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Fitch warns Poland it could get burned if it keeps playing with fire

A deteriorating relationship with the European Union could negatively affect Poland’s growth and government finances in the medium term, but any short-term fallout appears limited, Fitch Ratings has warned on Tuesday. reports.

Tensions mounted last week when the European Commission escalated the “rule of law” procedure against Poland, started in January 2016, to its third and last stage. The Commission said recently announced bills would “structurally undermine the independence of the judiciary” and asked the Polish authorities to address its concerns within a month.

It added that if Poland takes measures to dismiss or force the retirement of Supreme Court judges, the Commission could trigger an “Article VII” procedure. This is a formal warning that can be issued by four-fifths of the Member States if “there is a clear risk of a serious breach by a member state of the common EU values”. Article VII has never been used before.

“In the short term, the potential direct impact of the Commission’s move on Poland’s economy and government finances is limited. Even if Poland were to remain non-compliant and the Commission launched an Article VII procedure, it would lack the ability to implement sanctions, as this would require a unanimous vote and Hungary has already announced it would stand behind Poland,” Fitch Ratings said.

The main risk for Poland posed by the rising tensions is that EU funds are cut in the next budget cycle (2021-2027) or that additional conditionaly is placed on their disbursement.

“This would aggravate the funding impact of the departure of the UK, one of the biggest net contributors to the EU budget,” the rating agency warned.

It reminded that Poland is the largest recipient of EU funds in nominal terms and will receive EUR 86 billion over the 2014-2020 cycle (20% of its 2015 GDP). A meaningful reduction in EU funds would:

  • lower economic growth and,
  • if the government compensated for some lost funds from its own resources, weaken public finances.

The deterioration in the relationship with the EU, alongside increased political polarisation since the 2015 political transition, could damage Poland’s attractiveness for investment. But it has remained resilient so far: a sharp decline in 2016 was common to all central and eastern European countries and was due to the EU fund cycle. Investment started to recover on a quarterly basis in 1Q17 (up 0.3% qoq), and Fitch expects this trend to continue in 2017 as EU fund disbursements ramp up.

More broadly, growth was strong at 4% y2y in 1Q17, and we expect it to be 3.3% in 2017, up from 2.7% in 2016.

Fitch noted that the Polish government has remained compliant with the EU’s 3% of GDP deficit criterion despite its Eurosceptic rhetoric and a marked increase in social transfers. The budget deficit target for 2017 is 2.9% of GDP.

“But the first six months of the year show a cash surplus thanks to a strong increase in tax revenue, suggesting the government’s strategy to tackle the high VAT collection gap has yielded some results.” Fitch therefore expects the deficit to be 2.6% of GDP in 2017.

Whereas Fitch expects fiscal policy to remain compliant with the 3% of GDP deficit criterion and fiscal policy to tighten after 2018 to ensure government debt reduction, it also warned Poland.

“But any sign that the relevance of the deficit criterion has weakened as a fiscal anchor, or failure to tighten fiscal policy to stabilise the debt-GDP ratio in the medium term, would be negative for the ratings,” Fitch concluded.

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