Jan Cienski in Warsaw -

The Polish government's dramatic changes to the pension system caused the Warsaw Stock Exchange to tumble for two days as markets swung violently on the news, but the longer term consequences of the government's action are still very unclear.

In an announcement on announced September 4, Prime Minister Donald Tusk sharply curtailed the activities of the second pillar of the pension scheme - a system of privately run funds called OFE, which invested part of a worker's obligatory social security payments.

Tusk is forcing the 14 funds, which have about PLN280bn (€65bn) in assets, to hand over PLN120bn in holdings of state treasuries. The bonds will be shifted to the state-run ZUS pension system, dramatically improving Poland's fiscal condition - public debt will fall by about 8 percentage points from about 55% of GDP.

The benefits for Tusk are obvious. His government has been battered in opinion polls by the unexpectedly sharp slowdown in the economy and he had little fiscal scope to unleash much spending in hopes of stimulating faster growth before parliamentary elections due in 2015. "Make no mistake about it, Poland's controversial pensions overhaul is a fiscally and politically motivated one whose designers are far less concerned with the likely fallout in the country's capital markets," says Nicholas Spiro of Spiro Sovereign Strategy. "The overriding priority is growth, which is not surprising given that Polish policymakers underestimated the severity of the country's economic downturn."

While the political calculation is clear - the impact on both debt and equity markets is not. Many analysts thought that any market reaction would be restrained, given that the government had telegraphed its desire to dramatically overhaul the OFE system over recent weeks.

However, once the move was made markets plunged. The Warsaw Stock Exchange fell by 2.14% that day and by a further 4.16% on September 5, before clawing back almost 2% on September 6. Treasuries also reacted, with yields on 10-year Polish government bonds jumping to 4.75%, the highest in a year. The longer-term impact, though, is still difficult to measure.

Listing

On the equities side, the OFE funds had been solid buyers on shares issued in IPOs and secondary listings, making the WSE one of Europe's top exchanges for new listings. OFE purchases were also a key ingredient in the government's privatisation strategy, which often involved selling minority stakes in key state-controlled companies like copper miner KGHM, PKO BP, the country's largest bank, and insurer PZU.

Investors, particularly foreign ones, were reassured by regular infusions of OFE cash onto the market, which helped provide liquidity and added a "pension premium" on the value of Polish stocks.

OFE will now play a much smaller role on the market. The government is going to give OFE holders a three-month window to decide on whether to keep money with the funds or to shift their entire pensions back into the state system. Analysts think that anywhere from 50-80% will quit. Furthermore, as a person nears retirement, assets will be regularly shifted from the OFE to the ZUS system and final pensions will be paid out completely from ZUS. "We believe this is very negative for Polish equities as it means that pension funds are most likely to be net sellers of Polish equities in the future," notes Wood & Company, the investment bank.

Finally, benchmarks are likely to be changed and the funds will be able to invest more of their diminished assets outside of Poland, further diluting their impact on the market.

The 14 OFE funds are also likely to be dramatically pared back due to the government's decree slashing their fees as well, because they will have a smaller pool of funds to manage. Polityka Insight, an analysis service, estimates that only three to five funds will be left in the game once the changes take hold.

There could also be an impact on the Polish debt market, the largest and most liquid in the region. "The OFEs are a large holder of Polish government bonds and barring them from investment and active trading in bonds could reduce the depth of the Polish bond market," says Magdalena Polan of Goldman Sachs.

Although the government will need to borrow less because it will no longer have to prop up the OFE system, what borrowing it does do will be even more reliant on foreign investors.

In a research note, Moody's Investors Service, the ratings agency, worries that the move will hurt the credibility of the Polish government, but adds that the changes will not do much damage to Poland's creditworthiness. "The fiscal impact is likely to be positive as it implies a reduction of debt metrics, granting more fiscal space with respect to the country's fiscal and debt rules," said an analysis by Jamie Reusche of Moody's. "The potential increased revenues from workers that switch back to ZUS will also greatly aid the fiscal consolidation effort and allow the government more room for policy manoeuvre in order to support the nascent economic recovery."

And a recovery is what Tusk is hoping for. A decent burst of growth would quickly end the fuss over changes to the OFE system and possibly revive the ailing fortunes of his Civic Platform party.