Friday, 6 January 2012

The trouble with Hungary.....

.... is the European Union.

Let me explain.

Hungary has a silly government which is doing some objectionable things and playing fast and loose with the country's finances. On that we can all agree. But it has a two-thirds majority in its parliament and the disarray of the opposition parties means that there really isn't a credible electable alternative. Yes, there have been street protests against its policies. So what, frankly. There have been street protests against government policies in many European countries now, including the UK. That is no indication that the government is either undemocratic or about to fall.

Hungary, unlike the Eurozone members, is a sovereign country that issues its own currency, the forint. It is therefore technically unable to go bankrupt since it can if necessary print the money it needs. It also has control of its monetary policy as well as fiscal policy, which means it can raise interest rates to counter inflationary pressures and protect the value of its currency. There has been a lot of hype recently about the yields on Hungarian government debt, after it refused to pay over 10% on newly issued debt. But this isn't quite what it seems. The base rate in Hungary is a whopping 7.5% at the moment. Which means it is paying a spread of 2.5% over its own base on its debt. That doesn't sound nearly so bad, does it? It's actually about the same as the UK is paying on gilts.

However, Hungary has very large amounts of government and private debt denominated in Euros and Swiss francs. This is its real debt problem - not its forint-denominated debt. There is some evidence that Hungary wouldn't  be in such dire straits if the rest of Europe wasn't a mess as well - and in particular, if Eurozone banks were in better shape. In this post, Robert Peston notes that Eurozone banks have been shedding cross-border assets at a rate of knots to improve their capital positions. The Eurozone leadership prohibited them from unloading Eurozone assets or scaling back lending to the Eurozone. So they have been selling off non-Eurozone assets - which includes Hungarian private and government Euro-denominated debt. What a surprise, the yields on that debt have been rising as a result, and the Hungarian government is therefore having to find more Euros just to pay the interest. It can't print Euros, so it has to buy them on the open market.  Furthermore, because of those rising yields on both foreign and forint-denominated debt, coupled with investor nervousness about the behaviour of the Hungarian government, the forint is dropping like a stone versus just about everything else, so Euros are becoming more and more expensive. Rising yields on forint-denominated debt really aren't the issue. The major problems for Hungary are firstly capital flight causing rising yields on foreign currency debt, and secondly the collapse of the forint.

What can the Hungarian government do about this? Well, it could raid its foreign currency reserves. The Hungarian central bank is currently holding over 36 billion euros, which the government would dearly like to get its mitts on to meet its foreign-currency obligations. Alternatively, it could do a Weimar and print more and more forints to meet the ever-rising cost of buying the foreign currency it needs to meet its debt obligations.  So far the central bank has steadfastly refused to give the government the keys to the vaults or allow access to the printing presses. So it's not surprising, is it, that part of the legislation that the Hungarian government has railroaded through parliament is a measure that would allow it effectively to take control of the central. bank.

Both the IMF and the European Union have objected to this legislation. Central bank independence is a  requirement of European Union membership and a basic tenet of IMF fiscal prudence. Hungary was bailed out by the IMF in 2008 and is still paying IMF loans - most of the debt payments due in the next 6 months are to the IMF. Not surprisingly, the IMF still calls the shots.  And because the Hungarian central bank is refusing to allow the government to monetize debts or seize reserves, it is increasingly likely that the government will have to borrow more money to meet its debt obligations. It has already commenced talks with the IMF and EU about further financial assistance. So far the IMF and EU have refused to cooperate unless some of the legislation forced through parliament is repealed - not only the measures compromising central bank independence, but also flat income taxes, which in the IMF's view will not enable the government to raise sufficient in tax to meet its obligations.

What most sovereign governments tend to do when debts skyrocket and currencies collapse is the following:

- impose capital controls to stop people taking their money out of the country
- impose exchange controls so the external value of the currency is fixed
- redenominate foreign currency debt in local currency (or repudiate loans that cannot be redenominated)
- print enough money to monetize fiscal deficits and stimulate the economy
- wait for inflation and/or growth to sort out debts.

Hungary has actually managed to do one of these - it has forced external banks to take losses on their Euro loans, much to their annoyance, which amounts to fixing the exchange value of the forint for payments to private banks. But it can't do that to IMF loans. And all the other measures are prohibited under European law.

You see, although Hungary isn't a member of the Euro, it IS a member of the European Union. And the European Commission has made it clear that Hungary will not be permitted to break the rules, even to save its economy from collapse. Further, in order to qualify for the financial assistance that it will need because it is prohibited from sorting out its own problems, it must conform to the legislative and economic norms of the European Union even against the wishes of its elected government. So Hungary's position is no different from Italy's. It cannot do all that it would like to do. It does not have the right to choose its own path to hell.

So Hungary's problem is the European Union, isn't it?

2 comments:

  1. "Eurozone banks...have been selling off...Hungarian...Euro-denominated debt...the yields on that debt have been rising as a result, and the Hungarian government is therefore having to find more Euros just to pay the interest."

    That's not right. Yields rising just means that secondary-market bond prices are falling. That makes no difference at all to the number of Euros Hungary has to find for coupon payments on its existing fixed-interest debt. (It affects the interest it would have to pay on new Euro-denominated debt, should it choose to issue any.)

    As you say, it's the fall of the forint that's really hurting. And last month the government agreed to bear some of the cost of bailing out mortgage borrowers who'd imprudently taken out loans denominated in swiss francs or euros.

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  2. Fair enough, Paul - my mistake. They do have to find Euros to pay interest on foreign-denominated debt, but the problem isn't that the interest is rising, it's that the exchange rate is falling so Euros are becoming more expensive. I originally saw this as a currency crisis. Your comment confirms my original view. I should have stuck to that!

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