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Poland EMU – A Game-Changer for the Zloty? Global Prognosis? Protectionism! View GEF Archive

		The Global Economics Team

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•           Good proxy to express a bearish CEE FX view: In the current risk-averse environment, the zloty was viewed as a liquid currency, with minimal risk of market intervention by the authorities (unlike in Romania and Hungary). The perception that there was a policy of ‘benign neglect’ towards zloty weakness was reinforced by NBP policy: for example, after the January rate cut, the bank still maintained that the significant zloty depreciation would have a limited impact on CPI against the currently weak macro backdrop. References to falling inflation and a weak CPI pass-through led the market to believe that the NBP had no fundamental opposition to the zloty’s weakening trend.

•           Steadily deteriorating fundamentals: Poland’s stock of government debt or external debt is lower than that of Hungary (as a % of GDP), and its deficit appears to be still under control. However, there is an undeniable weakening in the country’s external vulnerability indicators that we track most closely. Short-term external debt exceeds FX reserves, the C/A gap has widened steadily (to nearly 9% of GDP if one includes unexplained outflows), FX mortgages account for over 60% of total mortgages and overall private sector credit to GDP rose to 47%, up ten percentage points in just one year. Pretty much all of the above are related to a surge in FX borrowing that boosted consumption and asset prices in 2007 and 2008. As these flows (which involve PLN purchases) progressively dry up and leave the economy exposed to a nasty downturn, the zloty comes under intense pressure.

•           FX hedging went badly wrong for corporates: Polish corporates, encouraged by the seemingly never-ending bullish PLN trend, decided to take out zero-cost options structures that protected their FX exports receipts from continued PLN appreciation. These zero-cost option structures left corporates heavily exposed to a PLN depreciation which at the time seemed unlikely and which has in fact materialized. As corporates rushed to buy EUR and cover their exposures, the PLN weakened further. Last week, Deputy PM Pawlak even argued that he wanted to cancel these options, on the grounds that they were mis-sold to corporates. These plans seem unlikely to go ahead, but they did raise serious concerns around compliance with EU laws and liabilities of local banks to foreign banks (who had originally structured the options).

•           Loss of confidence in the EMU plans: Last September, PM Tusk launched an ambitious bid to adopt the euro in 2012. At that time, we were constructive on Poland’s chances to enter the euro area in 2012, and viewed tight policy and a stable or stronger zloty as a necessary condition for the NBP to meet the HICP criterion. Since then, it has become clear that the PO-led government lacks the necessary votes to change Article 227 of the Constitution, which defines the powers of the NBP (this is a necessary step to adopt the euro as national currency). Also, this week the NBP released a report which argued in favor of euro adoption in the medium term, but cautioned against ERM II entry in the present circumstances. And of course, the 40% depreciation of the zloty versus the euro hardly argued in favor of setting a parity versus it any time soon. Decreased confidence in the ‘EMU anchor’ left the zloty more exposed to the vagaries of risk appetite.

FX Intervention and Positive EMU Plans Gave the Zloty a Lifeline. But For How Long?

This week, two developments suggested that the first and last factors have turned more PLN-supportive. 

First, senior NBP policymakers have clearly signaled unease about the level of PLN, moving away from the ‘benign neglect’ policy. Also, the government indicated that it plans to convert the EUR funds on the market if EUR/PLN approaches 5, rather than at the NBP. These funds currently total around €3 billion, but the total allocation in principle for 2009 is as big as €11 billion. The Min Fin has already started selling EUR in the market, helping to push EUR/PLN lower this week.

Second, the Min Fin indicated that it is in talks with the European authorities about ERM II entry even without a constitutional change. This looks like a bold move, given that ECB President Trichet had explicitly mentioned in November that amending the constitution would be a necessary step ahead of ERM II entry (more on this below). Polish officials’ latest comments suggest they believe that the EU will understand that Poland’s EMU ambitions cannot be hostage to internal political problems (i.e., opposition dissent), and therefore the EC/ECB will soften its stance. But will it?

The EU’s Dilemma: Some Thoughts on Linkages and Support

At the beginning of this crisis, we argued that the ongoing crisis is bringing EMU closer to the region, rather than pushing it further away (see WSJ op-ed, Eastern Woes, November 11, 2008). More recently, however, the increased problems at the periphery of the euro area have increased the risk that the EU authorities (especially the ECB) would be more reluctant to let in other ‘problem countries’ at the fringes. The decision to allow a country to join ERM II is a collegiate one, between the EC and the ECB. The former is more enthusiastic about the euro enlargement process; the ECB’s response is the main sticking point, in our view.

Poland has thus far failed to deliver the single most important condition to increase its chances of ERM II entry – namely, to amend the constitution. Based on President Trichet’s comments, the ECB would likely have denied Poland access to ERM II three months ago. Has the deterioration in the external environment been severe enough to persuade the ECB to relax its earlier condicio sine qua non? Will Poland’s assurances that the issue will be dealt with over the next two years be enough?

Ultimately, the issue is a political one, but economics does matter. The notion that the euro area (mostly made up of Western European countries) can just ignore the issues ongoing in Eastern Europe is fundamentally flawed, in our view, for at least two reasons. First, Austrian (mainly), but also German, Italian and French banks have lent aggressively in the region, and have an interest in ensuring that CEE can see through the current downturn. Second, the trade linkages between the euro area and Central and Eastern Europe have expanded significantly over the recent years: the euro area now runs a €50 billion annual trade surplus with the CEE (CE + Baltics + Bulgaria), by our calculations.

The reasons outlined above seem compelling enough to assume that some sort of additional support to the region will come, if needed. The issue is: in what form? First, the European Commission could issue bonds to finance loans to individual countries that apply, maybe as part of a larger IMF-led package (this was the case with Hungary and Latvia already). Second, the EU could bring forward the EU budget transfers (cohesion funds mainly) for the 2009-13 period, already agreed in the budget, and concentrate them in 2009-10. These funds are very sizeable, equal to nearly €150 billion between now and 2013. Moreover, both the European Investment Bank and the EBRD could help, and the ECB could agree more swap lines with CBs in the region. Most of these options involve higher or faster disbursement of capital, whereas ERM II entry does not. Therefore, if it serves to stabilize financial markets and reassure investors about the medium-term feasibility of investment into the region, admitting hopeful EMU members into the ERM II mechanism seems to be a relatively ‘cheap’ option from the EU’s standpoint.

What are the costs from the ECB’s standpoint? Well, the most obvious one would be that the ECB would commit to supporting the +/-15% band around the parity (together with the NBP), so it may have to sell EUR and buy PLN if the weaker side of the band was threatened, for example. We note, however, that the size of the ECB’s balance sheet might be enough to deter speculators from attacking the weaker end of the band. Second, some argue that the ECB would want to preserve the value of the EUR, and not admit countries with weaker fundamentals, especially now. While we see some merit to this argument, we stress that this is simply an issue of timing: by signing the Maastricht treaty, all these countries have already implicitly committed to adopting the euro at some point in the future.

To us, the most serious issue is setting a precedent in terms of FX volatility: the zloty has been incredibly volatile in the last six months, shedding around 40% of its value versus the euro. When Slovakia was first admitted into ERM II in November 2005, the currency had been fairly stable versus the euro for a few months and the parity was set close to the trading level. In Poland, the choice of the parity would be much trickier – a parity close to current weak levels might give Poland an unfair competitive advantage, and not help on the disinflation front either (we note that Poland no longer meets the Inflation criterion). A stronger level than the current one, say a 60-day average of around 4.25, would increase the likelihood of forced ECB/NBP intervention at the weaker end of the band. And more broadly, a reasonable macro case can be made for not fixing a parity level in the current volatile market environment, but waiting several months for volatility to subside.

Wait for Green Light Before Turning Constructive

There are still far too many question marks in Poland’s euro adoption strategy for us to be persuaded by its merits. This is the reason why our forecasts are tilted towards further near-term FX weakness, though the bulk of the adjustment is most likely behind us. Constructive EU comments and eventually an ECB decision to allow Poland into ERM II would be a game-changer, we think, and would dramatically reduce downside risks for the currency. It would also indicate that the likelihood of Hungary being allowed into ERM II at some point in the next 12 months has risen.

Global
Prognosis? Protectionism!
February 23, 2009

By Joachim Fels & Manoj Pradhan | London

Globalisation over? The gradual dismantling of many barriers to the free flow of goods, services and capital has strongly stimulated international trade and cross-border capital flows, and helped to propel global economic growth over the past several decades. Until recently, this trend towards globalisation appeared to be unstoppable.  However, the current global financial and economic crisis has clearly raised the risk that governments will resort to protectionist measures in order to support domestic industries, which could aggravate the recent collapse of global trade and depress global growth even further. 

Creeping protectionism to help create stagflation: In our view, a fierce global trade war similar to the one that helped turn the 1929 recession into the Great Depression will likely be avoided.  However, we do expect a multi-year period of creeping protectionism, which will weigh down on global potential output growth and help create inflationary pressures in the next cycle. As we see it, hyperactive monetary and fiscal policies, together with creeping protectionism, are a recipe for a stagflationary outcome for the world economy over the next several years.

Lessons from the 1930s abyss: History provides some stark lessons about the impact of protectionist waves on trade and growth.  The starkest of all comes from the 1930s Great Depression.  As Charles Kindleberger described in detail in his 1986 book, The World in Depression, 1929-1939, many governments resorted to raising import tariffs and some to competitive devaluations, which depressed global trade.  The Smoot-Hawley Tariff Act, which was signed into US law on June 17, 1930, provided for higher import tariffs on a wide range of goods and set loose a wave of retaliation by other countries. As Kindleberger noted, countries such as France, Italy, India and Australia had already raised tariffs on some goods in 1929 and that average tariff rates had already been on a rising trend in the US, Germany, the UK and Japan from about the mid-1920s.  Yet, Smoot-Hawley sparked reactions from a wide range of other countries, including Canada, Spain, Switzerland, Italy, Cuba, Mexico, France, Australia and New Zealand.  As a consequence, world trade went into a downward spiral, with the value of global imports falling by close to 70% between January 1929 and February 1933, which finally marked the trough for global trade and the Depression.

The global trade phoenix: The experience of the 1930s helped to lay the ground for the multi-decade trend towards trade and capital account liberalisation following World War Two.  Average tariff rates in the industrialised countries were reduced to low single-digit levels over time through eight successive rounds of the World Trade Organisation (WTO) and its predecessor, the General Agreement of Tariffs and Trade (GATT). According to the World Bank, as of 2005 the unweighted average tariff was roughly 3% in high-income countries, and 11% in developing countries, from respective levels at least three times as high in 1980.  The dismantling of barriers to trade helped propel global trade (exports plus imports) from less than 40% in the early 1980s to 62% of global GDP in 2008. 

Non-tariff barriers ever more important: With tariffs declining across the board, the relative importance of other barriers to trade (such as import quotas, export bans, anti-dumping duties, non-automatic licensing, technical barriers to trade such as health and environmental regulations, and subsidies to national industries) has naturally risen.  Economists have tried to transform all the information on such non-tariff barriers into a price equivalent to make it directly comparable to a tariff.  We illustrate, for a selected number of countries, the results of a World Bank study that estimates trade restrictiveness indices incorporating tariffs and non-tariff barriers to trade (H.L. Kee, A. Nicita, M. Olarreaga, “Estimating Trade Restrictiveness Indices”, World Bank Policy Research Working Paper 3840, February 2006).  In short, non-tariff barriers are a significant factor and, in some cases, are several times more important than tariffs. For example, in the EU the average tariff rate amounts to some 3%.  Yet, the equivalent tariff rate including tariffs and non-tariff barriers is around 12%, according to this study. 

Dwindling appetite for liberalisation and globalisation: Even before the current financial and economic crisis, there were reasons to worry about a revolt against further globalisation.  With the increasing success of China, India and other new players in global markets, economic anxiety among the wealthy nations of the West has been on the rise for some time.  This is nicely illustrated by a comparison of public attitudes towards free trade in two polls conducted by the Pew Research Center in 2002 and 2007. In these polls, respondents were asked whether they thought global trade was good for their country.  Large majorities backed trade in virtually all countries in 2007. However, compared to the same poll in 2002, support for trade deteriorated significantly, especially in some western countries. In fact, the largest decline in support for trade took place in the US: in 2002, 78% of US respondents said trade was good for their country; five years later support had fallen by 19 points to 59%.  Anxiety is also on the rise in Europe. 

According to the European Commission’s November 2008 Eurobarometer, a regular poll of public attitudes in the EU, only 38% of EU citizens considered globalisation a “good opportunity for national companies”, while 43% thought that globalisation “represents a threat to employment and companies”. 

No new wave of protectionism yet, but... To be fair, while protectionist sentiment and pressures are rising, there is so far little hard evidence of a new wave of protectionist measures.  In a recent media interview, WTO Director-General Pascal Lamy noted that “nothing dramatic” had happened in terms of an increase in protectionism since the start of the crisis in the autumn.  Still, there have been some cases of increased protectionism that might mark the beginning of a new trend. 

Some recent examples include increased state aid to particular industries, most notably the domestic auto industry in a large number of countries (e.g., the US, Germany, France, China, Canada, Australia, Sweden, Russia), tariffs on steel products in India, higher tariffs on 940 products in Ecuador, and other protectionist measures in Indonesia, Argentina, Korea and the EU.  Moreover, in several countries, governments are leaning on banks that have received capital injections or guarantees to lend predominantly to domestic households and companies rather than financing projects abroad.  With the recession deepening and broadening, further defensive action is likely to be taken by many governments.

Creeping protectionism... In our view, a fully fledged tariff war along the lines of that in the 1930s is unlikely.  Multinational companies stand much to lose from such policies and are likely to lobby successfully against significant tariff increases.  We deem it likely, though, that a multitude of non-tariff barriers to trade will be introduced over the next several years. Governments will likely twist their fiscal stimulus measures towards supporting domestic industries.  Also, calls for protecting domestic jobs are more likely to be heeded in an environment of rising unemployment.  And with governments assuming stakes in the banking sector, lending policies are likely to become more domestically oriented. 

…with stagflationary consequences: Throwing sand in the wheels of globalisation will have two important economic consequences, in our view.  First, erecting barriers to free trade will reduce economic efficiency and thus potential output growth.  Dismantling these barriers will likely produce stiff opposition. Second, by lowering potential growth and reducing international competitive pressures, barriers to trade will increase inflationary pressures.  Globalisation over the last few decades helped to propel global trade and economic growth and supported disinflation. Conversely, de-globalisation should produce a less favourable mix of output growth and inflation.  Together with super-expansionary monetary and fiscal policies, creeping protectionism will thus likely produce a stagflationary outcome for the world economy over the next several years.  The good news?  Well, the stagflationary 1970s were still a lot better than the 1930s.

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