Hungary in the firing line -analysis

In recent days a number of Eastern European economies have suffered from the global market turmoil that originated in the US subprime market. The Czech Republic’s benchmark index, the PX50, lost nearly 1,000 points in trading on August 16th to close at 1,653. A week earlier it had stood at 1,775. Poland’s WIG-20 index lost more than 5% of its value in trading on August 16th and was down 13% from one month earlier. Russia’s RTS index closed at 1,820, down from 1,886 one day earlier and 2,071 a month earlier.
Currencies have also been affected, albeit to a lesser extent. The losses on stockmarkets are hardly dramatic, as they mainly correct the sharp gains made in recent months. The region’s economies look in reasonable shape to weather anything other than a complete meltdown. Still, within the region Hungary stands out. The BUX index lost over 1,000 points in trading on August 16th, closing at 25,895, compared with 28,043 just a week earlier. As a result, the Hungarian bourse is the region’s worst performer. The forint too has tumbled, from Ft 250 per euro a week ago above Ft 260.5 per euro for most of August 16th and 17th. For much of July the currency had been steady in the Ft 245-246 per euro range; the currency has not been in the territory of Ft 260 per euro since the last round of jitters in October 2006.

There are three major risks for Hungary’s real economy arising from the currency and stockmarket troubles:
First, the weakening currency threatens the achievement of the authorities’ inflation target and so could the central bank to halt its monetary easing. The National Bank of Hungary (NBH) says that its inflation target is achievable at an exchange rate of Ft250-255 per euro; it follows that if the exchange rate stays around Ft260 per euro or worse, then imported inflation will threaten the target. In other regional economies, which are growing strongly, a mild monetary tightening would not be unduly worrying. Hungary, however, is in the midst of an austerity drive that has nearly brought the economy to a standstill. In a region where Q1 GDP growth averaged around 7%, Hungary’s economy grew by just 2.7%. The flash estimate for the Q2, at just 1.4% year on year, is even more alarming. In this context, the maintenance of relatively high interest rates at their current level is the last thing the economy needs. Still, this remains a serious risk.

Second, the government’s budgetary management-and its painstaking efforts to rebuild credibility-appear vulnerable. Prime Minister Ferenc Gyurcsány’s administration has cut its deficit target for 2007 twice already this year, in moves welcomed by markets, and has generally adopted a conservative approach to forecasting. However, July’s budgetary number exceeded the target. The comfort zone that the government has created, as part of its effort to rebuild its reputation, has shrunk dramatically. Because public-sector debt is at 66% of GDP, a serious liquidity crunch that increases the cost of borrowing could quite easily push the government’s budgetary management off-course, thereby undercutting Gyurcsány’s efforts to rebuild credibility among investors.

Third, the banking sector is potentially vulnerable and so too are Hungary’s legions of borrowers in foreign currency. The West European banks that dominate Hungary’s financial sector hail mainly from Austria, Germany and the Netherlands, all countries with some bank-sector exposure to the US subprime market. This raises a question as to whether borrowing costs in Hungary could rise if such banks experience liquidity problems and so are forced to tighten lending policies.
Moreover, despite the austerity measures enacted in recent months, Hungarian households are continuing to borrow—predominantly in Swiss francs rather than their own currency—as they seek to cushion the impact of falling real wages. Foreign-currency loans have been a feature of Hungary’s financial scene for several years. It wasn’t a problem when the forint faced mainly appreciating pressure. Now the Swiss currency is appreciating against the euro, and the forint has slumped. If this situation is maintained beyond a few weeks, Hungarian borrowers will struggle to meet their monthly payments. This will cast another shadow on an already glooming macroeconomic picture and could conceivably push several banks into serious trouble.

The irony of the current situation is that Hungary has been vulnerable to a financial crisis for a couple of years, but has been spared by the unduly generous approach towards risk shown by markets. Since re-election last year Gyurcsány has started to turn things around, but the job is far from complete—and his government can no longer rely on the indulgence of investors. (economist.com)