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UNCLAS  WARSAW 000058 
 
SIPDIS 
 
 
Sensitive 
 
STATE FOR EUR/NCE TARA ERATH AND MICHAEL SESSUMS 
USDOC FOR 4232/ITA/MAC/EUR/JBURGESS AND MWILSON 
TREASURY FOR OASIA MATTHEW GAERTNER AND ERIC MEYER 
FRANKFURT FOR TREASURY JIM WALLAR 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PREL PL
SUBJECT:  Markets Show Increasing Appreciation for the 
Polish Zloty's Strength 
 
Ref: 2004 Warsaw 386 
 
(U) This cable is sensitive, but unclassified, and NOT for 
Internet distribution. 
 
¶1. (SBU) Summary: The Zloty appreciated the most of any 
convertible currency against the Dollar, growing 20% in 
¶2004.  Most observers attribute this rise to a mix of 
factors, including greater political stability under the 
current technocratic government, Poland's entry into the EU 
in May, and the relatively high interest rate offered on 
Polish government bonds.  The Polish Government and 
financial markets are still trying to assess whether the 
Zloty's rise reflects a long-term shift in fundamental 
economic conditions, or whether it is a short-term 
phenomenon related to Poland's EU accession.  Most analysts 
believe it is the former, and expect the Zloty will 
appreciate further in 2005.  Although the Government would 
prefer to continue to let markets set the exchange rate, it 
will be forced to begin taking a stand on what the Zloty's 
`real' value is as part of its preparations to enter the ERM 
II in 2007 on the way to adopting the Euro by 2009. 
Pressure for the Government to intervene to lower the 
Zloty's value to help exporters has been muted until now, as 
exports have continued to grow.  Additional appreciation may 
increase calls from exporters for some relief, particularly 
given that 2005 is an election year.  End Summary 
 
The Zloty a Highly Appreciated Currency 
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¶2. (U) Despite a rough start, 2004 proved to be a banner 
year for the Polish Zloty (which means golden in Polish). 
The Zloty appreciated more than any other convertible 
currency against the dollar, gaining 20.14%, outpacing other 
Central European currencies by a comfortable margin 
(including the Hungarian Forint at 13.9%, the Slovak Koruna 
at 13% and the Czech Koruna at 12.4%).  By the end of the 
year, the dollar had fallen below three Zloty per dollar, 
the lowest level it has been in seven years.  The Zloty 
appreciated more than 14% against the Euro.  Private sector 
economists attributed the Zloty's rise to: the stabilization 
of the political scene after the appointment of Belka's 
technocratic government in July; improving economic 
fundamentals; Poland's entry into the EU on May 1; and the 
attractive carried interest rate on Polish Government bonds. 
 
2004: A Very Good Year: 
- - - - - - - - - - - - - - - - - - 
 
¶3. (U) In terms of fundamentals, for the fourth year in a 
row, exports were up significantly, growing approximately 
20% for the full year in 2004.  This strong growth helped 
push the current account down to 1.8%.  Exports helped push 
economic growth to an estimated 5.6% for the entire year. 
For the first time in three years, investment grew, by 4.1% 
through the first ten months (preliminary estimates suggest 
the full year's total could be up to 8%).  Foreign Direct 
Investment remained relatively constant, at an estimated $6 
billion, due in part to the revival of the government's 
privatization program. 
 
¶4. (U) Poland's entry into the EU opened Polish investments 
to many foreign investors (e.g., pension funds) who would 
not have previously bought government bonds or shares. 
Coupled with the stabilization of the political scene since 
the installation of a technocratic government, many 
investors perceived an "established" country's level of 
political risk with an emerging market's level of return 
(one-year Polish Government bonds averaged close to 6.35% 
for the year, reflecting lower ratings by investment 
agencies compared to other Central European counterparts). 
As a result, Poland attracted $12.2 billion of portfolio 
investment, the highest level since 2000.  This total 
includes $8.7 billion in foreign purchases of government 
bonds, more than three times the average level of 2001-3. 
This, combined with $680 million invested in Poland's stock 
markets, helped strengthen the Zloty.  The National Bank of 
Poland (Poland's Central Bank, NBP) does not believe that 
most of the portfolio investment increase is hot money, but 
is comprised primarily of more stable investors such as EU 
pension funds. 
 
How Golden is the Zloty? 
 
 
- - - - - - - - - - - - - - - - - - 
 
¶5. (U) The question is whether the Zloty will remain as 
attractive in 2005.  Government and private sector 
economists expect that investments will be the main driver 
for the 2005 economy.  Capacity utilization rates are at 
historic highs, and more than eight quarters of strong 
export growth have delivered good profits to Polish 
companies, which are now sitting on very large corporate 
bank accounts.  The one great unknown has been the 
composition of the new government that will take office 
after general elections later this year.  As this situation 
becomes clearer, Polish companies are expected to begin 
investing, which in turn should sustain economic growth, 
forecast at 5.0%. 
 
¶6. (U) The Polish Government anticipates completing several 
large privatizations in 2005.   The GOP conservatively 
forecasts that it will earn 5.7 billion Zloty ($1.84 
billion) from these sales, several of which are expected to 
attract foreign investors (including the state insurance 
company PZU, chemical and energy plants and industrial 
concerns).  The Polish Government will also embark on a 
number of EU funded projects, particularly in the 
infrastructure sector, taking advantage of its first full 
year of EU membership.  There should be significant inflows 
of EU money by the end of the year (up to 3 billion Euro). 
 
Pressure on Exporters: 
- - - - - - - - - - - - - - 
 
¶7. (U) Polish exporters have begun to complain that the 
relentless appreciation is making their exports less 
competitive.  Their complaints have been muted in part 
because a number of their inputs, including gasoline and, in 
some cases, bank loans, have been priced in dollars, meaning 
that their relative input costs were stable or declining 
while their revenues - measured either in Euro or Zloty - 
were appreciating.  Polish exporters have also compensated 
by increasing productivity throughout 2004, which has 
enabled them to continue making good profits even at the 
cost of having to trim prices to compensate for the stronger 
Zloty.  Productivity increases in 2004 outpaced appreciation 
against the Euro, although not against the dollar.  Market 
economists have estimated publicly that exporters would 
begin to feel the pinch at around 4.25 Zloty per Euro (it 
was trading just over 4.10 during the last week of 
December).  Bankers and companies tell us they remain 
confident about their ability to continue export growth, 
although further appreciation will pressure them to cut 
costs, including by freezing or cutting employment to lower 
labor costs.  Polish importers report they have been hit 
harder by the dollar's fall, as some industries compete with 
Asian suppliers who price their goods in dollars. 
 
Fundamental Shift or Short-Term Blip? 
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¶8. (SBU) An NBP exchange rate expert recently explained the 
Bank's dilemma in determining whether the Zloty's 
appreciation represents a fundamental change in the real 
economy, or whether it represents a temporary shifting of 
prices following Poland's accession to the EU.  NBP's 
inclination is that most of the Zloty's appreciation can be 
explained by a fundamental shift in the real economy rather 
than a short-term market, or speculative spike.  NBP expects 
that the real effects of joining the EU will continue to 
build, potentially even doubling total trade with the EU as 
smaller companies develop the ability to participate in the 
broader EU market.  This greater economic participation 
would justify a higher exchange rate. 
 
¶9. (SBU) The expert noted that the sharp fall of the dollar 
(35% against the Euro in three years) has exaggerated some 
of the Zloty's movement.  The Zloty has been more stable 
against the Euro in 2004, increasing 14%, versus 20% against 
the dollar.  He explained that the dollar's sharp fall has 
accelerated a shift in the Zloty's foreign exchange 
"basket," (a rough benchmark used by the market to gauge 
whether the Zloty is under- or over-valued) away from the 
traditional 55% Euro pricing/45% dollar pricing to something 
closer to 70/30.  The slower rise against the Euro has 
tended to shift greater volatility towards the dollar, 
compounded by currency arbitrage, typically betting against 
 
 
the dollar. 
 
¶10. (SBU) There is a real possibility, however, that the 
Zloty overshot in 2004, and that there could be some 
retreat, particularly if markets become more nervous about 
the effect of a new government after general elections later 
this year.  A new government will have an important effect 
in determining tax rates, the pace of inflation through its 
control of fiscal policy, and indirectly, on the exchange 
rate.  Many Polish companies will wait to invest until they 
have a better sense of which parties will form a new 
government, and what policies they will implement.  As a 
result, 2005 is likely to see more volatility than 2004. 
Most analysts, however, expect fundamentals to take over 
again by the end of the third quarter, and the Zloty to 
appreciate by year end. 
 
Interventions? 
- - - - - - - - 
 
¶11. (U) The question of whether and how the GOP should 
respond to the Zloty's appreciation has become a central 
question for policy makers.  The Central Bank and Ministry 
of Finance have welcomed the effect appreciation has had in 
damping down inflation after accession to the EU in May. 
However, they are also getting more nervous that the Zloty 
is appreciating too rapidly.  On November 30, a deputy NBP 
governor sparked a flurry of media attention by suggesting 
that Central Bank intervention in the exchange rate was 
technically possible under certain conditions.  The next 
day, NBP Governor Balcerowicz said publicly that NBP's 
strategy of "not intervening" was working well, and 
suggested the Zloty had further room for appreciation. 
Markets did not react to the specific event, but have begun 
a broader discussion about the possibility of interventions. 
 
¶12. (SBU) Market analysts tend to doubt that the Central 
Bank would intervene, noting that Poland has been steadfast 
in its adherence to free floating exchange rates.  There 
have been no interventions since 1998.  Central Bank 
officials also point out that it would be very hard to get 
the amount of intervention right, particularly in the 
current situation when the government statistical office is 
undergoing significant revamping of the way it collects 
basic data, including trade and investment.  Without a 
better sense of events in the real economy, the Central Bank 
is unlikely to intervene on currency markets, which could 
risk setting off market reactions which would take much 
longer to stabilize than adjusting to the current 
appreciation. 
 
¶13. (U) The Monetary Policy Council could respond by cutting 
its monetary policy bias, as an indication of the future 
direction of interest rates.  Currently, it remains 
negative, signaling its determination to fight inflation. 
The MPC could decide, however, that it needs to cut interest 
rates to ease pressure on the Zloty.  The MPC would prefer 
to have more data indicating that inflation really is on the 
way back down after the sharp spike after EU accession 
(prices increased from just under 2% inflation to 4.5%). 
Most analysts have interpreted public NBP and MPC comments 
as an attempt to signal a desire to ease monetary policy 
without cutting rates, sending a signal to potential 
speculators that they do not want to Zloty bid up 
artificially at the expense of exporters. 
 
ERM-II 
- - - - - - 
 
¶14. (SBU) The question of getting the exchange rate right is 
a crucial question for the GOP to resolve as part of its 
obligation to adopt the Euro.  Ministry of Finance and 
Central Bank officials will meet at the end of January to 
begin discussing policy towards entering the Exchange Rate 
Mechanism (ERM-II) required by the EU on the road to 
adopting the Euro.  Once countries meet the Maastricht 
criteria, they can apply for ERM II membership, during which 
they must remain in compliance with these criteria to 
demonstrate stability before entering the Euro zone.  NBP 
and Finance must jointly agree on a central exchange rate 
target to join ERM II, which in turn requires broad 
agreement on monetary and fiscal policy to keep inflation in 
check.  The GOP would then negotiate with the EU to fix a 
central exchange rate for the ERM II.  The GOP has already 
 
 
set out its policy targets in the Convergence Strategy it 
submitted last fall to the European Central Bank.  The 
challenge is for the current government to set Poland on a 
path to meet its Convergence targets and be ready to enter 
the ERM II in 2007 at an exchange rate which will sustain 
long-term growth.  From comments made by EU counterparts, 
GOP officials have the impression that some of Poland's EU 
trading partners may try to pressure Poland to adopt a less 
competitive exchange rate to reduce competition from Polish 
companies. 
 
¶15. (SBU) In informal talks with the ECB, GOP officials 
understand that it is virtually certain that Poland will be 
able to operate within the wide band of a central parity 
exchange rate while in the ERM II.  Poland had been 
concerned in 2004 by EU member state comments implying that 
Poland could be required to maintain a narrow band (of 2.5%) 
around the parity, and that the EU would pay particular 
attention to any sharp depreciations.  The dollar's 
continued sharp fall in 2004, particularly against the 
Zloty, would have made it exceedingly difficult to remain 
within that band, as three month volatility averages by the 
end of the year were still over 11%, compared to a more 
stable Euro range of 7.3%.  NBP notes that Poland expects to 
meet the Maastricht criteria on budget deficit/GDP by a 
relatively narrow margin (2.7% compared to the limit of 3%), 
suggesting that adopting a narrow band would have little 
credibility. 
 
Comment: 
- - - - - - 
 
¶16. (SBU) Perversely, the Zloty's appreciation is a 
byproduct in part of the political stability in 2004 which 
companies have long sought.  The silver lining for exporters 
is that the elections this year may stem the Zloty's rise 
for a while, although most observers expect the Zloty will 
appreciate further based on solid economic fundamentals. 
So far, most of the discussion about the exchange rate has 
been held within technical or financial market circles. 
Continued appreciation of the Zloty will increase calls from 
exporters, however, for politicians to "do something," 
particularly given that 2005 is an election year.  While the 
GOP would clearly prefer to let markets set the Zloty's 
exchange rate, it will have to take a policy stand on what 
the central parity exchange rate should be in order to meet 
its goal of entering the ERM II in 2007. 
 
Munter