Republic of Poland: 2017 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Republic of Poland

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Poland

Abstract

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Poland

Context

1. Poland has been one of the fastest growing economies in the European Union (EU). Historically, Poland’s performance has not been far off that of the fastest-converging economies (e.g., Korea). Even after the onset of the global financial crisis, Poland continued to grow faster than its regional peers at an average rate of 3¼ percent per year, rapidly closing its income gap with the EU, though its convergence relative to the US has slowed after the crisis. This strong performance reflects dividends from earlier institutional reforms, rapid integration into the European economic and financial systems, as well as sound economic management.

uA01fig01

GDP Per Capita

(PPS per capita)

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: WEO and IMF staff calculations.1/ Korea GDP Per capita starts in 1989 relative to Poland’s GDP per capita.

2. The strong growth momentum is expected to continue in the near term. Growth has accelerated to 4 percent in 2017:Q1 from 2.7 percent in 2016, on the back of continued strong consumption and inventory accumulation. Record-low unemployment and a near record-high capacity utilization suggest that the economy is already operating above potential. But the still subdued private investment and lower than pre-crisis total factor productivity (TFP) growth cast a shadow over the medium-term growth prospects.

3. Over the longer-term, growth will be more subdued, if demographic headwinds and structural challenges are not addressed (Figure 1):

  • Shrinking workforce. With birth rates among the lowest in the EU and persistent emigration, the Polish working-age population has been declining by 1 percent annually since 2012, and is expected to shrink by over a ¼ by 2050, resulting in more than doubling of the old-age dependency ratio. If left unaddressed, these trends will reduce potential growth and increase healthcare and pension-related spending. In addition to the demographic pressures, a relatively low participation rate, persistent labor market segmentation, and skill mismatches point to potential misallocation of labor with adverse effects for productivity.

  • TFP growth slowdown. In line with global trends, TFP growth in Poland has slowed significantly after the global financial crisis, falling from an average of 2.4 percent over 2003–07 to barely 1 percent on average over 2013–16. Prior to 2008, strong TFP growth was supported by the rapid institutional and structural transformation of the Polish economy and by Poland’s integration into the EU economic space and European supply chains. With slower expansion of the technological frontier and technology diffusion, Poland will need to rely more on internal drivers of TFP growth.

  • Infrastructure gaps. Compared to many EU economies, Poland has sizable infrastructure gaps. Furthermore, Poland relies heavily on the EU Structural and Cohesion Funds to finance public investment—under the 2014–20 EU funds program it can receive up to EUR 86 billion, and over half of the national public investment during 2014–17 was financed by EU funds. An eventual reduction in EU transfers will have to be offset by funding from other sources if public investment were to be maintained at current levels.

  • Low domestic private investment. The private investment rate in Poland is among the lowest in the EU, while the public sector continues to play a prominent role in the economy, especially in energy, transportation, and other network sectors. Ensuring a more prominent role of the domestic private sector in the future growth and economic transformation of Poland is another challenge.

  • Regional disparities. Eastern regions in Poland—with a relatively large share of small-scale farming—have significantly lower per-capita GDP, productivity and education attainment levels, as well as higher poverty and unemployment rates.1 Ensuring broad-based and inclusive growth requires greater focus on regional development.

Figure 1.
Figure 1.

Poland’s Structural Challenges

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

4. The current strong growth momentum provides an opportunity to advance structural reforms. The Responsible Development Strategy (RDS), which was formally adopted in February 2017, aims to address structural obstacles to sustainable, strong, and inclusive growth. But much work lies ahead to translate the strategy into concrete reform plans and to ensure that the rest of the policy mix is consistent with the goal of lifting Poland’s potential growth, while maintaining fiscal prudence and macro-financial stability.

Recent Developments

5. External demand and financial conditions remain supportive (Figure 2). External demand is recovering despite lingering policy uncertainties in major economies. While the expectations of a fiscal stimulus have lifted forecasts of growth and interest rates in the U.S., the external financing conditions have remained supportive for Poland, given low Eurozone interest rates and subdued global market volatility.

Figure 2.
Figure 2.

Recent Economic and Financial Developments

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

6. Domestic financial conditions are still accommodative (Figures 2, 11). The policy interest rate has been held at a historically low level for more than two years. Yields on government bonds are still relatively low, despite a moderate increase from 2.9 percent in September 2016 to 3.2 percent in June 2017. In line with global trends, Polish equities gained more than 30 percent since end-2016, recovering about three quarters of the stock market losses from mid-2015. Meanwhile, the recent REER appreciation and some tightening in bank lending standards, especially on corporate loans, have led to a slight tightening of the overall financial conditions.

Figure 3.
Figure 3.

Inflation and Labor Market Conditions

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Figure 4.
Figure 4.

External Risks and Vulnerabilities

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Figure 5.
Figure 5.

Inflation Risks and Monetary Policy Responses

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Note: The shock-policy response simulations for scenarios 1 and 2 were carried out by Zoltan Jakab using the semi-structural general equilibrium model (FSGM).
Figure 6.
Figure 6.

Fiscal Consolidation: Convergence Program and Staff Recommendations

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Source: The Convergence Program 2017 Update and IMF staff projections.
Figure 7.
Figure 7.

Banking Sector and Credit Developments

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Figure 8.
Figure 8.

Foreign-Currency Mortgage Loans

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Figure 9.
Figure 9.

Structural Reforms Gaps and Priorities

Structural Reform Gaps

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Figure 10.
Figure 10.

Potential Gains from Structural Reforms

Illustrative Reform Scenarios: Estimated Impact of Specific Structural Reforms on the GDP level by 2030

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Figure 11.
Figure 11.

Financial Market Developments

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: Bloomberg Finance L.P., Haver Analytics, Poland Ministry of Finance, and IMF staff calculations.1/ Selected Euro Area includes Greece, Portugal, Spain, Ireland, and Italy.

7. The near-term growth momentum is strong (Figures 2, 12). Real GDP growth accelerated to 4 percent in 2017:Q1 after a temporary slowdown to 2.7 percent in 2016 from 3.9 percent in 2015 due to weaker investment. The public investment decline last year was driven by a significantly lower absorption of EU funds during the transition to the 2014–20 program, with similar declines observed in other recipients of EU funds.2 Private investment growth has been disappointing as well, with the recent EIB survey pointing to political and regulatory uncertainties as the key factors. However, investment momentum appears to have strengthened in 2017:Q1, with more upbeat PMI and business sentiment indicators, and a pick-up in contracts and disbursement requests for EU-funded projects. Meanwhile, growth is still mainly driven by private consumption, which is supported by solid wage growth, minimum wage hike and higher social spending (the child benefits program).

Figure 12.
Figure 12.

Real Sector Developments, 2011–17

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: Haver Analytics, Poland Central Statistical Office, and IMF staff calculations.

8. The cyclical rebound is in an advanced stage. Different estimation methods consistently show that the negative output gap that opened during the global financial crisis had largely closed by 2015, and a positive output gap opened in 2016. Unemployment is at record low and reflation is gathering pace (Figure 3). Nonetheless, credit growth is moderate at 4.9 percent y-o-y (as of May 2017) and there are no signs of excessive asset price acceleration so far (see charts below).3

uA01fig02

Business and Financial Cycle Indicators

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

9. The labor market is increasingly tight (Figure 3, 12). The unemployment rate (seasonally-adjusted, harmonized) dropped to a historical low of 4.8 percent in April 2017. Firms are increasingly experiencing shortages of skilled labor, with about 30 percent of surveyed firms reporting labor shortages as a barrier to growth. A steady decline in the working-age population that started in 2012 is now felt more acutely amid continued strength of the economy. Compared to the steep fall in unemployment, the very recent acceleration in wage growth (from an annual average of 4 percent to 4.7 percent in the first five months of 2017 in the enterprise sector) seems moderate. A leading explanation of the still relatively restrained wage growth is the large inflow of Ukrainian migrants, reportedly around 1.3 million, many of whom work in Poland on short-term contracts (maximum of 6 months within 12 consecutive months) and at much lower effective wages than local workers.4 Even at the current rate, the real wage growth is already outpacing the real labor productivity growth (Figure 12).

10. Reflation is gathering pace (Figures 3, 13). Headline inflation accelerated from 0 percent in November 2016 to 1.9 percent in May 2017 on the back of rising food and fuel prices, but is still below the NBP’s inflation target of 2.5 percent. A model-based inflation decomposition suggests that the drag from the euro area inflation declined, while the contribution of domestic factors increased (Figure 3, chart 2). Core inflation (headline, excluding food and fuel prices) reached 0.8 percent in May 2017, and other measures of core inflation that capture domestic demand conditions signal even stronger domestic inflationary pressures.

Figure 13.
Figure 13.

Inflation Dynamics and Monetary Developments

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: Consensus Forecast, Haver Analytics, NBP, Statistics Poland, and IMF staff calculations.

11. The fiscal outcome in 2016 was better than expected. The realized general government fiscal deficit was 2.4 percent of GDP in 2016, the lowest level since the global financial crisis. Revenues outperformed due to a significant increase in the VAT and other tax receipts, reflecting improved compliance. Expenditures were under-executed due to weak public investment associated with low absorption of EU funds. However, with a positive output gap, the improvement in a cyclically-adjusted balance is smaller, likely representing a broadly neutral fiscal stance. Public debt had increased to 54 percent of GDP at end-2016, but remains sustainable under a wide range of shocks (Annex VIII).

12. The external position continued to improve (Figure 14). Poland’s current account deficit declined to 0.3 percent of GDP in 2016 (the smallest deficit on record since 1995). This reflects improved terms of trade and more competitive REER, as well as higher exports to the euro area in 2016:Q4 that were supported by the recovery in trade in the global value chains (GVCs).5 Net financial inflows remained weak in 2016, and the small positive financial account was primarily due to the accumulation of reserves that was partly driven by increased repo transactions of the National Bank of Poland (NBP). Net portfolio inflows turned positive in 2017:Q1 in line with broad EM patterns, leading to both nominal and real appreciation of the PLN following a depreciation streak since mid-2015. The overall external position is broadly consistent with economic fundamentals and desirable policies (Annex I), and gross reserves are adequate, amounting to 128 percent of the IMF’s composite reserve adequacy metric as of end-2016.6

Figure 14.
Figure 14.

Balance of Payments Developments, 2011–16

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: NBP and IMF staff calculations.

Outlook and Risks

13. Growth will remain strong in the near term, but longer-term prospects are more subdued. Real GDP growth is projected to accelerate to 3.6 percent in 2017 on the back of stronger EU funds’ absorption (see chart), robust private consumption, and modest recovery of private investment amid supportive external demand. But over the medium term, adverse demographics will weigh on employment growth, pulling GDP growth back to its potential rate of around 2.7 percent by 2022, despite moderate improvements in the investment and TFP growth (Annex II). As domestic demand strengthens and commodity prices recover, import growth is likely to outpace export growth, leading to a moderate widening in the current account deficit over the medium term.

uA01fig03

Poland: EU Structural and Investment Funds

(Expenditures in percent of initial year GDP, cumulative)

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: European Commission, Polish Authorities, and IMF staff calculations.

14. Headline inflation is expected to reach the mid-point of the target band in early 2018. The impulse from the recent strong growth in food and fuel prices will likely taper off in the second half of 2017. Core inflation, however, is set to accelerate amid an increasingly positive output gap and rising wage pressures in a tight labor market, including an 8 percent minimum wage hike that came into effect in January 2017. As rising domestic inflation offsets the diminishing effects from food and fuel price increases, headline inflation is likely to rise gradually toward the NBP’s inflation target of 2.5 percent with limited risks of overshooting in 2017, barring upside surprises on food and fuel price inflation. Assuming a timely monetary policy response, inflation will likely stabilize around the target after 2017.

15. In the near-term, risks to the outlook are broadly balanced (Figure 4 and Annex III):

  • External risks: The external environment can improve further if global growth accelerates on a stronger-than-expected recovery in advanced economies. The key downside risks for Poland include a faster-than-expected tightening in the global financial conditions, as well as growth, financial, or political shocks in Europe. A faster-than-expected monetary policy normalization in the U.S. would lead to higher external borrowing costs, which would have a negative impact on Poland given its relatively high external financing requirements (Figure 4). Possible growth or financial shocks in Europe would have negative spillovers for Poland through trade, GVC and financial channels (Figure 4). A rise of protectionism globally could reduce cross-border trade, capital and labor flows, but would likely have a moderate impact on Poland.7

  • Domestic risks: Both growth and inflation can surprise on the upside if the EU funds’ absorption and investment rise further or if wage growth accelerates faster than expected. On the downside, a delayed monetary policy response to higher-than-expected inflation could lead to inflation overshooting its target, while a weakening of institutions or fiscal slippages could dent investor confidence.

16. Should risks materialize, policy response would depend on circumstances. Poland’s flexible exchange rate, high reserve buffers, and a well-diversified foreign investor base should help mitigate adverse financial spillovers. In the event of an economic downturn, fiscal automatic stabilizers should be allowed to fully operate. In the event of significant capital outflows, the NBP should stand ready to provide both zloty and FX liquidity to the banking sector. If capital outflows intensify, interest rate hikes could be used to stem capital outflow pressure. Poland’s Flexible Credit Line (FCL) arrangement is an added insurance against adverse external shocks, and could also be used as needed to prevent disorderly market conditions. To safeguard against domestic risks, the authorities should remain focused on maintaining strong policies and institutions.

Authorities’ views

17. The authorities broadly agreed with staff’s assessment of outlook and risks. The NBP’s growth forecast is broadly in line with staff’s, with output gap projected to close later this year. The Ministry of Finance (MoF) is more optimistic, forecasting the real GDP growth of 3.8–3.9 percent in 2018–20, on sustained strong investment growth. After a period of deflation, the authorities see domestic inflationary pressures rising slowly, with inflation staying close to the target in the medium term. Higher wage growth is seen as a key driver of future inflation. However, the authorities’ wage growth and core inflation forecasts are more benign than staff’s. On the external side, the authorities saw further normalization of the monetary policy in the U.S. and earlier-than-expected ECB tapering as the key risks, with Brexit and other political event risks in Europe adding to uncertainties. Nevertheless, they noted that Poland’s strong external position, diversified investor base, and flexible exchange rate, supported by the FCL arrangement with the IMF, will help it to withstand external pressures.

Policy Discussions

18. The policy mix should reflect the need to rebuild buffers during good times and to address longer-term growth and fiscal challenges. This year’s consultation focused on policies to achieve higher potential growth over the long term, a durable structural fiscal consolidation over the medium term, and to maintain macro-financial stability amid the current cyclical upswing. The past policies have been broadly in line with Fund’s recommendations (Annex IV), but fiscal consolidation has stalled and the 2013 retirement age increase was reversed, against staff’s advice.

A. Monetary Policy: Managing Reflation

19. The authorities assess the current policy stance as appropriate to keep inflation within the target range over the forecast horizon. The NBP expects the effects of higher oil and food prices to taper off later this year, and the domestic price pressures to remain contained. Thus, the policy rate is expected to be on hold throughout 2017 and well into 2018, though a negative real policy rate is becoming more of a concern.

20. In staff’s view, monetary policy tightening will likely be needed in 2018 to stabilize inflation around its target.8 Staff’s baseline assumption is that wage growth will accelerate gradually amid tight labor market conditions9 with a relatively fast pass-through to core inflation, as suggested by historical patterns. Under these assumptions, headline inflation could reach the upper bound of the target band by end-2018 without monetary tightening (Figure 5). However, there is considerable uncertainty about the wage growth trajectory given the recent disconnect between the unemployment gap10 and wage growth (Figure 5, chart 1). A continuation of the moderate wage growth of around 4 percent in 2017–18 would bring headline inflation below target by end-2018, while faster wage growth could result in inflation breaching the upper bound of the target band in mid-2018 (Figure 5, chart 2). Other risks to inflation include a weaker-than-expected euro area inflation (downside risk) and the pass-through from potential exchange rate depreciation (upside risk) that could be triggered by bouts of global financial market volatility or policy uncertainties. While the risk of a premature tightening is well internalized, it is also important to recognize that a delayed response could lead to more significant and persistent inflation overshooting (Figure 5, charts 3–4). In recent months, all survey and market-implied inflation expectations have adjusted upward (Figure 13). Survey-based one-year and two-year ahead inflation expectations have risen toward 2 percent or higher, while five-year inflation expectations remain stable. Inflation expectations derived from the long-term inflation-indexed government bonds have increased to the 2.5–3.5 percent range. Consensus forecast of the short-term interest rate suggests that investors expect a rate hike in 2017–18.

uA01fig04

Inflation Projections 1/

(Annual percent change, period average)

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: World Economic Outlook and IMF staff estimates.1/ The uncertainty interval was calculated based on the annual CPI inflation forecast errors for Poland from the IMF World Economic Outlook during April 2006–October 2016, following the methodology described in Elekdag and Kannan (2009).

21. Overall, the monetary policy should be data dependent and supported by a clear communication strategy. Staff’s recommendations are as follows:

  • Holding the policy rate steady is appropriate for now. Staff does not see a need for immediate tightening, especially as the increase in headline inflation has so far been mainly driven by external factors, such as higher fuel and food prices, which are expected to taper off.

  • Inflationary pressures should be monitored and the authorities should tighten monetary policy if accelerating core inflation threatens the inflation objectives. The incipient domestic inflationary pressures should be monitored closely, given an opening positive output gap, a pro-cyclical fiscal stance, a negative real interest rate, and a record-low unemployment rate. Because of considerable uncertainty about the future wage growth, monetary policy decisions should be data dependent. When there are clear signs of accelerating core inflation,11 the authorities should tighten to prevent headline inflation from rising above the upper bound of the target range. Given long lags in the monetary transmission, timely actions will be crucial to avoid inflation overshooting and to maintain credibility.

  • The monetary policy response would also depend on the fiscal stance. In the absence of sufficient fiscal adjustment (see the fiscal policy section), monetary policy will need to shoulder a greater burden in managing domestic demand pressures.

  • The monetary policy should be supported by a clear communication strategy. The NBP shou ld provide clear state-contingent rather than time-bound forward guidance based on timely updates of inflation outlook to help guide inflation expectations. The MPC should avoid sending mixed messages that may undermine the credibility of the inflation-targeting framework.

Authorities’ views

22. The authorities agreed that monetary policy decisions should be data dependent and that clear communication is important, but were not in favor of formal forward guidance. The MoF envisages freezing the wage bill for the central government in 2018 to mitigate wage growth. In the NBP’s view, several factors will likely continue to restrain wage growth, including Ukrainian migrants (who earn much lower effective wages), policy-induced switching from the temporary civil law contracts to the labor code contracts (as an alternative to pay raises), and a structural change in labor demand toward less skilled, less experienced, and hence, lower-paid workforce (as the baby-boomers retire). Nonetheless, they noted the uncertainties about future wage growth and hence the risks to inflation outlook. Therefore, they agreed that monetary policy decisions should be data dependent and noted that the current “wait and see” policy is the best option. The NBP reiterated their commitment to timely actions if developments threaten the inflation objectives. However, the NBP was skeptical of a formal forward guidance, fearing that it might trigger market speculation.

B. Fiscal Policy: Rebuilding Fiscal Space

23. The 2017 fiscal stance is procyclical. The general government budget deficit of 2.9 percent of GDP is only a shock away from the EDP limit of 3 percent of GDP and represents a relaxation of about 0.5 percent of GDP in structural terms. Compared to the 2016 budget outcome, the 2017 budget accommodates additional expenditures of about 0.6 percent of GDP: the new child benefits program (the full year effect), a lower retirement age (effective from October 2017), lower revenues from an increased PIT tax-free allowance for low-income tax payers, and the co-financing of higher EU-funded capital spending. Part of the spending increase is expected to be offset by revenue gains from tax administration reforms and by postponing the reduction in the VAT rate planned for this year until 2019.

uA01fig05

General Government Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Source: IMF staff calculations.

24. Fiscal performance so far this year has been better than expected, reducing the risk of breaching the EDP limit. In the first four months of 2017, VAT revenue increased by 33 percent (y-o-y), reflecting strong private consumption, improved compliance (due to recently adopted measures to reduce the VAT fraud), and one-off adjustments of the VAT refunds and settlements12. Other taxes have increased broadly in line with expectations. The strong revenue collection suggests that the fiscal deficit in 2017 could outperform the budget target of 2.9 percent of GDP, though the stance is still likely to remain pro-cyclical.

25. Fiscal consolidation should start as soon as possible to take advantage of the cyclical upswing. The focus in 2017 should be on avoiding any slippages that could lead to breaching the EDP limit and on saving any revenue over-performance. In case of revenue underperformance, contingency measures could include mobilizing savings by using margins built into the budget expenditure assumptions,13 and rationalizing part of discretionary government consumption of goods and services, while avoiding public investment cuts. Although Poland may have some fiscal space for discretionary stimulus given its current debt position (Annex VIII), the fiscal space is limited if one takes into account the fiscal rules, including the debt limits and the Stabilizing Expenditure Rule (SER), which is linked to the medium-term objective (MTO). The need to create space to respond to future shocks coupled with the need to accommodate future aging costs and public investment spending imply that fiscal consolidation should start as soon as possible, at the time when the economy is strong (see Annex V for details). In this regard, the recent reversal of the 2013 retirement age increase, which will add to fiscal pressures through lower social security contributions, higher pension payments, and lower potential growth, is disappointing and goes against the staff’s advice (Annex VI).

26. The authorities’ 2017 Convergence Program update envisages an ambitious consolidation path over the medium term (Figure 6). Under the 2017 update, the headline deficit is expected to improve to 1.2 percent of GDP by 2020 and hit the MTO (a structural deficit of 1 percent of GDP) by 2021. This path is underpinned by assumptions of strong nominal GDP growth, sizable revenue gains from the tax administration reforms, and conservative projections of social benefits and wages (constant in real terms).14 Several new initiatives to further improve tax administration are planned for 2017–18, including mandating an online filing of “Standard Audit Files,” creating a centralized IT system to tackle tax fraud, and introducing separate VAT accounts under the “Split Payment Mechanism.” The authorities also stated their intention to contain spending in line with the SER, though specific cuts remain to be identified. In this regard, they are considering some discretionary measures, including freezing public-sector wages in 2018 and rationalizing spending on active labor market policies.

27. Staff supports the authorities’ intention to reduce the structural and headline deficits by about half a percent of GDP each year during 2018–19, in line with the 2017 Convergence Program Update. Such adjustment would help reverse the current pro-cyclical stance and build a “safety buffer” relative to the EDP limit. Beyond 2019, the pace of consolidation could be lower if there is a need to accommodate any direct fiscal costs of growth-enhancing structural reforms (see the structural reforms section).15 However, the MTO will still need to be reached no later than 2023, given projected aging costs, exacerbated by the retirement age reduction, and in anticipation of the phasing out of the EU funds.

28. Staff recommends a menu of measures that could be used if revenues from tax administration reforms turn out to be insufficient to meet the Convergence Program targets. Staff projects the headline deficit to decline to 2.3 percent of GDP by 2020, given announced policies and assuming: (i) a more conservative budgeting of potential gains from tax administration reforms; (ii) a higher public sector wage bill and social benefits reflecting upward pressures from accelerating private sector wages; and (iii) more conservative growth assumptions. The authorities’ efforts to close the VAT compliance gap by tightening regulations and improving the efficiency of tax administration focus on the right areas, and the results achieved so far are very encouraging. However, the expected revenue gains from these measures (1.3 percent of GDP by 2020) appear overly optimistic (Annex VII). International experience shows that revenue gains from tax administration reforms are uncertain, and therefore, should be budgeted conservatively (Figure 6).

29. The medium-term consolidation should be supported by comprehensive fiscal structural reforms. Staff’s main recommendations are:

  • Revenue collection: Efforts should focus on closing not only the tax compliance gaps, but also the tax policy gaps. Until higher revenues from tax administration reforms are realized, the 2011 VAT rate increase should be maintained. Meanwhile, given the large VAT policy gaps (Annex VII), staff encourages the authorities to consider removing some preferential rates and tax exemptions.

  • Expenditure efficiency: Increasing efficiency of current expenditures, notably on social protection, could generate additional savings without compromising income distribution.16 There is also some room to improve efficiency of public investment, where there is still a gap of about 20 percent relative to the efficiency frontier. Further improvements in public investment management—notably, in areas of project appraisal and management—could bring tangible efficiency gains as well.17

  • Pension system: Additional fiscal savings can be achieved through reforms of special pension regimes and measures to mitigate the adverse impact of the retirement age reduction. In this regard, the recent pension system review suggested introducing a minimum-years-of-service requirement, reducing incentives for double-dipping (getting a pension and working at the same time), and increasing public awareness of the old age poverty. However, these measures may not fully offset the negative impact of the retirement age reduction (Annex VI).

  • Fiscal institutions: Staff welcomes the authorities’ intention to develop a medium-term budgetary framework starting in the 2018 budget cycle with the IMF’s TA support. As a priority, staff urges the authorities to operationalize SER by identifying specific expenditure measures ex ante, underpinned by a well-defined system of medium-term expenditure forecasts for each ministry.

Authorities’ views

30. The authorities saw upside risks to fiscal performance in 2017 and underscored their commitment to the medium-term fiscal consolidation. They expected the deficit to outperform the budget target of 2.9 percent of GDP in 2017 on the back of strong revenue collection, and indicated their intention to save revenue overperformance. They agreed with staff’s assessment on the need to rebuild fiscal space, which would help increase the capacity to respond to shocks and to accommodate long-term pension expenditures and public investment. They were optimistic on the timing and magnitude of expected gains from tax administration reforms, and thought such revenue gains would be sufficient to achieve the medium-term fiscal objective. The authorities acknowledged that any additional structural adjustment will be politically challenging before the 2019 elections. They concurred that the reversal of the 2013 retirement age increase could entail additional fiscal costs, but noted that the defined contribution pension system and tight labor market conditions could encourage eligible retirees to stay in the work force longer.

C. Financial Sector Policies: Preserving Resilience

31. Banks remain sound, but profitability continues to decline (Figures 7, 14). Banks are well capitalized, with the average capital adequacy ratio of 17.7 percent and the average Tier 1 capital ratio of 16.1 percent in 2016:Q4. The banking sector liquidity continued to improve on the back of strong deposit growth from both corporate and household sectors, leading the loan-to-deposit ratio to decline to 106.6 percent in 2016:Q4 (Table 5). The bank asset quality improved as well, with the non-performing loans (NPLs) edging down to 7 percent of total loans. However, profitability continued to decline.18 The NBP’s latest assessment suggests that commercial banks remain resilient to a range of macroeconomic, market and liquidity shocks, albeit lower profitability reduced their buffers, while some of the credit unions and cooperative banks continue to struggle to stay afloat.19

Table 1.

Responsible Development Strategy–Key Areas and Selected Quantitative Targets

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Note: the areas not included in this table, but also covered in the RDS are digitization, transportation, energy, environment, and national security.
Table 2.

Selected Economic Indicators, 2013–22

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Sources: Polish authorities and IMF staff calculations.

Real GDP is calculated at constant 2010 prices, while the authorities’ definition is based on prices of the previous year.

According to ESA2010.

The difference from general government debt reflects different sectoral classification of certain units.

Credit defined as in IFS: “Claims on other sectors.”

NBP Reference Rate (avg).

Annual average (2000=100).

Table 3.

Balance of Payments, 2013–22

(Millions of U.S. dollars, unless otherwise indicated)

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Sources: National Bank of Poland and IMF staff calculations.

Net reserves are calculated as a difference between gross reserves (official and other FX reserves) and FX liabilities.

Short-term debt is on remaining maturity.

Table 4.

Monetary Accounts, 2010–17

article image
Sources: Haver, IFS, NBP, and IMF staff calculations.

The difference between deposit money bank claims on the central bank and central bank claims on banks relates to banks’ reserves and currency in vault.

Table 5.

Financial Soundness Indicators, 2010–16

(Percent)

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Sources: NBP and KNF.Note: Data according to Financial Soundness Indicators (FSI), except for asset composition and quality (indicators not part of FSI reporting template).

Data for domestic banking sector (Bank Gospodarstwa Krajowego excluded). Since 2014: data on capital in accordance with CRDIV/CRR.

32. Falling bank profitability reflects the challenges of operating in a low interest rate environment with rising costs (Figure 7). Interest margins remain squeezed amid low interest rates and stable lending rates. Banks’ non-interest expenses have increased, including from the bank asset tax, additional contributions to the Bank Guarantee Fund (for both deposit guarantee and bank resolution funds), as well as changes in tax deductibility. As a result, the aggregate banking sector return on equity has dipped below the cost of equity.

33. Profitability pressures have not affected credit supply yet. Lending standards tightened slightly in recent quarters (especially on corporate loans20), but do not appear to have constrained credit growth. A deceleration in corporate credit growth has been driven by weaker demand for working capital, while credit for investment continued to grow at 9.9 percent (as of March 2017). Mortgage lending has been constrained by the macroprudential measures,21 while consumer credit has seen the fastest growth.

34. The final solution for FX mortgage loans is still pending, but will likely entail further costs for banks. The stock of FX mortgages has been shrinking since March 2012 and now accounts for 7.7 percent of GDP (Figure 8). While these loans are not viewed as a source of systemic risk either by the NBP or by the Financial Supervision Authority (KNF), the solutions proposed by the authorities to address consumer protection concerns related to FX mortgages could entail significant costs to banks. The authorities’ approach appears to be two-pronged—legislative and regulatory—with the final solution possibly including both elements:

  • The legislative solution: the early-2016 proposal of a mandatory conversion of FX mortgage loans into PLN was replaced in August 2016 by the President’s Office (PO) proposal for banks to repay excessive FX spreads unfairly charged to borrowers. The PO proposal is currently under review by the parliamentary Public Finance Committee. Depending on the final decision, expected this summer, the cost could be in the range of PLN 4–9 billion (up to two-thirds of the 2016 banking sector profits).

  • The regulatory solution: The Financial Stability Committee (KSF) released nine recommendations in January 2017 aimed at encouraging banks to restructure FX mortgages, including through conversion of FX mortgages into PLN (Figure 8). The key measures include higher risk weights on FX mortgage loans (from 100 percent to 150 percent), and broadening the scope of the existing Borrowers’ Support Fund (established in 2015) to include a dedicated fund based on contributions by banks with FX mortgage portfolios to cover the costs incurred during voluntary restructurings. The expanded Borrowers’ Support Fund is viewed as the key tool to accelerate the restructuring of FX mortgage loans. Most regulations are expected to come into effect by end-2017 or early 2018. Progress on voluntary conversion has been slow so far, as banks are waiting for clarity on the final solution.

35. Recent polices have contributed to tighter sovereign-bank linkages:

  • Banks’ holdings of government bonds: Banks’ holdings of domestic government bonds, which are exempt from the bank asset tax, have seen a sharp step increase in February 2016, the first month when the bank asset tax was calculated and paid, and have continued to rise since then. By April 2017, banks held about 40 percent of total government bonds outstanding, which constituted about 14 percent of banks’ total assets. Larger holdings of government bonds imply higher exposure to market risk in the event of capital outflows triggered by global market volatility or a re-assessment of Polish sovereign risk in the event of fiscal slippages.

  • State ownership of financial intermediaries: With the sale of the UniCredit’s remaining share in Pekao S.A. to the state-controlled insurance group PZU and the state-owned Polish Development Fund (PFR), the share of domestic ownership of the banking sector has risen to above 50 percent, and the share of state-controlled banks to 36 percent (in percent of total banking system assets). In addition to increasing financial sector concentration, the latest transaction has also created a systemically important financial conglomerate operating in banking and insurance markets, which entails new prudential and macro-prudential challenges for supervisors.

uA01fig06

Sovereign-Bank Linkages

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

36. Preserving financial sector resilience is critical to ensuring financial stability and strong growth. Staff’s main recommendations are:

  • Foreign-currency mortgages. Staff’s view remains that a case-by-case approach to FX mortgage restructuring is preferable—that is, only distressed mortgage borrowers would be offered a restructuring. Both the legislative and the regulatory solutions appear to be significantly less costly for banks compared to the mandatory blanket conversion scheme proposed in early 2016. That said, their impact on the sector and on individual banks should be carefully assessed. The drawback of the proposal to repay excessive FX spreads (legislative solution) is that it does not address the stock of FX mortgages. In comparison, the regulatory solution does aim to provide incentives for banks to reduce their FX loan books, but there is a risk that the final package of measures could induce banks to offer overly generous terms to the FX mortgage holders (without due regard to the debt-to-income or loan-to-value ratios) because of pressures to meet the FX loan restructuring targets.

  • Profitability pressures on banks, including from tax burdens: The authorities should continue to monitor the impact of the bank asset tax on banks’ activities and risk profiles, and stand ready to revise its design, if adverse effects become apparent. Staff’s view remains that a tax on profits and remuneration (proxying the VAT from which the financial sector is exempt) would be less distortionary than a tax on assets. A more holistic assessment of the impact of rising total costs on banks’ profitability, resilience and credit supply would be warranted.

  • Credit unions and cooperative banks: The difficulties in the credit union and cooperative bank segments should be addressed in a sustainable way, including by encouraging further consolidation/integration and ensuring an orderly market exit of unviable firms.

  • Sovereign-bank linkages: The increasing sovereign-bank linkages warrant close monitoring, as they may mutually reinforce fiscal and financial vulnerabilities, increase banks’ exposure to market risk and affect liquidity in the government bond market. In this regard, maintaining a strong and independent supervision and robust macroprudential framework is critical.

Authorities’ views

37. The authorities shared the view that the final solution to FX mortgages should preserve financial stability, but were less concerned about the effects of the bank asset tax. The authorities believed that major risks associated with the introduction of the bank asset tax have not materialized and banks were strong enough to “digest” the bank asset tax without adverse impact on credit supply. While the final solution to address consumer protection concerns related to FX mortgages is still pending, the authorities noted the need to manage total costs to banks to safeguard their resilience and financial stability. The authorities viewed the rising sovereign-bank linkages in a more positive light: they saw the sizable increase in banks’ holdings of government bonds as reducing the financing risks for the government without adversely affecting banks’ risk profiles, and the acquisition of the subsidiary of UniCredit by the state-controlled insurer and the state-owned PFR as reducing the risk of negative financial spillovers from abroad.

D. Structural Reforms: Upgrading Poland’s Growth Model

38. Given demographic pressures and baseline policies, potential growth will likely remain below the pre-crisis level over the medium term. On current policies, staff estimates that the baseline potential growth will likely drift to 2.7 percent (Annex II), well below the pre-crisis average. These estimates already reflect positive spillovers from improving global environment on Poland’s TFP growth (Figure 18), without which the estimated potential growth rate would have been 0.2–0.3 percentage points lower.

Figure 15.
Figure 15.

Banking Credit Growth and Funding, 2011–17

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: Haver Analytics, International Financial Statistics, NBP, KNF, and IMF staff calculations.
Figure 16.
Figure 16.

Coping with Demographic Headwinds1

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: Eurostat, GUS, Ministry of Family, Labor and Social Policy, Total Economy Database, and IMF staff calculations.1/ For more details see 2017 Article IV Selected Issues Paper, Chapter 1
Figure 17.
Figure 17.

Investment Challenge1

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: The Polish authorities, EIB and IMF staff calculations.1/ For details see Article IV 2017 Selected Issues Paper Chapter 2
Figure 18.
Figure 18.

Total Factor Productivity1

Citation: IMF Staff Country Reports 2017, 220; 10.5089/9781484310304.002.A001

Sources: Penn World Table 9.0, WEO, Conference Boar