Poland -- 2003 Article IV Consultation, Concluding Statement of the IMF Mission
March 10, 2003
1. Following two difficult years, a strong recovery is within reach. The slowdown has taken a toll through rising unemployment, falling investment, and weak business and financial sector profits. Yet, in some other respects, adjustments have left Poland stronger: firms and banks approach this recovery leaner and more competitive than in the past; wage setting has responded to the rise in unemployment; and price stability has been achieved. These factors, together with the present large output gap, give a fair degree of confidence that growth will rebound over the next year.
2. But will this recovery be strong enough to reduce structural unemployment and realize the high end of Poland's economic potential? Certainly, the promise of membership in the European Union and eventual adoption of the euro present an historic opportunity to modernize the economy, converge rapidly to EU income levels, and strengthen trade and financial ties with the EU. But much still depends on whether policymakers seize the opportunities presented by the recovery to rein in the fiscal deficit, press ahead with labor market reform, push the privatization agenda, and address inefficiencies in the agriculture sector. Our talks over the past two weeks have focused on many of these issues.
3. The recovery is likely to gather momentum in 2003, but it will remain fragile. Poland enters 2003 with the beginnings of a recovery supported by the growth of exports and private consumption. We expect some deceleration of private consumption as unemployment continues to rise and wage growth remains weak. But exports, bolstered by the effective depreciation of the zloty, should continue to grow, and investment, responding to rising use of capacity and profits, should turn around. With a neutral impulse from fiscal policy, growth is projected to rebound moderately, to 2½-3 percent for the year. Even though import growth is likely to pick up rather strongly and the terms of trade to weaken, the current account deficit should be about 3¾ percent of GDP. Also, with wage moderation and continued productivity growth, we project year-end inflation at slightly below 2 percent, even with a recovery of domestic demand. The major downside risks for growth are the scope for even weaker-than-now-expected activity abroad, especially in Germany, and high global uncertainty about oil prices and prospects for peace. A weak expansion abroad and less appetite for risk would also lead to lower capital inflows, including foreign direct investment.
4. Beyond 2003, Poland should see a reasonably strong recovery from the cyclical weakness of the past two and a half years. Investment and productivity developments in that past several years suggest that with some recovery in employment and demand, output growth should rise to rates even as high as 5-5 ½ percent in the middle of the decade, before returning to potential of about 4 ½ percent. The nature of this upturn will be critical. With the sharp drop in investment in the past two years, an investment-led recovery is both possible and necessary to ensure strong growth. Fiscal adjustment is critical not only to keep the current account deficit in check as the recovery takes hold, but also to crowd in private investment, including from abroad. Privatization and efficient resolution of ailing state-owned enterprises can also play a large role in sustaining productivity growth and attracting foreign investors. Public infrastructure projects financed by EU funds will also enhance the growth potential of the economy.
5. The general government deficit is likely to widen in 2003, though mostly due to cyclical weakness in growth and inflation. We expect a general government cash deficit (including compensation payments) of 6.9 percent of GDP, slightly above the official estimate of 6.4 percent. Public debt should rise to about 52 percent of GDP. The increase in the general government deficit in 2003 relative to 2002 is due to larger deficits of the agricultural agencies and social security funds. With inflation well below projections underlying the tri-partite agreement on wages, increases in wages and social transfers will be larger than planned in real terms and will outpace the rise in revenues and contributions. Consequently, other budgetary spending will need to be squeezed to meet the state budget target, and the deficits of the social security funds will be higher than originally planned. Although some cyclical widening of the deficit is not unexpected early in a recovery, the delays in introducing structural expenditure reforms mean not only that public debt continues to grow rapidly this year, but also that benefits from needed expenditure reforms, which take time to produce significant savings, will come later.
6. In 2004, when we project a further strengthening of economic growth, fiscal policy needs to turn with determination to the task of reform. Without policy changes, current account pressures would emerge during the recovery, public debt would rapidly reach the constitutional limit of 60 percent of GDP, refinancing risk would escalate, and the scope for fiscal policy to cushion even partially any future slowdown in growth would be lost. Also, budget priorities need to be rearranged to create room for co-financing EU-financed projects. In our view, a reduction in the structural general government deficit relative to GDP by at least 1¼ percentage points in the coming three years is needed to reach a safe position on these fronts.
7. We welcome the fiscal consolidation program recently proposed by the Minister of Finance. Details of the measures underlying the deficit projections have yet to be spelled out, but the broad parameters suggest the beginning of a constructive approach to generating public savings and reform public finances. We understand that the program will reform the tax system in a broadly neutral way and start the process of significantly reining in current spending. On the tax side, we welcome plans to eliminate exemptions and reduce income tax rates. We hope that this first step will be followed by expanded efforts to broaden the tax base and tackle the long-delayed task of improving revenue administration—measures that would permit further cuts in tax rates and reductions in the tax wedge on labor income. On the expenditure side, de-indexing entitlements and other commitments and eliminating the earmarking of revenues would certainly increase the flexibility of fiscal policy, particularly after two years of larger-than-intended real increases in wages and transfers. However, these measures will have to be complemented by public sector retrenchment, further pension and social benefit reforms, farmer pension and support program reforms, and reductions in subsidies. Overall, estimates of the impact of the program will depend on the precise specification of the measures and the accuracy of the economic projections. We would note only that the more vigorous near-term expenditure reform is, the greater the room for tax rate cuts and the more likely that optimistic assumptions on activity, inflation, and interest rates will be realized.
8. With high public debt and open capital markets, continuing improvements in debt management will contribute to containing budget funding costs. Alongside falling interest rates, the introduction of the primary dealers system and reductions in non-marketable domestic public debt have positioned the government well to minimize debt service payments along a smooth schedule. In line with the new debt management strategy, future measures should concentrate on increasing the transparency, liquidity and efficiency of government securities markets. The questions surrounding the revaluation reserve of the National Bank of Poland (NBP) would in our view be best addressed by identifying the underlying issues and reaching agreement drawing on international best practices among central banks and governments. Many of these issues, which range from the appropriate capitalization of the NBP to the details of accounting procedures, are closely linked to the strategy for and cost of managing public liabilities and assets, in the widest sense including those of the NBP. In all deliberations, preserving the ability of the NBP to conduct monetary policy independently should be a central objective.
Monetary and exchange rate policies
9. Although the path to low inflation generated much controversy, it is now in everyone's interest to safeguard the hard-won gains. Inflation pressures should remain at bay through 2003. In 2004, high unemployment, still sizable slack in the economy, and an expected drop in oil prices should largely offset the inflationary impact of the pass-through of the recent depreciation of the zloty against the euro. In these circumstances, there is likely to be room for further cuts in the policy rates. In light of the large cumulative reduction in interest rates across the maturity spectrum since the beginning of the easing cycle and the high degree of uncertainty about the timing and size of their effects, especially in the new low-inflation environment, we support the Monetary Policy Council's (MPC) approach of small cuts. An ambitious fiscal consolidation in 2004 would most certainly increase the room for a continued easing of interest rates—a combination that would significantly improve the policy mix.
10. With the prospect of joining ERM2 on the horizon, the new medium-term strategy of the MPC provides a suitable framework for monetary policy. Direct inflation targeting is well-suited to the new low inflation environment. The absence of intervention in the foreign exchange market should remain a hallmark of Poland's strategy for addressing the risks of large and volatile capital flows. Complementing this practice, the government needs to ensure that its transactions in the foreign exchange market are transparent and predictable. The new medium term inflation target of 2½ percent, consistent with likely interpretations of the Maastricht criteria, is reasonable as long as expected relative price changes can be accommodated in some appreciation of the zloty. We continue to think that the inherent volatility of Poland's CPI inflation may well require wider bands than the ±1 percent agreed, and we see the shift to a continuous target as apt, particularly in a setting where price stability has been achieved. Exchange rate developments in the past several months have permitted a welcome easing of the zloty and an improvement in competitiveness. In our view, within the context of the medium-term monetary policy strategy, it will be important to be attentive to containing undue pressures for appreciation.
11. The reconstitution of the MPC next year could be a time of some volatility as financial markets anticipate whether there will be a change in the monetary policy strategy. It will therefore be crucial in the coming months that the commitment to an independent central bank remains clear.
Financial sector issues
12. The banking system weathered considerable strains in the last year. The cyclical slowdown, the depreciation of the zloty against the euro and weaknesses in some large enterprises all contributed to a large increase in classified loans and a drop in profitability. Banks have responded appropriately: they have restructured their operations aggressively and, according to bank supervision statistics, maintained full provisioning against classified loans. With the depreciation of the zloty against the euro and the narrowing gap between zloty and foreign interest rates, the rapid increase in foreign currency lending subsided, lessening concerns about increases in credit risk related to such lending. While these adjustments are reassuring, banks will continue to face a difficult environment in 2003. Housing loans, particularly those denominated in foreign exchange, have increased rapidly in recent years, suggesting that in an environment of high unemployment and recent zloty depreciation, further increases in their share in classified loans could occur. Banks have naturally become more cautious in extending loans to enterprises, and this will pose a burden, especially among small- and medium-sized firms, until a cyclical upturn is firmly rooted.
13. Privatization and efficient resolution of state-owned enterprises are vital to increase the growth potential of the economy and to limit the contingent liabilities of the budget. Progress in these areas was disappointingly slow in the past year. The government's plans to move ahead with privatization and eliminate residual state holding in a large number of companies would be important steps in the right direction. To re-establish credibility, these plans should be implemented in a timely and decisive fashion. Moreover, the restructuring of the coal, steel and defense industries, including closing of inefficient units, should be pursued vigorously and the privatization of financial firms should be completed expeditiously. To enhance transparency, the use of government-held shares of quoted state-owned companies to recapitalize other state-owned companies should be discontinued.
14. High and still-rising unemployment presents a challenge to understand the origins of the problem and respond in innovative ways. We welcome the recent amendment to the Labor Code and the introduction of a differentiated minimum wage for recent graduates. Addressing other aspects of labor markets that may have contributed to the fall in employment will also be important. From our discussions, we conclude that, beyond the cyclical downturn, structural factors—such as skill mismatches, benefits that are relatively high compared to the minimum wage, and low labor mobility—are also important. In this case, the focus of policies should shift from out-of-work benefits to in-work benefits. International experience suggests that earned income credit to low-wage earners or the possibility of retaining social transfers for a limited period after accepting a job are worthwhile to consider. To support fiscal consolidation, such changes should aim to be expenditure neutral. A shift toward in-work benefits would also reduce the importance of the minimum wage as an income support and could be an instrument for attracting labor away from low productivity agricultural activities. In other areas, job placement by employment agencies should be strengthened, and any legal impediments to labor mobility should be removed.
15. Over the next few years Poland, as part of its overall strategy as an EU member, will need to plan for adopting the euro as the national currency. We have heard compelling arguments, both within and outside the government, pointing to the net benefits from adopting the euro—increasing trade and technology transfer, reducing transaction costs, and eliminating emerging market exchange and interest rate risk—and the advantages of realizing these benefits as soon as possible. Indeed, aiming at early euro adoption would serve as a rallying point for the considerable fiscal and structural reforms that Poland needs to achieve higher potential growth whether or not early adoption of the euro materializes. As long as a clear path forward on these reforms is started, early membership in ERM2 should be feasible and position Poland to realize the gains from adopting the euro at the earliest point possible.
We would like to express our appreciation and thanks for the warm welcome and close cooperation we have received.