Jan Cienski in Warsaw -

Poland this week showed unexpectedly strong retail spending, which comes after recent data showing industrial production also expanding by faster than market consensus - none of which is helping the zloty.

The Polish currency has been battered in recent months both by concern over the domestic economy, but also by a general sense of unease in global financial markets over the prospects of the euro, which ends up rebounding on emerging markets as investors flee what they perceive to be risky assets."The mood is really nervous, people just don't know what to expect," says a senior Polish finance ministry official after meeting with potential investors.

The zloty started to gyrate wildly against the dollar, the euro and the Swiss franc this summer after a period of relative stability after the global economic crisis hit in 2008, when all of Europe's emerging markets saw their currencies take a beating.

The Swiss franc, in which about 700,000 risk-loving Poles have their mortgages denominated, hit PLN3.99 in early August, while most mortgages were taken when the rate was just above PLN2.00 to the franc.

The zloty's slump against the euro is also causing worries for the government, as about 28% of the country's public debt is denominated in the common currency. Analysts worry that if the euro rises much above PLN4.80 by the end of the year, Poland will end up breaching its legal public debt limit of 55% of GDP. Any breach of that level mandates painful spending cuts.

It took just PLN3.98 to buy a euro at the beginning of August, but this hit PLN4.49 in late September before falling back to PLN4.38 on October 25. The zloty's weakness against the euro has prompted the central bank and the finance ministry, through the treasury-owned Bank Gospodarki Krajowej (BGK), which sells euros obtained at structural funds payments from the EU, to stage combined market interventions to prop up the Polish currency. "That's a warning," said Marek Belka, the central bank (NBP) governor, after a recent intervention which saw the zloty jump by PLN0.12 in minutes. "Playing against our currency won't be a comfortable one-way trip. Something could be coming in the opposite direction."

Poland has a lot of ammunition left to keep markets on their toes. The central bank has currency reserves of about €70bn, while the BGK has about €14bn at its disposal. Added to that, Poland has a credit line from the International Monetary Fund worth $30bn.

The idea is not to defend a set rate, but to keep markets from assuming that Poland will do nothing to defend itself in the event of a speculative attack. "One area that continues to perplex us is the NBP line on interventions," writes Peter Attard Montalto of Nomura. "Governor Belka says that they are just part of the monetary policy guidelines (which are extremely vague on when and why FX intervention may be used), that they are useful for damping inflation, and that EUR/PLN levels do not reflect fundamentals. But at the same time, he also says that he does not target a level and does not commit to further interventions."

Deficit worries

Part of the worry over the zloty stems from concerns over the local fiscal situation, although Poland's numbers look better than almost everywhere else in the EU. The deficit is expected to come to 5.6% of GDP this year, down from 7.9% in 2010. The finance ministry hopes to drive that below 3% next year, although based on unrealistic expectations of GDP growth of 4%. Public debt, using the slightly fudged numbers favoured by the finance ministry is just below 55% GDP.

But there is growing pressure on the newly re-elected government of Premier Donald Tusk to undertake much deeper reforms such as raising the retirement age, reforming separate pension systems for farmers and uniformed services as well as revamping social programmes that do not direct the majority of their payments to the poor.

An analyst with Moody's Investors Service recently warned that Poland could face a downgrade if it did not undertake economic reforms, while Fitch Ratings warned: "the incoming government will have to implement more drastic fiscal measures. This will likely require further cuts in expenditure

But Poland is also being hit by general worries over the state of the euro. As the largest and most liquid of the Emerging European economies, the zloty is often used as a proxy for the region, and investors sell at the slightest hint of trouble - even that which does not come from Poland. One example happened toward the end of October when Poland showed unexpectedly strong retail spending data - rising by an annual 11.4% in September compared with market expectations of 10% - but the zloty ended up losing ground against the euro and the dollar on fears over the EU's euro rescue package.