Identifier
Created
Classification
Origin
05WARSAW58
2005-01-06 06:27:00
UNCLASSIFIED//FOR OFFICIAL USE ONLY
Embassy Warsaw
Cable title:  

Markets Show Increasing Appreciation for the

Tags:  EFIN ECON PREL PL 
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UNCLAS WARSAW 000058 

SIPDIS


Sensitive

STATE FOR EUR/NCE TARA ERATH AND MICHAEL SESSUMS
USDOC FOR 4232/ITA/MAC/EUR/JBURGESS AND MWILSON
TREASURY FOR OASIA MATTHEW GAERTNER AND ERIC MEYER
FRANKFURT FOR TREASURY JIM WALLAR

E.O. 12958: N/A
TAGS: EFIN ECON PREL PL
SUBJECT: Markets Show Increasing Appreciation for the
Polish Zloty's Strength

Ref: 2004 Warsaw 386

(U) This cable is sensitive, but unclassified, and NOT for
Internet distribution.

UNCLAS WARSAW 000058

SIPDIS


Sensitive

STATE FOR EUR/NCE TARA ERATH AND MICHAEL SESSUMS
USDOC FOR 4232/ITA/MAC/EUR/JBURGESS AND MWILSON
TREASURY FOR OASIA MATTHEW GAERTNER AND ERIC MEYER
FRANKFURT FOR TREASURY JIM WALLAR

E.O. 12958: N/A
TAGS: EFIN ECON PREL PL
SUBJECT: Markets Show Increasing Appreciation for the
Polish Zloty's Strength

Ref: 2004 Warsaw 386

(U) This cable is sensitive, but unclassified, and NOT for
Internet distribution.


1. (SBU) Summary: The Zloty appreciated the most of any
convertible currency against the Dollar, growing 20% in

2004. Most observers attribute this rise to a mix of
factors, including greater political stability under the
current technocratic government, Poland's entry into the EU
in May, and the relatively high interest rate offered on
Polish government bonds. The Polish Government and
financial markets are still trying to assess whether the
Zloty's rise reflects a long-term shift in fundamental
economic conditions, or whether it is a short-term
phenomenon related to Poland's EU accession. Most analysts
believe it is the former, and expect the Zloty will
appreciate further in 2005. Although the Government would
prefer to continue to let markets set the exchange rate, it
will be forced to begin taking a stand on what the Zloty's
`real' value is as part of its preparations to enter the ERM
II in 2007 on the way to adopting the Euro by 2009.
Pressure for the Government to intervene to lower the
Zloty's value to help exporters has been muted until now, as
exports have continued to grow. Additional appreciation may
increase calls from exporters for some relief, particularly
given that 2005 is an election year. End Summary

The Zloty a Highly Appreciated Currency
- - - - - - - - - - - - - - - - - - - - - - - - - - - - -


2. (U) Despite a rough start, 2004 proved to be a banner
year for the Polish Zloty (which means golden in Polish).
The Zloty appreciated more than any other convertible
currency against the dollar, gaining 20.14%, outpacing other
Central European currencies by a comfortable margin
(including the Hungarian Forint at 13.9%, the Slovak Koruna
at 13% and the Czech Koruna at 12.4%). By the end of the
year, the dollar had fallen below three Zloty per dollar,
the lowest level it has been in seven years. The Zloty
appreciated more than 14% against the Euro. Private sector
economists attributed the Zloty's rise to: the stabilization

of the political scene after the appointment of Belka's
technocratic government in July; improving economic
fundamentals; Poland's entry into the EU on May 1; and the
attractive carried interest rate on Polish Government bonds.

2004: A Very Good Year:
- - - - - - - - - - - - - - - - - -


3. (U) In terms of fundamentals, for the fourth year in a
row, exports were up significantly, growing approximately
20% for the full year in 2004. This strong growth helped
push the current account down to 1.8%. Exports helped push
economic growth to an estimated 5.6% for the entire year.
For the first time in three years, investment grew, by 4.1%
through the first ten months (preliminary estimates suggest
the full year's total could be up to 8%). Foreign Direct
Investment remained relatively constant, at an estimated $6
billion, due in part to the revival of the government's
privatization program.


4. (U) Poland's entry into the EU opened Polish investments
to many foreign investors (e.g., pension funds) who would
not have previously bought government bonds or shares.
Coupled with the stabilization of the political scene since
the installation of a technocratic government, many
investors perceived an "established" country's level of
political risk with an emerging market's level of return
(one-year Polish Government bonds averaged close to 6.35%
for the year, reflecting lower ratings by investment
agencies compared to other Central European counterparts).
As a result, Poland attracted $12.2 billion of portfolio
investment, the highest level since 2000. This total
includes $8.7 billion in foreign purchases of government
bonds, more than three times the average level of 2001-3.
This, combined with $680 million invested in Poland's stock
markets, helped strengthen the Zloty. The National Bank of
Poland (Poland's Central Bank, NBP) does not believe that
most of the portfolio investment increase is hot money, but
is comprised primarily of more stable investors such as EU
pension funds.

How Golden is the Zloty?


- - - - - - - - - - - - - - - - - -


5. (U) The question is whether the Zloty will remain as
attractive in 2005. Government and private sector
economists expect that investments will be the main driver
for the 2005 economy. Capacity utilization rates are at
historic highs, and more than eight quarters of strong
export growth have delivered good profits to Polish
companies, which are now sitting on very large corporate
bank accounts. The one great unknown has been the
composition of the new government that will take office
after general elections later this year. As this situation
becomes clearer, Polish companies are expected to begin
investing, which in turn should sustain economic growth,
forecast at 5.0%.


6. (U) The Polish Government anticipates completing several
large privatizations in 2005. The GOP conservatively
forecasts that it will earn 5.7 billion Zloty ($1.84
billion) from these sales, several of which are expected to
attract foreign investors (including the state insurance
company PZU, chemical and energy plants and industrial
concerns). The Polish Government will also embark on a
number of EU funded projects, particularly in the
infrastructure sector, taking advantage of its first full
year of EU membership. There should be significant inflows
of EU money by the end of the year (up to 3 billion Euro).

Pressure on Exporters:
- - - - - - - - - - - - - -


7. (U) Polish exporters have begun to complain that the
relentless appreciation is making their exports less
competitive. Their complaints have been muted in part
because a number of their inputs, including gasoline and, in
some cases, bank loans, have been priced in dollars, meaning
that their relative input costs were stable or declining
while their revenues - measured either in Euro or Zloty -
were appreciating. Polish exporters have also compensated
by increasing productivity throughout 2004, which has
enabled them to continue making good profits even at the
cost of having to trim prices to compensate for the stronger
Zloty. Productivity increases in 2004 outpaced appreciation
against the Euro, although not against the dollar. Market
economists have estimated publicly that exporters would
begin to feel the pinch at around 4.25 Zloty per Euro (it
was trading just over 4.10 during the last week of
December). Bankers and companies tell us they remain
confident about their ability to continue export growth,
although further appreciation will pressure them to cut
costs, including by freezing or cutting employment to lower
labor costs. Polish importers report they have been hit
harder by the dollar's fall, as some industries compete with
Asian suppliers who price their goods in dollars.

Fundamental Shift or Short-Term Blip?
- - - - - - - - - - - - - - - - - - - - - - - -


8. (SBU) An NBP exchange rate expert recently explained the
Bank's dilemma in determining whether the Zloty's
appreciation represents a fundamental change in the real
economy, or whether it represents a temporary shifting of
prices following Poland's accession to the EU. NBP's
inclination is that most of the Zloty's appreciation can be
explained by a fundamental shift in the real economy rather
than a short-term market, or speculative spike. NBP expects
that the real effects of joining the EU will continue to
build, potentially even doubling total trade with the EU as
smaller companies develop the ability to participate in the
broader EU market. This greater economic participation
would justify a higher exchange rate.


9. (SBU) The expert noted that the sharp fall of the dollar
(35% against the Euro in three years) has exaggerated some
of the Zloty's movement. The Zloty has been more stable
against the Euro in 2004, increasing 14%, versus 20% against
the dollar. He explained that the dollar's sharp fall has
accelerated a shift in the Zloty's foreign exchange
"basket," (a rough benchmark used by the market to gauge
whether the Zloty is under- or over-valued) away from the
traditional 55% Euro pricing/45% dollar pricing to something
closer to 70/30. The slower rise against the Euro has
tended to shift greater volatility towards the dollar,
compounded by currency arbitrage, typically betting against


the dollar.


10. (SBU) There is a real possibility, however, that the
Zloty overshot in 2004, and that there could be some
retreat, particularly if markets become more nervous about
the effect of a new government after general elections later
this year. A new government will have an important effect
in determining tax rates, the pace of inflation through its
control of fiscal policy, and indirectly, on the exchange
rate. Many Polish companies will wait to invest until they
have a better sense of which parties will form a new
government, and what policies they will implement. As a
result, 2005 is likely to see more volatility than 2004.
Most analysts, however, expect fundamentals to take over
again by the end of the third quarter, and the Zloty to
appreciate by year end.

Interventions?
- - - - - - - -


11. (U) The question of whether and how the GOP should
respond to the Zloty's appreciation has become a central
question for policy makers. The Central Bank and Ministry
of Finance have welcomed the effect appreciation has had in
damping down inflation after accession to the EU in May.
However, they are also getting more nervous that the Zloty
is appreciating too rapidly. On November 30, a deputy NBP
governor sparked a flurry of media attention by suggesting
that Central Bank intervention in the exchange rate was
technically possible under certain conditions. The next
day, NBP Governor Balcerowicz said publicly that NBP's
strategy of "not intervening" was working well, and
suggested the Zloty had further room for appreciation.
Markets did not react to the specific event, but have begun
a broader discussion about the possibility of interventions.


12. (SBU) Market analysts tend to doubt that the Central
Bank would intervene, noting that Poland has been steadfast
in its adherence to free floating exchange rates. There
have been no interventions since 1998. Central Bank
officials also point out that it would be very hard to get
the amount of intervention right, particularly in the
current situation when the government statistical office is
undergoing significant revamping of the way it collects
basic data, including trade and investment. Without a
better sense of events in the real economy, the Central Bank
is unlikely to intervene on currency markets, which could
risk setting off market reactions which would take much
longer to stabilize than adjusting to the current
appreciation.


13. (U) The Monetary Policy Council could respond by cutting
its monetary policy bias, as an indication of the future
direction of interest rates. Currently, it remains
negative, signaling its determination to fight inflation.
The MPC could decide, however, that it needs to cut interest
rates to ease pressure on the Zloty. The MPC would prefer
to have more data indicating that inflation really is on the
way back down after the sharp spike after EU accession
(prices increased from just under 2% inflation to 4.5%).
Most analysts have interpreted public NBP and MPC comments
as an attempt to signal a desire to ease monetary policy
without cutting rates, sending a signal to potential
speculators that they do not want to Zloty bid up
artificially at the expense of exporters.

ERM-II
- - - - - -


14. (SBU) The question of getting the exchange rate right is
a crucial question for the GOP to resolve as part of its
obligation to adopt the Euro. Ministry of Finance and
Central Bank officials will meet at the end of January to
begin discussing policy towards entering the Exchange Rate
Mechanism (ERM-II) required by the EU on the road to
adopting the Euro. Once countries meet the Maastricht
criteria, they can apply for ERM II membership, during which
they must remain in compliance with these criteria to
demonstrate stability before entering the Euro zone. NBP
and Finance must jointly agree on a central exchange rate
target to join ERM II, which in turn requires broad
agreement on monetary and fiscal policy to keep inflation in
check. The GOP would then negotiate with the EU to fix a
central exchange rate for the ERM II. The GOP has already


set out its policy targets in the Convergence Strategy it
submitted last fall to the European Central Bank. The
challenge is for the current government to set Poland on a
path to meet its Convergence targets and be ready to enter
the ERM II in 2007 at an exchange rate which will sustain
long-term growth. From comments made by EU counterparts,
GOP officials have the impression that some of Poland's EU
trading partners may try to pressure Poland to adopt a less
competitive exchange rate to reduce competition from Polish
companies.


15. (SBU) In informal talks with the ECB, GOP officials
understand that it is virtually certain that Poland will be
able to operate within the wide band of a central parity
exchange rate while in the ERM II. Poland had been
concerned in 2004 by EU member state comments implying that
Poland could be required to maintain a narrow band (of 2.5%)
around the parity, and that the EU would pay particular
attention to any sharp depreciations. The dollar's
continued sharp fall in 2004, particularly against the
Zloty, would have made it exceedingly difficult to remain
within that band, as three month volatility averages by the
end of the year were still over 11%, compared to a more
stable Euro range of 7.3%. NBP notes that Poland expects to
meet the Maastricht criteria on budget deficit/GDP by a
relatively narrow margin (2.7% compared to the limit of 3%),
suggesting that adopting a narrow band would have little
credibility.

Comment:
- - - - - -


16. (SBU) Perversely, the Zloty's appreciation is a
byproduct in part of the political stability in 2004 which
companies have long sought. The silver lining for exporters
is that the elections this year may stem the Zloty's rise
for a while, although most observers expect the Zloty will
appreciate further based on solid economic fundamentals.
So far, most of the discussion about the exchange rate has
been held within technical or financial market circles.
Continued appreciation of the Zloty will increase calls from
exporters, however, for politicians to "do something,"
particularly given that 2005 is an election year. While the
GOP would clearly prefer to let markets set the Zloty's
exchange rate, it will have to take a policy stand on what
the central parity exchange rate should be in order to meet
its goal of entering the ERM II in 2007.

Munter