Saturday, February 9, 2008

Poland-2007 Article IV Consultation

Poland-2007 Article IV Consultation
Preliminary Conclusions
January 21, 2008
Poland is enjoying strong and well-balanced growth, with only limited pressures on core inflation and the current account deficit so far. However, the expansion is facing emerging resource constraints, in particular labor shortages. Sustaining robust GDP growth and external competitiveness over the medium term will require meeting a dual challenge of containing demand pressures while strengthening the economy's supply response. A monetary tightening bias, the adoption of fiscal measures that will set the structural deficit on a steady downward path, and progress across a broad array of reforms aimed at boosting labor participation are among the mission's key recommendations. This would facilitate achieving the government's welcome objective of taking full advantage of Poland's EU membership through euro adoption.

Managing inflationary pressures and maintaining competitiveness.

1. Output growth is set to moderate to about 5 percent in 2008, as a weakening external environment tempers export growth and investment growth retreats from the earlier exceptional pace. Investment growth will, however, remain strong—sustained in part by steadily increasing EU funds—with continued robust growth in disposable income and consumption. Impetus to domestic demand will also come from the fiscal stimulus in store for 2008.

2. Inflationary pressures are, in our view, set to remain strong despite the slowdown in output growth. The rapid increase in employment, together with emigration, has now mostly absorbed the labor market slack, reflected in real wage growth well in excess of productivity gains and in real appreciation as measured by unit labor costs. Until recently, these cost pressures had only a limited adverse impact on core inflation and export growth as wage restraint in the first half of the decade had significantly bolstered profitability and export competitiveness margins. But the scope for squeezing profit margins will ultimately run its course, and cost pressures appear to be already feeding into prices, as evidenced by the increase in core inflation in recent months. Also—although still less conclusive—exports orders have shown signs of weakening.

3. Against this background, we believe that a continued tightening bias in monetary policy is warranted at this time. While headline inflation is likely to decline due to food price deceleration, our projections, based on unchanged policy, suggest that inflation will continue to run well above the 2½ percent target and will exceed the upper end of the band for most of 2008. Bringing inflation back to the target will not only prevent higher inflationary expectations from becoming entrenched, but also avoid the risk that expectations of a prolonged tightening bias in monetary policy causes speculative capital inflows and attendant upward pressures on the zloty.

4. Why do we not believe that the heightened risk of negative spillovers from the current financial market turmoil—through real and financial channels—calls for a pause in the tightening of monetary policy? Admittedly, the uncertainty regarding the external environment is substantial at this juncture and the spillovers could be stronger than we envisage. However, in our view, these downside risks are still more than offset by the risk that the continued significant excess of real wage growth over productivity growth will have a stronger-than-expected impact on inflation. While the potential negative external spillovers warrant caution, the MPC should be equally vigilant about the risk of second-round effects of food and energy price increases on wage demands, including the risk that current wage negotiations in the public sector ratchet up broader wage pressures.

5. Sustained fiscal consolidation is needed and we welcome the authorities' commitment to gradually reduce the structural deficit to 1 percent of GDP by 2011. This will help relieve monetary policy and thereby reduce the extent to which the burden of adjusting to tightening resource constraints falls on investment and exports. It will also increase the scope for automatic stabilizers to operate without jeopardizing Maastricht criteria, speed-up the reduction in public debt, and contain the widening of the external current account deficit. On the latter, our projections show that this deficit will increase over the medium term to the upper bounds of what is safe from a long-term perspective, suggesting that—in the absence of a reduction in the structural fiscal deficit—there would be an increased risk that the real exchange rate could overshoot its long-term equilibrium path in the event of a stronger-than-expected deterioration in the private sector's saving-investment balance. Indeed, if the economy threatens to overheat due to exceptionally high and sustained capital inflows, a more ambitious reduction in the structural deficit than currently envisaged would be the most effective means of preventing such overshooting.

6. The fiscal consolidation in 2008 could be more ambitious. The 2008 budget will, in our view, increase the structural deficit by up to ½ percent of GDP—in part because of cuts in social security contributions adopted last year (to cut the tax wedge)—requiring a stronger reduction in 2009-2011. To smooth the adjustment path, expenditure execution should be kept below appropriations, to the extent possible, in 2008. Being new in office, the government is in the process of formulating more detailed plans for how to achieve its fiscal objectives. While we agree with the objective of reducing the tax burden over the medium-term, deficit reduction should take priority. This implies considerable current expenditure reduction and, with as much as 70 percent of expenditures being non-discretionary, a key challenge facing the new government will be to streamline social benefit programs. In this regard, there will be important complementarities between fiscal objectives and measures to boost labor participation and long-term growth.

Sustaining strong growth over the medium-term

7. Boosting the labor force holds the key to long-term growth prospects. Much of the recent economic expansion has reflected increased labor utilization, but this is naturally coming to an end and continued strong growth will increasingly hinge on measures to raise Poland's exceptionally low level of labor participation, not least among those above 50 years of age. Reforming the generous provisions for early retirement, by tightening guidelines for eligibility, and further rationalizing the system for disability payments are key to increasing participation. Other important measures to increase participation and reallocate labor to more productive sectors include reducing the tax wedge, especially at lower level of incomes, and reforming the farmer's pension scheme (KRUS), with the ultimate goal of merging it into the general scheme. While changes in these areas will be politically and socially sensitive, incremental progress across such a broad array of reforms can significantly boost labor supply in the medium term. The potential of such reforms has been demonstrated by the experience of several EU member countries—including Ireland and the Netherlands—over the last two decades, especially in the context of social partnership frameworks.

8. Further deregulation and privatization are also necessary to bolster long-term growth prospects, especially since Poland lags its peers in this area. While EU accession has provided a welcome impetus, there is still scope for realizing significant catch-up gains in productivity by improving the business climate through deregulation, and accelerating privatization. Importantly, reforms in these areas have strong complementarities with the aforementioned labor market reforms. We therefore welcome the authorities' intention to give priority to reinvigorating the privatization program and cutting red tape.

Maintaining financial market stability

9. Polish credit and money markets have so far remained largely unaffected by the global market turbulence, even as credit growth has been increasingly financed by foreign borrowing. (The net foreign indebtedness of the banking sector remains, however, still relatively low.) Market participants attribute this to a high return on Polish assets and to the small share of the assets of Polish affiliates in parent groups' total assets. Importantly, any exposure to US sub-prime assets is expected to be minor and Polish banks have been somewhat sheltered from the recent turmoil, as the use of complex financial instruments and securization remains limited, and credit derivatives are absent. In this connection, the NBP's stress tests show continued banking system resilience, even in the face of increasingly uncertain global markets. Still, credit has expanded rapidly in recent years, particular into new, higher-risk markets, and part of this expansion has been financed by foreign borrowing. Supervisors need to closely monitor the risk of negative spillovers in the event of abrupt reductions in access to international capital markets. At this juncture, it is particularly important that the recent integration of banking sector supervision into the Polish Financial Supervision Authority (KNF) does not impair supervisory effectiveness.

Strengthening the policy framework

10. Additional steps are needed to ensure the KNF's supervisory effectiveness. We understand that a bilateral operational memorandum already governs the exchange of information between the KNF and the NBP and that all existing safety net arrangements, processes and human resources remain effective. The MoF, the NBP and the KNF have also agreed on a memorandum of understanding pertaining to financial stability. However, there is a need for legislation to make the tripartite framework operational. Also, the governance structure of the KNF falls short of international best practices concerning safeguards against political interference. Introducing fixed terms of appointment for all KNF board members would go a long way toward ensuring that board members, once appointed, are independent and serve in their technical capacity.

11. Achieving the government's fiscal objectives would be facilitated by establishing a medium-term fiscal framework centered on multi-year fixed expenditure targets. The current focus on annual budgets—with medium-term budget parameters in practice imposing no legal constraints—is not in line with international best practice. While such practices vary, we would recommend a 3-year expenditure framework, where global nominal expenditure ceilings are set on a rolling basis with limited scope for revision over time. The expenditure path should be derived from the government's medium-term deficit target and should encompass as much of general government expenditure as possible, with special provisions for EU funds. Improving coordination with local governments over spending targets would also be beneficial. Such a framework would reinforce the response of automatic stabilizers to demand shocks, and help build broader political support for medium-term fiscal priorities and underlying policies.

12. In conclusion, Poland has a fresh opportunity to take full advantage of its EU membership, including by adopting the euro. As this entails giving up independent monetary policy, the economy will need to be equipped to withstand shocks through increased flexibility in fiscal policy and in wages and prices. We therefore welcome the authorities' policy objectives as we believe that they—underpinned by concrete plans—will do much to foster a successful transition to euro adoption and ultimately allow Poland to thrive in the euro area.

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