Growth accelerated in 2004, buoyed by domestic demand and exports amid an improved company financial situation. That trend prompted Coface to upgrade the average Polish-company rating to A3 last September. The pace of economic activity should sag this year, however, due notably to the exchange rate appreciation and European demand slowdown.

Improving public finances and limiting the growth of public sector debt still constitute major challenges in integrating Poland into the euro zone. However, buoyant foreign trade has made it possible to contain the current account deficit. Debt servicing has nonetheless been inflating financing needs with at best one-third covered by foreign direct investment. The country has thus remained dependent on financial markets.

Politically, with a social democratic government weakened by scandal and a deteriorated social situation, protest and anti-European opinion has been gaining ground.

Company payment behaviour improved sharply reflecting the robust economic activity.

In a buoyant economic context, the Coface company payment-incident index declined substantially. That improvement has come after many years with late-payment frequency remaining high and very sensitive to economic trends. Company solvency improved in sectors like steel and pharmaceuticals. Telecommunications have continued to post very dynamic performance whereas the situation is still shaky in several sectors including shipyards, mass distribution, and textiles.

After two years of virtual stagnation, growth resumed in 2003 (up 3.8%) fuelled mainly by surging exports (up 13%) linked to the zloty depreciation against the euro. With domestic demand increasing only moderately (up 2.7%), inflationary pressures remained weak.

In 2004, economic conditions were particularly favourable as growth reached 5.4%. Private consumption (still the main growth driver) rose at the same rate as the previous year (3.2%). Meanwhile, fixed investment, which had suffered from the monetary tightening of 2000/2001 began to grow again, gaining 5.1%. Exports, moreover, have continued to grow at a relatively high rate (up 11.6%) benefiting from the zloty's past depreciation and notable productivity gains. However, the economic growth has not spurred much job creation with Poland registering the highest unemployment rate — about 20% —among the European Union's new country members. Price pressure, linked not only to the economic upturn but also to rising oil costs and the effects of EU accession (higher food prices and indirect taxes) largely eased in the 2004 second half.

Growth began to slow in the second half last year and that trend should persist in 2005. GDP growth should drop to about 4.3% due mainly to the negative effects on exports of the exchange rate appreciation and the slowdown of demand from the Europe of Fifteen, which absorbs 69% of Polish exports. Investment should remain robust, however, with companies having limited their indebtedness in 2004, household demand remaining relatively buoyant, and production capacity utilisation rates at high levels. Furthermore, the Central Bank could reduce its key interest rates (currently 6.5%) this year, after having raised them three times in 2004. Several factors should facilitate the loosening process including the weakness of inflationary pressures (the increase in consumer prices dropped to 4% year on year in January 2005 and should approach the government's 2.5% objective by year end), the growth slowdown, and the zloty's strength.

Public sector finances deteriorated sharply in recent years due notably to the lagging pace of fiscal reforms. However, the costs of structural reforms and EU accession have contributed to the imbalance. Moreover, sovereign default risk has remained limited considering the relatively high credit the country enjoys in financial markets.

The public sector deficit public remained high in 2003, stabilising at around 6% of GDP (central and local government + extra-budgetary funds). Spending, particularly for social purposes (pensions, unemployment benefits, and other entitlements), has continued to grow rapidly. The imbalance widened in 2004, reaching about 7% of GDP, due to reduction of the corporate income tax rate and to the costs of European Union accession whose fiscal impact is about one point of GDP. That deficit estimate integrates the amount of government subsidies for the pay-as-you-go pension system, intended to compensate for the contributions paid to the private second pillar pension funds.

The 2005 budget is intended to reduce the deficit to about 6% of GDP via higher fuel taxes and limited increases in social spending reflecting implementation of a modest set of reforms intended to reduce indexation and eligibility conditions. The medium-term fiscal consolidation plan envisions bringing the imbalance to 3% of GDP by 2007. That objective seems nonetheless very ambitious considering the expected growth slowdown and weak political support for new spending cuts.

Sovereign default risk has remained limited, however, with the government's ongoing capacity to borrow on favourable terms in domestic and international capital markets. The size of the deficit has nonetheless been delaying the country's integration into the euro zone while public sector debt has increased sharply and now represents about 50% of GDP.

Although foreign debt, notably its private component, has increased sharply, debt ratios have remained at sustainable levels.

Foreign debt ($116 billion) and the debt service ($12 billion) have increased markedly. Indeed, although trending down, current account deficits have been recurrent and, since 2001, debt amortisation has increased substantially.

Debt ratios, however, have not been a major source of concern. Although the debt does represent nearly 50% of GDP, it only represents 120% of export earnings and debt servicing, moreover, only absorbs 12% of those earnings. Furthermore, Poland plans to make early repayment of its Paris Club debt (public creditors) this year. Meanwhile, short-term commitments have remained limited, representing only 19% of total debt. Conversely, the Polish private sector's foreign currency debt rose markedly these past years increasing almost fivefold between 1997 and 2003, growing from $10.8 billion to $50.4 billion before nonetheless stabilising in 2004 ($51.8bn).

Exchange rate crisis risk has nonetheless remained significant due to the relatively low level of foreign direct investment with external financing needs tending to increase again. Moderate short-term debt and comfortable foreign currency reserve levels have nonetheless tended to reduce the country's vulnerability to a possible crisis of confidence.

Poland's external financing needs came to about $12.5 billion in 2004 and should increase slightly this year to around $14.8 billion, fuelled by increases in the current account deficit ($5.8bn) and debt amortisation ($9bn). After declining in 2002, the country's dependence on foreign capital should thus continue to grow.

Coverage of Poland's financing needs by foreign direct investment has been falling since 2001. After dropping from nearly 70% in 2000 to 39% in 2003, the coverage rate should decline to about 30% this year and thus necessitate even greater reliance on foreign borrowing. Currently, however, the country has been experiencing no particular difficulty in obtaining needed financing in the international market. For example, risk premiums (JP Morgan's EMBI+ index) have been hovering at about 40 basis points. However, the rise of American interest rates, expected increase in bond issues by the Polish government, and heightened concerns about the management of public sector deficits - if those deficits fail to come down as expected - could lead to higher financing costs. Meanwhile, a sudden exchange rate correction (the rate appreciated sharply since end-February 2004) resulting from disappointment over the government's capacity to pursue reforms, notably on fiscal matters, could cause payment difficulties for companies carrying foreign currency debt. Nonetheless, the flexibility of the free-floating exchange rate regime, the moderate short-term debt level (19% of total liabilities and 22% of export earnings) and ample foreign exchange reserves (four months of goods and services imports) will mitigate the risk.

The banking sector's main weakness stems from the poor quality of its portfolio. Well capitalised and dominated by foreign capital, however, it has remained generally sound. Moreover, its profitability has begun to improve again spurred by the growth recovery.

Although healthy overall, the Polish banking sector has remained relatively underdeveloped compared to other regional countries (with loans to the economy representing only 30% of GDP).

The reforms of the early 1990s, improved Central Bank supervision, the sector's relatively slow but effective privatisation, and creation of a well-regulated stock market have allowed creation of a financial sector that has thus far escaped the crises that have affected certain neighbouring countries. The privatisations, followed by numerous mergers, have produced a sector dominated by foreign investors (representing nearly 3/4 of capital and over 2/3 of the sector's assets). However, considering the government's known preferences, the capital of the giant PKO BP (one-sixth of the sector's assets) should remain in Polish hands after privatisation.

The 2001/2002 economic slowdown and the zloty depreciation nonetheless led to an increase in non-performing loans (which represented about 22% of bank portfolios in 2002 and 2003, against 15.5% end 2000 and 10.5% end 1997) and a drop in bank profitability. The low-point was reached in 2002 and 2003 with net return on assets (ROA) sinking to 0.5% from 1% in 2000 and 2001.

The sector has nonetheless remained well capitalised with a 13.8% Cooke ratio end 2003. Furthermore, the growth recovery and, to a lesser extent, the late-2003 loosening of Poland's particularly strict bank regulations on loan classification and provisioning have allowed bank profitability to begin improving again (with net return on assets rising to 1.5% for the first half last year). Moreover, the proportion of non-performing loans in bank portfolios has begun to decline, down to 18.1% end June 2004.

The political risk presented by Poland has remained manageable. The political landscape has nonetheless remained shaky and subject to constant reshuffling. The situation deteriorated with the coalition's breakdown, the scandals, and then the scission of the Social Democratic Alliance. Although the interim government headed by Marek Belka has avoided instability thus far, in a difficult social context, protest and anti-European opinion has been gaining ground.

The coalition, formed in October 2001 between the Social Democratic Alliance (SLD) and the PSL ex-communist agrarians, broke down in March 2003 (with the PSL refusing to back a government fiscal proposal). As a result, the government lost the majority in the Diet (the lower house of parliament) despite formation of a new parliamentary coalition with the Social Democratic Party UP. Dissension within the SLD, followed by its scission in March 2004, prompted Prime Minister Leszek Miller's resignation on 2 May 2004. After a period of uncertainty, Marek Belka, the candidate designated by President Kwasniewski to succeed Miller, won Parliament's confidence in June 2004 (renewed in October 2004). This interim government should remain in office until the legislative (and presidential) elections that should theoretically take place in Autumn 2005 (Parliament may nonetheless decide to move the elections to an earlier date in June 2005). Although the nationalist and populist formations (the Self-defence Party and League of Polish Families) should score well in the voting, the return to power of the centre right (PO, Civic Platform) remains the most likely outcome. However, that formation will probably have to seek alliances with other parties to obtain a majority in Parliament, which will limit the new government's effectiveness. European issues, notably, could cause divisions within the governing coalition.

Socially, although demonstrations and strikes have been reflecting popular discontent due mainly to rising unemployment, rural unrest should wane after the sharp increase in farm incomes in 2004 attributable to European subsidies. Various scandals and allegations of corruption, including the "Rywingate" affair where a figure close to the government attempted to obtain a bribe in exchange for amendment of a law affecting the media, have only served to exacerbate popular disillusionment. Although those tensions failed to affect the outcome of the June 2003 referendum on Poland's EU accession, they have contributed to delaying implementation of certain structural reforms (social spending cutbacks, shutdown of loss-making companies, speed-up of privatisations, labour market liberalisation).

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