Republic of Poland: Staff Report for the 2002 Article IV Consultation
Author: International Monetary Fund
Publication Date:
26 Jun 2002
eISBN:
9781451831849
Language:
English
Keywords:
ISCR; CR; government; arrears; deficit; rate; inflation expectation; foreign currency; public spending; broad money; current account; privatization proceeds; fiscal policy
Download PDF (1.6 MB)

This 2002 Article IV Consultation highlights that the fiscal deficit of the Republic of Poland widened sharply in 2001, reflecting both automatic stabilizers and a ½ percent increase in the structural deficit. State (central government) primary expenditures (excluding one-off transfers) rose relative to GDP by 1 percentage point, notwithstanding cutbacks late in the year. Two factors accounted for this rise: significant increases in transfers and subsidies to households, agricultural and state enterprises, as well as wages; and outcomes for inflation and growth that were far below budget projections.

Abstract

This 2002 Article IV Consultation highlights that the fiscal deficit of the Republic of Poland widened sharply in 2001, reflecting both automatic stabilizers and a ½ percent increase in the structural deficit. State (central government) primary expenditures (excluding one-off transfers) rose relative to GDP by 1 percentage point, notwithstanding cutbacks late in the year. Two factors accounted for this rise: significant increases in transfers and subsidies to households, agricultural and state enterprises, as well as wages; and outcomes for inflation and growth that were far below budget projections.

I. BACKGROUND

1. Poland has weathered a difficult two years. Following exogenous shocks (Russia crisis and oil prices), an aggressive policy response to rising consumption growth in 1999 and early 2000, and a downturn in Germany, output growth slumped from 4 percent in 2000 to 1 percent last year (Figures 1–2, and Table 1). The slowdown has taken a toll: lay-offs, coupled with a surge in school leavers, have raised the unemployment rate back to the high teens; the fiscal deficit has widened sharply; and the stock of non-performing bank loans has risen. The accompanying progress in lowering inflation and the current account deficit—the threats to prosperity of yesteryear—has done little to improve sentiment. Frustration is evident in the complete wipeout of Solidarity Electoral Action (the majority coalition partner) in last September’s elections. And, playing off this frustration as well as genuine concerns about high real interest rates especially in late 2000 and early 2001, fierce attacks have been made on the MPC, through a Parliamentary censure and threats to alter the structure of the MPC.

Figure 1.
Figure 1.

Poland: Selected Economic Indicators, 1991-2001

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Sources: Polish authorities and staff estimates.1/ Registered unemployment, annual averages.
Figure 2.
Figure 2.

Poland: Indicators of Fiscal and Monetary Policy, 1997-2002

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Source: Polish Authorities.1/ On commitment basis.2/ ECB fixed rate until July 2000, after that minimum bid rate is used.3/ Policy rate deflated by inflation over the past 12 months.
Table 1.

Poland: Selected Economic Indicators

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Sources: Polish authorities and staff estimates.

For 2001, cash basis.

Data for 1996-98 covers central government debt only.

uA01fig01

Poland: Year-on-Year Growth in Real Private Consumption, 1998-2001

(In percent)

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

2. At the heart of the slowdown was a collapse in investment (Figure 3). This largely reflected postponement and cancellation of projects by enterprises due to high borrowing costs, decelerating demand and low profitability. But even before its recent plunge, investment growth had weakened ahead of the domestic and external downturn, probably reflecting a slowing of post-transition obsolescence and the high ratio of investment to GDP. With non-privatization FDI remaining strong (Table 2), it appears that domestic investors are the ones holding back.

Figure 3.
Figure 3.

Poland: Balance of Payments Indicators, 1997-2001

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Sources: National Bank of Poland, the Central Statistical Office and staff estimates.1/ Derived on the basis of seasonally adjusted exports and imports. Defined as the deficit.2/ Quarterly data are available only from 1999 for extemal debt, and from 1998 for gross official reserves on the current official definition of reserves.
Table 2.

Poland: Balance of Payments, 1997-2005

(In millions of US dollars)

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Sources; NBP and Staff Estimates.

Net oil related imports are defined as net imports of mineral fuels, lubricants, and related materials (SITC section 3), using customs data.

Defined as external liabilities minus external assets, both exclusive of equity portfolio and direct investment.

uA01fig02

Year-on-Year Real GDP Growth

(in percent)

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

3. By 2001, weakening growth was cushioned by a considerable easing of fiscal and monetary policies. The general government deficit widened sharply in 2001, reflecting both automatic stabilizers and an increase in the structural deficit. State (central government) primary expenditures (excluding one-off transfers) rose relative to GDP by 1 percentage point, notwithstanding cutbacks late in the year. Two factors accounted for this rise: significant increases in transfers and subsidies to households, agriculture and state enterprises, as well as wages in an election year; but also outcomes for inflation and growth that were far below budget projections. Together with a cyclical slowing of revenues, this led to a general government economic deficit provisionally estimated by the staff at just under 5 percent of GDP, up from 2.6 percent of GDP in 2000 (Table 3).1

Table 3.

Poland. General Government Revenues and Expenditures

(In Percent of GDP)

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Sources: Polish authorities, and Staff estimates.

For 2001, cash basis.

Fiscal Developments 2001-2001

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For 2001, cash basis.

PSBR corresponds ID general government balance less. privatization proceeds.

4. Falling inflation and inflation expectations permitted deep cuts in interest rates (Figure 4). Headline inflation dropped from 11½ percent year-on-year in mid-2000 to 3½ percent at end-2001, well below the target range of 6–8 percent and indeed the end-2002 target of 5 percent, ±1 percentage points (Figure 5). Seasonally adjusted inflation in the first quarter of 2002 was less than 1 percent. A favorable harvest and declines in international oil prices last year helped; but inflation excluding those prices was some 4 percent year-on-year, and -0.5 percent in the first quarter of 2002. After some hesitation, monetary policy has been eased significantly: the key policy interest rate has been cut by 950 basis points since February 2001. However, with inflation having fallen sharply, real policy interest rates (deflated by either current or projected one year ahead inflation) at some 6 percent are high. Credit growth remains anemic (Table 4, Figure 6).

Figure 4.
Figure 4.

Poland: Spreads and Yield Curves, 1997-2002

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Source: Bloomberg.1/ Spread on US$ denominated 30 year bond and Republic of Poland US$ Brady bond maturing in 10/2024.2/ Emerging Markets Bond Index.3/ Nine-year bond yields used in 2002 instead of 10-yr yields.
Figure 5.
Figure 5.

Poland: Indicators of Inflation, 1997-2002

(12-month growth, in percent, unless otherwise stated)

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Source: Polish Authorities.1/ Three-month moving average annualized.
Figure 6.
Figure 6.

Poland: Indicators of Money and Credit, 1997-2002

(12-month growth)

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Source: Polish authorities.1/ Data for June 2000 are corrected for the effect of a privitization bid.2/ Deflated using CPI excluding food and fuel.
Table 4.

Poland: Monetary Survey, 1996-2001

(In billions of zlotys)

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

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

5. Despite the interest rate cuts, the real exchange rate has appreciated considerably, heightening vulnerability to shifts in market sentiment. The CPI-based real effective exchange rate has appreciated by some 25 percent since end-1999 (Figure 7), of which at most 6 percentage points can be attributed to Balassa-Samuelson effects. Also, despite labor shedding and wage moderation, relative unit labor costs have risen markedly. Beyond threatening further export volume expansion, the strong zloty and wide interest rate differentials have promoted a rapid rise in household foreign currency borrowing from domestic banks. With little evidence of hedging, this has heightened banks’ credit risk.

Figure 7.
Figure 7.

Poland: Indicators of Profits and Competitiveness, 1997-2002

(January 1997=100)

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Source: Polish authorities, Information Notice System, and Staff Calculations.1/ Trade weights for 1999 for Austria, Belgium, Denmark, Finland, France, Germany, Italy, Japan, Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom and United States.

6. The slide in investment coupled with resilient private savings cut the current account deficit. Despite the appreciating zloty and weakening external demand, export volumes expanded by 6 percent in 2001, well ahead of export market growth. Enterprises have accepted lower profitability to maintain market share. With activity subdued, import growth was weak, allowing the current account deficit to narrow to 4 percent of GDP.

7. Unemployment in Poland is among the highest in the OECD, reflecting structural and cyclical factors. After dropping to 10 percent in mid-1998, unemployment has risen to some 18 percent (Figure 8). In contrast, the unemployment rate is 8 percent in the Czech Republic (where labor force participation is much higher) and 6 percent in Hungary (though its participation rate is lower). Demographic factors have contributed to the rise in unemployment in Poland, with the working age population increasing by around ¾ million (close to 3 percent) since 1998. But more important was an 8 percent drop in employment since end-1998—a loss of more than a million jobs. The slowdown in activity, labor shedding by privatized enterprises after employment guarantee periods and the shakeout following the Russia crisis all have contributed. At the margin, high wage costs probably also are pricing workers out of jobs: whereas unit labor costs have trended downwards in other accession countries, they have remained high in Poland (Figure 9).

Figure 8.
Figure 8.

Poland: Indicators of Employment and Unemployment, 1997-2002

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Sources: Polish Authorities and Staff Calculations.1/ The quarterly Labor Force Survey was not undertaken in Q2 and Q3 of 1999.2/ The Mazowieckie region incompasses Warsaw.
Figure 9.
Figure 9.

Poland: Unit Labor Costs For Advanced EU Accession Countries, 1995-2001

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

Source: OECD.

II. REPORT ON THE DISCUSSIONS

8. The authorities confirmed the priority the new government attaches to regenerating growth and cutting high unemployment. Like many observers, they saw Poland’s annual growth potential at 4–5 percent, a rate that if sustained over time would rekindle job creation. They were committed to adjusting macroeconomic policies to preserve underlying gains in inflation and the current account deficit. Central to this effort was a rule limiting spending increases in future budgets, cutting to the quick of Poland’s fiscal problem—excessive spending and high taxation. The authorities also pointed to their medium-term plan for structural reform (“Entrepreneurship-Development-Jobs”) as key to their strategy for regenerating growth: the wide-ranging plan was a blueprint for eliminating institutional impediments to job-creation and growth of small and medium-sized enterprises, spearheading infrastructure development, and reining in social transfers. Considerable tension attached to further reductions in interest rates, which the government viewed as essential to support their program, and the MPC on balance viewed as risky for inflation. The new administration was skeptical about the benefits of further large-scale privatization and preferred to give priority to enterprise restructuring. While targeting a reduction in public ownership by half to 10–15 percent of GDP by 2005, the authorities expected to sell shares in enterprises selectively and mainly outside the financial sector.

9. The new government has firmly embraced the goal of early EU accession. The authorities were confident that EU accession by early 2004 was feasible and are directing considerable effort toward putting in place the institutional infrastructure to absorb EU funds. Internal debate had started on a schedule for adopting the Euro, and the authorities were considering how to mesh policies with the Maastricht criteria.

A. Outlook for 2002 and the Medium-Term

10. Recent indicators suggest that Poland is poised for a recovery. Lagged effects of the stimulus from fiscal and monetary policies last year and the anticipated pick-up in Germany should cement a recovery in the second half of the year. Nevertheless, with a weak first half expected, the authorities and staff agreed that average output growth for this year would only be at or somewhat above last year’s 1.1 percent, while unemployment would rise. Even with a pick-up in demand in the second half, pressures on the current account should be limited. Views diverged on the outlook for inflation. The authorities expect end-year inflation to be above 4 percent, reflecting a pick-up in demand pressures as well as food and fuel prices. Staff noted, however, with seasonally adjusted inflation now running at about 1 percent, a considerable acceleration of inflation would still leave year-end inflation closer to 3 percent.

uA01fig03

Poland: Indicators of Business Sentiment

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

11. Beyond 2002, Poland’s growth prospects are strong, though much depends on the forceful implementation of reforms. The authorities’ medium-term program envisages growth rising to 3 percent next year and 5 percent in 2004, driven by sharp increases in investment. Staff was somewhat less bullish (Table 5). Growth has been well below potential—which the staff estimates at 4–4½ percent—since mid-2000, and considerable slack now existed. Yet, staff felt that without a more pronounced rebalancing of the policy mix to lessen pressure on the real exchange rate, greater flexibility in labor markets and an acceleration of privatization, returning to potential would be slow.

Table 5.

Poland: Savings and Investment Balance, 1997-2006

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Sources: Polish authorities and staff estimates.

Commitment basis. See footnote on page 4 for definition.

Defined as external liabilities minus external assets, both exclusive of equity portfolio and direct investment.

12. This debate underscored the high uncertainty about the outlook for investment and, ultimately, the current account. At 19 percent of GDP, private fixed investment in Poland is the lowest among the leading EU accession countries. There was consensus that some pick-up in investment from last year’s depressed levels is likely, as enterprises will, at a minimum, invest to upgrade product quality and remain competitive. Beyond that, views differed somewhat. The authorities’ program envisages gross investment increasing to 27 percent of GDP by 2006. Reflecting rising incomes, they expect private savings also to grow, allowing the current account deficit to fall below 2½ percent of GDP. Staff projections show a more gradual recovery in private fixed investment to the levels of the late 1990s. This takes into account currently low capacity utilization and the TFP-driven nature of Poland’s past growth. Staff also argued that higher enterprise savings, as profits recover against the backdrop of a weak bargaining position for labor, are likely to be matched by a deterioration in household savings as prospects for permanent income rise with EU accession. With considerable increases in the private investment-saving imbalance, shrinking government deficits would be essential to curbing an increase in the current account deficit.2

uA01fig04

Private fixed investment in select CEE accession countries in percent of GDP

Citation: IMF Staff Country Reports 2002, 127; 10.5089/9781451831849.002.A001

B. Fiscal Policy

13. The discussion centered on the need to tackle the long-elusive fiscal adjustment. The sharp deterioration in public finances in 2001 has heightened the urgency of this adjustment. The authorities acknowledged that unless the PSBR is reduced, public debt would quickly rise to the 60 percent of GDP constitutional limit, from the present 43 percent. Staff stressed that failure to curb the deficit could impede credit growth to the private sector or, should private investment take-off, unleash a renewed widening of the current account deficit. The authorities and staff agreed that a successful fiscal adjustment absolutely required reining in the high level of spending, particularly on transfers to households (Box 1).

14. The 2002 State (central government) budget curbs spending growth, but the PSBR will remain high. The authorities pointed out that, given the time constraint, their draft State budget, submitted to Parliament in November, had merely sought to re-shape the draft submitted by the outgoing government at end-September. State primary expenditure growth was limited to some 4 percent, compared with last year’s estimated 14 percent. Numerous measures—including a public sector wage freeze, cuts in some benefits, and delays in introducing new spending initiatives—contributed to limiting spending growth. New taxes (notably, an excise on electricity and a tax on interest income) were introduced, and the coverage of other taxes was broadened. Considering the Ministry of Finance’s revenue projections overly pessimistic, Parliament subsequently increased State expenditures by Zl 1 billion (0.15 percent of GDP). For the general government, the authorities envisage an economic deficit of 4.9 percent of GDP. Staff considered the 2002 budget reasonable, and even thought a lower economic deficit likely on the basis of higher (State) revenue projections. It, however, noted that local government spending increases would need to fall from 14 percent last year to under 3 percent. The authorities argued that most government spending comprised wages and the wage freeze would facilitate the projected moderation. Staff estimates show that, if implemented strictly, the 2002 budget should more than reverse last year’s structural slippage.

Fiscal Outlook 2002

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For 2001 cash basis

PSBR corresponds to general government balance less privatization proceeds

15. For subsequent years, the authorities have announced their intention to limit total State spending increases to the projected increase in the CPI plus 1 percent—a rule that (though without legal force) will be the anchor for public finance. Previous medium-term frameworks in Poland focused on targeting reductions in the general government economic deficit. This objective had not been realized because of unexpected weakness in the economy as well as poor expenditure control. Against this backdrop, the authorities argued that the expenditure rule focused on Poland’s essential fiscal problem—high and rising public spending—and on a policy variable that could be controlled through the cycle. Moreover, provided growth picked-up, it would deliver increased public savings. Staff agreed with this assessment and welcomed the “CPI plus 1 percent” rule. But it also suggested some technical changes to improve the framework, including committing to an explicit nominal spending path to prevent expenditure base drift in the event inflation were overpredicted. The authorities acknowledged that the framework could be improved, but stressed that an important consideration in designing the rule had been simplicity and the ease with which it could be explained to the public.

Public Expenditures in Poland

The level of public expenditures and, in particular, social transfers in Poland, is high. In part, this is a legacy of socialism: Begg and Wyplosz (1999) show that government transfers and consumption for many transition countries are higher than the OECD average, as suggested by the correlation of government transfers and per capita income (top panel, see also Christou and Daseking, 2000).1 Even by transition country standards, however, transfers in Poland are higher.

Elevated expenditure levels have implied high taxes. Given the difficulty in taxing capital, this burden has tended to fall on labor income. Payroll taxes in Poland are close to the OECD average—not where a country with Poland’s unemployment rate should be, given the positive correlation between taxes and unemployment (lower panel). The figure also makes it clear, however, that high unemployment in Poland is not due merely to the tax wedge.

1/

David Begg and Charles Wyplosz, “How Big a Government? Transition Economy Forecasts Based on OECD History,” mimeo, September, 1999 and Costas Christou and Christina Daseking, “Balancing Fiscal Priorities: Challenges for the Central European Countries on the Road to EU Accession,” forthcoming, 2002.

16. The mission questioned whether the “CPI plus 1 percent” rule had a broad enough coverage. Staff agreed that with unchanged tax policies and even quite conservative assumptions on growth, successful application of the rule should reduce the fiscal imbalance sufficiently to stabilize the debt ratio (albeit at about 50 percent of GDP) and preserve a manageable current account position. Nevertheless, it questioned whether a more ambitious approach would not be better. Baseline simulations assumed that spending by non-State government entities (accounting for ½ of general government spending) would grow, as in recent years, by just over 3 percent in real terms. But extending the “CPI plus 1 percent” rule to spending outside the State sector would have three advantages. First, it would eliminate the risk that the rule could be subverted by shifting spending from State to local authorities. Second, it would deliver a stronger reduction in the PSBR and debt, even leaving room for tax cuts accounting for some 2 percentage points of GDP. Third, it would be a more even-handed approach to reining in overall government spending. However, the authorities felt that extending the rule to local government spending would be difficult in light of the lumpiness of some local government spending and would unduly complicate an otherwise simple rule. They preferred to rely on the existing constraints on local government—ceilings on debt and debt servicing—to restrain their spending.

Poland: Alternative Medium-term Fiscal Scenarios. in percent of GDP

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17. The authorities acknowledged that the success of the “CPI plus 1 percent” rule would depend critically on streamlining social transfers, where poor targeting is a problem. Staff questioned if the 2003 budget would adhere to the “CPI plus 1 percent” rule in light of possible delays in difficult legislative changes and the need to reverse the stop gap measures used to limit spending in 2002. The authorities explained that working groups had been formed to review the efficacy and efficiency of public expenditures. They would shortly report their findings, and legislative proposals would be formulated. The groups were examining many aspects of public finance, including pension benefits, eligibility for disability payments and public sector employment.3 The authorities confirmed their commitment to securing the legislative changes in programs as needed to stick to the spending rule. Staff noted that cuts of this nature would be essential in light of plans to increase future infrastructure spending.

C. Monetary Policy

18. Monetary policy discussions were complicated by on-going threats to amend the NBP’s mandate and the structure of the MPC. In the event, Parliament has passed a non-binding resolution blaming the MPC for the growth slowdown and high unemployment and calling on the Council to support the government’s economic policies. More intrusive legislation remained under discussion following the MPC’s decision not to cut rates in March. The mission expressed strong concerns about these developments. It stressed that the results of the hard-fought battle to tame inflation would be imperiled unless the principle of non-interference in the NBP and MPC, particularly with regard to setting interest rates, were placed beyond question. Staff also called for the traditional channels of communication between the government and the NBP to remain open for constructive dialogue. Aside from a vociferous group of Parliamentarians urging large interest rate cuts, the mission found that the debate on monetary policy had shifted to what scope remained for modest rate cuts.

19. The authorities and staff agreed that monetary policy decisions should be based on the end-2003 target of inflation below 4 percent. Neither the authorities nor staff saw any reason to reflate back to the targeted mid-point of the 4-6 percent range for end-2002. The authorities argued that the sharp deceleration in inflation last year owed much to the weak economy, strong zloty, and favorable supply-side influences: most expected inflation to rise back to 4–5 percent in 2002 as the economy recovered. Nevertheless, they were pleased by how well inflation expectations had responded to monetary policy. Some MPC members, pointing to the absence of demand pressures and the benign inflation outlook, were inclined to see some scope for further reduction in interest rates. Others felt that lower inflation expectations were not yet fully secure. In this view, threats to the inflation outlook included: (i) a possible rebound in food and fuel prices; (ii) recent declines in household bank deposits (though it was unclear whether this reflected an incipient consumption boom or a shift to alternative financial instruments induced by the new tax on interest income); (iii) a rapid increase in cash holdings; and (iv) uncertainties regarding fiscal policy in 2003. In April, after the mission, the key policy rate was cut by 50 basis points.

20. The staff was more sanguine about the inflation outlook but argued that any rate changes should be made cautiously to avoid an overshoot. The large cuts over the past year and their cumulative effects needed to be assessed carefully. But staff also noted that threats to inflation were modest and counterbalanced by the likely persistence of a sizable output gap for sometime. Temporary supply shocks could be in either direction and policy should neither anticipate nor react to them. Staff analysis shows that such price shocks in Poland, typically to food and fuel, have transitory effects on headline inflation (Box 2). Beyond the outlook for inflation, staff felt that other effects of high interest rates should not be overlooked. Specifically, rate differentials vis-à-vis industrial countries together with the persistent strength of the zloty were leading to unhedged foreign currency borrowing from domestic banks that was subjecting banks to heightened credit risk.

21. A new medium-term inflation target and changes to tailor the IT framework to a low inflation environment would be considered alongside the broader issue of adopting the Euro. Informal views of the monetary authorities tended toward early adoption of the Euro in order to reap the benefits of aligning Poland with a low-inflation and disciplining policy environment. Finance Ministry representatives were more concerned about the implications of the current value of the zloty, which they viewed as too strong for an early entry. In any event, the monetary authorities and staff agreed that a new medium term inflation target (to replace the current one which extends only through 2003) of 3 percent would be appropriate; it would likely be consistent with the Maastricht criteria while allowing room for ongoing relative price adjustments. Staff argued for wide bands—even ± 2 percentage points around the central rate—and for replacing the end-year target with a continuous one. The MPC agreed, but preferred bands closer to the current ±1 percentage point as wider bands would undermine usefulness of the target.

22. The MPC intended to continue refraining from direct intervention in the foreign exchange markets. They felt that the strength of the zloty owed as much to the drop in the current account deficit as to the tight monetary stance. They pointed to the continued strength of the currency, despite the near halving of the interest differential vis-à-vis the euro and U.S. dollar. While concerned about the implications of the strength of the zloty for competitiveness, they thought cyclical changes in productivity growth, which would be reversed with a recovery, had also influenced enterprise profitability. They did not believe that direct intervention could change the value of the zloty in a lasting way. While agreeing, staff felt that a rebalancing of the policy mix to tighter fiscal and easier monetary conditions so as to reduce pressure on the zloty would also be important for exporters’ profits. Staff supported the policy of non-intervention, noting that some degree of exchange rate volatility was desirable to discourage open foreign currency positions. Recently, the government has spoken out in favor of direct intervention and would like to come to an agreement on this matter with the MPC.

D. Financial Sector Risk and Vulnerability

23. The decline in the current account deficit has attenuated vulnerability, but other risks have emerged. The reduction in the current account deficit to some 4 percent of GDP—even less if part of the large positive errors and omissions inflows reflect current transactions—has reduced Poland’s net reliance on foreign creditors. Further, at US$27 billion, reserves continue to cover 7½ months of imports and 280 percent of short-term debt (Table 6). Discussion focused on other sources of vulnerability that have emerged, particularly in the banking system.

Table 6.

Poland: Indicators of External Vulnerability

(In percent of GDP, Unless Otherwise Indicated)

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Sources: Bloomberg, Polish authorities, and staff estimates.

Data for 1999 and beyond covers general government debt; data for earlier years includes central government debt only.

End-of-period.

Backward-looking with actual CPI.

By original maturity.

CPI based, using 1999 trade weights.

In Standard & Poor’s rating system BBB- is investment grade whereas BB+ is below. Date of latest observation refers to dale of latest change.

Spread on Polish bond 7 3/4 coupon expiring 07/2000 and US Treasury 5 7/8 coupon expiring 06/2000.

Spread on Polish bond 6 coupon expiring 03/2010 and German bond 5 1/4 expiring 07/2010

Spread on Polish brady bond PDI10/2014 and US Treasury coupon 11/3/4 maturing 11/2014.

Temporary Supply Shocks and Inflation in Poland

A persistent concern in Poland is the effect of food and fuel prices on headline inflation. Shocks to these prices over the last two years have been a source of significant upward and more recently downward pressures on the headline CPI, which the authorities target. Thus, gauging the impact and duration of shocks to these prices on headline inflation is important. These can be quantified with the aid of a VAR model comprising headline CPI, NETCPI (the headline index excluding food and fuel prices) and FFCPI (the food and fuel price index) (Hoffmaister, 2001) 1 The response of headline inflation to a shock in food and fuel prices is then discerned by comparing its evolution with and without a shock.

Staff estimates show that shocks to food and fuel prices have a significant impact on headline inflation only in the short-run. Specifically, a 1 percentage point shock to food and fuel prices raises headline inflation by about 0.4 percentage point after 1 month and this effect dies out quickly, disappearing within about a year (Figure, left panel). The price level, however, remains commensurately higher or lower depending on the direction of the shock. The approximate first-round impact of the shock is gauged by comparing the response of CPI to that of NETCPI (Figure, right panel). This suggests that to the extent monetary policy in Poland focuses on inflation 12 or more months ahead, the effect of food and fuel supply shocks can be largely discounted.

1/

Hoffmaister, Alexander, “Inflation Targeting in Korea: An Empirical Exploration,” IMF Staff Papers, Vol. 48, No. 2, 2001, pp. 317–13.

24. Staff and the authorities agreed that the banking system is generally sound. The authorities noted that non-performing loans (NPLs) had risen from some 13 percent of total loans at end-1999 to 17½ percent at end-2001 in response to the economic slowdown. They pointed out, however, that the classification of NPLs in Poland—requiring banks to mark as non-performing loans to creditors whose “economic” conditions have deteriorated even if they continue to service the loans on time—was more stringent than in many other countries. Excluding this class of impaired loans, the ratio had risen from 8 to almost 13 percent since end-1999. Moreover, they emphasized that the banking system is profitable and strongly capitalized with an average risk-weighted capital adequacy ratio of 15 percent, up from 13 percent at end-2000.

25. The mission asked about recent increases in banks’ foreign currency loans (FCL) to the private sector and whether the authorities were satisfied that they were adequately hedged. Total FC and FC-linked loans stood at US$14½ billion or some 8 percent of GDP at end-2001, up from US$11 billion at end-2000.4 The authorities noted that most of the new FCLs are long-term—typically for housing, but also for consumer durables or small enterprises. While the authorities acknowledged that FCLs to households are probably infrequently hedged, clauses that permit changes in currency denomination for a small fee constitute a built-in “safety-valve” for borrowers. The authorities expected demand for such loans to decelerate with falling interest differentials. Staff noted that the share of such loans in Poland is relatively high. In the event of an unexpected exchange rate change large-scale switches in currency denomination would shift exchange risk to banks. It is critical that banks appropriately price this risk. The NBP, already strengthening its stress testing capabilities with MAE technical assistance, decided to form a working group to examine these concerns.

Foreign Currency Loans (FCL), in percent

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Sources: Authorities, and Barajas and Morales (2002).

26. The authorities have decided to remove remaining controls on short-term capital flows with other OECD countries from October 2002.5 Originally planned for 1999, the removal of the controls on holdings—by non-bank residents and non-residents—of assets and liabilities with an original maturity of less than one year has already been delayed once. Staff welcomed the plan, agreeing that the effectiveness of controls has been limited; residents already have full access to FX credits through domestic banks and fairly liquid short-term zloty markets in major financial centers exist.

E. Structural Policies

27. The authorities attributed the high level of unemployment to cyclical, structural and policy-induced factors in about equal parts. Attaching considerable concern to the latter, the new government has put before Parliament a legislative program to revise the labor code to make it easier for employers to use fixed-term contracts, permit more flexibility in working hours, and cut overtime pay. In addition, the authorities are considering lowering the minimum wage for first-time labor market entrants. Plans are also afoot to exempt employers from their share of social security contributions (some 20 percent of gross salary) for up to one year for hiring school leavers. Staff welcomed the proposals to amend the labor code and differentiate the minimum wage for the young, but was skeptical about the benefit of a time-limited exemption of employers from social security contributions. Also, it noted that distortions in the labor market reportedly stemming from myriad detailed regulations and urged that further efforts to identify and change them be made. As the regional disparity in unemployment is large, it pressed for differentiating the uniform national minimum wage across regions, possibly on the basis of local unemployment levels. The authorities agreed that fully addressing labor market rigidities was an ongoing job.

28. With most of the easy-to-sell enterprises already disposed of, the authorities emphasized that most of the remaining state owned enterprises would be less likely to attract buyers absent further restructuring. Accordingly, the authorities intend to pursue a sector-specific restructuring and privatization strategy. In the heavily indebted and loss-making steel sector as well as mining, they intended to address the difficulty of finding buyers for individual enterprises in the current environment, by bundling individual entities into conglomerates, cutting costs, and making them available for privatization. Staff, however, questioned whether there were synergies that would help cost rationalization, and feared the strategy might even make the newly created entities less flexible and thus less attractive to buyers. More generally, the authorities raised questions about the economic benefits of privatization, beyond helping finance the fiscal deficit. They noted that privatized entities had tended to replace domestic suppliers with foreign ones, adding to the unemployment burden. In the telecom sector, the state owned company had been sold to a foreign public owned company. Staff noted the authorities’ concerns about the tendency for privatized enterprises to switch suppliers, and wondered whether it might not be a short-term dislocation from privatization. It advocated strong regulatory controls over any domestic or foreign-owned monopoly.

29. In banking, in view of the already high foreign ownership (70 percent of total assets), the authorities do not envisage any further privatization. They hoped that the state-owned banks would help advance the government’s economic program, by facilitating lending to small- and medium-scale enterprises and for housing, and infrastructure development. Staff cautioned against using publicly-owned banks, some of which are already burdened by high levels of NPLs, for quasi-fiscal objectives. More generally, the mission questioned whether, absent privatization in the banking and insurance sectors, the targeted ½ percent of GDP annual privatization proceeds over the next four years could be realized. But the authorities were confident that the sale of non-financial sector assets would allow them to meet their privatization revenue targets.

30. Trade liberalization, guided by WTO and EU commitments, remains on track. Notwithstanding pressure, the authorities have refused to rely on import surcharges as a tax handle. Accordingly, the weighted average MFN tariff is projected to decline from 2.6 percent in 2001 to 2.3 percent this year, though the bulk of imports will be unaffected as they are already covered by trade agreements.

III. STAFF APPRAISAL

31. After two difficult years, signs of a recovery are emerging. As yet these are mainly improving confidence surveys, while the slump in growth is just leveling off. But with supportive policies and a recovery in Poland’s main trading partners, growth should revive during the second half of the year. Poland approaches this juncture from a position of strength in some important respects: inflation is low and the fruits of the hard-fought battle to tame inflation expectations will bolster growth; the modest current account deficit leaves room for a pick-up in imports; and enterprises, having adapted to highly competitive conditions, are leaner and more efficient than before. With EU accession in sight, a recovery should prove strong and durable.

32. To realize this potential, however, policies need to shift toward sustaining the nascent recovery. Several challenges are emerging. The unfettered ability of the NBP to conduct monetary policy must be put beyond question. Only then will the time-proven benefits of low inflation and investor confidence be secured. Second, the policy mix must shift. Public spending must be curtailed to achieve a sizeable reduction in the fiscal deficit, a halt to the rising public debt ratio and significantly lower real interest rates. And, third, policy-induced distortions in the labor market need to be eliminated if firms are to have the flexibility to respond aggressively to new opportunities and create jobs. While addressing these domestic issues, Poland must finalize negotiations for EU accession and ensure that institutions for absorbing EU funds are in place.

33. With the 2002 budget, the new government has started the process of reining in the fiscal deficit and public spending. Withdrawing fiscal stimulus in a weak economy is less than ideal but nonetheless necessary since this year’s PSBR is likely at the limit of what can be financed without putting pressure on interest rates. Moreover, the consolidation creates conditions for the recent and possible further monetary easing. It is regrettable that the budget relied heavily on expenditure freezes and postponement, but this was perhaps unavoidable given the limited time for budget preparation after the election.

34. The real test for fiscal policy, however, will be to endow the “CPI plus 1 percent” expenditure rule with the necessary medium term credibility. The “CPI plus 1 percent” rule limiting state spending appropriately focuses on Poland’s central fiscal problem—revenue and expenditures are too high for its level of development—in an easily understood framework. And with even a modest rebound in growth, it should steadily lower deficits. Nevertheless, in implementing the rule, the authorities will need to address two critical questions. First, is it enough to rein in deficits and reverse rising debt dynamics? If growth failed to rise as envisaged, more stringent expenditure limits would have to be adopted. Also, the authorities will need to adapt the rule should spending drift, owing to possible overprojections of inflation or excessive local government spending. Second, will legislative changes to current spending programs be forceful enough to meet the ceilings without undue compression of public investment? Areas where the scope for achieving the greatest savings by better targeting social transfers—limiting enrollment in the agricultural pension fund, trimming public employment, equalizing retirement ages for men and women, raising the early retirement age, and tightening eligibility for disability benefits further, to name a few—are well known but require building a social consensus for change.

35. The scope for monetary policy action has greatly narrowed. After the 950 basis point cuts during the past year, the scope for further reductions is small and must be judged against an assessment of the easing effects already in the pipeline. But with indications that fiscal policy will be guided by lasting spending restraint and that wage pressures remain subdued, a case exists for meeting market expectations for further small cuts: expectations seem benign auguring for inflation below target even for 2003, a substantial output gap is likely to persist for some time, the zloty remains at the top of the manageable range; and incentives for unhedged FX borrowing would well be further reduced. Any changes should be made cautiously and in small steps to minimize the risk of overshooting.

36. Refraining from direct intervention in the foreign exchange market remains highly advisable. Direct intervention is unlikely to curtail upward pressure on the zloty significantly except at the cost of higher inflation, and this would yield little effect on the zloty’s real value. Moreover, volatility of the zloty, which has not been excessive, encourages hedging of foreign exchange risk. Resisting upward pressure would best be accomplished through a steady reduction in the fiscal deficit while monetary policy is eased.

37. The monetary policy framework needs to be adapted to the new low inflation environment. Poland has reached the stage where a more symmetrical inflation targeting framework, giving equal weight to deviations in either direction from the central target, is needed. A continuous single inflation target, with relatively wide bands to accommodate volatility of headline inflation would serve this purpose. These changes should be made soon for the benefit of the Council that will take office in 2004. More urgently, the MPC should announce a new medium-term inflation target, as the current one only extends to end-2003. While decisions on the adoption of the Euro have not been made, adopting an inflation target broadly consistent with Maastricht criteria would be appropriate and leave the timing of entry open.

38. Poland’s banking system is generally sound, but rising NPLs and foreign currency loans need to be monitored closely. NPLs are high, but as they are fully provisioned they do not now hamper the effectiveness of the banking system. The sharp increase in foreign currency borrowing, most of which is assumed to be unhedged, poses another challenge. While these loans are not a systemic threat, they could add to the already high NPLs in the event exchange market sentiment shifted adversely. To mitigate this possibility, supervisors should encourage banks to ensure that the risk weighting of foreign currency loans to households and unhedged enterprises is appropriate.

39. Structural reforms and privatization need to be accelerated. The authorities’ concern about the impact of action in these areas on short-run demand is evident, but should be balanced against the fiscal and other costs of labor and product market rigidities and of sustaining loss-making state enterprises. The government’s legislative proposals to remove some restrictions on hiring and worker compensation are welcome. But the much-needed impetus to employment from the recovery will need to be supported by continuing efforts to identify and address hindrances to labor market flexibility—including restrictions on hiring and firing and the minimum wage, which should be lowered for new labor market entrants and differentiated across regions for others. On privatization, the authorities face hard choices with many remaining state-owned enterprises unattractive to the market and downsizing or liquidation difficult given high unemployment. Nevertheless, in the interest of redeploying resources to the highest priority uses, the government should reinvigorate privatization so as to reduce its ownership in the real and financial sectors. Of particular concern are proposals to halt financial sector privatization and to use the largest state bank for quasi-fiscal projects.

40. The authorities’ have steered a steady course in maintaining open markets. The planned removal of remaining capital controls, which probably afford little protection, recognizes the existing near-full capital mobility. The decision not to heed popular calls for import surcharges to bridge the fiscal deficit was appropriate. Draft legislation to bring Poland’s ability to combat money laundering to international standards has been prepared, and this should be approved soon. The authorities should also consider completing the ROSC on data quality at their earliest convenience. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

APPENDIX I Poland: Fund Relations

(As of March 31, 2002)

I. Membership Status: Joined 6/12/86; Article VII

II. General Resources Account:

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III. SDR Department

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements:

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VI. Projected Obligations to Fund: None

VII. Exchange Rate Arrangement

Poland accepted the obligation of Article VIII, Sections 2, 3, and 4 on June 1, 1995. The exchange system is free of restrictions on the making of payments and transfers for current international transactions.

Since April 12, 2000, the zloty has floated freely.

Prior to that, the zloty had been pegged to a currency composite made up of the U.S. dollar, deutsche mark, pound sterling, French franc, and the Swiss franc. As of January 1, 1999, the currency composite was changed to a basket comprised of 55 percent euro and 45 percent U.S. dollar. From January 1, 1995, the zloty was redenominated, with new Zl 1 equaling old Zl 10,000. The central parity of the zloty was adjusted under a crawling peg policy at a preannounced monthly rate. On May 16, 1995, a band of ±7 percent was introduced around the central rate. Following the implementation of the new system, the zloty initially appreciated by about 5 percent above the central rate. In September 1995, the exchange rate was allowed to appreciate a further 1 percent within the band. In December 1995, the central parity was raised by 6 percent, and at the same time the authorities allowed the actual exchange rate to appreciate by 2½ percentage points. On January 8, 1996 the monthly rate of crawl was reduced to one percent. On February 26, 1998, with the zloty pushing towards its upper limit, the newly-formed Monetary Policy Council (RPP) widened the fluctuation band from ±7 percent to ± 10 percent. At the same time, the rate of crawl was reduced from one percent to 0.8 percent per month. On July 17, 1998, the crawling peg’s monthly rate of depreciation was cut from 0.8 percent to 0.65 percent. On September 9, 1998, the monthly rate of depreciation was reduced further to 0.50 percent. On October 29, 1998, the zloty’s trading band was widened to ±12.5 percent. On March 1, 1999, the zloty’s trading band was widened to ±15 percent, and the rate of crawl was lowered to 0.3 percent per month. On December 31, 1999, the official rate was Zl 4.08 per US$1. On April 12, 2000, the crawling band regime was abolished and the zloty has since floated freely.

VIII. Article IV Consultation

The last Article IV consultation was concluded on March 9, 2001 (EBM/01/--). In concluding the consultation, Directors welcomed the declines in inflation and the external current account deficit, but were concerned at low growth and rising unemployment. In this context, they endorsed the operation of fiscal stabilizers but emphasized the need to keep to budget spending totals to retain fiscal credibility. Fiscal consolidation would be needed in the medium-term if fixed investment recovered strongly and should be led by expenditure rationalization. Directors welcomed interest rate cuts and felt there was room for further action. Along with stronger growth, further labor market flexibility, notably on minimum wages, would boost jobs.

IX. Technical Assistance, 1992-01

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