forward-looking

22.03.2017

FEAR OR HOPE: WHAT’S REALLY GROWING IN POLAND?


Optimism dominates almost all comments about the Polish economy these days. JP Morgan, the European Union, many Polish business analysts and most of all the National Bank of Poland have all announced that the economy is now on track for fast growth. All foresee GDP expanding at better than a 3% clip in 2017 and 2018.

At the first sight, it all seems reasonable. In the fourth quarter of 2016, GDP accelerated to 2.7% yoy from 2.5% in previous quarter. Industrial output jumped to 9% in January from 2.1% in December 2016, while retail sales growth surged to 9.6% from 6.1%. At the same time, employment in corporate sector expanded  4.1% from a year earlier, while the unemployment rate reached a 27-year low. Great!

But is the picture really so spotlessly bright?  Let’s start from GDP.  A growth rate of 2.7% is certainly better than 2.5%, but acceleration of this magnitude is almost of the edge of statistical error. Growth was higher in the first half of 2016. The main driver of expansion is still private consumption. Over consecutive quarters of 2016, private consumption grew at an annual rate of 3.2%, 3.3%, 3.9% and 4.2%.

This is rather disappointing given the huge sums spent on children’s benefits (outlays for the so-called 500+ payment scheme amounted to more than 1% of GDP) last year. The future doesn’t look better. The 500+ program’s impact is strictly one-off, increasing incomes in 2016 and the first half of 2017. Inflation will gradually erode its impact in real terms.

Nominal wage growth in the corporate sector peaked in the middle of 2016 and has stabilized or even slightly declined since then. Deflation has steadily faded before flipping at the end of 2016 into inflation, which reached 2.2% in February. That means real wages which had grown by about 6% yoy in the middle of last year were only 1.8% yoy higher in February. 

Inflation is far from stabilized. Producer prices are rising at any annual rate of more than 4%, and one can expect some convergence with the consumer price index. Some elements of CPI basket that are sensitive to fuel prices (electricity, gas, transport services) remain close zero, which looks unsustainable with oil almost 30% more expensive than a year ago. 

If the current trend in wages continues, I expect that private consumption will grow no more than 2.5%-3% this year. Growth in public consumption will probably be very similar. This means that consumption’s total contribution to GDP growth in 2017 will be no more than 2-2.5 percentage points.

The second most important driver in 2016 was inventories, which contributed 1.4 percentage points to GDP growth. This is not good news. The nominal increase was four times higher than a year earlier and the highest since 2007 – a year when real GDP growth was 7%, industrial output increased 11% and construction output rose 15%.

Nothing about industrial production last year can explain (even partly) higher inventories. Output rose only 1.5% in the fourth quarter of 2016. One possible explanation is zloty volatility, since the currency had several strong rallies in 2016 after depreciating following the 2015 parliamentary elections.

My guess is that Polish firms assessed these corrections as only temporary, so they spent zloty to accumulate raw materials and intermediate goods. They may also have cut back on export sales, which might help explain the exceptionally low rate of output growth in late 2016. In any event, we must expect inventories to decline in 2017. My expectation is that they will make a negative contribution to growth of between 1.5 and 2 percentage points.

Largely hidden by the surge in inventories was the main problem of the Polish economy – a steep fall in fixed investments. The climax of this disastrous trend was observed in the third quarter of 2016, when fixed investments dropped by 7.7% yoy. Unfortunately, the next quarter was only slightly better, with a decline of 5.8%. The most popular explanation of this breakdown is the limbo produced in the transition period between two EU budget perspectives. To some extent, this may even be true. But the investment pause was amplified by the inexperience of the new Polish administration and a prevailing sense of uncertainty. In the public sector, personnel changes and anticorruption hysteria put a damper on investment. Private companies were spooked by the populistic rhetoric of the new government and doubts about its professionalism.

Will investments recover? Utilization of EU funds will probably will be better. I don’t expect radical improvement in the public sector, but there should be enough to add about 2 percentage points to fixed investment growth this year.   

Investment confidence in the private sector is more difficult to assess. Perhaps business people don’t mind the rules of democratic society being bent – such as independence of the courts – at least until they find themselves in litigation with public authority.  But visible efforts to collect more taxes cause real worry. The government has promised to enact what it calls “a business constitution” to protect the rights of entrepreneurs, but so far, this is still a promise. In the meantime, new laws have granted the tax office sweeping powers to monitor, audit and punish enterprises.

The financial sector has been burdened by new bank tax while the government has retaken control of the country’s second largest lender, Pekao SA. That puts almost half of assets in Poland’s banking sector under state control, which creates the temptation to subordinate credit allocation to political decisions.  

Lastly, the Polish government’s attempt to block Donald Tusk’s election to a second term as European Council president was an embarrassing display of incompetence. Even worse, by aggravating the conflict with the European Commission, it endangers Poland’s future access to EU funds.

None of this supports investments. The only bright spot in this gloomy environemnt is the financial position of Poland’s corporate sector, which was quite good in 2015 and even better in the 2016. Partly this was the effect of output cuts at loss-making coal mines, which isn’t a portent of higher investment activity. But improvement in more profitable sectors was also recorded.

The global economy seems to be gradually recovering, which should help Polish businesses. However, the situation in Europe is less certain, because of the potential economic consequences of Brexit and the danger posed by rising populist movements in some countries.

In such a situation, the main impulse for private sector investments in Poland will be greed. People start up businesses because they want to earn money and spend it for consumption. Naturally, they want to expand. In periods of uncertainty, entrepreneurs are willing to wait, but if noting really horrible happens for a few quarters, their aversion to risk decreases.  Fears are crowded out by hope.

Is now such a moment? In my opinion, only to a very small extent. The near future will probably show that the peak demand reached two quarters ago will not be sufficient to sustain even this tiny optimism. Therefore, I don’t expect any significant acceleration of investments in 2017. Annual growth of 3%-6% seems the most likely scenario, which would contribute 0.5-1.5 percentage points to GDP growth.

All told, this means that Polish domestic demand can support GDP growth of 0.5% to 2.5% GDP this year. How much can net exports add to this? I expect no more than 0  – 1 percentage point, with a negative correlation to domestic demand. This can be viewed as a rather pessimistic forecast in light of my explanations of the enormous increase in inventories last year. A reversal of this trend will suppress imports and boost exports.

January’s rapid increase in industrial output, exports and imports after a renewed depreciation of the zloty partly bear out such a scenario. 

But there were other reasons for fast output growth. First was a statistical base effect, since industrial production in January 2016 was exceptionally weak. The second was the timing of massive year-end bonus payments, which are ordinarily made in December but which were delayed this year until January. The extra funds naturally boosted retail sales and industrial output in that month.

There was also a base effect for exports, which were much lower in January 2016 than in the neighboring months. On the other hand, weak net exports in the fourth quarter of 2016 were accompanied by an exceptionally low level of investments, which are always import-intensive. Additionally, nominal net exports were lower in the last quarter of 2016 than a year earlier, despite a positive contribution to GDP growth. Measuring inventories and international trade prices is always tricky, so we have to be careful on this point.

It is possible that net exports will be corrected downward when the statistics office releases its next estimates. Even if this doesn’t happen, one should take into account that a positive real and negative nominal change in net exports at the same time is only possible if the terms of trade are negative. That could raise serious doubts about the prospects for further export growth.

On the other hand, higher investments may offset lower imports of raw materials and intermediate goods resulting from the decrease in inventories. Low investment activity last year and consumption-driven growth will also worsen the trade balance. On balance, I expect Polish GDP growth of between 1.5% and 2.5% in 2017.

I want to stress that this moderately pessimistic estimate is based on two observations. The first is that any improvement in the Polish economy in late 2016 and early 2017 is only virtual. The second is that the crucial factor deciding the pace of growth in 2017 will not be objective circumstances but emotional attitudes.

It will be a contest between fear and hope. Moderate improvement in the global economy, combined with the optimistic forecasts mentioned above, justify some hope. But the Polish government appears determined to do its very best – by means of an unprofessional and unpredictable economic policy – to instill fear in the business sector, and thus to banish hope for a return to fast economic growth.