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Monday, December 25, 2006

Hungary On The Threshold of a Recession?

During the Autumn of 2006 we had quite an exchange of opinion on this blog about the future destiny of the Hungarian economy, largely between me and Doug Muir. At the time Doug was relatively optimistic, and I much less so. We nearly even had a bet about whether Hungary would enter recession during 2007, a bet which it turns out I would have lost had I taken Doug up on the challenge, since, although the jury is still out on what happens in the 4th quarter, Hungary may just manage to eke out positive growth right through to years end, but only by a very short nose, as a quick glance at the chart in this post here will reveal.

In truth, at the time I didn't really know enough about the Hungarian economy to hold a strong opinion, but I was struck by the peculiar and combustible mixture of problems that the country seemed to be facing, with deficits everywhere (both fiscal and current account), private individuals who seemed to be addicted to the contraction of non-local currency debt (largely in Swiss Francs) at a rather alarming rate, a central bank which seemed to be condemned to try and drain the ocean with a teaspoon given the limitations and strong headwinds they faced when trying to implement standard monetary policy in the face of the new rules of financial globalisation, and a population which was falling due to both the low fertility level, and the comparatively low level of male life expectancy which existed (something which complicates enormously the normal policy remedy for ageing workforces of increasing the employment participation rates of the over 60 age group).

Twelve months later, and with a brief public scuffle with the Economist safely under my arm, I have no such doubts. Hungary is heading for recession, whether the dreaded R flag is actually raised in this quarter or the next one, and when it does come, unfortunately, it is unlikely to be a brief and easily brushed-off affair, since all the dials which now point to red indicate that unwinding this particular distortion is likely to be a very slow and painful process. One of the reasons I now feel so confident in making this statement is that some 12 months ago, and hot the heels of my debate with Doug, I founded the Hungary Economy Watch weblog, to study the problem, and while scratching and scratching my head, try to work out just why it is that Hungary is apparently so different from the rest of the EU10, and indeed whether the study of Hungary and its problems might not help us see what might eventually be in store for the rest of the group after the big overheating correction finally takes place.

Hungary Facing Stagflation?

Well briskly moving on to the topic in hand, things are really begining to move quite quickly in Hungary now, as one external observer after another begins to realise that policy in Hungary may now be well and truly stuck in a cul-de-sac (or even double bind). Indeed, unfortunately, as we will see below, I fear that they may soon start to move even more quickly. The first bit of relevant news in recent days has been the publication by PNB Paribas of an analysis entitled "Stagflation Fears". In their report the Paribas analysts highlight Hungary's weak consumption and investment activity and point to the gridlock which results from the need to apply at one and the same time stringent fiscal and monetary policy, while internal demand collapses, and exporters, who are doing a valiant job under the circumstances let it be said, struggle under the weight of the high value of the forint, which cannot, let it be noted, be allowed to drift downwards (which would be one sensible move under the circumstances) due to the problem of private indebtedness and all those Swiss Franc loans. I think the consumption problem is clear enough:

and if your not convinced by this, then you could try looking at retail sales, which tell a very similar story:

And if you are interested in Gross Fixed Capital Formation (investment) try this chart for construction:

As Paribas indicate, the only driving force of economic growth in Hungary in the near future is likely to be exports, but since the external demand situation is deteriorating by the day Hungary this may be insufficient to prevent Hungary falling off into recession (think Japan here).

This is the second report issued about Hungary by a major investment bank in quick succession (the other was Merill Lynch), and both of them have drawn attention to the combination of stagnant growth and high inflation under which Hungarian policy is labouring. The difficulty is that the need to maintain the value of the forint at or near its present levels (or otherwise all those with external debts - mainly households - will start to experience what they call in the parlance "distress". So no one anticipates drastic moves in monetary policy - which the situation surely merits, just look how the Fed is responding to a much milder problem in the US - and interest rate easing moves are expected to be limited. Paribas si - even in the face of the near recession call - sticking to its outlook for an interest rate reduction to 6.5%, while Merrill Lynch is predicting an even more aggressive reduction to 6.25%. None of this, of course, will be to the liking of yield driven financial investors, and the forint will certainly become rapidly vulnerable as monetary policy steadily moves down this path as it surely has to.

Large Sell-Off In Forint Denominated Assets

In addition we have just learnt from the Magyar Nemzeti Bank that foreign investors sold-off vast amounts of forint denominated financial assets in November. The curious thing is that the forint only weakened slightly, despite the fact that approximately HUF 750 billion of instruments were virtually dumped onto the local market in very short order. One explanation for this curious situation may well be the high demand for euro and Swiss franc denominated consumer loans in Hungary, a demand which has possibly even accelerated during the pre-Christmas shopping season. But if this is the explanation it does leave us with the very awkward question of what exactly happens when the demand for such loans slackens, and the associated flows start to dry up.

The trend towards forint divestment really got going in October, but the monthly rate was not extraordinary (approximately HUF 70 billion net). As a result the forint remained reasonably stable against the euro at around 251 throughout the month.

During the period from the end of September to the end of November, foreign investors sold a huge HUF 800 billion worth of Hungarian instruments in the short term forex market. Of this, increased swap positions accounted for HUF 500 billion (new synthetic short forint positions), while stock and government bond sales amounted to HUF 200 billion and HUF 100 billion, respectively. At the same time, even if on a smaller scale according to MNB, foreign investors were busily opening positions against the forint in the options markets.

The growing unease about higher risk instruments in the context of the ongoing global credit squeeze is undoubtedly the main driving force behind the sale of the Hungarian instruments, this and a growing wariness about Hungary's vulnerability in the face of a global downturn.

Hungary's recent macroeconomic performance and the absence of any sort of optimistic outlook have undoubtedly also played a role, and in particular the high level of external indebtedness of individual Hungarian citizens, the high current account deficit, the weak internal demand situation and the general concerns about ongoing and long lasting slow economic growth.

The central bank's figures reveal that foreign investors divested large amounts of Hungarian stocks in November (continuing a trend that really got started back in August). According to Portfolio Hungary - who have examined the available information on ownership structures and share prices, OTP and Magyar Telekom are likely to have borne the brunt of the sell off.

What was new this time round though was the divestment of Hungarian government bonds (mostly in the secondary market), which accounted for a significant part of forint sales in November.

In this way HUF 750 billion was pulled straight out of the market in November. As I say, the really striking thing is how this major capital transfer was only slightly reflected in the EUR/HUF rate.

One possible explanation for this surprising situation is the rage for foreign currency denominated consumer loans that continues to grip Hungary. The volume of new mortgage loans climbed to the previously unseen level of HUF 130 bn in October, and this increase was almost exclusively attributable to the increase in CHF-denominated loans (HUF 120 bn). Detailed data from the National Bank show that while the monthly amount of new CHF-denominated housing loans rose to the exceptional level of HUF 55-60 bn, mortgage loans for consumption purrposes (ie "refis" or liquidity extraction, not to buy houses) became almost inexplicably fashionable, rising by 30% month-on-month to reach the unprecedented level of HUF 62.5 bn.

Naturally such transactions create a large increase in demand for the forint (the banks flows coming in), a trend which is in and of itself more than likely powerful enough to have offset the negative impact of lost investor confidence on the exchange rate.

Clearly this situation is now really very very delicate, one strong push and a whole pack of cards can come tumbling down. Borrowing today to pay back yesterday is a dangerous policy at the best of time, but when your currency might be about to fall of a cliff (think what happens when the demand for new loans dries up) it has to border on recklessness if you are borrowing unhedged in another currency. And remember, when the bonfire starts (not the one of our vanities I hope) in Eastern Europe (and it may not start in Hungary at all in the first place) it will undoubtedly rapidly spread from one of the "at risk" countries to another.

What all this suggests to me is that a lot of Hungarians are trying to maintain current consumption by borrowing forward aginst their homes (ie some sort of "consumption smoothing) in the hope and expectation that rising property values in the future will help them sweat off the debt. If this rise does not materialise, then the very least that can be said is that all of this will need, at some point, to be clawed back from current consumption. All of this also represents a new form of moral hazard for the central bankers over at the ECB and indeed for the EU Commission itself, since all this borrowing in Swiss Francs has to be based on the assumption that with so many people doing it the Hungarian authorities will never dare to let the forint slide (you know, there's safety in numbers) or, pushing the buck back one stage further, the EU Commission and the ECB won't let the worst things come to the worst.

But this is very dangerous thinking, since in the first place there are a lot of people now out there riding around on the back of the same idea (think Italian government debt, for eg), and people may be seriously overestimating the ability of the political and monetary authorities to contain such a large and complex set of problems. It should also not go un-noted that the whole weight of the ECB is currently not able to stop the spread of the growing credit crunch across the entire eurozone and beyond (even if the most recent massive injection has temporarily stopped the rot). Thus they may well not be able to stop Spanish homeowners (some 75% of whom are on variable Euribor related mortgages) from really feeling the pain, and believe me if they could do this, they would, since having the Spanish economy well and truly down and out as we enter the next downturn is the last thing in the world they want.

Lastly and just as importantly, as I have been arguing, all of this puts the Hungarian central bank in a real double bind, since they cannot ease monetary policy at this point without precipitating a tremendous weakening in the forint, so interest rates are high and need to stay high, and meanwhile Hungarian domestic demand gradually gets strangled, at the same time as the ongoing internal inflation and the negative external environment act as a strong brake on export growth.

Now, as I said at the start of this post, my impression is that the recession Hungary is now entering is likely to be a protracted and difficult affair. In order to justify this assumption (which we will have time enough to think about in due course) I would need to get into Hungary's very special demography - which I have attempted to do in my Just Why Is Hungary So Different From The Rest of the EU10? post. But, as you may have noticed, I have managed to write all the above with barely a mention of this contentious topic, so I think I will leave it at that for now. As they are want to say over in San Diego "Sufficient Unto the Day is the Evil Thereof". Reputedly that is just before they "whack" you, so, exercising caution as the better part of valour, I will now take my leave of you.

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