at the local level should be strengthened. B.3. Areas where the World Bank leads and its analyses serve as inputs into the IMF policy formulation and advice. 12. Energy sector. While the Government has made important progress in energy sector reforms, the sector still remains largely government owned or controlled and energy consumption is still highly inefficient and heavily subsidized. In mid-2002, the Government approved an energy strategy that envisaged bringing household electricity prices to full cost recovery by 2004. Implementation of the price adjustment schedule has started and is central to the modernization of the sector together with the need to modernize the regulatory framework and initiate privatization of the downstream electricity distribution system. Costly investment in capacity should not be undertaken unless regulatory reforms are more advanced and private investors can assume a larger share of the market risk. 13. The Bank has played the lead role in assisting the Government in the design of the reform programn in the sector, and more importantly its implementation. Although an Energy Project was completed at end-2000, the Bank is continuing its dialogue on the developmental objectives of the sector meant to increase the energy efficiency. In early 2002, the Bank completed the Energy and Environment Review aimed at evaluation of alternative strategies-balancing the need for economic development and environmental protection-and providing policy recommendations. The Fund and the Bank's teams have worked collaboratively in close consultations with the Govenrnent, and the SBA includes a performance criterion focusing on announcement of a schedule for bringing electricity prices to full cost recovery level, and two benchmarks-one on implementation of the new regulatory pricing regime, and the other on preparing a new Energy Act to harmonize Bulgaria's legislation with EU Directives. The Government is still working towards achieving the latter benchmark-on harmonization of legislation. 14. Railways. The Bank has been the Government's main external partner in the transformation of the railway sector, particularly through the Railway Rehabilitation Project, which was completed in June 2002. This transformation is only half way achieved by now, however. Some essential measures have been implemented, especially the divestiture of all railway ancillary activities, a major reduction in staffing, and the institutional separation of the national company into two new infrastructure and rail services enterprises together with the opening of rail services to private operators. Yet, other key steps still need to be taken for the railway sector to become financially self-sustainable and reduce its support requirements from the State, which have been around 0.8% of GDP in recent years and could increase if the present situation does not improve. These steps include tariff reform, reduction of loss making services to only those that can be socially justified and supported by State contracts, further reduction of staff, and improved corporate governance. They were refined in the Annex 8 Page 5 of 9 context of the recent PEIR and are being supported by the Bank through the PALs. Detailed assistance with the design of these reforms will be further provided through transport sector work in the near future. 15. Education. The reform efforts in the education sector aim at improving expenditure management in view of the declining population, especially in school age, and at enhancing quality and access to education. The main priority in the education sector, including universities, is to reallocate expenditures from surplus capacity in teaching staff and underused facilities toward modernization and upgrading of curricula, textbooks, teaching materials, schools, and other quality-enhancing education inputs. The Bank is supporting the Government program in education through the Education Modernization Project loan, the PALs, and through the analytical work done for the Poverty Assessment and the PEIR. 16. Health care. Key reform priorities in the health sector include addressing the concurrent problems of surplus capacity issues in health facilities, the serious deterioration in the quality of facilities and health services, and the inadequate modernization of equipment. At the same time, the Government needs to ensure the financial integrity of the National Health Insurance Fund (NHIF), which is the central point of the reforms in the sector. For a long time the Bank has been supporting the restructuring of the health sector through the Health Sector Restructuring Project, which was closed in December 2001. The follow-up Health Sector Reform project approved in late 2000 is under implementation and focuses on the administrative and information systems of the NHIF, supports the ambulatory care sector, and the hospital sector. 17. Social protection programs. Social protection programs-pensions, labor market programs, social assistance, and short-term and family benefits-have a wide coverage among the population (over 80 percent of Bulgarians receive at least one type of social protection benefit.) On pensions, one reform priority is to improve compliance with, and coverage of, the public pillar, and define a clear rule for indexing pensions. On labor market programs, there is a need to monitor them closely to improve their effectiveness and long-term impact in helping the disadvantaged groups, such as the long term unemployed, low skilled youth, ethnic minorities and so on. Similarly, the recent changes on the unemployment insurance fund need to be monitored closely in terms of its expected increases in registry and contributions, its costs and effectiveness. Subject to progress in key reforms, consideration should be given to reduce the tax burden related to labor market policies in order to curtail labor costs. Some social assistance and benefit programs have become more pro-poor since the mid-1990s and are playing a major role in alleviating poverty. However, given the plethora of these programs and the complexity of program design in many cases, a constant challenge of the social protection system as a whole is to examine opportunities for consolidation and engage in systematic monitoring of the programs, their costs and effectiveness. 18. The Bank has been the main partner of the Government in its efforts to reduce poverty and meet its social development objectives. The main findings of the Poverty Assessment and 2 However, such fiscal adjustment requires lowering public expenditures to GDP before implementing tax reductions. Annex 8 Page 6 of 9 the PEIR contribute significantly to the enhanced policy dialogue with the Government on its policy options to improve living standards in the country, and the effectiveness and adequacy of social protection programs. The Bank is assisting these important reforms in the social protection system through providing grants amounting to US$ 2.2 million. These grants focus on poverty monitoring and evaluation, integration of ethnic minorities, child development and building social capital in disadvantaged communities. A Bank-financed Child Welfare Reform project helps address the needs of children in public care and other categories of children at risk, while a Bank-financed Social Investment and Employment Promotion (SIEP) project which supports community and employment creation and strengthening of active labor market programs (ALMPs) has recently been approved and will begin to be implemented. Although not subject to structural performance criteria or benchmarks, the IMF has also been monitoring the sustainability of the pension system and progress in the labor market reforms in terms of their relevance for the Fund's program objectives. B.4. Areas where the World Bank leads and there is no direct IMF involvement. 19. Private Sector Development. Bulgaria has completed the divestiture of about 95 percent (based on value of assets) of its non-infrastructure state-owned enterprises (SOEs) since 1995. However, job creation has not kept pace with labor shedding due to the liquidation of non-viable enterprises and the restructuring of viable ones, contributing to the persistence of the unemployment level. To encourage the entry of new firms and the expansion of existing ones, the business climate will have to be improved through reducing barriers to entry and compliance cost of the regulatory regime, developing a competitive environment, eliminating the constraints to bank lending, and establishing an efficient exit mechanism for non-viable enterprises. These initiatives require major changes in the basic legislation that govern commercial activity - notably the Commercial Code, the Civil Procedure Code, and the Labor Code-and the passage of legislation on how the State will regulate economic activity to ensure stability and predictability of regulatory regimes. The quality of public institutions dealing with the private sector - including regulators and service providers-will have to improve. Finally, judicial reform will have to be implemented, including the establishment of specialized commercial courts and the restructuring of the system of administrative courts. 20. In the context of two FESALs, the Bank has supported the Government in restructuring the non-infrastructure enterprise sector. Privatization of SOEs has been major component of the FESALs. With the first PAL, the Bank has led the dialogue on reforms covering the regulatory regimes, the insolvency process, labor markets, and competition. C. The World Bank Group Strategy and Lending Operations 21. The Country Assistance Strategy. The Bank's Board discussed a new Country Assistance Strategy (CAS) for Bulgaria on May 9, 2002. The overarching objectives of the CAS for FY03-05 are: (i) reducing poverty and raising living standards, and (ii) supporting the country's move towards EU accession. In achieving these objectives the Bank will focus its assistance on the following main CAS themes: (i) promotion of competitive private sector led growth, (ii) strengthening public administration reforms and anti-corruption initiatives, and (iii) mitigating the social impact of restructuring and delivering social services more Annex 8 Page 7 of 9 effectively. The strategy also envisages an important role for the International Finance Corporation (IFC), especially through support for privatization and restructuring of state- owned enterprises and new investments in private companies. 22. Programmatic Adjustment Lending. Up to three Programmatic Adjustment Loans (PALs) would support the Government's policy framework that underpins the Bank's overall assistance program in FY03-05. The policy framework supported by the PALs would, over time, (a) foster completion of privatization and restructuring in energy and infrastructure; (b) improve the environment for private sector led growth; (c) help deepen the financial sector; (d) lead to reduced poverty, improved human capital development, and better delivery of social services; and (e) support public administration reform and anti-corruption programs. 23. The Base-Case Lending Program. To maintain a robust base-case lending program, the Bank will ensure satisfactory progress towards a set of triggers that provide the basic conditionality for the Bank's assistance program. Besides a supportive macroeconomic framework and portfolio implementation, satisfactory progress will be necessary towards specific goals in key areas of reform, including privatization of large SOEs and banks, establishing separate generation, transmission and distribution companies in electricity, and adoption of a rational tariff system for power and district heating; terminating loss-making railway services outside areas of public service obligations; reducing red-tape for company registration and building permits; consolidating the revenue information systems; completing functional reviews for civil servants in two ministries and improving insolvency provisions in the Commercial Law and the Civil Procedure Code. Fiduciary responsibilities will be strengthened by completing the financial accountability assessment and implementing an action plan for public procurement. Some additional triggers will condition processing of the third PAL, currently scheduled for Board in FY05. 24. Bank Assistance Program in Bulgaria. The total Bank-assisted program in Bulgaria to date comprises 29 operations for a total original commitment of US$1,600.6 million equivalent. This includes ten adjustment loans (US$900.8 million equivalent), 17 investment projects (US$682.4 million equivalent), and two Bank-managed Global Environmental Fund (GEF) grants for US$17.4 million equivalent. Of these 29 operations, 21 have been completed, two of which have been restructured and partially cancelled during implementation, and 8 operations are currently under implementation. 25. The current portfolio is comprised of projects with commitments net of cancellations totaling US$230.6 million (Table 1) and complements the reform agenda articulated by the Government and supported by PAL-1. The current portfolio of projects was designed to upgrade the education and health services, improve child welfare, support environmental interventions, develop modem registration and cadastre systems, and modernize water and transport sectors. The projects under implementation are in the early implementation stages, with only three projects older than two years. The last loan approved by the Bank's Board was the Social Investment and Employment Promotion project (US$50 million equivalent; December 2002). In addition, a Wetlands Restoration and Pollution Reduction project (GEF grant of $7.5 million) was approved in June 2002. Three projects are in an advanced stage of preparation-Revenue Administration Reform, Forest Development and District Heating Annex 8 Page 8 of 9 Rehabilitation-all of which support the implementation of the Government medium term program articulated in PAL-1. Table 1. Bulgaria: World Bank Operations (net of cancellations) Operation Amount Board Date 1. Environment and Privatization Support Adjustment US$ 50 million 2000 Loan 2. Trade and Transport Facilitation in Southeast US$ 7.4 million 2000 Europe 3. Health Sector Reform US$ 63.3 million 2000 4. Education Modernization US$ 14.4 million 2000 5. Child Welfare Reform US$ 8 million 2001 6. Registration and Cadastre US$ 30 million 2001 7. Wetlands Restoration and Pollution Reduction US$ 7.5 million 2002 (GEF Grant) 8. Social Investment and Employment Promotion US$ 50 million 2002 26. Technical Assistance. Numerous grants provided under the Bank's trust fund programs complement the Bank's lending services through financing project preparation and advisory services in a number of areas, including poverty monitoring and alleviation, reform of the social protection system, energy sector reforms, enterprise divestiture, improving market institutions, governance, health and education sector reforms, and some technical aspects of EU accession. 27. Economic and Sector Work. The most recent Country Economic Memorandum (CEM) is entitled Bulgaria: The Dual Challenge of Transition and EUAccession, April 2001 (Report No. 22109-BUL). Other recently completed core diagnostic work includes a Public Expenditure and Institutional Review entitled Bulgaria: Public Expenditure Issues and Directions for Reform, August 2002, (Report No. 23979-BUL); a Joint World Bank-IMF Financial Sector Assessment Program; a Poverty Assessment 2002 is being finalized. Going forward, the Bank plans additional country diagnostic work to support its policy dialogue and operations in the CAS period of FY03-05. These include studies on municipal finances, pension funds, the energy sector, gender and ethnicity issues, private sector development, a country financial accountability assessment-planned for 2003) and a CEM update is to focus on policies for growth. 28. IFC's Activities in Bulgaria. IFC's activities in Bulgaria grew significantly with the improved business environment in the country after 1997. As of January 2003, IFC has on its books 16 projects for a total amount of US$188 million (US$170 million for IFC's own account). Of those, 13 projects were approved from 1998-on, including bank privatizations and restructurings, as well as credit lines and technical assistance to SMEs. Annex 8 Page 9 of 9 29. Financial Sector: In the banking sector IFC is focused on: (i) supporting the mortgage finance market; (ii) reviewing the possibilities for providing funding and guarantee products to enable banks to better meet the demand for long-term local currency loans; and (iii) establishing a credit bureau to improve risk analysis. In the non-bank financial sector, IFC is focused on further broadening capital markets by increasing volume, sophistication, and liquidity of alternative financial instruments such as mortgage and local corporate bonds. 30. General manufacturing: IFC continues to support the rehabilitation/modernization of post-privatized companies in sectors where Bulgaria has a comparative advantage and/or that are export-oriented such as wood, clothing, shipbuilding, metal processing, tourism, and agribusiness. To-date IFC has invested in a number of key manufacturing projects, such as Devnya Cement (modernization of a cement production plant), EPIQ Electronic Assembly (modernization and expansion of an electronic assembly facility), Kronospan I & II (wood panel and board production), and Sofia Med (revamping of a copper processing facility). To provide consumers with a wide variety of home improvement/repair products, as well as specialized services at affordable prices, IFC has financed a retail business, comprising five stores in Bulgaria and Macedonia. 31. Infrastructure. IEFC is ready to provide advice/financing for restructuring/privatization of the strategic sectors. In telecom, IFC will explore possibilities to finance BTC's digitalization program upon completion of the sale. In order to identify specific investment opportunities in ICT, IFC has been looking at system integrators, value added resellers and outsourcing companies (call-centers, remote help desks, contracted software development, etc.). IFC may also consider regional initiatives, especially in the areas of access and software development and integration. In Water, IFC has been actively tracking progress in tendering for the Varna and Shumen municipal water concessions and plans to evaluate potential investments such as in district heating. In Power, IFC will support post privatization investments in both distribution, where sales should begin this year, and in generation, which may follow shortly afterwards. EFC is working closely with an investor developing co-generation to sell heat to the Sofia Municipality and power to the grid. This approach is in line with the WB's strategy for the sector and there may be the potential to extend it to other cities. In Ports/Airports, following a request from the Ministry of Transport and Communications, IFC has prepared and sent a proposal for a concession transaction for two major seaports. In Posts, IFC is probing potential investors interested in co-financing a postal service privatization deal, once the restructuring of Bulgarian Posts has been completed. 32. Oil and gas: IFC is following the prospects for a major cross-country transit oil pipeline project (Bourgas, Bulgaria - Alexandropoulos, Greece) where it could help attract private investors and put together a financing package for the required investments. Also, IFC has mobilized financing for Galata, a small offshore Black Sea gas project (US$75 million) that will supply natural gas to the local market. Questions may be referred to Ms. R. 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