Recession in Bulgaria will continue in 2009 and 2010, the EC report on Public Finances in the EU forecasts.

The report has been prepared by the Economic and Financial Services at the European Commission and released Tuesday.

According to the report, Bulgaria faces the challenge of sustaining growth in a severe and protracted global economic downturn and should implement firm policies to correct the large external deficit, including through maintaining a tight fiscal policy and containing public sector wage growth. In addition, the country is confronted with the need to improve the quality of public expenditure by improving administrative capacity and stepping up structural reforms.

The EC report notes that in 2008, the general government surplus in Bulgaria was 1.5% of GDP, against an official target of 3% of GDP set out in the December 2007.

The budgetary under-performance was due to lower than expected revenues and lack of strict expenditure control. The deterioration in revenues reflects the negative impact of the global economic downturn taking hold since the last quarter of 2008 when the GDP growth rate decelerated sharply and the growth composition became less tax intensive, the EC points out.

Discretionary measures, such as the introduction of a 10% flat-rate personal income tax since the beginning of 2008 as well as a significant underperformance in planned EU funds absorption have also led to lower revenue growth.

On the expenditure side, discipline has not been fully maintained. Additional social and infrastructure maintenance spending of around 1.8% of GDP was adopted through a supplementary budget in mid-2008. In addition, pensions were increased by more than the statutory rate and budgetary sector wage increases were higher than initially planned.

In line with the budgetary surplus, the general government gross debt decreased to 14.1% of GDP from 18.2% of GDP in 2007.

The official target for the general government budget balance in 2009 is a surplus of 1.5% of GDP, as reported in the April 2009 fiscal notification. The target was revised downwards from a surplus of 3% of GDP in the December 2008 update of the convergence program reflecting the negative impact of the economic crisis on the budget revenue.

Even this revised target is above the Commission services' spring 2009 forecast which expects the general government balance to deteriorate to a deficit of 0.5% of GDP based on a much less favorable macroeconomic scenario. Due to the lack of fiscal room for maneuver, as a result of large external and domestic macroeconomic imbalances, the 2009 budget does not foresee any fiscal stimulus measures in response to the economic downturn.

Instead, the fiscal policy stance is broadly neutral and geared towards preserving investor confidence and contributing to macroeconomic stability through targeting positive budgetary balances.

Hence, to ensure meeting the budgetary target, the so-called '90%' budget execution rule, which was abandoned in 2008, has been re-introduced in the 2009 budget. Under this rule, only 90% of the noninterest budget allocations (excluding social transfers) can be disbursed to the spending units in the course of the year. Given higher risks to the public finances in the current economic juncture, maintaining a budget surplus would require further expenditure cuts beyond the 90% rule, which might prove difficult in a rapidly deteriorating economic environment.

Under a no-policy-change assumption, the Commission services' spring 2009 forecast foresees a general government deficit of 0.3% of GDP in 2010, which is below the latest official projection of a 1.5% of GDP surplus. The difference reflects a less favorable growth scenario, implying a less tax-intensive composition of growth.

In line with the economic slowdown and deteriorating budgetary outcomes, the Commission services' spring 2009 forecast projects the general government gross debt to increase to 16% and just above 17% of GDP in 2009 and 2010, respectively. According to the latest official forecast by the authorities, the debt ratio would increase to almost 17% of GDP this year and then fall to around 15% of GDP next year, based on less favorable nominal GDP projections, while assuming sustained fiscal surpluses. At the same time, debt-increasing stock-flow adjustments due to a further accumulation of net financial assets are envisaged.

In addition, a report of the World Bank released Monday points out that Bulgaria lacks enough currency reserves to cover its foreign debt.

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