Poland after the EU referendum

The political situation in Poland is anything but stable: the government now has to address the urgent tasks of consolidating the public-sector finances and reducing unemployment.

Poland: budget consolidation and unemployment still major challenges

With a population of roughly 40 million, Poland is by far the biggest country among the ten states joining the EU next year. In an EU-25, only Germany, France, the United Kingdom and Italy will be allocated more votes in the Council of Ministers than Poland. The income gap between the EU average and Poland continues to be very high, though, not least as a result of the fact that its economic structure is still strongly based on agriculture. The success of EU enlargement will largely depend on to what extent it will be possible to accelerate the catch-up process in the real economy. In this edition we will thus analyse Poland’s political and economic situation just one year ahead of EU accession.

The approval of EU membership by the solid majority of voters in early June’s referendum finally opened the way to Poland’s accession to the EU as of May 1, 2004. Until shortly before the referendum, there had been concerns that it could be declared invalid because of too low voter turnout. With 77% of the electorate voting yes“ and a turnout of 59%, the approval was more pronounced than forecast by many observers. The domestic political situation after the referendum has been anything but stable, however. Prime Minister Leszek Miller saw his chance and immediately after the referendum called a vote of confidence to show that his minority government has continuing parliamentary support. With the help of social policy promises and rejection of a strict fiscal consolidation course, the Miller government won the vote at a tight majority of 236 to 213. Just before the vote, the shifting of control of overall economic policy from the ministry of finance to the ministry of economics had led to the resignation of Finance Minister Grzegorz Kolodko. Within the cabinet Kolodko had stood for the consolidation of the budget; it is thus to be feared that the government will put the reform of public finances on the back-burner and instead pursue a demand-oriented policy to boost economic growth. However, it is unclear whether the government can remain in office until the end of the current legislative period, i.e. 2005. The parliamentary majority continues to be unstable.

The government now has to address the urgent challenges ignored in the last few months in the run-up to the June referendum. In our view chief tasks will be the consolidation of public-sector finances and the fight against unemployment. Success in these two problem areas will in part depend on the pace of the economic recovery in Poland.

Sluggish growth…

The Polish economy has probably bottomed out since end-2001, and growth picked up slightly in the last few quarters (see chart). However, growth in 2002 as a whole was only a moderate 1.4% yoy (following 1.0% in 2001). A look at GDP components shows that last year’s growth weakness was mainly attributable to the domestic economy: here, the decline in investment spending was of major importance (7.2% in 2002). By contrast, export performance continued to be favourable. Polish exports rose by 5% despite the stagnating economy in Western Europe (mainly in Germany). These trends continued in the current year: Q1 GDP growth was 2.2% yoy. While there are hardly any indications of a perceptible pick-up in domestic demand, export growth remains an important pillar for a gradual economic recovery.

As Polish exports have been increasing while the economic activity of Poland’s major trading partners in Western Europe is stagnating (a development which can also be observed in other Central and East European countries), Polish export companies are gaining market share. Nevertheless, Polish growth will probably not be able to decouple from the pace of economic expansion in Germany durably. Econometric estimates underscore the past st rong dependence on German GDP growth.

If Polish fiscal policy does not embark on a more expansionary course, further cuts in interest rates by the National Bank of Poland are likely. Inflation has remained below 1% yoy so far this year, and the year-end inflation target of 2-4% will probably again be undershot. Against this background the central bank has enough scope for further rate cuts. Lower real rates should lead to a slight increase in investment demand in the second half, so growth will probably pick up somewhat and reach roughly 2.5% in 2003. In the medium term, growth could reach 4-5% p.a. However, the prerequisite for this is that Western Europe overcomes the continuing period of sluggish growth.

… makes fiscal consolidation more difficult …

A consolidation of public-sector finances is urgently called for for several reasons:

• First, the budget deficit rose to over 5% of GDP in the last two years. In the same period, public debt climbed to over 45% of GDP and should rise further to over 50% in the next few years if no fiscal countermeasures are taken. According to the Polish constitution and the provisions of the Maastricht Treaty, general government debt must not exceed the limit of 60% of GDP. Furthermore, the current deficit has to be reduced to below 3% of GDP to meet the Maastricht criteria.
• Second, EU membership will incur costs from next year which will have to be compensated by the government budget. For Poland to receive aid from the EU structural and regional funds it will have to juggle revenues to provide co-financing. According to estimates, this increase in expenditure could widen the budget deficit by 0.5- 1% of GDP.
• Third, an expansionary fiscal policy would make it more difficult for the National Bank of Poland to cut interest rates further. Excessive deficits had already contributed to a renewed acceleration in inflation in 2000, so that the central bank had to tighten monetary policy. The repercussions of the economic nosedive are still noticeable today.

For the reasons mentioned above, there seems to be no alternative to a determined consolidation course. Ex-finance minister Kolodko had strongly called for the gradual reduction of the budget deficit. However, now it is to be feared that with economic policy firmly in the hands of the ministry of economics there will tend to be a delay of fiscal tightening. No doubt, the reduction of the deficit is a major challenge for the government. It has to be taken into consideration that only approximately 15% of public expenditure is at its discretion, since respective spending cuts require changes of existing laws. Furthermore, spending cuts will be difficult to push through politically due to the continuing high level of unemployment. Even if the original Kolodko plan is largely implemented, the deficit targets are unlikely to be met as they are based on too optimistic growth forecasts. Growth projections (3.5% in 2003, then gradual increase to 6% by 2006) have been called unrealistic by the Polish central bank, the IMF and the OECD. As described above, we also expect more moderate growth rates in the next few years. Against this backdrop, the budget deficit is unlikely to be reduced to below 4.0-5.0% of GDP in the years to come.

… and the reduction of unemployment harder to achieve

The Polish unemployment rate continued to rise in the last few years; at 18.7%, it has reached the highest level among the new member states and within the old EU. In ILO terms, Polish unemployment is as high as 20.5%. However, the rate of increase slowed down in the last few months as a result of the gradual economic recovery. The fact that the slower increase in unemployment has been referred to as “stabilisation“ by many observers reflects the severe problems in the Polish labour market. The negative development of the employment situation in the last few years is not only du e to the weakness of the economy. Structural factors also play a major part.

• Wage levels in Poland are comparatively high: at an average gross monthly figure equivalent to EUR 540, Polish wages are relatively high by regional standards (“more expensive“: only Slovenia and, for some time, also Hungary) although labour productivity ranks only about average.
• The flexibility of wages in Poland at regional and sectoral level is low. Although the wage levels agreed upon by a commission of government members, trade union and business representatives are supposed to be the upper limit and may theoretically be undershot by individual companies, they are actually a floor for wage increases – also for the public sector.
• High minimum wages make job creation in the low-wage sector more difficult. According to the OECD, minimum wages in Poland, at roughly 35% of the average wage, are substantially higher than in Hungary and the Czech Republic. As a consequence, unemployment of low-skilled labour is particularly high (similar to the situation in Germany). Among this group, the rate of unemployment is 28%. By contrast, the unemployment rate among university graduates is only 6.8% (as of 2002).
• The restructuring of the Polish economy continues to lead to job losses and has not been completed yet. Further redundancies are likely above all in the agricultural sector, which still employs roughly 20% of the work force. In addition, state-owned companies in the coal, steel and transportation sectors (railways) still require considerable restructuring, which will probably be accompanied by lay-offs.
• Substantial regional differences with regard to unemployment have strengthened in the last few years. Especially the scarcely populated, rural regions in the west and north-east of the country have insufficient infrastructure, and employment opportunities are unlikely to improve noticeably in the years to come. Regional labour mobility is low.

As a result of moderate economic growth this year and next, the government will probably be unable to bring down unemployment considerably. As in Germany, a substantial decline would require bold steps towards a more flexible labour market. Employment-intensive growth will probably not set in until the restructuring of the economy has been completed. Furthermore, the increase in labour costs needs to be kept at or – even better – below the rate of productivity growth. Poland’s upcoming EU membership could lead to a slight decline in youth unemployment as some EU member states (e.g. the UK) have refrained from long transition periods with regard to the freedom of movement, which may offer employment opportunities to mobile Polish job seekers. However, Poland’s employment problems cannot be solved by EU accession alone. Poland will also have to embark on a fiscal consolidation course to obtain EU funds and use them efficiently (e.g. for the development of infrastructure in remote areas). A short-term expansionary policy would currently be the wrong signal: higher budget deficits would unsettle financial markets and make Poland’s early accession to EMU impossible.

Read more analysis on the

Deutsche Bank Research website.