Poland: When Strong Money Hurts

Warsaw floated the zloty, hoping it would sink. Instead, it rose--clobbering the economy

Over the past 10 years, Poland has undergone one of Eastern Europe's most wrenching transformations. Whether it meant privatization, price reform, or trimming bureaucracy, Polish policymakers did their utmost to practice what the West preached. The payoff has been impressive. Since 1990, gross domestic product has soared from $59 billion to $155 billion, boosting the average monthly wage by nearly 70%, to $375. So when the Polish central bank announced on Apr. 11 that it had floated the zloty, removing the currency from a protective trading band, the government portrayed the change as a rite of passage. Poland had graduated to the big leagues.

Or did it? What some observers see behind the central bank's decision to remove the zloty's training wheels is not optimism but fear. Poland's economy is starting to show signs of overheating. The boom, plus high interest rates that have lured in foreign money, have driven the currency up 10% against the euro in the past six months. This strength has caused exports to collapse, since 65% of Poland's trade is with the euro zone: The strong zloty has made Polish goods increasingly unattractive to the country's trading partners.

"SOMETHING HAS TO GIVE." Warsaw's policymakers have been hoping that floating the currency would gradually weaken the zloty, make exports more attractive, and curb the country's appetite for imports. In the runup to floating the currency, Polish central bankers even tried to talk the zloty down to levels justified by economic fundamentals. Dariusz Rosati, a member of the monetary-policy council, went as far as calling investment in the zloty "risky." But high-rolling investors have kept pouring in, attracted to high yields on Polish debt. Since the zloty's flotation on Apr. 11, it has appreciated 4.5% against the euro.

There could be a crisis coming. If the zloty keeps strengthening, large swaths of industry and agriculture will wither and a downturn will ensue. And the zloty may go up so far so fast that it will have to crash. That would make the fight against inflation even harder. "Something has to give," says Giancarlo Perrasso, an economist at Chase Manhattan.

Some analysts are already drawing parallels between the zloty and the Mexican peso, which strengthened fast, only to crash in 1994. Poland is less exposed to short-term debt than Mexico, and its banking system is more stable, but the risks are still there. Some 45% of the foreign capital flowing into Poland goes to buy short-term debt and other portfolio investments. If investors feel drawn to ever higher rates in the U.S. and the safer greenback, they could drop that Polish paper fast. "We should be prepared for foreign investors to abandon Poland at any time," warns Krzysztof Bledowski, chief strategist for Wood & Co., a brokerage in Warsaw.

The stakes couldn't be higher. Poland's center-right coalition government, which is intent on joining the European Union in the first round, might see that goal slip away if it can't persuade investors to keep injecting cash. As it stands, that'll prove a tough sell. The chief cause for concern is the current-account deficit, which at 8.1% of GDP, is well above the 6% threshold economists consider sustainable.

TOP PRIORITY. By removing the trading band, the Polish government figured it would increase the risk of investing in the zloty and that the currency would fall. But investors seem to have more faith in Polish monetary policy than fear of the new floating currency. Central bank President Hanna Gronkiewicz Waltz, eyeing European Union entrance targets, has made combating inflation a top priority. "The central bank should take care of inflation, not the exchange rate," she says. With inflation a robust 7.5% despite short-term interest rates of more than 18%, the bank is unlikely to loosen rates any time soon. That's fine to foreign investors, who love the high rates they can lock in on Polish bonds.

That spells even harsher times for Poland's export sector. Exports fell more than 13% in the first two months of 2000 alone, after a similar drop last year. The flotation of the zloty has taken away the little security companies had. "Long-term planning for the export of cars or the import of components has become an unknown element," complains Krystyna Danilczyk, a spokeswoman for Korean auto maker Daewoo Motor Co., which operates the country's largest car factory. The outlook for agriculture, which comprises the largest chunk of Poland's exports, is just as gloomy.

Poland is also engineering a dangerous strength in the currency by attracting foreign money to its massive privatization plans. Communist-era giants such as the Huta Katowice steel mill are drawing millions in capital investment from such European heavyweights as Italy's Danieli and Belgium's Tractebel. The treasury expects to rake in an additional $5 billion this year, with the lion's share coming from the planned sale of the fixed-line telecom monopoly Telekomunikacja Polska.

Poland is hooked on this foreign capital, which just makes the zloty stronger. The government needs billions more to keep the expansion going by making much-needed improvements to the country's decaying infrastructure. Modernizing Poland's roads, railways, and telecommunications will be essential to attracting future investment. There's only one highway for the whole country. So Warsaw, despite dangers to the zloty, keeps courting foreign investors. The Polish government estimates that another $8 billion to $12 billion is on its way this year.

But the foreign money is creating other problems. Resentment over what some regard as a sell-out to anonymous foreigners has been on the rise. A dispute over the pace of foreign takeovers almost brought the government down in January. And unease about foreign investment has not gone away, especially now that foreign banks control 70% of the country's banking assets.

Poland: When Strong Money Hurts (int'l edition)

The inflow of funds has also fueled plenty of graft. "The degree of corruption, especially at the top, is shocking," says Wieslaw Walendziak, a leading Solidarity deputy. The corruption's not at the same level as in the Ukraine or Russia. But it's on the rise, nevertheless. Last month, the World Bank issued a report on corruption in Poland and warned that time was running out to bring the problem under control. "The moment to act is right now," says Basil Kavalsky, the World Bank's top official in the region.

The fear is that once Warsaw runs out of state enterprises to sell off, foreign companies may eventually decide Poland is too corrupt to warrant further investment. For now, Poland's center-right government remains committed to reform and to improving conditions for international investors. But however you look at it, Warsaw has a problem. It's going to be a scary ride.

Before it's here, it's on the Bloomberg Terminal.