23.03.2009   The Panalyst Perspective

Stuck on the roller coaster

In July 2008 Poland was a star performer. An EU member since 2004, strong fundamentals, stable growth, rising property prices, a growing stock market, large EU and privatecapital inflows and an appreciating currency.



Introduce in 2008, a full blown US driven credit crisis. For some months after the global contraction took hold, Poland's economy seemed relatively steady. Strong internal demand and less dependence on exports than Czech and Hungary seemed to maintain corporate and consumer confidence, the zloty continued to appreciate until August 2008.

In September 2008 as a sharp deterioration in foreign investor sentiment towards emerging markets took hold, the zloty began to weaken. Any benefits to exporters from the weakening zloty were countered by falling global orders. The weakening accelerated when on February 17th 2009, the ratings agency Moody's began to talk about the potential impact of a downturn in Eastern European on the risk ratings for Western banks with Eastern European subsidiaries (Raiffeisen, Erste Bank, Société Générale, UniCredit and KBC). Short term debt owed to these banks was around 300bn EUR. In the Central and Eastern European (CEE) region large current account deficits, reduced foreign investment and export dependent economies implied vulnerability to a global downturn. The markets had an immediate reaction to the regional currency basket and the zloty was drawn into a wave of depreciation.

Beyond a general economic downturn, the weakening zloty caused 2 problems specific to Poland and the CEE region.

• 1) Mortgages denominated in foreign currencies, particularly the Swiss Frank (CHF): In the West offering 1 year discounted interest-only mortgages and measuring incomes against these short term payments had clearly been a mistake. Almost as risky was selling repayment mortgages in Poland, at interest rates of around 1%, but in CHF. In 2007 52% of all mortgages in Poland were in CHF. As the zloty depreciated by around 40% against the frank individuals saw an equivalent increase in their mortgage payments, threatening a wave of defaults.
• 2) Currency options: It became apparent in early 2009 that Polish exporters such as the country's top chemical maker, Clech and steelmaker Odlewnie Polskie, had sold or "written" risky currency option contracts, exposing themselves to significant margin calls in the event of a zloty depreciation. While the government claimed the exposure was limited to around 15bn zloty in February, the damage was to confidence in the Polish financial system and further to the zloty.

While widely analysed ex post, few it seems fully predicted the likelihood and specific exposure of Poland and the CEE region to a significant devaluation. This despite strong similarities to the 1998 Asian crisis, where countries had borrowed during growth years and were then heavily impacted during a downturn by a flight of capital back to safe haven currencies. The potential for the CEE region's problems to become a tipping point for the global financial system was underestimated causing large short term swings in currencies.

In mid February as the zloty threatened to break the psychological barrier of 5 EUR, the Polish and CEE governments and central banks made veiled threats of market intervention. The Polish government held an immediate war chest of 3.2bn EUR in structural funds on February 18th (67bn from 2007-2013) and began what it called "routine" conversions. It seemed the region's governments and hardened speculators were preparing to do battle.
However in mid March 2009 the Swiss central bank cut rates close to zero and intervened in the markets resulting in CHF depreciation. The markets also began to differentiate between the nations of this region. The Baltic States, Bulgaria and Romania had built up large current account deficits exceeding 10% of GDP putting significant pressure on financing needs and foreign exchange reserves. Hungary and Ukraine had already required bailouts in October 2008. The debts of Poland and Russia were moderate compared to output and forecast growth of around 1% is still expected in Poland in 2009. Over half the debt of the aforementioned exposed Western banks was in the more robust CEE countries (Russia, Turkey, Poland, the Czech Republic and Slovakia).

More attention is now being paid to the specific cultural aspects of debts in the region. Household and corporate debts are well below western European levels. While in the last 2 years 100% mortgages were being introduced for the first time by some institutions and caught the headlines, unlike the UK and US, mortgage approvals were heavily linked to basic income levels as opposed to complicated and ill-advised wealth and buy-to-let calculations being used in Western banks. CEE citizens are well used to hard times and have faced significant economic changes during communist times. They often enjoy close links with family who help out during such periods of turmoil. As such lower wages and potential unemployment does not hold as much shock value as it does in the west.

Although we are not yet out of the woods, for Poland the lesson of this episode is already clear. Just as Americans and Western Europeans had come to expect ever-increasing asset prices and over leveraged against these, don't make the same mistake and leverage against an assumed future currency rate. An external shock such as that witnessed, can be enough to knock a rate far off it's steady state in the short term, damage a fundamentally healthy economy, related Western European banks, and from there, who knows.

Panalyst Sp. z o.o. is a Polish real estate developer and consultancy www.panalystpartners.com