VISEGRAD: An economic test for Polish ambition

VISEGRAD: An economic test for Polish ambition
Warsaw needs to extend the heady first quarter economic performance through the year and beyond.
By Tim Gosling in Prague June 5, 2017

Poland’s spiky PiS government likes a challenge; efforts to spark “revolution” within the EU or organise a huge Nato push in the neighbourhood to openly confront Russia are not short of ambition. However, Warsaw may have been uncharacteristically humble in targeting GDP growth of 3.6% this year.

With a healthy dose of luck on its side, the Polish government may be en-route to fulfilling its earlier grand promises to rekindle growth. The economy let the side down badly last year, but a surge in GDP in the first three months of this year has many observers reassessing their stance on that score.

“GDP growth performance is benefiting from a mix of supportive factors that include accommodative fiscal and monetary policies, a strong labour market performance, gradual recovery in disbursements of EU funds and fairly supportive external demand,” says Arnaud Louis at Fitch Ratings.

The Polish economy surprised in the first quarter as it boomed 4% in year-on-year terms, and 1.3% quarterly. The acceleration over the disappointing 2.7% gain recorded across last year is stark. The big question is whether the country can keep up the pace through 2017, and beyond.

Warsaw is delighted with the first quarter performance, but the populist PiS is walking a fine fiscal line. Having won power with promises of high social spending, the government has struggled to orchestrate revenue-generating schemes to keep the deficit within the Stability and Growth Pact’s limit of 3% of GDP.

Last year’s deficit looks solid at 2.4% of GDP despite the slowdown in the economy, but the details suggest one-off income from telecom frequency auctions and a bit of accounting magic to shift advance VAT payments onto last year’s books helped. The government targets a budget gap of 2.9% this year.

That leaves little room for error; Poland needs to extend the heady first quarter economic performance through the year and beyond. While there are few major new spending schemes expected in 2017, a lowering of the retirement age that will come into effect in October will weigh down the 2018 budget by an estimated 0.4% of GDP.

Growth spurt

The first quarter surge in Poland was in line with similarly strong results across the Visegrad region. While the headline GDP growth offered a positive surprise, the details deflated the optimism somewhat. In particular, investment – the main drag on the economy in 2016 with a 5.5% year-on-year fall – remained subdued in January-March. In other words, private consumption was still left largely alone in the driving seat.

The PiS government’s Family 500+ child benefit scheme has helped buoy household spending, while a labour market that has been tightening over the last three years or so has boosted consumer confidence. In other words, more jobs, higher wages and state benefits sent Poles flocking to the shops last year.

It’s a trend that persisted in January-March, but contrary to 2016, industry and investment are also doing their bit this year. PiS won’t want to shout about it, but the EU plays a central role in the revival.

Activity and confidence is robust in the Eurozone, which provides the bulk of export demand for the relatively small and open economies in Visegrad. That has Polish industry driving hard; the sector’s output rose 7.1% y/y in the first quarter of 2017, compared with just 1.3% growth in the final three months of 2016.

However, it is EU structural funds that could start to help most this year. Beset by a poor track record in absorption, Poland and its regional peers raced in 2015 to claim the last cash under Brussels’ 2007-14 budget. That left the country with few approved public projects last year, a situation some claim was antagonised by widescale personnel changes within the civil service as PiS took over the reins. Fixed investment nosedived 5.5% y/y in 2016.

The signs are that Poland is finally getting absorption on track again. The best indicator is the construction sector. The lack of EU projects last year saw the industry slump, but between January and March output boomed 17.2%.

“Construction and investment have tended to move together. We expect investment to remain strong through the year,” says Liam Carson at Capital Economics. “It could easily add 1pp to the headline.”

Will it last?

Private fixed investment is harder to gauge however. PiS has made confrontation with the EU a cornerstone of its domestic political support. With Brussels’ confidence rebounding following the French election, the tussle is likely to keep political risk in the international headlines.

More directly, policymaking in Warsaw remains erratic. The government will be tempted to seek new revenue generating schemes should economic momentum fade.

An effort to introduce a progressive tax on large retailers was overturned by the EU last year, for instance. There is speculation that the plan to grab some cash from the country’s busy shops has not been abandoned altogether.

“Political risk will be a problem at least for the medium term,” admits Carson. But with growth so strong, investors should remain bullish. “Inflows have really picked up on capital markets. The zloty has risen strongly and the stock market is gaining.”

However, in the longer term, the analyst suggests political risk is likely to become more of an issue. A potential flashpoint would be if the budget deficit crosses the EU’s 3% threshold, as many expect in the next three years or so.

For this year, the consensus is that Poland should just squeeze under the cap, but that crucially assumes growth remains on target. The first quarter data has analysts rushing to raise their forecasts for economic growth this year. But will it last?

Louis says Fitch expects GDP growth will accelerate to 3% in 2017 and 3.2% in 2018. However, he adds, “we might also take the opportunity to review our GDP growth forecasts” during a review of the ratings of the sovereign on July 7.

Carson, whose prediction sat at the upper end of the range at 3.5% at the start of the year, suggests 4% GDP growth now “doesn’t seem unreasonable”. At BZWBK and other Polish banks, revised forecasts are already under consideration.

Katarzyna Rzentarzewska at Erste says the pace of GDP growth in the first quarter “makes us revise the FY2017 GDP growth forecast from 3.3% to 3.8%”.

However, a cautionary note soon arrived. While still suggesting healthy growth, industrial, construction and retail sales data for April showed activity was well below the surging numbers in March.

“The April data remind us that there are perils to extrapolating such a powerful trend too far into the future,” warned analysts at Commerzbank. “Polish growth could still remain healthy, but the acceleration of Q1 may not repeat. Retail sales data also send out the same message.”

Several other hints have followed. April data also suggested weakening wage growth and job offers, and PPI inflation moderated by more than expected, pointing to a lack of demand-powered inflationary pressure. The following month, business sentiment dropped for the first time in 2017.

At the same time, accounting issues look to have exaggerated the first quarter GDP data. Statistics office GUS recently reduced its reading for the first quarter of 2016, which created a low base to boost the year-on-year result. However, the readings for the remaining quarters of last year were raised, suggesting an opposite effect through the rest of the year.

“The growth dynamics are likely to ease in the coming quarters,” points out Rzentarzewska. The Monetary Policy Council noted that it expects the pace of GDP growth to fade through the rest of the year, as it announced on May 17 that it sees no development in the economy that would justify a rate hike for the record low 1.5% benchmark.

“Given Poland’s economic openness, the main risk to the outlook is weaker-than-expected external demand,” notes Louis at Fitch. “Increased domestic political tensions and weaker predictability of economic policy could affect Poland’s attractiveness as a place to invest and are another risk to the outlook, although its impact is difficult to assess today.”

The picture is also far from clear in the medium term. “CEE economies are now running at close to full employment,” says Carson. “While we think growth should be strong this year, rising core inflation will prompt tighter monetary policy than most expect, and growth will start to slow by 2018/19.”

Fiscal risk

For the moment, the strong growth revival is also pushing the rating agencies back into line, at least from Warsaw’s point of view. Standard & Poor’s surprised many when it handed Poland its first ever downgrade in January 2016. Many claimed the move was political, but S&P’s peers were quick to warn the government over fiscal discipline.

However, Moody’s raised its outlook on the sovereign’s ‘A2’ rating to stable from negative in May. The agency cited “reduced risk of loose fiscal policy and contained uncertainties stemming from government policies”.

On top of the forecast for a strong acceleration in GDP growth in 2017, the Polish government has set a tight deficit target 2.9% of GDP. That rise of 0.5pp on the gap last year reflects spending plans that will see the Family 500+ scheme cost around 1.2% of GDP and the retirement age cut another 0.1%. That leaves little room for error, but most assume Poland will just remain inside the 3% threshold above which member states risk entering the EU’s excessive deficit procedure (EDP).

That’s thanks to a mix of good luck, clever accounting, and discipline. PiS proved during its previous spell in office in 2005-07 to be a capable fiscal manager, while it seems that despite the party’s bitter dislike of Brussels, it knows which side its bread is buttered on economically. At the extremes, entering the EDP can result in fines, or a reduction in EU funds. That would dramatic for Poland, which is scheduled to benefit by €100bn in 2014-20.

Hence, ironically enough given Poland’s numerous political confrontations with Brussels, the EU’s EDP limits are seen as a major anchor for PiS.

“Fiscal metrics have benefited from favourable circumstances,” says Fitch’s Louis. “The closing of the negative output gap (the EU Commission forecasts it will be positive in 2017) is supporting government revenues. The government balance has also benefited from contained interest payments, thanks to the low rate environment, and decline in investment linked to the EU-fund cycle in 2016. It is also likely that the government’s strategy to increase tax compliance, in particular in reducing the VAT gap, has delivered some results.”

In short, it’s tempting to ask how much Warsaw is tempting fate. The first quarter of 2016 also started off optimistically, before economic activity gradually tailed off throughout the year.  Challenged to find funding options for its spending plans, PiS has left the budget heavily reliant on strong GDP to support revenues, and will likely have to put off further populist expenditure for the meantime.

“Slower-than-expected GDP growth is the main risk to the forecast,” Louis sums up. “We expect no additional deficit-increasing policy initiative this year. However, weaker predictability of fiscal policy since the 2015 election creates another risk.”

The risk is summed up by the European Bank for Reconstruction and Development in its latest outlook published on May 10. The institution maintained its GDP growth forecast at 3.2% for 2017, based on recovering public investment and strong household consumption.

“Nevertheless, the generous social spending and rebounding public capital expenditure, coupled with a lower retirement age may lead to the breach of the 55% public debt ceiling by 2019,” the EBRD warns. “In which case the public finance law effectively mandates a very significant fiscal tightening.”