Investing In Poland? Not Now, Thanks

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Includes: EPOL, PLND
by: Simple Digressions

Summary

In October 2015 the Law and Justice Party (PiS) won an election in Poland. As a result, this party holds 51.1% of seats in the Polish parliament.

In my opinion, PiS is a nationalist, left wing party. Its populist program adds a set of risks to the weakening Polish economy.

That is why I think that investors, looking for some exposure to the Polish stock market, should refrain from investing in Poland now.

Despite the fact that since May 2004 Poland has been a member of the European Union, this country is still perceived as an emerging market. I think it is a reasonable thesis because twenty six years after the collapse of communism in Eastern and Central Europe, democracy in Poland is not as stable and well-established as it is in the West. What is more, in October 2015 the Law and Justice Party (PiS) won the national election by a majority of 37.6%. As a result, PiS holds 51.1% of total seats in the Polish parliament, which gives this party the total power to change law and exercise control over governmental institutions. Additionally, the PiS power is strengthened by the fact that Poland's president is a former member of this party. In Poland each parliamentary bill, in order to become binding, has to be approved by the president. Since he is still a strong supporter of PiS, any law accepted by the parliament becomes automatically a legally binding one. PiS is well aware of this fact and exercises its power in a very quick and brutal way. For example, just two months after winning the election this party was able to implement a new law on the Constitutional Tribunal, which practically made this legislative body out of business. In other words, from now on PiS is able to implement any law, even unconstitutional one.

Sorry for that political context. I know that Seeking Alpha is not about politics. However, to understand what may happen to the Polish economy, one has to understand the political context.

Economy

In my opinion, PiS is a nationalist, left-wing party. They won the election by making populist promises as, for example, their flagship promise to implement PLN 500 PLN per child program. Among other promises were such ideas as cutting the retirement age, increasing tax rates on top-earners, donating state-controlled and unprofitable businesses (as, for example, coal mines), halting privatization of state-controlled companies, increasing and tightening tax inspections etc.

To implement these promises (at least part of them) PiS will need quite a lot of money. For example, to fulfill its flagship promise of PLN 500 per child as much as PLN 41.6 billion per year would have been needed (around $10.7 billion). In 2014 Poland's governmental fiscal deficit amounted to PLN 29.0 billion (1.7% of Poland's Gross Domestic Product (NYSEMKT:GDP)) so this additional money outflow would have increased the fiscal deficit to PLN 70.6 billion (4.25% of the 2014 GDP).

Of course, PiS has a plan to increase the State revenue. Apart from increasing the before-mentioned tax rates on top-earners, the party wants to impose special taxes on the banking and retail sectors. Why? Because banks and big retailers are profitable businesses. According to PiS, since banks and big retailers are profitable, it is fair to impose additional taxes on these companies. Let me cite a few figures. At the end of 2014 the Polish financial sector was holding assets of PLN 1,425 billion ($365 billion). Although PiS has not decided yet how this special tax is to be constructed, the party inclines to impose a 0.39% tax on the bank assets. If such is the case, the government should be getting around PLN 5.6 billion a year. Taking into account that in 2014 Polish banks paid PLN 3.7 billion in taxes, implementing a new tax would have increased the value of taxes paid by banks to PLN 9.3 billion (an increase of 251%). To be honest, I do not think that PiS is going to introduce such a tax - it would have meant a very hard burden imposed on the whole financial system in Poland.

Note: At the end of 2014 Polish banks had equity of PLN 155 billion. It means that banks, to conduct their operations at the current levels (equity of PLN 155 billion and the current profitability), would have needed to raise PLN 5.6 billion from its shareholders each year. Having in mind that since the last crisis the European financial sector has been heavily struggling to survive, I am sure that a new tax is not aiming at improving the Polish banking system. Quite contrary.

As I mentioned above, in a search for additional money, PiS wants to tighten tax inspections. However there is a catch. Polish business people have long experience in conducting part of its operations in the grey area of the economy. Simply put, I am sure that Polish business people, when confronted with frequent and tight fiscal inspections, will move their operations out of the official market. If such is the case, the Polish economy is going to shrink, which will have a negative impact on the State revenue, banking system etc.

The above-described issues, if implemented, will have had a negative impact on the Polish economy. What is more, they are going to increase current problems. Although the Polish economy is perceived as one of the strongest in the European Union it has been facing some serious problems for a number of years.

Demography

The first problem is demography. The following chart presents the natural increase in population, starting from 2004 (that year Poland entered the European Union):

source: Central Statistical Office of Poland (GUS)

As the chart shows, since 2012 Poland's population has been shrinking. One of the biggest drivers standing behind this negative phenomenon is emigration. When a few European countries opened their labor markets for Poland, Polish workers, especially the young ones, started to emigrate (mainly to the U.K., Ireland and a few Scandinavian countries). According to the official statistics, between 2004 and 2014 as many as 291 thousand people had emigrated to other countries. As a result, since 2011 the population has shrunk from 38.54 million to 38.48 million people. Well, although the scale of this decrease is not high, the very fact is that if any country's population is shrinking it is not positive for its economy. That is why PiS wants to stimulate the fertility rate through its PLN 500 per child program.

GDP growth

The second problem is the weakening growth of Poland's economy - please, look at the chart below:

source: tradingeconomics.com

The chart shows that since 2007 each peak of economic activity has been printed at lower levels. I think it is no wonder - shrinking population plus no growth in the European Union, which is a primary economic partner to Poland, are standing behind this negative development.

Polish stock market

In 2011 a former Polish government made a fatal decision to partly nationalize the Polish private retirement sector. This decision had a huge negative impact on the Polish stock market. Simply put, Polish retirement funds (called "OFE") used to be the biggest player on the Warsaw Stock Exchange. Each month 7.3% of any Polish worker's salary was flowing into OFE. Then, around 40% of this money was invested in the stock market. In 2011 the Polish government cut the OFE contribution to 2.3% of a salary. As a result, the average turnover at the Warsaw Stock Exchange went down from PLN 998 million in 2011 to PLN 824 million in 2014 (a decrease of 17.4%). Putting it differently, the big, stabilizing impact of OFE on the Polish stock market has decreased significantly since 2011. PiS wants to cancel the remnants of OFE - if such is the case, the Polish stock market will become much more volatile than it is today.

Polish ETFs

Investors, looking for an exposure to the Polish stock market, have two alternatives. They may invest directly, using international brokers. Alternatively, they may also use two Exchange-Traded Funds: iShares MSCI Poland Capped ETF (NYSEARCA:EPOL) or Van Eck Poland ETF (NYSEARCA:PLND). Both funds have high exposure to the financial sector and state-controlled companies. For example, EPOL's exposure to the banking sector stands at 41.57%. However, in my opinion, the biggest negative feature of both funds is the fact that they are highly exposed to the State-controlled companies. For example, these companies account for as much as 52.8% of EPOL's exposure. Why do I regard it to be a negative issue? Well, here in Poland, it is infamous tradition that one of the first things any new government does is to install new management teams in the State-controlled companies. PiS is no exception and so far it has made changes in management boards of PGNiG, PKN Orlen and Enea. The CEO of PZU, the biggest Polish insurance company, resigned from the board a few days ago. All these companies account for 25.2% of EPOL's exposure.

Please, understand - PiS does what each new government in Poland does. The problem is that PiS has declared many times that it stands for more State control over the economy. In its radical form it means even the re-nationalization of some previously privatized companies, particularly banks. Therefore there is a risk that new management teams will become a tool to implement this strategy. In such a case the economic measures used to run the State-controlled companies will no longer be a priority and an ETF having a 52.8% exposure to such companies should be perceived as a risky one.

Summary

Although Poland is still one of the best economies in the European Union, the recent election victory of Law and Justice Party (PiS) adds some relevant risks, which, in my opinion, should be considered by investors looking for exposure to the Polish stock market. These risks have been described in this article. Nevertheless, the following chart summarizes my thesis:

source: Simple Digressions

The chart shows the relative strength of two stock indices. The first one, WIG, is a main index of the Polish Stock Exchange. The second index, DAX, replicates the action of the German stock market. As the chart shows, starting from the end of 2011 WIG was underperforming when matched against DAX. To remind my readers - in the end of 2011 a former ruling party, Civic Platform (PO), returned to power for a second term and it was that term that PO partly nationalized the Polish private retirement sector. Then, since the beginning of 2015 the underperformance of WIG against DAX has deepened. The turn of 2014 and 2015 was the beginning of the election campaign in Poland, featured by increasing popularity of PiS. Since that time the Polish stock market has been discounting the future election victory of this party.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.