Concluding Remarks of 1998 Article IV Consultation Discussions--Poland
December 15, 1998
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Poland--1998 Article IV Consultation
1. Poland’s transition remains squarely on track. With real output now more than twenty percent above its 1989 level and more than two thirds of all jobs in the private sector, the country stands out as a success among transition economies. This strong performance is a tribute to the consistent implementation of sound economic policies. There has been good progress in reducing the structural fiscal deficit in recent years. The monetary authorities’ steadfast policy of reducing inflation has permitted substantial reductions in nominal interest rates, which took place mostly in the latter half of 1998. Also key has been the government’s firm commitment to continued restructuring and privatization. Because of Poland’s strong policy fundamentals, the international capital markets have been increasingly distinguishing Poland in a positive way among emerging-market countries in the wake of the Russian financial crisis that began last August.
2. An important medium-term goal for Poland is to maintain high investment spending and growth, without exacerbating balance of payments pressures. Continued progress with structural fiscal consolidation will be essential to achieve these goals. First, further fiscal consolidation will strengthen the domestic saving rate, provide scope for an early reduction in real interest rates, and thereby permit more "crowding in" of investment. Second, such action will improve the external balance by helping to ensure that the current account deficit remains in a sustainable range in 1999 and over the medium term. This will be essential to maintain the strong confidence that international investors have been showing in Poland, especially over the past year. And third, it is important to maintain the established momentum for cutting lower priority fiscal spending during the next several years, in order to make room for the higher budgetary expenditures on infrastructure that will be essential for industrial development and restructuring, and also to meet the needs of accession to the European Union. Efforts to accelerate industrial restructuring and privatization are also critical, for they will allow the country’s potential output to expand at a faster rate by ensuring that resources can respond to market signals.
3. Since its inception in early 1998, the Monetary Policy Council (RPP) has achieved a high level of anti-inflation credibility and has contributed significantly to the growing perception that Poland has strong policy fundamentals. The RPP’s decision to move to an inflation-targeting framework provides guidance for the conduct of monetary policy and an anchor for inflation expectations. In the view of the Fund staff, the RPP’s medium-term policy statement is clearly argued and its inflation target of not more than 4 percent by 2003 is reasonable and achievable. The staff commends the RPP’s decision to begin publishing semi-annual inflation reports during 1999 that will have a forward-looking focus. The new framework will require the authorities to continue to expand the NBP staff’s research and analytical capabilities, especially in the areas of inflation monitoring and short-term liquidity forecasting.
4. In 1997 there were concerns that Poland’s economy was overheating. In line with Fund staff recommendations, the authorities tightened both monetary and fiscal policy and successfully engineered a "soft landing" in 1998. As growth of domestic demand has moderated to a rate more in line with output growth, the external current account deficit has remained in a safe range and the bulk of external financing has been in the form of foreign direct investment inflows, features that have proved to be important in light of the recent turmoil in world financial markets. It now appears that real output growth has been running at a little above 5 percent in 1998. Meanwhile, CPI inflation this year should register a sharp deceleration below the official target of 9½ percent (December on December), in part because of much lower agricultural prices related to reduced Russian food imports.
5. However, in recent months the economy’s momentum has decelerated further, with the weakness concentrated in exports and in the industrial and agriculture sectors. In part, the slowdown in exports has been associated with the retrenchment in Russia and other eastern European markets since September. Moreover, the persistent strength of the zloty throughout 1998 has also weakened Poland’s international competitiveness since mid-year. On the domestic front, although the authorities have reduced nominal interest rates since the spring of 1998 as the economy has slowed, disinflation has been stronger than anticipated. Real interest rates have thus remained higher than expected, especially in relation to forward-looking inflation expectations, and have thus slowed credit growth, weakened domestic demand growth, and appreciated the zloty. It now seems likely that, on current policies, output growth in 1999 will slow to roughly 4¾ percent while the unemployment rate, which has been falling steadily for five years, will rise above its current level of 9¾ percent. Given this growth slowdown and the prospects for continued low inflation in global commodity markets, inflation in 1999 is likely to be roughly 7½ percent (December on December)—somewhat below the current official target range of 8-8½ percent.
Macroeconomic Policies in 1999
6. Although the latest macroeconomic projections are more pessimistic than those that were used in September-October to formulate the 1999 draft budget, we believe the best strategy is to fully implement the proposed 1999 budget and achieve its targeted deficit. First, even if budgetary developments in the early part of 1999 are weaker than expected, modest contingency measures would likely be successful in putting the fiscal deficit back on track. Among the possible actions would be earlier implementation of increases in excise tax rates, higher-than-budgeted tax increases on fuels, a rise in the preferential VAT rate on certain items, and recourse to some further spending restraint. Second, it would be undesirable to apply fiscal stimulus in the short run, because if the downturn proved to be short-lived a fiscal expansion could impact on an economy that was already turning up, and thus could prove to be undesirably pro-cyclical.
7. Also important is the fact that persevering with the current path of fiscal consolidation will provide greater scope for adjusting the mix of macroeconomic policies by a marked relaxation of monetary conditions. Lower nominal and real interest rates would have several salutary effects. First, lower interest rates would help to stimulate investment spending. Second, they would work in the direction of strengthening the competitiveness of Poland’s exports, thereby helping to underpin exports and economic activity. In fact, it is possible that such a rebalancing of macroeconomic policies could end up exerting a net expansionary impact on output in 1999, while at the same time lowering the risk that the external current account deficit (which is likely to increase in 1999 if the adverse shock to exports persists) would rise to an unsustainable level. Finally, unlike a fiscal expansion, a mix of fiscal restraint and monetary relaxation would avoid raising the real interest rate, widening the current account deficit, and attracting interest sensitive short-term capital inflows that could prove volatile in the event of a change in external investor sentiment.
8. Strict implementation of the budget in 1999 will present challenges. The decentralization of the budget that will result from next year’s administrative reform will lead, in the longer term, to a more efficient system of government. But as local governments, social funds, and the health fund acquire greater budget autonomy (in both revenue and spending areas), it will be essential to sustain strict budgetary discipline. Health care, in particular, is an area where the state budget has not been able to exert adequate spending controls in recent years, and where arrears have increased dramatically. Although the authorities are putting measures in place to contain spending by other units of the general government, the possibility that these controls will not be sufficient is a major source of uncertainty for the 1999 budget outcome. Continued structural fiscal consolidation over the medium term will also require strong resolve. Poland spends a much higher share of its national income on the social sectors—especially on pensions and disability allowances—than do most other countries. Over time, it is essential that the authorities reduce untargeted transfers to the population and restructure the pension system so that it is financially sustainable, increases saving, and allows a reduction in excessively high payroll tax rates—the broad goals of the government’s pension reform that will be phased in during 1999. Reducing untargeted social spending will allow the overall tax burden to fall, leaving more money in private hands, and will also create room in the budget to increase capital spending, which is essential for sustaining economic growth in the medium term.
Monetary and Exchange Rate Policies
9. Given the continued reduction in the fiscal deficit in 1998, and the further progress foreseen in the draft 1999 budget, the RPP’s December 9 decision to cut the intervention rate—the interest rate on the 28-day NBP bill—by 150 basis points was a welcome and helpful development. If the 1999 budget is implemented as planned, there should be room for an early easing of monetary conditions through significant further reductions in interest rates in the first months of 1999, which would still be consistent with achieving the authorities’ inflation objectives for next year and the medium term. In addition to providing for a favorable adjustment of policies to support growth, lower interest rates would reduce the incentive for potentially destabilizing short-term capital flows into Poland. Lower interest rates would also tend to limit the incentive for banks and other financial intermediaries to offer currency-linked loans to domestic residents which, although currently manageable, could increase the private sector’s foreign exchange exposure risks over time.
10. The RPP has stated that, with the shift to inflation targeting, one aspect of the medium-term strategy is for the zloty to be allowed more freedom to vary with market conditions, so that it can move to a level that reflects its long-run fundamentals for transition to an ERM-II framework and, eventually, EMU. To move toward this goal, the RPP has—appropriately, in the mission’s view—widened the zloty’s trading band in 1998 and the NBP has undertaken less active intervention in the foreign exchange market. This policy shift has served the country well, as strong capital inflows during much of the year, and then sharp temporary outflows in response to the Russian crisis, were addressed without undue stresses on the system. In addition, the steady reductions in the rate of crawl of the zloty’s trading band were consistent with the authorities’ goal of reducing inflation. The staff is supportive of the increased flexibility of the zloty and agrees that the main focus of monetary and exchange rate policy should be disinflation. The general easing of monetary conditions described above for 1999 should take some of the upward pressure off the zloty, but still be consistent with the RPP’s inflation target.
11. The Ministry of Finance is developing proposals for major reform of personal and corporate income taxes for submission to Parliament in the spring of 1999. There appears to be broad acceptance for several of the basic tenets of tax reform: simplifying the personal income tax system, reducing marginal tax rates, broadening the tax base, and increasing the standard amount exempt from tax. These measures will improve the efficiency of the tax system while reducing the burden of taxes on low-income households. On the corporate side, there are also plans to create a better environment for business investment by reducing a poorly structured set of investment allowances and other tax preferences and substituting a simpler, more generous accelerated depreciation allowance system. These proposals are in line with modern tax policy thinking and would help Poland create a more efficient tax system that should also be more attractive to foreign investors. Better tax and customs administration would help to ensure that the revenue needs of the budget are met and that there is a high level of compliance with the tax system. There is considerable scope for the extension of modern methods of tax administration to Poland. These should remain a high priority of the government and should be seen within the context of European integration.
12. The present structure of the NBP’s balance sheet limits the effectiveness of its monetary instruments. The cost of sterilization operations has been significant and a large overhang of liquidity remains, while the high nonrenumerated reserve requirements risk serious disintermediation with the prospective opening of the capital account in 2000. The authorities’ plans to remove the fixing of the exchange rate should help the NBP manage liquidity better by closing a window at which commercial banks have obtained zloty liquidity on demand, and the recent introduction of a spread around the central fixing rate is an appropriate interim step in that process. The mission also supports the authorities’ intention to convert roughly Zl. 15 billion of government bonds currently held by the NBP into marketable securities that can be used for sterilization purposes. Besides facilitating NBP liquidity management, the conversion would help to make transparent the financial relationship between the government and the NBP by relieving the NBP of some of its quasi-fiscal operations, and would help deepen the market for longer-term securities.
13. This mission has undertaken an analysis of the financial regulatory framework and the procedures for supervising banks in Poland. A summary of the mission’s specific findings and recommendations is given in the Annex. The assessment is that the banking system is generally sound and well-supervised. Nevertheless, particularly in view of the rapid evolution of the domestic financial system, there are several areas where the authorities will need to be particularly vigilant. First, the growth in foreign currency or currency-linked lending to domestic residents may entail increased credit risk associated with the ability of local borrowers to service their foreign currency denominated liabilities. Lower interest rates will tend to diminish this activity over time, but regulators need to pay particular attention. The authorities also need to keep monitoring closely the rapidly growing off-balance sheet activity of banks. Second, the rapid integration of the financial markets and the universal banking system in Poland raises the risks of contagion among financial groups. The staff recommends that the authorities at the earliest feasible date, obtain the legal authority to conduct supervision on a consolidated basis and conclude memoranda of understanding among the relevant supervisory agencies toward that end. Thirdly, the established policy of rehabilitating some banks through selective reductions in reserve requirements—though it applies mostly for specific amounts of reserves and only for limited periods—imposes quasi-fiscal burdens on the NBP, and the mission recommends that this means of support be discontinued as soon as it is feasible to do so.
14. Privatization has been a clear area of success in 1998, and the authorities’ efforts are to be commended. In spite of an uncertain global capital market environment for emerging market countries, the initial public offering of TPSA proceeded well, and steady progress with a range of other privatization deals has put the government roughly on its privatization revenue schedule for the year. For 1999, an ambitious privatization schedule of Zl. 15 billion in sales is being planned. The authorities’ appear to be well prepared and have accelerated their activities (such as securing investment advisors) over the past year.
The mission would like to thank the authorities for their warm welcome and excellent cooperation, including candid and lively discussions, during our stay in Warsaw. We look forward to continued close and fruitful collaboration between Poland and the Fund during the coming year.