Analysis-Polish nationalist's election victory deepens fiscal uncertainty

By Karol Badohal, Karin Strohecker and Gergely Szakacs

WARSAW/LONDON (Reuters) -Poland's path to narrowing its fiscal deficit, maintaining its credit ratings and keeping investors on board looks more difficult following conservative nationalist Karol Nawrocki's presidential election triumph.

Nawrocki's victory in Sunday's election could deal a blow to the centrist government's efforts to cement the European Union and NATO member state's pro-European orientation.

Poland faces big spending demands, including a rise in defence outlays after Russia's invasion of Ukraine, and is grappling with the EU's second-highest fiscal deficit, driven in part by what are widely seen as generous social policies.

Prime Minister Donald Tusk, who returned to power in 2023, has struggled to fulfil electoral promises that could strain public finances and the outgoing president, Andrzej Duda, has used his presidential veto powers to block some of Tusk's political agenda.

Nawrocki, who like Duda is aligned with the opposition, could employ similar tactics, possibly delaying reforms and increasing the government's reliance on fiscal measures in the run-up to a 2027 national election.

"The Nawrocki presidency will fuel domestic political instability. Tusk's reform agenda will be paralysed," Eurasia group analyst Orsolya Raczova said in a note, adding that Nawrocki could "actively stoke tension among coalition partners."

S&P Global said that, at a minimum, Tusk could during Nawrocki's presidency expect similarly "uneasy relations" between the president and the government, and that Poland's economic strength and medium-term fiscal policies would remain the most important factors for Poland's credit rating.

Poland has pledged to bring its budget deficit below 3% of gross domestic product by 2028, but, given the high-stakes election calendar, Tusk's government has ramped up borrowing to record levels ahead of the presidential ballot.

UNDER PRESSURE

Polish stocks fell on Monday from near 14-year-highs, underperforming central European peers, and Poland's international bonds also came under pressure, with longer-dated maturities down between 0.5-0.7 cents on the euro, Tradeweb data showed.

Hasnain Malik, managing director with Tellimer, said the result was a "jolt" to investors. Before Monday, the zloty had been up 11% versus the dollar this year and the local equity index had been up 40% in total U.S. dollar return terms.

The International Monetary Fund projected in April that Poland's economy would grow 3.2% this year and 3.1% in 2026, and slow to 2.7% by 2030.

But last month the European Commission forecast that the deficit would be more than 6% of GDP this year and next, nearly double the average for the 27-member EU and the bloc's second-highest behind Romania.

The yield on Poland's 10-year domestic government bond - a key benchmark for borrowing costs - is currently at around 5.5% - below the 6% mark it hovered around for much of the first three months of the year.

"Poland is likely to face continued political polarisation in the coming years, with the next general elections scheduled for 2027, potentially increasing reliance on expansionary fiscal policies and delaying fiscal consolidation," Scope Ratings said.

S&P warned last week that while it was "not in a rush" to adjust Poland's 'A-' credit rating, the deep polarisation in Polish politics made lowering deficits potentially risky.

Poland has a narrow window before the next election to craft a medium-term fiscal adjustment. Some economic analysts say its ability to do so now looks more uncertain.

"It is likely to be increasingly more challenging to implement fiscal tightening measures after the loss by the ruling coalition in the presidential election," Ercan Erguzel, an economist at Barclays, wrote in a note.

One of Tusk's main unfulfilled electoral promises is a doubling of the income tax free threshold, with an estimated price tag of some 55 billion zloty ($14.76 billion), coming on top of social benefits already widely viewed as generous.

Aleks Szczerbiak, politics professor at the University of Sussex, said Tusk's government was hostage to its income tax pledge, with cost-of-living issues still weighing on Poles despite inflation retreating.

"If they get to the next election, and there's no road map and they haven't started implementing it, that tax free allowance thing is very, very difficult," he said, adding that the political demand was directly at odds with the economic imperative. "And I'm not quite sure how they're going to square that circle."

($1 = 3.7264 zlotys)

(Additional reporting by Paweł Florkiewicz, Editing by Libby George and Timothy Heritage)