As part of our regular emerging-market intelligence-gathering trips, we recently visited Poland and Romania. The two countries share few similarities today besides their communist past and catholic heritage. Indeed, in terms of economic outlook, the two economies appear to be on very different trajectories:
- Poland, on the one hand, is bearing the fruits of credible and prudent monetary and fiscal policies - its economy is exhibiting strong, broad-based growth.
- The Romanian economy, on the other, has overheated. Tax-cuts and repeated public-sector wage increases at a time when the economy was growing fast have resulted in high inflation and large fiscal and current account deficits.
Poland is enjoying the fruits of credible and prudent monetary and fiscal policies with its economy exhibiting strong, broad-based growth. Contrasting this, the Romanian economy looks overheated. Tax-cuts and repeated public-sector wage increases have resulted in large fiscal and current account deficits.
What’s new in Poland?
Poland: Economy growing fast with no evident macro-economic imbalances looming Investment growth higher than the numbers suggest
GDP growth rate in Q218 reached 5.1% year-on-year, propelled by an increase in private consumption and an encouraging rise in net exports. According to the policymakers we met with, the lower-than-expected investment growth rate may in part reflect the fact that leasing, which is widely used by SMEs due to a favourable tax treatment, is not fully accounted for in official statistics.
At our meeting with Professor Lukasz Hardt, MPC member at the Bank of Poland, in his office at the National Bank, he observed that two main factors had enabled Poland’s inflation rate to remain low relative to its neighbours:
- Big retail players weigh on prices: Inflationary pressure remains minimal despite a tight labour market and buoyant domestic demand. Intensifying competition in the retail sector following the recent entry of some big players such as Lidl, Tesco, Carrefour, has also weighed on prices.
- Ukrainian immigrants keep inflation in check: The growing number of Ukrainians (1- 1.5 million) now living in Poland, has kept wage-growth in check and the economy competitive.
A pragmatic approach for a populist government: As well as welcoming Ukrainians (culturally and linguistically close to Poland) we learnt that the government has been issuing work permits to workers from India, the Philippines, Nepal and Bangladesh via its embassies abroad in an orchestrated effort to meet labour shortages back home. This is good news given Poland’s demographic challenge – but nonetheless surprising, given the nationalistic, anti-immigration rhetoric of the ruling Law & Justice (PiS) party.
International banks choose Poland for business services hub: Our meetings with academics and think-tanks in Warsaw, reaffirmed our positive view on Poland’s economy: fiscal performance this year has outperformed market expectations led by strong revenue growth and prudent public spending. On the external side, the current account is balanced, and exports are growing fast, especially in the services sector; a testament to the quality and competitiveness of its well-educated, local human capital. Notably, a swathe of international banks including JP Morgan, Goldman Sachs, and UBS, have recently set up their middle-office operations in Poland. This has created thousands of jobs and is a ringing endorsement for Poland as a business hub.
So what’s not to like?
EC accuses government of tampering with the independence of the judiciary
The long-lasting dispute between the Polish government and the European Commission (EC) over the judicial system is damaging Poland’s reputation as a ‘safe-haven’ investment destination.
The contention surrounds the Supreme Court where a lowering of the retirement age to 65 from 70 has been proposed. This will force some judges to leave their positions and lays the government open to the charge that the change is politically motivated.
As anticipated by the EC representatives and constitutional law experts we saw in Warsaw, the EC has referred the matter to the European Court of Justice (ECJ) to preside. The Polish side is likely to downplay the importance of the ECJ. But if the ECJ rules against Poland and the government chooses not to comply, it will incur a hefty fine. The political cost however, for the government may be even higher, given the Polish population’s strong majority support for the EU. We therefore see room for compromise.
Rising deficits and high inflation warrant tighter policies
Contrasting with Poland’s economic prudence, is the Romanian government’s spending largesse. Our meetings in Bucharest only served to heighten our concern about the impact current policy is having on Romania’s fiscal trajectory.
Increased private consumption leads to high inflation and current account deficit
While on the surface Romania’s economy might appear solid (strong economic growth coupled with record low unemployment), a closer look points to an overheated economy: tax cuts and substantial public-sector wage increases implemented over the past few years have together stimulated private consumption, leading to a current account deficit and elevated inflation. These politically-motivated stimuli have given rise to a strong pick-up in import demand and the gradual erosion of competitiveness, with unit labour costs rising sharply over the last few years.
In our discussions with the Romanian Central Bank we understood that they share our concerns regarding competitiveness, noting that the current account deficit keeps growing despite a slowdown of the economy in the last 2 quarters. Nonetheless, the central bank continues to intervene in the exchange rate which serves to support the currency. We believe the reason for this is that inflation is still high (close to 5%) and that the pass-through effect from the currency to inflation is significant.
IMF and EC predict breach of EU’s 3% budget deficit limit:
The latest IMF budget deficit forecast for 2018 is 3.6% of GDP. In our view, the composition of the budget deficit is more problematic than its size. Both the IMF and the European Commission expect the cyclically adjusted deficit to exceed 4% of GDP this year, which leaves Romania vulnerable to external growth shocks or an abrupt fall in global risk appetite.
Why did we get here and what’s next?
Since early 2017 there has been a gradual increase in political instability and uncertainty, which has accelerated during 2018. The latest phase of this deterioration is infighting within the main ruling party, the PSD (Social Democrat Party). At the epicentre of the crisis lies PSD leader Liviu Dragnea and the changes brought by the ruling PSD -ALDE coalition to the Penal Code. The changes de-criminalise the offence of abuse of office, for which Dragnea was sentenced to 3 years and 6 months imprisonment in June 2018.
Politics at a crossroads?
Last week, several important members of the socialist party sent a public letter calling for Dragnea’s resignation. Interestingly, support for the PSD party is falling in opinion polls and public anti-corruption protests have been gathering momentum.
What Romania now needs in our view, from a macroeconomic perspective, is to consolidate its fiscal stance and reassess its priorities. For many years, political clientelism has resulted in the diversion of funds and resources away from badly needed investments in infrastructure, education and health services. Meanwhile, the absorption rate of EU funds remains relatively low, compared to other peripheral EU member-states.
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All rights reserved. Issued by Investec Asset Management, issued Septemeber 2018.