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Monday, January 21, 2008

Hungarian Central Bank Leaves Interest Rates Unchanged

In what was hardly a surprise move Hungary's central bank kept its benchmark interest rate unchanged today, after surging food prices and rising oil costs helped keep inflation at an unacceptably high level. The 12 members of the central banks monetary policy committee left the two-week deposit rate at 7.5 percent today. The council even discussed the possibility of raising the rate, to 7.75 percent, for the first time since February 2007. The decision was ``relatively clear,'' central bank President Andras Simor said afterwards at a press conference in Budapest.

Future rate cuts now hinge on the so-called second-round inflation effects, including wage cost growth, and on international market developments, the bank said in a prepared statement. The mention of intenational market development could be read as meaning that after what happened to global stocks today the external environment can no longer be considered to be benign, and the forint may need defending with interest rate policy. But here we are effectively caught in a policy trap, since in order to export we precisely need a more competitive exchange rate, but the level of swiss franc indebtedness makes this virtually impossible to contemplate at present.

Forward-rate agreements show investors have scaled back expectations for rate cuts in the next six months. The spread between the six-month forward rate and the base rate fell to seven basis points from an average of 40 basis points in the past six months. A basis point is equivalent to 0.01 percentage point. The three-month money market rate is 7.5 percent, the same as the central bank rate. That compares with a difference of as much as 24 basis points on July 23, also a sign of reduced expectations for lower rates.

Hungary's inflation rate rose to 7.4 percent in December from 7.1 percent in November.

Update Tuesday 22 January

Well the interpretation Andras Simor put on the debate and the decision confirms my earlier impression, the central bank has now withdrawn the easing bias, and is prepared to raise interest rates to protect the forint, even if internal demand in Hungary gets strangled in the process. Portfolio Hungary quote Eszter Gárgyán of Citibank as follows.

“Risks from domestic influences on the CPI outlook have been apparent in recentmonths, while the unwinding of global risk aversion has pushed risk premiums higher and depreciated the forint. We believe global market turmoil is likely to persist in the coming months, limiting the scope for monetary easing, as the exchange rate is still the key transmission mechanism to inflation."

She also makes the strong point that the MPC's statement “no longer hints that the next step will be a cut, as in previous months, due to deteriorating global sentiment, indicating that external factors are likely to remain the driver of Hungarian interest rates in the coming months".

My only minor quibble with this view is that more than of inflation the exchange rate is the key transition mechanism for what is known as translation risk, ie the danger that unhedged borrowers see a sudden and unsupportable rise in their borrowing costs. My guess is that the stranglehold on internal demand will be strong enough at some point to invert the inflation into deflation, unless there is a significant weakening in the value of the forint, which would, of course, also imply significant private debt default. No easy answers here.

This piece from Bloomberg this morning is just an initial warning shot. Mortgage backed coverd bonds in the East European context can't possibly sustain a AAA rating, and once market participants wise up to this, and the implications of that fact, then watch out. (Some explanation of what covered bonds are all about in the context of the Spanish cedulas hipotecarias can be found here).

Standard & Poor's may trim its top ratings on as many as 22 asset- and mortgage-backed securities insured by Ambac Financial Group Inc. as the effect of the bond insurer's downgrade spread to emerging markets.

S&P placed its AAA credit ratings on 18 securities backed by future cash receivables, three Mexican residential mortgage- backed securities and one bridge loan transaction on review for a possible downgrade, according to an e-mailed statement.

Ratings on securities issued by Banco Itau Holding Financiera SA of Brazil's Diversified Payment Rights Finance Co., Banco de Credito del Peru's CCR Inc. MT-100 Payments Trust, and Hipotecaria Su Casita SA's Construction Loan Trust, among others, were affected, the company said.

S&P is reviewing Ambac and MBIA Inc., the largest of the so- called monolines, casting doubt on the ratings of the $2.4 trillion of debt guaranteed by bond insurers. Ambac's Ambac Assurance Corp. was lowered two levels to AA and may be reduced further, New York-based Fitch Ratings Inc. said on Jan. 18.

Of course, this afternoon we have also seen another example of central bank reaction in the form of the emergency cut announced by Governor Ben Bernanke. The difference in approach and room to manoeuvre couldn't be clearer, as can be seen from the following quote from the Bloomberg article announcing the cut:

Policy makers set aside concerns about inflation to lower borrowing costs for the fourth time since September after unemployment hit a two-year high and U.S. stocks slumped. Chairman Ben S. Bernanke shifted the Fed's stance to a more- aggressive approach in remarks this month citing a need for ``decisive and timely'' action.

Now a couple of things need to be said here. Firstly, and for the sort of reasons I have been explaining on this blog the Hungarian Central Bank now doesn't enjoy the kind of liberty of action which the US Fed does, although it might be a useful exercise for people to ask themselves sometime how it was that we got here. So Hungarian monetray policy is in a bind.

Secondly , concerns about inflation have not eased everywhere, and I'm not talking about the eurozone in this context, since I think with the general slowdown inflation there will fall into line soon enough. However I do think that this is where we might look for the real "de-coupling" and fissures which are developing in the global economy - the distinction between those emerging economies which can grow rapidly - due to their favourable age structure - without provoking excessively high levels of inflation, and those which can't. Obviously Eastern Europe is in the front line here, and beyond Eastern Europe points further east passing through Ukraine and Russia and then onto China (where of course the now famous - or infamous one child per family policy was introduced some 30 odd years ago now. How important will this decision prove to be for China's growth capacity? Well we are all about to find out, as they try to stage manage their growing inflation problem by raising interest rates even as the US lowers.

So, as the rebalancing continues, and money keeps arriving willy nilly the "emerging economies" this is where I think we might see the tear in the sailcloth. Indeed, as I suggest here, we migh already be seeing in, as in countries like Romania and Hungary monetary policy moves away from internal demand management and onto protecting the value of the currency.

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