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Poland`s Experience with Convertibility

In Poland, after significant external liberalisation from 1995, the resultant huge capital inflows began to impair economic growth. Appreciation of the domestic currency damaged international competitiveness, leading to high trade deficits, while the inflow of "foreign savings" eventually crowded out domestic savings.

Poland’s Experience with Convertibility

In Poland, after significant external liberalisation from 1995, the resultant huge capital inflows began to impair economic growth. Appreciation of the domestic currency damaged international competitiveness, leading to high trade deficits, while the inflow of “foreign savings” eventually crowded out

domestic savings.


n 1990, after a decade of disintegration which, at its end, bordered on hyperinflation, Poland’s “planned economy” based on state ownership of the means of production was put to rest. An IMF-sponsored shock therapy brought about, within a short period, a market economy. Extensive, if at times chaotic, privatisation of firms and banks started. Private economic activities were legalised, prices freed, and shortages eliminated. Foreign trade was fully liberalised and tariff rates were drastically reduced. Following a dramatic devaluation, the exchange rate of the domestic currency, the zloty, was fixed and made internally convertible. The currency was convertible on almost all current account transactions. Importers had unrestricted access to foreign exchange. But capital account transactions were not liberalised. The restrictions practically prohibited official exports of capital. Then, the residents were obliged to repatriate and then sell their hard currency holdings to the state. The use of the Polish

currency for invoicing and making payments in foreign trade was not allowed.

The excessive fiscal squeeze and inordinately high interest rates imposed by the central bank, which were part and parcel of the initial stages of the shock therapy, had only a weak impact on inflation, which slowed down only sluggishly. By contrast, production and employment fell precipitously right away and then continued a downward drift for 30 months – cumulatively depressing real GDP by 20 per cent. In 1990, foreign trade played a positive role as the undervalued currency contributed to high trade and current account surpluses. But in 1991, as continuing inflation had finally resulted in high real overvaluation, large trade and current account deficits appeared.


The new policy that was launched in 1992 responded with devaluation and very high tariffs and other protectionist measures (including selective subsidisation of exports). Then there was a change in the exchange rate regime, substituting a preannounced sliding peg for the fixed one. Regular devaluation was linked to inflation so that real appreciation was effectively contained.

The illiberal policy initiated in 1992 proved spectacularly successful. It generated a sustained recovery over the years 1992-95, with an average annual GDP growth of 5 per cent. Fixed investment rose at 10 per cent pa, inflation and unemployment kept falling, and public finances were broadly balanced. The trade and current accounts improved. A handsome surplus on the current account was generated in 1994, followed by a huge one in 1995. Thus, the economy pulled itself out of the “transitional recession” on its own – without incurring new foreign debt and without selling its assets to foreigners.

The real success of that period had much to do with the fact that Poland had not, until 1995, for various seasons, been a target for capital inflows. In the early 1990s, the intensity of international capital movements was, in general, quite low, partly on account of the recent crises (including the turbulent collapse of the first version of the European Monetary System). Moreover, the reputation of the former Soviet bloc countries was very low at that time. Some of them (the former Yugoslav republics, the Baltic countries, the successor states of former Czechoslovakia) were still in the process of state-building. All of them were considered risky, unstable places facing an unknown future. Poland’s reputation was particularly low because the country had defaulted on its huge public foreign debt (already in 1982). The restrictions on capital movements, though aimed primarily at preventing capital exports rather than imports, were not improving the country’s standing. In these circumstances, the fact that nominal interest rates in Poland were still very high (inflation receding only gradually) did not – for several years – induce any significant capital inflows.

In the end, though, Poland fell victim to its own success. Actually, by 1994-95 Poland was the only “success case” among the former Soviet bloc countries. As such, it was becoming the darling of the international financial institutions (IMF, World Bank), western governments, and finally of the international business community, which eventually appreciated Poland’s performance. Consequently, Poland was richly rewarded: first with generous treaties on the reduction and rescheduling of its

Economic and Political Weekly May 13, 2006

foreign debt (1994), followed by the conclusion of the agreement on association with the European Union and admittance into the World Trade Organisation (WTO) and the Organisation for Economic Cooperation and Development (OECD). On its part, Poland accepted the obligations of Article VIII of the IMF statutes on full current account convertibility (June 1995). Besides, it pledged to dismantle, gradually, its trade protectionist scaffolding. This was soon followed by a whole series of further steps partially liberalising capital transactions: exporters were no longer obliged to convert their revenues into the domestic currency; residents (and domestic firms) were allowed to invest some (still limited) amounts in other OECD countries; domestic firms were permitted to engage in medium-term foreign exchange credit contracts with non-residents; the OECD set of regulations on foreign direct investment was adopted. Most importantly, already in 1995 the access to the short-term treasury bills market was opened to non-residents.

In 1995 Poland’s official reserves rose abruptly, more than doubling, to over $ 14.5 billion. Only part of the increase in reserves was due to the high current account surplus. For the first time the country experienced high inflows of foreign direct investment, private portfolio capital and credits drawn by the private sector. Capital inflows were only natural, given the reduced levels of risks/uncertainty, the predictability of Poland’s exchange rate (the pre-announced sliding peg) and the very high nominal levels of domestic interest rates (corresponding to inflation, running at about 25 per cent in 1995). The sudden overabundance of foreign exchange did not bring down interest rates on credits denominated in domestic currency. Rather, these interest rates were actually increased as the National Bank of Poland (the central bank) attempted to sterilise the inflows by “mopping up” the excess liquidity accumulating in the commercial banking system. The sterilisation, which was quite costly, was only partially successful as it did not completely prevent a credit boom fuelling private consumption and investment. On the other hand, increased domestic interest rates induced even higher capital inflows. Very soon the National Bank saw no other way out but to allow the currency to float, within some bounds, around the “central parity”, on the inter-bank forex market. Nominal appreciation followed immediately. Shortly afterwards the National Bank had to revalue the central parity even further. This alone produced huge gains to foreign speculators. The floating, which was to deter excessive short-term speculation by making it more risky, was outsmarted by the market, which quickly developed instruments allowing speculation all the same (first futures, then swaps and then more sophisticated currency and interest rate derivatives). The major players on the still rather shallow Polish forex financial markets were (and still are) the London-based traders gambling against Polish market participants (including the Treasury and the National Bank). It may be added that, as long as Polish interest rates were very high, the short-term speculation was not against the Polish currency. Such speculation was (and still is) potentially too costly. Under high interest rates speculation tends to inflate the value of the domestic currency – irrespective of its “fundamental value”. Conversely, speculation may tend to force an excessive weakening of the currency if domestic interest rates are believed to be too low.


The policy changes, initiated in 1995 continued to unfold.

  • (1) Capital account liberalisation has continued. In 1997, non-residents were given access to treasury bonds. In 1998, residents were allowed to engage in some kinds of transactions in some categories of derivatives. Finally, in 2002, the Polish currency became almost fully convertible. The only remaining restrictions pertain to foreigners’ acquisitions of farmland, and to some shortterm transactions with non-OECD parties.
  • (2) There has been a steady evolution of the exchange rate regime. The devaluation factor for the “central parity” was progressively lowered, thereby increasingly losing touch with domestic inflation. In effect, monetary policy was losing control over real appreciation. At the same time, the bands around the “central parity” widened over time. The National Bank’s involvement in the operation of the foreign exchange market was gradually reduced. This culminated in the pure free float formally introduced in early 2000. Actually, already in February 1998 the National Bank had burned its fingers during the attempts to stop currency speculation and withdrew from the forex market. The determination of the exchange rate has been left to the still shallow, and volatile, forex markets.
  • (3) Monetary policy has been increasingly relying on interest rate manipulations,
  • formally aiming at controlling inflation only. This culminated in the adoption of inflation targeting already in 1998. But inflationary pressures calmed slowly all the same. Continuing capital inflows made it possible for the banks to expand lending even if that collided with the intentions of the National Bank. In effect, domestic interest rates have been excessively high most of the time, leading to periodical high tides of foreign capital, “artificially” strengthening the currency. It may be added that the real interest rates on credit denominated in domestic currency had been very high (in excess of 10 per cent) from 1996 until 2004. (By contrast, real interest rates were very low, quite often close to being negative, until mid-1995). The problem monetary policy faced was (and essentially still is) that a rise in the interest rate meant to slow down credit growth was, at the same time, inducing higher inflows, which supported credit expansion. Conversely, cuts in interest rates meant to reduce capital inflows tend to strengthen credit expansion. Only occasionally, when major currency crises afflicted other “emerging markets” (as in mid-1996, in December 1997 and in September 1998) could monetary policy control domestic credit and inflation with a greater degree of efficiency. On such occasions, the domestic currency usually weakened, though never enough to eliminate the excessive real overvaluation that had accumulated since 1995.

    The year 1995 was a turning point as far as the depth and scope of currency convertibility is concerned. At the same time, that year marked a change in monetary and exchange rate policies. Eclectic monetary policies, adjusting their goals to the varying requirements of the moment, were no longer possible. In particular, monetary policy had to abdicate its responsibility for stabilising the exchange rate. The change of policy paradigms has had definite and, on the whole, rather negative consequences.

    First of all, strong real appreciation had immediate effects on foreign trade performance and the current account. Already in 1996 exports slowed down while imports expanded explosively. Within one year the trade surplus of 2.4 per cent of GDP turned into a deficit of 4.3 per cent. The current account surpluses of previous years were replaced by large deficits. Under continuing capital inflows and the resultant currency appreciation the current account deficits kept rising until early 2000 when they approached 9 per cent of the GDP. Interestingly, until 2001 (and also more

    Economic and Political Weekly May 13, 2006 recently) capital inflows overcompensated the current account deficits.

    Secondly, the high GDP growth prior to 1995 was sustained only for a couple of years thereafter. But, as the contribution of foreign trade to growth became negative (already in 1996), growth was to be driven by consumption and (until 2000) by capital formation. However, unlike in the previous period, both consumption and capital formation were increasingly financed by rising foreign debt. That was one of the effects of the very high real domestic interest rates engineered by the National Bank. Poland’s foreign debt (private and public combined) rose from 41 billion euro in 1995 to 75 billion euro in 2000. Currently it is close to 110 billion euros (of which private foreign debt is about 70 billion). The ballooning foreign debt is only one indication of the unsoundness of the course of development taken after 1995. Simultaneously, Poland has been selling off its assets. The bulk of the most efficient industrial firms, banks, insurance companies, utilities, etc, have already been sold to foreign multinationals, usually at huge discounts. Needless to say, without the “family silver” having been sold to foreigners, Poland’s foreign debts would have been much higher.

    Naturally, a loan-led and import-fed growth could not be sustained indefinitely. From 1998 growth was slowing down. Several years of intensifying external competition (supported by the strong currency) and high real interest rates finally eroded the profits of the corporate sector and weakened the financial position of households and firms (snowballing debt). Unemployment, falling from 1994, rebounded. In 2000 the rate of unemployment reached 17 per cent, rising to 20 per cent in the early 2000s. In 2001 GDP growth slowed down to a symbolic 1 per cent, followed by 1.4 per cent in 2002. The average GDP growth rate for the entire post-liberalisation period (1996-2005) is a lean 3.9 per cent, with gross fixed investment on average rising by about 4.2 per cent annually.

    The stagnation of 2001-02 eventually made the job of the National Bank easier. As the demand for credit dried up, the Bank risked, very reluctantly, cutting interest rates. A long overdue, if mild, currency depreciation followed. Nonetheless, the current (since 2003) recovery has been quite anaemic. Despite the recent relaxation of tight monetary policy, the exchange rate is still fundamentally too strong, and interest rates are too high. Wages have been suppressed for several years now. Consumption and domestic fixed investment have been rising only weakly. This seems to be a natural consequence of the exuberant debt-driven expansion of the late 1990s. Under suppressed domestic demand (and falling unit labour costs), there have been improvements in foreign trade. In the foreseeable future Poland may be condemned to an export-led growth – with rising shares of domestic income to be surrendered to the outside world in the form of interest and property income on foreign capital that has invaded the country since 1995. In 1995, 1.4 per cent of the GDP was appropriated by the rest of the world. By 2004, foreigners’ share in Poland’s GDP rose to 4.6 per cent.

    Summing Up

    There are two distinct periods in Poland’s recent history, differing as far as the levels of external liberalisation are concerned. The first may be dated as 1992-95. The second started in 1995-96 and has not yet ended.

    During the first period, imports were controlled through tariffs and other instruments, while exports were promoted through subsidies. Appreciation of the currency was controlled via a managed nominal exchange rate, which was possible under a rather illiberal approach to capital movements. Real interest rates were moderate. There was an acceleration of capital formation. The economy pulled itself out of a deep recession without incurring any new foreign debt – and without selling out its assets to foreigners.

    During the second period, there has been a steady and rapid liberalisation of imports and a discontinuation of subsidisation of exports. More importantly, capital inflows were liberalised all along

    – which paradoxically failed to bring down domestic interest rates. In fact, the high, essentially uninvited, capital inflows were responsible (via sterilisation operations) for the persistence of very high domestic interest rates. Moreover, under high capital inflows, there has been a tendency towards strong real appreciation, and this has impaired first exports and then overall growth.

    In conventional stories there is a “causality” running from high growth through high trade deficits to high compensatory capital inflows. Or, as it is often maintained, high-growth countries need “imports of foreign savings” – and this seems unimaginable without freedom of capital movements. Poland’s experience does not support that story at all. In Poland’s case the high growth in the illiberal years did not generate any need for “imports of foreign savings”, or foreign capital. And, it turned out that foreign capital started to arrive in large quantities, upon being allowed to do so, precisely when it was not at all needed. Moreover, soon after arriving, the uninvited capital in fact impaired growth in the host country. The impairment took the form of undue currency appreciation, which in turn damaged the external competitiveness of the host country, producing high trade deficits. It was the influx of “foreign savings” which eventually crowded out, or suppressed, domestic savings. Only then, after impairing the host country’s ability to generate high savings, may the inflow of foreign capital prove desirable, or even necessary. But, paradoxically, precisely then such capital may be reluctant to come. Or, it may just then show a propensity to extract high payments for the past “services”. m


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    Economic and Political Weekly May 13, 2006

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