Public Information Notice No. 02/65

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Republic of Poland

June 26, 2002

On June 7, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Poland.¹

Background

Poland has weathered a difficult two years. Under the weight of exogenous shocks, an aggressive policy response to rising consumption growth in 1999 and early 2000, and a downturn in Germany, output growth slumped from 4.1 percent in 2000 to 1.1 percent last year. And the slowdown has raised the unemployment rate back to the high teens, hit investor confidence and caused non-performing loans in the banking system to rise. At the same time, inflation has declined sharply (from 11½ percent in mid-2000 to some 3¼ percent in the first quarter of 2002) and the current account deficit has narrowed considerably (from 6¼ percent in 2000 to some 4 percent last year).

The fiscal deficit widened sharply in 2001, reflecting both automatic stabilizers and a ½ percent increase in the structural deficit. State (central government) primary expenditures (excluding one-off transfers) rose relative to GDP by 1 percentage point, notwithstanding cutbacks late in the year. Two factors accounted for this rise: significant increases in transfers and subsidies to households, agricultural and state enterprises, as well as wages; but also outcomes for inflation and growth that were far below budget projections. Together with a cyclical slowing of revenues, this led to a general government economic deficit (cash basis) provisionally estimated by the staff at just under 5 percent of GDP, up from 2.2 percent of GDP in 2000.

Monetary policy was eased significantly in 2001. The sharp declines in inflation and inflation expectations made deep interest rate cuts possible. Accordingly, the key policy interest rate has been cut by a cumulative 1000 basis points since February 2001, and reserve requirements were lowered from 5 to 4½ percent. But with inflation having fallen sharply, real policy interest rates (deflated by either current or projected one year ahead inflation) remain at some 6 percent.

The interest rate cuts have done little to stem the continuing appreciation of the zloty. The CPI-based real effective exchange rate has appreciated by some 25 percent since end-1999, of which at most 6 percentage points can be attributed to Balassa-Samuelson effects. Notwithstanding the strength of zloty, export volume growth remained strong in 2001—expanding by 6 percent, well ahead of export market growth. Coupled with weak import growth, this contributed to the improvement in the current account deficit.

Partly spurred by the easing of policies last year, signs of an economic recovery are now appearing. Further, the expected recovery in Germany, Poland's main trading partner, should cement this recovery in the latter part of this year. While the weak first half will leave growth this year at or somewhat above last year's 1 percent, prospects for growth beyond this year are strong. And Poland approaches this juncture from a position of strength in some important respects: inflation is low and the fruits of the hard-fought battle to tame inflation expectations will be conducive to growth; the modest current account deficit leaves room for a pick-up in imports; and enterprises, having adapted to highly competitive conditions, are leaner and more efficient. With EU accession in sight, Poland has the potential to do well.

But realizing this potential will require addressing the policy challenges that have emerged. A first requirement is to put the unfettered ability of the National Bank of Poland (NBP) to conduct monetary policy beyond question. Only then will the time-proven benefits of low inflation and investor confidence be secured. Second, public spending must be curtailed if private investment and exports are not to be crowded out and lead to the reemergence of a large current account deficit. And third, policy-induced distortions in the labor market need to be eliminated if firms are to have the flexibility to respond aggressively to new opportunities and create jobs.

Executive Board Assessment

Executive Directors noted that Poland has had a long and well-established track record in building the institutions and pursuing the policies for a successful transition to a market economy. In the past two years, the Polish economy has weathered a difficult period against the background of a weaker external environment. Economic growth has decelerated markedly, reflecting a sharp drop in investment, while unemployment has risen rapidly. Positive developments, however, include the decisive lowering in inflation and inflation expectations, and the reduced vulnerability to changes in investor confidence resulting from the sharp, if partly cyclical, drop in the current account deficit. Looking forward, Directors welcomed the emerging signs of a recovery, to which the upturn in the world economy should add welcome support.

To realize the potential of sustained high growth and make the most of impending EU accession, Directors considered that Poland faces several important challenges that will require prompt and resolute policy responses. Key among these are a sustained fiscal consolidation effort to set the stage for an improved policy mix and reverse rising debt dynamics, as well as the vigorous pursuit of labor market and other structural reforms that will be crucial for regenerating growth and job creation.

For the immediate future, Directors underlined the importance of preserving the institutional integrity and independence of the NBP. They were concerned that a continuation of the present debate, which has perpetuated perceptions of interference in the organization and role of the NBP, would have adverse short and long-term consequences, by diminishing investor confidence in Poland's commitment to sound policies and raising inflation expectations. Although differences in views on policy choices are quite natural, Directors urged the government and NBP to restore a constructive dialogue on monetary policy and to work expeditiously toward resolving their differences through dialogue and open communication. Directors also urged the government to oppose the amendments to the National Bank Law now before parliament that would curtail the central bank's unfettered ability to conduct monetary policy.

Directors welcomed the restraint on public expenditure growth in the 2002 budget as a first, important step toward correcting the widening fiscal imbalances. While recognizing that the budget entails a sizeable withdrawal of stimulus in a setting of weak growth, Directors considered this to be unavoidable, given the large size of the deficit and the need to pave the way for further monetary easing. They urged the authorities to ensure that the expenditure moderation expected of the local governments is achieved.

Directors stressed that sustaining fiscal consolidation in the coming years will be key to prevent general government debt from rapidly rising to the constitutional limit of 60 percent of GDP. They commended the government's decision to limit the rate of growth of State spending to the projected increase in the "CPI plus one percent", as a key first step, and urged its strict implementation to ensure a gradual lowering of the fiscal deficit and stabilization of the public debt ratio. Most Directors encouraged the authorities to broaden the coverage of the "CPI plus one percent" rule by extending, in due time, its application to the spending of local government and extra-budgetary funds. They considered that this would help ensure that fiscal consolidation goals are more safely achieved, thereby creating some welcome scope for tax cuts. Some Directors also suggested that the rule should be enacted by law and combined with explicit nominal spending ceilings to ensure its effectiveness.

Beyond lowering the fiscal deficit, Directors underscored the importance of re-orienting public expenditure to more productive uses. Directors noted that better targeting of social transfers, which at present account for close to half of total public spending, will be essential both for achieving the required fiscal consolidation as well as for releasing resources for much-needed infrastructure investment. They encouraged the government to build the required social consensus in favor of reforms in this area.

Directors commended the NBP for its effective conduct of monetary policy, which has reduced inflation and brought about cumulatively quite large interest rate cuts during the past year. Looking ahead, considering the generally benign inflation outlook, the likely persistence of a sizeable output gap, and the strength of the zloty, Directors saw some scope for further interest rate cuts. Directors generally supported the recent cautious approach of cutting by small amounts in view of the uncertainties about the effects still in the pipeline from the large cuts during the past year. However, a few Directors pointed out that the lagged effects of the zloty appreciation would suggest that there is scope for somewhat more ambitious easing.

Directors welcomed the continued improvements to the inflation targeting framework, which will be further enhanced with improved overall coordination of macroeconomic policies and information dissemination. They noted that, in the current environment, it would be appropriate to make the framework more symmetrical, by setting a single continuous inflation target with relatively large bands. They encouraged the authorities to adopt a new medium-term inflation target soon to help guide policies beyond 2003.

Directors considered that the freely floating exchange rate regime has served Poland well, and that the current strength of the zloty is a by-product of the macroeconomic policy mix combined with the normal tendency toward appreciation in the transition. Noting that direct market intervention to engender a depreciation is unlikely to yield any lasting benefit, Directors generally emphasized that concerns about competitiveness should be addressed through a reduction of the fiscal deficit and an acceleration of structural reforms that would permit a more substantial easing of monetary policy than would otherwise be possible.

Directors noted that Poland's financial system appears to be generally sound. They considered that the substantial increase in non-performing loans should not be a systemic concern, as banks have fully provisioned against them, and they expected this problem to subside as growth recovers. Directors noted, however, that a sizable increase in foreign exchange denominated or linked borrowing by households has heightened the risks to the banking system from a sudden exchange rate depreciation. While recognizing that the attraction of those loans would likely decline with falling interest differentials, Directors urged the NBP to ensure that banks are clearly aware of the credit risk embodied in foreign currency loans to unhedged borrowers, and are pricing this risk appropriately. They welcomed the NBP's intention to monitor closely the evolution of foreign currency loans, and stressed the importance of improving data coverage in this area.

Directors commended the authorities' commitment to further structural reforms aimed at improving economic efficiency and promoting business opportunities and job creation. They urged the authorities to undertake extensive labor market reforms to ensure that the economic recovery will be job-rich, and, in particular, to relax the regulations governing the hiring and firing of workers. Many Directors also supported measures to differentiate the uniform national minimum wage for labor market entrants and across the regions. Directors encouraged the authorities to deepen public enterprise reform so as to reduce the fiscal cost of sustaining these enterprises and remove the economic inefficiency that they entail for the economy at large. They also urged the authorities to reinvigorate privatization, including in the financial sector, and to refrain from using publicly-owned banks for quasi-fiscal objectives.

Directors welcomed the authorities' decision to remove the remaining controls on capital flows in the context of a sufficiently strong regulatory framework. They looked forward to the early enactment of draft legislation to further strengthen the framework for combating money laundering and the financing of terrorism.

Poland subscribes to the Special Data Dissemination Standard and its statistical base is adequate for surveillance. Directors encouraged the authorities to improve the timeliness of the compilation and dissemination of monthly fiscal data for the general government. Directors welcomed the authorities' decision to complete the Report on Standards and Codes on data quality in the coming year.