The Polish government continues to push controversial judicial reforms. While the economic outlook is solid, we think it is offset by growing policy uncertainty and growing downgrade risks.
The controversial judicial reforms cap an 18-month process that began right after Law and Justice Party’s election victory in October 2015. That victory was foreshadowed by the surprising victory of Law and Justice’s Andzrej Duda in the May 2015 presidential election. Even though it holds only a very slim majority in Parliament (235 out of 460 seats), Law and Justice is behaving as if it has a huge mandate from the people.
Party officials are pushing judicial reforms in order to address what they call “unaccountable” judges. Of course, this totally misses the point about checks and balances, having an independent judiciary that is NOT influenced by the legislative and executive branches. Tens of thousands of Poles took to the streets to protest the reforms.
President Duda vetoed portions of the judicial reform bill submitted by the Law and Justice party. He struck down the proposal to dismiss the entire Supreme Court and to revamp the Judicial Council, which makes key personnel decisions for the courts. Duda has asked lawmakers to craft a more conciliatory bill, but party officials (including Prime Minister Szydlo) have vowed to press on.
The European Commission (EC) is preparing possible sanctions against Poland. It noted that “In the commission’s assessment, this reform amplifies the systemic threat to the rule of law in Poland already identified in the rule of law procedure started by the Commission in January 2016.” The EC gave Poland one month to address these concerns.
In the meantime, the EU is discussing what measures to take next. Officials noted that Duda’s veto will influence the deliberations. The worse-case scenario is that Article 7 is triggered, which would lead to penalties and could suspend Poland’s voting rights in the EU. Poland is the biggest recipient of EU funds, and these transfers could be curtailed.
The next general elections will be held in 2019. Local elections will be held in 2018, while the next presidential election will be held in 2020. Recent polls show 35% for the ruling Law and Justice, followed by 21% for main opposition Civic Platform. These numbers are very close to the results of the 2015 elections.
Poland scores very well in the World Bank’s Ease of Doing Business rankings (24 out of 190 and down from 25 in 2016). Best components here are trading across borders (1), getting credit (20), and resolving insolvency (27). Poland also does well in Transparency International’s Corruption Perceptions Index (29 out of 176 and tied with Portugal).
The economy is recovering quite robustly. GDP growth is forecast by the IMF to accelerate to 3.6% in 2017 from 2.7% in 2016, before slowing slightly to 3.3% in 2018. GDP rose 4.0% y/y in Q1, the strongest rate since Q4 2015. Monthly data so far in Q2 suggest some modest slowing, but not by enough to endanger the full-year forecast.
Price pressures are falling. CPI decelerated to 1.5% y/y in June from the 2.2% cycle peak in February. This is the lowest rate since December and is right at the bottom of the 1.5-3.5% target range. PPI inflation has decelerated too, and suggests little in the way of pipeline price pressures ahead.
This supports the case for steady rates, and we believe the National Bank of Poland is on hold through 2017. Rates have been on hold at 1.5% since the last 50 bp cut in March 2015. The next policy meeting is September 6, and no change is expected then.
We think NBP forward guidance is shaping up to be too dovish, however. Officially, rates are seen steady until 2018 but some (including Governor Glapinski) have said that steady rates are likely until 2019. A split may be shaping up, as some bank officials have pushed back against such a dovish stance.
Fiscal policy is in good shape but bears watching. Law and Justice was elected on a populist platform. This should pose upside risks to the budget deficit, but expenditures have been kept under control even as revenues have jumped. The deficit came in at an estimated -2.4% of GDP in 2016, down from -2.6% 2015. The European Commission expects it to widen to -2.9% of GDP in both 2017 and 2018. However, based in the H1 outcome, we see risks of a smaller than expected deficit this year.
The external accounts are in good shape but likely to worsen. Strong EU growth has helped exports, but the rebounding economy and rising commodity prices should boost imports more. The current account deficit was about -0.2% of GDP in 2016, and is expected by the IMF to widen to -1.7% in 2017 and -1.8% in 2018.
Foreign reserves remain near all-time highs. At $112 bln in June, they cover nearly 5 months of import and are around 1.25 times larger than the stock of short-term external debt.
The zloty has help up relatively well. In 2016, PLN fell -3.3% vs. EUR and was in the middle of the EM pack. So far in 2017, PLN is up 3.5% YTD vs. EUR and remains in the middle of the EM pack. Our EM FX model shows the zloty to have WEAK fundamentals, so this year’s OK performance is likely to ebb.
Before this most recent spike above 4.25, EUR/PLN had traded largely in the 4.15-4.25 range since late April. Now, the pair is poised to test the April 21 high near 4.2835. A break of the 4.28 area would set up a test of the March 13 high near 4.3535. The 200-day moving average currently comes in near 4.30.
Polish equities are underperforming EM after a poor 2016. In 2016, MSCI Poland rose 1% vs. 7% for MSCI EM. So far this year, MSCI Poland is up 21% YTD and compares to 24% YTD for MSCI EM. This modest underperformance should ebb, as our EM Equity model has Poland at a NEUTRAL position.
Polish bonds have performed well recently. The yield on 10-year local currency government bonds is about -30 bp YTD. This is one of the best performers in EM, behind the best ones Brazil (-128 bp), Indonesia (-94 bp), Peru (-79 bp), Turkey (-73 bp), and Mexico (-55 bp). With inflation likely to continue falling and the central bank on hold for now, we think Polish bonds will continue outperforming.
Our own sovereign ratings model shows Poland’s implied rating steady at BBB/Baa2/BBB. As such, this suggests ongoing downgrade risks to actual ratings of BBB+/A2/A-, and we believe S&P’s initial cut to BBB+ last year was just the first of several to come. Indeed, EU sanctions related to the judicial reforms could be the trigger for the next downgrade.