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Policy and Legal Environment for the Growth of the SME Sector in Bulgaria
 

 

 

1.1 ACTION LINE 1.1: ECONOMIC STABILIZATION AND IMPROVING OF THE BUSINESS CLIMATE

1.1.1 BACKGROUND
1.1.2 OBJECTIVES
1.1.3 ACTIONS
ANTI-CRISIS PROGRAM
ACCELERATION OF THE PRIVATIZATION PROCESS
DOMESTIC AND FOREIGN INVESTMENT STRATEGY
ABSORPTION CAPACITY
TAX MEASURES
ACTIONS AGAINST SHADOW ECONOMIC AND CRIMINAL ACTIVITIES
1.1.4 EXPECTED RESULTS

1.1.1 BACKGROUND

The economic destabilization and deterioration of the Bulgarian business environment has seriously restricted the development of the SME sector. Moreover, not only has the sector experienced serious governmental neglect, but it has also undergone direct evolutionary oppression as a result of various official policies, including the anti-competitive practice of subsidizing the public sector. While such macro-economic failures affect all private enterprises, the impact on the SME sector is compounded due to its general inability to access capital and information.

 

1.1.2 OBJECTIVES

The objective of this action line is to address the development of the SME sector vis-a-vis the stabilization and improvement of the Bulgarian economy. More importantly, this action line emphasizes the importance of including specific policies and measures in such macro-economic actions that address the specific concerns and needs of SMEs. The purpose is not to propose those specific macro-economic actions necessary to stabilize the economy, but rather to acknowledge conditions that are essential for the development of the SME sector and to stress the importance of addressing SMEs in such macro-economic actions.. These actions are viewed as a function of several parameters, namely, the acceleration and expansion of economic reforms, anti-crisis regulation and stimulation, and the opening of the country to foreign investors and partners.

 

1.1.3 ACTIONS

The actions foresee:

1. the development of an anti-crisis program in which the place and role of SMEs will be clearly and responsibly stated (ANTI-CRISIS PROGRAM).

2. the development of a strategy for accelerated, full-scale privatization, with maximum broadening of the applied privatization techniques (ACCELERATION OF THE PRIVATIZATION PROCESS).

3. the development of a national strategy for mobilizing domestic investment and attracting foreign capital, including decisive measures for improving the general business climate in the country (DOMESTIC AND FOREIGN INVESTMENT STRATEGY).

4. the implementation of measures designed to increase the absorption capacity of the country with respect to international programs that provide financial aid and support for the SME sector (ABSORPTION CAPACITY).

5. the implementation of decisive measures (legislative and organizationally-administrative) for establishing steady tax policy and practices (TAX MEASURES).

6. the implementation of measures for narrowing the perimeter of activity and influence of the shadow economy and the creation of a competitive environment without distortions (ACTIONS AGAINST SHADOW ECONOMIC AND CRIMINAL ACTIVITIES).

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ANTI-CRISIS PROGRAM

Background

Since the restructuring of the economy which began in 1989, there has been no consistent and long term strategy for the development of economic priorities. While continuously stating the need for structural reform, the government still cannot point out the sectors it plans to prioritize. All this deprives the private sector, and SMEs in particular, of the ability to work out their own strategy, relevant to national economic policy. In addition, the dialogue between the authorized state institutions and private businesses has been disrupted, which deprives entrepreneurs of the ability to influence national economic priorities.

Recommendation

In recent months, structural reform in Bulgaria has been spoken of widely. While a discussion of the proposed currency board extends beyond the scope of this report, SMEs will face serious consequences either as a result of the board’s implementation, or lack thereof. Furthermore, the board and various other structural reform measures that have been independently mentioned are only several of the essential elements of an anti-crisis program.

In light of these measures, the successful development of the SME sector depends largely on how thoroughly anti-crisis actions embrace the crucial role of SMEs. Specifically, all measures stated below must incorporate objectives designed to strengthen the SME sector. While a basic anti-crisis program that successfully stabilizes the economy will undoubtedly benefit the SME sector as well, such a process, without specific SME consideration, will result in a lost opportunity to concurrently build a strong foundation of SME support and promote its expansion into the strategic industries of Bulgaria.

To establish a favorable working climate in which SMEs can thrive, such a program must contain several key components that also specifically recognize the special needs of SMEs: fiscal and monetary actions to lower interest rates, inflation and taxes (particularly of the profit tax); measures to stabilize and promote the development of the banking system; policies and support for the benefit of strategic industrial sectors; export programs which include financial backing and insurance; and foreign investment strategies that support the overall goals of the anti-crisis program.

In the framework of common measures, the development of a real and expedient structural reform package is of critical importance. In order to finally realize this reform, which for all these years remained in the sphere of promises and political speculation, what is needed is a clear, practical and transparent program for its carrying out.

 

ACCELERATION OF THE PRIVATIZATION PROCESS

Background

Experts estimate that the percentage of state owned property is still well above 90 per cent. Non-competitive state owned enterprise ("SOEs") business practices crowd out SMEs from competing in their common industries. SOEs also encumber the success of SMEs in developing industries by creating a deficiency of competitive suppliers, distributors, and industrial consumers. In addition, the slow privatization process has curtailed international interest in the SME sector and the Bulgarian market in general. Failure to carry out privatisation measures has provided fewer opportunities to purchase Bulgarian companies and to form joint ventures. It has also provided an unfavorable investment climate since maintaining significant public ownership runs counter to a free market system.

Further, budget losses continue to pileup from SOE employee benefit payments and foregone tax revenues. Also, maintaining state ownership of companies continues to erode both the value of their assets and their competitiveness. Thus, the longer an SOE is held, the greater the cost to the state and lower the price of the sale.

Recommendation

In addition to accelerating the privatisation process, as a whole, for the well being of the Bulgarian economy, SME privatisation must be made a priority of the process. While significant attention has been paid to the "gems" of Bulgarian industry, the privatisation of most state owned SMEs has been neglected. Within the economy, only a relatively small portion of the total national capital assets are "large" enterprises (statistically, these companies have constituted only 10-15% of the enterprises of centrally planned economies). SMEs should be sold off quickly and expeditiously. Consequently, in addition to its importance to the development of the SME sector, selling such enterprises will make the privatisation of large SOEs easier.

The relevant authorities need to adopt a simple policy for the immediate sale of SMEs and other small properties. Specifically, an accelerated system of sale, similar to those implemented in most Eastern European countries, must be established. This includes the establishment of a break even cost of holding the businesses and a minimum sales price for the enterprise. Then, following an impartial auction procedure, a competitive bidding process should be created which would result in prices at least above the break even level. The break even price can be estimated by determining the liquidation value of the assets of the company and subtracting the costs associated with keeping the company state owned, such as welfare benefits for employees, financing and other administrative costs. In addition, alternative forms of sale, such as management buyouts, must be administered. In many Eastern European privatisation programs, management was granted the business in return for the preparation of a sound business plan and long term commitment.

However, while emphasis needs to be placed on SME privatisation, this does not mean that SME privatisation should commence at the expense of accelerated large scale privatisation. The need for a fully functioning market economy is not only essential to the development of the SME sector, it is imperative for the success of the Bulgarian economy as a whole.

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DOMESTIC AND FOREIGN INVESTMENT STRATEGY

Background

Since developmental aid and government-initiated capital formation have become difficult to acquire, equity capital for SME development, and the development of the Bulgarian economy as a whole, must come from the private sector, both indigenous and foreign.

Commercial bank liquidity problems, a lack of experience lending to SMEs and poor economic conditions have created a credit shortage in the country. While SMEs are not the only businesses suffering from a lack of start up or development capital, their capital needs are presently being neglected in favour of large companies. Owners of such enterprises usually rely on self-generated capital, family or friends. Enterprises can not establish a long term, stable financial basis from the personal savings of the entrepreneur, nor does self financing provide sufficient capital accumulation.

As Bulgaria currently has little or no domestic risk capital available, it needs to attract capital from abroad. And therefore, foreign capital must be actively solicited. The Bulgarian banking system can not currently support the development of the SME market and other sources of funds, such as the Ministry of Industry’s Small Business Fund, established in 1991, remain underutilized. Foreign investment in which effective managerial control is established also serves to bring badly needed technologies and managerial techniques to SMEs. Unfortunately, according to data provided by BNB, foreign investments for the first half of 1996 amount to USD 49 million, USD 27.6 million less than the first six months of 1995.

Recommendation

Three areas must be targeted to develop the domestic investment structure:

  1. pension and insurance funds investing,
  2. capital market development, and
  3. savings mobilization.

Pension and insurance funds maintain large surplus capital balances which must be invested and often constitute a large percentage of the investment capital in developed and developing countries. However, without adequate investment vehicles, such capital will remain idle or be invested abroad. While it is unlikely that pension or insurance funds have the expertise to invest in SME development directly, the creation of a financial infrastructure in the country will draw large amounts of currently uninvested assets into financial intermediaries.

Coupled with a committed privatisation process, the country must turn its focus to creating a liquid and transparent capital market to provide a mechanism through which public and private enterprises can raise capital to invest in projects.

Capital markets must be created that offer liquidity and transparency in each of the following areas:

  1. the market for government securities;
  2. the market for stocks and bonds of privatized enterprises;
  3. the market for securities issued by commercial banks;
  4. the market for municipal bonds; and
  5. the market for securities issued by private, non-bank businesses formed outside the privatisation process, such as private investment funds and other collective investment vehicles.

This development requires attention to each of the following areas, many of which are addressed in this paper in greater detail:

1. Legal Development

  • Securities laws (fiduciary responsibilities, truth in new issues and due diligence requirements, and resistance to market manipulation)
  • Structure of a securities agency (government and self regulation by association, clear establishment of powers, law making and enforcement, and staffing)
  • Tax basis for companies (laws and regulatory agencies)

2. Company Development

  • Privatisation (elimination of government control and subsidies, separation of ownership and management, establishment of corporate by-laws, definition of role of boards and accounting standards)

3. Securities Industry Formation

  • Information and disclosure (accessible, high quality and timely)
  • Laws governing securities firms (capital requirements, management fitness and responsibility, employee registration and requirements)
  • Roles and regulations of banks (universal, subsidiary or holding company)
  • Market structure (intermediaries, trading exchanges, registration, clearing and settlement, price disclosure, and policies towards foreign investors regarding joint ventures and traded firms, ownership limits)

4. Perpetration and Training

  • Time schedule for implementation
  • Training people for jobs
  • Industry infrastructures (attorneys, accountants, and dispute settlement/arbitration

Developing the capital markets of Bulgaria will reduce the risk of the excessive expansion of the country’s already fragile banking system. Specifically, Bulgarian commercial banks are unable to meet credit demands because of a country-wide lack of savings. Policies such as reserve requirements, state or private banking insurance and other practices to increase the level of savings in the country must be reviewed and where necessary, implemented.

The improvement of the institutional conditions allowing easier access by SMEs to capital markets is extreamly important. However, the commercial bank will ultimately be the largest source of financing for SMEs. As evidenced by the obvious interdependency between commercial banks, capital markets and pension and insurance funds, simultaneous development of all sectors is required to provide financing and credit for SMEs.

In addition, to attract investment in SMEs from abroad, Bulgarian policy makers must make Bulgaria an attractive investment for international investors. This success relies heavily on the stabilization of the economy and

political system, privatisation of existing SOEs, reduced inflation, and the basic building of a better economic climate for investing. Recent political and economic events had diverted foreign investors attention to other Central and Eastern European Countries and foreign markets. In the midst of heavy competition from other developing economies for foreign investment, the availability of capital for aiding the SME sector from abroad may be difficult to attract in large quantities. And therefore, concrete actions must be executed under the umbrella of a comprehensive national economic plan.

As an adjunct to attracting foreign investment, the authorities must focus attention on the process for effecting such investments. Investors seek returns, which can be dramatically eroded by a cumbersome investment process that lacks transparency. Market potential and economic and political climates are all factored into foreign investment decisions. Governments that ignore the needs of investors and undermine their confidence risk losing local SME attractiveness as opportunities for investment. Investors want well developed capital markets, including a stable banking system in which commercial banks are capable of assessing risks and providing capital. In addition, the availability of other forms of financing, quality information, liquidity, hedging vehicles and an overall degree of stability add to the attractiveness of a market. Investors are also attracted to markets in which fiscal an monetary policies favor stability and policy makers have good governmental relationships with international donor organizations and banks.

Stable economic indicators are also a sign of a stable government and governmental policies. Investors want to know that governments are committed to the well-being of the nation as a whole. Fears of expropriation, changing regulations, and lack of support for private business increase as the stability of the government decreases, regardless of what is written in the laws. Signs such as frequent changes in Ministers responsible for the decisions regarding foreign investment in SMEs will cause foreign investors to reconsider the opportunities available for them.

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ABSORPTION CAPACITY

Background

In light of recent changes in the international interest in the promotion of SMEs and their role in the development process, focus must be placed on the implementation of programs designed to increase the absorption capacity of the country. For example, the European Investment Bank recently announced that it would allocate 25 per cent of its investment capital for the development of the SME sector in developing economies. However, previous international aid for Bulgarian SMEs has not been allocated in an efficient or timely manner. Unfortunately, the lack of an appropriate institutional framework, frequent changes in government and the crisis in the banking system led to inadequate utilization of those resources. Specifically, a 22.5 million ecu PHARE sponsored local structure development program established in 1992 (the only SME support program financed by the European Union thus far), has been met with serious delays and most of the funds have been reallocated to other projects within Bulgaria. Further, of the amount still left for SME development, 7 million ecu designated for direct firm level financial assistance, (the loan grant was designed to be disbursed in two tranches to the BNB: one tranche of 4 million ecu disbursed in the middle of 1995, and the second tranche to be disbursed pending the allocation of the first tranche to SMEs before the end of 1996), only 900,000 ecu has been allocated so far.

Recommendation

Several lessons can be learned from the PHARE program to increase absorption capacity. First, participation by competent and committed banks must be sought. The inability for banks to adequately determine the credit capacity of SMEs not only leads to bad loans, but is also responsible for the overly cautious lending habits that result in funds remaining idle. While the banks that participated as administrators under the BNB in the disbursement of the SME credit may have been competent, criticisms have been raised that they have been extreamly "credit-shy," despite their indemnity from default risk. Second, there must be adequate demand for the credit on the terms offered by the lending banks. The problem of overly cautious banks was compounded by inappropriate loan candidates. Companies that do not have the credit capacity to accept current lending terms create log jams of applications and increase bank costs. Applications should include self screening tests and minimal processing fees that would be reimbursed upon the issuance of loans to cut down the number of bad applicants. Third, banks must maintain the flexibility to set interest rates to reflect market risks and to cover costs. Fourth, a time horizon should be set that is large enough to properly develop such a program. With respect to the PHARE program, the majority of the 900,000 ecu in loans has been disbursed within the last two months of 1996, possibly reflecting both the approaching deadline and movement on the learning curve.

New trends indicate that international donor organisations, such as USAID, are increasingly turning to non-governmental organizations ("NGOs") to administer funds and provide assistance to SME development. Similar initiatives are being followed by the World Bank and the European Union, and some of its member states. In Greece, for example, absorption capacity was increased significantly by virtue of the passing of a law and a Presidential decree under which NGOs are allowed to manage such programs.

It is clear that Bulgarian authorities need to develop a system for involving NGOs in their attempt to increase the absorption of international funds, including those supplied by bilateral programs. Fortunately, the implementation of an NGO absorption program in Bulgaria is a matter of regulation, not legislation. Specifically, it can be enacted by a decree of the Council of Ministers that directs the use of NGOs to administer and assist the absorption capacity of the country. Absent adequate NGO infrastructure, such funding will bypass Bulgarian businesses.

 

TAX MEASURES

Background

The most characteristic feature of the widely accepted practice of carrying out state collections (taxes, excises, tariffs, customs duties, and other duties) is its chaotic nature. The inconsistent state policy in this sphere and the actions of the administration bring about tax disorder, rather than the required tax culture and discipline.

Recommendation

To increase budget revenue, the priority tax policy change must be the creation of a steady and predicable tax environment. It is imperative to finally abolish the practices of back dated taxes and the constant amendment of tax policies. Expedient and decisive measures for tightening the financial discipline must also be carried out, particularly in improving the work of the tax administration and other financial control authorities. Finally, as previously stated with respect to the privatization of SOEs, prompt and resolute cuts in the losses of the public sector must be completed thought mass privatisation.

Specific action must be taken to address the following obstacles SMEs face because of current tax policy:

  1. The regulation of the annual taxation results (taxable and nontaxable expenses) is decreed by an act of the Council of Ministers, which allows its easy and perpetual revision;
  2. The range of expenses which reduce the annual amount to be taxed deductible expenses constantly diminishes;
  3. The use of negative results from previous years is no longer used in the tax loss carry forward formation of the positive financial result for the current year;
  4. Depreciation and amortization schedules are problematic and should include accelerated depreciation for long term material assets;
  5. A practice of accepting limitations introduced with old dates is being widely accepted;
  6. Only 10% of education expenses are accepted as nontaxable expenditure, which is a serious drawback for SMEs, where education is crucial to their survival and stabilization;
  7. Expenses common to SMEs, such as the reconstruction and office, machine, and other improvements are not being reduced;
  8. The process of advanced payment of taxes must be developed and stabilized;
  9. There is an incredibly slow procedure of recovering VAT credit with no interest accumulation for blocked funds;

An additional burden for SME activity is the ineffective and inconsistent work of the tax authorities. In this respect the following problems must be addressed:

  1. Arbitrary interpretation of the laws and other normative regulations by public officers;
  2. Lack of control mechanisms for the structure of the tax administration to be used by the MF in supporting the interests of the economic entities;
  3. In many cases, tax inspectors are hostile and aggressive. Errors are sought deliberately, and a percentage reward is given for every "erred amount."

 

ACTIONS AGAINST SHADOW ECONOMIC AND CRIMINAL ACTIVITIES

Background

During the last few years, shadow economies and criminality have gained considerable influence within the Bulgarian economy. Among other problems, inadequate tax policies have pushed SMEs into shadow economics and entrepreneurs are being squeezed between the so-called "power organizations" and high-level institutional corruption. Thus, entrepreneurial spirit is being destroyed by pseudo market conditions. These factors are also extremely harmful to the activity of foreign investors. For example, United States Federal racketeering laws prevent American businesses and persons from engaging in activities such as bribery outside the United States. Therefore if local business practices include such activities as part of the modus operandi, American businesses are effectively excluded from the market.

Recommendation

Resources need to be allocated to protect upstanding businesses. The problems of corruption needs to be addressed by both the state and local SME organizations. Educational programs should be implemented within SME associations to inform member companies of the economic benefits created in a business environment which recognizes business integrity and mutual trust among its members. Specifically, credible accounting procedures and legitimate business practices provide opportunities to access additional sources of long-term funding.

 

1.1.4 EXPECTED RESULTS

This action line will result in governmental recognition of the important role of SMEs in the development of the Bulgarian economy, outline the necessary macro-economic conditions that are necessary for their development, and underline the importance of including measures that specifically address the needs of the SME sector in whatever macro-economic actions are undertaken. The stabilization of the Bulgarian economy through an anti-crisis program and accelerated privatisation program will lay the foundations for the development of Bulgaria’s SME sector. Additional business climate improvements will result from the availability of financing from international sources, consistent and enforced tax laws, and credible and legitimate business practices. Ultimately, The SME sector will become a major contributor to the economic growth of the country. Providing an environment suitable for SMEs to conduct business will lead to the creation of many new jobs necessary to absorb new unemployment created by restructuring former SOEs, and will also serve to redistribute income. SMEs will also provide an additional market for the purchase second-hand equipment from SOEs. They will also contribute to the success and efficiency of Bulgaria’s large corporations by providing services that facilitate business. As a result of these factors, the larger and more developed the Bulgarian SME sector, the greater the SME contribution to the growth of the economy.


 
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