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Thursday, March 19, 2009

Hungary, Watching A Tragedy Unfold

According to Secretary of State at the Hungarian Finance Ministry László Keller Hungary will post a public sector deficit of HUF 332.9 billion in March, up from the preliminary forecast of HUF 329.8 bn made only a month ago. At the same time the Finance Ministry has left its full-year deficit projection of HUF 730.6 bn virtually unchanged from the one made a month ago HUF 729.9 bn. (In fact the entire Q1 deficit is expected to run to HUF 581bn or 2.2% of annual GDP. There is a strong seasonal component here, and for comparative purposes we could note that the actual deficit for Q1 was HUF 508bn or 1.9% of GDP, so while the situation is not good, it may not be as bad as it seems - see comments).

As the months pass the ability of the government to live up to its budget objectives seems more and more remote, despite constant reassurances from Keller that “The cabinet is in control of the situation" and that “The government wants to keep the budget deficit under 3.0% (of GDP) at all costs".

The root of the problem is that the slowdown in Germany and other customers for Hungary's exports is much deeper (and likely to be of longer duration) than was originally anticipated. As a result, the Hungarian government's growth forecast of a 3.0-3.5% contraction this year now looks rather high, with the median estimate of analysts in a Reuters poll published this week suggesting Hungary's economy will contract by 4.5% in 2009 despite pleas from Keller to “stop the race" in who can forecast a bigger economic contraction for Hungary. The most pessimistic prognosis in the current Reuters survey is for a 5.6% fall, and I'd have to admit, despite being reasonably positive about the export potential for the Hungarian economy in the mid term, that from the data I am seeing, the 5% to 5.5% contraction range doesn't look at all exaggerated.

Data like the fact that January gross wages in Hungary fell by a significant amount - 5.2% year on year. The most important reason for such a drop was a cut in wages in the public sector (bonuses and premiums) where salaries fell by almost a quarter (-23,7%)compared to January 2008. In fact most of this was due to a reduction in earnings rather than basic wages, since basic pay excluding bonuses actually increased by 5.1% (5.8% in private and 3.4% in public sectors). Equally important is the rapid deterioration in purchasing power, since in real terms earnings fell by 6.9% year on year which supports the view that the economy will contract pretty sharply in 2009, and especially given the constraints on government spending resulting from the IMF programme. Equally important is the haemorrhage in jobs from the private sector with employment down by a hefty 3.5% year on year.

And another of these data points comes from the announcement that Hungary's construction industry output dropped by massive 16% year on year in January 2009, following an almost recovery like rise of 3.7% in the previous month. Even more shocking is the month-on-month number that showed a 13.8% drop, seasonally and working days adjusted numbers. Hungary's construction sector is now well and truly back in a very deep slump.

All of which makes Angela Merkel's statement today that European Union countries that run into a financial crisis can count on international help sound pretty hollow.

“We will help member states that get into a financial emergency,” Merkel said today in a speech to the parliament in Berlin before attending an EU summit in Brussels. “We showed that in the cases of Hungary and Latvia. And if it hits other member states, we will do the same"....EU countries in financial straits “can count on our solidarity -- we’ve repeatedly made that clear,” she said.

Well, as I made clear in this post, the Hungarian economy is not as bad as it is being made out to be in the medium term, although what it now needs more than anything is "incubation". The current measures can't work, the 3% deficit is almost unattainable, and more cuts will be counterproductive. What Hungary needs isn't Balance of Payments assistance, but real economic support. Nice words don't help here, what we need are facts and deeds. A tragedy is about to happen, it would be more than a pity if it wasn't averted.


Anonymous said...

Dear Edward,

HUF 332bn is not the expected cumulative deficit figure for Q1, it is the expected deficit figure for March alone. The Q1 deficit is expected at HUF 581bn or 2.2% of annual GDP. Please, note on the other hand that all this is flavoured by seasonality. Last year, the actual deficit for Q1 was HUF 508bn or 1.9% of GDP. This means the figure expected for Q1 this year is worse, but not necessarily a tragedy in itself. The other aspects you are mentioning are quite bad of course, but once again, you could equally speak more broadly of a European tragedy unfolding (see the latest industrial output data from Eurostat). In this sense, Hungary's "tragedy" could be that it is located in Europe, though I personally believe that it is much more of a good thing in the end.


Edward Hugh said...

Hello analyst,

Thanks a lot for this bit about the deficit. I was wondering about that, since the piece in Portfolio Hungary wasn't clear. But I couldn't believe that with a whole year target as low as it is, they would get such a high deficit in one month. But the thing is these payments are volatile from month to month.

Nonetheless I find the Q1 number (which I will incorporate in the post) most worrying, and this may offer some kind of explanation for the PM's resignation today. At least it is a threat that serious additional cuts are needed.

But this is why I describe the thing as a tragedy, since my feeling is that the more you cut the more you contract and the more you need to cut again, at this point. Sure, by the time we get to 2011 or 2012 this can all come to an end, but where will Hungarian debt to GDP be by that point, and what hope of Maastrict type euro entry, since as GDP contracts, debt to GDP rises.

The worst part will come if you get into outright deflation, and falls in even nominal GDP. To some extent it is the disinflation which is driving the process even now. So in this sense be thankful for all that devaluation, although of course, the more it goes on, the more those CHF loans creak.

Which is why I am arguing for a much broader approach to this.

I have an article in the US magazine Foreign Policy which argues my general view (see here) and which might interest you, but basically I think we need to be going about all this in a very different way, and from right at the top.

"though I personally believe that it is much more of a good thing in the end."

Edward Hugh said...

One more thing analyst. Take a look at Krugman's latest post on the US Bank Scheme on his NYT Blog, and the earlier Zombie Financial ideas one if you can find it (I am basically in the same pot as Krugman).

Now, my argument would be that most of the banks who are arguing "silly things" about the BIS bank lending numbers are basically making some sort of equation like:

"US Housing Price Recovery" = "Convergence For The CEE"

Let me explain.

What the whole US debate reminds me of is the current debate over here about Eastern Europe's banks. The argument is basically the same, with the EU arguing it is a "Balance of Payments Crisis", so what they need is the lending to get them through to the other side. So this:

"If you think it’s just a panic, then the government can pull a magic trick:"

is what they are doing. Of course the Spanish case and ECB liquidity is another example of the same.

But then we have "the underlying asset is a banana" situation, and of course the thing won't work.

This is why I am so strong in criticising the "convergence" argument here, since when I look at the demographics it is very clear to me at least that the Eastern Countries aren't going to "converge", ever in the way the theory has it.

I mean some of these people (UBS, Erste, Thomas Mirow) have even gone as far as to sort of suggest that the whole BIS 1.7 trillion outstanding loans figure is just something being hyped by Ambrose Evans Pritchard.

This is why they have to do qualitative easing and balloon up those EU bonds (whoops, I can feel my father turning in his grave as I say this). It is a one off long shot, but at this point that is better than simply doing nothing.

So what are the chances that domestic demand can make a recovery?

Well, according to some, quite substantial. According to a recent report from UBS bank on Eastern Europe Lending:

"We retain our firm view that convergence is a ‘sure thing’ for those economies already in the EU – it is just a question of time before levels of GDP per capital approach those of the established members. If convergence is perhaps a thirty or forty year process, the most advanced are perhaps half way through (Poland introduced its free market reforms on 1 January 1990). The uncomfortable period we are entering is one where local growth goes from above-trend to sharply below. It may well take a number of years before nominal GDP (in Euro) recovers the levels of summer 2008, but we believe markets can be forward-looking when outcomes are predictable".

So the issue is convergence, and the justification for "plan A" is essentially based on this idea, as UBS analysts:

"Why does convergence matter so much? Because equity markets – and therefore companies – are essentially about growth. And convergence drives excess growth. The new EU members offer legal systems becoming increasingly like those in old EU states, with labour productivity comparable and labour costs a fraction of those back home – particularly following recent currency declines. Margins on banking products are typically higher than in ‘old’ Europe and levels of penetration much lower."

"These arguments were a staple of a thousand corporate presentations through the good times and we suspect will be little mentioned except where necessary over the next twelve or eighteen months. But we believe them to remain essential to an understanding of likely outcomes in the region: they raise the bar for all stakeholders faced with a challenge of whether to prioritise the long-term or the immediate. It is an active debate what the Ukraine will look like several years hence; we believe it is not for the EU members: they will look more like the old EU states, in form and substance."

So what we are going to do, is lend money to all those poor East European States, so that they can load up their debt to GDP, then when things get better, the banks can have business as usual. The idea would be pretty horrid even in the sort of world Leibniz dreamed of, but we aren't in that world, even.

and note this:

"they will look more like the old EU states, in form and substance"

Yeah, but which ones, Greece and Portugal, or Holland and Finland?

Anonymous said...

Well, perhaps let us go back for a second to Hungary's budget, and take a look at what is in fact happening in these days. First, yes, the expected March deficit is quite high, but that, as I said, is seasonal. Last year, the March deficit number was HUF 325bn, in one month only, due to that seasonality. Mr. Keller, who you were quoting, said that they have a stability reserve of 0.3% of GDP, which is now untouched, and also decided to cut spending for this year by HUF 230bn, the impact of which will be felt in the rest of the year. But of course, your legitimate question remains, ie. how on earth they can achieve their revenue targets if GDP growth is not -3.5% this year, as the government expects, but worse, in part exactly because they are cutting demand further. Well, here comes the "incubation" thing, which has a lot to do with the balance of payments assistance that you are mentioning in your second comment. Well, the IMF and the EU have committed very substantial amounts in loans to Hungary, part of which has already been distributed. On the back of this, the government now has very high liquidity - deposits up to 7% of GDP at end-February, which is completely unprecedented, and more will be created by further IMF/EU disbursements. But they do not need that much of money in their purse. So what they are doing is to buy back expensive HUF debt, replacing it by cheap EU funds. This week eg. they bought back some HUF60bn of HUF bonds at yields of 10-12%. They realise on this some capital gains I guess, but more than this is the savings in funding costs. The EU (AAA-rated) passes on the funds to Hungary at the same cost as its own funding cost, meaning that essentially it borrows for Hungary, which, as a BBB-rated issuer, can save the risk spread. This way the the government can cut its funding costs by 0.4% of GDP this year, assuming that the risk spread for BBB-rated EUR debt over AAA-rated EUR issuance is 500-600 bps, as it is now, or even more if it replaces HUF issues. Using the IMF funds in the same way would add to these savings, but of course, one needs to take into account that risk spreads for last year were lower on average, so the net improvement compared to 2008 may not be quite as big. But even so, IMF/EU funding may reduce financing costs for the Hungarian government by over 1% of GDP pa. when it is fully raised, and by several decimal points in fact during 2009. This is certainly not the full answer to the problem, and there is probably no perfect answer at all, but a very important contribution indeed.