The pandemic and the war have turned a period of Great Moderation into a time of Great Volatility. Poland has been strongly affected by the stagflationary shock of the war in Ukraine, and the coming quarters may bring a recession, but Poland should keep outperforming vast majority of other EU economies.

Global financial conditions, tightened by aggressive Fed rate hikes, are revealing weaknesses in many economies. The fundamentals of the Polish economy remain sound, providing a strong footing for continued robust, sustained economic growth in the years ahead. Tectonic geopolitical shifts may increase the importance of the Polish economy ‒ instead of being positioned on the periphery of a highly globalised economy with China dominating the production chains, Poland may well play a significant role in one of the areas in the world that is splitting into politico-economic blocs.

In a Stagflation Vice

Russian aggression has caused a stagflationary shock, which struck a global economy that was already destabilised by the pandemic. In many economies, inflation is rising to its highest level in decades, while at the same time, a marked economic downturn is taking place. That stagflationary impulse is also felt much more acutely on our side of the Atlantic. Despite the geographical proximity to the war in Ukraine, the Polish economy is coping with the stagflationary impact relatively well.

In terms of growth, Poland’s economy is performing well compared with the EU and can be expected to remain so in the coming quarters. This stems from a long list of factors. First, high competitiveness resulting from rapid productivity growth combined with limited wage growth. Second, very low debt levels in the private sector, especially in the corporate sector, which limits the burden imposed by a significant hike in interest rates. Third, extensive diversification of the economy, limiting the impact of specific shocks affecting individual sectors and facilitating adjustments to fluctuating external conditions. Fourth, it is helped by the large inflow of foreign direct investment in previous years, which had built additional export potential and now ensures the continued double-digit growth of Polish exports, despite the decline in global trade volumes and sharp deceleration in Poland's main export markets ‒ Germany and the euro area as a whole. In addition, the Polish economy benefits from the relatively low share of natural gas in electricity generation, resulting in more favourable wholesale market electricity prices than in many other EU economies.

In terms of inflation, Poland's position looks worse. A tight labour market with the second lowest unemployment rate in the EU means that even a huge influx of foreign workers does not guarantee containment of underlying inflationary pressures. Elevated inflation was taking root in Poland even before the pandemic broke out. Global fiscal-monetary stimulation in response to the pandemic and the pro-inflationary effects of the war are now complicating efforts to bring inflation back to target. Inflationary processes in Poland, however, are not out of step with the European mainstream. While at the turn of 2020/2021 inflation in Poland was the highest in the EU, in recent quarters, it has been growing at a slower rate than in many EU economies and is now at levels similar to those in the Czech Republic and the Netherlands, for example. All this is taking place despite the relatively high energy intensity of Polish economy. Core inflation momentum is lower in Poland than in other major economies in the region, which have a similar structure and started tightening monetary policy at a similar time, or even slightly earlier. There are increasing signals that next year may well be characterised by disinflation. The global environment is seeing a reduction in the fluctuation of food prices, as well as a decline in the prices of energy commodities and industrial metals. Freight prices are normalising. Tensions in supply chains have eased significantly. There are also abundant local signs of a future decline in inflation. Nowhere in Europe has the growth rate of liquid money, as measured by the M1 aggregate (cash in circulation and current deposits), declined so much in recent quarters as in Poland, with a deep slowdown in the growth of household credit. For the first time ever, the annual mortgage growth rate has turned negative. New housing construction and the number of building permits is falling more sharply than after the outbreak of the global financial crisis. Real household incomes have been declining for several months and sales of consumer durables have been declining in real terms.

However, before inflation starts to ease and the economy returns to rapid growth, the beginning of 2023 could still bring the intensification of stagflationary trends, with a technical recession and CPI inflation rising above 20%.

Resilience Testing

The decisive tightening of monetary policy in the US is playing a key role in restoring normality to the global economy. For some time now, the Fed has been emphasising its determination to fight the inflation not only with words, but also with substantial interest rate increases and downsizing its balance sheet (QT). Without this, bringing inflation under control globally, including in Poland, would not be possible. Transitionally, however, this means ‒ through depreciation pressure on currencies other than the dollar ‒ that the US is exporting inflation abroad; it also poses a threat to the financial stability of many economies. Global financial conditions, tightened by aggressive Fed rate hikes, are revealing fundamental weaknesses in many economies. This has been painfully evident in the UK. Due to a number of structural factors, the period of Great Moderation has become a time of Great Volatility. Deglobalisation, a decline in global labour supply and the necessary energy transition mean that the era of cheap and easily accessible money is over. Despite appearances, though, the Polish economy is not doomed to suffer severe turbulence in such conditions. Significantly reduced foreign debt, negligible USD-denominated debt, a good balance of payments situation compared to the major economies in the region, one of the smallest fiscal deficits in the EU, low public debt, a minimally leveraged private sector, a deep reduction in loan growth in recent months preceded by several years of decreasing loan-to-GDP ratios and real interest rates at the level of the EU median ‒ these are not the features of an economy susceptible to a crisis shock under the influence of a decisive tightening of Fed policy.

Nevertheless, the room for manoeuvre for local macroeconomic policy has narrowed considerably. There is no more room for growing 'twin deficits'. After a radical tightening of monetary policy (the biggest and fastest NBP interest rate hikes in more than 20 years), fiscal policy now has a key role to play. Even a moderate increase in the fiscal deficit could be a challenge unless the US central bank performs a long-awaited pivot. In this context, the issue of access to EU funds gains great importance. With tighter global financial conditions and balance of payments deteriorating as a result of the negative shock to terms of trade (triggered by Russian aggression), access to tens of billions of euros of EU funds has become more important than ever for maintaining macroeconomic stability and investor confidence. The inflow of these funds would make it much easier to carry out important investments of strategic importance to Poland, including in the field of energy transition and defence, without the risk of market disturbances. The banking sector is also a key buffer against various shocks. In the stress tests conducted by the European Banking Authority in recent years, Polish banks have been top performers. Since then, however, their regulatory and legal cost burden has increased significantly. In a world of Great Volatility, it is necessary to ensure the strong capital position of domestic financial institutions.

Improved Geopolitical Position

Geopolitics has not been favourable to Poland in recent centuries. Its geographical location, sandwiched between authoritarian states pursuing imperial policies, contributed to Poland's loss of independence over 200 years ago. However, the tectonic frictions in the geopolitical layout of the world, visible in recent decades, seem to be conducive to the development of Poland's economy.

The collapse of the Soviet Union triggered an economic transition and the process of closing the development gap. NATO and EU membership integrated the Polish economy with the West, providing security (crucial in the face of current Russian aggression) and access to the vast EU market (exports have been a key driver of the Polish economy in recent decades). The creation of the eurozone has increased the competitiveness of Polish goods in many European markets (the economies of the southern countries of the common currency bloc are not able to implement competitive devaluations). Brexit has diverted a lot of foreign investment to Poland ‒ since the 2016 referendum, Poland's share of all greenfield investments made in the EU has increased significantly. The strategic conflict between the US and China, as well as the logistical difficulties revealed during the pandemic, encourage relocating production closer to consumers in Europe and the US. In many areas, nearshoring is already a reality and offers an opportunity to increase the role of the Polish economy in global production chains. Poland has long sought independence from Russian energy resources, which should now help it adapt more quickly to the new reality, one without access to cheap Russian natural gas. Poland has never developed significant financial and economic ties with China, which, in the face of a potential intensification of the West's conflict with the Middle Kingdom, may prove to be an advantage. China has largely been a competitor to Poland with regard to global production chains, rather than a destination market or source of capital.
Strong economic fundamentals, still-substantial competitive advantages and geopolitical developments mean that the golden era of the Polish economy can continue. It does, however, require a very mindful macroeconomic policy. ©℗

Piotr Bujak, Chief Economist of PKO Bank Polski