Poland Watch – Strong stimulus helps to contain economic downturn

by: Anke Martens , Georgette Boele

In this publication: Sharp hit to Polish economy, but less than some others. Strong fiscal stimulus helps to contain economic downturn. Inflation exceeds the MPC target, but the policy interest rate likely to remain stable. We expect a weak zloty in the near-term and a modest recovery next year.

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Sharp hit to Polish economy, but less than some others

At the beginning of this year, we had expected the Polish economy to slow down modestly from 4.1% in 2019 to 3.5% in 2020. Then the Covid-19 crisis started to spread across the globe. When the pandemic reached Poland in March, the country moved relatively quickly and effectively towards a lockdown in the first phase of the crisis. It suffered comparatively few deaths and was quick to reopen again. GDP contracted by 8.2% in the second quarter, which is substantial but less than for example the Czech Republic (-10.8%) or Hungary (-13.6%).

The Polish economy started to show signs of revival in the third quarter, but the pace of recovery seems to have slowed in August. Currently, the country is experiencing a severe second Covid-19 wave outbreak, with also president Duda testing positive for the virus recently. New restrictions on public life have been imposed and like in many other countries in Europe, the current “second wave” threatens the early stage recovery. Real GDP is estimated to fall by 4% this year, which is substantial for a country which has shown uninterrupted growth for more than 25 years. Still, compared to other countries, such as the Czech Republic (-6.5%) and Hungary (-5.5%), the economic damage is estimated to be relatively limited. All three countries are expected to outperform the eurozone, which we expect to contract by around 7.5% this year.

Poland’s GDP is expected to recover in 2021, supported by pent-up domestic demand, an economic recovery in the eurozone, and EU funding. We expect the Polish economy to grow by 4% in 2021, which would bring GDP back to end-19 levels. This return to pre-Covid levels is relatively rapid compared to many other countries. Still, we expect Polish GDP to be 7%-points lower compared to our pre-Covid-19 scenario.

Strong fiscal stimulus helps to contain economic downturn

Poland’s fiscal response has been one of the largest in Emerging Europe. This – together with the comparatively large size and closed nature of Poland’s economy (compared to small and highly export oriented countries like the Czech Republic or Hungary) and its relatively diversified and competitive export base – helps to contain the downturn. The budget deficit is estimated to widen to 9% of GDP this year, from 1% in 2019. As a result, government debt is estimated to stand at a significant but manageable level of 58% of GDP end-2020. Given the constitutional limit on gross public debt at 60% of GDP, the authorities used state development institutions to finance part of the emergency fiscal measures.

Going into 2021, room to stimulate the economy is expected to remain available, given good access to capital markets and still manageable debt levels. In addition, the outlook for EU funding after 2020 has improved on the back of EU wide fiscal initiatives, such as the new €750 billion Coronavirus Recovery Fund. However, relations with the EU remain strained. Poland is already the subject of an EU sanction procedure for its reform to increase government control of the judiciary. The Polish government has also been chastised by the EU for its control of the publicly-financed state media. Access to the EU’s EUR750bn fund could come with conditions on for instance rule of law in the recipient country. This could constrain Poland’s ability to benefit from EU funding.

Inflation exceeds MPC target, but policy interest rate likely to remain stable

With the advent of the Covid-19 pandemic, already easy monetary policy in Poland became even more accommodative. The Monetary Policy Council (MPC) cut interest rates from 1.5% in March to just 0.1% in September. Inflation fell to around 3% in the April-August period, but the most recent numbers, of September, show some acceleration in price growth. Headline inflation added 0.3 pp to 3.2% YoY, while core inflation increased 0.2pp to 4.2% YoY. These increases reflected some regulated price effects, but mainly the impact of strong fiscal stimulus on consumption, and rising prices of services. Companies in the service sector are transferring the increased cost of sanitary measures to consumers, while an outflow of workers from abroad also increased prices of social welfare services, household maintenance and childcare. Real interest rates (official rates corrected for inflation), which were already in negative territory pre-Covid, turned even more negative. They currently stand at around -3%.

The MPC expects the pick-up in inflation to be temporary. While inflation is currently above the MPC target of 2.5%, it is expected to fall back when the situation in the economy starts to normalise. Also given the risks to economic growth, we expect the MPC to keep the policy rate on hold the coming year.


Volatile zloty

Like most emerging market currencies, the złoty had a volatile year so far. In Q1 it declined by 13% versus the dollar and by close to 9% versus the euro. This was because investors turned risk averse when the Covid-19 pandemic hit, buying the US dollar and also the euro versus the zloty. When investor sentiment improved in May, investors were again willing to buy less liquid currencies such as the złoty. However, since the start of September investors have been concerned about a second wave of Covid-19. They have shied away from less liquid currencies of countries that have reported substantial increases of Covid-19 cases, such as the Czech Republic and Poland. The złoty has declined by close to 8% versus the euro year to date. The złoty is now approaching 4.60 against the euro again. This brings the złoty almost back to the low seen in March.

We expect a weak złoty in the near-term and a modest recovery next year

For the coming months, we expect that investors will continue to shy away from the złoty. The złoty tends to outperform the euro if the eurozone economy is doing well and the economy in Poland is outperforming (which would then fuel rate hike expectations in Poland). Currently, the situation is completely different. Investors are concerned about the double dip in the eurozone and the second wave of Covid-19. The eurozone is an important export market for Poland. Poland is also battling this second wave of Covid-19. So there is not much relative strength. It is likely that investors will try to test the previous low in the złoty versus the euro (high in EUR/PLN just above 4.63).

Next year we expect a vaccine for Covid-19. As a result the global economy is set to recover. We also expect the Polish economy to recover and even to outperform the economy of the eurozone. Investors will likely focus on the relative growth performance and yield spreads again. All of this is positive for the złoty. Furthermore we think that the Polish central bank will unlikely cut rates into negative territory. The ECB has a negative deposit rate and when investor sentiment improves, the difference in official rates starts to play a role again. Therefore this will probably support the złoty. Finally we expect that Polish real yields will become less negative. Currently they are around -3%. As inflation is expected to decline, real rates will become less negative. This will also give some support to the złoty.

Even though we expect the currency to recover next year, it is unlikely that the złoty will rally sharply. The strained political relationship with the EU remains a negative for the złoty. All in all, we expect a weak złoty in the near-term and a modest recovery next year. Our new forecast for the end of this year in EUR/PLN is 4.6 (was 4.4) and end of next year 4.3 (was 4.25).