Republic of Poland
2007 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Poland

The external sector has an increasing drag on the economy. The current account deficit remains fully financed by FDI, and the underlying balance is consistent with external-debt stabilizing levels. The stock market retrenchment has been severe, but it followed substantial gains since 2006. Stress tests show that resilience of the banking system is well capitalized and highly profitable. Executive Directors stressed that the key to boosting long-term growth will be to increase low labor market participation. The financial supervision authority should give priority to formalizing understandings.

Abstract

The external sector has an increasing drag on the economy. The current account deficit remains fully financed by FDI, and the underlying balance is consistent with external-debt stabilizing levels. The stock market retrenchment has been severe, but it followed substantial gains since 2006. Stress tests show that resilience of the banking system is well capitalized and highly profitable. Executive Directors stressed that the key to boosting long-term growth will be to increase low labor market participation. The financial supervision authority should give priority to formalizing understandings.

I. Introduction1

1. Poland is experiencing strong and well-balanced growth, in large part because of rapid financial deepening and an EU accession related investment boom. So far, the recovery has resulted in only limited upward pressure on core inflation and the external current account deficit. Similarly, the zloty remains within the estimated equilibrium range.

2. Resource constraints are, however, beginning to emerge, especially in the labor market, where real wage growth has outpaced productivity for some time. The recent steady increase in core inflation suggests that scope for continuing to absorb unit labor costs (ULCs) by squeezing profit margins is diminishing. And with limited observed spillovers thus far from the slowdown in major industrial countries, GDP growth is set to remain at or above potential, increasing the risk of a wage-price spiral. Cost pressures could also erode competitiveness and lead to a faster deterioration in the current account than seen in recent years.

3. Against this background, discussions with the newly elected government focused on the dual challenge of containing demand pressures and strengthening the economy’s supply response. As to the former, the main topics included spillovers from the financial market turmoil, the appropriate near-term monetary and fiscal policy stance, and the need for fiscal consolidation over the medium term. On the supply side, the focus was on the role of the financial sector, the scope for boosting Poland’s exceptionally low labor participation, and the prospect for accelerating catch-up gains in productivity through liberalization and privatization. Discussions also focused on the frameworks for fiscal policy and financial sector supervision.

II. Strong Growth Continued in 2007, But Bottlenecks Have Emerged

A. Recent Economic Developments

4. After years of sluggish performance, Poland enjoyed a second year of strong economic growth in 2007 (Table 1). The upturn has been underpinned by robust and well-balanced growth as EU accession has bolstered business confidence and spurred a long-awaited rise in investment. Meanwhile, private consumption has remained strong, driven by rapidly rising real wages, increasing employment, and record-high credit growth, but also tax cuts. The external sector, however, has become an increasing drag on the economy since mid-2006. This, and incipient signs of a gradual slowing in GDP growth, likely reflect emerging capacity constraints.

Table 1.

Poland: Selected Economic Indicators, 2002-09

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Sources: Polish authorities; and IMF staff estimates.

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

Fund definition (including the cost of the pension reform).

Polish definition of debt including risk weighted stock of outstanding guarantees.

Yield on 7-day NBP money market bills.

The methodology for computing interest rates was changed in 2004 to fulfil ECB requirements.

The main reasons for the increase in international reserves since 2004 are an accumulation of EU transfers held in euros in the Ministry of Finance’s account at the NBP, the appreciation of the euro against the dollar and, in 2007, a repo operation ($5.3 billion) that will be reversed in 2008.

uA01fig01

High Frequency Series

(Y-o-y percent change)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: GUS; NBP.
uA01fig02

Real GDP Growth

(Percent change)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: WEO, IMF; Staff projections.
uA01fig03

Poland Contributions to GDP Growth

(q-o-q percent change, sa)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: GUS.

5. The output gap is closing and labor markets are tightening. Capacity utilization indicators have reached record-high levels, and staff estimates that GDP growth is still running above potential, despite the rise in investment in recent years. Pressures are particularly evident in labor markets. Driven by plummeting unemployment, wage growth reached close to 10 percent in the fourth quarter (year-on-year), and real wage growth continues to significantly outstrip productivity gains. Labor shortages have been compounded by continuous emigration to Western Europe since EU accession.

uA01fig05

Wages

(Y-on-y, percent change)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: GUS; and NBP.1/ Assuming half of the new jobs are filled with previously unemployed people.2/ Assuming 1.5 million Poles emigrated since May 2004, out of which 60 percent were previously unemployed.
uA01fig06

Unemployment Rate and Contributions to Cumulative Decline

(In percent)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: GUS; and Staff calculations.

6. Demand pressures are beginning to affect inflation. Headline CPI inflation has been increasing since 2006, reaching 4¼ percent (year-on-year) in January 2008, despite some appreciation of the zloty. This lies not only well above the National Bank of Poland’s (NBP’s) inflation target of 2½ percent, but also above the 1½–3½ percent band. Until the Fall of 2007, this increase almost entirely reflected soaring food and energy prices, and core inflation remained stable as rising ULCs were absorbed by lower profit margins, which had been boosted by wage restraint in the first half of the decade. Core inflation has edged up during the last six months, suggesting that the scope for squeezing profit margins is narrowing. Consistent with this, market-based indicators suggest that inflation expectations remained well-anchored through most of 2007, but began to pick up toward the end of the year.

uA01fig07

Inflation

(Y-o-y, percent change)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

uA01fig08

Unit Labor Costs

(Y-o-y, percent change)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

uA01fig09

Net Turnover Profitability and Capacity Utilization Rate 1/

(In percent)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: GUS; NBP; Bloomberg; Staff calculations.1/ Net profit in percent of turnover.
uA01fig10

Inflation and Inflation Expectations

(In percent)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

2/ Derived from inflation-indexed Treasury.

7. Despite demand pressures, the current account deficit is still relatively low and the zloty is within the estimated equilibrium range. Buoyant imports have resulted in a slight widening of the deficit—to about 3¾ percent of GDP in 2007—even as Poland has continued to gain export market share and remittances have grown. However, the deficit has remained fully financed by record levels of FDI, and the estimated underlying deficit of 4½ to 6 percent of GDP in 2007 is consistent with external sustainability inasmuch as it remains below the estimated debt-stabilizing level of 6 percent of GDP (Tables 2, 3, and 4).2 Furthermore, staff estimates of the equilibrium real exchange rate do not point to misalignment, despite the real appreciation that has taken place since mid-2006.3

Table 2.

Poland: Balance of Payments on Transaction Basis, 2004-13

(In millions of US$)

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

The main reasons for the increase in international reserves since 2004 are an accumulation of EU transfers held in euros in the Ministry of Finance’s account at the NBP, the appreciation of the euro against the dollar and, in 2007, a repo operation ($5.3 billion) that will be reversed in 2008.

By remaining maturity.

Exports of goods and services.

Excluding repurchase of debt.

Table 3.

Underlying Current Account in 2007 1/

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Source: WEO, IMF; Staff calculations.

Calculations are based on the formula proposed in “A Calibrated Model of the Underlying Current Account,” by Messrs. Bayoumi and Faruqee (Chapter 5, in Occasional Paper 167, IMF); transition economies’ elasticities are taken from that paper.

Table 4.

Poland: External Debt Sustainability Framework, 2002-2012

(In percent of GDP, unless otherwise indicated)

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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, ε = nominal appreciation (increase in dollar value of domestic currency), and α = 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).

For projection, line includes the impact of price and exchange rate changes.

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

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Poland: Export Margin, 2003–07

(Year-on-year rate of change)

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Source: IMF, World Economic Outlook.

Assumes a common unit labor cost for the economy.

Balance of Payments, 2005-07

(In billions of US $)

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Sources: NBP, Staff projections.
uA01fig11

Current Account Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: NBP; IMF Direction of Trade.1/ Data as of 2007q3.
uA01fig12

ULC-based REER

(2000=100)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: NBP for Poland, IMF for other countries.

B. Economic Policies

8. Adjusting for cyclical factors, there was a fiscal tightening of about ¾ percent of GDP in 2007 (Table 5). Expenditures were below budgeted limits at both state and local levels, an under-execution that largely reflected difficulties in carrying out public investments, including those related to EU funds. At the same time, strong cyclically-driven tax collections contributed to a substantially lower-than-budgeted general government deficit of 2½ percent of GDP, a full ½ percent of GDP below the 2007 Convergence Program target.

Table 5.

Poland: General Government Revenues and Expenditures, 2002-09

(In percent of GDP)

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

Fund definition (including the cost of the pension reform).

Actual balance corrected for economic cycle.

Actual balance corrected for economic cycle and one-off/special effects.

Polish definition of debt including risk weighted stock of outstanding guarantees.

uA01fig13

Poland: State Budget Outcome, 2007

(Percent of budget)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Source: Ministry of Finance.

Poland: Summary General Government Balance, 2006-07

(In percent of GDP)

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

Fund definition (including the cost of the pension reform).

Actual balance corrected for economic cycle.

9. A monetary tightening cycle is underway. Reflecting the Monetary Policy Council’s (MPC)’s concern about rising inflation, policy interest rates have been raised six times since April 2007 and now stand at 5½ percent. Simultaneously, the zloty has appreciated in response to a widening spread of domestic interest rates over euro and dollar interest rates. Nonetheless, monetary conditions have loosened, as the increase in nominal rates have not prevented real interest rates from falling in the face of accelerating inflation. Besides liquidity management operations (including repos), the NBP has continued to refrain from directly intervening in foreign exchange markets although international reserves have increased since 2004 as a result of EU transfers and re-evaluation.

uA01fig14

Policy Rate and Inflation

(In percent)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: GUS; NBP; Staff calculations.
uA01fig15

Monetary Conditions Index

(1998-2001=100)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

C. Financial Sector Developments

10. The impact of the international capital market turmoil has been limited so far. The banking sector’s profitability has remained high and it has little, if any, exposure to U.S. sub-prime mortgage assets. Foreign capital inflows have held up well, and the increases in both credit default swap and bond spreads have been limited, especially in relation to other European emerging markets. In contrast, the stock market retrenchment in Poland has been more severe, following substantially larger gains than elsewhere in the region since 2006.

Selected Financial Indicators

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Western Europe comprises, France, Germany, Italy, and the UK.

Sources: GFSR, IMF; and country authorities.
uA01fig16

EMBI Global Spreads

(In basis points)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Source: J.P. Morgan1/ Comprises Bulgaria, Hungary, Kazakhstan, Poland, Russia, Serbia, Turkey, and Ukraine.
uA01fig17

Equity Indices

(January 2003 = 100)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Source: Bloomberg
uA01fig18

Government Bond and Stock Market, CE-4

(February 1, 2007 - February 15, 2008)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Source: Bloomberg.1/ Spread of 5-year local currency government bond versus 5-year Bund.2/ JP Morgan Euro EMBI Global government spreads.3/ The credit default swap (CDS) is an over-the-counter contract whereby the buyer pays the seller a periodic fee in return for a contingent payment by the seller upon default of the issuer of a credit instrument. The fee is the spread time the face value of the bond.

11. Credit growth remains strong. The fastest growth is taking place in the mortgage market, where a rapidly rising number of households are benefiting from first-time access to mortgage credit (Figure 1). But while mortgage growth is slowing, markets for enterprise and consumer loans remain strong. After years of deleveraging, corporate credit growth has also resumed, reflecting the buoyancy of investment. While corporate and mortgage interest rates have increased in line with policy rates, interest rates on consumer loans have declined, reflecting heightened competition in a segment of the market that still offers banks relatively high risk-adjusted returns. Whereas the banking system was increasing its net foreign assets until 2006—as foreign-owned local banks were net lenders to their parent groups—domestic credit has been increasingly funded from abroad, consistent with the rising interest differential in favor of the zloty.

Figure 1.
Figure 1.

Poland and Other Emerging European Countries: Private Credit, 2000-06

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Source: Egert and Mihaljek (2007); European Central Bank; national authorities; and IMF staff calculations.1/ The speed of credit growth is defined as the annual percentage-point increase in the credit-to-GDP ratio, averaged over the period 2002-2006. Credit measure includes direct cross-border credit and refers to households and nonfinancial corporations.2/ Credit measures exclude direct credit from abroad. The sample of countries consists of Bulgaria, Croatia, Czech (data not available in 2000), Estonia, Hungary, Latvia, and Lithuania.3/ Credit measures exclude direct credit from abroad. The sample of countries consists of Bulgaria, Croatia, Czech, Estonia, Hungary, Latvia, and Poland.
uA01fig19

Poland: Credit Growth

(In percent)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Source: NBP.

Sources of Growth in Net Domestic Assests, 2005-07

(Changes in terms of net domestic assets, in percent)

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Sources: NBP, Staff estimates.
uA01fig20

Interest rates on new deposits

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Source: NBP.
uA01fig21

Interest rates on new loans

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

III. Outlook: Gradually Slowing Output Growth, But Inflationary Risks Remain

12. Economic growth is expected to continue to ease in 2008. Staff and the authorities agreed that the slowdown evident in the data would continue. Staff’s baseline scenario shows growth slowing to 5 percent, compared to the authorities’ projection of 5–5½ percent. In addition to base effects, the further slowdown reflects weaker export markets and a tightening of domestic resource constraints. As to the latter, with real wage growth set to continue to outstrip productivity gains and with some evidence that there is only limited scope for further squeezing profit margins, staff expects investment growth to gradually moderate. The authorities are somewhat more optimistic about the remaining slack in the labor market. In terms of the output gap, staff projects it to narrow for a third year, with only a marginal increase in potential growth to 4¾ percent; the authorities foresee little change, reflecting their assumption of higher potential growth.

Potential and Output Growth and the Output Gap, 2004–08

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Source: Ministry of Finance; and Fund staff estimates.

Poland’s Outlook, 2007–08

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Sources: WEO, IMF; and Fund staff projections.

13. Inflationary pressures will remain high, and could possibly increase. Pressures on prices are expected to remain elevated, despite the growth slowdown, in line with emerging supply-side constraints under the baseline scenario. Upward pressures could be magnified by secondary effects from the large food and energy price increases last year still in the pipeline. In view of these considerations, staff projects that, absent further tightening, inflation will systematically exceed the upper end of the plus/minus 1 percent inflation band round the NBP’s central inflation target in 2008–09. NBP projections also show such an overshooting.

uA01fig22

Inflation projection under unchanged monetary policy

(y-o-y, in percent)

Citation: IMF Staff Country Reports 2008, 130; 10.5089/9781451832037.002.A001

Sources: NBP Inflation Report; Staff projections.

14. The outlook for growth is subject to increasing uncertainty, but risks appear equally balanced. Staff agrees that there is some upside risk stemming from the possibility that investments will not slow as much in face of cost pressures as assumed in the baseline scenario. On the other hand, downside risks—arising from the possibility of larger-than-expected spillovers from the weakening external environment, through both real and financial channels—are also clearly present. At this juncture, staff believes that these risks are broadly balanced, and that the problem already evident in the data of gradually emerging resource constraints, with decelerating growth and accelerating core inflation, will most likely remain the key challenge facing policy makers. This assessment drives staff’s recommendations to tighten policies, as discussed below. Clearly, should the aforementioned downside risks materialize—to such an extent that stronger-than-expected negative external spillovers cause growth to fall below potential and inflationary pressures to ease—a pause in the tightening cycle of monetary policy would be warranted. In that case, there would also be scope for some fiscal support to activity, by allowing the automatic fiscal stabilizers to operate.

15. Looking to the medium term, the external current account deficit is expected to widen (Table 9). While the deficit is currently well contained—and the zloty is within its equilibrium range—it is projected to gradually increase but remain below the upper limit of what is safe. In this regard, however, the experience of other countries in the region suggests that some downside risks, especially if consumption growth fails to moderate. This could be the case if expectations of persistently large income gains and increased access to consumer financing, possibly fueled by large capital inflows, trigger greater consumption smoothing. The additional fiscal consolidation discussed below would thus serve to reduce external vulnerabilities.

Table 6.

Poland: Financial System Structure, 1998-2007

(Number and millions of euro)

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Sources: NBP, Polish Financial Supervision Authority, National Association of Credit Unions.

Explanatory notes:

Exchange rate used for calculations - at the end of month; for the year 1998 exchange rate PLN/ECU has been taken.

Brokerage houses’ assets in 2007 - data for end of June.

Investment funds sector includes UCITS and non-UCITS; number of authorised entities.

Pension funds were created as a result of pension system reform of 1998/1999.

As regards memorandum items:

a) Presented data include commercial banks and insurance companies; Data on majority foreign-owned institutions include branches of foreign banks; For insurance companies data on number and assets in 1998 and on assets in 2000 not available.

b) As regards cooperative banks and credit unions no majority government- or foreign-owned institutions operated.

c) Data on brokerage houses not available.

d) According to the Polish law two separate entities: investment fund (pension fund) and management company of this fund should be distinguished. According to the ESA 95 these entities should be classified into two different categories: management companies as “Financial auxiliaries,” investment funds (except for money market funds) as “Other financial intermediaries” and pension funds as “Insurance companies and pension funds”. In terms of ownership we should take into account the shareholders of management companies. As in the table we present assets of investment funds (pension funds), hence memorandum items on ownership structure are not applicable to the categories of investment funds and pension funds.

Table 7.

Poland: The Core Set of Financial Soundness Indicators for Banks, 1998-2007

(In percent)

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Source: National Bank of Poland.

Tier 1 capital consist core capital reduced by a shortfall in specific / impairment provisions.

Non-financial sector, arrears over 90 days.

Non-financial sector.

In 2002 change in sector definition.