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Friday, February 15, 2013

Hungary's Matolcsy Joins Japan's Abe In Practicing The Ancient Art Of Verbal Intervention

It's amazing what you can achieve these days just by promising to do something. It's also fascinating to watch just what a storm you can stir up.

Last July Mario Draghi surprised markets when he  vowed to do anything - whatever it would take - to save the Euro. He didn't go into details, he didn't really need to. He simply informed his audience that whatever he did it would be enough. What I suppose no one - not even Mr Draghi himself -  imagined at the time was that doing precisely nothing would turn out to be sufficient. Yet since that time that is just what has happened, he has done nothing, nothing whatsoever - no bonds have been purchased and no country has even asked for aid. So to date this verbal style intervention has been exactly what he said it would be, enough.

Then in November Shinzö Abe, at that point a candidate who looked highly likely to become Japan's prime minister, spoke out over the  problem the high yen was causing the country's exporters, and the desirability of his country's central bank conducting substantially more bond purchases to fight deflation and drive down the yen. The result was not hard to predict -  the Japanese currency came tumbling down.

While the Japanese prime minister may since have backtracked somewhat, he was quite clear back in December what his objectives were:
Mr. Abe on Sunday called on Japan's central bank to resist what he described as moves by the U.S. and Europe to cheapen their currencies and noted that a yen level of around ¥90 to the dollar—it was at ¥84.38 in early Asian trading Monday, down from ¥84.26 late Friday—would support the profit of Japanese exporters.
"Central banks around the world are printing money, supporting their economies and increasing exports. America is the prime example," said Mr. Abe, referring to the Federal Reserve's policy of flooding the market with dollars by purchasing massive amounts of Treasury bonds and other assets.

"If it goes on like this, the yen will inevitably strengthen. It's vital to resist this," said Mr. Abe, who will become prime minister on Wednesday.

Now, surprising as it may sound, the latest player to join this intriguing new game is not the ECB's Mario Draghi. Far from being eager for a bit more verbal fun, he will have none of this even as Euro Area economies wilt. No, the latest player in this rather exclusive game is Hungary's economy minister, György Matolcsy. Since the end of last year he has now spoken out no less than five times on major policy issues, each of them  related directly or indirectly to the value of his country's currency, and each and every time he has provoked a sudden and sharp forint weakening. Topics covered have ranged from issues involving central bank independence, through unconventional monetary policy measures to the latest (January 10) declaration that it was a policy mistake to try and keep inflation low by maintaining a strong forint.

One curious footnote to the phenomenon is that in the wake of the furore being produced inside the country by the sudden shifts in value (not everyone is convinced a weaker forint would be a good thing) the Economy Ministry felt forced to issue a statement blaming a research report by  non other than Nouriel Roubini for the last in the line of abrupt market movements. According to the Hungary Economy Ministry statement, the forint began to depreciate after Roubini said in a newsletter that failure to secure a deal with the International Monetary Fund was bad news for the currency. Consequently RGE advised investors to short the currency. Naughty Nouriel!

According to the Minsitry version "On Thursday speculators seem to have taken Roubini's advice and attacked the forint." "It has become clear that the weakening of the forint since the middle of the week was not triggered by an article of the Minister for National Economy," instead, the ministry suggested that it was speculators who were using this as "an excuse to mask their attack." Naturally, as RGE analysts stress, it is much easier to sell the wicked speculator version to a voting community with only low level macroeconomic analysis skills.

Two Countries, One Problem

But my choice of Japan and Hungary for this comparison is far from being an incidental one. Both countries, arguably, suffer from one and the same problem - structurally deficient internal demand due to an ageing and declining workforce. Logically this phenomenon, which we are now witnessing in an ever growing number of developed countries,  produces a continually stronger dependence on exports for achieving headline GDP growth, a dependence which creates the surprising situation that  even countries with a significant  current account surplus can find positive economic growth hard to come by. As it happens, both Japan and Hungary now run current account surpluses. Japan's has been a constant over many years (although it is now notably weakening) while Hungary's is more tenuous, and of more recent origin.

Yet despite these surpluses in both cases growth is very weak, and during the second half of last year both economies remained mired in recession. Japan's economy surprised once more on the downside in Q4 2012, contracting by a worse than expected 0.1% over the last three months of the year. Hungary's performance was a real shocker, with output falling 0.9% on the quarter and by 2.8% year on year, sending the economy back to a level it first achieved at the start of 2005.

The sad truth is that long term trend growth in both countries is very low- Japan's 10 year average is now under 1%, while the Hungarian equivalent is only slightly higher. Perhaps the Japan case is not so surprising. After all most economists and analysts now recognise that ageing and declining populations will inevitably slow growth, although many, like Paul Krugman here, think that this is not so dire as long as GDP per employed worker continues to perform well. Many, on the other hand, may be surprised by the situation in Hungary, especially since it is still, in theory a catch up, converging economy. Indeed one can be forgiven for being surprised since the country's leaders from both main parties have consistently argued that trend growth for the country should be something like 4%.  This kind of assumption is made in the original Széll Kálmán plan which informs the policy of the present government and lay behind the 2009 statement of the then prime minister Gorgon Bajnai that "Hungary’s potential economic growth should be 2 percentage points over the corresponding EU figure in order to ensure convergence".

Similar thinking informed the 2009 model produced by Zsuzsa Mosolygó and Lajos Deli, of the Hungarian Government Debt Management Agency, which attempted to show that Hungarian sovereign debt was on a sustainable path. As they argued then:
"Market analysts tend to assume in their debt models a 2% economic growth for the Hungarian economy. The National Bank of Hungary estimates currently a 2% potential GDP growth rate, however, it does not mean necessarily the long-term economic growth. A few years ago the estimates were higher and it seems to be possible that adequate reforms to encourage employment would result in a 3-4% or even higher potential GDP growth rate".

This around 4% potential growth rate has been a regular theme over the years, with the only other constant being its non achievement, which, as I have been arguing all along is hardly surprising due to the country's dire demographics. If we compare with the case of Japan, the actual fall in population is much more severe in Hungary.

and the decline in the labour force (population 15 to 64) is now unrelenting.

Nor is it any real consolation to find out, as Paul Krugman puts it, that the lower trend growth rate is actually "not bad" since "you can argue that demographically adjusted, the whole tale of Japanese... [or Hungarian, EH)....stagnation is a myth" since what matters are the debt to GDP dynamics being produced by the much higher elderly dependency ratios. These are what will tell us whether a country is on a stable or sustainable path or not. Saying that Japan (or Hungary's) "performance isn’t that bad given the shortage of Japanese" (or Hungarians) seems to magnificently fail to get the point.

On the other hand, to state that "while there is much shaking of heads about Japanese debt, the ill-effects if any of that debt are by no means obvious," is surely to make a historic error of judgement of monumental proportions. (For a fuller discussion of the theoretical issues raised by Japan's debt problem, see "The Looming Singularity").

The Same Only Different

Having made this comparison, there are of course many ways in which the two countries differ, and some of them are very important In the first place Japan has been struggling with a very high yen parity, which has seen the country's goods trade balance steadily drift into the red.

Hungary on the other hand has no such problem, since the trade balance is well in surplus.

Differences also emerge when we drill down into the respective current account surpluses, since while Japan's is largely boosted by an income flow from a large stock of overseas assets (see second chart below - Japan has a positive NIIP of around 50% of GDP, click on the image for better viewing), in the Hungarian case we find the inverse - the large negative international investment position (around 100% of GDP) leads to a negative income flow which mitigates the impact of the significant trade surplus.

Surely there are lessons from the Hungarian case for the future outlook on the southern periphery of the Euro Area. Improving goods trade balances are steadily pushing current account balances in countries like Portugal, Spain and Greece back into the black. But far from being like Japan and having a large stock of external net savings these countries are more like Hungary with a large negative net external investment position (again hovering near 100% of GDP in all cases) and consequently a large external debt. What this means is that they are totally unprepared to receive the full impact of the kind of population ageing we have seen in Japan, an impact which is surely now under a decade away.

The Hungarian lesson is that exports can do well, very well, and the current account can correct, but the economy can still languish permanently on the verge of recession unable to generate sufficient growth to break out into a sustainable growth dynamic.

And there's another aspect to the Hungarian situation that needs to be taken note of, and that is the fact that one of the reasons for this very high negative net external investment position is the fact that government debt was reduced to some extent during the early years of this century by a SELL-OFF OF STATE ASSETS. Now this kind of sell off often highly desirable, but in a country with an external debt problem there is one important condition - the purchasers need to be domestic savers. If there are insufficient domestic savers, as was the case with a country like Hungary with a large current account deficit, then the external debt simply shifts from being public to private, which looks good in an accounting sense if what you are concerned about is the size of public debt, but since the debt still needs to be serviced the macroeconomic implications are often not that significant - an external debt is still an external debt (even if it only shows up on the net external investment position, rather than under the external debt account) and it still has to be serviced. Indeed part of Hungary's monthly exports still effectively go to pay the interest charges (or dividends).

So Troika representatives be warned, in Portugal and Greece you can only get so much juice out of a single lemon, and while privatization looks good on the sovereign debt balance, if what you are after are solutions to external debt burdens simple asset sales may not be as productive as they seem.

A second major difference is that Hungary hasn't got a deflation problem. In fact it has an inflation one, which is hard to understand in an economy which has seen domestic demand deflating for so long. Certainly you couldn't exactly say the economy was "overheating".

The second major difference is that for all the talk of unorthodox policies, monetary policy is conducted well away from the so called "zero-bound". In fact the central bank monetary policy rate is currently running at 5.5% - and that is after six quarter point rate cuts over the last six months. Prior to that the reference rate was 7%. Hardly stimulative policy, but this is just the point, with an external debt of around 60% of GDP which needs to be financed interest rates have to be maintained high in order to sell the debt, and keep external investors inside the country. Just this week Hungary issued 3.25 billion 5 and 10 year US dollar denominated bonds  paying 345 basis points and 335 basis points over the respective US Treasuries.

And this is during a period of  global "risk on", under conditions of "risk off" the country would surely need to be negotiating with the IMF again.

So to go back to where we started, with the various attempts to talk down JPY and HUF, the difference is clear enough, isn't it. Japan can do this since far from having external debt it has a very large positive external balance, which means the yen value of its assets goes up. In Hungary we have the exact opposite situation, whereby any fall in the value of the forint forces up the HUF value of the external debt, and with it the size of government debt as a proportion of GDP. So while both countries may wish to try and increase the scale of their export operations to try and squeeze out some more growth, only one can do it (and even then only with the implicit blessing of G7 central bankers if they don't want a verbal currency war to become a sanctions based trade one).

Who Is Turning Into Whom?

(or what the hell does convergence now mean?)

What I have tried to do here is two things. In the first place draw attention to the flaw in the reasoning of those who argue in the Japan case that the sovereign debt problem is benign since the BoJ can always monetise it and swallow part of the losses if need be. The BoJ can do this for just as long as the country maintains a significant positive external stock of assets. But as these are drawn down as the elderly population need their savings, Japan's current account will steadily deteriorate (as it already shows signs of doing) until the country reaches the point that it will look more like Hungary than, say, Germany, and end game will draw near.

On the other hand I have emphasized how Hungary's  deteriorating demographic profile makes it look increasingly look like Japan, without the large external asset base, and without the deflation. I have been arguing on my Hungary blog since 2006 that this is where we were going and that something serious and substantial needed to be done to address the demographic issue. Unfortunately there has not been one serious study either from the IMF, or from the EU, or from the World Bank, or from the OECD which has tried to situation Hungary's ills in the context of its demographic trajectory. Hence nothing, absolutely nothing has been done to address the issue. Hope may spring eternal, but opportunities don't - they are played out in finite time. This week I have already drawn the conclusion that it is probably now too late for Japan to avoid becoming another Hungary. It is hard not to escape the conclusion that it may now also be too late for Hungary to avoid becoming another Japan.

Thursday, January 12, 2012

Playing Chicken And Rooster With Hungary

Tension surrounding the application of a series of so-called "unorthodox policies" by Hungary's Fidesz government has certainly been rising in recent days. While Washington has been reasonably quiet as govenment emissary Tamas Fellegi meets with top IMF officials, Brussels has seen a veritable avalance of official statements and policy initiatives. Despite constant rumours that an agreement with the IMF is near, I find it pretty implausible that any deal can be reached without some kind of EU assent.  At the present time this assent is unlikely to be forthcoming, and indeed the "ante" has been pushed up and up. The latest example here is the fact that Brussels has given the Hungarian administration till next Tuesday to do something about altering the country's new constitution or face the prospect of legal action, and possible suspension from the EU under article 7 of the EU Treaty. Budapest on the other hand has been full of conciliating words, but the key point is we have yet to see anything meaningful in terms of action.

Brussels now has issues pending with Budapest on a number of fronts. In the first place Hungary has been tried and  found wanting in relation to its compliance with the conditions of the EU excess deficit procedure to which it has been submitted for some time now. This issue is important in its own right, since it was with the balooning of the fiscal deficit in 2006 that all the recent political problems really began.  The current deadlock with Budapest on the deficit front has added importance in the present context since the EU is in the process of formulating a new treaty whereby states using the Euro will be compelled to bring their debt and deficits into line with EU regulations or face sanctions.

All of this will sound very hollow if Hungary, which is not in the Euro but is bound by the excess deficit agreements already in the Treaty, cannot be brought to heel. The issue is a complex one in the Hungarian case, where many of the underlying issues are interconnected (like the decision to change the constitution and the appropriation of assets worth about 9.75% of GDP from the private pension fund, since without the constitutional change those having their assets effectively expropriated would have had recourse to law on the issue). What the EU are concerned about is the credibility of their policy, and in this case the key question is the sustainability of the Hungarian debt and deficit, since one-off measures (like money from the sale of private pension fund assets) do not reduce the underlying structural deficit the country has. As the EU statement says:
"Hungary has not made sufficient progress towards a timely and sustainable correction of its excessive deficit." The EU executive proposes to "move to the next stage of the Excessive Deficit Procedure (EDP) and recommends that the Council of Ministers decides that no effective action has been taken to bring the deficit below 3% of GDP in a sustainable manner."
This is a bit of beaurocrat-speak, but what it effectively means is that the European disciplinary procedure is being put to work on the country, and that one of the consequences may be the application of a sanction involving the withholding of EU structural funds (estimated to be equivalent to 1.7% of GDP):
 "Subject to this Council decision (under Article 126(8) of the EU Treaty), the Commission will then propose to the Council new recommendations addressed to Hungary (under Article 126(7) of the Treaty) with a view to bringing to an end its excessive government deficit,"
Prime Minister Orban is very proud of the fact that the deficit came in at under 3% of GDP in 2011 for the first time since the country joined the EU in 2004. In fact the country had a budget surplus, estimated to be  between 2% and 3% of GDP, but this surplus is entirely due to juggling with revenues that come from appropriating the private pension funds. As the EU Commission put it in their autumn forecast.

"Following a deficit of 4.2% of GDP in 2010, the  general government balance is expected to turn to  surplus thanks to one-off revenues linked to the elimination of the obligatory private pension scheme. The official estimate for this year's surplus has been revised up from 2% of GDP (contained in the April 2011 Convergence Programme update (CP)) to 3.9% of GDP in the autumn notification. The larger surplus is mainly due to: (i) higher one-off revenue stemming from the elimination of the obligatory private pension scheme (now amounting to 9¾% of GDP, i.e. ½% of GDP higher than previously assumed); (ii) an intention not to assume the debt of the public transport companies (1.4% of GDP) and not to buy out selected PPP projects (0.7% of GDP), contrary to earlier plans; and (iii) additional measures of 0.4% of GDP adopted in September 2011".
The EU Commission calculate that the underlying deficit in 2011 (that is the deficit stripping out the one-off cash injections) was around 6% of GDP, and while the budget promise for 2012 is under 3% of GDP there are lots of factors (like lower GDP growth, higher interest costs, and higher expenditure from automatic stabilsers) that could easily mean the real number continues to be over 3%.

So, enough is enough with "unorthodox fiscal policies" is what the country is now being told.

But the fiscal deficit is only one, small, part of the problem as far as the EU is concerned. Of much greater concern are the recent changes in the constitution and the independence of the countries institutions like the central bank. The EU is now studying whether parts of the constitution violate the fundamental EU Treaty, and Hungary has been given until Tuesday to present changes to the constitution which would comply with EU membership requirements. If the Commission decide the unchanged constitution does violate the Treaty, legal action against the country will surely follow, and it is not to be entirely ruled out that the country could be temporarily suspended from the EU under the terms of Article 7 of the Treaty (details of which can be found here). As Commission spokeswoman Pia Ahrenkilde Hansen told the press:
“A legally stable environment, based on the rule of law, including respect for media freedom, democratic principles and fundamental rights, is also the best guarantee for citizens’ trust and confidence of partners and investors,” Ahrenkilde Hansen told journalists. “This is particularly vital in times of economic crisis.”
So the question now posed is that someone here is going to have to back down, and to do so  significantly. The question really is "is Orban ready and willing to do so". Friends and acquaintances of mine in Hungary had been warning me for some time that this kind of confrontation would (almost inevitably) come. Orban had gone one bridge too far, and it would be hard for him to turn back. Over the last few days a close acquaintance, who has been becoming increasingly concerned about the situation, has sent me a number of e-mails on the topic. Below I reproduce a selection of extracts, just to give a feel for how some (perceptive and sensitive) people inside the country see the situation.
As far as finding a way out is concerned, I am very, very sceptical. Given the super-majority in parliament and the trenchwarfare between left and right, except for a full blown revolution or the landing of US paratroopers (both, eveidently, extremely unlikely), the only way to topple Orban is to have a revolt within Parliamentary group of FIDESZ. This is also very unlikely, as Orban is a very charismatic and ruthless leader with an uncanny ability to get through to people and to preserve his leadership.

Moreover, all FIDESZ MPs are personally selected by Orban, and only God knows what kind of "documents" are existing in Orban's hand with which he could blackmail them. There ought to be a good deal given the widespread corruption in the Hungarian political system. It seems that nobody either could or would be ready to challange him. Even, I could safely say - reading the right wing press and speaking with supporters of Orban - that a decade of gradual shift towards a radical and anti-capitalist and anti EU ("Empire") position has created a mindset which may even accept a break with EU in order to save "freedom", "independence" and "national goals" and reduce "foreign capitalist exploitation".

Thus, I don"t really see the internal force, which could stand up to the government. Those lonely voices, who criticised Orban on grounds of economics, have been successfully isolated and there was never any attempt to build up a formal institutionalised form for expressing different policy options within the broad right wing camp. We could even find that any measures on behalf of EU against Hungary only reinforce Orban's stand-alone policy and rally behind him the ultra-nationalist camp, which could be easily as large as 30% of the population.

Given that he controls state administration and the armed forces, and taking into account the complete reaoganisation of these branches of the state together with the wholesale nomination new staff, he may have enough resources to sustain a populist autocratic order for a long period of time, like in Belorussia. Here comes to play also the aging population and the flight of young professionals into other  EU states: older people typically are not those one who are revolting, and those who would revolt may increasingly decide to try and escape in time before the new "iron-curtain" falls down.

Actually,  to be precise: maybe a break with the EU is not an option at this point, but once the  EU suspends Hungary, that option maybe more easy to sell.  We are faced with a charismatic leader who may  actually have an agenda, and not be only "surfing" on the current reality trying to get the best for himself.

Launching WWII was huge misinterpreation of their own capacity on the part of Germany, especially when coupled  with  Barbarossa, and was not supported by much of the population and may be even the army and the conservativies had their misgivings, but still, Hitler prevailed, and.... I dont want to say that Orban is comparable with that truly evil person, but we are facing with a similar charismatic leader with a strong will and with deeply internalised goals. ..

And maybe there is not a masterplan a la Mein Kampf or Hossbach notes. But the changes, the events, the steps he is taking, sometimes irrationally, sometimes rationally, are taking him towards this final irrational step. He may stop at the last moment, but it may happen that fear of loosing power pushes him over the brink and he may choose the completly irrational step. I cannot say how the future will happen. But I can say that his speeches, acts, messages belong to a distinct political family of radical right wing views and these inevitably lead to a break with the current EU. And his personality traits also suggest a certain kind of personality, one who is able to carry out this radical step, if the circumstences arise, and he feels forced to do so. Lets just hope that this scenario will not be the real one. ..
I think we need to be clear at this point, nothing here is inevitable, but the usual kind of "bandaid" kick-the-can-a-little-bit-further-down-the-road solution is not going to be easily available. I think it is going to be very hard for Orban to back down significantly, and especially so in the case of having the constitution rewritten significantly. In many ways this  is why I used the cryptic headline and final paragraph in my last Hungary post.

What I was getting at there is the thought that this is now Orban’s great opportunity to go down in the history books, possibly even as the man who opened up a chain of events which finally destroyed the Euro. This is his challenge, and his possibility to live eternally ( I doubt there is any other one). He is currently just three steps from heaven, so it is comparatively easy for him to get to his intended destination. But its also easy for him to get things wrong (from his point of view). I mean, he could do the "right thing", be a gentleman and back off to make a deal with the EU under which he had to retire from politics. I can just see José Barroso now, alighting from the plane and waving the critical  piece of paper to the delighted press photographers. That way, of course, five years from now no one would even remember Orban's name.

So the question of whether a deal is still possible is  the billion dollar issue in  all this. We have a chicken and rooster situation: who will blink first. Hungary may blink since the country's leaders may not wish to find themselves outside the EU and forced into default. Or alternately, some of Orban’s advisers may already accept this scenario as an inevitability, and welcome default as the only way of getting to grips with the forex debt problem. They may even already be thinking in terms of a post Euro scenario, and assuming that the Euro cannot hold together. On the other hand the IMF (under EU pressure) are unlikely to accept the forex default and debt restructuring that Hungary probably needs to achieve sustainability in the longer term while they are still in the EU.

The constitution law is probably going to be the real sticking point, since if the government needed this to avoid letting the people who had their pension savings appropriated take recourse to the law, then unwinding it would probably mean the public finance issue would quickly get bigger, and quite possibly right out of control.

On the other hand while the EU may dig in for a time, they may ultimately fear contagion more than they do an unruly Hungarian government. Europe's leaders have basically been motivated by fear of something or other throughout the whole Euro debt crisis, they have never really been out there in front of the curve. No pain today please seems to have been the rule. So with the second Greek bailout visibly wobbling, and much of the rest of Eastern Europe vulnerable to retrenchment by West European banks, fearing the inevitable contagion they may well finally go for a "peace in our time" deal.

Naturally, in this post I have dwelt on the political dynamics (and dangers) of the current situation (and indeed the post contains not one single chart), but we should never forget there is a real economic backdrop to what is happening in Hungary, one in which IMF programmes in Eastern and Southern Europe are not working out as planned, possibly due to a faulty diagnosis of the problem (see my earlier post for explanation). In addition, it is hard to say at this point whether what is happening in Hungary is unique (due to its 20th century history) or whether it is a harbinger of what is to come along the EU periphery as populations steadily get disillusioned with policy packages which simply don't work. To answer this question we  will need to see into the future, but to see into the future we will have to get there first.

Postscript Friday Morning

In the above post I argued that the IMF was very unlikely to open negotiations with Hungary before the Hungarian administration responded satisfactorily to the EU requests for compliance. Last night the IMF issued a press statement where Christine Lagarde made plain that this is indeed the stance they are taking.
“I met today with a Hungarian delegation led by Minister Tamas Fellegi. We had a useful exchange about the latest economic developments in Hungary and about how best the IMF can assist the country in addressing the current economic situation. “I indicated that, before the Fund can determine when and whether to start negotiations for a Stand-By Arrangement, it will need to see tangible steps that show the authorities’ strong commitment to engage on all the policy issues that are relevant to macroeconomic stability. Support of the European authorities and institutions would also be critical for successful discussions of a new program.”
Thus Orban's "divide and rule" strategy isn't going to work. On the other hand, reading between the lines in his latest speech, I don't think Orban is getting ready to eat humble pie, rather he is getting ready to play "now you see me, now you don't" with Europe's leaders.
"Our general approach is that we are open and flexible, we are ready to negotiate all the points, but what we need is not political opinion but arguments. And when the arguments on behalf of the European Union are convincing, then it's better to accept and follow that line. There is no reason not to do that. We are absolutely open and flexible and waiting for the argument. But yesterday's comments from the EU did not contain any argument, just opinion, saying that they don't like it, it's against the general legislation of the EU. But we would like to get more specific points on the points (where) they would like to see modifications or corrections. And we are ready to consider it."
As far as I can see, he is simply stonewalling. He is saying a lot and saying nothing, which may well be his best strategy, effectively copying Merkel and Sarkozy on other issues. Continuing in this way he will force the EU's bluff, either they have to act and try to see things through to the end, or they have to back down. They show no sign at present of having any inclination to back down, so we are now facing a very high risk situation. Back in the summer of 2010 György Lázár wrote the following very perceptive lines:
"Orbán’s unusual high-wire act might work, but he must avoid Hungary’s debt downgrade to “junk”. This is easier said than done, because the debt is currently under review and the other shoe can drop at any moment. A sovereign debt downgrade, with a run on the forint or on the banks will probably finish his government".
Of course, that's just it, Hungary's debt has now been downgraded to junk, and Orban's government is now facing a "life or sudden death" situation.

Saturday, January 07, 2012

From Here To Eternity, Hungarian Style

Hungary's unofficial ambassador to the IMF,Tamás Fellegi, is reportedly facing a "terrible atmosphere" after his arrival in Washington on an exploratory mission whose objective is to open up communication about a new financial lifeline for the country. Frankly, given the recent record of relations between the two institions involved it isn't hard to understand why. Leaving aside the long list of recent grievances, it was Hungary who decided to walk away from the IMF in the first place, suggesting it could manage quite well on its own, thank you very much, so the Washington based lender is now hardly likely to welcome the country back as some sort of long lost prodigal son.

To make matters worse, the country has now opened up a second front by generating a serious dispute with the EU Commission, and other European institutions like the ECB, so it is only to be expected that the Fund will not reach any sort of agreement with the Hungarian government, until after the path has been cleared at the Brussel's level. Indeed such is the degree of dishumour of Europe's leaders with the present government, that it is still not clear whether the price for any form of aid might not be Orban's own head, and the installation of a more technocratic caretaker government. There are, after all, recent precedents for such a development in Greece and Hungary, and indeed the former Hungarian prime minister Ferenc Gyurcsány was effectively forced out by Brussels in March 2009.

Not unnaturally Viktor Orban has been visibly trying to back away from the rapidly deteriorating confrontation, and only last Friday said his administration believes striking a deal with the European Union and the International Monetary Fund on a financial safety net for the indebted country is "an urgent task". Just to rub it in, he went on to declare his total support for the idea of central-bank independence.  Government spokesman Andras Giro-Szasz went even further, saying the country was ready to "adjust any law that's against European Union regulations."

Yes, Sorry No... OK, Yes Is What I Really Meant To Say

Meanwhile both the EU and the IMF are digging their heals in, and taking a hard line. European Commission President Jose Manuel Barroso has written to the Hungarian prime minister, calling on him to withdraw recent offending legislation  since they likely failed to comply with community law and could well prove to be incompatible with the EU Treaty itself. According to a report which appeared on the website Origo.hu, Barroso asked Orban to withdraw the legislation on the central bank as well as a 'stability law' proposed earlier this month which would tie the pace of debt reduction to the rate of economic growth. "I would forcefully advise you to withdraw two pieces of cardinal law now in front of parliament,"  he is reported as writing in late December. Taking a leaf out of Angela Merkel and Nicolas Sarzozy's book perhaps, Orban seems to have ignored Barroso's plea, since the bill went into law on 30 December.

In fact, in what might now turn out to be a classic example of "famous last words" a defiant Viktor(ious) Orban stated after the passage of the bank bill: “It is a European fashion that the central bank must be in a sacred state of independence...Nobody can interfere with Hungarian legislative work, there is no one in the world who might tell the elected deputies of the Hungarian people which act to pass and which not to.”

Only 6 days and a downgrade or two later, the mood is rather different, and Tamas Fellegi told reporters before boarding the plane to Washington that Hungary is open to talks about the central-bank law, indeed there is nothing the country isn't open to talking about if need be to secure a loan.

Nonetheless both the IMF and the EU will surely continue to play hardball, after all they now have the upper hand. Hence a report which appeared on another Hungarian website (Figyelo) this weekend, which cites a "precautionary" programme that was being prepared for Hungary. The document the website reproduced also suggested the IMF board (which will meet on 18 January to discuss Hungary) was of the opinion that the country  could receive a Stand-By Agreement - which carries more conditions than a precautionary agreement.

According to the document summary, the IMF will require Hungary to re-establish the independence of the National Bank of Hungary, strengthen the Fiscal Council, exercise a stricter fiscal policy, reduce and then withdraw crisis taxes, end ad hoc economic policy measures, fully implement agreed reforms, restructure the social welfare system, restructure public transport companies, and introduce a personal bankruptcy law. ,

The report describes  Hungary’s political climate as "complicated", and suggests the chance of Hungary losing its EU Cohesion Fund support because of an excessive deficit procedure that has dragged on for eight years a "real danger". Should this eventuality materialise Hungary would loose funding equivalent to 2% of GDP.

Short Term Crisis, But Long Term Deep-Seated Issues That Won't Simply Go Away

Yet whatever the political obstacles, it is very likely that some sort of deal will be patched together. The consequences on both sides of the fence are too large to play with for too long (although remember accidents in history do happen, indeed following one school of thought they are the very motive force of history).

Last weeks downgrade from Fitch (to BB+ aka "junk") will have concentrated everyone's minds, since it was one further warning of what would quickly happen if agreement were not reached - the currency would fall through the floor, the debt would become rapidly unsustainable and  the country would default, and even continuing membership of the EU would be put in doubt. As in then Greek case, it is doubtful at this point that anyone is ready to walk through this particular door, even if they repeatedly keep getting shown it.

Naturally the financial markets have responded badly to all the brinksmanship and uncertainty, with the forint repeatedly hitting record lows against the euro (the latest was of 324 to the Euro on Thursday), while the yield on 10 yr government bonds has spiked sharply (see chart above from Portfolio Hungary). Following the Fitch decision Hungary’s 5-yr CDS spread leaped by 38 basis points to 754 bps, dragging Poland's  (up 16 bps to 307 bps) and those of the Czech Republic (up 15 bps to 194 bps). Naturally, as in the Greek case, it is the risk of regional contagion which is the biggest headache facing policymakers.

Chronicle Of A Problem Foreseen But Not Dealt With

The danger to the Hungarian CDS has been obvious for some time, since six months ago markets were badly underpricing Hungarian risk. As I said in July:

"And if we move over to Hungary, then we find that as of last Friday CDS stood at around 285, well below the highs of over 400 seen as recently as last November in the wake of the Irish crisis. Arguably the Hungarian case is the most glaring example (of risk underpricing), since it is the East European country with the highest debt to GDP levels (around 80%, of GDP, of which 45% is forex denominated) it has very high gross foreign debt (around 135% of GDP), and it is a country where institutional quality is a constant cause for concern. In many ways Hungary is the Italy of the East. Apart from the presence of a strong trade surplus there is not that much to commend in Hungary's recent economic performance, yet its CDS has fallen into line with a regional pattern, and there is little in the way of what is happening in Spain and Italy to be seen in the spread, let alone what is going on in Slovenia and Slovakia".
Obviously market sentiment has changed, and the question now is whether markets are overreacting. In the short term they may be, since although the danger of falling into a default spiral is real, there is the also a genuine possibility (but not certainty) of a deal being reached. But in the longer run they are not, since what Hungary is not suffering from is a short term liquidity crisis (or even a balance of payments one, the current account is in surplus), but a long run solvency and social sustainability one.

But to get to see what the end of this story may be, we need to go back to the beginning, and the origins of the present Hungarian crisis in the market correction of 2006.  Those who could see that the global imbalances which were developing would eventually unwind couldn't fail to see the warning signs that year, as Iceland, Turkey and Hungary all wobbled under the force of those early seizmic tremors.  That was when I got interested in Hungary, and took the decision to set up a dedicated blog for the country.

Hungary seemed interesting for a number of reasons. It was a harbinger for many of the things which were to come, the rapid expansion of a fiscal deficit following the ending of a credit driven consumer boom (think Spain or the UK today), the ageing and declining population phenomenon in Eastern Europe, and it became the test pad for the application of "confidence building" measures, austerity programmes and structural reform to the economy of a country which had serverely lost competitiveness.

Nearly six years later, and with the Hungarian economy on the brink of a possible default, perhaps it is now a good time to take stock of whether this approach has worked.

The 2006 Fiscal Deficit

The key to getting inside the Hungarian problem is to ask yourself the simple question why the country had such a whopping fiscal deficit (over 9% of GDP)  in 2006. For the popular press the answer was easy, it was the result of a spednthrift government trying to buy votes. In fact the then Prime Minister Ferenc Gyurcsany  made it easy for them, he inadvertently admitted what they had been up to:
Some came who did not bother whether they would have a place in the country's government, because they understood that this bloody country is about something else. They can understood that it could be worth being a politician here at the beginning of the 21st Century because we can create a different world......Instead, we lied morning, noon and night. I do not want to carry on with this.
While this answer may well satisfy journalists and political sociologists, it cannot be entirely satisfactory for economists, who realise there are underlying processes (beyond flawed and corrupt individuals) behind these phenomena and want to get tot he heart of them. Could it be, for example, that the 2006 deficit was the culmination rather than the start of something. Certainly there had already been large deficits from 2002 onwards.

I've looked at a number of examples now of where fiscal "extravagance" suddenly breaks out in a country - Portugal in the late 1990s, Spain more recently - and a common pattern I note is that government deficts often surge at the end of a consumption boom as politicians try to keep economic growth humming and living standards rising, even while revenue falls. To some extent this does seem to have been Hungary's case. As can be seen in the chart below, the country did have a very large consumption driven boom between 1999 and 2002.

After 2002 the thing evidently eased off, meaning government revenue slowed, and hence the start of the deficit problems. Why the consumption boom ended is not clear, but it does form part of a pattern. Although conventional economic theory doesn't seem able to account for the phenomenon, many countries seem do seem to pass through some sort of transition wherby they move from been consumer driven to export driven economies. Germany is a good case in point, since as we can see Germany had a substantial consumer boom in the 1990s before converting itself into the export champion we have now grown to know and love.

Competitiveness Loss Which Precedes Fiscal Lunacy

The big difference between the German and Hungarian economies though, is in the extent to which they lost competitiveness during the boom years, and in the extent to which the government tried to use deficit spending to sweep the problem under the carpet. The chart below shows a comparison of movement in unit labour costs between the two countries over the relevant period. Now it is important to realise that unit labour costs are not about "catch up" improvements in living standards, they simply tell you how productive your workers are for each hour worked (or the cost in labout terms of each euro of GDP), and as we can see, while Germany held costs almost constant, Hungary let them rip. Which simply means that once you can no longer rely on consumer borrowing or spending for headline growth in GDP, you can't fall back on exports, because your economy isn't competitive enough, which is the issue all along the EU periphery, although Europe's leaders are mainly in denial on the issue, simply following the fiscal paper chase without digging any deeper to try to get at what might be at the root of the problem.

Now the interesting point is that Hungarian exports have in fact risen substantially over the years.

But impressive as all this looks, it has not been enough to get the kind of GDP growth that Hungary evidently needs (among other things to pay its debts and its contingent liabilities to its elderly population).

In fact, despite the massive increase in exports since the end of the global financial crisis, Hungarian GDP has only recovered slowly. Hungary’s economy fell by 7% in 2009, grew 1% in 2010, and is heading back into recesssion at the end of 2011. Even leaving out the crisis year of 2009 Hungary has only managed average growth of under 1% since the austerity measures began in 2006. Something, somewhere evidently isn't working as it should. In addition to the ongoing programme of structural reforms what Hungary needs is a short sharp shock in the form of forint depreciation, to recover a large chunk of competitiveness and boost investment into the export sector. In this sense "competitiveness" means having an export sector which is large enough (as in Germany) to drive GDP growth forward. At present value added in Hungarian manufacturing is only just over 20% of GDP as compared with over 40% in the German case (the gross export values are misleading, since Hungarian industry is highly intergrated with German industry, and a lot of the activity is processing components which are imported and then re-exported).

But this kind of forint depreciation (which to some extent we are seeing now under the impact of the crisis) is impossible to achieve without debt restructuring (or outright default) since so much Hungarian debt is denominated in other currencies (largely Swiss Franc - roughly 85% of Hungarian domestic mortgages are denonominated in CHF). Gross external debt is around 140% of GDP and rising as the forint falls, while government debt stood at 83% of GDP at the end of September, and around 45% of this is forex denominated.

No Devaluation High Interest Rate Trap?

So far from wishing for the forint to fall, the central bank is busily raising interest rates to try to sustain its value. Base rates have now been increased twice since October, and now stand at 7%, even though the country is heading towards recession and most central banks are near the zero bound.

Naturally, raising interest rates only helps choke off declining domestic demand even further.

Incidentally, the sharp drop in Hungarian retail sales that can be seen in July 2009 is the product of a 5% rise in VAT, a rise from which Hungarian sales have never really recovered. So much for the received folk wisdom that consumption tax hikes are "comparatively harmless", since the real situation is "it depends".

Naturally, this export dependence is not simply anecdotal. Hungary, like many of its Central and Eastern European peers, has a massive demographic problem. Population is already falling, and any sudden default would only precipitate the added issue of a sharp surge in the numbers of qualified young people packing their bags and leaving.

And the potential labour force is both ageing and shrinking.

So the problem isn't going to go away, and is only set to get worse with time.

The Harbinger Of Things To Come On The Periphery?

Thus Hungary is in a similar situation to many countries on Europe's periphery (in or out of the Euro), without real devaluation the economy will never get enough growth traction, and restructuring of the debt at some stage or another is more or less inevitable.

But there is another factor which gives what is happening now in Hungary special significance, and that is the problem of "reform weariness".

Basically, if the solutions which are being promoted by the IMF and the EU Commission are based on a faulty or incomplete analysis of the situation, then the measures being promoted eventually won't work as they should, and this will lead to disappointment. The political dynamics of what then happens is what should be concerning those who are able to think about such things. Could Hungary be the first example of a country that has lost hope and gone down the road of believing in demagogic politicians? Will there be more Hungaries? Could this be what the future in countries like Greece, Latvia, Portugal and Italy will look like. And if it is, how the hell do you hold the EU, let alone the Euro together? This is the burden of responsibility that now falls on the shoulders of those with responsibility for taking the decisions.

It was, after all, in Hungary that the new orthodoxy of relying on “non-Keynesian” effects related to expectations and credibility was formally announced and put to work.
In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged. IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008
Naturally this approach was subsequently transferred from emerging market countries (like Hungary) to more developed economies along Europe's southern fringe. Private consumption, unfortunately, has notably failed to rise. Perhaps there will be more than a little historic irony involved in Hungary being the country where the whole experiment eventually went badly wrong, although I doubt the Hungarians themselves will se it that way.
Back at school I remember learning about the example set by the British army sargeant at Vimy Ridge who lead his troops out of the trenches and into the withering fire of the German machine guns with the phrase "Come on You Bastards, Do You Want To Live For Ever!" This was the classic example, it seems, of charismatic leadership. Only years later did I twig the double entendre of the expression (which could also have been, "Come on You Bastards, Don't You Want To Live For Ever!"

So this weekend, as he tosses the coin to decide whether to accept the EU conditions or not, Viktor  (she loves me, she loves me not, she loves me....) Orban may do well to pass an idle moment perusing over the immortal lines left for our greater edification by the late, great and one and only Eddie Cochrane.

Now there are three steps to heaven
Just listen and you will plainly see
And as life travels on
And things do go wrong
Just follow Steps 1, 2 and 3