Poland's growing pains

Meanwhile, the ongoing labor shortage and a chronic lack of reinvestment mean that Polish firms face hard times. The good news is that the strong złoty could lure expats home.

As inflation spirals far beyond the central bank's targets in even the most optimistic predictions, interest rates will have to rise and GDP growth will slump. Experts claim tackling high taxes on labor and relaxing regulation on businesses are the keys to boosting employment, production and GDP, while at the same time curbing inflation

Experts last week blamed growing inflationary pressure on the economy's rapid development and shortage of skilled labor. They warned that labor costs must be reduced and investment increased if GDP in 2008 is to reach last year's robust level of growth without an accompanying inflationary increase. This is a long-term goal, however. In the short term, the economy will have to cope with a slowdown in growth as the Monetary Policy Council (RPP) - the National Bank of Poland's interest rate-setting arm - increases interest rates to curb inflation.

"The dynamic growth of the Polish economy has caused inflationary pressures to increase. Wages are growing faster than productivity," X-Trade Brokers Dom Maklerski's Adam Narczewski told WBJ. He added, "From the macroeconomic standpoint, companies are producing less while paying their workers more. Higher costs of production for companies are passed on to the consumer, who has to pay more for products. At the same time, consumers earn more money so they have more to spend. All of that is causing prices to rise."

Inflation grew to more than 3.5 percent at the end of last year, surpassing the limit set by the National Bank of Poland. The central bank's target is set at 2.5 percent +/- one percent. Narczewski said that inflation is expected to grow to more than four percent this year, and could continue to increase. He added that it could even breach the five-percent threshold. "The RPP already reacted by hiking interest rates by 25 basis points, to five percent, but further increases are very likely. In order to fight inflation, which could reach five percent or even more in 2008, the RPP needs to hike interest rates at least to six percent. That is an extreme forecast since the Ministry of Finance has forecast inflation at four percent - in that case interest rates would not go over 5.5 percent," Narczewski said.

Domestic dangers

At a Polish Confederation of Private Employers (PKPP) Lewiatan conference last week, Polish Academy of Science economist Leszek Zienkowski said, "The year 2007 was one of records for companies and the economy as a whole. But the growth rate has been greater than the potential of the economy, which is leading to a dangerous imbalance."

He added, "We are now faced with a growing level of inflation, which is bad for the economy and if we try to cut inflation now [through raising interest rates] we will see a drop in GDP growth - growth which should remain stable and not fluctuate hugely between years."

X-Trade's Narczewski disagreed that last year's GDP growth level exceeded the economy's potential. He said, "Poland is still an emerging economy and there is still great potential for growth, it is only slowing as the global economy slows."

Kamil Kajetanowicz, an expert at the Adam Smith Research Institute, supported Narczewski's view that the economy could maintain high levels of growth. However, he told WBJ, "I don't think GDP can be too high if the conditions in an economy are normal. But the conditions here are not normal." Kajetanowicz believed the forecast slowdown was linked more closely with domestic issues than global ones. He said, "growth in Poland is linked to the global market, and we can say we live in a global age. But, on the other hand, Poland is heavily dependent on local factors."

"The inflation issue is largely being driven by a lack of skilled labor, because millions of people have left Poland to work in the UK, Ireland and elsewhere. This has put pressure on wages, which in turn is driving up the cost of production. The prices of goods are increasing and so inflation increases," Kajetanowicz added. He also said that the mass exodus from Poland has cost the country an opportunity to increase GDP without aggravating inflation and, consequently, interest rates. He explained, "Inflation can be reduced by increasing interest rates or by increasing production. But the question is, how does the government do this?"

Hard labor

The biggest barrier to production is high employment costs paid to the government, which drastically increase the overall cost of labor, argued Kajetanowicz. In 2007, the government brought in revenue from taxation of labor equal to around 80 percent of each employee's net salary. For example, a fully contracted employee earning a gross salary of zł.5,000 would have received a net salary of zł.3,310. The total cost of employment would have been zł.6,030, leaving a difference between net salary and total cost of 82 percent of the net salary.

Kajetanowicz explained that of the two main production factors - labor costs and capital costs, meaning machinery and supplies - the tax on labor is strikingly high compared to the VAT on capital, which is charged at 22 percent.

But, he added, businesses have become more aware of this problem and the government has been forced to act. The previous government brought down taxes on labor so that as of this year the same zł.5,000 gross salary will have a net payment to the employee of zł.3,511 and a total tax on labor of 69 percent of the net salary. He still argued, however, that more drastic action would be needed to correct the imbalance. "All economies are based on simple supply and demand. If the government wasn't so greedy and it lowered the tax on labor, then employment would increase, production would increase, GDP would increase and inflation would fall," said Kajetanowicz.

Investing in investments

The experts all agreed that increasing investments in the economy would increase production and GDP without increasing inflation. Gdańsk Institute for Market Economics (IBnGR) vice president Bohdan Wyżnikiewicz told WBJ, "Investment in Poland is low. It is growing at between 10 and 20 percent, which is still relatively low when compared to China, which is seeing investment growth of around 40 percent." A crucial barrier to investment is the heavy regulation on business, experts agreed. "Our system is overloaded with bureaucratic regulations, it's a very significant barrier to economic growth," Wyżnikiewicz said.

In response to persistent demands from businesses to cut these regulations, Economy Minister Waldemar Pawlak told a news conference last week, "We will make Poland the easiest country for business activity." He added, "We want to improve regulations and cut administrative barriers by 25 percent."

Złoty power

"The Polish economy is one of the most dynamically developing economies in Europe. A skilled and relatively cheap labor force has made Poland an attractive site for investment for foreign companies. Recently, this situation has changed and one of the reasons is a stronger złoty, which may continue to strengthen in 2008," said XTrade's Narczewski.

He explained that, "Inflationary pressures causing interest-rate hikes are good news for the złoty. The Polish currency is likely to keep increasing in 2008, although perhaps not as strongly as in 2007. We also have to remember that the closer Poland gets to the euro zone, the stronger the złoty will become, regardless of other fundamental influences."

Narczewski argued that a stronger złoty will decrease exports and increase imports, which in turn will increase the current account deficit. However, the Adam Smith Research Institute's Kajetanowicz said this was true only to a point.

He explained, "When you look at the companies that export, it turns out some 80 percent of production parts are foreign, so the strong złoty means that products can be made for less. A good example is Germany, which became a major manufacturer in the 1960s and 1970s while having a strengthening Deutsche Mark."

"When a currency becomes weaker, imports become more expensive, goods become more expensive, inflation rises, interest rates are increased - which no one likes - and the stock market suffers. The stock market benefits from a strong złoty," said Kajetanowicz.

Coming home

Experts agreed that one major benefit of a strengthening złoty would be its reduction of the value of foreign salaries. This could encourage Poles that left to work in the UK and Ireland to return home. Kajetanowicz said, "Of course the stronger the złoty becomes, the less attractive foreign salaries will be. In fact, there have already been complaints from workers abroad that their salaries are not worth what they were a few years ago."

Narczewski said, "When Polish workers left to work abroad, the unemployment level dropped. Nowadays, because of the strong złoty, the return on working abroad is not as good as even last year. As workers return, the skills shortage may fall but unemployment may rise."