Turning The Screw on Hungary; Three Possible Tipping Points

Hungary's forint firmed slightly today after standing up to several waves of pressure, settling around what still amounts to a one-week low against the euro. The mildly favourable retail sales data that came out in the US during the afternoon eased some of the pressures on emerging market economies and in the collective upswing the forint managed to get back below the 262 to the euro level. Just enough to knock out stop-loss levels, but hardly anything to get excited about. The forint had been as far down as 266 to the euro earlier last week - amid a spate of rumours which included the idea that the prime minister was about to resign, and that the central bank was about to announce an emergency rate cut (or was that increase, I never was sure which possibility was most in people's minds at that point). Indeed it was clear that a general downturn in global risk appetite which struck all across emerging market instruments was hitting Hungary's long-unsteady markets the hardest.

Hungary's economy has slumped to decade-low in growth following a government belt-tightening campaign aimed at straightening out its public finances.







Danske Bank Analysis


Portfolio Hungary reports this morning on the view of Danske Bank analyst Lars Christensen. Christensen's argument is that it is only a matter of time before the forint follows the leu, the kronur and the rand in weakening significantly. In particular he argued that the forint is not sufficiently protected by adequately high interest rates.

Since the outbreak of the global credit crunch in August 2007 many currencies in the EMEA countries which have been running large current account deficits and/or have accumulated large ratios of foreign debt have been under significant selling pressures. According to Christiansen:

“Most notable has been the weakening of the Romanian leu, Icelandic kronur and the South African rand, which have all weakened around 15% since the beginning of August. The lira has more or less been flat against the euro since early August and the forint has “only" weakened around 5%".


“While we clearly see a risk that these currencies can weaken significantly more, there is also a risk that this weakening will spread to other EMEA economies with similar problems. In particular, the Turkish lira and the Hungarian forint stand out,"

“While high interest rates in Turkey give some protection, it is hard to use the same argument for the forint and hence we believe that it is only a matter of time before the forint follows the leu, the kronur and the rand and weakens significantly."

(The base rate is currently 13.75% in Iceland, 11.00% in South Africa, 9.00% in Romania, 15.75% in Turkey and 7.50% in Hungary.)

As he points out, imbalances have been reduced in the Hungarian economy on the back of last year's tightening of fiscal policy, but the markets have also 'rewarded' the Hungarian government for this by not selling the forint as much as the continued large imbalances and large foreign debt could 'dictate'.

Also, as the global credit crisis drags on there is an “increasing risk that we will have a repeat of the forint 'crisis' of 2006", where the HUF fell sharply from around 250 against the euro to 285 in a comparatively short space of time. And the global financial environment at that time was significantly more benign than is the case at the moment. So a forint at 280 or below to the euro hardly seems an unlikely level at this point in time, and indeed Lucy Bethell from RBS was arguing exactly this earlier in the week.

In particular, Christiansen stressed that any “slippage" on fiscal policy in Hungary would hit investor confidence hard and this would also “likely lead to downgrades of Hungary's credit ratings". And this is just why tomorrows Q4 2007 preliminary GDP data will be so important, since if the figure slips to any great extent on the downside this is bound to place strong question marks around Hungary's 2008 budget targets which are - let us remember - based on government estimates of GDP growth in the 2.8 to 3% range.

And before we leave Christiansen's analysis, I would like to draw attention to one point: the comparison with Turkey. Back in August 2007, just after the credit market crunch started to close its grip, I wrote a long post (and an even longer analysis) of Turkey, where I tried to argue that even though Turkey's economy would come under pressure just like those of its East European neighbours, the underlying soundness of Turkey's demography, and hence the element of homeostatic regulation which it would enjoy following from any significant downward correction, meant that it could well emerge with a lot less medium term damage from the coming global storm than the rest of Eastern Europe. This view is now about to be tested, as indeed is the whole thesis that demography and fertility don't matter to economics. As I wrote at the time:

There are good theoretical reasons - at least if you take demography seriously there are - for imagining that the Turkish economy might well prove to be more robust than some of the Eastern European ones will under the strains the various economies are under and about to receive. These latter economies, despite their apparent vibrance are actually much more fragile under the surface, and it is for this very reason that the observed response differences bear examination day by day.

I Suppose That's The Hill Sergeant, and I Guess You Are Going To Make Me Climb It.


The most probable scenario we now face is for the forint to experience a succession of waves of attack, and a systematic attempt to knock it of the perch on which it is so delicately poised. All free-market economists of course believe in the workings of financial markets as a regulatory mechanism, but we don't have to believe they are fair, kind or forgiving.

There seem to be three critical tests facing the forint in the short term. The first is the GDP and inflation data coming tomorrow. Starting with the Q4 2007 GDP data, my opinion is that this will surprise on the downside, and possibly give every indication of just how unrealistic most of the 2008 GDP forecasts for Hungary currently are. The second is the inflation data, and here the Hungarian central bank is now almost certainly in a heads I lose, tails I lose situation. If the CPI - Hungarian inflation was running at an annual rate of 7.4% in December - surprises on the downside this may encourage currency dealers to feel that the central bank will bow to political pressures and reduce interest rates - a move which the collapse in Hungarian internal demand suggests is badly needed.







But the reduction in yield differential would make forint denominated assets less attractive, suggesting that the foring would face a more testing toime and that an acceleration in capital exit would probably occur. If, on the other hand, the data surprises on the upside - which after today's December agricultural PPI data (38.1% y-o-y) seems more likely, then this may lead people to feel that the central bank will have no alternative but to increase rates. Indeed many market analysts have now reached the conclusion that such rate rises are more or less inevtiable. The latest of these has been Gillian Edgeworth of Deutsche Bank, who today projected a total of 100-bp rate hikes in the next six months (over the course of the next six policy meetings.), and in this she has joined a fine galaxy of observers including Goldman Sachs and Citigroup - who are projecting a 50-bp hike at the 25 February policy meeting, while Citibank analyst Eszter Gárgyán is on record as saying she does not believe that even a 50-bp hike could be enough to stop the weakening of the forint. I am not sure how much of the macro-economics of what is involved in all this these forecasters understand, but I am quite happy to say that the sort of monetary tightening that Gillian Edgeworth is contemplating is just not posible at this point in the game, since, apart from the fact that it would send Hungary off into one whopping and unholy recession (especially if it was accompanied - as it would have to be - by a continuing tightening of the loan conditions on Swiss Franc mortgages, due to the hightened currency risk default issues), the political dynamics would not accept it. You can only ask people to accept so much belt tightening before they rebel, and we are already over 18 months into this round, so tolerance must be wearing thin, and another year of monetary tightening is most definitely out at this point. If you have any doubt whatsoever on this, look at what has happened in other countries in other epochs.

So, given that not all market analysts are competely devoid of foresight, any move to press the tightening trigger can alos lead to a similar conclusion to a rate cut about the desireability ditching Hungarian assets, since more monetary tightening would only close even further the noose which is currently extending its grip over the internal economy. Such are the difficulties when you back yourself so tightly into a monetary and fiscal corner.

The second hurdle, or critical point, the forint will have to get over - assuming it survives tomorrow - will them be the meeting of the central bank itself on the 25 February, and again rate policy decisions either way can have unpredictable effects, and once more it is likely that an attack will be mounted, regardless of the decision taken, given (as I argue above) there are sufficient reasons for doubting that either policy option is a good one. What all this amounts to is that the Hungarian central bank has now run out of policy options, and it is just a question of time before we get to see what the financial market participants decide to do about the situation.

Finally, and assuming that the currency passes muster relatively unscathed in the first two initial skirmishes, the cherry is most decidedly and firmly likely to be planted on the top of the cake if the proposed referendum on some of the more controversial measures in Hungary's adjustment programme actually gets to be held on March 9th. Since a vote to abandon the contested education and health service charges - which seems on the face of it to be the most probable outcome - would virtually present a frontal challenge to the whole "adjustment" process, it is hard to see how the Gyurcsany government could continue under the circumstances (even if there would be no formal obligation to resign). This kind of situation is, of course, "more power to my elbow material" for those market participants with an acquired taste for warm, freshly-spilled blood, and really if we got through to this point, without anyone having the presence of mind to take the bull by the horns first (by which I mean making a virtue out of a necessity, and openly accepting that policy is now in a no-exit bind, and that a significant drop in the value of the forint is both inevitable and desireable, depite the fact that there will be a lot of renegotiating and cleaning up to do in the aftermath), then the outcome may well not be a pleasant sight to watch.

Are Spain's Banks Likely To Be Spared Global Financial Pain?

So are Spains banks likely to escape the pain associated with the global financial turmoil? Well the Financial Times' Gillian Tett obviously thinks they are, and she has been argueing her case in two interesting and valuable pieces in the Financial Times - "Spanish banks spared huge writedowns" (Feb4 2008), and "Why the pain in Spain has mainly been contained" (Feb1 2008). In support of her Tett makes the important and valid point that:

"In the past few years, the Bank of Spain, which acts as financial regulator, has prevented banks from holding any kind of special purpose vehicles off balance sheet."

But could it be that in the Spanish case the financial pain, likely the proverbial rain, falls mainly in the plane? Namely, and as I try to explore in this post, could it be that the large Spanish banks have largely weathered (and may well continue to weather) the storm that is brewing in Spain's troubled domestic mortgage market due to the fact that they stayed to some considerable extent on the sidelines in the massive cedula hipotecaria (covered bond) boom market, leaving most of the risk - and comparatively little of the return - to be shouldered by the smaller players, like the regional cajas.

Certainly I would argue that the little model which I present in the diagram in the above linked post of mine probably has some sort of general validity, and may help us to see how things will pan out here.

The argument Tett advances, which is pretty much common currency here in Spain at the present moment is technically correct:

When the subprime crisis exploded in the US last year, a majority of analysts predicted the contagion would soon spread to Spain. Spain, like the US, had an overheated housing market and banks that had lent freely into the construction boom. Six months on, part of this prediction has played out, in the sense that Iberian banks are suffering from the effects of the liquidity squeeze, like the rest of the global banking system. However, many analysts have been surprised to discover that Spain’s financial groups have had no exposure to the kind of mortgage-linked investment vehicles that have wreaked so much havoc in the US and Europe.

It is technically correct in that while the Spanish banks are - as she admits - experiencing liquidity problems, these problems are not essentially connected to the subprime problem in the US, but they are connected with the ensuing credit crunch which has followed in its wake, as I explain here. Indeed Tett also accepts this:

Spanish lenders are now furtively turning their mortgage loans into privately placed bonds to use these as collateral to get access to liquidity from the European Central Bank. Meanwhile, the cost of buying insurance against default for medium Spanish lenders, via the credit default swap market, has recently soared, amid rumours that hedge funds can smell blood.

So not everything in the garden is completely rosy. The Spanish financial sector is essentially having to swallow its own bonds in order to be able to raise day to day liquidity at the ECB, and there is a huge problem looming after 2010 as the 10 year term cedulas need to be rolled over. The problem has assumed a particularly acute form since noone at this point in time has any real ideal what the pool of properties which back Spanish covered bonds is going to be worth in both the near and the longer term future.

Gillian Tett notes that something is afoot in Spain:

Twice a year I travel down to Spain to visit my relatives - and almost always return feeling worried about financial risk. For nobody can fly over the Spanish coastline these days without noticing that the country has recently been in the grip of a construction boom. And that, unsurprisingly, has led to an explosion in the balance sheets of banks, with a corresponding boom in the Spanish residential mortgage bond securitisation (RMBS) market. It is a fair bet that this credit party will produce plenty of hangovers in the coming years. Indeed, where my relatives live in southern Spain, house prices are already tumbling and flats stand empty (albeit, on a scale that still looks modest compared with the subprime-scarred areas of Los Angeles, say.)

Well, Gillian, I don't know what you consider modest, but according to Leslie Crawford writing in the FT last week the IPE business school are suggesting that by March there may be 500,000 unsold homes in Spain - more or less one year's residential construction output at the old pace. And that was the old pace. If we assume that one of the impacts of the current correction may well be a slimming down of Spain's construction industry, then this may turn out to mean that we already have an inventory which is nearer to two years supply, and growing.

From here on in financial market calculations may well take the back seat while the real economy takes over. Most calculations of what we can expect going forward depend on what is going to happen to Spain's economy as a result of this correction, since that will be the factor which ultimately determines where Spanish housing prices finally settle, and since the correction has hardly begun let alone ended most calculations on this front should be treated with a very strong measure of caution.

One problem though is puzzling me, Spain's external deficit. Basically Spain runs a very large balance of trade deficit, and one of the principal factors sheilding Spain from difficulties on this front has been the steady inflow of funds associated with foreign investors purchasing the cedulas. These flows have now virtually stopped so the deficit will either have to be financed in some other way, or turned round. Both of these, given the magnitude of the issue, seem very complicated indeed. To give some idea what I am getting at, and on an off the top of my head basis, we could note that a large part of the trade deficit is to pay for oil and natural gas imports - all that central heating and air conditioning for all those extra houses - and that most of the money to pay for these imports has been indirectly borrowed via the mortgage demand from would be householders. It may even be the case that Spain has not yet paid for a drop (let alone a barrel) of all that oil which has been used since 2000. Whether or not this is exactly the case the problem clearly exists, and Spanish consumption is going to be reduced on an ongoing basis, and over a number of years, to pay down the accumulated debt, at just the same moment as Spain will have to reinvent a new driver for economic growth, since construction as the principal driver is clearly finished. In that sense comparisons with the United States may not be so far from the mark, and even more so, since proportionately Spain's boom has been much larger.