Public Information Notice No. 08/46

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with the Republic of Poland

April 18, 2008

On April 16, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Poland.¹

Background

After two years of sluggish performance, Poland entered its second year of strong economic growth in 2007. Output expanded by 6.5 percent, underpinned by robust and balanced growth in domestic demand. EU accession continued to bolster investors' confidence and private consumption was supported by several factors, notably rising real wages and record-high credit for Poland.

The external sector has been an increasing drag on the economy. Still, the current account deficit (3¾ percent of GDP) remains fully financed by foreign direct investment (FDI), and the underlying balance, estimated to be 4½-6 percent of GDP, is consistent with external-debt stabilizing levels. Moreover, staff estimates do not point to exchange rate misalignment, despite real appreciation since mid-2006.

Inflationary pressures are mounting, most evidently in the labor market. Unemployment fell by about 8 percentage points since early 2006 to about 9 percent—partly fuelled by emigration to Western Europe—and real wage growth has outstripped productivity gains starting in end-2007. So far, this has been largely absorbed through lower profit margins, but core inflation is estimated to have risen from about 1¾ percent at end-2007 to 2½ percent at end-February. With fuel and food prices soaring, headline inflation picked at 4¼ percent (year-on-year) in February, far above the 2½ percent target and beyond the 1½-3½ percent inflation band.

Macroeconomic policies tightened in 2007. Adjusting for cyclical factors, fiscal tightening reached about 1½ percent of GDP, underpinned by expenditure under-execution. The general government deficit is estimated to have fallen to 2 percent of GDP. Meanwhile, reflecting concerns about rising inflation, policy interest rates were raised seven times since April 2007, to 5¾ percent. Still, the increase in nominal rates has been insufficient to prevent real interest rate from falling in the face of accelerating inflation.

The turmoil in international capital markets has had only a limited impact in Poland. Spreads in bond and credit default swap have only risen moderately. In contrast, the stock market retrenchment has been severe, but it followed substantial gains since 2006. While strong domestic credit has increasingly been funded from abroad—consistent with the rising interest differential in favor of the zloty—the overall share of net foreign liabilities is still small and the banking system remains well capitalized and highly profitable. Stress tests show resilience of the banking system to a potential deterioration in the debt burdens of both households and corporates, even in the face of international shocks.

Executive Board Assessment

Executive Directors noted that Poland is enjoying strong and well-balanced economic growth, in large part because of a boom in investment following EU accession. There have been only limited upward pressures on core inflation until recently, the external current account deficit is still relatively low, and the zloty has remained within its estimated equilibrium range.

At the same time, Directors noted that resource constraints are beginning to emerge. This is especially the case in the labor market, where real wage growth has outpaced productivity gains. The more recent uptick in core inflation suggests that there may be diminishing scope for profits to absorb rising unit labor costs, and increased risks to competitiveness. The challenge facing the new government is thus to contain demand pressure, while boosting the economy's supply response, in particular by raising the exceptionally low rate of labor participation.

With output growth remaining robust and inflationary pressures continuing to be relatively high, Directors welcomed the tightening monetary policy cycle under way since last April. Looking forward, and noting that labor market pressures point to the risk of a wage-price spiral, Directors stressed the importance of ensuring that higher inflationary expectations do not get entrenched. They supported the authorities' intention to maintain the tightening bias in monetary policy in order to bring inflation back to target. Some Directors encouraged the authorities to enhance their communication policy to further strengthen monetary policy credibility. Directors welcomed the authorities' commitment to the adoption of the euro as soon as the necessary conditions are met on a sustainable basis.

Directors noted the importance of strengthening Poland's medium-term budgetary framework in order to facilitate the needed expenditure-based consolidation and safeguard against a pro-cyclical fiscal stance. They therefore welcomed the authorities' determination to speed up fiscal consolidation and reduce the structural fiscal deficit to 1 percent of GDP over the medium term. This would help unburden monetary policy, create appropriate cyclical safety margins, and reduce the risk to external sustainability in the event that the private sector's saving-investment balance deteriorates faster than expected over the medium-term. Some Directors saw scope for automatic stabilizers to work in the event that external spillovers cause growth to drop below potential, but a few others urged caution in allowing full play of automatic stabilizers in such circumstances.

Directors noted that the negative spillovers on the Polish economy from the global financial market turbulence have been limited so far. There have been some modest increases in credit default swap and bond spreads, but no major slowdown in credit volumes. Spillovers may have been contained because of the absence of exposure to the US sub-prime market, the limited use of advanced structured products, and the generally high profitability of banks, including the Polish subsidiaries of international banks. Directors also noted that the banking system is well capitalized, and that the overall share of foreign liabilities is small. Nevertheless, they called for continued vigilance.

Directors noted that the recent unification of supervisory functions under the auspices of the Financial Supervision Authority has come at a time when extra vigilance is essential. They called on the authorities to ensure that there are no disruptions in the timeliness and effectiveness of supervision. The Financial Supervision Authority should give priority to formalizing understandings with the National Bank of Poland and the Ministry of Finance on future cooperation.

Directors stressed that the key to boosting long-term growth will be to increase the exceptionally low labor market participation. They welcomed the authorities' intention to pursue reforms that would enhance work incentives, and encouraged them to move ahead with the formulation of such policies. Directors took note of the experience in other EU countries in which labor participation has been boosted with incremental improvements in areas such as product market regulation and the tax wedge. Some Directors pointed to the complementary effects of labor market reforms on medium-term fiscal consolidation. Directors also welcomed the authorities' determination to restart the privatization program, and saw scope for further deregulation of the economy to catalyze more rapid productivity growth.

Directors found that the authorities' commitment to macroeconomic stability, reinvigoration of structural reforms, and the adoption of the euro augur well for Poland's prospects of taking full advantage of its EU membership.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.