Tim Gosling in Prague -

Hungarian Prime Minister Viktor Orban announced on March 12 that the government plans to launch a programme within the next three months that will allow small business to convert its foreign currency debt, in what is being regarded as yet another step to extend the government's heavily criticised unorthodox economic policy.

The high volume of forex debt is a brake on Budapest's ability to implement more unorthodox economic measures as it tries to boost the economy and push populist moves ahead of elections next year, because such policies would cause the forint to fall further and hurt these forex borrowers even more. By ridding households and businesses of this forex debt, perhaps with the aid of a pliant central bank, Budapest believes it would free itself of the last remaining shackle on its unorthodox economic policy.

"The issue of foreign currency loans is fundamentally a question of sovereignty," Orban told a conference in Budapest, according to portfolio.hu. "Never mind that we have our own currency... we cannot use it for our benefit because we are in a foreign currency debt trap. That is why we need to rescue families from the forex debt trap and that is why our endeavour with respect to government debt is clear-cut, ie. to lower the ratio of foreign currency debt."

Hungary is in talks with the commercial banks over reducing household forex debt, which grew in the pre-crisis years as local currency appreciation helped popularize forex mortgages. While the banks were hit by a temporary programme in 2011 that saw them forced to allow early mortgage repayment at rates below the market, this time around there is speculation that the central bank could use its reserves to convert the debts.

At the same time, there's no certainty that the banks won't also be pushed into helping. "We cannot deal with consumer loans right now," the PM noted. However, a scheme for commercial forex loans is imminent, he added, despite admitting that the government is not in a fiscal position to implement it.

Indeed, the cost of such a scheme would be huge. Analysts at RBS write that their "preliminary estimates suggest that upon conversion into forint loans, Hungarian households may require up to 55% forgiveness of principal on [Swiss franc] mortgages and up to 45% forgiveness of principal on euro mortgages to render monthly forint installments serviceable at current mortgage rates."

Therefore, the government will first kick off efforts to deal with the issue in commercial loans, the PM said. "We need to deal with the foreign currency loans of small businesses. So far we were unable to do anything in this regard by the use of fiscal means, but the truth is there were no more funds in the budget. But we will need to find, already in this half of the year, such financial programmes that will facilitate small and medium-sized enterprises to convert their existing foreign currency debt into forint debt," Orban was quoted as saying.

The brokerage Equilor points out that although the forex debt of small and medium-sized enterprises (SME) is far less than that of households, about HUF1.1 trillion [€3.5bn], it still represents a significant risk to the banks. "Converting this amount would not dramatically decrease [Hungary's forex] reserves, but it could damage market confidence," it says. "Furthermore, there is 300-400 [basis points in] difference between the forex and forint interest rates for SMEs, thus such a plan would only work if some 30% of the loans is written down. In the current budget situation, we see that this estimated HUF330bn (€1.1bn) may be levied on banks."

Stressing that new Economy Minister Mihaly Varga is now working on the problem, Orban said that the SME programme will be up and running by July. That urgency reflects the difficulties that the forex debt position poses for the government's plans for the economy.

All in the timing

The National Bank of Hungary is ready to continue its easing cycle, and has hinted that unorthodox monetary policy is on the cards now that former economy minister Gyorgy Matolcsy is in the governor's chair. However, that, on top of the risk of further policy shocks out of Budapest, has already hit the forint hard.

March 11 and 12 saw another large sell-off in the currency as the government shrugged off criticism from Brussels and Washington over constitutional changes that sees the ruling Fidesz party take an even stronger grip on power. However, while those centres of power have proved unable to restrain Orban's hand, the forex debt issue is a powerful master. Until it is dealt with, Budapest will be constrained in its policy making.

Analysts at RBS predict that Matolcsy's first monetary council meeting later this month could even see a rate cut of as much as 100 basis points to 4.25%. "We believe that the Hungarian administration would like to see interest rates in the 3% - 3.5% range," they write, "facilitated partly by the [central bank's] downward forecast path of inflation. However, bringing rates all the way down to 3% may be problematic, and largely depends on the success of the government's upcoming schemes to assist households and SMEs in converting their FX loans into forints. If the administration is successful in substantially reducing households' and SMEs' FX exposures, then it may attempt to employ currency weakness as a strategy to boost export growth."

Hence, Budapest is seeking a plan to try to throw off those shackles, without alarming the market too greatly. It's all in the timing. While the government mulls its next move to tap international debt markets in order to boost the government's forex reserves, the country's banks may well be able to hold off the risk of being pulled into the effort to convert the debt of the country's households and small businesses. However, should the government secure the funding it needs, at that point there will be little to constrain it.

Having held off the markets for the best part of 18 months, Hungary is apparently happy to risk sailing closer and closer to the wind, point out analysts, but they note the delicacy of the balancing act. "[T]he extent to which Hungarian policymakers seem to be completely ignoring the risks is a significant concern," writes Danske Bank.

"If the Hungarian government and the new central bank leadership continue to pursue such a highly unorthodox policy, there is a serious risk of a major market meltdown," they caution. "We find it difficult to see how the Hungarian government will fund itself on the international capital markets if the government and central bank do not move very soon to calm market fears. Unfortunately we do not hold out much hope of this happening and the risk therefore continues to be skewed towards an even bigger forint sell-off."