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Thursday, July 23, 2009

Escaping Original Sin in Hungary?

by Claus Vistesen: Copenhagen

According to the well known textbook in international economics by Maurice Obstfeld and Paul Krugman [1] the notion of original sin refers to the fact that many developing economies are not able to borrow in their own currencies but are forced to denominate large parts of their sovereign debt in order to attract capital from foreign investors. The argument then goes that if and when the goings get tough those countries will face difficulties paying off their liabilities and once the dust have settled the sin, as it were, has only become more binding when these same economies yet again venture onto international capital markets.

It is interesting to ponder this story in relation to Eastern Europe where far from being a sin the ability to denominate liabilities in foreign currencies such as Euros and Swiss Francs was almost seen as a virtue of modern capital markets during the boom years which followed the famous meeting in Copenhagen which saw the European family expand to 25 countries, a number which now has risen to 27. On the face of it, it is not difficult to see where this virtue came from. Aggressive expansion by western European banks into the CEE and a low volatility environment ultimately driven by the notion of a road map towards convergence bound to bring forth an equalization in living standards and, in the case of many CE economies, a certain membership into the Eurozone underpinned the fact that the ability to shop foreign currency loans was hardly a sin, but a natural counter product of the newly formed European community.

Now, all this has capsized and those economies who where so busy raising rates going into crisis in order to quell the massive inflationary pressures, which further intensified the flow of foreign currency loans, are now effectively stuck with no ability to tweak monetary policy since the low rates which are needed are either impossible (in the case of the Baltics and their Euro pegs) or de-facto impossible in the context of e.g. Hungary and Romania. Moreover, and in a world where major central banks are stuck at the zero bound and where the level of volatility may itself be volatile as we move from optimism to pessimism all that liquidity may yet again prove to be a destabilising factor in the context of Eastern Europe where we were all, I am sure, amazed, to learn a couple of months ago how some analysts were advising clients to play the carry trade with Eastern European economies as designated targets, for more on this see this post.

So what does all this has to do specifically with Hungary? Well, today we learned from Finance Minister Peter Oszko that Hungary would certainly prefer to issue local currency debt in the future, but given the fact that the IMF loan is not, by nature of it being a loan, permanent Hungary also need to find a viable way to make its policy tools work most effectively. The following excerpt is from Bloomberg;

Hungary doesn’t plan to raise foreign-currency debt in the “near future” and will increase sales of forint-denominated bonds to finance the budget, Finance Minister Peter Oszko told Nepszabadsag. “In the short term, the budget doesn’t need foreign- currency denominated financing sources,” Oszko said in an interview with the Budapest-based newspaper. The Finance Ministry has confirmed the comments to Bloomberg. “Increasing forint-based issuance is more worthwhile.”

Hungary sold 1 billion euros ($1.42 billion) of debt last week in its first offering since the flight of investors forced it to take a 20 billion-euro bailout from the International Monetary Fund, the European Union and World Bank in October. The country is working to wean itself off emergency financing. The IMF-led loan, which “secures a comfortable situation,” runs out in March 2010 and the government must work to ensure the country can finance itself from the market at lower rates by then, Oszko said.

“The July auction’s primary importance wasn’t to secure financing but rather to strengthen confidence in the country,” Oszko said. A “smaller” foreign debt sale is possible in the future as “it’s our basic interest to be active in the market.” Hungary could next target U.S. investors with the sale of dollar-based bonds, the newspaper Napi Gazdasag reported today, citing Laszlo Balassy, a Budapest-based executive at Citigroup Inc., which helped organize last week’s sale.

It should immediately be clear that this represents the original sin issue in full vigour although somewhat in reverse one could argue. Consequently and notwithstanding the obvious problems facing Hungary in the context of lowering rates, the country needs to balance the between issuing debt in foreign currency which would mean further currency translation risk and an even further entrenchment of the high domestic interest rates or issuing in domestic currency which might not be possible at current rates (i.e. rates would need to go up further) or simply not viable given the future financing needs.

To put all this in the context of a solid macroeconomic analysis I am in luck since Edward has just dished out an up to date look at Hungary's economy. As Edward notes straight away, Hungary has now embarked on the great experiment also currently being tested in Latvia of internal devaluation and the long hard climb, through deflation, towards the competitiveness Hungary so badly needs. Now, I know that I tend to move closely together with Edward on many accounts but I dare anyone not to share the sentiment expressed by Edward as he points to the obvious point. The current strategy taken in Hungary to battle the crisis is not working and at some point one really has to stop to ask why.

One striking data point is the fact that while the real economy seems in absolute free fall real wages are still rising and given the inevitable point that Hungary needs wages to fall, and a lot, absent devaluation one wonders silently what kind of contractory jolt the real economy needs in order to engender this effect. Meanwhile, Hungary has also recently pulled out the good old trick of raising the VAT something which will surely to push up the main inflation index, once again pulling in the wrong direction.

As usual Edward is thorough, very thorough, and I can only suggest to spend the 20 minutes it takes to superficially digest his points. Especially the point about a monetary policy trap is mandatory reading. In terms of a summary of the situation the following gets to the heart of the matter;

And in case you had forgotten, here is what is happening to Hungarian GDP: while wages and prices are rising steadily, GDP is in free fall. Year on year it was down 4.7% in Q1 and Hungary’s government currently expects the economy to contract 6.7 percent this year, the most since 1991. My view is a total policy trap is in operation here, since neither monetary (interest rates are currently 9.5%) or fiscal policy are available, so there is little support to put under the economy at this point. The only way to break the circle in my opinion is to let the forint drop, bring down rates, and restructure the CHF loans.

As will no doubt come as a big surprise, I completely agree. Hungary needs to address the already existing asymmetry inherent in the economic edifice which should entail a strategy on how to deal with the stock of CHF loans on the households' and corporates' balance sheet. This also gives a final spin on the actual topic of play in this entry.

In all probability the dilemma difficulties facing the Hungarian treasury in terms of constructing a viable and solid platform on which to finance its operations is greatly dependent on the issue with the already existing fx denominated loans. If Hungary were to construct a credible and realistic solution to the issue of how to write down/pay off the stock of CHF loans my guess is that the original sin would be a little easier to escape even if not all together.


[1] Who follow the lead of Eichengreen and Hausmann.

Wednesday, July 22, 2009

Hungary Struggles To Apply Its Own Unique Version Of "Internal Devaluation"

Just what the hell is going on in Hungary? This is the question which even the most cursory inspection of the latest round of data coming out of the country leads me to ask myself. What the hell is going on and just what kind of correction is this the IMF are presiding over here?

In May, according to the latest data from the Hungarian statistics office, in the Hungarian private sector real wages were up, and employment was down. Meanwhile in the public sector, real wages were down, but employment was up (contrary to what was supposed to be happening). A recent programme to get workers off the unemployment roles and back to work seems to have had the perverse and contradictory impact of offsetting the fall in private sector employment by giving a sharp boost to public sector employment. So while total employment has remained more or less stable, the balance has shifted, and in the wrong direction. Meanwhile, in an attempt to stem the bloodletting in public finances (the economy remember will probably contract by about 7 percent this year) VAT was raised - by the significant margin of 5 percent (from 20% to 25%) on July 1st, giving consumption, which was already falling sharply, another sharp jolt downwards. Not only that, the Hungararian economy, in order to maintain the value of the forint more or less where it is (all those forex loans) was supposed to be having a major downward correction in wages and prices, yet inflation (which was already at an annual 3.7 percent in June) will surely now be given a hefty kick upwards. So, I ask myself, how does any of this actually make sense, and to who? And meantime the problem of the forex denominated loans remains, and goes jangling around (like any good jailor does) in the background, putting an effective stop on monetary policy just as fiscal policy switches over to complete contracton mode. This is why I talk of "internal devaluation", since the Hungarian authorities (with the agreement of the IMF and the EU Commission) seem to have decided that, rather than resolving the issue of the CHF loans once and for all, they will down the same road that is proving to be so disastrous in Latvia, even though they have their own currency to devalue, should they choose to do so.

At the end of the day, the big question which we are all left with is, whether this structural shift in employment, away from the private sector and towards the public sector, and the increase in the consumer price index to be caused by the sharp VAT hike, plus the ongoing rise in real wages, really is the outcome the IMF support programme was intended to achieve?

Wages Up, Employment Down

Amazingly, with an economy contracting at at least a 7% annual rate, Hungarian real private sector wages aren't falling, they are still rising. They were up (over and above inflation) by 1.7% in May. Evidently those who are still in employment say, crisis, what crisis?

Unsurprisingly Hungary’s consumer confidence index rose in July for a third month (to minus 63.1) after hitting a record low in April.

“Consumers’ perception of their ability to save in the short-run is what improved the most from June,” GKI said in their statement. Well certainly a 5 point hike in VAT is unlikely to encourage them to spend. In fact, paradoxically, saving is what Hungarians collectively really need to do, to reduce the ballooning government debt and pay down the level of net international indebtedness. But all this simply means is that to get the economic growth necessary to do all the required saving Hungary is going to need to export, and a lot more than it was doing previously, which is why the shift towards public sector employment is so serious.

As I say, private sector employment is down in Hungary, by 4.8% y-o-y. While industrial output was down 22.1% in May over a year earlier. Something just doesn't seem to be working as it should be here.

On the other hand, public sector employment is on the up and up in Hungary, due to job creation under the short term stimulus programme, courtesy indirectly of the IMF, who have permitted a large than anticipated budget deficit. Don't get me wrong, it's not the stimulus I am quibbling about, it is what it is being used for. The outcomes we are seeing at present don't seem to me to be producing a large structural change in the right direction.

Actually the rise in public sector employment is not a direct result of the increase in the IMF permitted deficit, but rather comes from restructuring funds earlier used to finance social assistance payments. The same ammount of money (at about 100 billion HUF) was used to provide public work opportunities for people who before April were entitled to receive social assistance for staying at home. Now those considered capable of working can only receive benefits if they are registered as public workers and if they are offered a job opportunity by local governent they are compelled to accept it. Thus, like so many things in Hungary, the intention was good even if the execution wasn't.

Meanwhile, far from the current recession leading to a significant downward shift in wages and prices, real wages are - as we have seen - still rising, and Hungary's consumer prices were still running year on year at 3.7% in June, down it is true from 3.8% in May, but still far to high to start restorting competitiveness. And of course, the July 1st VAT rise will give consumer prices another stout kick upwards, with some analysts suggesting that year end inflation could be running as high as 6%. If this is anywhere near accurate, and the HUF stays in the region of its current euro parity, then Hungary's agony looks set to continue unabated into 2010.

And in case you had forgotten, here is what is happening to Hungarian GDP: while wages and prices are rising steadily, GDP is in freefall. Year on year it was down 4.7% in Q1 and Hungary’s government currently expects the economy to contract 6.7 percent this year, the most since 1991. My view is a total policy trap is in operation here, since neither monetary (interest rates are currently 9.5%) or fiscal policy are available, so there is little support to put under the economy at this point. The only way to break the circle in my opinion is to let the forint drop, bring down rates, and restructure the CHF loans.

The result of all this botched policy - Hungary’s unemployment rate rose to the its highest level in at least a decade in May. The rate rose to a seasonally adjusted 10.2 percent, the highest since at least 1996. And the situation is more likely to deteriorate than improve, with the central bank forecasting lay-offs of around 180,000 in 2009-2010, nearly 5% of the total number of employed.

One of the important things to grasp about the current situation in Hungary is that this is not a constant size wheel running constantly around the same spindle. The long run outloook is steadily deteriorating as population falls and ages. The same is also true of the working age population, which has now been falling steadily for some years (see chart below).Unsurprisingly therefore the NBH now project that employment will fall by 3.2% this year, followed by a 1.7% contraction in 2010, notably primarily due to layoffs in the private sector.

Hungary’s industrial output fell at a slower annual pace in May than it did in April as stimulus plans in the European car industry added to demand, but production was still down 22.1 percent on May 2008 (following a 25.3 percent annual decrease in April). Output rose 2.6 percent over the month.

Hungary's contraction seems to be more or less moving sideways at the moment, and the June PMI came in at 45.8, a slight uptick from 45.4 in May, but hardly a seismic shift. The output improvement was almost all due to the export sector.


Hungary recorded its fourth monthly trade surplus in May, and came in at 497.7 million euros as compared with 430.3 million euros in April and a deficit of 30.3 million euros in May last year.

Now good news is always good news, but it is important to understand that this result was almost entirely achieved via a dramatic drop in imports, which plunged 32.3 percent in May (following a 35.4 percent decline in April). It is impossible to talk of any marked improvement in exports, since these fell by an annual 24.1 percent, accelerating from a 29.4 percent drop in April. While in the short term this substantial drop in imports (and hence rise in the trade balance) is GDP positive, it is very negative for living standards in the longer term, and the whole situation needs to be reversed by a large boost in exports leading imports as the eurozone economy eventually recovers. But to be able to achieve this Hungarian industry needs to do more, much more, to achieve competitiveness.

Investment Activity

Hungary is suffering from a generalised drop in demand - domestic, export, government, and investment - for which it is difficult to see any short term remedy. In the first quarter of 2009 investments fell by 7.7% compared to the same period of 2008, while they decreased by 1.1% in comparison with the previous quarter (according to seasonally adjusted volume indices). Within this fall machinery and equipment decreased by 9.9%, while investment in manufacturing industry was down by 6.8%. Evidently the first sign of any real recovery in the Hungarian economy will come when investments stabilise and even start to increase, since that will be a reflection of the expectation of future demand arriving further down the pipeline.


Construction activity was down by 10.1% compared to May 2008. In the first five months of the year, output decreased by 6.9%. In comparison with April production decreased by 3.3%. Construction output showed a decreasing trend in connection with the global economic crisis in the past months. In fact there was a significant difference between the performance of the two construction branches, with buildings activity falling by nearly a quarter, while civil engineering works were up by 7.9%. On a seasonally adjusted basis, building activity was 8.6% lower in May over April, while civil engineering was up one percent on the month.

Retail Trade

Retail sales fell 3.4% year-on-year in the first four months of 2009. In April the fall in retail sales accelerated, and the volume index was down 4.1% compared with April 2008. Retail sales decreased by 0.3% over March according to seasonally and calendar adjusted data.

But the real problem is that Hungary's retail sales are now in long term decline, and it is hard to see this situation turning round as the population declines. The peaked in mid 2006, and it has been downhill ever since. This highlights the important point that Hungary's economic difficulties - like Italy's, which bear some resemblance, are not of recent origin, but go back to the adjustment process that started following the mini crisis of June 2006, an adjustment which has never, at the end of the day, achieved the results which were expected of it, and the real question is, why not?

Monetary Policy Trap

Back in April, the Hungarian Finance Ministry were expecting a 155 billion forint budget surplus for the second half of this year, but since then the economic outlook has continued to deteriorate, and according to their latest estimate there will actually be a 149.6 billion forint deficit in H2. This anticipated shortfall is the principal reason why the IMF and the European Commission recently agreed to let Hungary raise its deficit target to 3.9% of GDP for 2009 from the 2.9% previously agreed. They did this in response to the larger-than-expected economic recession, thus avoiding the additional fiscal tightening measures which would have been needed to hold the deficit below the Maastricht 3.0% target level. The gap in 2010 is now expected to come in only a tad lower than this year at 3.8% of gross domestic product (although this number is subject to considerable revision given the levels of uncertainty facing the economy and hence government revenue and spending). As a result, the EU Commission in their latest forecast suggest gross government debt to GDP will reach 80.8% in 2009, and 82.3% in 2010, way above the 60% euro adoption level.

Nonetheless the Hungarian government is in bullish mood. According to Finance Minister Peter Oszko in a Bloomberg TV interview “Recently there has been a turning point......Financial risks are very quickly decreasing in terms of the whole budget. The Hungarian government is committed to implementing a reform program quite quickly.”

Capital Economics' Neil Shearing isn't so convinced:

But is this new-found optimism justified? Possibly. The National Bank will certainly take heart from the fact that the bond market is functioning once again following a complete freeze late last year. This adds weight to the case for interest rates to be gradually lowered, with a 50bps cut to later this month looking increasingly likely. But amongst all the euphoria, it is important to keep some sense of perspective. First, while the government managed to complete the bond auction successfully, it came at a price. At 6.79%, the yield on the new bonds is around 90bps higher than what existing 2014 euro-bonds currently trade at.
There is indeed a general feeling in the air that monetary easing is coming, and in fact three members of the central bank's Monetary Council voted even at the last meeting to lower the key policy rate by 50 basis points, according to minutes of the 22 June rate setting meeting. The MPC is set to hold its next policy meeting on 27 July, and is widely expected to start a monetary easing cycle. My view: just watch out what happens next.

Basically the problem is the value of the forint. My opinion is that the recent recovery in the currency value (see chart below) has been almost entirely driven by yield differentials, and by self-fulfilling expectations (traders expect the currency to rise), rather than by any change in the underlying economic fundamentals, which as we have seen, has not taken place.

And if you are in any doubt about the extent to which Hungary has lost competitiveness since the start of the century, just take a look at the comparative REERs for Germany and Hungary below (REERs are trade weighted, and take account not only inflation but also movements in unit labour costs, ie productivity).

The problem the central bank and the Finance Ministry have to address is the ongoing issue of the mountain of Swiss Franc denominated mortgages (see chart).

These have stopped increasing in recent times, but still constitute a serious obstacle to any devaluation of the HUF, due to the non performing loans issue this would create for the banking sector. Not only has money been borrowed against homes for to fund house purchases, it has also been loaned for consumption (see chart below), so indeed the fact that even these loans are stagnating hardly bodes well in any way for domestic demand.

The thing is, as long as the interest rate differential remains as it is, there is no possibility of convincing people to take out HUF denominated mortgages. So domestic rates have to come down, but as they come down the forint will fall, and the number of distressed loans will spiral up. So the authorities are stuck in a real policy trap, where they have to wriggle uncomfortably around, carrying out what can only be described as a weird variant of voluntary internal devaluation, an intenral devaluation which again, as we have seen from the wage and price data, just isn't happening.

Obviously the whole idea IMF idea here was some sort of long term "play" - moving the focus of taxation from employment to consumption (addressing the tax wedge issue). Initially this shift was supported by the argument, that, amidst a deflationary backdrop, businesses wouldn't be able to pass the tax increase on to consumers in its entirety. At this point it would seem the Hungarian government has no real room for manouver and are desperate to implement the tax restructuring, therefore they opted for the significant VAT raise.

Part of the thinking which lies behind the present approach seems to be some new concept of financial orthodoxy. The IMF put it like this in the Hungary Standby Loan Report

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

So from Tallinin, to Riga, to Budapest, to Bucharest, the same sonata on a single note is being played, and the message is a clear one - cut spending and you will expand.

But with consumption sinking, government spending falling and exports insufficiently competitive to drive the necessary surplus, the whole thing is now becoming rather a mess, with no clear economic policy objective in the short term (except, of course, maintaining a strong exchange rate) and while in the long term the emphasis is rightly on export. But no one has any idea of how exactly to correct prices sufficiently with the CHF mortgages stuck in the middle.

And the new bond issue only makes things worse here, since as Neil Shearing emphasises:

it is worth noting that the latest euro-bond issue only adds to the mountain of foreign currency denominated debt that lies at the heart of Hungary’s current woes. With the banking sector still in deep trouble and fiscal policy set to tighten, the recession is likely to intensify over the coming quarters.

So, with the Hungarian government currently forecasting a GDP contraction of 6.7 percent,this year, and the likelihood being of further contractions next year and possibly even in 2011, something somewhere is going to give here.

And among the casualties, well why not Hungary's unborn children, the ones she needs to start turning round that population decline I started this post with.

According to preliminary data from the stats office, in the first five months of 2009 38,964 children were born, 1.9 percent less than in the first five months of 2008. But that isn't all, if you look carefully at the chart you will see that the number of children born fell substantially from about March 2007, just nine months after the first financial shock hit Hungary in June 2006. So here's a nice prediction, if economic conditions do work as a short term influence on fertility, then we should see another sharp drop in Hungarian births starting in from July, just nine months after the last financial crisis hit the Hungarian economy. There, I bet you never imagined that the collapse of Lehman Brothers could have such far reaching consequences, now did you?