The fact that Hungary's National Bank did not decide to make an unexpected interest rate cut at its meeting earlier this week seems to have surprised some, but it really should not have done. According to James Morsink, head of the IMF delegation to Budapest, Hungary only has room to cut its benchmark interest rate at a “gradual and cautious” pace. The reasoning behind this view is simple, any more rapid reduction in the bank's benchmark rate risks being accompanied by a devaluation of the forint, and and any such devaluation would inevitably lead to a rise in mortgage defaults and problems for the banking system as holders of Swiss Franc forex loans find themselves unable to maintain their payments as unemployment rises and wages and salaries fall.
Thus it is that even though the Hungarian economy is now in its worst recession in over a decade the IMF representative finds the decision to cut the key policy rate for the second time in two weeks just before Christmas (by 50 basis points to 10.00%) “appropriate”. Such "snails pace reductions mean that over the last two months the central bank has now clawed-back only half of the 3% hike made back in October, a hike which was rapidly put in place in an attempt to mount a firewall defence around a Hungarian banking system faced with the imminent threat of financial meltdown at the end of October. The problem is, having put the firewall in place it is proving very hard to remove it, and Hungarian monetary is now well and truly trapped between the proverbial rock and a hard place.
The diificulty of this situation is implicitly recognised by András Simor, Governor of Hungary's central bank, who told Reuters this week that the 10.00% base rate needed to be lowered as fast as possible. Yes, but how?
“The Monetary Council has declared that we would like to lower the base rate as fast as possible because both real economy prospects and inflation prospects would justify a significantly lower interest rate level than the current level," Simor said.The problem is that since the original sharp interest rate hike decision was taken largely in order to defend the forint, the question now naturally arises what will happen to the currency as the guard is now gradually lowered - and given the severity of Hungary's recession there is no doubt that the guard will have to be lowered. Personally I would simply express the hope that in the intervening period as many Hungarians as possible have had the good sense to make the currency switch from CHF to Forint for their mortgages - the opportunity for which was offered to them in law by the government. Basically the steadily deteriorating trade data - see below - which is accompanying the collapse in internal demand will leave the authorities with no effective alternative but to let the currency slide, if they don't even provoke the slide themselves, that is.
So monetary policy has now been "relaxed" by 15 base points - but there is still a long road - a hell of a long road - left to travel.
The Hungarian government remember secured 20 billion euros in IMF-led loans back in October, and apart from the monetary tightening which has accompanied the "easy as she goes" IMF internal deflation strategy, there will be no fiscal support for the beleagured economy, since the other leg of the strategy is for Hungary to cut its fiscal deficit faster than previously planned in order to achieve a short sharp reduction in its financing needs. In fact Hungary seems to have complied with it's 2008 goal of cuuting the deficit to 3.4 percent of gross domestic product in 2008 and is now set to reduce it to 2.6 percent in 2009. Whether these two pro-cyclical squeezes count as a package of anti-crisis measures or not (certainly they bear little resemblance to what Barack Obama has in mind of the United States, or José Luis Zapatero is doing in Spain - to mention two other countries which are suffering the after effects of a "twin deficit problem"). But then here what is sauce for the goose obviously is considered to be something akin to caviar for the gander, and the Hungarian's must be patient, and simply grin and bear it like the long suffering people they undoubtedly are.
Sharp Economic Contraction Ahead In 2009
If we look at what has been happening to Hungarian GDP in recent quarters we will see that the weak performance of the economy is not of recent origin, and that headline GDP has been struggling to keep its head above water since the end of 2006, and this despite a surprisingly good harvest in 2008, and a reasonable export performance in the first half of the year to offer the only real bright spot support to what was otherwise a pretty dismal general horizon. So basically, when the global shock hit in October 2008, we were talking about a patient that was already severely weakened by both the underlying illness from which it is undoubtedly suffering (but what is the illness'') and some of the standard-recipe medicine which was being applied.
Even the briefest of glances at the recent evolution in household consumption should make the root of the problem abundantly clear, since Hungarian household consumption peaked all the way back in 2002 (just as it did in Portugal in 1998/99), and it has not rebounded - just as we have seen in the Portuguese case. Nor will it, in my humble opinion, ever rebound in the way that most analysts expect, since Hungary is now showing all the signs of being destined to add its name to that venerable list of export driven economies, a list currently so nobly and venerably headed by countries with such illustrious histories as Japan and Germany. And what exactly do these countries have in common: oh yes, they are in the throes of an economic trasition brought about by negative population momentum and rapid ageing.
Basically, weak as the momentum in household demand before October 2008 was - we have to be grateful for small mercies here - it was still positive, and it stayed positive all the way through to Q2 2008 - probably as a result of all those forex mortgages and "refis" which were being so avidly contracted.
Since October, however, we can now expect the "bird" to have been well and truly knocked of its perch, with the outlook for 2009 being undoubtedly negative, and possibly strongly so. Since there are a number of reasons why it is interesting to think of Hungary as being some sort of second Portugal (the similarities even extend to negative population shocks - since Portugal's population actually fell beck in the mid 1990s, partly because of out migration headed for other EU member countries), and since domestic demand in Portugal did not (and has not) recovered from the 2000/01 momentum shock (or adjustment process) people might like to take a look at the chart below.
The strongest argument for assuming that we will get a bounce back in domestic demand in Hungary is the convergence argument, and the idea that it "has to be like that". The simple case of Portugal shows that convergence is not inevitable (you only need one negative case to falsify an inductive chain), and that it does not "have to be like that". This evidence alone, of course, does not mean that there will not be a recovery in the houshold consumption path, but it does mean that those who want to suggest there will be need to dig a bit deeper, and find some more arguments, arguments which can be subjected to empirical testing, and which can, should they not be the case, be falsified. Remember, Hungary was the native country of Imre Lakatos, not that I imagine too many contemporary Hungarian economic analysts are aware of the relevance of his work for how they do their job.
So, as I said, there is still some road to travel for the National Bank of Hungary in its rate cutting cycle, and one of the principal reasons that they have a long road to travel here is the competitive readiness of Hungarian industry to serve as an export machine to drive growth, a competitiveness which is currently being tried and found wanting. Some evidence to back my assertion in this regard can be found in the current level of Hungary's Real Effective Exchange Rate (see chart below).
The REER (or Relative price and cost indicators) is a tool economists use to assess a country's price or cost competitiveness relative to its principal competitors in international markets. The indicator is a useful one, since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER used by the EU for its Sustainable Development Indicator (which is the one used in the above chart) is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness.
Another indicator - the Nominal Effective Exchange Rate (NEER or, if you prefer, the “Trade-weighted currency index”) of a country aims to track changes in the value of that country’s currency relative to the currencies of its principal trading partners. It is calculated as a weighted geometric average of the bilateral exchange rates against the currencies of competing countries. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The REER (or, if you prefer, the “Relative price and cost indicator”) aims to assess a country’s price or cost competitiveness relative to its principal competitors in international markets, which basically means it is the NEER deflated by nominal unit labour costs (total economy) and consumer prices (CPI/HICP). Which means, cutting through all the mumbo jumbo, that it is an extremely useful and powerful tool for assessing the state of competitiveness of any given country.
So if we come to look at the state of Hungarian competitiveness, and we do it through a comparison with what could be the benchmark value for aspirant export driven economies - and that is of course the German index - then we can see just how much the Hungarian position has been allowed to deteriorate, and all that loss with now have to be clawed back - if you want to have anything that half way resembles a modern pensions and health system that is. True the index measures relative price and productivity movements across all sectors (tradeables and non tradeables alike), and true Hungary's export oriented sector has performed much worse than the rest, but that is just the point, since the position of the non tradeable sector is even worse than the chart suggests, and a very large scale mis-allocation of resources into non tradeables has been going on, and one way or another this mis-allocation will now need correcting. And there are only two ways to do this correction, through a substantial internal deflation (not adviseable) or through an outright devaluation (my prefered path).
That the loss of competitiveness in the non tradeable sectors has been particularly strong is shown by the difference between domestic and export producer prices you can see in the above chart, since domestic producer prices have hardly budged since the early summer in y-o-y terms, a very bad sign indeed, I think. Domestic producer prices were donw by 1.3% in November compared with October but they were still 10.8% above those of November 2007. Export prices (measured in HUF) were up by 1.1% on October and by 4.4% on November 2007 - again the uptick is worrying. Combined producer prices for both domestic and export sales were thus up 0.1% on October and 7.1% on November 2007.
The sharp uptick in HUF export prices was undoubtedly the result of currency movements (and the fact that the euro value of the exports seems to have been held constant (which is not the best way of getting the benefits from devaluation), since the HUF was down by 2.8% against the EUR (and by 7.8% against the USD) in November (compared to October) following a 7.2% drop against the EUR (and a 15.4% one against the USD) in October (compared to September). What this seems to indicate is that exporters held their euro prices constant, rather than taking advantage of the cheaper forint to reduce them, although the move may have been seen as temporary, and we will have to wait to see how export prices evolve in the coming months.
Belgium's luxury lingerie maker Van de Velde is to close down its Hungarian factory in Szekszárd, business daily Világgazdaság reported on Thursday. The company's CEO said it is impossible to make textile goods in Hungary cost efficiently. The shutdown would put 345 employees on the street. Production is still on at the plant, but it will need to be stopped as in Hungary there is no way to produce textile goods cost efficiently, the CEO said. He noted that the same job can be done at one third of the costs in Tunisia therefore the entire Hungarian production will be moved there.
Construction Activity Stays Down At A Very Low Level
Although Hungarian construction activity expanded very slighly in October, output remains at a very low level. According to Central Statistic Office data, production was up 0.2% month-on-month, while the year-on-year reading fell back 2.2%. More to the point output has now been stuck since 2007 at a level first reached in 2003, and it is also worth bearing in mind that we have not yet seen the real impact of the October credit crunch.
As can be seen from the chart below, the current data is more a reflection of the long-term stagnation in economic activity that followed the introduction of the austerity programme in late 2006 and is thus not a result of the recent financial crisis. Put another way, the impact of this crisis is about to be seen, but it will be operating on an economy which was already severely weakened, as such the end result may well not be any too pretty.
New orders placed in October give some idea of what we may expect, since new contracts for residential and commercial real estate were down by 41.1% year-on-year (and remember October 2007 was not that high a base reference).
Unemployment Rising Steadily
Hungary’s unemployment rate rose in the three months to November - to 7.8 percent, up from 7.5 percent in the three months to August and from 7.5 % in the three months to November 2007. Of the 329,000 currently unemployed, 49.6 percent have been out of work for at least a year.
The rise is not dramatic, but that is only because of the earlier weak position of Hungarian employment, and because the full impact of the slowdown in industry is only now about to bite. But if we look at the employment, rather than the unemployment, chart it is plain that the jobs trend is down, and has been for some time. Not only has the Hungarian economy not creating jobs, it has been losing them.
One of the reasons this poor job creation performance has not lead to more unemployment is, of course, because the Hungarian working age population has itself been steadily declining.
Consumer Confidence Continues To Slide
Hungary’s economic sentiment index plunged to a record in December as the onset of recession darkened the outlook for both businesses and consumers, according to the latest report from the GKI institute. The overall index fell to minus 36.7, the lowest since measuring began in 1996, from minus 33.3 in November, the Budapest- based institute said. The indexes for business and consumer confidence also fell to new lows. The outlook for industrial production and orders, specifically exports, led the decline in the business confidence index to minus 28.2 from minus 25.1 in November. Fear of job losses dragged down the consumer confidence index, which fell to a record low of minus 60.8 in December from minus 56.7 the previous month, GKI said.
Retail Sales Continue To Fall
Calendar and seasonally adjusted constant price retail sales dropped by 0.1% month on month in October, following a 0.3% drop in September, and fell 1.4% year on year. Combined sales of cars, car parts and fuel were down 5.6% year on year following a decrease of 2.1% in September.
Thus retail sales have been contracting steadily for some time now, basically since the middle of 2006 - as can be seen in the chart below - although as I keep stressing all of this predates the October shock, and we should be ready now for another sharp deterioration in consumer demand in the coming months. Also I now think there are good theoretical reasons for thinking that Hungarian retail sales may never attain the mid 2006 peak again (oh, I know, never is a long time, but I simply don't see how this declining and ageing population process is going to reverse itself, but then all of this is perfectly testable/falsifiable).
While Industrial Output Slumps
Hungarian industrial production declined the most in 16 years in Novemberber as western European demand plunged and Hungary's economy headed into what now looks sure to be its worst recession in at least 15 years. Industrial output dropped a working day adjusted 10.1 percent from November 2007, following a 7.2 percent year on year decline in October, according to data from the statistics office. Output fell 2.1 percent month on month.
As we can see from the seasonally adjusted monthly volume chart, Hungary's industrial output has now been dropping steadily since it peaked in February.
And the future looks set to get worse, since the stock of total orders grew by only 2.0% year on year in October, as compared with a near 10% increase in September. Domestic orders were down 2.4%, which compares with an increase of the roughly the same size in September.
This outlook is confirmed by the December Purchasing Managers' Index (PMI) which, while it recovered slightly from the lowest point ever achieved since records began in November (39.9 down from 42.8 in October) to hit 41, still showed a quite strong contraction taking place, since 50 is the dividing line between expansion and contraction on this type of index. The rebound was to some extent the result of an improvement in the new orders index, which rose 2.8 points from November to 39.9, although both the purchasing and production volume indexes also climbed in the month. But still we come back to the same problem, industrial output will not be pushed back up by domestic demand, only exports can now do that, but to push up exports we need to attract investment, build factories, and sell, and to do all that we need to get competitiveness back. Is all this so hard to understand?
Current Account Deficit The Key
Now, as I am saying, one of the key factors we all need to think about here is just where future growth in Hungary is going to come from - and I think it very important to bear in mind that without growth the living standards gap simply isn't going to close. The main argument I have been advancing is that as far as all the evidence we have seen for the last 18 months goes you can forget about domestic demand as a driver of growth - and that was before the credit crunch shock wave hit. Basically Hungary now has to live (and pay the rising old age related health and pension costs) from exports, which is why it comes as no good news at all that the current-account deficit widened more than expected in the third quarter when compared wih the same period a year ago - as imports increased faster than exports and the income stream to external investors continued to rise.
The deficit was 2.49 billion euros, which compared with 1.68 billion euros in the third quarter of 2007, according to the latest data from the central bank. The goods trade deficit was 206 million euros, compared with a surplus of 47 million euros in the same quarter last year and a 169 million euro surplus in the second quarter. Due to a very health services surplus (582 million euros) the combined trade balance stayed in surplus (376 million euros), but all this hard work (and sweat) was undone by the continuing deterioration in the income balance - which is one of the core problems for Hungary (see chart below) - where there was a deficit of 2.51 billion euros (or nearly 6 times the combined trade surplus), up from the 1.73 billion euro shortfall registered a year earlier and the 2.12 billion euro one registered in the second quarter of 2008.
So payments to owners of Hungarian equities, and holders of Hungarian debt constitute a substantial, and growing, dead weight for the entire Hungarian economy now. Essentially this situation is a result of funding all those years of current account deficit (see chart below) with inward fund flows - these funds all attract interest, and they will eventually have to be paid back, even the recent IMF and EU loans fall into this category. So basically this is just one more reason why exports have become important, since Hungary now needs to move from being a CA deficit nation to a CA surplus one, and the only way to get to this position is to start borrowing (and consuming) less, and saving more. And this transformation has to come one day or another, and the later it comes the worse the correction will be. So maybe here one day is not as good as another, maybe tomorrow is, in fact, a good day to start.