Hungary: In Between a Rock and a Hard Place

Includes: ESR, RNE
by: Mark Boucher

The problems in periphery European PIGS are similar to the problems of new entrants lined up to join the Euro. Hungary is their new poster-child. In each case competitiveness has deteriorated rapidly and currency devaluation would help solve the problem, but massive foreign currency denominated loans make devaluing a problem for huge private-sector debts. These countries do not yet have the huge government debt/GDP problems of Greece, but they face dilemmas that Hungary is an example of that could easily lead to government debt/GDP surging. This is therefore a potential next flare-up zone for contagion that investors must watch and could play if breakouts are clearly triggered.

Hungarian government debt/GDP is around 75% now, certainly above the Rogoff/Reinhart threshold of 60%, where problems start for emerging markets historically. Interest costs are a high 4.5% of GDP and represent 10% of government expenditure however because Hungary has kept its interest rates artificially high in order to try and preserve the exchange rate versus the Euro. The problem is that keeping the interest rate artificially high kills the economy, and a further contraction in the economy could send government debt/GDP through the roof quite quickly. The artificially high interest rate also hurts the current account, leading to bigger debt buildup. 10-year government bond yields hover around the 8% level, strangling an economy that is still contracting. Private sector foreign debt denominated in other currencies is 100% of GDP.

The economy is in a contraction. Retail sales volumes are contracting, employment is declining, and private sector credit and money supply are both negative. PMIs are falling back under 50 after a brief shot above as industrial production volumes remain weak. Exports dropped 12% in 2008 and have only recovered 4% this year. The government is already cutting spending in response to fiscal problems and this is hitting an already contracting economy. Like much of weak-economy Europe, the Great Austerity will simply poor gasoline on the fire of weak economies and won’t help restore debt sustainability much without other policy help. Like Greece, Hungary needs to default, devalue its currency, and improve incentives for capital investment and business formation in the tax structure to help bring growth back. This would hinder its EUR entry substantially though.

The problem is that if Forint interest rates come down and the spread vs Euro rates drop, the Forint could take a hit and this would trigger private sector defaults on massive private sector foreign loans. You can’t cut rates and the currency in an open capital account system simultaneously. Imbalances have grown by attempts to do so. Authorities have kept rates high to prevent the currency from falling and this simply forced private sector borrowing into other currencies. It also is killing the economy and making the fiscal problem worse. Authorities need to bring rates down but this will cause the forint to plunge. If they keep rates artificially high the currency won’t devalue but fiscal deficits will soar and the economy will contract further. Either the public sector will run into deficit problems soon and face Greek-style market rioting, or the private economy must be sacrificed. Hungary, like many potential entrants, is economically between a rock and a hard-place now.

The newly elected Fidesz party suggests that restoring growth is its primary objective. Without growth debt sustainability won’t be enhanced. Thus there has been a push on the central bank to cut interest rates and currency depreciation has been hinted at. Exports are 65% of GDP in Hungary, so devaluation could help dramatically. Policy-makers have stated that their goal is not to support foreign “knights” who profit from the high carry in the forint. They are trying to figure out how to help households (the private sector) if foreign currency denominated debts rise as a result of currency depreciation – including possibly converting foreign debts into forints at a favorable exchange rate – which would be a de-facto default. Hungary could use the debt crisis in Europe to devalue and restructure its own debts. Hungarian stocks are likely to underperform and aggressive forex traders could look to short the HUF versus the EUR and dollar if the EURHUF clearly breaks out over the last year’s highs.

Look to short EURHUF, HUF, and Hungarian stocks vs Euro index.

Disclosure: Looking to short EURHUF and Hungarian stocks versus German Exporters