Hungary's Central Bank Raises Interest Rates

Hungary's central bank increased the benchmark interest rate for the first time in 17months this morning, opting for a larger-than-expected increase in an attempt to halt soaring government bond yields and stem inflation. The Magyar Nemzeti Bank's 12 policy makers, led by President Andras Simor, raised the two-week deposit rate at a meeting earlier this morning to 8 percent from 7.5 percent.

Hungary is the seventh country to raise rates this month after central banks from Poland to Iceland lifted borrowing costs to tame global inflation and reverse a trend of investors flocking to what are seen as less risky assets.

The yield on the benchmark three-year Hungarian government bonds rose to 9.78 percent on March 7, which was their highest level since October 2004, as the weakening in Hungary's economy, growing political uncertainty and problems in global credit markets prompted investors to favor less risky assets. The three-year yield was 9.32 percent on March 27, and the yield has risen 126 basis points since the last meeting of the Hungarian central bank monetary policy committe was held on February 25. At that point policy makers last voted 8-4 to keep interest rates on hold for a fifth month, opting instead to try to fight inflation by letting the forint trade freely for the first time ever and betting on the currency's strengthening. Events have subsequently turned this into a completely false hope, hence today's changed vote.

Hungary's inflation rate did fall back slightly to 6.9 percent in February from 7.1 percent in January, but it still remained at more than twice the bank's 3 percent target level, and really their credibility was also at stake if they continued to sit back and watch. The bank last month raised its inflation forecast to 5.2 percent this year and 3.6 percent for 2009, from 5 percent and 3 percent, respectively.

As Portfolio Hungary comments:

The larger-than-expected hike by the cenbank may signal its strong commitment to meeting its medium-term inflation goal (3%), and that the MPC wanted to “get over with" the rate hike pressure with a single big step.

It is not net clear as yet whether the MPC considered in its decision the medium-term impacts of the political tension between the governing coalition parties that took a drastic turn over the weekend and today.

Hungary's Governing Coalition Set To Split?

Porstfolio Hungary are reporting that parliamentary group of Hungary's junior governing coalition member, the liberal Free Democrats (SZDSZ), are going to propose to the party's executive body at a meeting set for this evening that they recall every minister and state secretary of the party from the government as of 30 April. The news was given by party head János Kóka and Gábor Fodor at a press conference earlier this morning. As PF say:

In practice this means that the SZDSZ wants out of the coalition. The most likely scenario appears to be a minority government by the Socialists, but it cannot be excluded either that the political tug of war that seems to be inevitable will lead to Gyurcsány's ousting. Should neither of these scenarios materialise, another option could be early elections.

The move which precipitated the decision was the sacking by Prime Minister Gyurcsány of Health Minister and SZDSZ member Ágnes Horváth earier today (with effect from 30 April), ostensibly for failing to push through an overhaul of the health care industry.

The sacking of Horváth and the recall of SZDSZ ministers from the government are both with effect from 30 April, which means that Hungarian political tensions are set to remain for at least the next 30 days. One option is clearly that the two governing parties join forces and oust Gyurcsány if they believe that this would be a way out of the immediate impasse.

SZDSZ have 20 and the Socialists 190 MPs in the 386-strong Parliament. If the Socialists want to avoid becoming a minority government they need at least four liberals to remain supportive. In another unrelated issue the socialists are in the process of deciding whether to bar Socialist MP József Karsai from the party, if they decide to do this they will need 5 SZDSZ members. The fate of Karsai is being decided even as I write.

It is, of course, just a coincidence but the central bank has today decided to raise Hungarian interest rates by half a percentage point - to 8% - in a move which has to be highly controversial given the very weak state of Hungary's domestic economy, but is in fact essential given the very weak state of the forint, and the dependence of many Hungarian citizens on mortgages and loans which are denominated in Swiss francs.

Symbolically the forint also fell on the news of the political rift, falling to 259.38 per euro by 2:28 p.m. in Budapest from 257.77 late on March 28, and reaching in so doing its lowest level since March 11.

Obviously this seems to be the opening of a crisis which is set to run and run. I have a much fuller consideration of the background to the whole situation in this post here.

I will try and update this post later today when the dust starts to settle, assuming, that is, that it does.

Update Tuesday

The executive body of Hungary's junior governing coalition member, the Liberal Free Democrats (SZDSZ) decided at a meeting late last night to recall its members from the government, thus confirming the decision taken by the parlimentary faction. At the present time it is not clear what the eventual outcome of this "mini-crisis" will be. At the present time the SZDSZ see their decision to leave the coalition as irrevocable, but they have said they will continue to support the fulfilment of the convergence programme, the reforms and the necessary structural reshuffle from outside the coalition. This would, if adhered to, allow the Socialist MSZP to continue to govern in minority, but it is hard to see how they can realistically hope to adhere to this since it is precisely the reforms which are being implemented which are so unpopular, and thus it is hard to see what they could hope to have gained by leaving the government if they maintain this posture.

On the other hand, Socialist faction leader Ildikó Lendvai has announced that unless the situation changes, the MSZP to go ahead and form a minority government, with Ferenc Gyurcsány remaining the Prime Minister. Lendvai emphasised they were not preparing to replace the PM and that there would be no vote of confidence either.

Gyurcsány meanwhile is signalling that he is willing to stand down if his person is the only obstacle to an agreement between the two parties. But as Portfolio Hungary suggest, his willingness or otherwise to go is hardly the issue here, since what needs to be decided between the two parties is - assuming an agreement between them might be possible - would lead the government. It can be taken for granted that under this scenario it would not be Gyurcsány. The question is, can the two sides reach any sort of agreement at this juncture?

All of this is very hard to evaluate at this point, since undoubtedly a lot of the "positioning" that is taking place forms part and parcel of the underlying theatricality of Hungarian politics.

What is very clear, however, is that the economic backdrop to all this is simply not going to go away, whatever decisions ae eventually taken on the political front. That would seem to be the one fixed point we have here. And since it is the economic backdrop which is producing all the political instability, then it is not unreasonable to imagine that the political instability will also continue.

The decision by the Bank of Hungary to raise interest rates in the face of an economy which is struggle to get any kind of positive growth in 2008 is simply a symptom of the severity of the situation. News today that Hungary's fiscal deficit was 5.5% of GDP last year (rather than the previous estimate of 5.6%) hardly seems big news, yet the forint did manage to strengthen on the back of it, advancing at one point by as much as 1.3 percent to 257.17 per euro, before dropping back to 258.07 by 5:20 p.m. in Budapest, from 260.65 late yesterday.

But equally, maybe what is leading the forint to strengthen at the moment is not the news on the fiscal front, but the continuing rise in the Hungarian yeid curve and the prospect that the now severely weakened Hungarian National Bank (weakened in the sense that it has now shown its willingness to cede to pressure from the markets, although in reality it probably had little alternative) may raise rates even further (or be psuhed into doing so).

Hungary's Government Debt Management Agency (ÁKK) sold HUF 40 bn worh of 3-month discount T-bills at auction this morning, and the average yield was set to 8.83%. That is up 11 basis points from Monday's benchmark fixing and 34 bps higher than at the previous auction of the same instrument. Anyone want to bet we now go from 8% to 8.5%, even as internal demand in Hungary moves down and down?

Hungary Unemployment February

Hungary's unemployment rate dropped back back slightly - to 8.0% - over the December 2007-February 2008 period from 8.1% in Nov-Jan, the Central Statistics Office (KSH) reported today. This was up from a 7.4 percent over the same period one year ago.



Hungary's economy only grew at an annual 0.8 percent in the fourth quarter, which was the slowest pace in 11 years, in part due to the government's budget and austerity measures to cut the fiscal deficit.

KSH said the number of unemployed was 337,000 down 5,600 from the previous 3 month period but up by 24,500 over the same period a year earlier. There were a total of 3,854 million persons employed, which compares with 3,873 million in the Nov-Jan period and 3,926 million in the same period a year earlier. That is employment is consistently down, and the basic reason why this is compatible with falling unemployment to some extent is that a larger number of people are leaving the economically active population, presumeably a significant number of these former employees in the state sector who have taken early retirement.




The employment rate of the population aged 15-64 was 56.3% in the period, which compares with 56.5% in the previous 3 month period and is down 1 percent compared with the same period a year earlier.

The KSH said 44.9% of all unemployed have been seeking jobs for a year or more (down from 45% in the previous 3 months). The average duration of joblessness came to 16.4 months, unchanged from the previous 3 month period.

Hungarian Retail Sales January 2008

Hungarian retail sales fell for the 12th consecutive month in January after government measures to reduce the European Union's widest budget deficit, falling wages and high interest rates continued to weaken consumer demand. Hungarian retail sales (adjusted for calendar effects) fell 3% year on year in January. The volume of retail sales adjusted for calendar and seasonal effects remained unchanged from December 2007.

In January food sales dropped 2.4% year on year. Sales at hypermarkets and other general shops - which provide 91% of sales - dropped 2.3% in January. Non-food sales fell 3.5% in January year on year. Sales of medicines and drugs suffered the largest drop in January. Sales of cars and car parts - which are not included in the European statistical system as retail sales - fell 2.6%, while the volume of retail sales of fuel remained unchanged.

While sales continue to decline, the rate of decline may well now have stabilised, and we should be thankful for small mercies I suppose. On the other hand there seem to be few grounds for anticipating any imminent turnaround in the situation. So the question is really, what to do about it?

Reading around most of the analysts an interest rate hike would seem to be the preferred move, although this is hardly a textbook response to a rapid decline in domestic demand. Essentially you only have two tools to strengthen weak demand, the direct fiscal one, or the indirect monetary one via interest rate policy. Since fiscal policy as a mechanism for demand management is out both for now, and for the entire forseeable future given the structural difficulties of the deficit, we are simply left with monetray policy, which is why I think a rate hike is the last thing the real Hungarian economy actually needs at this point. On the other hand the financial component of the Hungarian economy may well need a rate hike. Hence the dilema.

One of the problems here is that inflation has been stubbornly high in Hungary, and it is hard to understand this in the light of the rapid economic slowdown and the reasonably tight monetary policy from the NBH, unles perhaps we start to think about the foreign currency personal consumption mortgage loans we have been so popular in Hungary over the last 6 months. These have been available at rates in the 6 to 7% range - ie just below the rate of inflation - and people have taken them out assuming they run no currency translation risk. A rate hike from the NBH would continue to reinforce that illusion, and hence inadvertently will serve to encourage people to get in deeper.

Policy makers will next meet on March 31 to discuss interest rates, but I don't imagine we are in for any surprises, and a quarter point hike at least seems well on the cards. Since this dynamic is, quite simply, unsustainable, the unknown question is what gets to happen next, and when.

One example of the kind of dynamic we might get into is brought to our attention in Portfolio Hungary coverage this morning of a SEB Bank report which advises people to sell forint and buy zloty, using the following argument:

Polish base rate is 5.5% at the moment which will be raised to 6.25% in three steps in the next three months. At the same time forint`s 7.5% base rate might be raised to 7.75% in April, but decreased again to 7.5 in November, as worries about inflation fade, according to SEB's expectations. Strategists of the bank are definitely pessimistic in connection with the outlook for the forint. They forecast 270 forint/euro exchange rate by the and of April and 274 by the end of June. In the end of September however forint will be at 270 again.

Leaving aside the details of the SEB forint forecast, they are obviously more or less on the right lines. There is little real justification for expecting a serious and sustained hiking process in Hungary, and it will fold under pressure - if for no ther reasons - of Hungary's own social and political dynamics. Coupled with which any easing in inflation will leave the NBH with few credible reasons to maintain such a tight monetary policy.

Hungary's Revised Inflation Forecast

Hungary's government raised its forecast for inflation and lowered its prediction for growth this year citing a worsening outlook for exports.

Consumer prices will probably rise 5.9 percent in 2008 after 8 percent last year, while gross domestic product will increase 2.4 percent after 1.3 percent in 2007, Finance Minister Janos Veres said in Budapest today. The previous prediction was for 4.8 percent inflation and 2.8 percent growth.

The Hungarian government yesterday reiterated that it expects the budget deficit to shrink to 4 percent of gross domestic product this year from an estimated 5.7 percent last year and a record 9.2 percent in 2006. The government is aiming to reduce the shortfall to 3.2 percent next year.

The government has cut budget reserves by 20 billion forint ($122 million) to reach its deficit target, Veres said today. The widely announced planned tax cut may be as much as 100 billion forint less than earlier expected as rising bond yields make it more expensive to finance the deficit, he added. Hungary earlier planned to reduce taxes by as much as 250 billion forint.

Hungary Wages and Salaries January 2008

Hungary's monthly average gross wages dropped by 1.5% year on year in January, according to data from the Central Statistics Office (KSH) this morning. At the same time net wages were down by 0.2% year on year in January.



As a result real wages - derived by subtracting the annual inflation rate - declined by 6.8% year on year in January, following the 7.1% increase of in the consumer price index.



Given the existence of a high-inflation environment in Hungary there has been no yearon year decline in gross wages, possibly since the time of the regime change, so as Portfolio Hungary note there may well be some one-off impact at work in the background.

And indeed there is, since the KSH note that for the first time January wages in the public sector do not contain the entire 13th month bonus payout, only its monthly proportionate share, as this bonus is now being distributed fractionally, and indeed it has been paid some monthly instalments wrere already paid last year. According to the statistics office, they paid four of the 13th monthly wage bonuses last year and the remaining eight will be paid as of January this year. So that explains the dramatic nature of the change, but it doesn't entirely get us out of the woods, since the presence of these pre-paid installments in Sept to December help explain why there was some easing up (the hump you can see in the chart above) in the rate of wage deflation in the last quarter of 2007. But the underlying trend is still one of very strong wage deflation, which is why we shouldn't be at all optimistic about any sudden improvement in comestic consumption in the coming months.


In addition, if we look at the two sectors (public and private) separately, we can see that the situation is even more complicated (see chart) since while the public sector is in strong depression (both in terms of wages and employment) the wages are moving in the other direction in the private sector, even as employment in January is up slightly over December, and was in fact the best month since August last year.

On the employemnt side, the number employed in the whole economy dropped by 2.0% year on year to 2,724,600 in January, versus -2.3% in December. There were 1,933,500 people employed in the private sector marking a 1.0% yr/yr decline in the first month of the year, while the headcount in the public sector was down 5.8% year on year in January to 710,200, which compares with a 6.4% fall in December.

Hungary Construction Output January 2008

Hungarian construction resumed its long march downwards in January, since year on year output plummeted by 27.4%, according to both unadjusted data and figures adjusted for working days, according to data from the Central Statistics Office (KSH) this morning. This follows the 20.8% yr/yr decline in Decmber and a 4.0% fall in January last year. There was a 5.9% rise in output month on month over December according to seasonally and working day adjusted data. Thia compares with a 1.4% m/m rise in December over November, and a 1.1% fall m/m in January 2007. So there is some slight improvement in the underlying trend, although it would be very premature to attribute any importance to this at this stage, since all sorts of factors - like the weather, and this winter being milder than the last one or whatever - can be having an impact here.



To get a better picture of what is happening we could look at the quarterly construction activity index over the last few years, where - if we take a glance at the chart - we will see that total activity peaked sometime in 2005, since which point the overall trend has been steadily down, and I see no compelling reason why that tendency is likely to change anytime soon.



Now for the details. According to the KSH release:



The building of complete constructions was down by 31.6% yr/yr in January, and this compared to a 28% drop in December and a 14.3% decrease in January 2007. Building installations were down 12.7% yr/yr in January as compared with a 3.9% fall in December and a 16.8% jump in January 2007. Completed buildings dropped by an incredible 43.7% yr/yr, as compared with a 1.9% fall in December and an 18.1% rise in January 2007.

The stock of orders at the end of January (HUF 674.8 bn at current prices) was down by 29% from a year earlier. The stock of orders for buildings (which totalled HUF 334.7 bn in Januray) was down 15.5% yr/yr, which compares with a rise of 9.4% in December and a rise of 6.9% in January 2007. For civil engineering the stock of orders was down 38.6% yr/yr (to HUF 340.1 b), which compared with a drop of 53.2% in December and a 46.1% drop in January 2007.

The volume of new orders in the construction industry as a whole (at HUF 129.1 bn) was up by 49.5% which compares with a 1.2% rise in December, and a sharp drop of 61.8% in January 2007.

The change in the stock of new orders for buildings was much less positive, as this was down by 24.8% in January, following a 4.3% yr/yr increase in December and a decline of 5.4% yr/yr in January 2007. New orders at current prices were down to HUF 42 bn from HUF 116.2 bn in Dec.

At far as civil engineering is concerned the picture was much brighter since there was a massive 185.6% leap as against a drop of 3.8% in Dec and a plunge of 81.8% in January 2007.

Unfortunatley this is the one-off impact of a major contract sealed in January for the extension of the M6 motorway. In this sense we can see why the increase in total orders look vaguely positive, since a one off civil engineering contract to some extent compensated for the continuing decline in domestic housing construction. This is liable to happen from time to time with the arrival of EU funding, but since the general fical direction is towards tightening we should not be expecting to much positive news in this department.

The value of total construction industry production was HUF 87.6 billion in January, down from HUF 205 bn in Dec and HUF 115.3 bn in January 2007.

The Week Ahead

Well this looks like being a busy and active week in the Hungarian financial markets. Global conditions are hardly calm, and we face a slew of potentially very revealing macro economic data. The Monetary Council of the Hungarian Natioinal bank is holding is to hold a non-rate-setting meeting today. Although we are unlikely to see any surprises here, it does give members of the council an opportunity to make their views known to the press in a way which might be considered as "steering" future expectations.

With this in view Monetary Council member Péter Bihari has not let us down, since this morning he went on the record as saying that needs to raise interest rates to defend its inflation target and narrow the gap between the base rate and much higher government debt yields. Since Bihari is regarded as a somewhat dovish member of the 12-strong MPC, his remarks are important, and especially the fact that he argues for monetary tightening in connection with the rapid incrrease in yields we have ben seeing in the government debt market. Bihari's statement could also be regarding as presenting the more or less "politically correct" view in the face of the recent statement from fellow policymaker Tamás Bánfi to the effect that it was no longer realistic to target 3% inflation for 2009.

More evidence of market expectations for an imminent rise in interest rates came this morning when Hungary's Government Debt Management Agency (ÁKK) sold at auction HUF 40 bn 4-week liquidity discount T-bills at an auction on Monday. The offer was well oversubscribed and the original amount on offer went for an average yield of 8.90%, a rate which could be interpreted as indicating that the market expects a rate hike (or hikes) of some 150 basis points over the coming month or so.

Of course the yield on government bonds indicates that interest rates should move in one direction, while some of the fundamentals being expressed in the macro economic data we are going to get sight of later in the week may well suggest they should in fact move in the opposite direction. Tomorrow the Central Statistics Office (KSH) will publish the January construction data, while the Finance Ministry is scheduled to hold a press conference giving details on February's budget processes. Last week the ministry reported a HUF 215.9 bn deficit for the second month of the year, better than the previously projected a gap of HUF 219.8 bn (on a cash-flow basis, excluding local governments). The finance ministry will almost certainly be very vigilant on these numbers in the coming months, since they will almost certainly want to avoid and suggestion that they are loosening the fiscal purse strings in the aftermath of the recent referendum. Indeed Prime Minister Ferenc Gyurcsany was notably at pains to reassure markets in the Hungarian Parliament this morning, stressing the fact that Hungary's government may now have even less room to reduce taxes in 2009 after voters on March 9 abolished a number of medical and university tuition fees.

The referendum, in which Hungarians voted against the government's measures by a margin of four to one, may unnerve investors and increase borrowing costs, eating into funds for the tax cuts, Gyurcsany said. The Hungarian government had been discussing tax cut proposals worth as much as 250 billion forint ($1.5 billion) to boost economic growth, which was down to an annual 0.8 percent in the fourth quarter, the slowest in 11 years. Hungary is currently trying to reduce the widest budget deficit in the European Union, from 9.2 percent of gross domestic product in 2006 to 3.2 percent next year, and the earlier talk of tax cuts had raised criticism from the European Comission and the Ratings Agency Standard and Poor's.

Then on Wednesday the KSH will publish January employment and wage data while on Friday we will have the January retail sales figures. As I say, the combination of all this macro data should enable us to carry out some sort of effective interim weather check on the state and prospects of the Hungarian economy, always provided, of course, that developemnts in the golbal financial markets leave us with the tranquility to be able to do so.

Another Bad Friday in Budapest

Oh why is it always Friday, we may ask ourselves, that things get choppy in Budapest! I say this since in each of the three last weeks the greatest pressure seems to come on HUF denominated instruments on a Friday. This morning "efficient cause" was the release by Standard & Poor's Ratings Services of a revision to its Hungary outlook on Hungary to ‘Negative' from ‘Stable' reflecting the “weakening perspective for sustained consolidation of public finances".

“We believe that the increasing political incentives and pressure to dilute the fiscal reforms ahead of upcoming elections, coupled with the increasing cost of external borrowing, will interrupt Hungary's progress in reducing its deficit from 2009 and will keep the debt burden rising," said Standard & Poor's credit analyst Frank Gill.

They argue that political opposition to budgetary reform is increasing and cite - obviously, whoever could have thought otherwise - the results of the 9 March referendum which reflected a weakening in the government's mandate a large majority of Hungarian voters rejected highly sysmbolic aspects of the package.

“The defeat will not meaningfully increase this year's budget deficit but it nevertheless confirms fading appetite among Hungarians to continue with the consolidation process. The recent ill-timed announcement of various tax-cutting proposals for 2009 (ranging from 0.7% to 1.4% of GDP) point in the same direction. Moreover, the possibility of new opposition referenda, which amount to votes of no confidence in Prime Minister Gyurcsány's fiscal reform plan, will further undermine the government's goal of reducing public sector debt dependency"

S&P sees important dangers of slippage in Hungary's public sector deficit reducing programme, with the deficit only coming down to 4.5% of GDP this year (while the government target is 4%) from an estimated 5.7% in 2007 and a massive 9.2% in 2006. More importantly, S&P forecast that budgetary deficits will remain unchanged in 2009 and 2010. The cabinet's agreed aim is to reach a deficit of 3.2% of GDP next year.

Hungary's Finance Minister János Veres dived straight into the fray this morning asserting that Hungary's public sector deficit will drop below 4.0% of GDP this year and that the government has no intention of changing its deficit reduction path set out in 2006.

Personally I think it is very hard to put firm numbers on future budget deficit outcomes before we know the future path of Hungarian GDP growth (and it is noteworthy that Fitch Rating analyst David Heslam has come straight out today and said he thinks this year's deficit target can be met - long live competition between the agencies!). At the present time it is clear that the main risks are all downside, and in this context S&P's general slippage concerns would seem to be entirely justified. What this means is debt to GDP could rise even further, and S&P project a ratio of over 68% of GDP in 2010. In this context the following warning is an important one:

"Lack of a clear perspective for stabilization could eventually lead to a downward revision of the ratings, which would risk undermining investor confidence and could severely hamper Hungary's ability to refinance itself"

This warning should be taken very seriously by all those countries (like Italy) with rapidly ageing populations and important structural problems in achieving fiscal balance.

The Standard & Poor's revision was also commented on in Brussels by Hungarian Prime Minister Ferenc Gyurcsány, who said the change in credit outlook will cost the country billions (of forints). Gyurcsány said the credit rating agency became concerned after the outcome of the 9 March referendum, saying that it considerably diminished chances for Hungary to put in place the necessary structural reforms. This reaction is hardly surprising since Gyurcsany would obviously like to make political capital from it by making the point that it is the initiators of the referendum who are to be blamed for the outlook revision. Political gameplaying it may be, but that doesn't make his point any the less valid, I think.

Industrial Output Blues

To the already existing gloom was added the impact of Hungary's final adjusted output figures which showed that industrial output inched up by 1.0% month on month in January, according to final figures adjusted seasonally and by working days, the Central Statistics Office (KSH). This rate was a downward adjustment from a preliminary 1.3% growth reported earlier. The month on month increase in Dec 2007 was also 1.0% (adjusted upward from 0.9%). So while the short term performance is far from a disaster (although clearly not sufficient to pull forward the now export dependent Hungarain economy) since output volume has risen now for the third consecutive month, today's detailed figures do paint a very gloomy picture on the extent of the likely future deceleration of growth. Total new orders for industrial products were down 2.5% year on yearr in January. New exports orders were up 0.8% year on year, but domestic orders slumped by 11.9%. Total orders dipped by 9.2% year on year. Since Hungary is so highly interlocked with Germany, and further slowdown in the German economy will be sorely felt in Hungary.



The response to all this gloom wasn't long in arriving since the forint was back down in 260 to the euro territory falling 0.6 percent to 259.97 per euro, after trading at a two-week high of 257.07 earlier, up from 258.48 late yesterday. Today's trading follows a very volatile session on Thursday (euro/HUF even reached 262 at one point), and the rapid rise in the yield curve at the long end ( with 10-yr bonds going at auction with an average yield set of 8.62% - up 115 base points on the previous auction of the same instrument) seems to be attracting investors, although evidently yields are now likely to be stuck at these very high levels.

Hungary Inflation February 2008

Hungary's inflation rate remained at more than double the central bank's target rate in February, reinforcing the general impression that policy makers will raise interest rates again, and probably as early as this month, even though this months annual rate was slightly down on the January one. Hungary's consumer prices rose in February by 1.1% month on month and by 6.9% year on year. There is still considerable debate among analysts about where end of the year inflation will be, although the consensus number seem to be somewhere in the region of 4.7%.

Seasonally adjusted core inflation was in fact up slightly at 5.3% year on year as compared with 5.2% in Jan 2008. The monthly rise in core inflation was 0.4% compared with 0.6% in January. Again this could be read as suggesting that pressure from "second round effects" stemming from the original increase in fuel, food and administered prices is still growing slightly.



Hungarian inflation has now consistently exceeded the central bank 3 percent target since August 2006, heading upward under pressure from global food and energy prices, and following "own goal" inflation pressures due to the increase in state administered prices as the Hungarian government lifted utility bills and social security contributions in an attempt to reduce a record budget deficit. Last months "bright idea" of attempting to fight inflation by trying to induce a stronger currency has foundered on the unwillingness of market participants to take the proposition seriously. In fact market players have been increasingly betting against the forint and trying to force higher interest payments, leaving policy makers with little alternative but to consider higher borrowing costs when they next meet on March 31.

Yields in the fixed income market continue to rise, and 3-month discount T-bills were sold at auction yesterday with the average yield set at 8.78%, up 33 basis points from Monday's benchmark fixing, and 69 bps higher than at the previous auction of the instrument a week ago. Meanwhile the forint continues to firm slightly, hovering close to the 260 level against the euro in morning trade today. This development is more a product of the cautiously optimistic global investor sentiment which followed the Fed's liquidity easing decision yesterday than a reflection of any underlying change in Hungarian fundamentals.


So the central bank continues to struggle, and its credibility is certainly under the microscope at this point. Last month they raised their inflation forecast to 3.6 percent from 3 percent for 2009 and to 5.2 percent from 5 percent for this year, and markets will be keen to observe how this situation evolves, both in terms of slippage on the forecast and in terms of attitudes inside the bank itself. Really the bank have set themselves a pretty high inflation target for this year (since most market analysts year end inflation comfortably below 5%, although the rate of deceleration is still unclear), so we could be more or less optimistic on the delivery count here, but we do need to note that core inflation (which strips out volatile food and energy prices, and is one of the central bank's most closely watched indicators) rose this month to an annual 5.3 percent from 5.2 percent in January.

The February price increases were still largely driven by food and energy costs. The price of natural gas rose 15.4 percent and power prices increased 9.8 percent in a month while the cost of cooking oil rose 4.2 percent.

February's annual consumer price index reading was thus influenced by a number of factors. It was evidently pushed higher by a rise in fuels prices, the delayed accounting of several regulatory price hikes, but we also saw the ending of the deflation process in consumer durables. This latter component could be attributed to some extent to the weakening in the forint, although - since consumer durable prices rose by 0.2% on the month after rising by 0.1% in January - an accelerating increase in this component so early in the year should certainly raise some eyebrows. Downward pressure was exerted on CPI by the base effects of the fact that several of last year's sharp price hikes - in e.g. medicines - fell out of the index.

Services prices rises decelerated, increasing by 0.7% on the month following a 1.7% increase in January, which seems to confirm the view that the bulk of the administrative price changes had already shown up in the index in the previous month.

All in all a most difficult picture for the central bank who are certainly ging to face some hard decisions in the coming months, as the needs of Hungarian internal demand would seem to indicate monetary loosening, while the inflation problem and the need to protect the forint make tightening an almost foregone conclusion.

Hungary Q4 2007 GDP Detailed Breakdown

Hungary's gross domestic product grew by 0.1% quarter on quarter in the fourth quarter of 2007, according to revised seasonally and working day adjusted data published by the Central Statistics Office (KSH) last Friday. Hungarian GDP at this point is virtually stationary and the largest adjusted quarter on quarter GDP growth during 2007 was the 0.2% rate achieved in Q3.

Economic growth in Q4 was 0.8% year on year on an unadjusted basis and 0.7% when allowance is made for working day impacts. The comparative figures in the previous quarter were 0.9% and 1.0%.



Hungarian economic growth thus came very close to total stagnation in 2007, and this does not bode well for 2008, when (even if financial market turbulence does not have a direct impact via forint effects) we can expect the central bank interest rate policy to continue to put downward pressure on real wages and hence domestic consumption, further fiscal tightening on the government front to restrain government spending (the deficit was still at 5.6% in 2007) and a worsening in the external environoment and in price competitiveness (via domestic) price inflation to mean that little in the way of meaningful growth is likely even if Hungary doesn't fall straight into outright recession.



The engine of what growth there was last year was industrial output, which achieved a 6.2% year on year growth, this being largely attributable to the strong 10.4% rate of export growth. Within the industrial sector manufacturing industry grew by 6.8% year on year.

despite the fact that total fixed capital investments were largely flat over the year (due mainly to the collapse in construction activity) the level of investment in machinery and equipment grew by 10.9% in 2007, with the increase being largely driven by investments of manufacturing industry. The volume of other investments (which have little weight in the total) rose by 8.3%, while construction investment decreased by 6.8%. In 2007 the manufacturing component - which constitutes 25% of total investment - expanded significantly, by 23.9%. Unfortunately we may be seeing to some extent here the "one off effects" of the construction and installation of the 500 million euro factory which was built for South Korea's largest tyre maker Hankook Tire in Dunaujvaros during 2007 - and it may be hard in the present climate to attract similarly important projects in the near future - since within manufacturing itself the statistics office highlight the high value of investments in the manufacture of rubber and plastic products as playing an important part. Nonetheless the investment increase was also deemed to be significant in the manufacture of electrical and optical equipment, radio, television and communication apparatus as well as in manufacture of transport equipment.

The only slight glimmer of hope in the whole bleak Hungarian outlook I can find at the moment could be that very slight uptick in total fixed capital investment - on a year over year basis - that we can identify in the chart above toward the end of the year. Construction may be now bottoming out, and even if we should not expect much in the way of growth it will gradually cease to be a drag on the situation. So if the manufacturing investment component can continue to rise, and create jobs, and the price competitiveness issue can be resolved, then in the medium term we could see more and more in the way of export driven growth. But this is early days yet, and there are plenty of very difficult hurdles to get across before we reach there from here.

Annual economic growth in the whole of 2007 came in at 1.3%, greatly below the expectations of most analysts. This was the smallest annual GDP growth rate in the whole Europe Union.

For the rest there were few surprises in Q4, with private consumption remaining in negative territory (although slightly less negative than in Q3). Surprisingly government consumption was up considerably (+5.5% vs -6.1% year on year on average in previous three quarters) and this pushed total domestic consumption up to -0.3%year on year from -2.3% year on year in Q3. This boost from government spending is hardly likely to be sustainable in the coming quarters.

In the chart below we can see that private household consumption generally did better than total household consumption since the latter includes government transfers to housholds, which of course have been considerably down, and are likely to continue to remain down.



On the production side, there was a slight uptick in services that saved the aggregate reading from slipping to even lower levels. Services accelerated to a 1.8% year on year rate - up from 1.2% in Q3, despite an across the board weakness in the other components. In the services category the relatively strong performace of financial and real estate services (up 2.7% year on year) is worthy of note.

Growth rates in this sector are of course well down on the peaks in 2002 and 2005, but still, something is better than nothing. If we look at the chart for Real Estate and Financial Services as a % of total GDP on the production side we can see that - despite a sharp fall in the autumn of 2006 - the share has generally been up over the last two years.



What makes this uptick just a little worrying from a sustainability point of view is that it coincides in time with the very strong increase in Swiss Franc mortgage activity, and in particular in the contracting of mortgage finance for personal consumption (refis, or equity withdrawals, see chart below ) and this source of temporary underpinning for domestic consumption may turn into a clear liability if there is any sort of sharp increase in risk aversion in the financial markets.

Sunday's Referendum in Hungary

Hungarians are set to vote tomorrow on whether to scrap government-imposed fees on visits to doctors and hospitals in a referendum that may initiate a period of political instability as Prime Minister Ferenc Gyurcsany's fights to maintain the credibility and integrity of his adjustment programme.

The ballot which is sponsored by the opposition Fidesz party proposes the abandonment of the charges for doctors visits, typically 300 forint (1.30 euro)per visit, for hospital stays and university tuition fees. These were introduced a year ago as part of the Socialist government's attempt to put some order into Hungary's large budget deficit problem. Voters are being asked to offer a straightforward "yes" or "no" decision on each of the three issues.

The referendum is expected to result in a rejection of the charges, and one survey of 1,200 voters by Budapest-based pollster Median showed that 61 percent of those who expressed the intention of voting supported the abolition of the fees. The poll, published on Feb. 27, had a margin of error of between 2 and 5 percentage points. For the referendum to be valid and have effect at least 25% of the eligible voting population will need to vote in favour of rejection of the charges (since even if less than 25% vote on each side the status quo would prevail, the referendum would fail, and the charges would say in place). At the present point the polls indicate a turnout of around 40% of eligible voters, but they have been very unreliable in the past, and it would still seem that with 61% being for abolition the validity of the result (a majority in favour of rejection of the charges seems more or less assured) will be a touch and go affair.

The next step, if the referendum were to be valid,would be for the Hungarian parliament to vote to scrap the measures (constitutionally it will have until January 2009 to do this, but there is every indication that in the evetuality this was the verdict they would act earlier, possibly within a few weeks of the vote).

Many commentators are suggesting the referendum could constitute a point of no return "breaking point" for the Gyurcsany administration.

The biggest opposition party, Fidesz, has taken advantage of a clause in the Hungarian constitution that permits referendums on specific government policies if sufficient signatures are gathered in order to attempt to undermine the authority of the current government and try to force elections. In my opinion they are being pretty opportunistic about this whole affair, since while the particular details of the present package may certainly be open to legitimate debate, there is no doubt that a large majority of those voting against these measures will be voting against coming to terms with the fact that Hungary has an ageing and shrinking population, and in these circumstances (and being a poorish country to boot) high quality free health care is going to be a very hard objective to sustain financially. That is, at this point in time a majority of Hungarians are undoubtedly still in denial on the severity of their economic situation, and the difficulties involved in sustaining a health and welfare system in current circumstances.

Opinion polls are now showing that most Hungarians are badly disillusioned with Gyurcsany and favour his departure following the implementing of an austerity programme which cut public jobs and raised taxes and utility prices in order to reduce what had become a balooning fiscal deficit, fueling protests that even on occasion turned into violent street riots in mid 2006.

Support for Fidesz was running at 35 percent support in February, compared with 17 percent for the Socialists, according to a poll of 1,500 voters by Budapest-based Szonda Ipsos. Gyurcsany's personal approval rating was 28 percent, compared with Fidesz leader Viktor Orban's 45 percent. The poll had a margin of error of 2.5 percentage points.

Gallup in their February poll found 42% support for Fidesz among eligible voters, up 4 percentage points from a month earlier, while support for the MSZP edged up 2 percentage points to 15%. Gallup also said that 19% of the respondents felt the Prime Minister was doing a good job, while 69% of them felt he was not delivering, as he should. In January 71% of those polled had said Gyurcsány was doing a bad job.




Viktor Orban first called for this vote during a rally in Budapest back in October 2006. Since that time he has called repeatedly for Gyurcsany's resignation.

``The government is legal but not legitimate, because the people do not accept it,'' Orban told reporters on Feb. 27. ``Leadership, policy, something must be changed. An early election could be a solution.''

Gyurcsany has so far remained defiant, rejecting calls for his resignation. He has said he will stay on regardless of the referendum's outcome, but as we have seen yesterday, whether events in the financial markets will give him the possibility of staying on even as his authority - like the liquidity in Hungaries financial markets - evaporates remains to be seen.

"After March 9, it will be March 10" he wrote on his Internet diary on Feb. 22. "The politics that we started will continue on the 10th."

Formally Gyurcsany can only be removed against his will by a majority vote in parliament. His party and its coalition partner, the Free Democrats' Alliance, have consistently given him their backing in difficult moments such as the confidence vote in October 2006 and can be expected to continuie to do so. But will Gyurcsany have the will to continue in office should he lose the referendum and the central bank, as seems likely, find itself forced to tighten Hungary's already high interest rate even further? This would seem to be a much more open question.

And even if Gyurcsany does decide to soldier-on his defeat in the referendum would undoubtedly serve to increase pressure for fiscal loosening ahead of the 2010 general elections. We have already seen some indication of the growing pressure in this direction, and on Feb. 18 Gyurcsany announced a package of tax relief measures intended to boost the country’s stagnating economy, saying, "Our primary target is to create jobs by lowering the tax burden. (...) The government is aware that payroll taxes have to be reduced to have fewer obstacles to legal employment." This change in tone and direction has already caused the EU Commission to give Hungary a specific and explicit warning, since it is not at all clear how the deficit can be reduced and taxes lowered at one and the same time. Or at least this can't be done without very large changes in the scope and quality of the free social services provision which makes up a significant part of the spending which the taxes are used for, and this is just what electors may be about to vote against today.

Again even if the rumour were worse than the reality here, Gyurcsany might well have to work hard to convince sceptical market participants that a further deterioration in the deficit wasn't about to take place. In other words, after tomorrow, and happen what may happen in terms of the outcome, the pressure is really going to be on this administration, and it isn't going to lessen anytime soon.

The Charges Themselves


The fees which are at issue were first introduced a year ago, involve fees for doctors vistits and hospital stays, and the introduction of university tuition fees. One of their objectives is to discourage unnecessary use of state medical resources in a country which currently has one of the highest per capita rates of doctor's visits in Europe. In 2005, the average adult in Hungary made 12.6 visits to the doctor a year, compared with 7.5 by Belgians and 5.4 by the Dutch, according to the latest available figures from the Organization for Economic Cooperation and Development.

The charges have added around 21 billion forint to doctors' incomes, the Health Ministry says, while the resulting 25 percent decline in visits allowed the state to save about 15 billion forint on drugs, the Ministry estimates. Clearly what is at stake tomorrow isn't especially the actual revenue received, since the government estimates that losing the fee revenues would cost them no more than HUF50bn ($289m, €189m) but rather the whole principle of the reform process.

Among those defending the fees is Miklos Szocska, acting director of the Health Services Management Training Center at Semmelweis University in Budapest. Abolishing the fees may discourage investment in health-care infrastructure he suggests, and as he pointed out at a press conference in Budapest last month: "The issue is, where will the health-care system get its resources" since if the referendum triumphs "the profit-producing potential of health care will be restricted." The decision to allow for-profit firms to buy stakes in the state-controlled health insurance companies has been especially unpopular.

And Szocska isn't alone in his worries here. The EU Commission itself only last month warned the Hungarian government that that slower-than-forecast economic growth over the next two years may adversly affect deficit-cutting plans and far from suggesting the present charges were unnecessary in fact advised the government to take further measures if needed. Indeed the Commission specifically identify age-related spending and health, education and pension structural reform as urgent and pressing priorities for any Hungarian adminstration.

In view of the Commission assessment and of the recommendation under Article 104 of 10 October 2006 and given the need to ensure sustainable convergence, the Council should invite Hungary to: (i) rigorously implement the 2008 budget, take adequate action to ensure the correction of the excessive deficit by 2009 as planned; where necessary through additional measures; and allocate the better-than-expected revenues to further deficit reduction, also given the insufficient margin in 2009 in view of the risks, thereby also contributing to accelerating the pace of debt reduction towards the 60% of GDP threshold; (ii) ensure permanent expenditure moderation by continuing to enhance fiscal rules and institutions and by adopting and swiftly implementing the remaining streamlining measures announced in the fields of public administration, healthcare, and the education system; (iii) in view of the level of debt and the increase in age-related expenditure, improve the long-term sustainability of public finances by making adequate progress towards the MTO, and continue to reform the pension system as announced after the initial steps taken in 2006-2007.

The problem is not only the existence of a short term annual deficit, but rather that the level of Hungarian state indebtedness still stands above the 60% of GDP Eu limit - at a level of 65.9% of GDP in 2007.



While the median age of the Hungarian population is about to shoot up over the next decade:



Clearly the short term future of the Hungarian economy may well be decided tomorrow, since if the electorate decide to make the governments position impossible, the financial markets may well prove to be unforgiving. But longer term it gets even worse, since the challenges are enormous. Perhaps the whole thing is easily summarised in two graphs moving in opposite directions. First we have the total Hungarian population which will steadily decline in size between now and 2020.




The we have the over 60 population, which of course moves in the opposite direction, rising by roughly 25%, from just below 2 million to just over 2.5 million.




Update Sunday Evening: at 22:00 CET according to data on the Hungarian National Election Office Referendum Website with 95.52% of the vote counted the results are as follows:

Abolish the Daily Hopspital Fee "Yes by 84.37% to 15.683%
Abolish the Consultation Fee "Yes" by 82.73% to 17.27%
Abolish the Tuition Fee "Yes" by 82.53% to 17.47%

The referendum is thus valid in all three cases and the charges now will have to be abandoned.

Postcript

Since writing the above post I have come across a very well written and well informed blog by a Hungarian living in the United States (see here). While most of the press have been busy talking about how surprising the outcome is, our erstwhile blogger is basically unphased. He, like me, could see this one comin a mile off. And he also sees the significance of what has just happened. Perhaps I would write and say things in a rather different way, but in essence I think the following extract sums up what it has all been about:

The overwhelming percentage of "yes" votes should not have been surprising, even though the Pollyannas (including me) hoped for less of a thumping. What nobody foresaw was the large turnout: slightly over 50% of all eligible voters went out, and over 80% of those who voted said "yes" (in effect "no") to three cleverly worded questions about co-payment, daily hospital fee, and tuition. They don't want to pay. Understandable. Unfortunately, the overwhelming rejection of the introduced changes means a bit more than simple answers to three simple questions. It means, in my opinion, that the overwhelming majority of the Hungarian people doesn't want any part of the New Hungary Ferenc Gyurcsány talks so much about. They don't want to change. They don't want to accept the new rules of a new game. They want to be taken care of by the state. They believe that the state will find the way to support them, provide them with free university education and with absolutely free medical services (not counting the envelopes, of course, but they are accustomed to that). Where will the money come from? They don't rightly care.

..........it is obvious that the "re-education" of the Hungarian people has failed miserably. What to do in this department? The often mentioned criticism about the lack of good communication is, in my opinion, not the real culprit. They explained, and explained, and explained. The problem is not with the understanding. The problem is that the majority has equivocally rejected this new concept of the relation between state and citizen.

Will Hungary's 2008 referendum bring about Gyurcsany's downfall?

Guest post by Manuel Alvarez-Rivera, Election Resources on the Internet

Hungary held today a referendum on fees for visits to the doctor, hospital stays and university tuition, which were imposed by the Socialist-Liberal coalition government of Prime Minister Ferenc Gyurcsany, as part of an austerity package to reduce the country's large budget deficit - the highest in the European Union as a percentage of GDP - and pave the way for Hungary's adoption of the euro as its currency. The referendum, which was called after the conservative Fidesz-Hungarian Civic Union - Hungary's main opposition party - collected enough signatures to force a vote on repeal of the fees, has become a test for Gyurcsany's government, which advocates their retention.

With most electoral districts reporting, results so far confirm findings from opinion polls which indicated the proposals would pass by a large margin, but the outcome of the referendum won't be binding unless votes in favor of the proposals constitute both a majority of ballots cast and more than one-quarter of the number of eligible citizens. However, the latest figures indicate just over half the electorate turned out to vote, and the vote appears all but certain to be conclusive.

Hungary's National Election Office has referendum results in English and Hungarian.

Since 2002, Hungary has been ruled by a coalition of the post-communist Hungarian Socialist Party (MSZP) and the liberal Alliance of Free Democrats (SZDSZ). Prime Minister Gyurcsany, a former minister of children, youth and sports, has been in office since August 2004, when he replaced Peter Medgyessy - who had lost the confidence of the ruling parties - as head of government and leader of the Socialist Party. With Gyurcsany at the helm, the ruling coalition went on to prevail in the April 2006 parliamentary election, increasing its narrow parliamentary majority and becoming the first Hungarian government since the fall of Communism to be returned to office. However, in September 2006 a leaked tape revealed that Gyurcsany had lied about the state of the Hungarian economy to secure re-election.

The revelation, which triggered widespread protests that degenerated into rioting, proved to be extremely damaging for the government. The following month, the ruling alliance was heavily defeated in municipal elections, yet despite mounting calls for his resignation, Gyurcsany refused to step down, and won a subsequent vote of confidence in the National Assembly (Parliament). Nonetheless, Gyurcsany's government has yet to recover from the events of two years ago. Opinion polls indicate Fidesz would score a landslide victory if early elections were held this year, and the referendum results are likely to increase pressure on Prime Minister Gyurcsany to step down.

The 386-seat Hungarian National Assembly is elected by one of the world's most complicated electoral systems, which combines French-style runoff voting in single-member constituencies with county-based, party-list proportional representation and a cumbersome top-up national list intended to compensate parties for the disparities between votes and seats introduced by runoff voting at the constituency level and (to a lesser degree) PR at the county level. Part I of Elections to the Hungarian National Assembly has detailed results of parliamentary elections in Hungary since 1990.

Black Friday in Budapest?

Question: how do you know they are holding a referendum on the government's difficult and unpopular economic adjustment package in Hungary on Sunday? Answer: take a look at what happened in the Hungarian financial markets on Friday.

It should not have been too difficult to see all this coming, yet financial analysts seem to have been strangely silent on the potential implications of the latest political twist in Hungary's ongoing economic agony. And where they have not been silent they have generall been trying to downplay its importance. Only last week Goldman Sachs' Hungarian analyst István Zsoldos was busy reassuring us that the coming referendum would have no lasting impact on the evolution of Hungary's long drawn out economic crisis (although he did admit that the short-term political noise was “likely to intensify"). I beg to differ. I think the consequences of Sunday's vote are going to be important and long lasting (indeed I had the referendum pencilled in in this post as the third of my potential tipping points for Hungary's economy, with the the second one being the last interest rate setting meeting of the central bank, when, of course, they did scrap the currency band), and they are going to be important and long lasting regardless of whether or not the Hungarian authorities manage to plug the now growing breach in their credibility and the value of HUF denominated instruments in the short term.


So why is there a problem? Well, anyone with even a passing and cursory knowledge of political and financial crises should know by now that you can't forever fill the growing disatisfaction of a population with their lack of nice fresh bread by sending them over cake for ever. Basically, any government has a limited amount of ammunition stacked in the chamber (which is why you need to be careful how you fire it off) and once your bullets are spent, or you get to fire off as many as you are able before your voters finally get mad, then you need to watch out, since events have a nasty habit of moving swiftly. And this is what is starting to happen right now, before our very eyes in Hungary.

Hungary had a sudden financial crisis back in the summer of 2006, on the back of a massive "twin" deficit (ie fiscal and current account) problem, and subsequent to this the government introduced a series of "austerity measures" principally designed to try and correct the fiscal deficit situation. The core of this package was a downsizing of government spending (including a reduction in services and employment in the public sector), and an increase in social security contributions, charges for the state administered utility sector, and individual charges for clients in the state health and education system. The first two of these have played no little part in generating the dynamic which means that Hungary is now labouring under a 7% inflation rate, while the latter (the health and education charges, and their constitutionality) constitute the core of the issue for Sunday's referendum.

Basically the government has become highly unpopular on the back of the package and its evident lack of success in resolving the underlying issues facing Hungary (see chart below, Fidesz is the opposition and MSZP the government) and the opposition are trying (pretty opportunistically in my view) to create a climate of "no confidence" in the government in the hope of achieving early elections.

What I am not saying is that voters will be right to reject the parts of the austerity package they are being asked to vote on on Sunday. Far from it. The new social welfare charges may or may not be an intelligent way of adressing the issue to hand, but they do now constitute the symbolic core of the adjustment process, and rejecting them will be tantamount to rejecting the whole process which lies behind them. Hungary is poor, and has a rapidly ageing and steadily declining working population, and you can't give yourself a five star welfare service if you only have a two star economy. There is just no way you can pay for it, whatever the politicians say. So somewhere or other along the line the Hungarian people are going to have to accept that they will have to cut their coat according to their cloth, and this is what Sunday's vote is all about in my book.

The problem now is that there are various kinds of realism at work here, one of these is the dynamic needed to face up to a hard and complex reality, and another is the kind of political realism that economic analysts have to factor in to their policy packages, since once citizens and voters get fed up with promised results which continually fail to arive - and this is what is starting to happen now in Hungary and why it is that all those "ever so optimistic" and rosy forecasts which have been busily going the rounds in Brusssels and Budapest of late are really so very very dangerous - then what were once upon a time sobre and calculating people may well become irrational, and economic policy has to take this kind of irrationality into account just as much as it takes the more normal kind of rational inflation expectations into account. Basically I think the Hungarian voters are reaching the limit of their endurance with being sold cake when all they really want is bread, and it is this weariness that we are about to see expreesed on Sunday, after which point, unfortunately, the credibility and legitimacy of the whole present adjusment process may well be increasingly called into question.

So Why Black Friday?

So why do I call it black Friday? Well yesterday morning the corridors of Budapest were as thick with rumour as they normally are with smoke. Things got off to a very early start (around 10:00 am Budapest time) with Portfolio Hungary announcing that an emergency meeting had been convened between the National Bank of Hungary (NBH), the Finance Ministry and the Government Debt Management Agency (ÁKK). The reason for the meeting was apparently that an "emergency situation" had arisen on the foreign exchange market, with liquidity having become "practically non-existent" and ... "even if contracts were being made, they would normally signal unrealistically high yield levels," as one Portfolio Hungary source is quoted as saying. (This description is so reminiscent of the Paribas statement on August 9th 2007 that liquidity in the european securitised wholesale money market had practically evaporated).

The purpose of the tripartite emergency meeting was ostensibly to decide on how to stabilise the market situation by making purchases on the bond market. Effectively this could be construed as being an emergency meeting of the Monetary Council of the central bank in advance of the next scheduled rate meeting due on 31 March.

No sooner had Portfolio Hungary made this announcement than one hour later (around 11:00 am) Judit Iglódi-Csató, communications director of the central bank, was out and about denying that any such meeting was taking place:

"The NBH has not held an extraordinary rate meeting and there was no extraordinary joint meeting by the NBH and the ÁKK,....The central bank has not intervened into fixed income market processes"

Ferenc Pichler, press chief at the Finance Ministry, was also entered the fray, issuing a statement to Portfolio Hungary rejecting the rumour about a joint meeting. He did acknowledge, however, that ÁKK officials had visited the NBH, but emphasized that talks were on a completely different matter.

Later the same morning, however, Hungary's Finance Minister János Veres accepted that the ministry did in fact hold talks with the Government Debt Management Agency (ÁKK) and the central bank (NBH) about the situation in the fixed-income market. He denied, however, knowledge of any central measure - like buying bonds - to be implemented in the secondary market. "There is no need for concern, experts are dealing with the situation," he is quoted as saying.

What has provoked all this concern has been the sudden jump in the benchmark three-year bond yields, which rose yesterday to the highest level since November 2004. Traders and analysts were busy speculating that this rise might force policy makers to raise the central banks benchmark interest rate, which is already (at 7.5%) the European Union's second-highest (after Romania), or to start buying back bonds to jumpstart the market after bond trading had suddenly dried up.


Bloomberg quote Marian Trippon, an economist at the local unit of Intesa Sanpaolo SpA, as saying "There is no market...Everybody is waiting on the sidelines, afraid to get in. If this is sustained and the government securities market ceases to exist, then the central bank can't watch idly."

Hungary's forint was down by more than 1% against the euro late yesterday afternoon and government securities yields leaped by some 20-30 basis points, partly as stop-loss contracts kicked in (forced sales). In the secondary market, yields leaped by 40-70 basis points from late Thursday levels (to levels which are currently around 10%).

The forint weakened further during the morning to 266.20 to the euro by 1:30 p.m. in Budapest from 264.44 late on Thursday, but it firmed again in late afternoon trade to around 264 although at the peak of negative sentiment in the morning session it was almost as weak as 267.


The yield on the benchmark three-year bond rose to 9.86 percent from 9.27 percent. The yield has now climbed more than 2 percentage points in a month. Market participants generally seem to be now pricing in a rate hike of around 100 bps within the next month. According to data from the Government Debt Management Agency (ÁKK), the yield on the 3-m T-bill jumped by 34 bps to 8.60% today (the base rate is 7.50%).

Hungarian bond yields started soaring a little over a week ago following the decision on Feb 28 by Peloton Partners LLP, a London-based hedge-fund firm, to begin liquidating its ABS Fund following "severe" losses on mortgage-backed debt. Then last Friday (29 February) a local bank was unable to sell a bond portfolio which lead the yield on the three-year bond to rise 46 basis points in a single day.


Following this the Hungarian debt management agency AKK revealed on March 3 that it was going to decrease the volume of government bonds it offered for sale by as much as 30 percent, while at the same time increasing its auctions of Treasury bills, which are closer to cash and viewed as safer. The agency made the decision after a joint meeting the biggest local bond traders.

The current situation has been described by Portfolio Hungary as a tsunami of risk aversion. Another indication of the growing scarcity of liquidity in the Hungarian market came on Thursday when the AKK sold HUF 35 bn of 12-month discount T-bills at an average yield of 8.51%. This yield was up another 6 basis points from Wednesday's benchmark fixing and was 28 bps higher than at the previous auction of the same instrument two weeks ago.

Hungarian central bank (NBH) Governor András Simor and MPC member Gábor Oblath have both been working hard to try to maintain the central banks credibility in the present situation, in particular by vigourously stressing earlier in the week that the national bank remained strongly committed to achieving its present inflation target. This is viewed as being important, since it is an indication of the bank's intention to remain firm on interest rates in the face of what must be growing political pressure to do something to support weakening domestic demand and to slow down the steady rise in unemployment.

Reacting to recent rumours about the possibility of the bank abandoning its target Simor said that such rumours were “ridiculous and unfounded", while Gábor Oblath stressed that the National Bank would obviously need to resort to monetary tightening if prolonged weakness of the forint began to threatenen the target. This may well be where we are now. And central bank policy may well be driven by the need to support the forint rather than address the economic stagflation position - rising inflation and falling growth, see chart below - which is resulting from the collapse of internal demand.



But the bank will only be able to maintain this stance for as long as the voters are willing to accept the medicine. Hence the importance of Sunday's vote. We are in the garden of the forking paths, where political and economic dynamics both intercept and separate, and who knows at this point just what pace of evolution we will see in each of them.

Household Currency Risk

The principal preoccupation of the central bank, and the spine stiffner for their resolve to defend the currency value, comes of course from household exposure to rapid currency adjustments via their loan portfolio. Nearly 60% of the outstanding loanscurrently being paid by Hungarian households were FX-based at the end of January, and any forint weakening, and especially any weakening against the Swiss Franc (the euro is in fact virtually irrelevant here), represents a substantial potential distress burden for all of those involved. According to figures provided earlier this week by the National Bank of Hungary (NBH) the weakening of the HUF in and of itself boosted household debts to banks by HUF 189 billion in January alone (since with the loans being measured in Swiss Francs, as the forint goes down the loans go up).

Loans granted to the household sector rose by HUF 274.1 bn or 4.5% (to the new high of HUF 6,190.9 bn) in January. Forint loans were down in fact down (by HUF 16 bn) and all of the increase was in foreign currency loans (up by HUF 290.1 bn). Exchange rate valuation effects directly contributed HUF 189.2 bn, to the increase in the value of foreign currency loans held. This latter development is largely due to the fact that the HUF weakened by nearly 5% against the CHF between end-December and end-January. The forint's depreciation versus the euro was 2% during the same period, but as I said the euro is virtually irrelevant here.

Since the HUF weakened by further 4% vis a vis the CHF in February we can be pretty sure that the household burden grew further simply due to the weaker forint in the second month of the year too. If we look at the HUF-CHF chart for the last couple of years we can see that while the forint has deteriorated against the CHF since June last year, HUF values are still well above what they reached in June/July 2006.




So anyone who took out CHF loans in mid 2006 would still be well protected at this point in time. Unfortunately, if we come to look at the term profile of the contracted loans we will see that foreign loan mortgage finance is heavily weighted towards the second half of the two year period (2006 - 2007).




In fact in recent times the share of foreign currency loans within the total has only risen and risen. In January it was up to 57.3% from 55.0% in December. This ratio has been rising continuously over the past two years, and in January 2007 it was nearly twice the level of January 2005. Within aggregate loans to households, housing loans expanded by 4% to HUF 3,260 billion, and foreign currency loans rose to 48.8% from 46.4% as a percentage of housing loans. Of particular note is the fact that the stock of mortgage loans for consumption grew by nearly 13% in January over December, to HUF 1,383 billion, and this increase can be attributed almost exclusively to a rise in the stock of CHF-denominated loans.



So basically domestic consumption demand in Hungary is now very much being held to ransom by future movements in the valuation of the forint vis a vis that of the Swiss Franc, with the Hungarian Central Bank's ability to do anything meaningful to soften the severity of Hungary's current economic crisis being reduced to an effective zero. Hungarian citizens should consider themselves lucky in the coming months if they do not face a sharp tightening in monetary conditions simply generated by the need to protect the currency (as a say above the markets a currently pricing in at least a 100 base point increase in the central bank rate). Since movement in the value of the CHF is particularly hard to forsee, and doubly so given its potential role as a safe haven currency in times of global uncertainty, I basically still can't really understand how what would appear to be otherwise reasonably rational and intelligent people (the central bankers and those responsible for Hungary's financial affairs) allowed private debt exposure to currency movements to reach this state of affairs in the first place.