Jan Cienski in Warsaw -

Poland's zloty has been one of the hardest hit currencies in Central Europe during the current economic crisis, something which is now causing increasing danger for the banking system, corporate earnings and the government budget.

The zloty has been pummelled by the general flight from risk that began when Lehman Brothers was allowed to collapse in September. Although Poland's economic fundamentals are among the healthiest in the region, just being in the same neighbourhood as troubled cases like Hungary, Latvia and Ukraine has been enough to spook investors and send them fleeing from the zloty.

Normally, a depreciating currency can be an advantage to a country during an economic slowdown because it reduces imports and makes exports more competitive. That is certainly what Leszek Woliszewski, CEO of Krosno FA, a car parts maker in the south-eastern Polish city of Krosno, believes. Woliszewski has reduced his work hours from five to four days a week, cutting the pay of his 200 workers by a fifth to deal with plummeting orders from Europe's troubled car industry, but he sees possible salvation in the weak zloty. "That has been an enormously positive effect of this crisis," he says. "If the rate is low, then our products are competitive and our profits will be higher."

But Woliszewski's voice is a rare one in a country that has become increasingly mesmerised by the steady fall in the value of the zloty, which has declined by about 30% against the euro since peaking last summer.

A hedge too far

A growing issue for the corporate sector are rising losses due to ill-timed currency hedges. Many companies bought foreign exchange options last summer, when the zloty was gaining strength, and it seemed prudent to guard against continued appreciation. However, many companies bought more options than they needed to cover their foreign currency exposure, figuring it would be an easy way to make additional profits. Most worrying, in a bid to avoid bank fees for the options, companies used zero-cost options, which exposed them to significant risk if the zloty unexpectedly changed direction, as has in fact happened.

Poland's Financial Supervision Authority, the financial markets regulator, now estimates that companies faces losses of about PLN15bn (€3.3bn), the equivalent of about 2% of GDP, on the options. However, some senior government officials say that "thousands" of companies may be in danger. "The problem is that no one seems to have any idea of the size of the problem," says Matthew Vogel, head of emerging markets research at Barclays Capital.

Adding to the uncertainty is a proposal by Waldemar Pawlak, the economy minister, for the government to pass a law that would allow companies to cancel currency options. However, such a law could violate the constitution, and would open the government to lawsuits from banks facing losses over the options.

Direct aid for the affected companies also seems unlikely, as the government is adamant that the deficit won't be allowed to grow beyond the currently planned PLN18.2bn, and adding PLN15bn to government spending would cause enormous problems, as well as further depreciating the zloty, says Jana Krajcova, an analyst with Ceska Sporitelna.

For ordinary consumers, the biggest worry has been the zloty's decline against the Swiss franc, because about 60% of outstanding mortgages are denominated in francs, something that had been common until recently due to the franc's historically lower interest rate. But now borrowers are watching their monthly payments soar. "Taking a Swiss franc loan seemed like a good idea a few years ago; now I'm not so sure," says Wojciech Heydel, a Warsaw insurance broker.

For now, Polish banks are still reporting very low levels of non-performing loans, as most clients are able to handle the higher payments, thanks in part to a couple of years of double-digit wage increases. But problems could increase if the zloty's weakness lasts through the end of the year. Furthermore, the country's unemployment rate, which only recently had started to come down from stubbornly high levels, is showing signs of reviving - Poland's forecast unemployment rate for January jumped a percentage point to 10.5% - which could cause more trouble for borrowers.

The current gloom over the zloty could change later this year if the government decides to enter the European Exchange Rate Mechanism, the waiting room to joining the euro. That could send a message of confidence about the zloty to international markets and help start it appreciating again. However, political battles between the government and the president over the desirability of adopting the euro could raise enough concern at the European Central Bank that Poland would be prevented from joining.

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