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Upcoming crash in E Europe?

From the latest Economist:

IMAGINE some souped-up old bangers driven confidently but not expertly on a smooth road in fine weather. That is the economic picture of the ten east European countries that are now in the European Union. If the road gets wet or slippery, bad brakes and bald tyres make a crash, even a pile-up, horribly likely.

The country that most troubles outsiders is Latvia. It has a whopping current-account deficit: some 21% of GDP in 2006, and bigger still so far this year. That reflects soaring consumption and household debt, financed mainly by foreign-owned banks. Wages are rocketing—up by a third year-on-year. Inflation is over 8%.

This points to a need for tough restraining measures. But the currency, the lats, is pegged to the euro, so the central bank's ability to raise interest rates is constrained. Although the IMF issued a sharp warning in May about the need for a fiscal squeeze, the government is keener on harvesting the dividends of double-digit GDP growth than on acting to avert the risk of a crash.

Aware of the dangers, the banks, mainly Swedish-owned, are reining in lending. Their share prices wobbled during a brief financial crisis in February. Prudent behaviour by the banks may amount to a monetary tightening on its own. Other modest measures include making tax declarations a mandatory part of loan applications, deterring those with undeclared wealth. A speculative attack on the lats may tempt some, but it is tricky to organise in Latvia's puny financial markets.

Latvia is a financial pipsqueak, with only 0.2% of the euro area's GDP. If it does run off the road—for example, if it is forced to unpeg its currency—the main victims will be local borrowers and foreigners who have lent to them (in theory, but probably not in practice, Western banks could refuse to bail out local subsidiaries, even if their loan books shrivelled). Any crash in the Baltics is unlikely to affect outsiders' views of other regional economies. The likeliest route for contagion would be to next-door Estonia. It is also overheating, but its somewhat more responsible government has a modest budget surplus.

The other early candidate for a crash has long been Hungary, which admitted last year that it had been running a budget deficit of 10% of GDP. But a combination of tax rises and modest spending cuts has trimmed the deficit. Exports and industrial production have risen. The central bank has begun to cut interest rates. Hungary has been “disgustingly lucky”, says Juliet Sampson of HSBC, a bank.

Even if a pile-up is avoided, overheating is still undesirable. As euro members like Portugal have found, a boom stoked by low interest rates and a fixed exchange rate can lead to a long period of uncompetitiveness and slow growth. Except for Slovenia, which is now in, none of the east European countries is likely to join the euro for some time—but they have mostly been able to borrow as cheaply as if they were already members.

So how to cool things down? For countries that can do it, keeping their interest rates above the euro's and letting their currencies appreciate helps. So does bringing in foreign workers from places such as Ukraine in order to reduce upward wage pressures. Slovakia is a prime example of how to pull off both tricks.

The only long-term answer is not to add coolant or to drive more slowly, but to fix up the car. Unfortunately the process of structural reform in the region has largely stopped. Fast growth in tax revenues plus weak political leadership makes for less pressure to get a grip on public finances. Poland and Romania, in particular, have proved alarmingly ready to make expensive spending pledges for political reasons.

A new World Bank study of public spending (see chart below) highlights the bad bargain that the region's taxpayers are getting. Almost everywhere, public spending is higher than it should be for middle-income developing economies. In Albania, the study finds that overstaffing, poor debt collection and wasteful management at the state-run water industry alone costs 1% of GDP. Despite the spread of flat taxes, the “tax wedge”, which includes social-security and other charges, can be as much as 40% of wages.

Changing this is a political matter, not an economic one. But the evidence is that voters do not much like reform. Reforming governments have usually lost the next elections. A report from the European Bank for Reconstruction and Development shows that, in most of the region, only minorities of voters, and sometimes not even a plurality, support both a democracy and a market economy (many choose the “don't care” option instead).

Nor is there any obvious punishment for a failure to reform. Romania and Bulgaria have been backsliding ever since they joined the EU in January, and yet there have been only mild complaints from Brussels, which has lost the leverage that it had before the two countries' entry. Capital markets are accommodating too. The lesson that other countries take from Hungary's financial shenanigans is that it is possible to spend like crazy to win an election and then sober up afterwards.

That will change when global conditions make growth a hard scrabble, rather than a bonanza, and borrowing money means dealing with flinty-eyed sceptics, not rosy-eyed thrill-seekers. The politicians may then have to concentrate on the real sources of competitiveness: brains, hard work and clean government.

Re: Upcoming crash in E Europe?

A super article. Thanks, MikeC.

Re: Upcoming crash in E Europe?

Check this one out - from this weekend's ed of Wall Street Journal:

Foreign Real-Estate Funds Boom
Firms Unveil Scores of New Plays, Spurred by Strong Returns and Growth in Overseas REITs

July 7, 2007; Page B1

It is getting easier to invest in Australian shopping malls and Norwegian office towers.
Financial-services firms are rolling out scores of foreign real-estate funds. In the past few weeks alone, Charles Schwab Corp. launched a global real-estate fund that is betting in part on strong rental growth in London office properties. WisdomTree Investments Inc. listed a new exchange-traded fund that tracks an index heavily weighted to Australia, Hong Kong and Japan.

Several new closed-end funds, aimed at more-conservative investors, also have been launched, including Alpine Global Premier Properties Fund that began trading in April after raising $2 billion.
Investors have poured about $6 billion into foreign real-estate funds this year, substantially more than was invested in domestic property funds, according to Morningstar Inc. Those big inflows follow strong past returns for foreign real-estate-investment trusts, the main holdings of these funds, which rose nearly 31% a year in the three years ended April 30, according to Fidelity Investments. By comparison, U.S. REITs rose 22% in that period, while the S&P 500 was up 8.5%.

Driving the trend: the number of REITs overseas, which makes it easier to launch foreign real-estate funds, money managers say. For decades, REITs, which usually own income-producing properties -- apartment complexes, commercial buildings and other buildings that charge rent -- traded mainly in the U.S. and a few other places. But in recent years, the REIT structure has gained wider approval, and they are now found in nearly two dozen countries. Earlier this year they were introduced in the United Kingdom.
Still, REITs can vary between countries. In Japan, for instance, REITs are passive investment vehicles that are mostly barred from redeveloping properties they own. In other places, however, including Singapore, the REIT structure is more similar to what is found in the U.S., money managers say.

"We finally feel comfortable that there's a universe of investable companies, and growth in the number of new companies," says Steve Buller, portfolio manager for Fidelity International Real Estate Fund.

Foreign funds also often take small stakes in non-REIT companies, including home builders, property developers, and construction or lodging concerns. These holdings can spice up a portfolio, but also can be more volatile than REITs.

AIM Global Real Estate Fund, for instance, has a small stake in Chinese property developer Agile Property Holdings Ltd., and the Dryden Global Real Estate Fund owns shares in Orient-Express Hotels Ltd., a Bermuda-based operator of upscale hotels.

One of the first decisions to make in buying a fund is whether to choose an international real-estate fund, which invests almost entirely in foreign property, or a global fund, which can hold a third or more of its assets in the U.S. A global fund can be more stable, because of the large size and depth of the U.S. market. But an international fund, because it has greater exposure to foreign economies, could mean more diversification for your portfolio.

Where They Invest

Most foreign real-estate funds have the bulk of their holdings in large, developed markets in Western Europe, North America and Asia, where the range of available companies is wide. Franklin Global Real Estate Fund has about 75% of its assets in the U.S., Australia and Japan.

The fund, which has returned about 2% this year, also holds a small stake in retail properties in South Africa. That country "is benefiting from a large and growing middle class," says portfolio manager Jack Foster.

Alpine International Real Estate Equity Fund, a pioneer in foreign-property-fund investing, has more than half of its assets in residential and retail REITs, and is in 28 countries around the world, including Hong Kong and Poland. Another target: Brazil, whose expanding economy could make it "one of the great places to invest over the next decade," says Alpine Funds President Sam Lieber. The Alpine fund is up nearly 15% this year. Investors can research what individual funds own and where at Morningstar.com or at each fund company's Web site.

Danger Zones

There can be significant risks. One big concern: Many real-estate stocks around the world are relatively pricey, following several years of gains. Mr. Foster at the Franklin fund, says the value of REIT shares around the world has, in some instances, surpassed the value of the underlying properties.

"We think Asia is very strong and will continue to have good growth in returns from the local property stocks and REITs. Europe and the U.S. are overvalued a bit," he says.

Currency is another risk. If the dollar weakens against other currencies, as many economists are concerned it might continue to do, it reduces the value of U.S. investors' foreign holdings. So far this year, the dollar has fallen 2.9% against the euro, but it is up 3.3% against the yen.

A few funds hedge against the dollar's fluctuation, reducing the currency exposure for the investor. At Franklin Global Real Estate, for instance, fund managers concluded that "property is a unique asset class, and we want the real-estate attributes -- high income and low volatility" without the volatility of currency movements, Mr. Foster says.

Fund companies detail their currency strategy in a fund's prospectus, typically available online. Fees, too, can vary widely. Fidelity International Real Estate fund charges about 0.85% annually, and the Alpine International Real Estate fund charges about 1.17%. At Kensington International Real Estate Fund, investors pay about 1.65% for the C-class shares, which charge no front-end load, though their continuing expenses can be higher than other classes.

Help From ETFs
Investors can also trim expenses by switching to index-tracking funds and ETFs that passively mirror proprietary indexes of real-estate holdings, rather than relying on active stock-picking. The new WisdomTree International Real Estate Fund tracks an index that is heavily tilted toward Australia and some Asian countries, while Northern Global Real Estate Index Fund, from Northern Trust Corp., is tied to an index heavily dependent on U.S. real-estate stocks.

That fund is up about 1.4% this year. And State Street Global Advisors runs the Dow Jones Wilshire International Real Estate ETF based on an index that excludes the U.S. and travels to smaller markets like Poland and Malaysia. This year the fund is up about 11.6%.

Investors looking for a more-conservative play on global real estate might consider closed-end funds, which trade on a stock exchange and generally concentrate on generating income. ING Clarion Global Real Estate Income Fund, for instance, currently yields nearly 7% annually, while Alpine's new Global Premier Properties fund yields nearly 8%.