Public Information Notice No. 04/74

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Republic of Poland

July 26, 2004

On July 12, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Poland.¹

Background

Since mid-2002 a recovery has taken shape, but it is not yet fully entrenched. With strong exports and robust consumption, GDP growth picked up gradually, reaching 6.9 percent (year-on-year) in the first quarter of 2004. Nevertheless, investment growth remains moderate. Although the fiscal stance in 2003 was slightly restrictive, a considerable easing of monetary conditions since 2001 supported the recovery: policy rates were massively reduced between early 2001 and mid-2003, while falling interest differentials and unsettled politics contributed to a 20 percent real effective depreciation of the zloty in the past two years. With strong gains in the service sector, employment has grown modestly in the past year, for the first time since 1997. This, combined with accelerating wages and rising social transfers, kept consumption growth robust.

Slack in the economy is diminishing but without signs yet of excessive demand pressure. The output gap narrowed slightly in 2003, but at over 2 percent of potential GDP, was still sizable. The unemployment rate of 20 percent is well above the estimated structural rate of 15 percent. Falling unit labor costs and, in turn, strong increases in profit margins have been key to containing current account and inflation pressures during the upswing. The strong increase in corporate savings, while investment fell, pushed the current account deficit down to 2 percent of GDP in 2003; and in the absence of domestic cost push and with an unusually small pass-through of the zloty depreciation by profit-rich firms, net inflation (excluding food and fuel) was steady at 1-1½ percent. A rise in headline inflation to 3.4 percent in May (still within National Bank of Poland's 2½ percent ±1 percent target) was mostly due to food and oil price increases.

Financial markets have been unsettled. Despite low inflation, long-term interest rates have risen since mid-2003, initially in response to the announcement of an expansionary 2004 budget and more recently to unsettled politics. Unlike in most other new EU countries, the domestic spread over the 10-year euro yield has more than doubled since mid-2003. Pointing to weak political and fiscal fundamentals, S&P and Fitch downgraded Poland's domestic debt and the outlook on its foreign debt in the past year.

The weak responses of investment and employment raise concerns about fundamental impediments to the recovery. Uncertainties about the recovery in western Europe likely play a role. But investment and employment growth remain substantially weaker than in other central European countries facing the same markets. And while excess capacity may still be a factor in some sectors, it seems likely that policy weaknesses during the past several years are influencing investor confidence and employment trends.

A weak fiscal situation inherited from the 1990s has been allowed to drift. Repeated fiscal reform efforts have failed in the face of vested interests and fractious politics, and social expenditure remained excessive and poorly targeted. An increase in unemployment owing to the cycle and enterprise restructuring was aggravated by policy-induced disincentives in the labor market. With considerable rigidities in labor market and poorly targeted social transfers, the economic slowdown worsened poverty. Lax fiscal policy left the burden of responding to a large current account deficit and rising inflation in the late-1990s to monetary policy. Excessive tightening and a simultaneous large real appreciation (more than 25 percent during mid-1999-mid-2001) produced a sharp, though short-lived, diminution in price competitiveness. This contributed to a deep decline in investment in 2001-02 and, as it was most severe in labor-intensive industries, to massive lay-offs.

Privatization slowed sharply in the past years. Several major companies slated for privatization in 2001 have still not been sold. Slowing privatization, and stronger competition from neighboring countries led to a decline in foreign direct investment (FDI). The recently adopted Economic Freedom Act was an important first step to improve the investment climate.

Executive Board Assessment

Executive Directors welcomed Poland's accession to the European Union on May 1, 2004, which sets the stage for faster economic growth and income convergence based on stronger policy coordination with Europe. They noted that the Polish economic conjuncture is favorable, with a strong cyclical recovery alongside a small current account deficit and low underlying inflation. Improved overall competitiveness underpinned by modest wage growth and a large depreciation of the zloty have supported the recovery. The near-term economic outlook is also positive, with the prospect of strong growth in exports and output being supported by an improved external environment, strong profitability of enterprises, and domestic fiscal stimulus.

At the same time, Directors noted that the response of employment and investment to the pickup in activity has thus far been modest and that unemployment and public debt remain high. Furthermore, Poland remains vulnerable to policy slippages stemming from political uncertainty and a lack of consensus for adjustment and reform, factors that have deterred private investment by weakening market confidence and increasing the cost of financing.

Against this background, Directors urged the Polish authorities to seize the opportunity provided by the current favorable conditions to implement ambitious fiscal and structural reforms. A durable recovery will require a sustained increase in investment and fiscal consolidation consistent with the provisions of the Stability and Growth Pact. In addition, tackling deep-rooted structural weaknesses will require building a political consensus for reform. Decisive actions in these areas will help secure a balanced and lasting recovery into the medium term, and demonstrate that the authorities are embarked on a clear agenda of policies to reap the full benefits of EU membership and to move ahead with the adoption of the euro.

Directors expressed concern about the steady worsening of the fiscal position during the past several years and the attendant threat to keeping the debt-to-GDP ratio within the constitutional limit. Although pension reform has mitigated an important part of potential difficulties related to population aging, costs will still be significant, particularly in the health care sector; this strengthens the case for timely fiscal consolidation. Directors were therefore disappointed that the 2004 budget introduced an undesirable fiscal stimulus and is likely to further increase the debt ratio. While welcoming the initiatives that have been taken to reduce the corporate income tax rate and co-finance the sizable increase in EU funds, Directors regretted that the opportunity to reprioritize budget spending to make such policies sustainable was missed. They therefore urged that, at a minimum, any windfall revenues from higher-than-predicted growth in 2004 be saved and used to lower the government debt.

Directors welcomed the Hausner plan for fiscal reform and felt that its full implementation would be a major step in the process of medium-term fiscal consolidation. They agreed that its key reforms—aimed at streamlining social transfers, restructuring state-owned enterprises, and broadening the tax base—would target Poland's most acute fiscal excesses. Directors urged that the 2005 budget reflect full implementation of the plan. They also encouraged the authorities to begin consideration of measures beyond the Hausner plan, which will be necessary to stabilize the debt ratio, minimize the vulnerability of public finances to shifts in market sentiment, and support the recovery in private investment. Such measures should focus on further streamlining social benefits and public administration and reducing mandated public spending, while also improving revenue administration.

Directors agreed with the view that the authorities' inflation targeting framework has served the country well. In the immediate future, headline inflation will remain at elevated levels owing to one-off influences. Directors stressed that the new Monetary Policy Council (MPC) should continue to ensure that these influences do not feed into expectations and become entrenched in an inflationary process, and they welcomed, in this context, its cautious approach—whereby the MPC first shifted to a tightening bias and subsequently raised interest rates as the risk of one-off factors influencing expectations increased. Looking ahead, Directors considered that the still sizeable amount of slack in the economy will help inflation revert toward the middle of the target range as temporary shocks dissipate in 2005.

Directors underscored the importance of fiscal and structural reform for monetary policy. They felt that decisive measures to ensure a strong supply-side response to rising demand will be the best insurance against pressure on interest rates through the recovery. Directors also agreed that an improved policy mix—with tighter fiscal policy avoiding the need for monetary tightening as the recovery proceeds—should provide maximum protection for Poland's currently strong external competitiveness.

Directors agreed that a flexible exchange rate continues to serve Poland well, both as a shock-absorber and as assurance that the zloty is well-aligned upon Poland's entry into ERM2. They commended the MPC for signaling its support for continuing a policy of non-intervention in the foreign exchange market. Directors noted Poland's comfortable reserve cushion, which they considered a strength for attracting and maintaining the confidence of international capital markets. They cautioned that any decisions about the optimal level of central bank reserves should take into account both the role played by this cushion and needs associated with prospective participation in ERM2.

Directors noted that the banking system had adjusted well to the slowdown in activity in 2001-02 and the depreciation of the zloty. They welcomed the slowdown since late 2003 of the previously rapid growth in foreign exchange-denominated credit. Going forward, Directors urged the authorities to continue to monitor the health of the banking system closely, as credit growth to the private sector, and households in particular, is likely to remain strong. Directors noted that the new loan classification system adopted in January 2004 moves practices in Poland closer to those in other countries in the region. Although Directors were reassured that the changes to the system would not ease oversight unduly or free provisions excessively, the authorities should be ready to act if developments during the next few months created any room for doubt.

Directors urged the new government to give high priority to reinvigorating economic restructuring and reducing the size of the public sector. They cautioned that inefficient state enterprises could impede Poland's competitiveness, and called on the authorities to speed up privatization and divestment of the government's minority shareholdings in privatized enterprises. They welcomed the recent adoption by Parliament of the Economic Freedom Act aimed at reducing red tape and simplifying procedures for setting up new enterprises. Directors noted that Poland's structural unemployment problem is attributable in part to the shifts in the industrial structure in response to changes in competitiveness. In this context, they emphasized the importance of pursuing labor market reforms, measures to reduce skill mismatches, and changes to social benefits in order to increase incentives to work and lower structural unemployment.

Poland's statistical database is adequate for surveillance. Directors noted the progress in improving fiscal transparency, and encouraged the authorities to further reduce budget fragmentation and emphasized the importance of transparent recapitalization of loss making state-owned enterprises.