Just What Is The Real Level Of Government Debt In Europe?

“If you don’t fully understand an instrument, don’t buy it.”

To the above advice from Emilio Botín, Executive Chairman of Spain’s Grupo Santander, I would simply add one small rider: Don’t sell it either, especially if you are a national government trying to structure your country’s debt.

In a fascinating article in today's New York Times, journalists Louise Story, Landon Thomas and Nelson Schwartz begin to recount the mirky story of just how the major US investment banks have been able to earn considerable sums of money effectively helping European governments to disguise their growing mountain of public debt.

Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece and undermining the euro by enabling European governments to hide their mounting debts.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

In fact, concerns about what it is exactly Goldman Sachs have been up to in Greece are not new, and the Financial Times have been pusuing this story for some time, in particular in connection with the investment bank's ill fated attempt to persuade the Chinese to buy Greek government debt (and here, and here). Nor is the fact that the Greek government resorted to sophistocated financial instruments to cover its tracks exactly breaking news, since I (among others) have been writing about this topic since the middle of January - Does Anyone Really Know The Size Of The Greek 2009 Deficit? - following the arrival in my inbox of a leaked copy of the report the Greek Finance Minister sent to the EU Commission detailing the issues.

What is new in today's report from the NYT team is the extent to which they identify the problem as a much more general one, involving more banks and more countries, since "Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere". I very strongly suggest that our NYT stalwarts take a long hard look at what has been going on in Spain, and especially at the Autonomous Community level.

So the question naturally arises, just how much in debt are our governments, really? As the NYT team point out, Eurostat has long been grappling with this matter, and as far back as 2002 they found themselves forced to change their accounting rules, in order to try to enforce the disclosure of many off-balance sheet entities that had previously escaped detection by the EU, since up to that point the transactions involved had been classified as asset "sales", often of public buildings and the like. Following advice paid for from the best of investment banks many European governments simply responded to the rule change by reformulating their suspect deals as loans rather than outright sales. As we say in Spain "hecha la ley, hecha la trampa" (or in English, when you close one loophole you open another). According to the NYT authors:

"As recently as 2008, Eurostat.... reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”"

So just what is all the fuss about. Well, in plain and simple terms it is about an accounting item known as "receivables". Now, according to the Wikipedia entry:

"Accounts receivable (A/R) is one of a series of accounting transactions dealing with the billing of a customers for goods and services received by the customers. In most business entities this is typically done by generating an invoice and mailing or electronically delivering it to the customer, who in turn must pay it within an established timeframe called credit or payment terms."

However, as we can learn from another Wikpedia entry, often the use of "accounts receivable" constitutes a form of factoring, and this is where the problems Eurostat are concerned about actually start:

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.

But how does all this work in practice? Well, the World Wide Web is a wonderful thing, since you have so much information near to hand, at just the twitch of a fingertip. Here is a useful description of what are known as PPI/PFI schemes, from UK building contractor John Laing:

A Public Private Partnership (PPP) is an umbrella term for Government schemes involving the private business sector in public sector projects.

The Private Finance Initiative (PFI) is a form of PPP developed by the Government in which the public and private sectors join to design, build or refurbish, finance and operate (DBFO) new or improved facilities and services to the general public. Under the most common form of PFI, a private sector provider like John Laing will, through a Special Purpose Company (SPC), hold a DBFO contract for facilities such as hospitals, schools, and roads according to specifications provided by public sector departments. Over a typical period of 25-30 years, the private sector provider is paid an agreed monthly (or unitary) fee by the relevant public body (such as a Local Council or a Health Trust) for the use of the asset(s), which at that time is owned by the PFI provider. This and other income enables the repayment of the senior debt over the concession length. (Senior debt is the major source of funding, typically 90% of the required capital, provided by banks or bond finance). Asset ownership usually returns to the public body at the end of the concession. In this manner, improvements to public services can be made without upfront public sector funds; and while under contract, the risks associated with such huge capital commitments are shared between parties, allocated appropriately to those best able to manage each one.

And for those still in the dark, Wikipedia just one more time comes to the rescue:

The private finance initiative (PFI) is a method to provide financial support for "public-private partnerships" (PPPs) between the public and private sectors. Developed initially by the Australian and United Kingdom governments, PFI has now also been adopted (under various guises) in Canada, the Czech Republic, Finland, France, India, Ireland, Israel, Japan, Malaysia, the Netherlands, Norway, Portugal, Singapore, and the United States (amongst others) as part of a wider program for privatization and deregulation driven by corporations, national governments, and international bodies such as the World Trade Organization, International Monetary Fund, and World Bank.

PFI contracts are currently off-balance-sheet, meaning that they do not show up as part of the national debt as measured by government statistics such as the Public Sector Borrowing Requirement (PSBR). The technical reason for this is that the government authority taking out the PFI contract pays a single charge (the 'Unitary Charge') for both the initial capital spend and the on-going maintenance and operation costs. This means that the entire contract is classed as revenue spending rather than capital spending. As a result neither the capital spend nor the long-term revenue obligation appears on the government's balance sheet. Were the total PFI liability to be shown on the UK balance sheet it would greatly increase the UK national debt.

And here are two more examples of what is involved which were brought to light by a quick Google. First of all, the case of Italian health payments. Now according to analysts Patrizio Messina and Alessia Denaro, in this report I found online from Financial Consultants Orrick:

In the last years many structured finance transactions (either securitisation transactions or asset finance transactions) have been structured in relation to the so called healthcare receivables.The reasons are several. On one side, the providers of healthcare goods and services usually are not paid in time by the relevant healthcare authorities and therefore, in order to gain liquidity, usually assign their receivables toward the healthcare authorities. On the other side, due to the recent legislation that provides for very high interest rates on late payments, the debtors as well as banks and other investors have had the same and opposite interest on carrying out different kind of transactions. In this brief article we will analyse, after a quick description of the Italian healthcare system, some of the different structures that have been used in relation to transactions concerning healthcare receivables and, in particular, we will focus on transactions concerning the so called “raw receivables”, which are lately increasing in the Italian market practice, by analysing the legal means through which it is possible to ascertain/recover such receivables.

This system thus has two advantages (apart from the fact that it effectively hides debt). In the first place the healthcare providers gain liquidity in order to continue to run hospitals, pay doctors, etc, while those who effectively intermediate the transaction earn very high interest rates for their efforts, interest payments which have to be deducted from next years health care provision, and so on.

As the Orrick report points out, Italy’s national healthcare service (servizio sanitarionazionale, “nhs”) is regulated by the legislative decree of December 30, 1992, no. 502 (“decree 502/92”).The reform introduced by decree 502/92, as amended from time to time, provides for a three-tier system for the healthcare service, as outlined below: State level The central government provides a national legislation limited to very general features of the NHS and decides the funds to be allocated to the single regions according to specific criteria (density of population, etc.) for the NHS.

As the Orrick analysts note: "the Healthcare Authorities usually pay the relevant Providers with a certain delay".

Usually, when healthcare funds are allocated, in the national provisional budget, the central government underestimates the amount of healthcare expenditure. Since the central government does not provide regions with enough funds, regions are not able to provide enough funds to Healthcare Authorities, and payments to the Providers are delayed. Since the Providers need liquidity, they usually assign their receivables toward the Healthcare Authorities. To deal with all the above issues, Italian market practice has been developing an alternative system of financing through securitisation and asset finance transactions of Healthcare Receivables.

As the analysts finally conclude:

Despite of the risks concerning the judicial proceedings, Italian market players are still very interested on carrying on securitisation transaction on this kind of asset, principally because Legislative Decree no. 231/02 provides for very high interest rates on late payments (equal to the interest rate applied by ECB plus 7%) - my emphasis

Another technique Eurostat have identified as a means of concealing debt relates to the recording of military equipment expenditure, as described in this report I found dating from 2006. At the time Eurostat were worried about the growing provision of military equipment under leasing agreements. Basically they decided that such provision was debt accumulable.

Eurostat has decided that leases of military equipment organised by the private sector should be considered as financial leases, and not as operating leases. This supposes recording an acquisition of equipment by the government and the incurrence of a government liability to the lessor. Thus there is an impact on government deficit and debt at the time that the equipment is put at the disposal of the military authorities, and not at the time of payments on the lease. Those payments are then assimilated as debt servicing, with a part recorded as interest and the remainder as a financial transaction.

However, a loophole was found in the case of long term equipment purchases:

Military equipment contracts often involve the gradual delivery over many years of a number of the same or similar pieces of equipment, such as aircraft or armoured vehicles, or including significant service components, such as training. Moreover, in the case of complex systems, it is frequently the case that some completion tasks need to be performed for the equipment to be operational at full potential capacity. Some military programmes are based on the combination of several kinds of equipment that may be completed in different periods, so that the expenditure may be spread over several fiscal years before the system, globally considered, becomes fully operational.

In cases of long-term contracts where deliveries of identical items are staged over a long period of time, or where payments cover the provision of both goods and services, government expenditure should be recorded at the time of the actual delivery of each independent part of the equipment, or of the provision of service.

Payment for such items are only to be classifed as debt at the time of registering the actual delivery, which may explain why, if my information is correct, the Greek military as of last December were still officially "testing" two submarines which had been provided by German contractors, since final delivery had still to be formally registered, and the debt accounted.

A lot of information about the kind of things which were going on before the 2006 rule change can be found in this online presentation from Europlace Financial Forum. Here are some examples of private/public sector cooperation in Italy.



And here's a chart showing a list of advantages and possible applications:



Now, at the end of the day, you may ask "what is wrong with all of this"? Well quite simply, like Residential Mortgage Backed Securities these are instruments that work while they work, and cause a lot of additional headaches when they don't. I can think of three reasons why debt aquired in this way in the past may now be problematic.

a) they assume a certain level of headline GDP growth to furnish revenue growth to the public agencies committed to making the payments. Following the crisis these previous levels of assumed growth are now unlikely to be realised.
b) they assume growing workforces and working age populations, but both these, as we know, are now likely to start declining in many European countries.
c) they assume unchanging dependency ratios between active and dependent populations, but these assumptions, as we also already know, are no longer valid, as our population pyramids steadily invert.

Given all this, a very real danger exists that what were previously considered as obscure securitisation instruments, so obscure that few politicians really understood their implications, and few citizens actually knew of their existence, can suddenly find themselves converted into little better than a glorified Ponzi scheme.

And if you want one very concrete example of how unsustainable debt accumulation can lead to problems, you could try reading this report in the Spanish newspaper La Verdad (Spanish, but Google translate if you are interested), where they recount the problems being faced by many Spanish local authorities who are now running out of money, in this case it the village of San Javier they have until the 24 February to pay a debt of 350,000 euros, or the electricity will simply be cut off! The article also details how many other municipalities are having increasing difficulty in paying their employees. And this is just in one region (Murcia), but the problem is much more general, as Spain's heavily overindebted local authorities and autonomous communities steadily grind to a halt.

So where is Hungary?

Response to Edward Hugh

by Peter Oszko
Minister of Finance, Hungary

The financial crisis has re-shaped the regions and countries in financial terms. New country groups emerge in analyses and decisions by the investors receiving specific interest or countries far from one another are compared. It is honourable that Hungary enjoys distinguished attention especially because international institutions, investment houses or even rating agencies more often than not appreciate that Hungary has been capable of a huge fiscal consolidation in the most difficult times of the crisis. Edward Hugh’s article ‘Hungary Isn’t Another Greece……Now Is It?’ is all the more striking.

I think we could easily agree that the Hungarian economy and financial policy management by the Government had and have to face a lot of challenges while correcting mistakes made mostly in the past. It seems, however, that the greatest test is to prevent prejudices, perceptions based on false findings, poor information and mistaken conclusions or the consequences thereof. Unfortunately, we find several examples of this kind in Edward Hugh’s article as well. In this context, now we can take occasion to clarify the most characteristic mistakes and misunderstandings in relation to the Hungarian economic and financial policies.

Such is one of the key findings in the article that plays down structural reforms made in the recent period. The author makes ironic remarks that reform measures would lie in the elimination of 13th month pension benefit and restructuring family allowances in total suggesting that it was all to take place as far as changes to the pattern of public expenditure are concerned. Against this background, if we want to list only the last year’s most important measures the following should be mentioned in addition to the elimination of 13th month pension benefit:


- We changed pension indexation with anticyclical effects for the subsequent years;

- We modified the conditions of early retirement with the pension benefits included. Retirement before the statutory age shall involve lower pension benefit;

- Retirement age will gradually increase from 2012 by six months each year until 65 years of age both for men and women;

- We restructured our too generous housing subsidy scheme including the elimination of interest subsidies and social policy aid replaced by a narrower new subsidy scheme;

- Energy price subsidies will be phased out of the social policy system in 2010;

- We changed the method of sick-pay disbursement with a general rate lowered by 10 percentage points;

- Entitlement criteria of family allowance were modified. Now it is available only until the lower limit of age,

- We changed child-care subsidies with shorter periods of eligibility for both child-care allowance and child-care aid;

- Headcount stop entered into force in government agencies from the summer of 2009;

- Nominal wages were frozen for those employed in the public sector;

- To limit spending on curing and preventing healthcare services, hospital financing regulation was created in support of focussed hospital care, i.e. the so-called “performance limit-based accounting system”;

- Scheme of Treasurers was set up from the summer of 2009 to ensure disciplined budgetary management.

These measures will cut pension expenditure in the general government budget by more than 3 per cent of GDP as a result of only the structural moves involving the pension system as shown in the Table below.



In addition, restructuring of housing subsidies, energy price subsidies as well as family and sickness allowances will result in an expenditure cut by 1.0 per cent of GDP in the year of entry into force with increasing order of magnitude in the subsequent years. The Table below indicates well what size of savings we can achieve for more years from the measures relative to the Convergence Programme of Hungary created before 2009. While postponement of investment and development projects could obviously help short-term savings in the crisis period, restructuring of the social system, restraint on public sector wages, sustainable pension expenditure and controlled financing in healthcare should result in long-term, sustainable and structural savings for government budget.



It follows that restructuring moves we took will ensure a declining budget deficit and public debt from 2010. Therefore, the following governments will not need any more to take new austerity measures requiring political sacrifices but to remain on the budget course now established and reap the profit from the results arising in the subsequent years.

Of course, there are reform tasks left on the next government even after the present budget restructuring. The most recent fiscal reorganization involved the composition and balance of government budget. However, six or more month could not be enough to transform institutions and institutional framework. Only formal agreements could be signed for long-term restructuring of companies providing for public transport, which are yet to be fulfilled. Furthermore, more should be done to improve healthcare, education and local governments functioning with the purposes of efficient use of financial resources and raising the level in public services offered, rather than only financing. Thus, after the present fiscal restructuring should be followed by institutional changes during the next election period.

As far as labour market conditions and tendencies are concerned, Edward Hugh has again some wrong findings. It is false that public sector employment grew. Headcount in the public sector went down by 100,000 from 2006. Last year saw only further slowing cut in employment, given the government order (approved in the summer of 2009) of unchanged staffing in force including vacancies.

The new is the start of “Pathway to Work” Program, which is intended for those living on social aid to get back to labour market through communal services projects. In statistical terms, employment in communal services is included in the public sector. To receive a realistic picture, the figures must be adjusted for these effects. Presently, some 100,000 have been involved in the program that opens the way for those concerned to the business sector, rather than to the public one.


This process is reinforced by the shift in tax burden of 3 per cent of GDP. In this context, there is no understanding Edward Hugh’s remark that “… we have seen little in the way of noticeable impact on either employment or on Hungarian exports”. These measures have entered into force only recently (for a few weeks) so it is not reasonable to expect spectacular changes in export statistics applying to the present period yet to be published. That said labour cost cut is the highest in the lower income bracket while it is important for average wage as well. Tax wedge on average wage and marginal tax wedge will go down by 9 per cent and 20 per cent, respectively, relative to the previous year. As a result, changing tax legislation may cause significant improvement in not only labour cost but also in labour efficiency to entail increasingly better international competitiveness and position heading for export markets. As is seen from the figures below, independent analysts’ views underline this improved situation and positions of Hungary.





Based on the most conservative estimates, it is slowly expected that growth outlook in Hungary’s export markets improve putting the country on a more stable and sustainable course of growth than could be hoped on the basis of domestic consumption artificially boosted through further indebtedness both of the public sector already strongly indebted and of the private sector still more strongly indebted.

Revision of 2010 forecasts does not reckon with higher domestic consumption from the former projections. We do not expect, in contrast with Edward Hugh’s allegation, economic growth. In our view, recession of 0.3 per cent could be achieved at export growth of 5.5 per cent. Since Hungary managed to achieve export growth at a higher rate than demand for imports grew in the export markets, the shift in tax burden, lower labour cost and higher labour efficiency, e.g. improving competitiveness suggest that the forecast below is reasonable or even much more careful than many projections given by analysts.




Critics over public debt are in sharp contrast with Edward Hugh’s remarks criticising domestic consumption drop. In particular, the lack of coherence seems on such an economic analysis that would, at one time, require artificial boost on the domestic consumption and a decreasing government debt. Public debt may be lowered below 60 per cent relative to GDP by 2015, due particularly to the fiscal consolidation underway while peaking undoubtedly at around 79 per cent in 2010. However, for the sake of decency, it must be said that 3 per cent of public debt makes only a part of debt in gross since it increases FX reserves from the IMF package.

Also, it should be noted that average public debt relative to GDP in the euro zone will make 84 per cent at the same time. That said there is not much criticism to make over the ruling government moves, especially in relation to public debt since the measures taken in the recent past were as good as only suitable for pushing down the debt level. It is interesting that Edward Hugh’s analysis refers to Eurostat forecasts (autumn of 2009) in relation to fiscal deficit where the European Commission now admitted to have assessed Hungarian fiscal outlook with too much criticism. That is, while they had first found that government deficit would make 4.1 per cent of GDP for 2009, now they see it below 3.9 per cent as originally set out.

Partly with reference to Mark Pittaway, Edward Hugh highlighted external debt as Hungary‘s most pressing problem, somewhat misunderstanding the economic history after the regime change in 1989, and implying that public debt had kept the Hungarian economic growth trapped all the way unlike other countries in the region with better debt figures at the time of regime change. However, this analysis does not consider the economic policy achievements in the second half of the 90s or the fact that public debt has resumed to seem growing since 2001 while private sector indebtedness increased importantly from 2006 on.



If this is really supposed to be the most worrying problem of the domestic business environment, then it should be considered that definitely positive processes were shown on the country’s external debt in the recent months. We saw in 2009 that external financing capacity of Hungary could be positive amid a slightly negative balance of payments as a permanent feature for the coming years since the difference between the balance of payments and financing capacity results from EU capital transfers that may increase further in the years ahead. As a result of these processes, Hungary’s external indebtedness may continuously plunge. Therefore, the package of measures placing emphasis on domestic financial equilibrium and competitiveness in export markets due to which the ratio of imports to exports significantly improved, may offer a solution to external indebtedness as most pressing problem as well.




Also, measures taken in the recent past allowed for Hungary to restore market confidence and do without drawing on IMF loans. It is interesting that Edward Hugh cites separately my statement that “We don’t need IMF money any more and my expectation is that since Hungary is targeting the same track for the future, we won’t need financial help”. This comprises no novelty, however, for those being aware of financing plans of the Hungarian public sector. The country has not drawn down instalments due from the International Monetary Fund since September 2009.

Also, it is well-known that the Government wished to maintain co-operation with the IMF even in this form. What is more, the Parliamentary opposition made statements on similar plans in the recent past. There is no ground for the assumption that the country would deviate from the path of structural reforms, and that the market-based financing would endanger the structural balance of government budget. In this respect, drawing a parallel to Greek political declarations cited does not consider the – not so insignificant - fact that the Hungarian statement was made on the stable market financing after a stabilisation programme and as a result, beside an improving structural balance while Greece, in contrast, did so after a significant deterioration of its fiscal balance.

Based on the foregoing, it could well be a matter of mistake or misunderstanding that this analysis found Hungary’s path similar to Greece’s in terms of economic and budgetary processes of 2009. However, it must be a warning to Hungary since it shows that unchanged preconceptions, perceptions and prejudices could imply the risk of misunderstanding even despite huge fiscal restructuring with the greatest political sacrifices.

Hungary Isn't Another Greece........Now Is It?

I couldn't help being struck earlier this week by the following statement in an interview the Financial Times had with Hungarian Finance Minister, Peter Oszkó:

"Structural reforms of the pension and social welfare systems, plus a rebalancing of the tax system, should allow the government to report a 3.9 per cent budget deficit in 2009, on a par with the preceding year and in line with IMF requirements".

"Structural reforms", I asked myself, "exactly which structural reforms are we talking about here?" Certainly the EU Commission and the OECD have been pounding away at the Hungarian authorities on the pressing need for major changes in the health and pension systems (these areas - and the way they are rising as the population ages - are, after all, the underlying cause of the structural deficit in the Hungarian budget). In fact it seems to me that the FT is merely re-iterating here Peter Oszko's own claim that the government's austerity measures are working (and no matter how many times you repeat something, it doesn't make it true).

As I have argued time and time (and time) again, major doubts remain about whether the recent "austerity" measures (whether we are talking about the post June 2006 package, or the 2009 one) have really done anything substantial to restore long term competitiveness to the Hungarian economy, since the only measures which could come near to being called "structural reforms" which have been implemented to date are the withdrawal of a 13th month pension payment together with cuts in the maternity leave system (and these are not really "reforms" at all, but deficit reducing measures). The rebalancing of the tax system the FT refers to is the shift from payroll and income to indirect taxes, which could make labour cheaper to employ, but since the reduction is countebalanced by an increase in consumption tax (which weakens domestic demand) to date the only visible consequence has been a sharp fall in retail sales, while we have seen little in the way of noticeable impact on either employment or on Hungarian exports.

Indeed the situation is rather worse than the above chart suggests, since the anti crisis measures have lead to a sharp increase in public employment.



while private sector employment has fallen quite sharply.



Peter Ozsko has also been appearing in the press in recent days to inform us that Hungarian 2010 gross domestic product numbers could be positively revised when compared with an earlier government forecast for a 0.6 percent fall. His reasoning - as put to Reuters - is that "export markets will perform better so there is a better outlook for the country." In fact what he said was that he expected the country to return to quarter-on-quarter growth in either the second quarter or third quarter of next year - a possibility that is certainly not excluded. What he did not say - although some newspapers seem to have implied this - was that annual growth would be positive. "That does not mean growth, but at most a smaller contraction," the finance ministry told Reuters later, in order to clarify the reported comments.

The correction to the earlier optimistic interpretation seems totally warranted, since the Organisation for Economic Co-operation and Development currently expect eurozone real final domestic demand to stagnate in 2010, with the Germany economy being forecast to grow by only 0.2 per cent, so it is hard to see the export market in the country that is Hungary's main customer giving that much-needed lift to Hungarian exports.



But even beside this point, it is hard to see any forseeable increase in exports making up for the drop in domestic demand. In the first place Hungary has badly lost international competitiveness in recent years.



And in the second both the Forint and consumer price inflation have been rising of late, only adding to these competitiveness problems. The best guess is that the Hungarian economy contracted by around 7% in 2009, yet despite this Hungarian consumer prices continued to rise, and are now up a whopping 72% on the 2000 level, yet the Forint has only fallen around 8% over the same period.




Something seems badly out of line in Hungarian policy. As Mark Pittaway, Senior Lecturer in European Studies at the UK Open University points out, the difficult issue for Hungarian economic management has always been what to do about the external debt.

The key is public debt, and the decision to which every Hungarian government has held to, not to ask for any re-scheduling and to insist on its precise repayment. This has forced the government to pursue consistently policies based on overly high interest rates to attract capital into the country - and this has been consistently the case since 1988-9.

During the transition period this had two effects - to deny domestic businesses of credit, and to make it difficult for them to export given that the consequence was an overly strong Forint. In addition, the first post-1990 government was among the first to fully implement its bankruptcy law (earlier than Poland, and way earlier than either the Czech Republic and Slovenia) in 1991, in the depths of the first recession. The real economy was sacrificed on the altar of the financial stability of the state given the decisions made about public debt (remember the Czech debt was small, Slovenia de-facto defaulted on its share of the Yugoslav debt and eventually renegotiated it, and Poland gained partial forgiveness).

Hungarian gross government debt is now expected by the EU Commission to hit over 80% of GDP in 2011, but this is hardly the issue, since unless growth and competitiveness can be restored to the economy, the ageing and shrinking working age population problem will lead to what Moodys recently called (in the Greek and Portuguese cases) a slow death.



And to the large government debt must now be added the indebtedness of households in Swiss Francs, which simply reinforces an "unrealistically" high forint policy, as Mark says, sacrificing the future of the real economy to the needs of maintaining financial stability.

And during the term of the present government the situation has only worsened, since last week the Hungarian Central Statistical Office announced that the consumer price index rose 5.6% year-on-year in December (see chart above), up from the 5.2% growth in the previous month, and well above the average consumer price inflation for 2009 of 4.2%.




And the culprit isn't hard to spot, since the government raised the VAT rate in June by 5%. The impact on retail sales was not that hard to imagine either - they were down an annual 7.5% in October, and by a seasonally adjusted 0.6% on September.



Elections Loom In Hungary

And on top of all these issues, Hungary is shortly to have elections, a situation which is leading to all sorts of speculation about what might happen to the deficit. According to a recent research report from HSBC analyst Kubilay Ozturk, there is a clear risk that Hungary's budget deficit could deviate from the current fiscal path agreed with the International Monetary Fund (IMF), if - as seems likely - opposition party Fidesz assumes power later this year. While this year's budget deficit may well come in on target, economists close to the opposition party have been warning that the 2010 deficit could balloon again to 7% of GDP. The ins-and-outs of the argument are complex (since the figure is based on incorporating debt accumulated in state owned entities), but clearly the IMF would not be happy at such a development. But then Peter Ozsko argues Hungary may well no longer need the IMF money - which is only well and good, since the lending agency have specifically warned against declaring this level of deficit, and may be hard to convince if the deficit figure starts to head north again.

Today, the IMF has warned Hungary again that it would not tolerate the country’s budget deficit swelled to 7.0% of GDP this year, a level envisaged by the opposition party Fidesz, the likely winner of this year's general elections. The government targets a budget shortfall of 3.8% of GDP, under its IMF-European Union credit line. In an interview with Dow Jones, IMF Hungary representative Iryna Ivaschenko noted that "the definitions [of government debt]are not always comparable, so you should not compare the 3.8% [of GDP] with the 7%. You cannot say they are not right, but it is comparing apples and oranges." "But if you do take, consistent with our definition, the deficit all the way to 7% [of GDP], such policies can clearly not be tolerated, because that would undermine fiscal sustainability and be detrimental for market confidence," Ivaschenko added.

But what if Fidesz simply didn't want to accept the unpopularity for a policy which may not be working, and a further fiscal squeeze? The political logic of coming straight out with a "they have overspent" type of argument could be compelling, although it should be remembered what just happened to the last government who did this (in Greece), or what happened in Hungary in June 2006, after the then Prime Minister Ferenc Gyurcsany's "lies morning noon and night" speech.

"I know that this is easy for me to say. I know. Do not keep bringing it up against me. But this is the only reason it is worth doing it. I almost perished because I had to pretend for 18 months that we were governing. Instead, we lied morning, noon and night. I do not want to carry on with this".

That time the country had to admit to a fiscal deficit which was way beyond what they had been talking about previously, and the country then enetered a financial crisis which has now lasted three and a half years. Of course, this time nothing so dramatic will have been happening (there has been an IMF programme in place), but this does not mean problems may not arise, since financial markets are, after all, extremely nervous. And certainly analysts are anticipating upward movement in the 2010 deficit level. As Portfolio Hungary notes: "The market is now more convinced than a month ago that Hungary will not meet its budget deficit target in 2010, the consensus estimate of analysts showed in a Reuters poll on Thursday. The median forecast for Hungary’s 2010 budget deficit came to 4.4% of GDP, up from 4.1% a month ago".


Greece Serves As the Example

"We don’t need IMF money any more and my expectation is that since Hungary is targeting the same track for the future, we won’t need financial help."
Peter Oszkó, Hungarian Finance Minister

'We are not expecting anyone to come to our rescue. Greece has not asked for it, nor is it expecting anything of that sort....We will be able to satisfy our borrowing requirements in international markets in the next weeks and months, according to the schedule we have,'
George Papaconstantinou, Greek Finance Minister

So if Hungary does, as seems quite possible, decide not to take up more loans from the IMF, where exactly does that leave the country? Who will have the leverage to ensure the structural reforms which evidently are still needed. Evidently Greece can give us some indication, since while at the present time it is not totally clear whether or not the Mediterranean country will finally have to go the IMF itself, Europe's institutional structure is changing rapidly as a result of the challenge which Greek statistics and debt have presented for all the other EU countries. Only this week Europe's Finance Ministers warned Greece that it had to step up its efforts to tackle a fiscal crisis that threatens to spread to other countries across the region.

Indeed the bulk of the discussion an the finance ministers meeting was occupied up with their concerns over Greece, since despite being in the eurozone, the country's credit ratings have plunged following the revelation that its government deficit estimates for 2009 were grossly understated.

Greece has now presented the commission with a new plan aimed at cutting its deficit from the currently estimated 12.7 per cent of gross domestic product to below the EU's threshold of 3 per cent of GDP by the end of 2012. As a result of that report, the commission will propose an action plan in February and will 'lay down certain dates from June onwards in order to launch a discussion at least three times during the rest of the year on how the programme and reforms are going to be implemented,' according to Commissioner Almunia. That is, progress in deficit correction procedures will now be carefully monitored. As many observers have commented, this is the closest the EU has so far come to putting its hand directly on the economic policy of a eurozone member. 'The Greek programme concerns Greece firstly, but also concerns all the eurozone,' Luxembourg Finance Minister Jean Claude Juncker said on leaving the meeting.

The Credit Rating agency Moody's Investors Service maintained its negative outlook on Greece following the announcement of country's stability and growth program saying that while the Greek government's plan to restore its fiscal credibility, reform its tax system and combat tax evasion is relatively well designed, at least for the short term, uncertainty remains about the Greek government's ability to implement the program. That is to say, it is action not words which now matter in the financial markets, and both Greek and Hungarian governments would do well to remember this.

Where Does Greece Go From Here?

The next step is for the EU Council to set a deadline for when the Greek government must achieve its goals. This deadline is likely to be 2012, simply because the Greek government itself has set this target. All the relevant recommendations will finally be endorsed by euro zone finance ministers at their next meeting on Feb. 15-16 when they formally give notice to Greece to reduce the deficit, marking the last stage of the procedure before sanctions of various kinds that are provided for under the EU Stability and Growth Pact.

Greece will then have four months, so until June, to act on the recommendations for policy action endorsed by the ministers. If it acts in a way which the Commission consider to be consistent with the undertakings given, the excessive deficit procedure will be then held in abeyance, until Greece reaches its target of a deficit below 3 percent. If, at the end of the three year period the Commission believes that the improvement is sustainable, it will ask the ministers to end the excessive deficit procedure.

If on the other hand the Commission decides in June that Greece has not complied (unlikely), the Finance Ministers can then consider imposing sanctions. Since such measures should be imposed no later than 16 months after the decision that Greece had an excessive deficit, which was taken on April 27, 2009, the time scale would imply August 2010.



The sanctions envisaged in EU agreements first take the form of a non-interest-bearing deposit with the European Commission and comprises:

* a fixed component equal to 0.2 percent of GDP;

* a variable component equal to one tenth of the difference between the deficit as a percentage of GDP in the year in which the deficit was deemed to be excessive and the reference value of 3 percent of GDP.

The deposit cannot, however, be higher than 0.5 percent of GDP per year. If Greece were to find itself at that stage, this is how much it would have to pay.

Sanctions could also include:

- stopping the EU's cohesion funds to Greece.

- stopping credit from the European Investment Bank.

- asking Greece to issue additional information, as specified by the ministers, before issuing bonds and securities.

If Greece continued to ignore the recommendations, ministers could in 2011 intensify the sanctions by requiring an additional deposit equal to one tenth of the difference between the deficit as a percentage of GDP in the preceding year and the reference value of 3 percent of GDP.

If, after two years, the deficit still remains above 3 percent, the deposit is converted into a fine. If the deficit falls below 3 percent, the deposit is returned.

The interest on the deposits lodged with the Commission and the yield from any fines is distributed among EU countries without an excessive deficit, in proportion to their share of the total gross national product of those eligible.

Commission Powers Now To Extend Well Beyond Monitoring Deficits

Luxembourg Finance Minister Jean-Claude Juncker also announced that there was about to be an overhaul of how the 16 nations using the euro coordinate their economies, with countries being be formally warned if they are running much higher inflation, average wage rises or current account deficits than their neighbors. Juncker said Finance Ministers are about to get involved into a range of far wider issues on how the economy is run, including government policies on structural reforms - such as making labour markets more flexible.

From next month, countries will probably be warned by the European Commission if their countries differ too much from the rest of the euro zone on broad policy guidelines or on specific areas such as inflation, wages or current account deficit. That warning would not be backed by any penalty.

"We need to broaden surveillance in the euro area," Juncker said, adding that closer monitoring should also extend to European countries whose currencies are linked to the euro and who hope to join the currency zone, such as Estonia and Latvia.

So, Hungarian politicians be warned- You are not Greece right now, but you could so very easily end up where that poor, unfortunate country finds itself, and especially so if you make wildly optimistic growth scenarios, and debt to GDP forecasts, and doubly so if you think that coming out of the loving arms of the IMF will leave you free to go about your business as you see fit. The world around you is changing, and you need to get ready to adapt to those changes.