Interest rate convergence between Poland, Hungary and the EU has reversed, according to a California-based independent investment research firm. Investors are generally unaware of the negative impact such a reversal will have on assets in Poland and Hungary, says Jeph Gundzik, president of Condor Advisers, an eight-year-old investment consulting company based in Mammoth Lakes, California.
“Convergence trades, driven by the May 1 E.U. accession of several former Soviet-bloc countries, has made international and domestic bonds in Poland and Hungary extremely expensive,” Gundzik says. Gundzik, publisher of a monthly newsletter analyzing investment risk in emerging markets, says the very high prices of Polish and Hungarian international and domestic bonds don’t reflect high investment risk, particularly in Poland.
According to Gundzik, among the countries that will join the E.U. on May 1, Poland’s political and social risks are the highest. Underlying these risks are political instability, recently demonstrated by Prime Minister Leszek Miller’s decision to resign, and failing popular support for his center-right coalition government. Rapidly rising popular support for leftist political parties, and the growing probability of the coalition’s collapse, suggests that a radical change in government policy is imminent in Poland. This will lead to larger fiscal deficits and rapid growth of the public sector debt stock over the next two years.
Poland’s general government deficit, which was equivalent to 4.4 percent of GDP in 2003, is expected to increase to 5.7 percent of GDP this year and 6.5 percent of GDP in 2005. As a result, Poland’s public sector debt stock is expected to exceed 65 percent of GDP in 2005. In addition to the growing fiscal deficit, slowing domestic demand growth and budding deflation are pushing the public sector debt stock higher. “It will be almost impossible for Poland to avoid breeching its constitutionally mandated debt ceiling in 2005,” says Gundzik. If the public sector debt stock exceeds 60 percent of GDP, Poland’s constitution requires that the country’s budget generate a surplus the following year.
According to Gundzik, once Poland’s dire fiscal situation becomes apparent a confidence crisis is likely to develop leading to rapid capital flight. “The ratio of foreign portfolio investment to foreign exchange reserves is almost 70 percent in Poland,” he says. Capital flight from Poland could easily trigger capital flight from Hungary, which has a similarly weak fiscal position. “The ratio of foreign portfolio investment to foreign exchange reserves in Hungary is about 170 percent. A confidence crisis in Poland could easily trigger a confidence crisis in Hungary, leading prices to collapse for both countries’ bonds as well as sharp currency depreciation.”