Poland -- Concluding Statement of the IMF Staff Mission
October 20, 2004
The economic climate has improved significantly in Poland since our last visit six months ago. The recovery has been stronger than expected, price shocks have been addressed, and fiscal reforms and privatization plans are progressing. Although weaknesses remain—high unemployment, still-tentative evidence on fixed investment growth, and a large fiscal deficit pushing up public debt—underlying trends, even in these areas, appear to be improving. Policy choices at this favorable juncture are stark: this opportunity can be seized to deepen fiscal and structural changes essential to Poland's development; or the cyclical strength can cultivate complacency and inaction that will dim growth prospects. In our visit during the past week we have focused on the immediate fiscal and monetary policy choices.
An export-led recovery is in place, helped by deep private sector restructuring, strong external competitiveness, and EU accession. Underlying GDP growth in 2004-05 should be just above 5 percent. However, if data indicating an unusual inventory build-up in early 2004 are correct, year average GDP growth rates are likely to be quite uneven—about 5 ½ percent in 2004 and about 4 ¾ percent in 2005. This assumes that fixed investment growth picks up—an assumption still subject to considerable uncertainty—export growth is strong, and consumption remains robust. Downside risks include the possibilities of stalling fiscal reforms, increasing political uncertainty, or a weak recovery in the EU. The current account deficit is likely to stay at 1½-2½ percent of GDP.
Nurturing the favorable economic prospects requires policies to preserve competitiveness, make room for strong private investment, and ensure price stability. A high priority is on reducing the fiscal deficit to a level that will stabilize the public debt-to-GDP ratio under cautious estimates for future growth. Equally important is improving the responsiveness of the supply side of the economy through privatization and an array of reforms to increase labor market flexibility. Such fiscal and structural changes, which will reduce potential inflationary pressures, will create scope for a supportive monetary policy.
The 2005 budget starts an improvement in public finances. The general government deficit is projected to be 5 ¾ percent of GDP, down from 7 percent expected for 2004.1 The implied withdrawal of fiscal stimulus—about 1 percent of GDP—is appropriate at this stage of the cycle, although it only partially corrects the procyclical increase in the structural deficit this year. Moreover, about one-third of the adjustment stems from a change in the pension indexation system, which will entail substantially higher pension payments in 2006. Nevertheless, the budget benefits considerably from fundamental reforms in the Hausner plan, and it is important that measures awaiting Parliamentary approval—especially changes to the farmers' pension scheme (KRUS) and the social security contribution of self-employed—be implemented. Also, ensuring that the new rules related to these two changes contain no loopholes allowing tax avoidance and that revenue administration is fully prepared to enforce the rules will be important.
Notwithstanding recent advances, fiscal reform is not finished. The Hausner plan is making significant inroads on a number of fiscal problems—in particular by eliminating tax distortions, improving incentives to work, and reducing wasteful spending. But further reform is essential to stabilize public debt at a safe level and create room for tax reform and infrastructure investment. Some social transfers, locked in through automatic indexation, remain generous and poorly targeted; the health care system needs redesigning to cope with population aging; the high tax wedge must be reduced once matching expenditure cuts are made; and the creation of a modern infrastructure will require massive public investments, substantially, but not fully, financed by EU funds.
Recent supply shocks—from food, fuel and EU accession—have challenged monetary policy. The MPC, through increases in the policy interest rate by 125 basis points since June, gave a strong signal of its determination to maintain price stability. As the largest share of the supply shocks is now dissipating, we believe that these hikes and high unemployment will curtail any second round effects on wages and that the recent appreciation of the zloty will further constrain price increases. Thus, we expect headline inflation to return to about 2½ percent by end-2005. And while the MPC must be ready to respond rapidly should fuel price increases or future wage pressures become more threatening, the absence of signs of generalized wage acceleration means that the MPC can take more time to assess wage and price trends before adjusting interest rates.
Responding to large supply shocks while establishing a modus operandi for the new MPC has raised several questions about monetary policy processes. We remain supportive of the inflation targeting framework and welcome the increasing role of models and forward looking indicators of inflation in MPC decisions. The publication of the NBP's inflation projections was an important step in making monetary policy more transparent. Nevertheless, justifiable concerns that markets were surprised by several recent decisions need to be addressed. While an element of surprise is almost inevitable when large price shocks occur, minimizing it helps reinforce markets' understanding of the MPC's objectives and lowers costs of meeting inflation targets. In this spirit, renewed efforts to coordinate signals to markets from the monetary authority and to ensure the clarity of MPC communiqués—including announcing on a quarterly basis projections that incorporate the most recent interest rate decisions—should help.
A strong recovery and vigorous restructuring have strengthened the banking system. Return on equity and the capital adequacy of commercial banks have increased significantly. Also, the share of classified loans has declined, although partly as a result of changes in the loan classification system. And while data to fully assess of the new loan classification system are not yet reported, the impact on bank loan provisions so far has been small. The stock of foreign exchange-denominated loans declined substantially in the first half of the year. While this is a welcome development, with increasing zloty interest rates and an appreciating zloty, the trend may turn again. Banking supervision should therefore continue to closely monitor foreign exchange-denominated loans and work with banks to ensure that risks are adequately assessed.
We will review structural policies in our annual consultation discussion in the spring of 2005, but would like to mention two priorities here. First, the favorable economic environment offers an excellent opportunity to move ahead at full speed with the privatization program. The long-overdue IPO of PKO BP is an important step in revitalizing the sale of state assets and should boost the development of the financial sector. Second, the fight to reduce unemployment will be long and hard, and it cannot be won without labor market reform. Jobs need to be created not only for the unemployed, but also for a large number of new and re-entrants to the labor force and those who will be released from agriculture and the public sector where over employment is significant. The fight must be pursued on many fronts: increasing the flexibility of the labor market, reducing disincentives to work, lowering the tax wedge, improving skills and opportunities for mobility.
A unifying goal for all of these policy choices would reside in a determined push toward euro adoption. The reforms still needed to position the economy for this next step in European integration will be demanding. But they are in any event required for strong growth and job creation. Their effects will only be enhanced by the gains from trade and investment that euro adoption would deliver.
1 The IMF monitors the deficit on a cash basis including all transfers to the social security funds and compensation payments. The corresponding numbers on ESA95 basis are 6.7 and 5.8 percent of GDP for 2004 and 2005, respectively, excluding second-pillar pension funds (OFEs); and 5.2 and 4.1 percent of GDP for 2004 and 2005, respectively, including OFEs.