- We have adjusted our growth forecast upwards to 3.5% in 2017
- Sluggish investment due to EU funding issues and political uncertainty
- We expect two (possibly three) 25 bp rate hikes in 2018
- We expect a gradual strengthening of the zloty in the coming year
- Serious EU action (e.g. triggering Article 7) still unlikely
Economic growth was strong in the first half of 2017 …
Economic growth in 2016 (2.7%) was disappointing compared to the rather rapid recovery in 2014 and 2015 in the aftermath of the eurocrisis. However, the start of 2017 showed a revival of growth. Going forward, in our base case scenario we expect annual growth at 3.5% in 2017 and 3% in 2018, underpinned by continuing momentum in household consumption and a further uptick in the eurozone.
The economy grew by 3.9% yoy in Q2 2017, broadly in line with the first quarter (4% yoy). This was marginally above market expectations, but in line with similarly strong results in the other Visegrad countries. But the composition of growth changed somewhat in the second quarter, with government final consumption performing better in Q2 than in the first quarter (1.5% qoq versus 0.1%-point in Q1). Furthermore, while both imports and exports cooled compared to the previous quarter, imports slowed more than exports.
… mainly driven by consumption
Over the past half-year, growth was driven by a strong rise in consumption, fuelled by increasing social transfers and higher wages. Unemployment came down to a historical low of 7.1% in July this year. The unemployment gap (the difference between the natural rate of unemployment, NAIRU, and the current unemployment rate) is currently negative. As a result, wages have risen, supporting household consumption. We expect wage growth to continue for a while. In June this year, the EU lifted visa requirements for Ukraine. This visa waiver does not grant Ukrainians the right to work in the EU, only allows them to enter for visits and business trips. However, Polish employers worry that many will find black-market jobs in EU countries. This may trigger an outflow of Ukrainian workers from Poland, who currently comprise 4% of the total Polish workforce. Meanwhile, the lowering of the retirement age will enter into force in October, reducing the number of available workers by as much as 200,000. And in the run-up to Brexit, more Polish workers have already started to leave the UK and some of them will return to Poland. This will somewhat offset the negative labour supply forces we mentioned before. In sum, however, we believe that this, together with the unfavourable demographics, will sufficiently strain the supply of labour to result in a continuing boost to wages.
Investment has been lagging, but will pick up
Investment, measured by gross fixed capital formation, was negative in annual terms throughout 2016. A major reason for this lack of investment was the termination of the EU funding cycle in 2016. The EU’s medium-term budget (2016-2020) was implemented with a delay and hence the availability of EU funds for investment projects only started to pick up in 2017. Other Visegrad countries experienced the same decrease in investments throughout 2016. However, in Poland the first half of 2017 was also disappointing. The first quarter of 2017 showed negative investment growth (-0.4% yoy), albeit less so than the four previous quarters, and Q2 2017 showed a modest positive figure of 0.8% yoy. This low growth in investments is related to the political uncertainty fuelled by the national conservative PiS party. Clearly, an uncertain political and institutional environment deters foreign investors. Furthermore, when we look at business manager surveys, we find that the low supply of highly skilled workers acts as an impediment to investments. Yet, given the growing pace of available EU funds in the second half of 2017, we expect investments to grow further in the second half of 2017. We have calculated that the new EU funding cycle (2016-2020) will contribute to an annual investment inflow of 3.5% of bbp.
Leading indicators point to some loss in momentum
The manufacturing PMI has slowly trended down since the beginning of the year, although it picked up slightly in August (to 52.7, so still clearly above the neutral 50 mark). The optimistic rally seen at the end of 2016 may be over, but managers remain generally positive. The economic sentiment indicator has seen a slow recovery since 2014, but continues to improve.
Meanwhile, retail sales have been strong since the beginning of this year. While retail sales grew by 11.4% yoy in January, the latest figure from July shows 7.1% growth yoy. Compared to the last 5 years, that is still significant. Industrial production growth has been volatile since the beginning of 2016. While it was negative in April this year, it increased by 6.2% yoy in July, disappointing the market (consensus 8.4%). It is difficult to draw lessons from this indicator, since it does not point to a trend of sustainable growth or decline.
Overall, our reading of the leading indicators points to a continuation of economic growth at a somewhat lower rate than the first half-year. We expect growth to slow to around 3% for the second half of 2017, which would bring the annual average growth figure for 2017 to 3.5%. In the medium term, we expect growth to continue around the same rate. While investments may contribute positively in 2018, the labour shortage will put a brake on further growth. Therefore, we expect annual economic growth to fall to 3% in 2018.
Inflation back in positive territory
Headline inflation has been persistently negative during the period end-2014 to end-2016, due to falling energy prices and a lack of spending. However, since end-2016, inflation left negative territory, reaching 2.2% yoy in February 2017 on the back of higher consumer spending. Since then, inflation has fluctuated between 1.5% and 2%. We expect this figure to remain around 2% for the remainder of this year. Next year, we expect that wage growth will lead to further demand-driven price pressures, leading to a gradual increase in inflation up to around 2.5% at the end of 2018. This means average inflation for 2018 will be 2.25%, which is slightly higher than the current market consensus of 2.1%.
Monetary policy will become tighter in 2018
The official central bank statements show that it expects headline inflation to remain well below target (2.5%) and therefore sees no need to increase the policy rate (1.5%). We believe that the modest slowdown in inflation over the last two months offers enough support to the Polish Monetary Council (MPC) to preclude the need for monetary policy tightening before 2018. Besides, the surge in inflation at the beginning of this year was mostly due to a low base in early 2016. All in all, we do not expect a hike to be announced at the September MPC meeting.
Looking at 2018, the Polish central bank Governor Adam Glapinski confirmed that the rate pause will probably last until 2019. We believe this is unlikely. Although average inflation in 2018 may not meet the central bank target of 2.5% (our average forecast is 2.25%), we expect it will still pressure the MPC to take action. The 2.5% target is perceived as too high by some MPC members and we believe that the current monetary policy will be seen as excessively loose during a cyclical upswing with inflation above 2%. Furthermore, some members of the MPC are of the opinion that the impact of negative real interest rates on lending, asset prices and savings rate should be taken into account. This could further discourage savings, which Poland needs. These MPC members have already publically voiced their discontent and most certainly the pressure on the MPC to hike rates will increase. Lastly, the argument that rate hikes will act as an impediment to investment has been refuted by many economists since investment only minimally depends on the cost of lending when rates are so low. In sum, while we do not expect inflation to reach the central bank’s target until the end of 2018, we expect two, or possibly even three, rate hikes of 25 bp in 2018.
Zloty will gradually strengthen against the euro
The zloty started the year strongly. It rallied versus the euro, rising from 4.41 at the start of 2017 to a high of 4.1591 on 17 May (a lower EUR/PLN is a rally of the zloty). Thereafter, the currency lost momentum. The market unsuccessfully tried to keep EUR/PLN below 4.20 and since the end of June, the euro has risen considerably across the board on ECB tapering expectations. This has also pushed EUR/PLN higher. Another factor that has negatively affected the zloty is changes in investor sentiment due to the political turmoil. Our expectation of two or maybe three rate hikes by the Polish Central Bank should support the zloty in 2018 versus the euro. Meanwhile in the near term we expect EUR/PLN to be toppish at around 4.3 and to then move lower. This is because, in our view the euro has risen too sharply in a short period of time in our view. We expect ECB President Mario Draghi will dampen expectations about early rate hikes. The ECB is concerned that tapering will trigger an early tightening of financial conditions and seems focused on tapering without triggering a tantrum. This will likely weigh on the euro across the board in the near term. As a result, EUR/PLN could once again move towards 4.25 (some recovery of the Polish zloty). All in all, we maintain our forecasts for a gradual strengthening of the Polish zloty over the next 18 months.
Politics may spoil the rosy growth picture…
Since being elected in 2015, the government led by the national conservative Law and Justice party (PiS), has targeted the freedom of media and the rule of law, and has exerted greater control over a number of government bodies. In the beginning of 2017, the government abandoned the plan to convert foreign currency mortgages into local currencies. This meant one less worry for the banking sector, which faced substantial costs if the plan had been passed. Nevertheless, policy uncertainty remains an issue. Recently, PiS proposed thee controversial bills to reform the judiciary. Under the first bill, the Minister of Justice would gain the right to appoint the head of all lower courts. Under the second, the body that nominates the Supreme Court judges would be selected by parliament. And the third bill would terminate the tenure of all current judges in the Supreme Court, unless the Minister of Justice advises otherwise. PiS argues that these reforms are necessary in order to get rid of judges whose legacy lies in the communist past. However, many Polish citizens disagreed, fearing the erosion of rule of law, and took the streets in protest. Unexpectedly, Poland’s President Andrzej Duda (a PiS loyalist) vetoed the last two bills, most likely due to the swelling protests and the recent drop in popularity of the PiS party. However, it is still likely that watered-down versions of the bills will be passed.
… and Poland continues to quarrel with its biggest ‘investor’
The EU and the US expressed concerns over the latest actions by the PiS. The EU has sent a formal notice setting out complaints about the new laws and arguing that the Minister of Justice will be given too much power under the new bills. Last week, another verbal warning came from German Chancellor Angela Merkel who said she takes rule of law issues in Poland ‘very seriously’. Although some EU representatives have threatened to invoke Article 7 (a formal warning that could lead to economic sanctions and a loss of voting rights for Poland), we believe it is unlikely that this will happen in the near future. In order to invoke the article, the European Commission (EC) first has to complete the three-step mechanism for addressing systemic threats to rule of law (which they initiated in January this year), and this may take a while. Furthermore, in order to deprive Poland of its rights in EU bodies under Article 7, the EC must be unanimously in favour (excluding Poland). But it is very unlikely that Hungary will vote for such a proposal given that it has similar issues with the EU. Investors seem to share this view as CDS spreads have actually come down in the last months. In sum, we do not expect the Polish government’s actions to have serious consequences, but we do consider it a potential downside risk.