The Hungarian government is reportedly considering asking the European Central Bank (ECB) to allow the Hungarian National Bank (MNB) to operate with negative equity, after soaring interest rates look set to plunge the central bank into a record loss.

Prime Minister Viktor Orban's radical rightwing regime would like to avoid recapitalising the MNB as it is struggling to close a huge budget deficit. The government has already amended the rules for compensating losses of the central bank, allowing a five-year period to cover them.

Comments by Gergely Gulyas, head of the Prime Minister's Office, Finance Minister Mihaly Varga and MNB Deputy Governor Virag Barnabas indicate that the government and the central bank are looking for a legal solution that would allow the MNB to operate with permanently negative capital, leftist daily Nepszava commented.

Easing the rules would mean an amendment to the Central Bank Act, which would need to be approved by the European Central Bank. The fact that last year's interest rate hikes put several central banks in a similar position could support the MNB’s case.

The central bank is on track for a record HUF1.8-2 trillion (€4.9bn-5.4bn) loss this year because of the impact of rising interest rates on the cost of holding Hungarian bank assets. MNB's books are also burdened by trillions of subsidised corporate loans under the Funding for Growth Scheme (FGS), launched in 2013. The monetary stimulus switched to higher gear during the pandemic. The FGS programmes were phased out in September 2021, 14 months after the central bank began its tightening cycle from 0.6%. 

The base rate peaked at 13% in September 2022 but a month later the central bank introduced a new tool, the one-day quick deposit tenders offered at daily tenders at 18% after a rout of the forint.

The MNB began reducing its interest rates in May, reducing the O/N deposit rate to 17%, which was followed by a similar cut last week. At 16%, Hungary's reference rate remains the highest in the EU. 

The State Audit Office (ASZ) has warned that recapitalising the MNB will require HUF400bn (€1.1bn) in budget funding in the coming years and that the 2024 budget bill, set to be approved next week, makes no provisions for recapitalising the MNB. The first tranche would come to HUF430bn for 2024, equivalent to around 0.5% of GDP.

This would push the full-year budget even deeper into deficit. Orban’s pre-election spending splurge left it with a deficit of 6.2% of GDP last year and gross public debt of 76.1% of GDP – the worst in the region – as well as the highest inflation and interest rates in Europe. Analysts predict a deficit of 4% this year and 4.4% for 2024, well over the 3% allowed under the EU's Stability and Growth Pact. 

The country’s Fiscal Council warned last month that a further delay in EU funds, slower economic growth in Hungary's  main export markets or the prolongation of the Ukraine war could jeopardise the 2023 budget’s (very optimistic) revenue targets. The government remains committed to meeting the 3.9% deficit target in 2023.

The cash-flow-based general government deficit reached 81% of the full-year target at the end of May. Expenditures in real terms fell by 10% and revenues by 8%, both figures suggesting a sharp economic contraction. This is underscored by the moderate growth in VAT. Hungary has the highest value-added tax in the EU at 27% but due to a sharp fall in consumption, proceeds edged up only 2.5% in the first five months.

In Q1 the economy remained in recession for the third consecutive quarter, declining by 0.3% q/q. Analysts predict the economy will flatline this year.

The freeze of EU transfers has also put a strain on the budget as Hungary continues, albeit at a smaller pace, to finance EU-funded projects from the budget without being reimbursed.