12 Oct 2021
Despite being significantly less attention-grabbing than many of its better-known peers in the EM debt investment universe, Poland plays a sizeable role in many EM debt investors’ portfolios, accounting for about 8% of the total amount of debt covered by the JP Morgan GBI-EM index. Historically, Polish government debt delivered solid risk-adjusted returns and valuable portfolio risk diversification benefits to investors due to its creditworthiness, robust fundamentals and prudent macro management. But the investment case has since reversed, as we discuss later in this piece.
The Polish economy has shown remarkable resilience in the face of the global pandemic. Output has already returned to pre-pandemic levels – making a much faster recovery than many of its EU peers, according to the latest GDP data (Q2 2021). Undoubtedly, Poland’s robust monetary and fiscal policy response to the pandemic shock deserves credit for this strong rebound and pandemic’s relatively limited impact on employment; it was timely, adequate and coordinated. But this is about more than just good crisis management. The improvement in Poland’s ability to withstand external shocks seen over the past two decades can be attributed to its economic structure, the quality of its human capital as well as its EU membership and all the benefits that brings.
Poland has built up a large domestic market and grown to become a diversified economy – with a relatively high share of retail trade in value-added and a lower share of manufacturing. Its manufacturing sector also has the benefit of being diversified, with a high share of food and beverages production and a relatively small share of car industry and transport equipment – this proved just the right mix during the pandemic, as spending patterns changed.
The most recent success story for Poland is the services sector – Poland has managed to establish itself as a significant operations hub for global banks, thanks to its large pool of talent and very strong emphasis on technical education and mathematics. The attractiveness of Poland’s workforce to international organisations is evidenced by large investment banks (including Goldman Sachs, JP Morgan and UBS, among others) significantly expanding their operational centres in the country in recent years.
In addition to Poland’s domestically derived strength, it is hard to over-emphasise the benefits that it enjoys from the steady inflow of EU investment funds, irrespective of cyclical economic considerations. Over the last three years, net inflows of EU funds into the country exceeded 2% of GDP annually and the prospects are even better due to the additional Recovery and Resilience Funds, with Poland set to receive around 117 billion euros in total over the next seven years. Furthermore, Poland has its own currency, which acts as an economic shock absorber in periods of stress as evidenced during the global financial crisis of 2007–2008.
At odds with this positive picture lies the fact that the share of foreign investors in domestic government debt dropped to just 16% last year from 39% back in 2014. In absolute terms, net debt outflows have exceeded 21 billion euros since the Law and Justice party (PiS) assumed power in November 2015, with Polish stocks also recording net outflows over the same period. So, what is the problem with Poland as a financial investment destination? What factors led to the exodus of international investors from the Polish fixed income market, and what would need to happen for them to return?
Every economy, developed or emerging, has its weaknesses and Poland faces two major challenges, in our view. The first is the rapid shrinkage of its working-age population, which is expected to intensify in the years and decades ahead as a result of its ageing population. This is a pan-European phenomenon, of course, but the projections for Poland are particularly worrisome.
The second major challenge is the scale of the energy transition that needs to take place in the country for it to achieve the net-zero target by 2050 and the economic impact of its energy mix in the meantime. Prices on CO2 emissions have increased sharply over the past few years and this is becoming increasingly painful for Poland, which generates more than 70% of its electricity from highly polluting coal. As detailed in the box below, the situation has been exacerbated by policy inaction.
We acknowledge the complexity and political sensitivity of the necessary power transition for an economy so dependent on coal, but it is precisely those pivotal points in history where political leadership is mostly needed. Instead, the PiS party made a new coal-fired power plant (to replace the older Ostrołęka B plant built in 1972) a flagship pledge in the 2015 election. That decision came at a time when new coal projects were becoming increasingly difficult to justify on both political and financial grounds. Fast forward to 2020, the project was abandoned after the two state-controlled utilities developing the plan pulled out, citing difficulties of obtaining external financing.
This means that the inevitable energy transformation not only needs to accelerate at a greater pace but will also be more complex and expensive than necessary.
There is still much to be done for Poland to have a hope of reaching its net-zero commitments. Its latest long-term energy programme still predicts that coal will be responsible for 22% of power generation by 2040 and its final coal mine is expected to close in 2049 — putting Poland at odds with the rest of the EU which is making a much faster transition to clean energy.
As real as they are, unfavourable demographics and energy mix concerns in the context of the global transition do not explain the full extent of investors’ aversion towards Polish capital markets. Rather, it is the set of choices, priorities and policies pursued by the authorities since 2016 that pushed foreign investors to the exit door.
Entering power at a time when populism was in the ascendance, the economic plan of the ruling Law and Justice (PiS) party was simple: the government was to take a “leading role” in Poland’s economy. To this end, large parts of the economy were re-nationalised, appointments to top positions in state-owned companies were politically motivated, while a drift towards a state-controlled banking industry was accompanied by various sectoral taxes and state-imposed fees. Media businesses and press freedom came under attack via anti-monopoly investigations blocking unfavoured mergers, licensing changes and the use of retroactive tax penalties and discretionary fines.
All of the above are textbook examples of what investors do not want to see. However, what’s proven most damaging of all is the long-lasting dispute between the Polish government and the European Commission (EC). This stems from the reforms of the Polish justice system carried out since 2015, which raised serious concerns over the rule of law, in particular judicial independence. It is now apparent that the EC is determined to use its new rule of law conditionality mechanism to limit Poland’s access to EU funds in cases of infringement of fundamental principles that endanger the EU budget.
Last but not least, a major cause of concern to fixed income investors has been monetary policy enacted during the recent, maturing phase of Poland’s economic recovery. Despite clear evidence of a strong recovery, a tight labour market and sharp, broad-based inflationary pressures, the National Bank of Poland (NBP) has maintained its ultra-loose monetary policy stance. This manifests in deeply negative real policy rates, physical and verbal interventions against the zloty, and a large programme of asset purchases. The controversy over the suitability of this stance is evident just by reading the minutes of the Monetary Policy Council meetings: views within the Board have become polarised, communication is poor, and all this translates to a gradual erosion of NBP’s credibility as an independent, inflation-targeting central bank.
Barring the issue of an ageing population, none of the above shortcomings are insurmountable or set in stone. Yes, they are justified reasons for shying away from the country’s debt at present, but what might warrant a reassessment of the investment case for Polish debt? We believe three criteria – if met – would signal the promise of a more attractive investment prospect for Polish debt.
A more pragmatic central bank focused on managing inflation risks and anchoring inflation expectations would be a critical first step to restoring credibility among the international investment community. The recent rate hike – the first since the pandemic – is a step in the right direction. A potential catalyst for meaningful change could be the forthcoming change in key personnel at the National Bank – the term of eight (out of ten) members, including the governor, will expire by June next year. We will be watching closely to see the calibre and credibility of replacements.
Even though desperately lagging its European partners, Poland is finally edging away from coal. A more ambitious path in the transition away from coal and real leadership in this area would be a significant positive signal for investors.
As debt investors, we would be looking for Poland’s political leaders to embrace climate goals and change the narrative – making the energy transition and addressing of climate risks a national goal for the benefit of Polish people, rather than treating it as a cost imposed by the EU. To this end, we would also need to see the government confronting the strong coal lobby in the country.
A positive shift in politics to a more consensus-building and less polarised environment, coupled with more orthodox policymaking and the strengthening of institutions, are all vital steps necessary to restore faith in Poland as an investment destination.
In this vein, we will also be looking for greater cooperation with the EU as a sign of a move in the right direction. Parliamentary elections are scheduled for Autumn 2023, and with the dominance of the ruling party declining in the polls, there is hope for a more balanced shift in Polish politics. As the FT notes, the latest ruling by Poland’s tribunal over the incompatibility of EU’s law with the Polish constitution “could backfire politically against Law and Justice and its allies, who seem increasingly out of line with a public that remains strongly pro-European.”*
With its many and varied strengths, it is not difficult to find positive things to say about Poland’s economy. But an increasingly polarised political narrative and associated deterioration in several key governance-related areas are among factors that have – understandably – prompted many active international bond investors to flock to the exit door. There are three shifts that could signal a more promising outlook from the perspective of debt investors. Should the country’s policymakers rise to the challenge and make these relatively straightforward, yet fundamental, changes, it is entirely possible for Poland to lure back international bond investors and reap the benefits of strong macroeconomic foundations. The choice between paradox and promise rests firmly in the hands of Poland’s politicians and, ultimately, of the Polish people.
* A legal secession from the EU will cost Poland dearly. Financial Times, 10 October, 2021.