Contagion Turns East

Well, I don't know how many other people have noticed, but the Hungarian forint has been having rather a hard time of it over the past few days. The currency was down by as much 1.3 percent against the euro at one point today, today making the two-day intraday loss 3.6 percent, and this according to Bloomberg, was the biggest such fall since March last year. The Polish zloty also has weakend slightly, and fell by 0.1 percent to 3.9333 against the euro today while the Czech koruna gained 0.1 percent to 25.582 against the euro. At the same time the cost of credit default swaps on Hungarian debt rose 23.5 basis points to 240. Now virtually all currencies associated with the euro have been having a hard time of it in recent days, but what matters is the magnitude of the pressure being felt in each case, and Hungary here has been unlucky enough to have entered a period of political uncertainty at just the time when the level of market nervousness is higher than normal. There is another problem too. Over 85% of Hungarian home mortgages are not in forints, they are not even in euros, they are in Swiss francs, and the CHF has risen sharply against the euro since the start of the year. So unfortunately Hungarians don't even benefit from the euros woes.



Really, and unfortunately, this is the one I had been waiting for, and expecting. And precisely why did has the forint tanked in this way? What is so special about Hungary? After all, aren't many of Europe's economies seeing the cost of financing their government debt rising sharply over recent days. Basically one of the key reasons the forint has taken such a sharp knock is that Viktor Orban, Hungary’s new premier-in-waiting, just said in public what everyone following Hungary has been thinking (and saying) for weeks now: Hungary's fiscal deficit is going to be higher (possibly significantly higher) than the target agreed with the IMF. Other factors have also added to the level of concern about the country. What exactly will the core orientation of the incoming government economic policy be, and how much political interference might there be in the financial and monetary institutional structure? Certainly things haven't been helped by the way Hungary's incoming Prime Minister has publicly criticised the financial markets regulator (PSZÁF) and even gone so far as to give the impression he would like to replace central bank (National Bank of Hungary - NBH) governor Andras Simor (see Portfolio Hungary account here). In a world like the one we live in right now, what you ask for is what you get, and so get it they did.

The Comeback of a Political Survivor

Guest Post by Mark Pittaway


The outright victory of Viktor Orbán’s FIDESZ party in the first round of Hungary’s parliamentary elections on 11 April, and the likeliehood that they will win a two-thirds majority in parliament after the second round on 25 April marks a new stage in the unfolding of Hungary’s entangled political and economic crises – crises that have been in process since the summer of 2006. Most discussion of the election outside Hungary has focussed on the 16.67 percent won by the neo-fascist Jobbik party, with its explicit racist rhetoric towards Hungary’s Roma, its open anti-Semitism and its uniformed paramilitary wing, the Hungarian Guard. Within the country attention has focussed, especially among FIDESZ’s defeated left-liberal opponents, on the probability that FIDESZ will use its new found power and influence to purge the public sector and the media of its opponents, waging an intensified version of the “culture war” it conducted against the liberal left when it was last in power between 1998 and 2002.

Viktor Orbán himself ranks among Europe’s most persistent political survivors. In 2002 he was narrowly defeated by a coalition of Socialists and the liberal Alliance of Free Democrats in an election he was widely expected to win that took place in a benign economic climate. This defeat was largely self-inflicted and a product of FIDESZ’s authoritarian and confrontational policies towards its opponents. A further, and larger defeat in 2006 seemed to confirm the outcome of 2002 – that Orbán’s divisive style and widespread suspicion of his authoritarianism and use of right-wing populism would keep FIDESZ out of power for a long period. In the light of this, Orbán’s political survival and return to power are worthy of explanation. In the morrow of his defeat in 2002, Orbán began to transform FIDESZ from a traditional political party into an alliance of disparate movements originally integrating elements on the far right into a broad political coalition. A politics of using the deep-seated left-right polarization within Hungary to integrate the far right into his coalition was combined with a reach for the political centre by seeking to present FIDESZ as a party that stood for an expansion of welfare protection for the population – a kind of social democracy in national colours. Re-launched as FIDESZ-the Hungarian Civic Alliance in 2004, the party promised an expanded welfare state and lower taxes, while it began using the provision in the Hungarian constitution to initiate referenda as a campaigning strategy. Between 2004 and 2006 this strategy failed, yet it has been used to considerable effect since 2006 – though this effect has been less the result of trust in Orbán than a consequence of the political failures of his opponents and the unwinding of Hungary’s post-socialist economic model.

After the deep recession that followed the collapse of state socialism during the early 1990s, Hungary produced growth of 4-5% per annum during the latter half of the decade as a consequence of favourable economic circumstances, the apparent stabilization of the country’s external debt as a consequence of receipts from the privatization process, and an influx of FDI, largely of German and Austrian origin, in the expectation of speedy Hungarian membership of the European Union. Growth peaked in 2000 and after this date the circumstances that underpinned it began to unwind. Hungary’s competitiveness vis-a-vis its German and Austrian neighbours declined progressively, exacerbated by the strength of the Forint, while the EU’s decision in 2000 to support a large eastern enlargement, rather than one in which a select number of countries in Central Europe would gain EU membership intensified competition for FDI. While growth averaged 3-4% per annum until 2006, this was only maintained by running larger fiscal deficits and as a consequence of the demand created by increased consumer indebtedness fuelled by the de-regulation of financial markets that occurred in the wake of the consolidation of the banking sector and with EU membership.

As predominantly Austrian-owned entrants into the personal lending markets sought to increase market share they used the strong Forint, and high Forint interest rates to offer loans to households denominated in foreign currency, predominantly in Swiss Francs, but also in Euros, and even in Japanese Yen.

In 2004 the Socialist-Free Democrat government, believing they faced defeat in subsequent elections, ditched Prime Minister, Péter Medgyessy, and replaced him with Ferenc Gyurcsány. Faced with a large opinion poll deficit and attacks from FIDESZ that called for an expansion of welfare spending, Gyurcsány sought to gain re-election through maintaining large public deficits. As a consequence of pre-election spending both the European Union, and international credit rating agencies became increasingly nervous at Budapest’s poor control over public spending, and its attempts to move some public expenditure – notably on motorway construction projects – off the balance sheet.

The patience of financial markets was stretched up to the elections in April 2006, which Gyurcsány won, aided by a cut in the rate of VAT on luxury goods from 25% to 20%, and unfunded promises of tax reduction over the coming parliamentary term. Austerity followed the election as taxes were hiked, spending was cut, while co-payments in health and higher education were introduced. The government became severely unpopular by the beginning of summer, a situation compounded by a series of communication errors that culminated in the leaking to the press of a recording of a speech by Gyurcsány in which he admitted “we lied morning, noon, and night” to win the elections in September, and several months of disturbances on Hungary’s streets.

The austerity programme effectively removed demand from the economy, while the strong Forint policy was maintained by the central bank, and foreign currency lending continued apace. The economy stagnated, entering its first recession since 1993 in early 2007. Enormous discontent with austerity measures focussed on the figure of Gyurcsány, who many believed had shamelessly lied to win the election. Street demonstrations radicalized sections of right-wing opinion, which laid the basis for the future rise of Jobbik, and FIDESZ attacked directly the austerity programme with a series of several citizen-initiated referenda, three of which – on two sets of co-payment in health, and one in higher education- made it onto the ballot.

When these referenda succeeded in March 2008 by large margins, they weakened Gyurcsány fatally, but also strengthened FIDESZ’s credibility with a Hungarian electorate tired of market-based reform and frustrated at cuts in living standards as a party that offered social democracy in national colours. Thus, even before Hungary was forced to call in the IMF in October 2008 at the height of the global financial crisis the stage was already set for FIDESZ’s return. Events since – the fall of Gyurcsány in March 2009 and his replacement with Gordon Bajnai along with continued IMF-sponsored austerity; the electoral collapse of the Socialist Party; the rise of an explicitly neo-fascist party with mass support, especially in ex-Socialist voting industrial areas; and the victory of FIDESZ stems from the intensification of the impact of factors already visible in 2002.

The FIDESZ led list with its 52.73% of the first round list votes has become the first party to win an absolute majority of the popular vote since 1990. Its success reflects the considerable support among large sections of Hungarian society for a government that offers social democracy in national colours, and a desire for a period of respite from continued falls in living standards. This is revealed by opinion poll data and the broad geographical distribution of its support in the first round, where it was able to lead its opponents even in many of the formerly Socialist-voting strongholds in the working-class eastern suburbs of Budapest. Its electoral success was aided by its failure to offer any kind of concrete programme to the electorate, which allowed potential supporters to project their desires onto the party.

Yet this strength is now clearly a weakness moving forward. The latest figures suggest that Hungary’s GDP declined by 6.3 percent in 2009, and will continue to decline at a slower pace in 2010 – though the precise extent is uncertain due to the country’s dependence on exports to the Eurozone. Independent experts believe that Hungary will have severe difficulties in keeping its budget deficit below 4% in 2010 without urgent remedial action to raise revenues and cut spending. Furthermore, these figures do not include the deficits and the lending undertaken by local authorities, many of which are on the edge of bankruptcy, as are Hungarian State Railways and the Budapest Public Transportation Company. Consolidating these entities will place further pressure on the budget. There remain question marks over the long-term financial health of the Hungarian financial sector.

At the same time, given the high value of the Forint against the Euro, the consequent persistence of the problem of Hungarian competitiveness, and the continuing burden of financing debts in both the public and household sectors, Hungary’s economy seems to be condemned to either stagnation or sluggish growth for the foreseeable future. FIDESZ’s approach to these problems is almost completely unknown. It is difficult, however, to imagine that the measures they will have to undertake to deal with this situation, in all probability underpinned by an IMF loan, will be anything other than extremely painful.

Hungarian households are under severe pressure from declining real incomes, unemployment and the fear of unemployment, and the burden of servicing loans denominated in foreign currency. Furthermore, Hungary is now entering its fifth year of austerity and consequently the climate in the country is very tense, as the patience of the population with this situation is thin. Orbán has never been a universally popular leader and his divisive style seems to make him deeply unsuited to leading Hungary through the crisis. Furthermore, he will face considerable opposition both from his left, and from a militant, insurgent neo-fascist right. At the same time in a clientelist political system he will face enormous pressure to reward his supporters, and failure to do will meet with negative consequences. For these reasons, despite the size of his victory, it is difficult to see his position as being very secure. Hungary’s road out of the crisis will be, at the very best, a bumpy one.

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.