COMMENT: Hungary’s resilience has its limits

By bne IntelliNews September 26, 2014

Dr Nicholas Spiro of Spiro Sovereign Strategy -


For those like myself who lived in Hungary during the 2008 global financial crisis, the improvement in investor sentiment towards the country over the past several years – and particularly in the last two – has been remarkable.

At the end of 2007, Hungary’s fiscal deficit was over 5% of GDP, its current account deficit was over 7% of output, inflation was at 7.5% and interest rates stood at 7.5%. When Lehman Brothers went under in September 2008, Hungary had to call in the International Monetary Fund (IMF) to help stabilise its financial markets and shore up its vulnerable banking sector. Since then, Hungary’s resilience to external shocks has improved markedly.

Even at the height of the Eurozone crisis in November 2011, the yield on Hungary’s 10-year local currency bonds remained under 10% – having surged to 12.2% in March 2009.

In the biggest test of market sentiment towards Hungary, the fallout from the unexpected announcement by the US Federal Reserve in May 2013 that it planned to wind down its programme of quantitative easing (QE) – a crucial pillar of support for emerging market (EM) assets – proved relatively benign.

While Hungarian 10-year yields shot up to 6.7% in August 2013, they were back down to 5.5% as early as October and now stand at just 4.7% – 100 basis points below the level at which they stood before the Fed let the “tapering” genie out of the bottle.

From a strictly debt market perspective, Hungary is proving extremely resilient to the toxic combination of US interest rate risk and geopolitical tensions over Ukraine.

Good news, bad news

Part of this is attributable to the dramatic improvement in Hungary’s balance of payments position over the past five years. The current account balance has been in surplus since 2010 and currently stands at over 3% of GDP.

The economy, moreover, is on a firmer footing. Export growth remains buoyant and, crucially, domestic demand is beginning to recover, with the European Bank for Reconstruction and Development (EBRD) – the most bearish among the multinational forecasters – revising its 2014 GDP estimate for Hungary upwards by as much as 1.2 percentage points to 2.8% (the biggest upward revision in the Emerging Europe region and roughly on a par with Poland’s projected growth rate for 2014).

Indeed Hungarian interest rates have fallen below Poland’s and, given the severe disinflationary conditions, are unlikely to rise anytime soon barring a sharp and sustained depreciation in the forint.

This is the good news.

The bad news is that beneath the favourable sentiment towards Hungarian sovereign debt lie some troubling developments that suggest Hungary’s resilience is waning at an inopportune time for emerging markets  – particularly those in the more vulnerable Emerging Europe region.

Firstly, while Hungary’s local currency bond market remains resilient, the equity market has taken a beating of late, with stocks down 16% this year (and 9% over the past three months), mainly as a result of east-west tensions over Ukraine but also due to a number of idiosyncratic risks.

These risks – which have also contributed to a 5% decline in the forint against the euro this year and a 13% fall against the resurgent dollar – centre around the credibility of Hungary’s policy regime and the corrosive effect which the Orban government’s nationalistic policies (particularly towards the country’s ailing banking sector) are having on foreign perceptions of Hungary.

Hungary’s central bank (MNB) has been throwing caution to the wind by cutting interest rates to excessively low levels and, what’s more, signalling its intention to keep them at this level for as long as possible. With inflation barely above zero and still a lot of slack in the economy, the MNB was right to prolong its rate-cutting cycle. But with comparable inflation and growth rates as in Poland, Hungary’s borrowing costs should not be below its much more creditworthy Central European peer.

Another area where Hungary is pushing the envelope is in the residential mortgage market. The government’s highly controversial plans to phase out foreign currency-denominated mortgage contracts by forcibly converting the loans into forint-denominated contracts are putting further financial strain on an already overtaxed and overregulated foreign-owned banking sector. The mortgage debt relief scheme, which could cost Hungary’s banking sector as much as $4bn according to the government, is almost certainly the straw that broke the camel’s back as far as Western parent firms are concerned.

All this would not be as significant in a benign US interest rate environment in which sentiment towards EMs was likely to remain favourable for a considerable period of time. Yet this is patently not the case.

Hostage to fortune

Hungary’s government is tempting fate by waging war on its foreign-owned banking sector while its central bank is not preparing itself sufficiently for an abrupt and sustained deterioration in market conditions – a prospect which has become more likely after last week’s more hawkish statement from the Fed.

It was already clear in January – when the forint slid sharply against the euro as part of a broad-based sell-off in emerging markets – that Hungary couldn't hide behind its current account surplus, not least given the country’s dangerously large stocks of public and private debt.

The very high foreign holdings of Hungarian domestic bonds – the second-highest in Emerging Europe after Poland and one of the highest in emerging markets along with Malaysia and Indonesia – render the country particularly vulnerable to a sharp deterioration in sentiment.

Hungary’s resilience has its limits.

Nicholas Spiro is Managing Director of London-based Spiro Sovereign Strategy Ltd and a board member of Warsaw-based Lauressa Investments. Dr Spiro advises private and institutional clients on the idiosyncrasies of developed and emerging government debt markets and is an expert in central and east European affairs.  Dr Spiro will be speaking at the Budapest Economic Forum on October 2.


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