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Concluding Statement of the IMF Mission to Poland
May 23, 2001
1. Mid-2001 finds Poland facing a difficult, yet also promising, situation. On the positive side, progress towards EU accession continues apace, and, thanks to the quick responses of macroeconomic policies, inflationary and current account pressures have receded. Also, Poland has proved resilient to recent turmoil in emerging markets, and a wave of restructuring triggered by the Russia crisis has resulted in remarkable gains in productivity and lower labor costs. At the same time, rising unemployment, together with external shocks and the tightening of policies, have ushered in a period of weak demand and output growth. Adding to these difficulties are the strong zloty and declining growth in export markets. In this environment, there is some scope to set policies so as to support growth and employment while remaining vigilant about the risks of re-igniting inflation and current account pressures. Our discussions during the past week have focused on how policies-both in 2001 and in the medium term-can achieve these goals.
Outlook and Policies for 2001
2. As we see little evidence yet of a pick-up in activity from late-2000, our projection for GDP growth this year, at 3 percent, is at the lower end of the spectrum. Consumption growth is likely to be constrained by falling employment and this, alongside already weakened corporate profitability, will dampen investment growth. Weakening external demand and the strength of the zloty will likely limit export growth. Without obvious reasons to expect an early reversal of these conditions, the risks to the growth projection are mainly on the downside. The outlook for inflation and the current account in 2001 is more positive. We expect the end-year inflation rate to be below the 6-8 percent target range and the current account deficit to fall to 5½ percent of GDP. These projections rest on the assumption that both interest rates and the value of the zloty will fall according to current market expectations and that the general government economic deficit will be in the range of 2½-3 percent of GDP.
3. In this environment, the task for policies in 2001 is to use opportunities to support activity within the constraint of preserving macroeconomic stability. For fiscal policy, this means avoiding an undue contractionary influence which would result from cutting spending to compensate fully for the expected revenue shortfall. We estimate this shortfall to be some 1 percent of GDP in the state budget. With moderate efforts to tighten spending relative to budget plans, an economic deficit of 2½-3 percent of GDP should be feasible. Such a deficit would represent modest underlying progress towards the objective of medium-term consolidation, while appropriately limiting the negative effects of a fiscal tightening in a weak growth environment. As important as the execution of the 2001 budget are decisions about draft bills now before the Sejm that, if passed, could have a major effect on public finances in 2002 and beyond. These pertain to policies in the areas of health spending, unemployment and other social benefits, agriculture, defense and industrial restructuring. We have strong reservations about the merit of any bill that would have large implications for spending not explicitly considered in the context of a medium-term expenditure plan. Thus we believe that these decisions should be delayed until a new medium-term framework is in place (see below).
4. Monetary policy can help foster a recovery by steadfastly pursuing the goal of lowering inflation below 4 percent by 2003 and, consistent with this objective, making use of the room available to cut interest rates. The recent interest rate cuts are welcome in this regard. Nonetheless, since end-2000, monetary conditions have tightened: inflation expectations appear to have fallen faster than short-term interest rates, and the zloty has strengthened considerably. The realization of market expectations of a further 200-250 basis point reduction in the remainder of this year would likely lower real interest rates and help ease upward pressure on the zloty from what it otherwise would be. The Monetary Policy Council (MPC) should be ready to adjust interest rates in either direction relative to current market expectations as the balance of medium-term inflation risks shifts.
5. Abstaining from intervention even as the zloty strengthens remains in Poland's long-term interest of promoting hedging and minimizing vulnerabilities to external shocks. We note that the government transferred proceeds from a recent Euro bond issue through the National Bank. While clearly a one-off transaction, it nevertheless was an intervention and such transactions should be avoided in the future. We support the government's plans to eliminate remaining controls on short-term capital flows in due time.
Outlook and Policies for 2002 and Beyond
6. The government that will be formed following September's elections will need to move quickly to establish a medium-term framework for policies to start even as soon as 2002. Such a framework will need to be built on estimates about the economy's growth potential and the sustainable current account deficit and a reasonable target for inflation. Such estimates are likely to be controversial but recent experience suggests that with strong policies, output could grow on average by about 5 percent annually, the current account deficit could be sustained at about 5 percent of GDP, and inflation should be targeted below 4 percent from 2003.
7. Central to achieving these objectives will be revised medium-term fiscal goals. The prospect of weak growth this year and next means that the present objective of a balanced budget in 2003 is now out of reach. Formulating fiscal goals might best be approached with the following considerations in mind:
· The government should estimate the level of public savings required for a sustainable current account deficit, while making room for rising private investment and assuming the private savings rate will return to the level of the late 1990s. In our view, an increase in public savings from the 2000 level on the order of 1½-2 percent of GDP within 3-4 years is likely to be needed.
· The fact that the tax burden in Poland is high relative to other leading EU accessants and EU members such as Greece, Portugal, Spain and Ireland should rule out tax increases. Indeed, creating room to lower the tax wedge on labor would be beneficial to promoting labor demand.
· The centerpiece of the fiscal framework should be a clear and firm commitment to a path for expenditures consistent with the targeted increase in public savings. This should be based on credible structural measures. Discussions with officials indicate, and comparisons with other leading EU accessants confirm, that there is significant scope for savings in social transfers. Savings on the public wage bill and subsidies to enterprises may also be possible. At the same time, room will have to be made for higher EU-accession-related spending..
· On implementation, we would strongly urge making medium-term expenditure targets the primary yardstick for assessing the execution of fiscal policy while placing less emphasis on the year-to-year deficit outcome. Such a shift would appropriately focus attention on the aspect of fiscal policy most amenable to policy control and most critical to securing needed public savings over the medium-term. This would also permit some flexibility for revenues to offset temporary fluctuations in output. Full transparency of government operations, clarity, and timely dissemination of information will, of course, remain essential.
8. Ideally, the 2002 budget should be formulated in this framework and incorporate progress towards medium-term goals. Assuming supporting policies, a nascent recovery is envisaged next year with GDP growth rising to as much as 4 percent. A pick-up in consumption and investment growth prompted by the expected interest rate cuts underpins this outlook. In this setting, aiming for an increase in general government economic spending slightly below potential nominal GDP growth would be consistent with an economic deficit of 2-2½ percent of GDP. The actual outcome would be at or below the lower end of this range if output growth and revenues were stronger than now envisaged and vice versa. Such a fiscal stance should pave the way for improved coordination of monetary and fiscal polices.
9. Adjustments to the monetary framework would also better enable the MPC to guide inflation expectations. First, a continuous inflation target with a regularly extended horizon is needed. Second, while a band around the inflation target recognizes important uncertainties in forecasting and about the transmission mechanism, emphasis should be shifted to the central point in the band rather than to the band edges. This would focus expectations and policymaking on the central target. In this regard, we recommend that consideration be given to adopting a quarterly target path for inflation, extending over 2-3 years, and to adopting the central point in the band as the target. When inflation moves outside the band, the MPC could provide a public assessment of the deviation and state if monetary policy actions were necessary to bring inflation back within the band.
10. The present high unemployment rate indicates that there are rigidities in the labor market. These are recognized by the government, proposals have been put forward, but no action has been taken. We therefore welcome the government's initiatives to address these issues. We would strongly urge the authorities to advance a reform agenda which should include: (i) revising the labor code to allow greater flexibility to employers and employees in reaching agreement on work practices and schedules; (ii) differentiating the minimum wage by regions and by workers' years of experience; (iii) minimizing the bureaucratic burden especially on small enterprises; (iv) permitting greater use of fixed-term contracts; and (v) limiting benefits that stifle job search. In addition, investment in education and training programs should be directed toward reducing the mismatch between the skills of new labor market entrants and the requirements of new jobs being created.
11. Poland's banking system is generally sound, as exemplified by its resilience to shocks in the past few years. The proposed revisions to the banking law are clear steps toward addressing some supervisory issues identified in the recent Financial System Stability Assessment (FSSA). We urge early enactment of this legislation. For the immediate future, we see two potential sources of rising credit risk. First, further declines in corporate profitability and employment may trigger an increase in non-performing loans. Second, any tendency for corporations to increase their borrowing in foreign currency in view of the large interest differentials could be a further source of vulnerability if these loans are not adequately hedged.
12. The challenges facing the Polish economy during the next year are immense. Careful management of economic policies will be necessary to bring the economy back towards its full growth potential without compromising macroeconomic stability. Yet, with close coordination of policies and determination to pursue needed changes on all fronts, the prospects for long-term growth and stability are excellent.
We would like to express our thanks for the warm welcome and close cooperation that we have received in Warsaw.