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Wednesday, October 24, 2007

Poland's External Position - Don't Forget the Income Balance

By Claus Vistesen Copenhagen

This note links up with the coverage of the recent Polish elections as well as an accompanying analysis of the Polish economy with specific focus on the labour market. As such and as Edward also noted in his writings on the Polish economy I would be in hot on the heels with a look at indebtedness, capital flows and the current account balance situation. Now, I should say before we begin that I won't be looking much at indebtedness in this note but more so on the two latter topics. In this way it is also important to understand that the analysis applied to the Baltics in terms of a rigorous look at translation risk does not apply with the same degree to Poland. This does not mean that currency wobbles couldn't hit Poland; but for two principle reasons namely that the Polish Zloty is floating against the Euro as well as the fact that the run-up in credit and thus consumption and subsequent wage costs, although extensive, have not reached the proportions seen in the Baltics the situation is a little bit different in Poland. I should note however, that Poland only shines because in relative comparison with some of its CEE peers and that in general the economic fundamentals are rather shaky at this point in time.

In this note I shall home in specifically on the external balance of the Polish economy. I will especially try to emphasize what it (potentially) means that the CA deficit is largely covered by FDI. As such, let us commence and let us begin by looking at the CA deficit;

As we can see and despite the reverse U shape of the series the Polish external balance pretty much looks like in the case of the rest of the CEE and Baltic economies although that the ratio to GDP would be somewhat lower than some of really fast movers in the region. Furthermore we observe that quite naturally the overall evolution of the current account deficit is dictated by the trade balance. In terms of financing or coverage, as it were, of the balance Poland constitutes the opposite end of the continuum relative to the Baltics with respect to the situation in the region. As such, while the latter has a large share of their external deficits covered by foreign credit extended by financial intermediaries the former (Poland) has its external deficit almost entirely covered by foreign direct investment (FDI). The following quote as cited from a recent very comprehensive World Bank report on the EU10 sums up the situation:

External positions in 2Q 07 in most EU8+2 were financed by FDI. In the Baltic countries they were financed by foreign borrowing through the banking sector. In most countries current account deficits remain largely covered by FDI – fully in the Czech Republic and Poland, in 90% in Bulgaria and 2/3 in Slovakia and Romania. Meanwhile in the Baltic countries, which have the largest imbalances, FDI cover 1/3 of CAD in Latvia and Estonia and slightly more (58%) in Lithuania with banking sector foreign borrowing remaining the primary source of financing.

In the case of Poland we can see from the chart below that the net balance of FDI flows is virtually equal to the inflows which suggest that this pretty much is a run way street in Poland's case.

At this point it can already be seen that an implicit narrative is emerging which revolves around how it is better to have your CA deficit covered by FDI than external credit extended by foreign banks and other financial intermediaries. In essence there is little practical sense in this claim in the sense that 'hot money' just as well may take the form of FDI and credit inflows and what really matters are factors such as expectations, policy choices, economic fundamentals etc. Yet, there does seem to be some fundamental economic reasoning to the claim in the sense that it would seem far easier for banking credit inflows to retreat in the very short term than for FDI. In this sense alone the positions held by the Baltic economies does seem to be more risky than Poland's. However, we must also consider the fact that FDI in essence is asset and return driven at all time horizons and since an economy's supply of investable assets and ability to create return depends on its capacity we run into the same problems in terms of the underlying economic fundamentals of most of the Eastern European economies. Yet, there may also be another aspect related to the inflow of FDI and thus foreign ownership of domestic assets. Essentially, I am talking about a steady build up of repatriation/collection of earnings and dividends from foreigners with assets in the domestic economy; such flows are measured on the income balance which measures the net gain Polish citizens earn on their investments abroad relative to what foreigners earn on their assets in Poland.

In order to see where this is going we can return to the chart above which plots the evolution of the overall current account balance. By performing a closer inspection there seem to be a breaking point around Q1 2004. Now, before this period the trade balance actually exceeded the current account deficit which means that something else had to be contributing to offset and thus make the CA deficit smaller. At this point we should not get too much into details here but in Poland's case this was offset by the service and current transfer balance. But what about the income balance then? Well, for the entire period in question (Q1,2000-Q2,2007) it was negative but take a look at the chart below and as such when things really began to run negative.

As can readily be seen Q1 2o04 does indeed seem to mark a breaking point and alongside a widening trade deficit it seems clear that the hefty decrease in the income balance has done its part to move the current account deficit into a firm negative territory at this point. Doesn't this leave us with a rather perverse conclusion with respect to the benefits of FDI? Unfortunately and as is often the case the devil is in the detail. In this way you can say that, all things equal, the FDI and income balance are often inter temporally negatively correlated (although of course many strides have been made to prove this claim false in the context of the dark matters of the US current accounts) Ok, let us put some words on this mumbo jumbo shall we. In essence it has already been partly explained above. When the FDI balance is positive and to the almost extreme extent it is in Poland it also means that while foreigners will have a lot of Polish assets on which to earn income Polish citizens have comparatively very few foreign assets on which to earn income. So, we can understand why this leads to a negative income balance, but does it also necessarily lead to an overall negative current account?

This is where my dear reader we get to very heart of the problem in terms of the way the Polish external balance is moving and something which is likely to be the case in many other countries in the region; most emphatically Hungary. As such, the fact that you get a lot of FDI as an emerging market is not bad; in fact this is a good sign and essentially quite as we would expect on the basis of the classical economic growth theory (i.e. where capital enjoys a higher marginal productivity in less developed countries). However, once we relate this to the evolution of the trade balance (in both goods and services) we can see that if the inward flows of FDI does not result in some kind of increasing export performance the deterioration in the income balance becomes just another ball-and-chain around the country's foot in the sense that it takes a comparatively much more vigorous boost in exports of goods and services to swing back into balance or just to keep the edifice from crumbling. This then also relates to the nature of FDI investments themselves which I won't go into here. But given the obvious underlying capacity problems which face Poland and many other countries the current trajectory needs to be watched.

Ok, I am sorry that all this got a bit technical with respect to the formal functionings of the current account of an economy but I do hope that you have been able to take some important points away. Before I sign off, I have a couple of remarks.

- First off and for all intent and purposes the analysis above is a hypothesis on the potential evolution of the external balance in the light of interconnected issues discussed. What we need to do now is to watch!

- Secondly, FDI is not bad! In fact, inflows of FDI generally is a pretty good indicator for the relative attractiveness of the country's domestic assets and thus economy. Yet, when take into account the rather unique economic situation in Poland and the rest of Eastern Europe the factors above need to be watched.

That was all.