IMF Executive Board Concludes 2006 Article IV Consultation with the Republic of PolandPublic Information Notice (PIN) No. 06/116
October 16, 2006
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report for the Article IV consultation with Poland may be made available at a later stage if the authorities consent.
On October 4, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Poland.1
In the last five years, economic performance has not lived up to the promise of Poland's early reform record. In the 1990s, growth surpassed that in other transition countries, but since then has disappointed, in part reflecting a second wave of restructuring, particularly in the export-oriented manufacturing sector, lagging openness to foreign trade, slow growth in trading partners, and a large government sector. Less measurable features-policies that stifle competition, a large low-productivity farming sector, poor infrastructure, and political tensions-probably also played a role. Thus, while benefiting from successful disinflation and protected from key external vulnerabilities by small current account deficits, a floating exchange rate, and sizable external reserves, Poland trails most other new member states of the EU in per capita GDP, investment, and employment.
Nevertheless, by mid-2005, cyclical influences alongside the benefits from EU membership and the impetus from manufacturing sector restructuring produced an economic upswing. Output has expanded at an annualized rate of almost 6 percent since mid-2005 despite restrictive macroeconomic policies. Following a pickup in investment growth in early 2004, export growth has strengthened on the back of solid competitiveness and improving prospects in the Euro Area and in countries to the east. As prolonged net labor shedding ended, private consumption picked up with a short lag. Supply-side developments have been particularly strong in the externally exposed manufacturing sector. There, employment is rising strongly, profitability is robust, and exports are steadily climbing the technology ladder.
Monetary and fiscal conditions were contractionary last year and have been broadly neutral thus far in 2006. During March 2005-March 2006, the Monetary Policy Council cut policy rates by 250 basis points to 4 percent. Nonetheless, overall monetary conditions tightened during 2005 as the zloty appreciated and falling inflation added to real interest rates. With the value of the zloty little changed since end-2005, monetary conditions have now stabilized. Public finances were a positive surprise. The general government deficit fell to 3.9 percent of GDP in 2005 (2.4 percent of GDP according to ESA95 and excluding pension reform costs), two percentage points less than in 2004. Deficit reduction was driven by buoyant taxes, partly reflecting strong profit growth, while expenditure growth was contained marginally below GDP growth. Revenue strength extends into 2006, and with spending so far below plan, fiscal policy was contractionary in the first eight months of the year.
The upswing has not tested resource constraints. Although domestic savings are low by regional standards, investment, even with the recent pickup, is lower still, and the current account deficit hovers around 2 percent of GDP. Labor market slack appears substantial with only 54 percent of the working-age population employed. Wage costs thus remain contained, although the fall in unit labor costs during 2002-04 has ended and sector-specific threats are to be watched (in state-controlled mining, health care, and construction).
Vulnerability indicators are generally favorable. The modest current account deficit is more than fully financed by foreign direct investment, and helped by zloty appreciation, the external debt ratio fell to 43 percent of GDP in 2005. Official reserves fully cover short-term debt. Overall growth of bank credit to the private sector is modest by regional standards (13 percent in 2005) and banks are well capitalized, although rapidly expanding foreign currency mortgages require close monitoring. Poland's weak spot remains high and rising public debt (48 percent of GDP or 42 percent of GDP according to ESA95 and excluding government debt held by second-pillar pension funds) with a sizable rollover rate of 22 percent, despite recent improvements of public debt management. More generally, EU membership appears to impart a substantial degree of confidence to markets, reflected in low measures of risk premiums. Nevertheless, after a smooth ride in 2005, Poland has been buffeted recently by turmoil in emerging markets.
Executive Board Assessment
Directors welcomed the upswing in the Polish economy that has been developing since mid-2005 and noted that prospects for this year and next are broadly favorable. The upswing has been well-balanced between consumption, investment, and exports, and underpinned by strong employment growth and enterprise profitability. Directors called on the Polish authorities to secure the momentum of the recent strong growth and maximize the benefits from EU membership by pressing ahead with fiscal and structural reforms.
Directors noted that the upswing is unlikely to run into resource constraints in the near term, as inflation remains subdued, the current account deficit is moderate, and the labor market still has substantial slack. In these circumstances, they considered that past monetary policy decisions had been appropriate and felt that rates could be kept on hold longer, pending evidence that the economy is closing in on resource constraints over the policy horizon. Nevertheless, it will be important for the central bank to remain vigilant against possible emerging inflationary pressures. Directors noted the volatility of inflation. They urged the Monetary Policy Council to make further efforts to anchor expectations at the central target rate by clearly communicating their aim of targeting this rate with symmetric deviations. Overall, they considered the monetary policy framework to be sound, and pointed to the vital role an independent central bank has played in maintaining stability.
Directors saw the exchange rate as within a range appropriate to ensure external competitiveness. Exports are gaining market share, relative unit labor costs are not rising, and exports have moved up the technology ladder.
Directors regretted that the general government outturn for 2006 is unlikely to improve over 2005, despite strong growth and buoyant revenue collections. With respect to the 2007 budget, they acknowledged that spending pressure has been resisted by sticking to the PLN 30 billion anchor for the central government deficit. They regretted, however, that because of insufficient expenditure savings, earlier tax reform plans could not be financed and had to be largely abandoned. In Directors' view this underscores the need to tackle poorly-targeted and high social spending as well as large administrative expenditures to reduce the deficit, while also making room for tax cuts, particularly on labor. They therefore felt that a more ambitious fiscal target, possibly supplemented by an expenditure ceiling, would help focus attention on the critical need for stronger expenditure based adjustment to stabilize the government debt and meet the Maastricht criteria. They also emphasized that adhering to the objectives of the 1999 pension reform would be critical for long-term fiscal sustainability.
Directors encouraged the authorities to move decisively to increase the flexibility of the economy. They stressed that improvements in Poland's low-rated business environment would be critical for extending the strong performance of the competitive export sector to the economy more generally. In this context, Directors expressed concern about the stalling privatization process. They underscored that Poland's still-low employment rate points to the need to make labor markets more flexible, especially by lowering the tax wedge and strengthening incentives to work. Moreover, Directors saw full and efficient use of EU funds as a priority and a welcome opportunity to raise productivity.
Directors agreed with the conclusions of the Financial System Stability Assessment (FSSA). They welcomed the finding that the banking system is well-capitalized, profitable, resilient to shocks, and soundly supervised. Noting Poland's limited progress in financial deepening in previous years, Directors viewed the recent pickup of credit growth as a generally positive development. However, the potential risks of a high concentration of credit growth in foreign currency housing loans require careful monitoring by supervisors, and Directors welcomed recent market-based steps that supervisors had taken in response.
Directors expressed concern about the new law on financial sector supervision. They noted that the governance provisions in the legislation for the establishment of a new unified financial sector supervisory agency fall short of best practice, providing insufficient assurances of the agency's independence and leaving scope for a politicization of its operations. Directors emphasized that it will be essential for the authorities-through effective implementation of the legislation-to send a strong signal of their commitment to the high standards of supervision that have characterized the experience of recent years.
Directors stressed that euro adoption will be an important opportunity to provide an impetus to trade, investment, and growth. They expressed concern that a slippage in the timeline for measures supporting euro adoption could result in a weakening of an important anchor for domestic reform and adversely affect market confidence. Directors agreed, however, that careful preparation for this important step, especially by reducing the fiscal deficit, increasing the flexibility of the economy, and ensuring broad political support, is essential for its success.