Poles apart

Finance Minister Marek Belka wants to get Poland into the EU. But first he must slash spending and persuade skeptical central bank chief Leszek Balcerowicz to do his part for growth.

Finance Minister Marek Belka wants to get Poland into the EU. But first he must slash spending and persuade skeptical central bank chief Leszek Balcerowicz to do his part for growth.

By Tom Buerkle
December 2001
Institutional Investor Magazine

The gray slab building that houses Poland’s Ministry of Finance presents an image of drab, Soviet-era functionality. But hanging in the waiting room of Finance Minister Marek Belka is a relic that evokes an earlier Polish epoch of historical grandeur: an ornate 16th-century map of the Poland-Lithuanian Union, which dominated Central Europe as far east as Kiev and represented the pinnacle of Polish might.

The union has long since faded, but Poland is determined to reclaim what it considers its rightful place in Europe. Prime Minister Leszek Miller led his Democratic Left Alliance, the SLD, to victory in the September 23 elections by promising to end the divisiveness and scandals of the previous Solidarity-led government and lead the country into a bright and prosperous future inside the European Union.

But turning the SLD’s vague platform into reality will not be easy. Poland’s progress toward EU membership has been grindingly slow over the past two years, and the country now lags behind several of its Central European neighbors, having fulfilled only 18 of the EU’s 29 entry criteria.

What’s more, after a decade as the star economic performer of Central and Eastern Europe, Poland has begun to look more like an emerging market on the verge of crisis than the dynamic product of successful shock therapy. The budget deficit is ballooning upward, growth has shuddered to a near halt, and consumer and business confidence are flagging. Poland today, much like the Czech Republic a few years ago, risks descending into a vicious circle where deficit begets recession begets ever-worsening deficit.

Belka promises tough measures to rein in the deficit. The 49-year-old economist’s first official action was to declare a spending ceiling of 183 billion zloty ($44.6 billion) for 2002. This would imply almost no increase in real spending, in contrast with an election-fueled, double-digit burst of public extravagance this year. But his real aim is to restore growth. Indeed, the government has made EU membership its overriding economic and political goal precisely because the EU is, in Belka’s words, a “powerful engine of economic growth” at a time when Poland has few others.

Unfortunately, Belka’s pro-growth agenda puts him on a potential collision course with Leszek Balcerowicz, the man who introduced shock therapy as Poland’s first post-Communist finance minister by liberalizing prices and opening the country up to import competition. Today Balcerowicz oversees interest rates as head of the National Bank of Poland. Belka is pressing Balcerowicz and the central bank’s Monetary Policy Council to slash the bank’s key short-term intervention rate; despite 600 basis points of easing this year, it still stands at 13 percent, a full 9 percentage points above inflation. The bank’s hard-line stance over the past 18 months has stifled consumer demand this year and caused car sales to plunge by nearly one third.

“I don,t believe that there is any good economics in the proposition that we have to put the economy into recession for the sake of decreasing inflation below the level of 4 percent,” Belka told Institutional Investor. But Balcerowicz wants to see solid evidence of spending restraint before loosening the money taps to stimulate the economy. “The most crucial point is reducing the rate of growth of spending,” says the central bank chief.

Getting out of the deficit quagmire and into the EU also will require difficult choices that risk alienating the SLD’s working-class supporters. Many party members believe that Belka’s election-eve decision to announce plans for curbing the deficit , including possible increases in the value-added tax , prevented the SLD from winning an outright majority. The result forced Miller to form a coalition with the Polish Peasants, Party, an agrarian group whose desire for power only just outweighs its distaste for reform and the European Union.

Belka promises to stick to his agenda, but Miller,s commitment to reform remains in doubt. A Politburo member in the last Communist government, Miller today likes to style himself as a modern center-left leader in the mold of Gerhard Schröder or Tony Blair. Last month, on one of his first trips abroad, he visited the British prime minister to obtain an endorsement of Poland’s drive for EU membership. But Miller blocked proposals for pension reform when he served as labor minister in the 1993,,97 SLD-Peasants, coalition, and he is aware that many coalition members today will resist efforts to cut social spending.

Is Leszek Miller really a Tony Blair? Can he lead his country down the U.K.'s path? “This is the most important question,” says Balcerowicz. “Certainly, if they want to show they are a new left, then that is a good place to look and learn. What does it mean? It means look to the flexible labor markets, to privatization, fiscal discipline, an independent central bank.”

For Belka, control of the budget holds the key to achieving his ambitions of renewed growth and EU membership. In a symbolic early gesture, he ordered an immediate salary freeze for himself and other top officials. His draft budget for 2002 contains modest tax increases that should limit the deficit to Zl 40 billion, or roughly 5 percent of gross domestic product. That’s up from this year’s projected shortfall of 3.9 percent of GDP but well below the 11 percent deficit that the previous government projected shortly before leaving office.

Belka is a political pragmatist, though, not an antideficit zealot. Echoing one side of the budget debate currently rumbling among his EU neighbors to the west, Belka says he wants to focus on the cyclically adjusted deficit, a sign that he is ready to tolerate a rise in the nominal deficit if the economy tumbles into recession. And without any prompting, he suggests the potential desirability of a zloty depreciation to stimulate exports and growth. “Our economy is plunging into recession,” he says. “You don,t need to be a very sophisticated policymaker to draw conclusions.”

But Balcerowicz wants to see clear evidence that Belka will deliver on his promise of spending restraint. As finance minister in the early years of the previous government, the central banker was stymied in his attempt to push through labor reforms as a key part of his deficit-cutting efforts. Balcerowicz, 54, also is haunted by the central bank’s premature declaration of victory over inflation in 1998. The bank eased rates dramatically then, only to see government spending rise and inflation surge to more than 11 percent last year. “We are investing in permanently low inflation,” he told II. “We don,t want to repeat the mistake of the past, because it would be costly to start again.”

The need for growth in Poland is clear. With the labor force increasing by about 1 percent a year and delayed layoffs from privatized industries kicking in, the country’s unemployment rate has surged from 8.6 percent four years ago to 16 percent. The economy needs to grow by nearly 5 percent a year just to stabilize unemployment. Given the current slowdown, the jobless rate could quickly rise to 20 percent or more.

That threat is especially potent now that the global economic slowdown is beginning to hit Polish exports, exacerbating the country’s homegrown weakness. That prospect leads some outsiders to endorse Belka’s view that the central bank’s stance is too tight. “A cyclical downturn imported from abroad requires a temporarily more relaxed monetary policy stance,” says Willem Buiter, chief economist of the European Bank for Reconstruction and Development. “This is not the time for inflationary heroics.”

For all their jostling, many insiders believe that Belka and Balcerowicz are secretly one another’s best ally. Each provides a useful spur to the other to hold the course on budget reform on the one hand and to ease monetary policy on the other. In a notable exception to the highly partisan pattern of Polish politics, Belka was one of the first SLD members to acknowledge the achievements of shock therapy. He was instrumental in turning President Alexander Kwasniewski from a harsh critic of economic reform into a proponent of it when he advised him from 1996 to 2001.

But Belka and Balcerowicz have also clashed in the past. Balcerowicz proposed income tax reductions in 1999, only to see them vetoed by Kwasniewski, who took Belka’s advice that the reductions would exacerbate the deficit.

As that dispute demonstrated, the two men are different brands of reformer. Belka’s critics regard him as an economic ultraliberal, dubbing him Balcerowicz Mark II. Yet Belka has always adopted a more pragmatic approach than the central banker. As an adviser to Poland’s privatization agency in the early 1990s, he published a seminal paper with a World Bank economist that challenged the then-prevailing liberal orthodoxy to privatize at breakneck speed.

“If I am a liberal, I,m probably a left-wing extremist among liberals,” he says. “Leszek Balcerowicz thinks that everything can be solved by the invisible hand of the market. I, on the other hand, believe there is room for an active part played by the state in the economy, especially during the period of transition.”

Poland’s ambivalence over economic reform is nothing new. Although the country was the first of the former Soviet bloc states to embrace free markets, in 1990, key segments of society , the unions, the farmers and the Catholic Church , have sustained support for generous social welfare benefits. Poland today spends roughly 20 percent of its GDP on social security and welfare benefits.

The system is rife with abuses, particularly of disability benefits. In the nonfarm sector nearly 4 million Poles , one in ten , draw disability pensions of about half the average Polish wage. Astonishingly, roughly 40 percent of the claimants belong to a special category that allows them to hold another job, typically in a loss-making, state-run company, while receiving benefits.

The Solidarity-led government enacted four major reforms that were intended to overhaul public finances and foster long-term growth. These included a gradual shift from a pay-as-you-go state pension scheme to a contribution-based pension fund system; the decentralization of the state-run health system; the devolution of powers and budget resources to local government; and education reform aimed at raising academic standards and increasing vocational training. Whatever their merits in the long run , and the measures were engineered to produce benefits over ten to 30 years , the reforms have worsened the deficit in the short run.

The changes in health and local government policy transferred money from the federal budget without imposing clear cost controls. Employers will feel the pinch when health insurance premiums rise to 9 percent of salaries next year, from 7 percent. The state social security fund, ZUS, has allowed state-run industries to run up major contributions arrears.

Hanna Gronkiewicz-Waltz, a former Polish central bank governor, contends that governments have dodged serious fiscal reforms since the introduction of the value-added tax and the partial deindexation of pensions and welfare benefits in 1993. She would like to see Belka crack down on early retirement, disability and teachers, salaries and introduce means-testing for welfare benefit but is skeptical he will. “We observe reform fatigue almost since 1991. I would say it’s our permanent mood,” she says.

That mood may be deepening. Despite the victory by the SLD, the recent election also produced dramatic gains for some of the most antireform voices in the country. They include Self-Defense, an unabashedly populist rural party that won 53 seats in the 460-seat Sejm. Its leader, Andrzej Lepper, ran a campaign that called for raiding the country’s foreign reserves to pay for increases in unemployment benefits, pensions and the minimum wage. For the first time in the post-Communist era, the new Sejm also contains a party, the League of Polish Families, that opposes Polish membership of the European Union. “We have a tradition for more than 1,000 years of fighting for our independence. We are prepared to pay for independence in terms of a lower standard of living, if that’s the price,” says Maciej Giertych, one of the party,s founders.

Voices like Lepper’s and Giertych’s are what fuel doubts about Belka’s ability to deliver fiscal discipline. Stanislaw Gomulka, an economist at the London School of Economics who acts as an informal adviser to Belka, says the government ought to be able to avert a financial crisis but may not be able to restore high growth. “The reform of public finances may not be as dramatic and radical as required,” he says.

Belka insists that he will prove the skeptics wrong. So far the details of his spending plans are few , he hints at cutting back Poland’s numerous quasigovernmental agencies, attacking benefits abuse and eliminating waste in state-owned industries , but he insists that his budget ceiling will force “significant cuts” in spending. “We are introducing many lasting changes that will not bring immediate results but will start to change financial flows more and more with time,” he says.

Belka’s tax plans are more visible and controversial. In November he pushed through the Sejm a package designed to raise Zl 4.2 billion by imposing a 20 percent tax on savings deposits and capital gains and suspending inflation indexation of tax brackets. The measure won a rebuke from Balcerowicz. “I don,t think introducing the taxation of capital income is good for sustained and systematic growth,” he says. “Programs that focus on reductions in spending are much more likely to generate sustained growth than programs that rely mostly on increased taxation.”

Some business executives are even more critical. Wojciech Morawski, chairman of Atlantic, Poland,s leading maker of underwear, dismisses Belka’s initial proposals as “the plan of an accountant.” Politicians are “afraid to make a really strong change,” he says. “We need a brave political leadership.”

Industrialists complain about Poland’s minimum wage and mandatory severance payments. In some poorer regions the minimum wage nearly equals the average wage. “They have to do something that will attract capital,” says Zbigniew Niemczycki, president of the Polish Business Roundtable and chairman of Curtis Group, operator of a charter airline. “Creating a proper atmosphere for small and medium-size businesses and start-ups , that’s the only way to create jobs.”

Poland’s economic slowdown has not been without its side benefits. Instead of soaring to Argentinean proportions, the current account deficit has fallen sharply, in line with consumer demand. It’s expected to be less than 5 percent of GDP this year, down from 8.1 percent in 1999. The deficit is almost entirely financed by foreign direct investment, which grew to a record E9 billion ($7.9 billion) last year. On a per capita basis, Poland still trails Hungary and the Czech Republic in foreign investment, but the flows have been strong enough to strengthen the zloty.

The currency rose sharply after being put in free float in April 2000 and is up 9 percent against the euro from its prefloat level. Sustained investment inflows should maintain upward pressure. “Poland is still a cheap country, and Poland is obviously a big economy with a great deal of available labor guaranteed,” says Istvan Racz, an analyst at Credit Suisse First Boston.

For Belka, however, the strong zloty is too much of a good thing. He says the government isn,t contemplating a policy of depreciation; given that the currency floats freely, he might not be able to steer it lower if he wanted. But raising the issue sends a message to Balcerowicz that interest rates are too high.

The tension between Belka and Balcerowicz has been enlivened by a political brouhaha over salaries at the central bank. Six of the nine members of the Monetary Policy Council recently demanded Zl 350,000 each in back pay from the government for the years 1998 to 2000. They insist that they are entitled to parity with the bank’s vice president, who was awarded a hefty bonus for that period. The demand and its timing enraged politicians. After all, they believe that the MPC’s tight policy stance is choking growth. They also regard council members , whose industry-linked salaries of Zl 25,000 a month are nearly 80 percent higher than the president’s , as obscenely overpaid to begin with. Members of the Sejm last month introduced a budget amendment to cut the link between council members, salaries and banking industry scales, a not-so-subtle attempt to curb the central bank’s independence via the payslip.

Belka insists he believes in central bank independence but makes it clear that he prefers the British model , where the Treasury sets the inflation target , to the European model, where the European Central Bank decides both target and policy. “Any mention of the inflation target being not exclusively set by the MPC is treated by MPC members as some kind of coup d,état, which is a distortion of reality,” he says. His real concern is that the MPC will ignore next year’s official inflation target of 5 percent and seek to lock in a rate of less than 4 percent, regardless of the impact on growth. “Monetary policy should remain as it is , independent,” he says. “But this does not mean that it should remain unaccountable.”

As far as the EU is concerned, the dialogue between Warsaw and Brussels has improved since the SLD government took office. The European Commission,s annual report on the transition process in Central and Eastern Europe, issued last month, had mostly praise for Warsaw’s efforts. Provided that Poland “continues and intensifies its present reform efforts, it should be able to cope with the competitive pressures and market forces within the Union in the near term,” the report says. Günter Verheugen, the EU enlargement commissioner, made it clear that he believes that as many as ten of the applicant countries , all except Romania and Bulgaria , could be ready to join the EU as early as 2004.

Miller, meanwhile, has hinted at a willingness to compromise on two crucial issues that have stalled Poland’s membership negotiations for much of the past year. He said Poland would consider a shorter, 12-year transition period for allowing EU nationals to buy Polish land, a key stumbling block to the free movement of capital. Miller also suggested that Poland might accept an EU demand to bar labor migration from new members for up to seven years. The EU position largely reflects German fears of an influx of Eastern European workers.

Plenty of obstacles to EU membership remain. Both sides have until now avoided the most sensitive issues, particularly the extent to which new members will be allowed to share in the EU’s lavish agricultural subsidies and regional development programs. And then there are matters like a proposed Polish import tax, which the Peasants, Party and the government’s populist opponents view as a way to protect the country,s farmers and industry while closing the budget gap.

Belka hints that he might accept such a levy as long as it is temporary. “This is something that I treat with very little enthusiasm at best, although as minister of finance I should treat it sort of neutrally if you offer me a heap of money in one or two years,” he says. Western European industry is hostile to such a tax, however, and EU officials suggest that it could hinder Poland’s membership negotiations. “The political signal to Western Europe will be catastrophic,” says one senior EU official.

Just one more headache for Belka.

Engineering growth

Not so long ago Poland was Eastern Europe’s model economy, the dynamic product of shock therapy. Today it looks more like an emerging market in incipient crisis. Poland risks entering a deficit spiral that could jeopardize its best shot at sustained growth: joining the European Union. Here Finance Minister Marek Belka discusses with Institutional Investor European Editor Tom Buerkle his cure for the deficit and his key policy differences with central bank chief Leszek Balcerowicz.

Institutional Investor: Central bankers and finance ministers haven,t been getting along very well in Europe these days. . . .

Belka: The world is probably plunging into recession. The discussion is whether it,s going to be a mild one or a deeper one, and protracted. And we see that the reaction of central banks is somewhat different. On the one hand, the [U.S. Federal Reserve Board] is quite aggressive in lowering interest rates. On the other hand, the European Central Bank is not. Being an outsider, I treat it as a function of psychological factors. [Fed chairman Alan] Greenspan is credible and can afford to be aggressive. The ECB is a new creation, and it has to grow up to the size established by the Bundesbank.

In Poland, clearly, we have the same credibility and psychological problems. The Monetary Policy Council is a new creation, and it is fighting for credibility. For four years in a row, they have missed the inflation target. So we have problems here of good coordination of monetary policy and fiscal policy, and of monetary policy itself.

The current slowdown that we are going through in Poland is only partially the outcome of the general macroeconomic environment in the world. Mostly, it,s our own product. We have mismanaged the cooling-off process of the economy. We have mismanaged the process of creating a positive policy mix. Our fiscal policy was chaotic and vague. So the reaction of the monetary policy was to keep a very tight orientation, a very tight policy. And the product is that we are on the brink of recession. I clearly think that monetary policy in Poland is too tight.

You,ve said you,ll tolerate a bit higher inflation for more growth. How much higher?

By the end of this year, inflation is going to get to 4 percent. Let me remind you that the MPC target is 6 to 8. If you look at if from the professional point of view, it’s at best disturbing. Next year’s target is 5 percent [plus or minus 1 percentage point]. What I am really afraid of is if the inflation rate creeps up from 4 percent by the end of this year to 5 percent by the end of next year, the council will act nervously and will try again to tighten monetary policy. And what it should do, especially in the case of recession, is tolerate inflation creeping up. If we try to get inflation down at every cost, we can forgo every success, every economic achievement of the last years, including [managing] inflation.

I would expect a bold move from the Monetary Policy Council, but I would like to make it easier for them by preparing a budget that stabilizes public finances. Stabilizes means limiting the growth of expenditures to basically the rate of inflation, maybe a little bit more. I don,t believe that the primary target of fiscal policy is to reduce the budget deficit at any cost. What that means is that if next year the economy falls into recession or slows down further, I would tolerate an increasing budget deficit but not tolerate an increase in expenditures. We hope that we could grow out of the budget deficit.

Some economists and business people say you are focusing too much on the revenue side , potential tax increases , and not enough on spending restraint.

This is totally misplaced. First, constitutional deadlines put a pressure on us. We have to have personal income tax changes published by the end of November. This is our internal law. So we have to go forward with this at first. But clearly, the tax changes are slight compared to the expenditure changes. And the sense of what is going to come is obvious, because if I declare that the ceiling for the next year’s budgetary expenditures is 183 billion zÚloty, what it means is that significant cuts are in the pipeline.

Are you concerned that taxing savings and capital gains will discourage investment and growth?

That doesn,t make sense. We are thinking in terms of looming recession next year. The channel between savings propensity and investment is a very long time. Savings propensity, as a matter of fact, is growing very much this year. It’s not because of very high interest rates; it’s because of the economic situation. On the other hand, what the entrepreneurs say is that interest rates at the bank are so high that only a stupid guy in Poland invests money in productive purposes. Hey, if they say so, then why should we not try to diminish the rate of return on bank deposits. Let the people invest. Let the gap between the market rate of return on productive uses of capital and bank deposits be a little bit lower.

What plans do you have to reduce subsidies to industry and get the pace of privatization moving again?

They are two issues, which are of course interconnected. One is to look at this issue from the point of view of industries in crisis. In the case of coal, our goal is to solidify the achievements of the previous government. The equilibrium in the system is very fragile, and if we stop, we lose everything, but at least we have resumed the operational profitability of the system. Now we have to go further and strengthen the financial discipline within the individual coal mines and start privatizing them. We have to look for capital connections between the energy producers and coal mines. We would like also to privatize a handful of coal mines to set an example for other coal mines. Steel is more problematic because we have committed so many mistakes, but we are determined to go forward and privatize and look for an investor. Decisions can be made in the coming months.

You can look at the subsidy issue from another point of view, the state aid dimension. State aid in the form of direct subsidies is quite limited. However, we have for years tolerated hidden state aid in the form of delayed taxation, tolerating all kinds of payments: state aid that is nontransparent, that is distorting competition. We have a system of supporting the employment of disabled persons that boils down to tolerating or installing certain fiscal privileges for certain classes of companies. The fact is that we are losing money, that we are creating real parasites and that competition is distorted in many fields.

Cracking down on misused disability insurance and other abuses will take a lot of political capital. Is this government willing to spend it?

We can help disabled people by means of direct subsidies. As a matter of fact, it would be much cheaper for the state to do so because the idea is that we have disabled people, not companies. Almost one half of all state aid is connected with these kinds of practices. We are going to crack down on it. This means that we will have to substitute for these hidden or nontransparent subsidies something that is civilized, that is tolerated in the European Union, like direct grants to investors.

Are you considering an import tax?

Politically, yes. This is something that I treat with very little enthusiasm at best, although as minister of finance I should treat it sort of neutrally if you offer me a heap of money in one or two years and if it does not influence the expenditure path. But we have said that even if it’s introduced, it’s not an excuse to increase expenditures.

The EU is hostile to an import tax.

I spoke to one of the higher EU officials, and his first reaction was, well, yeah, this is bad, this is wrong, but we don,t see it as derailing the process of negotiations. If it doesn,t derail your budgetary policy and it doesn,t derail your structural reforms, well, we can live with it for a year or two.

Would you like to weaken the zloty to encourage growth?

We are not even discussing it. Maybe we should in a time of crisis. The problem is that our payments situation is excellent. The zloty is strengthening, and our economy is plunging into recession. I mean, not just slowing down: We are plunging into recession. You don,t need to be a very sophisticated policymaker to draw conclusions. After all, you have to be in good shape in a year or two to enter the European Union. The only thing that is attractive in the Polish economy for the European Union is its dynamics. It’s not good roads, it’s not Polish agriculture.

You need a 5 percent growth rate to stabilize unemployment. When can Poland return to that kind of growth, and should it be even higher?

The year 2002 is the year of stabilizing public finances and instilling the values of growth, so to speak, in the economy. Don,t ask me about a timetable. It would be inappropriate. If it works, there is an inherent dynamic in the Polish economy through global demand, EU prospects and the need to modernize infrastructure. These are powerful engines of growth. So if the situation normalizes, 5 percent should not be a problem in two years. We are not a mature industrial economy. This is a country to grow. But the policy mix is simply the worst you could imagine.

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