Oh how I do wish I could have something more in the spirit of a yuletide message for the people of Hungary at this point. Unfortunately this is not the case, and entering in media-res as it were, directly onto the topic in hand, things are really begining to move quite quickly in Hungary now, as one external observer after another begins to realise that policy in Hungary may now be well and truly stuck in a cul-de-sac (or even double bind). Indeed, unfortunately, as we will see below, I fear that they may soon start to move even more quickly. The first bit of relevant news in recent days has been the publication by PNB Paribas of an analysis entitled "Stagflation Fears".
Well First There Is the Inflation
Of course, one head of the stagflation coin is the inflation part, and in Hungary's case, inflation has been running at far higher levels than anyone would have hoped for when the austerity package was introduced in the autumn of 2006. As we can see from the chart, it has been persistenly and troublingly high throughout 2007, and although it dropped significantly in September (as some of the earlier one-off austerity hikes started to drop out of the system) it has been on the rebound again since, reaching 7.1% in September.
And inflation at this point is far from having been "bled" from the system despite the apparently tight monetary policy being applied by the central bank, and the auterity package from the central government. One indication that inflationn is far from being purged is provided by the recent agreement reached by Hungarian government with public sector employee representatives to raise wages by 5% on average in 2008. This would seem to me to put in immediate question the realism of the governments notional inflation target of 4.8% annual average inflation for 2008. (Note that the austerity package announced in the autumn of 2006 said wages in nominal terms would not go up in 2007 and 2008., however the government is justifying the agreement by indicating that the fiscal adjustment package remains intact since the number of employees in the public sector has been reduced by 6% (45,000 people) in the past 12 months, and hence the total cost to the treasury will not rise (actually this is a really ropey bogus argument, since you do have to take into account the cost of those who remain unemployed, but even more to the point one needs to know just how many of the people who left public service were offered some sort of early retirement, and again the cost of the pensions which accrue here do also need to be accounted for). But this does not mean that this rate of increase will not become a landmark for private sector workers, in a situation, remember, where the value of real wages - which have been falling as the chart below reveals - have to continue to decline, given that the forint (or if you prefer the REER) can't. Have to continue to decline that is, if Hungary is to be able to attain a significant export lead recovery, which is, I would argue, at this point in Hungary's history about the only path available.
What we can see immediately is that the bulk of the reduction in real wages (which has been real enough, and can be see from the consumption data below) has not been a cost efficiency in Hungarian business activity, but a transfer of fiscal obligations from the government debt onto the individual employee via social security contributions. So really, in a round about way, the cost of Hungary's population ageing problem is being transfered from the government onto the wagearner consumer. And I'm sure it hurts. The thing is, the fact that much of this has been a bookeeping exercise (the whitening of undeclared wages, etc) doesn't get us out of the inflation problem which has been produced at the same time (and one is immediately put in mind here of Germany, and that infamous 3% VAT hike to pay for the health system, and the way that sent domestic consumption shooting downhill in a way which is not un-reminiscent of what has happened in Hungary). So the fact that wages are now set to rise at around 5% in the public sector in 2008 (and the fact that this is only the public sector simply doesn't cut any ice as an argument, given that wages in the private sector have risen consistently faster than those in the public sector throughout 2007) should lead us to imagine that we could easily be looking at headline inflation in the 6% to 7% range in 2008, and at exporters struggling to mantain competitiveness in the face of a high forint and rising internal costs (assuming that is that the forint doesn't tank in the meantime, which may not be a realistic assumption, see below). So you can't just hand yourself out a 5% wage rise and hope that in some miraculous way you can get a consumer "feel good" effect and say 3% headline inflation. Things just don't work like that in the real world, and not when you are in the sort of situation which Hungary is in they don't.
And Then There is the Stagnation
In addition to the inflation problem, the Paribas analysts also stressed Hungary's weak consumption and investment activity, and pointed to the type of economic gridlock which results from needing to apply at one and the same time stringent fiscal and monetary policy, while in the background internal demand simply collapses, and exporters, who are doing a valiant job under the circumstances let it be said, struggle under the weight of the high value of the forint, which cannot, let it be noted, be allowed to drift downwards (which would be one sensible move under the circumstances) due to the problem of private indebtedness and all those Swiss Franc loans. I think the consumption problem is clear enough:
and if your not convinced by this, then you could try looking at retail sales, which tell a very similar story:
And if you are interested in Gross Fixed Capital Formation (investment) try this chart for construction:
As Paribas indicate, the only driving force of economic growth in Hungary in the near future is likely to be exports, but since the external demand situation is deteriorating by the day Hungary this may be insufficient to prevent Hungary falling off into recession (think Japan here).
This is the second report issued about Hungary by a major investment bank in quick succession (the other was Merill Lynch), and both of them have drawn attention to the combination of stagnant growth and high inflation under which Hungarian policy is labouring. The difficulty is that the need to maintain the value of the forint at or near its present levels (or otherwise all those with external debts - mainly households - will start to experience what they call in the parlance "distress". So no one anticipates drastic moves in monetary policy - which the situation surely merits, just look how the Fed is responding to a much milder problem in the US - and interest rate easing moves are expected to be limited. Paribas si - even in the face of the near recession call - sticking to its outlook for an interest rate reduction to 6.5%, while Merrill Lynch is predicting an even more aggressive reduction to 6.25%. None of this, of course, will be to the liking of yield driven financial investors, and the forint will certainly become rapidly vulnerable as monetary policy steadily moves down this path as it surely has to.
Large November Sell-Off In Forint Denominated Assets
In addition we have just learnt from the Magyar Nemzeti Bank that foreign investors sold-off vast amounts of forint denominated financial assets in November. The curious thing is that the forint only weakened slightly, despite the fact that approximately HUF 750 billion of instruments were virtually dumped onto the local market in very short order. One explanation for this curious situation may well be the high demand for euro and Swiss franc denominated consumer loans in Hungary, a demand which has possibly even accelerated during the pre-Christmas shopping season. But if this is the explanation it does leave us with the very awkward question of what exactly happens when the demand for such loans slackens, and the associated flows start to dry up.
The trend towards forint divestment really got going in October, but the monthly rate was not extraordinary (approximately HUF 70 billion net). As a result the forint remained reasonably stable against the euro at around 251 throughout the month.
During the period from the end of September to the end of November, foreign investors sold a huge HUF 800 billion worth of Hungarian instruments in the short term forex market. Of this, increased swap positions accounted for HUF 500 billion (new synthetic short forint positions), while stock and government bond sales amounted to HUF 200 billion and HUF 100 billion, respectively. At the same time, even if on a smaller scale according to MNB, foreign investors were busily opening positions against the forint in the options markets.
The growing unease about higher risk instruments in the context of the ongoing global credit squeeze is undoubtedly the main driving force behind the sale of the Hungarian instruments, this and a growing wariness about Hungary's vulnerability in the face of a global downturn.
Hungary's recent macroeconomic performance and the absence of any sort of optimistic outlook have undoubtedly also played a role, and in particular the high level of external indebtedness of individual Hungarian citizens, the high current account deficit, the weak internal demand situation and the general concerns about ongoing and long lasting slow economic growth.
The central bank's figures reveal that foreign investors divested large amounts of Hungarian stocks in November (continuing a trend that really got started back in August). According to Portfolio Hungary - who have examined the available information on ownership structures and share prices, OTP and Magyar Telekom are likely to have borne the brunt of the sell off.
What was new this time round though was the divestment of Hungarian government bonds (mostly in the secondary market), which accounted for a significant part of forint sales in November.
In this way HUF 750 billion was pulled straight out of the market in November. As I say, the really striking thing is how this major capital transfer was only slightly reflected in the EUR/HUF rate.
One possible explanation for this surprising situation is the rage for foreign currency denominated consumer loans that continues to grip Hungary. The volume of new mortgage loans climbed to the previously unseen level of HUF 130 bn in October, and this increase was almost exclusively attributable to the increase in CHF-denominated loans (HUF 120 bn). Detailed data from the National Bank show that while the monthly amount of new CHF-denominated housing loans rose to the exceptional level of HUF 55-60 bn, mortgage loans for consumption purrposes (ie "refis" or liquidity extraction, not to buy houses) became almost inexplicably fashionable, rising by 30% month-on-month to reach the unprecedented level of HUF 62.5 bn.
Naturally such transactions create a large increase in demand for the forint (the banks flows coming in), a trend which is in and of itself more than likely powerful enough to have offset the negative impact of lost investor confidence on the exchange rate.
Moral Hazard and the Coming Correction
Clearly this situation is now really very very delicate, one strong push and a whole pack of cards can come tumbling down. Borrowing today to pay back yesterday is a dangerous policy at the best of time, but when your currency might be about to fall of a cliff (think what happens when the demand for new loans dries up) it has to border on recklessness if you are borrowing unhedged in another currency. And remember, when the bonfire starts (not the one of our vanities I hope) in Eastern Europe (and it may not start in Hungary at all in the first place) it will undoubtedly rapidly spread from one of the "at risk" countries to another.
What all this suggests to me is that a lot of Hungarians are trying to maintain current consumption by borrowing forward aginst their homes (ie some sort of "consumption smoothing) in the hope and expectation that rising property values in the future will help them sweat off the debt. If this rise does not materialise, then the very least that can be said is that all of this will need, at some point, to be clawed back from current consumption. All of this also represents a new form of moral hazard for the central bankers over at the ECB and indeed for the EU Commission itself, since all this borrowing in Swiss Francs has to be based on the assumption that with so many people doing it the Hungarian authorities will never dare to let the forint slide (you know, there's safety in numbers) or, pushing the buck back one stage further, the EU Commission and the ECB won't let the worst things come to the worst.
But this is very dangerous thinking, since in the first place there are a lot of people now out there riding around on the back of the same idea (think Italian government debt, for eg), and people may be seriously overestimating the ability of the political and monetary authorities to contain such a large and complex set of problems. It should also not go un-noted that the whole weight of the ECB is currently not able to stop the spread of the growing credit crunch across the entire eurozone and beyond (even if the most recent massive injection has temporarily stopped the rot). Thus they may well not be able to stop Spanish homeowners (some 75% of whom are on variable Euribor related mortgages) from really feeling the pain, and believe me if they could do this, they would, since having the Spanish economy well and truly down and out as we enter the next downturn is the last thing in the world they want.
Lastly and just as importantly, as I have been arguing, all of this puts the Hungarian central bank in a real double bind, since they cannot ease monetary policy at this point without precipitating a tremendous weakening in the forint, so interest rates are high and need to stay high, and meanwhile Hungarian domestic demand gradually gets strangled, at the same time as the ongoing internal inflation and the negative external environment act as a strong brake on export growth.
Now, as I said at the start of this post, my impression is that the recession Hungary is now entering is likely to be a protracted and difficult affair. In order to justify this assumption (which we will have time enough to think about in due course) I would need to get into Hungary's very special demography - which I have attempted to do in my Just Why Is Hungary So Different From The Rest of the EU10? post. But, as you may have noticed, I have managed to write all the above with barely a mention of this contentious topic, so I think I will leave it at that for now. As they are want to say over in San Diego "Sufficient Unto the Day is the Evil Thereof". Reputedly that is just before they "whack" you, so, exercising caution as the better part of valour, I will now take my leave of you.