Inflation Performance

Monetary growth and inflation have been declining quite steadily, as shown in Chart 3–1. The year-on-year inflation rate was reduced from 250 percent in 1990 to 60 percent in 1991 and further to 44 percent in 1992. Further progress was made in 1993, with the year-on-year rate in October down to 30 percent. In the last two months of 1993, however, there was a spurt in inflation, with consumer prices increasing by an average of 4.8 percent per month (compared with an average of 2.3 percent per month for the first ten months of the year). Thus, the year-on-year inflation rate for 1993 ended up at nearly 38 percent, not much below the 1992 figure. After this uptick in late 1993—which reflected “once-off” effects such as a seasonal rise in food prices and wages and, perhaps, some anticipations of relaxed wage and price discipline as a result of the change in government—inflation slowed markedly in the first quarter of 1994, and the year-on-year inflation rate in March 1994 fell to 30 percent.

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Money and Inflation

Sources: Polish Central Statistical Office, Biuletyn Statystyezny; and National Bank of Poland.

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Inflation reduction and the maintenance of financial discipline have been relatively successful in Poland despite the extension of significant amounts of credit to government to finance budget deficits. This has been possible because of an increase in the amount of private savings that was channeled into bank deposits, especially in 1992; in Poland these deposits are essentially equivalent to total financial wealth. The associated increase in the demand for money led to an increase in loanable funds that were used primarily to finance budget deficits rather than being lent to the nongovernment sector. Trends in credit expansion and in the demand for money are discussed in greater detail below.²

Credit Expansion

Domestic credit expansion has been driven largely by the need to finance the budget deficit. In 1992, domestic bank financing of the deficit amounted to over 80 percent of the increase in net domestic assets; this proportion fell to about 40 percent in 1993 (see Table 3–1). In a similar vein, deficit financing from banks contributed to about half the growth of the money supply in 1991–92, and about a third in 1993. Furthermore, the bulk of this financing has been obtained directly from the NBP, making central bank credit to government by far the chief source of base money expansion. Direct NBP credit to government was a particularly high proportion of deficit financing from banks in 1993, as the Treasury was unwilling to let interest rates in the primary treasury bill auctions rise, thus limiting the amount of financing raised from commercial banks (see Table 3–1 see also Chart 3–5 and the subsection “Interest Rates” below).

Table 3–1.

Deficit financing banks

(In trillions of zlotys)

Source: National Bank of Poland

¹For general government, net basis.

Table 3–1.

Deficit financing banks

(In trillions of zlotys)

		1991	1992	1993
Domestic bank financing1		41.2	75.6	35.2
	Of which: Direct gross NBP financing	26.2	35.1	30.0
Memorandum items:
	Nominal money growth (percent change)	47.4	57.5	36.0
	Contribution of domestic bank financing to nominal money growth (percentage points)	21.6	29.0	8.6
	Domestic bank financing as a percentage of increase in net domestic assets	51.4	80.9	39.4

Source: National Bank of Poland

¹For general government, net basis.

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Table 3–1.

Deficit financing banks

(In trillions of zlotys)

		1991	1992	1993
Domestic bank financing1		41.2	75.6	35.2
	Of which: Direct gross NBP financing	26.2	35.1	30.0
Memorandum items:
	Nominal money growth (percent change)	47.4	57.5	36.0
	Contribution of domestic bank financing to nominal money growth (percentage points)	21.6	29.0	8.6
	Domestic bank financing as a percentage of increase in net domestic assets	51.4	80.9	39.4

Source: National Bank of Poland

¹For general government, net basis.

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Treasury Bills Outstanding, May 1991 -December 1993¹

Source: National Bank of Poland.¹ Bills sold by auction to commercial banks and the nonbank public.

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Credit to Government and Nongovernment Sectors

Sources: National Bank of Poland.1 Includes household sector and both state-owned and private enterprises.2 December 1991 only.3 Bank credit to government excluding domestic public debt indexed to the dollar and bank recapitalization bonds.

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Real Interenterprise Credits and Revenue Arrears

Sources: Polish Central Statistical Office, Biuletyn Statystyczny; and Polish Ministry of Finance.1 Payables due arising from supplies of goods and services deflated by the producer price index.2 December 1989 only.3 Sum of tax arrears and arrears on social security contributions; amounts are stocks at end of the year.

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Velocity of Money¹

Sources: National Bank of Poland; and IMF staff estimates.1 Velocity is measured as nominal GDP divided by the average of M2 or M3. The break in the series in 1991 is due to the introduction of a new monetary accounting system. “Deposits” include demand, savings, and time deposits.

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Although there has been a significant expansion in net banking system credit to government, credit to the nongovernment sector has been sluggish. (The nongovernment sector comprises the household sector and both state-owned and private enterprises.) In real terms (using the CPI as the deflator), credit to the nongovernment sector declined by nearly 13 percent in 1992 and by 4 percent in 1993 (see Table 3–2). Credit granted to state enterprises has been especially tight, declining in real terms by 22 percent in 1992 and by 12 percent in 1993.³ Credit to the private sector grew very rapidly from a low base in 1991 but declined in real terms in 1992; this credit grew by 2 percent in real terms in 1993. The most rapidly growing component of credit was loans to households, the outstanding stock of which has risen from a low base of Z1 7 trillion at the end of 1991 to Zl 12 trillion at the end of 1992 and further to Z1 23 trillion at the end of 1993.

Table 3–2.

Credit to the Nongovernment Sector

(Twelve–month percent change in real terms)

Sources: National Bank of Poland; and IMF staff estimates.

Table 3–2.

Credit to the Nongovernment Sector

(Twelve–month percent change in real terms)

	1991	1992	1993
Total	1.2	–12.9	–4.0
Households	…	15.5	36.91
State sector	–8.9	–22.1	–12.0
Private sector	54.9	–3.4	2.0

Sources: National Bank of Poland; and IMF staff estimates.

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Table 3–2.

Credit to the Nongovernment Sector

(Twelve–month percent change in real terms)

	1991	1992	1993
Total	1.2	–12.9	–4.0
Households	…	15.5	36.91
State sector	–8.9	–22.1	–12.0
Private sector	54.9	–3.4	2.0

Sources: National Bank of Poland; and IMF staff estimates.

The stock of credit to the nongovernment sector is about evenly divided between working capital credits and investment credits. The structure of credit has changed somewhat over the last two years as banks have cut back on granting working capital credit: previously granted investment credits, therefore, have become a larger proportion of credit outstanding to the nongovernment sector. In addition, the proportion of government-guaranteed credit outstanding for central investment projects has increased from 8.4 percent of the total in March 1992 to 10.2 percent at the end of 1993. Overall, there has been little progress in scaling back such directed and preferential credit programs for central investments, housing, and agriculture, mainly because of the contractual capitalization of interest from old loans. At the end of 1993, directed credits accounted for 26 percent of total credit outstanding to the nongovernment sector, only a 2 percentage point drop from the end of 1991.

In an environment where lending to firms was perceived by banks as being risky given uncertainties regarding credit quality, commercial banks have clearly been reluctant to lend to enterprises and have concentrated on investing in government securities. (One implication of this behavior is, of course, that commercial banks are concerned about the quality of their own balance sheets, pointing to enhanced corporate governance in the financial sector.) Treasury bills, which were first issued in May 1991, are seen as a high-quality asset with a market-determined rate of return. The treasury bill market has therefore grown rapidly, as shown in Chart 3–2, and these securities are now an important part of the portfolios of commercial banks. Specifically, at end-1993, the commercial banks held Zl 103 trillion in treasury bills (measured at face value) while the stock of loans outstanding to state enterprises was Zl 143 trillion. By contrast, in the middle of 1991, credit to state enterprises stood at Z1 121 trillion, and banks held virtually no treasury bills. For the entire banking system (i.e., including the NBP), zloty-denominated credit to the general government as a proportion of credit to enterprises increased from 15 percent at the end of 1991 to 55 percent at the end of 1993 (Chart 3–3).

As Calvo and Kumar (1994) point out, the process of recapitalization and loan consolidation may have made banks excessively cautious in lending to enterprises. State-owned commercial banks were required to restructure their loan portfolios by the end of April 1994, and against this background banks have essentially stopped granting credit to firms with bad or doubtful debts unless the loan is associated with a bank-led restructuring of the firm. (The recapitalization and loan recovery strategy is discussed in greater detail under “Reform of the Banking Sector” below.) However, this has had spillover effects, since banks have essentially retrenched their lending to all enterprises (and particularly to midsize and small enterprises) because of limited expertise in assessing creditworthiness. Calvo and Kumar (1994) also note that the dampening of banks’ overall lending to the enterprise sector has likely been exacerbated by the incentives given to banks’ management under the restructuring strategy. Specifically, as bank employees are given generous stock options that can be exercised upon privatization, they have a personal interest in the health of their banks’ balance sheets.

In addition, it is important to recognize the institutional difficulties in establishing creditor-client relationships in a new market-based environment. The uncertainties created by the transformation program have been enormous, and even if banks possessed the necessary expertise for credit evaluation or were not hampered by the need to recapitalize and consolidate loans, a cautious lending policy under such circumstances would not be surprising. As a result, banks have been driven to invest primarily in government securities (which, in any event, were in relatively plentiful supply, especially in 1992) and to build up liquidity.

Banks’ cautiousness in lending to enterprises has contributed to the hardening of budget constraints faced by firms. Apparently, a major source of finance for firms has been retained earnings rather than external finance⁴ Although there is little concrete data concerning the reliance on internally generated funds to finance the recent robust expansion in industrial output, such a scenario is not inconsistent with the large divergence between productivity and real wage growth that has enabled large increases in profitability. During 1993, for example, industrial productivity is estimated to have increased by about 10 percent, while real wages (CPI-based) are estimated to have declined by about 2.5 percent. Furthermore, interenterprise credits have not provided a way out of the budget constraints in Poland. Interenterprise credits increased rapidly early in the reform process as enterprises attempted to increase liquidity and circumvent strict credit ceilings, but these credits have stayed virtually constant in real terms in 1992 and 1993 (Chart 3–4). However, the shift in banks’ preferences toward lending to government rather than to firms may have contributed to the rise in tax arrears, which was an important means of avoiding budget constraints, especially for large enterprises (Chart 3–4, bottom panel).

Trends in Money Demand and Currency Substitution

As mentioned earlier, inflation has been reduced despite significant amounts of deficit financing from banks because the amount of private savings intermediated through the banking system has increased.⁵ In view of the growing importance of money as a store of value and an instrument of savings in Poland, an increase or rechanneling of savings is likely to manifest itself through an increase in the demand for broad money (or its converse, a decline in velocity).⁶ Indeed, the velocity of broad money declined by 20 percent in 1991, followed by declines of 7 percent and 6 percent in 1992 and 1993, respectively (see Chart 3–5). The sharp reduction in inflation and interest rate deregulation, which initially pushed up deposit rates in real terms following the implementation of the stabilization program in 1990, played an important role in inducing larger holdings of bank deposits in zlotys by households and has accounted for much of the increase in M2 (Chart 3–6); see also Calvo and Kumar (1994).

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Household Deposits

(In trillions of zlotys)

Sources: National Bank of Poland; and IMF staff estimates.1 December 1991 only.

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These trends, however, have not been uniform over time. In addition, there have been shifts between domestic money (that is, currency and zloty deposits) and foreign currency deposits, with important implications for deficit financing. Specifically, the attractiveness of holding domestic money diminished during the course of 1993—household zloty deposits declined by 3 percent in real terms during 1993, whereas they had increased by 23 percent during the previous year. Similarly, an increasing proportion of money was held in the form of foreign currency deposits—the ratio of foreign currency deposits to M3, which had been stable at about 25 percent in 1992 and the beginning of 1993, began to rise and was nearly 30 percent at the end of 1993 (Chart 3–7).⁷

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Foreign Currency Deposits

Source: National Bank of Poland.

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These trends have been mirrored in banks’ ability to finance the budget deficit. With the large increase in household zloty deposits in 1992, banks’ loanable funds increased and were used to purchase government securities. In 1993, however, with the reversal of the trend in household deposits, commercial banks’ ability to finance the deficit was very limited. This was compounded by the Ministry of Finance’s decision to cap interest rates on treasury bill auctions and to rely instead on direct central bank financing. (The Government’s deficit financing needs were much lower than had been anticipated in the budget for 1993 because revenues exceeded expectations and cash expenditures were contained. The Ministry of Finance, however, chose to rely disproportionately on direct financing from the central bank rather than raise more funds from commercial banks.)

The shifting trends in 1993 can to a large extent be traced to declining deposit rates, which fell particularly following the February 1993 reduction in the NBP’s refinance rate.⁸ As a result, the interestrate differential between six-month deposits in zlotys and in U.S. dollars, which had been more than 2 percentage points above the annualized rate of crawl of 24 percent until February 1993, fell and remained around 3 percentage points below the annualized rate of crawl until the August 1993 devaluation (Chart 3–8). The lowering of the monthly rate of crawl to 1.6 percent (equivalent to 21 percent on an annual basis) after the August 1993 devaluation has again resulted in the interest differential being somewhat above the annualized rate of crawl, although the interest differential itself has remained broadly unchanged.⁹

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Zloty-Dollar Interest Differentials

Sources: Polish authorities; and IMF staff estimates.1 January and February 1994 only.

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The decline in the attractiveness of zloty assets and the move into foreign currency deposits, that is, an intensification of the process of currency substitution or dollarization of the economy, has important implications for the inflationary impact of the fiscal deficit because of its tendency to reduce the domestic monetary base. More concretely, as the government inflates to acquire resources, residents can reduce their domestic cash holdings by shifting into foreign-currency-denominated assets as well as domestic goods; as a result, the inflation tax base will shrink at a more rapid rate than if substitution takes place only between domestic money and goods.

Increasing the attractiveness of holding zlotys would raise the amount of bank financing that could be provided both for the budget and for enterprises without compromising inflation and reserve targets. That attractiveness clearly hinges on policy measures to increase yields on zloty-denominated assets relative to foreign-currency-denominated assets. In particular, returns on zloty assets would need to be fully arbitraged to the returns on foreign currency assets, adjusted for the expected rate of depreciation of the zloty and other risk factors. In principle, this can be achieved either by raising nominal interest rates, given inflation expectations, or, as is the stated intention of the Polish authorities, by implementing financial and incomes policies that lead to lower inflation.

To appreciate the task faced by the authorities, it is noteworthy that Poland’s level of monetization is significantly below that of the Czech Republic and Hungary. The ratios of M3 to GDP and of M2 to GDP in 1993 for the three countries are noted in the tabulation below.

	Poland	Czech Republic	Hungary
		(In percent)
Average M3/GDP	30	72	58
Average M2/GDP	22	66	50

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	Poland	Czech Republic	Hungary
		(In percent)
Average M3/GDP	30	72	58
Average M2/GDP	22	66	50

These ratios can be taken as a measure of the real size of the banking system and also as a rough gauge of the flow of loanable funds. As can be seen, the level of intermediation through the banking system in Poland is exceptionally low. Policies that increase the attractiveness of holding domestic financial assets, such as zloty demand and time deposits, will be critical in determining the extent to which the financial system will deepen and he able to mobilize and allocate savings to finance the enterprise sector and government.¹⁰

Interest Rates

Banks in Poland are free to set their own deposit and lending rates. In view of the high and volatile inflation rates, banks have tended to use a variable rate policy during the period of a time deposit or loan. However, a Supreme Court ruling requires banks to specify clearly in deposit and loan agreements the circumstances under which interest rates may be changed during the period of the agreement. In practice, banks have satisfied this requirement by specifying an external reference rate.

Until the end of 1992, the most common reference rate applied was the NBP interest rate on refinancing credit. Wyczanski (1993) notes that in 1990 some 80 percent of loans were granted with the refinance rate serving as the basis for defining the interest rate on the loan. (The refinance, rediscount, and Lombard credit facilities of the NBP are discussed in the subsection on monetary policy instruments below.) Since the NBP’s policy was to keep the refinance rate positive in real terms, banks regarded the refinance rate as the official projection of inflation compiled by the central bank on the basis of the best available information. By setting interest rates on this basis, banks were relieved of preparing their own forecasts of the monetary situation and at the same time they hoped their rates would stay positive in real terms. Thus, although banks were permitted to set their own interest rates, deposit and loan rates were initially fixed in an administrative fashion instead of taking into account demand and supply considerations.

Toward the end of 1992, however, with development of money markets and government securities markets, banks began to move away from the practice of tying the level and timing of changes in banks’ interest rates to the refinance rate. Banks began to pay increasing attention to the cost of obtaining funds in the interbank market and to the yield on treasury bills. In addition, the behavior of competitors in deposit and loan markets became an important consideration. Nevertheless, the NBP continues to play an important guiding role in the setting of interest rates, a situation that is likely to persist until money markets have developed even further. Indeed, the NBP’s refinance and rediscount interest rates are still key indicators of the stance of monetary policy.

Banks’ lending rates have generally been positive in real terms, although barely so toward the end of 1993 (Chart 3–9).” The NBP’s refinance rate and the ¹¹ week treasury bill rate were both positive in real terms in 1992, but turned negative in 1993. Deposit rates, in contrast, have been almost consistently negative in real terms.¹²

In July 1992, in an effort to stimulate the economy the refinance rate was lowered from 40 percent (a level that had been in force since September 1991) to 38 percent. This reduction led to a lowering of both deposit and lending rates, as well as a fall in the yields on treasury bills, by a similar amount (Chart 3–10). In February 1993, the refinance rate was reduced by a further 3 percentage points, to 35 percent. This reduction was prompted by the fall in inflation and what was seen as the beneficial effect of the adoption of the 1993 budget on financial markets. Deposit rates, which had already been reduced somewhat in late 1992 by a few banks, plunged by some 10 percentage points after this change in the refinance rate. (The observed reduction in deposit rates is actually understated because effective rates fell even further due to a change by many banks’ in the timing of paying out interest.) Treasury bill yields also fell sharply, while loan rates were reduced by the same amount as the adjustment in the refinance rate. Favorable economic developments in the first few months of 1994 led the NBP to lower its refinance rate to 33 percent in May.

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Real Interest Rates

(In percent; annual basis)

Sources: National Bank of Poland; and Polish Central Statistical Office, Biuletyn Statystyczny.¹ Based on a three-month centered moving average of consumer price inflation excluding services and food, except for the prime lending rate, which is based on a three-month centered moving average of producer price inflation.

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Nominal Interest Rates

(In percent; annual basis)

Sources: National Bank of Poland; and Polish Ministry of Finance.1 January and February 1994 only.

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In light of subsequent losses in reserves and increased currency substitution, the February 1993 reduction in the NBP refinance rate proved to be premature and too large. For the rest of 1993, nominal interest rates remained basically unchanged, which reflected in the first instance the decision of the Ministry of Finance—the dominant supplier of paper to the market—to keep interest rates on treasury bill auctions fairly constant. Thus, the Treasury sold only the quantity of paper that banks were willing to buy at the targeted interest rates, while availing itself of substantial credit from the NBP.

The spread between commercial banks’ average lending rates and deposit rates has therefore increased quite significantly (Chart 3–11). Specifically, the spread between the lending rates for lowest risk customers and the three-month time deposit rates narrowed from 10 percentage points in the first half of 1992 to about 8 percentage points in the second half of the year, but then jumped to 15 percent in March 1993 and have remained unchanged since then.

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Interest Rate Spread

(In percent; annual basis)

Source: National Bank of Poland.1 January and February 1994 only.

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Limited competition in the banking sector has contributed to the wide spread, although there is no clear evidence of collusion among banks. Several other factors related to taxes and inefficiencies have also contributed to the large spread. These additional factors include:

• The reserve requirements of 10 percent on time deposits (about 70 percent of the deposit base) and 23 percent on demand deposits are high compared with international standards and are not remunerated. Assuming that lending rates are guided by treasury bills yielding 33 percent, the wedge created by the nonremuneration of required reserves would be 3.3 percent for time deposits (10 percent times 33 percent) and 7.6 percent for demand and savings deposits (23 percent times 33 percent).

• Poor liquidity management by commercial banks, resulting in part from an underdeveloped payments/settlements system, compelled banks to hold large excess reserves. Since excess reserves are not remunerated either, intermediation costs are high, contributing to a wider spread.’¹³

• Most banks have significant portfolios of nonperforming loans. To earn their way out of trouble, banks have likely resorted to charging burden-sharing premiums on their performing loans and pushing up interest rate spreads. Thus, banks are in effect imposing a tax on financial intermediation to recapitalize.

• Partly out of a concern about the authorities’ ability to monitor exaggerated losses, Poland’s tax regulations have until recently prevented banks from deducting the loan-loss provisions from their profits, except in highly special circumstances. Thus, the effective rate of taxation of a bank’s realized profits was much higher than the 40 percent nominal income tax rate applied to gross profits. All else equal, this pushed up banks’ effective cost of funds and resulted in higher lending rates.

• As noted earlier, banks are required to specify the circumstances in which interest rates may be changed during the period of a deposit. In the current environment of declining inflation, to minimize this nuisance banks have reportedly offered lower deposit rates than they would have offered otherwise.

A narrowing of the spread could serve the overall objective of increasing financial savings by permitting banks to raise deposit rates without commensurate increases in lending rates. However, in view of the factors that have led to the wide spreads, a significant narrowing can only be achieved in the long run as the necessary structural measures are put in place to reform the banking system and increase competition. Nevertheless, some measures that address inefficiencies could help reduce—in the shorter run—the spread between lending and deposit rates. Indeed, one step has already been taken. Beginning January 1, 1994, provisions for loans classified as "losses” can be charged to costs, hence reducing taxable income. Other measures would include a reduction in required reserves for zloty demand deposits, with the ultimate aim of unifying required reserve ratios across bank liabilities.’¹⁴ Consideration should also be given to remunerating required reserves and to introducing a system of reserve averaging to improve banks’ liquidity management, thus lowering the cost of intermediation. (At present, required reserves cannot be used for intraday or end-of-day settlements with the result that banks need to maintain high current account balances to facilitate settlement.)

Money Market Development and Monetary Policy Instruments

During 1992, the interbank market became more active and better established. By early 1994, the market had broadened to include nearly 40 banks, although it was still dominated by the largest 10. The daily volume of interbank transactions was around Z1 2 trillion. The Warsaw Interbank Offered Rates, or WIBOR, are now widely quoted in the press and have become an established benchmark for the cost of short-term funds. The market is most active in the interval from spot transactions (i.e., settlement trade date plus two) out to three weeks. Several factors have contributed to the growth of the interbank market including the growing awareness of profitable opportunities in the money market and the opportunity cost of holding free reserves; the improvement in the efficiency of the payments system: the introduction of indirect monetary instruments by the NBP; and the efforts of market participants, both domestic and foreign, to make use of the market.

As discussed above in the section on credit expansion, the treasury bill market has also grown rapidly since it was introduced in May 1991, and government securities are now an important part of the portfolios of commercial banks. The bills have maturities of 8, 13, 26, 39, and 52 weeks; 13-week T-bills are especially popular, since they provide a natural offset for banks against most depositors’ preference for three-month time deposits. The Ministry of Finance has also been attempting to increase the size of the offerings of one-year treasury bills, and the market has responded positively to this maturity. The positive response to one-year bills, which offer a fixed rate of return, suggests that market participants have been encouraged by the recent successes in reducing inflation. In view of the lack of a book-entry system for clearing and settlement of treasury bills, secondary market trading is limited.

To help with the goal of budget financing, especially from the nonbank public, the Ministry of Finance introduced one-year and three-year treasury bonds in 1992. The interest rate on the one-year bonds is indexed to the inflation rate, while the rate for the three-year bonds floats and is linked to the 13-week treasury bill rate. Demand for the one-year bond has been higher than for the three-year bond, but in general demand for both has been disappointing, with the total outstanding stock of these bonds at the end of 1993 amounting to only Z1 14.2 trillion. Nearly 60 percent of this amount is held by the nonbank public. It would appear that, given comparable maturities, the public prefers a fixed-rate yield (as on 52-week treasury bills) over an inflation-indexed yield (as on one-year treasury bonds). Although these bonds are listed on the stock exchange, little trading has occurred and the bonds are considered illiquid. In February 1994, the Government also introduced two-year and five-year fixed interest rate bonds, with annual coupons of 18 percent and 15 percent, respectively; these bonds received a poor reception at the first auction, with only Z1 145 billion sold.¹⁵

The progress in developing an interbank money market and a market for treasury hills, as well as improvements in the efficiency of the payments and settlement system, has contributed to the transition toward indirect, market-based tools of monetary control.¹⁶ Indeed, basic refinance credit has lost its significance as a source of funds for the banking system. (However, as discussed earlier, although diminishing somewhat in importance, the refinance interest rate (which is presently 33 percent) is still a key monetary policy instrument affecting the general level of interest rates on the market.) Similarly, the significance of the rediscount and Lombard credit facilities has begun to erode.¹⁷ Ceilings imposed by the NBP on the amount of credit that major banks could extend were removed at the beginning of 1993, and open market operations are now the main tool for controlling bank liquidity. These operations are conducted in the form of repurchase and reverse repurchase agreements in treasury bills, and they have grown in size and importance since the beginning of 1993.

Some recent developments, however, have exposed weaknesses in the effectiveness of open market operations and the linkage between various segments of the money market. The specific problems (which are largely interconnected) include: (i) cyclical phenomena (for example, a seasonal bunching up of NBP financing of the budget deficit combined with low seasonal demand for credit from the nongovernment sector) that lead to conditions of excess liquidity in the banking system at certain times of the year (ii) the lack of effective instruments available to the NBP to counteract such cyclical phenomena by withdrawing liquidity for longer periods of time; (iii) constraints on the ability of the structure of interest rates to adjust because of the Ministry of Finance’s de facto interest rate ceiling at treasury bill primary auctions for all maturities (although at times this becomes an interest rate floor because of the cyclical problems noted above): and (iv) the inability of the NBP to affect the yield curve in these circumstances because its open market operations are mainly for one to three days (and occasionally two weeks), which means that the NBP can affect only very short term rates.¹⁸

Tackling these problems would strengthen the management of monetary policy. In this regard, a key priority would be to increase the NBP’s capacity to sterilize liquidity on a more permanent basis to affect monetary conditions as well as to counteract seasonal phenomena. To achieve this the NBP would need to begin outright transactions in treasury bills in addition to its present one- to three-day repurchase and reverse repurchase agreements. This has been hampered, however, because the NBP purchases securities from the Ministry of Finance in large blocks that are not divisible and therefore difficult to market. The planned move to a book-entry system for government securities, in which all transactions will be recorded in a ledger, would overcome this problem.

Apart from sterilizing seasonal liquidity problems, the strengthening of open market operation tools would permit the NBP to conduct operations to affect liquidity conditions and interest rates as a matter of policy. In other words, open market operations could be used to achieve certain monetary management goals or targets for the quantity of liquidity in the system. For such policy-style open market operations, it will be important that the NBP announce the size and term of the operation and let the market determine the yield based on liquidity conditions and expectations of the NBP’s monetary stance. Thus, fixed-rate open market operations would not be advisable for such policy-style operations because it is important that the NBP let interest rates adjust in the market rather than pick a particular interest rate level. Furthermore, as the NBP would also be able to affect longer term interest rates with such operations, the market linkage all along the yield curve would be strengthened.

Banking Supervision and the Payments System

Two additional areas—banking supervision and the payments system—that have an important bearing on the conduct of monetary policy and the efficient functioning of the financial system deserve separate discussion. In the initial years of the transition program, little progress was made in these two areas.¹⁹ Indeed, this lack of progress had serious consequences regarding the health of the banking system. For example, the lack of adequate prudential regulations and supervisory capacity contributed to the problems faced by private banks (discussed in greater detail in the next subsection). Similarly, check kiting scams were used to exploit inefficiencies in the payments system: the most damaging of these scams was one carried out in mid-1991 by a private holding company called Art-B.²⁰

In both these areas, however, encouraging progress has been made in the last year. Basic prudential regulations are now in place. The General Inspectorate of Bank Supervision (GIBS) of the NBP introduced regulations governing commercial banks’ classification of nonperforming loans and related provisioning requirements in November 1992. Regulations on foreign exchange exposure limits were introduced in April 1993. The revision of a new accounting plan for banks (prepared with IMF technical assistance) has been completed, and it is expected that by 1995 all banks will report under the new system. Both off-site analysis and on-site inspections by GIBS are being conducted, and a detailed training program (including an inspection manual) to further strengthen these capabilities is being developed.

As regards the payments system, in addition to introducing several regulatory changes in August 1991 to prevent reoccurrence of the check kiting scam, the NBP has consolidated a multitude of clearing accounts into a single centralized account for each bank. Furthermore, the National Clearinghouse, which was created in 1991 as a private company with ownership by 17 major commercial banks and the NBR implemented a new system of overnight clearing and settlement of paper documents in April 1991. This system has been operating effectively and efficiently, and membership has been expanded to 45 banks and more are expected to join in the near future. An electronic payments system is also being developed to complement and eventually replace the paper transaction system.

Restructuring of State-Owned Banks and Enterprises

With the breakup of the previous monobank, the NBP, nine state-owned commercial banks took over its commercial operations. Two of the state banks Wielkopolski Bank Kredytowy and Bank Slaski, which was the largest of these banks—have already been privatized. The current and former state-owned commercial banks, together with the four specialized banks, continue to dominate the financial system, accounting for over three-quarters of total banking sector assets. Despite the regional character of their deposit taking, the state commercial banks hold geographically diversified portfolios.

A focal point of the reform effort in the financial sector has been to prepare the state-owned commercial banks for privatization by recapitalizing them. At the same time, the banks have been given a pivotal role in the restructuring of their delinquent debtor enterprises in an effort to improve their portfolios and identify the recoverable part of their had loans. This process was also expected to facilitate the liquidation, restructuring, or privatization of state-owned enterprises with bad debts.

To prepare the state banks for eventual privatization and establish an enhanced governance structure, they were “commercialized” in October 1991, that is, they were transformed into joint-stock companies fully owned by the Treasury, with a supervisory board as the main governing body. In addition, with World Bank funding, “twinning” arrangements with foreign banks were put in place to facilitate the transfer of banking know-how and integrate the Polish banks into the international banking system.

The banking sector was highly profitable in 1990 when banks were permitted to set deposit and loan rates freely, which initially led to the emergence of very wide spreads. This boost in profitability enabled banks to strengthen their capital from 3 percent of total domestic credit at end-1989 to 11 percent at the end of 1990. In addition, the quality of the portfolios of the nine state banks analyzed by foreign auditors was judged to be relatively good at the end of 1990.

The developments in 1990, however, overstated the soundness of the state banks. Bank portfolios were highly vulnerable to the ongoing behavior of state-owned enterprises. (At end-1991, the state-owned commercial banks held nearly 50 percent of the socialized sector’s total debt to the banking system. The rest was held by the specialized banks.) The financial position of the state enterprises deteriorated in 1991 as temporary factors that had inflated enterprise profits in the previous year subsided and as the slow pace of adjustment in that sector increasingly took its toll on profits. These developments were compounded by banks’ inertia in revising their lending policy—they continued to lend to the state sector since they had little experience in evaluating creditworthiness or seeking other customers. Consequently, the quality of the banks’ loan portfolio deteriorated sharply in 1991, largely as the result of loans made in 1990 and 1991.²²

According to audits conducted in mid-1991 of seven state-owned commercial banks, on average 16 percent of outstanding loans fell into the “loss” category. 22 percent were “doubtful,” and an additional 24 percent were “substandard.” (In value, the “loss” and “doubtful” categories represented about $3 billion in mid-1991.) Provisioning needs increased on average from 15 percent of the gross risk portfolio at end-1990 to 35 percent by mid-1991. Fulfilling these provisioning needs would result in the seven commercial banks being insolvent in the aggregate, although the aggregate information masks considerable variation in the condition of the banks.

Portfolio reviews updated as of mid-1992 indicate that the quality of bank portfolios stabilized somewhat after 1991. This reflected both the stabilization of economic activity and tougher lending attitudes by the state banks after the program for bank restructuring began to take shape. The tougher lending attitudes were clearly influenced by the announcement that eligibility for recapitalization would be assessed on the basis of a credit portfolio analysis as of December 1991. Another important factor was the growing importance of government securities in banks’ portfolios.

A Law on Financial Restructuring of Enterprises and Banks became effective in March 1993 and established the basis for an innovative plan to recapitalize banks, restructure their loan portfolios, and deal with state enterprises with bad debts. Key features of the plan, which was supported by an Enterprise and Financial Sector Adjustment Loan (EFSAL) from the World Bank, are summarized below.²³

• The state banks were told to separate out loss-category and doubtful-category loans and to set up new internal organizational units ("workout departments") to manage the bad loan portfolio.

• The state banks were required to create provisions amounting to 100 percent for loss-category loans and 50 percent for doubtful-category loans. On the basis of a December 1991 portfolio analysis, the recapitalization amount was calculated and was set at a level sufficient to ensure that upon creating the required provisions, the banks would reach a 12 percent capital ratio. As the banks did not have a liquidity problem, the recapitalization was undertaken by transferring a treasury bond to seven public banks in September 1993. (The two privatized state-owned commercial banks did not need to be recapitalized.) In aggregate, this recapitalization amounted to Zl 11 trillion ($560 million at September 1993 exchange rates).²⁴

• Banks were required to complete the restructuring of their bad loan portfolios by the end of March 1994—a deadline later extended by a month. The main approach for portfolio restructuring was an out-of-court settlement process known as “conciliation proceedings,” under which banks can work with the management of delinquent debtor enterprises to draw up a financial and business restructuring plan, much like a streamlined version of a Chapter 11 proceeding under U.S. bankruptcy law led by a commercial bank. Conciliation agreements could include a rescheduling of claims, a partial write-off, or a conversion of debt into equity in the firm. An alternative avenue available to banks was the public sale of debt. As noted in Kawalec and others (1994), given the fixed deadline for completing restructurings, the purpose of this option was to encourage banks to enter into conciliation agreements that offered good prospects for the recovery of debt, while at the same time discouraging banks from entering into economically nonfeasible arrangements. Loans not subject to other measures stipulated in the Restructuring Law were to be sold by end-April 1994.

• Finally, the plan includes a mechanism for “subsidiary government intervention” that was designed to provide limited access to government support for restructuring or cushioning the liquidation of firms deemed important for sociopolitical reasons and which were unable to reach a conciliation agreement with banks. Financing for this mechanism is provided for in a separate line item in the budget and is supported by the World Bank’s EFSAL.

A key issue regarding any such plan is whether it contains the appropriate incentive mechanisms. The Polish plan was well designed in this respect, with a key element of the incentive mechanism being the transformation of banks into joint-stock companies with supervisory boards and the eventual prospect of privatization. Within such a setup, workout departments were to operate as separate profit centers where the bank kept whatever it recovered; since the amount of the ex ante recapitalization was not dependent on the amount of had debt to be recovered by banks, there were incentives to recover as much of the bad debt as possible. An additional element of the incentive mechanism was provided by the administrative supervision of banks’ compliance with the plan. The Government also made it clear that banks would not have a second chance this was meant to be a once-and-for-all operation after which the banks would be fully accountable for any future losses.

The factors that led Poland to adopt a decentralized approach also deserve some mention.²⁵ First, it was felt that a centralized, government sponsored agency would not vigorously and effectively recover bad loans. There were concerns about the ability of such an institution to resist political pressure, attract high-quality staff, and devise adequate incentive systems. And second, it was felt that a centralized solution would not address the root cause of the problem, which lay primarily in the lack of experience and expertise of the banks in handling credit activities in a market environment.

Considerable progress has been made under this plan. A number of bank-led restructurings have been completed, and preliminary data suggest that planned actions by banks cover some Zl 13 trillion ($650 million) in principal. Banks have used all available instruments under conciliatory proceedings—debt forgiveness, rescheduling, and debt-equity swaps. In addition, a number of firms have been liquidated by their founding organs or by court decisions. Because of the narrowness of the secondary market for loans, however, some problems have been encountered in selling claims. Audits are being conducted to check the portfolio restructurings completed by the April 1994 deadline.

As noted, two state banks have already been successfully privatized. Wielkopolski Bank Kredytowy of Poznan was privatized in April 1993, with 30 percent of the shares sold to the European Bank for Reconstruction and Development. 27 percent sold to the public through an initial public offering (IPO), 20 percent offered to employees, and the remainder retained by the Treasury. Bank Slaski of Katowice was privatized in December 1993, with 26 percent of the shares sold to a strategic investor (ING Bank of the Netherlands), 31 sold percent to the public through an IPO (which attracted orders for Zl 8 trillion of shares, an oversubscription of more than sixfold), 10 percent offered to employees, and 33 percent retained by the Treasury. A third bank, Bank Przemyslowo-Handlowy SA in Krakow, is slated for privatization in late 1994. The bank privatization program is expected to be completed by the end of 1996.

State-Owned Specialized Banks

There are four large state-owned specialized banks in Poland: Bank Handlowy, which deals with foreign trade; PKO-SA, which deals with consumer foreign currency deposits and transactions; the Bank for Food Economy (Polish abbreviation. BGZ), which deals with agro-industry lending and local cooperative banks; and PKO-BP, which deals with consumer deposits and housing construction loans. At the current stage of the reform of the banking system in Poland, detailed plans have not been developed for the restructuring of these specialized banks. In view of the strategic importance of these institutions and their specialized character, it appears likely that the Treasury will retain majority interest for some time.

Of these banks, PKO-BP and BGZ are in particularly dire straits.²⁶ Prior to developing a coherent strategy to rehabilitate these banks, a first step was taken in December 1993, when they were provided with Treasury-issued recapitalization bonds: PKOBP was given bonds amounting to Zl 5.7 trillion in connection with its commercial, nonhousing portfolio, and BGZ was given Z1 4.3 trillion in bonds. These specialized banks have made only a small fraction of the loan-loss provisions required by prudential regulations. Considerable additional work is required to provide these banks with a proper governance structure and to resolve their portfolio problems. For example, Parliament has decided that BGZ will not be recapitalized unless its form of ownership is changed. At present, the ownership structure of BGZ gives the Treasury only one vote in important management decisions (although it has a 56 percent stake), while cooperative banks have more than 1.000 votes. The rehabilitation of these banks will also require complementary reforms in the housing and agricultural sectors and in the financing of these activities. The poor financial standing of BGZ is related, among other things, to the problems of state farms. An overwhelming proportion of its loans to state farms will not be recoverable unless these farms receive external assistance. A special government agency has been set up to manage, privatize, or even liquidate state-owned agricultural enterprises, and this agency and BGZ are now in negotiations over the settlement of state-farm debts. Without broad action, the problems are likely to be magnified, imposing a significant drain on the budget and the NBP.

Against this background, in June 1994 the Polish Parliament approved a law that provides for recapitalization and fundamental change in the structure of both BGZ and the rural cooperative banks. (The problems of the cooperative banks are discussed further below.) The law provides for a three-tier system with the primary cooperative banks at the local level; a number of regional banks as umbrella organizations for all primary banks in a specified geographical area; and a national bank of which regional banks would be members. At the apex of this structure, BGZ will become the proposed national bank, after being transformed into a joint-stock company with a 56 percent share held by the state Treasury, thus increasing the role of the Treasury in its management. Restructuring plans for BGZ, however, remain to be fully defined. In the design and execution of these plans, it will be crucial that improvements in the governance of BGZ are such as to avoid future bad loan problems, particularly given the economic weakness of BGZ’s traditional client base—the state farms and agricultural processing and distribution sectors.

Private Banks

The Banking Law of 1989 laid out a liberal approach to the entry of new private banks. The underlying reason for the liberal approach and easing of the barriers to entry was the desire to demonopolize the banking sector before privatization of the large state banks. As a result of the changes in legislation and administrative procedures, a relatively large number of new private banks opened. By the end of 1990, the number of private banks had grown to about 75 and by the end of 1992 nearly 90 private banks were in operation. Reflecting the problems in this sector, however, the number of private banks fell to about 85 in 1993. Several banks have been set up with foreign capital input, and some foreign banks have opened up branches in Poland. Despite the growth of the number of private banks, they remain very small compared with their state-owned counterparts, holding only 10 percent of banking sector assets.

Many of the private banks are undercapitalized, and the NBP believes that about 15 are threatened by liquidation or collapse. Minimum capital requirements were set too low and were quickly eroded by inflation.²⁷ In addition, private banks were at a competitive disadvantage vis-à-vis publicly owned banks; state banks, for example, enjoyed open-ended deposit insurance from the Treasury, less-cumbersome procedures for loan collection, and substantial technical assistance not offered to private banks. Furthermore, supervision activity was not adequate to monitor risk taking. Hogan and others (1993) also note that a number of the private banks were set up with participation by state-owned and in some cases private enterprises that envisaged them as sources of credit for main shareholders, as banks were not prohibited from lending to owners. The majority, however, are owned by private entrepreneurs and investors, many of whom have little prior experience in banking.

Since 1989, Polish licensing policy for new banks has become considerably more restrictive as the authorities reached the conclusion that initial requirements were too lax with respect to the qualifications of bank management, the scope of operations, and the provisions of bank articles of association. Nevertheless, the damage had already been done, since private banks had been allowed to enter the market but were not provided with sufficiently strong foundations.²⁸ In view of these factors, it is not surprising that problems of bad loans, inadequate capita], and insolvency have emerged in the private banks.²⁹

The NBP has directly supported the restructuring of some private banks. Specifically, the NBP has made direct capital injections totaling ZI 0.45 trillion in three banks (Lodzki Bank Rozwoju, Pierwszy Komercyjny Bank in Lublin, and Prosper Bank in Warsaw) after owners’ capital was written down to cover losses. In addition, it has purchased long-term obligations issued by these banks and has provided them with rediscount credit amounting to some Z1 3.4 trillion. Such intervention, however, has been at the cost of increasing base money and is directly inflationary. Several other private banks that are experiencing difficulties have been asked by the NBP to submit “recovery” plans.

It is generally acknowledged that considerable consolidation is needed among the private banks. This process has already started: a prime example is the merger of Lodzki Bank Rozwoju (one of the banks that received direct NBP support) with Bank lnicjatyw Gospodarczych (BIG).³⁰ Without such a merger, it is likely that the NBP would have had to declare the Lodz bank bankrupt. Further mergers in the private banking sector are likely to be encouraged by the NBP.

So far, the approach to dealing with the problems of private banks has been somewhat ad hoc and dominated by NBP bailouts. It would appear that there is considerable reluctance to close any banks without compensating depositors, and there seems to be a great fear of precipitating a bank panic that might affect the confidence in the banking system.³¹ As Hogan and others (1993) note, although NBP bailouts serve to stabilize the situation in the short run, they also signal that all of the banking system is backed, leading to a serious moral hazard problem.

Cooperative Banks

There are over 1.600 cooperative banks in Poland, accounting for some 6 percent of total banking sector assets. Together, these banks hold about Zl 18 trillion of Treasury-guaranteed deposits. The cooperative banks, which were all initially under the umbrella of BGZ, are small with average total assets of Zl 2 billion per location (Hogan and others (1993)) and service the agricultural sector. Since September 1992, the NBP has become the de facto supervisor for cooperative banks: at that time it ordered them to affiliate with one of four large “associate” banks, one of which was BGZ. Thus, many of the cooperative banks are no longer controlled by BGZ. Of the 1,000 cooperative banks already inspected by the NBP, about 200 holding about Zl 7 trillion of deposits would qualify for bankruptcy. Activities of some 60 cooperative banks have already been suspended and they have been recommended for liquidation.

The cooperative banks are no longer fully autonomous; credit decisions are to be taken by a credit committee that includes representation from the associate bank. Cooperative banks have also been prohibited from issuing guarantees, since a major part of the problem facing these banks is off-balancesheet activities. (In the past, guarantees were extended outside the region where the cooperative bank operated making it very difficult to foreclose.) In view of the large number of institutions involved, the supervisory burden on the NBP is enormous. In addition, although cooperative banks represent only a small part of the banking system, their problems could have significant budgetary consequences because deposits in these banks are fully guaranteed by the Treasury. A systemic solution to the problem of cooperative banks, which will require a joint effort by the Government, the NBP, and Parliament, is needed. As discussed above, a law approved in June 1994 provides for a three-tier structure, with cooperative banks at the first level, regional banks at the second level, and BGZ at the apex. By combining cooperative banks into regional groupings, more effective supervision will be possible at the regional level.

Priorities for Future Banking System Reforms

To date, the focus has been on tackling the problems of state-owned commercial banks and the innovative program for this purpose is proceeding satisfactorily; continued progress in this area will require that the pace of bank privatization be maintained. The problems of other parts of the banking system, however, cannot be ignored and require urgent attention in a coherent and systematic manner that creates the right incentives and minimizes moral hazard. Improved governance of banks that remain in state hands will be essential. Paradoxically, despite the large number of banks, competition within the system has been quite limited because banks have been reluctant to encroach on the territory of other banks and because of the competitive disadvantages faced by private banks. However, progress is being made on the issue of deposit insurance—although state-owned and privatized banks have open-ended Treasury guarantees of deposits, private banks do not. Of course, with the introduction of formal deposit insurance, it will become even more critical that prudential regulations and supervisory capacity be up to the task of preventing risky behavior induced by such insurance.

Warsaw Stock Exchange: Some Background

The WSE was reopened in July 1991, some fifty years after being closed in 1939. The legal regulations regarding securities and the operation of the exchange are designed to conform to the Eli standards set out in various directives; the supervision of capital markets has been entrusted to the Securities Commission, a central government agency specially created for this purpose.³³ No restrictions are placed on foreign participation in the WSE and nonresidents are free to repatriate all profits earned in Poland. Nonresident investors are subject to the same levels of taxation as Polish residents. Between 1992 and 1995 all capital gains are exempt from tax, with dividend income charged at a flat rate of 20 percent.

By January 1994, the shares of 24 companies were listed on the exchange, up from 16 at the end of 1992. (One of these companies is listed on the parallel market operated by the WSE. The securities listed on this market must meet less stringent criteria than on the main market.) Of the 24 companies. 4 are banks, and others include export-import firms, manufacturing firms (e.g., glass), breweries, electronics firms, and firms in the food industry. All but two of the companies listed on the WSE were privatized through public offers. In many cases, the state Treasury remains a significant shareholder, with holdings ranging from 10 percent to 47 percent. In addition, ten Treasury bond issues are also traded on the exchange, although trading in Treasury bonds is not very active, averaging the equivalent of about $I million a session.

Recent Stock Market Developments

After a slow start with lackluster performance in 1991–92, the stock market came alive in the second quarter of 1993. Starting with a base value of 1.000 when the market began operation in mid-1991, the Warsaw Stock Exchange Index (WIG)—a total return index weighted by market capitalization and covering all the stocks listed on the main WSE market—stood at 919 at the end of 1991, rising to 1,041 by the end of 1992, and then soaring to 12,439 by the end of 1993 (Chart 3–12). Thus, in 1993 the WIG increased by 1.095 percent in local currency terms. There was a further rise in early 1994, and the WIG reached 20,196 by the end of February, a 62 percent increase from the end of 1993. The increase in early 1994 was largely fueled by the share price of Bank Slaski—the second state-owned commercial bank to be privatized—rocketing to more than 13½ times the opening issue price on its first day of trading.³⁴ From mid–March 1994, however, the market retreated sharply, and by mid–June the WIG had fallen by 60 percent compared with its high in February. The market rallied, however, in the first two weeks of July, with the WIG rising from around 7,800 at end–June to 11,063 in mid–July.

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Warsaw Stock Exchange Index

(End–of–month)

Source: Warsaw Stock Exchange.

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There are three trading sessions a week. Trading volume per session, which as recently as June 1993 was only Z1 0.33 trillion ($20 million), had also reached record highs of over Zl 4 trillion ($200 million) by early 1994; annual turnover amounted to Zl 77.5 trillion in 1993, compared with Zl 2.3 trillion in 1992. The number of investment accounts has grown from 76,000 at the end of 1992 to about 400,000 in early 1994. Although the WSE has coped remarkably well with this rapid growth, some infrastructure strains are appearing. For example, problems are being experienced in the processing of orders, running at about 100,000 per session. Problems are also being experienced with opening new investment accounts in brokerage firms.

Market capitalization has risen rapidly, from Z1 1.6 trillion ($142 million) at end–1991 to over Z1 58 trillion ($2.8 billion) at the end of 1993. With the continuing stock market boom and the addition of Bank Slaski—the largest individual firm on the exchange—market capitalization doubled in January 1994. Companies quoted on the WSE were selling on average at 33 times current earnings at end–1993, compared with an average price/earnings ratio of 4.5 in 1991 and 3.4 in 1992. The average price–to book value in December 1993 was 4.85 compared with 0.69 in 1992 and 0.70 in 1991: the average dividend yield in 1992 was 5.5 percent. Despite the high market value of shares, with only a small number of companies quoted on the exchange, the ratio of market capitalization to GDP of about 3^½ percent of GDP at end–1993 was still very small. Nevertheless, all in all, the WSE was by far the fastest–growing emerging market in the world in 1993.

The stock market has not yet been an important source for raising new capital. Four companies listed on the WSE, however, are planning to issue additional stock to mobilize capital. Until recently, raising capital on the stock market was unattractive because of the low price/earnings ratios. In addition, there was general ignorance about such new issues and lack of intermediaries such as investment banks to prepare the equity offerings. By spring 1994, with average price/earnings ratios ranging between 30 and 35, the cost of capital secured on the equity market was around 3 percent of net earnings, in contrast with bank lending rates of 45–50 percent. Corporate bonds are not yet an option, mainly because of the difficulty in fixing a coupon given continued high inflation rates. Floating–rate notes would appear to be an option but are apparently also viewed as technically difficult to develop without adequate assistance from investment banks to help with the issues.

Factors Underlying Stock Market Developments and Some Implications

Several elements played a role in the astounding rise of the stock market from April 1993 to March 1994, most of which have implications for future developments. At the most general level, it would appear that there was a basic reassessment of Poland’s economic and financial prospects based on continued strength of industrial output and evidence of a strong recovery based on domestic demand. This reappraisal of the outlook raised demand while supply remained severely limited, leading to a fundamental imbalance. More specifically, share prices were initially very low in Poland, and the listed companies were generating attractive earnings. Furthermore, after commercial bank deposit rates plummeted in March 1993, it appears that there was a shift of household portfolios to equities and away from bank deposits (see the subsection “Monetary Policy” above). Finally, the stock market boom also reportedly flushed out cash held outside the banking system. Thus, the rising prices reflected swelling ranks of small private investors attracted by high rates of return, which further stoked the price rise and attracted more new investors all of whom were chasing a limited supply of stocks. Rising demand has also been propelled somewhat by the inflow of foreign capital that was attracted, among other things, by the low initial prices and the two–year extension of the capital gains tax exemption in May 1993. Precise estimates of shares held by foreign investors are not available, but various estimates are in the range of 20–30 percent of the stock market.

With continued low interest rates and lack of investment alternatives, the market rise lasted for several months. As the WSE became relatively high priced, it would appear that the excess demand was fueled by high expectations rather than increasing fundamental values. However, the market slump since March 1994 suggests that market participants have become much more cautious. As noted in a column in the Warsaw Voice newspaper on April 17, 1994, while previously a drop in prices was seen as an encouragement to buy shares thus leading to yet another bullish wave after a few mild sessions, more recently price increases have led to increased selling.

Given the nature of its growth, based largely on the short–term expectations and speculative holdings of numerous small domestic retail investors, the WSE is particularly prone to volatility.³⁵ With the exception of one domestic open–ended mutual fund and some foreign participation, there is virtually no institutional investor base on the WSE. Some observers have expressed the concern that excessive share price volatility could hinder Poland’s longterm privatization plans because launching a privatization issue into such a market—as in the recent case of Bank Slaski—is vulnerable to accusations of mispricing state assets. Furthermore, significant stock market volatility could damage the confidence of numerous new investors with possible spillover effects for popular support for privatization and long–term development of capital markets.

Accordingly, a key priority must be to boost equity supply to broaden the market and take some pressure off excess demand. In this regard, speeding up privatization and new company listings, as well as selling into the market some of the remaining Treasury holdings in companies that are already quoted on the WSE, will be important. The mass privatization program and creation of associated National Investment Funds will clearly have a significant role to play in the more balanced development of the equity market in Poland. In addition, the plans to issue additional stock by companies already listed on the exchange are a positive development. If these new offerings are successful, it is expected that other firms will follow.

Developing a more diversified investor base will also be important for reducing volatility and sustaining market growth. Broadening the market should contribute to this process. Foreign and domestic institutional investors can be expected to hold relatively stable portfolios and trade far less than domestic retail investors. Finally, although stringent regulations and supervision are essential to ensure confidence in market operations, these need to be adequately balanced to ensure that overregulation does not result in excessive transactions costs and bottlenecks that discourage both suppliers of equity and potential investors, especially from abroad. In this regard, development of a parallel market on the WSE or an over–the–counter market with less–stringent listing requirements might he helpful.