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.

Spain's Election Hubris and the Property Bust

Leslie Crawford has a reasonably balanced contribution to an opinion editorial in the Financial Times today, where he raises the issue of the excessive optimism of the Spanish government in the face of the growing crisis here. As he notes ...."Only the government predicts Spain will grow by as much as 3.1 per cent in 2008." This view is evidently ridiculous, as far as I can see from the current data Spain may well have entered recession (being defined in this case as having the first of two consecutive quarters of negative economic growth) in Q1 2008. And even allowing for some sort of rebound later in the year annual GDP growth in 2008 is hardly going to be above the 0.5% - 1% range, and may well be lower. What is so striking about Spain at the present moment is the speed with which it is slowing, like an airplane that is losing velocity fast, as if someone punctured an air cushion.

Another interesting point contained in his piece is the estimate from the IPE business school 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. This is going to need a long time to correct and work out of the system. Of course, Zapatero is right when he mentions that Spain is running a 2% of GDP fiscal surplus, and so fiscal policy is available to correct the problem to some extent. But as we have learnt in the previous case of Japan - which went into a major economic crisis in 1992 following a significant housing bust - this strategy can only be a short term holding operation, the Spanish economy needs to "reinvent itself" and quickly.

(of course, the other lesson we were supposed to have learned from the Japanese experience is that to prevent a country in this situation - where they may be a major and severe correction in housing prices, and a "wealth effect" motivated deflation in demand, is that a rapid and decisive loosening of monetary policy is called for to ward off the risk of price deflation - constinuing strong price inflation in Spain is very unlikely if we look at what is happening to domestic demand - but the ECB seems to be light years away from waking up to this danger at the present time. Of course, since what we have is inpart a credit crunch, even traditional monetary policy measures like lowering short term interest rates may have little effect, but that is no excuse for not doing so).

Since in terms of the demographics of the time and the general profile of the problem Japan 1992 and Spain today are so strikingly similar it is hard to resist the comparison (it may be the only relevant one we have to go by) and it is interesting to note that one of the first people to dismiss out of hand Dominique Strauss Kahn's recent proposal to have a concerted G7 fiscal response to the weakening in global demand was Fukushiro Nukaga, Japan's finance minister, who reportedly responded to the proposal by saying: "We have learned what such fiscal spending could mean from our experience after the burst of the bubble," referring to attempts to spend Japan out of recession and deflation in the 1990s. I think Spain's next government really needs to take note of this experience. Short term fiscal stimulus is fine, but you need to get to the root of the problem.

Crawford also points to the growing global presence and importance of Spain's major companies, and this is important, but as Japan has gradually learnt to its cost, in macroeconomic terms it is hard to substitute global corporate prowess for local domestic demand. Spain's economy has been largely driven by domestic consumption and increasing consumer credit in recent years. This is now done. Finished. The situation in this sense - if we look at the comparative demographics - is much more severe than in the United States. Worse, people are going to have to start paying back what they have borrowed, both individually and collectively. The recent boom was not financed by Spanish savings but by a steady and sustained inflow of funds made possible by the eurosystem. Some 60% of the investment which went to finance the Cedulas Hipotecarias came from outside Spain, and these capital flows now have to reverse to some extent. So all of this will be a negative are far as medium term consumption in Spain is concerned. Spain now needs to become an export driven economy, and this is a huge change, and is obviously going to need some years to achieve.

My only real doubts at the present time relate to what is actually going to happen to the immigrants and what will happen to inflation. Maintaining the roughly 5 million recent immigrants who currently live and work in Spain is important to the country's demographic future, given the long term very low fertility that the country has been experiencing. These "replacement migrants" make up for the missing births produced by the birth postponement process (as I explain here). So holding onto these migrants is going to be critical, if hard, since many will be without work in the not too distant future, and with little in the way of formal financial support from the Spanish authorities. Again, this is going to be another of the major items on the "to do" list of the incoming government.

Lastly inflation. Basically the accelerating inflation we are currently seeing is unsustainable in the light of the collapse in internal demand. So the process will reverse, indeed if it doesn't - and the euro stays near current levels - it is hard to see where Spain will get the competitivity from to begin the long march to an export driven nation. The German experience post the collapse of their 1995 construction boom might be instructive: ten years of almost constant wage deflation as relative prices come back into line. This may be hard to contemplate in Spain at this point, but my best guess is that this is where we are headed. Oil prices are unlikely to increase in 2008, and may well drop back if there is a significant decline in global demand - although even this isn't guaranteed, since whatever happens in the US and Europe some countries (like India) will keep growing, and they will be energy guzzlers. Also Spanish property and land prices may start to fall drastically at some point - looking at the one years supply of unsold homes (and remember this is one years supply at the old level, it may well be two years supply at the new one) - so a sharp correction downwards may well take place at some point as bankruptcies start to occur. If this were to happen, then rather than moderate but long term wage deflation, Spain might face outright and straightforwad price deflation, Japanese style. At this point it is too early to say, but this is the other factor to watch for as we move forward.

And now for Leslie Crawford:

Eurostat, the European Union’s data compiler, in December published a dry table that revealed a remarkable fact: Spaniards had become richer per head than Italians, writes Leslie Crawford.

Anyone who knew Spain in the 1970s – when it was a byword for backwardness and governed by an ageing dictator – can only marvel at its political and economic transformation. Along with Ireland, Spain has been one of the unequivocal success stories of the EU, which it joined in 1986. The new member states of central and eastern Europe regard Spain as their role model, for the skill with which it used EU funds to spearhead its development.

But never did Spaniards think they would one day overtake in terms of per capita income one of the founding members of the EU. José Luis Rodríguez Zapatero (pictured), the Spanish prime minister who faces a general election next month, boasts that overtaking France and even Germany by that measure is possible within five years.

Mr Zapatero’s grandstanding, however, has been obscured by doubts. The end of a 10-year housing boom, coupled with financial turmoil abroad, is leading Spaniards to question the foundations of their leap forward. The Spanish sorpasso took place just as the country’s growth was peaking. Might it prove as fleeting as Italy’s famous overtaking of the British economy in the 1980s?

Moreover, its economy is now big enough to affect Europe’s performance as a whole. “If residential construction in Spain contracts in 2008 as sharply as it did in the US in 2007, it could shave 0.2 percentage points off eurozone economic growth,” Holger Schmieding of Bank of America wrote in the Financial Times last month.

During the peak of the construction frenzy two years ago, economists described the Spanish economy as a “monoculture” of bricks and mortar and worried that there was nothing to take its place if the building boom came to an end. Construction employed 13 per cent of the workforce. The banking system channelled 60 per cent of all credit to housing-related activities.

Spain was building more homes than France, Germany and the Benelux countries combined. It was consuming half of all the cement in the Europe and it was borrowing massively abroad. Economists agreed that Spain’s credit-fuelled property boom accounted for most of the country’s growth differential with the EU.

The credit squeeze hit Spain at its most vulnerable point in the economic cycle, with an overpriced and oversupplied housing market and families and companies deep in debt. As a result, the country is on the brink of a property slump that will affect employment, consumer confidence, bank earnings and the economy as a whole, according to a number of recently published reports.

IPE, a business school that specialises in urban planning and property, estimates that there will be 500,000 unsold new homes by the end of March – roughly the number built in an average year. Given government forecasts that 500,000 more were to be built this year, the unsold stock is worrying. About half the country’s estate agents are already out of business, according to their trade association.

One consequence of the building slowdown is that unemployment has shot above the 2m mark. January’s 6 per cent increase in the number of unemployed was the highest monthly rise in 10 years. Immigrants and temporary workers are feeling the brunt of the cuts. The end of the property boom is also worrying for Spanish commercial and savings banks, which have €290bn ($425bn, £217bn) in outstanding loans to property developers and are trying to cut their exposure to the sector.

Not everyone shares the gloom, however. Mr Zapatero is unabashedly confident about his country’s economic prospects, on which his re-election prospects also depend.

“I am an optimist,” he tells business. He expects the economy to grow by “at least” 3 per cent in 2008. Mr Zapatero’s Socialist party is promising to create 2m jobs over the next four years and to raise minimum pensions and wages. If the economy fails to grow at the predicted rate, Mr Zapatero thinks old-fashioned fiscal stimulation should do the trick. The government has a “comfortable” budget surplus of 2 per cent of GDP, he says, to get things moving.

Another reason for optimism is that Spain’s big companies have used the profit windfalls of the past several years to diversify out of Spain. Joaquín Ayuso, chief executive of Ferrovial, the company that in 2006 bought BAA, the British airports operator, says: “Back in 1992, construction – mainly public works – was 90 per cent of our business and it was all in Spain. Then there was a devaluation and a recession.

“We had four horrible years. I was the director for
construction then and I was convinced I would be fired. Those years taught us a lesson: that we couldn’t depend on just one country, one business and one client, the government.”

Today, 90 per cent of Ferrovial’s assets are in the UK, Canada and the US; they include toll roads, airports and baggage handling. Less than 15 per cent of Ferrovial’s income comes from construction.

Santander and BBVA, Spain’s two big banks, have expanded abroad so that a big part of their business is based in Latin America and the UK, where Santander owns Abbey National. Telefónica, the former telecommunications monopoly, has also become world-scale.

Diversification means that even if Spain starts to flag, some companies will be able to cushion the blow with income from other parts of the world. Tighter credit conditions, however, will make it much harder for them to continue an acquisition spree that has included investments of more than €60bn in the UK alone.

In this jittery environment, resilience is a big advantage. What frightens some is the hubris that appears to have taken hold of Mr Zapatero and some of the business establishment. Only the government predicts Spain will grow by as much as 3.1 per cent in 2008. The International Monetary Fund estimate is 2.7 per cent. The Organisation for Economic Co-operation and Development forecasts Spain will grow by 2.5 per cent.

“To draw up economic policy on the basis that we are going to grow by 3 per cent this year is unrealistic, even irresponsible. Not to recognise a problem is the first step to not solving it,” says Lorenzo Bernaldo de Quiróz, of Freemarket, an economic consultancy in Madrid.

Complacency is also frightening because Spain could easily slip into Italy’s “do nothing” malaise. For the moment, Europeans prefer to shop at Zara rather than Benetton. Iberia is a going concern whereas Alitalia is bust. Telefónica is a big shareholder in Telecom Italia rather than the other way around.

“Spain has undergone such a tremendous transformation in the past two decades. Now it has to take the next step,” says Stefan Bergheim, a senior economist at Deutsche Bank. An inflation differential with the EU needs to be tackled. Productivity, which is low, has to be addressed and Spain must move on from bricks and mortar to find a more sustainable route to prosperity.

Emerging Market Correction and Pressure on the Forint

Unfortunately Hungary's coming correction seems to be getting very near now. Portfolio Hungary reports this morning on the latest readings on the Calyon Risk Aversion Barometer. Caylon reported on Monday that global equity gyrations continue to dictate the direction of emerging market currencies, with risk aversion remaining high and European equities closing lower again on Monday. Indeed many currencies remained under pressure throughout the trading session yesterday. Budapest Economics also said yesterday that the HUF continued to be the most vulnerable currency in the region, with the currency temporarily hitting 259 against the euro yesterday, although it did finally manage to stabilize at slightly stronger levels by the end of the session.

Mitul Kotecha, head of global FX research at Calyon, confirmed the Budapest economics view, saying Hungary's forint appeared to be highly exposed to rising risk aversion. “Reflecting the vulnerability to risk aversion, correlations between the Calyon Risk Aversion Barometer and some emerging currencies are quite high at present," Kotecha is quoted as saying, adding that Hungary's forint “appears highly exposed to rising risk aversion, with the 1-month correlation between the Barometer and EUR/HUF at a strong 0.85." Of course, the HUF is also suffering from deteriorating domestic fundamentals, an aspect which of course he did not ignore.


Stefan Wagstyl, picks up the theme to some extent, and has another long and relevant piece in the Financial Times this morning, reflecting just how a change in tone is taking place even as I write.

The turmoil in financial markets is turning into a nerve-racking test for the economies of central and eastern Europe and the former Soviet Union. Economists have said the fast-growing region faces a slowdown following the financial shockwaves reverberating around the globe. But the precise impact is uncertain, especially on weaker economies.

The differences are registering in the financial markets. As investors reconsider their strategies, they are becoming more risk averse. Some have turned against emerging markets, including the ex-communistregion. Others are discriminating more between countries.

The spread on five-year credit default swaps (a measure of risk) has widened by 26 basis points for the Czech Republic since last June and by 44 basis points for Poland. But for Serbia and Ukraine the increase is 151 basis points; for Kazakhstan it is 218 basis points.

Given the recent unprecedented credit-fuelled growth surge, this slowdown could be welcome in countries trying to cope with inflationary pressures, including Ukraine, Kazakhstan and Russia, and those facing labour shortages, such as Poland.

The benefits could be even greater in economies facing yawning current account deficits, notably the Baltic states, Romania, Serbia and Bulgaria. As Leszek Balcerowicz, the former Polish central bank governor, told a business conference this month: "We should welcome some amount of a slowdown, especially in the Baltic states, which have been growing the fastest . . . We don't have the information that would make us predict a hard landing. Based on the current information a soft landing in the countries which have been growing fastest is more likely."

I am not as optimistic as Wagstyl is here that we will see soft landings. The existence of virtual currency pegs - which will need to be broken during the correction - virtually guarantees an abrupt change, as does the level of household debt in non local currency .

Wagstyl had an earlier FT piece where he drew attention to the way in which ageing populations and labour shortages were playing their part in this emerging crisis.

Fuelled by strong economic growth and soaring foreign investment, employment is increasing in availability just as emigration has sucked around 5m workers from eastern to western Europe. According to Eurostat, the EU’s statistics agency, labour costs are growing at their fastest rate since the end of Communism – with a 30 per cent increase in nominal costs in Latvia in the year to last September and rises of more than 20 per cent in Romania, Estonia and Lithuania. In Poland, the largest new member, the rise was just under 12 per cent.

In real terms, average gross wages in Poland rose more than 7 per cent in the first nine months of 2007 and in Romania by nearly 16 per cent, according to the Vienna-based Wiiw research institute.

While unemployment levels in western Europe have stayed at around 8 per cent since 2002, in the east they have slid from 14 per cent to under 9 per cent. In the region’s booming capital cities, almost everybody who wants work has a job. Leszek Wronski, head of the central Europe division of KPMG, the accountant and management consultant, says: “We have a job market controlled by employees.”


Even if labour markets ease a little, there will be no return to the super-abundance of workers of five years ago. The region’s populations are ageing even faster than in western Europe and, with the added effects of migration, the number of working-age people is falling in the Baltic states and central Europe. Eurostat predicts that the population of the new member states will decline from 103.6m in 2004 to under 100.6m in 2015, with particularly sharp drops in working-age people.

However, for governments and companies alike, rising labour costs and growing skills shortages raise big questions about the region’s future competitiveness. Everything from decisions on investment location to education, migration and population policies is coming under scrutiny.

So even while he doesn't directly go into how long term fertility may be playing a role in the drama we are watching unfold before our eyes, his mention of "population policy" seems to be a euphemism for this very topic. And if fertility isn't an important determinant in what has been happening, I would be grateful is someone could explain to me why we aren't seeing similar sorts of labour shortages in places like Thailand, Turkey, Chile, Brazil or Argentina, all of whom are growing - or have been, Turkey has slowed recently - very rapidly at the present time.

Back on the 28 August 2007 - just after the financial "turmoil" started - I posted the following, in a piece which still looks extremely good when looked at in the cold light of today, on Global Economy Matters:

"But any looming "credit crunch" is also likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to Eastern Europe I think and to economies like those in the Baltics, Latvia, Estonia and Lithuania), to Hungary, and then maybe (if there were to be contagion) to the larger economies like Poland and Romania. Alarm driven reports about the dangers of a hard landing in the Baltics have been floating around for some months now (I say alarm driven not because the danger isn't real, but because most of the reports are quite superficial, and don't really appreciate the magnitude of the problem). Whatsmore, as the Bank for International Settlements pointed out in the June edition of its quarterly review , in 2006 Eastern European economies accountedfor a staggering 60% of new emerging market credit:"

At the start of September, and as part of an in depth analysis of Turkey, I posted the extract you will find below. The issue here is foresight, and our ability to see things coming. What is happening now has been obvious for some time, completely obvious, even if many people have had difficulty in seeing it. I completely resist the idea that economics cannot be scientific. I think it has to become much more of a science. But if we are to get from here to there we first need some paradigmatic models which enable us to see things coming rather better than we appear able to do right now.

In a much quoted paper - published back in 2004 by two UCLA economists (Schneider and Tornell) - it was argued that:

"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."

In starting off with this quote I really want to draw attention to two things.

First off, the way in which the current sub-prime liquidity problem in the banking sector of many developed economies is now steadily extending itself into a credit crunch in several emerging market economies. We are now beginning to see a clear and all too familiar pattern. There has been a lot of talk about the Asian crisis, and evidently there are some similarities with the pre 1998 situation, especially, as I shall be arguing over the coming days, in the emerging economies of Eastern Europe.


Secondly there is the "typical crisis came as a surprise to financial markets" argument, since it puzzles me why exactly this should be, or better put, why it should be assumed as a "stylised fact" about currency crises that such major events are in principle not forseeable. I find this very hard to accept. Are we really so inept we are not able to see trouble coming when it finally does come? Is economic theory really so useless in the face of complex "on the ground" facts. Something inside me resists this view. We ought to be able to see things coming, even if we need to distinguish between the where and the when. What I mean is that it should be possible, if the theories you are working with are worth any sort of candle, to pinpoint the areas of likely vulnerability. On the other hand, given that often seemingly random events precipitate the ultimate unwind, it is pretty well impossible to say in advance which random event will turn out to be the detonator on any given occassion.

The sub prime debt issue in the US is a good case in point here, since only at the start of August the Federal Reserve were assuring everyone that problems associated with the US housing market were well under control, while obviously they weren't and aren't, and equally obviously, now, such problems will be seen from the vantage point of hindsight to have played a key role in the events which are now unfolding before our eyes.

So even with this caveat, and with due regard for the well known problem of human fallibility, lets see if this time any of us are able to do just that bit better than normal, and in attempting to see things coming lets see if we can learn something which may make us better able to handle and foresee macro economic problems in thefuture.

For a fuller analysis of the specifics of Hungary's present crisis see "Just Why Is Hungary So Different From The Rest of the EU10?", "Hungarian Central Bank Leaves Interest Rates Unchanged" and "The EU Comission Warns Hungary on 2008 Budget Deficit".

For e theoretical exposition on why fertility matters to the EU10, see Claus Vistesen "Catch Up Growth and Demographics - Evidence from Eastern Europe".