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Poland: will rising US rates halt progress?

The central European economy boasts strong internal demand and a healthy export status, but will that be enough to tempt investors?
May 31, 2018

Later this year, in the first such promotion in the FTSE Russell’s classification system in almost a decade, Poland will be upgraded from an ‘advanced emerging’ to a ‘developed’ market. The switch is the result not only of improvement in the country’s capital markets infrastructure, but its economic progress. It could also create a positive feedback loop; some market watchers estimate the move could result in billions of dollars of foreign inflows into the country.

The key economic indicators point to a bright outlook. Real gross domestic product was up4.6 per cent last year, Poland’s fastest growth rate in six years, buoyed by rising domestic demand and the robustness of the European Union, its main trading partner. That rate is expected to moderate slightly to 4.3 per cent this year, according to the World Bank, a level that still outstrips forecasts for neighbours the Czech Republic and Hungary at 3.4 per cent and 4 per cent, respectively. Low consumer prices inflation and greater disposable income have also boosted Poles’ own consumption of goods and services.

However, like its emerging market peers, Poland’s assets have not been immune to rising US interest rates and government debt yields. After an impressive 2017, the MSCI Poland index has declined by 9 per cent since the start of this year, while the Polish zloty is trading at a six-month low against the US dollar. What’s more, the government’s ongoing dispute with the European Commission over budgetary reform could soon increase the political risk premium attached to Polish assets.

Aspirations (and GDP) rising

In common with several other emerging (or near-developed) market economies, Poland’s GDP expansion during the past decade has been fuelled by rapidly growing domestic consumption. That has only added to the upward trend in living standards since the country’s emergence from decades of communist rule almost 30 years ago. Last year, GDP per capita was 72 per cent of the EU average, according to data from the Organisation for Economic Co-operation and Development (OECD), up from 48 per cent upon Poland’s accession to the trading bloc in 2004.

At the same time, unemployment has been gradually declining, and fell to a post-communist low of4.4 per cent in March, according to Eurostat. That, along with rising wage inflation, has fuelled household spending. What’s more, that uptick in wages has not yet been accompanied by a broader rise in consumer prices inflation, part of the reason interest rates have been held at an historically low1.5 per cent. “It’s fundamentally a fantastic economy,” says Renaissance Capital’s chief economist, Charles Robertson. “The only problem is that the labourforce is shrinking.” That’s been caused not only by an ageing population but emigration to other parts of Europe. Mr Robertson estimates that – based on UN statistics – the Polish working age population will decline by up to 1 per cent a year for the next 15 years.  

A surge in labour from neighbouring Ukraine has mitigated that in recent years, with the number of Ukrainians receiving temporary work registrations rising sixfold  to 1.3m during the three years to 2016. However, since the EU visa regime for those nationals started to ease in May last year, some Polish officials, including central bank governor Adam Glapinski (right), have voiced concerns over the nation’s ability to continue to attract the workers needed to sustain economic growth. Poland’s Union of Entrepreneurs and Employers has estimated around five million additional workers are needed over the next three decades for this to happen.

 

EM, but a bit different

However, it’s not just internal demand that is driving economic growth. One source of Poland’s fiscal strength is its healthy level of exports, spurred by foreign multinationals establishing production facilities in the country since the removal of state control. A skilled and well-educated workforce, low levels of inflation, central location and EU membership have all contributed to its attractiveness as an export hub.

Despite rising internal demand, the rate of export growth has been outstripping that of imports, resulting in the country’s first trade surplus in 2015 (see chart). Admittedly the country reported a marginal trade deficit during the first three months of this year – €317m (£276.13m) in March – but that needs to be viewed in the context of its European neighbours and other emerging market countries, which have consistently run far greater trade deficits.

Fellow EU members account for the majority of exports, with Germany its top trading partner – unsurprising given automotive-related goods are Poland’s largest export line by volume. And with German GDP growth hitting 2.2 per cent in 2017 – its fastest rate in six years – that’s invariably a good thing for Poland. Then again, there is the risk that the unwinding of quantitative easing by the European Central Bank – which has propped up growth since its introduction in 2015 – may temper demand from the rest of Europe for Polish goods.  

For now, a robust level of exports has been one of the factors contributing to a gradual improvement in Poland’s current account position. Last year its deficit declined to €7.7bn, or a decade-low of 1.7 per cent of GDP (see chart). That’s lower than neighbouring Romania and Hungary, as well as European G20 members France, Italy and the UK.

Indeed, a greater degree of fiscal balance sets Poland apart from many other emerging market economies. Unlike Brazil, Argentina and Turkey, for example, the central European country is less reliant on foreign direct investment; a handy scenario when US rates and the dollar are rising. That’s not to say Poland will be unscathed by rising rates. The cost of its borrowing would likely rise, given external debt accounted for 66.5 per cent of GDP last year – although that’s compared with the EU average of 121 per cent.

Its local currency debt has not fallen out of favour with investors, with the yield on 10-year government bonds contracting towards the 3.1 per cent mark in recent weeks. And while a 3 per cent yield on US treasuries makes the risk/reward of holding Polish bonds less desirable, Oxford Economics senior economist Evghenia Sleptsova reckons the fiscal balances and macroeconomic drivers within Poland have the potential for the zloty to eventually strengthen against the US dollar.

Political calm or confrontation?

Political wrangling may also dampen sentiment among foreign investors. The ruling Law and Justice Party (PiS) is locked in a row with the European Commission over judicial reforms, which could strengthen proposals to curb future funds to the country. The source of the government’s ire is the Commission’s plan to link its next cohesion funding – running between 2021 and 2027 – with members’ respect for ‘the rule of law’. Unfortunately, the Commission and many observers believe Poland’s judicial independence is under threat. These reforms – pushed through the lower house of parliament at the end of last year – included giving parliament control over the body that appoints judges. PiS argues that the changes are necessary to curb corruption and inefficiency. And despite offering some amendments the government remains in dispute with the EU.

The country is already in line for a cut to its EU support, following plans to consider factors including unemployment rates and education levels when allocating funds, rather than just member states’ GDP. That will likely divert assistance from some Eastern European members to struggling southern states such as Greece and Italy. In its draft long-term budget, the EU has allocated €72.7bn in funding for Poland, a 16 per cent reduction on the 2014-20 figure.

After repeated warnings, in December the EU threatened to trigger Article Seven – a punishment clause against member states that demonstrate a “serious breach” of the bloc’s democratic values. Yet ally Hungary, whose own judicial reforms came under EU scrutiny in 2013, looks likely to block any sanctions, which would require the approval of all member states.

It’s not the first time Poland has got into hot water over its legislative reforms. The European Commission last year ordered Warsaw to suspend a law that would tax large retailers, predominately foreign-owned supermarkets like Tesco and Carrefour, based on their monthly turnover – a move seen as part of a broader ‘RePolonisation’ agenda by the government. The policy has been most marked in the state’s banking system. Last year, UniCredit sold its controlling stake in Poland’s second-largest bank, Pekoa, to state-owned insurance company PZU and the Polish Development Fund.

The renationalisation of part of the banking system followed concerns over international banks providing liquidity to their Polish subsidiaries, says Jakub Celinski, a partner in the Warsaw capital markets practice of law firm Dentons. “The foreign shareholders took very high dividends just to provide cash to their own mother companies that were struggling in other markets,” he says. That’s less possible now lending can be directed towards Polish industries which previously lacked credit lines from foreign-owned banks, argues Mr Celinski.

However, not everyone believes the moves will bring benefits. “There is plenty of research that finds that state ownership is associated with lower efficiency and productivity relative to private ownership, so renationalisation of the Polish banking sector does not bode well for overall financial intermediation in the banking system,” says Oxford Economics’ Ms Sleptsova. However, with one of the more developed financial systems in the EU, Poland’s increased state ownership will not necessarily feel much short-term pain if it is well-capitalised and prudently managed, she adds.

Where the judicial reforms are concerned, the EU has turned to indirect financial sanctions. Poland has been the biggest beneficiary among member states of the trading bloc’s regional and cohesion policy between 2014 and 2020, with €86.1bn earmarked for spending. However, while Poland’s economic growth has outpaced its peers in central and eastern Europe since its accession, growing by 32 per cent over the decade to 2016, EU aid accounted for just one percentage point of that growth, according to analysis from Oxford Economics .

That said, a reduction in access to EU funds could damage confidence in the country among other member states, which account for 80 per cent of Poland’s exports and 88 per cent of foreign direct investment. Commission president Jean-Claude Juncker has said an agreement on the budget proposals should be in place before European Parliament elections in May next year.

While the spat between Poland and European authorities is likely to play out a while longer, the imposition of real sanctions – under Article Seven – looks doubtful given the unanimity required to secure approval. The impact of rising US rates is more pressing – it gives little impetus for investors to hold Polish debt. However, the underlying economy looks robust enough that we think gaining a relatively small amount of exposure to Polish companies could be worthwhile. What’s more, on a cyclically-adjusted price/earnings basis, Polish equities are trading at a ratio of 12.1, according to Star Capital. That’s a slight premium to the rest of emerging Europe at 9.3, but below an emerging markets average of 17.3.  

Like most emerging markets, retail investors’ best bet for accessing the country is through funds. If you want to gain exposure to this economy – which looks to be at the safer end of the emerging market spectrum – we’ve included some of the most appropriate funds in the box below.