Poland: Institutional Deterioration and Legal Disputes With EU Weaken Credit Standing

The EU’s latest legal actions follow the signing into law by President Andrzej Duda of a bill that would establish a panel investigating whether Donald Tusk’s opposition Civic Platform (PO) allowed Russia to influence policy making. The President says the law is intended to curb Russian interference in Poland’s policy arena and support democracy, but the EU believes it runs counter to European values as it could result in opposition politicians being barred from office.

On 2 June, the President amended the contested law removing a possibility of sanctioning persons from public office, but a person’s ability to hold public positions may nevertheless be hindered by the legislation.

Back sliding on rule of law and disputes with the European Commission, resulting in the suspension and placing of conditionalities on European funding, were key drivers behind Scope Ratings’ decision to downgrade Poland’s sovereign rating on 2 June to A (Stable Outlook) from A+ (Negative Outlook).

The Latest EU Actions Add to the Consequences of Governance Backsliding

The European Court of Justice furthermore recently upheld a decision against Poland’s disciplinary regime for national judges, although it stopped further accrual of daily penalties.

The latest EU announcements respond to governance challenges ongoing since 2015. But upcoming parliamentary elections by the autumn create uncertainties with respect to policy making and Poland’s institutional direction moving ahead. PO has gained although Law and Justice remains the largest party according to most recent opinion polling. Further institutional deterioration following the elections would prove negative for Poland’s ratings.

Fraught relations with the European Union undermine the investment outlook – which is significantly premised on EU funding. This, in turn, tempers longer-run economic growth. The consequences for Poland have been serious. In 2022, the EU adopted conditions on Poland’s EUR 35.4bn allocation under the Resilience and Recovery Plan and suspended the transfer of European Cohesion Funds under the 2021-27 EU budget, the latter amounting to a significant EUR 76.5bn, equivalent to 9.9% of average 2021-2027 annual GDP.

It appears unlikely that any new EU funding will flow to Poland ahead of this year’s elections, beyond final 2014-20 EU budgeted monies. Delays and uncertainties to the timing and availability of European financing cut the real value of allocated financing and affect the ultimate absorption capacity of the funds, where Poland holds an otherwise strong historical track record. The country absorbed 78% of allocated structural and investment funding during the 2014-20 EU budget phase.

Budget costs from monetary penalties and the effects on economic and fiscal performance from delayed European funding accrue with time, especially if the government replaces delayed EU funding with higher-cost national financing.

Several Inflation Drivers at Play

Another factor behind the rating downgrade is challenges to the outlook for underlying inflation, with monetary policy staying accommodative ahead of elections.

Poland’s headline inflation has fallen in the recent months (to 13% YoY by May 2023, from February 2023 peaks of 18.4%) but remains elevated. Headline inflation is seen averaging 13.5% this year, before receding to 8.1% by next year, nevertheless significantly above the National Bank of Poland’s upper tolerance band of 3.5% (Figure 1). Core price rises sit near multi-decade highs: 12.2% YoY as of April, pointing to persistent domestic price dynamics even though core inflation will likewise gradually moderate.

Figure 1. Headline CPI inflation, % year-on-year

Such dynamics partly reflect near-record unemployment of just 2.7% in April, fuelling nominal wage growth of 12.1% YoY. After a first hike in January, the minimum wage is set to rise again in July, bringing cumulative gains to about 19% by the end of this summer. Expansionary fiscal policy is boosting inflation. The granting of residential mortgage payment holidays furthermore slows the effects of higher rates on household demand, undermining near-term disinflationary effects of central-bank hikes.

The reference policy rate has stayed at 6.75% since September, despite entrenchment of inflationary risks. This has resulted in a sizeable negative real policy rate of -5.5% in May.

Higher Rates Restricting Government Fiscal Space

At the same time, the higher rates environment is contributing to a weakening of sovereign fiscal space. Net interest payments are forecast to rise to 5% of revenue by 2028, from 2.6% at 2021 lows. After picking up sharply since the second half of 2021, the yield on 10-year zloty government bonds has, however, stabilised in recent months, averaging around 6.1% since the start of the year.

The weaker structure of Polish government debt compared to that of peer sovereigns makes the former more exposed during phases of tightening in funding conditions and/or zloty weakening. Namely, the moderate average maturity of Poland government debt (5.3 years) favours a faster pass-through of higher market rates to interest expenses, as an outstanding share of foreign-currency-denominated liabilities (23.3% of aggregate treasury debt) generates currency risk exposure. Still, Scope expects Poland’s debt-to-GDP ratio to remain moderate around 50% over coming years.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Senior Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Keith Mullin, Senior Editor at Scope Ratings, contributed to writing this commentary.