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Wednesday, October 29, 2008

After Wearing The Hair Shirt For Over Two Years Hungary Is Now Helped Into The Straight Jacket

Well we now have some of the details of the IMF package for Hungary, and interesting reading it makes. Hungary has in effect secured a 20 billion-euro ($25.5 billion) loan which is going to be sourced by three institutions: the IMF, the EU and the World Bank. The International Monetary Fund is going lend Hungary 12.5 billion euros, the European Union will provide another 6.5 billion euros, and the World Bank is chipping in with a symbolic 1 billion euros. (Really the reasoning behind the tripartite division of the loan may relate more to the pressure which it is thought might fall on IMF funding provision - which stands at about $250 billion at the present time - if more emerging market economies follow the lead of Ukraine, Hungary and Iceland. See this post here for more details and argumentation on this whole problem).

The forint naturally rose - to 257.05 per euro at 9:10 a.m. in Budapest - on the news, in the process getting below the psychologically important 260 mark and very near to a two-week high.

The Analyst View

``The agreement is designed to restore investor confidence and alleviate the stress experienced in recent weeks in the Hungarian financial markets,'' IMF Managing Director Dominique Strauss-Kahn said in a statement in Washington yesterday.

“One way to look at the EU assistance to New Member States is that this is also part of the operation aimed at making sure Euroland banks don't get into trouble. The banking systems in New Member States are practically owned by foreign (mainly Euroland) banks, and if their NMS subsidiaries get into trouble, that would not be good news for the holding companies either. In the current environment that is a strong additional argument for major Euroland countries to make sure that New Member States (and their banking systems) do not get into trouble because of the liquidity crunch."
István Zsoldos, Goldman Sachs, London

``The aid package won't make Hungary immune to the real economy effects of the financial crisis..........Where the IMF appears with its strict conditions, the requirement of consolidation inevitably leads to real economy and social consequences.''
Laszlo Andor, European Bank For Reconstruction and Development Board Member

``A sharp economic slowdown, driven by declining foreign- currency credit flows to the private sector, tight fiscal conditions and weak external demand is unlikely to be avoided''
Eszter Gargyan, Citigroup Inc, Budapest

“We expect the EU and the IMF to announce additional rescue packages for other Central and Eastern European economies in the coming days and weeks. Top of the list are the most imbalanced countries in the region - the Baltic States, Romania and Bulgaria."
Lars Christensen, Danske Bank, Copenhagen

“All in all, the crisis seems to have been averted and even though it is no doubt a major shame that Hungary got to this situation, the authorities managed well in the rough waters, far better than Iceland (major policy mistakes in particular by the CB), Ukraine (political fragmentation still a major problem, currency peg had to be abandoned after failed interventions) and Romania where politicians remain ignorant even now, after the problems are more than evident. Bulgaria also does not seem to be prepared, though the currency board, the fiscal reserves and the significant budget surplus at least provide more cushion."
Gábor Ambrus, 4Cast, London

Of course, none of this comes free. In effect the IMF is providing Hungary with a 17-month stand-by agreement, and just the fee for making the stand-by available will be 0.25% of the total quantity per annum, according to information provided by Central Bank (NBH) Governor András Simor in a press conference this morning (Wednesday). The rescue package is available up to the end of March 2010, with 3-5-year repayment period and an interest rate of 5-6% per annum (fixed).

And then, of course, there are the conditions.

Conditions For The Loan

The International Monetary Fund (IMF) has effectively imposed two conditions on Hungary in exchange for the package, according to Prime Minister Ferenc Gyurcsány addressing a press conference yesterday (Tuesday).

1) The 2009 budget needs to be framed in such a way that even under a pessimistic scenario spending targets will not exceed the actual funds available (thus a new budget deficit target has been set for 2009 at 2.6% of GDP, under the assumption that Hungary will experience a 1% contraction in GDP - see more below - while the primary balance on the budget should produce a surplus of 1.8% of GDP. This is of course very strong stuff indeed in view of the looming recession);

2) Hungary should not embark on measures that could have a negative influence on the revenue side of the budget (e.g. extensive tax cuts).

Hungary's Finance Ministry has accordingly lowered its 2009 public sector deficit target down to 2.6% of gross domestic product, from the already previously reduced goal of 2.9%. In fact the Hungarian cabinet had recently rewritten the 2009 budget draft (which in any event still needed to go before parliament) due to the pressure on Hungary's financial system, lowering the deficit goal to 2.9% of GDP from 3.2%). Really all this does seem incredibly ritualistic, since I for one am hardly convinced that coming down from a 3.2% deficit to a 2.9% one is going to be all that earth shattering in terms of the economic results produced, although it will of course provide some nice red meat to feed to those ever so hungry external investors, who, if they think the fiscal deficit is at this point is the main issue in Hungary, far from being the shrewd and caluculating economic actors assumed by rational agent theory simply have no idea of what is going on at this point in time.

The fiscal problem arose much earlier in the day and Hungary's government has been struggling to put it right, operating a deficit reducing policy since the summer of 2006, and had managed to cut the shortfall to 5 percent of gross domestic product last year from 9.2 percent in 2006. The 2007 target has also already been reduced to 3.4% of GDP from 3.8%, so I can hardly imagine what positive macro economic benefits people expect to see from turning the screw even more on an economy which is already reeling under the extent to which the screw has already been turned.

The main problem facing Hungary right now, apart from its very large external funding requirement, is really the fact that the civil population have become addicted to taking out their debt obligations in foreign exchange - largely Swiss Francs - and the flow of these is now drying up as the banks get scared about the downgrades they can get from any write-downs they may have to do. So the what the Hungarian economy needs now more than anything else is external support to ease the economy off the external borrowing steroids which have been being pumped into the household sector, and it is not clear to me how the IMF package is going to help with this. At least at this point it isn't.

One way forward which many are considering right now across Eastern Europe is early euro adoption. The Hungarian government and the central bank have now pledged to meet euro- adoption requirements for the deficit, inflation and national debt by next year. Hungary still doesn't have a target date for the switchover to the euro, due to the earlier deficit overruns and ongoing inflation issues, but given that we are now likely to see sustained GDP contractions, deficit reductions and price deflation rather than inflation, I doubt Hungary will continue to have difficulty meeting existing EU/ECB criteria in the future. The issue is rather going to be, what sort of shape will the Eurozone itself be in when Hungary finally does get the opportunity to officially present its application form?

A PainFul Process

Naturally all these cuts and withdrawals of bank funding will have substantial consequences for the real economy and it is not without significance that Gyurcsány also stated yesterday that, in his opinion, the foremost challenge Hungary must now tackle is how to avoid mass employment layoffs, as corporates are cut back or suspend production in the face of the developing recession both within and without of Hungary's frontiers. He described what was currently happening in Hungary as “the gravest economic and financial crisis of the past 80 years", and for a country which has obviously suffered so much that is really saying something. The sad part is that I find it hard to disagree with him.

Gyurcsány also said Hungary should brace itself for a European and global environment where combating recession, rather than achieving growth, has become the watchword. “Hence neither will the Hungarian economy grow," he said, noting that the 2009 Budget has been drawn up under the assumption of a 1% GDP contraction during the coming year. Actually even this forecast appears to be optimistic, and Gordon Bajnai, Minister for Development and Economy, pointed out that the International Monetary Fund (IMF) had suggested "pencilling-in" a 2.5% GDP fall for 2009. This idea was obviously put forward with the idea of making a "worst case scenario" assumption on which there would have been no backsliding (thus getting all the bad news out of the way at once), but again unfortunately, the worst case scenario also appears to be a highly probable one at this point, and while really we should avoid getting into the game of bandying about numbers just for the sake of bandying them about, I personally have pencilled in a drop of between 3 and 5 percent in Hungarian GDP for 2009, since, among other issues not really being discussed at present, I am also expecting a very nasty shock to hit German GDP on the rebound from all the crises which we are seeing unfold in one country after another across Eastern Europe.

Obviously the IMF do not spell out the details of just how Hungary can make the sort of budget cuts which are now going to be required of it, but there is no doubt that they will be painful. Among the proposals which are being floated around are the scrapping of the 13th month wage civil servants receive and a halving in the 13th month pension.

Many observers have been surprised by the size of the loan, but as Lars Christensen (Danske Bank) notes, the size does gives us some indication of how the IMF see the financial crisis as being significantly greater in Central and Eastern Europe than most market participants have been willing to accept until now. Anne-Marie Gulde-Wolf, IMF's Division Chief at the Monetary and Financial Systems Department and Elena Flores, European Commission Director, both stressed - at a press conference organised by Hungary's Finance Ministry - that the EUR 20 bn facility was a credit line and Hungary would not necessarily be drawing on it if market and macroeconomic conditions were to improve or normalise (although since there is not much likelihood of this happening in the near term, it is not unreasonable to assume they will need to draw on a significant part of the loan). What they said in effect was that they wanted to give the markets a "strong sedative" at this point, one which was strong enough to make people think twice before acting.

Flores also stressed that the EU Commission had attached three conditions to Hungary's receiving the credit line. Hungary must:

- tame and cut expenditure;
- continue fiscal reform measures;
- continue structural reforms.

The 20 billion euro figure considerably increases the 17 billion euros of existing reserves available to the NBH for covering external payment obligations which for the next 12 months are estimated at around 32 billion euros. This 32 billion is, howvere, another worst case scenario, assuming that the foreign owners of the Hungarian banking sector completely cut access to financing (not totally improbable, or at the very least new financing is going to be greatly reduced) and that import levels remain unchanged despite an potentially contraction of exports (much less likely).

This line of thinking is reinforced by András Simor's statement today that the financial package is a credit line which if drawn on will boost Hungary's foreign currency reserves. Simor underlined that if Hungary draws the full amount available the bank's foreign currency reserves would more than double. Simor also stressed that any decision to use the credit would need to be taken by the government. In order to put the size of the loan into some sort of perspective Simor said it is: - twice as large as the stock of Hungarian government securities held by non-residents (currently around HUF 3,000 bn); - about five times as large as the country's external debt maturing next year; - about one third of Hungary's total government debt.

Why Do I Call This A Straight Jacket?

Basically Hungary is about to take some extremely tough medicine, medicine which in the short term will see GDP actually shrinking. To put this in perspective, I think we need to remember that Hungary is a comparatively poor emerging economy, with per capita incomes way below the EU average. Thus these cuts will really be felt, especially any cut backs on pensions or health facilities, since remember Hungary is already a rapidly ageing society, with a comparatively short male life expectancy (ie poor health among older males), and all these cuts will not make this problem any better.

Instead of simply repeating what I have already written time and time again on this blog, I will quote extensively from 4Cast analyst Gabór Ambros, at this point, since I essentially agree with the points he makes:
“At the same time, there is no doubt that to ensure Hungary's long-term survival a major diet is needed (this is in fact true to every emerging country which experiences the same problem)."

“The thirst for debt financing, domestic or local, has to be drastically reduced and not just for a period of a year but for longer, given that credit markets are not going to be the same in the foreseeable future as they had been before the world 'subprime' become known outside the circles of the debt securitization market."

“This implies not only a reduction of the public debt but also the substantial reduction of the deficit of the current account which implies a major diet for consumers (how much is needed exactly is highly uncertain, given that the massive errors and omissions row on the C/A statistics render the C/A figures rather meaningless)."

“While the increased credit costs and the restricted credit availability will drive demand down, a key tool to rebalance the economy is the exchange rate. Hungary needs a week forint to ensure the sustainability of financing and in this anti inflationary global environment the NBH should in our view be ready to accept a slightly slower paced disinflation to allow the financing thirst to reduce and ensure the long term sustainability of growth."
Gábor Ambrus, 4Cast, London

So basically, and in a few words, domestic private consumption - which has already been very, very weak following the "austerity package" of 2006 (what I am calling the hair shirt) - is now going into full speed reverse gear, as all those personal consumption swiss franc mortgage loans come to a dead stop. Government spending is also going to go backwards, as the deficit is cut and cut, over a GDP which is itself reducing. And exports - the third platform of any economy - is also set to go full speed reverse, as Russia and the other EU countries all shoot off into what is probably going to be quiet an important recession.

As Gabór Ambrus says, Hungarian consumers are about to go on quite a drastic "diet", and the only way forward is through exports, which means a weaker forint (god, how I have been tirelessly arguing this on this blog since late 2006), which means all those swissie mortgages have to go (ditto), which means some of these banks will need to take a substantial haircut on the write-downs (good job the EU is on-board then). And on and on, or down and down we go. Of course, with population in decline anyway, when exactly will we see GDP growth again in Hungary????

Whither Monetary Policy?

Obviously one last point which is worth making on this most hectic of hectic days, concerns monetary policy. As we know the central bank base rate is currently at the ridiculously high level of 11.5%. But does this now make sense, and in particular if you want a weaker forint? Well some comments from central bank governor András Simor earlier today seem to suggest that changes may well be on the way.

“In this new situation monetary policy makers will need to rethink which way to go from here," Simor said.

The Central Bank Monetary Council, Simor noted in his press conference, is faced with a “new macroeconomic situation" in Hungary due to the changes that have taken place in the world economy. The rate-setting body he assured his audience will carefully analyse the processes and draw its conclusions in the coming one to two months. That is, you have been warned.

Well, I think that will do for now, but don't any of you dare complain that you haven't had the priviledge of living in "interesting times". Fascinating, I would say, especially for those of you with sufficient interest to learn from them.

The Bank Bailouts Are Very Well Intended, But Where Is All The Money Going To Come From?

As every woman who has ever had dealings with a man knows only too well, it is a lot easier for people to make promises than it is for them to keep them. And when Europe's leaders met in Paris on the 12 October, a lot of fine promises (which were all, surely, very well intentioned) were made. The reality of having to live up to them, however, is turning out, as might only have been expected, to be much more complicated.

Basically, the kernel of the plan which is now being operationalised seems to have been thrashed out in Washington on 11 October, when key G7 leaders met with Dominique Strauss Kahn of the IMF, and it was decided to try and erect two great firewalls (corta fuegos) - at least as far as Europe is concerned. One of these was to be co-ordinated by the EU governments, and the other by the IMF, who were to act in the East. Both these parties essentially agreed to guarantee the banking systems in the countries for which they took responsibility, so the action, in a sense, moved from the banks (which are now, more or less "safe") to the governments and the IMF (who is ultimately backed by cash from governments), and it is the "safety" of these institutions which is likely to be more or less tested by the markets, with the first trial of strength taking place right now in Iceland.

So the big question now is, do these various institutions have the resources to back up their guarantees, should the need arise?

Problem Selling Bonds

In this context the Financial Times had a very interesting article yesterday about the fact that the Austrian government had decided to cancel a bond auction.

Austria, one of Europe’s stronger economies, cancelled a bond auction on Monday in the latest sign that European governments are facing increasing problems raising debt in the deepening credit crisis.
According to the FT article the difficulties Austria, which has a triple A credit rating, is facing only serves to highlights the extent of the deterioration in the sovereign bond market, where benchmark indicators of credit risk such as the iTraxx index hit fresh record spreads yesterday.

Austria now is the third European country to have cancelled a bond offering in the last few weeks - in the Autrian case the markets are getting more and more nervous over the exposure of some of its key banks (Erste, Raffeison) to the mounting disaster over in Eastern Europe - both Hungary and Ukraine received IMF loans this week (see below) and they certainly won't be the last.

Austria seems to have dropped its plans for a bond launch next week due to the size of the premiums (spreads) investors seemed likely to demand, although the Austrian Federal Financing Agency did not give any explanation for the decision.

Spain, which alos currently has a triple A rating, and Belgium have both cancelled bond offerings in the past month because of the market turbulence, with investors again demanding much higher interest rates than debt managers had bargained for.

So really many European governments are now facing similar problems to those their banks faced earlier, they can get finance, but only at rates which they consider to be punitively high (remember, the interest has to be paid for from somewhere, in the present recessionary climate from cuts in services more than probably, since, remember, if we look over at Eastern Europe, investors are very likely to "punish" those governments who try to go down the easy road, and run large fiscal deficits over any length of time).

Market conditions have steadily deteriorated in recent days with the best gauge to credit sentiment, the iTraxx investment grade index, which measures the cost to protect bonds against default in Europe, widening to more than 180 basis points, or a cost of €180,000 to insure €10m of debt over five years, on Monday.
This is a steep increase since only as recently as Monday of last week, when the index closed at 142 base points. Also the cost of default protection on European companies has risen to record highs this week on investor concern that the global economic slowdown will curb company profits. The Markit iTraxx Europe index of 125 companies with investment-grade ratings fell 3.5 basis points yesterday to 166.5, after hitting a record high on Monday.

The FT cites analyst warnings that the there is now a huge quantity of government debt building up in the pipeline, and the government bonds due to be issued in the fourth quarter and early next year will only add to the problems some countries are facing, and particularly those countries like Greece and Italy who already carrying large amounts of debt that needs to be refinanced or rolled over.

It has been estimated that European government bond issuance will rise to record levels of more than €1,000bn in 2009 – 30 per cent higher than 2008 – as governments seek to stimulate their economies and pay for bank recapitalisations.

The eurozone countries will raise €925bn ($1,200bn) in 2009, according to Barclays Capital. The UK, which is expected to increase its bond issuance from the current €137.5bn in the 2008-09 financial year, will take the figure above €1,000bn.

Italy, and Greece, both with a debt-to-GDP ratios of over 100 percent, are certainly the most exposed to continuing difficulties in the credit markets, (with analysts forecasting that Italy alone will need to raise €220bn in 2009). At the present time the Libyans are lending the Italian government a helping hand (and here) in struggling forward, but even oil rich Libya doesn't have the money to fund the long term needs of the Italian banking, health and pension systems.

IMF Have Only $250 Billion

On the other hand Bloomberg had an article yesterday on the growing pressure on the IMF's somewhat limited resources, as one country after another in Central and Eastern Europe joins the "consultation queue" in the hope of getting a bail out.

Bloomberg report that the cost of default protection on bonds sold by 11 emerging-market nations has now either approached or surpassed distress levels, raising the very immediate likelihood that the International Monetary Fund's ability to bailout countries may soon start to be put to the test.

Credit-default swaps on eight countries including Pakistan, Argentina and Russia have now passed the 1,000 basis points mark, the level which is normally considered to signify "distress", according to data provided by CMA Datavision. Funding one basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

``The resources of the IMF may not be sufficient for wider bailouts if needed,'' said Vivek Tawadey, head of credit strategy at BNP Paribas SA in London. ``If it can't raise the money, some of the more distressed emerging markets could end up defaulting.''
Ukraine, Hungary, and Iceland have already received IMF loans, while the fund is currently in "consultation" talks with Belarus, Turkey, Latvia, Serbia, Romania, Bulgaria and Pakistan, at the very least.

According to Simon Johnson, former chief economist at the fund the IMF only has up to $250 billion it can currently lend (as quoted in the Financial Times yesterday).

Credit-default swaps on Pakistan currently cost 4,412 basis points. Contracts on Argentina are at 3,650 basis points, Ukraine at 2,850, Venezuela at 2,400 and Ecuador costs 2,072. Default protection on Russia, Indonesia and Kazakhstan also costs more than 1,000 basis points, while Iceland costs 921, Latvia 850 and Vietnam 837. Contracts on Turkey cost 725 basis points.

The IMF agreed at the weekend to lend Ukraine $16.5 billion for 24 months and stated yesterday that they would contribute $12.5 billion towards a $25.5 billion loan for Hungary (with the other participants being the EU and the World Bank. Iceland got a $2 billion loan on Oct. 24 and Belarus has asked for at least $2 billion. Just how many more loans are now in the pipeline, and if the IMF does start to see its funds stretched, just who exactly is going to step up to the plate and fork the necessary money out? The sheer fact that they only put part of the cash for the Hungarian loan, and that the World Bank had to come on board with a symbolic $1 billion shows they are already aware that the problem may arise.


Well just after writing this, I see from reading the FT that Gordon Brown got there just before me. Beaten by a short head!

Gordon Brown on Tuesday spearheaded calls for a multi-billion pound "bail-out fund" to prevent the global crisis spreading to more countries, and warned of the need to stabilise economies "across eastern Europe".....

The prime minister on Tuesday urged the oil-rich Gulf states and China to provide "substantial" funding to the International Monetary Fund, before flying to France for talks on an increase to the European Union's bail-out fund. The government is keen to emphasise the link between global action and domestic voters' interests, as well as portraying Mr Brown as a world leader.

The prime minister said it was "in every nation's interests and the interests of hard-working families in our country and other countries that financial contagion does not spread". While he did not rule out the UK making a contribution, he insisted the "biggest part can be played by the countries that have got the biggest [balance of payments] surpluses".

The IMF's $250bn (£158bn) bail-out fund "may not be enough" to prevent the crisis destabilising more countries, Mr Brown said. His spokesman added the UK was "looking at a figure in the hundreds of billions of dollars" for the IMF. Mr Brown called for "action on this new fund immediately".

Also, another story in Bloomberg gives us a further glimpse of how the EU governments are planning to do all that financing. The German government, it seems, is going to print IOUs (sorry, bonds) and give them directly to the banks. That is, they are not going to auction bonds and give the proceeds, they are simply giving the paper, and presumeably paying a coupon (or interest). Oh yes, and the bonds will not be sellable, since this would, of course, damage the yield curve via the supply and demand process, but they will count as debt, which means that the German government is being very naieve here (assuming the report is accurate) since of course the rise in the debt may well mean a breach of the 2011 balanced-books commitment, and falling back on this will almost inevitably have an impact on the extra implied risk investors will be looking to get paid for holding the bonds.

Germany plans to finance part of its 500 billion euro ($636 billion) bank rescue package by issuing bonds to banks in exchange for new preferred stock, according to Finance Agency head Carl Heinz Daube.

``The banks will not be allowed to sell the injected government bonds,'' Daube said in an interview in Tokyo today. ``So far there's obviously not a huge demand for any rescue measures, but this might change in the coming weeks.''

Germany's rescue plan, approved by lawmakers on Oct. 17, amounts to about 20 percent of the gross domestic product of Europe's biggest economy. Chancellor Angela Merkel's administration pledged 80 billion euros to recapitalize distressed banks, with the rest allocated to cover loan guarantees and losses.

....Hypo Real Estate Holding AG, the Munich-based lender that's already had a 50 billion euro bailout, today asked the Deutsche Bundesbank for 15 billion euros to cover short-term liquidity needs. ....Frankfurt-based Deutsche Bank AG may also need 8.9 billion euros of new capital, more than any bank in Europe, Merrill Lynch & Co. analysts Stuart Graham and Alexander Tsirigotis wrote on Oct. 20.

The bailout plan is still being discussed in Berlin and more information will probably be released at the end of this week, Daube said.

Germany may meet additional funding needs for its bank rescue by selling six-month bills before examining options for borrowing using longer-term securities, Daube said. The government plans to offer between 212 billion euros and 215 billion euros of debt through its 2009 program, about the same as the 213 billion euros scheduled for this year.

The debt-for-equity swap will probably have ``next to no effect'' on the country's yield curve because the notes offered to banks won't trade in the so-called secondary market, he said. The yield curve plots the rates of government bonds according to their maturities, and increases indicate higher borrowing costs.

``The government deficit of course will increase, the outstanding volume of bonds will increase as well,'' Daube said. ``The number of outstanding bonds available in the secondary market will stay exactly the same.''

Gentlemen, we are out of our depth here.

Friday, October 24, 2008

And So It Ends - Hungary's Government Announces Foreign Currency 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.

Tuesday, October 21, 2008

Despite The "Sudden Stop" Kazakhstan Won't Be Calling On The IMF For Help

"The Kazakh government is ready to step in,'' Kazakhstan's Prime Minister Karim Masimov said this morning in a telephone interview with Bloomberg "The Kazakh banking system with the support of the government and central bank will fulfill all obligations to international investors.....We have our own specific plan to survive without any external support....I don't think we need support from the International Monetary Fund or overseas.''

Well that is good news, so at least we know that one of the CIS and CEE economies won't be looking to the IMF for bail-out support in this crisis which is presently growing by the day. So Kazakstan, that country which is reputedly host to reserves of approximately 95% of the elements in the periodic table, with a population of around 15 million housed on a surface area greater than the whole of Western Europe, is going to be able to look after itself. But hang on a minute, just where is Kazakhstan, and just what have they been getting up to over there, and why the hell should I take Karim Masimov's word for it, when just about all the other Iceland Look-alike show contestants seem to be saying the same? After all, didn't those extermely bright and able young people over at RBC Capital Markets in Toronto say in a report only last week that, along with Latvia, the country's $100 billion oil-led economy is among the most vulnerable to the present global credit crisis and the skid-row economic trajectories that go with it simply because of its excessive reliance on short-term foreign borrowing. And isn't it the case that the cost of protecting Kazakhstan government debt against default has more than doubled this month - to over 1,000 basis points (or 10%), the level for borrowers that investors term ``distressed,'' according to CMA Datavision credit-default swap prices. Only Ukraine, which as we know is already seeking IMF support, is classified as being a bigger risk among European emerging-market governments. Surely all those highly dedicated, bright, and extremely able young people who are doing all that trading know what they are about, don't they?

Sunday, October 19, 2008

Training Session on the Spanish Bank Bailout Plan

Keynes, however, once semi-seriously proposed, as an anti-deflationary measure, that the government fill bottles with currency and bury them in mine shafts to be dug up by the public.
Ben Bernanke, Deflation: Making Sure "It" Doesn't Happen Here
Many of the macro-economic fundamentals of Spain today are very different from those of ten or fifteen years ago...........A lot of factors look better this time around. Compared to its history, Spain has low interest rates, low unemployment and a strong fiscal position........the 2007 levels of government debt, unemployment and interest rates are about half the level of 1993. Equally, a lot of factors related to debt levels, housing and bank funding are worse versus the last downturn. For instance, the relative size of mortgage debt or total private sector debt to GDP, or the size of the construction sector to GDP, were all about 60% bigger in 2007 than in 1993. As was the bank system’s loan-to-deposit ratio. And the housing PE has expanded almost as much. So when Spanish bank management’s argue that the world today is not like the early 1990s, they are right: some things are better, but others are worse. As Mark Twain noted many years ago, history may not repeat itself but it does rhyme.
Spanish Banks, How Bad Can It Get? - Citigroup, September 2008

As I suggest in the title, the contents of this post resembles more an online training session about how the recent proposals to refloat and reinforce the Spanish banking sector may work out in practice than a conventional blog post, but still, this is the weekend, and at weekends, as well as all that interminable football, hiking and tapas snacks in bars, people are supposed to enjoy complementary and value-enhancing activites like going on courses, aren't they? So why don't we have a try. But remember, this topic is only for those with the sternest of stomachs, and the greatest of abilities to find - now what was the word Krugman recently used, ah yes, beauty - in that otherwise most arid of landscapes, the world of financial book-keeping.

So, as is the custom in all good training sessions, let's all start by watching a video, just to get us in the mood, and into the swing of things as it were. I think after the viewing what follows may be a lot more digestable, and certainly it should be more comprehennsible. (The version is conveniently supplied with substitles in Castellano the benefit of any Spanish speaking readers who might drop by).

Thursday, October 16, 2008

Hungary Is Headed For A Substantial Recession As Foreign Exchange Lending Seizes Up

Hungary's agony continues with both currency and stock markets falling sharply yesterday while bankers continue to report acute credit shortages. At the same time contagion has started to extend its ugly reach right across eastern Europe, with Ukraine, the Baltics and Serbia (at a minimum) all in ongoing negotiations with the IMF, with the credit crunch which has followed in the wake of the global financial turmoil really starting to bite.

"Many central and eastern European countries simply don't have either the financial strength or the technical expertise to bail out banks,'' said Lars Christensen, a senior emerging-markets analyst at Danske Bank A/S in Copenhagen. "It's like an Iceland look-a-like contest and there are a number of candidates looking very fragile at the moment.''

Emerging-market banks plunged this morning after Standard & Poor's warned that Korea's lenders will struggle to refinance debt, raising pressure on developing nations to bail out their own institutions. Standard & Poor's has announced that it placed its 'BBB+/A-2' sovereign credit rating on Hungary on CreditWatch with negative implications. S&P has also placed the following ratings on Ukraine on CreditWatch with negative implications: its 'B+/B' foreign currency and 'BB-/B' local currency sovereign credit ratings on its global scale; and its 'uaAA' ratings on its national scale. Hungary has a 'BBB+' rating at Fitch and 'A2' at Moody's.

In Budapest yesterday the forint fell 5.3 per cent to Ft266.09 to the euro and the BUX index of leading stocks closed with a fall of 11.9 per cent, dragged down by a 15 per cent per cent fall of shares in OTP, Hungary's biggest bank. Currencies and stock markets also fell in Poland, the Czech Republic, Romania and Ukraine.

The European Central Bank announced this morning that it will support the Hungarian central bank's money market operations with as much as 5 billion euros ($6.7 billion) to help it ease the present financial tensions. The agreement will provide the central bank with a facility to borrow up to 5 billion euros in order to provide additional support to the central bank's operations, the ECB said in a statement this morning. The move will support the Hungarian central bank's "instruments of euro liquidity provision.'' This move is an important "first", since Hungary isn't a member of the 15-nation euro region, a may well set a precedent which will need to be followed as more and more of the walking wounded limp over and present themselves at the Kaiserstrasse front door, before being politely shown round the back to the overnight lending window.

According to Portfolio Hungary:

Chaos rules among institutional investors, as well, at least the majority of the investment fund managers polled by Portfolio.hu on Wednesday admitted, speaking on condition of anonymity, that they have absolutely no idea about the possible outcome of the current financial crisis. A number of them noted they are at a loss as to what to do with their portfolios in the current situation. Interestingly enough, the only parallel the respondents were able to draw between the present predicaments and the 1998 Russian economic crisis was the mass unwinding of leveraged positions.

As one fund manager interviewed said “From this perspective, the current situation is the same as in 1998 only to the second power. Margin calls are being received, you gotta put in the deposits but as there's no money you have to execute brutal sales irrespective of the price of assets.....Frankly, I haven't got a clue as to when and how this would end, I'm just staring into empty space."

One of the main problems Hungary is facing right now is that if foreign currency lending continues to be discontinued in Hungary on a "sudden stop" basis, then this will mean that domestic economic activity will slow sharply and capital inflows will be considerably reduced which will cause a problem since at the present time these capital inflow amount to about €3-€4bn a year, and are thus close to the covering the ongoing current account gap.

Key Points in the Crisis

1/ Hungary has a large debt -- the gross external debt of the Hungarian state and companies amounted to 89.9 billion euros or 93.8 percent of gross domestic product (GDP) in the second quarter of 2008, while net debt was 46.3 percent of GDP.

2/ Hungary had an excessively loose fiscal policy between 2001 and 2006 and this boosted the budget deficit to above 9 percent of GDP. Following a mini financial crisis (and run on the forint) in the summer of 2006 the Hungarian government adopted an "adjustment programme", whereby tough measures were introduced by the government to cut the deficit, which has been falling and is now projected to reach 3.4 percent of GDP this year.

3/ As a result of the measures adopted to correct the twin deficits proble internal demand in Hungary (construction, retail sales etc) has been more or less in contraction mode since the start of 2007. What little headline GDP growth the Hungarian economy has been able to achieve (see the sharp drop in growth after Q2 2007) has either been in agriculture (which is largely responsible for the rebound in y-o-y growth which can be noted in the first two quarters of 2008) and in exports. The export outlook is now worsening considerably, as most of Hungary's key client economies are now entering recession, and it is this deep structural weakness as much as the credit crunch itself which has meant that the Hungarian financial economy has collapsed so quickly.

4/ Hungary has been running a current account deficit, and although this has been improving, it is still expected to reach 5.3 billion euros or 4.9 percent of GDP this year according to the central bank. Next year this deficit is seen rising because slowing export growth will widen the trade gap.

5/ In similar fashion to Spain, for example, Hungary now needs to refinance its existing debt by issuing forint-denominated and foreign currency bonds, and it is this rollover which has now become much more difficult due to the global credit crunch.

6/ The Socialist government rules in a minority at the present time. There is therefore a significant element of political risk, since the government needs opposition support to pass the 2009 budget in parliament in December. This can obviously condition the kind of measures the governing party feels able to agree to, and its ability to make them stick.

Seize-Up In Forex Loans

Oesterreichische Volksbanken AG's Hungarian unit yesterday suspended Swiss Franc and U.S. dollar loans in Hungary. The bank, which has declined to elaborate to the local press on its decision, will continue to lend euros. Bayerische Landesbank local subsidiary MKB was the first bank in Hungary this week to announce the suspension of new foreign-currency personal loans, saying the volatility of the forint made them too risky for clients.

As local banks have no access to CHF they will either stop or at least limit CHF-based lending to clients in the months to come, the Hungarian business daily Világgazdaság reported on Wednesday. OTP has announced that it will not accept loan applications submitted by those who are passive debtors in the Central Credit Information System (KHR, formerly BAR) and that it too is going to greatly reduced the ratio of FX-based lending, as has the K&H Bank. All of this is pretty important, since something like 85% to 90% of new mortgage and refi lending in Hungary is denominated in Swiss Francs. Loan to deposit ratios have been rising (120%-150%) while the share of money market and foreign liabilities in funding sources has gone up considerably since mid-2007.

Those who already have CHF-based loans will also be non too happy either as the interest charged on their loans is likely to rise considerably in the coming months as the HUF falls.

According to the latest data available from the NBH the total value of outstanding loans to households fell in July - by HUF 36.1 billion to HUF 6,320.8 billion. Forint denominated loans were up by HUF 2.7 billion, while foreign currency loans fell by HUF 38.8 billion and stood at HUF 3,703.7 billion. Exchange rate valuation effects need to be taken into account here, since they were calculated by the bank to have reduced the value of foreign currency loans by HUF 156.2 billion (debt to banks were reduced in HUF terms due to the strengthening of the forint) while new transactions increased it by HUF 117.5 billion.

Thus as of July of the total stock of household loans 58.6% forex were 41.4% forint denominated. But this is slightly misleading, since the majority of the older loans are in HUF, while the vast majority of the post January 2007 loans have been forex ones, principally swiss franc ones.

The share of housing loans in the total dropped very very slightly from 51.8% to 51.7%, while the total value of outstanding housing loans fell by HUF 23.9 billion. Foreign currency loans remained unchanged at 51.3% as a percentage of total outstanding housing loans. Again HUF revaluation effects make mortgage lending appear excessively stationary, but even allowing for the currency revaluation effect, it is clear that the rate of increase in private credit expansion has slowed considerably. If we look at the chart for forex mortgage loans for consumption purposes, the level of these has been virtually stationary since January, after a twelve month period when they virtually doubled.

If we look at forex mortgage lending generally we see a similar picture, even if the rate of increase in 2007 was nothing like as rapid as in the case of consumption directed loans.

Again, if we look at total mortgage lending, it is obvious that there is more than forint valuation effects at work here. It seems to me that we were already able to see clear signs of the impact of the credit crunch back in July, whether this be due to tighter liquidity conditions on the banking side, or due to the pressure of interest rates on the consumer demand side. In any event, this steady slowdown is now more than likely about to turn itself into a "complete stop".

The situation is of course reflected at the level of construction permits for new dwellings, which stood at 3,710 in Q1 2008 (down from 4,105 in Q1 2007) and 4,936 in Q2 (down from 5,318 in Q2 2007). And again more support is offered for the gradual credit crunch view from this statement in the last KSH report on building permits:

Holiday home new construction has shifted in the opposite direction from building permits. Building permits were up by 26% , while newly built holiday houses were down by 30% over the same period last year. In the first half of 2008, 650 holiday units got building permits and only 200 units were built, with the average size of 66sqm.

That is, there are more obtaining permission to build, but less of them - for some "strange" reason - are building.

But while our attention is currently focused on the crisis in the financial system we should never lose sight of the underlying problems in the real economy, and how they are likely to be adversly affected by what is happening now.

Industrial Output Slumps In August

Hungary's industrial output dropped for a third consecutive month in August as slowing growth in western Europe curbed demand for its exports, which are now the only real drive of Hungarian GDP growth. Production fell an annual 1.2 percent after declining 1.8 percent in July, and 0.3% in May according to data from the national statistics office. Output did however rise 0.8 percent over July.

Industrial output fell for the first time in three and a half years in June as the looming recession in the eurozone stifled demand for products assembled in Hungary such as Audi cars and Nokia phones. This slowdown already threatened to bring Hungarian GDP growth close to recession in Q3, and the recent financial turmoil now makes it almost certain that any (possible) Q3 contraction will be followed by a further one in Q4 with worse to come as we enter 2009.

The volume of industrial exports plunged by 7.2% yr/yr vs. an increase of 0.3% in July. If we look as the seasonally adjusted industrial output index, we will see that the level of output more or less peaked in December 2007 - February 2008, with the high point being in February, and with the level of output steadily slowing since.

If we look at the most recent purchasing managers index (PMI) reading we find that the rate of expansion in Hungary's manufacturing sector expansion slowed again in September (after August's mini boost) and remained close to stagnation as new orders growth dropped sharply while the rise in output also eased, according to the monthly report from the Hungarian association of logistics, purchasing and inventory management (MLBKT). The September PMI fell to a seasonally adjusted 50.3 from 51.9 in August. The figure is the lowest for any September in the past three years. In Sept 2007 the index stood at 55.1 (a reading of 50 marks the frontier between expansion and contraction, and 50.3 is this a very, very fractional expansion, if it be confirmed by the final data from the KSH).

One clear indication of problems to come can be found in the fact that European car sales fell 8.2 percent in September, extending a decline that began in May, as higher fuel prices and financial-market turmoil reduced demand. Registrations in September dropped to 1.3 million vehicles from 1.42 million a year earlier, the Brussels-based European Automobile Manufacturers' Association said in a statement earlier this week. Sales for the first nine months fell 4.4 percent to 11.7 million vehicles, compared with a 3.9 percent contraction through August.

Industrywide sales in western Europe, including the 15 countries that were members of the EU before May 2004 plus Iceland, Norway and Switzerland, slid 9.3 percent to 1.21 million vehicles. Deliveries in the 10 eastern European countries that have joined the EU since 2004 increased 7.8 percent to 93,275. The association's figures don't include deliveries in Russia.

New car sales inside Hungary are also well down, and dropped by 4.6% year on year in the January-September period, according to data published today by the Association of Hungarian Vehicle Importers (MGE) . The lions share of this drop must have come during the July to September period, since MGE only reported a 1.4% drop in the first six months of the year.

Inflation Eases Back In September, But Will We Now Head For Deflation?

Hungary's inflation saw stationary month on month in September with consumer prices remaining unchanged over August. On an annual basis prices rose by 5.7% over September 2007, greatly undershooting analysts expectations (the median forecast in the Portfolio.hu analysts poll had been 6.1% , for example)

Seasonally adjusted core inflation decelerated to an annual 5.0% from 5.8% in Aug, according to Central Statistics Office (KSH) data. In monthly terms, core CPI also remained unchanged as comparesd with the 0.3 % rise registered in August. This deceleration is pretty swift, and were in not for the sharp fall in the forint, we would now be expecting strong disinflatioary pressures to make themselves felt in the coming months.

The big surprise seemed to be in the processed food components, where a much slower disinflation (following the drop in fresh food prices resulting from this years excellent harvest)had been foreseen. Bread prices were for instance down, despite the fact that local bakers had been threatening further increases. Processed foods were flat month on month taking the year on year index down to 13.2% from 16.0% a month earlier.

In what could be interpreted as an early warning signal of what may be in store further down the road, however, durable and non-durable industrial goods prices continued to rise as the weaker forint fed rapidly through rather quickly to prices.

Producer prices were up in Hungary by only 3.2% year on year in August, down from July's 3.7% rise, and way down from April's 6.5% peak. The breakdown of these price increases is also interesting, since domestic sales prices were up 12.9% over August 2007, while export sales prices (measured in HUF) actually decreased by 3.9% year on year.

Employment Remains (more or less) Stagnant As Hungary's Population Falls

One thing the Hungarian economy is NOT doing to any great extent these days is creating employment. The number of employees in companies employing at least 5 people and in the public sector (combined) dropped by 0.5% year on year in July to hit 2.755 million. This decline follows a 0.9% annual drop in June. Actually this process is only natural (and more or less to be expected) as the Hungarian population declines, but of course it does mean that the only real way the Hungarian economy can grow is by increasing productivity, and that in June something like the first 1% of productivity any productivity improvement Hungary was getting was eaten up by diminished employment. Clearly the answer to this is to increase labour force participation rates, but while this sounds fine in theory (and is generally what is recommened by think tanks grom the World Bank to the OECD, see for eg the World Bank report from Red to Grey), but we are a long way from seeing it happen in practice in Hungary.

The distribution of the labour force is changing, however, since the number of employees in the private sector rose by 0.3% year on year in July while employment in the public sector decreased by 3.5%. On the other hand, and to put all of this in some perspective, there are now over 100,000 fewer employees in the private sector than there were in June 2003.

Hungary's present population is something like 10.03 million, and this is down from 10.22 million in 2000. The rate of decline is small, but the attrition is constant.

But as well as falling, Hungary's population is also ageing, and we know from basic life cycle theory (Modigliani) that saving and spending patterns change across the life cycle, with the propensity to borrow against future income to buy now declining significantly after 50, and since it is increasing consumer credit that drives retail sales growth in the dyamic internal consumption economies, then it is highly likely that ageing will now act as a drag on sales growth generally in Hungary. As we can see in the chart below, Hungary's median population age has been rising steadily, but the rate of ageing is now about to accelerate quite sharply, with the only real substantial unknown between now and 2020 being life expectancy, which may accelerate more than anticipated (in which case the population ageing will be even more rapid).

It's All About Exports Now

Apart from retail sales, another indicator of domestic demand which is worth thinking about is housing construction. Let's look at the chart.

As we can see the number of new buildings peaked in 2004. Since that point the sector has struggled. Obviously the absence of new households can be offset to some extent by holiday homes, but this has limits, and in the present credit crunch environment is unlikely to be as important as many anticipated. Despite the general economic slowdown there was a rebound in housing activity in 2007, but in the wake of the US financial turmoil of August 2007 this now seems to have faded. It will be many a long year (if ever) before we see construction on the 2004 scale in Hungary again, since housing is, above all, about demographics.

So what does all this mean for Hungary? Should people simply pack their bags and leave. No, not at all. What it means is that it is all about exports now, as far as the Hungarian economy goes, and the sooner Hungarian civil society (together with the civic institutions - parliament, central bank etc) faces up to this, the better.

Given the rapid ageing that Hungary is now faced with, and the need to maintain a health and pension system with some kind of minimum guarantees, then economic growth is essential, and the only way to get this economic growth is through the export sector, and this is now a hard fact of life. Indeed it is precisely because the structural commitments to current expenditure are so large in the Hungarian case, that the downturn in public sector construction has been so strong following the austerity package. The sooner everyone faces up to all of this the better.

And if we look at the short term outlook for Hungary's export sector, then it doesn't look too bright, since Hungary posted a trade deficit of EUR 103.7 million in August, according to first estimate figures released by the Central Statistics Office. This compares with a deficit of EUR 365.1 m in July and EUR -176.5 m in Aug 2007. Exports - at EUR 5,378.3 m - were down 0.7% year on year, which compares with a growth of 8.2% in July. The August drop is significant, since the last time the 12 month export index was in the negative territory was in June 2003 (-1.3%).

Imports - at EUR 5,482 m - were down 1.9% year on year, while in July they were up by12.4%.

Tightening credit standards and the cut-back in credit lines to producers and wholesalers suggest there will be a further dramatic fall in new orders, which is likely to weigh on export performance. The question is how long and how far credit standards will continue to tighten, but the chances of a prolonged deterioration in financial conditions have increased, pointing towards sustained weakness in the real economy for some time to come.

Construction Drops Back Again In July

Construction output is falling steadily in Hungary, and output fell more strongly in July - down by 11.8% year on year, than it did in June, when there was an 8.1% drop. Taking the number of working days into account, the decline was 12.8% in July, and 9.0% in June.

Adjusted seasonally and for working days, output contracted by 2.8% month-on-month from June, following a 5.5% month on month contraction in June. July was the third consecutive month when construction industry output dropped. Output in January-July was down 10.9% over the same period of 2007.

While the index will probably settle down a bit in the autumn, given the base effects due to the strong plunge in output last autumn, we are unlikely to see any short term improvement in construction output, and given the ongoing turmoil in the sector globally the position will more than likely continue to deteriorate for some time to come. Maybe someone will one day wake up to the fact that with an ever smaller and older population in the longer term you need fewer and fewer houses. As can be seen from the chart below, the level of construction activity peaked in Hungary in 2005 (along with domestic private consumption growth), and given the population situation, and that civil engineering will be continuously constrained by government budget commitments to health and pension programmes in an ageing society, it is very unlikely that we will ever again reach that level. Remember here, we are talking about the RATE of output, and not the STOCK of buildings, bridges, motorways etc. I simply can't see why none of this can enter the mindset of those who are sitting stoically, arms folded, waiting for the "inevitable" upturn in Hungarian domestic consumption. Less retail sales, less building, less people working, this is, I think, what you should expect with a declining and ageing population. And, of course, we are about to see this phenomenon repeated in one society after another as the process spreads. Hungary is simply unfortunate enough to be among the first.

Falling Retail Sales

Hungarian retail sales were down by 0.1% month on month in July, following a 0.3% drop in June, according to the most recent calendar and seasonally adjusted data from the Hungarian Central Statistics Office (KSH). Using calendar-effect adjusted data, there was a fall of 1.8% year on year in July, following a 1.9% decline in June.

Retail sales declined in 2007 by 2.9%, which compares with an increase of 4.4% in 2006 and 5.6% in 2005. As can be seen from the monthly seasonally adjusted sales index (below), Hungarian retail sales peaked in early summer 2006, from which time they have been steadily falling. As far as I can see, with an ageing and falling population, and domestic demand stagnating, is quite possible that Hungarian retail sales will never reach this historic peak again.

A Long And Deep Recession Looms Over The Horizon

Despite the slight acceleration in Hungary's annual economic growth seen in the second consecutive quarter in Q2 - which was largely as a result of a surge in agricultural output - underlying trend growth in the Hungarian economy is now extremely low - I would say between 0 and 1% per annum. So the charts are deceptive at this point, since agriculture was up 33.8% year on year, meaning that it contributed about 50% of the quarter on quarter growth despite being a very small segment of the economy. Such significant movements in GDP due to volatility in one small raw materials sector is a characteristic wich is much more typical of a developing than of a developed economy, and therefore what is so striking about Hungary's current situation is just how little it has been able to move away from this role model over the last seven or eight years, despite all the financial wizardy to which it has been subjected.

Gross domestic product was up by an annual 2 percent in Q2 2008, and this was the fastest rate since the first quarter of last year. The figure compares with the 1.7 percent growth achieved in the first three months of 2008. Over the previous quarter GDP was up by 0.6%, equalling the performance in Q1 over Q4 2007.

Agricultural production rose an "extraordinary'' 33.8 percent compared with Q2 2007, largely due to a bumper wheat harvest which was up 40 percent this year (to 5.6 million metric tons) following a very poor harvest in 2007 after frost and drought damaged the crop.

Industrial production was up only up 4.2 percent year on year, due to the slowing pace of export increase. IP had risen by 6.9 percent in the first quarter. Private Household consumption also showed some signs of life and rose 1.4 percent. This was the biggest leap in private household consumption since Q3 2006.

Indeed, quarter on quarter, household consumption was up 0.5%, which was the fastest quarterly rise since Q4 2005. Since this is really quite a surprising result it will be interesting now to see what happens as we move forward. On the other hand there is evidence that the stronger forint has been having an effect on exports. Indeed the annual growth in imports (at 11.2%) just exceeded the annual growth in exports (11.1%), hence the net impact of trade on GDP growth was marginally negative. The services and real estate sectors also slowed in Q2, with finance and real estate contracting by 0.3% quarter on quarter. Given that the rate of increase in new mortgage lending has now been slowing for some months, and new building permits are way down year on year, can we start to detect the first initial effects of the extending global credit crunch in Hungary at this point?

Investments as we have seen in a previous post were down year on year by 2.2%, while construction was down year on year by 6%. Given that the external environment in the Eurozone is now deteriorating, the industrial output (as we are also seeing for July today) is losing steam on the back of the high forint, I think we are more than likely going to see a steady reduction in the annual rate of growth as we move forward again, especially since one off factors like agriculture will not be so important, and can't be guaranteed to always show up just when you want them.

It is hard to put a precise number on future GDP growth at this point, given the dramatic events which are unfolding around us. We first need to see the actual GDP data for Q3 2008, but if we look at the industrial output, retail sales, construction and exports data presented above, it is hard not to come to the conclusion that the economy may well have contracted quarter on quarter in Q3 (even despite the good agricultural performance, which will, after all, enjoy a strong base effect from Q2), and if this is the case then with Q4 almost certain to see quite a strong contraction, it isn't unreasonable at this point to think that Hungary entered recession on 1 July 2008.

Central Bank Caught In A Double Bind

Hungary's Magyar Nemzeti Bank left its benchmark interest rate unchanged at the three-year high of 8.5 percent at its last meeting on 29 September as the global financial crisis and upside risks to inflation forced prevented the bank from initiating a rate cut cycle. Hungary's rate is currently the second-highest in the European Union after Romania, whose current base rate is 10.25 percent.

Back in February Hungary's central bank and government took a joint decision to remove the trading band within which the currency had been moving and go for a free float. At the time this decision was applauded, since it was quite fashionable to think that allowing a currency to float upwards was one way of containing internal inflation. Whilst welcoming the move to a free floating currency, I have never been convinced that the reason for doing this was primarily to cap inflation, since in an economy with such weak underlying economic fundamentals as Hungary has (or Ukraine indeed, for that matter), I fail to see the justification for having an especially strong currency, especially given the need to sell exports to live. I was always worried what was going to happen when the banks upward interest rate project of hoisting itself on its own petard ran out of steam, and the florint started to weaken as high yield seeking risk appetite started to weaken, as it had to do at some point given that we were living in the middle of a global credit crunch. In my post at the time I said this:
Basically I think this is the point, when the HUF rally runs out of steam
the NBH is going to be in a very difficult situation indeed, and it will run out
of steam when Hungarian housholds let up on their frenzy to borrow money in
Swiss Franc denominated loans, a decision which may be made easier for them now
that the band has been removed and the currency risk is evident to all. A
difficult decision, but then maintaining the band was only encouraging people to
keep going on contracting the loans.

So now, as the economy itself continues to head downwards, and with more fiscal tightening on the agenda and an evidently more difficult external environment for exporters to confront as the eurozone economies themselves slow it is hard to see where growth can come from, and Hungarian economy now seems to be badly in need of some sort of stimulus shot or other. The ECB loan announced to day is really more of an "additional damage avoidance life support package" than it is any kind of monetary stimulus, while the NBH clearly can't start to enter a monetary losening mindset without undermining the forint, and with it the solvency of those who are paying the CHF denominated mortages. So we really now at a stage where things will inevitably move on over to the political front, and we need to ask ourselves just one more time, exactly how much more of this type of medicine with no tangible results is the Hungarian voter actually going to put up with before we see evidence of some sort of substantial protest? And when the protest does come - with all the technicians and economic specialist having failed them - just what kind of form might we expect this political protest to take?