Hungary drops currency band; Baltics unlikely to follow

By bne IntelliNews February 26, 2008

Mike Collier in Riga -

Hungary may have removed the band within which its currency, the forint, is allowed to trade against the euro, but investors shouldn't expect the three Baltic economies to follow suit any time soon.

On Monday, February 25, the National Bank of Hungary decided to remove the shackles keeping the currency trapped between 240 and 325 forints to the euro, leaving it free to find its own level. The forint looks set to appreciate in value quickly; indeed, even before the peg had been lifted, and within hours of the announcement, the currency had gained more than 2% against the euro.

The move leaves the Baltic states as the largest bloc in a dwindling band of currency peg loyalists. Poland, the Czech Republic and Slovakia, which joined the EU at the same time as Hungary in May 2004, all opted to have freely trading currencies from the beginning and Slovenia has already adopted the euro in place of the tolar.

"The primary objective of the Magyar Nemzeti Bank is to deliver and maintain price stability in the long run. Under an inflation targeting regime, the central bank reacts to inflationary pressures that may arise from a wide range of developments in the economy and financial markets. Limiting exchange rate fluctuations in an inflation targeting regime does not contribute to firmly anchoring long-term inflation expectations," a release from the Hungarian National Bank said on February 25.

"The abandonment of the peg constitutes a step toward the adoption of the euro in Hungary. A floating exchange rate regime provides the central bank with better conditions to achieve its inflation target and, through this, to meet the nominal convergence criteria," it continued.

Other candidates

At first glance, it would seem that dropping the euro peg might be an option in the Baltic region as well. After all, it too is plagued by high inflation and there is unanimity about the need to replace the kroon, lats and lita at the earliest opportunity and adopt the euro.

However, a similar move by central bankers in Estonia, Latvia and Lithuania would likely prove disastrous, reckons Neil Shearing, Emerging Europe Economist with Capital Economics in London. The difference is that while the forint appears to have been pegged too low against the euro, the Baltic currencies have been pegged too high.

"I don't think this is likely to prompt a similar move in the Baltics," Shearing says. "Today's decision was aimed at boosting the credibility of Hungary's inflation targeting regime, which should boost the forint and help the National Bank in its fight against stubbornly high inflation. If the Baltic states were to relax their currency regimes, the currencies would almost certainly fall given the extent of the external imbalances that exist in the region. This could be messy and given the large share of foreign currency denominated debt could tip the region into recession."

Such a fall (or "correction" to unpegging enthusiasts) could easily turn into full-scale currency devaluation, a scenario recently described as "poison" by Bank of Latvia Governor Ilmars Rimsevics. A man with an almost pathological hatred of devaluation talk, as recently as February 16 he stated: "During my tenure as the chief officer of the Bank of Latvia, it will not happen."

Nor does Shearing think it likely that the European Central Bank was involved in the Hungarian move. "The ECB doesn't tend to comment on the exchange rate regimes followed by other countries and there is no suggestion that it has lent on Hungary behind the scenes. I think this was a move driven purely by domestic considerations," he says.

With the currency set to rise further, Capital Economics expects Hungary's policymakers to turn their attention towards cutting interest rates during the second half of 2008 and expects to see 100 basis points of cuts to 6.5% by the end of the year.

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