Abstract
Republic of Poland: Selected Issues
Balance Sheet Effects from Lowflation1
Private and public sector balance sheets in Poland are generally healthy and have weathered well two years of below-target inflation. However, the recent softening of banking sector profits and public sector revenue indicates that low inflation has started to feed into income flows, albeit so far with only mild consequences for the economy. Against this backdrop and in light of still-high risks of continued very low inflation (lowflation), this chapter assesses balance sheet risks from prolonged lowflation for households, nonfinancial corporations (NFCs), banks, and the general government, taking into account interlinkages across sectors. The chapter finds that while sectoral balance sheets are generally resilient to periods of deflation, a protracted spell of lowflation could exacerbate existing vulnerabilities and in a tail risk scenario reduce household debt tolerance, put a dent in corporate and bank profits, and increase government deficit and debt. This could occur in the context of an adverse loop of lower consumption and investment, higher nonperforming loans (NPLs), lower bank lending, and lower growth. These findings underscore the importance of bringing inflation back to target in a timely manner and managing risks from lower-than-expected inflation.
A. Introduction
Balance sheets are generally healthy…
1. Sound policies have helped sustain balance sheet health. Able macroeconomic management helped avoid a boom-bust cycle experienced in many other countries around the 2008–09 global financial crisis. Poland was the only EU country to maintain positive growth in 2009. As a result, despite pockets of vulnerabilities (including relatively sizable external corporate debt and a still-large legacy stock of foreign currency-denominated mortgages in banks), overall balance sheet health is stronger than in many other European economies. Despite rapid rise during the past decade, household debt is still manageable, particularly when compared to more advanced European peers. NFCs are competitive and profitable. Poland’s banking sector is well capitalized and liquid and is able to withstand substantial stress. Public sector debt has been declining steadily.
2. Overall, this has made the economy resilient to moderate deflation, with only limited impact so far. Growth in the fourth quarter held up well on the back of strong domestic demand, suggesting that lowflation has so far not fed into the real economy. Strong consumption and still-robust investment growth indicate that both households and NFCs remain unscathed by deflation, not least as declining prices have increased real disposable income and NFCs are helped by lower non-wage input costs. However, fiscal revenue has softened somewhat in recent months, while banks’ interest-rate margins have narrowed, weighing on profits. These developments highlight the risks associated with a protracted period of low inflation, which could ultimately negatively affect balance sheets and growth.
…but an adverse scenario with protracted lowflation is associated with risks
3. While the near-term consequences of lowflation appear manageable, risks surrounding a severe adverse scenario of protracted lowflation remain a concern. Protracted low inflation, combined with sluggish disposable income, increases the household debt burden, which could prompt households to cut back on consumption. In turn, this could weigh on corporate profits and induce firms to postpone investment, further reducing domestic demand. In addition, corporations may be affected already in the near term by low inflation alongside still-sticky wages. For the banking sector, lower interest rates could squeeze bank interest-rate margins, which combined with lower demand for credit and rising nonperforming loans would weigh on bank profits. Lower public sector revenues, combined with public wage rigidities, would increase deficit and debt, making it more difficult to achieve fiscal targets, potentially triggering procyclical fiscal consolidation, which could further harm growth. The unfortunate outcome could be a self-perpetuating negative feedback loop where low inflation leads to a decline in domestic demand, which reduces inflation further (Figure 1).
Balance Sheet Effects from Protracted Low Inflation
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
1/ The initial decline in inflation may arise from external factors. However, in the protracted lowflation scenario, an adverse feedback loop would maintain low domestic inflation.2/ Near-term effects of low inflation on households are likely positive as lower prices increase disposable income, boosting consumption. However, in the protracted lowflation case, lower wages and/or higher unemployment would worsen consumption.Balance Sheet Effects from Protracted Low Inflation
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
1/ The initial decline in inflation may arise from external factors. However, in the protracted lowflation scenario, an adverse feedback loop would maintain low domestic inflation.2/ Near-term effects of low inflation on households are likely positive as lower prices increase disposable income, boosting consumption. However, in the protracted lowflation case, lower wages and/or higher unemployment would worsen consumption.Balance Sheet Effects from Protracted Low Inflation
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
1/ The initial decline in inflation may arise from external factors. However, in the protracted lowflation scenario, an adverse feedback loop would maintain low domestic inflation.2/ Near-term effects of low inflation on households are likely positive as lower prices increase disposable income, boosting consumption. However, in the protracted lowflation case, lower wages and/or higher unemployment would worsen consumption.4. Our findings suggest that while all four sectors in Poland are generally resilient to periods of deflation, prolonged lowflation could have negative economic repercussions. In particular, a protracted period of low inflation could exacerbate existing pockets of vulnerabilities, including the rising household debt burden and narrowing interest margins in banks. In a tail-risk adverse scenario, a protracted spell of lowflation could reduce household debt tolerance, put a dent in corporate and bank profits, and increase government deficit and debt. This could result in an adverse loop of lower consumption and investment, higher NPLs, lower bank lending, and lower growth.
5. The findings underscore the importance of bringing inflation back to target in a timely manner and managing risks from lower-than-expected inflation. Given the heightened sensitivity of household debt dynamics to the real interest-income differential, higher inflation would mitigate the risks from unwarranted increases in debt and debt service, and allow households to continue expanding consumption at a healthy pace. Alongside, stronger macroprudential regulations would help contain risks of rapid debt accumulation. The potential adverse effects from narrowing corporate and bank profit margins in the context of prolonged lowflation call for setting aside sufficient buffers to reduce vulnerabilities and manage risks. These risks should be internalized in the authorities’ routine stress tests to ensure that banks have sufficient capital buffers to withstand prolonged periods of low inflation. Similarly, fiscal risks from lowflation could be addressed by using conservative inflation projections in preparation of budget forecasts and identifying contingency measures to facilitate a timely and effective response to any inflation surprises.
B. Households
Households are on average net creditors with largely long-term liabilities, and household debt is manageable in international comparison. Amid improving labor market conditions and positive nominal wage growth, risks related to near-term debt defaults are limited. However, low inflation has recently contributed to a rising debt-to-income ratio. Hence, should deflation continue for a protracted period, some households may begin to experience debt servicing problems and cut back on consumption.
6. Household balance sheets have so far remained strong. Household assets are more than twice as large as household liabilities and more than 40 percent of assets are held in the form of currency and deposits. Household liabilities are essentially long-term, and variable-rate mortgages are currently benefitting from low interest rates, helping to contain debt servicing costs. In addition, nominal wage growth at above 3 percent alongside deflation has supported real disposable income, boosting purchasing power (Figure 2).
Household Economic Position
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Household Economic Position
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Household Economic Position
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
7. However, Poland’s household debt has tripled over the past decade and is now one of the highest in the Central Eastern and Southeastern Europe (CESEE). While household gross debt has remained broadly constant relative to GDP during the post-crisis period, it went up notably in terms of disposable income in recent years, increasing from about 20 percent of disposable income in the early 2000s to 58 percent in 2013 (Figure 3). Most of this debt is in the form of long-term mortgage loans, while the share of short-term debt has been stable over time, limiting rollover risks. At the same time, household incomes are highly pro-cyclical as they mostly originate from wages and government transfers.
Household Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: Eurostat Annual Macroeconomic Database, Organisation for Economic Cooperation and Development (OECD) statistics, Haver analytics and, IMF staff estimates.Household Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: Eurostat Annual Macroeconomic Database, Organisation for Economic Cooperation and Development (OECD) statistics, Haver analytics and, IMF staff estimates.Household Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: Eurostat Annual Macroeconomic Database, Organisation for Economic Cooperation and Development (OECD) statistics, Haver analytics and, IMF staff estimates.8. Declining inflation has been contributing to debt accumulation. To analyze household debt dynamics, the change in the debt-to-income ratio is decomposed into contributions from the interest rate and income growth differential (it − πt − gt), primary savings rate (st), and financial and residential asset accumulation aat as a share of disposable income (see equation (1) below). The decomposition shows that the increase in the interest-growth differential—driven in part by the rise of real interest rates on the back of declining inflation—has become an important contributor to debt accumulation in recent years.
Factors Contributing to Debt-to-Income Dynamics
(Percent of household disposable income)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.Factors Contributing to Debt-to-Income Dynamics
(Percent of household disposable income)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.Factors Contributing to Debt-to-Income Dynamics
(Percent of household disposable income)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.9. High levels of debt are associated with lower household savings. The household primary saving rate has declined from 10 percent of disposable income in 2002 to only 4 percent in 2013 as the debt-to-income ratio increased. Recent high-frequency data also confirm this trend, with the saving rate declining further to 1.3 percent in the third quarter of 2014. To better examine the relation between savings and the level of debt, two econometric exercises are conducted: a nonparametric model (LOWESS) and an OLS regression (see Appendix I). The results suggest that current levels of household debt are weighing on household saving rates.
Poland. Non-Parametric Estimates of Saving-Debt Nexus (LOWESS)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.Poland. Non-Parametric Estimates of Saving-Debt Nexus (LOWESS)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.Poland. Non-Parametric Estimates of Saving-Debt Nexus (LOWESS)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.10. This suggests that some households may be facing reduced debt tolerance. The decline in household savings alongside the increasing debt ratios could indicate that debt service payments for some households may be approaching the levels at which they have to dip into their savings to maintain consumption levels. This suggests that some highly indebted households may be reaching their debt tolerance limits, at which they are no longer willing or able to reduce their consumption to generate savings to service the level of debt. This phenomenon might become more widespread if protracted lowflation negatively affects labor markets, while further increasing debt servicing costs.
11. Stress tests of household debt suggest that a protracted period of low inflation could lower debt tolerance. We adapt the approach traditionally used by the IMF to assess public debt sustainability to analyze household debt dynamics as in Lee and Lim (2014). The framework also allows to examine the impact of low inflation and income growth on changes in debt limits and to assess the existing debt space available to households (see Appendix I). While disaggregate data would provide a richer picture, allowing to differentiate between households with foreign currency debt and varying income levels, detailed household-level balance sheet data are not easily available. For the purpose of this analysis, we therefore rely on aggregated data. Assuming unchanged macroeconomic conditions (the baseline), the aggregate household debt limit is estimated at 68 percent of disposable income. With the current household debt ratio at 58 percent of disposable income, this implies a debt space of 10 percentage points of disposable income. However, under various stress scenarios (of deeper deflation and sluggish disposable income growth), the aggregate debt space declines further to as little as 2 percentage points of disposable income.
Household Debt Limits
(Percent of disposable income)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff calculations.Household Debt Limits
(Percent of disposable income)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff calculations.Household Debt Limits
(Percent of disposable income)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff calculations.12. Lower debt tolerance would ultimately weigh on growth and increase financial stability risks. Considering the need to maintain some precautionary liquidity, this implies that as households approach their debt limits, they will have an increasing tendency to cut on consumption with negative implications for growth. At the same time, reduced debt tolerance and smaller liquidity cushions increase the likelihood that households would default on their debt obligations, with negative consequences for financial stability.
13. This underscores the importance of tackling deflation before it becomes entrenched and strengthening macroprudential regulations. With the increased role played by the interest-income differential in explaining debt dynamics, bringing inflation back to target would help contain the dynamics of the debt-to-income ratio, expand the household debt space, and reduce macroeconomic risks. The strengthening of macroprudential policies to reduce risks of rapid household debt accumulation would further reduce macro-financial risks.
C. Nonfinancial Corporations
Corporate balance sheet vulnerabilities appear manageable. The recent period of deflation has had little impact on corporate performance to date. Going forward, an adverse scenario with a protracted period of lowflation, particularly if combined with slowing growth, could reduce corporate profits and weigh on investment and growth.
14. Corporate balance sheet vulnerabilities appear manageable. NFC nonconsolidated corporate debt2 is elevated, accounting for about 108 percent of equity and 80 percent of GDP. This reflects an increase of around 12 percentage points of GDP over the past decade. Alongside, the share of debt with interest coverage ratio (ICR)3 below 1 has gradually increased over the past years (Figure 4). Nonetheless, NFC debt is lower than in many other European countries both in terms of gross operating surplus and equity. And while NFC external debt is high when compared to non-European emerging peers, there are a number of mitigating factors, including a high share of the relatively stable intercompany debt. In addition, the median expected default rate is low (see IMF, 2014, for further analysis of corporate sector vulnerabilities).
Assessing Corporate Default Risk
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Assessing Corporate Default Risk
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Assessing Corporate Default Risk
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
15. So far NFCs appear to be unscathed by the recent spell of deflation. Private investment has been increasing at a healthy pace, contributing to the recovery. Purchasing Managers Index (PMI) in expansionary territory points to continued positive investment prospects, and growth in NFC bank deposits suggests still-strong profits (Figure 5). However, healthy performance in a lowflation environment is not surprising in the near term. To the extent that low inflation is matched by low input costs, arising from low commodity prices and imported inputs from the euro area, and domestic demand growth remains robust (which is currently the case), profit margins may initially be little affected by low consumer prices.
Recent Corporate Developments
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Recent Corporate Developments
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Recent Corporate Developments
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
16. However, protracted low inflation could reduce profits, weighing on investment and growth. While output prices have been declining, wages have continued growing at a robust pace of more than 3 percent year-on-year. Should compensation of employees continue to grow at unchanged pace (e.g., owing to temporary wage rigidities associated with multiyear labor contracts) in an environment of subdued price growth, corporate profit margins would eventually narrow, crowding out investment. In this regard, investment and profit prospects are closely correlated in Poland, with corporate (nominal) fixed investment declining by more than 10 percent during 2009–10 following a sharp deterioration in the gross profit share—uncertainty related to euro area growth at the time likely also impacted investment prospects. Over the longer run in a downside tail-risk scenario, firms could turn to additional cost-cutting measures, including a reduction in employment or a downward adjustment of wages. Subsequently, lower employment, household demand, and investment would pull down growth (Figure 6).
Republic of Poland: Corporate Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Republic of Poland: Corporate Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Republic of Poland: Corporate Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Scenario Analysis: Gross Operating Surplus 1/
(Percent change)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: Eurostat and IMF staff calculations.1/ See Appendix for detailed assumptions.Scenario Analysis: Gross Operating Surplus 1/
(Percent change)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: Eurostat and IMF staff calculations.1/ See Appendix for detailed assumptions.Scenario Analysis: Gross Operating Surplus 1/
(Percent change)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: Eurostat and IMF staff calculations.1/ See Appendix for detailed assumptions.D. Banks
Banks have healthy capital buffers and are able to withstand substantial stress. So far, there are only mild signs of deflation impacting bank balance sheets. Effects have mainly been observed through narrowing interest margins on the back of declining lending rates alongside easing monetary policy, putting pressure on profit margins. In an adverse scenario with protracted lowflation, further narrowing of interest margins could reduce profits, deterring credit supply.
17. The Polish banking sector is able to withstand substantial stress. Banks have ample capital buffers, with capital adequacy ratios at around 15 percent. Reliance on foreign funding has declined and stress tests routinely show that the sector is able to withstand substantial stress. Amid continued deflation since July last year, the authorities have also initiated work to examine the potential consequences of low inflation on the banking sector.
18. So far, there are no substantial signs of balance sheet spillovers. A steady decline in nonperforming loans in the consumer loan segment supports the finding that household balance sheets remain resilient. Nonetheless, nonperforming corporate loans picked up moderately in late-2014, though NPLs may not provide the full picture of credit risk (for example, length of recovery, including legal proceedings, impacts these statistics) and are somewhat impacted by end-year seasonal factors. Hence, substantial balance sheet spillovers have not materialized on account of the overall still-robust household and corporate sector health.
19. However, interest margins have narrowed. A reduction in policy interest rates to reinvigorate growth and inflation fed into lending rates. In particular, the 100 basis point reduction in the Lombard rate in October 2014 translated into lower interest rates on consumer credit with 4× Lombard rate defining the upper limit for lending rates. The recent additional 50 basis point reduction in March would likely further squeeze margins. With declining lending rates, the interest rate spread4 gradually narrowed, reaching its lowest level in ten years at 3.3 percentage points in December 2014. As market interest rates tend to impact the interest rate on assets faster than on liabilities, net interest margins also started to decline. In the bank lending survey, banks reported easing interest rate spreads on average corporate and housing loans. Nonetheless, non-interest charges, such as fees, limit the full spillover from declining interest rate margins to profits. In addition, as the interest rates on liabilities fully reflect changes in market interest rates, the net interest margin would likely stabilize.
20. The narrowing interest margins are weighing on bank profitability, despite still-robust credit growth. Narrowing interest margins have adversely impacted bank profitability. While cumulative profits in 2014 grew about 7 percent, the return on assets declined toward the end of 2014 (Figure 7). Nonetheless, year-on-year credit to the private sector strengthened during 2014, ending the year with credit growth at around 7 percent. However, consumer credit growth diminished about 2 percentage points to around 4½ percent during the last half of 2014, suggesting that domestic demand could weaken going forward.
Republic of Poland: Assessing Effects on Bank Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Republic of Poland: Assessing Effects on Bank Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Republic of Poland: Assessing Effects on Bank Balance Sheets
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
21. Going forward, potential adverse balance sheet effects should be carefully monitored. To the extent that protracted lowflation in a tail risk scenario reduces the demand for credit by households and corporations, the profit-generating base for banks (i.e., lending) would be directly affected. In addition, the quality of outstanding credit would worsen and deter credit supply. This would feed into the real economy, resulting in slower economic activity. While strong capital buffers in banks help mitigate financial stability concerns, going forward it will be important to carefully monitor balance sheet health in light of the still-high risk of prolonged lowflation. In this regard, the ongoing work by the authorities to assess the potential implications of low inflation for the banking sector is welcome.
E. General Government
Poland’s budget structure makes it sensitive to price developments. While the recent spell of deflation has had limited effect on public finances so far, there are early indications that the decline in prices may have started to adversely affect revenue performance. Scenario analyses suggest that a protracted period of lowflation could reduce fiscal space and make it more challenging to achieve fiscal targets. Policies should therefore aim to manage the associated fiscal risks, including by using conservative inflation projections in preparation of budget forecasts and identifying contingency measures to support the implementation of the stabilizing expenditure rule and facilitate a timely and effective response to any inflation surprises.
22. Poland’s budget structure makes it sensitive to price developments. On the revenue side, this is reflected in the prominence of taxes on goods and services, which account for about 18 percent of the annual revenue collection. On the spending side, while some expenditure categories are sensitive to price developments (e.g., government purchases of goods and services or social expenditures indexed to inflation), other categories, such as the public wage bill, are inherently more rigid. With the wage bill at around 10 percent of GDP (amounting to one quarter of primary expenditures), a combination of protracted low inflation and a rigid wage bill could significantly reduce fiscal buffers.
Poland: Composition of Revenues and Expenditures, 2014
(In percent of total)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: IMF staff calcuations.Poland: Composition of Revenues and Expenditures, 2014
(In percent of total)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: IMF staff calcuations.Poland: Composition of Revenues and Expenditures, 2014
(In percent of total)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Sources: IMF staff calcuations.23. So far, deflation in Poland has had limited impact on fiscal space. Gradual fiscal consolidation continued in 2014, supported by wage restraint, lower debt service following the pension reform, and a partial rebound in tax revenues on the back of stronger domestic demand. As a result, the headline deficit declined by 0.8 percentage points of GDP. However, recent disappointing VAT revenue collection indicates that the decline in prices may have started to adversely affect revenue performance. And given the risk of protracted low inflation going forward, it is important to understand potential implications of such a scenario for the budget.
24. To analyze the impact of protracted low inflation on public finances, we augment the macro-fiscal framework with specific behavioral parameters.5 The macro-fiscal framework takes into account specific characteristics underpinning the fiscal framework in Poland. With the ongoing wage freeze, we assume that public sector wages do not react to inflation.6 Social benefits are indexed to inflation with some lags, and investment responsiveness to inflation is reduced by the high external financing content from EU funds. On the revenue side, Poland’s high dependency on indirect taxes implies high sensitivity of tax revenue to inflation developments. Social contributions are linked to nominal wages, while income taxes are impacted by both current and past inflation developments. The simulation assumes that under the low inflation scenario, yields on government bonds would come down, reflecting easing monetary conditions. The framework also takes into account possible divergence between CPI inflation and the GDP deflator in the short-run.7 The baseline CPI inflation path follows staff’s baseline projection, whereas the downside scenario for inflation is presented in the Appendix.
25. A protracted period of low inflation could reduce fiscal space. A protracted period of low inflation would entail an increase in the primary deficit and overall fiscal deficit of 1 and 0.7 percentage points of GDP, respectively, compared to the baseline (Figure 8). This is the result of higher expenditure ratios, partly reflecting wage rigidities, which are only partially offset by higher revenue ratios on account of lower nominal GDP. At the same time, public debt is some 7 percentage points of GDP higher by 2020, thus breaching the debt threshold of 48 percent of GDP set in the Public Finance Law and used in the authorities’ expenditure rule.8
Impact of Low Inflation on Public Finances
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff calculations.Impact of Low Inflation on Public Finances
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff calculations.Impact of Low Inflation on Public Finances
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff calculations.26. A smaller fiscal space would make it more difficult to achieve fiscal targets. The authorities target a structural fiscal deficit of 1 percent of GDP (medium-term objective (MTO)) by 2019, and the expenditure rule has an objective of stabilizing the debt-to-GDP ratio below 48 percent of GDP. Reaching and maintaining these targets in a protracted low inflation scenario would require additional fiscal measures of more than 0.5 percent of GDP.
27. Policies should aim at managing the resulting fiscal risks. This calls for using conservative inflation projections in preparation of budget forecasts, particularly when the risks of lower-than-expected inflation are high, as is currently the case. The corrective mechanisms embedded in the authorities’ stabilizing expenditure rule require fiscal adjustment following accumulated deviations of the deficit from the MTO, including those stemming from erroneous inflation forecasts. While effective implementation of the rule should substantially reduce the risks of fiscal slippages, it should be supported by specific fiscal measures. Identifying contingency measures ahead of time would strengthen the credibility of the stabilizing expenditure rule and facilitate a timely and effective response to any inflation surprises.
F. Conclusion
28. Low inflation has so far had only limited economic impact. The generally healthy private and public sector balance sheets have shielded the economy from adverse developments. Household debt has increased but remains below debt tolerance thresholds. NFCs and banks remain profitable, though recent indicators point to some loss in banking sector profitability. In addition, public sector revenues have started to show signs of weakness.
29. However, protracted lowflation raises risks of adverse real-financial loops. While consequences of low inflation so far appear mild, in a tail-risk adverse scenario a protracted period of lowflation risks feeding into sectoral balance sheets and weighing on growth. Such a scenario could result in an adverse loop of reduced household consumption, weaker corporate and bank profits, declining investment, and lower domestic demand pulling inflation further down.
30. Policies should focus on guiding inflation back to target and managing risks from lower-than-expected inflation. To prevent a tail risk stagnation scenario, monetary policy should focus on avoiding low inflation becoming entrenched in expectations. Alongside, careful monitoring of the health of sectoral balance sheets would ensure timely policy response should lowflation persist. The authorities’ ongoing work to assess potential implications for the banking sector of low inflation is therefore welcome. Conservative inflation projections in the public sector budget would help preempt unwarranted surprises for revenue collection and identifying contingency measures to respond to lower-than-expected inflation would facilitate meeting fiscal targets.
References
End, N., Tapsoba, S., Terrier, G., and Duplay, R., 2014, “Sailing With No Wind: The Impact of Deflation and Lowflation on Fiscal Aggregates,” IMF research Bulletin, Vol. 15, No. 4, International Monetary Fund, December.
IMF, 2013, “Euro Area Policies. 2013 Article IV Consultation. Selected Issues Paper,” Chapter III: Indebtedness and Deleveraging in the Euro Area, IMF Country Report No. 13/232, International Monetary Fund, July.
IMF, 2014, “Republic of Poland. Selected Issues,” Chapter II: Corporate Sector Vulnerabilities, IMF Country Report No. 14/174, International Monetary Fund, June.
Lee, D. and Lim, H., 2014, “Is Household Debt Sustainable in Korea?” Journal of the Asia Pacific Economy, http://dx.doi.org/10.1080/13547860.2014.940760.
Appendix I. Methodology
A. Households: Estimating household debt space and sensitivity analysis
A simple econometric model shows a strong response of household saving-to-debt ratios. The econometric model fits the household primary saving ratio to lagged levels of household debt ratios in a cubic form. The cubic form is chosen as it is found to be the closest representation of the functional form between the two variables as highlighted by a non-parametric LOWESS function. We use quarterly data for all variables from 2003:Q1 to 2014:Q1, including seasonally-adjusted series for household debt, saving, and disposable income. The model includes several other determinants of savings to check the robustness of the results (Table AI.1).
Poland: Econometric Estimates of the Household Saving Reaction Function
(Dependent variable: Household primary saving-to-income ratio)
Poland: Econometric Estimates of the Household Saving Reaction Function
(Dependent variable: Household primary saving-to-income ratio)
| (1) | (2) | (3) | (4) | (5) | |
|---|---|---|---|---|---|
| Household debt-to-income (t-1) | −6.054*** | −4.996* | −5.660* | −6.357** | −6.119** |
| (-2.861) | (-1.928) | (-1.976) | (-2.486) | (-2.588) | |
| [Household debt-to-income (t-1)]2 | 0.145** | 0.120* | 0.137* | 0.156** | 0.148** |
| (2.703) | (1.836) | (1.905) | (2.305) | (2.482) | |
| [Household debt-to-income (t-1)]3 | −0.00107** | −0.000870* | −0.00103* | −0.00118* | −0.00109** |
| (-2.442) | (-1.694) | (-1.792) | (-2.031) | (-2.277) | |
| Real disposable income growth | 0.475** | 0.577** | 0.469* | 0.462* | 0.468* |
| (2.426) | (2.518) | (1.968) | (1.825) | (1.742) | |
| PLN/CHF exchange rate | −8.647* | −7.386 | −7.328 | −8.028 | −8.542 |
| (-1.699) | (-1.224) | (-1.257) | (-1.222) | (-1.347) | |
| Household saving ratio (t-1) | 0.346* | 0.226 | |||
| (2.023) | (0.961) | ||||
| Lombard rate | −0.936 | ||||
| (-0.978) | |||||
| Household loan rate | −0.289 | ||||
| (-0.359) | |||||
| CPI inflation rate | −0.0733 | ||||
| (-0.157) | |||||
| Intercept | 105.1*** | 85.99* | 100.6* | 109.0** | 105.5** |
| (2.982) | (1.915) | (1.910) | (2.510) | (2.528) | |
| Observations | 41 | 41 | 41 | 41 | 41 |
| R-squared | 0.392 | 0.469 | 0.488 | 0.393 | 0.392 |
Poland: Econometric Estimates of the Household Saving Reaction Function
(Dependent variable: Household primary saving-to-income ratio)
| (1) | (2) | (3) | (4) | (5) | |
|---|---|---|---|---|---|
| Household debt-to-income (t-1) | −6.054*** | −4.996* | −5.660* | −6.357** | −6.119** |
| (-2.861) | (-1.928) | (-1.976) | (-2.486) | (-2.588) | |
| [Household debt-to-income (t-1)]2 | 0.145** | 0.120* | 0.137* | 0.156** | 0.148** |
| (2.703) | (1.836) | (1.905) | (2.305) | (2.482) | |
| [Household debt-to-income (t-1)]3 | −0.00107** | −0.000870* | −0.00103* | −0.00118* | −0.00109** |
| (-2.442) | (-1.694) | (-1.792) | (-2.031) | (-2.277) | |
| Real disposable income growth | 0.475** | 0.577** | 0.469* | 0.462* | 0.468* |
| (2.426) | (2.518) | (1.968) | (1.825) | (1.742) | |
| PLN/CHF exchange rate | −8.647* | −7.386 | −7.328 | −8.028 | −8.542 |
| (-1.699) | (-1.224) | (-1.257) | (-1.222) | (-1.347) | |
| Household saving ratio (t-1) | 0.346* | 0.226 | |||
| (2.023) | (0.961) | ||||
| Lombard rate | −0.936 | ||||
| (-0.978) | |||||
| Household loan rate | −0.289 | ||||
| (-0.359) | |||||
| CPI inflation rate | −0.0733 | ||||
| (-0.157) | |||||
| Intercept | 105.1*** | 85.99* | 100.6* | 109.0** | 105.5** |
| (2.982) | (1.915) | (1.910) | (2.510) | (2.528) | |
| Observations | 41 | 41 | 41 | 41 | 41 |
| R-squared | 0.392 | 0.469 | 0.488 | 0.393 | 0.392 |
The estimated saving reaction function is used to compute the household debt limit. Following Lee and Lim (2014), we estimate the household debt limit as the debt ratio at which household debt is stabilized and additional primary savings are no longer generated to meet the debt servicing needs. In other words, it is the intersection of the equilibrium saving rate (when debt and asset accumulation are null in the debt dynamics equation (1) of the main text) and the saving-debt reaction function estimated econometrically. Since the rate of inflation enters directly into the debt dynamics equation, it is possible to generate stress scenarios of the response of debt limits to inflation levels. The corresponding debt limits are depicted in the text chart “Household Debt Limits” of the main text.
B. NFCs: Scenario analysis
A simple scenario analysis can illustrate the transmission from low prices to profit shares. We use annual sectoral accounts data from Eurostat and compute the gross profit share as follows:
Here, we deflate output and intermediate goods with consumer price inflation. Under different scenarios for the inflation path, real output and input growth, and the growth rate of compensation of employees, we explore the resulting implications for gross operating surplus and the gross profit share (see Table AI.2 for detailed assumptions and results).
Nonfinancial Corporations: Adverse Scenario Simulation1/
(Percent)
Assumptions in italics. Real growth rates are computed from nominal values and CPI inflation.
Nonfinancial Corporations: Adverse Scenario Simulation1/
(Percent)
| 2013 | 2014 | 2015 | 2016 | 2017 | |
|---|---|---|---|---|---|
| Baseline | |||||
| Real output growth | 0.8 | 1.8 | 1.8 | 1.8 | 1.8 |
| Real input growth | −0.2 | 1.3 | 1.3 | 1.3 | 1.3 |
| Nom. compensation of employees growth | 3.5 | 3.5 | 3.5 | 3.5 | 3.5 |
| Inflation | 0.9 | 0.0 | −1.0 | 0.8 | 1.8 |
| Resulting profit share | 51.5 | 51.1 | 50.3 | 50.3 | 50.8 |
| Percent change in gross operating surplus | 3.9 | 2.0 | 0.1 | 3.6 | 5.7 |
| Scenario A | |||||
| Real output growth | 0.8 | 1.8 | 1.8 | 1.8 | 1.8 |
| Real input growth | −0.2 | 1.3 | 1.3 | 1.3 | 1.3 |
| Nom. compensation of employees growth | 3.5 | 3.5 | 3.5 | 3.5 | 3.5 |
| Inflation | 0.9 | 0.0 | −1.5 | −1.0 | −0.5 |
| Resulting profit share | 51.5 | 51.1 | 50.0 | 49.1 | 48.5 |
| Percent change in gross operating surplus | 3.9 | 2.0 | −1.0 | −0.1 | 0.9 |
| Scenario B | |||||
| Real output growth | 0.8 | 1.8 | 0.5 | 0.5 | 0.5 |
| Real input growth | −0.2 | 1.3 | −0.5 | −0.5 | −0.5 |
| Nom. compensation of employees growth | 3.5 | 3.5 | 3.5 | 3.5 | 3.5 |
| Inflation | 0.9 | 0.0 | −1.5 | −1.0 | −0.5 |
| Resulting profit share | 51.5 | 51.1 | 49.9 | 48.8 | 47.9 |
| Percent change in gross operating surplus | 3.9 | 2.0 | −1.6 | −0.9 | 0.0 |
Assumptions in italics. Real growth rates are computed from nominal values and CPI inflation.
Nonfinancial Corporations: Adverse Scenario Simulation1/
(Percent)
| 2013 | 2014 | 2015 | 2016 | 2017 | |
|---|---|---|---|---|---|
| Baseline | |||||
| Real output growth | 0.8 | 1.8 | 1.8 | 1.8 | 1.8 |
| Real input growth | −0.2 | 1.3 | 1.3 | 1.3 | 1.3 |
| Nom. compensation of employees growth | 3.5 | 3.5 | 3.5 | 3.5 | 3.5 |
| Inflation | 0.9 | 0.0 | −1.0 | 0.8 | 1.8 |
| Resulting profit share | 51.5 | 51.1 | 50.3 | 50.3 | 50.8 |
| Percent change in gross operating surplus | 3.9 | 2.0 | 0.1 | 3.6 | 5.7 |
| Scenario A | |||||
| Real output growth | 0.8 | 1.8 | 1.8 | 1.8 | 1.8 |
| Real input growth | −0.2 | 1.3 | 1.3 | 1.3 | 1.3 |
| Nom. compensation of employees growth | 3.5 | 3.5 | 3.5 | 3.5 | 3.5 |
| Inflation | 0.9 | 0.0 | −1.5 | −1.0 | −0.5 |
| Resulting profit share | 51.5 | 51.1 | 50.0 | 49.1 | 48.5 |
| Percent change in gross operating surplus | 3.9 | 2.0 | −1.0 | −0.1 | 0.9 |
| Scenario B | |||||
| Real output growth | 0.8 | 1.8 | 0.5 | 0.5 | 0.5 |
| Real input growth | −0.2 | 1.3 | −0.5 | −0.5 | −0.5 |
| Nom. compensation of employees growth | 3.5 | 3.5 | 3.5 | 3.5 | 3.5 |
| Inflation | 0.9 | 0.0 | −1.5 | −1.0 | −0.5 |
| Resulting profit share | 51.5 | 51.1 | 49.9 | 48.8 | 47.9 |
| Percent change in gross operating surplus | 3.9 | 2.0 | −1.6 | −0.9 | 0.0 |
Assumptions in italics. Real growth rates are computed from nominal values and CPI inflation.
C. General government: Assumptions
The set of assumptions is as follows:
CPI inflation declines by 0.5 percentage points compared to the baseline in 2015 and by 1.8 percentage points in 2016. Throughout the forecast horizon, CPI inflation remains about 2.5 percentage points below the baseline. The resulting headline inflation path in the downside scenario corresponds to that of the corporate sector analysis, scenario A, above (Table AI.2).
The GDP deflator is projected to co-move with CPI inflation. The pass-through from inflation to the changes in the deflator is 0.9, in line with past correlation.
The pass-through from inflation to nominal wages is assumed to be 0.5, assuming some nominal rigidity. In other words, a 1 percentage point decline in inflation results in a 0.5 percentage point decline in the nominal wage growth in the enterprise sector.
The pass-through from inflation to the nominal interest rate on public debt is 0.5 percentage point. In other words, a 1 percentage point decline in inflation results in a 0.5 percentage point decline in the nominal interest rate. In a deflationary environment, we make the assumption that monetary policy would remain accommodative with low interest rates.
Inflation
(Percent)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.Inflation
(Percent)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.Inflation
(Percent)
Citation: IMF Staff Country Reports 2015, 183; 10.5089/9781513518589.002.A002
Source: IMF staff estimates.Prepared by Lone Christiansen and Christian Ebeke.
NFC debt is defined as the sum of liabilities of debt securities, loans, and other accounts payable.
ICR is defined as earnings before interest and taxes (EBIT) in a given period relative to interest expenses for the same period.
The interest rate spread is defined as the percentage point difference between the rate on total new deposits and the rate on new zloty loans. The net interest margin is defined as the difference between 12-month interest income and 12-month interest expenses relative to 12-month average assets.
Simulations of the effects of deflation on fiscal aggregates have recently been discussed at the IMF by End et al. (2014): http://www.imf.org/External/Pubs/FT/irb/2014/04/index.pdf.
An alternative scenario which assumes a gradual decline in wages (including public sector wages) would partially improve the fiscal aggregates. However, the gains from the reduced wage bill would be partially offset by a decline in social contributions.
This aspect is crucial when assessing the effects of short-term CPI inflation shocks on fiscal ratios. For example, lower CPI inflation would affect revenues in the numerator, whereas any decoupling between CPI inflation and the GDP deflator would further lower the revenue-to-GDP ratio.
The debt thresholds set in the Public Finance Law apply to the national definition of public debt, calculated using the average exchange rate for foreign-currency-denominated liabilities, and reduced by the value of liquid funds used for pre-financing of the following years’ borrowing requirements.
