Republic of Poland -- Concluding Statement of the 2006 Article IV Consultation Mission
May 22, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. A cyclical recovery and the benefits of EU membership are coming together to produce promising opportunities for Poland. For the first time in years, Poland is enjoying a combination of strong and balanced growth, low inflation, rising employment, and a small current account deficit. Substantial restructuring of businesses, alongside moderate wage growth, has strengthened Poland's global competitiveness. Large transfers from the EU as well as closer integration with EU trading partners are starting to bolster investment. These developments coincide with very favorable near-term prospects for global growth.
2. But it cannot be taken for granted that these auspicious conditions will produce a sustained improvement in living standards and economic strength. Fundamentally, strong growth will require lasting increases in investment to raise employment and productivity. These will be possible only if domestic savings and foreign investment inflows rise from current levels. Moreover, as neighboring countries too are enjoying favorable conditions, the competition for investment and export market shares will be intense. Without policies to create conditions supportive of growth and investment, Poland would risk not just sacrificing opportunities within its reach, but, especially if growth were to falter, becoming more vulnerable to adverse market sentiment. Our discussions have thus focused on how to ensure that policies provide the right conditions to realize the opportunities at hand.
The Near-term Outlook
3. Prospects for 2006-07 are strong. We have raised our projection for GDP growth to 4.8 percent in 2006 and 4.5 percent in 2007. The revisions are underpinned by improving investor sentiment, rising employment, private wage increases in line with productivity, and strengthening export markets. We expect that near-term growth will be well balanced between private consumption, private investment and export growth. We project the external current account deficit to rise to 1.7 percent of GDP in 2006 and just over 2 percent in 2007. These deficits should be easily financed by capital inflows.
4. Fiscal policy seems broadly on track to meet the 2006 deficit target. Although we are concerned that revenues for 2006 may be less buoyant than assumed in the budget, collections through April appear to be on target. It should be possible to offset any shortfall in the remainder of the year through expenditure restraint. From this perspective, restraining spending now would be wise so as to avoid the need for a spending squeeze later in the year, should a revenue shortfall materialize. Even though the general government deficit would fall to about 4½ percent of GDP, public debt would rise to 49 percent by year-end (with OFEs classified outside government).
5. Monetary policy is likely to continue to face a low inflation environment for the remainder of 2006. Low inflation reflects in part one-off factors, but also subdued core inflation, which excludes direct effects from food and energy. Inflation will rise with the recovery and the lapsing of the one-off factors. We nevertheless expect headline inflation to remain ¼-½ percentage point below the 2½ percent target by end-2007. While a cut in policy rates could be justified, we see a case for keeping rates on hold until clearer indications of the medium-term trade-off between growth and inflation emerge: this is because the economy is gaining speed, possibly strongly; current interest rates are probably neutral for economic growth; and the global interest rate environment is tightening. However, keeping interest rates on hold now means that any tightening further into the recovery should be delayed to ensure that inflation rises to the 2½ percent target, with symmetric risks around it. We support current monetary policy goals to center inflation at the 2½ percent target over the policy horizon with a view to firmly anchoring inflation expectations.
6. The possibilities for increasing growth over the medium term are clear, but it will take a commitment to strong policies and economic institutions to realize them. Since 2000, growth has averaged about 3¼ percent - a weak showing by emerging market standards. However, the opportunities of EU membership, the efficient use of EU funds to boost the economy's potential, and the large advantages that would result from euro adoption, could all contribute to higher growth over the next 5-10 years. This would come with a larger, though still sustainable current account deficit. Such a favorable outcome would require getting policies right. Three imperatives stand out. First, fiscal policy should stabilize the ratio of public debt to GDP below the present level while reducing the share of government spending in GDP. This would increase savings available for private investment. Second, the strength of financial institutions needs to be protected. Third, public policy should strive to remove impediments to entrepreneurs' and workers' responsiveness to economic opportunities.
7. A major challenge for fiscal policy will be to stay well within the PLN30 billion anchor for the state budget deficit in 2007. In fact, assuming continued cyclical strength in 2007, we would recommend reducing the deficit target to PLN26 billion. This would be an adjustment of ½ percent of GDP, a solid step toward stabilizing the public debt ratio. Discipline in the budget process will be essential to realize this challenging target. The tax reform plans under discussion contain several commendable measures. We particularly applaud the proposed reduction of the tax wedge and measures to reduce red tape in tax administration. The reforms under discussion may not be revenue neutral: expenditure restraint is likely also to be needed to meet the deficit target. In this light, it would be desirable to integrate the discussions of the tax reform and the 2007 budget to ensure that reforms are compatible with spending needs and the deficit target. We look forward to the announcement of the new Public Finance Act, which could include good initiatives for containing spending growth and improving transparency. Beyond that, we recommend a careful assessment of possibilities for spending restraint not only in the state budget but also in the broader public sector.
8. Beyond 2007, further deficit reduction will be needed. Experience in other countries shows that economic growth is strongest when the size of government - measured by expenditure or revenue relative to GDP - and public debt ratios are substantially below current levels in Poland. Also, Poland risks losing access to EU cohesion funds if general government deficits remain above 3 percent of GDP. To support growth prospects, public expenditure growth should be restrained sufficiently to reduce the deficit, ideally to around 2 percent of GDP (with OFEs classified outside the public sector), while lowering tax rates. This restraint should focus on administrative costs and better targeting social transfers. To this end, short and long-term costs of decisions on bridging pensions, the pension indexation formula, and salaries of various groups of public employees need to be considered carefully. Building on the planned 2007 tax reform, further changes - especially to lower payroll tax and PIT rates, reduce the range of goods subject to preferential VAT rates, and improve tax compliance - will help job creation and promote entrepreneurship. They must be coupled with measures to pay for them.
9. Clear fiscal policy frameworks typically help with deficit reduction and fiscal reforms. Poland has a constitutional debt ceiling and politically-agreed fiscal anchor (the PLN30 billion deficit limit). As the debt limit is not yet binding, its disciplining effect is minimal. The PLN30 billion anchor, however, is binding. And because it is widely publicized and easily understood, it should be effective. However, two issues need consideration. First, as a nominal target, it does not require sufficiently strong adjustment in cyclically strong conditions. Second, stabilizing the public debt ratio in a reasonable timeframe will require deficits well below PLN30 billion. Thus, while we strongly support the well-understood PLN30 billion anchor as an upper limit, keeping deficits well below it (particularly in cyclically strong years) and containing deficits at other levels of government will be key for stabilizing debt below current levels.
10. A second priority for strong growth is maintaining a sound financial sector. Most fundamentally, Poland has benefited from a strong and independent central bank with a sound inflation targeting framework, commitment to a transparent floating exchange rate system, adequate foreign exchange reserves, and an effective role in bank supervision. The development of the financial sector during the past decade is in no small part due to the confidence instilled by the professionalism of the National Bank of Poland. Public policy should be directed at maintaining this confidence.
11. The banking system appears to be in good health. Bank performance, capital adequacy, and balance sheets are strong, although there is still room for further cuts in costs of operations. Privatization and the opening of the financial sector to foreign participation have served Poland well: bank restructuring has occurred quickly and at minimal cost to the budget, management practices and risk-assessment systems have improved, and competition in the sector has helped increase product variety and reduce costs. Further public sector disengagement from the banking sector would not only be beneficial for the efficiency of the banking system but also would free resources for other needs.
12. Developments in bank lending present challenges for supervisors and banks. Lending to enterprises remains subdued, probably reflecting as much low demand from enterprises (which, in aggregate, hold large bank deposits) as banks' caution - at least in the past - to take on the relatively risky business of lending to enterprises without credit histories. A better investment climate should raise enterprise demand for loans. Improving access to credit information and enforcement of collateral should help banks engage with new borrowers. In contrast, mortgage lending is growing strongly, as in neighboring countries. With two thirds of this lending indexed to foreign currency, the risks for banks and borrowers are clear: a large depreciation of the zloty would sharply increase the debt servicing burden of borrowers. Still, the stock of such loans remains low, and stress tests indicate that borrowers and banks could absorb without disruption the likely effects of sizable adverse shocks. Thus, we question the need for generalized restrictions on this lending at this stage, although maintaining strong supervisory oversight of the situation is imperative.
13. In this connection, we have concerns about the authorities' recently-aired proposals for establishing an integrated supervisory agency. Currently, financial conglomeration - the standard reason for introducing an integrated financial supervisor - is minimal, and the present arrangements for managing cross-sectoral linkages meet Poland's needs. The financial system is about to undergo several changes with the introduction of Basel II and Solvency II standards. And rapidly changing patterns of credit growth allow for no slippages in supervisory attention or expertise. Thus, while an integrated supervisor may be a good idea at a later stage of financial development, there are no compelling arguments to do it now, and several for not doing it now. Should the authorities advance the idea, it would need meticulous preparation to ensure the new institution has a governance structure independent from political influence and sufficient power and expertise to use best international practices. A cost-benefit analysis with participation of key stakeholders would also be needed.
14. Beyond financial markets, Poland's post-transition economic history is essentially about the growing efficiency of its labor and product markets. Market mechanisms are now the backbone of the Polish economy: improving the functioning of markets is the best way to spread the benefits of Poland's prosperity to all parts of the population while making the economy more responsive to the opportunities ahead. Despite improvements in labor markets, the share of the working-age population actually employed remains the lowest in the EU. This means that some combination of poor targeting of compensation for those who do not work, skills that do not match the needs of businesses, a high tax wedge, and reluctance of firms to invest owing to uncertainties about future fiscal or other policies is preventing the full use of Poland's generally well-educated labor force. Particularly as opportunities for emigration expand, improving the investment climate and increasing employment demand will be critical to retaining productive workers. Similarly on product markets, measures to open markets to competition, privatize companies still under state ownership, and reduce the costs of starting businesses are important for growth prospects.
15. An overarching strategic consideration for economic policies will be the timing of euro adoption. Two considerations are critical. First, the economic gains from adopting the euro would be substantial. Evidence from existing members suggests that euro adoption with the right preparation substantially increases trade opportunities and growth. Also, by eliminating exchange rate risk, euro adoption would make Poland a more attractive destination for foreign capital inflows, increasing funds available for investment and growth, and stabilize interest rates at the Euro area level. Indeed, as countries in the region adopt the euro in coming years, Poland will increasingly feel the competitive pressure from them. Second, adopting the euro takes considerable preparation. To thrive in the Euro area it is critical to enter with a low fiscal deficit and markets that can adapt to the opportunities of EMU and Euro area monetary policy. But these conditions are identical to those needed to maximize growth outside the Euro area. Fully embracing the goal of euro adoption would simply be the culmination of Poland's commitment to realizing the strength of its economic potential.
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We would like to thank all our interlocutors for their gracious cooperation and kind hospitality during our stay.