Poland -- Concluding Statement after the IMF Staff Visit

November 21, 2005

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.

The post-election imperative is to revive private investment and employment creation so as raise growth and spread its benefits to all segments of the population. These objectives call for a three-pillar policy program—to contain public debt by rationalizing expenditure, to strengthen institutions and structural conditions, and to fully use the benefits of EU membership. Right now, the world economic environment for pursuing these goals is unusually favorable—global growth is strong, European growth is firming, and financial market conditions are benign. And for Poland in particular, markets have been bolstered by EU membership, a track record of low inflation, and an expectation that the move to euro adoption will be expeditious. Still, markets are watching the actions of the new government closely and early signs of decisive policies to address fiscal and structural weaknesses essential to sustaining, and indeed strengthening, confidence.

The ambitiousness of the program will be pivotal to economic outcomes in the next several years. To whether the share of private investment in GDP will rise or remain at its current low level. To whether net job creation, virtually dormant since the transition, will resume. To whether growth will continue at the 3½ percent average of the past five years or move up to rates now seen in the region's faster growing economies where strong policy records are producing potentially lasting competitive advantages.

Near-term prospects

In 2006, growth is likely to increase, though by how much will largely depend on investment. Coming off the soft patch since mid-2004, private consumption should accelerate while exports continue to benefit from good export market growth and improvements in competitiveness over the past few years. The current account deficit remains within safe limits. Investment is the major uncertainty. With indecisive signals on policies, it could remain sluggish, or if investors concerns about future policies and the business environment are addressed, it could pick up strongly. Thus, from about 3 percent this year, GDP growth should rise in 2006, but it is too early to say whether this increase will be modest—to 3½-4 percent—or, with faster investment growth, substantially stronger.

Inflation should remain subdued, though uncertainties are substantial. Currently, low net inflation, anchored by stable import prices, healthy domestic competition, and substantial slack in the labor market, are reassuring on low second-round effects from the oil price increase. Thus, while we project inflation just below the target during the next two years, larger second round effects cannot yet be ruled out. In this environment, the reductions in policy interest rates since early 2005 have been appropriate. We see good reason to hold interest rates steady pending stronger evidence that second-round effects from the oil price increase are contained and clarification of the government's economic program.

The Macroeconomic Program—Three Central Pillars

Fiscal policy will play a key role in securing the confidence of markets and potential investors—both domestic and foreign. The most important objective is to stop and reverse the trend increase of public debt. The PLN 30 billion cap on the state deficit for 2006 is a welcome start and a good anchor for a budget revision that must be prepared quickly. In our view, however, the revenue estimates in the draft 2006 budget, which assume continuation of the high tax buoyancies in 2005, are optimistic. Thus, not only would any tax cuts or new tax incentives in 2006 be a mistake, but also greater-than-planned spending restraint will be needed. Even more important is the fiscal strategy beyond 2006. State deficits will need to be reduced well below PLN 30 billion—with deficits of the general government (excluding OFEs) below 3 percent of GDP—even to stabilize the debt ratio under any plausible scenario for growth. With government revenues already high and limited scope for generalized expenditure compression, a strategy to selectively restrain spending growth will be essential.

Expenditure restraint should be designed to support investment and employment. Currently, social transfers—among the highest in the region relative to GDP—absorb a disproportionate share of government spending, are poorly targeted, largely fail to achieve desirable income redistribution, and hinder employment growth by discouraging work. These adverse effects come with the costs of a higher debt burden for future generations and the crowding out of needed infrastructure investment. A priority in the medium-term fiscal strategy is to better target social transfers and reduce the share of government resources they absorb. Beyond this, other initiatives, including plans under consideration to merge and close government agencies, could be welcome sources of savings and efficiency gains. To sharpen the focus on spending restraint, such a growth-enhancing fiscal strategy should be guided by a ceiling on the medium-term spending path, grounded in objectives for debt reduction.

Tax reform should also be part of the fiscal strategy. However, as primacy must be given to reducing the deficit, such reforms should be phased in gradually. With flat taxes no longer under consideration, the priority should be on reducing the tax wedge—through cuts in social contribution rates or personal income taxes. Such a change, which would have to be introduced in a deficit-neutral package, would likely have a significant impact on employment creation. In the meantime, revenue neutral simplification of taxes should be pursued to increase efficiency of the system..

A second pillar of the program should involve strengthening institutions. Poland has made enormous progress in this area since the days of central planning—witnessed by solid democratic institutions, an independent central bank, a well-supervised financial system, and generally transparent government accounts to name a few of special importance to the macro economy. But on many other indicators, Poland has much room for improvement, even relative to its closest neighbors. These relate to judicial function, regulatory quality, administrative and financial burdens on business start-ups, tax administration, and still-extensive state ownership in the economy. They are not all areas of IMF expertise, but insofar as experience throughout the world indicates their importance to the macro economy, we welcome intentions to move decisively on many of them. Such efforts should be broad based, guided by the goal of enhancing competition and entrepreneurship, and in line with best international practices.

Labor market institutions also need urgent attention. At about 50 percent of the working age population, employment is unusually low by regional standards. The problems are wide-ranging. Beyond reductions in the tax wedge and better targeting of social transfers, greater flexibility of labor contracts, better infrastructure in regions with low employment rates, better relating training to industry's needs, and reducing housing market restrictions would help. Wage flexibility must be vigorously promoted, ideally by regional and age differentiation of minimum wages but at least by avoiding increases of the minimum wage.

Taking full advantage of the opportunities offered by EU membership is a third challenge. The use of EU funds has as yet been low. This is not surprising given the complexity of the steps involved. But failure to improve the record in the next year would be a serious missed opportunity. The establishment of a separate ministry to oversee the process is a first step toward greater efficiency, but seeing early results in terms of higher disbursement and effective prioritization of projects will be the true test.

The even larger opportunity in EU membership is euro adoption. Euro adoption, properly prepared, would boost growth by increasing trade with the euro area, by eliminating costly risk premia on exchange and interest rates, and by removing inherent exchange rate risk as a constraint on the use of foreign savings for domestic investment. The implications for growth and stability are very large. Meeting the Maastricht criteria—and for Poland (assuming inflation remains low) the fiscal deficit criterion is the primary challenge—is often seen as a burden. It should not be. The adjustment needed to push the general government deficit below 3 percent of GDP is no larger than what is needed in any event to stabilize the debt ratio. In fact the bigger challenge is pursuing labor and product market reforms to ensure that the economy is competitive and resilient to shocks. Even if the government does not want to commit to a precise timetable, the medium-term policy program should be formulated against an unannounced target entry date so that this remarkable opportunity to boost investment, job creation, and growth can be seized with the shortest possible delay.

The challenges for the new government are large, but so are the potential rewards. The key is to steer a course that uses markets and market mechanisms to maximum advantage in support of goals for raising investment and employment. This is the surest path to increasing growth and opening its benefits to all segments of society.

It is a pleasure to have been welcomed by the new government so early in its tenure. We thank our interlocutors for their cooperation and wish them success in the job ahead.


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