Global Manufacturing, France Outperforms, As Spain Continues To Flounder

Well, it is not as if I relish rubbing salt into old wounds, but this quote from the latest piece by Ben Hall in Paris and Ralph Atkins in today's Financial Times is just too good to resist.

French manufacturing output rose at its fastest rate for nine years, according to a survey on Monday, confirming that France has become the economic powerhouse of continental Europe. Purchasing managers’ indices for manufacturing showed France performing significantly better than the continent’s other main economies – thanks to robust domestic demand.

Plenty of food for thought in this paragraph it seems to me. As foreshadowed in this earlier post, it is the French economy - and not the German one - which is rebounding sharply, and this seems to be for essentially three reasons:

i) there is still life in domestic demand, due to the fact that demographics are good, and lending to households (at an average rate of increase of 11%) was a lot less during the last boom than it was in the bubble societies (20% per annum in Spain and Ireland

ii) France's more favourable demography means that the French government has more space for fiscal stimulus (when compared with Germany) which means the "cash for clunkers" can roll on a bit longer.


iii) the combination of these above two factors means that stimulus actually can work, since it can fire up domestic consumption which is not already dead on its feet. That is, the situation is a win-win one in the classic sense (although, as I was arguing at the end of last week, the ECB will now need to do some pretty adroit monetary footwork if it wants to avoid firing up an asset bubble in France, to follow hot on the heels of the one which has just deflated in Spain.

As Jack Kennedy, economist at PMI survey organisers Markit put it:

“The strong recovery in French manufacturing continued in October, with output rising at the fastest pace for nine years. While some of the current strength reflects a rebound from the extreme financial crisis, it nevertheless offers further evidence that the France is towards the front of the pack among developed economies in emerging from the downturn. Domestic demand remains the key driver of growth as confidence continues to recover.”

Climbing The Tourmalet

The current recovery could be conceptualised as a group of Tour de France cyclists set on scaling the slopes of the notorious Tourmalet. One group of riders - mainly emerging economies like China (current PMI 55.4), Brazil (53.7), India (54.5) and Turkey (52.8) are out in front, with just two developed economies having "escaped" from the main group to try and catch them, France (55.6) and Sweden (56.7).



Then comes the main group, who continue to show a modest recovery, howevering around or even (at last) somewhat over the 50 point break even mark (Germany (51), the US (55.7), Japan (54.3), the UK (53.7), the Netherlands (50.5), Austria (51.1), etc). In Eastern Europe, the Czech Republic (49.8) and Poland (48.8) though still weak continue to gain ground, while the Russian team this month unexpectedly had a puncture, and dropped back into contraction territory (49.6), after registering growth in September.




And then come the stragglers lead by Italy (which is peddaling furiously, but - with a PMI of 49.2 - doesn't seem to ever quite make it over that critical 50 mark, oh well, next month perhaps),followed closely by Hungary (48.2), Greece (48), Ireland (48), South Africa (47.8) and of course, in last place, I think the rider is now so weary he is getting off to walk the bike up the hill, comes poor old Spain (46.3), where more or less predictably, the contraction continues. In particular Spain stands out as almost the worst case scenarion now, with a manufacturing sector which continues to bleed jobs in a country where no one seems to have any serious proposals about what to do except wait in the hope that things might get better eventually, and of their own accord. The sky in front with always be clearer mañana, of course.

Italy

Commenting on the Italy Manufacturing PMI survey data, Andrew Self, economist at Markit said:

“Italian manufacturers reported that their recession which has spanned eighteen months finally ended in October, two months behind the Eurozone as a whole. Production rose for the first time since March 2008, driven by a marginal return to growth of new orders. Although the October survey represents a step in the right direction on the road to recovery, weakness persists which suggest that a sustainable upturn is by no means guaranteed."

Hungary

Hungary's manufacturing purchasing manager index dropped 0.8 percentage points to 48.2 points in October, according to the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM). The October reading suggest the steady improvement that started in the spring may now have come to a halt.



Greece

The seasonally adjusted Markit Greece Purchasing Managers’ Index fell marginally to 48.0 in October from 48.5 in the previous month. The latest reading signalled another slight deterioration in operating conditions across Greece’s manufacturing economy.



Commenting on the Greece Manufacturing PMI survey data, Gemma Wallace, Economist at Markit said:

“The hope raised in August of an imminent recovery in Greek manufacturing production has dwindled somewhat over the past two months, as the PMI has sunk back into negative territory. Nevertheless, the headline index continued to signal only a slight weakening of the business environment. Additionally, almost all of the surveyed variables are improved on their twelve-month averages – in most cases noticeably so. These are clear signs that progress has been made and therefore show that the sector is on the right path to stabilisation and recovery, even if it has not quite got there yet.”

Ireland

In Ireland the October data indicated that, while operating conditions at Irish manufacturers continued to deteriorate during the month, the sector moved a step closer to recovery. Both output and new orders fell only slightly, and purchasing activity decreased at a markedly slower rate. The seasonally adjusted NCB Purchasing Managers’ Index rose to 48.0 in October, from 46.6 in the previous month. This signalled that the rate of deterioration in business conditions eased to the weakest since February 2008.



Commenting on the NCB Republic of Ireland Manufacturing PMI survey data, Brian Devine, economist at NCB Stockbrokers said:

“The output and new orders components very nearly breached the sacred 50 mark in October. New export orders did however fall away marginally after breaching 50 last month. The fall in new export orders reflected sterling weakness which is continuing to squeeze the manufacturing sector. With UK exports under pressure it is a welcome sign that the US economy posted impressive GDP growth in Q3, even when account is taken of their scrappage scheme. With global economic activity gathering momentum we are still hopeful that the Irish economy will begin growing in Q4 of this year and the latest PMI was comforting in this regard.”

South Africa

South Africa’s purchasing managers’ index rose to its highest level in 16 months in October as the country’s first recession in 17 years eased, according to the monthly report from Kagiso Securities. The seasonally adjusted index increased to 47.6 from a revised 45.9 the month before. The index has been below 50, which points to a contraction in output, since May 2008.




Spain

Operating conditions in the Spanish manufacturing sector continued to deteriorate in October. Output fell further over the month, while new orders contracted at the sharpest pace since May. Supplier lead-times lengthened for the first time in nineteen months.

The seasonally adjusted Markit Purchasing Managers’ Indexcontinued to signal a marked decline in overall business conditions, posting 46.3 in October. Operating conditions have worsened in each month since December 2007. Output decreased modestly in October as the wider recession in Spain continued to impact negatively on demand. Production has now contracted in twenty of the past twenty-one months.



Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker, economist at Markit, said:

“Spain's recovery continues to lag the upturn seen across the Eurozone as a whole, and a steeper contraction of manufacturers' order books in October will be of particular concern as it points to a further delay to any prospects of stabilisation.Competition is so intense that firms are being forced to slash prices, despite their raw material prices increasing. The stabilisation of unemployment in the third quarter signalled by official figures is likely to be only temporary with PMI data continuing to show considerable falls in employment in the manufacturing sector as firms seek cost cuts.”

Global Improvement - But Watch Out For The Stragglers, And Those Overly Dependent On Exports

So, as JPMorgan say in their Global Manufacturing report, the Global Manufacturing PMI hit a 39-month high in October, and at 54.4 posted its highest reading since July 2006. The PMI has now remained above the neutral 50.0 mark for four successive months. But while the general picture is one of solid, if modest, growth, the group of stragglers at the back of the pack (to which would could add names like Latvia, Portugal, Romania, Finland, and Ukraine, where PMI surveys do not currently exist) point to potential problems further on down the line in 2010.



Also of concern is the way the index in export dependent countries like Germany and Japan (both suffering the added impact of having a high currency following the ongoing dollar weakness) continue to struggle for air. This is more apparent in the German than the Japanese case at this point, but the survey organisers specifically highlightend the way in which survey respondents in Japan are already reporting a lack of "bounce" in export orders, and this once more serves to highlight the weak spot in the current recovery picture - where are all the customers for all those exports eventually going to come from.

Commenting on the Nomura/JMMA Japan Manufacturing PMI data, Minoru Nogimori, Economist of Financial & Economic Research Centre at Nomura, said:

“October’s Japan Manufacturing PMI fell for the first time in nine months, by 0.2 points to 54.3. It remains above the key dividing line of 50.0, indicating that production activity continues to recover, but suggesting that the pace of improvement is slowing. The New Export Orders Index, a leading indicator of Japanese exports, fell 2.5 points to 51.6. Although this is the fifth consecutive month in which the figure has been higher than 50.0, the October reading suggests that the pace of improvement has obviously slowed. An improvement in export demand was the main factor behind the rebound in Japanese manufacturing output. Therefore, we think that the strong rebound in production activity in Q2 and Q3 now looks likely to run out of steam from 2009 Q4.”

This final point, along with the negative impact that problems among the "stragglers" may present for the main group later on up the hill suggests, to me at least, that while many emerging markets remain strong, we will almost certainly not see anything resembling a "V" shaped global recovery, and especially not in the OECD countries. As far as I am concerned this hypothesis can already be safely discarded.

As Hungary's "Correction" Heads For A Dead End, Time For A Change Of Course?

Hungary's economic correction still fails to convince. Indeed I am not the only one who remains unconvined by the viability of what is currently taking place it seems, since according to the opposition supporting local daily newspaper Magyar Hírlap, none other than the Hungarian Prime Minister himself may be having doubts, as he is reportedly thinking of leaving the helm of the struggling ship placed under his charge before the next general election, which is scheduled to take place sometime early next year.

If this version of events is ultimately confirmed it will only add to the IMFs growing problems out East, since events in Latvia are not going at all according to their liking - see FT Alphaville's Izabella Kaminska's "Another Latvian wobble" of last Friday - and indeed Latvia’s government rapidly cobbled together another 275 million lati ($575.6 million) in spending cuts for 2010 yesterday after EU Economic and Monetary Affairs Commissioner Joaquin Almunia called on Latvia on Friday to “renew a national consensus”, and Prime Minister Valdis Dombrovskis paid a flying vist to Brussels, following a parliamentary vote against sending a real-estate tax bill through to the committee stage, implicitly rejecting part of an agreement with the IMF and EU. How many times this year does that now make it that the national consensus has had to be urgently renewed under directives from either Washington or Brussels, could someone please remind me?

Further, Hungary's main opposition party - Fidesz - which looks well-positioned to win next year's general elections, are threatening to rewrite the current ever-so-carefully written 2010 budget when they comes to powe next year, according to the latest statements from party president Viktor Orban.

"This (the IMF text, EH) is the most dangerous budget of the past 20 years ... never before has a budget put hundreds of. thousands, or even millions of Hungarian families at such grave risk," Orban told private broadcaster Hir TV in an interview late on Friday. "This budget will not remain in place, we will draw up another one instead," said Orban, a former prime minister, adding that if in power, his government would create one million new jobs in 10 years.

Well, things certainly do not look good either for Gordon Bajnai or for the EU Commission/IMF team who are behind the budget. Perhaps that is why the IMF's representative in Hungary, Iryna Ivaschenko, told national news agency MTI yesterday that while the government was committed to its 2010 fiscal targets, there were economic and implementation risks on the nature of which she declined to elaborate.

As Political Pressures and Bad Loans Mount, While The Economy Retreats Underground, It Is Hard To See How The "Correction" Can Work

Clearly the above mentioned report about the PMs intentions does come from a rather biased source, but it is interesting to note that credibility is being given to it by normally more impartial sources like Portfolio Hungary, and as they themselves point out there has been no outright denial of the suggestion from government sources.

Perhaps even more astonishing was the statement by the Hungarian Finance Minister Peter Oszko to Dow Jones Newswire on Friday that the most difficult reforms to address economic imbalances have now been completed. "I believe the most difficult part of our job is done - our package creates not only short-term but mid- and long-term fiscal balances" he said. I say astonishing, since as far as I personally can see (take a look for yourself at the charts below) the changes that are needed haven't even begun yet. The whole emphasis have been on cutting the deficit, with little serious thought being given about how the Hungarian economy can get back to growth - which is the only real way the fiscal balances can become stable - all that seems to have happened is a 5% VAT hike to squeeze domestic consumption even further, and some compensatory tax changes on the other side to stimulate employment, but the real economic imbalances have been left untouched. A supply side micro-economists paradise, whisper the words "long term steady state growth" to yourself three times, cross your fingers, and hope for the best.

However, the underlying mirky political realities may soon burst their way into the parlour room, to disrupt this happiest of happy families. Indeed everything may well now hinge on getting the budget through parliament and then disrcetely leaving by the side entrance, since Magyar Hirlap suggest that the Hungarian Parliament may well be dissolved directly after the vote on the 2010 budget - which is currently scheduled for 30 November. Apparently everyone's calculations have been thrown awry by the early re-election of José Barroso, and the imminent reappointment of the EU Commission. Plenty of food for thought here.

The paper also suggests that Prime Minister Gordon Bajnai now totally accepts that the forthcoming electtions are inevitably lost - the only bit of realism I can see in all this - and as a consequence seeks to have them advanced to February from the currently probable date of April or May.

In this way Bajnai would be able to offer himself to replace the present Hungarian representative László Kovács, who is currently Commissioner for Taxation and the Customs Union. Bajnai, it will be remembered, has only been Prime Minister since last April, but then, with these sort of techniques it doesn't take that long to put a country straight, now does it?

Advancing elections in a situation where the present budget proposals are massively unpopular may make perfect sense according to a certain democratic political logic, but the economics lying behind the idea must be making people in Washington and Brussels throw up their arms in despair.

More evidence to back the idea that the current programme is not working came in the latest report released by the committee which monitors the long term legalisation of Hungary's underground economy. The process is not only not advancing - it has been thrown into reverse gear, it seems.

According to Committee president, and Central Statistical Office analyst, Csák Ligeti some HUF 100 billion (EUR 369.17 million) in tax revenues were lost in the first half of the year due to a ressurgence in the growth of the black economy. In his report he noted, by way of contrast, that during the previous two years the state budget had received around HUF 200-250 billion (EUR 738.1-922.6 million) in extra revenue due to the "whitening" process initiated in the autumn of 2006 as part of a programme to correct the large fiscal deficits the country was running.

On another front, the IMF warned last week that while Hungary's banking sector had so far weathered the crisis reasonably well - thanks to the multilateral rescue programme - and now has sufficient capital buffers, asset quality still looks set to deteriorate steadily due to weakness in the domestic economy, and especially rising unemployment. This, of course, is another good reason why they should have been including a rapid return to export lead growth in the correction strategy, since obviously if you simply sit back and wait to see what happens, there will be no big surprise - the percentage of Non Performing Loans will just go up and up.


"Developments in the banking sector have been positive; so far so good, and in line with one of the main objectives of the (IMF) program to preserve financial stability," Iryna Ivaschenko, the IMF's resident representative in Hungary, told Down Jones in an interview on Thursday.

However she immediately added that the IMF projects the amount of non-performing loans, which stood at a "still moderate" 4.8% of overall loans at the end of June, "will peak and at least double in the first quarter of 2010,".

This IMF warning follows a Standard and Poor's one at the end of August. The financial profile of Hungarian banks is set to weaken over the near term as a result of the country's ongoing recession, the weak and volatile national currency, and pressure on funding, according to the S&P report.

The report, which was entitled "Banking Industry Country Risk Assessment: Hungary", followed the recent decision by Standard & Poor's to revise its ranking of the Hungarian banking system to reflect increased economic risks in the country (BBB-/Negative/A-3) and structural weaknesses in the country's economy and banking industry.

"Hungary's significant external financing needs, which stem from high public-sector leverage and large external imbalances, represent a structural weakness that exposes the economy to the tight and expensive funding conditions in global markets," according to Standard & Poor's credit analyst Harm Semder, who wrote the report.

The report argues that nonperforming loans and depressed recovery rates are likely to cause a material rise in credit losses, which will in turn subdue bank profits and capital through 2011.

Credit risk is heightened by the rapid growth of unseasoned loans - particularly commercial real estate mortgages - over the past five years and a significant increase in loans denominated in foreign currency that lack the foreign currency revenues to service them.

The report estimates that cumulative gross problematic assets, which include restructured loans and repossessed collateral, could increase to 25%-40% of total loans during the course of the current domestic recession. It further suggests that the eventual recovery will be slow.

Which Way To Turn?

The entire situation in Hungary vis-a-vis wages, employment and inflation continues to be preoccupying. The country is in the midst of a huge correction, and depends on improving exports in order to attain economic growth.

Yet the correction is not proceeding as planned. Inflation - at an annual rate of 5% in August, is far too high in contrast to benchmark German inflation which remained negative in August (minus 0.1% ) to be recovering competitiveness. Real wages have continued to rise, and only sneaked into negative territory for the first time in over six months in July - with a 1.1% drop in the benchmark ex-bonus hourly rate in the private sector. Total employment is falling slowly, but even this process masques an important shift towards public sector employment, as the number of public employees has risen substantially in recent months while the number of employees in the private sector has continued to fall - exactly the opposite of what was meant to be happening. Meanwhile the country continues to get ever deeper in debt thanks to the relatively generous financing conditions offered by the EU and the IMF. The point is where does this all end? Where is the correction here?

The National Bank of Hungary is struggling to find an adequate monetary response. The bank lowered its benchmark interest rate by 50 bp to 8% last week, but this still represents a real interest rate of around 3%.

The move followed a surprise 100-bp rate cut at the end of July. While a month ago, the market was expecting 50 bp easing, this time there was no real surprise. As for the future, the National Bank of Hungary release uses standard central bankspeak that intentionally remains ambiguos and guarantees the Bank Council is not committed in any particular direction. As long as there is no change in the international environment over the coming months, the the Council will be most likely having to decide whether to cut a further 50 bp or more.

So while the bank has evidently eased policy considerably, monetary conditions are evidently still far too tight to stimulate dynamic activity in the private sector, which is almost literally wilting on the vine at the present time.

Meanwhile, in a further sign that the recession is settling in for the long haul, Hungarian retail sales extended their decline to 29 months in June as IMF/government measures to narrow the budget deficit continued to sap consumer spending.

True Love In The Eternal Embrace?

Well, despite the fact that many may think the expression "eternal triangle" in the present context refers to the Hungarian government, the EU Commission and the IMF, they would be wrong since one convenient way of thinking about what just happened in Hungary could be to use another kind of eternal triangle the one developed in Nobel Economist Paul Krugman’s model of the same name, which postulates that when it comes to tensions within the strategic trio formed by exchange rate policy, monetary policy, and international liquidity flows, maintaining control over any one implies a loss of control in one of the other two.

In the case of the Central Europe “four”, Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to “freefloat” and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

A second problem which stems from this “initial decision” has been the tendency for households in the latter two countries to overload themselves with unhedged forex loans, a move which stems to some considerable extent from the currency decision, since in order to stabilise the currency, the central banks have had to maintain higher than desireable interest rates, which only reinforced the attractiveness of borrowing in forex, which in turn produced lock-in at the central bank, since it can no longer afford to let the currency slide due to the balance sheet impact on households. Significantly the forex borrowing problem is much less in Poland than it is in Hungary or Romania, and in the Czech Republic it is nearly non-existent.

The third consequence of the decision to loosen control on domestic monetary policy has been the need to tolerate higher than desireable inflation, a necessity which was also accompanied by a predisposition to do so (which had its origin in the erroneous belief that the lions share of the wage differential between West and Eastern Europe is an “unfair” reflection of the region’s earlier history, and essentially a market distortion). The result has been, since 2005, a steady increase in unit wage costs with an accompanying loss of competitiveness, and an increasing dependence on external borrowing to fuel domestic consumption.

So, if we look at the current state of economic play in the four countries, we find two of them (Hungary and Romania) undergoing very severe economic contractions - to such a degree that in both cases the IMF has had to be called in. At the same time both of them are still having to “grin and bear” higher than desireable inflation and interest rates. In the other two countries the contraction is milder, the financial instability less dramatic, and both inflation and domestic interest rates are much lower. Really, looked at in this light, I think there can be little doubt who made the best decision.

Hungarian GDP - The Big Slide

While wages and prices more or less steadily wend there way upwards, we have no hurry hear, you understand, GDP has been in freefall. Year on year it was down an annual 7.5% in Q2 (and a seasonally adjusted 2% from the first quarter) . The Hungarian government currently expects the economy to contract 6.7 percent this year, in the largest drop in outout since 1991. My view is that we have a total policy trap in operation here, since neither monetary or fiscal policy are available to an adequate degree (even after today's change interest rates are still at 8%), and there is thus little support available to put under the economy at this point. The only way to break the circle in my opinion is to violently kick start exports by letting the forint drop, bringing down interest rates, and restructuring all those CHF loans.




If, instead of browsing over all those diplomatic statements we look at what is going on on the ground, then we find that private sector employment is now well down, by 9.2% y-o-y in July. While in the same month industrial output was down 19.4% over a year earlier. Something just doesn't seem to be working as it should be here.



Unbalanced Movements In Employment


Not surprisingly given the strength of the contraction total employment fell back again, for the second consecutive month, in July, and stood at was 2.657 million. There were 1.803 million in the private sector and 765 thousand in the public sector. Total employment was thus down 4.4% over July 2008.




Private sector employment is well down in Hungary, by 9.2% y-o-y in July.



On the other hand, public sector employment has been chugging away on the up and up, due to job creation under the short term stimulus programme, courtesy indirectly of the IMF, who have permitted a larger than anticipated budget deficit.

But don't get me wrong, it's not the stimulus I am quibbling about here, it is what it is being used for, and the absence of a realistic plan. It's easy enough to run up debt, especially when the EU Commission and the IMF guarantee you, but its a lot harder to pay it down again later, and Hungarian debt to GDP now looks set to go through the 80% of GDP level in 2010. So, the outcomes we are seeing simply don't seem to me to be producing a large enough structural change in the right direction. On the other hand, even this public sector employment boost now seems to have started to turn, since even public sector employment fell back on the month in July - for the first time in six months - although it was still up 5.6% year on year.



Hungary's gross average ex bonus private sector real wages entered negative territory in June, for the fisrt time in over six months, and fell at annual rate of minus 1.1 percent.

Real public sector wages continue to fall sharply, and contracted by an annual 11 percent year-on-year in July following a 13.4 percent contraction in June - although some of the volatility here is the result of a changed system of payment for the additional (13th) month's salary. What is happening in Hungary is really an obvious example of "sticky wages" if ever there was one as far as I can see, since employment in the private sector is falling, and unemployment rising, so you would expect the opposite effect to operate, and real wages to be falling sharply at this point. According to Erika Molnarfi of the stats office, the upward drift in average private sector salaries is the outcome of a sharp decline in production workers which was not accompanied by a decline in administrative workers, exactly the opposite result to that you want to see.



Inflation Stubbornly High

Far from the current recession leading to a significant downward shift in wages and prices, real wages had been rising continuously until July, while Hungary's consumer prices were still running year on year at 5% in August - up from 3.7% in June due to the VAT effect, and still far to high to start restoring competitiveness. . If the current trend continues, and the HUF remains in the region of its current euro parity, then Hungary's agony looks set to continue unabated well into 2010.



And Hungarian manufacturing output fell back again in July, and industrial output decreased by 19.4% compared to July 2008. The volume of production was 22.1% lower over the first seven months of 2009 than in the same period of the previous year. The volume of industrial production fell back in July by 0,7% on June according to seasonally and working-day adjusted indices. Industrial export sales declined by 25.2% in the first seven months of 2009 and by 19.8% in July compared to the same period of the previous year, as a result of a sharp fall in external demand.



So Hungary is suffering from a generalised drop in demand - domestic, export, government, and investment - for which it is difficult to see any short term remedy.

Investments fell in the second quarter of 2009 by 4.7% compared to the same period of 2008. In the first half of 2009 investments in the national economy were 6% down over the corresponding period of the previous year. Investments did however increased by 0.4% quarter on quarter, but when we break this down we find that of the 4.7%annual drop in investments in the second quarter those in machinery and equipment fell by 11.6%, while the volume of construction investments – due to investments in dwellings and motorway constructions – grew by 1.1% compared to the same period of 2008. But when we look at the construction data we find that the improvement in construction is all about civil engineering, so any increase in machinery and equipment investment is still some way off at this point.

Evidently the first sign of any real recovery in the Hungarian economy will come when machinery and equipments investments stabilise and even start to increase, since that will be a reflection of the expectation of future demand arriving further down the pipeline, and will be a measure of real employment creating possibilities.


But things don't look set to improve soon, since Hungary's purchasing manager index dropped by 3.4 points to 45.8 points in August, according to the most recent report from the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM). The latest data is highly disappointing not only because Hungarian manufacturing has now been contracting for 11 straight months, but because the August eurozone PMI index showed a larger-than-expected pickup. This thus suggests that Hungary is being left behind in the scramble.



Exports Remain Weak, And Imports Are Even Weaker

Hungary recorded its fifth monthly trade surplus in June, coming in at 457,3 million euros slightly below the 490.1 million euros acheived in May but well above the 30.8 million euros of June last year.

Now good news is always good news, but it is important to understand that this result was almost entirely achieved via a dramatic drop in imports, which plunged an annual 30.4 percent in June (following a 32.3 percent decline in May). It is impossible to talk of any marked improvement in exports, since these fell by an annual 21.1 percent, decelerating from the 24.1 percent drop in May, but still very large. While in the short term this substantial drop in imports (and hence rise in the trade balance) is GDP positive, it is very negative for living standards in the longer term, and the whole situation needs to be reversed by a large boost in exports leading imports as the eurozone economy eventually recovers. But to be able to achieve this Hungarian industry needs to do more, much more, to achieve competitiveness.



Over the January-June period, the volume of exports and imports fell by 20 and 25 percent, respectively, compared to the same period of the preceding year. The trade balance showed a surplus of HUF 606 billion (EUR 2,055 million), which meant an improvement of HUF 534 billion (EUR 1,766 million) compared to the surplus of HUF 72 billion (EUR 288 million) in January-June 2008. In January-June 2009, the forint price level of exports and imports both increased by 6 percent, respectively, The forint exchange rate had however weakened by 17 percent with repsect to a basket of leading foreign currencies, and within this by 14 percent to Euro and by more than 30 percent to the dollar. So, if getting the growth needed to drive GDP is the objective, and this is any evidence, then there is still a long long way for the forint to fall.

Over January-June 2009, the export and import volumes of machinery and transport equipment, which constitute 60 percent of exports and nearly 50 percent of imports, fell by and above average 24 percent in the case of exports, and by 27 percent in the case of imports.




Domestic Demand Drifts On Downwards

Construction activity was down by 5.1% in July as compared to July 2008. In the first seven months of 2009, output was down by 2.4%. In comparison June, production fell by 12.2% in July according to indices adjusted for seasonality and working days. This large drop is really only a reflect of the pre VAT introduction surge registered in June.



The two construction sectors are moving in opposite directions at the moment. Within the 5.1% aggregate increase, building construction was down by almost a quarter, while civil engineering works expanded by 19.6%. From the start of the year the construction of new buildings is down by 12.7% while civil engineering works are up by 12.3%.

From the September 2006 peak construction activity as a whole is now down by 27.58%. September 2009 will mark the start of the third year of contraction.



Hungary's retail sales fell by 2.2% in June compared to June 2008, although sales did increase by 0.5% compared to the previous month. Of course, we need to remember in this case that the 5% VAT hike was introduced on 1 July, so it is perhaps surprising that the increase wasn't bigger.



Thus the month on month increase is very misleading, since it was evidently driven by the government decision to raise value-added tax on the first of July - in an attempt to compensate for revenue losses which will be produced by forthcoming reductions in personal income and payroll taxes . So the increase in sales was in fact due to an attempt to avoid the 5% rise in VAT, and we should be ready for a sharp drop in July. Prime Minister Gordon Bajnai is in the process of implementing spending cuts worth 1.3 trillion forint ($6.9 billion) over a period two years in an attempt to keep the budget deficit in check.




While The Central Bank Is Caught In A Policy Trap

Hungary’s central bank cut its benchmark interest rate to the lowest level in 17 months at the end of August to try to help jolt the countryt out of its worst recession in almost two decades. The Magyar Nemzeti Bank lowered the two-week deposit rate to 8 percent from 8.5 percent. Monetary policy makers voted for the 50 basis-point cut with an “overwhelming” majority over a reduction to 7.75 percent according to central bank President Andras Simor. In fact the minutesd showed that the bank cut interest rates by a seven to one majority, with one member voting for a 75 base point cut.

In fact many analysts now see further easing in the pipline, but in taking this stance they need to think about two points.

i) The Hungarian government is still incredibly complacent about the inflation problem, and currently forecasts that inflation will only slow by the end of next year to something just below the central bank's current medium-term target which is itself very complacent.

"We expect inflation to slow from [an annual average of] 4.5% this year to 4.1% in 2010. As for 2010, the December inflation figure may start with a digit 2," Finance Ministry State Secretary Tamas Katona told journalists last week.

In its latest report on inflation, published in August, the National Bank of Hungary projected that inflation will likely dip below the 3% mark from the third quarter of 2010 onward. The central bank's annual inflation forecast is 2.5% on average for the second half of next year.

But if Hungary wants to avoid a substantial devaluation then the internal devaluation needs to operate, and to a significant degree, which makes these current forecasts simply laughable. You wouldn't have thought, given all the complacency that the economy was contracting at around an annual 7% rate.

ii) the key problem for the central bank is the value of the forint - given the level of household exposure to Forex loans. My opinion is that the recent recovery in the currency value has been almost entirely driven by yield differentials, and by self-fulfilling expectations (traders expect the currency to rise), rather than by any change in the underlying economic fundamentals, which as we have seen, has not taken place.

But with consumption sinking, government spending falling and exports insufficiently competitive to drive the necessary surplus, the whole thing is now becoming rather a mess, with no clear economic policy objective in the short term (except, of course, cutting the bfiscal deficit and maintaining a strong exchange rate), while in the long term the emphasis is rightly on increasing exports. But no one has any idea of how exactly to correct prices sufficiently with the CHF mortgages stuck in the middle, and it remains to be seen how the markets will ultimately respond to these rate reductions as and when the wind of risk sentiment changes, as it will.



Basically the problem is the value of the forint. My opinion is that the recent recovery in the currency value (see chart below) has been almost entirely driven by yield differentials, and by self-fulfilling expectations (traders expect the currency to rise), rather than by any change in the underlying economic fundamentals, which as we have seen, has not taken place.



The problem the central bank and the Finance Ministry have to address is the ongoing issue of the mountain of Swiss Franc denominated mortgages.



These have stopped increasing in recent times, but still constitute a serious obstacle to any devaluation of the HUF, due to the non performing loans issue this would create for the banking sector. Not only has money been borrowed against homes for to fund house purchases, it has also been loaned for consumption, so indeed the fact that even these loans are stagnating hardly bodes well in any way for domestic demand.



The result of all this botched policy is that Hungary’s EU harmonised unemployment rate rose to the its highest level in at least a decade in May and has been stick there ever since - and with the rise of unemployment, of course the percentage of impaired loans in the banking sector will also continue to grow. The rate rose to a seasonally adjusted 10.3 percent, the highest since at least 1996 and was still there in July (the latest month for which we have Eurostat data).

And the situation is more likely to deteriorate than improve, with the central bank forecasting lay-offs of around 180,000 across 2009-2010, nearly 5% of the total number of employed, and now even the number of employees in the public sector is starting to fall back.

From Original Sin To The Eternal Triangle - Lessons From Central Europe

The non-biblical concept of original sin, as Claus Vistesen notes in this post, when propounded in its standard Obstfeld & Krugman textbook version refers to the situation where many developing economies who are not able to borrow in their own currencies feel forced to denominate large parts of their sovereign and private sector debt in non-domestic currencies in order to attract capital from foreign investors - as evidenced most recently in the countries of Central and Eastern Europe. Well, piling insult upon injury, I'd like to take Claus's point a little further, and do so by drawing on another well tried and tested weapon from the Krugman armoury, the idea of the "eternal triangle".

As is evident, the reality which lies behind the current crisis in the EU10 is complex, and has its origin in a variety of causes. But one key factor has undoubtedly been the decisions the various countries took when thinking about their monetary policy and currency regimes. The case of the legendary euro "peggers" - the three Baltic countries and Bulgaria - has been receiving plenty of media attention on late, and two of the remaining six (Slovenia and Slovakia) are now members of the Eurozone, but what of the other four, Romania, Hungary, Poland and The Czech Republic? What can be learnt from the experience of these countries in the present crisis.

Well, one convenient way of thinking about what just happened could be to use Nobel Economist Paul Krugman’s Eternal Triangle” model (see his summary here), which postulates that when it comes to tensions within the strategic trio formed by exchange rate policy, monetary policy, and international liquidity flows, maintaining control over any one implies a loss of control in one of the other two.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

A second problem which stems from this "initial decision" has been the tendency for households in the latter two countries to overload themselves with unhedged forex loans, a move which stems to some considerable extent from the currency decision, since in order to stabilise the currency, the central banks have had to maintain higher than desireable interest rates, which only reinforced the attractiveness of borrowing in forex, which in turn produced lock-in at the central bank, since it can no longer afford to let the currency slide due to the balance sheet impact on households. Significantly the forex borrowing problem is much less in Poland than it is in Hungary or Romania, and in the Czech Republic it is nearly non-existent.

The third consequence of the decision to loosen control on domestic monetary policy has been the need to tolerate higher than desireable inflation, a necessity which was also accompanied by a predisposition to do so (which had its origin in the erroneous belief that the lions share of the wage differential between West and Eastern Europe is an “unfair” reflection of the region’s earlier history, and essentially a market distortion). The result has been, since 2005, a steady increase in unit wage costs with an accompanying loss of competitiveness, and an increasing dependence on external borrowing to fuel domestic consumption.

So, if we look at the current state of economic play in the four countries, we find two of them (Hungary and Romania) undergoing very severe economic contractions - to such a degree that in both cases the IMF has had to be called in. At the same time both of them are still having to "grin and bear" higher than desireable inflation and interest rates. In the other two countries the contraction is milder, the financial instability less dramatic, and both inflation and domestic interest rates are much lower. Really, looked at in this light, I think there can be little doubt who made the best decision.


Appendix

Here for comparative purposes are charts illustrating the varying degrees of economic contraction, inflation, and interest rates. GDP contraction rates actually present a little problem at the moment, since one of the relevant countries - Poland - still has to report. However Michal Boni, chief adviser to the Prime Minister, told the newspaper Dziennik this week that the economy expanded at an annual rate of between 0.5% and 1% in Q1. So lets take the lower bound as good, it is still an expansion.

The economy in the Czech Republic contracted by an estimated 4.9% year on year in the second quarter.

The Hungarian economy contracted by an estimated 7.4% year on year in Q2.



While the Romanian economy contracted by an estimated 8.8% year on year.


Inflation Rates

Poland's CPI rose by an annual 4.2% in July.


The CPI in the Czech Republic rose by an annual 0.3% in July.



Romania's CPI rose by an annual 5.1% in July.


Polands CPI rose by an annual 5.1% in July.


Interest Rates

The benchmark central bank interest rate in Poland is currently 3.5%.

The benchmark central bank interest rate in the Czech Republic is currently 1.25%.


The benchmark central bank interest rate in Romania is currently 8.5%.



The benchmark central bank interest rate in Hungary is currently 8.5%.

Escaping Original Sin in Hungary?

by Claus Vistesen: Copenhagen

According to the well known textbook in international economics by Maurice Obstfeld and Paul Krugman [1] the notion of original sin refers to the fact that many developing economies are not able to borrow in their own currencies but are forced to denominate large parts of their sovereign debt in order to attract capital from foreign investors. The argument then goes that if and when the goings get tough those countries will face difficulties paying off their liabilities and once the dust have settled the sin, as it were, has only become more binding when these same economies yet again venture onto international capital markets.

It is interesting to ponder this story in relation to Eastern Europe where far from being a sin the ability to denominate liabilities in foreign currencies such as Euros and Swiss Francs was almost seen as a virtue of modern capital markets during the boom years which followed the famous meeting in Copenhagen which saw the European family expand to 25 countries, a number which now has risen to 27. On the face of it, it is not difficult to see where this virtue came from. Aggressive expansion by western European banks into the CEE and a low volatility environment ultimately driven by the notion of a road map towards convergence bound to bring forth an equalization in living standards and, in the case of many CE economies, a certain membership into the Eurozone underpinned the fact that the ability to shop foreign currency loans was hardly a sin, but a natural counter product of the newly formed European community.

Now, all this has capsized and those economies who where so busy raising rates going into crisis in order to quell the massive inflationary pressures, which further intensified the flow of foreign currency loans, are now effectively stuck with no ability to tweak monetary policy since the low rates which are needed are either impossible (in the case of the Baltics and their Euro pegs) or de-facto impossible in the context of e.g. Hungary and Romania. Moreover, and in a world where major central banks are stuck at the zero bound and where the level of volatility may itself be volatile as we move from optimism to pessimism all that liquidity may yet again prove to be a destabilising factor in the context of Eastern Europe where we were all, I am sure, amazed, to learn a couple of months ago how some analysts were advising clients to play the carry trade with Eastern European economies as designated targets, for more on this see this post.

So what does all this has to do specifically with Hungary? Well, today we learned from Finance Minister Peter Oszko that Hungary would certainly prefer to issue local currency debt in the future, but given the fact that the IMF loan is not, by nature of it being a loan, permanent Hungary also need to find a viable way to make its policy tools work most effectively. The following excerpt is from Bloomberg;

Hungary doesn’t plan to raise foreign-currency debt in the “near future” and will increase sales of forint-denominated bonds to finance the budget, Finance Minister Peter Oszko told Nepszabadsag. “In the short term, the budget doesn’t need foreign- currency denominated financing sources,” Oszko said in an interview with the Budapest-based newspaper. The Finance Ministry has confirmed the comments to Bloomberg. “Increasing forint-based issuance is more worthwhile.”

Hungary sold 1 billion euros ($1.42 billion) of debt last week in its first offering since the flight of investors forced it to take a 20 billion-euro bailout from the International Monetary Fund, the European Union and World Bank in October. The country is working to wean itself off emergency financing. The IMF-led loan, which “secures a comfortable situation,” runs out in March 2010 and the government must work to ensure the country can finance itself from the market at lower rates by then, Oszko said.

“The July auction’s primary importance wasn’t to secure financing but rather to strengthen confidence in the country,” Oszko said. A “smaller” foreign debt sale is possible in the future as “it’s our basic interest to be active in the market.” Hungary could next target U.S. investors with the sale of dollar-based bonds, the newspaper Napi Gazdasag reported today, citing Laszlo Balassy, a Budapest-based executive at Citigroup Inc., which helped organize last week’s sale.

It should immediately be clear that this represents the original sin issue in full vigour although somewhat in reverse one could argue. Consequently and notwithstanding the obvious problems facing Hungary in the context of lowering rates, the country needs to balance the between issuing debt in foreign currency which would mean further currency translation risk and an even further entrenchment of the high domestic interest rates or issuing in domestic currency which might not be possible at current rates (i.e. rates would need to go up further) or simply not viable given the future financing needs.

To put all this in the context of a solid macroeconomic analysis I am in luck since Edward has just dished out an up to date look at Hungary's economy. As Edward notes straight away, Hungary has now embarked on the great experiment also currently being tested in Latvia of internal devaluation and the long hard climb, through deflation, towards the competitiveness Hungary so badly needs. Now, I know that I tend to move closely together with Edward on many accounts but I dare anyone not to share the sentiment expressed by Edward as he points to the obvious point. The current strategy taken in Hungary to battle the crisis is not working and at some point one really has to stop to ask why.

One striking data point is the fact that while the real economy seems in absolute free fall real wages are still rising and given the inevitable point that Hungary needs wages to fall, and a lot, absent devaluation one wonders silently what kind of contractory jolt the real economy needs in order to engender this effect. Meanwhile, Hungary has also recently pulled out the good old trick of raising the VAT something which will surely to push up the main inflation index, once again pulling in the wrong direction.

As usual Edward is thorough, very thorough, and I can only suggest to spend the 20 minutes it takes to superficially digest his points. Especially the point about a monetary policy trap is mandatory reading. In terms of a summary of the situation the following gets to the heart of the matter;

And in case you had forgotten, here is what is happening to Hungarian GDP: while wages and prices are rising steadily, GDP is in free fall. Year on year it was down 4.7% in Q1 and Hungary’s government currently expects the economy to contract 6.7 percent this year, the most since 1991. My view is a total policy trap is in operation here, since neither monetary (interest rates are currently 9.5%) or fiscal policy are available, so there is little support to put under the economy at this point. The only way to break the circle in my opinion is to let the forint drop, bring down rates, and restructure the CHF loans.

As will no doubt come as a big surprise, I completely agree. Hungary needs to address the already existing asymmetry inherent in the economic edifice which should entail a strategy on how to deal with the stock of CHF loans on the households' and corporates' balance sheet. This also gives a final spin on the actual topic of play in this entry.

In all probability the dilemma difficulties facing the Hungarian treasury in terms of constructing a viable and solid platform on which to finance its operations is greatly dependent on the issue with the already existing fx denominated loans. If Hungary were to construct a credible and realistic solution to the issue of how to write down/pay off the stock of CHF loans my guess is that the original sin would be a little easier to escape even if not all together.

---

[1] Who follow the lead of Eichengreen and Hausmann.

Hungary Struggles To Apply Its Own Unique Version Of "Internal Devaluation"

Just what the hell is going on in Hungary? This is the question which even the most cursory inspection of the latest round of data coming out of the country leads me to ask myself. What the hell is going on and just what kind of correction is this the IMF are presiding over here?

In May, according to the latest data from the Hungarian statistics office, in the Hungarian private sector real wages were up, and employment was down. Meanwhile in the public sector, real wages were down, but employment was up (contrary to what was supposed to be happening). A recent programme to get workers off the unemployment roles and back to work seems to have had the perverse and contradictory impact of offsetting the fall in private sector employment by giving a sharp boost to public sector employment. So while total employment has remained more or less stable, the balance has shifted, and in the wrong direction. Meanwhile, in an attempt to stem the bloodletting in public finances (the economy remember will probably contract by about 7 percent this year) VAT was raised - by the significant margin of 5 percent (from 20% to 25%) on July 1st, giving consumption, which was already falling sharply, another sharp jolt downwards. Not only that, the Hungararian economy, in order to maintain the value of the forint more or less where it is (all those forex loans) was supposed to be having a major downward correction in wages and prices, yet inflation (which was already at an annual 3.7 percent in June) will surely now be given a hefty kick upwards. So, I ask myself, how does any of this actually make sense, and to who? And meantime the problem of the forex denominated loans remains, and goes jangling around (like any good jailor does) in the background, putting an effective stop on monetary policy just as fiscal policy switches over to complete contracton mode. This is why I talk of "internal devaluation", since the Hungarian authorities (with the agreement of the IMF and the EU Commission) seem to have decided that, rather than resolving the issue of the CHF loans once and for all, they will down the same road that is proving to be so disastrous in Latvia, even though they have their own currency to devalue, should they choose to do so.

At the end of the day, the big question which we are all left with is, whether this structural shift in employment, away from the private sector and towards the public sector, and the increase in the consumer price index to be caused by the sharp VAT hike, plus the ongoing rise in real wages, really is the outcome the IMF support programme was intended to achieve?

Wages Up, Employment Down

Amazingly, with an economy contracting at at least a 7% annual rate, Hungarian real private sector wages aren't falling, they are still rising. They were up (over and above inflation) by 1.7% in May. Evidently those who are still in employment say, crisis, what crisis?



Unsurprisingly Hungary’s consumer confidence index rose in July for a third month (to minus 63.1) after hitting a record low in April.



“Consumers’ perception of their ability to save in the short-run is what improved the most from June,” GKI said in their statement. Well certainly a 5 point hike in VAT is unlikely to encourage them to spend. In fact, paradoxically, saving is what Hungarians collectively really need to do, to reduce the ballooning government debt and pay down the level of net international indebtedness. But all this simply means is that to get the economic growth necessary to do all the required saving Hungary is going to need to export, and a lot more than it was doing previously, which is why the shift towards public sector employment is so serious.

As I say, private sector employment is down in Hungary, by 4.8% y-o-y. While industrial output was down 22.1% in May over a year earlier. Something just doesn't seem to be working as it should be here.



On the other hand, public sector employment is on the up and up in Hungary, due to job creation under the short term stimulus programme, courtesy indirectly of the IMF, who have permitted a large than anticipated budget deficit. Don't get me wrong, it's not the stimulus I am quibbling about, it is what it is being used for. The outcomes we are seeing at present don't seem to me to be producing a large structural change in the right direction.



Actually the rise in public sector employment is not a direct result of the increase in the IMF permitted deficit, but rather comes from restructuring funds earlier used to finance social assistance payments. The same ammount of money (at about 100 billion HUF) was used to provide public work opportunities for people who before April were entitled to receive social assistance for staying at home. Now those considered capable of working can only receive benefits if they are registered as public workers and if they are offered a job opportunity by local governent they are compelled to accept it. Thus, like so many things in Hungary, the intention was good even if the execution wasn't.


Meanwhile, far from the current recession leading to a significant downward shift in wages and prices, real wages are - as we have seen - still rising, and Hungary's consumer prices were still running year on year at 3.7% in June, down it is true from 3.8% in May, but still far to high to start restorting competitiveness. And of course, the July 1st VAT rise will give consumer prices another stout kick upwards, with some analysts suggesting that year end inflation could be running as high as 6%. If this is anywhere near accurate, and the HUF stays in the region of its current euro parity, then Hungary's agony looks set to continue unabated into 2010.



And in case you had forgotten, here is what is happening to Hungarian GDP: while wages and prices are rising steadily, GDP is in freefall. Year on year it was down 4.7% in Q1 and Hungary’s government currently expects the economy to contract 6.7 percent this year, the most since 1991. My view is a total policy trap is in operation here, since neither monetary (interest rates are currently 9.5%) or fiscal policy are available, so there is little support to put under the economy at this point. The only way to break the circle in my opinion is to let the forint drop, bring down rates, and restructure the CHF loans.



The result of all this botched policy - Hungary’s unemployment rate rose to the its highest level in at least a decade in May. The rate rose to a seasonally adjusted 10.2 percent, the highest since at least 1996. And the situation is more likely to deteriorate than improve, with the central bank forecasting lay-offs of around 180,000 in 2009-2010, nearly 5% of the total number of employed.


One of the important things to grasp about the current situation in Hungary is that this is not a constant size wheel running constantly around the same spindle. The long run outloook is steadily deteriorating as population falls and ages. The same is also true of the working age population, which has now been falling steadily for some years (see chart below).Unsurprisingly therefore the NBH now project that employment will fall by 3.2% this year, followed by a 1.7% contraction in 2010, notably primarily due to layoffs in the private sector.



Hungary’s industrial output fell at a slower annual pace in May than it did in April as stimulus plans in the European car industry added to demand, but production was still down 22.1 percent on May 2008 (following a 25.3 percent annual decrease in April). Output rose 2.6 percent over the month.





Hungary's contraction seems to be more or less moving sideways at the moment, and the June PMI came in at 45.8, a slight uptick from 45.4 in May, but hardly a seismic shift. The output improvement was almost all due to the export sector.



Exports

Hungary recorded its fourth monthly trade surplus in May, and came in at 497.7 million euros as compared with 430.3 million euros in April and a deficit of 30.3 million euros in May last year.



Now good news is always good news, but it is important to understand that this result was almost entirely achieved via a dramatic drop in imports, which plunged 32.3 percent in May (following a 35.4 percent decline in April). It is impossible to talk of any marked improvement in exports, since these fell by an annual 24.1 percent, accelerating from a 29.4 percent drop in April. While in the short term this substantial drop in imports (and hence rise in the trade balance) is GDP positive, it is very negative for living standards in the longer term, and the whole situation needs to be reversed by a large boost in exports leading imports as the eurozone economy eventually recovers. But to be able to achieve this Hungarian industry needs to do more, much more, to achieve competitiveness.




Investment Activity


Hungary is suffering from a generalised drop in demand - domestic, export, government, and investment - for which it is difficult to see any short term remedy. In the first quarter of 2009 investments fell by 7.7% compared to the same period of 2008, while they decreased by 1.1% in comparison with the previous quarter (according to seasonally adjusted volume indices). Within this fall machinery and equipment decreased by 9.9%, while investment in manufacturing industry was down by 6.8%. Evidently the first sign of any real recovery in the Hungarian economy will come when investments stabilise and even start to increase, since that will be a reflection of the expectation of future demand arriving further down the pipeline.



Construction

Construction activity was down by 10.1% compared to May 2008. In the first five months of the year, output decreased by 6.9%. In comparison with April production decreased by 3.3%. Construction output showed a decreasing trend in connection with the global economic crisis in the past months. In fact there was a significant difference between the performance of the two construction branches, with buildings activity falling by nearly a quarter, while civil engineering works were up by 7.9%. On a seasonally adjusted basis, building activity was 8.6% lower in May over April, while civil engineering was up one percent on the month.





Retail Trade

Retail sales fell 3.4% year-on-year in the first four months of 2009. In April the fall in retail sales accelerated, and the volume index was down 4.1% compared with April 2008. Retail sales decreased by 0.3% over March according to seasonally and calendar adjusted data.



But the real problem is that Hungary's retail sales are now in long term decline, and it is hard to see this situation turning round as the population declines. The peaked in mid 2006, and it has been downhill ever since. This highlights the important point that Hungary's economic difficulties - like Italy's, which bear some resemblance, are not of recent origin, but go back to the adjustment process that started following the mini crisis of June 2006, an adjustment which has never, at the end of the day, achieved the results which were expected of it, and the real question is, why not?



Monetary Policy Trap

Back in April, the Hungarian Finance Ministry were expecting a 155 billion forint budget surplus for the second half of this year, but since then the economic outlook has continued to deteriorate, and according to their latest estimate there will actually be a 149.6 billion forint deficit in H2. This anticipated shortfall is the principal reason why the IMF and the European Commission recently agreed to let Hungary raise its deficit target to 3.9% of GDP for 2009 from the 2.9% previously agreed. They did this in response to the larger-than-expected economic recession, thus avoiding the additional fiscal tightening measures which would have been needed to hold the deficit below the Maastricht 3.0% target level. The gap in 2010 is now expected to come in only a tad lower than this year at 3.8% of gross domestic product (although this number is subject to considerable revision given the levels of uncertainty facing the economy and hence government revenue and spending). As a result, the EU Commission in their latest forecast suggest gross government debt to GDP will reach 80.8% in 2009, and 82.3% in 2010, way above the 60% euro adoption level.

Nonetheless the Hungarian government is in bullish mood. According to Finance Minister Peter Oszko in a Bloomberg TV interview “Recently there has been a turning point......Financial risks are very quickly decreasing in terms of the whole budget. The Hungarian government is committed to implementing a reform program quite quickly.”

Capital Economics' Neil Shearing isn't so convinced:

But is this new-found optimism justified? Possibly. The National Bank will certainly take heart from the fact that the bond market is functioning once again following a complete freeze late last year. This adds weight to the case for interest rates to be gradually lowered, with a 50bps cut to later this month looking increasingly likely. But amongst all the euphoria, it is important to keep some sense of perspective. First, while the government managed to complete the bond auction successfully, it came at a price. At 6.79%, the yield on the new bonds is around 90bps higher than what existing 2014 euro-bonds currently trade at.

There is indeed a general feeling in the air that monetary easing is coming, and in fact three members of the central bank's Monetary Council voted even at the last meeting to lower the key policy rate by 50 basis points, according to minutes of the 22 June rate setting meeting. The MPC is set to hold its next policy meeting on 27 July, and is widely expected to start a monetary easing cycle. My view: just watch out what happens next.



Basically the problem is the value of the forint. My opinion is that the recent recovery in the currency value (see chart below) has been almost entirely driven by yield differentials, and by self-fulfilling expectations (traders expect the currency to rise), rather than by any change in the underlying economic fundamentals, which as we have seen, has not taken place.



And if you are in any doubt about the extent to which Hungary has lost competitiveness since the start of the century, just take a look at the comparative REERs for Germany and Hungary below (REERs are trade weighted, and take account not only inflation but also movements in unit labour costs, ie productivity).



The problem the central bank and the Finance Ministry have to address is the ongoing issue of the mountain of Swiss Franc denominated mortgages (see chart).



These have stopped increasing in recent times, but still constitute a serious obstacle to any devaluation of the HUF, due to the non performing loans issue this would create for the banking sector. Not only has money been borrowed against homes for to fund house purchases, it has also been loaned for consumption (see chart below), so indeed the fact that even these loans are stagnating hardly bodes well in any way for domestic demand.



The thing is, as long as the interest rate differential remains as it is, there is no possibility of convincing people to take out HUF denominated mortgages. So domestic rates have to come down, but as they come down the forint will fall, and the number of distressed loans will spiral up. So the authorities are stuck in a real policy trap, where they have to wriggle uncomfortably around, carrying out what can only be described as a weird variant of voluntary internal devaluation, an intenral devaluation which again, as we have seen from the wage and price data, just isn't happening.

Obviously the whole idea IMF idea here was some sort of long term "play" - moving the focus of taxation from employment to consumption (addressing the tax wedge issue). Initially this shift was supported by the argument, that, amidst a deflationary backdrop, businesses wouldn't be able to pass the tax increase on to consumers in its entirety. At this point it would seem the Hungarian government has no real room for manouver and are desperate to implement the tax restructuring, therefore they opted for the significant VAT raise.

Part of the thinking which lies behind the present approach seems to be some new concept of financial orthodoxy. The IMF put it like this in the Hungary Standby Loan Report

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

So from Tallinin, to Riga, to Budapest, to Bucharest, the same sonata on a single note is being played, and the message is a clear one - cut spending and you will expand.

But with consumption sinking, government spending falling and exports insufficiently competitive to drive the necessary surplus, the whole thing is now becoming rather a mess, with no clear economic policy objective in the short term (except, of course, maintaining a strong exchange rate) and while in the long term the emphasis is rightly on export. But no one has any idea of how exactly to correct prices sufficiently with the CHF mortgages stuck in the middle.

And the new bond issue only makes things worse here, since as Neil Shearing emphasises:

it is worth noting that the latest euro-bond issue only adds to the mountain of foreign currency denominated debt that lies at the heart of Hungary’s current woes. With the banking sector still in deep trouble and fiscal policy set to tighten, the recession is likely to intensify over the coming quarters.

So, with the Hungarian government currently forecasting a GDP contraction of 6.7 percent,this year, and the likelihood being of further contractions next year and possibly even in 2011, something somewhere is going to give here.

And among the casualties, well why not Hungary's unborn children, the ones she needs to start turning round that population decline I started this post with.



According to preliminary data from the stats office, in the first five months of 2009 38,964 children were born, 1.9 percent less than in the first five months of 2008. But that isn't all, if you look carefully at the chart you will see that the number of children born fell substantially from about March 2007, just nine months after the first financial shock hit Hungary in June 2006. So here's a nice prediction, if economic conditions do work as a short term influence on fertility, then we should see another sharp drop in Hungarian births starting in from July, just nine months after the last financial crisis hit the Hungarian economy. There, I bet you never imagined that the collapse of Lehman Brothers could have such far reaching consequences, now did you?