Polish zloty fell victim to strained relationship with the EU

The Narodowy Bank Polski (NBP), the Polish central bank, was among the first to have tightened monetary policy after the onset of the Covid pandemic. Rising short-term interest rates have pushed Polish 10-year government bond yields above 4%, a 2.8 percentage points increase from early 2021. The rise in yields was most evident since last summer: at the end of August, the 10-year yield was around 1.6% but then rose quickly after the change of attitude of the NBP. Until August, the central bank had indicated that an interest rate hike was not imminent, only to take a more aggressive approach and raise policy rates on five occasions between October and February by a total of 2.65 percentage points.

Following the monetary tightening, the yield spread between Polish and German government bonds, the benchmark of the eurozone bond market, rose from about 1.8% to around 4%. The increase in the yield differential with respect to the eurozone should have supported the zloty. Surprisingly, the exchange rate of the zloty against the euro, its reference currency, did not react much.¹ The EUR/PLN exchange rate remains around 4.5 (see Chart 1), close to levels seen in early October before monetary policy was tightened.

Chart 1. EMU-Poland 10-year yield spread and EUR/PLN

Source: Refinitiv and EFGAM calculations

From a longer-term perspective, the zloty appears undervalued relative to yield spreads, which have returned to the levels last seen in 2012-13. After a period of relative stability between 2013 and 2020, the zloty has lost about 8% against the euro since the start of the pandemic.

The zloty also appears undervalued based on Purchasing Power Parity (PPP). Using the producer price index (PPI) as a proxy for tradeable goods prices, the equilibrium value of the EUR/PLN exchange rate is estimated at around 3.9, about 13% stronger than current levels (see Chart 2a). This is the highest valuation gap in favour of the zloty in more than fifteen years and reflects the much higher increase in tradeable goods prices in the eurozone than in Poland (see Chart 2b).

Chart 2a. EUR/PLN exchange rate and PPP estimates

Chart 2b. PPI inflation in Poland and in the eurozone

Source: Refinitiv and EFGAM calculations

Interestingly, the EUR/PLN exchange rate was almost perfectly aligned with the PPP-based estimate between 2012 and mid-2020. Since then EUR/PLN and the PPP estimate have diverged and the zloty has weakened despite improving fundamentals. This begs the question: what has driven negative zloty sentiment over the past eighteen months?

One factor that has surely played against the zloty is the escalation of tensions between the Polish government and the EU Commission.² In the summer of 2020, the EU Commission made the disbursement of funding under the Recovery and Resilience Plan and the multiannual EU budget conditional on respect for the rule of law. Furthermore, following the 2017 EU Commission initiative to activate Article 7 of the EU Treaty against Poland, the European Court of Justice (ECJ) ruled that Polish judicial reform of the past few years violates EU principles and ordered its suspension.³

Tensions continued as the Polish government refused to follow the ECJ's decision and in October 2021 the Polish Constitutional Court ruled that some EU laws are incompatible with the Polish constitution. In response, the ECJ imposed a fine of EUR1 million per day for Poland's refusal to enforce its rulings and review the reform of the judiciary system. On 19 January, the EU Commission announced that it will withhold funding for Poland until it pays the fines imposed by the ECJ.

The Commission's decision shows how strained the relationship between Poland and EU institutions has become. It also poses a risk to the Polish economy: according to Moody's estimates, without EU funding, GDP growth could be reduced by up to 0.5 percentage points per year between 2022 and 2025.

Furthermore, the Polish economy and financial assets, including the zloty exchange rate, will be under pressure if foreign capital flows remain weak, as in 2021. According to IMF data, last year foreign direct investment and portfolio inflows towards Poland were less than their historical 20th percentile.

Conclusions

Despite ongoing monetary policy tightening, the Polish zloty appears undervalued. The divergence from equilibrium estimates based on Purchasing Power Parity that emerged from mid-2020 coincided with the escalation of tensions with the EU Commission on the application of the rule of law. The Commission's recent decision to withhold EU funding will hurt the Polish economy and will likely dampen capital inflows, extending the weakness of the zloty despite otherwise sound macro-financial fundamentals. Only an improvement in relations with the EU would create the conditions for a rise in the zloty in line with underlying fundamentals.


¹ Trade between Poland and the eurozone absorbs about 60% of the Poland total trade and in 2021 it was worth more than 65% of Poland GDP.
² Another headwind for the zloty might have been the tensions related to Russia and Ukraine.
³ Article 7 is the toughest punishment procedure provided for in the EU treaty to hold accountable governments whose actions threaten the bloc’s rule of law, human rights, and democratic principles. It can lead to sanctions and the suspension of the voting rights of member states that do not comply with it.