Republic of Poland: Staff Report for the 1999 Article IV Consultation

Poland is placed high among the most successful transition economies owing to its strong macroeconomic and structural policies. Executive Directors commended this development, and stressed the need to maintain monetary and fiscal policies. They appreciated the tax and pension systems, banking supervision and regulatory framework, and industrial restructuring and privatization. They welcomed the policymakers' focus on ensuring progress toward membership in the European Union accession. They agreed that the country's statistical base is adequate for surveillance, and encouraged the authorities to improve the quality of macroeconomic data.

Abstract

Poland is placed high among the most successful transition economies owing to its strong macroeconomic and structural policies. Executive Directors commended this development, and stressed the need to maintain monetary and fiscal policies. They appreciated the tax and pension systems, banking supervision and regulatory framework, and industrial restructuring and privatization. They welcomed the policymakers' focus on ensuring progress toward membership in the European Union accession. They agreed that the country's statistical base is adequate for surveillance, and encouraged the authorities to improve the quality of macroeconomic data.

1. The 1999 Article IV consultation discussions with Poland were held in Warsaw during November 30-December 15, 1999.1 The mission met with: Deputy Prime Minister Balcerowicz (Finance Minister); National Bank of Poland (NBP) President Gronkiewicz-Waltz; several members of the Monetary Policy Council (MPC); senior officials in government ministries, the NBP, the Council of Ministers, and the office of the President; Parliamentary leaders; and representatives of the private sector and research institutions. Mr. Szczuka, the Alternate Executive Director for Poland, participated in many of the meetings. The Managing Director visited Warsaw during the mission, in honor of the 10th anniversary of transition in Poland.

2. Poland formally accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Articles of Agreement of the Fund as from June 1, 1995, and maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions.2

3. In concluding the 1998 Article IV consultation on March 11, 1999, Directors commended Poland’s strong economic performance, notably sustained output growth and declining inflation. They approved of the intended rebalancing of economic policies—with continued fiscal consolidation accompanied by monetary relaxation—in response to the crisis in Russia in late 1998 and the slowing of growth in the EU. Directors welcomed the introduction of an inflation-targeting framework for monetary policy and considered the inflation target of not more than 4 percent by 2003 reasonable and achievable. They supported the parallel shift toward more exchange rate flexibility. Directors commended the authorities’ initiatives for pensions, health care, and administrative reforms that took effect in early 1999 and called for similarly bold steps in industrial restructuring.

4. Opinion polls have moved against the center-right coalition government which came to power in late 1997. This largely reflects startup problems with structural reforms and frustration with the slow progress in EU accession. Strains within the coalition have posed an increasing challenge for economic policies: in November 1999, Mr. Balcerowicz threatened resignation in a dispute with his coalition partners over tax reform and more recently the Treasury Minister charged with privatization faced a vote of no confidence. The next Presidential and Parliamentary elections are due in late 2000 and 2001 respectively.

I. Economic Background

5. Poland has recently marked the tenth anniversary of its transition. Progress during those ten years has put Poland consistently among the five most successful countries transforming from centrally planned to market economies, and is reflected in its investment grade ratings. As in those other countries, the focus of policies over the next decade will shift from managing the transition to securing a place among industrialized countries with stable and attractive investment conditions. The challenges in this task will substantially reflect the course transition has taken—building on Poland’s comparative strengths in the transition process and addressing the problems remaining from the era of central planning.

6. After successfully pioneering the shock therapy approach to stabilization and liberalization during 1990-91, Poland settled into a steady, step-by-step pace of transition during 1992-97. Overall, Poland kept pace with the most advanced transition countries. Rapid progress was made with the commercialization and mass privatization of small and medium-sized enterprises, and the scale of governance problems in some other countries was avoided. But the restructuring and sale of larger enterprises has been drawn out, owing to resistance of entrenched interests and efforts to maximize revenues (Figure 1). Sales of banks began in 1993 but proceeded more slowly than planned—by 1998 half of bank assets were still in state banks. Tax reform moved at a faster pace: direct income taxation and a VAT were introduced in the early 1990s; corporate income tax rate reductions and a honing of the tax code have occurred since then. This, as well as improvements in the legal system, hardened enterprise budget constraints and enhanced the investment climate. Foreign trade benefited from the almost complete elimination of exchange and trade controls during 1990-92 and reductions in tariffs in the mid-1990’s.

Figure 1.
Figure 1.

Poland: Structural Reform Indicators in Selected Transition Countries, 1992-99

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: EBRD Transition Report 1999.1/ Excludes Ceska Sporitelna and Komercni Banka.

7. The aggressiveness with which large fiscal deficits and inflation were addressed also moderated from that in the initial stabilization period, but efforts were strong and well-focused. With the introduction of the VAT in 1993, revenue rose sharply, and the general government deficit fell to about 3 percent of GDP. Thereafter, the effects on the deficit of a steady containment of spending relative to GDP and the debt write-off in 1994 were largely offset by a declining ratio of revenue to GDP. Though falling, the government spending ratio, and particularly that on transfers to households, is high in Poland relative to other advanced transition countries. Deficits were financed mainly by domestic borrowing, which has kept interest rates high and, with accommodative capital inflows, the pace of disinflation gradual. A crawl in parity at rates below concurrent inflation helped moderate price increases. Between 1992 and 1997, inflation fell from over 40 to 15 percent.

uA01fig01

Social Security and Welfare Spending 1/

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Sources: Government Finance Statistic and WEO.1/ Data consolidated for central government.

8. On several fronts, macroeconomic performance improved dramatically during 1992-97. What stands out, relative even to the other advanced transition countries, is the steady rise in gross investment, rapid productivity growth and increase—albeit modest in comparison to the high unemployment rate—in employment (Figure 2). Correspondingly, output growth, averaging over 5 percent per year, exceeded that in other advanced transition countries, and the unemployment rate fell (although reductions in the labor force contributed). The pace of Poland’s integration with the outside world also stands out: with competitive unit labor costs and low barriers to imports, the ratio of foreign trade to GDP rose by half. And helped by the restructuring of external debt in 1994, the ratio of debt to GDP dropped sharply, paving the way for large capital inflows—about half in direct foreign investment—in 1996–98.

Figure 2.
Figure 2.

Poland: Investment and productivity in selected transition countries, 1992-99

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: WEO

9. Thus, by 1997, Poland had secured a strong position among the transition countries but still faced substantial challenges. Most fundamentally, evidence of the dynamism of Poland’s private sector is strong: a recent EBRD/World Bank survey of firms’ views of the investment climate shows Poland as one of the most attractive among transition countries owing particularly to the legal and regulatory system, availability of finance, and quality of infrastructure; growth during the 1990s was built on robust small and medium size business entry and expansion; and, with competitive labor costs and strong productivity growth, the profitability of traded goods is high. Yet even after eight years of remarkable adjustment and reform, the agenda of unfinished items was substantial: the agricultural sector, absorbing up to 25 percent of the labor force and producing only 6 percent of output, needed consolidation and modernization; the restructuring and privatization of large state enterprises and banks needed to move ahead; and the fiscal deficit and government spending remained high.

10. The new government that took power in late–1997 acted quickly on its mandate to accelerate reforms. Displaying the hallmark Polish confidence in markets, reforms in many critical structural areas have picked up. A new thrust of privatization, aimed at selling, primarily to strategic investors, all but a handful of remaining state enterprises by 2002, started in 1998 and remains broadly on schedule. Privatization revenues amounted to 1.3 percent of GDP in 1998 and 2.2 percent in 1999. A restructuring of the coal sector began in earnest in 1998, supported by the World Bank: mines have been closed, production cut and some 25 percent of the coal workforce has accepted redundancy packages or early retirement.3 Bank privatization picked up speed with the sale of two large state banks in 1999. On the fiscal side, a wholesale reform of government operations was initiated with effect from early 1999. This comprised introducing a multi-pillar pension scheme; devolving much more of the authority for public spending to local governments; initiating a multi-stage process for establishing an internal market in the public health system; and reforming the education system up to secondary school level. In late 1999, Parliament passed a major tax reform: it substantially reduces corporate taxes, closes corporate tax loopholes, and broadens the VAT in a revenue-neutral manner.

11. These reforms were implemented in an adverse economic environment. In 1998–99, the macroeconomy faltered for the first time since the early 1990s. Hit hard by the Russian crisis in mid–1998, Poland sustained a sharp drop in exports and sizable, albeit short-lived, downward pressure on the zloty.4 With an additional drag from the slowdown in EU demand, the loss of competitiveness to Asian countries, and the lagged effects of a countercyclical monetary tightening in 1997, real GDP growth slipped from about 5 percent in 1998 to about 2 percent in the first half of 1999. Registered unemployment reversed a four year drop and rose to 13 percent in 1999. The current account deficit widened to 7.6 percent of GDP in 1999, reflecting the export demand shock on top of a structural trend of rising investment and unchanged savings ratios (Figures 3 and 4). Disinflation continued through mid–1999 helped by excess agricultural stocks as Russian demand fell; inflation reached a low of 5½ percent in early–1999. These developments broadly parallel those elsewhere in the region: all countries struggled with the same external shocks that weakened growth and current account positions.5 The recorded weakness in Poland’s exports, however, stands out (Figure 5). A drop in competitiveness in 1998 (subsequently reversed) explains some of the weakness (Box 1). But the experience of the other countries strengthens the staffs suspicion that the extent of the weakness in recorded exports is overstated due to the discontinuity in data collection.

Figure 3.
Figure 3.

Poland: Selected Economic Indicators, 1991-99

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: Polish authorities, and staff estimates.
Figure 4.
Figure 4.

Poland: Savings-Investment Balances in Selected Central European Countries, 1994–99

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: WEO.
Figure 5.
Figure 5.

Poland: Export Performance in Selected Central European Countries, 1994-99

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: WEO, DOTS and staff estiamtes.1/ Based on DOTS exprot growth.

12. In response to the external shocks, the authorities attempted to rebalance macroeconomic policies—essentially to bolster exports and activity while containing inflation. The monetary easing that had begun in early 1998 continued into early 1999—the last of the interest rate cuts being associated with a fall in the value of the zloty from some 8 percent above parity to close to parity early in 1999, while yield spreads on Polish sovereign bonds remained tight. Until late-1999 the monetary stance was broadly neutral. On the fiscal side, however, a planned reduction in the general government deficit relative to GDP of ½ percentage point failed to materialize. Though cyclical factors played a part in this, the slippage mainly reflected teething problems with the 1999 reforms of the pension system. The deficit of general government looks set to come out at 3.8 percent of GDP in 1999, overshooting its target by 1½ percent of GDP on a commitment basis (Box 2).

uA01fig02

NBP Intervention Rate 1/

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: Polish authorities.1/ 14 day reverse repo upto February 1998 and 28 day re verse repo rate afterwards.2/ Nominal rates deflated by one year ahead CPI For 1999, kite rest rates are deflated by the CPI target for 2000.

Trends in Polish Competitiveness 1998–99

During 1998, a sizeable nominal appreciation of the zloty helped disinflation, but resulted in a marked appreciation of the CPI- and PPI- based REERs (Figure 6).1 RULCs and profit share in manufacturing deteriorated, and the external current account deficit rose. Also, the price of traded goods fell vis-à-vis nontraded goods. In early 1999, however, the zloty depreciated by some 8 percent. The impact on competitiveness is apparent from all indicators, notably the RULC and the profitability of export production (the inverse of real unit labor costs). But the depreciation did not reverse the trend decline in the price of tradeables relative to nontradeables.

Two conclusions are suggested by these data for policy. First, lagged effects of the deterioration in competitiveness in 1998, compounded by weakening export market growth explain at least part of the officially-reported weakness of exports in 1999. But the deterioration in unit labor costs and in export profitability recovered during 1999. Second, the increase in the price of non-traded to traded goods, which has persisted, probably reflects Balassa-Samuel son effects to a large extent, as well as administered price increases which disproportionately affect non-traded goods. The Balassa Samuelson effect makes the task of lowering headline CPI more onerous.

1 The drop in competitiveness in 1998 may be understated because INS weights are based on 1989 data, implying that Asian countries are likely underrepresented in Poland’s index and the effect of their depreciation on Poland’s competitiveness in 1997-98 is not captured in Figure 6.
Figure 6.
Figure 6.

Poland: competitiveness Indicators, 1993-99

(January 1996=100)

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: Polish authorities, Information Notice Systems and staff estimates.1/ Based on weights for Austria, Australia, Belgium, Canada, China, Denmark, Finland, France, Germany, Hungary, Italy, Japan, Netherlands, Romania, Russia, Spain, Sweden, Switzerland, Taiwan, UK and USA. Weight for Russia calculated using DOTS and unclassified transactions.2/ Based on INS weights which do not include Russia. For other countries in INS see footnote 1.3/ Based on weights for Austria, Australia, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, UK and USA.4/ Based on weights for Germany, Italy, Canada, France, UK and USA. Polish unit labor Cost/Partner country unit labor cost.
uA01fig03

Interest Rate Spread

(Basis points)

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: WEO and Bloomberg.1/ Spread on Polish bond 7.25 coupon expiring 07/04 and US Treasury 7.2 5 expiring 08/042/ Spread on Hungarian bond 8.8 coupon expiring 10/02 and US Treasury 5.7 5 coupon expiring 10/02

Fiscal Slippage in 1999

In 1999, the authorities targeted a deficit of 2.3 percent of GDP for general government. They projected the 1999 outturn to be 3.8 percent of GDP on a commitment basis, a slippage of Z18.9 billion (Table 5).

The slippage occurred almost entirely in the social security system (FUS), with the remainder (Z1 2.0 billion) accounted for by unpaid interest on the stock of expenditure arrears. With respect to FUS, first, many contributors exploited a loophole in the legislation reforming social security to postpone all their contributions by one month, giving rise to a “one month” loss of revenue during 1999. Second, fraud in the sickness benefit system, which had been targeted for reduction, remained substantial through the first three quarters. Finally, collection ratios fell in 1999 reflecting financial difficulties in some state-owned firms and some loss of taxpayer payment discipline in the context of a collapse of the FUS management information system.

The central government budget on a cash basis, however, remained on track; cyclical slippages in revenues were offset by midyear increases in excise tax rates and cuts in expenditure allocations. The FUS deficit overrun was funded by commercial and central government credit, rather than by central government transfers, which many observers thought would have been more transparent. The authorities avoided a mid-year increase in central government transfers in part because of concerns that the required Parliamentary approval for the overrun of the central government deficit could have been accompanied by added spending commitments.

Table 1.

Poland: Main Economic Indicators

article image
Sources: Data provided by the authorities; IFS; and staff estimates.

National accounts basis.

End of period.

Consists of the central budget, social security funds, extra-budgetary funds, and local governments.

This excludes net interest payments from the government balance.

These estimates equate the current account balance with foreign dissavings, and differ in this regard from the authorities’ estimates.

The zloty currently floats within a ± 15 percent band around the central rate, which depreciates at a fixed monthly rate (0.3 percent since March 24, 1999) against a basket of currencies.

Table 2.

Poland: National Accounts and Medium Term Framework

article image
Sources: National authorities; and Fund staff estimates.

End of period.

Table 3.

Poland: Balance of Payments

article image
Sources: National authorities; and Fund staff estimates.

Projected nominal goods trade values for 1998 include staff adjustments for underrecording in the official settlements data.

On medium-and long-term debt.

The sum of the current account deficit, amortization, and the change in reserves.

Table 4.

Poland: Monetary Survey, 1994-99

(In billions of zlotys)

article image
Sources: National Bank of Poland, and Fund estimates and projections.

There was a break in this series at the end of 1996.

Table 5.

Poland: State and General Government Summary, 1994-2000 1/

article image
Sources: Polish authorities and staff estimates

The staff presentation and forecast are slightly different from the authorities’.

Beginning in 1999, the health premium is allocated to the health funds and is not included in state budget totals. For comparability with previous years, this is estimated at Z1 18 billion in 1999 (3.1 percent of GDP).

Fund presentation includes EU grants as revenue and associated spending as expenditure; governments presentation excludes EU grants entirely.

Treats all local government financing as bank financing. For 1999 includes Z1 2.8 billion bank loan to FUS.

In 1999, includes loan from state budget to FUS; in 2000, government’s accounting treats ZL 3.4 billion in compensation payments and ZL 1 billion in loan to health funds as financing; Fund presentation puts these above the line in the state budget and treats the latter as a transfer to the health funds.

Total general government revenue and expenditures shown exclude some very small funds.

13. A strong recovery of growth began in early 1999. Alongside the stabilization of the Russian market and the pick-up in EU demand, investment and household demand accelerated from the first quarter. This was reflected in a sharp increase in credit to households, industrial sales and GDP growth. At the same time, the long-standing downward momentum in inflation was interrupted as year-on-year price increases rose to 9.8 percent in December. The official target of 6.6–7.8 percent inflation in December 1999 was therefore exceeded by 2 percentage points. Although measures of core inflation have risen, increases in the CPI also reflect rising oil prices and the weakening of the zloty (Figure 7). Wage increases have, however, remained moderate.

Selected quarterly rates in 1999

(Percent changes over the same quarter in the previous year)

article image

14. The Monetary Policy Committee (MPC) reacted decisively to these developments by raising the central intervention rate by 100bp in September and by a further 250bp in November. These actions and a subsequent easing of political tensions saw the zloty strengthen by some 5 percent during December–January, while yield spreads on Polish sovereign paper tightened further.

15. The current account deficit for 1999 has turned out to be substantially larger than was projected during the December mission. Then, the authorities and staff projected a deficit of about 7 percent of GDP. But a much weaker than expected outturn for December left the deficit for the year at 7.6 percent of GDP. This sharp drop reflected strong imports and a large drop in “unclassified transactions,” despite strong exports. The reasons for these weaknesses and the degree to which they reflect permanent or soon-to-be reversed developments are not yet understood.

II. Report on the Discussions

16. With transition well advanced, Poland has now set its sights squarely on early accession to the European Union. The enthusiasm of politicians across the party spectrum for EU accession at the earliest possible date together with the propitious cyclical position of the economy means that the next few years should present unprecedented opportunities for moving ahead with structural reforms. Beyond the acceleration of reforms since 1998, EU accession will force the issues of agricultural reform, environmental protection, scaling down production in the steel and defense sectors, as well as a broad array of legal and regulatory changes. The prospect of EU entry also has enormous implications for macro policies. Over the medium run when Poland will enter ERMII, macroeconomic policies will be anchored by the Maastricht criteria. More immediately, however, making room for needed infrastructure, environmental and restructuring expenditures heightens the importance of containing other government spending. Equally important, minimizing vulnerabilities to changes in market sentiment will remain crucial during the accession effort.

17. The authorities’ program to address these challenges is outlined in “The Strategy of Public Finance and Economic Development Poland 2000–2010” which was adopted in mid-1999. It anticipates a balanced budget for general government in 2003, restraint in public spending, privatization, liberalization of the labor market, and an improved legal and regulatory environment. In this context, inflation is projected to fall to 3 percent by 2003, fixed investment to rise above 30 percent of GDP, and growth to rise to 6–8 percent.

18. The discussions focussed on four themes in this agenda.

  • With high productivity growth and moderate wage increases, Poland is likely to have persistently strong capital inflows, high investment ratios, and large current account deficits. A balance has to be struck between exploiting the opportunities for rapid investment growth and limiting the vulnerability to changes in market sentiment consequent on large external current account deficits. This vulnerability may be heightened if prospective EU accession takes country risk premia below levels warranted by the strength and credibility of prospective Polish policies.

  • Reestablishing the downward momentum in inflation is essential. Some reversal of the recent sharp drop in food prices relative to nonfood prices may complicate this task, but a prospective drop in oil prices should help. In light of the large current account imbalance, relying solely on monetary policy to secure ambitious disinflation targets is risky, if not futile: higher interest rates are likely in the short run to attract capital inflows, erode competitiveness, and widen current account deficits.

  • In this setting, fiscal consolidation focused on expenditure reform becomes all the more important. Lower fiscal deficits will reduce the external imbalance, inflationary pressures and the constraint on monetary policy. The next few years will see substantial pressures on spending in connection with EU entry. The task for fiscal policy will be to build on the recent reforms to pensions, health care, and devolution of spending decisions to secure sustainable reductions in the share of social spending in GDP.

  • Unemployment may be boosted by demographic trends, needed reforms in the agricultural sector, and ongoing industrial restructuring. Job creation will be critical to absorb the large inflow of youth into the labor force and the existing extensive hidden unemployment in the rural areas. Pressures for distortive job creation are likely to grow, even while resistance to removing impediments to job creation persists.

Figure 7.
Figure 7.

Poland: Indicators of Inflation, 1995-99

(12-month growth)

Citation: IMF Staff Country Reports 2000, 045; 10.5089/9781451831825.002.A001

Source: Polish authorities, INS and staff estimates.1/ 1999 Wage data corrected for changes in social securtty contribution arrangement.2/ Q/(Q-4) growth.3/The band was widened from +/- 7% to +/- 10% on February 26, 1998, to +/- 12.5% on October 28, 1998, and to +/- 15% on March 24, 1999.

III. Macroeconomic Outlook for 2000 and the Medium term

19. The macroeconomic framework underlying the 2000 budget as well as staff projections show output growth above 5 percent in 2000, a modest strengthening of the external current account balance, and a decline in inflation (Table 2). These projections rest on key assessments, notably on export potential, wage behavior, and domestic savings and investment.

20. The authorities were confident of Poland’s export potential in 2000, despite the reported weakness of U.S. dollar export values for 1999 as a whole. In their view, the latter reflected more rigorous enforcement of coding guidelines for banks reporting BOP transactions from early 1999, the collapse of eastern markets, and the revaluation effect of the depreciation of the Euro vis-à-vis the U.S. dollar, rather than competitiveness or structural problems. The pick-up in exports towards the end of the year supported this view. Staff concurred, noting the absence of anecdotal evidence of major export difficulties and partner countries’ trade data which indicate appreciable growth of Polish exports in 1999. In 2000, Poland looks well-placed to take advantage of a projected improvement in eastern markets and the recovery in the EU. With evidence of excess capacity and new capacity coming on stream, the staff expect merchandise export values to grow by some 20 percent in 2000.

21. After peaking around 10 percent in early 2000, the authorities and staff project that 12-month inflation will fall during 2000 owing to tighter monetary and fiscal policies, the recovery of the zloty from its late 1999 lows, continued high productivity growth, and moderating international energy prices. Administered price increases and some acceleration in the price of food relative to nonfood prices were factored into the projections. There are no signs that nominal wage growth has—or will imminently—pick up in response to the overshoot of the 1999 inflation target. Instead, high unemployment rates, the budgetary commitment to nominal wage growth in 2000 of 6.7 percent for civil servants and 6.8 percent for other public sector employees, high labor productivity growth and firm macroeconomic policies would contain this risk.

22. Fiscal consolidation and the rebound in economic activity dominate the outlook for domestic savings and investment in 2000. Domestic savings should strengthen relative to GDP by about 1½ percentage points, a result of a planned fiscal adjustment relative to GDP of 1½ percentage points, the consequent partial offset in private savings rates, and an increase in corporate savings during the cyclical upswing. Both staff and the authorities project a return to double-digit fixed investment growth rates in 2000: increased corporate savings and higher economic growth rates should more than offset the effects of increased real banking interest rates. On these projections, staff expect the external current account deficit to fall to 6.9 percent of GDP in 2000, at the high end of the authorities’ forecast of 6–7 percent of GDP. Uncertainty about the causes of the weak December 1999 current account outturn, however, introduces added risk into this projection.

23. Looking beyond 2000, the outlook is for sustained high growth associated with sizeable current account deficits. Consensus estimates of Polish growth range from 5-7 percent, largely reflecting increased labor productivity and continued high investment rates. Markets, the authorities, and the staff all anticipate continued large Polish current account deficits because the gap between private investment and savings will remain large or even grow. Fixed investment will be buoyed by strengthening demand in the EU, prospective EU accession, and continued industry restructuring. Private savings, however, are unlikely to rise much. While rapid economic growth would boost household savings, prospective EU entry, financial sector reform, and improved employment prospects are likely to offset this effect. Corporate savings rates could strengthen further, but are already high by international standards.6 In this context, the authorities were confident that the prospective current account deficits could be readily financed: FDI inflows boosted by privatization receipts should amount to over half of the projected current account deficits to 2001; thereafter as privatization-related FDI inflows decline, portfolio inflows are likely to take up the slack.

A. Fiscal Policy

24. The authorities viewed the 1999 fiscal reforms as a major step in improving government efficiency and controlling expenditures, especially on transfers. Devolution has passed control over a large part of general government expenditure to people directly affected by those decisions. The establishment of public health funds separated buyers and sellers of health services and presaged an internal market in the public health service. In the education sector, control of schools up to the secondary school level was transferred to local governments. The pension reform—which includes a new mandatory private pension pillar—would diversify risks to pension funding across both the labor and capital markets through the use of the dual pay-as-you-go and funded pillars, and promote household management of savings in the long run. The reform largely leaves management of the deficit of the pension system at central level, but implementation has been troubled leading to deficit overruns in 1999. The authorities noted that, once bedded down, the reforms will substantially improve the targeting of government spending, without loosening effective central control of the general government deficit. Staff warmly welcomed the thrust of these reforms.

25. In this context, the planned fiscal consolidation in 2000 is the first step towards budget balance in the medium term. The general government balance is targeted to decline from 3.8 percent of GDP in 1999 to 2.7 percent in 2000. The underlying adjustment on the staff definition is, however, 1½ percentage points of GDP.7 The authorities project revenue as unchanged at 41.3 percent of GDP, the result of revenue neutral changes to tax policy. The adjustment thus reflects planned spending restraint, notably in the public wage bill and transfers, and lower interest costs. Investment spending is projected to rise relative to GDP. The authorities acknowledged that the planned fiscal adjustment was large, but felt this was needed to strengthen the external current account balance, curb inflation, and make progress towards medium-term fiscal goals. With the economy showing signs of a strong recovery, these considerations took on even greater force.

26. The authorities stated that the tax reforms to be introduced in 2000 aimed to strengthen Poland’s competitiveness, simplify the tax system, shift from direct to indirect taxation, anticipate EU requirements, and indirectly support the adjustment of public spending. Reduced-rate VAT was extended to previously exempt services, and excises continue to be raised towards EU norms. The rate of corporate income tax (CIT) in 2000 will be cut from 34 to 30 percent, alongside the elimination of investment incentives and the simplification and acceleration of depreciation allowances. The legislation also commits the authorities to reduce the CIT rate according to a fixed schedule to 22 percent in 2004. A parallel reform of the personal income tax (PIT) was vetoed by the President mainly on procedural grounds. Similar measures will be proposed to parliament for implementation from 2001, which will include a commitment to a fixed schedule of reductions in the main tax rates.8 Taken together, the reforms are expected to be revenue neutral. The authorities emphasized that the precommitments to cuts in direct tax rates signaled the direction of policy to investors and, alongside the fiscal deficit commitments, would provide essential momentum to public expenditure reform. Since decision–makers at all levels would be involved in making expenditure adjustments, the process required the momentum garnered by the fiscal deficit and tax reform commitments to succeed.

General Government—Budget and Official Projections

(In percent of GDP)

article image

See footnote 7 for explanations of the adjustments.

27. Staff welcomed the 2000 budget and the tax reform proposals. The targeted adjustment was appropriate and the macroeconomic assumptions underlying the estimates were rightly cautious. Confidence in the estimates was bolstered by the history of firm execution of spending ceilings in the state (central government) budget. Nevertheless, with the new fiscal systems operating in largely uncharted waters, the risks of expenditure overruns outside the state budget seemed substantial: it was not clear whether problems in 1999 with revenue collections in the FUS had been eliminated; although local governments are believed to have compressed spending in 1999, only partial data exist; and even if the assumptions for 1999 are correct, the staff wondered whether compression of local government spending would continue, as had been assumed in the projections.

28. The authorities noted that several steps had been taken to minimize the risks of slippages in the new fiscal systems. On ZUS (Social Security Administration), management had been changed and strengthened in mid-1999, data collection problems were being addressed (although this process would be slow), and the “one month” revenue loss would not be repeated. ZUS had also requested IMF technical assistance on data collection issues. On local governments, the authorities were confident that conservative financial behavior would continue, but a review of financial discipline measures was scheduled for 2000. The staff noted that tax and customs administration were still weakened by longstanding difficulties which could compromise the revenue targets, and retained concerns about deficit slippages outside the state budget. But staff noted that the conservative forecasts for state revenue and spending allayed fears that the adjustment for the general government would be substantially less than targeted. Staff underscored that if significant slippages emerged and the external current account shows no sign of stabilizing, it would be critical to take prompt corrective action, especially if inflation were also above target.

29. For the medium-term, the authorities are committed to eliminate the deficit in general government to make room for private investment without straining the current account position. The commitment helped to clarify fiscal prospects and support investor confidence.9 But the authorities underscored that if pressures on the current account did not subside, greater fiscal adjustment could be necessary. In light of the balanced budget target and the Revenue Expenditure Primary current expenditure Interest payments Capital expenditure Balance Public sector debt parallel commitment to reform taxes in a revenue neutral manner, staff projections suggest that current non-interest spending would need to fall from 38¼ percent in 1997-99 to 35¾ percent in 2001-03.10 The authorities stated that expenditure restraint was central to their plans and that the high level of social spending made it a prime focus. The 1999 reforms were a first step in this process.

Poland: General Government Finance, 1999-2003

(In percent of GDP)

article image

30. Staff welcomed the commitment to a balanced budget. They cautioned, however, that if the deficit targets were to be adhered to without resort to higher tax rates, early steps would be necessary to identify and secure savings by the central and local governments. In this regard, staff expressed concerns about the fiscal discipline on local governments where, in the context of significantly expanded spending responsibilities, current legal ceilings on borrowing were quite high. Though credit constraints now limited their scope to borrow these constraints were easing. Staff suggested that action be taken immediately before problems began: for example, limits on borrowing might be lowered and then gradually increased to current levels, central government transfers to local governments could be reduced when the latter borrowed excessively, and higher capital requirements could be applied on bank lending to local as opposed to central government. The authorities agreed to examine these suggestions in the imminent review of local government financing arrangements. Staff also suggested that some flexibility in the targets might be necessary to accommodate automatic stabilizers and that more publicity could be given to the commitments until they were firmly understood by the general public.

31. The authorities noted the difficulties some commentators had voiced during 1999 with the transparency of fiscal data. In particular, concerns had been raised with the reporting of transactions between the central and other levels of government. The authorities were eager to address all such concerns and requested IMF assistance in completing a fiscal transparency assessment during 2000. Staff supported the request and suggested that meanwhile some concerns could be mitigated if official commentary on the budget focused on the general government rather than the state budget balance. This would be consistent with devolution and would reinforce to the public that the macroeconomic effect of policies must be judged by the impact on the general government balance. Also, the collection and dissemination of data on operations of local government and on the newly devolved public health facilities should be accelerated.

B. Monetary and Exchange Regime Policies

32. Inflation is targeted to fall to the range of 5.4–6.8 percent by December 2000. The 1999 target having been overshot, the monetary authorities placed a high premium on meeting the 2000 target. In their view, an increase in official interest rates in late 1999 had been necessary for several reasons: headline inflation was substantially above the target and rising; the influence of special factors—rising oil prices and low food price increases—largely cancelled each other out; domestic demand was growing strongly and was being fed by an increase in household credit of some 50 percent; and given the lags in the effect of monetary policy on inflation the window for action to affect the 2000 target was closing. Because banking interest rates have been slow to respond to changes in official rates, a large adjustment that would force an early response and obviate the need for further small increases later was deemed desirable.

33. Reaction to the increase has been positive. Banking interest rates rose approximately in line with official interest rates, and the yields on medium-to-long term government paper dropped following the action, signaling a renewed confidence in the prospects for disinflation in the medium term. The MPC was confident the action had been sufficient to meet the 2000 target and ensure progress toward the medium term target. Nevertheless, fiscal, trade, and agricultural policy actions could still exert a substantial influence on the 2000 inflation outturn. The MPC was therefore actively publicizing the implications of decisions in these areas for inflation. Staff agreed that the inflation target was within reach given anticipated economy-wide labor productivity growth and nominal wage growth of 5 and 11 percent respectively. But much would depend on how nominal wages would respond to recently increased inflation. Thus, it was critical that public sector wage policy and decisions on import tariffs and agricultural price support should buttress the disinflationary effort.

34. The MPC was not concerned about potential conflicts between the recent or any possible future increases in interest rates and avoiding pressure on the external current account. The MPC emphasized that it had been formally charged to target inflation. Even if monetary policy played a part in determining the real exchange rate and the current account imbalance in the short run, fiscal policy had a larger effect on the underlying savings and investment decisions. Staff, while agreeing on the primacy of the focus on inflation, emphasized that in an environment of large fiscal and current account deficits decisions on interest rates had to take into account effects of capital flows, the exchange rate and ultimately the current account. Thus, in the near term, when inflation is likely to remain at current levels or even to rise further, any consideration of a further increase in interest rates would have to be weighed carefully against the likely effect on the current account.

35. The monetary authorities target inflation below 4 percent in 2003. This will complete Poland’s progressive disinflation process and set the stage for eventual entry into EMU. In pursuit of this objective, the inflation targeting framework for monetary policy was being strengthened. From 2000, inflation reports would be published on a quarterly basis rather than annually, and research on inflation was being extended. Staff agreed that the inflation target was appropriate and consistent with inflation rates in partner countries while allowing scope for Balassa-Samuel son effects.

36. Staff discussed additional steps to strengthen the inflation targeting apparatus. Specifying the inflation target range for each year until 2003, rather than only one year ahead would help convey the authorities’ intentions to markets. To avoid the complete reconstitution of the MPC when all the current members’ terms expire in 2004, members’ terms in office should be made to overlap and provision should be made for reappointments. And staff agreed with the authorities that completion of bank privatization is necessary to ensure full effectiveness of the transmission of official to banking interest rates. The authorities felt that the medium term inflation target provided a clear anchor for medium-term inflation expectations, though a path to that goal could strengthen it further. The step reconstitution of the MPC was undesirable but it is enshrined in law which would be difficult to change.

37. Abolition of the exchange rate band remained under active review. 11 The monetary authorities favored abolition of the band to establish the “purity” of the inflation targeting regime. For the most part, they were not persuaded that the band was a bulwark against excess appreciation of the zloty. Staff suggested that the band was so wide that possible conflicts with the inflation target seemed unlikely, but agreed that the role of the band in capping appreciation pressures was probably small. The band may play a residual role in guiding market assessments of the appropriate value for the zloty and in guiding inflation expectations, though neither of these arguments for retaining the band was overwhelming.

38. The authorities decided, subsequent to the mission, to delay the abolition of the remaining controls on capital flows. These controls require prior NBP approval of non-bank short-term capital flows and were scheduled for abolition at end-1999 under a 1996 agreement with the OECD. The authorities were concerned that the scheduled timing was inappropriate: they expected the removal of controls to appreciate the zloty and to generate higher capital inflows, higher external debt, and greater vulnerability. They had examined the possibility of price-based controls on short term capital flows and concluded that these would be ineffective in Poland. Staff argued that the sizeable offshore spot and forward markets in the zloty alongside unfettered access for residents to foreign currency deposits and credits from domestic banks meant that the remaining exchange controls did not constitute much of an impediment to speculative pressures on the zloty or the accumulation of foreign debt. Abolition would, however, promote the development of domestic financial markets, improve monitoring of foreign exchange transactions, and facilitate hedging. While abolition should be postponed until possible Y2K problems had been resolved and the current account balance had declined sustainably below 7 percent of GDP, further delays seemed unwarranted.

39. The NBP intended to continue to refrain from intervention in foreign exchange markets—a position staff strongly supported. Following elimination of the daily exchange rate “fixing” in mid-1999, the NBP had only sold foreign exchange to the government to cover its foreign debt servicing obligations. The exchange rate otherwise floated freely. Staff agreed with the authorities that the volatility of the exchange rate, even over the past year, had not been excessive but had promoted responsible hedging. To preserve the principle of non-intervention, staff suggested sales of foreign exchange to cover government debt service should be matched by purchases in the market. The authorities were concerned that privatization receipts if not fully sterilized could distort the foreign exchange market. Accordingly, plans were being made to put some receipts from non-residents in a special account in the NBP to be held against future debt service. Staff suggested that large privatization receipts had been absorbed during 1999 without evidence of a distorting effect on the foreign exchange market. If, however, the special account were activated, it should be managed according to strictly defined rules that would eliminate the risk that the account would be used even implicitly to manipulate the exchange rate.

40. While the large current account deficit is a source of vulnerability, staff agreed that other key indicators put Poland at the safest end of the spectrum (Table 6). Current gross reserves covered seven months of imports and 400 percent of short-term debt. This level struck an appropriate balance between the cost of holding reserves and the need to provide investors with a signal of financial strength. Alongside Poland’s robust performance on other indicators of vulnerability, including the ratio of reserves to broad money and external debt, the authorities saw no need to participate in the CCL (Table 6).

41. Banking and financial sector supervision was being continually strengthened. The banks remained well capitalized, on average reporting capital of 16 percent of risk-weighted assets. In mid-1999, 60 percent of equity in banks was foreign owned. The banks had been little exposed to Russia in 1998 and had weathered recent exchange rate and interest rate shocks well. Regulators were alert to prudential risks that could emanate from rapid growth of credit to households, but no signs of strain were yet apparent. Vulnerabilities have been examined with Fund staff on several occasions, including during the 1998 Article IV Consultation, and on each occasion the assessment was favorable. But staff underscored that the challenges arising from possible large capital inflows and the development of the non-bank financial sector spawned by the recent three-pillar pension reform meant that Poland could gain from a full Financial Sector Stability Assessment. The authorities agreed to consider this proposal.

Table 6.

Poland: Indicators of External Vulnerability

(In percent of GDP, unless omerwise indicated)

article image
Sources: Polish authorities and staff estimates.

End-of-period.

Backward-looking with actual CPI.

By original maturity.

CPI based.

In Standard & Poor’s rating system BBB- is investment grade whereas BB is below.

Spread on Polish bond 7 3/4 coupon expiring 07/00 and US Treasury 5 7/8 coupon expiring 06/00.