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Thursday, October 23, 2008

And So It Ends - Hungary's Government Announces Foreign Curreny Loan Wind-up Package

Hungarian Prime Minister Ferenc Gyurcsány announced this morning (Wednesday) that the government had reached an agreement with commercial banks intended to protect the interests of those who have taken out foreign currency loans.

The agreement, which is expected to be signed early next week, has three key components:

1) At the request of the debtor the banks will allow the duration of the loan to be extended (with fixed monthly instalments) so that the depreciation of the forint “does not place an unbearable burden on the debtors".

2) FX debtors who deem that exchange rate fluctuations carry excessive risks for them will be allowed to convert their foreign currency-based loan to a forint loan. In this case the banks “will accept this request and make the switch without extra charges".

3) If a debtor finds him- or herself in a position where he or she cannot pay the monthly instalments, e.g. due to becoming unemployed, the banks will be amenable to transitionally reducing the instalments or even suspending them entirely at the request of the debtor.

I say "agreement" here, but in fact the banks had little alternative, since Gyurcsány made it plain to them that if they did not agree then legislation would be introduced to enforce the government package.

So here, right now, and on 23 October 2008 in Budapest ends, in my opinion, a fashion for taking out non-local currency denominated loans, which lasted the best part of a decade and sewpt across half a continent, and especially in Central and Eastern Europe . Basically government after government in one CEE country after another will now find themselves with little alternative but to follow Hungary's lead, as the parent banks turn off the tap on the one hand and the citizens themselves grow more and more nervous on the other.

The situation is in fact a little bit complicated, since (unless there is some part of the fine print which has not been made public yet) we have to assume that the conversion rate be the going market one, which will mean that many of those who such mortgages will take some form of capital loss on the transfer, which can thus only be seen as some form of "late in the day" protection against subsequent falls in the value of the forint. Jiri Stanik at Wood & Co estimates that most bank clients took out their FX loans at a level of around CHF/HUF 170, so despite the fact that the forint has depreciated by some 30% against CHF over the last two months, its current level (HUF/CHF is about 185 at the time of writing) only represent s an 8/9% depreciation from the average client purchase price. Most of the risk and all the really bad news will come for these mortgage holders if the forint were to continue to depreciate further against CHF. Will this depreciation continue? Well, even we economists don't really know the answer to that question, and certainly Hungarian householders have no idea at all, which is one very good reason why most of these clients may decide to get out now. Cerainly they will probably be uncomforable with the realisation that they have suddenly all become day traders in the forward HUF/CHF swap market using their homes as security.

Also the rate of interest to be charged on the HUF morgtgages will be based (it would seem, again there are no details) on some mark-up or other over the current base rate of the the NBH, which was, we will remember hiked to 11.5% yesterday. So at the end of the day the people who make the transition will take a (small, at this point) capital loss, but at the same time their short term interest servicing payments will skyrocket (this is presumeably why Gyurcsány has insisted on their being able to extend the term of the payments) . Thus, in terms of the macroeconomic recession, here we go.

For this all to form part of a coherent rational policy (perhaps a very large assumption indeed at this point) , it can only suggest one thing, in my opinion: that the base rate hike is a TEMPORARY support for the forint while people move over (which we could expect to see in the form of a flood, rather than a trickle - see the point about "herd behaviour" below). Basically when you have half your army trapped in an excessively advanced position, you need the heavy artillery to lay on some cover while you pull them back.

Once the troops are safely back under cover, then, in my humble opinion, we should anticipate a rapid easing cycle on the part of the NBH, and a sudden tanking in HUF partities, since the looming priorities will be to ease distress on all the new HUF mortgage payers, and an attempt to "jump start" a new export-driven Hungarian economy. I think it is important to bear in mind that Hungary is now about to head into quite a severe recession, and the fiscal stimulus door is effectively closed. Monetary easing is the only real policy tool the Hungarian authorities have available. And remember, we are going into all of what is now to come with national morale severely weakened by two years of policy measures which didn't work, to cut a very long story down to a very, very short one.

In other words the current situation is like having your population distributed across two very high buildings, one of which is about to collapse (or at least disappear), and the Hungarian government has just thrown a plank across from one building to the other so that people can "move over" in single file, before the one which is about to go, goes. The people in the other building may suffer from overcrowding and shortage of food, but they will at least be "safe". But the big danger might be, just how many will get trampled in the rush?

Basically, and to cut another very long story down into a very, very short one, the building which is about to disappear is the one which was to have housed Hungary (and several other of the EU12) as a full member of the Eurozone. This, ever more distant possibility in recent months, is now about to move off into a much longer term futures, and it is this distancing, of course, which makes all the forex borrowing suddenly unsustainable. The man who has been hanging desparately over the parapet by his fingernails for two years, now finally lets go.

Plus there is still the thorny little issue of just how Hungary is going to fund the conversions, and how much bad news there might be for the banks here.

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

At the end of August total housing loans were running at around 3,380 billion HUF or about EUR 12 billion equivalent at todays prices. Of these around 18 billion HUF (or 53%) were fx housing loans. Which means there are something like 6.5 billion euro in fx housing lonas which could be translated over. To this could be added another 1,500 billion HUF in mortgage financed personal loans (so say around another 5 billion euros to cover this). These numbers put the recent 5 billion euro loan from the ECB in some sort of perspective I think.

My impression is that this move by the Hungarian administration will soon be followed by one government after another across the other central and Eastern European Economies where forex mortgage borrowing had become so popular. So basically, the situation is that Hungary can, to some extent, protect its citizens from excessive exposure in times of turbulence, via this channel. The foreign banks who have been providing this service, and who in the main come from other EU member states, will then be left to pick up the exposure tab themselves, and my guess is that several of them will need to seek protection via the EU15 bank support scheme thrashed out in Paris on 12 October last, in just the same way that other financial entities have been receiving protection from the US Sub-prime write-downs.

In the meantime, we can expect to see the shares of the main banks involved coming under severe attack. Erste Group Bank AG, Austria's biggest publicly traded bank, lost 1.95 euros, or 8.8 percent, on Tuesday to hit 20.10, a five-year low, while Italy's Unicredit - another very exposede bank in CEE terms - fell to an 11-year low in Milan this morning (Wednesday) on market speculation the company will need to further strengthen its already recently "strengthened" finances. Italy's biggest bank by assets declined as much as 8.8 percent to 1.90 euros, its lowest price since September 1997. Unicredit is now down 65 percent since the beginning of the year and shares in the bank were again suspended from trading earlier today due to excessive declines.

A Ten Year Craze Comes To An End

As I say above "and so it comes to an end". A phenomenon which in many ways has served to characterise an epoch is now being drawn to a close, and as my own personal contribution to commemorating this pretty historic moment, I would like to take you all back a deceade or so to take a look at how the whole thing got started in the Austria of the late 1990s, since it was in Austria that the fashion for CHF mortgages really took off, and it is no coincidence that in Hungary it has been CHF and not euro denominated borrowing (as for example in the case of the Baltics or Romania) which has been the hallmark, since the Asutrian banks have played a key role in the Hungarian "transition". Dimitri Tzanninis explains the origins of Autrian CHF borrowing as follows:

The practice of borrowing in foreign currency (mainly Swiss francs) began in the western part of the country, where tens of thousands of Austrians commute to work in Switzerland and Liechtenstein. This partly explains why the share of these loans was higher in Austria, even during the 1980s. Word of mouth and aggressive promotion by financial advisors helped spread the popularity of these loans to the rest of the country. By the mid-1990s, newspaper ads placed by banks began to appear, fueling public interest.

Now Dimitri Tzanninis refers to this as an example of "herd behaviour" (see note at foot of post, and of course herd behaviour is the word, since his is about fads and fashions, and largely "non-rational behaviour - since if people understood the risk they were taking on board, then basically they wouldn't do it, and it is precisely herd-behaviour that we are now about to see in action again as people "unleverage" from the CHF as best they can). So, herd behaviour is essentially a non-linear process, and one which in this case is characterised by a lot of press and "word of mouth" driven "copycat"decision taking. The following charts of news stories in the Austrian press sum the situation up pretty well:

Herd Behaviour

For the record book I reproduce below the explanation of the herd behaviour phenomenon offered by Dimitri Tzanninis.

"Herd behavior occurs when people do what others do rather than rely on their
own (incomplete) information, which might be suggesting something different
(Banerjee, 1992). The suppression of private information could lead to
“information cascades” when decisions are made sequentially and a large enough
number of people choose identical actions. In such settings, the decisions of a
critical few people early on are enough to tilt group behavior toward a certain
direction. Mimicking the behavior of others might be rational because of
uncertainty about one’s own information as well as the need to economize on
information-gathering costs. Rational herd behavior is the subject of a recent
strand of behavioral finance (see Montier, 2002, for an introduction). "

Herd behavior can arise in a variety of environments, including in financial markets. However, it is difficult to disentangle empirically the effects of macroeconomic or other fundamental determinants from those caused by herd behavior. Herd behavior often results in volatility because it is susceptible to abrupt shifts or reversals, and thus has the potential to destabilize markets.

Empirical studies have shown that the dynamics of herd behavior often resemble an S curve: initially only a few adopt a certain behavior, but, past a certain critical mass, a take-off state takes hold where a rapidly growing number of people adopt this behavior. Toward the end of this process, a moderation of the dynamics takes place as the potential pool of adoptees is exhausted.


Banerjee, A. V., 1992, “A Simple Model of Herd Behavior,” The Quarterly Journal of Economics, Vol. CVII(3), pp. 797-817.

Montier, J., 2002, Behavioural Finance: Insights into Irrational Minds and Markets (Chichester: John Wiley & Sons Ltd.)

Waschiczek, W., 2002, “Foreign Currency Loans in Austria—Efficiency and Risk Considerations,” in Financial Stability Report 4, OeNB, pp. 83-99 (Vienna: Oesterreichische Nationalbank).

And to close this little commemoration of the closing of an epoch, here is a post I put up on this blog on 5 November 2007.

Swiss Franc Morgtages in Hungary

The use of non-local-currency denominated loans has become a widespread phenomenon in Eastern Europe in recent years. In Hungary the most common currency for such purrposes is the Swiss Franc and around 80% of all new home loans and half of small business credits and personal loans taken out since early 2006 have been denominated in Swiss francs. A similar pattern of heavy dependence on foreign currency denominated loans is to be found in Croatia, Romania, Poland, Ukraine (US dollar) and the Baltic States, although the mix between francs, euros, the dollar and the yen varies from country to country.

So let's look at the extent of the issue in Hungary, and some of the likely implications. First off, here's a chart showing the evolution of outstanding mortagages with terms over 5 years since the start of 2003. As we can see the outsanding debt is now over 5 time as big as it was then.

Now if we look at the growth of forint denominated mortgages over the same period, we can see that while they initially expanded very rapidly, they peaked around the start of 2005, and since that time they have tended to drift slightly downwards.

Then if we come to look at the growth of non-forint mortgages, we will see that since early 2005 the rate of contraction of such mortgages has increased steadily.

Finally, if we look at the distribution of non-forint mortgages between those in euros, and those in "other" currencies (which may contain some yen, and some USD mortgages, but in the main will be Swiss Franc ones) we can see that those in euro form only a very small part of the total.

It is perhaps also worth pointing out that the fashion for non-forint loans is not restricted solely to mortgages, car loans and other longer duration personal loans also tend to be denominated in Swiss Francs or other currencies. The reason for this is obvious, the rate of interest is cheaper. But this non forint loan predominance has two important consequences.

In the first place the Hungarian central bank does not have sufficient control over monetary policy inside the country, being to some significant extent influenced by monetary policy in Switzerland, a country we may note which is not even inside the European Union. Secondly, the difficulties which would present themselves in the event of any substantial reduction in the value of the forint would be considerable - the is known as the translation problem, and is ably reviewed by Claus in this post here - and as a result the central bank is one more time a prisoner of others in terms of monetary policy, since it cannot take interest rate decisions which might influence excessively the swiss franc-forint crossover rate.

The fashion for borrowing in Swiss francs really took off in Eastern Europe after the Swiss National Bank dropped interest rates to 0.75% in 2003 in order to stave-off a perceived deflation threat, a move which at the same time converted Switzerland into the cheapest source of loan capital in Europe. External lending in Swiss francs reached $643 billion in 2006, according to data from the Bank for International Settlements . The huge scale of the borrowing in fact drove the Swiss franc to a nine-year low against the euro, and has lead to an accelerating slide in its value over the last two years - even though by this point the Swiss National Bank had been busy raising rates (Swiss interest rates have now been increased 7 times since the 2003 trough). The extreme weakness in the Swiss Franc is in fact rather perverse (shades of Japan, of course, here), since currently Switzerland enjoys the highest current account surplus in the developed world (some 17.7% of GDP in 2006). At the same time the Swiss hold more than $500 billion in net foreign assets, making them in these terms the wealthiest nation on earth.

A recent issue of the Bank for International Settlements publication Highlights of International Banking and Financial Market Activity has some revealing comments on the Swiss situation(the data used for the report came from 2006):

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.

The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.

Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research

Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention) - at least among theoretical economists) is that of the so called balance sheet cosnequences of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil
? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises


This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.

In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.


Anonymous said...

it's not consistent, at all. On one side you create -by incouraging people to close forex credits- new demand of foregn currencies on the other side you make substitution (HUF credit) more expensive. In addition, you give a hint of further losses of the fx rate, starting a race for the reserves of the NBH. If there was a recipe for confidence, this is just the opposite.

Anonymous said...

I am not sure about the "flood" of people moving over from fx to HUF loans. If the conversion takes place at the current rate and the HUF interest rate is higher, then the conversion does not lead to lower installments (in fact it should lead to HIGHER instalments).
Extending the duration of the loan can reduce instalments, but it is not necessary to convert for an extension of duration.
Conversion would then only make sense if the anticipated FURTHER weakening of the HUF is higher than the HUF/FX interest differential. But should we take it for granted that the HUF will weaken further from the current HUF per EUR levels of between 275 and 285?

Anonymous said...

Just taking this a bit further. Say the HUF interest rate is 12% and the EUR interest rate is 6%. The current HUF/EUR rate is, say, 280. If you convert from an EUR loan to a HUF loan, you would avoid a loss on your decision if the HUF/EUR rate was at least 280 x 1.12/1.06 = 296 in one years time.

Would you convert?

Antal Dániel said...

I wonder if you can swap a public finance crisis to a banking crisis this way. If anything, this is moral hazard taken to the extreme: the costs will be put on those bank debtors, creditors and equity holders who had not had an open fx position when it would had been favorable to them.

Edward Hugh said...

Hello kisvakond,

You raise interesting, and of course, important points.

"Conversion would then only make sense if the anticipated FURTHER weakening of the HUF is higher than the HUF/FX interest differential."

I think the problem here would be reference to the term "make sense". You are making a fairly rational calculation - based on the idea that the forint might stay in the area 275 - 290 to the euro. And your arguments are perfectly valid it seems to me.

The problem is that you are assuming that this process is a rational one. In your case it is, and you are able to take a guess, make a calculation, and then take a risk. And good luck to you.

Personally, I have no idea whatsoever where the relevant parity will be over the meaningful time horizons, what the rate of inflation (or deflation) will be in Hungary over a 3 to 5 year horizon (which would presuemably enter into any calculation people would want to make about whether it is worth extending the term of the mortgage etc). I am in the fortunate position of being merely a theoretical economist, personally I hate taking these kind of risks, which is why I seldom do (although I do take other ones).

But my main point is that I doubt most of the people with such mortgages are as rational as you are being. I imagine they will mainly be influenced by what they see others doing, what the government says (or doesn't say) and what they read in the newspapers.

Which is why I have all the stuff about "herd behaviour". Basically they all rush in, and then they all rush out again, and maybe a more rational person like yourself suddenly finds himself sitting around in an empty room wondering what it was that just happened.

Basically the most likely reaction - as Daniel is indicating - is that people will assume that the government is going to transfer the burden over to the banks (and thus to the Austrian and Italian taxpayers - don't miss what is going on with Italy and Libya right now, eg on my Italy blog), and put themselves to wait patiently in line for the government bail out of private households (I mean, if governments can't help private households, then who the hell can they help??), and this is why I have updated the original pot adding a lot of references to theoretical papers at the end.

Note what Sneider and Tornell (in waht is really a classic on the subject) say:

"lenders are bailed out if a critical mass of borrowers defaults"

So the "rational action" here comes to be lining up and joining the queue of defaulters so that it tips over into that critical mass, with the banks and multilateral agencies left scratching their heads and wondering how it was that they allowed the loaded pistol to be primed next to their head in the first place.

"I wonder if you can swap a public finance crisis to a banking crisis this way."

I think the answer is Daniel, a resounding yes, as we are about to see. Although of course, it is far from being a "painless" way.

Also, I don't think the EU leaders who met in Paris realised that this was what they were opening the door to.

kisvakond said...


Thanks for yor response.
Your point about herd behaviour vs rational decisions reminds me of a debate at

Generally, the current crisis seems to strengthen the position of behavioural economists and those favouring central intervention against market self regulation, but - I believe - there are two problems:

1. Behaviour is not scientifically predictable, it is just too complex, dependent on too many variables, and so the predictive value of behavioural economics, as opposed to "rational" economics, is pretty low. Rational economics has a predictive value if it applies to a large enough market and a long enough time interval.
2. Central intervention/regulation makes sense as long as those making the intervention decisions understand what's going on. But they don't.

Going back to our debate, I doubt that people would choose higher instalments. It would be obvious for herd behaviour to be aimed at short term gains against longer term uncertainty, but it is unlikely to be aimed at short term losses. People converting from fx to HUF would see right away that they would have to pay a higher instalment next month and possibly pay a price for the conversion.

Also, as Péter Felcsuti said in an interview in Figyelő (2008, No 43), banks will be trying to sell more forint loans by pricing fx loans higher. This is just a sign that the supply of foreign currency is becoming restricted. The demand side is that there will still be ample demand for fx loans at a higher price, otherwise some banks could pinch market share by offering fx loans at lower prices than Mr Felcsuti.
So why would herd behaviour be aimet at higher costs (at least on the short term) and away from a product (fx loans) the availability of which is becoming restricted?

Edward Hugh said...

Hi again kisvakond,

and thanks for the lengthy response.

"Your point about herd behaviour vs rational decisions reminds me of a debate at"

Again, thanks for the explanation. Really I wasn't trying to enter a methodologocial debate, since I try to avoid these like the plague. I studied economics at the LSE, but got very bored with the whole thing after my first year, since people seemed to be talking about a world which I couldn't find anywhere. What excites me (almost to the point of passion) about economics is real world data, and trying to forcecast (in a testable way) what actually goes on.

I went on to study philosophy, and most of the debates which seem to interest non-macroeconomists in economics remind me of something Gilbert Ryle once said: "the wheels of metaphysics turn and turn, but somehow there is no motion in the central crankshaft".

I was fortunate to go to the LSE however, since while I was busying myself avoiding studying what I tend to call "mumbo-jumbo" economics, Sir Karl Popper was busy giving lectures on the philosophy of science, and his views that I became familiar with at that time have long influenced how I see things.

My opinion is that economics *could* become an empirical science - just like the rest of them (more like biology than physics, we are after all living, sentient beings) - but first we need to consensually ground some kind of rigourous testability criteria. I especially like Popper's idea of "falsifiability" , and the notion that the creative scientist advances bold hypotheses and then systematically tries to disprove them. A far cry this from the lamentable world of most contemporary analysts and research institutes, who seem to have fallen into the unfortunate practice of conveniently forgetting the errors in last years forecasts by moving onto next years, without learning anything about possible flaws in the methodology they are using along the way.

I will give you an example of "testability". I have conjectured on this blog that Hungarian retail sales (due to ageing and declining population phenomenon) may now be passed their historic peak. I think this is perfectly falsifiable. They would only have to get past the H1 2006 level again for me to be wrong - although of course, following Imre Lakatos (a great Hungarian that one, and Schumpeter while I am extolling the Hungarians) I could add some sort of lemma to the original postulate if I thought there was some exceptional factor I hadn't taken into account. Popper's point would be that you can't simply keep doing this ad infinitum. If your forecasts turn out to be wrong, wrong and wrong again, then you need major roadworks on the fundamental axioms you are working with. This is the basic issue I have with contemporary neo classical economics as it is deployed in my field - macroeconomics.

Basically, something like this happened with all those famous growth correclates that were run in the 1990s, where the only real thing people were able to learn was what they didn't know, since no conclusive results whatsoever were produced. Yet convergence theory continues to be an underlying assumption, though there is no real empirical evidence to back this up, rather the contrary.

Well, you have gotten me going, haven't you.... :)

"Behaviour is not scientifically predictable, it is just too complex, dependent on too many variables"

I agree. Nowehere is this more obvious than in the fertility field, and in the way people take decisions about how many children to have. There are biological explanations (life history theory), economic ones, social ones, anthropological ones, even technological ones, and all of these have some validity. What there is NOT is any single reductionist methodology which enables you to capture such rich behaviour with any single model. And yet there are clear patterns: Southern Europe, Eastern Europe, Scandinavia, the German speaking countries, emerging Asia, North Africa etc etc.

So while we recognise the limitations of what we do, we should not be content with this situation. My approach is to try and cut straight through the undergrowth, and ask, even if we don't know exactly why this is happening, why don't we think about the implications, since these are there for all to see, and can be measured. (If it moves, measure it, would seem to be a good motto for economists).

What I am not clear about is how what you call "rational" economics differs from behavioural economics here, since I thought the whole issue for the former was the claim that rational agent theory had been able to provide the micro-foundations for macro theory. Paul Krugman makes this claim on numerous occassions.

Basically I tend to operate using a kind of restricted methodological behaviourism (not behaviouralism) a la Wittgenstein: which simply means I tend to black box what I am pretty sure I don't know anything about. What goes on inside the head of my fellow human beings is certainly one of the things I currently have no information on (since I cannot get inside and take a look), and first order personal experience does seem to suggest that it is rather different from what goes on in my head (there is a very long and rather tiresome philosophical literature on all this).

Basically, this is the same sort of reason why I am an agnostic (rather than an atheist, or a believer, say), since I have simply no information which would enable me to decide one way or another.

So I don't say that in principle we can't know what goes on inside the head of another person, but simply that at the moment we don't, and thus methodolologically we need to adapt to this, rather than inventing fairy tales about what we THINK is happening. I mean - if you look at all the charts I churn up across the blogs - we do have lots and lots of material to work on, without taking recourse to things we are just guessing about. Somehow, strangely, however, what we do know (more or less) seems to interest people less than speculation about the things we don't.

So, to get back to the point, I said that as a matter of fact (since I don't really see there is any serious way people can carry out the sort of calculations you were mentioning at the start) I expected we would see some kind of herd phenomenon in terms of behaviour (without in any way wanting to commit myself to what you call "behaviouralism" as a methodology).

On the other hand...

"Rational economics has a predictive value if it applies to a large enough market and a long enough time interval."

Well basically, this was what lay behind Keynes' famous joke that there are many things we don't know about, but we do know one thing, in the long run we are all dead. What should be interesting about macroeconomics is our ability to predict outcomes over much shorter time periods (like next year). If we can't do this, then I think we are wasting our time, and people are right to be contemptuous of economists.

(also, does what you call rational economics predict that over a long enough time period - say a couple of hundred years - all economies will converge to one single role model. Indeed - in an age of ever smarter computers and biotechnology, can it even predict that being which we currently call "humans" will continue to exist two or three hundred years from now?).

I do agree, however, that macroeconomics is about looking at aggregates and is holistic (and should thus make few - normally unnecessary - assumptions at the micro level). I mean, couldn't we simply agree that as the weather turns colder a critical temperature is reached at which point you put a pullover on (ie a behavioural phenomenon, which we can observe), and is it really necessary to speculate about whether what you are trying to do is run a calculation about how to produce an optimum level of tostesterone in order to guarantee the maximum number of your descendents even up to an infinite generation (Robert Lucas, for example, I think, goes down this rather unfortunate road).

"Going back to our debate, I doubt that people would choose higher instalments."

Right. Good. This is a prediction. And I am predicting that not only will they give up on their forex borrowing in Hungary, but that this kind of currency speculation with your own home will now come to an end across the whole of Eastern Europe. Now lets go and test.

Edward Hugh said...

Robert Solow, who is an economist I admire enormously, put some of the issues we are talking about here, in the following way (In his Nobel Prize Lecture, which you can find by Googling):

(All that follows is Solow)


One important tendency in contemporary macroeconomic theory evades this problem in an elegant but (to me) ultimately implausible way. The idea is to imagine that the economy is populated by a single immortal consumer, or a number of identical immortal consumers. The immortality itself is not a problem: each consumer could be replaced by a dynasty, each member of which treats her successors as extensions of herself. But no short-sightedness can be allowed. This consumer does not obey any simple short-run saving function, nor even a stylized Modigliani life-cycle rule of thumb. Instead she, or the dynasty, is supposed to solve an infinite-time utility-maximization problem. That strikes me as far-fetched, but not so awful that one would not want to know where the assumption leads.

The next step is harder to swallow in conjunction with the first. For this consumer every firm is just a transparent instrumentality, an intermediary, a device for carrying out intertemporal optimization subject only to technological constraints and initial endowments. Thus any kind of market failure is ruled out from the beginning, by assumption. There are no strategic complementarities, no coordination failures, no prisoners' dilemmas.

The end result is a construction in which the whole economy is assumed to be solving a Ramsey optimal-growth problem through time, disturbed only by stationary stochastic shocks to tastes and technology. To these the economy adapts optimally. Inseparable from this habit of thought is the automatic presumption that observed paths are equilibrium paths. So we are asked to regard the construction I have just described as a model of the actual capitalist world. What we used to call business cycles - or at least booms and recessions are now to be interpreted as optimal blips in optimal paths in response to random fluctuations in productivity and the desire for leisure.

I find none of this convincing.......

Edward Hugh said...

Ok, now here's another quote from Solow, from the famous and earth shattering 1956 paper, which changed the face of economics, and really set up some of the core components of modern neo-classical economics as we now know them:

All theory depends on assumptions which are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.' A "crucial" assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect.
Robert Solow, A Contribution To the Theory of Economic Growth

And now, here's another quote, from another epoch defining paper -Greg Mankiw, David Romer, and David Weil's “A Contribution to the Empirics of Economic Growth”.

This paper takes Robert Solow seriously. In his classic 1956 article Solow proposed that we begin the study of economic growth by assuming a standard neoclassical production function with decreasing returns to capital. Taking the rates of saving and population growth as exogenous, he showed that these two variables determine the steady-state level of income per capita. Because saving and population growth rates vary across countries, different countries reach different steady states. Solow's model gives simple testable predictions about how these variables influence the steady-state level of income. The higher the rate of saving, the richer the country. The higher the rate of population growth, the poorer the country.

Now what is this rigmarole all about? Well basically the second of the two testable predictions which are deemed to flow from Solow's seminal (and neo-classical economics foundational) paper turns out to be FALSE.

There is strong EMPIRICAL evidence that long term per capita income growth in countries with higher rates of population growth (the UK, France and the USA) is higher than in countries with lower (or negative) population growth - Italy, Japan, Germany.

Basically, Solow was right back in 1956, when the demographic transition was only half done. The problem is that the situation is a non linear one, and the normal mathematical models conventional macro economists use don't capture the complexity of the situation.

Of course, it may be possible to "rescue" Solow, I don't go so far as to say you can't, simply that no one has yet bothered to try, since they have ignored the problem (busy with other more interesting topics, like just how many angels can you balance on the head of a needle, no doubt). Meantime in Eastern Europe people continue to bet that the original paper can be rescued. That and forex loans being rational, you guys certainly like gambling. At least, you like it a lot more than I would be able to convince myself to like it. But then, as I say, I simply can't get in the other persons head to see what is happening, and perhaps it isn't gambling at all, but rather a very sound and sophistocated way of solving a Ramsey-type optimal-growth problem through time (with or without infinite generations and dynasties), using a methodology which I, evidently, am not up to.

kisvakond said...

Hi Edward,

Thanks for your responses, I feel truly privileged to have all this feedback on what I was (or still am) afraid might be silly comments under a silly pseudonym.

I still feel that I just can't help pointing out something:

I wonder if it's really gambling to choose forex loans. Yes, I may lose if the HUF weakens but I may also lose on a HUF loan if the HUF interest rate is raised when the HUF weakens.

I think that the key is Hungary's convergence to the euro zone.
For convergence, growth is needed. Growth needs to be financed in a large part from abroad. Foreign investors require real returns. If the Hungarian population and the government claim more of the value created in the economy than left after paying off foreign investors, then a bubble will arise, through rising inflation and/or overborrowing. Both will lead to increased costs of financing because of the requirement of real returns, and the fact that foreign lenders will be nervous at seeing overborrowing, and so will require higher risk premiums. The increased cost of financing will appear in higher HUF interest rates. As a result, both private borrowers and firms/institutions will prefer cheaper forex loans, and they will be just as exposed to the consequences of a depreciating HUF as the whole Hungarian economy. Hungary cannot afford a too quickly depreciating HUF because that raises the required returns for foreign ivestors, which in turn leads to HUF interest hikes - which is happening now. Similarly, private borrowers cannot afford a too quickly depreciating HUF, but - and this is my point - having HUF loans does not help, because the increased cost of financing the whole economy will appear in the costs of HUF loans as well.

Back to convergence, inflation and deficit have been brought back closer to convergence criteria, and foreign investors should really appreciate that. However, Hungary's reputation has been seriously damaged, probably for what happpened before Sep 2006, the launch of the austerity package. Increased risk premiums (Hungary is regarded similarly risky as Brazil or Mexico by the international financial community, see CDS spreads at Deutsche Bank's site) are a consequence of the damaged reputation, and will now force the Hungarian population and the government to consume/retain even less of the value created by the economy, because the risk premiums will have to be paid - by all Hungarians, those who have forex loans and those who have HUF loans alike.

Edward Hugh said...

Hi again,

"on what I was (or still am) afraid might be silly comments under a silly pseudonym."

Well possibly the pseudonym was silly, but the argument you wanted to talk about was a serious one. It is worth taking time to think about. Plus, it was the weekend, and the work load of an economist is normally light at weekends, so we can afford to enjoy ourselves a bit. Personally I welcome feedback and these types of exchange.

Anyway, now a new week is commencing, so lets go and see what gets to happen next.

Take care,