Sunday, August 8, 2010

Hungary - Save The Last Waltz For Me

"We must pay the debt precisely and punctually, even if we destroy the economy in so doing".
Katalin Botos, Secretary of State in the Hungarian Finance Ministry during the government of József Antall (1990 - 1993).

Background: On November 6, 2008 Hungary received IMF approval for a 17-month Stand-by Arrangement to the value of €12.5 billion (a figure which represents 1015 percent of the country's estabilshed IMF quota) and in the process became the first EU nation to enter a conditional program with the IMF. The European Union also agreed to provide a loan of €6.5 billion (funded via the issuance of EU bonds) of which some €5.5 billion have so far been disbursed. The World Bank also agreed to provide an additional €1 billion.

Access to the loan was front loaded, with €5 billion becoming available on the approval date, €2.5 billion at the time of the First Review (March 2009), and €1.55 billion at the time of the Second Review (June 2009). During the Second Review the arrangement was extended for a further six months (new expiry date October 6, 2010), and the undisbursed amounts were re-phased over the remainder of the arrangement. A fourth installment of €60 million was paid at the time of the Third Review (September 2009).

Judging the economic and financial situation of the Hungarian economy to be improving steadily, the authorities chose not to draw the €865 million which became available to them on completion of the Fourth Review (December 2009). During the program period the European Union has also disbursed €5½ billion of the €6½ billion that were initially approved. The World Bank loan was approved by their board of directors in September 2009, but the loan documents have still to be signed by the parties to the agreement.

Subsequently, feeling again reassured by what seemed to be a positive improvement in external financing conditions, the government did not draw on either the IMF or EU resources that became available at the completion of the fifth review (March 2010). At the time gross international reserves had almost doubled from the pre-program level of €17.4 billion in September 2008 to €35.2 billion in June 2010. Parent banks continue to maintained their exposure to their Hungarian subsidiaries, in line with their European Bank Coordination Initiative (EBCI) commitments, and rollover rates of bank liabilities are running close to 100 percent.

But behind this apparenty "poster boy" type success story, a rather more compex chemistry has been at work, since a Hungarian citizenry who have been living under the weight of one "austerity program" after another since the June 2006 run on the forint (a prelude to, and foresadowing of the November 2009 Greek crisis) which followed the then Prime Minister Ferenc Gyurcsány's post election victory admission that the fiscal deficit was far larger than had been acknowledged, has now visibly grown sick and tired of the whole situation. As Gyurcsány said at the time, "We lied to them in the morning, we lied to them in the evening."

So when the IMF announced in June that it would conclude its mission without having agreement with the newly elected government of Viktor Orban, few should really have been surprised, since the ground had already been being prepared following the decision not to draw on the November tranche. As both parties prepared for the April elections they knew only too well that the tolerance in Hungary for further IMF-type programs was wearing thin.

As a result it appears that market participants are seriously under-appreciating the potential for events in Hungary to take a nasty turn, since despite all the years of austerity programmes the underlying macro position is not as sound as many think. Hungary’s economy is now almost totally dependent on export surpluses for economic growth, and thus it is very sensitive to movements in demand elsewhere in the EU. That is to say, if the Eurozone economy does catch a cold in the second half of the year, Hungary will be among the first to sneeze.

At the same time, the high level of external debt means that the economy is very vulnerable to externally induced contagion, and while financing this year's debt may well not pose excessive problems for the authorities, with rating reviews looming from two of the major ratings agencies, and external debt to GDP dynamics highly sensitive to movements in the forint, the risk of adverse developments in 2011 is far from negligible, especially if, as Prime Minister Orban is already suggesting, the government does decide to go ahead with a fiscal deficit significantly over the 3% EU Stability and Growth Pact target.

Economic Profile

After several years of above-par (and more than likely above capacity) performance, Hungary's GDP growth started to weaken in the third quarter of 2006. Since Q2 2008 the economy has only seen one period of quarterly growth (in Q1 2010). That is to say there were seven consecutive quarters of economic contraction. Even more significantly first quarter growth was not sustained, and in Q2 2010 the economy essentially trod water (0% growth q-o-q), despite a seeing a sharp surge in exports, and a considerable trade surplus. The fact of the matter is that Hungary's export oriented industrial sector is just not large enough to pull the whole economy forward in the face of a significant and sustained decline in domestic demand. It is thus not improbable that we will see more quarter-on-quarter contactions during the coming twelve months.

Hungarian GDP declined by 6.3 percent in 2009, which was, in fact, slightly less than had been expected. The pace of economic contraction started to ease back in Q4 2009, with real GDP falling by 4.0% (y-o-y), down from the 7.1% peak in 2009Q3. Many observers and analysts have been surprised by the way the economy rebounded strongly in Q1 2010 - as the positive contribution from net exports began to offset weak domestic demand - but it is important to avoid overly simplistic and optimistic interprepations of this phenomenon. In fact, the economy grew by a seasonally adjusted 0.6% over the previous quarter, largely due to a resurgence in export demand (driven partly by the strong German performance - Hungarian exports are strongly inter-linked with the German industrial machine). However all the old doubts about long term sustainability remain, as witnessed by the fact that even though GDP in Q2 2010 was up 0.8% over the level of Q2 2009, private consumption continues to decline, the unemployment rate remains very high by Hungarian standards (10.4 % in June) while private sector credit continues to stagnate.

On the credit front, loans to households have remained broadly stable during 2009 and the first half of 2010, and although the emphasis in new lending to households has now shifted from foreign to domestic currency, revaluation effects from the downward movement in the vale of the forint vis a vis the CHF mean that the forex mortgage stock remains relatively constant (at around 75%) as a proportion of the total. Indeed there is a slight uptick in the outstanding value of household debt in June and July which is almost certainly a simple reflection of revaluation effects.

While a great deal of emphasis has been placed on household forex borrowing, the situation regarding corporate and government borrowing is not materially different. Corporate borrowing reached a high point in Q1 2009 (and by March this year it had fallen by around 13% from the peak), while at the same time the level of forex borrowing also peaked - at around 63% of total copporate debt.

Given the evident lack of vibrance in the private credit market, it is hardly surprising that domestic consumption continues to decline. Indeed, retail sales have now been in constant (almost terminal) decline since the summer of 2006.

The construction sector has likewise been in freefall.

If we look at new building permits, which have collapsed since mid 2009, it would seem that there is little likelihood of a turnround in the secular decline in construction activity anytime soon. Indeed, recent government proposals for infrastructure projects could be read as an attempt to breathe some life back into this beleagured sector.

The underlying constraints in the credit market (which are largely a by-product of the country's high level of external indebtedness), when placed alongside the fact the country has an ageing and declining population give us the key to understanding why private consumption in Hungary has remained flat to negative for so long now, and will, it appears, continue to do so.

Little Job Creation In The Private Sector

When we come to the labour market, while the unemployment rate peaked in March at 11.2%, by June it was still only down to 10.4% (Eurostat EU harmonised - seasonally adjusted - rate).

And if we come to look at employment, it is not hard to see (from the accompanying chart) that total Hungarian employment (despite some seasonal fluctuation) has been trending steadily down since 2006.

Even more importantly, one of the explicit aims of the austerity program that was introduced in the summer of 2006 was to shift the balance of employment away from the country's public sector, and this it has manifestly failed to do, since despite some initial success in reducing the public sector workforce, following the introduction of rural employment creation schemes, the current proportion of the total workforce who are employed in the public sector (29%) is virtually identical to what it was at its earlier peak in May 2006 - before the adjustment process started.

The reason for this secular downward drift in Hungarian employment is not hard to locate, since it has its roots in the fact that the working age population is both declining and ageing, a factor, in our opinion, which needs to be kept closely in mind when assessing the sustainability of the country's accumulated external debt in the longer term.

Given this context, much of the thrust of the recent structural reform process has been oriented towards trying to increase the labour market participation rate, although with little evident success to date, since apart from normal seasonal fluctuations the level has remained reasonably constant at just under 62% since the start of the adjustment process.

Improved Current Account Balance

The Hungarian current account was in surplus in 2009 for the first time in over 15 years (by 0.4% of GDP).

The reason for the improvement was the significant increase in the trade balance as the fall in domestic demand led to a more rapid decline in imports than exports. Now the process is reversing, as imports rise more slowly than exports, given that domestic demand is weak to negative. But the net result is the same - a positive impact on the trade balance and on GDP growth.

Along with the trade balance the income one also improved as profits fell, with the result that the current account adjusted by over 7.5 percentage points of GDP, a not unimpressive achievement. However, since what comes down also goes back up, the current account balance may well deteriorate slightly in 2010 as profits increase the income account will again deteriorate, and there may also be a small reduction in current transfers. At the same time EU capital transfers will probably more than offset the shortfall.

The problem here is the very large negative external position (especially loans and equities) that Hungary has accumulated over the years, and the ongoing cost of servicing this, which very nearly mirrors the size of the trade surplus.

This means that, in order to see "daylight" and start to seriously reduce the size of the long term external debt Hungary needs to produce a much larger trade surplus than the one the country is currently generating. Given that manufacturing industry only accounts for some 19% of total value added this is not going to be easy. Thus, while externally driven industrial output has rebounded reasonably strongly in recent months, on the back of Europe wide demand, GDP has in fact stagnated.

In fact, while aggregate output shows some significant improvement, this total is the sum of output from two fundamentally different sectors, the export oriented one (which has been growing strongly) and the one which depends on internal demand - which is steadily declining as retail sales etc continue their fall.

Since export oriented output now constitutes about 55% of Hungarian IP (in value added terms) this means that the whole economy is trying to leverage itself on about 10% of national capacity, a very difficult job indeed, and especially with the current value of the HUF.

Devaluation The Nub Of The Problem

Evidently the most intelligent policy move in a situation like the one Hungary finds itself in would be to devalue the currency sharply, but for a variety of reasons (principally the large external debt and consequent forex loan exposure) this road has not been considered viable (see, for example, the quote from the Finance Ministry official cited at the start of this report, which characterises exactly the ongoing mentality: never mind the impact on the economy, the debt must be paid, and to pay the debt the forint must stay - more or less - where it is). As a result Hungarian monetary policy has been more a question of protecting the currency than stimulating the economy, which is one of the reasons the National Bank of Hungary currently has the highest policy rate in the European Union (5.5%).

The enormous disadvantage of this road is that it discourages credit, and at the same time makes contracting yet more forex loans an attractive proposition. Notwithstanding this extremely tight monetary policy stance (in an economy which contracted 6.3% in 2009) inflation was still running at 4% in July. This figure (which is down from the 5.3% registered in June, following the base effect of last year's VAT increase dropping out) is still extraordinarily high for a country which effectively attempting to peg its currency & drive economic growth via export sales.

The longer run price rigidities to which the Hungarian economy is subject are evident, and even by years end we could be looking at annual inflation rate of something like 3%. Real wages in the private sector have started to fall since last summer (which will also further depress domestic demand), but they are still up around 2% in nominal terms, and the only really, really surprising thing here is that policymakers can be so complacent about the situation.

Declining And Ageing Population Create Debt Sustainability Problems

It is no secret that Hungary's population is now in long term decline, and that its working age population is declining and getting older even as the elderly dependency ratio (which is a good indicator of health and pension liabilities) rises and rises.

This problem only adds to the doubts about the sustainability of Hungary's heavy external debt, which is currently hovering around 150% of GDP (gross debt). As the IMF themselves recognise in their March sba review:

"The current account adjustment and projected pick-up in growth over the medium term should place the high external debt on a declining path. Having increased sharply over the past two years, external debt is projected to have peaked at 137 percent of GDP in 2009 and is expected to decline to 113 percent of GDP by 2015. These projections, however, are particularly sensitive to the exchange rate."

This last paragraph effectively hits the nail on the head, since the recent forint weakening (plus some early bond sales) have meant that gross external debt was more like 140% of GDP at the end of Q2 2010. If the forint declines the debt rises for revaluation reasons, and if it isn't devalued then the economy is effectively "destroyed" in the words of that Finance Ministry official.

It is for these reasons that we consider the Hungarian economy to be extremely vulnerable, perhaps the most vulnerable of the EU's Eastern contingent at this moment. As finance scholar Michael Pettis puts it in his article "Do Sovereign Debt Ratios Matter?" the structure of the balance sheet really does matter:

"The structure of the balance sheet matters, and this may be much more important than the actual level of debt. In my book I distinguished between “inverted” debt and hedged debt. With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times (when asset prices and earnings rise) and rise in bad times. With hedged debt, they are negatively correlated."

"Foreign currency and short-term borrowings are examples of inverted debt, because the servicing costs decline when confidence and asset prices rise, and rise when confidence and asset prices decline. This makes the good times better, and the bad times worse."

"Long-term fixed-rate local-currency borrowing is an example of hedged debt. During an inflation or currency crisis, the cost of servicing the debt actually declines in real terms, providing the borrower with some automatic relief, and this relief increases the worse conditions become."

"Inverted debt structures leave a country extremely vulnerable to debt crises, while hedged debt helps dissipate external shocks. Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks."
Hungary's high external debt exposure is a classic example of what Professor Pettis calls inverted debt, and this makes the country deeply vulnerable to a combination of economic slowdown in Europe, and credit rating downgrades, both of which are entirely possible as we enter 2011. If you add to that a government which seems hell bent on defying both the IMF and the EU Commission, then you have all the ingredients for a very explosive cocktail.

Indeed, with the Hungarian government now set to pursue a more expansionary fiscal policy in 2011, the odds are growing that it will miss its deficit targets and expand the debt — already around 80 percent of gross domestic product. Slippage on fiscal targets in any kind of delicate moment could push Hungary into a Greek-style financial crisis early next year. We feel the comparative ease with which Hungary may meet its financing needs in 2010 may well lull both the government and many financial market participants to seriously underestimate the challenges which lie ahead. On the surface the external funding needs - some €3.3 billion are not galactic, but the danger for the economy would more likely come from a bond market sell off, a spike in spreads, and a run on the currency, which forced the central bank to hike sharply, sending the economy off into another significant recession, and the population out onto the streets (a serious possibility at this stage) in protest.

At present time the financial markets seem prepared to tolerate the stance of the Orban government. Perhaps they feel that the EU and the IMF have gone too far in the Hungarian case - especially given their agreement to a deficit target of over 6% in Romania, and that Hungary's budget deficit seems to be under control. Perhaps also they feel that the Orban government is simply posturing before the local elections, and once October has passed, Hungary will return to the fold. Also, the return of the Hungarian economy to growth in the first quarter may have produced overly optimistic expectations about the future path of GDP, expectations which may now be rather dampened by the Q2 reading.

The real question, then, is whether the market participants are being overly sanguine at this point, and they are, just how will they react when they do realise that this time it may well be different, and when they do react, just how will the Fidesz government respond.

Further, the budget deficit expectation is highly sensitive to movements in nominal GDP. If, as seems entirely possible, Europe's economies start to slow in the second half of this year then growth in 2011 may well be under 1.5%, and certainly nothing like the 3% that the government is predicting or the 3.2% that the central bank has forecast.

Then there are those government measures which evidently pose economic and political risks. The first of these is the bank tax. A tax whose revenues were allocated to either restructuring FX loans, or the creation of a fund to provide cheap long-term credit for SMEs would be one matter, but a tax whose sole objective is to fill a budget hole created by the decision to introduce a flat tax is only going to irk the entire banking sector, and risks inducing a mini-credit crunch, or, in the best of circumstances will simply produce an intensification of the current credit freeze, with negative consequences for both households and businesses.

Then there is the issue of the flat tax itself. Because – unlike its Slovak namesake – it removes the tax credits that guarantee a tax free income for those earning the equivalent of the monthly minimum wage, the 16% flat tax will mean a pretty sharp tax increase for most of the Hungarian population. Estimates suggest that some 55-60% of wage earners will pay more, while taxes will be substantially reduced for the top 20-25%. The longer term economic consequences of this move are hard to evaluate, but since the 55-60% of wage earners who will pay more are those who in principle have the highest marginal propensity to consume, while the 20-25% who gain will more than likely save a higher share, the net impact of this measure on the economy would seem to be to increase the imbalances and make the economy even more export dependent.

In any event, the impression that the government is persuing policies which are ideologically motivated, and for this reason is in conflict with the main multilateral institutions involved will more than likely weigh on investor sentiment in the longer term, as will the battle that is being waged against the Governor of the central bank.

We Were Left A "Heap Of Manure"!

Also market participants need to ask themselves just what sort of constraints Viktor Orban is under, how these may influence his scope for decision taking, and what implications all of this may have for other countries where IMF endorsed programs may come unstuck later on down the road.

Prime Minister Orban has cast himself as the socially-concerned, nationally purposeful leader and he is now seeking to re-invent this appeal in a way which does not completely destroy his credibility when it becomes clear to his voters just how restricted his freedom of manouver actually is. So it would seem to be the case that he just doesn't have the political option of choosing the route of the responsible national leader who bravely implements the IMFs prescriptions and retain his credibility. It is far more likely he will project himself as the national populist who defends his small country from powerful forces – and he will blame the negative market reactions on foreign, cosmopolitan intellectuals and investors. As his close companion and Chief of Staff Mihály Varga delicately put it recently "It will take months and years to clean up the heap of manure the previous administration left us". He was of course referring to the Bajnai government, and the IMF programme it implemented. He also stated that IMF "therapy" has never been effective and successful, and their "one-fits-all" recipe leads nowhere, and denied the EU had the right to tell the government what to do about private pension funds.

What such statements illustrate is just how easily the Hungarain prime minister and his aides could be drawn into a dynamic of radicalization in part due to his own volatile character, and partly because his voter base is constantly under pressure from the far-right Jobbik party. Investors need to ask themselves very carefully just how far down the "radicalisation" road this government could actually go. While the question is almost impossible to answer at this point, the very difficulty in answering it seems to be perhaps one of the most disconcerting features of all.

If there were to be an outright confrontation between the IMF/EU and the Orban government, the Hungarian population would effectively be caught in the middle, and it is hard to see how they would react. Most observers either believed or hoped that the new Orban government would simply be some sort of repeat of the 1998-2002 one, and and as a result didn't see the present situation coming. This, in itself, is a measure of the corroding impact of a three year adjustment process that simply hasn't worked, and there are surely lessons here for other countries in similar situations, for those who are able to hear them.

When the dust finally settles what will happen is surely highly uncertain - although it important that everyone is aware this is 2010, and not 2006, Hungary has just been through a difficult adjustment process, and is not simply about to enter one, which means that the dynamics of the situation are completely different. At the present time Viktor Orban's stance has neutralized the Jobbik threat, but his government faces another risk. If - as we expect - the general lack of confidence in the ability of his government to handle the situation produces a run on the currency, and the HUF falls sharply, then all those FX mortgage payers will start to believe that the FIDESZ government is playing politics with their homes, and that could well create a very dangerous political constellation which could have impredictable consequences.

Bottom Line Watch Out For Problems In 2011

While Hungary's primary budget deficit position is among the best in the EU, problems with the debt to GDP ratio potentially remain, especially given the likelihood that GDP growth will not be up to the government's optimistic forecasts, and the structural on-costs of population ageing and workforce decline, and it is only by keeping its current ultra-tight fiscal stance that Hungary can hope to stabilise its debt ratio in the region of 80% of GDP. Any loosening in posture now could easily drive the debt ratio much higher over the decade to come.

Also, the idea that Hungary does not need the IMF and can fund itself from the market without support is a dangerous one, and is only realistic under the best of scenarios, where emerging market inflows continue unabated and the general risk appetite stays were it is. Both of these are more than risky assumptions, especially in a country which seems virtually incapable of generating headline GDP growth, and where influential politicians describe IMF programes as generating "heaps of manure".

So, with credit ratings under review by both S&Ps and Moody’s, and downgrades likely in both cases, the potential for a sudden surge in the country risk premium is evident, especially if differences with both the IMF and the EU turn out to be more about substance than about detail. If this surge in risk premium is also accompanied by a weakening in external demand, then the recent slight improvement in the external debt dynamic could easily be reversed, with serious implications for the country’s capacity to finance itself.

It would also not be adviseable to remain complacent about the extent to which Hungary could become a source of contagion risk farther afield. Not only is the Orban government on trial at the present time, so too are the IMF programmes in Eastern Europe and Greece. After proclaiming a substantial underlying improvement in the country, should the reality turn out to be somewhat different, then evidently there will be clear implications for the Baltics, Romania, Bulgaria, and even Greece and Ukraine. Programmes which don’t work in one country will in all likelihood not work in others, and it would be foolish to imagine that markets won’t catch on to this at some point. Indeed, with a Spanish economy which has been stabilised still remaining far from recovery mode, and an opposition party which seems more focused on persuing internal political disputes than on reaching consensus with the other key actors over the difficult steps which will need to be taken to bring Spain back to "normality", could events in Budapest be offering us a warning signal of what might all too easily happen in 2012 in Madrid, if a substantial change in mindset doesn’t ocur in the meantime?

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