Hungary - A victim of its own success

Gyorgy Suranyi

Western bankers had been expecting a cut in rates as the government and central bank became increasingly alarmed at what they called the "almost frightening" inflow of foreign money. Even though the central bank was buying large amounts of foreign exchange, the forint was hard against the top of its exchange rate band. If bankers expressed surprise at the both the timing and aggression of the move, they were even more shocked when the central bank lopped a further 50bp off a few days later.

"The decision to lower interest rates was expected but the speed at which the National Bank moved was surprising. If you look at the figures for capital inflows, the decisions are quite justified", says Tibor Draskowics, deputy chief executive of ABN Amro Hungary.

Other western bankers were less convinced. "The rate decision was surprising because of the size of the recent unfavourable developments in inflation. December 1999 inflation edged up to reach a high of 11.2% year on year," says Wike Groenenberg, European emerging markets analyst at Salomon Smith Barney.

More cuts unwelcome

Although opinions are divided about the wisdom of cutting rates at this stage of the economic cycle, there is a growing consensus that no further cuts should be made until there is evidence of a significant reduction in inflation. "There is limited scope for further rate reductions," says a banker. "The central bank may knock of a further 50 basis points or at most 150 basis points from the repo rate during the year. But any more substantial cut would result in negative real interest rates on the basis of inflationary expectations."

There is a clear policy imbalance. "Inflation was more than 10% in January, the same as one month earlier," says Jurgen Odenius, senior emerging markets analyst at Warburg Dillon Read. "Industrial production growth is 15% and retail sales are growing at double-digit rates. The best way to fight inflation would be to let the currency float. But the fact that it is cutting rates at this time indicates that the National Bank prefers keeping an exchange rate regime to cutting inflation."

The dilemma comes at a time when international analysts are expressing concern that inflation is not being reduced quickly enough and that structural reform, particularly of healthcare and municipality financing, is being delayed too long. There are also reports of growing tension between the finance ministry and central bank though Hungarian bankers say this reflects the contrast in style between Suranyi and the more flamboyant finance minister, Zsigmond Jarai. Bankers also hint at a degree of resentment about an alleged critical assessment of the present government's economic policies by the central bank in the run-up to the 1998 election.

There is also international concern about the toughness of banking regulation, a worry illustrated by the Postabank saga. Despite alarm about the bank's financial health, which led to a run on deposits in February 1997, the full extent of the problems of what was at one time the second-largest bank in the country were not revealed until after the election when senior managers were replaced. Bailing out the bank, which is now almost entirely state-owned, added 1.8% to the budget deficit. "This episode highlighted worrying deficiencies in banking supervision," says David Riley, senior director for European emerging markets at international rating agency Fitch IBCA. "Action against the bank by the authorities was delayed because of the former management's close political connections. It also revealed the limits to supervision implemented on a non-consolidated basis."

Yet these are minor difficulties compared with those facing many other emerging markets in the region. Hungary has effectively become a victim of its own success, which was demonstrated recently when it was upgraded by Standard & Poor's from BBB to BBB+, bringing that assessment in line with those of Moody's and Fitch IBCA.

Hungary is expected to join the EU in the middle of the decade and the eurozone a few years later and has a booming economy, an internationally oriented industrial sector and the strongest banking sector in eastern Europe.

Says Groenenberg: "While the interest rate reduction lowers the attractiveness of holding Hungarian fixed-income assets because of a reduced carry and less favourable prospects for inflation, the prospects for medium-term convergence remain intact with Hungary still expected to join the European Union in the first wave of central European countries in 2004. Thus Hungary remains attractive for investors with a medium-term horizon."

The country also has a proven track record of being able to access international bond markets when others in the region were unable to. "Hungary is the most sophisticated sovereign borrower in central and eastern Europe," says Fitch IBCA's Riley. "They have competitive spreads and trade better than their rating. They have a strong investor following, particularly from German retail investors who appreciate the combination of a reasonable yield and low risk."

Less funding, lower profile

Csada Lantos

To Hungarian bankers, this concern about future capital outflows seems perverse as the country tries to deal with the massive capital inflows that offer the clearest evidence of international confidence in the economy but also provide a difficult test of economic management. Foreign exchange reserves rose by $420 million in January alone, equivalent to 10% of monthly GDP. Equity and bond investment figures for January are not yet available but are likely to have shown comparable increases. These rises have come on top of steep rises in 1999 when foreign equity holdings rose from $2.3 billion to $4.3 billion and foreign forint bond holdings rose from $1.4 billion to $3.9 billion.

This poses a delicate policy balance for Hungary's economic managers. Reducing interest rates is likely to give a boost to an economy that is already growing at more than 5% and could expand even faster as Hungary's main markets in western Europe start to grow strongly. However, the medium-term effect is potentially inflationary. Leaving interest rates at present levels could have led to further capital inflows, keeping the forint uncompetitively strong and leaving dangerously large amounts of liquidity in the market. The result would have been either a rising current account deficit or higher inflation.

The central bank response has raised fundamental questions about the long-term sustainability of the currency regime and possibly ended a period in which Hungary had been so attractive to international bond investors that it had been able to raise money with ease during the crisis of confidence in emerging markets. "The combination of high real interest rates, a strong currency and a steady squeeze on inflation made Hungarian paper extremely attractive to foreign investors," says Riley.

The currency regime has been based on a crawling devaluation that has gradually reduced inflation while maintaining a competitive position in international markets. At the start of this year, the basket of currencies was changed. The old formula, which was weighted 30% dollar and 70% Deutschmark, was replaced with a basket based on the euro. The crawling peg had proved highly successful, enabling the country to avoid a repetition of the 1994 balance of payments crisis.

But bankers increasingly doubt that this strategy is still appropriate. "What we have now is a classic example of what happens when you have a too loose fiscal policy, a tight monetary policy and what is effectively a fixed exchange rate," says a banker.

According to another banker: "If the Forint remains under appreciating pressures, the National Bank has three options. It can either float the currency, speed up the pace of the reduction in the currency crawl or widen the forint band to perhaps plus or minus 7%". None of these options looks likely to appeal to the central bank. The crawling peg helped pull Hungary back from the brink of default in 1994 and the combination of that and a tight adjustment programme has helped create a stable economy. Floating the currency would, ministers fear, make Hungarian goods uncompetitive and could lead to another balance of payments crisis. Nor is there much enthusiasm for a move to a wider band so soon after one policy change from the basket of currencies to the euro.

Most significantly, Hungarian bankers and foreign investors believe Suranyi has got the balance right and that the interest rate reductions will reduce the influx of hot money without stirring up inflation. "If we look at the developments of the last three months, they are very positive. The current account and fiscal deficits are more sound than people expected them to be. The upturn in inflation seems to be under control. There is growth in western European markets which is also a positive sign," says Harold Galob, eastern Europe equity fund manager at Austrian bank, Erste Sparinvest, which manages Julius Baer's Co-op Central Europe Fund.

A medium term equity play

The fund's managers regard Hungary as a stable, attractive market. Although only 27% of the $60 million fund is invested there, compared with 41% of the $40 million fund a year ago, this reflects both the better performance of the Russian and Czech markets and the belief that the Hungarian exchange, which has risen 45% from its low point last March, may be due for a fall. "We have seen a good rise in blue chips," says Galob. "But the market is ripe for a correction, and then I think it will start rising again. In the short term, I would not want to be overweight in Hungary. But in the medium term of three to five years I would not want to be underweight."

Local bankers remain confident that the reduction in interest rates will not cause the share market to overheat. "Lower interest rates will not have an impact on the stock exchange because, first, at least three-quarters of the investors are foreigners and secondly the major domestic investors are institutional. Only a small amount of growth could be generated by private local investors who will benefit from the lower interest rates," says Csada Lantos, chairman and chief executive of Hungarian bank and brokerage company CAIB Securities. Nor does ABN Amro's Draskowics believe there is any justification for thinking that lower interest rates will have an adverse effect on inflation. "Decreasing interest rates eases pressure on inflation and internally could help growth and public sector deficits to meet their targets," he says. "The inflation results have been quite impressive. I am not worried about the inflation increase in the second half of last year. That is not real core inflation. I think that the decline in inflation will continue next year."

The key question is the extent to which inflation will come down. Draskowics acknowledges that the "6% to 7% government forecast is not realistic and the most likely outcome will be something in the region of 8%. That is what the market is expecting and that will be acceptable".

The government's determination to lower inflation in the short term is reflected in the decision to delay a scheduled 25% increase in gas prices. To some bankers, that looks like a short-term gain that will have a longer term price. However Lantos takes a more positive view of inflation. "The reduction in interest rates is a demonstration by the National Bank that it believes the country is going in the right direction and that the convergence story is continuing," he says. "It means the government thinks it can hit its inflation target. Otherwise there is not a realistic calculation which shows a real interest rate for investors."

Hungary has some way to go before it hits the convergence criteria on inflation and interest rates which are necessary for EU membership. There is a risk that the reduction of interest rates will feed through into higher underlying inflation in two years' time. Bankers are also concerned that the government has failed to address key structural reforms and that, as a consequence, it could lose out on some of the opportunities of EU membership.

The timing of the electoral cycle, with elections due in 2002, means that unpopular reforms are unlikely to happen before then. "In the short term the indicators are good and possibly for the medium term as well, says Draskowics. "My main concern is the failure to address important issues like healthcare and the financing of municipalities, where significant financial savings can be made. If you look at EU membership, a large amount will have to be spent on co-financing projects where we will have to match EU funds. We must start now creating room in the budget for this."

Other Maastricht criteria have been met. The total debt of the country is less than 60% of GDP and the annual government deficit does not exceed 3% of GDP. "We thought demand would be higher last year, increasing imports and creating a bigger deficit. But in reality, the current account deficit is $2 billion which is not a huge amount, particularly as some $600 million was caused by dividend transfers and that is not related to macroeconomic behaviour", says Lantos.

Consumer price inflation

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Real GDP growth