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.

References:


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
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

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.

Colonialism Goes Into Reverse Gear As The Libyan Government Bails Out Unicredit

Taking my cue from the worthy and well thumbed play-book of the Brothers Coen, I thought every now and again I might follow up all those, long, desperately serious, and highly indigestible posts about how Italy should now be considered to be "No Country For Old Men", with something in rather lighter vein.

The highly acclaimed and award winning Miss Iceland Look-alike show is not the only prime time TV talent contest we are going to see over the coming weeks and months it seems. We are also apparently on the verge of watching a beefed up and much more macho version, whose pilot screenings have now been launched under the working "Man-City/Emirates Stadium" look-alike title, since news today informs us that the Libyan government is at this very moment in the process of bailing out Italy's much troubled banking system (following in the well trodden footsteps of AC Milan, who were, it seems, able to partially finance the acquisition of the the world's former number one footballer - Ronaldinho Gaucho - thanks to a fundraising trip to the Arab Emirates).

UniCredit SpA surged after Libyan investors including its central bank boosted their stake in Italy's biggest bank and said they will invest more. The shares gained as much as 12 percent to 2.42 euros in Milan, valuing the bank at 32.2 billion euros ($42.4 billion). Libya's investment is ``good,'' UniCredit Chief Executive Officer Alessandro Profumo told reporters in Milan. ``It's a confirmation of their interest in our company, which they also consider to be very attractive.''

The investment may be worth much as 1.3 billion euros, according to a note by Centrosim analyst Marco Sallustio published this morning. It could allow Libya to obtain a seat on the bank's board. Central Bank of Libya, Libyan Investment Authority and Libyan Foreign Bank bought shares to boost their holding to 4.2 percent, the investors said in a statement late yesterday. They intend to buy as much as 500 million euros of securities that UniCredit plans to sell over coming months.

But then, where do you imagine that the greatest risk to the viability of Italy's Unicredit lies? And what do think is the the principal reason why both Italy and its banking system need this sudden Libyan support? Well you might try looking "over there", you know, where they are holding the Miss Iceland look-alike contest.

Here, courtesy of Reuters, are some basic facts about Unicredit:

- - UniCredit is one of Europe's top 10 banks by market value, with a capitalisation of about $39 billion. It is second to Intesa Sanpaolo SpA among Italian banks.

-- In a U-turn on Oct. 5 it announced plans to boost capital by 6.6 billion euros. It will ask investors for 3 billion euros in a capital increase and offer shares rather than a cash payout on 2008 results, putting 3.6 billion euros instead in its own coffers.

-- UniCredit on the same day boosted its target for Core Tier I to 6.7 percent at the end of 2008 based on Basel II requirements from its previous aim of 6.2 percent. The figure was 5.7 percent at the end of June.

-- It also slashed earnings per share forecasts for this year to 39 euro cents from around 52 euro cents previously.

-- It is the Italian bank with the most foreign exposure. UniCredit gets about half its revenue from outside Italy and its conservative lending market.

-- UniCredit, whose units include Germany's HVB, is among market leaders in Germany and Austria.

-- UniCredit's share price has dropped about 62 percent since the start of the year, pushing it second to Intesa Sanpaolo among Italian banks. The DJ Stoxx European banks index has lost about 52 percent.

-- First-half net profit was 2.9 billion euros on operating income of 14 billion euros. Deposits from customers and debt securities totalled 639.8 billion euros.

-- The bank traces its origins back to 15th century Bologna. The current UniCredit resulted from the merger of nine of Italy's biggest banks in 1998, as well as the purchase of HVB in 2005 and Italy's Capitalia last year.

-- The biggest shareholder is the Fondazione Cassa di Risparmio di Verona Vicenza Belluno e Ancona, at 5 percent.

-- Libya now comes second with its combined 4.23 percent, followed by:

Fondazione Cassa di Risparmio di Torino with 3.83 percent

Carimonte Holding with 3.35 percent

Gruppo Allianz with 2.37 percent

Fondi Barclays Global Investors UK Holdings Ltd with 2.01 percent.

-- UniCredit is the biggest shareholder in powerful investment bank Mediobanca SpA with an 8.7 percent stake.

Evidently, in this type of business, what you pay for is what you get:

Italian Prime Minister Silvio Berlusconi pledged $5 billion over 25 years to Libyan leader Muammar Qaddafi in compensation for the occupation of the country in the 30 years before World War II.

Italy will pay $200 million per year to Libya in the form of investments in infrastructure. The money will finance the construction of a coastline highway that runs about 1,600 kilometers (994 miles) between the Egyptian and Tunisian borders.

``It's a full moral recognition of the damage done to Libya during Italy's colonial period,'' Berlusconi said after arriving at the airport in the Libyan city of Benghazi, where the two leaders met to sign the accord. ``This will end 40 years of misunderstandings.''

And why, we might ask ourselves, does the Italian government find itself in need of such recourse to what we might now term "the Libyan Connection" in order to recapitalise its banks. Well, Global Insight in a very informative recent survey of the recently adopted EU government commitments to the banking sector perhaps offer us one part of the explanation: quite simply, after years of letting the public finances drift, Italy simply doesn't have any borrowing capacity left with which to raise the necessary money itself, since with debt at around 104% of GDP, people - apart from those ever so kind Libyans that is - have become increasingly reluctant to lend it to them.

In a deviation from the measures seen in France and Germany, Italy has not created a fund for its rescue plan, with Finance Minister Giulio Tremonti stating that, "As of today, we estimate that it's not necessary to have a predetermined figure."......Italy is in stark contrast to other European nations by providing no firm capital commitments; however, the government's reluctance to create a rescue fund could partly be a reflection of the restraints imposed by its substantial public debt, which stood at 104% of GDP in 2007.

So, as I said, with people becoming increasingly apprehensive about buying Italian government paper, then having rich and obliging friends like the Libyan government is going to be a real boon. Oh yes, but of course when I said "people" in the last sentence, I wasn't, of course, including, at least for the moment, that other untiring friend and trusted workhorse the Italian government can still count on for support over at the ECB in Frankfurt.

The Bank of Italy will also engage in a 40-billion-euro debt swap, taking on inferior bank debt for government bonds that can then be used to obtain financing from the ECB.

So don't let yourself get behind the curve, and don't miss out on the very latest talent-stalking trend towards ever more exotic varieties of global look-alike contests. Now which country was it where the banks were being busily underwritten by the Shanghai Pudong Development Bank, just let me go and check my records......?

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?

The Baltic States May Soon Follow Hungary Into IMF Receivership

Well, the Icelandic authorities seem to have bitten the bullet, and after some coming and going agreed to accept assistance from the IMF. An IMF mission is on the island preparing a plan which will then be put to the Icelandic government (protocols here are important). Under negotiation are the terms of any possible loan. According to Einar Karl Haraldsson (a political adviser to the Icelandic government) the plan is expected to be finalized in the next few days, after which the government will have to decide whether to accept the aid and the terms under which it is being offered.

Meantime a growing number of countries now seem to be at risk of following Iceland and Hungary into the arms of the IMF, with the Baltic republics of Estonia, Latvia and Lithuania now looking particularly vulnerable, according to a warning from the International Monetary Fund itself yesterday.

Dominique Strauss-Kahn, managing director of the IMF, which was formally approached yesterday for assistance by Hungary as well as Iceland, said: "The fallout for most banking systems in emerging and developing economies has been limited so far but signs of stress are growing, " Strauss-Kahn said some banks in eastern Europe have become increasingly exposed to struggling property markets, having raised funds on international money markets in the same way as the ill-fated Icelandic banks.

For the time being the various national governments are denying the possibility, with Edgars Vaikulis, spokesman for Prime Minister Ivars Godmanis, being quoted in Bloomberg as saying "There is no reason to speak of threats to the Latvian financial system......Latvia's situation is different from some of the eurozone members.''

I'm sure that the latter statement is true, even if not in the sense that Vaikulis meant. Nonetheless the Latvian government has taken the step of raising guarantees on all bank deposits to 50,000 euros ($68,225), in line with an earlier decision by European Union finance ministers.

In my view the threat to the Baltic financial systems is real, as is the threat to the Bulgarian and Romanian ones. Action, of some form or another needs to be taken, and soon. Latvia and Estonia are now in deep recessions, and Lithuania, while still clinging on to growth, can't be far behind. Basically it is hard to see any revival in domestic demand in the immediate future, which means these countries now need to live from exports. But with the very high inflation they have had it is hard to see how they can restore competitiveness while retaining their currency pegs to the euro. The IMF will almost certainly insist on a currency float as a condition of rescue, and if you look at the speeches of Lorenzo Bini Smaghi and Jürgen Stark over the last year, it is clear that thinking at the ECB runs along pretty much the same lines. So better get it over and done with now I would say, and take advantage of the shelter offered in the arms of the IMF. Indeed the more I look at what is happening, the more it would appear that a division of labour was agreed to in Paris last weekend, with the EU institutional structure sorting out the mess in Ireland and the South of Europe, and the IMF taking care of all that broken crockery out there in the EU10.

In what is likely to become a sign of the times Hungary's MKB Bank announced that yesterday that it is going to stop providing euro- and Swiss franc-denominated loans until further notice. In defence of its decision MKB said the huge volatility registered in the value of forint in recent weeks, and especially the strong depreciation at the end of last week, make the outlook on the currency extermely uncertain. Most other Hungarian banks are expected to follow MKB's lead. This practice of bringing an end to the extremely dangerous practice of offering foreign exchange denominated loans in countries running large external deficits is now likely to come to a screeching halt all across the CEE and CIS economies, and bit by bit the IMF will have to be brought in to offer support during the transition back to reality.

For a full and thorough analysis of the current threat to the Baltic economies, see this whopping post this morning from Claus Vistesen.