The Polish economy has continued to perform strongly in recent years. GDP growth has been sustained and rapid, delivering further income convergence. Unemployment has declined to a historically-low level and, alongside higher social spending, has reduced income inequality and the incidence of poverty. At the same time, macroeconomic imbalances have been contained and vulnerabilities have declined. These commendable achievements place Poland in a strong position to address the challenge of population aging and moving to a more technology-intensive growth model.
Developments and outlook
1. The Polish economy has been growing rapidly, fueled by social transfers, EU funds, recovery in Europe and strong wage growth amid a tight labor market . The inflow of—mainly temporary—foreign workers has relieved labor shortages and dampened inflationary pressures. Continuous reductions in fiscal and external vulnerabilities since the global financial crisis have helped to shield Poland from the recent financial turmoil that beset several major emerging market economies. In recognition of its strong economic performance, Poland is assessed highly by international rating agencies and was recently upgraded to developed-market status by several international equity index providers, while ongoing disputes with the European Union have had little impact on investor sentiment.
2. Poland’s cyclical upswing appears to have recently peaked, and GDP growth is expected to moderate to a more sustainable pace. After reaching more than 5 percent in H1:2018 and likely around 4½ percent for the full year, growth is expected to ease in 2019 to a still-strong 3½ percent as trading-partner demand slows. Nonetheless, EU funds will continue to support activity in the near term. The output gap is expected to remain positive, but to narrow gradually. Over the longer term, with potential output increasingly held back by labor shortages, subdued private investment and tepid productivity gains, growth is projected to gradually moderate to around 2¾ percent by 2023.
3. Risks to the outlook are two-sided in the near term, although they are tilted down in the longer run. Rising EU funds absorption could provide a demand stimulus and raise near-term growth relative to the forecast, although the effect would be limited owing to supply bottlenecks. On the other hand, a sharper-than-expected global growth slowdown would have knock-on effects on Poland’s growth. In the medium term, downside risks tend to dominate and could arise if foreign workers were to view Poland as a less-attractive destination relative to other countries with labor shortages, if global trade tensions were to escalate further, or in the event of a “no-deal” Brexit or intensifying turbulence in global financial markets. Additionally, investors’ risk appetite could be dented in the event of slippage from prudent policies or a deterioration in Poland’s relations with the EU.
Policy Recommendations
4. Fiscal policy is expected to deliver substantial reductions in the headline and structural deficits for 2018. These large improvements reflect structural revenue gains from improved tax compliance, the temporary boost to revenue from the economy’s strong cyclical position and the sharp increase in the number of foreign workers, and the autonomous effect of indexing some—mainly expenditure—items at rates below nominal GDP growth. In addition, capacity constraints in sectors utilizing EU funds likely precluded the full absorption of budgeted amounts this year. All told, we expect the headline deficit to reach a record-low of 0.3 percent of GDP this year, with the structural deficit declining to about 1¼ percent of GDP. Public debt is forecast to have fallen below 50 percent of GDP on the combination of a sizable primary surplus and fast growth in the denominator. While standard approaches would suggest that fiscal policy was appropriately countercyclical, fiscal support to GDP growth was nonetheless provided through increased spending of EU funds even though it did not increase the fiscal deficit.
5. Building on this recent progress, some additional front-loaded structural consolidation is needed to replace temporary adjustment measures and to ensure adequate buffers. Reaching and then maintaining a structural deficit of 1 percent of GDP would create space for aging costs, replacing part of declining EU funds with national resources, and providing stimulus in the event of a sustained adverse shock. While the fiscal adjustment so far has been impressive, it relies in part on temporary measures, such as limiting growth in the public-sector wage bill, which may be difficult to sustain over the long term, in addition to a permanent increase in the private sector’s tax burden, which would be difficult to repeat. Additional spending planned or under consideration could add to fiscal pressures in the medium term. Therefore, additional savings would be needed in the event of larger-than-budgeted increases in public sector wages or compensation of energy users for price increases, if the proposed increase in health spending or cut in the standard VAT rate were implemented, or if pension indexation were to be raised to enhance social sustainability. With the output gap currently still positive, front-loading the adjustment is appropriate, even though growth is moderating. While the expenditure stabilizing rule imposes nominal spending limits, consolidation should be underpinned by well-identified and sustainable measures. These could include reducing the proliferation of VAT rates, better targeting social benefits (including means testing currently universal programs), raising the pension age (consistent with past gains in life expectancy), and phasing out generous special pension schemes. Greater smoothing of EU funds absorption across time would improve public spending efficiency and limit fluctuations in the economic cycle. In addition, caution is advised with earmarking revenue from narrowly-based taxes and levies for financing new spending as these can create distortions and a tendency to overestimate revenue yields.
6. Following a data-dependent approach, monetary policy should guide inflation back to the target and keep it well anchored. Monetary policy has been appropriately accommodative against the backdrop of low inflation in the euro area, several temporary factors (including a drop in financial services prices) and the increase in foreign workers, which have kept Polish inflation subdued. While participation in regional supply chains will continue to moderate domestic cost and price dynamics in the tradables sector, we expect inflation to gradually edge up toward the target next year on the dissipation of temporary factors and pass-through of previous wage growth. An increase in household electricity prices will also add to inflation, although at this time, the extent of the administered price increase remains to be determined. From 2020, second-round effects of energy price increases in the corporate sector could push up inflation on a sustained basis amid a positive output gap, while the still-tight labor market could reignite wage pressures. As a result, there is a risk that inflation could continue to drift up. Once inflation picks up to the point target on a sustained basis, we advise to raise the policy rate in tandem with any persistent increase in inflation beyond the point target. Should inflation pressures continue to build, the real policy rate should be adjusted, with the size and timing conditional on forecasted inflation. On the other hand, if inflation were to stabilize around the target or remain subdued over the medium term, monetary policy should be appropriately accommodative.
7. The financial sector remains resilient, although emerging risks warrant monitoring and distortions in financial intermediation should be addressed. The IMF’s 2018 financial sector assessment program (FSAP) finds that in the aggregate, commercial banks are resilient to sizable macroeconomic, market and liquidity shocks. However, the current environment of low interest rates, subdued demand for corporate loans, financial institutions asset tax and other required contributions have induced banks to increase their exposure to riskier, unsecured consumer lending. To better understand the risks associated with this lending, further analysis and close monitoring are needed. While almost all mortgage loans are at floating interest rates, the effect of a gradual increase in the policy interest rate on debt service costs and the quality of the loan portfolio would be limited given moderate household indebtedness and recent robust income growth. The financial institutions asset tax (FIAT), which exempts holdings of government securities, may have steered banks’ asset allocations away from potentially more-productive lending for private investment. Taxing banks’ profits and remuneration would be less distortionary. The legacy foreign currency-denominated mortgage portfolio does not pose a systemic risk, and bilateral negotiations to restructure distressed loans would be preferable to mandatory centralized approaches. Sustainable solutions should be found for the cooperative bank and credit union sectors, including mergers and consolidation of viable firms on the basis of sound business plans, with the orderly exit of unviable firms.
8. Addressing shortcomings in resources and independence for supervision and investor protection is a priority. Pending legislation and its implementation should ensure: (i) a well-resourced Polish Financial Supervisory Authority (PFSA) with high-quality supervisory capacity; (ii) a structure and composition of the PFSA board that is insulated from undue political influence; and (iii) a governance arrangement that delegates the more technical supervisory tasks to the PFSA chair and staff. These objectives assume additional importance in view of the significant state control of the financial sector. Paramount is that state-controlled institutions continue to operate on commercial terms, and that supervision across the financial sector is evenhanded and free from conflicts of interest. Moreover, an adequately-resourced PFSA will be able to better calibrate supervision to institution-specific risks, rather than relying on broad regulatory measures.
9. Growing the effective workforce and boosting labor productivity are key to sustaining rapid and inclusive growth . Lowering the pension age and raising child benefits had the side effect of encouraging large numbers of workers to withdraw from employment at a time of growing labor shortages. Raising labor force participation and continuing to attract foreign workers would help alleviate constraints on labor supply and real activity in short term. However, accelerating output per worker is essential to tackle Poland’s severe demographic headwind and to raise per capita income, but is held back by subdued investment, despite persistent labor shortages. In the context of the Strategy for Responsible Development, numerous initiatives have been adopted or are underway to improve the business climate, especially for smaller firms, and to incentivize innovation and R&D. Boosting investment also requires increasing the availability of skilled workers through high-quality education and training, as well as longer-term contracts and a more-stable immigrant status for foreigners with in-demand technical skills. In addition, maintaining a predictable regulatory and tax environment, preserving a level playing field between state-owned and private (foreign and domestic) firms, protecting minority investors’ rights, safeguarding the financial viability and efficiency of public investment in the corporate sector, and ensuring that price signals reflect market conditions are recommended. In the near term, the new PPK scheme to encourage private saving for retirement could inflate prices of financial assets and raise employment costs, but if existing barriers to investment were to be addressed, the scheme could result in higher real investment in the longer term.
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We thank the Polish authorities and our private sector counterparts for their hospitality and productive discussions.
