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Poland's harsh fiscal choices

October 26, 2016

Lower demand for Polish treasury bonds has reflected but also fueled fears that the nation's Law and Justice (PiS) government may have bitten off more than it can chew on the economic front. So far, optimism prevails.

Währungen polnische Zloty & Euro
Image: picture-alliance/dpa/P. Pleul

"So far the Polish economy, despite some obstacles and the negative image of the Law and Justice (PiS) government abroad, is doing OK," says Jan Muś, a political scientist in Warsaw. But he is wary - like others - that the budget deficit could upset the well-meant spending plans.

The draft budget plans for revenues of 296.88 billion zlotys (70.1 billion euros, $76.6 billion) and spending of 351.50 billion zlotys in 2017, with a resultant budget deficit of just over 54.6 billion zlotys. This is based on assumptions of GDP growth of 3.6 percent and CPI inflation of 1.3 percent and also hinges on increased tax revenues to offset higher spending.

But a projected slowdown in economic growth has cast some doubt on these assumptions. The budget plan assumes tax revenues next year to be much higher against the forecast performance in 2016. This means the tax gap could narrow further, especially in the case of VAT and excise tax, but that's a rather ambitious expectation.

The government has been in rough waters already over its bank tax, which was set to bring on 3.9 billion zlotys and a retail sales tax to bring on 1.6 billion zlotys until September, when it was suspended.

Welfare spending is also increasing, with 1 billion zlotys allocated to higher family benefits and 1.4 billion zlotys in terms of costs of a one-off increase in retirement payments and increasing public sector wages, which have been frozen since the start of 2010. This will also add to the deficit.

Bonds: canary in the mineshaft

Foreign investors reduced their net holdings of Polish government bonds by 9 percent in the first four months of 2016 as fears about the new government's potentially "reckless" social spending fed through into investor sentiment. But local banks - many of which the government wants to renationalize - were on hand to step in, also induced to do so by tax incentives for banks to hold more of the debt. Demand was up 28 percent in the first five months to 219 billion zlotys, according to Finance Ministry figures at the end of August.

But even that has seemingly changed and the government may now struggle to meet its maximum sales goal. If unable to finance higher spending, Poland - which was taken out of the Excessive Deficit Procedure (EDP) by the European Council earlier this year following a reduction in the deficit to below the 3 percent of GDP threshold - could return to it in 2017.

Ratings agency Standard & Poor's lowered Poland's status in January, citing political risk to the independence of institutions. In May, Moody's cut Poland's outlook from stable to negative over the fiscal risks posed by the government, while Fitch affirmed Poland at A- in July with a stable outlook.

Poland's government is giving pensioners a better deal, but it comes at a costImage: picture-alliance/dpa/R. Vennenbernd

The government's fourth-quarter debt issuance plans - the most ambitious to date - include selling new 10-year benchmark notes with a 3.098-percent yield, 10 basis points above similar securities on the secondary market.

The yield on 10-year Treasury bonds on the secondary market reached an average level of 3.11 percent in June, an increase of 2.89 percent since March.

Central bank chief Adam Glapinski said in October after the bank's rate setting council (the RPP) left rates unchanged at 1.5 percent for the 18th straight month that any European Central Bank rate tapering plans could potentially have "significant consequences" for Poland.

Analysts sanguine, but undecided

"We think that there is a risk that Poland's deficit may breach the EU's 3-percent deficit ceiling in 2017 which in turn could bring the country back into the EU's EDP," Felix Winnekens, Associate Director Sovereign and International Public Finance at S&P Global Ratings told DW.

"On the revenue side the government has had to postpone the introduction of the retail tax until 2018 and will not benefit from some of the one-off revenues it received in 2016. As a result, our deficit forecast for 2017 is 3.2 percent of GDP which could trigger a return to the EU's EDP. Given the ongoing conflict between Poland and the EU over the changes to the constitutional court, we would not expect much leniency from the EU should Poland breach the deficit target," Winnekens adds.

"Poland has seen some capital outflows over the course of the year but as liquidity in the Polish banking sector remains high, local banks were able to step in. Polish banks have an additional incentive to hold Polish government bonds, as these are exempt from the bank asset tax that was introduced earlier this year," he added.

S&P sees three main risks for the budget in 2017, Winnekens said. Firstly, growth could be lower than the government's forecast, which could lead to a revenue shortfall especially from VAT and corporate income taxes. Second, further reforms that the government is currently discussing, especially lowering the retirement age, could have a negative impact on the budget and potential growth. Lastly, the government hopes to improve its revenue collection through closing loopholes and improving the tax administration. The positive effects of such measures are difficult to measure and there is a risk that the government could fall short of its target.

"There's a risk that the government will have to choose between keeping its election promises and making its public finances subject to greater EU scrutiny again. If it chooses the latter, it will likely have to face higher borrowing costs as well," Winnekens said.

Carsten Hesse, an EME equity strategist at Berenberg in Germany said that for 2017 the budget deficit should be around 3 percent. "But the risk is to the downside," Hesse said.

Hesse says Finance Minister Mateusz Morawiecki "comes from the capital markets (ex-CEO of Santander Poland) and is very powerful inside PiS, so it is more likely now that Poland will not breach the budget limits to endanger Poland facing the EDP."

A little over half of Polish government debt is held by foreign investors, who may be more prone to leave the country should interest rates start to rise elsewhere. "We have seen recently that foreigners bought 95 percent of the 30-year Polish bond issues amid a low global interest rate environment and relatively high net yields in Poland. We've also seen inflows into Polish mutual bond funds over the last months," Hesse said.

"So, I wouldn't be so negative," Hesse says. "The Fed is likely going to increase interest rates only very gradually and much slower than in previous rate hiking cycles."

 "Investors might not be fully aware yet of how strong the budget is this year in Poland. Yes, inflation expectations have gone up slightly amid a weaker zloty, but the break-even rates suggest inflation will be only around 1.5 percent over the next 7 years on average," Hesse added, noting that the bond yield differential between Poland (10-year at 3 percent) and the Czech Republic (10-year at 0.4 percent) offers room for Polish yields to drop.

Will PiS have to pull back on some of its spending promises?

 "So far not. The reduction in the retirement age will cost them 0.5 percent to 1 percent of GDP, this is manageable. They plan to offset the costs of the increase in the PIT tax-free threshold by increasing personal income tax for high income earners. However, more populist measures such as increasing pension payments significantly could lead to a breach of the 3-percent ceiling," Hesse concluded.


Head shot of a man (Jo Harper) with grey hair and brown eyes
Jo Harper Journalist and author specializing in Poland