Poland -- 2005 IMF Article IV Consultation Mission, Concluding Statement
April 27, 2005
This year offers a major opportunity to recommit to macroeconomic policies that would reduce the uncertainties hindering investment, job creation, and the inclusion of all citizens in the benefits of a market economy. Such policies, combined with the gains from early euro adoption, would put a rapid improvement in living standards within reach. Postponing reforms, however, could lock Poland in a cycle of financial volatility and fiscal deterioration, low growth, and high unemployment-trends that would hurt all segments of society, but most seriously those marginalized by low employment.
The past year has been one of remarkable contrasts for the Polish economy. A surge in growth supported by EU accession in the first half of 2004 subsided in the middle of the year. Inflows of greenfield FDI, the equity market, and corporate and financial sector profits were strong, but overall investment picked up only modestly. And employment grew for the second year in a row, though unemployment remained exceptionally high. On the price side, inflation jumped in mid-2004 but retreated to low month-on-month rates by end-year helped by a sharp reversal of the previous zloty depreciation. Fiscal developments were also mixed: the appreciation, together with renewed privatization, temporarily halted the upward trend of the public debt ratio, even as the fiscal deficit increased.
These volatile developments reflect the uncertainty that has hindered sustained high growth. Particularly with an election on the near-term horizon, the public is looking for a clear direction for policies aimed at realizing the potential of Poland's substantial assets-a young and plentiful supply of labor, a credible record of low inflation, a strong external balance, and EU membership, to name a few. To be sure, risks to economic stability are low; but reducing uncertainty about public policies is key to getting investors to make the long-term commitment needed to expand employment and raise living standards. From the perspective of macroeconomic and structural policies, three requirements stand out-permanently reversing the increase in the public debt ratio, eliminating disincentives to job creation, and preparing decisively for early euro adoption.
For the remainder of 2005, economic growth should pick up without igniting imbalances. Putting aside uncertainties about recent preliminary data, we expect GDP growth of almost 4 percent for 2005 as a whole. The key influences will be a strengthening of private consumption while investment growth picks up moderately. Following soft results in late 2004, consumption should benefit from rising employment even though real wage growth remains subdued. Investment should continue to be supported by large greenfield FDI inflows alongside ample corporate liquidity. Owing to slower demand in major markets and the 2004 zloty appreciation, export growth is likely to diminish modestly later in the year. But with import growth rising as the recovery of domestic demand proceeds, the current account deficit should widen to over 2 percent of GDP, and the contribution of net exports to growth should turn negative.
For 2006 and beyond, much will depend on the policies of the next government and the course of the world economy. Some developments early on-pension indexation, higher transfers to farmers, and greater utilization of EU funds-will temporarily boost domestic demand in 2006. But sustained strong growth, for example above 5 percent a year, will require decisive macroeconomic policies to address the fiscal and employment problems and prepare for euro adoption. Without such clear policy directions, a pick-up in 2006 is likely to be shallow and short-lived, and thereafter prospects for medium-term growth much in excess of 3 ½ to 4 percent would be limited.
Fiscal policy in 2004-05, on balance, has added to uncertainties about future economic strength. In 2004, the drop in the public debt ratio due to privatization and zloty appreciation was a welcome, but on present policies transitory, respite from the underlying increase. At the same time, improvements in the structure of debt-lengthening of the average maturity, the ongoing buy-back of Paris Club debt, and highly successful international issues-placed debt on a stronger footing for the medium term. Also, new EU-related expenditure and the corporate tax rate cut were, in themselves, positive developments; but in the absence of other measures to offset their effects on the fiscal balance, the general government deficit increased. Another major setback in 2004 was the limited success in gaining parliamentary approval of Hausner Plan reforms to social transfers, despite the government's strong efforts. This has made execution of the 2005 budget difficult, although higher cyclical revenues and the shift in pension indexation from 2005 to 2006 should produce a drop in the general government deficit to 5.8 percent of GDP (on a cash basis including transfers to OFEs). Nevertheless, the public debt ratio is likely to resume its climb, and could exceed 53 percent of GDP (Polish definition) by end year. In this light, it is critical that Parliament not approve any additional spending increases this year.
The most important macroeconomic challenge for the next government will be to redefine fiscal policy. Three components of this redefinition should be priorities.
· First, announcing a plan to lower the general government deficit to about 2 percent of GDP by 2008 (on a cash basis including transfers to OFEs). Such an adjustment would put debt on a convincing path to a comfortable level within the decade.
· Second, identifying expenditure savings focused on better targeting social transfers. These should be large enough to reach (with conservative estimates of supply-side effects) the deficit goal. Ideally, such savings would be deep enough to provide scope for reducing the tax wedge on labor within the envelope of the deficit target.
· Third, simplifying the tax system. We support the discussion of single-rate personal and corporate income and value-added taxes. By reducing distortions and lowering compliance costs this could complement the benefits for growth and investment of cutting the fiscal deficit. But the rates must be set to avoid revenue loss and protect the primary goal of fiscal policy-lowering the deficit.
Experience in other countries speaks to the motivating and credibility-enhancing role that a Fiscal Responsibility Law could play in these efforts. Such a law would include a fiscal rule, transparency requirements, and introduction of medium-term budgeting. The fiscal rule would ideally take the form of annual current expenditure ceilings for a 4-year political cycle. This would be backed by expenditure subceilings and changes in policies to respect the rule over the whole period. The rule would complement the existing constitutional debt limit by constraining fiscal behavior before dire (and possibly unrealistic) actions are required, should the debt ceiling be reached. The second component of the law would specify norms for expert independent assessment of macroeconomic assumptions and fiscal projections in the annual budget and medium-term framework. The third component would require detailed rolling 3-year budget projections alongside each annual budget-the goal being to anchor market expectations about future fiscal policies. Fiscal Responsibility Laws have proved highly effective in other countries in accelerating the benefits of fiscal consolidation in terms of lower interest rates, higher investment, and stronger confidence. Also, for Poland such a law would reduce uncertainty that would otherwise hinder a timely monetary policy response to stronger budget policy.
The quick reversal of the mid-2004 pick-up in inflation is testimony to the credibility that monetary policy has earned. The jump in CPI inflation in mid-2004 reflected transitory influences. But the combined effects of an increase in policy rates, labor market slack and subsequent zloty appreciation effectively prevented any second-round effects; core inflation remained low throughout the year and headline inflation quickly retreated. The increase in policy interest rates is now appropriately being reversed.
The outlook for inflation is benign. Low wage pressures, falling food price inflation, and zloty appreciation since mid-2004 should push inflation to the lower half of the target range by mid-2005. But on present assumptions and risk assessments, it should rise to about target by end-2006. We therefore see the shift to a neutral bias as appropriate. We urge the MPC to strictly implement the objective of aiming for inflation outcomes symmetrically distributed around the target, especially given the importance of avoiding undue appreciation of the zloty as Poland approaches ERMII entry.
The inflation targeting framework is sound. The rapid monetary response to the inflation fillip in 2004 was effective; as credibility continues to improve, smaller interest rate increases may be equally effective in the future. Publication of inflation projections has increased transparency, and we urge the MPC to move toward ownership of the related fanchart: this could eliminate the need for announcement of a bias as all relevant information would be in the agreed fanchart. On communications, a range of views within the MPC is natural, but members should agree on a common framework for addressing the public between meetings.
In preparing for ERMII, a critical issue will be judging the appropriate range in which the parity will be set. Equilibrium values of the exchange rate should continue to be scrutinized based on trade and competitiveness in the region and beyond to ensure that Poland enters ERMII at a parity that supports strong medium-term growth without inflationary pressures. In the meantime, we support the absence of intervention in foreign exchange markets as an instrument of active monetary policy.
Deep bank restructuring followed by the recent cyclical rebound have significantly strengthened the banking sector. In 2004, reflecting improved risk assessment, cyclical developments, and last year's change in loan classification rules, the share of classified loans in total bank loans declined significantly. Contrary to our concerns in last year's consultation, the change in loan classification rules has not resulted in any sizable release of previously accumulated provisions. Capital adequacy ratios have reached comfortable levels and, despite a slowdown in corporate lending, banking sector profitability has increased rapidly. This appears to reflect lower provisioning charges, improved interest and non-interest earnings, and tight control over wage costs.
Nevertheless, challenges for the financial sector remain. A priority for financial sector development (and for improving the business climate) is legal system reform to speed court case resolution and improve contract enforcement. On the prudential side, bank supervision should stay vigilant to any signs of banks easing credit standards in a favorable economic setting where liquidity is ample and competition intensifying. Although the share of foreign exchange-denominated loans in total loans has declined and the quality of such lending has improved in the past year, the exposure of borrowers, in particular households, to unhedged exchange rate risk remains significant. Persistently rapid growth of mortgage loans also requires attention to preserve the current high quality of mortgage portfolios. The size of assets managed by mutual funds has continued to increase, and market capitalization of the stock exchange is growing, helped by privatization in 2004. Still, further efforts are needed to accelerate capital market development, so as to ensure both an adequate range of corporate financing options and a sufficient supply of good quality assets for pension funds.
The revitalization of privatization was a major achievement of the past year. After years of inaction, the government downsized its portfolio by outright sales, divestment of government shares in viable enterprises (including the partial IPO of PKO BP) and liquidation of some unviable firms. We strongly support the further actions planned for 2005 both to enhance efficiency and meet the budget targets for privatization receipts. Looking ahead, the next government should expeditiously prepare a timetable for the full privatization of PKO BP and PZU as well as a plan for disposal of still-substantial state interests in other sectors where private ownership is most efficient.
Improving the absorption of EU funds is a priority. These funds, amounting to over 1 percent of GDP net of contributions annually in 2005-06, provide a unique opportunity for Poland to accelerate growth and income convergence. While the disbursement of pre-accession funds has improved significantly, similar improvements for new financing facilities are needed. We welcome the recently-formed working group to coordinate this effort. Given the large budgetary implications of EU-financed projects, we have several times in the past week heard the view that a multi-year budgeting framework for these projects would significantly help planning. This could be part of the comprehensive multi-year budget framework we, in any event, support.
But the biggest challenge in terms of resource utilization resides in securing more rapid employment growth. At 52 percent of the working age population, Poland's employment rate is the lowest in the EU-a result of adverse shifts in labor supply and demand. Poorly targeted pre-retirement and disability benefits as well as labor immobility and a large tax wedge have held down effective supply despite rapid growth of the working age population. At the same time, skill mismatches, immobility of capital between regions, high non-wage labor costs, and employment protection regulations have constrained labor demand. The result has been, even in periods of strong output growth, little change or even drops in employment. The fact that productivity growth has recently been high does not change some basic conclusions: mitigating poverty, restoring the health of the pension system, and reaching EU living standards will require a significant boost in employment.
The next government should construct a multifaceted plan for raising labor force participation and employment. As the largely older cohort of disabled and pre-retirement beneficiaries and the baby-boom cohort age, participation and employment should improve. But getting the employment rate up to the EU15 average (65 percent) will require policy changes: reducing the tax wedge without worsening the budget balance; measures beyond the 2002 changes in the labor code to reduce regulations that impede flexible use of labor; tightening eligibility for disability and pre-retirement benefits; improved targeting of education at needed skills, especially at the vocational level; measures to increase interregional mobility of labor and capital, especially through improvements in infrastructure, in job matching and in communications in low employment regions, and elimination of housing market impediments to mobility. All these changes will reap the largest results in an environment of high growth, fostered by sustainable macroeconomic policies.
Euro adoption offers an added opportunity to decisively curtail uncertainty. Reining in a fiscal deficit, curbing a rising debt ratio and addressing a deep unemployment problem are always difficult. But Poland could multiply the potential benefits of such actions by using them as stepping stones to early euro adoption. Provided the fiscal deficit is well below the Maastricht limit, parity is set at an appropriate level, inflation is low, and labor market flexibility has been improved, euro adoption should bring substantial benefits for trade and output growth. But the risks of moving ahead without adequate preparation could be substantial. Large deficits and debt have hindered the performance of some existing euro area members, and market rigidities of any sort impede adjustment to country-specific shocks in the absence of an independent monetary policy. We therefore urge the government and National Bank to continue work on identifying macroeconomic and structural changes that will enhance prospects for successful participation in the euro area.
In concluding, we would like to thank the authorities for their excellent cooperation and kind hospitality.