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Does Poland’s Economy Face Insider Threats From Its New Government?

Law & Justice (PiS), the Polish populist party that won last year’s November election, has caused concern over its economic policies for those with financial interests in the country. Plans for a forced re-denomination of Swiss franc mortgages alongside a recently introduced asset tax have fuelled fears over the health of its banking sector. Institutional independence is another worry, especially regarding the Central Bank. Investor concerns over the current government administration coupled with recent credit rating actions have caused fluctuations in the country’s usually stable debt and currency. Although Poland’s economy remains strong, government plans could have a detrimental effect in the short term.

Jul 15, 2016 // 12:28PM

Plans for a forced re-denomination of Swiss franc mortgages alongside a recently introduced asset tax have fuelled fears over the health of its banking sector. Institutional independence is another worry, especially regarding the Central Bank. Investor concerns over the current government administration coupled with recent credit rating actions have caused fluctuations in the country’s usually stable debt and currency. Although Poland’s economy remains strong, government plans could have a detrimental effect in the short term.

A Swiss Mortgage Plan, Full of Holes

PiS has plans for banks to re-denominate their Swiss franc mortgages worth US$38.12bn (PLN148bn) into zloty at historic exchange rates and force these institutions to accept the losses. Poland’s central bank has warned the plan could cost the banking sector PLN44bn (€10.3bn) and KNF, the country’s financial regulator, has estimated the cost to banks could reach PLN67bn, nearly 4 times their 2015 profits.

Under the re-denomination plan, banks would have to buy around CHF30bn, leading to open FX positions. The conversion would eradicate about 25% to 30% of the sector’s current liquidity. As many Polish banks are listed, they would have to comply by international accounting standards, whereby a conversion would have to be done immediately.

“A re-denomination would cause substantial risk to banks; they will experience a reduction of capital and outflow of deposits,” says Rafal Benecki, Chief Economist at ING’s Polish branch.

Regulators warned that if the plan is not amended, it could lead to a banking crisis in the country. Analysts predict that converting the mortgages would bankrupt many of the country’s financial institutions.

“No ruling party would be willing to trigger a banking crisis, and the mortgage issue will not lead to a financial crisis,” says Ernest Pytlarczek, Chief Economist at mBank, Commerzbank’s subsidiary in Poland.

William Jackson, a Senior Emerging Market Economist at Capital Economics believes PiS understands that its re-denomination plans could significantly affect the banks’ capital ratios, negatively impacting the economy.

“PiS are aware of the importance of the banking sector to Poland’s economy, and are afraid of exploiting its weak spots. Therefore, they will not push their reforms through,” Pytlarczek says, adding that the planned conversion is unrealistic as banks would not accept such losses.

Felix Winnekens, Associate Director of Sovereign and International Public Finance at S&P Global Ratings, says that some type of law would likely have to be passed, though it would probably be a watered down version of the initial proposal as the original plan’s costs would be too high for the sector to absorb.

“Nevertheless, there will still be a negative impact on the sector.”

Although there is talk of a diluted proposal, an agreement seems far off. The cabinet seems unlikely to give up on the issue as there has been no real dilution of the initial proposal, and the government is not taking to alternative options, explains Roxana Hulea, Vice President of Emerging Market Strategy at Societe Generale.

Banks will likely pay the FX spreads that the mortgage borrowers were charged, a cost of around PLN12bn to PLN15bn. This would erase about one year’s worth of the sector’s profits, but should be a manageable risk according to Michal Dybula, Chief Economist of Central and Eastern Europe at BNP Paribas.

“There is uncertainty regarding the banks, and confidence in sector has come down.”

Although many of the foreign banks in Poland are susceptible to a re-denomination, a conversion would also be a burden for state banks like PKO BP, which has a substantial portfolio of FX mortgages. Whilst any re-denomination would put pressure on many banks’ finances, most lenders should be able to shoulder the burden without too significant an impact.

Feeling The Strain

A banking tax and capital requirements have added to bank woes, which has impacted lending, and asset growth. PiS imposed a 0.44% tax on bank assets that has further eroded the sector’s profits, which hovered near PLN20bn annually. It has affected the structure of many of their balance sheets.

The tax led to an increase of 2 percentage points in bank holdings of tax free government bonds amid a considerable slowing of credit growth since January 2016, according to Winnekens.

He explains that the additional contribution required for a bank-guaranteed deposit fund, due to the bankruptcy of a smaller lender, has pressured finances further. This weighed on S&P Global Ratings’ action in January, which lowered the sovereign from A- to BBB+, with a negative outlook.

Banks may reduce their credit activity due to the asset tax. Many are increasing their portfolios of tax free government bonds, crowding out funding for the private sector. Increased lending costs have impacted profitability. Combined with increased holdings of government bonds, banks are limiting their lending operations.

The costs of mortgages and corporate credit for SMEs are now higher, lowering deposit rates. Larger corporates have been affected to a lesser extent. Pytlarczek says that the tax has affected the price of lending at mBank.

Despite the tax, rigid capital requirements imposed by local regulators have proven more damaging to the sector and could affect a bank’s credit creation. Weaker banks struggling with demanding capital requirements could increase their proportion of consumer loans to mortgages, as they are cheaper than the latter, not requiring foreign capital. Bigger banks would likely remain largely unaffected.

“Although the banking tax has lowered profits, Q1 results were not as bad as expected, and we predict Q2 results will be similarly positive,” Benecki says. “ING’s growth in Poland will be slower in the near future due to lower credit flows resulting from capital requirements and the banking tax. We have capped our forecast of total credit for the year by one third, but so far the slowdown has not really materialised. We expect it to occur in the second half of the year.” Pytlarczek is seeing much the same at mBank.

Despite a substantial deceleration in credit activity, there has been no real credit crunch. However, there will be less credit growth in the near future; investment spending has fallen, and there has been poor GDP data from the banking sector for Q1. Foreign banks like UniCredit, Santander, ING, Commerzbank, BCP, BNP Paribas and Raiffeisen constitute around 60% of total Polish banking assets. There are concerns that increasing financial pressures could lead them to withdraw.

“If foreign banks pulled funding for their Polish subsidiaries credit conditions would tighten, leading to a slowdown in real economic growth,” Jackson says.

Banking sector consolidation over the next few years is likely according to some analysts. Still, it is unlikely that the pressures from PiS policies will result in foreign banks withdrawing.

“The likelihood of foreign banks withdrawing their Polish operations due to government policies is about as likely as Donald Trump using nuclear weapons,” says Benecki.

Don’t Bank On It

The nomination of a close ally of PiS to the head of Poland’s central bank has caused concern that the government may influence monetary policy. Adam Glapinski, the former head of the Monetary Policy Council (MPC), has been named by PiS as a candidate for the head of the Central Bank.

Winnekens says S&P Global Ratings’ negative outlook on Poland speaks to concerns over the independence of other institutions, most importantly the Central Bank, the independence of which would be a key trigger for another rating action.

The independence of other institutions is also a concern. Of nine new members of the MPC, eight were nominated by PiS. However, the new MPC members and Glapinski have said that financial stability will be their overarching aim, especially as inflation levels are above target.

Benecki says the MPC’s new members are more prudent than first thought, and that Glapinski had historically taken a hawkish stance when head of the MPC, also favouring an independent Central Bank.

“Throughout its campaign PiS said it expected the Central Bank to continue to support growth and be more active in economic affairs,” he says, hinting that it would more than likely retain its independence.

“The central bank will of course support the government, just as the central banks of many countries have become more supportive of their respective governments under current economic conditions,” Pytlarczek says.

Highs And Lows: Zloty And Debt

Poland’s debt and currency have traditionally remained relatively stable. However recent credit rating actions and concern over PiS have caused fluctuations in both markets. Despite concerns over PiS, Poland’s debt markets are traditionally quite strong and have remained relatively stable; yields on local currency debt are low. Total public debt exposure is also relatively low at around 50% of GDP, with FX debt lower still.

Poland’s strong external position has recently increased. Its FX debt stood at 5% of GDP five years ago, but currently amounts to 0.5% to 1% of GDP. Poland’s debt ratio may edge up a bit, but not significantly, analysts suggest.

S&P Global Ratings’ sovereign downgrade in January did have an impact on the performance of Poland’s debt, however the impact on the credit front remained minimal. This is especially true of external debt, which tends to be more resilient to shocks than local currency debt.

However, Polish bonds are trading slightly above where they would be expected to as a result of the rating action. The downgrade led to a 28bp rise in the yield of the country’s 10 year bonds, to 3.28%. This is in comparison to a 99bp rise over the previous 12 months. The country’s 2025 Eurobonds saw yields rise 12bp to 1.6%.

Shorter government bonds were affected less severely, as being exempt from the banking tax they benefitted from bank demand.

“As most of Poland’s debt is owned by dedicated emerging market credit funds there was little reason for them to reduce their exposure, as they are used to this sort of credit rating action,” says Regis Chatellier, Senior Emerging Market Credit Strategist at Societe Generale.

However, in April yields on Polish bonds reached two week highs when the country’s legal system was paralysed after Poland’s top court declared new PiS reforms unconstitutional, which the government refused to recognise.

Disagreements between the government and other institutions have been a concern for Polish bondholders. There has been some impact on the country’s local bonds, with investors lowering their holdings of zloty paper, Chatellier says.

He says concerns over the government’s grip on some institutions and the impact of its policies on certain sectors, including banking, will affect the performance of Polish debt in the long term.

However, more recent activity has caused a rebound in the performance of Polish debt. After Moody’s held its rating at A2, albeit lowering its outlook to negative, Polish bonds rose. Yields fell the most since January, and the return on 10-year sovereign bonds fell 7bp.

The months between December and February saw a selloff of government bonds with tenors of 10 or more years on concerns over the performance of the zloty and Poland’s ability to service its dollar-denominated debts.

Despite this, the decline in the country’s reliance of foreign funding has reduced the vulnerability of the zloty to a sharp selloff.

Most analysts believe there are few questions over whether Poland would be able to repay its debt obligations for the foreseeable future. Marco Zaninelli, a sovereign analyst at Moody’s says Poland still has deep access to foreign and domestic funding to service its moderate debt burden.

However, the Zloty is still the fourth worst performer across emerging markets in Q1 this year despite only falling 5% against the euro, after ending 2015 in the top 10 best performing currencies. At the time of writing it was trading at 4.41097 to the euro.

In January, the zloty briefly reached 4 year lows after a selloff, falling 2.1% to 4.48 against the euro. It continued its downward streak on the news of Glapinski’s nomination to the central bank. On Moody’s rating action in late May however it headed for its biggest advance in 2 months, at the time appreciating 0.8%.

Despite various fluctuations, Poland’s debt and currency have remained relatively stable. Interestingly, this has negatively impacted its popularity.

“The conditions for Poland’s foreign debt are currently unfavourable. It has underperformed versus the debt of other developing economies because it has relatively tight spreads in a market where emerging market investors favour high yields,” Chatellier says.

“The performance of Poland’s debt could see it exit the emerging market index.”

The reopening of Poland’s €750mn January Eurobond in April did not attract significant demand because Polish bonds do not offer much yield, even when markets rally. “It would be difficult for the pricing of Polish debt to be tightened by even 20bp.”

Although there is concern over PiS’s policies, Polish debt remains strong. There are no concerns over Poland’s ability to service its foreign debt, and despite fluctuations, due to low external debts the zloty is less exposed to sharp selloffs.

Caught Between a Rock And a Hard Place

Despite its strong performance, investors are increasingly avoiding Polish debt as it currently trades between that of a developed and emerging market, effectively reducing its investor base. The fact that Poland is now seen as an attractive market within the European Union rather than an emerging market has deterred many EM investors.

Franklin Templeton reduced its ownership of zloty debt to 3.5% of its portfolio at the end of March, down from 14.4% in 2012. International investors have cut their exposure to Polish bonds by 10% over the first two months of 2016 alone after S&P Global Ratings’ downgrade.

Although Poland is in a macroeconomic sense relatively strong, emerging market investors tend to avoid Polish debt as its bonds see tight spreads with low yields.

The country has a natural base in the emerging market index. If it leaves, it will face traditional investors who will not appreciate the political noise and upheavals that emerging market investors are accustomed to.

But the country is in a tricky position. Some analysts believe Poland will need a more market-friendly government if it is to meet developed market investors’ needs. Although Polish debt is performing increasingly like that of a developed market, emerging market investors are still concerned over the government’s policies.

Investors had considered Poland a compromise, being an emerging market that offered good returns without the associated risks. However, PiS is upping the risk.

“The outlook for Poland in the long run is not optimistic, especially if political actions lead to a further deterioration of the credit space,” Chatellier explains.

“The market will continue to keep a close eye on PiS. Political risk has already been factored into the country’s external debt, which is trading wider than usual.”

Hulea says that although Poland is able to service its debts, questions over the government’s willingness to abide by old fiscal rules have arisen, and its outspokenness has added to investors’ concerns.

The markets reacted negatively when it looked like PiS would win the November election. S&P Global Ratings’ downgrade was affected by institutional investor concerns more than anything else, one analyst claims.

Economy and policy

Poland’s economy has performed well despite the global economic backdrop, and even PiS’s policies are unlikely to impact the country’s short term growth.

The country’s economy enjoys strong fundamentals, and it weathered the 2008 financial crisis relatively well. These fundamentals have contributed to continued economic growth.

However, government policies are having a negative effect on growth in certain areas of the economy.

“Policy initiatives by PiS mark a political shift from the previous government. We view this shift as credit negative,” Zaninelli says.

In the banking sector, the slowdown in credit growth and shift in bank assets towards government bonds has impacted the country’s economic growth, which was weaker than expected in Q1, according to Winnekens.

“Government actions have weakened the financial sector, where a healthy banking sector is ultimately needed to fuel investment-led growth.”

The performance of Polish debt and the government’s influence on other institutions could impact foreign investment, which would affect economic growth. Under PiS, the budget deficit is likely to widen this year, and Poland’s debt dynamics have already worsened slightly.

However, as Winnekens says, Poland still has a solid investment grade rating of BBB+ from S&P Global Ratings.

“This speaks to the country’s strong fundamentals such as a robust growth outlook and relatively low public debt, including external indebtedness, compared to its peers.”

Regardless of whether a looser fiscal policy is implemented, Poland’s economic growth is predicted to be around 3.5% to 4% this year. In the short term, PiS could strengthen the economy through its policies.

Jackson says PiS’s looser fiscal policy and higher social benefits could strengthen domestic demand, which would increase economic growth.

“Social benefits should provide a boost to consumption. Even without changes to fiscal policy, unemployment rates have come down sharply and consumption rates are increasing.”

But this is also due to Polish households enjoying a windfall from the lower price of oil, of which the country is a net importer.

Although there is a risk to the banking sector under PiS, other sectors of the economy are likely to benefit in the short term. However, the good fortune from low oil prices is unlikely to remain forever.

Despite the mortgage re-denomination plan and the asset tax imposed by PiS, Poland’s banking sector has remained relatively strong, and although profits have suffered, it will likely survive a watered down mortgage plan. Furthermore, the MPC and Glapinski, if appointed, could be more independent than first thought.

Poland’s debt and currency have remained relatively stable, and have responded better than feared to rating actions. Higher yields on PiS concerns could also attract emerging market yield-hungry investors in the short term. Investors don’t seem overly concerned over the performance of Polish debt, and there is unlikely to be a significant deterioration of the credit space. Poland’s economy remains strong, on which in the short term PiS’s policies are likely to have a positive effect, but the longer-term impact seems far from certain and hangs on a range of contingencies.

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