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Saturday, March 08, 2008

Black Friday in Budapest?

Question: how do you know they are holding a referendum on the government's difficult and unpopular economic adjustment package in Hungary on Sunday? Answer: take a look at what happened in the Hungarian financial markets on Friday.

It should not have been too difficult to see all this coming, yet financial analysts seem to have been strangely silent on the potential implications of the latest political twist in Hungary's ongoing economic agony. And where they have not been silent they have generall been trying to downplay its importance. Only last week Goldman Sachs' Hungarian analyst István Zsoldos was busy reassuring us that the coming referendum would have no lasting impact on the evolution of Hungary's long drawn out economic crisis (although he did admit that the short-term political noise was “likely to intensify"). I beg to differ. I think the consequences of Sunday's vote are going to be important and long lasting (indeed I had the referendum pencilled in in this post as the third of my potential tipping points for Hungary's economy, with the the second one being the last interest rate setting meeting of the central bank, when, of course, they did scrap the currency band), and they are going to be important and long lasting regardless of whether or not the Hungarian authorities manage to plug the now growing breach in their credibility and the value of HUF denominated instruments in the short term.

So why is there a problem? Well, anyone with even a passing and cursory knowledge of political and financial crises should know by now that you can't forever fill the growing disatisfaction of a population with their lack of nice fresh bread by sending them over cake for ever. Basically, any government has a limited amount of ammunition stacked in the chamber (which is why you need to be careful how you fire it off) and once your bullets are spent, or you get to fire off as many as you are able before your voters finally get mad, then you need to watch out, since events have a nasty habit of moving swiftly. And this is what is starting to happen right now, before our very eyes in Hungary.

Hungary had a sudden financial crisis back in the summer of 2006, on the back of a massive "twin" deficit (ie fiscal and current account) problem, and subsequent to this the government introduced a series of "austerity measures" principally designed to try and correct the fiscal deficit situation. The core of this package was a downsizing of government spending (including a reduction in services and employment in the public sector), and an increase in social security contributions, charges for the state administered utility sector, and individual charges for clients in the state health and education system. The first two of these have played no little part in generating the dynamic which means that Hungary is now labouring under a 7% inflation rate, while the latter (the health and education charges, and their constitutionality) constitute the core of the issue for Sunday's referendum.

Basically the government has become highly unpopular on the back of the package and its evident lack of success in resolving the underlying issues facing Hungary (see chart below, Fidesz is the opposition and MSZP the government) and the opposition are trying (pretty opportunistically in my view) to create a climate of "no confidence" in the government in the hope of achieving early elections.

What I am not saying is that voters will be right to reject the parts of the austerity package they are being asked to vote on on Sunday. Far from it. The new social welfare charges may or may not be an intelligent way of adressing the issue to hand, but they do now constitute the symbolic core of the adjustment process, and rejecting them will be tantamount to rejecting the whole process which lies behind them. Hungary is poor, and has a rapidly ageing and steadily declining working population, and you can't give yourself a five star welfare service if you only have a two star economy. There is just no way you can pay for it, whatever the politicians say. So somewhere or other along the line the Hungarian people are going to have to accept that they will have to cut their coat according to their cloth, and this is what Sunday's vote is all about in my book.

The problem now is that there are various kinds of realism at work here, one of these is the dynamic needed to face up to a hard and complex reality, and another is the kind of political realism that economic analysts have to factor in to their policy packages, since once citizens and voters get fed up with promised results which continually fail to arive - and this is what is starting to happen now in Hungary and why it is that all those "ever so optimistic" and rosy forecasts which have been busily going the rounds in Brusssels and Budapest of late are really so very very dangerous - then what were once upon a time sobre and calculating people may well become irrational, and economic policy has to take this kind of irrationality into account just as much as it takes the more normal kind of rational inflation expectations into account. Basically I think the Hungarian voters are reaching the limit of their endurance with being sold cake when all they really want is bread, and it is this weariness that we are about to see expreesed on Sunday, after which point, unfortunately, the credibility and legitimacy of the whole present adjusment process may well be increasingly called into question.

So Why Black Friday?

So why do I call it black Friday? Well yesterday morning the corridors of Budapest were as thick with rumour as they normally are with smoke. Things got off to a very early start (around 10:00 am Budapest time) with Portfolio Hungary announcing that an emergency meeting had been convened between the National Bank of Hungary (NBH), the Finance Ministry and the Government Debt Management Agency (ÁKK). The reason for the meeting was apparently that an "emergency situation" had arisen on the foreign exchange market, with liquidity having become "practically non-existent" and ... "even if contracts were being made, they would normally signal unrealistically high yield levels," as one Portfolio Hungary source is quoted as saying. (This description is so reminiscent of the Paribas statement on August 9th 2007 that liquidity in the european securitised wholesale money market had practically evaporated).

The purpose of the tripartite emergency meeting was ostensibly to decide on how to stabilise the market situation by making purchases on the bond market. Effectively this could be construed as being an emergency meeting of the Monetary Council of the central bank in advance of the next scheduled rate meeting due on 31 March.

No sooner had Portfolio Hungary made this announcement than one hour later (around 11:00 am) Judit Iglódi-Csató, communications director of the central bank, was out and about denying that any such meeting was taking place:

"The NBH has not held an extraordinary rate meeting and there was no extraordinary joint meeting by the NBH and the ÁKK,....The central bank has not intervened into fixed income market processes"
Ferenc Pichler, press chief at the Finance Ministry, was also entered the fray, issuing a statement to Portfolio Hungary rejecting the rumour about a joint meeting. He did acknowledge, however, that ÁKK officials had visited the NBH, but emphasized that talks were on a completely different matter.

Later the same morning, however, Hungary's Finance Minister János Veres accepted that the ministry did in fact hold talks with the Government Debt Management Agency (ÁKK) and the central bank (NBH) about the situation in the fixed-income market. He denied, however, knowledge of any central measure - like buying bonds - to be implemented in the secondary market. "There is no need for concern, experts are dealing with the situation," he is quoted as saying.

What has provoked all this concern has been the sudden jump in the benchmark three-year bond yields, which rose yesterday to the highest level since November 2004. Traders and analysts were busy speculating that this rise might force policy makers to raise the central banks benchmark interest rate, which is already (at 7.5%) the European Union's second-highest (after Romania), or to start buying back bonds to jumpstart the market after bond trading had suddenly dried up.

Bloomberg quote Marian Trippon, an economist at the local unit of Intesa Sanpaolo SpA, as saying "There is no market...Everybody is waiting on the sidelines, afraid to get in. If this is sustained and the government securities market ceases to exist, then the central bank can't watch idly."

Hungary's forint was down by more than 1% against the euro late yesterday afternoon and government securities yields leaped by some 20-30 basis points, partly as stop-loss contracts kicked in (forced sales). In the secondary market, yields leaped by 40-70 basis points from late Thursday levels (to levels which are currently around 10%).

The forint weakened further during the morning to 266.20 to the euro by 1:30 p.m. in Budapest from 264.44 late on Thursday, but it firmed again in late afternoon trade to around 264 although at the peak of negative sentiment in the morning session it was almost as weak as 267.

The yield on the benchmark three-year bond rose to 9.86 percent from 9.27 percent. The yield has now climbed more than 2 percentage points in a month. Market participants generally seem to be now pricing in a rate hike of around 100 bps within the next month. According to data from the Government Debt Management Agency (ÁKK), the yield on the 3-m T-bill jumped by 34 bps to 8.60% today (the base rate is 7.50%).

Hungarian bond yields started soaring a little over a week ago following the decision on Feb 28 by Peloton Partners LLP, a London-based hedge-fund firm, to begin liquidating its ABS Fund following "severe" losses on mortgage-backed debt. Then last Friday (29 February) a local bank was unable to sell a bond portfolio which lead the yield on the three-year bond to rise 46 basis points in a single day.

Following this the Hungarian debt management agency AKK revealed on March 3 that it was going to decrease the volume of government bonds it offered for sale by as much as 30 percent, while at the same time increasing its auctions of Treasury bills, which are closer to cash and viewed as safer. The agency made the decision after a joint meeting the biggest local bond traders.

The current situation has been described by Portfolio Hungary as a tsunami of risk aversion. Another indication of the growing scarcity of liquidity in the Hungarian market came on Thursday when the AKK sold HUF 35 bn of 12-month discount T-bills at an average yield of 8.51%. This yield was up another 6 basis points from Wednesday's benchmark fixing and was 28 bps higher than at the previous auction of the same instrument two weeks ago.

Hungarian central bank (NBH) Governor András Simor and MPC member Gábor Oblath have both been working hard to try to maintain the central banks credibility in the present situation, in particular by vigourously stressing earlier in the week that the national bank remained strongly committed to achieving its present inflation target. This is viewed as being important, since it is an indication of the bank's intention to remain firm on interest rates in the face of what must be growing political pressure to do something to support weakening domestic demand and to slow down the steady rise in unemployment.

Reacting to recent rumours about the possibility of the bank abandoning its target Simor said that such rumours were “ridiculous and unfounded", while Gábor Oblath stressed that the National Bank would obviously need to resort to monetary tightening if prolonged weakness of the forint began to threatenen the target. This may well be where we are now. And central bank policy may well be driven by the need to support the forint rather than address the economic stagflation position - rising inflation and falling growth, see chart below - which is resulting from the collapse of internal demand.

But the bank will only be able to maintain this stance for as long as the voters are willing to accept the medicine. Hence the importance of Sunday's vote. We are in the garden of the forking paths, where political and economic dynamics both intercept and separate, and who knows at this point just what pace of evolution we will see in each of them.

Household Currency Risk

The principal preoccupation of the central bank, and the spine stiffner for their resolve to defend the currency value, comes of course from household exposure to rapid currency adjustments via their loan portfolio. Nearly 60% of the outstanding loanscurrently being paid by Hungarian households were FX-based at the end of January, and any forint weakening, and especially any weakening against the Swiss Franc (the euro is in fact virtually irrelevant here), represents a substantial potential distress burden for all of those involved. According to figures provided earlier this week by the National Bank of Hungary (NBH) the weakening of the HUF in and of itself boosted household debts to banks by HUF 189 billion in January alone (since with the loans being measured in Swiss Francs, as the forint goes down the loans go up).

Loans granted to the household sector rose by HUF 274.1 bn or 4.5% (to the new high of HUF 6,190.9 bn) in January. Forint loans were down in fact down (by HUF 16 bn) and all of the increase was in foreign currency loans (up by HUF 290.1 bn). Exchange rate valuation effects directly contributed HUF 189.2 bn, to the increase in the value of foreign currency loans held. This latter development is largely due to the fact that the HUF weakened by nearly 5% against the CHF between end-December and end-January. The forint's depreciation versus the euro was 2% during the same period, but as I said the euro is virtually irrelevant here.

Since the HUF weakened by further 4% vis a vis the CHF in February we can be pretty sure that the household burden grew further simply due to the weaker forint in the second month of the year too. If we look at the HUF-CHF chart for the last couple of years we can see that while the forint has deteriorated against the CHF since June last year, HUF values are still well above what they reached in June/July 2006.

So anyone who took out CHF loans in mid 2006 would still be well protected at this point in time. Unfortunately, if we come to look at the term profile of the contracted loans we will see that foreign loan mortgage finance is heavily weighted towards the second half of the two year period (2006 - 2007).

In fact in recent times the share of foreign currency loans within the total has only risen and risen. In January it was up to 57.3% from 55.0% in December. This ratio has been rising continuously over the past two years, and in January 2007 it was nearly twice the level of January 2005. Within aggregate loans to households, housing loans expanded by 4% to HUF 3,260 billion, and foreign currency loans rose to 48.8% from 46.4% as a percentage of housing loans. Of particular note is the fact that the stock of mortgage loans for consumption grew by nearly 13% in January over December, to HUF 1,383 billion, and this increase can be attributed almost exclusively to a rise in the stock of CHF-denominated loans.

So basically domestic consumption demand in Hungary is now very much being held to ransom by future movements in the valuation of the forint vis a vis that of the Swiss Franc, with the Hungarian Central Bank's ability to do anything meaningful to soften the severity of Hungary's current economic crisis being reduced to an effective zero. Hungarian citizens should consider themselves lucky in the coming months if they do not face a sharp tightening in monetary conditions simply generated by the need to protect the currency (as a say above the markets a currently pricing in at least a 100 base point increase in the central bank rate). Since movement in the value of the CHF is particularly hard to forsee, and doubly so given its potential role as a safe haven currency in times of global uncertainty, I basically still can't really understand how what would appear to be otherwise reasonably rational and intelligent people (the central bankers and those responsible for Hungary's financial affairs) allowed private debt exposure to currency movements to reach this state of affairs in the first place.


Eric said...

Hugh, that's a great tour-de-force of what's going on. You filled me on several details I sensed but didn't have evidence for.

Please clue me in on a couple more things:-
- given the constraints on options left to the national bank and debt agency, why don't investors buy bonds worry that their HUF denominated bonds won't lose value? Why do they keep buying them?
- you said that the government is trying to cut costs, but isn't it just "adjusting the deck chairs" - or are they really looking at the big ticket items? I recall seeing that HU alone has something like 30 times as much local gov't as the UK; and that this is something the country can ill-afford - but doesn't tackle as it would put too many people out-of-work?
- what happens if investors stop buying the bonds? Would this gum up the country's finances?
- The debt agency is talking about issuing EUR debt. How does this play given the huge number of CHF mortgages?

Looking forward to your thoughts.

Edward Hugh said...

Hello Eric,

Sorry I took my time getting back but I had a busy day yesterday.

"why don't investors buy bonds worry that their HUF denominated bonds won't lose value?"

Well I'm sure they do, worry I mean. That is why the yields go up, to pay them for worrying. Basically I am a macro economist rather than a financial markets person, and I'm sure one of these could answer your question much better than I can, but I think its all about timing.

Which way will the forint move: this month, over three months and over 12 months? Really it is anyone's guess. I imagine that over a 12 month horizon the forint is going to be well down, but not everyone agrees, and they back their intuitions with money. The financial markets are just like a big betting shop really.

But even if the HUF slides at some point later this year, maybe one month from now, or three months from now it will be up. And if it is up you can always buy and sell, and take profits. So the underlying value of what you hold doesn't seem to me to be that important, what matters is how it moves week by week and day by day.

Which is why traders cannot ever afford to go to sleep. In a way that is why they can earn so much money, since they have to devote so much time. Everything is about time and timing.

So basically you can sell virtually anything (junk bonds for example), it all depends on the price and the implicit yield, and then again people hedge (ie take out some insurance by buying a comparable instrument - in smaller quantities - which might move in the opposite direction), just like taking insurance when you have a mortgage that you might be unemployed for 3 months or something.

"- you said that the government is trying to cut costs, but isn't it just "adjusting the deck chairs" - or are they really looking at the big ticket items?"

Well it isn't simply trying to, they have made a substantial adjustment, but they need to make a lot, lot more, and this is the big worry, since the population at large in wilting under the weight of the economic crisis the fiscal reductions have produced, and hence the political pressures are on to start to ease off, and even spend relatively more than planned, and of course they are going to have a large problem with credibility and with financing if they try any such move. But the population don't agree - even though they have no suggestions as to where all the money could come from - and hence Sunday's referendum result.

Really my opinion is that the Hungarian authorities are in a no easy way out double-bind at present, where problems are likely to get considerably worse on both the economic and the financial fronts before they get any better.

Will they ever get better? This is an interesting question, since Hungary has very large ageing society problems, but assuming you think they will, then you could go in very long on HUF assets and hold and wait. This is where the macro economics comes in, since if my feelings that the economic prospects even long term are difficult then the people who do this may well lose a lot of money, but if I am wrong they may get to make a lot. Once again it is all about risk and time really.

So this is where you get back to the betting shop mentality, the "punters" in the financial markets are really like people who back horses in the Derby and the Grand National after studying the recent form cards pretty hard, but without much knowledge of horse biology, or jockey psychology for example. Usually you can go a long way on the form cards, but when this doesn't work you can get to lose big time.

But why believe one macro economic analyst rather than another - since there are opinions to suit all palates? This is the problem the "punters" face. You get a lot of bravado, of course, but in the end this is all hot air, since no matter how loud you shout you still get to lose money like the next man.

"- what happens if investors stop buying the bonds?"

Well in the short term this is pretty easy to answer since as we see the yield simply goes up and they start to buy again, since the bonds start to become "attractive". But the money to pay these extra yields has to come from somewhere, so then obviously this starts to strangle the Hungarian economy as borrowing money for economic activities gets to be more difficult and more expensive, and then the central bank has to raise rates, and all this makes investing in the country look eveb less attractive, as companies start to make less profits etc.

The key at the moment is inflation, since people are anticipating that the central bank will raise rates to stem the inflation, so yields go up, and this is why people will buy instruments. But if at some point the "pontoon playing" central bank fails to raise their stake since unemployment has risen too high, or something, then the people who are now buying could sell, and quickly, and then the HUF could fall suddenly. This would be the so called "crisis of confidence".

"- The debt agency is talking about issuing EUR debt. How does this play given the huge number of CHF mortgages?"

Well they are issuing more euro denominated debt, since in this case they pay less - remember if Hungary has to pay more in ineterst cahrges on the debt then that is even less available for hospitals and schools - since they assume the currency risk rather than the debt holders. They also add credibility, since they appear to believe in their own forcecasts that the HUF will stay where it is. They could, of course, be wrong, in which case they will end up with a chunk of what could become very expensive debt to service.

The CHF mortgages are a different story. These are held by private individuals and the Hungarian authorities are trying to discourage recourse to these since in the event of a sudden downward movement in the HUF the households holding them would be subject to immediate distress.

My feeling is that if a financial crisis comes there is no way that these obligations could be paid at 100% face value by those who have contracted them. So we would, I think, be into some pretty messy negotiations between the Hungarian authorities and the banks.

OK. I hope that was helpful.


Eric said...

Hugh, thanks for coming back to me. Just so you have some perspective. I have an honors degree in Economics (Micro not Macro) - 25 years ago; but have been in IT (Business Analyst/Developer) even longer.

I live in HU (married to a national) and feel I've got a ringside seat of what I sense should be an economic meltdown that just never seems to come to a boil.

I truly appreciate your thoughts as to what's going on.

To the comment on yields: of course you're right! The system dynamics here is self balancing as long as there is still a supply of money; if that dries up then the system will break down.

To the source of funds to continue to service the debt... I cannot but sense this is a Ponzai (sp?) scheme (or "Peter to pay Paul"); the gov't doesn't have the tax base from which to repay in the future so all it can do is issue more bonds. I don't see the country getting more out of its tax base.

In fact, it's doing the opposite to improving the tax base; its increasing rates on taxes it has, and implementing new taxes and tighter tax inspections which require more bureacracy. At the moment, the businesses and people that drive growth survive through tax avoidance (and evasion); but there'll come a point when coupled with inflation, evasion is no longer possible - leaving flight as the only option.

The debt of the country is nearly 2 times annual tax receipts; and the debt is growing at 7%. Not that this is a bad thing; I recall reading somewhere that if you follow the trail, you'll see America is still paying for the 1776 Revolution.

- -

I agree that the gov't is in a bind; but they don't win points by also continuing to splurge (replacing 2 year old cars with top range Audi's, not amalgamating town councils, bridges over dis-used railroad tracks). But as you pointed out, the investors don't look at the specific evidence, just the racing form and follow the rest of the crowd (I guess its either this or Tulip bulbs).

- - -

Had an experience a few days ago while investigating mortgages. The brokers I spoke to all pushed nonHUF mortgages; all waived fees, discounted the first year, etc.; and their fees were only 2% above ECB or swiss. For HUF, they're 7% (above MNB).

One broker explained:-
a) the banks make their money on changing money between HUF and CHF/EUR
b) they have few deposits on which to draw; and must borrow for Swiss and Euro sources.

I conclude when MNB raises interest rates it'll have little effect on borrowers (2/3rds of personal loans are now foreign denominated).

On the other hand, dropping out of a commitment to track the EUR will.

Edward Hugh said...

Hello again Eric,

nice to see you back, and thanks for the personal background and insight. Especially this bit:

"Had an experience a few days ago while investigating mortgages. The
brokers I spoke to all pushed nonHUF mortgages; all waived fees,
discounted the first year, etc.; and their fees were only 2% above ECB or swiss. For HUF, they're 7% (above MNB). ....I conclude when MNB raises interest rates it'll have little effect on borrowers (2/3rds of personal loans are now foreign denominated). On the other hand, dropping out of a commitment to track the EUR will. "

Which basically confirms something I had been arguing this morning, namely that monetary policy at the NBH is virtually dead in domestic demand management terms. If you can borrow money in foreign currency for personal consumption (mortgage refis, which have been the big growth area of late) at less than the rate of inflation, then on you go, especially if the central bank is making the government and commercial bond issuers pay much higher rates to insure your risk. On you go, that is, until you don't.

here's a post extract

"One of the problems here is that inflation has been stubbornly high in Hungary, and it is hard to understand this in the light of the rapid economic slowdown and the reasonably tight monetary policy from the NBH, unles perhaps we start to think about the foreign currency personal consumption mortgage loans we have been so popular in Hungary over the last 6 months. These have been available at rates in the 6 to 7% range - ie just below the rate of inflation - and people have taken them out assuming they run no currency translation risk. A rate hike from the NBH would continue to reinforce that illusion, and hence inadvertently will serve to encourage people to get in deeper. "

So yes, it looks like you are going to have a ringside seat, and please do keep dropping by, since this situation shows every indication of getting very interesting and very tricky indeed at some point.