SEB MERCHANT BANKING – COUNTRY RISK ANALYSIS 17 February 2015
Economic growth has been surprisingly healthy given weak eurozone demand and negative spill-over effects stemming from the Ukraine conflict. The fiscal deficit and gspill-overnment debt are gradually declining while the current account deficit has shrunk.
Country Risk Analysis
Summary
The Polish economy is deeply integrated with the Eurozone economy through the production chain, through trade and through its banking system. It is also one of the European countries that is most exposed to Russia and Ukraine. While increasing global integration indeed benefits the economy in the long run, the weakness of eurozone demand and the ongoing Russia/Ukraine conflict currently has a cooling effect on economic activity. Against this background, Poland did surprisingly well in 2014 as far as the business cycle was concerned. The growth engine switched to domestic demand, likely pushing real GDP growth to just above 3% despite some slowdown at the end of the year. Weak demand in Germany and rapidly decreasing trade with Russia and Ukraine generated a negative
contribution from net exports. Economic growth is expected to moderate marginally this year. However, most risks to this forecast are on the downside. The current account deficit has come down clearly below the past years’ average 4-4.5% of GDP and continues to be comfortably financed by foreign investment and portfolio flows. International reserves have declined. With growth below potential, inflation has come down sharply since the peak in 2011 while unemployment has fallen. The central bank responded with an interest rate cut in October and it is likely that more cuts will follow in 2015 as inflation is likely to remain well below the central bank’s target.
The fiscal policy framework has been strengthened further, cementing expectations of government debt remaining well below the constitutional limit of 60% of GDP for the foreseeable future. External debt is high and rising.
Recent economic developments
Strong connections to the EU and Russia/Ukraine: Poland has become
increasingly integrated with global trade and financial markets, in particular with EU markets. Goods exports to the EU amount to more the 75% of total exports and close to 90% of foreign direct investment (FDI) originated from the EU in 2013.The banking sector too has strong connections to the global financial system with more than 60% of assets in foreign hands.
While a longer-term benefit, integration also means dependence. Poland is one of the countries suffering the most from the Russian bans on food exports and limits on gas supplies. Although exports to Russia and Ukraine do not amount to more than 8% of total exports, a significant share of Polish exports to other countries has Russia as their final destination.
Stable economic growth: Poland’s economic performance has been
impressive since the early 2000s allowing it to gradually converge towards EU15 average levels of GDP per capita. By 2013 the country had achieved a level of wealth never experienced before. The economic recovery that started in mid-2013 largely continued during 2014, with GDP expanding more than expected despite some slowdown at the end of the year. The growth engine switched from
foreign to domestic demand, pushing real GDP growth for the year to an expected 3.4%. Household spending has been supported by rising employment and a
significant real wage growth. Meanwhile, investment activity has been bolstered by healthy credit growth and, on the public side, EU transfers. A negative
contribution from net exports comes both from weakening demand in Germany and from rapidly falling trade with Russia and Ukraine.
Recent downward revisions to GDP forecasts across Europe, Poland’s most important export market, point to some cooling of economic activity in 2015. Risks to the forecast are on the downside, including a weaker-than-expected recovery in the Eurozone, as well as rising tensions related to the Ukraine/Russia conflict that would threaten the continued vigour of domestic demand. Another risk to
household spending would be a worse than expected development in the labour market.
Some observers see the rise in CHF-denominated mortgage debt in the wake of the rising Swiss franc posing a threat to household spending. However, these loans do not amount to more than one fifth of total household loans, or 8% of GDP. In addition, the households sitting on the FX loans are relatively high-income earners. The recent FX movement is estimated to raise household debt servicing costs on mortgages by around 0.15% of GDP. This suggests that any effects on consumer spending are likely to be modest. Nevertheless, summing up the risks to our forecast of marginal slowdown in economic growth in 2015, we would argue that risks are on the downside.
Gradual improvement in labour market: The past year’s economic recovery has contributed to improving labour market conditions. The unemployment rate has been on a gradual downward path and fell to 8.2% at year-end (Eurostat
definition). Structural unemployment in Poland remains higher than in most economies in the region, according to the OECD. Nevertheless, long working hours has contributed to lifting labour utilization to roughly the EU average despite one of the lowest employment rates in the OECD.
Deflationary pressures: With growth below potential, inflation has come down sharply since the peak in 2012. A bottom-up approach reveals that lower food prices have been an important factor in driving prices lower. In January, consumer prices fell by 1.3% yoy, far below the 1.5% lower end of the central bank’s 2.5% ±1 percent inflation target range. Core inflation has fallen too but remains positive, suggesting that oil prices have been the main reason for the recent drop in
headline inflation. We see consumer prices recovering only very gradually later in the year. The central bank in its most recent inflation report, perhaps slightly optimistic, argues that the nature of the sources of deflation indicates that there is limited risk that deflation will hurt economic growth.
Current account deficit is manageable: The deficit on the current account has averaged roughly 3% in the past five years, due to a relatively low national savings rate and large investment needs. It has been financed by capital transfers from the EU and relatively strong net FDI and debt inflows. While the deficit came in just above 1% in 2014, it should fall below 1% of GDP in 2015, helped by the slump in oil prices.
Economic policies
Despite relatively healthy GDP growth, budget deficits have been higher than in most rating peers in the past, remaining above the 3% of GDP mark since 2009. Following the 2013 slowdown when fiscal policy allowed automatic stabilisers to operate, some consolidation followed in 2014 when the deficit is expected to have fallen to about 3%. This year, the government looks at reducing it to 2.5% which would allow it to exit the Commission’s Excessive Deficit Procedures (EDP) in 2016. We view this as realistic. The government’s drive to exit the EDP is strong and a deficit reduction will also be helped by effects following the pension reform (see below). However, there is a non-negligible risk that the fiscal grip may be loosened in the run-up to the elections.
Public debt to stabilise: Although growth in public debt slowed sharply in 2012 due to fiscal consolidation efforts, it climbed to about 55% of GDP in 2013. This is high compared to credit rating peers but
it still makes Poland one of the few economies within the EU with a debt below the Maastricht criteria. During 2014, changes to the pension system were made that reversed part of a 1999 pension reform which had produced transitional costs. In essence, the government now took back Pillar II savings into the Pillar I pension fund. A significant scaling down of the private funded pension pillar involved transfers equivalent to more than 8% of GDP. These changes had a
one-off effect on public debt, which together with other measures will have reduced it to about 49% at end-2014.
Strong macroeconomic policy framework: Poland’s sound macroeconomic framework was strengthened further last year. The constitutional limit capping general government debt to 60% of GDP remains. However, the additional debt ceilings putting restrictions on the budget were lowered to 48 and 43% respectively (previously 55 and 50%) to accommodate for the pension system changes. We see debt remaining below 50% in the coming years as there is broad political support for fiscal prudence and a strong will to avoid constitutional restrictions on spending. In addition and perhaps more importantly, the government adopted a new fiscal rule that limits spending as long as the budget deficit is higher than 3% of GDP or public debt is higher than the lower of the two constitutional limits. The country’s external debt was on a moderate upward trend already before the global financial crisis, but jumped 9 percentage points to almost 60% of GDP in 2009. After stabilising in the past couple of years it is expected to rise to above 80% of GDP in the near-term. The vast majority of debt is owed by the private sector. Less than one third of government debt is denominated in foreign currency, mostly in euros. The overall level of debt is high compared to rating peers. A mitigating factor is that a high share of the private debt is intercompany-related. Another factor limiting the external vulnerability is the country’s IMF credit line. In early 2015, Poland secured a successor IMF programme, a two-year Flexible Credit Line with access of about USD 23 bn. Access is smaller than in the previous IMF-programme and the authorities intend to treat the arrangement as
precautionary. The lower access is also in line with the intention to phase out the use of IMF facilities. While external finances remain a relative rating weakness for Poland, we see the precautionary measures taken by the government to be sufficient to support the current rating.
The monetary policy framework is adequate: With inflation falling, the National Bank of Poland (NBP) cut the main policy rate by 50 basis points to 2% in October 2014, and is expected to reduce it further in 2015. Since late 2014, the central bank has taken a flexible approach to inflation targeting and puts more emphasis on resilient short-term growth rather than the inflation outlook. While there is
inflation target, the monetary policy council is divided on the details of the outlook. This brings communication challenges which could risk undermining the
credibility of policy making.
The financial sector is somewhat smaller than that of most peers, with banks’ assets equivalent to about 85% of GDP. This is similar to the Slovak Republic but both Hungary and the Czech Republic feature banking sectors with assets/GDP well above 100%. The banking system remains well capitalised and profitable. The financial supervisory authority’s most recent stress tests also confirm that the system is resilient to shocks. Non-performing loans (NPLs) are relatively high at roughly 8% of total loans. Nevertheless, the system-wide
Tier 1 capital ratio is at nearly 14%. The central bank sees limited risks to banks’ lending portfolios from the CHF denominated mortgage loans. The view is supported by stress tests that have been run based on assumptions of even larger depreciations of the zloty which still have not been alarming.
Political situation
Political uncertainty in the run-up to elections: A new prime minister, previously the speaker of the Sejm, commenced in September as the long serving Mr Tusk left for a post as president of the European Council. The transition went smoothly. Expectations are that the overall direction of policies will not change in the near-term. Much focus is likely to be on making full and effective use of EU funds. Nevertheless, the relative inexperience of the new leadership, including a new foreign minister, has slightly raised policy uncertainty, not least when it comes to dealing with the Ukraine/Russia crisis and the euro adoption.
Furthermore, the busy political agenda ahead, with presidential elections in the spring and elections for the Sejm and Senate in the autumn, creates some
uncertainty. The incumbent president Komorowski, formerly with the ruling Civic Platform (PO), enjoys very broad public support and is likely to be re-elected. His likely re-election may give the ruling PO additional electoral support. However, despite this and despite a fairly healthy economic performance, the Civic Platform party cannot be certain of a re-election. The PO may be leading the opinion polls but it is not unlikely that the populist Law and Justice (PiS) party could return to power, a return that may be perceived as less palatable by foreign investors.
The quality of Poland’s political institutions lags its Western European peers: Poland ranks on average in the 25th percentile among the 210 countries covered in the World Bank’s governance indicators, roughly the same as Hungary, but slightly worse than the Czech Republic. On governance, the World Bank reports that the rule of law and corruption has improved somewhat during the past few years. The business environment, on the other hand, has deteriorated marginally according to the World Bank's "Ease of Doing Business" report. Poland lags the Baltic States but
still scores better than Hungary and the Czech Republic. The economy lags Estonia and the Czech Republic on the World Economic Forum's competitiveness ranking, but is considered significantly more competitive than that of Hungary.
Outlook
In the medium term, strong domestic demand is expected to support the economy while the current account balance should be underpinned by a gradual rebound in the European economy leaving only a small current account deficit. As a result, the economy is expected to expand by about 3.5% in the next few years. With oil prices set to recover only gradually and with economic growth remaining below potential, there is a high risk that deflation persists for most of 2015 and that it remains well below the central bank’s target in 2016 too.
Over the longer term, Poland’s sound economic fundamentals and well-functioning financial sector provides ample opportunity for catching up with living standards of the EU. This being said, most forecasts of potential GDP indicate some
moderation in the growth rate compared to the past decade. One important reason is the country’s worsening demographic profile.
Graph:The pentagon shows Turkey's risk worse than average in all respects including to its traditional competitor, Brazil, reflecting weaker liquidity, macro balance and absence of event risk.
External ratings: Fitch: BB-/pos Moody's: Ba3 S&P: BB-/pos
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The information in this document has been compiled by SEB Merchant Banking, a division within Skandinaviska Enskilda Banken AB (publ) (“SEB”).
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