Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No. 48644-PL

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT FOR A PROPOSED LOAN

IN THE AMOUNT OF EUR 1 BILLION (US$1,300,240,000 EQUIVALENT)

TO THE

REPUBLIC OF POLAND

TO SUPPORT AN

EMPLOYMENT, ENTREPRENEURSHIP, AND HUMAN CAPITAL DEVELOPMENT POLICY PROGRAM

DEVELOPMENT POLICY LOAN

(SECOND IN A PROGRAM OF THREE)

June 3,2009

Human Development Sector Management Unit Central and South Central Europe and the Baltic Countries Department Europe and Central Asia Regional Office

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

AAA A L M P BEEPS

CEE CP DB D C

EC E C A ECB ERM2

ESA ESF EU FDI GDP Gmina

GNI GUS HBS IALS IBRD

IFIs I M F KRUS LFS LM Matura

M I C MLSP MNE

POLAND

CURRENCY EQUIVALENTS (Exchange Rate Ef fec t i ve as o f April 30,2009)

US$ 1.00: EUR 0.769: PLN 3.338 variable

ABBREVIATIONS, ACRONYMS & TERMS

Analytic and Advisory Activities Active Labor Market Programs Business Environment and Enterprise Performance Survey Central and Eastern Europe Convergence Program Doing Business Defined Contribution pension plan, in Poland, funded and privately managed European Commission Europe and Central Asia Region European Central Bank Exchange Rate Mechanism (2nd phase) European System o f Accounts European Social Fund European Union Foreign Direct Investments Gross Domestic Product Municipality/commune administrative unit (2,478) Gross National Income Ma in Statistical Office Household Budget Survey International Adult Literacy Survey International Bank for Reconstruction and Development International Financial Institutions International Monetary Fund Farmers’ Insurance Fund Labor Force Survey Labor Market Exam taken at the end o f secondary education Middle Income Country Ministry o f Labor and Social Policy Ministry of National Education

M O E MOF M O H M O T MTEF

MYSFP N B P N D C

N F Z N H S NUTS

OECD

PARSP PBB P F M PISA

P i s P IT Powiat

PPP SME SOE TA TC VAT Voivodeships

zus

Ministry o f Economy Ministry o f Finance Ministry o f Health Ministry o f Treasury Medium-Term Expenditure Framework Multi-Year State Financial Plan National Bank o f Poland Notional Defined Contribution, pay- as-you-go pension plan National Health Fund National Health Service Nomenclature o f Temtorial Units for Statistics (EU geocode identification) Organization for Economic Cooperation and Development Post Accession Rural Support Project Performance Based Budgeting Public Finance Management Program for International Student Assessment Law and Justice Party Personal Income Tax County administrative unit, (379) NUTS3 Public Private Partnerships Small and Medium Enterprises State Owned Enterprises Technical Assistance Technical Cooperation Value Added Tax Province administrative unit (16), NUTS2 Social Insurance Fund

V i c e President: Shigeo Ka tsu

Sector Director: Tamar Manue lyan A t inc Count ry Director: Theodore 0. Ahlers (Acting)

Task T e a m Leader: Truman Packard

.. 11

FOR OFFICIAL USE ONLY

REPUBLIC OF POLAND SECOND PROGRAMMATIC POLICY LOAN (PL2)

TABLE OF CONTENTS

LOAN AND PROGRAM S U M M A R Y .................................................................................. iv I . INTRODUCTION ......................................................................................................... 1 I1 . COUNTRY CONTEXT .............................................................................................. 3

2.1. RECENT ECONOMIC DEVELOPMENTS IN POLAND ................................................. 3 2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ............................... 6 2.3. SOCIAL IMPACT OF THE SLOWDOWN AND THE GOVERNMENT’S PLANS ........ 9

I11 . THE GOVERNMENT’S REFORM PROGRAM ................................................ 14

4.1. LINK TO COUNTRY PARTNERSHIP STRATEGY ...................................................... 19 4.2. RELATIONSHIP TO OTHER BANK OPERATIONS ..................................................... 21 4.3. ANALYTICAL UNDERPININGS .................................................................................... 21

V . THE PROPOSED POLICY LOAN ......................................................................... 27 5.1. PROGRAM OBJECTIVES ................................................................................................ 27 5.2. REFORMS SUPPORTED BY THIS LOAN - PRIOR ACTIONS FOR PL2 ................... 28 5.3. CONTINUATION OF THE REFORM PROGRAM DURING 2009: TRIGGERS FOR PL3 ............................................................................................................................................ 34 5.4. CONSULTATION PROCESS ........................................................................................... 41 5.5. ANALYTICAL AND ADVISORY ASSISTANCE .......................................................... 41

V I . OPERATION IMPLEMENTATION ..................................................................... 42 6.1. POVERTY AND SOCIAL IMPACT ................................................................................ 42 6.2. ENVIRONMENTAL ASPECTS ....................................................................................... 45 6.3. IMPLEMENTATION MONITOFUNG AND EVALUATION ......................................... 46 6.4. FIDUCIARY ASPECTS AND PROCUREMENT ............................................................ 46 6.5. DISBURSEMENT AND AUDITING ............................................................................... 48

VI1 . R I S K S AND R I S K MITIGATION ....................................................................... 48 ANNEX 1 : GOVERNMENT’S LETTER OF DEVELOPMENT POLICY (LDP) ................. 50 ANNEX 2: POLICY MATRIX ................................................................................................. 53 ANNEX 3: MONITORING AND RESULTS FRAMEWORK ............................................... 67 ANNEX 4: ASSESSMENT FROM INTERNATIONAL MONETARY FUND ..................... 78 ANNEX 5: STATUS OF BANK GROUP OPERATIONS IN POLAND ................................ 89 ANNEX 6: POLAND AT A GLANCE .................................................................................... 91 ANNEX 7: MAP OF POLAND ................................................................................................ 93

I V . POLICY FOCUS AND THE BANK-SUPPORTED PROGRAM ....................... 18

This loan. the second in a program o f policy lending and analytical advisory assistaw to the Republic of Poland. was prepared by an IBRD team consisting o f Charles Griffin (Sr . Advisor. ECAVP). Mukesh Chawla (Sector Manager. HDNHE). Alberto Rodriguez (Country Sector Coordinator. ECSHD). Jan Rutk66ski (Lead Economist. ECSHD). Kaspar Richter (Sr . Economist. ECSPE). Leszek Kasek (Economist. ECSPE). Anita Schwarz (Lead Economist. ECSHD). Ufuk Guven (Economist. ECSHD). Owen Smith (Economist ECSHD). Ewa Korczyc (Research Analyst. ECSPE). Marta Michalska (Program Assistant. ECCPL) and Truman Packard (Task Team Leader. Sr . Economist. ECSHD) . Regina Nesiama (Program Assistant. ECSHD) and (Malgorzata Michnowska (Program Assistant. ECCPL) provided essential support . Radoslaw Czapski (Operations Officer. ECSSD). Anna Kowalczyk (Communications Associate. ECCPL). Heinz Rudolph (Sr . Financial Sector Specialist. FPDFS). Roberto Rocha (Sr . Adviser. MNSED). and John Pollner (Lead Financial Officer . ECSPF) arovided valuable inaut to the team .

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties . I t s contents may not be otherwise disclosed without Wor ld Bank authorization .

LOAN AND PROGRAM SUMMARY REPUBLIC OF POLAND

EMPLOYMENT, ENTREPRENEURSHIP AND HUMAN CAPITAL DEVELOPMENT POLICY PROGRAM

(SEC Borrower Implementation Agency Amount Terms

Tranching Description

IND POLICY LOAN IN A PROGRAM OF THREE) REPUBLIC OF POLAND MINISTRY OF FINANCE

~~~ ~~

EUR 1 Bi l l ion (US$1,300,240,000 equivalent) Euro-denominated IBRD Flexible Loan at six-month LIBOR for Euro plus Variable Spread, payable in 30 years, including a five year grace period. Front- end fee o f 0.25 percent o f the loan amount to be paid by the borrower from own funds. Single tranche This i s the second policy loan (PL2) in a program o f three lending operations supporting a policy program aimed at accelerating Poland’s convergence with average EU living standards. PL2 w i l l continue to support reform o f public financial management, the business environment, and improvements o f labor market efficiency in line with the first loan, as well as structural improvements to the finance and provision o f health, education and social protection services. The second lending operation in the program has the following objectives: (i) to support structural reforms that w i l l ensure fiscal consolidation over the medium term; (ii) to protect priority investment programs and the up-front fiscal costs o f structural reforms critical to meeting Poland’s goals o f convergence with the rest o f the EU; and (iii) to mitigate the social cost o f the economic crisis. In the months since the first policy loan in the program was disbursed, the external economic environment has changed dramatically, causing growth in Poland to slow sharply. To better manage the uncertainty that the world economic crisis has introduced into Poland’s outlook and fiscal targets, while pushing ahead with the reform o f public financial management and improvements in the business environment, the Government i s now focusing on elements o f the program specifically targeting the labor market, education, health and social protection. Consequently, PL2 continues to support reforms initiated with the first loan, and expands its focus to structural improvements and maintaining critical programs in the social sectors. The Government has met al l o f the agreed prior actions for the second loan. These are : (i) satisfactory continued implementation o f the 2009 budget in light o f the changed economic outlook including consideration o f the assessments by the European Union and the IMF; (ii) submission to Parliament o f an amended Law on Public Finance satisfactory to the Bank; (iii) amendments to the Law on Freedom o f Business Operations that unify and coordinate business inspection procedures, scheduling and duration among al l inspection authorities; (iv) offer for sale (through stock exchange or by auction) or via competitive tenders the first 80 public sector enterprises in the privatization program (or those constituting 10 percent o f aggregate asset value); (v) implementation o f the government program to increase labor force participation o f older workers, known as “50+”; (vi) enactment o f the Law on Bridging Pensions that reduces the number o f people eligible for early retirement from 1.7 mil l ion to 300,000, while safeguarding the base level o f pensions for those affected by the change; (vii) approval o f an implementation plan for the participation o f public hospitals in a voluntary program that would convert them into corporate entities operating under the Commercial Code; (viii) adoption by the National Health Fund (NFZ)

iv

Benefits

R i S k S

Operation ID Number

o f a payment system based on diagnostically related groups (DRGs) for 90 percent o f al l hospital services; (ix) passage o f a law to initiate a pre-primary program for 5 year-old children (Grade 0), implemented initially on a voluntary basis but on a mandatory basis beginning in 2012; and (x) provision for a reserve in the 2009 budget to protect vulnerable households affected by the economic downturn. As a condition o f effectiveness, the Government has agreed to initiate the process o f revising its 2009 budget in form and substance consistent with the measures being supported by this Program. The actions supported by PL2 constitute substantive structural reforms that w i l l support fiscal consolidation over the medium term. In a sharply slowing economy, and as government revenues fall, PL2 will help to protect priority programs and the up-front fiscal costs o f structural reforms critical to meeting Poland’s goals o f convergence with the rest o f the EU. Furthermore, the financial support provided by PL2 and accompanying AAA wi l l help the Government to mitigate the social cost o f the economic crisis. There are three principal risks as the Government takes the next step in its reform program in partnership with the World Bank. First, the medium-term macroeconomic scenario o f slowing economic growth i s subject to further downside risks. While the exogenous risk cannot be fully mitigated, as a condition o f effectiveness, the Government has agreed to initiate the process o f revising its 2009 budget consistent with the measures being supported by the program. Second, Poland’s external and financial vulnerability may be further affected by the risk o f contagion from other countries in the region, and access to external financing sources may become more difficult and more expensive. Third, the projected deterioration o f economic prospects may undermine support for the Government and reduce i ts willingness to continue i t s structural reforms. Reform momentum i s already constrained by the risk o f Presidential veto on new legislation passed in Parliament, in particular in the area o f social services. To mitigate this, the Bank can support the Polish Government with communications about the necessity o f the reform measures proposed under this program. P116125

V

IBRD PROGRAM DOCUMENT FOR A

PROPOSED SECOND PROGRAMMATIC POLICY LOAN TO THE

REPUBLIC OF POLAND

TO SUPPORT AN

EMPLOYMENT, ENTREPRENEURSHIP, AND HUMAN CAPITAL DEVELOPMENT POLICY PROGRAM

I. INTRODUCTION

1. This i s the second policy loan (PL2) in the amount of EUR 1 billion (US$1,300,240,000 equivalent) in a program of three lending operations supporting a reform program aimed at accelerating Poland’s convergence with average European Union (EU) living standards. Poland has made impressive progress towards creating a modern, market-based economy. It has successfully acceded to the EU. However, constraints to the country’s continued rapid convergence with i t s EU partners are becoming visible. K e y challenges identified by the Government and the Bank, which this program i s designed to address, are: supporting structural budget and public sector management reforms to ensure fiscal consolidation and reduction o f the government’s deficit to levels consistent with i t s obligations under the EU’s Stability and Growth Pact, increasing the supply and skills o f the labor force, and strengthening the business environment. PL2 includes, as an elaboration o f the public financial management, private sector development, and sk i l ls agendas, a more complete treatment o f reforms in social sector spending that wi l l contribute to efficient, equitable, and effective investments in the Polish population through education and health programs, as we l l as a more robust safety net for the vulnerable that i s consistent with labor market policies. In parallel with this series o f policy loans, the Bank has undertaken a Public Expenditure Review (PER) that focuses o n the same sectors as the loans. I t wil l be discussed with the government in mid-2009. It provides the analytical underpinnings o f this loan and i s intended to assist the government in formulating further structural reforms in social sector spending that will affect budgets in 2010 and beyond.

2. The first loan in the program (PL1) supported policy actions to strengthen public financial management, increase participation in the labor market, and improve the environment for doing business. Consistent with the convergence aims o f the program, the policy actions taken by the Government prior to presentation o f the f i rst loan to the Board in December 2008, included: satisfactory implementation o f the 2008 budget and presentation o f the 2009 budget bill consistent with the Convergence Program and personal income tax (PIT); a reduction in payroll taxes to reduce the tax wedge on labor; elimination o f work permits for foreign workers from neighboring countries to increase labor supply; tightening eligibility requirements for disability benefits; presentation o f legislation to Parliament that reduces the minimum capital required to start a business; and the approval o f a privatization program encompassing the sale o f 740 state owned enterprises.

1

3. This operation, the second loan in the series (PLZ), will continue to support reforms in public financial management, the business environment, and improvements of labor market efficiency in line with the first loan, as well as structural improvements to the finance and provision of health, education and social protection services. The second lending operation in the program has the following objectives: (i) to support structural reforms that w i l l ensure fiscal consolidation over the medium term; (ii) to protect priority investment programs and the up-front fiscal costs o f structural reforms critical to meeting Poland’s goals o f convergence with the rest o f the EU; and (iii) to mitigate the social cost o f the economic crisis. In the months since the f i rs t loan in the program was disbursed, the external economic environment has changed dramatically, causing growth in Poland to slow sharply. To better manage the uncertainty that the world economic crisis has introduced to Poland’s outlook and fiscal targets, while pushing ahead with reform o f public financial management and improvements in the business environment, the Government i s now focusing on the part o f the program specifically targeting the labor market, education, health and social protection. The second lending operation in the program (PL2) continues to support reforms initiated with the first loan and expands the focus to include structural improvements in, and the maintenance of, critical programs in the social sectors.

4. Government has met all o f the agreed prior actions for the second loan (as reported in Section V). These are: (i) satisfactory continued implementation o f the 2009 budget in light o f the changed economic outlook, including consideration o f the assessments by the European Union and the IMF; (ii) submission to Parliament o f the amended Law on Public Finance satisfactory to the Bank; (iii) amendments to the Law on Freedom o f Business Operations that unify, and coordinate business inspection procedures, scheduling and duration among all inspection authorities; (iv) offer for sale (through stock exchange or by auction) or via competitive tenders the f i rst 80 public sector enterprises in the privatization program (or those constituting 10 percent o f aggregate asset value); (v) implementation o f the government program to increase labor force participation o f older workers, known as “50+”; (vi) enactment o f the Law on Bridging Pensions that reduces the number o f people eligible for early retirement from 1.7 million to 300,000, while safeguarding the base level o f pensions for those affected by the change; (vii) approval o f an implementation plan for the participation o f public hospitals in a voluntary program that would convert them into corporate entities operating under the Commercial Code; (viii) adoption by the National Health Fund (NFZ) o f a payment system based on diagnostically related groups (DRGs) for 90 percent o f all hospital services; (ix) passage o f a law to initiate a pre-primary program for 5 year-old children (Grade 0), implemented initially on a voluntary basis but on a mandatory basis beginning in 2012; and (x) provision for a reserve in the 2009 budget to protect vulnerable households affected by the economic downturn. Poland and the world continue to cope with extraordinary economic conditions, and r isks o f hrther deterioration remain high. As a condition o f effectiveness, the Government has agreed to initiate the process o f revising its 2009 budget in form and substance consistent with the measures being supported by this program, a measure that highlights i t s continued commitment to the first prior action o f this loan in the uncertain economic environment.

2

11. COUNTRY CONTEXT

2.1. RECENT ECONOMIC DEVELOPMENTS IN POLAND

5. Poland has successfully managed its integration into the EU since accession in 2004. The EU and i t s institutions are now Poland’s main external partners, to which the World Bank i s committed to play a supporting role. Poland also has access to considerable external financing, including EU Structural and Cohesion Funds on a grant basis.’

6. The Government has political room to continue pursuing a substantial reform agenda with the objective of convergence with EU partners, although upcoming elections will increase political debate around reforms. The Government, created by the Civic Platform and the Polish Peasant’s Party and led by Prime Minister Donald Tusk, operates without any major political tensions and enjoys strong social support. However, the Government’s lack o f a qualified majority in Parliament poses obstacles to i t s reform program that are likely to grow over the coming months as Presidential elections in the Fal l 2010 approach. Controversial reform measures are at risk o f veto by the President Lech Kaczynski o f the opposition Law and Justice (Pis) party, as has been demonstrated on several recent occasions. In some cases, such as the tightening o f early retirement conditions, the Government was able to overcome the Presidential veto with support from other parties. Elections to the European Parliament and Sub-National Governments scheduled for June 2009 are expected to generate heated political debate.

7. Poland has thus far avoided the direct impacts of the financial crisis, and its vulnerability remains moderate, but the country i s being affected by the deterioration in the external economic environment. Among the EU new member states, Poland i s in better fiscal and financial shape but i s affected by the ongoing crisis through declining demand for Polish exports, a slowdown o f credit activity, and lower FDI inflows. Poland i s less reliant on external demand than other, more open countries in the region and wil l be relatively less affected by a recession in the Euro area. At the onset o f the crisis, the Polish economy was in a strong position after five years o f rapid growth and historically low unemployment. Inflation, the current account deficit, external debt, the fiscal deficit, and public debt are moderate. The financial system remains relatively sound. Nevertheless, the weakening o f the zloty in the last quarter o f 2008 and early 2009 and high volatility o f the exchange rate show that there i s l i t t le room for complacency on the part o f the authorities.

8. Poland’s financial system i s well poised to cope with the increasingly adverse external environment. While the banking system is dominated by foreign banks whose external fbnding conditions appear to have deteriorated - owing to problems o f the parent banks - some domestic banks o f significant size operate in the sector as well, including a large state-owned bank. Credit growth in Poland and the overall ratio o f credit-to-GDP

’ The new CPS presents details o f the programs o f the EU and related institutions in Poland.

3

has been moderate and much lower than in most o f the other countries in the region. Most o f the credit expansion has been financed through domestic deposits, although foreign financing has been playing an increasing role in recent years. A large share o f domestic investment has been financed through enterprise profits. While there are some concerns for foreign currency mortgage lending, the overall level o f this lending i s relatively small. The recent depreciation o f the zloty follows a period o f very strong appreciation in 2007 and 2008. Bank profits have reached record highs in recent years and banks remain wel l capitalized. However, credit conditions are likely to tighten significantly this year and some enterprises may find it difficult to ro l l over maturing short-term loans (which constitute about one-half o f total enterprise loans).

9. The rapid deterioration of the external environment, especially in the Euro zone, and tightening of financial markets have slowed growth in Poland. In 2008, the Polish economy expanded by 4.8 percent, down from 6.7 percent growth in 2007, as year-on-year growth moderated from 5 percent in the third quarter to 2.9 percent in the fourth quarter. Weak global demand has undermined the supply response o f exports to the 25 percent depreciation o f the zloty relative to the Euro since the end o f September 2008 so that the contribution o f net exports to growth i s l ikely to remain broadly neutral during 2009. With private investment declining, the 2009 growth outcome wil l hinge critically on private consumption. Overall, the Government’s real growth projection o f 1.7 percent compares to April projections o f 0.5 percent by the Wor ld Bank and -0.7 percent by the IMF. In any case, forecasts are subject to an unusual degree o f uncertainty in the current environment.

10. Higher than planned government consumption and lower than assumed non- tax revenues together with the slowdown in economic activity towards the end of 2008 contributed to an unexpected increase in the fiscal deficit. The 2008 general government fiscal deficit reached 3.9 percent o f GDP, some 1.2 percentage points higher than projected by the Government in the December 2008 Convergence Program. T h i s was due to higher-than-expected deficits o f both local and central governments (due to higher than planned expenditure and lower than expected revenue), while social security funds performed according to plan. Based on the fiscal outcome for 2008, the E C opened Excessive Deficit Procedures o n M a y 13, 2009.2 Excessive Deficit Procedures are

~~ ~ ~~

The E C reported the following: “The general government deficit in Poland reached 3.9% o f GDP in 2008, above and not close to the 3% reference value. The breach o f the threshold mainly reflects the fact that good times were only to a certain extent used as an opportunity to consolidate public finances and undertake deep reforms on the expenditure side. Poland’s general government deficit over the past five years averaged 4.3% o f GDP, at the same time as GDP growth on average exceeded 5%. The Polish authorities have revised their 2009 deficit target to 4.6% o f GDP which shows that the excess over the reference value i s not temporary. The Commission services’ spring forecast projects the deficit to increase to 6.6% this year and, under unchanged policies, to further widen in 2010. The reduction in social contributions, an increase in personal income tax reliefs for families, and a generous indexation o f pensions and social benefits increased the deficit in 2008. In addition, higher-than-planned intermediate consumption and investment, as well as a drop in revenues at the end o f 2008 due to the economic slowdown, al l resulted in a higher than expected deficit both at the central and local government level. The excess over the reference value cannot be qualified as exceptional within the meaning o f the Treaty and the SGP nor can it be considered temporary. This suggests that the deficit criterion in the Treaty i s not fulfilled. General government gross debt remains below the 60% o f GDP reference value.” The excessive

4

triggered when the deficit-to-GDP ratio exceeds 3 percent or debt-to-GDP ratio exceeds 60 percent and which requires countries to produce a plan for how this will be corrected. The E C i s expected to come to a conclusion in July 2009 on the existence o f an excessive deficit. This would give Poland until January 2010 to take corrective actions. These corrective actions would be presented in an updated Convergence Program expected in December 2009.

11. Inflation accelerated to 4.2 percent on average in 2008, from 2.5 percent in 2007, but the peak was reached in the first half of 2008 and inflation has eased significantly since. With GDP growth expected to slow sharply in 2009 and world commodity prices falling, expectations for inflation have eased and the National Bank o f Poland (NBP) began reducing interest rates in late 2008. Inflation i s projected to return to around the middle o f i t s target range o f 1.5 to 3.5 percent in 2009.

12. The balance of payments has come under some pressure but Poland’s external position remains strong. The current account deficit remained at around 5.5 percent o f GDP in 2008, but weaker capital inflows have been associated with a sharp depreciation o f the zloty following strong appreciation in recent years. Fol lowing a hiatus o f 7 months, the government returned to international capital markets with a Euro 1 bi l l ion issue in January 2009 at a spread o f around 300 basis points above German Bunds. In early M a y 2009, Poland successfully placed a EUR750 mi l l ion issue at a spread o f about 40 basis points below the January level. Poland’s external debt o f about 56 percent o f GDP i s moderate by regional standards, but gross financing needs are sizeable and could add further strains on the balance o f payments. Inflows o f EU funds and FDI should finance a major part o f the external gap. Poland’s floating exchange rate regime i s serving it well to help absorb the external shock.

13. The Government approached the IMF for a USD 20.5 billion one-year facility under the new Flexible Credit Line (FCL), which was approved in M a y 2009. The primary objective o f the Government’s application i s to obtain the IMF’s “seal o f approval” on i t s macroeconomic policies, to strengthen market confidence and to differentiate Poland from other regional economies. The IMF Board approved the request in M a y 2009. The financial market reacted positively to the news.

14. After a remarkable improvement of labor market performance in recent years, unemployment i s expected to rise in 2009 on the back of the economic slowdown. In recent years, Poland recorded an unprecedented improvement in labor market performance. The unemployment rate measured by the labor force survey (LFS) f e l l from over 20 percent in 2004 to around 7 percent in 2008. The data disaggregated by gender indicate that unemployment among women remains higher than among men but also decreased considerably, from 19 percent in 2004 to around 8 percent in 2008.

deficit procedure i s also to be opened against Romania, Lithuania and Malta. A similar procedure against France, Spain, Ireland, Greece, UK and Hungary i s already in progress. Source: IP/O9/752, Brussels, 13 May 2009. “Commission presents reports under the excessive deficit procedure for Lithuania, Malta, Poland and Romania.” Accessed June 1,2009, at http://euroDa.eu/raDid/~ressReleasesAc tion.do?reference=IP/O9/752&fo~a~PDF&a~ed=O&lan~ua~e=EN &guiLanguarte=en

5

Unemployment i s expected to rise back into the double digits as the economy slows sharply. In January 2009, the inf low to unemployment was a quarter higher than a year earlier, and the number o f the newly registered unemployed due to layoffs was twice as high. The registered unemployment rate reached 1 1.2 percent in March 2009.

Figure 1. At Risk of Poverty Rate in the EUS3 (percent)

12

1 1 !-

Czech Estonia Latvla Lithuani Hungary Poland Slovenia Slovakia IRepublic I I .I I ~ I I

Source: Eurostat.

15. The decline in unemployment from 2004 to 2007 was accompanied by lower poverty rates. Relative poverty levels (measured using the Eurostat Laeken “at risk o f poverty” statistic) have decreased. Poverty i s concentrated in rural areas, among the long-term unemployed, and households with many children (see Figure 1). Nonetheless, despite vibrant growth o f real GDP and domestic consumption, Poland s t i l l has a relatively high poverty rate compared to other countries in the region, especially among children. Absolute poverty levels are considerably lower although measurement depends on the choice o f poverty line. When measured as the percentage o f population below the social assistance eligibility income threshold, poverty dropped from 19 percent in 2004 to 14.6 percent in 2007. The poverty gap also narrowed, meaning that the incomes o f the poor moved closer to those o f the non-poor. The main determinants o f absolute poverty in Poland include: rural residence, l o w educational attainment o f a household head, unemployment o f a household member, and a higher number o f children in the household.

2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

16. Medium-term economic prospects for Poland have been seriously affected by shrinking external demand and tighter international and domestic credit conditions. Growth i s now projected to recover slowly from 0.5 percent in 2009 to 1.0 percent in 2010, provided the external environment improves. Inflation i s expected to remain stable

The EU poverty measure (“at risk o f poverty rate”) i s defined as the share o f the population living in households with income below 60 percent o f the national median disposable income after transfers.

6

at around the central inflation target o f 2.5 percent. Lower domestic absorption should lead to a significant moderation o f imports and an improvement in the external current account deficit (around 4 percent o f GDP in 2009-2010). Table 1 shows recent macroeconomic forecasts for Poland prepared by the Government and international organizations.

Table 1. Economic developments and prospects in Poland 2004-2011 (change in percent unless otherwise indicated)

2004 2005 2006 2007 2008 2009 2010 2011 CP December 2008 6.7 5.1 3.7 4.0 4.5

IMF W E 0 April 2009 5'3 3'6 6'2 6.7 4.8 -0.7 1.3 -- WB May 2009 6.7 4.8 0.5 1.0 3.0 CP December 2008 5.0 5.3 4.5 3.7 3.8

EC Spring Forecast May 2009 6.6 4.8 -1.4 0.8 -- Real GDP (% change)

Private consumption EC Spring Forecast May 2009 5.0 5.3 0.6 0.2 -- (% change) IMF WE0 April 2009 4'3 2'1 5.0 5.3 1.0 1.5 --

WB May 2009 5.0 5.4 1.9 1.4 4.4 CP December 2008 17.6 6.5 4.4 5.0 8.6

Gross fixed capital EC Spring Forecast May 2009 17.6 7.9 -6.2 -0.8 -- formation (% change) IMF WE0 April 2009 6'4 6'5 14" 17.6 7.9 -4.5 2.5 --

CP December 2008 2.6 4.2 2.9 2.5 2.5 Consumer prices (% EC Spring Forecast May 2009 2.6 4.2 2.6 1.9 --

change) IMF W E 0 April 2009 3'6 2'2 2.5 4.2 2.1 2.6 -- WB May 2009 2.5 4.2 3.1 2.7 2.5

EC Spring Forecast May 2009 CP December 2008 -4.7 -5.1 -4.2 -3.6 -3.8

-5.1 -5.3 -4.7 -3.7 -- -4.4 -1.2 -2.9 Current Account Deficit (% of GDP) IMF WE0 April 2009 -4.7 -5.5 -4.5 -3.9 --

Source: Poland's Convergence Program - Update December 2008; recent publications o f international financial institutions; and World Bank staff.

WB May 2009 -4.7 -5.5 -4.3 -3.6 -4.1

17. The global financial crisis has worsened Poland's macroeconomic and fiscal outlook, even though it i s faring better than other countries in the region. With limited resources in a fast evolving economic environment, the Government faces the difficult challenge o f reconciling three objectives: to ensure fiscal consolidation over the medium term; to protect priority programs for economic and social development so that growth prospects are enhanced; and to mitigate the potential social cost o f the economic crisis.

18. The Government took precautionary steps in January and February to ensure adherence to the state budget deficit target for 2009, but additional steps will be required. In late January 2009, the Government revised downwards the 2009 real GDP growth forecast from 3.7 percent, as estimated in the December 2008 Convergence Program, to 1.7 percent. To compensate for the expected shortfall in revenue, line ministries were asked to prepare plans for reducing state budget expenditures. Certain expenditure items, such as pension and disability payments, capitation grants to local governments for primary and secondary education, public sector wages, debt servicing, and co-financing for the absorption o f EU funds, were protected from these reductions. In addition, the Government shifted transport infrastructure spending o f 0.8 percent o f GDP o f f the state budget to the National Road Fund. While this measure reduces the state budget deficit, i t leaves the general government deficit unchanged.

7

19. During the second review of the 2009 budget implementation planned for June 2009, the Government expects to decide on the adoption of a supplementary budget, which could include a combination o f additional expenditure rationalization and an increase in the state budget deficit target. In the Government's latest projection, the general government fiscal deficit could reach 4.6 percent o f GDP in 2009. The EC's spring forecast shows a fiscal deficit o f 6.6 percent o f GDP.

20. In the recent update of the Euro adoption roadmap, the Government reiterated its commitment to adopt the Euro in 2012. However, i t abandoned plans for entry to European Exchange Rate Mechanism (ERM2) in mid-2009 due to exchange rate volatility, lack o f political consensus on the required constitutional changes and weak fiscal performance. Furthermore, Euro adoption in 2012 would require the Government to reduce the general government fiscal deficit to below 3 percent o f GDP by 2010. A slow economic recovery would make it difficult to achieve the required fiscal consolidation. In l ine with the recent EC forecast, the headline fiscal deficit i s to deteriorate further to 7.3 percent o f GDP in 2010 under the assumption o f no additional policy changes.

Table 2. Fiscal developments and prospects in Poland 2004-2011 (percent o f GDP unless otherwise indicated)

Source 2004 2005 2006 2007 2008F 2009F 2010 F 2011 F CP December 2008 -2.0 -2.7 -2.5 -2.3 -1.9 EC Spring Forecast May 2009 -5.7 -4.3 -3.8 -1.9 -3.9 -6.6 -7.3 --

Fiscal balance G O ~ . Fiscal Notification, April 2009 -1.9 -3.9 -4.6 -- _- IMF FCL Arrangement, April 2009* -- -3.9 -3.9 -2.0 -3.9 -4.3 -4.2 -- CP December 2008 -2.4 -3.2 -2.6 -2.0 -1.8 EC Spring Forecast May 2009 -5.9 -4.1 -4.1 -3.2 -5.3 -6.0 -5.6 --

Structural Gov. Fiscal Notification, April 2009 _ _ _ _ _- _ _ _ _ IMF FCL Arrangement, April 2009' -- _ _ _- _- -_ -_ _- _ _ CP December 2008 0.5 -0.3 0.1 0.2 0.5 EC Spring Forecast May 2009 -1.2 -0.3 -1.1 0.4 -1.7 -3.7 -4.3 -- Gov. Fiscal Notification, April 2009 _ _ _ _ _ _ __ -_ Primary balance

IMF FCL Arrangement, April 2009' -- -1.3 -1.3 0.3 -1.7 -1.8 -1.5 -- CP December 2008 44.9 45.9 45.8 45.5 44.8

Public debt EC Spring Forecast May 2009 45.7 47.1 47.7 44.9 47.1 53.6 59.7 -- G O ~ . Fiscal Notification, April 2009 44.9 47.1 51.0 -- _ _ IMF FCL Arrangement, April 2009* -- 47.5 47.8 44.9 47.1 51.6 53.3 -- CP December 2008 6.7 5.1 3.7 4.0 4.5 EC Spring Forecast May 2009 6.6 4.8 -1.4 0.8 _ _

Real OD' (% change) Gov. Fiscal Notification. Aoril 2009 5'3 3'6 6'2 6.6 4.8 _ _ _- _ _ IMF FCL Arrangement, A&~I 2009' 6.7 4.8 -0.7 1.3 -- CP December 2008 _ _ _ _ _- 1.1 1.2 0.1 -0.4 -0.4 EC Spring Forecast May 2009 0.6 0.1 1.7 3.4 3.5 -1.5 -3.8 --

Output gap Gov. Fiscal Notification, April 2009 -- _ _ _- __ -_ _ _ _- -_ IMF FCL Arrangement, April 2009' -- __ _ _ _ _ _ _ _ _ _ _ _ _

*) Based on IMF definition (including pension reform costs)

Source: Poland's Convergence Programs, Spring 2009 Fiscal Notification, and EC Spring Forecast, M a y 2009.

21. The 2010 budget will be critical for the Euro adoption agenda and should envisage firm commitment to medium-term fiscal consolidation. This commitment should be institutionally strengthened by rapid passage o f the amendment to the Public Finance Law aimed at consolidating budgetary units, strengthening precautionary debt

8

rules, increasing performance orientation in the budget, and strengthening the medium- term fiscal framework. In particular, introduction o f elements o f a Medium Term Expenditure Framework (MTEF) should enhance the credibility o f the gradual fiscal consolidation path from 2010, facilitate a permanent reduction o f the structural fiscal deficit, and stabilize the public debt-to-GDP ratio.

22. Poland’s economic and fiscal outlook remains subject to unusually large uncertainty in view of the unclear prospects for global economic recovery. While the forceful pol icy responses in many countries have contained the risks o f a systemic financial meltdown, there are reasons to remain concerned about the potential impact on activity o f the financial crisis. The process o f deleveraging could be more protracted than has been factored into the macroeconomic projections for emerging markets. Another r i s k relates to the growing r isks o f deflationary conditions in advanced economies.

2.3. SOCIAL IMPACT OF THE SLOWDOWN AND THE GOVERNMENT’S PLANS

23. So far the impact of the crisis on labor market conditions - and by implication on poverty - has been moderate. Layoffs have occurred largely in export- oriented industries and in construction. The most vulnerable groups - those that face the highest risk o f unemployment if the crisis deepens - include less skilled workers in manufacturing and construction. In contrast, households that depend primarily on subsistence agriculture - among whom the rate o f poverty i s highest - are to some extent insulated from the impact o f the crisis, at least temporarily.

24. The primary transmission channel of the economic slowdown i s through the labor market. I t i s therefore critical that Poland’s social protection system be able to respond effectively to increasing unemployment and vulnerability. Labor market programs - both passive (unemployment benefits) and active (public works, employment subsidies, and training) are financed from the Labor Fund. The Fund i s financed from a 2.45 percent payroll tax.

25. Thanks to low unemployment in recent years, the Labor Fund has accumulated a large surplus that will be the main source of contingent resources to address the impact of the crisis. In 2008, the revenues o f the Labor Fund accounted for 0.7 percent o f GDP, and the surplus o f the Fund represented close to 60 percent o f expenditures. This has generated a substantial reserve with which to respond to growing unemployment using a combination o f both passive and active measures. The Government i s confident that sufficient resources are available to address the potential surge in unemployment and provide the unemployed with income support and job search assistance. Local labor offices can also organize public works to provide temporary employment opportunities should these become necessary.

26. Using the Labor Fund proactively, the Government i s putting in place measures to increase the adaptability of the labor market to the downturn, with the support of labor unions and employers. In the context o f the program, and with the agreement o f social partners, measures are planned that wil l help workers smooth hours

9

and increase flexibility during an economic downturn. Further, labor unions and employers are coming to an agreement that would allow employers to reduce wages temporarily as an alternative to employment adjustment that would be applied selectively during the crisis. The Government plans to complement this agreement by financing a subsidy to workers whose wages are reduced o f up to 50 percent o f the minimum wage, financed from the Labor Fund. These measures are expected to reduce pressure for higher unemployment by providing more flexibility to adjust hours. As o f the negotiation o f PL2, the Government does not plan to introduce additional large scale public works, although this remains an option for local governments, and finding has been prioritized to protect EU-funded infrastructure projects. Concerns remain for the part o f the labor force working informally and not covered with r ights to unemployment protection.

27. The ability of Poland's targeted social assistance programs for the poorest households to respond quickly i s more limited, but the Government i s deploying better targeted resources to vulnerable parts of the country. Means tested social assistance in Poland is comprehensive and relatively well targeted when compared to means tested programs in other countries in Central Europe (see B o x l), although leakage o f targeted benefits to non-poor and otherwise ineligible groups remains a challenge. Social assistance programs are financed from general revenues, and by law are adjusted every three years to take into account o f changes in the cost o f living. As shown in Table 3, about a third o f households receive pension benefits. Both pensions and labor market programs are fairly evenly distributed across deciles, except they reach somewhat fewer households among the richest 20 percent. Social assistance benefits reach almost hal f o f households, but they are concentrated within the lower hal f o f the distribution. Table 4 shows the percentage o f transfers reaching each decile. Except for pensions, which are related to earnings and are therefore skewed to the richest, Table 4 shows a somewhat stronger pattern o f targeting o f expenditures than might be expected from Table 3.

Table 3. Social Protection Coverage (% o f Households in Each Group who Report Receiving Benefits)

All social protection All social insurance

Old Age Retirement Pension AIL labor market programs

Unemployment benefits & assistance Early retirement benefits

Family allowance (and complemeting benefits) Carer's benefit & nursing benefit Housing Benefit Social assistance (permanent social pension)

All social assistance

Deciles b y Household Consumption Total 1 2 3 4 5 6 7 8 9 10 72.3 84.8 82.2 45.6 44.0 47.5 30.5 23.2 27.7 5.3 6.3 6.8 2.7 3.9 4.0 2.1 2.5 2.9 47.6 63.6 58.9 24.2 47.3 40.6 3.1 5.3 6.2 5.0 11.3 9.6 1.6 2.8 2.6

79.8 49.2 30.5 6.0 3.0 3 .O

56.0 36.0 5.0 8.1 1.9

77.5 76.4 12.6 70.6 66.1 61.6 51.0 49.4 50.6 48.2 47.7 45.5 41.8 32.3 33.4 34.7 33.7 33.3 33.2 31.1 24.5 5.9 6.5 5.9 5.5 4.1 3.8 2.6 2.9 3.1 3.0 2.3 2.1 1.8 1.1 3.1 3.5 2.9 3.4 2.0 2.0 1.5 51.7 49.2 45.6 43.8 40.1 36.6 30.5 29.9 25.0 21.1 16.9 12.2 8.6 4.0 4.8 3.6 3.4 2.9 2.5 2.1 1.3 6.2 4.4 4.2 2.6 1.7 1.1 0.6 1.9 1.7 1.5 1.0 1.0 0.7 0.6

Social assistance (temporary benefits, cash & in kind) 5.1 15.9 9.6 6.5 5.6 3.7 3.5 2.5 2.2 1.4 0.5 Source: Staff estimates using HBS 2007

10

Table 4. Social Protection Targeting4 (% of Total Transfers Reported Going to Households in Each Group)

Deciles by Household Consumption Total 1 2 3 4 5 6 7 8 9 10 C G H d l C G H q l

AU social protection 100.0 7.0 8.0 9.0 9.8 10.2 10.8 11.5 11.6 11.7 10.4 0.7 0.7 All social insurance 100.0 5.6 7.0 8.4 9.6 10.2 11.0 12.1 12.3 12.6 11.3 0.6 0.6

Old Age Retirement Pension 100.0 4.6 6.0 7.7 9.2 10.2 11.1 12.3 12.8 13.6 12.5 0.5 0.5 All labor market programs 100.0 9.0 11.4 10.8 11.3 12.2 11.3 11.9 8.5 7.8 5.7 0.9 1.0

Unemployment benefits & assistance 100.0 13.9 13.9 12.0 9.4 10.6 10.9 9.3 8.5 6.5 4.9 1.4 1.4 Early retirement benefits 100.0 6.6 10.1 10.2 12.3 13.0 11.6 13.2 8.6 8.5 6.1 0.7 0.8

All social assistance 100.0 16.9 14.7 12.7 11.4 9.3 9.1 7.4 7.1 6.4 5.0 1.7 1.6 Family allowance (and complemeting benefits) 100.0 19.4 16.5 15.0 12.6 10.0 8.3 7.0 5.4 4.1 1.8 1.9 1.8 Carer’s benefit & nursing benefit 100.0 13.5 15.2 14.3 14.2 9.3 10.1 8.2 7.1 4.9 3.3 1.3 1.4 Housing Benefit 100.0 19.6 19.1 16.5 13.5 9.8 8.6 5.3 3.8 2.2 1.6 2.0 1.9 Social assistance bermanent social pension) 100.0 17.0 16.1 11.9 12.6 9.6 11.4 7.0 6.4 4.2 3.7 1.7 1.7 Socialassistance(temporary benefits,cash &inkind) 100.0 25.2 17.4 11.5 10.2 6.8 7.4 6.3 6.1 7.2 2.0 2.5 2.1

Source: Staff estimates using HBS 2007 Notes: CGH d l : CGH indicator constructed for targeting to decile 1 CGH q l : CGH indicator constructed for targeting to quintil 1

28. As the downturn becomes more severe, Government anticipates the need to use budget resources for social assistance and emergency interventions more efficiently. General revenues are declining as the tax base shrinks, lowering tax receipts. At this juncture, no additional emergency assistance programs are being considered. However, the Government is preparing for increased household vulnerability by mapping the regions that are l ikely to be hit hardest by the crisis (see Box 2). Furthermore, new taxes have been passed on alcoholic drinks, tobacco products and luxury cars which are expected to generate P L N 1.14 bi l l ion that would finance additional assistance to households (a measure supported in this program). Some o f these funds wil l be used to finance a response to the anticipated needs o f households in the parts o f Poland that are l ikely to feel the impact o f the economic crisis deepest. The Prime Minister’s Office (PMO) and the Ministry o f Labor and Social Policy (MLSP) are proposing that the next regular adjustment o f family benefits (scheduled for November 2009) be targeted only to families with three or more children. This approach would improve targeting to the poorest families and reduce the cost o f the adjustment from PLN 3.0 bi l l ion to P L N 0.7 billion.

In Table 4, CGH i s the “Coady-Grosh-Hoddinnott” indicator as cited from Ringold, D. and L . Kasek, (2007) “Social Assistance in the N e w EU Member States: Strengthening Performance and Labor Market Incentives” Working Paper No. 117, Washington DC. The CGH indicator i s constructed by dividing the actual outcome by the neutral outcome for the bottom quintile (or decile) o f the distribution o f households (by consumption). If the poorest 20 percent o f households received 30 percent o f benefits, the CGH indicator would be (30/20) = 1.5, i.e. targeting has led to the poorest quintile receiving 50 percent more than they would have received had benefits been distributed evenly. As a means o f comparison with neighboring countries, a regional study on social assistance in the new EU member states found social assistance in Lithuania to be the best targeted with a CGH just over 3.00. A t the other extreme are social assistance benefits in Russia with a CGH o f 1.10.

11

Box 1. Unemployment and Social Assistance in Poland

Expenditures on the social safety net absorbed about 1.4 percent o f GDP in 2006. The main programs include means tested social assistance (0.2 percent), a housing benefit for the poor (0.1 percent), means- tested family benefits (0.8 percent), and unemployment benefits (0.3 percent). Means tested programs are well-targeted relative to similar programs in neighboring countries, although substantial leakage to non-poor groups i s still a concern. Poland, along with the Czech Republic and Slovenia, are the only countries among those in the region that joined the EU in M a y 2004 that target family benefits based on a means test. Since 2004, all benefits targeted to children have been consolidated with family benefits, contributing to the relatively more progressive distribution o f Poland’s social assistance programs.

In 2007 about 47 percent o f the population received some form o f social assistance. About 24.2 percent received means tested family allowances and complementary benefits, and 6.7 percent received targeted social assistance cash and in-kind benefits. Only 10 percent o f the unemployed (and only 2.7 percent o f the population) received an unemployment benefit, which reflects tight eligibility conditions for these benefits (12 months o f covered employment in the preceding 18 months) their limited duration (6 months, 12 months in high unemployment regions, and 18 months in regions where the unemployment rate i s twice the national average), and the large share o f long-term job-seekers among the unemployed. The number o f recipients o f unemployment benefits surged in the last couple o f months (in February 2009 i t was nearly 1/3 higher than a year earlier).

The average social assistance cash benefit accounts for about 15 percent o f the average wage and 44 percent o f the minimum wage (2007). The average family benefit accounts for 6.5 percent o f the minimum wage (2 percent o f the average wage), however, in over 50 percent o f cases i t i s supplemented, which doubles i ts amount. The regular unemployment benefit accounts for some 20 percent o f the average wage and 50 percent o f the minimum wage. Young workers (contribution record o f less than 5 years) receive a benefit that i s 20 percent lower, and older workers (contribution record over 20 years) receive a benefit that i s 20 percent higher.

Coverage i s fairly good, with 85 percent o f households in the first decile and 82 percent in the second decile receiving some form o f social protection. This includes “contributory” social insurance benefits, primarily old-age pensions. Not surprisingly, the coverage o f social insurance benefits i s relatively even across the consumption distribution. Social assistance - programs that are universally available to households with children regardless o f their means, and means-tested programs - cover over 64 percent o f households in the poorest group.

Although most social assistance benefits are means tested, there i s room for improving their targeting efficiency. Estimates for 2007 show that gains in targeting efficiency could be made to mop up leakage o f means tested social assistance benefits being received by households in the higher consumption quintiles (see Table 4). However, a majority o f families covered by social assistance programs are families with children (7 1 percent), nearly half o f them representing single parent or pensioner families. Furthermore, 44 percent o f families who receive social assistance live in rural areas where the rate o f poverty i s highest. This incidence i s greater than the share o f these households in the population leading to progressive outcomes.

29. The ability of the social safety net to respond could be hampered by an ongoing process that began in 2004 of devolving financing responsibility for social assistance to sub-national governments. The Ministry o f Labor and Social Policy (MLSP) i s continuing the process started with the Administrative Reform o f 1999 that decentralizes benefits and services for the poorest households, and since 2004 devolves a portion o f financing for these services. Local governments in Poland perform a set o f tasks delegated to them, with financing, by the central government. They also are free to take on their “own tasks,” with their own financing, as they see fit to serve their communities. Prior to 2004, local governments were only responsible for delivering social benefits and services, but since then, have taken responsibility for hllyfinancing a

12

growing set o f “own tasks” in this sphere, along with a greater share o f tax revenue to cover these obligations. MLSP i s pushing ahead with i t s pol icy o f shifting social assistance activities to the set o f “own tasks.” With the shift in financing responsibility, local governments have a strong incentive to look for savings and to be more efficient. In other parts o f the region, this incentive has sometimes led to compromised standards and uneven delivery o f entitlements to the poorest households across municipalities o f

Box 2. Mapping Household Vulnerability to the Economic Crisis

To better prepare to meet the needs o f households vulnerable to the crisis the Government, through the PMO, is planning targeted regional interventions to support the powiats (counties) that are most affected. There are 379 powiats in Poland, each considered a local labor market. The Government’s plan is to strengthen local capacity to weather the crisis, by both improving the effectiveness o f existing programs (employment and social assistance) and if necessary, b y allocating additional resources for emergency assistance. T h i s initiative has three components and w i l l be implemented in three corresponding stages. The first component i s the creation o f a crisis vulnerability map, meant to identifypowiats that are at the highest risk o f suffering from the economic crisis. The map (see Box Figure) has been constructed based on 50 indicators characterizing powiats’ economic structure, labor market conditions and their degree o f urbanization. Factor analysis was applied to construct a composite measure o f powiats’ vulnerability to the crisis. Four groups o f vulnerable powiats are identified, w i th the potential that somepowiats may fall into more than one group:

Group A (Red in the Map, “Powiaty typ I ’ y : Industrial and urbanizedpowiats w i th strong labor markets; Group B (Orange, “Powiaty typ I I ’ y : Mixed industrial-agricultural powiats, moderately urbanized w i th relatively strong labor markets; Group C (Green Pin, “Powiaty ehportujqce”)): Export orientedpowiats; Group D (Grid, “Powiaty nu liicie”): Otherpowiats that are vulnerable based on expert opinion.

Note that this mapping i s focused on the impact o f economic recession, not just poverty indicators. Thus, vulnerable powiats include some o f the most developed with strong economies, rather than the poor, lagging regions. They are particularly susceptible to higher unemployment rates and tend to contain many people living close to poverty who have migrated to these prosperous places to seek opportunities. The lagging regions - rural, predominantly agricultural - are insulated from the crisis, at least temporarily, and benefit from longer term anti-poverty programs aimed at structural problems.

13

different incomes. The PER examines to what extent the shift in financing responsibility has changed the coverage and targeting efficiency o f spending on social assistance. An important consideration i s whether the process o f decentralizing not only administration but financing o f targeted social assistance programs to sub-national governments, has impaired their ability to respond. Reflecting this concern, MLSP i s closely monitoring sub-national governments to ensure they meet the needs o f households eligible for targeted social assistance.

111. THE GOVERNMENT’S REFORM PROGRAM

30. Despite this economic uncertainty, convergence to average EU living standards remains the Government’s overarching policy objective, for which it sees adoption of the Euro as a key step. In September 2008, Prime Minister Tusk announced that Poland was committed to Euro adoption from 2012, an ambitious target even before the economic crisis. It will require maintaining financial stability and ensuring that the Maastricht Criteria’ are met in a sustainable manner, including through a continuation o f a restrained fiscal policy. An acceleration o f structural reforms aimed at increasing the efficiency o f public spending - particularly in the social sectors - and flexibility in the labor market wi l l be needed both to support Euro adoption and a quick recovery o f growth.

31. The authorities have taken steps to preserve financial stability in the current difficult external environment. In reaction to the escalation o f the global crisis in the fall o f 2008, the NBP, the Government, Parliament and the Financial Supervision Authority have taken steps to maintain confidence and support the effective functioning o f the financial system. In October, the NBP announced a “package o f confidence” aimed at preserving trust and liquidity in financial markets through expansion o f i ts term liquidity management operations and foreign exchange swap operations.

32. The Government i s committed to maintaining fiscal discipline. The 2009 budget w i l l be amended in July 2009 to reflect weaker growth and revenue prospects. The most recent statements by the Ministry o f Finance, following Poland’s application for a Flexible Credit Line from the IMF, suggest that the Government w i l l attempt to reach i t s original budget deficit goal o f PLN 18.2 billion. Because o f the slowdown in growth, the Government estimates that the budget deficit w i l l increase to 4.6 percent o f GDP in 2009, up from the original estimate o f 2.5 percent. Obviously stringent fiscal discipline would be needed to preserve market confidence, allow for further interest rate cuts, and meet the criteria for adoption o f the Euro in 2012.

A candidate to adopt the Euro as i ts currency must meet the Maastricht or Convergence Criteria, which are a set o f macroeconomic indicators that measure price stability (to show inflation i s controlled); soundness and sustainability o f public finances (through limits on government borrowing and national debt); exchange-rate stability (through participation in the Exchange Rate Mechanism for at least two years without strong deviations from central rate); and long-term interest rates (to assess the durability o f the convergence achieved by fulfil l ing the other criteria). For more details see http://ec.euroDa.eu/economv financelthe eurolioining euro94 13 en.htm.

14

33. Need for flexibility on the macro framework. This loan provides an opportunity for the World Bank to support the Government o f Poland in an uncertain environment in which the Bank’s support could contribute materially to increased confidence in the Government’s program, helping to lower i t s financing costs, reduce pressures o n the currency, and increase the feasibility o f maintaining a challenging trajectory to joining the Euro zone. The Government i s committed to initiating revisions to i t s budget after it has more information on the economic and budgetary record from the f i rst hal f o f the year. On M a y 6, 2009, the IMF Board approved an FCL o f US$20.58 billion, which i s based on the country’s track record rather than specific conditionality connected to the current policy regime (see the B o x 3).

Box 3. IMF Flexible Credit Line

Excerpt from IMF Press Release No. 09/85, “IMF Overhauls Lending Framework,” March 24,2009

“The IMF i s introducing a new credit l ine for countries wi th very strong fundamentals, policies, and track records o f policy implementation. Access to the F C L credit l ine w i l l be particularly useful for crisis prevention purposes. FCL arrangements would be approved for countries meeting pre-set qualification criteria. Access under the F C L would be determined on a case-by-case basis. Disbursements under the FCL would not be phased or conditioned to policy understandings as i s the case under a traditional Fund-supported program. This flexible access i s justified by the very strong track records o f countries that qualify for the FCL, which give confidence that their economic policies will remain strong.

The pre-set qualification criteria are at the core o f the FCL and serve to signal the Fund’s confidence in the qualifying member’s policies and ability to take corrective measures when needed. A t the heart o f the qualification process i s an assessment that the member (a) has very strong economic fundamentals and institutional policy frameworks; (b) i s implementing-and has a sustained track record o f implementing-very strong policies, and (c) remains committed to maintaining such policies in the future. The relevant criteria for the purposes o f assessing qualification for an F C L arrangement include: (i) a sustainable external position; (ii) a capital account position dominated by private flows; (iii) a track record o f steady sovereign access to international capital markets at favorable terms; (iv) a reserve position that i s relatively comfortable when the F C L i s requested on a precautionary basis; (v) sound public finances, including a sustainable public debt position; (vi) low and stable inflation, in the context o f a sound monetary and exchange rate policy framework; (vii) the absence o f bank solvency problems that pose an immediate threat o f a systemic banking crisis; (viii) effective financial sector supervision; and (ix) data transparency and integrity. Strong performance against al l these criteria would not be necessary to secure qualification under the FCL, as compensating factors, including corrective policy measures under way, would be taken into account in the qualification process.”

34. Management o f Macroeconomic Risks. In approving Poland’s FCL, the IMF concluded, “The authorities have responded in a timely and effective manner to the global downturn. They have embarked on a monetary loosening cycle, and stand ready to cut rates further if downside risks to the economy materialize. Financial sector stability has been safeguarded, through liquidity provision and intensified surveillance. Despite the slowdown in growth, the authorities remain committed to the 2009 state budget, primarily by cutting expenditure at the state level. They reaffirmed their full commitment to strengthen the medium-term fiscal framework to maintain a sustainable path for public

15

debt.”6 Acknowledging that Poland continues to operate in an extremely uncertain economic environment with a high risk o f a further deterioration, the Government has agreed to a condition o f effectiveness requiring that the government has initiated the process o f revising i t s 2009 budget in form and substance consistent with the measures being supported by the Program. This condition aims, in particular, to review continued compliance with the f i rst prior action o f this loan, “Satisfactory continued implementation o f the 2009 budget in light o f the changed economic outlook (including consideration o f EC and IMF assessments)”. This effectiveness condition would provide up to 90 days after signing for review o f 2009 budget implementation.

35. To improve the quality of public financial management, the Government i s gradually pushing ahead with reforms aimed at ensuring sustainable fiscal consolidation. A new law on public finance was submitted and i s currently being discussed in Parliamentary committees. The Government expects the measure to be passed in the fall o f 2009. The draft law incorporates an organizational consolidation o f budgetary units and institutional measures that would make the budget more transparent and predictable over the medium-term (through a 4-year budget planning horizon), and more performance oriented. The draft law also aims to take corrective measures triggered by increases in public debt and to strengthen expenditure control through new regulations on internal control and external audit.

36. To boost labor force participation, the Government has launched a package of measures to reduce incentives for people to remain inactive that have been created by social transfers and associated taxes, particularly among women and older workers. The tax wedge on labor was substantially reduced by a cut in payroll taxes by seven percentage points in 2007 and 2008. The Government also prepared a comprehensive program, known as “Intergenerational Solidarity - 50+”, which includes a number o f incentives to stimulate labor force participation by older workers, in particular a substantial tightening o f early retirement provisions. “Bridge pensions” for those employed in special difficult conditions, effective from 2009, replaced generous early retirement schemes. The Government expects these reforms to reduce the number o f people eligible for early retirement pensions from about 1.7 million to around 300 thousand. In the medium term, the Government intends to raise labor force participation by improving workforce sk i l ls and developing opportunities for life-long learning, reforming labor market intermediation services, improving the impact o f active labor market programs, supporting women willing to re-enter the labor market after child birth, and promoting longer working lives through social campaigns.

37. To support and complement reforms to the labor market, the Government has pursued a program of reform in education. The Government’s education reform agenda aims to reduce the gap between needs and available sk i l ls in the labor force, to develop flexible sk i l ls and a strong base for lifelong learning, and to address long- standing problems in the financing o f higher education and research. I t i s struggling to

“IMF Executive Board Approves US$20.58 Billion Arrangement for Poland Under the Flexible Credit Line,” Press Release No. 091153, May 6,2009. Accessed May 13,2009 at http://www.imf.ore/external/n~/sec/~r/2009/~rO9 153.htm

16

adjust the education system to a declining population while redeploying limited resources to increase i t s competitiveness and the equity o f i t s subsidies for human capital investments.

38. At the primary and secondary levels of the education system, the Government’s reform objective i s to adjust to demographic trends that will not be easy to change. Since 2000, primary and secondary enrollments have dropped by almost 1.5 mi l l ion students to about 5.5 mil l ion in total. Two major constraints slow the adjustment o f teachers and schools to the number o f students. The Teacher’s Charter governs employment relations between al l levels o f government and teachers. It limits the ability o f municipalities to demand more from their teachers or to reduce their numbers. A second constraint i s a requirement that the capitation-driven education subvention not decrease in total amount below the previous year’s level; hence localities with falling numbers o f students are under less pressure than they otherwise would be to make appropriate adjustments. The response o f Government has been to give municipalities more tools to adjust supply to demand at the primary levels o f the education system while also taking this opportunity to pull younger cohorts - ages 6, 5,4, and 3 - into schools both to prepare them for formal education and to use excess educational resources more effectively.

39. The Government’s reform strategy in education charts a course of actions to improve secondary and tertiary instruction and to increase the efficiency of research spending. At the secondary level, the Government has increased quality by delaying the tracking o f students into vocational education and by simplifying the vocational track so that it converges with general education. The success o f this effort has led to improvements in Polish students’ performance on international examinations and, in turn, to an even more energetic effort to converge tracks and delay tracking to the tenth grade. At the university level, the Government’s focus i s to rationalize public subsidies in higher education and become one o f the f i rs t Eastern European countries to start allocating state-financed tuition and housing subsidies as wel l as subsidies for student loans based on need, starting in 2010. Finally, the Government i s preparing reforms to increase the relevance o f research. As o f 2009, Poland is increasing allocations to research while trying to move from a preponderance o f basic research to a greater share o f research with a direct impact on the economy. I t i s shifting as wel l to a system o f professionally refereed, competitive grants.

40. The key challenges of health sector in Poland are to maintain services to all during a financial downturn, to achieve higher efficiency in resource allocation, and to improve the quality and appropriateness of service delivery. In this regard, the major impediment for two decades has been the overhang o f an economically unviable hospital sector characterized by excessive infrastructure and beds. Despite substantial progress rationalizing the hospital network and cutting down the number o f beds, with important exceptions, hospitals have continued to accumulate public debts (failure to pay social security and other taxes) and c iv i l debts (borrowings and receivables owed to suppliers).

17

41. The Government plans to address the hospital debt problem through an initiative to corporatize hospitals under commercial law so that debts are treated as for a commercial enterprise, subject to commercial audit standards and bankruptcy. Corporatization w i l l be done initially using a voluntary approach because a law making it compulsory was vetoed in early 2009. The voluntary window was opened by a resolution by the Cabinet o f Ministers taken in February 2009, with implementing arrangements approved in May 2009. In the past eight years, 72 hospitals have been corporatized as a result o f local government decisions. 90 percent o f these hospitals are current in their accounts. In contrast, the roughly 630 hospitals operating as government organizations have run up about PLN10.5 billion o f debt on roughly PLN25 billion in annual revenue (a 42 percent debt-to-revenue ratio, about 25 percent in public debt and 75 percent in debt to other f i rms and banks). The Government expects about 210 hospitals to join the corporatization program. The public hospitals w i l l be liquidated, with the MOF financing the public debt and the local authorities taking on most o f the private debt. When a hospital emerges from liquidation as a new entity under the commercial code, it will be debt free, w i l l be operating under an approved 5-year restructuring program, and w i l l be monitored twice yearly for financial and technical adherence to the program. The M O H and NFZ estimate that virtually all hospitals can operate on a cash basis, with the revenues they earn, once current debt service requirements are removed. The corporatized hospitals are expected to have surpluses once they emerge from liquidation, which would allow them to invest in themselves as well. The program w i l l be monitored through yearly reports to the Council o f Ministers.

42. T o further rein in costs, Poland i s implementing DRGs (Diagnostically Related Groups) as a cost accounting mechanism in all facilities in 2009. This i s a major step forward in shifting reimbursements from inputs to outputs. DRGs will allow NFZ to stop reimbursing hospitals based on their activities and start paying a predetermined rate based on a patient’s diagnosis. DRG financing creates an incentive for hospitals and doctors to economize in the use o f resources. I t facilitates cost comparisons across facilities and the use o f treatment protocols to improve patient care.

43. The corporatization of hospitals allows the MOH and NFZ to improve the accreditation and regulatory framework under which hospitals and clinics operate. The M O H has drafted enabling regulations to develop this framework, which will create a tool that can be used in conjunction with DRG-based reimbursements to raise the cost- effectiveness and quality o f the health services being financed. Other reforms, including the introduction o f a multiple competitive private insurance system and the expansion of long-term care services, are seen as longer term challenges for which the Government i s beginning to develop options. Monitoring and evaluation remains an underused tool in the health sector even though excellent methods are now available to improve the efficacy o f spending, and the Government plans to begin developing this capability as part o f i t s performance-base budgeting initiative.

IV. POLICY FOCUS AND THE BANK-SUPPORTED PROGRAM

44. The EU has become Poland’s main external partner. The EU has committed EUR 67 billion in grants to Poland over the period 2007-2013, equivalent to about 4

18

percent o f Poland’s GDP per year, to support income convergence o f the country and i t s regions with the wealthier parts o f Europe. This support is focused on development o f a knowledge economy and infrastructure. The EIB has increased i t s lending substantially in recent years to provide co-financing for the EU structural and cohesion funds through loans on attractive terms. Further increases are envisaged in response to the ongoing global financial and economic crisis. The EIB has traditionally focused o n infrastructure projects (especially transport) but has become more involved in other sectors o f the economy, including sub-national lending. The EBRD has largely phased out o f Poland and the EU’s new member states, as has the IFC, although this may change again in response to the crisis.

45. The Bank adds value to Poland’s convergence agenda by focusing its support in areas where it has an established track record of experience, particularly public financial management, labor market efficiency, structural improvements to the social sector expenditures, and encouraging a culture o f evaluation and performance. The Bank has worked with the Government to marshal knowledge and international experience o n performance based budgeting and the effective use o f MTEF. The Bank’s labor economists have engaged with the Government on reform o f unemployment insurance, increasing flexibility in the labor market, encouraging labor market participation, and making active labor market programs more cost-effective. Their work has been complemented by technical collaboration with the ministries handling education, science, and higher education on issues in education financing, testing, and shifting the focus to general education and life-long learning. The Bank has been engaged for over a decade in support o f Poland’s pension and health sector reforms.

46. These engagements complement the EU’s Lisbon Agenda in support of growth and competitiveness. Both education and health are largely excluded from the EU Acquis Communuutuire and EU-support programs. The World Bank was deeply engaged with Poland in these areas prior to accession in 2004. Subsequently, i t has maintained technical involvement through cross-country AAA focused o n the accession countries, and in education i t re-engaged technically beginning in 2008.

4.1. LINK TO COUNTRY PARTNERSHIP STRATEGY

47. The second operation in the program i s being presented alongside a new Country Partnership Strategy (CPS). As described above, the CPS aims to situate the Bank’s engagement in Poland firmly in the context o f other external partners and focuses o n niche areas o f engagement where the Bank can add value. The Bank’s strategic partnership with Poland i s based on four pillars: (i) Growth and Competitiveness; (ii) Public Sector Reform; (iii) Social and Spatial Inclusion; and (iv) Regional and Global Public Goods. Public financial management reform, labor market efficiency and social sector reform are key elements o f the f i rs t three pillars. As such, the pol icy lending series provides an anchor for the strategic dialogue between the World Bank and the Polish authorities, supported by analytical work and technical co-operation activities.

19

Box 4. Supporting High and Sustainable Economic Growth in Poland over the Medium Term

Although recent economic performance has been impressive, Poland still faces constraints which may slow down the real convergence process. In 2007, Poland’s GDP per capita at purchasing power parity amounted to 53.6 percent o f the average for the EU-27. A continued rapid reduction o f the income gap requires high and sustainable growth based on productivity increases, higher employment, and increased investment rates. Potential medium- to long-term growth rates are estimated at around 4.5 percent, assuming a continued gradual increase in employment rates, rapid investment growth, and continued robust productivity growth. There i s broad consensus among the government and i ts international partners that policy interventions aimed at promoting high and sustainable growth should be focused on the following three broad areas that characterize this policy program:

(a) Public finance and administrative reforms aimed at continued fiscal consolidation, lowering o f the tax burden, re-orientation o f spending towards more productive areas, improved public financial management, and improved public administration (public finance and administrative reform);

(b) Promoting private sector investment through an improved investment climate, more product market flexibility, and restructuring o f key sectors (structural reforms); and

(c) Increasing labor force participation and employment to mher reduce poverty and encourage social inclusion (labor supply mobilization).

Public finance reforms are required to improve the quality and efficiency of public finances. Further fiscal consolidation i s needed to improve macroeconomic stability and provide room for countercyclical fiscal policy. A lower tax burden and simpler tax system would encourage formal private sector activity. A re-orientation and restructuring o f spending would provide fiscal space for increased productive spending, notably on infrastructure, and improved outcomes in health and education. Public financial management reforms would improve the transparency and predictability o f public finances. Public administration reforms would improve management, service delivery, policy coordination, and a capacity and results orientation at a l l levels o f government (including the reform and modernization o f Poland’s courts).

Structural reforms are needed to improve the general investment climate and support the restructuring of low-productivity sectors. Poland ranked 76 out o f 181 countries on Doing Business Indicators. For starting a business, construction, and paying taxes, it ranked 142 or worse. Further deregulation that includes a simplification o f its onerous legal, tax, and administrative environment for entrepreneurship and business development continues to be a priority. In addition, by restructuring sectors such as coal and energy generation, removing incentives for people to remain in low- productivity agriculture, and accelerating the privatization process (including in what are considered strategic sectors), the Government could facilitate a faster shift from old industrial, low-productivity sectors to new job-rich, high-productivity sectors.

Labor suppry mobilization i s needed to raise low employment rates, not least among the older cohorts and women, and to improve the skills of the workforce. Reform o f the system o f social protection and labor taxation, development o f more flexible forms o f employment, improving and evaluating active labor market programs targeted at disadvantaged groups, and promoting life-long learning are important actions to increase labor force participation and productivity. The Government’s actions to l imit the number o f professions entitled to early retirement i s in line wi th the principles o f the pension reform introduced in 1999 and supports increased labor force participation. Yet i t s t i l l has a pressing need to increase the pace o f reform in the education system to improve labor market relevance and skills. While outward migration has been a concern following EU accession, remittances have been substantial, and people are beginning to return as economic prospects improve at home.

Source: New Poland Country Partnership Strategy

48. The overarching goal of the CPS i s to support Poland’s convergence towards

20

EU living standards. The program o f pol icy lending i s an important instrument in the strategy. In the short term, as Poland faces an outlook o f high economic uncertainty created by the global economic crisis, i t wil l be important for the Bank to support adequate social safety nets during the economic downturn and changes in labor market regulation likely to accelerate economic recovery. In the medium-term the program i s not yet wel l defined but wil l support the resumption o f growth and convergence with EU living standards. N e w modalities o f engagement are being explored, including sub- sovereign activities and a move towards cost-sharing or fee-based services.

4.2. RELATIONSHIP TO OTHER BANK OPERATIONS

49. The reforms supported in the program will benefit from prior Bank financed assistance at the local level. The Post Accession Rural Support Project (PARSP), approved by the Bank in 2005, provides assistance to rural gminas to enhance the capacity o f local governments to identify, plan, and execute social protection strategies through a Social Inclusion Program (SIP). The project i s implemented in 500 rural gminas, where it has helped to increase the capacity o f local governments as well as to engage communities - by emphasizing participation and building on social capital - in monitoring the use o f resources and social transfers. As the reforms supported by the program o f pol icy lending help to put more decisions into the hands o f local authorities, the capacity created with support o f the PARSP will become critical. The Bank has also provided support to the agricultural insurance fund (KRUS) reform to improve the efficiency o f the KRUS Agency by strengthening its administrative and analytic capacities, i t s management, and i t s decision-making processes.

4.3. ANALYTICAL UNDERPININGS

50. The specific measures supported by the program have been identified through analytical work conducted prior to and in parallel with loan preparation. The measures selected for support in the second and third pol icy loans are fully owned by the government and address core policy issues in each o f the sectors. In many cases, the economic and financial crisis has given specific actions particular urgency, as explained in this section, and the pressure may mount during the coming months for additional structural reforms to reduce long-term expenditure obligations while redirecting resources in the short term to the social protection system to respond to additional demands in the constrained fiscal environment.

51. The reform of public financial management practices has become even more important than before the crisis. Two major reforms -the introduction o f medium-term expenditure frameworks (MTEF) and performance-based budgeting (PBB) - have been central elements in improving the management o f public finances. MTEFs have been developed and refined by many countries to help build fiscal pol icy credibility and predictability v ia a strategic, multi-year, budget planning perspective. At the same time, PBB concepts and methods have been important in many countries to bring a greater focus on the results from government spending. International experience suggests that, implemented together, PBB and M T E F reforms can significantly raise the quality and consistency o f forward estimates o f public expenditures through common use o f policy-

21

based expenditure programs and program- and activity-based costing methodologies. These budget reforms have been on the agenda o f most new EU Member States and candidate c o u n t r i e ~ . ~

52. Poland has made substantial progress in the last three years in performance budgeting and will introduce a multi-year system of budget preparation. An indicative performance budget - including a programmatic breakdown o f expenditures, program objectives, and key performance indicators - i s now presented to the Parliament for information alongside the traditional annual budget. Further steps will be required to move from this promising start to a position where the budget is appropriated o n a program basis and budgeting becomes truly performance-informed. Accounting and financial management information systems would need to be reformed to support budgeting by program. Performance indicators and program evaluation mechanisms would be required. On-going refinement o f the program structure and definition o f program objectives would need to be institutionalized.

53. Improved institutional collaboration in the design and implementation of these reforms will be crucial to their success. The key element o f the government’s medium-term budgeting initiative i s a new Multi-Year State Financial Plan (MYSFP), to be voted on by the parliament. The MYSFP will be a four-year fixed plan covering the period o f each government’s te rm in office. I t i s not expected to set binding multi-year aggregate fiscal limits but wil l instead focus on improved fiscal projections and a statement o f the government’s medium-term fiscal policy. For this to make a difference to macro-fiscal policy, the required statement o f medium-term fiscal pol icy should be specific (e.g. including numerical fiscal targets) rather than general in nature. However, the most important requirement for improved medium-term budgeting in Poland i s a substantial improvement in the quality o f projections o f medium-term expenditures and revenues. Only on the basis o f much better projections will it be possible to properly assess, and then take action to ensure, the compatibility o f existing expenditure and revenue policies with medium term aggregate fiscal policy.*

54. With respect to the labor market, the priorities lie in maintaining (and hopefully increasing) labor force participation,, particularly among older people. Until 2007, the unemployment rate was in double digits and the employment to working age population ratio was around 55 percent, far below the Lisbon target o f 70 percent adopted by the EU. One major factor contributing to the l ow ratio was the l o w labor force participation rate among older workers, which i s the lowest in the EU. In addition, the incidence o f long-term unemployment was high, leading to labor market exclusion and poverty. Labor resources were thus substantially underutilized. In this context the

Kasek L., Webber D. (ed.), Performance-based budgeting and medium-term expenditurefiameworks in

The success o f performance budgeting and medium-term budgeting in Poland requires substantial Emerging Europe, forthcoming, World Bank Study.

additional capacity building, extending the thematic scope o f the major performance budgeting training effort which i s currently underway with EU support. Further technical support would be beneficial in a number o f areas, including accountinghancial management information systems, evaluation and performance indicator development.

22

Government has undertaken reforms aimed at increasing the employmentipopulation ratio, especially among older workers.

55. Recent improvements in employment and labor market efficiency will be challenged by the crisis. The improvements in economic activity and employment could be severely hampered by the global economic crisis. Since the last quarter o f 2008 the unemployment rate has started to increase again. The Government faces a challenge o f preventing large scale job losses, mass unemployment and labor market exclusion. I t i s focused on measures that wil l not only help employers and workers mitigate the costs o f the downturn but wil l also prepare the labor market for a recovery. T o cope with these challenges the Government recently initiated tripartite negotiations, including trade unions’ and employers’ representatives, on an “anti-crisis package.” In addition, the Government decided to reform the unemployment benefit system to strengthen job search incentives and to shorten the duration o f unemployment. Finally, the Government plans to improve the efficiency and targeting o f active labor market programs (such as (re)training, wage subsidies and public works) to help the unemployed find new jobs and prevent long-term unemployment.

56. Features of Poland’s retirement income security (pension) system encourage early retirement, at a substantial fiscal cost, and contribute to the low labor force participation of older workers. In most pension systems in the region the rate o f system dependency (the ratio o f beneficiaries to contributors) i s high relative to population dependency (the ratio o f elderly to the working age population).’ The number o f beneficiaries per contributor i s significantly higher than the ratio o f retirement-age population to working-age population, leading to high pension expenditures coupled with moderately l ow revenues and a fiscal problem. Two o f the most common reasons for the high system dependency rates are the high rate o f disability pensions awarded to those below the normal retirement age and the high rate o f early retirement pensions. Reducing these components wil l help bring down pension expenditures and help raise additional contribution revenue, bringing the systems closer to balance. Reducing incentives for choosing disability pensions and tightening the criteria for early retirement will both help to reduce system dependency rates and increase the fiscal sustainability o f the publicly managed pillar.

57. As privately managed, mandatory retirement savings gain in importance as a part of old-age income security, the funded pillar of the pension system will need to become more efficient. The payout options need to be designed so that they are flexible enough to withstand market fluctuations while protecting workers. The use o f multiple portfolios with a mandatory shift toward a fixed income portfolio in the years just prior to retirement i s being pursued as a way o f protecting workers against sudden drops in the valuation o f financial assets just prior to retirement. Measures40 lower costs to affiliates will help increase the balances available to participating workers when they retire.

See Mukesh Chawla et al. (2007) From Red to Gray: The “Third Transition ” ofAging Populations in Eastern Europe and the Former Soviet Union, available at http://go.worldbank.org/OOQO6F6QKO.

23

58. The foundation to accelerating Poland’s convergence with EU living standards, i s improving the return on the country’s investment in education. Total spending on education in Poland stood at 5.25 percent o f GDP in 2007, which i s slightly higher than the OECD average, but in absolute amount it i s less than hal f the OECD average because o f Poland’s lower GDP. H o w Poland spends its money o n education i s critical to i t s effectiveness in building human capital equitably and investing in i t s f i ture productivity and competitiveness.

59. Primary and secondary education are fully decentralized to local governments. Management o f schools became a responsibility o f local governments in 1999, the complete antithesis o f the old management structures relying o n central administration. Gminas manage primary schools. Powiats and Voivodeships are responsible for secondary and post-secondary schools. Public colleges and universities are funded directly by the State. The Ministry o f Finance transfers an education subvention to local governments through an algorithm that emphasize student enrollment. A share o f tax revenues (51% o f the personal income tax and 24% o f the corporate income tax) i s transferred to local governments, and an equalization grant that takes into account local revenues i s also distributed. These finds are transferred f rom the Ministry o f Finance to 2,487 municipal governments, over 300 counties, and 16 regions. Local governments autonomously decide how the money i s spent. In fact, they may fund non- educational expenditures with the education subvention, as it enters their budgets as an “unmarked” grant with no specific earmarking. In practice, local governments spend more than the amount o f the education subvention on schools, and for the country as a whole, i t covers approximately 100 percent o f the wage bill, with localities covering the remaining costs through other revenues.

60. At the primary and secondary levels of the education system, there has been a precipitous drop in the number of students, caused by demographic trends that will not be easy to change. Since 2000, primary and secondary enrollments have dropped by almost 1.5 mi l l ion students to about 5.5 mi l l ion in total. While some urban schools continue to grow, rural schools are extremely hard hit by the declining number o f children. In the past 4 years, college and university enrollments have leveled o f f at about 2 million, after nearly tripling in the 1990s. Unless Poland’s already high enrollment rate at the tertiary level, which stands at about 50 percent today, continues to increase, the smaller cohorts will soon also drag tertiary enrollments down. I t is dif f icult for the system to adjust fast enough to maintain efficient use o f education finds. The Teacher’s Charter limits both the ability o f municipalities to demand more from their teachers and to reduce their numbers. The figure below shows the inadequate adjustment o f the number o f teachers to the decline in the student population. As this discrepancy is compounded year by year, the stock o f teachers relative to the stock o f students has become increasingly distorted: a 16 percent decline in students was accompanied by only a 6 percent decrease in teacher full time equivalents. A second constraint requires that the education subvention not decrease in total amount below the previous year’s level; hence localities with falling numbers o f students are under less pressure than they otherwise would be to make appropriate adjustments. Municipalities require more flexibility to adjust supply to demand at the primary levels o f the education system while also taking this opportunity to pull younger cohorts - ages 6, 5, 4, and 3 - into schools

24

both to prepare them for formal education and to use excess educational resources more effectively. The latter effort should increase Poland’s l o w enrollment o f children in preschool and correct the inequity caused by much higher enrollment rates in cities relative to rural areas.

Figure 2. Dynamics of enrollment and teachers employment 2000-2007

2001 2002 2003 2004 2005 2006 2007 O,O%

-0,5%

-1 ,O%

-1,5%

-2,0%

-2,5%

-3,0%

-3,5%

-4,0%

I

I year to year change in the number of teachers year to year change in the number of students

-4,5% ‘

61. At higher levels of education, the priorities are to improve quality and to achieve greater equity. At the secondary level, the Government has increased quality by delaying the tracking o f students into vocational education and simplifying the vocational track so that it converges with general education. The success o f this effort has led to improvements in Polish students’ performance on international examinations and, in turn, to an even more energetic effort to converge tracks and delay tracking to the tenth grade. In addition, the Government has overhauled achievement testing by introducing external exams at a l l levels and reforming the school-leaving exam (matura) at the secondary level. Recently the authorities added foreign language testing to both types o f exams and for the first time in 2009/10 will introduce mathematics testing to the matura. At the university level, a hallmark o f Poland’s development since 1989 has been a flourishing network o f private institutions to meet an explosion o f pent-up demand for tertiary places. Unfortunately, the system o f financing has not kept pace with the change in the composition o f students and the market. Merit-based, all-expenses-paid entrance to public university day classes has always skewed public subsidies to better-off households, but the introduction o f unsubsidized night classes and full-cost private options for students not qualifying for public subsidies has made outcomes more inequitable. To a large degree, better-off families succeed in getting subsidies and poorer

25

families pay. A subsidized student loan program was introduced, but take-up by banks and students has been low, as the design o f the program makes it unattractive to potential lenders and borrowers. Starting in 2010, Poland will begin to rationalize public subsidies in higher education and become one o f the f i rst Eastern European countries to start allocating a significant share o f state-financed tuition and housing subsidies, as wel l as subsidies for student loans, based on need.

62. Poland's performance in improving health through ambitious reforms of the health sector has been impressive. Through a series o f reforms since 1997, the Government has achieved virtually 100 percent coverage o f the population through its public health insurance system, using a combination o f social health insurance and general budget financing. Workers who lose their jobs retain insurance and access to services, but the payment o f premiums is shifted to another source o f funds. A measure o f the relative success o f Poland in improving health outcomes i s shown in Figure 3, which compares Poland with its neighbor, Ukraine, as well as the EU countries before 2004. Although health care i s only part o f the explanation, o f course, Poland has been one o f the best performers in Eastern Europe in improving health. Convergence with the EU, never feasible before 1990, becomes possible as the rate o f improvement has started to accelerate.

Figure 3. Life Expectancy at Birth, in Poland and Neighboring Countries

Source: WHO Health for All Database

May2004

63. The measures supported by the program are aimed at modernizing the hospital network. Poland's ability to reallocate funding to primary and preventive programs has been limited by i t s inherited stock o f outmoded, costly, and inefficiently large hospitals. L ike schools, the hospitals are owned by local governments and other entities such as universities, so the central government can only affect decisions through the insurance payment mechanism, legal requirements, and incentives. Nevertheless, the

26

Government has whittled away at the number o f beds successfully since 2005, which reduces costs and has begun to “right-size” the system relative to the need for beds. However, with important exceptions, hospitals have consistently accumulated public debts (failure to pay social security and other taxes) and c iv i l debts (borrowings and receivables owed to suppliers). The program o f hospital “corporatization” launched by the Government this year, supported by this loan, i s key to increasing efficiency o f health service delivery.

2003 2004 2005 2006 2007 Total 44.6 42.6 43.3 43.8 42.2 General public services 6.3 6.3 6.3 6 5.5 Defence 1.2 1 1 .I 1.2 1.4 Publicorder and safety 1.7 1.6 1.7 I .8 1.8

1 Economic affairs 3.4 3.4 3.8 4.4 4.6 I Environmental protection 0.6 0.6 0.6 0.6 0.6

Health 4.3 4.2 4.4 4.6 4.6

Education 6.1 5.7 6.1 6 5.7 Social protection 18.8 17.6 17 16.9 15.8

Housing and communityamenities 1.4 1.4 1.4 1.2 1 .I

Recreation, culture and religion 1 1 1 1 .I 1 .I

V. THE PROPOSED POLICY LOAN

64. This i s the second lending operation in a program of three. The second lending operation (PL2) wil l support reforms to public financial management, further steps to strengthen the private sector, structural measures to improve labor market efficiency, greater openness to private sector development, and reforms to the finance and provision o f health, education and social protection. The latter three areas account for about 62 percent o f public spending, down from 65 percent in 2003. O f spending on social protection, 9.4 percent o f GDP i s spent on old age pensions. See Table 5.

Table 5. General Government Expenditure, by Sector

(Percentage o f GDP)

Source: Eurostat

5.1. PROGRAM OBJECTIVES

65. The second lending operation will continue to support the convergence agenda, but will focus more narrowly on sector reforms. The f i rs t loan in the program (PL1) supported a broad range o f pol icy actions to strengthen public finance management, improved business environment, and higher labor market participation. The policy actions taken by the Government prior to presentation o f the f i rst loan to the Board included: satisfactory implementation o f the 2008 budget and presentation o f 2009 budget bill consistent with the Convergence Program; a reduction in payroll taxes to lower the cost o f labor; elimination o f required work permits for foreign workers from neighboring countries to increase the labor supply; tightening eligibility requirements for disability benefits; legislation that reduces the minimum capital required to start a

27

business; and the approval o f a privatization program encompassing the sale o f 740 state owned enterprises. As reported in the sections below, the Government has met al l the triggers agreed for the second operation PL2.

66. The second lending operation in the program (PL2) will continue to support reforms initiated with the first loan while broadening the focus to include structural improvements in, and maintenance of, critical programs in the social sectors. In the months since the f i rst loan was disbursed, the external economic environment has changed substantially, causing growth in Poland to slow sharply. To better manage the uncertainty that the economic crisis has introduced to Poland’s outlook and fiscal targets, as well to push ahead with reform o f public financial management, the Government is now focusing on the part o f the program specifically targeting the labor market, education, health and social protection. The second operation has the fol lowing development pol icy objectives: (i) to support structural reforms that will ensure fiscal consolidation over the medium term; (ii) to protect priority investment programs and the up-front fiscal costs o f structural reforms critical to meeting Poland’s goals o f convergence with the rest o f the EU; and (iii) to mitigate the social cost o f the economic crisis. In taking stock o f the Government’s progress in meeting the triggers for PL2, i t s careful fiscal management amidst growing constraints; policy achievements in education and health; and the steps it has taken to mitigate the impact o f the crisis, should be taken into account.

5.2. REFORMS SUPPORTED BY THIS LOAN - PRIOR ACTIONS FOR PL2 (see Annex 2 Policy Matrix)

67. Public Financial Management. AAer three years o f strong economic performance, even though Poland is faring better than other countries in the region, the global financial crisis has worsened i t s macroeconomic and fiscal outlook. With fewer resources and in a fast evolving economic environment, the Government faces a dif f icult challenge to reconcile longer term with shorter term fiscal objectives. In public financial management, PL2 supports three prior actions:

Satisfactory continuing implementation of the 2009 budget in light o f changing economic circumstances. In January, line ministries were prepared for the need to curtail discretionary expenditure by 10 percent. Certain priority expenditure items were protected from expenditure reductions. For example, in the education sector, the per-capita transfer to sub-national governments was set aside before the 10 percent savings were identified; while in health, financing for specific public health programs was set aside. The Government is expected to present a supplementary budget in late June or July that makes the January cuts permanent and may include other cuts and revenue measures. As a condition o f effectiveness, the Government has agreed to initiate the process o f revising its 2009 budget in form and substance consistent with the measures being supported by the program. Throughout the program, the Bank wil l continue to consult with the IMF and the E C on their assessment o f Poland’s fiscal pol icy stance.

28

. Further advances in the preparation and introduction of performance-based budget and medium-term expenditure framework (MTEF). These institutional reforms can help to prioritize expenditures and support medium-term fiscal consolidation. The introduction o f a performance-based budget for 2009 was a major achievement. As part o f the 2010 budget preparation, Government envisages broadening the coverage, improving the classification o f functions, clarifying objectives, and developing indicators.

Submission to Parliament o f the amended Law on Public Finance: The law, which incorporates institutional measures to improve public financial management, was submitted to Parliament in late 2008 and is expected to be adopted by Parliament in fal l 2009. The amended law includes provisions for a four-year rol l ing medium-term expenditure framework.

68. Private Sector Reforms. The Government has focused on two specific aspects o f private sector development: improving i t s regulatory interface with businesses and continuing to privatize remaining state-owned enterprises. The privatization program was rejuvenated by the current government after lapsing for several years. In both aspects, the prior actions agreed for PL2 have been met, namely: . Amendment of the Law on Freedom of Business Operations to unify and

coordinate business inspection procedures, scheduling and duration among all inspection authorities. The Act was amended in late 2008, and the changes in business inspection have been in full effect since March 2009. This amendment limits the amount o f time inspections can take place and the number o f inspections that a business can be subjected to at the same time. I t opens additional avenues o f appeal for business owners who dispute inspection findings. The amended law creates a “one-stop shop” for business licensing and registration, makes it substantially less onerous for businesses to cease operations either temporarily or permanently, and reduces the ability o f government officials to reject regulatory submissions for incompleteness, allowing them to be amended. In addition, the Government began an intensive effort to catalogue al l inspections done by al l branches o f government to remove additional redundancies and inconsistencies, with the intention o f reorganizing l ike activities into one agency. This work wil l be supported by PL3.

Offer of the first 80 public sector enterprises in the privatization program (or those constituting 10 percent o f aggregate asset value) for sale on the market (through stock exchange or by auction) or via competitive tenders. Despite difficult market conditions, out o f 740 firms in i t s privatization program, the Government sold shares o f 75 companies in 2008 and 11 in 2009, or 86 in total. The program continues to put together packages for sale and has recently introduced auctions. Large power f i r m s are expected to be sold in 2009 (Enea) and 2010 (Tauron and Energa), causing a steep rise in expected revenues from the program at exactly the time that the Government may have additional financing needs due to the economic downturn.

.

29

69. Labor Market Reforms. Turning to labor and employment, the Government has continued to implement the reform program documented in PLl . Key prior actions for the second lending operation are:

. Implementation of the government program to increase labor force participation of older workers, known as “50+.” In 2008 the Government markedly reduced the tax wedge for labor by reducing disability payroll taxes by six percentage points. A second major issue the Government has faced i s the l o w participation rate o f older workers. I t has addressed this problem by reducing eligibility for early retirement, reducing some o f the social security contributions as they near retirement age, and making older workers eligible for employment services. These changes have been implemented in the f i rst quarter o f 2009. In addition, legislation is being prepared to allow those with disability pensions to work without losing their benefits. . Improvements to the incentive structure of unemployment benefits. Legislation was enacted in December 2008 to raise benefits to improve the consumption-smoothing function o f unemployment insurance, but at the same time benefits were reduced after 3 months o f unemployment to encourage j o b search. These changes have been implemented as o f January 2009.’’

70. Education Sector Reforms. There has been substantial progress in reforming Poland’s education system, focused on expanding access to preschool education and improving the efficiency and quality o f primary and secondary education. Current reform efforts in higher education are also set to deliver more equitable access and more relevant ski l ls among graduates. The lending program recognizes this progress. K e y actions taken by the Government supported by PL2 are: . Legislation approved that initiates a compulsory pre-primary program for 5

year-old children (Grade 0) starting from 2011/12 and begins voluntary implementation in 2009/10. The same law initiates a compulsory school program for 6 year-old children from 2012/13. Given 40 years o f accumulated evidence o f the impact o f early childhood education in helping children succeed once they are in formal school, Poland will require 5-year-old children to enter school beginning in the 201 1/12 school years. These children will then become the first mandatory class o f 6-year-olds in regular primary school the fol lowing year. Up to that point, it wil l be voluntary for 5-year-olds but mandatory for 6- year-olds to be in kindergarten. This reform wil l help Poland catch up to other EU members in investing in the early participation o f children in formal education.

~~ ~ ~ ~~ ~~

lo Currently the unemployment benefit i s a flat rate set at P L N 504 (for comparison, the minimum wage in Poland i s PLN 1260). From January 2010, the amount w i l l rise to P L N 717 during the f i rst 3 months o f unemployment, and to P L N 580 thereafter. The maximum duration o f benefits i s 6 months in powiats (districts) where the rate o f unemployment i s less than 125% o f the national average, 12 months in powiats where unemployment i s less than 200% o f the national average, and 18 months where unemployment i s greater than 200% o f the national average.

30

. Development of primary and secondary education: The other elements o f the matrix capture the Government’s efforts to help municipalities manage the reduced need for classrooms and teachers as cohort sizes shrink; to attract and retain young, well educated teachers by raising entry-level salaries relative to those o f older teachers; and to improve quality and outcomes through the reform o f vocational education, improved testing, and analysis o f test results to improve schooling.

7 1. Health Sector Reforms. Poland has developed a robust and adequately financed health insurance program that protects citizens from the adverse consequences o f health costs. For years i t has struggled with a number o f efficiency problems that are being effectively addressed by the Government through a series o f structural reforms. For example, a key element o f health sector reform that has never been successfully tackled has been the tendency o f hospitals to accumulate debt, which i s periodically paid o f f at tremendous cost to national and local government budgets, only to be run up again. In addition, incentives to control costs in the hospital sector have never been successfully imposed. The resultant drain on resources for hospitals has l imited authorities’ ability to shift resources to programs that would be more effective in improving the health o f the population. A core structural initiative o f the Government i s to gain control over these persistent problems. Supported by PL2, key actions in the Governments program are: . Approve an implementation plan for the participation of public hospitals in a

voluntary program that would convert them into corporate entities operating under the Commercial Code. . The Government has developed a program to corporatize hospitals under commercial law. After a veto by the President in February 2009, and supported by a Cabinet Resolution, the original plan to make this change compulsory will be implemented as a voluntary change o f status. By M a y 2009, the voluntary program wil l open for business. Once corporatized, hospitals wil l fol low commercial financial reporting requirements and wil l face the possibility o f bankruptcy if they cannot pay their bills. . Adoption of DRGbased payments system for 90 percent of all payments from NFZ to hospitals. A complement to the corporatization program wil l be to account for costs in hospitals and outpatient clinics using Diagnostically Related Groups, which gives the insurance system a tool for reimbursement that shifts from inputs to outputs and which has an in-built incentive structure to reduce costs and to standardize care against treatment guidelines for diagnostically related conditions. 2009 wil l be the f i rs t full year o f using DRGs to account for costs. In 2009 and 2010 they wil l be analyzed and will start to affect tariffs paid by NFZ, the national insurer. . Other elements of the reform program complement these structural changes with similar efforts for hospitals that cannot participate in the corporatization program and initiatives to improve the quality o f care and evaluation o f programs in health.

31

72. In Social Protection - starting with contributory social insurance/pensions - the Government has made substantial progress. To increase the long-term financial sustainability o f the publicly financed part o f the pension system, the key prior action for PL2 is:

Enactment of the L a w on Bridging Pensions reducing the number of people eligible for early retirement from 1.7 million to 300,000, while safeguarding the base level of pensions for persons affected by the change. This reform i s expected to increase the effective retirement age, increase participation in the labor market, and improve fiscal sustainability, while maintaining the base level o f pensions for those close to retirement age.

73. The Government has made substantial efforts to secure passage of additional legislation to strengthen the pension system but has faced political opposition. The Government recognizes the importance o f making the disability/survivor benefit consistent with the reformed f i rst pillar old-age benefit. A draft law was presented by the Government and adopted by the Parliament, but it was vetoed by the President. Similarly, an annuity law that defines the payout provisions for the lifetime pension from the funded pillar (which was originally envisioned as a trigger for PL3) was presented and adopted by the Parliament in December 2008, but this measure was also vetoed by the President. The path forward for these measures i s unclear at the moment given the political obstacles. However, on both counts, while legislation would be desirable now, it i s not urgently needed, and it wil l not be essential until cohorts with a significant balance o f accumulated savings in their private retirement accounts begin to retire in 2014. MLSP estimates they have a 5-year window for a more favorable political environment to submit these reforms again.

74. In social assistance, the single priority i s to ensure that a responsive safety net can meet greater needs anticipated in the wake of the economic crisis. The Government, led by the PMO, has taken the initiative on a number o f fronts to prepare for increased vulnerability, as described in earlier sections. Reflecting the imperative to prepare Poland’s social assistance programs for the crisis, the key prior action taken by the Government, supported by PL2 is:

Provision of a reserve in the 2009 budget to protect households vulnerable to the crisis: The higher levies on alcohol and luxury cars passed in 2008 are generating a PLN 1140 mi l l ion reserve to address the needs o f households made vulnerable by the economic slowdown. The Government i s mapping the areas o f the country where households and workers are especially vulnerable to an economic downturn.

75. prior actions that were part o f the loan agreement.

Table 6 summarizes progress for the core prior actions for PL2. These are the

Table 6. Agreed Prior Actions for the Second Policy Loan, P L 2

Area Prior Action Status Public Financial Management

32

Area Prior Action Status 1. Satisfactory continued implementation of the 2009 budget in light of the changed economic outlook. Assessment of EC and IMF would be considered.

Done, although i t i s a dynamic process that our assessment and loan documentation acknowledge. Government plans a supplementary budget to adjust to changed economic conditions. IMF assessment for FCL i s complete and positive. The next Art icle 4 consultation i s planned for June. The EC excessive debt procedure will be considered in formulation of the 2009 supplementary budget and beyond.

2. Submission to Parliament of amended Law on Done. Public Finance.

3. Implementation o f the government program to increase labor force participation of older workers, known as “50+”

4. Enactment of the Law on Bridging Pensions which reduces the number o f people eligible for early retirement from 1.7 mission to 300,000, while safeguarding the base level of pensions for those affected by the change. .

5. Amendments to the Law on Freedom o f Business Operations that unify and coordinate business inspection procedures, scheduling and duration among all inspection authorities. , 6. Offer for sale on the market (through stock exchange or by auction) or via competitive tenders the first 80 public sector enterprises in the program (or those constituting 10 percent of aggregate asset

Labor Market Reforms Done: Program reduces the cost o f employment and ensures the availability of public employment programs to older participants in the labor force.

Done. Law passed and signed by President. Pension Reforms

Private Sector Development Done. The Government amended the law in late 2008 and the changes introduced have been in full effect since March 2009.

Done.

Health Sector 7. Approval of an implementation plan for the participation of public hospitals in a voluntary program that would convert them into corporate entities operating under the Commercial Code. 8. Adopt DRG-based payments system for 90% of all payments from NFZ to hospitals.

9. Pass a law to initiate a compulsory pre-primary program for 5 year-old children (Grade 0) starting from 201 1/12 and begin implementing it on a voluntary basis in 2009/10. The same law initiates a compulsory school program for 6 year-old children from 2012/13. [Mandatory for 6 year-olds today in kindergarten; compulsory in regular primary school

Done: The program will begin with authority of the Council of Ministers by mid May.

Done: DRGs are being implemented, data available beginning in 2008.

Done: Law has been passed. Education Reform

Social Assistance 10. Provision for a reserve in the 2009 budget to protect the vulnerable affected by the economic downturn.

Done. The Social Solidarity Reserve (PLN 1.14 billion) i s in the State budget for 2009. I t i s financed from an increase in the excise tax on alcoholic drinks and cars with engine capacity above 2000 cm3.

33

5.3. CONTINUATION OF THE REFORM PROGRAM DURING 2009: TRIGGERS FOR PL3 (see Annex 2 Policy Matrix)

76. The PMO, MOF, sector ministries, and the Bank have come to a preliminary agreement on the triggers for the proposed third policy loan (PL3). These measures represent milestones in the Government’s program that are expected to be completed by the end o f November 2009. Reaching these milestones would trigger the third policy loan in the program. The milestones and issues surrounding them are described briefly below

77. Public financial management. The trigger for PL3 i s the approval o f the 2010 budget consistent with the medium term fiscal consolidation, taking into account assessments by the Bank, the IMF, and the EC. In addition, the Government i s expected to begin implementing the amended Law on Public Finance. The MOF has already taken several steps to improve the quality o f budget performance information. At the request of the MOF, IMF experts reviewed the education function o f the program classification in early 2009. Recently, the MOF commissioned external consultants to review and evaluate an additional five functions. Based on this work, the MOF will revise the performance information included in the budget documentation by the end 2009.

78. Despite the slowdown in economic growth, the Ministry of Economy (MOE) continues its efforts to improve Poland’s environment for doing business. The MOE has taken on the task o f further reforming the Government’s business inspection apparatus which operates across ministries and affects whole sectors o f private economic activity. In discussions o f the proposed third policy loan (PL3), the following actions are proposed as prior actions in the area o f private sector development: . Completion of background work and a draft Government strategy for

“Rationalization of Inspection Processes in Poland:” The most difficult and time consuming task - identification o f overlapping inspection requirements in over 500 pieces o f legislation - has been completed. With additional technical assistance being discussed with the Bank, the MOE wi l l draw up a plan o f action to rationalize business inspection process to further improve the environment for doing business. . Appointment of a high-level inter-ministerial task force to review the strategy and prioritize actions for implementation of the reforms: The next step wi l l be to reorganize government inspection and monitoring structures to reduce onerous, inconsistent, and repetitive procedures while retaining the legitimate purpose o f core inspection. As it touches on inspection regimes in almost all the ministries, implementation o f the rationalization plan will require commitment from the Council o f Ministers. The formation o f a high level, inter- ministerial task force with a mandate to formulate a strategy and implement the rationalization plan i s an agreed key action.

34

. Privatization program continues. Despite difficult conditions in the equity markets, the Government i s moving ahead with i t s program o f selling State shares in businesses. If successful, there wil l be a large spike in revenue from privatizations in 2009 and 2010 even though the number o f f i r m s sold i s likely to decline. . Continue business process simplification. Apart from the effort to simplify inspections, the Government has made substantial progress in simplifying the construction permit process while maintaining environmental protections and improving the basis for land use planning at the local level.

79. As the economy slows, the Government i s preparing additional labor reforms expected in the second half of 2009 that will mitigate the immediate effects of the crisis, but just as importantly, they will support future employment when the economy begins to recover. These measures include critical amendments to the labor code to increase labor market adaptability, policies that use the Labor Fund to reduce household vulnerability to the economic slowdown, and improvements in active labor market programs (ALMPs)' The Labor Fund has a substantial surplus - amassed during the recent period o f high economic growth and relatively l ow unemployment - that can be used proactively to face challenges posed by the economic slowdown. With some important reservations, the Government's plans appear both prudent and farsighted given the current economic uncertainty. The policies are aligned with the convergence agenda, and with respect to employment, the Lisbon goals. Specific measures planned for the second hal f o f 2009 that would be supported by PL3 include: . Temporary legislation that will allow employers to redistribute working

hours over a longer period: As a crisis measure, the Government i s securing agreement with employers and trade unions to increase work-time flexibility to cushion the impact o f the crisis. The temporary measure would allow employers to redistribute working hours over a 12 month (rather than the current 3 month) period. The measure would encourage the labor market to adjust through working hours to discourage layoffs as the economy slows.12 This measure provides

l1 The main active labor programs are: training; apprenticeships (on-the-job training) for school leavers; wage subsidies; public works; and business start-up support. The regulatory framework for the provision o f employment services (Law on the Promotion of Employment) i s defined by the MLSP. The Ministry allocates resources from the Labor Fund to districts (according to a pre-defined algorithm) to finance programs, sets quality standards for employment services, and plays a coordinating role. The Ministry intends to improve the efficiency o f employment services by allowing greater competition in the sector, including the entry o f non-public providers, public-private partnerships, and contracting out o f selected services. The rationale for the reforms, including the introduction o f activation policies, i s to increase the currently low employment rates among certain groups (youth, low-skilled workers, older workers) and to reduce the incidence o f long-term unemployment, which i s relatively high despite the relatively l ow overall unemployment rate. '' The idea i s to give employers the possibility to reduce work hours during periods o f low demand and increase them during periods o f high demand, provided that the total number o f work hours within 12 months i s unchanged and the work week does not exceed 48 hours. Moreover, employers are not required to pay an overtime premium as long as the total yearly amount o f work hours i s not exceeded. This measure i s meant to stabilize employment by allowing employers to adjust labor input by adjusting work hours rather than employment levels. Workers would face a lower risk o f job loss and unemployment

35

workers and their households with additional tools with which to manage downturns in the economic cycle.

To prepare for the recovery, higher quality employment services: The authorities wil l develop a monitoring and evaluation system for active labor market programs implemented by local employment offices to ensure support i s given to programs that demonstrate a measurable positive impact.

Liberalizing provision of employment services: Planned reforms will improve the efficiency o f public employment services by allowing services to be contracted-out to private providers.

.

. 80. The Government’s reforms are expected to contribute to better labor market performance - to better absorb the impact of the slowdown and prepare for Poland’s economic recovery. The Bank team i s helping to estimate the cost implications o f each measure and offer ideas for their design. For example, options being considered for a “technical leave” scheme assume that workers would be paid the minimum wage financed in equal proportion by employers and the State (from the Labor Fund).13 This may be too generous and too costly, requiring revenues o f the Labor Fund to be significantly increased, either by increasing the contribution rate (currently 0.1 percent o f payroll), or by providing a subsidy from the national budget. In either case the opportunity cost could be ~ubstantia1.l~ There are other new labor market measures being introduced as an “Anti-Crisis Package” agreed between employers and trade unions within the Tripartite Socio-Economic Commission. Items in this package may incur substantial costs for the Government and could hinder labor market performance (e.g. the proposal to raise the minimum wage to 50 percent o f the average wage, f rom the current level o f 37.3 percent). There i s a risk that items in the package being discussed could create additional contingent liabilities and distortions that would worsen employment outcomes and slow Poland’s recovery.

81. In education, the Government will sustain the pace of measures to improve performance and equity. The steps agreed in discussion o f PL3 are aimed at ensuring adequate financing o f the new programs for 5- and 6-year olds and improving the equity o f higher education finance. The proposed prior actions in education pol icy for PL3 are:

during the period o f downturn. Under the proposed change, for example, a worker could be put on 2 month leave during an economically slow period, then work 48 hours a week for the remaining 10 months. This i s a temporary measure through 201 1 and i s limited to employers experiencing a fall in production or revenues. Implementation o f the measure requires that a collective agreement i s signed between the employer and the enterprise’s trade unions. l3 With the support o f labor unions and to help businesses manage the downturn at a lower social cost, employers would be given the option to put workers on mandatory temporary leave (commonly referred to as “technical leave”) during which employers pay reduced wages, and workers’ incomes are subsidized from the Labor Fund. This i s a measure being negotiated between employers and labor unions independently o f Government. l4 As part o f its assistance to the Government, the Bank team has been suggesting alternatives to the MLSP that could be proposed in the current discussions between employers and labor unions. The Bank team and its counterparts are monitoring this dialogue closely, providing technical feedback where and when i t i s appropriate.

36

. Adequate budget to finance educational programs for 5 and 6 year-olds enacted in 2008 and first implemented in 2009. In the 2010 budget, the Government wil l fund the pre-school program fully. Financing wil l include preparatory activities by local governments for the forthcoming mandatory preschool program by supporting gminas to adopt diversified supply options including non-publicly managed institutions. . Shift public resources for financing education finance toward students with greater material need. By September 2009, the Government expects to have reformed the student loan program so that students coming from poorer households wil l receive a higher proportion o f subsidies (without expanding the fiscal cost o f subsidies, but by targeting these resources). In addition, i t wil l introduce legislation to shift a larger share o f public stipends for tertiary education to a needs basis, while reserving funds for performance prizes during the period o f matriculation.

82. reforms to improve efficiency. The measures that are planned, supported by PL3 are:

I n the health sector, the Government will continue its program of structural

Adequate budget proposed in 2010 to finance hospitals to be liquidated and corporatized through December 2010 (estimated to be approximately 80 hospitals). Even though the voluntary program o f corporatization wil l begin in 2009, i t i s expected to take approximately 4-8 months to get a hospital to the stage o f being corporatized. I t would have to be liquidated first, its debts cleaned up, then resurrected as a corporation. The process wil l require negotiation and agreement among many parties. Therefore, the MOF and MOH expect the major costs related to this program to begin in the 2010 budget. The success o f the process depends critically o n i t s being fully budgeted to meet demand for the program. . Managing other hospitals. Because the corporatization program i s voluntary, it i s assumed that some o f the worst-off hospitals will not be able to participate. The M O H plans to develop a program to monitor them closely. In addition, a separate program for university-affiliated hospitals wil l need to be developed because they cannot legally participate in the corporatization program as it i s currently set up.

. Accreditation and evaluation. The MOH also proposes to develop i t s accreditation program, which wil l become a means to become more selective in contracting with provider organizations under NFZ. As part o f improved public sector management, the corporatization program wil l be evaluated annually and a report prepared for the Council o f Ministers.

83. Looking beyond these lending operations, plans for multiple insurers to replace NHZ and reform of Long Term Care are under development. The MOH believes that introducing multiple insurers could open the system to additional competition and choice for patients. However, such a change would also create risks; the

37

MOH is just at the beginning o f the analysis and design work necessary to develop these options in this area. Financing options for long-term care (care o f the elderly and immobile, LTC) are also being considered, but this pol icy area requires broad consultation and cross-ministerial cooperation (the MOH, MLSP, MOF, and local governments). The Government i s at an early stage in public discussions and formulation o f options, making this i s an area where the Bank can add technical value although the timing o f actions i s not suitable for inclusion in the current series o f pol icy loans.

84. In pensions policy the Government thinks the time i s right to pursue changes to the privately managed funded pillar of the system to increase investment options and lower management fees. Given the political obstacles to full enactment o f the pension reform measures passed by the Parliament, the Government has decided to focus on improving the performance o f the private funded pillar. Looking ahead to PL3, the following measures are agreed triggers:

. Introduction of legislation allowing multiple portfolio options: Most countries in Central and Eastern Europe that introduced funded individual retirement savings pillars - including Slovakia, Hungary and Estonia - have allowed multiple portfolio options for workers’ mandatory savings. Mult iple portfolio options provide more instruments with which affiliates can manage financial risk as they approach retirement.”

. Introduction of legislation to further reduce management fees: Poland’s pension funds operate with relatively l o w administrative costs and fees. This outcome is due to centralized revenue collection arrangements and regulation that caps management fees. Total fees amount to 160 basis points on assets, which i s reasonable given the short period the funded pillar has been operating and the small volume o f assets under management. However, to increase the accumulated savings balances workers can rely on at retirement, and to safeguard the funded pillar from political threat, the Government plans hr ther measures to reduce fees. l6

l5 The portfolios o f Polish pension funds are not well diversified. A preponderance o f government bonds is observed in the pension portfolios o f most countries that have recently introduced mandatory funded pension systems (the second pillar), although in Poland the funds have relatively larger holdings o f domestic equity and investments in privately-issued fixed income instruments. The lack o f diversification o f pension find portfolios reflects in part some investment restrictions. The crisis and i t s impact on capital markets reinforces the need to combine greater choice in funded private pension pillars wi th better default options for portfolio allocation. The multi-fund or “lifestyle model” was pioneered in Chile at the beginning o f the decade to give affiliated workers more options to manage financial risk as they approached retirement. Proponents o f greater investment choices did not expect low financial literacy to be a barrier. Affiliates were slow to exercise their choices, those who did selected portfolios irrationally, and once they chose a portfolio rarely changed their allocations. Lifecycle funds provide a better risk allocation along the working l i fe o f individuals. They alter the default “do nothing” portfolio allocation progressively away f iom variable return securities to fixed return options as individuals get older. (Rudolph, H. and R. Rocha, “Competition and Performance in the Polish Second Pillar” mimeo). The Bank i s advising the authorities on the importance o f setting age-related default options as more investment choices are offered. l6 Fees on contributions are capped at 7 percent for al l new contracts issued after 2004. This cap will be progressively reduced to 3.5 percent in the year 2014. All but one fund manager currently charges the

38

85. As part of the AAA accompanying the program, the Bank team i s helping the authorities to project the financial outlook for the public Notional Defined Contribution, pay-as-you-go, pension pillar under different economic scenarios. The authorities report that the revenues o f the pension or social insurance system (ZUS) have not been significantly affected by the economic slowdown although contributions have been slightly lower than projected up to March 2009. The real impact o f the crisis can only be evaluated at the end o f the second quarter o f the year. The Bank team is modeling several different scenarios for the public N D C pension pillar, assuming different developments in the economic outlook, to have a better understanding o f the short and long-term financial ba1an~e. l~

86. For social assistance, with an increasingly constrained fiscal envelope, the Government’s strategy i s to use resources more effectively by improving targeting. In 2009, to increase the family benefit across the board under the regular 3-year benefit adjustment cycle would cost approximately PLN 3 billion. However, in response to budgetary pressures, the Government is preparing to allocate this adjustment more efficiently by targeting it better. The core action in this area that would serve as a trigger for the lending program is: . Council of Ministers decision to limit the scheduled increase in family

benefits to households with three or more children: Instead o f an across-the- board adjustment, the Government i s planning to spend only PLN 0.7 bi l l ion by targeting the adjustment in family benefits to the poorest families - those with 3 or more children.

87. In the area of social services for vulnerable groups, MLSP has noted an increase in the number of children being left in foster care. The Ministry expects this trend to continue as household incomes are put under strain. As a way to lower the cost o f care and to improve social outcomes, the Ministry i s seeking to shift the system away from institutional to household-based foster care. As a key prior action for PL3 to improve foster care services, MLSP i s planning to:

Present legislation that shifts the provision of foster care from a primarily institutional to a family-based model. The shift has a small up-front cost o f

maximum contribution fee. Fees on assets are capped according to the volume o f assets under management (Rudolph, H. and R. Rocha, “Competition and Performance in the Polish Second Pillar” mimeo). The Government i s drafting legislation that would accelerate the pace o f fee reductions. l7 As discussed in a recent review by the European Commission o f Poland’s Convergence Program update, the Government projects pension expenditure to drop from 12.6 percent o f GDP in 2006 to 10.9 percent in 2010 to 9.6 percent in 2020 and 8.3 percent in 2050. This would be a substantial achievement o f the 1999 reform and follow-on measures, despite a rapidly aging population. This said, Poland i s one o f the few EU countries where the retirement age for men and women still differs (65 and 60 respectively). Possible gradual leveling o f the retirement age for men and women, combined with firther measures to stimulate employment and to reduce early retirement benefits, could contribute to boosting labor participation among women o f age 50+, currently one o f the lowest in Europe. (see European Commission Directorate General Of Economic And Financial Affairs, Brussels, 4 March 2009, ECFIN/G3(2009)Rep/50415-EN, “Poland: Macro Fiscal Assessment, An Analysis Of The December 2008 Update Of The Convergence Programme”),

39

PLN 30 mi l l ion but i s expected to translate into considerable medium term financial savings, as wel l as better quality care for abandonedorphaned children.

88. Furthermore, the Bank’s work with the Government on a Long T e r m Care reforni will also have important implications for the delivery social care. As discussed earlier, although not yet ready for support as part o f PL3, in the context o f the longer lending program, and keeping a focus on important structural reforms, the Government i s conducting analysis o f LTC structures and outcomes in Poland and how they compare with other countries in the region. A team o f Bank specialists in this area wil l contribute to this effort. The Bank’s L T C staff have engaged in a technical exchange with the Senatorial Working Group examining reform options, chaired by Senate Commission on Family and Social Policy. L T C reform i s a clear area where the Bank can add considerable technical value, as wel l as draw benefit from an exchange with the Government over the coming months.

89. Linking employment and social assistance, the Government i s planning to take a number of steps to support activation of long-term unemployed reducing dependence on social assistance. The MLSP has presented plans to strengthening the l i n k s between agencies administering active labor market programs and social assistance to help recipients o f social assistance move back into the labor force. The Ministry i s eager to improve the coordination between public employment services (which are under district governments) and social assistance administered by the social welfare offices (which are run by local governments). Better information sharing and coordination o f benefits between employment and social assistance offices would improve client services and encourage the movement o f people out o f long-term unemployment and social assistance and into the labor market.

90. to be prepared between July and December 2009.

Table 7 summarizes the core triggers for the third pol icy loan, which is expected

Table 7. Agreed Triggers for the Third Policy Loan, P L 3

Public Financial Management 1. Approval of the 2010 budget consistent with medium term fiscal consolidation. Assessments of EC and IMF would be considered.

2. Allow employers to redistribute working hours over 12 months rather than the current 3 months to encourage adjustment of working hours and discourage layoffs, as a measure to mitigate the economic crisis.

3. Introduce legislation to enable multiple portfolios within the second pillar. 4. Introduce legislation to reduce fees by fund managers.

5. Completion of background work and a draft Government strategy for “Rationalization o f Inspection Processes in Poland” by the Ministry of Economy, appointment o f a high-level inter-ministerial task force to review the strategy and prioritize actions by the Government for implementation o f the reforms, and action by the Council o f Ministers to initiate the first steps in the reform program.

6. Adequate budget proposed in 2010 to finance hospitals to be liquidated or corporatized through December 2010 (estimated to be approximately 80 hospitals).

Labor Market Reforms

Pension Reforms

Private Sector Development

Health Sector

Education Reform

40

Area Trigger 7. Adequate budget to finance educational programs for 5 and 6 year-olds enacted in 2008 and implemented in 2009. The Government will finance preparatory activities in local governments for 5-year-olds by supporting Gminas to adopt diversified supply options including non-publicly managed institutions. 8. Shift government subsidies in the student loan program to a sliding scale to increase the subsidy for poorer students. Introduce legislation to reorient Government higher-education subsidies for students to the material

Social Assistance 9. Triennial cost-of-living adjustment in 2009 for family benefits will be limited to those families with 3+

5.4. CONSULTATION PROCESS

91. All legislative measures - particularly social sector reforms - in Poland are subjected to a demanding consultation process with social partners and groups likely to be impacted by particular proposed reforms. The consultation process i s an important institutional feature o f Poland’s process o f government. The reforms supported by this operation have been subject to extensive stakeholder consultations. For example, the program Generational Solidarity 50+ was consulted with a l l stakeholders - trade unions, employers’ associations and local govenunent representatives as wel l as with other institutions dealing with labor issues. Education and health reforms have been subjected to long periods o f consultation among al l stakeholders as they have been developed and before submission to Parliament. During consideration by Parliament, they have been subjected to extensive coverage by the news media, public discussions, and hearings and debate in Parliament.

5.5. ANALYTICAL AND ADVISORY ASSISTANCE

92. The Bank’s analytical and advisory services can support the Government’s program. Currently a Bank team i s preparing the f i rst Public Expenditure Review for Poland since 2003 and since the country’s accession to the EU. This was a key element in the analytical assistance agreed in the negotiation o f the f i rs t lending operation. The PER not only provides analytical support for the implementation o f performance based budgeting and the MTEF, but from extensive analysis o f the social sectors, lays the technical foundations for the measures supported in PL2 and PL3.

93. As part of the agreements reached for the second loan, several pieces of technical assistance have been requested. To help the Government meet some o f the triggers for PL3 outlined in the matrix in Annex 2, the fol lowing technical assistance will be provided by the Bank, financed through trust fund resources identified by the Country Management Unit. The specific TA being discussed with the Government i s presented in Table 8. I t is unlikely that resources will be available to provide al l o f the inputs requested o f the Bank.

41

Table 8. Program of Further Analytical and Advisory Assistance

AAA Item

a) Performance based budgeting and use o f a medium term expenditure framework (including technical assistance to help design and establish institutional structures for rigorous monitoring and impact evaluation as part o f the budget allocation process).

b) Rationalization o f Licensing Activities within Government c) International good practice in consolidation and coordination o f business

inspection procedures across public sector agencies

MinistrylAgency MOF

MOP MOE

I MLSP d) Development o f a monitoring and impact evaluation protocol for

employment assistance and social assistance programs

g) Identifying bamers to closer ties between employment assistance and social assistance (strategy to “activate” long term unemployed)

h) Analysis and reform options for Long Term Care i) Evidence-based prioritization o f health financing (NICE-style evaluation) j) Hospital corporatization good practice;

k) Strategic use o f accreditation, DRGs, and other reimbursement mechanisms to elicit improvements in quality, cost consciousness in delivery o f care, and consumer satisfaction.

1 e) Assessment and taxation o f farmers’ incomes 1 MLSP

MLSP

M L S P M O H MOH MOH MOH

I MLSP/ZUS I f ) Actuarial analysis o f the long-term financial stability o f the pension

svstem. under different macroeconomic scenarios

1)

m) Analysis o f PISA results and implications for policymaking. Impact o f

Analysis o f household vulnerability to the economic slowdown and crisis (to support the vulnerability mapping already underway)

NGO-managed schools on expenditures, costs o f operation, and effectiveness.

n) Technical assistance and analytics o f higher education subsidy allocation options.

PM’s Office

MNE

M S H E M O F

VI. OPERATION IMPLEMENTATION

6.1. POVERTY AND SOCIAL IMPACT

94. Household data available through 2007 show Poland’s substantial strides in lowering poverty. Even absolute poverty levels are considerably lower. Poverty - measured as the percentage o f population below the social assistance income threshold - dropped from 19 percent in 2004 to 14.6 percent in 2007. The poverty gap also narrowed, meaning that the incomes o f the poor moved closer to those o f the non-poor. The main determinants o f poverty in Poland include: rural residence, low educational attainment o f a household head, unemployment o f a household member, and a large number o f children in the household. Table 9 shows the improvement in poverty indicators from 2004 through 2007.

42

Table 9. Poverty in Poland since Accession

Poverty rate Percentage o f Dopulation living in households below 2004 2005 2006 2007

50% o f median expenditure 20 18 17.7 17.3 Social assistance threshold 19 18 15.1 14.6 Subsistence minimum 12 12 7.8 6.6 Poverty gap Distance below poverty line

2004 2005 2006 2007 50% o f median expenditure 23 22 21 21 Social assistance threshold 24 23 21 21 Subsistence minimum 22 22 19 19

Source: HBS 2007

95. Although not a reason for complacency, and while there i s still room for efficiency gains, poorer households are well served by the social protection system. The multiple elements o f Poland’s social protection system (pensions, family benefits, and social assistance taken as a whole) cover 72 percent o f the population, and 85 percent o f the poorest 10 percent o f the population (according to HBS 2007 data). Reflecting the geography o f Poland’s poor areas, the social protection system covers 86 percent o f the rural population at risk o f poverty - i.e. those who consume less than 60 percent o f median consumption by EU convention (as compared to 82 percent o f the urban population in the same category o f consumption).

96. The measures being supported by the second operation in the program are expected to have a substantial and beneficial impact reducing poverty by improving services in the medium and long term, while protecting vulnerable households in the immediate term. The Government’s “50+ Program” improves the labor market options o f older people by reducing the costs o f employing workers who are close to the retirement age. I t ensures that public employment services are available to active people aged 45 and older to help them remain in the labor force longer. In designing the fiscal savings measure that reduces the number o f people eligible for early retirement (from 1.7 mi l l ion to 300,000) the Government included important safety net safeguards that protect the base level pension benefits received by households affected by the reform. By initiating measures that lower the age at which formal education begins, the Government expects to give children a head start to achieve better learning performance and education outcomes. After a short period during which the new education structures wil l be voluntary, they wil l be made mandatory to ensure the benefits o f earlier instruction accrue to al l children, including those from lower-income households. Finally, the expected revenue from the new taxes on alcohol, tobacco products and luxury cars, wil l give the Government extra resources with which to target supplementary social assistance as the current crisis unfolds.

97. As the program proceeds to the third lending operation, further positive social impact i s expected, particularly in the short term to mitigate the crisis. First, the program supports measures that increase working time flexibility, as part o f the “anti-

43

crisis package” agreed by the social partners. The measures will be in place until 2011, will cover enterprises which are experiencing sharp falls in production due to the economic crisis, and are expected to discourage lay-offs. Second, the program supports reforms to the unemployment benefit system that increase the total amount o f benefits, but also introduce benefit reductions after three months o f j o b search. These changes are expected to improve the efficiency o f the system by strengthening labor supply incentives while providing the unemployed with better income support. The program also includes reforms that shift the structure o f Government subsidies for higher education financing hrther away from purely merit based criteria and toward greater consideration o f household means. In doing so, the Government expects to lower the percentage o f applicants for student loans whose applications are rejected for insufficient collateral guarantees, from over 10 percent to 8 percent by the end o f 2010. Finally, and with direct impact on the poorest and most vulnerable households, the Government plans to target the triennial adjustment o f family benefits to recipients with three or more children. Given the close correlation between the number o f dependent children and poverty (see Table lo), this targeted adjustment i s expected to redistribute between 0.4 and 1 percentage point o f spending on family benefits from non-poor to poor households (depending o n the size o f the adjustment, s t i l l to be determined), and to reduce the share o f families with 3 or more children who are poor, by between 1.3 to 3.4 percentage points.18

Table 10. Distribution of Households by Number of Dependent Children and Consumption Decile

Households by Consumption Decile

1 2 3 4 5 6 7 8 9 10

no children 6.9 7.9 8.6 9.5 10.1 10.6 10.9 11.3 11.7 12.8

1 child 6.8 6.4 8.1 8.9 9.9 9.3 11.7 11.7 12.6 14.5

2 children 9.1 9.8 10.6 10.5 10.2 10.3 9.9 9.8 10.2 9.5

3 children 14.7 15.7 12.9 12.1 9.6 10.0 8.3 7.2 5.7 3.7

4+children 25.3 17.7 14.4 10.2 9.3 6.8 5.8 4.8 3.6 2.1

Source: H B S 2007 Note: The distribution across the deciles sums to loo%, Le. 25.3 percent o f households with 4 or more dependent children are in the 1‘ consumption decile.

98. The Government’s growing concern i s for the flow of newly vulnerable households into poverty in the wake o f slowing economic growth. Facing the economic crisis the Government is planning targeted regional interventions to support powiats that are most affected by the drop in economic activity. There are 379 powiats in Poland and they are each considered a local labor market. The Government i s planning to strengthen local capacity to weather the crisis, by both improving the effectiveness o f

~ ~~

’* Three targeted benefit adjustments have been simulated for households who in the 2007 H B S and who reported 3 or more dependent children: an increase in monthly benefits o f 20 zlotys, 40 zlotys and 60 zlotys. The three adjustments redistribute 0.4%, 0.7% and 1%, respectively, o f spending on family benefits f iom non-poor to poor households.

44

existing programs (employment and social assistance programs) and if eventually necessary, by allocating additional resources and implementing extraordinary programs.

99. As discussed earlier, the PMO i s leading efforts to map vulnerability to the crisis in order to eventually target interventions. This initiative has three components and wil l be implemented in three corresponding stages. The f i rst component i s the creation o f a regional “crisis vulnerability” map to identifypowiats that are at highest r isk o f suffering from the current global economic crisis. The second i s the implementation o f a monitoring system that wil l screen powiats that are actually hit by the crisis. The final component i s the creation o f an agency with a mandate to support to worst affected powiats. The initiative wi l l be ready by September 2009. As shown in Box 2, by definition, the regions that are considered the most vulnerable to short-term dislocations are the also those with an export-oriented economy, rather than the poor, lagging regions. The latter - rural, predominantly agricultural region - are insulated from the crisis, at least temporarily, and well covered by existing social protection programs.

100. The Government will monitor the crisis’ impact by tracking a large number of indicators. Leading indicators include changes in tax revenues, social security payments, inflows into unemployment and outflows f i om unemployment to jobs. Lagging indicators include changes in the unemployment rate, the number o f social assistance recipients, and the number o f contributors to the social security system. The data wil l be compiled, processed and analyzed by a special regional monitoring unit under the PMO. The Government plans to have the monitoring system operational by the end o f June.

101. The Government i s considering a new agency to represent its crisis initiative at the local level. The role o f the agency will be to determine and recommend ways to support the powiats most affected by the crisis. This could include strengthening existing institutions and mechanisms, as wel l as designing and implementing new special programs financed from government reserves and extraordinary funds. The mandate o f the new agency would include negotiating and signing contracts with powiat governments to implement special programs. The Government expects the agency to be created and ready to operate by the end o f September 2009. This crisis initiative is tentatively planned to last for two years. However, if it proves to be an effective means o f strengthening local capacity to respond to regional economic shocks then it may become institutionalized on a permanent basis.

6.2. ENVIRONMENTAL ASPECTS

102. The specific policies supported by the second policy loan in the program are not likely to have significant effects on Poland’s environment, forests, and other natural resources. Unanticipated and unintended r isks o f adverse effects to the environment and natural resources are minor, although acknowledged. However, Poland has adequate environmental controls in place. Poland’s environmental legislation and regulation i s reinforced by EU environmental directives, including the EU’s guidelines o n adoption o f environmental assessments at the planning and programming level (June 2001) and the EU’s Environmental Liabilities Directive setting out liability for damage to

45

properties and natural resources (April 2007). Pre-privatization environmental audits are required to determine the existence and scope o f any liabilities o f companies in state hands, manifested as contamination o n real property or other conduits. The quantification o f such liabilities i s then used as part o f the overall valuation o f the state enterprise for purposes o f negotiating a fair purchase price with the private party. Private sector bidders o f enterprises wil l be subject to the environmental provisions embodied in Polish and EU law once they acquire previous state assets in the process o f ownership transfer.

6.3. IMPLEMENTATION MONITORING AND EVALUATION

103. The Bank continues to work closely with the MOF, PMO and sector Ministries to monitor and assess reform progress and impacts during the course of the program. Monitoring and evaluation will be supported by the various Ministries as wel l as budgetary, legislative and economic data provided by the authorities and verified in official disclosures, directives and regulations. Baseline and updated data are provided by the respective specialized agencies for the pertinent functions and tracked according to the indicators and outcome measures as shown in the Monitoring and Results Framework.

6.4. FIDUCIARY ASPECTS AND PROCUREMENT

104. The fiduciary risk to this operation arising from Poland’s public financial management system and use of budget resources i s low. As part o f i t s accession process to the EU, Poland has achieved significant progress in reforming its public financial management system (PFM).19 It has upgraded i t s legislative framework, in l ine with the EU acquis, introduced an internal audit function, and prepared for the EU accreditation process o f fund-managing agencies. Poland has also made significant improvements related to the public availability and coverage o f fiscal information, particularly the adequacy o f accounting and reporting standards and regularity o f reconciliations o f bank accounts.

105. The PFM reform agenda supported by this program will enhance budget transparency, predictability and performance-orientation over the medium term. The proposed amended Law on Public Finance, expected to be adopted in 2009, enhances budget transparency, predictability and performance-orientation over the medium term. I t introduces performance-oriented multi-year budget planning, integration o f remaining Extra Budgetary Funds and externally-financed expenditures within the State Budget, and strengthened internal control over public expenditures and debt via new regulations o n internal audit and internal control. These measures, if adequately implemented, wil l result in significant progress in the country public financial management. However, one o f the main challenges i s implementation o f the proposed reforms on the operational level as most o f the detailed procedures need to be defined and applied in practice. Furthermore, to achieve expected results o f the reform, the introduction o f performance budgeting should be supported by additional changes in the financial control framework

l 9 The status o f the P F M was derived from the World Bank’s ongoing monitoring o f PFM reform and previous diagnostic works conducted by the Bank and external organizations.

46

including accountability, updated and compatible budget classification, accounting and reporting systems, and an integrated financial management information system.

106. Other areas o f ongoing reform include cash management. This includes the introduction o f a single treasury account (TSA) system, computerization o f al l cash transactions and central monitoring o f commitments and liabilities. The State Budget TREZOR computerized system includes the 1st and 2nd tier State budget holders, with the remaining units to be included in the final stage. In 2005, the TREZOR system gained an ability to communicate with the National Bank o f Poland’s accounting system, allowing direct coordination o f pending payment orders and State Budget cash availability, improving internal controls.

107. In the area of external audit, Poland i s advanced in relation to availability o f the audit reports to the public, independence o f the Supreme Audit Institution (NIK) from the executive, and control o f the NIK budget, providing a well functioning public financial accountability and assurance mechanism for the legislature and the public.

108. The National Bank of Poland i s part o f the European System of Central Banks, and it has upgraded its accounting and reporting policies in accordance with the guidelines of the European Central Bank. I t s financial management and operations are transparently disclosed and presented on i t s website. The NBP’s annual financial statements are regularly audited. The most recently available audit reports (for 2004- 2008) have unqualified audit opinions and were approved by the Council o f Ministers. Overall, the fiduciary r isk to this operation arising from Poland’s public financial management system and use o f budget resources and i t s foreign exchange environment as controlled by the Central Bank i s low.

109. Finally, Poland has made significant progress in reforming its public procurement system. Adoption o f a new law in January 2004 made Poland a pioneer in Central and Eastern Europe in setting up a sound public procurement system that met the requirements o f the EU. In April 2006 and April 2007 the Public Procurement Law was further amended to implement the provisions o f the EU directives 2004/18/EC and 2004/17/EC, on the (i) coordination o f procurement procedures for the award o f public works, supply, and service contracts and (ii) coordination o f procedures o f entities operating in the water, energy, transport and postal services sectors. The latest amendment to the Public Procurement Law entered into force in October 2008 to adjust the Law to EC directives but also to enhance and streamline the implementation o f procurement procedures, Improvements and hrther simplifications o f the public procurement system were also a result o f the development and upgrading o f e- government procurement tools. Other areas o f ongoing reform relate to: (i) increasing the effectiveness o f public expenditures; (ii) strengthening competition in public procurement; (iii) facilitating access o f SMEs as bidders; (iv) improving the quality o f procured goods, works, and services; and (v) promoting innovative and ecological solutions in public procurement.

47

6.5. DISBURSEMENT AND AUDITING

110. As with the first loan in the program, loan proceeds will be disbursed in one single tranche to the foreign currency national budget account at the National Bank of Poland (Central Bank). Disbursement wil l be made upon declaration o f loan effectiveness and submission o f a withdrawal application to IBRD. At the request o f the MOF, IBRD will deposit the proceeds o f the loan into the foreign currency national budget account indicated by the Government that forms part o f the budget management system o f the country. The proposed loan will follow the Bank’s disbursement procedures for development policy lending. Disbursements wil l not be linked to specific purchases, thus no procurement requirements will be necessary. The Government shall maintain accounts and records with respect to the deposit o f loan proceeds in the NBP. If the loan proceeds are used for ineligible purposes as defined in the loan agreement, IBRD will require the borrower to refund the amount directly to IBRD.

111. N o additional fiduciary arrangements will be required. The Bank wil l not require an audit o f the Deposit account but will require the Government to provide confirmation to the Bank in the form o f an official letter from the Ministry o f Finance o n the amounts deposited in the foreign currency account within 30 days o f receiving the funds.

VII. R ISKS AND RISK MITIGATION

112. The medium-term macroeconomic scenario of slowing economic growth and moderating inflation i s subject to further downside risks. While inflationary pressures have abated significantly with the recent global slowdown and tighter credit conditions as well as moderation o f wage pressure, the depreciation o f the zloty could rekindle inflationary pressures. Poland has one o f the most solid financial systems in Europe, but the interbank market continues to experience problems due to lack o f confidence. The authorities may need to respond with additional confidence-restoring and liquidity- enhancing measures. In the context o f the Euro adoption agenda requiring fiscal discipline, the supply side o f the economy needs to be f i r ther stimulated through acceleration o f structural reforms. While the exogenous risk cannot be mitigated, one option is for the Bank to scale up i t s lending operations if the risk materialized.

113. The deterioration of Poland’s economic outlook raises fiscal risks to the program. Although the assumptions on which the 2009 budget and Convergence Program are based are clearly outdated, and the Government has exercised good judgment in implementing informal savings measures, a formal revision to the budget has not yet been announced. This could pose a fiscal risk to the measures being supported by this loan. However, as a condition o f effectiveness, the Government has agreed to initiate the process o f revising i t s 2009 budget in form and substance consistent with the measures being supported by the program, to ensure continued compliance with the f i rs t prior action o f this loan. In addition, the third loan in this series will provide opportunities to engage with the authorities in the development o f the 2010 budget.

48

114. Poland’s external and financial vulnerability may be further affected by global and regional developments. Recent developments demonstrate the r i s k o f contagion from other countries in the region, and access to external financing sources may become more difficult and more expensive. Entering the ERM2 during significant volatility on global financial markets poses r isks for exchange rate stability as required by the relevant Maastricht criterion over a minimum two-year period. At the same time, there i s risk o f a misaligned EUR/PLN central parity in ERM2 and during the ultimate conversion rate from zloty into euro. On the other hand, the Government’s commitment to euro adoption lends credibility to fiscal policy and may help preserve confidence in a very difficult external environment, even if the current economic circumstances force the exact date o f entry into the single currency to be reconsidered.

115. The projected deterioration of economic prospects may undermine social support for the Government and reduce its willingness to push for additional structural reforms. Reform momentum i s already constrained by the risk o f Presidential veto on new legislation passed in Parliament, in particular in the area o f social services. In this context, there i s a risk o f general elections earlier than scheduled for fa l l 201 1. This may be provoked, for example, by internal tensions in the governing Civic Platform and in the coalition if Prime Minister Tusk decides to run for President in 2010. The Government’s lack o f a constitutional majority in Parliament and elusive compromise with the opposition Pis, which demands a referendum on euro adoption, could complicate the euro adoption plan and aggravate r isks related to the E R M 2 transition period.

49

ANNEX 1: GOVERNMENT'S LETTER OF DEVELOPMENT POLICY (LDP)

Mr. Robert B. Zoelllck President The World Ikrak

1818HStreet,NW Washington, I1.C. 20433 United States of America

Dear Mr. President,

As you are aware, the Republic o f Poland and the International h b for Reconstruction and Development h v e sig& Ihr Public Fiaanoe Management, Ernploymmt, and Private Sector Development Pm,grammatic Policy Loan on December 23, 2008 in the amount of EUR 975 million (USD 1.25 billion equivalent). which constilutd the first of thrcc loam totaling USD 3.75 million. The loan is aimed at supporting Poland's efforts in the areas of economic and social reforms. Currently. the Polish administration i s working in close coqxratim with World Bank staffon the cxccution of thc first

loan BS well as on identifying objectives to be supported by the second loan of the swim.

Therefore, I wish to request the International Hank for Reconstruction and Development to deliver the second of the Development Policy Loans, including the associated technical cooperation program, in the amount of approx. EUR 1 billion (USD 1.3 billion equivalent).

The overarching god set out for the Fmployment, Entrcppencurship and Human Capital Dcvclopment Policy Program is that of accclcrating Poland's convergence with the EU. Taking into consideration the deterioration of rhe external environment that significantly and adversely impacls the condition and pcrfimancc of the Polish economy. thc attainment o f the above g d requires the accomplishment of the

followring detailed objectives: (i) achieving medium &nn fiscal mbilization through rcinfmcing structural rcforms. (ii) ensuring sufficient support for the priority programs crucial for the convergence objective, (iii) mitigating the social cost of the economic crisis.

50

The loan shall focus on a compreheasive set of key reforms and policy actions identified under thc DPL program. In addition Lo building on the achievements and continuing the efforts o f the refomi program supported by tbe first DPL in the areas of public finance management. private scctor development and the labor market. the DPL li waq envisaged to focus on more detailed sector reforms.

Publlc Finance ManPgtmrnt In light the prevailing economic cavironment the task of matching short krm fiscal goals with strategic

considerations becomes increasingly difficult but also requires the execution of accurate mEaSUrCS to

accomplish them. In that respea the key developments in lhis ares to be supported under the DPL program include the implemmtation ofthe amended 2009 budget. considering the nmssary adjustments resulting f m intensive efforts towards the institutionat reform of the budgeting procedures,

etlcompassing improvements towards the full implementation of the principles of performance-based budgeting (PBR) and the medium-tenn expenditure f m e w d (MTEF) in the mneded law on public finance, expected to be adopted in late 2009.

Education aector

The worsening demographic trends will require greater flexibility within the education sector so as to facilitate the necessary adjustmcnts towards the actual needs of the population in lhis ana. The sectoT- wide reform p t m include increased delegation of decision-making powers towards local government and

introducing mandatory education for younger age groups. 0 t h key developments 81c Linked with the simplification and M e r alignment between vocational and general education and the continued implementation of external testing, specifically for the secondary leahg examination (maruru).

Health sector The main challenge facing the Polish health sector remains the delivery of quality service under the adverse financial conditions. The primary goal in that respect i s to impmve the quality of management, in order to avoid the accumulation of debts of hospitals and subsequently LO e w the burden on the state budget. The proposed remedy to the issue of indebtedness i s the participation of hospitals in a voluntary

program to cxravcrl lhrm into cmpowe entities, subjw lo lhe provisions of the commercial code BS wll as corresponding financial audit procedures. An additional measure to enhance the payments systcm in healthcam will be the adoption of BI DRO-basd s y s m for payments from the National Health Fund to

hospitals.

Labor mark4 and peasion reforms Considering the sevm impact of& economic turmoil on the labor markel, lhe DPL program provides a suitable tod to counter the negative develojments and provide a boost towards the convergence

2

51

objectives in this ma. Thc "SO+" program aimed at imxcased labor force participation of oldcr workers

aod the intcrconnccted chaages in the provisions governing the eligibility for early retirement h u l d ensure the proper impetus towards convergence with the respective EU staadatds. The newly introduced incentive struclure of' unemployment bcncfits i s also apactcd to contribute to thc impvcd standing of

the Polish economy in this respect.

I f d y believc that the support by tbe World Bank, involving both f-e tlnd expertise, of the

ambitious reform p r o m of the Polish Chvemment will provide thc crucial additional impetus towards the fulfillment of the objectives set out in it. Concurrently, I am confident that our cooperation ghall

provide valuable experience to the Bank towards the provision of similar assistance to othcr clients within

the c m t highly volatilc CCMlomic environment.

Yours sincerely.

Jm&nceni-Roa towski

Ministet of Fiaance

3

52

3 E

2E Y Y a

I I

L

I

a

3

tt % Z w w d U

4

c .-

4 a 8

w

sE 3 8 c

k

E i W

Er: e

V a B

e!

a E

Y

s z 10

s z 10

s oq s

I? 4 m

s z m

s 8 m

s ? cu

s ? d

s z c

0 b

g G

m

L

I 3

ANNEX 4: ASSESSMENT FROM INTERNATIONAL MONETARY FUND

On May 6, 2009, the IMF’s Board approved a Flexible Credit Line for Poland in the amount o f US$20.58 billion. The Board made i t s decision with reference to the Staff Report “Arrangement under a Flexible Credit Line” prepared by the Fund’s European Department in consultation with other departments. The Staff Report was completed on April 24,2009. Section I o f the Staff Report i s provided in this Annex, and includes the Fund’s assessment and outlook for Poland.

78

I. C o n i m

A. Very Strong Fundamentals

1. recent years-averaging about 6 percent in 2 0 0 & 0 8 4 a s k e n well-balanced, as EU accession bolstered business confidence and spurred a long-awaited rise in investment (Table 1). Private consumption growth has also been robust, driven by rapidly rising real wages. increasing employment. and record-high credit growth. The output response reflected primarily a significant increase in labor utilization. altlioiigh rising investment and producti\ ity also played a role. Emerging c a p c i t y constraints, not least in the labor market, had caused some moderate weakening o f output growth even before the global crisis began to spill over to Poland. Moreover, itlflationary pressures started to increase in early 2007 but such pressures r e m i n e d manageable.

Poland’s macroeconomic performance has been very strong. Output growth in

2. low and the external position sustainable. Even as export growth was robust and Poland con th ied to gain export market shares. buoyant imports resulted in some widening o f the current account deficit. However, as a s h e of GDP. this deficit has remained relatively low and external debt has been stable at about 40-50 percent o f GDP (Tables 2 and 3).l Staff estimates suggest that the real exchange rate is broadly in

Despite a booming economy, the current account deficit has remained relatively

I Poland: Current Account Balance I (In percent of GDP)

2 1.8

0

-2 1.6

-4 1.4

EE3 Current Account Balance (94 of GDP) - Polish Exports Market Share, rhs -8

-10 ‘ 1.0 2003 2004 2005 2006 2007 2008

Sources: NBP; IMF Direction of Trade.

The estimated underlying ciurent account deficit i s consistent with the debt-stabilizing level in the niediwn tena

’ Prelimmy CGER estinlates (March. 2009) suggest that estimated deviations fioin the ecpulibriuun real exchange rate are within the nlaw of enor of the estimation.

79

n

4. strong and timely policy response:

e a\-oidance o f reute imbalances during the boom years owes much to very

80

July 2008. Still. the fiscal deficit exceeded 3 percent o f GDP in 2008, pritllarily due to revenue shortfalls associated with a marked slowdown in the economy in late 2008. Spending cuts in foiuth q i m e r o f 2008 allowed the state budget to remain on target (with a small tuargin), but these cuts did not offset higher deficits at lower levels o f government (Tables 5 wd 6).

Financial sector. Banking supervision has been strengthened to be fidly compliant with EU laws and directives. As foreign ciurencydenomhated mortgage lending gained pace. supv isors responded in a timely manner with measures that. in effect, placed constraints on FX-lending. Furthermore, the institutional h e w o r k for f inwcia l stability has been buttressed by the imification of h c i a l silyervision imder the aegis o f the Polish Financial Supervision Authority (KNF) on January 1 , 2 0 8 and the recent creation o f the Financial Stability C o d t t e e . The c o d t t e e - c o t u p r i s e d o f representatives from the Ministry o f Finance, the National Bank o f Poland and the KNF- provides a f o m l h e w o r k that has e d m c e d informational flows and analytical activities and has been actively engaged in fiuthering contingency planllillg.

Structud reforms. In view o f the einerging labor d e t bottlenecks, stnichual policies have focused on boosting t i e exceptionally l ow labor participation rate. The tax wedge has been lowered by cutting in half disability contributions and eligibility for early retirement has been significantly curtailed, slashing the number o f eligible workers fiom above one mi l l ion to about 250,000. The authorities have also given priority to deregulation and completing their privatization plan.

5. The Fund has strongly supported the authorities’ policy stance. The most recent Article IV consllltation was concluded in April 2008 (Coimtry Report No. 08/130), wi th Executive Directors assessing policies very positively. Directors noted the strong and well- balanced growth and credible institutions, and welcomed the commitment to macroeconotllic stability. reinvigoration o f structural reforms, and adoption o f the euro. They recognized the lirnited upward pressures on core inflation, despite rising demand pressures. and noted that this reflected the credibility o f the authorities’ strong anti-inflation policy. They stressed the importance of strengthening the medium-term budgetary framework and welcomed the authorities’ determination to speed up fiscal consolidation and reduce the mediiuu-term deficit. Finally, Directors noted the soiudness o f the banking system and the limited exposure to the U S subprime market.

81

C. Spillover from the Global Crisis

6. affected by the global crisis, albeit less so than other countries in the region. Spillovers are affecting Poland through both real and h a n c i a l sector channels (Figures 1-3):

Despite very strong fundamentals, Poland’s economy is now being severely

e Real sector channel. Export values 5

contracted by 35 percent (year-on-

o f exports in GDP o f about -5 -5

40 percent i s relatively low -10 -10

compared to most countries in the i q z i o ~ e f l e c t i n g the huger size of the Polish economy-the -20 -20 contraction in exports i s very large and it i s having a si_pificant impact on the economy. GDP growth fe l l

0 year) in early 2009. While the &are

-15 -I5

V i g f j g ql,g sowce Eumtd

from about 5 percent (year-on-year) earlier in 2008 to 1% percent iu the fourth quarter, ststaiued by relatively robust private c o m i q t i o n growth. Hi& fiequency indicators suggest that economic activity has slowed fiuther in the early 2009. Specifically, industrial output declined by about 10 percent.

Financial sector channel. There is no evidence that foreign brurks have b e p n to reduce exposures to their Polish subsidiaries. Nonetheless, a shap slowdown in credit growth is underway. as parent banks have significantly ciutailed net iuflows, which u n t i l recently fimded about ha l f o f credit growth. Indeed, surveys suggest that banks began ti_nllteuing credit criteria drmatical ly during the last quarter o f 2008, particdarly for corporate borrowing. Meanwhile, the interbank market h s remained partially frozen despite liquidity-e&mcinnp measures.

7. sovereign and 5-year CDS spreads have recently eased, they remain about 200 basis points higher than at endSeptember. The authorities placed a €1 billion bond at about 300 basis p i n t s above Geman Bunds in Janwuy. In addition, Poland’s domestic debt market has continned to attract strong demand for government paper, iucl iding fiom foreign investors, who bought a sigmficant share o f the Treasury bills and bonds issued during the March auctiom. Nevertheless, with FDI coverage of the current account deficit declining rapidly and coritinued portfolio outflows. the zloty has come uder s ip i f icant pressure, depreciating by about 35 percent against the euro since end-September 2008.

But Poland has maintained access to international capital markets. -le

82

D. Strong Policy Response to the Recent Spillovers

8. The authorities have responded in a timely and effective manner to the downturn: monettuy policy has been easing: financial sector surveillance has intensified, with importaut pro-active ineasuues: while fiscal policy has balanced shoit-term cyclical considerations with long-teim policy objectives. Specifically.

0 Monetary policy: 011 the basis o f cyclical considerations and takitlg account o f euro interest rate cuts. the MPC has embarked on a loosening cycle, reducing policy rates by 225 basis pints since November. The most recent cuts were tempered by concern about pressures on the zloty. The MPC has umderscored that it stands ready to cut rates filrther if downside risks to the economy materialize, while monitoring the exchange rate pass through and potential balance-sheet effects.

0 Financial sector. The Polish authorities have been actively safeguarding financial sector stability (Box 1). Notably, to increase domestic l i qu id i t y the NBP has arranged dollar, Swiss franc, aiid euro swaps, widened the list o f collateral that can be used at its discoumt window, mid will extend the mahuity o f reyo transactions effective M a y 1. Moreover. as the interbank market froze late last year, the authorities have proposed to guarantee inteihauk: transactions, althoitgli concern about adverse signaling effects could limit the effectiveness o f this. hi addition, the firecueiicy o f stress testiug and on-site inspections has been stepped utp to fiwther tailor recommendations to individual banks and, when appropriate, encourage smaller institutions to consolidate.

0 Fiscal policy: With a view to adheiing to their EU comi tmeuts and euro adoption timetable, the nuthoiities remain determined to ensure that the state budget deficit does iiot exceed the budpet limit o f zl. 18.2 bil l ion hi 2009-even though t h y foresee GDP growth to be sietllfcantly weaker than assumed in the budget. They intend to achieve this primarily by cutting expenditure at the state level. While the deficit of the general goveiment will remain above 3 percent o f GDP in 2009,111 part because o f I ip l ier deficits at lower levels o f govemient, these pro-cyclical expenditure cuts at the state level will s ip i f icant ly limit the extent to which automatic stabilizeis are at play. Ths, at the ctuxeut jumctwe, the authorities’ concern about the negative implications o f a I i d i e r nominal deficit for borrowing costs and their euro adoption timetable are outweighing the benefits o f allowing a strong coiuiter-cyclical impact though automatic stabilizers.

83

E. Outlook

9. intensification of adverse spillovers will weigh on the outlook. The authorities are l ikely to reduce fiuther their forecast for real GDP growth in2009: in their View, the economy is projected to continue to expand this year, although at a very slow pace. They take confidence from the s t i l l robust growth in domestic consumption evident in early 2009. StaPs baseline projection envisages a somewhat sharper slowdown in economic activity, with growth falliug fiom about 4% percent in 2008 to about -% percent in 2009, reflecting less favorable assumptions about growth in main export markets and the view that domestic demand growth is set to slow notably from its current pace. The projected recovery o f growth to about 1% percent in 2010 h g e s o n the realization o f cunmt WE0 assirmptions.

Notwithstanding Poland's solid fundamentals and sound policy response, the

10. Inflation is set to fall further. As world oil prices have M e n and wage developments have tracked real activity. price pressures have eased markedly since last sumner. despite the sharp zloty depreciation. With growth wel l below potential, inflation i s projected to remain w i t h i ts tolerance range for the foreseeable fiilure.

1 1. financial markets without undue pressures on the zloty. Declining hport volumes and firvorable t e r m o f trade developments-weakening comnodity prices, notably o i l prices- will more than offset a projected decline in exports and the ciurent account position i s set to Lerasl~lly improve. Whde FDI inflows are declining and Poland faces rollover requirements o f about $105 bi l l ion (25 percent of GDP) in 2009. s t a f f s baseline scenario that Poland can continue to satisfy its financing needs through &et borrowing.

The balance of payments i s expected to continue to be financed through access to

12. manageable. Recent data suggest that banks will remain profitable, with solvency ratios that are declining. but will remain at comfortable levels in 2009. The zloty depreciation has prompted the authorities to revisit foreign current risks in the banking sector thou$ its h lance sheet impact on corpoiates and households. On the corporate side. there have been soue concerns regarding FX options that were contracted when the zloty was strong. The vast majority o f these derivatives have been found to be associated with export hedging.; only a small portion was overhedged because export demand projections have proven optimistic. In these cases. banks have been encouraged to negotiate with their client suitable loan t e r m and ensured that banks provision for possible losses. On the household side, the authorities have seen no worsening in the quality o f banks' FX-denominated mortgage portfolios and this asset chss has continued to exhibit the lowest NPL ratios (0.6 percent at end-2008 compared to 4.4 percent for total lending). reflecting offsetting declines in FX-interest rates and earlier regulatory recommendations regarding FX lending.

Risks to the banking sector have increased, but are expected to remain

84

Figure 1. Poland: Recent Economic Developments, 2001-09

25 25

m 20

15 15

10 10

5 5

0 0 -20 - 0

-10

-M

-30

-5

-lo 4o

-15

E m lmpats - ....-.

I

-15

10

0

-10

-m

-30

40

50

consuner Business ..-...

50

40

30

20

0 10

40

m

0 3 0

-10 20

-20 10

40

30

20

10

0

-10

-20 2001 2oM 2005 2007 2009 2001 2003 2005 2007 2009

sourceS: European Cammission; Bbomberg; and Haver.

85

Figure 2. Poland: Recent Financial Markets Developments April 2008- April 2009

im 120 im 120 (April 21, rnos=loo) (Apnl21,2008 = 100) - 110

Sharp zloty depreciation against the e m reversed cwrse

Exchange Rate per E m

... while the stock market moved in tandem with regional recerlliy... peers.

Stock Market Index

- 100

- 9 0

- 8 0

- 70 9 0 -

80 - 80 6 0 - - - Poland

----. - Czech RepuMi

7 0 - _ _ _ 60 30 30 60 I I I i I I I " " " " " "

Sovereign bond spreads trended hgher, but remain contained relative to CEE peers...

1200 12M) Euro EMBIG Sovereign Spreads

loo0 - (In basii points) - lo00

8 0 0 -

6 0 0 -

4 0 0 -

Czech Republic I ' 0 100

Source: Bloomberg.

86

figlure 3. Poland: Balance of Payments Deveioprnents, 2 ~ ~ ~ - ~ 8

4 4 8 6

2 2 5 5

O 4 4 0

-2 -2

4 4

-6 -6

3 3

2 2

-8 8 1 i

-10 -10 0 0 m 2008 2004 2005 2006 2007 2008

20

25

10

5

0

-5

-10

7 7 3 3

6 2 2

3 3 O 0

2 2 -1

6 5 5 4 4

1 1

-1

1 1 -2 -2

0 0 -3 -3

Sources: European Commission; Bloomberg; and Haver.

87

Box 1. Measures to Safegnard Financial Sector Stab-

To increme bank's capitol biflws Encouraged banks to retain earnings to boost onn capital. With all p f i t s froru 2008 retained capitaldequacymtio would iucrease by 1.5 percentage poiuts.

To pim.rde :lop and foreign ctiireiiq Iiqinidit.v 0 weekly three-mth (and starting In May. six&) r e p operatlom haw been introduced.

0

The range of collateral for Lombard crectt has been broadened and haircuts reduced. The NBP started pviduqt euro swaps to domestic banks. NBP has secured jmticipatiou in the weekly euro-Sn;iss h c exchange map operations of the S ~ i s s National B a d and the Ewosystem A repo line with the ECB of up to €10 billion has bee11 made alailable to the NBP.

To intens@$nancwI sector siiivedlonre h d freqwncy of stress testing and onsite larpections. Requested banks to review their lending policy rmnd contingency p h . Request4 banks to submit daily reports on new exposures to fmign entities.

To pivnprh issue coirecmr nieosiws Stepped up inclivdual measures towards certain banks. For emny.de. early wafnhgs were issued to some banks to stop mortgage lending in foreip currency when they started experiencing FX fimdmg difficulties. * Issued reconnnendations to a couple of sinall banks to increase their capital base as their CARS were Elllmp close to 8 percent. Planned consolidation for s d banks that are not viable.

To boost co?$dence in the qstein The Bank Gumantee Fuml law has been d e d to increase dx la-el of deposit guarantee from t22.500 to €SO.OOO and eliminate EO' murawe. A draft law to guarantee interbank lending has been submitted to the parliament. Tbe government has set aside d. 40 billion for these guarantees.

To increme coordi,lotios between ogencies Frequent meetings of the Financial Stability C&ttee to discuss issues and mxtsures. The committee was legally established in the fdl of 2008 and it i s coIllprised of repremtatives from the m P . KNF and MOF. The KNF has been in close contact with parent banks and supenisors. 0

To boost donredic credit Increased the capital of state-owned BGK bank by d. 2 billion enabling it to lend about A. 20 billion to domestic firms. A $500 d o n credit line from the World Bank for Polish SMEs i s in the pipeline.

88

ANNEX 5: STATUS OF BANK GROUP OPERATIONS IN POLAND

Protection Subtotal FY07

Poland: Planned and Actual Deliveries, FY05-09

A. Lending Deliveries

184.0

FY09 I None

I FY08 I None I I None 1 - 1

I Development Policy Loan I 1,250.0

Total FY05-09

(DPL) Subtotal FY09 1,250.0

620.5-680.5 Total FY05-09 1,859.5

11 Approved on July 1,2004, prior to the CPS. The operation was included in the previous CAS

89

B. Non-Lending Deliveries, FYOS-OS (excluding Regional Studies)

FY07

FY08

None Ownership Policy for SOEs Hard Coal Sector Dialogue

None Performance Based Budgeting Conference Insolvency and Creditor Rights ROSC

90

ANNEX 6: POLAND AT A GLANCE

Poland a t a glance Y 1 2/09

Key Development Indicators

(2008)

Pcpulstion, mid-year (millions) S l r f xe aea( tbusad sq. km) Pcpuldion gavth ( O h )

Urban ppuldion(% oftotal populaticn)

GNI (Atlas method, U S balions) GNI per capita(Atlas metimd, US$) GNI DercaDitaIFPP,intemdionrl $)

GDP growth (%) GDP per capita growth (%)

(most fecent esdimate, 2003-2008)

Prxelty headcourt ratio d $1.25a day (PPP, %) Pwefty headcourt ratio d $2.00a day (PPP, %) Life expectancy at birth(years) Infant mortalty (per 1 ,003 Ike births) Child mdnutition(% ofchldren mder5)

Adult Steracy, male (% d ages 15 an3 ol&r) Adrlt Heraw, female (%of ages 15and older) Gross primary enmlmert, male (% d age group) Grcss primary enmilmert, female (% of agegrmp)

Access to an improved water wurce (% cf population) Access to improvedsatitation fadlites(% ofpopuhtion)

Poland

38.1

0.0

373.2 9790

15500

4.9 4.9

<2 <2

100 99

Europe & Central

Asia

446 23,972

0.2 64

2,697 6,052

11.262

6.9 6.7

4 9

70 21

99 96 98 96

95 89

Upper mddle incane

a 4 41,497

0.7 75

5,854 7,107

12.072

5.8 50

71 21

95 93

112 109

95 83

Age distribution, 2007 I

6 4 2 0 2 4 6 percent of toblpopulalon I

Under-5 mottalty mte(per 1,000)

I 6 0 1

50 i i_i 10

0

Net Aid Flows

IUS$ nilionsf Net ODA a d offcial ad Top ddonors (h 2000:

European Canmission Franc? Postria

Ad (% of GNI) Ad per capita (US$)

Lcmg-Term Economic Trends

Consumer prices (annual % chage) GDP 'mplicit deflator (annual % change)

Exchangerate(mnua1 average, bcal per US$) Terms d trade index (2000 = 1 03)

Pcpuldion, mid-year (mibns) GDP (US$ milloffi)

Agcutture Indrstry

services

Household fnal consumption eqerditure General govY final coffiumpionexpendibre Grcss cadtalformatiin

Exports of gods a d services Impr6 ofgoodsand sewices Grcsssavirgs

Mnufadurirg

1980

358

I990 2000

1920 1,396

289 838 2 197

27 124

2.4 0.8 35 36

70.3 10.1 55.2 7.2

0.9 4.3 104 100

38.1 38.5 58,976 171,276

(%o fGDq 8.3 5.0

50.1 31.7 18.5

41.6 63.3

48.0 63.1 19.3 18.5 25.6 24.8

286 27.1 21.5 33.5 15.9 18.8

2008 a

I, 524

1,101 197 83

0.6 40

4.2 31

24 102

323 I 526,923

4.2 30.9 17.0 64.9

60.6 17.9 250

39.5 430 232

Growth of GDP and GDP per capita ( O h ) I 8 6 4 2 0 P 4 6 a

-N)

95 05

198040 1990-2000 2000-08 (averageannud growth %) 0.7 0.1 -0.1

4.7 4.3

0.5 1.3 7.1 5.6 9.9 8.2 5. I 4.0

5.2 3.7 3.7 3.7

10.6 6.6

11.3 10.2 16.7 9.3

Note: Figures in italics are fcr yearsotherthm those specified. 2008data are pdimnary. .. indicates daB are not wailable. a. Aid &ta are f u 2037.

Develcpment kommics, Dwebpmert Data Group (DECDG)

Poland

2000 2008 Balance of Payments and Trade

(US$ m'lbns) Total merchmdise emorts (bb) Total merchmdise 'mports (af) Net tra& in wods and services

Cunent aocaint batance i6 a % ofGDP

Workers' remittances and compensation ofemployes (receipts)

Reserves, ircbdirg gold

Central Government Finance

(% of GDP) Current revenue (lncbdirg grants)

Current expendture

Overal surplus'defcit

Himest margin4 tax rate (%)

Tax revenue

hdiwdllal Copcrab

External Debt and Resource flows

(US$ niRbnsf Total debt aitstmdirg and dsbursed Total debt service DebtreAef (HBC, MDRO

Total debt (% of GDP) Total debt service(% of Bcpcrts)

Foreig, dired iwestment(net inflows) Pat fdb equity(mt inlows)

31.729 185.647 49,023 195,906

-10,904 -19,371

- 10,343 -29,029 6 . 0 -5.5

1,726 10,496

27,466 6,180

38.1 39.2 19.8 22.8 38.2 37.8

-3.0 3.9

40 40 28 19

64,834 217,376 10,156 17,435

- -

37.9 41.3

9,343 19,198 447 -2,134

L-J FTvab, 152e40

U S millions

Private Sector Development

Timereplired tostat abueness (days) Cost to start a busiress (% of GNI per capita) Timereplired torqister property (days)

Ranked as a mqorcmstrant to tuslness (% of mmagers sunieytxl who igreed)

Tax rates Access tdcost of Ranarg

Stockmarket capitalnation(% ofGDP) Bmk captal toasset rata (%)

2000 2008

- 31 - 18.8 - 197

2000 2007

.. 57.5

.. 50.7

18.3 48.8 7.1 7.4

I Governance indlcators, 2000 and 2007

Vaceanc acMunBbhty

Pdllcal sebltty

Regulatoryquality

Rule of h w

Con eo I of co rmpt lo n

0 25 fo 75 100

a2007 e2CKXI

Country's pe rcenlle rank (C- 100) hgher mfues mpiy bfb?rmfms

Technology and Infrastructure

Paved roads (% of total) Fixed fine m d moblephone

High tectnoicgy e x p r k subscnbfts (per 100 pmple)

(%of marufacbrd exports)

Environment

Agmutural land (%of land area) Forest sea(% oflandarea) Natanaliyproteded areas (Oh of lard area)

Freshwzier resources per capita (cu meters) Freshwzierwithcfawl (bXlan cublc meters)

COPemissons per capita (mt)

G DP per unit of energy use (2005PPP$ per kgof O B eplivafert)

Enwav use DFI capita (ka d oil eaulvdent)

2000

68.3

46

3.3

60 30.6 5 6

1,402 16.2

7.8

5.1

2,325

2007

69.7

136

3 8

52

1,453

Z9

5 7

2.562

Note:Figuresin t a l a arefcr yearsotherthm those specifid. 2008data aepreliminary. .. indicates dab are not walatle. -indicates cbservatim isnot applicatle

Develcpment Ecommics, Dwebpmert Data Group (DECDG).

511 2/09

92

Wisla

San

Notec

Warta

Vistula

Odra

Odra

Nysa

Warta

Wis

la

Bug

N

arew

K U J AW S K O -K U J AW S K O -P O M O R S K I EP O M O R S K I E

L Ó D Z K I EL Ó D Z K I E L U B E L S K I EL U B E L S K I E

LUBUSKIELUBUSKIE

MAZOWIECKIEMAZOWIECKIE

OPOLSKIEOPOLSKIE

PODKARPACKIEPODKARPACKIE

P O D L A S K I EP O D L A S K I E

P O M O R S K I EP O M O R S K I E

W I E L K O P O L S K I EW I E L K O P O L S K I E

ZACHODNIOPOMORSKIEZACHODNIOPOMORSKIE

WA R M I N S K O -WA R M I N S K O -M A Z U R S K I EM A Z U R S K I E

SWIETOKRZYSKIESWIETOKRZYSKIESLASKIESLASKIE

DOLNOSLASKIEDOLNOSLASKIE

MALOPOLSKIEMALOPOLSKIE

RadomRadom

KoninKonin

PlockPlock

TorunTorun

KrosnoKrosno

TarnówTarnów

KaliszKaliszLesznoLeszno

LegnicaLegnica

SieradzSieradz

SiedlceSiedlce

SuwalkiSuwalkiKoszalinKoszalin

WloclawekWloclawek

CiechanówCiechanów

TarnobrzegTarnobrzeg

JeleniaJeleniaGóraGóra

Zielona GóraZielona Góra SkierniewiceSkierniewice

PiotrkówPiotrkówTrybunalskiTrybunalski

PilaPila

SlupskSlupsk

ElblagElblag

OstrolecaOstroleca

CzestochowaCzestochowa

Nowy SaczNowy Sacz

LomzaLomza,

BialaBialaPodlaskaPodlaska

ChelmChelm

ZamoscZamosc, ,

PrzemyslPrzemysl,

Bielsko-Bielsko-BialaBiala

WalbrzychWalbrzychOpoleOpole

KrakówKraków

KielceKielce

LublinLublin

RzeszówRzeszów

OlsztynOlsztyn

KatowiceKatowice

SzczecinSzczecin

BydgoszczBydgoszcz BialystokBialystok

GorzówGorzówWielkopolskiWielkopolski

LódzLódz

PoznanPoznan,

WroclawWroclaw

WARSAWWARSAW

RUSSIANRUSSIANFEDERATIONFEDERATION L I T H U A N I AL I T H U A N I A

UKRAINEUKRAINE

CZECH REPUBLICCZECH REPUBLIC

SLOVAK REPUBLICSLOVAK REPUBLIC

BEL

AR

US

BEL

AR

US

GE

RM

AN

YG

ER

MA

NY

To To BerlinBerlin

To To BerlinBerlin

To To BerlinBerlin

To To DresdenDresden

To To PraguePrague

To To PraguePrague

To To BrnoBrno

To To ZvolenZvolen

To To KosiceKosice

To To L'vivL'viv

To To Kovel'Kovel'

To To Kovel'Kovel'

To To VilniusVilnius

To To GusevGusev

To To PinskPinsk

To To BaranavichyBaranavichy

To To NeubrandenburgNeubrandenburg

K U J AW S K O -P O M O R S K I E

L Ó D Z K I E L U B E L S K I E

LUBUSKIE

MAZOWIECKIE

OPOLSKIE

PODKARPACKIE

P O D L A S K I E

P O M O R S K I E

W I E L K O P O L S K I E

ZACHODNIOPOMORSKIE

WA R M I N S K O -M A Z U R S K I E

SWIETOKRZYSKIESLASKIE

DOLNOSLASKIE

MALOPOLSKIE

Radom

Konin

Plock

Torun

Krosno

Tarnów

KaliszLeszno

Gdynia

Legnica

Sieradz

Siedlce

SuwalkiKoszalin

Wloclawek

Ciechanów

Tarnobrzeg

JeleniaGóra

Zielona Góra Skierniewice

PiotrkówTrybunalski

Pila

Slupsk

Elblag

Ostroleca

Czestochowa

Nowy Sacz

Lomza,

BialaPodlaska

Chelm

Zamosc, ,

Przemysl,

Bielsko-Biala

WalbrzychOpole

Kraków

Kielce

Lublin

Rzeszów

Olsztyn

Katowice

Szczecin

Bydgoszcz Bialystok

GorzówWielkopolski

Gdansk´

Lódz

Poznan,

Wroclaw

WARSAW

RUSSIANFEDERATION L I T H U A N I A

UKRAINE

CZECH REPUBLIC

SLOVAK REPUBLIC

BEL

AR

US

GE

RM

AN

Y

Wisla

San

Notec

Warta

Vistula

Odra

Odra

Nysa

Warta

Wis

la

Bug

N

arew

Bal t ic Sea

Gulf ofGdansk

To Stralsund

To Berlin

To Berlin

To Berlin

To Dresden

To Prague

To Prague

To Brno

To Zvolen

To Kosice

To L'viv

To Kovel'

To Kovel'

To Vilnius

To Gusev

To Pinsk

To Baranavichy

To Neubrandenburg

Rysy(2,499 m)

54°N

52°N

50°N 50°N

52°N

54°N

18°E 20°E 22°E 24°E

16°E14°E 18°E 20°E 22°E 24°E

POLAND

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

0 25 50 75

0 25 50 75 Miles

100 Kilometers

IBRD 33467R

MARCH 2007

POLANDSELECTED CITIES AND TOWNS

PROVINCE (WOJEWÓDZTWO) CAPITALS

NATIONAL CAPITAL

RIVERS

MAIN ROADS

MAIN RAILROADS

PROVINCE (WOJEWÓDZTWO) BOUNDARIES

INTERNATIONAL BOUNDARIES