Republic of Poland: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund
Publication Date:
26 Jul 2004
eISBN:
9781451831863
Language:
English
Keywords:
ISCR; CR; GDP; government; current account; state government; headline inflation; labor market; GDP deflator; foreign currency; monetary policy; interest rate; Inflation; Current account deficits; Western Europe
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This 2004 Article IV Consultation for Poland highlights that with strong exports and robust consumption, its GDP growth picked up gradually, reaching 6.9 percent (year over year) in the first quarter of 2004. Nevertheless, investment growth remains moderate. Financial markets have been unsettled. Despite low inflation, long-term interest rates have risen since mid-2003, initially in response to the announcement of an expansionary 2004 budget and more recently to unsettled politics. The weak responses of investment and employment raise concern about fundamental impediments to the recovery.

Abstract

This 2004 Article IV Consultation for Poland highlights that with strong exports and robust consumption, its GDP growth picked up gradually, reaching 6.9 percent (year over year) in the first quarter of 2004. Nevertheless, investment growth remains moderate. Financial markets have been unsettled. Despite low inflation, long-term interest rates have risen since mid-2003, initially in response to the announcement of an expansionary 2004 budget and more recently to unsettled politics. The weak responses of investment and employment raise concern about fundamental impediments to the recovery.

I. Background

1. Poland is in a challenging economic situation. Although a strong recovery is underway, private investment is still flat and financial markets are jittery. This paradox is the legacy of several years of weak policies which produced an unsustainable fiscal position and, together with slow growth, worsened a rising unemployment problem. Exacerbated by uncertainty about the strength of the recovery in Western Europe, Poland’s principal export market, these setbacks continue to strain political stability and market confidence even as the recovery takes off. While the government has proposed a comprehensive program to tackle the fiscal and structural problems, political support needed to implement it has wavered. Thus, Poland, a star performer in the 1990s, entered the EU with substantive economic and social problems and a weak government.

2. Throughout the past year, a recovery strengthened, but it is not yet fully entrenched. With strong exports, robust consumption, and a leveling off of the drop in investment, GDP growth picked up gradually, reaching 4.7 percent (year-on-year) in the last quarter of 2003 (Table 1, Figure 1). Continued high export growth and accelerating retail sales suggest that the recovery strengthened substantially in early 2004, but still without any indication of investment growth (Figure 2). Although the fiscal stance in 2003 was slightly restrictive, a considerable easing of monetary conditions since 2001 supported the recovery: policy rates were massively reduced between early 2001 and mid-2003, while falling interest differentials and unsettled politics contributed to a 20 percent real effective depreciation of the zloty in the past two years (Figure 3). With strong gains in the service sector, employment has grown modestly in the past year, for the first time since 1997. This, combined with accelerating wages and rising social transfers, kept consumption growth robust.

Table 1.

Poland: Selected Economic Indicators, 1999-2004 1/

(In percent, except where indicated)

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Sources: Polish authorities; and staff estimates.

GDP series for 2000-2002 are based on the authorities’ new methodology introduced in late 2002. GDP series prior to 2000 are staff estimates of the new methodology, using growth rates from the old methodology. This applies to all tables and figures of the staff report.

Derived as a difference between total savings and current account.

Including the full amount of transfers to social security fund.

With second pillar pension funds part of general government.

With second pillar pension funds outside general government.

Including risk weighted stock of outstanding guarantees.

Figure 1.
Figure 1.

Poland: Activity and Demand, 1998-2004

(Year-on-year real growth rates, in percent)

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Polish authorities; and staff calculations.
Figure 2.
Figure 2.

Poland: Indicators of Investment Climate, 1998–2004

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Polish authorities; and staff calculations.1/ Deflated by CPI.
Figure 3.
Figure 3.

Poland: Indicators of Monetary Policy, 1998-2004

(In percent, except where indicated)

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Polish and other country authorities; International Finance Statistics; and staff estimates.1/ The real interest rate and the REER have weights of 50 percent.2/ Since end-March 2002, rates reflect revisions of monetary accounts.3/ 28-day intervention rate through end-2002; 14-day intervention rate thereafter.4/ Policy rates deflated by the percentage change in CPI over the previous 12 months.5/ ECB fixed rate until July 2000; minimum bid rate thereafter.

3. Slack in the economy is diminishing but without signs yet of excessive demand pressure. The output gap narrowed slightly in 2003, but at over 2 percent of potential GDP, was still sizable. The unemployment rate of 20 percent is well above the estimated structural rate of 15 percent (Figure 4). Falling unit labor costs and, in turn, strong increases in profit margins have been key to containing current account and inflation pressures during the upswing. The strong increase in corporate savings, while investment fell, pushed the current account deficit down to 2 percent of GDP in 2003 (Table 2); and, in the absence of domestic cost push and with an unusually small pass-through of the zloty depreciation by profit-rich firms, net inflation (excluding food and fuel) was steady at 1–1½ percent. A rise in headline inflation to 2.2 percent in April (still below NBP’s 2½ percent target) was mostly due to food and oil price increases.

uA01fig1

Poland: Unit Labor Costs

(2000=100)

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Polish authorities and staff calculations.
Figure 4.
Figure 4.

Poland: Indicators of Economic Slack, 1998-2004

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Polish authorities; Labor Force Survey; and staff calculations.1/ The quarterly Labor Force Survey was not undertaken in Q2 and Q3 of 1999, and observations in these quarters are extrapolated.
Table 2.

Poland: Balance of Payments on Transaction Basis, 2000-09

(In millions of US$)

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Sources: NBP; and staff estimates.

Excluding repurchase of debt.

4. Financial markets have been unsettled. Despite low inflation, long-term interest rates have risen since mid-2003, in response initially to the announcement of an expansionary 2004 budget and more recently to unsettled politics (Figure 5). Unlike in most other new EU countries, the domestic spread over the 10-year euro yield has more than doubled since mid-2003. Pointing to weak political and fiscal fundamentals, S&P and Fitch downgraded Poland’s domestic debt and the outlook on its foreign debt in the past year.

Figure 5.
Figure 5.

Poland: Indicators of Market Sentiment, 2002–04

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Bloomberg; and staff calculations.1/ The ten-year bond was discontinued in early 2002 and reinstated in 2003.

5. The weak responses of investment and employment raise concerns about fundamental impediments to the recovery. Uncertainties about the recovery in Western Europe are likely playing a role. But investment and employment growth remain substantially weaker than in other central European countries facing the same markets (Figure 6). And while excess capacity may still be a factor in some sectors, it seems likely that policy weaknesses during the past several years are influencing investor confidence and employment trends.

Figure 6.
Figure 6.

New EU Members: Growth, Investment, and Unemployment, 2000-2003

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Source: WEO
uA01fig2

Spreads in New EU Members

(10-year domestic currency yield over 10-year euro reference rate)

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Eurostat, Bloomberg, and IMF staff

  • A weak fiscal situation inherited from the 1990s has been allowed to drift. With a widening output gap, the headline deficit doubled during 1999–2002 and narrowed only slightly last year. As a result, public debt increased from below 40 percent of GDP at end-2000 to 51½ percent by end-2003 (Figure 7). Repeated fiscal reform efforts have failed in the face of vested interests and fractious politics (Box 1).

  • As fiscal reform attempts failed, social expenditure remained excessive and poorly targeted. According to the World Bank, half of the 6.3 percent of GDP social spending (excluding old-age pension) in 2002 was paid to non-poor families or in excess of what was necessary to keep families above the poverty line.

Figure 7.
Figure 7.

Poland: Indicators of Fiscal Policy, 1999–2004 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: Polish authorities; and staff calculations.1/ Data for 2004 are staff projections.
uA01fig3

Poland: Social Transfers per Capita by Consumption Deciles in 2002

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Source: The World Bank.

Fiscal Reform Attempts in Poland, 1999–2004

The authorities realized as early as 1999 that public finances needed to be strengthened to enhance Poland’s growth potential and fully benefit from EU accession. Excessive current, mainly social, expenditure was diagnosed as the root of the fiscal problem. Since then a series of fiscal reform attempts have failed, reflecting vested interests and inadequate political cohesion around reforms. Each year since 2000, the finance minister resigned when his effort to incorporate reforms in the budget met political resistance and the government temporarily gave into the pressure. The Fund has supported these efforts and provided technical assistance to help design them.

The Balcerowicz strategy

The 1999 fiscal strategy—building on previous fiscal reforms and an ambitious reform agenda—aimed to reduce the general government deficit below 1 percent and public debt below 30 percent of GDP by 2003 (IMF Country Report No. 01/56). The strategy addressed the crux of the fiscal problem by aiming to restrain high current expenditure. As growth slowed in mid-2000, fiscal slippages emerged, political support for reforms faded, and the ruling center-right coalition lost its majority in 2000.

The Bauc period

Election politics got the upper hand in 2001, the structural deficit rose relative to GDP by ¾ percentage point and fiscal reforms were halted.

The Belka rule

After the 2001 election, Finance Minister Belka attempted to introduce a fiscal rule limiting central government expenditure growth to the CPI inflation rate +1 percent. To make this rule sustainable, the MoF started preparations for fiscal reforms to reduce social expenditure. Staff supported the plan and called for extending the rule to the general government (IMF Country Report No. 02/127).

The Kolodko package

The consolidation plan in 2003 focused on eliminating widespread formulaic expenditure adjustments. Welcoming the plan, staff called for structural fiscal reforms and warned that more needed to be done to restore fiscal sustainability (IMF Country Report No. 03/187).

The Hausner plan

The plan, proposed in 2003, aims to reduce social expenditure, streamline government, and accelerate the restructuring of ailing public companies. Deputy Prime Minister Hausner has accompanied well-specified proposals with a major outreach effort to gain public support, PM-designate Belka has endorsed the plan, but its fate remains uncertain.

The large fiscal problem Poland is facing now could have been avoided if past plans had been implemented. For example, had the augmented Belka rule been followed from 2003 onward the deficit would now be well-positioned to drop below 3 percent of GDP by 2006, and public debt would have been stabilized below 50 percent of GDP.

  • An increase in unemployment owing to the cycle and enterprise restructuring was aggravated by policy-induced disincentives in the labor market.1 A large tax wedge and high minimum relative to average wage for low-skilled workers hindered wage adjustment where it was needed most. In addition skill mismatches persisted, and the social transfer system created benefit traps. By 2002, the share of long-term unemployed had risen to over half of the total.

  • With considerable rigidities in the labor market and poorly targeted social transfers, the economic slowdown worsened poverty. Rising (particularly long-term) unemployment was the prime source of the increase in poverty. Poorly targeted fiscal transfers meant that even high social spending was less effective in addressing this problem than it should have been.

  • Lax fiscal policy left the burden of responding to a large current account deficit and rising inflation in the late-1990s to monetary policy. Excessive tightening and a simultaneous large real appreciation (more than 25 percent during mid-1999–mid-2001) produced a sharp, though short-lived, diminution in price competitiveness (Figure 3). This contributed to a deep decline in investment in 2001–02 and, as it was most severe in labor-intensive industries, to massive lay-offs (Box 2).

uA01fig4

Poverty and Unemployment in Poland, 1994-2001

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: The World Bank and the authorities.

The Changing Structure of Exports and Labor Demand

Substantial changes in the product structure of Polish exports have had a strong impact on labor markets. As the accompanying selected issues paper shows, the share of low-tech and labor intensive exports declined rapidly following the Russia crisis, while medium-to-high-tech exports rose rapidly. As a result, employment in export industries fell by 25 percent between 1998–2003, accounting for most of the decline in employment in the corporate sector. Low-skilled jobs were likely lost to competition from other emerging markets.

uA01fig5

Poland-Structure of exports, 1993-2002

(in percent of total)

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Source: U N Com trade and IMF staff calculations.

  • Privatization slowed sharply and the environment for private investment has not improved. Several of major companies slated for privatization in 2001 have still not been sold. Slowing privatization, the deteriorating economic climate, and stronger competition from neighboring countries lead to a rapid decline in FDI.

uA01fig6

Poland: Privatization Receipts, 1998-2004

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: The authorities and IMF staff calculations.

6. High unemployment, controversy over a fiscal reform plan, and scandals linked to the ruling coalition destabilized the political situation. Prime Minister Miller resigned in May, and the President asked former Finance Minister Belka to form a new government. The first-round confidence vote failed to deliver the needed majority and ongoing negotiations will determine whether a government can be formed or early elections (ahead of the 2005 schedule) must be held. Prospects for implementing the previous government’s fiscal reform plan are uncertain.

II. Report on the Discussions

7. The discussions focused on policies needed to foster a pick-up in investment and employment growth so as to secure the recovery. On the fiscal side, the Hausner plan and debt dynamics were the main issues. For monetary policy, keeping inflation within the target range in the face of rising oil prices and several temporary shocks was viewed as a major challenge. The discussions about longer term goals centered on the adoption of the euro.

8. The authorities were confident that growth in 2004–05 would be strong and provide a robust foundation for containing the fiscal deficit. They saw the Hausner plan as well-targeted at Poland’s central fiscal problems and were determined to see it through to full implementation. While they expected that it would be sufficient to stabilize debt below the constitutional limit of 60 percent of GDP, they acknowledged that additional measures could be needed should growth disappoint. Staff shared the authorities’ positive assessment of short-run economic trends, but cautioned on vulnerability to policy slippages.

9. Despite previous ambitious plans, early euro adoption is unlikely. The depth of the conviction about the benefits of early adoption varies within policy-making circles, but most accept that gains for trade and growth could be substantial. The authorities thought that achieving the necessary fiscal adjustment would be the most difficult hurdle to overcome.2 Staff emphasized that a strong fiscal position—a structural deficit of 1–2 percent of GDP—before entering ERM2 would provide scope for automatic stabilizers to operate and minimize the risk of speculative attacks in ERM2. Inflation, on the other hand, was low and meeting the Maastricht criterion should be feasible. The monetary authorities were concerned about market stresses on the exchange rate in ERM2, depending on how limiting it would be, but agreed with staff that a stay limited to two years would be manageable.

10. The authorities thought that staff’s past policy recommendations had served Poland well, although political constraints had hindered their implementation. They acknowledged that inadequate political support had prevented fiscal reforms (Box 1), and frequent changes in privatization strategies reflecting political resistance had delayed restructuring. Regarding monetary policy, the authorities thought that the policy of non-intervention—on which there had been an agreement with staff since the move to the float in 2000—had been a critical aspect of risk management.

A. Economic Outlook

11. Short-run prospects are favorable. A modest recovery in Europe and improved competitiveness will help maintain high export growth, but political and fiscal uncertainties could keep a recovery of fixed investment gradual. Fiscal stimulus, mostly through accelerating public investment, will boost domestic demand. Reflecting job creation and some acceleration in real wages, private consumption growth should increase. Thus staff project growth rising to 5 percent in 2004, with an external current account deficit of 2.3 percent of GDP. Indications of strong growth in early-2004 suggest risks for full-year growth are on the upside, although some doubt remains about whether the robust first half reflected a bunching of consumer demand before EU accession. The authorities broadly agreed with staff’s assessment, though NBP staff were less optimistic on growth and expected that higher domestic demand would lead to a faster deterioration in the external current account balance.

12. Though core inflation should be low, headline inflation is likely to increase this year due to one-off factors. Staff expect CPI inflation in 2004 to rise, perhaps briefly above the 2½–3½ percent target range, due to a closing output gap and temporary shocks—rising oil prices, possible effects of EU accession, and the pass-through from depreciation. Yet even rising inflation expectations and, in turn, wage growth are consistent with the center of the target range. Assuming expectations increase no further, staff expect headline inflation to revert to the central target in 2005 as the one-off factors dissipate. While trends so far are no cause for concern, the authorities viewed a further increase in inflation expectations—which, if translated into further wage acceleration, could turn a temporary increase in inflation into a more lasting one—as a major risk.

uA01fig7

Poland: Corporate Wage Dynamics and Inflation Expectations, 2002-04

Citation: IMF Staff Country Reports 2004, 217; 10.5089/9781451831863.002.A001

Sources: GUS, NBP, and IMF staff calculations.

13. The authorities were optimistic about the medium-term. They expected growth to increase, to 5½ percent in 2006–07, driven by a sharp upturn in investment and gradually rising consumption growth owing to confidence effects from the Hasuner plan. They projected a small deterioration in the current account deficit.

14. Staff pointed to substantial risks to the recovery without structural and fiscal reforms. Assuming a partial implementation of the Hausner plan in their central scenario, staff projected GDP growth to return to around 4¼ percent in 2005 and slightly below 4 percent in the longer run (Tables 6 and 7). Staff stressed that with only tepid fiscal adjustment—which would keep financial markets unsettled and interest rates increasing—the recovery of private investment would be slow—stabilizing the external current account deficit below 4 percent of GDP, but limiting job creation and private consumption growth. Staff emphasized that a higher growth path would require ambitious fiscal reforms (Table 8). External debt remains manageable under most stress tests (Table 9), but public debt continues to grow under the staff’s central scenario (Table 10). In this scenario, a sudden depreciation of the zloty, especially if combined with a substantial increase in international capital market yields, would increase public debt sharply and would threaten required rollovers.

Table 3.

Poland: Monetary Survey, 1999-2003

(In millions of zloty, end-of-period)

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Sources: National Bank of Poland; and staff estimates.
Table 4.

Poland. General Government Revenues and Expenditures, 1999-2004

(In percent of GDP)

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Sources: Polish authorities and staff estimates and projections.

Revenue and expenditure exclude non-returnable resources from the European Union.

Including social security contributions.

General government overall balance on a cash basis including payments in compensation for insufficient indexation in the 1990s.

The estimates for other budgetary units are preliminary and may be subject to revisions.

Table 5.

Poland: Indicators of External Vulnerability, 2000-04

(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.

In Moody’s rating system Baa is investment grade whereas Ba is below.

Table 6.

Poland: Savings and Investment Balance-Central Scenario, 1999-2009

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Sources: Polish authorities and staff estimates.

BOP basis.

Table 7.

Poland: Medium-Term Debt Dynamics-Central Scenario 2002-09 /1

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Sources: Data provided by the authorities; and Fund staff estimates and projections.

General government.

Table 8.

Poland: Medium-Term Debt Dynamics-Staff Recommended Scenario 2002-09 /1

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Sources: Data provided by the authorities; and Fund staff estimates and projections.

General government.

Table 9.

Poland: External Debt Sustainability Framework, 1997-2008

(In percent of GDP, unless otherwise indicated)

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Sources: Polish authorities and staff calculations.

Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.