Commission Report (2002): Poland

The existence of a functioning market economy

The overall consensus in favour of economic transformation has been shared by all governments in office since 1997. However in the more recent past, the consensus on macroeconomic policies has weakened. There has been an increasing divergence of views between the monetary authorities and the government which has led to a sub-optimal macroeconomic mix and a further breakdown in co-operation. In turn, the situation has led to proposals in Parliament to amend the statute of the central bank and potentially curtail its independence. This dispute, together with mixed signals on the commitment to the remaining agenda for privatisation could ­ if not adequately addressed -- have a cost in terms of investor confidence and the attractiveness of the Polish economy. The track record on the implementation of Poland's commitments in international agreements is generally good, even though the full liberalisation of capital movements as per OECD undertakings has been postponed twice and is now set to be completed by October of this year.

Growth of real GDP has averaged 4.2%, with a slightly falling trend between 1997 and 2000 and a subsequent sharp slowdown. The highest growth rate was 6.8%, recorded in 1997. The downturn starting in the second half of 2000 led to a weak growth rate of just 1.1% in 2001 and 0.5% in the first quarter of 2002. One of the determining factors behind Poland's high growth since 1997 ­ and the slowdown since the second half of 2000 ­ has been private investment. Over the 1997--2000 period, domestic demand has systematically outpaced overall GDP growth. The investment ratio has averaged close to 25% of GDP over the period, with very high rates of growth for gross fixed capital formation, especially until 1999. The deceleration of output has been due to a sharp contraction of investment in 2001, and is continuing into this year, with growth in the first quarter of 2002 at a mere 0.5% compared to the corresponding period of the previous year. In 2001, for the first time, output growth was driven by net exports. Prior to the recent, domestically induced, slowdown the Polish economy had demonstrated a high degree of resilience to external shocks in the face of the Russian crisis in 1998. The loss of export markets in the former Soviet Union amounted to some 3 percentage points of GDP, but triggered a new round of enterprise restructuring that helped to moderate the decline in profitability and allowed a rapid resumption of export growth. Productivity increases, however, translated into higher unemployment, a moderation of household incomes and ultimately lower short-term growth, exacerbated from mid-2000 by excessively tight macroeconomic policies.

The current account balance has been showing continuous deficits of at least 4% of GDP, which have been increasingly financed by FDI inflows. The balance of current account has shown an annual average deficit of nearly 5.5%. Whereas in 1997 and 1998, and lately in 2001, the deficit was in a sustainable 4 ­ 4.5% range, in 1999 and 2000 it reached significantly higher levels (1999: 8.1%), mainly due to a weak export performance in the immediate aftermath of the Russian crisis. Subsequently, Polish exporters were able to continue to penetrate European markets, even with an appreciation of the zloty in real effective terms of almost 30% between the end of 1999 and the middle of last year (CPI-deflated). Export volumes were still growing at around 14% in 2001, while imports were almost flat due to the slowdown in domestic demand. The trade and current account deficit correction experienced since 2000 is therefore a reflection of the re-balancing of the sources of growth in the Polish economy. At an estimated 4% in 2001, the current account deficit is more easily financed through non-debt-creating inflows in the form of foreign direct investment. Among these, net FDI inflows have averaged 3.4% of GDP since 1997, after peaking at above 5% of GDP in 2000.

The significant rise in unemployment is due to a combination of cyclical, structural and demographic factors. The unemployment rate rose rapidly from around 11% in 1997, and a subsequent small decline in the year after, continuously over the past years to a high rate of 18.4% in 2001. It is unlikely to contract or even stabilise unless the Polish economy returns to potential output. The rise in unemployment reflects the pace of job destruction, which has accelerated with enterprise restructuring since 1999 and, to some minor degree, a rise in labour force due to demographic developments. On the other hand, job creation is hampered by a skills gap between supply and demand and other barriers in the transition between sectors of the economy, such as the costs of labour, limitations in the labour code, relatively easy access to early retirement, transport and housing impediments to mobility.

Inflation has been on a falling trend. Whereas annual inflation in 1997 still amounted to 15%, it has fairly continuously fallen over the past years, translating into an average of 9.9% over the period. After a temporary reacceleration in 2000, inflation has again fallen back rapidly. Headline inflation dropped to 3.5% at end-2001 compared to the corresponding period of the previous year, already below this year's initial target for the end of the year of 4 to 6%. This sharp decline reflects not only demand factors, but also a reversal of previous supply side shocks to food and fuel prices, the tightening of monetary policy and the impact of the currency's appreciation on the price of imported goods. Price growth is stronger in the services sector, which explains why the National Bank of Poland's main measure of ``net'' inflation is still close to 3% and above other measures of core inflation.

Poland has switched its exchange rate regime from a crawling peg prevailing until 2000 to a regime of free float since then. Since the exit of the crawling peg in April 2000, Poland has been maintaining a monetary and exchange rate policy framework combining a floating exchange rate with direct inflation targeting that serves the economy well at this stage of advanced transition and in the run-up to EMU. The set of instruments of the NBP is flexible and has been progressively diversified and extended to effectively carry out monetary policy. Nevertheless, the implementation of direct inflation targeting is proving difficult, in particular because of the uncertainties and lags surrounding the monetary policy transmission mechanism, given the state of development in the financial sector. After overshooting the target in the first two years of existence of the inflation targeting regime, the Monetary Policy Council is now confronted with the prospect of a significant undershoot. The exchange rate remains, in any case, the most powerful transmission mechanism, and cannot be disregarded as an element of the policy mix. The present exchange rate regime has so far helped to mitigate domestic and external economic policy trade-offs, achieve gradual disinflation and accommodate a trend real exchange rate appreciation in the context of strong capital inflows. With short-term real interest rates close to 6%, monetary conditions are tight, in particular given the appreciation of the zloty. Since the floatation of the zloty, the monetary authorities refrained from direct intervention in the foreign exchange market, as this would probably have yielded little effect on the currency's real value and could only have been undertaken at the cost of higher inflation.

Poland's effort of fiscal consolidation has been hampered by the slowdown in growth and the reluctance of the Polish authorities to undertake a deep restructuring of public expenditures. General government net borrowing, on the basis of harmonised EU standards (ESA 95), dropped from 4.3% of GDP in 1997 to levels of around or below 2% in the subsequent three years, but has widened significantly since last year, parallel to the slowdown of economic activity. Last year, the accounts deteriorated to a deficit of 3.9% of GDP. Most of the deterioration of the fiscal accounts is attributable to the deficit of the central government budget, even though the net lending of social security funds was also lower than forecast. Reforms in health care and pensions, which were initiated in 1999, have still not been completed. This forms a liability to the sustainability of government finances over the medium term. In response to the deteriorating budgetary situation, the government adopted an expenditure rule, according to which central government expenditures are limited to an annual rise of one percentage point above the inflation rate, which should allow fiscal consolidation as long as economic growth is sufficiently high and the rule is adhered too at all levels of government. Reflecting the development of the government deficits, government debt had been falling significantly from around 47% of GDP in 1997 to 38.7% at the end of 2000. That trend was reversed in 2001, with the debt ratio reaching 39.3% at the end of last year. Annual interest charges are rising in parallel with debt, and now represent some 3% of GDP.

After a policy mix in the mid nineties which enabled economic growth and stability, this policy mix has become less supportive since 1999. After a sharp easing of monetary policy in 1999 and a rapid pick up in inflation and in the current account deficit, macroeconomic policies were considerably tightened in 2000. Since then, the relaxation of monetary policy has been lagging while the deterioration of the fiscal stance in the course of 2001 has gone beyond cyclical factors and reflects a discretionary relaxation of policy. The lack of transparency in the fiscal accounts is also an obstacle to the appropriate setting of monetary policy. In the medium term, further fiscal consolidation will be needed to alleviate current account pressures. The main pressures on the fiscal front are to reduce the tax burden, define an appropriate degree of deficit reduction and make room for increased capital expenditures.

Prices and trade are broadly liberalised. Most of the price liberalisation took place very early in the transition. Since 1997, the share of administered prices in the CPI has remained fairly constant at low levels. The NBP defines officially controlled prices as those which are principally made up of excise duties (fuel and alcohol), capped by price ceilings or otherwise regulated (electricity, pharmaceuticals) and or set by local authorities (municipal transport). Together they accounted in 2001 for 25% of the total CPI basket weights. However, it is only the prices of pharmaceuticals, electricity and heating that are subject to formal regulations, while cost recovery or maintenance is taken into account in the price setting mechanisms for other categories, notably housing rents. Trade liberalisation has been guided by WTO and EU accession-related commitments, that have enabled a fall in Poland's effective trade-weighted average tariff from 5.8% in 1997 to 2.6% in 2001.

More than 3 million private sector firms now produce over 70% of GDP, compared to about 65% five years ago, and employ more than 70% of the workforce. Although still in need of deep restructuring and plagued by obstacles to professional and geographic mobility in rural areas, agriculture is also dominated by the private sector. Large state farms now account for 5.2% of total agricultural land compared to 5.8% in 1997, while private ownership has increased over the period from 91.7% to 92.9% of that total.

Privatisation accelerated in Poland in the period since the Opinion. The privatisation process is close to full completion in most sectors. However, the number of companies in state ownership, even if falling, is still considerable. It has declined from 3 369 in 1997 to 2 054 in 2001. The key sectors that remain to be privatised and restructured are coal, steel, energy, heavy chemicals and defence-related industries. A large share of privatisation has taken the form of sales of majority stakes to foreign strategic investors, a technique that has fostered effective restructuring in most of the sectors concerned. Over the last year, however, privatisation has considerably slowed down.

There are no significant legal or institutional barriers to the establishment of new firms in Poland. The main remaining problem is the implementation of bankruptcy procedures and the exit of insolvent firms. Since the Opinion, the adoption of a new law on economic activity which ensures the equal treatment of private and public entrepreneurs, the introduction of modern statutes for competition, consumer protection and intellectual property, the removal of legal barriers to the development of competition in sectors that were previously exempted by law (since the Opinion notably in energy and the railways) have all contributed to the improvement of the business climate. The government has also established a unified entrepreneurs' electronic registry system for new enterprises whose coverage is progressively becoming more comprehensive. In January 2002, the Polish government adopted a medium-term economic programme which contains a large set of measures to simplify the tax system (corporate tax rates had been reduced, and the tax base broadened, in 1999) and reduce administrative burdens by streamlining procedures. These procedures, notably for the registration of new businesses, are still time consuming and involve a number of steps and administrative actors that can be considered high by international standards. As far as exit is concerned, the new commercial code, in force since January 2001, facilitates consolidation through mergers or acquisitions, but this applies mainly to large firms. Overall, however, the existing bankruptcy and liquidation framework is costly, poorly enforced due to resource constraints on courts and excessively favourable to the debtor. For the public sector, since 1997, 869 state firms have been liquidated under Article 19 of the law on state-owned enterprises.

In general, property rights are established and transferable. The main shortcoming that has not been sufficiently addressed in the period since 1997 is the improvement of the land registry. This limits in practice the possibility to establish ownership over land, and therefore makes it difficult to use property as collateral in loans. The entrepreneurial climate is good, although a certain degree of bureaucracy, the lack in transparency in some government decisions and difficulties with the enforcement of court decisions are general obstacles to activity. Moreover, the continuing uncertainty surrounding cases relating to the restitution of property represents an additional obstacle.

The financial sector is maturing slowly. The restructuring and privatisation agenda in banking is well advanced, but not fully complete. The government maintains ownership in only 7 institutionscompared to 15 in 1997, but the role of the former State savings bank -- PKO Bank Polski SA -- remains significant. The market is also fairly concentrated, with the largest 10 banks accounting for more than 70% of assets. One of the main characteristics of the sector is the high degree of foreign ownership. There are now 47 banks with majority foreign equity (against 29 in 1997), representing almost 70% of the total assets of the sector. Financial intermediation is still very low in international terms. Banking assets represented some 64% of GDP at the end of June 2001, while the overall deposit base of the banking sector as a whole represented less than 38% of GDP. The domestic credit-to-GDP ratio has only increased to 29.1% (March 2002), from a level below 25% at the time of the Opinion. For about a third of firms reporting to the Statistical Office, investment is still mostly financed through retained earnings.

Polish banking intermediation remains characterised by a lack of effective competition. However, the sector seems stable and well capitalised. Efficiency of banking intermediation, measured in terms of interest rate spreads remains low and is improving only slowly. At 7.7%, the spread between average lending and deposit rates in 2001 was at a similar level to the one that prevailed in 1997. The high degree of foreign ownership in the financial sector is an important factor underpinning soundness and stability. Systemic threats are also limited in view of the fact that the financial sector is still small. Nevertheless, in the banking sector, there has been a rapid and sharp deterioration in asset quality over the last two years. The share of non-performing loans as a percentage of total portfolio has increased to 18.3% in 2001 from 10.5% in 1997. On the other hand, the regulatory and supervisory framework for the financial sector as a whole has been continuously upgraded over the period to keep pace with developments, and is now close to international standards and best practice ­ and compliance with the acquis. The legal framework and the supervisory process had already been significantly improved on the occasion of the previous change to the Banking Law in 1997. A new amendment to the Banking Law entered into force at the beginning of 2001 and has addressed several major shortcomings, including the supervisors' authority to conduct consolidated supervision, capital requirements to apply on a consolidated basis to banks and market risk, improved anti-money laundering legislation and clear rules for bank ownership transfer, as well as large credit exposure and provisioning.

The non-bank financial sector is relatively small, but growing rapidly. Insurance companies and ­ since the 1999 pension reform ­ pension and investment funds are becoming important players. The Polish equity market is still very small, with a capitalisation of less than 15% of GDP. The corporate bond market (as well as other fixed-income markets) is also small but (notwithstanding relatively high costs and stringent information requirements) should now develop in parallel with the growth of institutional investors. The commercial paper market is expanding rapidly and becoming an alternative source of financing for the biggest firms.

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