Mission Concluding Statement 

Poland -- 2002 Article IV Consultation, Concluding Statement of the IMF Mission

March 14, 2002

1. After a difficult year in 2001, signs of a recovery are appearing. But just as Poland's growth slowdown at least in part played off the global slump, the timing and strength of the recovery will be tied to the pick-up in activity in Western trading partners—probably lagging it slightly. Fortunately, Poland will start from a position of strength in some important respects: inflation is low and the fruits of the hard-fought battle to tame inflation expectations will support growth; the modest current account deficit leaves room for a pick-up in imports; enterprises, having adapted to a highly competitive market environment, are leaner and more efficient; and private financial institutions are well-placed to support a recovery with diversified financial services. With EU accession in sight, Poland has the potential to grow strongly.

2. The aim of economic policies over the next year will shift gradually to managing a nascent recovery. Many hurdles lie ahead. A recovery that nurtures a strong increase in private investment and exports would be crowded out unless the recent deterioration in public finances is reversed and high public sector spending is curtailed. The time-proven benefits for growth from sustained low inflation and investor confidence will be lost unless the institutional integrity of the National Bank of Poland (NBP) and its unfettered ability to conduct monetary policy are put beyond question. And firms will only have the flexibility to respond aggressively to new opportunities and to foster a job-rich recovery if the labor market is reformed. While addressing these domestic issues, Poland must continue to pursue negotiations for EU accession and put in place procedures to ensure EU funds are used fully and efficiently.

The Economic Outlook

3. Even as the early signs of returning confidence appear, activity remains sluggish. Responding to lower inflation and a brightening outlook for incomes, private consumption seems to be picking up. But robust activity will require a revival of export growth and a reversal of last year's sharp drop in investment. The deep interest rate cuts during the past year and recent weakening of the zloty should help, although still weak demand in Germany together with excess productive capacity of Polish companies and trimmed profits will be a damper. Thus, a convincing rebound may not come until the second half of 2002, leaving growth at 1-1½ percent and unemployment higher yet again. With weak demand, inflation should remain at about 4 percent and the current account deficit 4 percent of GDP.

4. Looking beyond 2002, Poland's growth potential should be at least 4-4½ percent per year. Simple "catch-up" to Western European income levels at a moderate pace would suggest such growth. But the benefits from EU accession as trade links deepen and institutions are harmonized makes it all the more likely. Still, growth in this range cannot be taken for granted. It may well require sharp increases in private investment which, together with downward pressure from EU accession on private saving rates, would push current account deficits back even beyond the levels of 1999-2000. Thus without reining in fiscal deficits, maintaining low inflation, and renewing the commitment to structural reform, Poland could sap the strength of its recovery.

Strengthening Public Finances

5. The sharp increase in the deficit in 2001 has eroded the credibility of fiscal policy. To some extent, the widening of the deficit was due to the unanticipated slowdown in economic activity—in particular, revenues declined with the drop in economic growth. But it also reflected large increases in non-interest State spending, which is influenced far less by the business cycle yet rose by more than 12 percent. Sharp increases in transfers and subsidies to households, the agricultural sector and state enterprises as well as in wages all contributed. The result was an economic cash deficit which we provisionally estimate at some 5 percent of GDP, up from 2.2 percent in 2000.

6. The 2002 State budget has made a fresh attempt at the task of reining in spending growth. It is regrettable that this restraint relied heavily on expenditure freezes and postponement, but this was perhaps unavoidable given the limited time for preparation. Also regrettable was parliament's decision to increase spending beyond what was proposed in the draft budget. The original revenue projections were reasonable for a year of nascent recovery. Assuming some restraint on the part of local governments, it seems safe to expect that the economic deficit will again be about 5 percent of GDP. In cyclically adjusted terms, this more than reverses the deterioration in the fiscal position in 2001.

7. The real test for fiscal policy, however, lies beyond 2002 when policies must address several weaknesses in public finances. Structurally, the level of expenditures, and taxation, is high for Poland's level of development. Some spending on subsidies and transfers to households is inefficient and would better be saved or partly diverted to more productive uses. Equally important are the threats to the strength of the recovery from high public sector borrowing requirements and a relatively heavy tax burden. Failure to curb spending increases and reduce the deficit would impede needed growth of credit to the private sector and unleash a renewed widening of the current account deficit as private investment takes off. Beyond this, Poland should start to look to the Maastricht criteria for the fiscal deficit so as to facilitate ERM2 at the earliest possible date.

8. An effective way to meet the fiscal requirements for a strong recovery is to adopt a clear expenditure rule—that is, to anchor public finances on a firm and specific expenditure path. The intention to limit State spending growth to projected CPI inflation plus 1 percent through 2006 is a step in this direction. Such a rule, if strictly applied, is well-suited to Poland's circumstances. It focuses policy on expenditure, which has been the main source of deficit bias. And by holding spending growth below nominal GDP growth in all but the very weakest environments, it provides for a gradual reduction in the size of the government and in the cyclically adjusted deficit. It also gives fiscal policy a much-welcome medium-term orientation—moving away from the pre-occupation with year-to-year fiscal deficits and allowing automatic stabilizers to work through the cycle. During years of slow growth, deficits may expand as revenue weakens; but equally as growth recovers, the spending rule together with stronger tax collections would lower the fiscal deficit—just when stimulus for private demand is strongest.

9. The proposed spending rule—limiting State spending growth to projected CPI inflation plus 1 percent—raises two key questions: first, as the recovery progresses will this be sufficient to rein in deficits and reverse rising debt dynamics? The rule has several loopholes. Applied only to State spending, it leaves open many avenues for passing funding of expenditure obligations to budgetary funds or local governments. Also, without an enforced correction for over-projected inflation, an upward drift in spending could be a problem. It will be difficult to resist using these loopholes as budget pressures tighten. Thus, while the "CPI plus 1" rule could produce a gradual drop in the deficit relative to GDP after 2004 and stabilize the debt ratio at about 50 percent of GDP, this would require stiff conditions. Growth must recover to rates consistently over 4 percent; privatization inflows must amount to about ½ percent of GDP each year; and local governments and budgetary funds need to restrain their spending even if state transfers were cut back. Any slip from these conditions would unleash worsening deficits and potentially a steady rise in the debt ratio above 50 percent. To guard against these threats, and to advance even-handedness and transparency, we would recommend more restrictive caps on local government borrowing or even extending the "CPI plus 1" rule to local governments, perhaps on a 3-year average basis to take into account their lumpy expenditures. Such an extension of the rule would make the fiscal accounts robust to slower-than-projected growth, and ensure that the deficit and debt relative to GDP decline sharply. Just as important, it would allow room for tax cuts.

10. The second key question is whether spending programs can be changed as needed to adhere to the rule. The "CPI plus 1" rule will succeed only if budget formulation moves beyond the ad hoc expenditure compression of 2002. Even as early as 2003, when the budget will be burdened by the expenditures postponed in 2002, the "CPI plus 1" rule will be difficult to achieve without some changes to the earmarking of revenues and formulas for social transfers. The government's medium term plan recognizes the importance of a comprehensive approach to expenditure rationalization. In this process, all types of spending—including those that cater to deeply held social attitudes on the acquired rights of citizens—must be on the table. At the same time, the government's development plans, while addressing some genuine needs, must be scaled to available resources: careful consideration of the housing development plans and the pace of the road development plans is needed.

Preserving the Credibility of Monetary Policy

11. The resolution now before Parliament on the role of the NBP is ominous. The NBP, one of the fundamental institutions born of the transition, is a bulwark of Poland's market economy. More recently the Monetary Policy Council (MPC) has built a strong operation of the inflation targeting framework, securing the confidence of international investors. Any effort to interfere in the operations of these institutions or change the established rules would significantly imperil Poland's hard-won gains in establishing a stable market economy. Whatever one's position on the present stance of monetary policy, one should not lose sight of the deep interest rate cuts that have been possible in the last year, without affecting inflation expectations. Placing the integrity of the NBP and MPC, particularly with regard to setting interest rates, beyond question is critical to market confidence. Moreover, it is essential that traditional channels of communication between the government and the NBP are open, so that information flow can improve and a constructive dialogue take place.

12. Monetary policy decisions in the coming months will be difficult. They should be based on the end-2003 target of inflation below 4 percent. The 900 basis point reduction in the NBP bill rate over the past year was large and its cumulative effects need to be assessed carefully to avoid an overshoot in interest rate cuts. Consideration also needs to be given to the subdued levels of core and PPI inflation as well as the prospect of a substantial output gap even after a recovery takes hold. Under these conditions, any possible changes to interest rates should be made cautiously. Temporary supply shocks—which could be in either direction—may well cloud the inflation outlook, but policy should neither anticipate nor react to them.

13. The policy of non-intervention in the foreign exchange markets remains appropriate. While the zloty has been fairly volatile and is perhaps now at the strong-end of what is desirable, intervention is likely to be futile and costly. Moreover, the non-intervention policy is transparent to the market, and the volatility of the exchange rate is a factor discouraging unhedged foreign currency borrowing. We welcome the decision to remove the remaining controls on short-term capital transactions. Since liquid short-term assets and liabilities—in Polish and offshore derivatives markets—are readily available, the controls are unlikely to have deterred speculation. Their abolition should bring these markets onshore and enable better monitoring.

14. With the emergence of a low inflation environment, the inflation targeting framework should be updated. The MPC needs to announce a new medium-term inflation target, as the present target extends only to end-2003. Looking ahead to the requirements of ERM2 and ongoing relative price adjustment, a target of 3 percent through end-2005 should be considered. Given the volatility of headline inflation, wider bands than at present would seem appropriate. Also, the end-year "test date" for inflation should be replaced with a continuous target to help guide inflation expectations.

Minimizing Risks in the Financial Sector

15. Although the slowdown has taken a toll on the financial sector, it remains generally sound. The low inflation environment will be more conducive to financial intermediation. But other risks have emerged. Not surprisingly, in the weak economic environment, the share of non-performing loans has risen. Close monitoring must continue to ensure that capital and provisioning remain adequate. Another important development has been a sharp increase in foreign exchange borrowing of households as well as businesses. This growth, which started from a low base, partly reflects large interest rate differentials during the past two years. Demand for such lending should be decelerating with falling differentials. But other factors may also be at work, including anticipation of future stability in the zloty-euro rate. It is critical that banks continue to inform borrowers of the exchange rate risk, and the supervisory authorities monitor this source of credit risk.

Policies for a Job-Rich Recovery

16. The rise in unemployment is a major concern. It is difficult to disentangle the importance of various causes—the cycle as well as restructuring have both had a part. But these influences have dealt an even harsher blow because of overly restrictive labor market practices—hindrances to hiring and firing, workplace regulations, excessive payroll taxes, and high minimum wages, to name a few. Fortunately, both cyclical and restructuring effects will be short-lived if the recovery is greeted with an easing of restrictions and regulations.

17. The list of reform measures in the medium term strategy is a good start. It identifies a set of key impediments—excessive bureaucratic burdens on businesses, non-wage labor costs, and restrictions on setting work times, using fixed-term contracts and terminating employment. The critical test, however, is implementation. Looking ahead, efforts are needed to identify other labor practices that might stymie foreign direct investment and prevent especially small- and medium-sized enterprises from taking appropriate risks. The proposal to differentiate the minimum wage for labor market entrants is welcome. But it should be followed with a differentiation of the minimum wage across regions, ideally reflecting local price levels. The plethora of social benefits whose duration and value rise with the level of unemployment weaken incentives for job search. Their duration should be standardized across the country. These steps are key to redressing the high disparities in unemployment across regions—a problem that will remain a challenge as restructuring continues.

18. Poland can ill-afford the inefficient use of financial and human resources that many remaining state-owned enterprises entail. The shift in privatization strategy and, in some cases, abandonment of privatization plans is of concern. In many sectors the focus should be on minimizing restructuring costs and preparing for early privatization. This is all the more urgent with an approaching recovery which should not only improve market conditions for privatization, but also open opportunities for absorbing retrenched labor and employing freed financial resources. The reversal of plans to privatize PKO BP is a particular concern: not only does it entail fiscal costs but also PKO BP's dominant role in the financial system impedes the efficiency of monetary policy. More generally, the direct subsidies and tax forbearance that have been necessary to sustain many state-owned enterprises could provide the backbone to financing the needed improvements in transportation infrastructure. Concern about possible monopolistic market structures that have developed post-privatization in some sectors should be addressed through improved regulatory control.

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19. In sum, with a rebound in the world economy Poland's prospects are strong. But they will need to be nurtured by continued reform and stabilizing macroeconomic policies. The agenda for reform has been clear for sometime, and the new government has embraced many aspects of it. Decisive implementation is now needed.

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We would like to express our thanks for the warm welcome and close cooperation that we have received.

Annex: Rationalization of Public Expenditure

Achieving the spending restraint implicit in the CPI plus 1 percent rule is predicated on significant improvements in the efficiency of spending and major cuts in lower priority areas. In the near term, expenditure will have to be restrained primarily in areas not subject to legislative or formulaic mandate. Over time, changes in the basic budgetary framework will be needed to comply with the overall expenditure limits. Currently, spending is driven by a set of implicit and explicit rules, including earmarking of revenue and social attitudes on the acquired rights of citizens to budgetary transfers. In the coming years, large-scale investment on infrastructure and restructuring costs envisaged in the government's medium-term strategy will likely add to expenditure pressures. Even if a case could be made for each of these expenditures individually, the government does not have sufficient resources to honor them simultaneously. The budget framework—including the laws and regulations that govern it—should be adjusted to explicitly recognize that choices must be made among different types of spending within an overall budget envelope.

The government's medium-term strategy recognizes the need for a comprehensive approach to expenditure rationalization. Indeed, efforts are already underway on several fronts to identify expenditure reforms. First, the strategy itself includes a number of suggestions in the areas of social insurance, social assistance and public administration. Second, the World Bank is conducting a public expenditure and institutional review (PEIR) that will assist the government by providing a comprehensive set of policy options, together with their estimated savings, consistent with spending constraints. Third, the OECD is conducting a country review that can contribute to the policy debate. The intergovernmental working groups currently reviewing expenditure policies on the central and regional levels can develop the details of these options and present a comprehensive set of recommendations to the government. Implementing these reforms is a matter of urgency as the benefits of most policy changes will start small and build with time.

The scope for improving efficiency and generating savings is evident in a few priority areas; the ongoing reviews of spending will undoubtedly identify many more.

Social Insurance (pension, disability and sickness benefits administered by ZUS). The government has taken a number of important steps to address problems in these programs. In particular, the pension system is in the midst of a comprehensive reform, eligibility criteria for disability and sickness benefits have been tightened, and compliance procedures have been strengthened. Nevertheless, room for significant savings remains in the residual pay-as-you-go pension scheme (for instance, by indexing pensions for price change only, raising the retirement age for women to that for men, and increasing the early retirement age) and in the calculation of disability benefits under the new pension scheme (primarily by changing the formula for disability benefits to be consistent with the formula for old-age benefits). In addition, consistent adherence to the new procedures for awarding disability benefits not only on new applications, but also on applications for the extension of benefits, can achieve substantial reductions in outlays for these benefits without compromising the program's goals.

Agricultural social insurance (KRUS) and agricultural subsidies. Significant changes in the system of social insurance and subsidies in the agricultural sector need to be considered. Since KRUS is, in effect, a social welfare program, the benefits must be focused on those most in need of assistance now and during restructuring the agricultural sector. This could be facilitated by freezing enrollment in KRUS, moving higher income agricultural workers into FUS, means-testing social assistance for those remaining in the system. The fundamental problem is that the current programs provide disincentives for the surplus labor in rural areas to shift into non-agricultural employment. Without such a shift, Poland will be unable to achieve its economic potential.

Wages and employment in the public sector. The wage bill has been frozen for 2002. This was necessary to achieve the immediate budget objective, but would create efficiency and morale problems if it were applied over a prolonged period. Careful examination of the structure of the current workforce—on a program-by-program and agency-by-agency basis—can identify opportunities to improve efficiency. Without such improvements it will be difficult, if not impossible, to increase wages and remain within expenditure limits. An example of a potential efficiency improvement is to merge local offices of different state and local programs, not only taking advantage of economies of scale, but also making government services more accessible.

Health and education. These sectors must function much more efficiently given that sizable increases in budgetary resources are not likely to be available in coming years. Reforms in the health sector should target a more efficient service delivery. Investment in education should take into account the changing demographics in Poland and the need to invest in teacher training and in advanced technology.