Could do better?

IFR Emerging Europe and Turkey Special Report 2014
10 min read

A strong Poland may be set to lead the CEE pack this year, but there are those who believe it could be doing even better.

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Sturdy Slavic reason underpins the popular Polish proverb, “Better is the enemy of good”, a deeply conservative maxim that suggests trying too hard to excel poses risks.

Poland’s economic performance is undoubtedly good – banks and brokers are now revising growth forecasts upwards and the figures suggest it will lead the pack in emerging Europe this year.

But a lingering sense among some observers that the country could be doing better – underpinned by a recent OECD call for more reform – highlights the dilemma at the heart of this Polish saying.

“The hard and soft data both confirm a rebound in the Polish economy in coming quarters, although I’m not excessively optimistic because for Poland growth of about 3.3% this year is not very high and simply takes it close to its potential. But when we look at the situation outside Poland, things obviously look optimistic,” said Jaroslaw Janecki, chief economist in Warsaw at Societe Generale.

Consensus forecasts were until recently pointing to 2.9% growth in 2014 and 3.4% in 2015, but most analysts now agree that the economy is likely to exceed these figures, with estimates ranging between 3.0% and 3.3% for this year and between 3.8% and 3.9% for 2015.

Importantly, this is the right kind of growth, with a reliance on domestic demand supported by improved business sector confidence and public investment spending. Finance Minister Mateusz Szczurek has indicated that stronger-than-expected growth means Poland will make significant progress in cutting its budget deficit this year.

Domestic driving

“Everyone is assuming that Poland is growing now because of the eurozone recovery, but this year the main driver will be domestic demand. It’s a kind of a sweet spot – they are getting good support both from external and internal demand,” said Marcus Svedberg, chief economist at East Capital.

While growth will primarily be driven by domestic demand, that is not to discount the role of trade, with Poland’s current momentum starting in Germany. Regions such as Poznan have long benefited from investments by German giants such as Volkswagen, which in March said it would spend another Z3.4bn (US$1.1bn) to build a factory at Wrzesnia.

A number of factors underpin Poland’s recovery and make it broadly balanced.

First and foremost, domestic demand is being fuelled by growth in real disposable incomes. A long period of low inflation and low interest rates has enabled higher growth in real disposable income compared with other eurozone economies.

Wage growth is stable, and unemployment, which hovered at 14% in Q1, has begun to fall, according to Labour Minister Wladyslaw Kosiniak-Kamysz.

In April, the central bank Narodowy Bank Polski decided to keep key rates at an all-time low of 2.5%. Inflation is expected to stay below the 2.5% target this year.

Societe Generale’s Janecki said: “I think that during this year, CPI will be even below 2% and the central bank target is 2.5%. But I still see a risk that the central bank may start to hike rates in November, although this risk is not very high at the moment and the first hikes will probably be in 2015.”

Soft data are also positive, with PMI factors suggesting new domestic and external orders and a growth in investment, sales and production. In recent years it has not been uncommon for Poland to experience negative investment growth, but cash-rich companies now appear to be investing more, buoyed by EU transfers.

Sound banking

Underpinning Poland’s real economy performance is unrivalled stability in the financial sector, bolstered by a conservative regulator. While the share of non-performing loans increased during the financial crisis, strict regulations have meant the banking sector remains one of the soundest parts of the economy.

“Poland’s banking sector is very robust, with quite a conservative central bank and regulator, the PFSA. There were no problems with toxic loans or instruments in Poland, and the only problem on the revenue side is the relatively low level of central bank interest rates and the low level of market rates that limit interest income,” said Arkadiusz Krzesniak, chief economist for Deutsche Bank in Warsaw.

While credit growth remains muted, most observers see it picking up. The central bank has pointed to a likely increase in consumer and corporate loan growth rates this year and the Association of Polish Banks (ZBP) forecasts rising mortgage loans.

Conservative financial regulation is backed by tough budget laws that are unique among CEE countries, whereby public debt levels are fixed by the constitution at between 50% and 55% of GDP. Pension reforms this year will reduce that to about 48%.

Professor Tadeusz Kowalski of the Poznan University of Economics said: “I would stress that we have developed since 1996/97 a certain culture of controlling budget deficits. Of course, this is always a highly politicised issue as everywhere, but the rules that were imposed by the government are such that I would not see major problems coming from the sovereign debt area or the general government budget deficit.”

In February, Poland privately placed a €300m 20-year bond issue with German investors but Deputy Finance Minister Wojciech Kowalczyk said it did not plan any more public euro or US dollar-denominated bond issues this year.

Yet even though the country is poised to clock the fastest growth this year among its CEE peers, given the strength of its fundamentals should it be doing better?

In its latest economic survey on Poland published in March, the OECD said more reforms were needed and called for further liberalisation of the labour market and more privatisation of state-owned companies.

Business reform

Most observers also say that authorities need to make doing business easier, and Poland also ranks among the lowest in total government support to R&D among OECD members.

East Capital’s Svedberg said: “You could still do more in terms of business reform, improving the ease of doing business – Poland doesn’t score all that well in the World Bank ranking on how difficult it is to do business, on regulations and so on. It’s not catastrophic – but given how modern Poland is and how well developed it is, it should really score better.”

A significant change under way to the pension system offers an illustration of the conservative reflex to resist the urge to excel.

Changes will reallocate a large portion of contributions that used to go to funded schemes to the state in a move aimed at improving public finances. While this will improve the fiscal balance, it fails to address longer-term demographic challenges and has strategic implications for the Warsaw Stock Exchange.

“There may be some unforeseen consequences. First of all, less liquidity on the stock exchange, and second there may be also some impact on thePolish government bond market. However, the main potential threat is a reduction in liquidity in the stock market. It’s not an imminent danger – the problem is that this pension reform makes the private part of the pension system more dependent on the stock market and on the fluctuation of stock prices,” said Krzesniak at Deutsche Bank.

Kowalski argued that the reform might make sense statistically – but it is certainly not elegant from a macroeconomic point of view.

“On the macroeconomic side, of course, you will have negative impact on the Warsaw Stock Exchange because the flow of funds going from the pension schemes to the exchange will be reduced, but on the other hand, I understand the government trying to reduce the cost of functioning of the general pension system because the very idea behind this reform was to achieve a slightly reduced level of public debt.”

Eastern burden

And a key challenge facing Poland is also the worsening crisis to the east.

The main economic risk posed by a failure of diplomacy in Ukraine is to gas transit to CEE markets: Poland imports about 97% of its crude oil and about two-thirds of its natural gas from Russia.

Deutsche Bank and Societe Generale estimate that the potential impact on trade of the Ukrainian crisis ranges between 0.2 and 0.5 percentage points of lower GDP growth in Poland.

Krzesniak at Deutsche Bank said: “Ukraine and Russia combined account for 8% of Polish exports, with Russia Poland’s second trading partner after Germany and much more important when it comes to energy imports. So the direct impact of the Ukrainian crisis this year could be a reduction of GDP growth up to 0.3 percentage points – although the long-term consequences may be higher.”

Yet while Ukraine generates uncertainty, there are those such as OECD secretary-general Angel Gurria who see the crisis geopolitically in terms that will ultimately consolidate a broader CEE embrace of Europe.

So if Poland appears content to be satisfied with consistent improvement even if this means it does not excel – its robust performance in an uncertain neighbourhood might suggest that this remains the right choic