Currency Outlook

It may seem odd to speak about a 'virtuous circle' in a country with so many well-publicised fiscal deficiencies, but our economists think there are good reasons to see the Polish economy as enjoying a self-reinforcing cycle of good news over the next few months.

That should perpetuate the recent recovery of the zloty without undermining the strong growth that is now evident in the real economy.

Poland's virtuous circle works in the following way.

In the first place, the real economy is being strongly supported this year by two dominant forces:

i) the cheapness of the real exchange rate; and
ii) the fact that real interest rates are historically very low.

The combination of these two factors has produced very rapid growth.

Gross domestic product (GDP) rose by 6.9% year-on-year in the first quarter, and although this growth rate was boosted by a large accumulation of inventories in the run-up to European Union accession, it seems very likely that the Finance Ministry's forecast of 5.7% GDP growth for the whole of 2004 will be achieved.

Moreover, the cheapness of the real exchange rate ensures that the composition of GDP growth is healthy, in that it biases firms towards the external sector, which ensures that the current account deficit remains low.

This year's deficit is likely to reach no more than 2.2% GDP, which will be by far the lowest current account deficit among the CEE3.

Strong growth is at the heart of Poland's virtuous circle primarily because of the impact that it has had on public finances. There is a high degree of confidence in the Finance Ministry that this year's target fiscal deficit (PLN45.3 billion, not including transfers to the open pension funds) can be met and even exceeded.

Year-to-date fiscal performance suggests there is a good deal of support for this optimism: the deficit in the first five months of the year was only 34% of the target for the full year.

The market's response to strong growth and robust public finances has been to allow for a 7% strengthening of the nominal exchange rate since mid-February, and this is where the virtuous circle really gets going. In the first place, the stronger nominal exchange rate is likely to stimulate corporate investment, and therefore support the continuation of strong growth.

Investment spending contracted for three consecutive years from 2001 to 2003. While there are many reasons for this contraction, one important factor has been the impact of the weak zloty on corporate balance sheets.

As at last December, 32% of Polish corporate debt was denominated in foreign currencies, and this large stock of foreign debt means that the degree of risk aversion by corporates is probably closely related to the path of the exchange rate.

In other words, the weakness of the exchange rate in 2002 and 2003 made Polish companies more worried about the health of their balance sheets, which in turn contributed to a lower level of investment. These days, in contrast, the strengthening of the zloty is likely to make companies feel more confident about their balance sheets, and hence more willing to take risk.

The other important consequence of a stronger nominal exchange rate is its effect on the balance sheet of the public sector. Some 40% of the government's debt stock is external and so, with the private sector, there is a positive confidence shock that results from the appreciating nominal exchange rate.

This is particularly true given the high degree of sensitivity on Poland's debt/GDP ratio, since Poland's Public Finance Act would require specific action on fiscal policy if the debt/GDP ratio breaches 55% this year (from 51.3% at the end of 2003).

The strengthening nominal exchange rate makes it increasingly less likely that the 55% debt/GDP ratio will be breached. Other things being equal, a 1% strengthening of the zloty against the euro improves the debt/GDP ratio by almost 0.2 percentage points of GDP.

Inflation has risen sharply in recent months, primarily the result of:

a) the effect of supply shocks from the food and energy markets;

b) the impact of European accession, because of changes in VAT and excise duty, and the incentives this creates for cross-border arbitrage; and

c) some degree of pass-through from the weakness of the zloty.

For the time being at least, Poland's Monetary Policy Council (RPP) is likely to be relatively relaxed about the inflationary threat that the economy faces. There are a number of reasons for this.

First, real wage growth is still fairly moderate. Although real wages have been growing more rapidly in the manufacturing sector in recent months, the growth of real wages is, at around 3.7% of GDP, still much lower than the growth rate of the economy.

Although there is unlikely to be any big inflationary shock in Poland, the fact is that the year-on-year inflation rate is very likely to move above the RPP's target ceiling of 3.5% in the next few months, primarily thanks to very strong base effects.

Since inflation expectations in Poland are rather sensitive to the current rate of inflation, the RPP will need to move to manage expectations effectively. An important issue is likely to be the way in which interest rates and the zloty will affect each other.

It seems reasonable to assume that as interest rates go up in Poland, the effect will be to help to strengthen the exchange rate. In addition, however, the strength of the exchange rate that has taken place so far is likely to limit the RPP's need to raise interest rates, since the zloty's appreciation since February constitutes a tightening in monetary conditions.

For all these reasons, our economists are relatively optimistic about the PLN over the next few months, and this optimism is reinforced by a number of other factors:

¤ the market has very low expectations about structural reform, particularly regarding the Hausner Plan and privatisation; and

¤ the Finance Ministry's cash balance increases its funding flexibility.

In conclusion, our economists expect the zloty to perform well over the next few months.

Risks are likely to mount as September approaches - when the 2005 budget has to be presented to Parliament and when the market begins to debate the accounting changes that might result from Eurostat's second ruling. Before them, however, the zloty could well continue to appreciate from its still undervalued level.

This report has been compiled by HSBC Bank Malta plc on the basis of economic research carried out by HSBC International Bank's team of economists and financial analysis.