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Monday, December 10, 2007

Just Why Is Hungary So Different From The Rest of the EU10?

By Edward Hugh: Barcelona

According to the Hungarian Statistics Office (KSH) gross domestic product grew in Hungary by just 0.3% on a quarter by quarter basis from to July-September 2007. The KSH also took the opportunity to reduce their growth figure for the second quarter to zero, which was down from the previous 0.1% estimate.

On a year on year basis, economic growth in Q3 was just 0.9% according to unadjusted data or 1.0% if you prefer your figures to be adjusted for seasonal and calendar effects. In either case this is a very low reading end especially when you bear in mind the very rapid growth we are seeing in many other EU10 countries, and all the indications are that this figure is likely to drop further. Which raises three questions directly in our minds: a) why is Hungary so different from the rest of Eastern and Central Europe, b) where is Hungary headed, and c) what can we learn from Hungary about the future path of those EU10 economies who are now visibly overheating, after they have passed through their inevitable "correction" that is.

Looking at the evolution of Hungary's GDP on a year on year basis, the slowdown is evident. The first thing that strikes you when you look at the chart below is that annual growth rates seem to have peaked in 2004 (that is before the correction and fiscal adjustment of 2006), growth slowed entering 2005, and it was at this point that the expansion in the fiscal deficit became important, but it was a fiscal expansion to try to arrest a general downward tendency in the rate of output expansion(very reminiscent in its way of things we have seen in Japan and Italy if we work our way back through the data). And on a year on year basis Q3 2007 represents yet another step backwards, since the comparative figure for Q2 was 1.2%. And this process seems set to continue, and I would go so far as to say that no-one at this point has any idea where the bottom is on this one.

The engine behind what little growth Hungary is now getting continues to be industrial output which registered a 7.4% yr/yr growth in Q3, and this output was pulled along to a considerable extent by the 14.6% export growth which was registered.

The main drag on growth was, unsurprisingly, final household consumption, which declined by 2.0% yr/yr. Previously, the slowest pace of growth in recent memory was back in 1996 when the fiscal adjustment package of Economy Minister Lajos Bokros pushed growth to below 1% y-o-y.

If we now come to look at the evolution of GDP shares for some of the components, we will see, for example, that both agriculture and construction have been more or less stable in recent years (ie we have not had any sort of dramatic construction lead boom in recent years. On the other hand, if we look at manufacturing and real estate and financial services, we will see that the latter have clearly grown in importance in relation to the former, which is in many ways a pretty normal development.

On a quarterly basis, the largest growth was observed in industry (3.1%), followed by services (1.3%) and transport, storage and communications (0.9%). Consumption expenditure of households fell by 0.8% yr/yr and 0.2% q/q, while public consumption fell by 3.8% yr/yr and 3.2% on a quarterly basis.

Exports rose by 4% q/q (vs. 2.0% in Q2) and imports increased by 5.9% from the previous quarter, against a q/q decline of 0.3% in Q2. What this means is that while Hungary has now managed to achieve a small goods trade surplus:

The rise in imports pegs pretty closely on to the the coat-tails of the rise in exports, something for which the very strong value of the forint must undoubtedly bear some responsibility, since as the euro rises, and the forint clings on to par with the euro, the general tendency of opening the doors to products from China and other low-cost manufacturers (as well of course Japan, and a now much cheaper and more competitive United States) must have a reflection of the Hungarian import situation.

So it is really rather cold comfort that the 0.3% q/q growth obtained in Q3 is the largest so far this year, firstly because, as Portfolio Hungary indicate, it is disappointingly small and secondly, because it would really be very premature to start speaking of any kind of upswing even in the short term.

Hungarian central bank (NBH) Deputy Governor Ferenc Karvalits is quoted this morning as saying he believes the central question is not whether the growth rate of the Hungarian economy will start to increase but to what extent and up to which point. I think he is basically right, but he forgets one additional issue, when it will stop falling, and how much farther it still has to fall? Certainly if we look at the path of domestic retail sales, there is no sign at all that we are done yet.

And to this slowdown in private consumption we need to add future purchasing power, since real wages are also falling in Hungary. If we look at the chart below, the sharp improvement in the negative real wage tendency which we can observe in September 2007 is due to the base effect of the austerity package tax and social security measures introduced in September 2006 having moved out of the calculations (since these meant that between September 2006 and August 2007 net wages rose much more slowly than gross wages) and hence the change does not reflect any sudden spike in actual wages paid, and of course, inflation continues to be strong.

And when we come to think about public consumption it is important to bear in mind that the Hungarian government - according to its own latest Dec 1st estimates - is still running a fiscal deficit this year of 6.2% of GDP. The government are committed to reducing the deficit further next year, so this has naturally to be subtracted from GDP: that is we are going to face more fiscal tightening. In fact, what is incredible is that Hungary is currently only able to get 1% y-o-y GDP growth despite this whopping fiscal stimulus. Which is why a close examination is needed of just how Hungary got into this mess in the first place, and in that context why it is that Hungary is so apparently different from the rest of the EU10.

Obviously the presence of fiscal deficits has been one issue.

But again, and in the end, what is so striking is just how little "bang for the buck" (or forint) Hungary has been getting for all this fiscal stimulus. As I pointed out above, a lot of the sparkle had already been going out of Hungary's GDP growth some time before the fiscal correction came into force.

In addition monetary policy is likely to remain restrictive. The current Central Bank base rate of 7.5% is the highest in the European Union, and there is little room for any substantial reduction given the rate of domestic inflation - the government has just agreed to raise public sector wages by an average 5% in 2008, so it is hard to see inflation being anywhere near the "comfort zone" yet awhile.

Ideally, even considering the current inflation, given the state of domestic demand, you might have though that some element of monetary loosening would be desirable, especially since this would probably serve to weaken the currency, and this would help exports and in so doing increase that at present very minimal trade surplus. But it is just here that we hit one of Hungary's biggest headaches moving forward, the Swiss Franc Mortgages.

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 purposes 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.

First off, here's a chart showing the evolution of outstanding mortgages with terms over 5 years since the start of 2003. As we can see the outstanding 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.

The Magyar Memzeti Bank (the Hungarian central bank) recently published the October edition of its bulletin on Household and non-financial corporate sector interest rates, interbank lending rates (careful PDF). This bulletin contains a lengthy summary of the state of play with non-forint denominated loans to individuals, and in particular a section on Swiss Franc loans in Hungary.

According to the Bank, following a moderation in the demand from Hungarian households for Swiss franc-denominated consumer loans, a sharp turnaround in demand occurred in October. The monthly volume of new mortgage loans for consumption purposes (ie not for buying homes, refis) leaped by 30% to reach an all-time high. It is also a noteworthy that even before the start of the real Christmas season the volume of new CHF-denominated consumer credit jumped by 25% from September, setting yet another historic high.

The amount of new mortgage loans rose to the previously unseen level of HUF 130 bn in October, and this increase is almost exclusively attributable to the increase in CHF-denominated loans (HUF 120 bn). Detailed data from the bank show that while the monthly amount of new CHF-denominated housing loans rose to the exceptional level of HUF 55-60 bn, mortgage loans for consumption purposes (ie "refis" or liquidity extraction, not to buy houses) became pretty fashionable, rising by 30% month on month to reach the level of HUF 62.5 bn.

Within these new mortgage loans, the ratio of foreign currency to total loans increased to 92.5%, setting yet another record. What all this suggests to me is that a lot of Hungarians are trying to maintain current consumption by borrowing forward in the hope and expectation of rising property values in the future. If this rise does not materialize, then the very least that can be said is that all of this will need, at some point, to be clawed back from current consumption. This whole process also represents a new form of moral hazard for the central bankers, since such borrowing in Swiss Francs is based on the assumption that with so many people doing this the Hungarian authorities will never dare to let the forint slide (you know, there's safety in numbers) or, pushing the buck back one stage further, the EU Commission and the ECB won't let it happen.

But this is very dangerous thinking, since in the first place there are a lot of people now out there riding around on the back of the same idea (think Italian government debt, for eg), and people may be seriously overestimating the ability of the political and monetary authorities to contain such a large and complex set of problems. It should not go un-noted that the whole weight of the ECB is currently not able to stop the spread of the growing credit crunch across the entire eurozone and beyond. Secondly, and just as importantly, all of this puts the Hungarian central bank in a real double-bind, since they cannot ease monetary policy at this point without precipitating a tremendous weakening in the forint, so interest rates stay high, and Hungarian domestic demand gradually gets strangled, while all the inflation puts a strong brake on export growth.

The translation problem that all these foreign currency loans may represent for Hungary, and some of the other EU10 economies where this kind of borrowing has become popular, are a matter which has been addressed by Claus Vistesen in this post. But what exactly is translation risk? Well let's take a standard type definition, such as this one from investopedia.com. Translation risk is "The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk".

Now as Claus points out much of the literature here refers to companies, and most of the words spent on the subject have been devoted to the description of companies' exchange rate risk when operating in foreign countries under insecure exchange rate systems and obviously subsequently how this risk can be hedged through the use of derivatives, or simply by adequately calibrating the denomination of the stock of liquid assets held on the balance sheets. But the issue in Eastern Europe is that the majority of this credit has been extended to households through loans intermediated by foreign financial institutions and thus it is unhedged, and even more to the point this borrowing is being facilitated either by bank flows or inward FDI which is what enables the current account at the end of the day to balance. The big problem will come if ever the direction of these capital flows reverses, and this is precisely why the Hungarian central bank is constrained in the way it can loosen monetary policy, since it simply cannot afford to either risk a reversal in the flow of funds, or a sharp rise in the cost of private debt servicing should the forint weaken significantly in value.

Those analysts who focus only on the secondary issue of steering inflation expectations are missing the bigger part of the problem here. As we are now seeing in the United States, and as we may well be about to see in an ECB context (indeed arguably we have already seen, since the inflation data treated alone may well have warrented an ECB raise this month) if expectations are your only problem, then the central bank can afford to be more flexible than many imagine.

It's the Demography?

So to return to where we started, just what is it that makes Hungary so different. The simple answer is that I don't know, but I know that it is, and that we need to keep digging. The philosopher Francis Bacon held that the important thing about doing science was to know how to put the right questions to nature, and the answers we get to some extent depend on the questions we ask. My intuitions tell me that Hungary's very special demography has something to do with it all, but others do not agree, and do not ask this type of question. But if we come to look at the demography, there are some things which we can hardly fail to notice. In the first place Hungary's population has been falling, and for many years now, in fact it peaked around the start of the 1980s.

Now something has to be said here. Noone knows what the long term consequences of having a declining (and ageing) population like this is going to be. We don't know, because quite simply we have never been here before. In previous periods, after a war or a plague, when population had fallen the Malthusian homeostatic mechanism of increasing wages lead to increased fertility, and this in and of itself corrected the problem. Indeed in some parts of Eastern Europe (though not Hungary) we are seeing a demographically driven form of wage inflation, but this is not leading to a homeostatically corrective rise in fertility because, quite simply, the old correlation between increasing wealth and increasing fertility has now been broken. More money today does not mean more children, indeed under certain circumstances it may mean less. So basically we don't know where we are going here, and my advice is don't let anyone convince you otherwise.

Having said all this, intuitively less people ought to constitute less domestic demand pressure, but this issue is undoubtedly more complex than this.

Turning now to fertility, it is worth noting that, apart from a brief episode in the late 1970s, Hungary has in fact been struggling with below replacement fertility since the early 1960s. The only real "novelty" about the 1990s is that Hungary transited from below replacement fertility, to lowest-low fertility (1.2/1.3 Tfr region).

Returning then, and in a demographic context to Deputy Central Bank Governor Ferenc Karvalits' question about how far and to what extent Hungarian growth will recover, as we have noted, domestic demand has been in virtual free-fall in recent quarters. What is not clear is when (ot whether) this component will ever recover to the extent of being able to drive growth, since now start to get into age-related elements (which I know not many people agree with me about at this stage, but still).

As a result of ongoing low fertility, and rising life expectancy, Hungary's median age is, of course, climbing steadily, and calibrating the macroeconomics of this ageing process in the context of Eastern Europe's comparatively low male life expectancy (ie calibrating how domestic consumption loses its relative strength as median age rises, in the way we have seen in Germany, Japan and Italy) is something noone has done at this point to my knowledge. In fact most people you talk to don't imagine that this is important, but then most of them didn't imagine that Hungary would fall into the hole it is currently falling into. As we can see below, Latvia and Hungary, despite having started the 1990s at not such a great distance from Germany, now have considerably lower median ages (please click on image for better viewing).

But this lower population median age is hardly a positive outcome, since it is not due to higher fertility or strong inward migration. Rather it is due to their much lower male life expectancy.

As we can see, male life expectancy is considerably lower in both Hungary and Latvia, than it is in Germany, and this must have consequences for economic behaviour and performance. Increasing the working life to 67 and beyond as they have in Germany is just not the same proposition at all in a lower life expectancy society like the other two, nor is the issue of getting employment participation rates among the over 60s comparable given the evident health problems of one part of the population.

So while we would not normally expect domestic consumption to run out of steam until the median age reaches 41/42 (this is the sort of lesson we can garner from Germany, Italy and Japan) there may be good reasons for imagining that this median age needs rounding down somewhat in the Latvian and Hungarian contexts. I will certainly stick my head out and say that the property boom which is now in the process of petering itself out in Latvia, like the 1992 one in Japan, and the 1995 one in Germany, is very likely to be the last of its kind we will see there, high median age societies just don't work like this. They do not ride on the backs of credit driven booms, and I would have thought that the reasons why would be obvious. Indeed, if we look at the proportion of construction in Hungarian GDP, this sort of confirms my suspicions, since in general terms this has not constituted a large share.

Indeed what we can note, as might be expected, is a very strong weather-driven annual cycle, and if there is any sort of trend discernible, it is ever so slightly downwards rather than upwards. This, again would fit in with a gradually ageing and declining population. The position is only confirmed if we come to look at the housing cost index.

So the first thing that strikes us is a local boom which we can see in the early months of this year, and which has since faded (and this is more than likely associated with a removal of public housing subsidies, a sharp rise in rents, and therefore a shift in the relative appeal of purchased property - always, of course, on low interest Swiss loans - and all of this at a time when internal demand is to all intent and purpose collapsing). Before this we can note the surge in prices in 2003/04. My guess is that this is/was Hungary's property boom, and that this phase has now come and gone. This also helps explain how the Hungarian fiscal side got into such a mess in 2005, as the government was increasingly having to shoulder the load against a faltering domestic demand. All of this is, as I say, very different from other parts of the EU10.

In conclusion then, we can assume that given sufficient determination by the central bank to hang on at all costs to the value of the forint, and absent a major external exodus from Hungary on the backs of a more general crisis, the systematic and sustained tightening on all fronts will eventually produce nominal as well as real wage deflation, especially if we sink into a deepish recession, which seems to look all but unavoidable when we come to think about the third factor - external conditions - which are almost certainly going to deteriorate over the next 6 to 9 months, as the powerhouse economies of the eurozone - Italy, Spain and Germany (France is the only semi-brightish star on the horizon) are all slowing mightily even as I write. So the message here is now twofold. Strap yourself in tight, since it is going to be a very bumpy ride, and secondly, Hungary is now about to join that honoured group, the export dependent economies. Of course, how rich she will ever get to be due to all the structural difficulties must remain a very open question.