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Monday, February 25, 2008

Hungarian Central Bank Removes Trading Band

(Updated) The Hungarian central bank unexpectedly allowed the forint to trade freely on currency markets this morning, according to official explanation "to help Hungary's euro adoption preparations".

“The abolishment of the exchange rate band is an important step towards the adoption of the euro in Hungary. A floating exchange rate regime creates more favourable conditions for the central bank to achieve its inflation target, and via this to meet the nominal Maastricht criteria and to enter the ERM-2."

“Given the openness of the Hungarian economy, the exchange rate will continue to play an important role in forming inflationary processes. If other developments in the economy fail to counterbalance, a sustained and considerable change in the nominal exchange rate will be reflected in the central bank's inflation prognosis and as such will exert an impact on monetary policy."

The forint's trading band is going to be scrapped with effect from tomorrow, with the bank adding that the decision was made jointly with the government. (So all those who were forecasting "not under this government they won't" got this one wrong too). The forint climbed as much as 2.3 percent in the trading session which followed the announcement, rising as high as 258.5 per euro at one point, and trading at 262.15 as of 7:05 p.m. in Budapest, which was up from 265.14 on Feb. 22. It was the currency's biggest daily gain since June 28, 2007, and in fact the forint has been falling of late, dropping 3.4 percent this year, the third- biggest drop among the nine European emerging-market currencies which are openly traded. The euphoria however may be short lived, since Hungary continues to face substantial economic problems, inflation is continuing above the central bank target, and under the stagflation dynamic which the economy now seems to have fallen into we are far more likely to see increased downward pressure emerging now that the theoretical safety net effectively provided by the band has been removed.

Hungary set the existing trading band seven years ago as part of its preparations for adopting the euro. Under the system, the forint was allowed to trade between 240.01 and 324.71 per euro. As can be seen this was a rather theoretical limit, since the forint was in fact trading well into the upper half of the band. Now of course the sky is the limit, in either direction.

The central bank has missed its 3 percent target for inflation in both of the past two years, and the current forecast is that consumer prices will rise by 5.9 percent this year and 3.6 percent in 2009.

The biggest challenge facing policy makers at present is to turn round an economy that expanded by a year on year rate of only 0.8 percent in the fourth quarter of last year - which was the slowest pace in the European Union. Annual inflation was running at 7.1 percent in January, down from the annual rate of 7.4 percent attained in December.

This development certainly makes my "three tipping points" argument advanced some ten days ago look not too bad at all, since this unexpected movement coincides exactly with the second of the forthcoming critical moments I identified, namely the rate-decision announcement from the central bank (although it appears from statements from central bank sources that the decision was taken on Sunday in consultation with the government, and thus policy deliberations at this weeks meeting already had the decision as a backdrop).

Portfolio Hungary quote Nigel Rendell, Royal Bank of Canada, London as follows:

“By scraping the HUF band the central bank hopes that an appreciating currency will do the trick. However, the risk remains, particularly against an uncertain global environment, that the HUF rally runs out of steam. This would leave the NBH in a very difficult situation, particularly if there are disappointments on the inflation side."

Basically I think this is the point, when the HUF rally runs out of steam the NBH is going to be in a very difficult situation indeed, and it will run out of steam when Hungarian housholds let up on their frenzy to borrow money in Swiss Franc denominated loans, a decision which may be made easier for them now that the band has been removed and the currency risk is evident to all. A difficult decision, but then maintaining the band was only encouraging people to keep going on contracting the loans.

Statement wat NBH's post-meeting press conference were hawkish, trying to create the impression that that rates would be raised if upcoming macro data (e.g. CPI, wages) failed to indicate a lower risk of second round effects - ie that rate policy is going to be driven by macro data. This is really near bravado on their part, since the reality is, and they must know this, that the decision to remove the band means that it is policy towards the HUF that is now going to be the main focus of interest rate decisions.

The interesting question is what happens next? Clearly, simply indicating that they want the currency to rise on its own won't get the currency to rise. It had been falling in recent weeks, and this is the tonic - in the absence of future rate rises from the bank - that we could expect to see continue. Really this decision has been taken - as I am suggesting - to avoid taking another one, which is whether to raise or lower interest rates. It seems the bank would like to give the impression that it wants to be firm on the rates front (which would imply rate rises) since otherwise talk of upward movement in the forint doesn't make sense, but that it could only get the government to agree to scrapping the band by holding fire. In fact the few that the HUF is about to weaken significantly seems to be strongly held by one group of analysts. Citigroup's Budapest-based Eszter Gargyan for example, who is cited by Bloomberg as saying.

``Rate hikes in the coming months cannot be avoided...Those who favored keeping rates on hold wanted to see the initial market reaction before taking further policy action, but the'' central bank ``is likely to act if the forint fails to strengthen.''

JPMorgan analyst Nóra Szentiványi is saying she expects a 50 base point rate increase spaced across the next two meetings assuming there is no HUF rally (which she doubts there will be).

Skandinaviska Enskilda Banken (SEB) have also stated that it is their view that the forint will remain vulnerable to any reduction in risk appetite, given the macroeconomic situation in the country and rising political risks in the run-up to the referendum on 9 March. (Hard to say whether they are reading me, or I am reading them at this point, since our views coincide entirely in this regard).

On the other hand, the economy itself continues to head downwards, and with more fiscal tightening on the agenda and a more difficult extrenal environment as the eurozone economies themselves slow it is hard to see where growth can come from, and the economy seems in bad need of some sort of stimulus shot or other. So we really now move over to the political front, and need to ask ourselves how much more of this type of medicine with no tangible results is the Hungarian voter actually going to put up with without making some sort of protest. Which brings us back to the third tipping point, the proposed referendum for March 9th.

The History of the Band

The HUF trading band system was effectively created as part of what has become known as the Bokros package, which was announced in the spring of 1995. The key component of this package for our present purposes was the shift to a crawling peg exchange rate regime with a narrow (+/-2.25%) fluctuation band.

In May 2001 the HUF band was widened to +/-15% from the original +/-2.25% (at EUR/HUF of around 273.50), but the crawling peg devaluation system remained in effect. The expansion of the band was followed by a considerable HUF strengthening.

The crawling peg devaluation system was abandoned on 1 October 2001, and the central parity of the band “settled down" at 276.10, allowing an effective fluctuation in the HUF between 234.69 and 317.52. In January 2003, the (NBH) thwarted a "hot money" attack against the top end of the currency band, by buying EU 5.2 b in the open market and slashing interest rates. In late May, the bank annouced that it had resold EUR 3.8 bn and stopped currency market interventions.

In early June 2003 the central bank and the cabinet devalued the central parity rate by 2.3% to 282.36 against the euro from 276.10. While this did not constitute an official forint devaluation, it still triggered a massive slide of the HUF to below 270 vs. the EUR. By this action the central bank effectively allowed the HUF to fluctuate in a band ranging from 240.01 to 324.71.

The official rationale behind the parity shift was that an overly strong forint (below 240 vs EUR) was not in the interest of economic policy The move - as iw wryly noted by Portfolio Hungary (to whome many thanks for the background information which forms the basis for these notes) was later called a mistake by both the NBH, government officials and economists.

Finally, on Monday 25 February 2008 the band was scrapped.


Antal Dániel said...

The timing of the decisions is meant by some of the makers of the decision to show that Hungarian policy-makers are confident that those reforms, especially a very drastic cut in government spending and the broader tax base, have increased the stability of the national economy. Although the economy is very close to recession and political support for the government is very low, many people in the National Bank and the government believe that these measures start to pay off. So you are right to assume that in a way this is a bid, if that confidence does not exist or will evaporate than the forint may sink into a historical low.

I live in Hungary and work within the government, and I not only hope, but somewhat convinced that there are some signs that support the optimistic view of the Monetary Council: a very much improved trade balance, extremely favorable agriculture product prices, 8 per cent growth in the industry despite the near-recession, the growing number of tax payers at a stable unemployment rate. We tend to believe that the Hungarian national economy is in fact still divided. One part of our economy is very competitive and keeps the country afloat, the other part is very uncompetitive and relies on excessive government spending. Now that it is cut, the latter part is in a deep recession. But it may be a constructive destruction in the longer run.

Edward Hugh said...

Hello again Daniel,

Thanks one more time for your thoughtful and informative comment.

"I live in Hungary and work within the government, and I not only hope, but somewhat convinced that there are some signs that support the optimistic view of the Monetary Council"

I appreciate why you have these hopes, and fully understand why you hold these views. I would like to be able to agree with you, but think that we are now embarking on a very long hard road.

For ageing population related reasons I think after this is over Hungary will not be able to go back to a domestic demand lead economy, and you will have to live from exports. To achieve this you will need to convert a larger proportion of your economy into a tradeable sector. You will also need to be able to attract more FDI into greenfield industrial sites to sell the product to those of your neighbours (whoever they will be) who will be able to support the domestic demand to justify such activity (or of course to Western Europe or farther afield). I fear that given the degree of inflation which you have still stuck in the system, the only real way to return strong competitiveness back to a sufficient portion of your economy to make export lead growth viable is to adjust the value of the HUF substantially downward, and this solution passes through the other issue of addressing what to do about all those Swiss Franc denominated loans.

Sorry I can't be more positive.

Antal Dániel said...

I really appreciate your independent opinion, and I absolutely agree with your focus on demography. It is a very unusual state of the economy historically that you have a shrinking labor force and somewhat growing capital, and I fear that there are no textbook cases how to solve this. However, I believe that in an open economy the exchange rate is less part of the toolbox and more part of the result of the policies, so it would be difficult to raise competitiveness with devaluing the forint. I think a currency depreciation just hides to uncompetitive parts of the economy and it is not a shortcut to regain competitiveness. Now there would be room for the forint to fall, but it started to appreciate. I believe that we have a tragic labor market: a shrinking population, an extremely low participation rate and an effective labor shortage in the growing part of a small country. This really calls for a more active labor policy and a migration strategy. The problem is that I do not see who could finance the former, since the government is very short of disposable money and the private sector finds it easier to relocate into better labor conditions than to invest in improving it. So I am not very optimistic a this point, but at the moment I do not worry about the exchange rate. I hope the monetary bank can reduce inflation because it is at such a level that disrupts microeconomic decisions.