Poland fared better than most in eastern Europe’s capitalist revolution. Problems remain, but impending EU membership will be a driver for growth, says BNP Asset Management (London)
Poland first caught the world’s attention in the late 1980s and early 1990s, as the communist regimes in eastern Europe began to disintegrate. Poland, at the forefront of these changes, rapidly established a new legal infrastructure, a capital market framework and a democratic political system.
Today, the Polish economy is one of the largest and most dynamic in central Europe, with GDP growth of above 5% per annum over the last five years1. At the same time, the Polish stock market has developed to become the largest in the region. It is currently capitalised at $26.2bn compared to Hungary’s $16.2bn and the Czech Republic’s $13.9bn2. With short-term interest rates now in the low teens, and inflation expected to be 7 to 7.5% by the end of 1999, the economy looks in fairly good shape. However, in spite of the scale of the achievements to date, the extent of the remaining challenges for Poland should not be underestimated.
One of the most pressing issues is foreign direct investment (FDI) and privatisation. After an initial burst, FDI flows have been disappointing, having been directed principally towards large bulky projects, often overlooking grass roots businesses on which much of the economy is based. Hence, small companies have generally remained underdeveloped, while thriving middle-sized companies are a rarity. Privatisation, too, has fallen behind schedule.
Although FDI clearly plays an important role as a source of finance for the country’s large current account deficit, it also tends to shake up formerly closed and cosy industrial structures, introducing new management and new objectives. FDI’s ability to create jobs, competition and know-how for the long term, means that the need for acceleration is critical if Poland is to compete effectively within a rapidly developing Europe.
The Polish stock market has grown in size and maturity since its launch in 1993, although it remains bureaucratic and over-regulated. In addition, local speculation combined with weak takeover legislation has deterred large-scale foreign investment. As a result, foreign institutional investors are relatively under-represented as owners of Polish enterprises. Indeed, the Polish stockmarket’s performance has undermined the paradigm that high growth countries experience soaring stock prices; Poland has seen the paradox of strong GDP growth and weak earnings growth at the corporate level for over four years now. Over the same period, the Warsaw exchange has shown poor average annual returns of 1.2% in US dollar terms3.
These anomalies and problems can largely be explained by FDI and privatisation weaknesses referred to above. Large holdings in listed companies (and a significant part of Poland’s industrial production) are still owned by the public sector, and have consequently seen little real restructuring and thus continue to demonstrate low levels of profitability. At the same time, small and medium-size firms which have been set up recently, or companies that have foreign strategic investors/partners are severely under-represented on the stock exchange. As a result, foreign investors are denied access to many of the more dynamic and entrepreneurial pockets of the economy.
However, each of these problems provides scope for progress. Take, for example, privatisation. Although Hungary has attracted more FDI than Poland (Hungary has attracted annual FDI per capita of $212 from 1993 to 1998, whereas the figure for Poland is only $614), the situation is showing signs of change. FDI in the first half of 1999 year was $2.3bn, and $5bn is expected to be raised for the full year. On another measure, FDI per capita is expected to average $180 over the next few years. Privatisation is now swinging into gear with in excess of $3.5bn expected this year.
The creation of private pension and mutual funds is set to add depth to the domestic investor base, and is a key factor in the development of the economy and the capital markets. From the point of view of the economy, it reduces the strain on government finances over the medium term and in terms of the stockmarket, liquidity inflows should help the market advance. Polish pension funds currently have 6.7m participants. By the end of 1999 these should have 9m subscribers, rising to $3.7bn under management by the end of next year, and an expected $16.2bn by the end of 2004.
The growth of retail and institutional Polish mutual funds is also important. By the end of July, total Polish mutual fund assets amounted to PLN2.6bn (about $650m), a 43% rate of growth since the beginning of the year. Despite this growth, mutual fund assets per capita are still very small: $16 per capita compared to $120 in Hungary, $2,800 in Greece and $10,000 in France. Poles currently have most of their savings (PLN147bn or $1,000 per capita) in domestic bank accounts5. But, as interest rates fall, equities should start to attract money away from risk-free assets.
On the basis of these factors, it is fairly easy to construct a case of how the combined effect of increased privatisation and FDI on the one hand, and more equity investment on the other, could lead to some revaluation of the stockmarket.
The final driver for growth in Poland is likely to be the EU convergence story. There has been continued political consensus with regard to Poland’s intention to forge closer ties with western European countries. Poland’s clear goal is EU membership, followed by Euro-zone entry by 2005.
This poses several challenges. Inflation and long-term interest rates will need to fall sharply, the budget deficit will need to be held below 3% of GDP and the debt-to-GDP ratio must remain under control. Finally, the exchange rate must stay within normal margins of the ERM for two years. However, if this macroeconomic stability can be achieved, the benefits will be huge. Credit growth will grow as the risk premium falls, investment should increase sharply, trade will increase and the economy should benefit from non-inflationary growth. At the same time, liquidity flows into the stockmarket should increase sharply. The sticking points are likely to be agricultural subsidies and labour-market reform.
These macroeconomic advances will have a particular impact on certain key sectors of the Polish economy. In particular, the banking sector is an obvious beneficiary; as short-term interest rates fall and reserve requirements come into line with those of the EU, consumer credit growth should pick up, coupled with growth in a variety of fee-based asset-management services, property and mortgage lending, as well as other more tailored personal banking services.
The telecom sector should be another beneficiary in terms of growth since lower interest rates are likely to provide an important stimulus to investment spending. To this extent, it is likely the stock valuation discounts to developed market peers will narrow, a process which has, to a limited degree, already begun to happen over the past two to three years.
On balance, EU entry serves as the driving force for Poland. It should provide the impetus necessary to keep the reform process on track. EU entry, as we have detailed, requires further changes in the regulatory framework of various industries, reform of the social security and pension systems and further privatisation. These changes, when they occur, should reduce both micro and macro uncertainty, encourage FDI and generate sustained low inflationary growth. This virtuous circle typically leads to a rerating of the equity market, as we have seen in Spain, Portugal and, more recently, Greece. Although there will be ups and downs along the way, we believe Poland is well poised to take advantage of the opportunities provided as the economy continues to mature and become an integral part of western Europe.
Sources: 1BNP Asset Management
(London); 2CSFB, 8 September 1999; 3Bloomberg; 4Flemings; 5CSFB; 6CSFB
This article is contributed by BNP Asset Management (London)