Construction Activity in Hungary

According to the latest release from the Hungarian Statistical Office the volume of construction activity in Hungary decreased in June 2007 by 15.8% when compared with June 2006. In the first six months of 2007 output was 4% below the level of the same period for 2006. When compared with May 2007 production fell by 8.9% based on the seasonally and working days adjusted index. The general downward trend in activity can be seen from the chart below.





But what can also be observed is the steepness of the decline in June, which can also be noted in the chart for monthly changes (see below). As a result of the June drop - which according to the statistical office occurred in both large construction companies involved in areas like road construction and small firms involved in residential construction activity - the 12-month index fell 15% to reach its lowest since 2003. Although the construction industry constitutes a comparatively small share of the overall Hungarian GDP (in the region of 5%), these poor results may partly help to explain Hungary's poor Q2 GDP growth figure, although we will have to await the detailed breakdown of Q2 GDP due in September to confirm this.



The construction of buildings fell by 15.2% and that of civil engineering decreased by 16.6% when compared with June 2006. Since the start of 2007 construction of buildings has fallen by 1.3% while civil engineering is down by 6.8% as compared with the first six months of 2006. Month on month (ie when compared with May 2007) the construction of buildings decreased by 7.4%, while activity in civil engineering fell by 5.2%.

The stock of orders at the end of June was 41.3% below the level for June 2006. Within this, the stock of orders for building construction decreased by 23% while that for civil engineering was down by a half.

All of this is consistent with a sharp reduction in government spending (civil engineering) and in domestic consumption (housebuilding), as such it really should have been expected, although as I say, given the small share of construction in GDP this reduction alone cannot explain the low Q2 reading.

The extent of the slump in construction activity is also very clear from the following chart which shows annual changes in output by month. The extent of the drop in June is very clear, as is striking the fact that positive y-o-y readings have only been registered in 3 months since the start of 2006.




What is really puzzling me is what can be seen from the chart below, which shows trend construction from the start of 2004. As can be seen there was something of a boom in 2005 which then petered out, since which time it has been downhill all the way. What I don't really understand is why construction should have slowed after mid 2005, while across the rest of the EU8 and in the rest of Europe generally activity was accelerating. This just seems to be one more area where the evolution of the Hungarian economy seems to be somewhat out of step with the rest. I only wish I understood why. Comments welcome.

Emerging Markets and Safe Havens

Danske Bank's Lars Christiansen had a research note last week which is of some interest for Hungary's current situation. Entitled "Emerging Markets: Looking for the safe haven" (watch out pdf), and published last Thursday, Christiansen accepts that there is a global credit crunch, and that it is now spreading to Emerging Markets (EM), with many of the high-risk EM currencies (the Turkish Lira, the Hungarian Forint, etc) now coming under heavy fire. As to the question what countries may be most at risk, he answers the following:

In a situation where liquidity is tightening there is no doubt that the most liquidity-“hungry” countries are those with large current account deficits and large external debt. In this category we find Turkey, South Africa, Hungary, and Iceland. Furthermore, risks are heightened in the Baltic states, Romania, and Bulgaria.

That would seem to put Eastern Europe pretty generally on the map I would have thought. Chrisiansen seems to accept the arrival of the credit crunch as now a fact:

For the last couple of weeks, we have warned that the global credit crunch could spread to Emerging Markets. This has now clearly happened, but given the major moves in the global credit and equity markets there clearly is potential for even more contagion to Emerging Markets. Therefore, there is also reason to start looking for safe havens within Emerging Markets. Here external funding needs will be the key.

Furthermore:

The credit crunch has triggered a strengthening of the yen and to a lesser extent, the Swiss franc. We would in particular watch the Swiss franc as many households in Central and Eastern Europe have funded their property investments with Swiss franc loans. Hence, if the Swiss franc strengthens further then it could put additional pressures on the CEE markets mostly exposed to the Swiss franc.

This is really code language for speaking about Hungary, since in Hungary around 80% of the mortgages which have been taken out in recent times have been Swiss Franc denominated (via Austrian banks I should mention, so the Austrian banking sector is also partially at risk, although the Austrian Central Bank think they can withstand the shock if you look at the "Stress Testing the Exposure of Austrian Banks in Central and Eastern Europe" paper presented here.

So here are Danske Banks recommendations. The countries you are told to avoid are in red:




There is also another conclusion drawn from the dependency on the Swiss Franc:

If the markets continue to run away from the above-mentioned markets then it will also have ramifications for monetary policy in these countries. We would particularly argue that the planned / signalled monetary easing in Turkey and Hungary will be postponed – maybe long into 2008.

That is to say it will not be possible for the Hungarian Central Bank to reduce interest rates as it would like to to support internal demand since this would most likely send the Forint hurtling down, and this would make the position of those on Swiss Franc mortgages well-nigh impossible.

All of which brings us back to Danske Bank Chief Economist Carsten Valgreen, and his widely quoted paper on how in an age of global capital flows the monetary authorities in small open economies may lose effective control over the direction of their domestic economies. In particulatr we might like to examine the following chart, which comes from the paper. entitled The Global Financial Accelerator and the role of International Credit Agencies.



Now the data Valgreen uses comes from 2005, and since that time the position can only have changed in the direction of increased dependence on non-locally denominated currency loans (and especially in those countries who are coming from a lower base). Thus it can be seen that the risk level coming from any currency adjustment is quite significant. The following summary of the content of Valgreen's paper is also interesting, since it reveals to what extent the monetary authorities in a small open economy (and perhaps a not so small one, think Poland) may well lose control in a way which makes any adjustment process very difficult, with or without pegs:

The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency” economies based on foreign fiat money or gold.

The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.


One bright spot - or potential safe haven - does exist in Eastern Europe however: the Czech Republic:

Finally it should be noted that the Czech koruna (CZK) – unlike most other CEE currencies – should be expected to strengthen in the present environment due to unwinding of CZK-funded carry trades. That said, the CZK is fundamentally not undervalued and the Czech central bank should be expected to keep interest rates below the ECB rate – especially if the CZK strengthening accelerates. That will limit the potential for strengthening of the CZK.

In case any of you notice some inconsistency in this view of the Czech Republic, since of course Czechia is also one of the "reds" identified by Christiansen in his CA chart above (though to a much lesser extent than some of the others it needs to be said), I think it should be pointed out that other factors beyond the CA deficit need to be taken into account when evaluating the situation (the value content of exports would be one of these, what the deficit is based on would be another - ie are you importing machinery and equipment which can subsequently be used for exports - and the openness of the labour market to immigration would be another - there is of course an acute labour shortage in the Czechia , but they are they are actively attempting to address this and they are even out trying to recruit in Vietnam). Essentially the Czech economy seems to be on pretty solid ground (as may also be the Slovenian one), and you do need islands of tranquility in Oceans of tempest. So some countries will for this very reason prove to be win-win, while others may well, by the same token, prove to be lose-lose. Unfortunately historic reality is seldom just.

I also would be much more cautious than Christiansen is about Russia, political instability is evident, as are labour shortages. We need to see what happens next to oil and other commodity prices before sticking our necks out on Russia I think.

Hungary Second Quarter 2007 GDP

Hungary’s economy grew by only 1.4% year-on-year in the Q2 of 2007 according to data relesed by the Hungarian Central Statistical Office last Tuesday.

This was the lowest quarterly rate to be recorded in Hungary since 1996 (as can be seen to some extent from the chart below which unfortunately only goes back to the start of 2005) and well below the general expectations of analysts, who had mainly been predicting GDP growth of over 2% for 2007. This number would now seem highly optimistic.




Hungary is in fact in the middle of a really tough fiscal readjustment as the government attempts to reduce its budget deficit, which at 9.2% in 2006 was by far the largest in the European Union. The main impact of the austerity programme has been on internal demand and thus Hungary’s GDP growth - which had been hovering around the 4% mark in recent years (see chart below) - has inevitably taken a hit.



Lars Rasmussen, analyst at Danske Bank, says in a research note that:

Preliminary GDP numbers for Q2 published this morning, showed that growth continues to slow quite dramatically. More specifically, economic growth plunged to 1.4% y/y in Q2 – well below our projection (2.4% y/y) and the market expectation (2.5% y/y) – and down from 2.7% y/y in Q1. Growth is the lowest in 11 years, and the slowdown in inflation continues pretty much as expected. The numbers are confirmation that last year's fiscal tightening is working. This is obviously positive and we would expect inflation to continue to ease in the coming months, which could keep the door open for a fur-ther moderate easing of monetary policy. That said, the worsened global credit conditions could weigh on the Hungarian forint going forward and make monetary easing harder, and the Hungarian central bank is likely to move very cautiously on monetary easing.

We will have cause to return to this issue in subsequent posts, but it is clear that the current global market volatility - and the accompanying pressure on the Forint - will only serve to make it very difficult for the National Bank of Hungary to lower interest rates, and thus put some sort of platform under domestic demand. All of which, being blunt, means that the Hungarian authorities now face a very difficult situation indeed.

This is especially true given that some 80% of Hungarian mortgages are in Swiss Francs (and a more substantial analysis here), which means that any significant drop in the Forint would really cause substantial problems for domestic consumption way beyond those which are already arising. On the other hand, of course, given Hungary's currently high inflation rate (in the 8 to 9% range) it will be really hard to achieve export competitiveness without some sort of devaluation of the Forint (which is, of course, already happening as part of the global credit correction). So the Hungarian authorities are stuck between the proverbial rock and the hard place.

If we look at the chart below we will see that the actual GDP growth in Q2 2007 which was only 0.2% was very low indeed. With domestic demand dropping rapidly, and the external environment possibly about to take a turn for the worse things do not really look any too good.



However, if it is any cheer for any of my Hungarian readers, Lars Rasmussen's Danske Bank colleague Lars Christensen is widely quoted as saying that Hungary should not be too worried by apparently falling behind the region. “The slowdown will make more room for growth,” he said. “A lot of countries in Central and Eastern Europe - Bulgaria, Romania and Slovakia - have not taken the measures Hungary have and will be in a worse situation in a few years.” Well, leaving aside the issue of whether we should really be taking delight in others difficulties, I'm afraid that while Christiansen may well be right that it may well not be long before "the Baltic disease" (strong inflow of funds coupled with strong outflow of people, after many years of very low fertility, producing massive overheating and dramatic wage inflation) strikes the mentioned countries, it should be noted that this has NOT been Hungary's problem, although Hungary does - like all the other Eastern European countries - have a very limited demographic time window across which to address the underlying problem, so unfortunately it may well not be true that the ground lost during the current impending slowdown can be so easily recovered later. More on this as we move forward.