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Wednesday, February 13, 2008

Turning The Screw on Hungary; Three Possible Tipping Points

by Edward Hugh: Barcelona

Hungary's forint firmed slightly today after standing up to several waves of pressure, settling around what still amounts to a one-week low against the euro. The mildly favourable retail sales data that came out in the US during the afternoon eased some of the pressures on emerging market economies and in the collective upswing the forint managed to get back below the 262 to the euro level. Just enough to knock out stop-loss levels, but hardly anything to get excited about. The forint had been as far down as 266 to the euro earlier last week - amid a spate of rumours which included the idea that the prime minister was about to resign, and that the central bank was about to announce an emergency rate cut (or was that increase, I never was sure which possibility was most in people's minds at that point). Indeed it was clear that a general downturn in global risk appetite which struck all across emerging market instruments was hitting Hungary's long-unsteady markets the hardest.

Hungary's economy has slumped to decade-low in growth following a government belt-tightening campaign aimed at straightening out its public finances.

Danske Bank Analysis

Portfolio Hungary reports this morning on the view of Danske Bank analyst Lars Christensen. Christensen's argument is that it is only a matter of time before the forint follows the leu, the kronur and the rand in weakening significantly. In particular he argued that the forint is not sufficiently protected by adequately high interest rates.

Since the outbreak of the global credit crunch in August 2007 many currencies in the EMEA countries which have been running large current account deficits and/or have accumulated large ratios of foreign debt have been under significant selling pressures. According to Christiansen:

“Most notable has been the weakening of the Romanian leu, Icelandic kronur and the South African rand, which have all weakened around 15% since the beginning of August. The lira has more or less been flat against the euro since early August and the forint has “only" weakened around 5%".

“While we clearly see a risk that these currencies can weaken significantly more, there is also a risk that this weakening will spread to other EMEA economies with similar problems. In particular, the Turkish lira and the Hungarian forint stand out,"

“While high interest rates in Turkey give some protection, it is hard to use the same argument for the forint and hence we believe that it is only a matter of time before the forint follows the leu, the kronur and the rand and weakens significantly."

(The base rate is currently 13.75% in Iceland, 11.00% in South Africa, 9.00% in Romania, 15.75% in Turkey and 7.50% in Hungary.)

As he points out, imbalances have been reduced in the Hungarian economy on the back of last year's tightening of fiscal policy, but the markets have also 'rewarded' the Hungarian government for this by not selling the forint as much as the continued large imbalances and large foreign debt could 'dictate'.

Also, as the global credit crisis drags on there is an “increasing risk that we will have a repeat of the forint 'crisis' of 2006", where the HUF fell sharply from around 250 against the euro to 285 in a comparatively short space of time. And the global financial environment at that time was significantly more benign than is the case at the moment. So a forint at 280 or below to the euro hardly seems an unlikely level at this point in time, and indeed Lucy Bethell from RBS was arguing exactly this earlier in the week.

In particular, Christiansen stressed that any “slippage" on fiscal policy in Hungary would hit investor confidence hard and this would also “likely lead to downgrades of Hungary's credit ratings". And this is just why tomorrows Q4 2007 preliminary GDP data will be so important, since if the figure slips to any great extent on the downside this is bound to place strong question marks around Hungary's 2008 budget targets which are - let us remember - based on government estimates of GDP growth in the 2.8 to 3% range.

And before we leave Christiansen's analysis, I would like to draw attention to one point: the comparison with Turkey. Back in August 2007, just after the credit market crunch started to close its grip, I wrote a long post (and an even longer analysis) of Turkey, where I tried to argue that even though Turkey's economy would come under pressure just like those of its East European neighbours, the underlying soundness of Turkey's demography, and hence the element of homeostatic regulation which it would enjoy following from any significant downward correction, meant that it could well emerge with a lot less medium term damage from the coming global storm than the rest of Eastern Europe. This view is now about to be tested, as indeed is the whole thesis that demography and fertility don't matter to economics. As I wrote at the time:

There are good theoretical reasons - at least if you take demography seriously there are - for imagining that the Turkish economy might well prove to be more robust than some of the Eastern European ones will under the strains the various economies are under and about to receive. These latter economies, despite their apparent vibrance are actually much more fragile under the surface, and it is for this very reason that the observed response differences bear examination day by day.

I Suppose That's The Hill Sergeant, and I Guess You Are Going To Make Me Climb It.

The most probable scenario we now face is for the forint to experience a succession of waves of attack, and a systematic attempt to knock it of the perch on which it is so delicately poised. All free-market economists of course believe in the workings of financial markets as a regulatory mechanism, but we don't have to believe they are fair, kind or forgiving.

There seem to be three critical tests facing the forint in the short term. The first is the GDP and inflation data coming tomorrow. Starting with the Q4 2007 GDP data, my opinion is that this will surprise on the downside, and possibly give every indication of just how unrealistic most of the 2008 GDP forecasts for Hungary currently are. The second is the inflation data, and here the Hungarian central bank is now almost certainly in a heads I lose, tails I lose situation. If the CPI - Hungarian inflation was running at an annual rate of 7.4% in December - surprises on the downside this may encourage currency dealers to feel that the central bank will bow to political pressures and reduce interest rates - a move which the collapse in Hungarian internal demand suggests is badly needed.

But the reduction in yield differential would make forint denominated assets less attractive, suggesting that the foring would face a more testing toime and that an acceleration in capital exit would probably occur. If, on the other hand, the data surprises on the upside - which after today's December agricultural PPI data (38.1% y-o-y) seems more likely, then this may lead people to feel that the central bank will have no alternative but to increase rates. Indeed many market analysts have now reached the conclusion that such rate rises are more or less inevtiable. The latest of these has been Gillian Edgeworth of Deutsche Bank, who today projected a total of 100-bp rate hikes in the next six months (over the course of the next six policy meetings.), and in this she has joined a fine galaxy of observers including Goldman Sachs and Citigroup - who are projecting a 50-bp hike at the 25 February policy meeting, while Citibank analyst Eszter Gárgyán is on record as saying she does not believe that even a 50-bp hike could be enough to stop the weakening of the forint. I am not sure how much of the macro-economics of what is involved in all this these forecasters understand, but I am quite happy to say that the sort of monetary tightening that Gillian Edgeworth is contemplating is just not posible at this point in the game, since, apart from the fact that it would send Hungary off into one whopping and unholy recession (especially if it was accompanied - as it would have to be - by a continuing tightening of the loan conditions on Swiss Franc mortgages, due to the hightened currency risk default issues), the political dynamics would not accept it. You can only ask people to accept so much belt tightening before they rebel, and we are already over 18 months into this round, so tolerance must be wearing thin, and another year of monetary tightening is most definitely out at this point. If you have any doubt whatsoever on this, look at what has happened in other countries in other epochs.

So, given that not all market analysts are competely devoid of foresight, any move to press the tightening trigger can alos lead to a similar conclusion to a rate cut about the desireability ditching Hungarian assets, since more monetary tightening would only close even further the noose which is currently extending its grip over the internal economy. Such are the difficulties when you back yourself so tightly into a monetary and fiscal corner.

The second hurdle, or critical point, the forint will have to get over - assuming it survives tomorrow - will them be the meeting of the central bank itself on the 25 February, and again rate policy decisions either way can have unpredictable effects, and once more it is likely that an attack will be mounted, regardless of the decision taken, given (as I argue above) there are sufficient reasons for doubting that either policy option is a good one. What all this amounts to is that the Hungarian central bank has now run out of policy options, and it is just a question of time before we get to see what the financial market participants decide to do about the situation.

Finally, and assuming that the currency passes muster relatively unscathed in the first two initial skirmishes, the cherry is most decidedly and firmly likely to be planted on the top of the cake if the proposed referendum on some of the more controversial measures in Hungary's adjustment programme actually gets to be held on March 9th. Since a vote to abandon the contested education and health service charges - which seems on the face of it to be the most probable outcome - would virtually present a frontal challenge to the whole "adjustment" process, it is hard to see how the Gyurcsany government could continue under the circumstances (even if there would be no formal obligation to resign). This kind of situation is, of course, "more power to my elbow material" for those market participants with an acquired taste for warm, freshly-spilled blood, and really if we got through to this point, without anyone having the presence of mind to take the bull by the horns first (by which I mean making a virtue out of a necessity, and openly accepting that policy is now in a no-exit bind, and that a significant drop in the value of the forint is both inevitable and desireable, depite the fact that there will be a lot of renegotiating and cleaning up to do in the aftermath), then the outcome may well not be a pleasant sight to watch.