Divergence spells capital flight from Poland and Hungary

On May 1, eight Central and East European countries, as well as Malta and part of Cyprus will join the E.U.

In most of these countries, the process of economic convergence with the richer countries of the E.U., or the equalization of GDP per capita, is well under way. In addition to economic convergence, interest rate convergence, or the equalization of long-term interest rates, is also well entrenched in most of the acceding countries.

Economic and interest rate convergence between Poland and the E.U., however, is diverging. In the past, interest rate convergence between Spain, Portugal and Greece and the E.U. provided a windfall for bond investors.

Using history as a guide, investors have piled money into Poland and Hungary, home to the most liquid domestic bond markets among the acceding countries.

As investors come to realize that divergence has overtaken convergence in Poland, capital flight could rapidly develop, spreading from Poland to Hungary, leaving domestic and international bond prices much lower and exchange rates sharply depreciated in both countries.

Economic fundamentals in Poland have deteriorated sharply in the last two years. Though economic growth recovered last year, domestic demand has remained weak. This has encouraged rapid disinflation bordering on deflation.

Restraining domestic demand growth has been political and social instability associated with efforts to implement austere fiscal policies - a strong prerequisite for Poland's highly anticipated entry into the ERM. Poland's electorate has become increasingly averse to fiscal austerity, causing support for the center-right government to plummet.

Prime Minister Leszek Miller's planned resignation is a direct result of this aversion. Meanwhile, popular support for Poland's leftist political parties has increased. In the event Poland's government collapses this year (a high probability), a coalition of leftist political parties is very likely to gain control of the government.

The erosion of popular support for the government has come more from word than deed in tightening fiscal policy. This suggests that implementating fiscal policies that actually reduce the general government deficit and public sector debt burden could trigger social revolt.

Between 2000 and 2002, Poland's general government deficit nearly doubled from 2.2 percent of GDP to 4.2 percent of GDP. At the same time, public sector debt increased from 40 percent of GDP to 48 percent of GDP.

Last year, the general government deficit increased further to 4.4 percent of GDP while the debt stock continued to grow. This year the deficit and the debt stock to are likely to reach 5.7 percent of GDP and 58 percent of GDP, respectively.

By next year the debt stock will exceed the constitutional limit of 60 percent of GDP. Poland is at a crossroads - it must either implement draconian fiscal policies to stabilize the debt stock or admit that such policies would push the economy into recession, igniting significant social instability. In either event, the outcome for asset prices will probably be similar.

The interest rate convergence trade has attracted substantial foreign portfolio investment to Poland and Hungary. At the end of last year, the stock of foreign portfolio investment in each country was about €16 billion. This was equivalent to 64 percent of Poland's foreign exchange reserves and an astonishing 168 percent of Hungary's foreign exchange reserves.

Clearly the scope for capital flight in both Poland and Hungary is significant. However, capital flight must have a trigger. In the past 10 years, episodes of large-scale capital flight in Mexico, Turkey, Russia and Brazil have been triggered by confidence crises. Just such a confidence crisis, emanating from growing political, social, fiscal and economic uncertainty, could be brewing in Poland.

A confidence crisis in Poland could easily spread to Hungary. Though Hungary does not share Poland's political and social instability or structural economic weaknesses, it does suffer from similar fiscal lassitude.

Guilt by association, or more popularly contagion, could encourage capital flight from Hungary. The increasing risk of capital flight and sharp sell-off of investment assets and currencies in Poland and Hungary is not reflected in asset values, especially the international bonds of both countries.

Investors should strongly consider reducing exposure in Poland and Hungary. Where this is impractical, zloty forward sales or put options offer relatively cheap disaster insurance. The price of this insurance will rise over the next few months.