Republic Of Poland: Staff Report for the 2005 Article IV Consultation
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International Monetary Fund
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Publication Date:
02 Aug 2005
eISBN:
9781451831979
Language:
English
Keywords:
ISCR; CR; rate; authority; costs lender; deficit; current account; debt ratio; labor market; GDP deflator; foreign currency
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This 2005 Article IV Consultation highlights that the annual growth in Poland in 2004 reached 5½ percent, with a surge in growth in the run-up to European Union accession dissipating in the second half of 2004. Both domestic and net external demand contributed to the slowdown. Consumption and inventory accumulation had supported output growth as contribution of net external demand diminished, but by mid-2004, these sources of demand growth slackened. The recovery has started to produce jobs, but the employment rate remains low owing to structural rigidities and demographic pressures.

Abstract

This 2005 Article IV Consultation highlights that the annual growth in Poland in 2004 reached 5½ percent, with a surge in growth in the run-up to European Union accession dissipating in the second half of 2004. Both domestic and net external demand contributed to the slowdown. Consumption and inventory accumulation had supported output growth as contribution of net external demand diminished, but by mid-2004, these sources of demand growth slackened. The recovery has started to produce jobs, but the employment rate remains low owing to structural rigidities and demographic pressures.

I. Introduction

1. In its first year in the European Union, Poland has shown its mettle. Export growth remained buoyant and FDI picked up sharply—rendering a solid external position stronger. Policymakers successfully coped with accession-related price and demand shocks. And international financial markets, helped by ample global liquidity, reacted positively: market access improved; spreads on external debt narrowed, and the zloty appreciated. Looking ahead, the prospect of euro adoption promises to provide an anchor for economic policies. The convergence plan should make macroeconomic policies more forward-looking and strengthen the medium-term orientation of fiscal policy. Access to structural funds and agricultural subsidies should enhance growth potential and reduce large regional differences by upgrading infrastructure and modernizing agriculture.

2. Nevertheless, overall economic performance remains disappointing relative to the promise of the early transition years and the most dynamic emerging markets. Economic growth has slowed significantly since the Russia crisis, employment has fallen, and, under the burden of rising fiscal deficits, public debt has increased sharply. Thus, despite low inflation, the local currency risk premium on the zloty is higher than on most other EU8 currencies (Text Figure 1). This, together with a falling investment ratio and employment rate over the period, suggest investor concerns about policies and structural impediments to growth

Text Figure 1.
Text Figure 1.

Poland and Other Emerging Market Economies

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Sources: JP Morgan; Bloomberg; and Eurostat.Note: EU-8 countries are the new Central and Eastern European EU members.

3. Fragmented politics have been largely responsible for repeated failures of reform efforts and market uncertainties. The disintegration of the senior party in the ruling minority coalition has continued since the resignation of the Miller government in May 2004. Prime Minister Belka, who then formed a government to bridge to general elections due by fall 2005, submitted his resignation in May to prompt early elections. But President Kwaśniewski rejected the resignation, opting for elections in September. Polls put two center-right parties—which plan to form a coalition and have broadly pro-reform, though not fully convergent, economic policy agendas—in the lead, but are unclear on whether they will secure a majority. Populist parties with significant support generally oppose public finance reforms and euro adoption. The mission held discussions with leaders and economic advisors of the leading opposition parties.

II. Background

4. A surge in growth in the run-up to EU accession dissipated in the second half of 2004.1 One factor behind this profile was a bunching of inventory accumulation prior to tax and regulatory changes accompanying accession in May (Text Figure 2). Nevertheless, and despite the fact that annual growth reached almost 5½ percent, the sharp deceleration of GDP in the second half of the year dampened hopes of pushing growth potential up to 5 percent in the ongoing recovery (Table 1). Both domestic and external demand contributed to the slowdown. Whereas consumption and inventory accumulation had supported output growth as the contribution of net exports diminished, by mid-2004 these sources of demand growth also slackened. Preliminary data for the first quarter of 2005 show falling domestic demand—mostly owing to drops in inventory accumulation and highly import-intensive investment—but with some rebound in output growth as net exports recovered sharply.

Text Figure 2.
Text Figure 2.

Poland: GDP Growth and Its Composition, 2001-05

(annualized seasonally adjusted quarter-on-quarter changes in percent)

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Source: Polish Central Statistical Office.
Table 1.

Poland: Selected Economic Indicators, 2001-05

(In percent, except where indicated)

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Sources: Polish authorities; and IMF staff estimates.

Derived as total savings minus the current account minus capital transfers.

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

With second-pillar pension funds part of general government.

With second-pillar pension funds outside general government. Fiscal notification to the European Commission will be on this basis from March 2007.

Polish definition of debt including risk weighted stock of outstanding guarantees and excluding second-pillar pension funds.

Yield on the 7-day National Bank of Poland money market bills.

Data for 2005 are actual as of April.

5. Even as the contribution of net external demand fell in 2004, exports had remained strong. Export growth, which led the recovery, hit a soft spot in mid-2004, but by end-year had rebounded to rates of about 40 percent (quarter-on-quarter annualized) (Text Figure 3). This pick-up was particularly impressive in view of slackening demand in Western Europe and the appreciation of the zloty during the second half of the year. Exporters appeared strongly motivated to price to market, especially as domestic demand softened.

Text Figure 3.
Text Figure 3.

Poland: Export Growth and Real Effective Exchange Rates, 2001-05

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Sources: Polish authorities; IMF Information Notice System; and IMF staff calculations.

6. Private fixed investment has lagged the cycle, indicating that potential investors remained cautious. Staff analysis (see Selected Issues) shows that corporate fixed investment growth has been significantly lower than model-based projections since 2000. This is corroborated by a rather steady increase of capacity utilization since early-2002 to historical highs by early 2005 (Figure 1). Thus, strong corporate profitability since 2002 translated mostly into an accumulation of financial assets, while bank credit to the corporate sector fell—indicating a considerable unrealized capacity to invest (Table 2). A slow recovery of fixed investment during 2004 lost pace in early 2005.

Figure 1.
Figure 1.

Poland: Factors Influencing Corporate Investment, 2000-05

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Source: Polish authorities; and Eurostat.1/ Deflated by PPI.2/ Decline in 2004 was partly due to valuation effects from zloty appreciation.
Table 2.

Poland: Monetary Survey, 2000-04

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

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Sources: National Bank of Poland; and staff estimates.

7. The recovery has started to produce jobs, but the employment rate remains low owing to structural rigidities and demographic changes. The Russia crisis and the large appreciation of the zloty in 2001 created two waves of job destruction just as a baby-boom generation entered the labor market. Job creation was stymied by supply side problems—skill mismatches, immobility between regions, and disincentives to work—while demand was weakened by the cycle, poor infrastructure particularly in high unemployment regions, and high non-wage costs of employment. Thus, the employment rate, which was close to the euro area average in 1998, is now 52 percent—the lowest in the EU. The gap is particularly large for young workers while the long-term unemployment rate is one of the highest in the EU (Text Figure 4). These developments have their counterpart in impressive productivity gains during the recovery and, as high unemployment has kept wage growth low, falling unit labor costs.

Text Figure 4.
Text Figure 4.

Poland and Selected EU Countries: Labor Market Indicators, 1997-2004

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Sources: Polish authorities; Eurostat; European Commission; and OECD.1/ The quarterly Labor Force Survey was not undertaken in Q2 and Q3 of 1999, and observations in these quarters are extrapolated.2/ Share of unemployed over one year in total labor force in percent. Annual average.

8. These developments suggest sluggish interplay between consumption and investment since the recovery began in mid-2002. With slow job creation and low wage growth, household incomes have grown modestly. By late 2004, even with falling savings rates, strong consumption growth could not be sustained (Text Figure 5). In contrast, corporate savings have risen rapidly without a commensurate increase in investment. Corporate bank deposits have escalated, but banks continue to hold a large share of assets in government bonds. With limited scope for further cuts in household savings rates, future growth will depend on stronger investment in job-creating capacity both to push up household incomes and to ease potential supply constraints.

Text Figure 5.
Text Figure 5.

Poland: Savings, Consumption, and Investment, 2000-04

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Sources: Polish authorities; and IMF staff calculations.

9. Thus far, however, resource constraints have not been evident in inflation or the current account. A pickup in nominal wage growth, rising oil prices, and an increase in food prices as agricultural exports were liberalized created mid-year price pressures (Text Figure 6). Monetary policy reacted swiftly with cumulative 125-basis point interest rate hikes during June-August. This, together with a deceleration of demand, contained inflation and wage increases. Meanwhile the current account deficit narrowed: for the year as a whole, export growth was strong, while import growth picked up modestly with investment (Table 3).

Text Figure 6.
Text Figure 6.

Poland: Inflation, 2001-05

(quarter-on-quarter annualized percent change)

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Sources: Polish Central Statistical Office; and The National Bank of Poland.
Table 3.

Poland: Balance of Payments on Transaction Basis, 2001-10

(In millions of US$)

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Sources: National Bank of Poland; and staff estimates.

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

Exports of goods and services.

Excluding repurchase of debt.

10. Fiscal policy continued to drift in 2004. Adding EU-accession related spending to a cut in the corporate tax rate and upward drift in non-discretionary spending resulted in a procyclical (though lower-than-initially projected) rise in the general government deficit (Text Table 1 and Table 4). Despite strong efforts of the Belka government to secure Parliamentary approval of fiscal reforms (Hausner Plan), only about a third (in terms of potential savings) of the plan was implemented. Some key reforms—to limit coverage of the farmer pension scheme, close social security contribution loopholes and better target disability programs—were not implemented, although pre-retirement benefits were reined in and pension indexation rules were changed. Notwithstanding the large deficit, a renewal of the privatization program, the zloty appreciation and strong growth resulted in the first drop in the debt ratio in four years.

Text Table 1.

Poland: Fiscal Trends, 2000-04

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Sources: IMF staff calculations, Polish authorities.
Table 4.

Poland: General Government Revenues and Expenditures, 2000-05

(In percent of GDP)

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Sources: Polish authorities and staff estimates and projections.

In 2004, the transfer to the FUS (Social Security Fund) to compensate for contributions paid to the OFEs is treated as an expenditure.

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

The improvements in the overall an structural balances in 2005 are in large part due to the postponement of the indexation of pensions to 2006. The corrected structural balance nets this effect out.

Polish definition of public debt.

Including the risk-weighted stock of outstanding state guarantees.

11. Financial markets turned strongly positive during 2004. Despite low inflation, long-term interest rates had risen sharply in mid-2003 and a two-year depreciation of the zloty persisted following the announcement of an expansionary 2004 budget (Text Figure 7). But EU accession, formation of the pro-reform Belka government, and signs of stronger-than-expected budgetary developments (including privatization) prompted a mid-2004 turnaround while the equity market also surged. Despite narrowing interest rate differentials vis-à-vis the euro and the dollar, the zloty appreciated through early 2005.

Text Figure 7.
Text Figure 7.

Poland: Interest Rates and the NEER, 2002-05

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Sources: IMF Information Notice System; and Bloomberg.

12. The authorities thought that past IMF policy recommendations had been apt, although political constraints had hindered their full implementation (Box 1).

Implementation of Previous Recommendations

Despite the government’s efforts, fiscal reforms, long supported by staff, have been slow. However, the government used a window of opportunity immediately after its formation last year to accelerate privatization, also a longstanding staff recommendation. Staff views on monetary policy have been well received and were seen as on the mark in managing the price shock last year. Similarly, the NBP and its supervisory arm have acted forcefully, also consistent with staff views, to step up prudential regulation and supervision of foreign exchange-denominated loans. Staff’s concerns about the changes in the regulation on loan classification, however, turned out to be unnecessary as the changes have had the benign effects the authorities expected.

III. Report on the Discussions

13. After a successful first year in the EU, the authorities were for the most part confident about the medium term. Pointing to potential gains from EU membership for FDI and institutional and infrastructural development, most expected growth to increase to 5–5½ percent in 2006–07. They were puzzled about why investment had not taken off in 2004, but felt that underlying conditions (competitiveness, preparations for absorbing EU funds, and high capacity utilization) were conducive to a significant strengthening in 2005. They acknowledged, however, the importance of an electoral outcome that would give a strong base to a pro-reform government. Reversing the rising public debt ratio, reining in social transfer spending, and reducing and simplifying taxes would be key for a favorable growth scenario.

14. Job creation, a special focus of this year’s consultation discussions, was seen as critical for raising growth, easing strains on the pension system, and reducing poverty (box 2). Analyses by government, opposition advisors, and staff (see Selected Issues), identified many influences constraining job growth, with no obvious ranking of importance. The discussions therefore explored a variety of possible actions. Views on the likely response of job creation to policy change, however, differed. The more optimistic expected a sharp rise in employment and indeed foresaw pockets of labor shortages over the medium term. Others felt that high and persistent structural unemployment was a legacy of the transition in which social transfer schemes had been used to effectively remove many affected by restructuring from the labor force. On either view, the authorities were concerned that longterm unemployment and persistent regional differences in employment were depriving many of the benefits of Poland’s prosperity.

15. Preparations for euro adoption were another focus of the discussions. The government had targeted euro adoption in 2009–10. Formally, this would require entering ERM2 by mid-2006-mid-2007 and meeting the Maastricht criteria by mid-2008-mid-2009. The authorities viewed the major hurdle as reducing the fiscal deficit and aimed to get it significantly below the Maastricht criterion of 3 percent of GDP. The criteria for inflation (below about 2½ percent) and general government debt (below 60 percent of GDP) were viewed as well within reach. Looking beyond the Maastricht criteria, the authorities were also examining structural aspects of the economy—such as the flexibility of the labor market, structural characteristics that influence monetary transmission, and any challenges for bank supervision—that could impact the success of euro adoption. Staff welcomed the ambitious policy goals and underscored that fiscal and structural reforms needed to secure strong growth were also critical for a safe journey to euro adoption.

A. Economic Outlook

16. All forecasts envisaged a pick-up in growth from the low end-2004 rates, but views on its strength differed. Staff saw several influences that would constrain the rebound. Weak demand in Western Europe and the zloty appreciation should slow exports. Moderating export growth and political uncertainties are likely to delay a full-scale recovery of investment—a projection supported by the drop in Q1 2005 investment reported after the mission. The planned withdrawal of fiscal stimulus in 2005, mostly from postponement of pension indexation, should counterbalance the impact of increasing employment on private consumption. Staff, thus, projects growth of 3.7 percent in 2005, with the current account deficit staying at about 1½ percent of GDP. Risks to these forecasts were evenly balanced: export growth could continue to surprise on the upside, while political uncertainty could lower investment growth. The authorities, especially the NBP, were more optimistic on investment and labor income growth and therefore expected growth of about 4 percent.

The Interactions of Labor Market, Fiscal, and Poverty Trends

Negative employment trends have contributed importantly to a deterioration of the financial position and coverage of the pension system (see Selected Issues). Projections in 1999 (when a pay-as-you-go system was replaced by a three-pillar mixed private-public scheme) showed a small, transitory deficit followed by long-term sustainability of the state-managed first pillar. However, owing to unfavorable labor market developments, combined with changes in the parameters, and generous pension indexation since 1999, official projections now show a significant deterioration relative to the 1999 projections. Declining employment has also limited the accumulation of savings in the privately managed second pillar, increasing the likelihood of future claims on the budget to support those who will not accumulate sufficient pension rights. The authorities were discussing the possibility of setting up a National Actuary Office to safeguard the pension system. Staff welcomed this plan.

Long-term joblessness, persistent regional differences in unemployment and poorly targeted social benefits have marginalized an increasing part of society. The share of people living below the existence minimum rose from 5.6 percent in 1998 to 11.7 percent in 2003. Social spending relative to GDP is among the highest in the OECD, but the social support system is uneven and poorly targeted (Table 5). Almost 30 percent of social benefit recipients live in deep poverty, while families headed by old-age pensioners have one of the highest per capita incomes.

Box Figure 1.
Box Figure 1.

Poland: Projected Balance of the State-Managed Part of the Old-Age Pension System

(in percent of GDP)

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Box Figure 2.
Box Figure 2.

Poland: Regional Differences in Employment Rates

(National employment rate=100)

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Sources: IMF staff projections and calculations, Polish authorities, and Chłon, A., M. Góra, and M. Rutkowski, “Shaping pension reform in Poland: Security through diversity”, Social Protection Discussion Paper Series No. 9923, The World Bank, August 1999.
Table 5.

Public Social Expenditure in OECD Countries, 2001

(In percent of GDP)

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Source: OECD (2004), Social Expenditure database 1980-2001.

17. Staff saw a range of possible medium-term outcomes, depending on the resolution of uncertainties about the political situation, economic policies, and timing of euro adoption. The authorities and staff agreed that, supported by strong fiscal and structural policies and a competitive parity, euro adoption would be a significant impetus to investment, trade, and growth. With a strong coalition after the elections committed to early euro adoption and the required reforms—most importantly expenditure-reform-based fiscal adjustment—average growth should be above 5 percent. Without fiscal reforms, however, staff projected growth to stay at 3½–4 percent (Table 6): market concerns about the deficit could produce persistently high interest rates and modest investment, locking the economy into a sub-par growth equilibrium characterized by moderate current account deficits, but low employment and sluggish private consumption. The authorities saw the danger in continued postponement of reforms and agreed that investment would be crucial for rapid income convergence.

Table 6.

Poland: Savings and Investment Balance-Baseline Scenario, 2000-10

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Sources: Polish authorities; and IMF staff estimates and calculations.

BOP basis current account deficit less capital transfers.

B. Fiscal Policy

18. The authorities viewed the 2005 budget as a first step toward rapid fiscal consolidation. Parts of the Hausner Plan that had been implemented—particularly a shift from annual pension indexation to indexation only in years after cumulative inflation reached 5 percent and reductions in defense spending and support to employers of disabled people—would contribute to the projected cut in the general government deficit from 6.1 percent of GDP in 2004 to 5.7 percent in 2005. In fact, the authorities hoped that tight expenditure control, lower-than-assumed interest rates, and higher-than-planned dividends would reduce the deficit below target. Staff agreed with the assessment of revenue and interest costs, but felt that these would just compensate for the loss from elements of the Hausner plan that had not received parliamentary approval but had been assumed in the budget. Looking ahead, staff questioned the basis for assuming further adjustment. Indeed, in view of the need to index pensions for 2005 and 2006 inflation, staff projected that without new measures the general government deficit would rise above 6 percent of GDP in 2006.

19. Building on the envisaged reduction in the deficit in 2005 the authorities planned to leave the next government an ambitious 2006 budget proposal. A new strategy, termed Plan B, would reduce the deficit in 2006 to 4.6 percent of GDP and in 2007 to below 3 percent.2 The authorities explained that the strategy, still in early stages of definition and obviously subject to post-election changes, would rely on the initiative of spending units to identify savings and efficiency gains, entailing an array of small measures. Also, an overhaul of cash management was expected to generate savings relative to GDP of up to 1 percentage point. Tax reform was another key element. A central plank also of the opposition’s platform, the new tax regime would have a uniform-rate (provisionally set at 18 percent) PIT, CIT, and VAT phased in over three years. The authorities stressed that these changes would be revenue neutral and would provide an impetus to growth through the elimination of distortions.

20. Staff welcomed the ambitious fiscal targets and tax reform plan, but doubted the durability of fiscal consolidation without fundamental expenditure reform. As concrete steps to rein in spending had not been developed, it was not possible to assess the feasibility of the targets. Nevertheless, in staff’s view, such ambitious fiscal targets would require measures to reduce poorly-targeted social transfer spending—the root of the fiscal problem. These would cut the deficit not only directly, but also indirectly by strengthening incentives to work and raising employment. Measures to improve cash and expenditure management could be important supplements, but savings would accrue over time and with large investments in information systems. Noting that the simplification of the tax system would strengthen enforcement capacity and nurture a compliance culture, without major negative distributional effects, staff supported a move to single-rate taxes carefully designed to ensure revenue neutrality.

21. In discussions with the government and opposition leaders, staff focused on the immediate post-election opportunity for introducing fiscal reforms. It emphasized that under present policies and historical average growth rates, public debt would continue to grow and public finances would become more vulnerable to shocks (Table 7, box 3). Indeed, with such debt dynamics, assuming growth at the historical average would be optimistic, and dynamics could look even worse. Staff therefore urged four immediate post-election initiatives for fiscal policy.

Table 7.

Poland: Medium-Term Fiscal Developments, Baseline Scenario 2004-101/

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

The general government.

The definition of public debt in Poland includes the risk-weighted stock of outstanding government guarantees and the debts of some public institutions that are outside the general government.

Debt Sustainability Analysis

Although favorable developments in 2004 lessened immediate concerns about public debt, medium-term trends remain worrisome. After a ten-percentage point increase in 2002-03, public debt (excluding guarantees) relative to GDP fell in 2004 owing to zloty appreciation, strong growth, and large privatization receipts. In staff’s baseline scenario, however, without a sizable cut in the deficit and with average output growth of 3¾ percent, public debt rises to 63 percent of GDP in 2010 and stabilizes at above 65 percent after 2014.

More importantly, with staff’s projected debt profile, the vulnerability of public finances to shocks would be high. As detailed in previous staff analysis (Country Report No. 03/187), real shocks pose a major risk: a two-year slowdown in output growth in 2006 similar to that in 2001–02 (a 2¾ percentage point-drop), reversed in 2008, would push public debt to 75 percent of GDP by 2010 (Box Figure). An increase of this magnitude could lead to strong market reactions and, thus, necessitate a large procyclical fiscal adjustment—further exacerbating the negative impact of the real shock (Table 8). A 300 basis-point increase in the average interest rate on public debt in 2006–07 (returning to the baseline afterwards) would increase public debt relative to GDP by some 3¼ percentage points only.

Box Figure.
Box Figure.

Poland: Debt Sustainability Analysis, 2005-10

Citation: IMF Staff Country Reports 2005, 263; 10.5089/9781451831979.002.A001

Source: IMF staff calculations presented in Table 8.Note: For a description of the shocks, see the text and Table 8.

Macroeconomic risks from external debt are much smaller. Although the gross external debt ratio has risen in the past few years, much of the increase was due to increased non-resident holding of the stock of domestically issued public debt. Under the baseline assumption, a current account deficit of 2–3 percent of GDP over the next five years, external debt would remain below 50 percent of GDP—leaving an ample safety margin for

Table 8.

Poland: Public Sector Debt Sustainability Analysis, 2000-2010

(In percent of GDP, unless otherwise indicated)

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Public sector gross debt (Polish definition, excluding the risk-weighted stock of guarantees).

Derived as [(r - π(1+g) - g + α∊(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ∊ = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as α∊(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

The implied change in other key variables under this scenario is discussed in the text.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.