John Dizard: Appetite created for Hungary’s bonds

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Inner-city American schools sponsor programmes called “scared straight”, which involve taking groups of “at risk” students through local prisons or morgues to show them the results of choosing a criminal career.

While there have been debates over the effectiveness of the programme, the financial markets appear to have taken favourable note and this spring joined the European Commission and the rating agencies to take the Hungarian government through a version of scared straight. It seems to have worked.

Now there is a chance that Hungarian bonds could deliver both high coupons and capital gains, without excessive currency risk. For euro-based investors, these could be as high as 9 per cent over the next year, more than most hedge funds have been delivering.

Only months ago the Hungarian government was notorious for its willingness, in the words of Ferenc Gyurcsány, the prime minister, to lie “morning, noon and night” about its fin­ances. Now Hungarian ministers are jetting around the capital markets, disclosing their past sins and future plans with all the fearlessness of co-operating witnesses guaranteed full imm­unity. They promise deficits on the current account and the national budget will be cut to European Union-acceptable levels by 2009.

This, along with a series of interest rate increases by the Hungarian National Bank, have stabilised the currency and led to a rally in forint-denominated bonds. The HNB still seems to be in a tightening mode, with its governor, Zsigmond Járai, worried about inflation expectations. Much of the currency and bond strength, however, has come from covering short positions. There is not much of that left to do.

So at this point the questions are: can, or will, the Hungarian government stick to its reform programme? And will other investors follow with their money to buy into the turnround story?

I believe the odds are with the optimists at this point. There is going to be a temporary rise in inflation through the first quarter of next year, as previously subsidised prices rise to levels reflecting internal costs (healthcare) or world market rates (energy). In spite of the well-reported riots in Budapest, though, there is enough public support, particularly among the middle class, to allow the government to continue to cut the deficit.

Hungary’s proposed accession to the eurozone, while postponed, has induced much of the middle class to borrow in the euro and the Swiss franc. Consumers can save 300-400 basis points annually by using European currencies. That means, though, that if the government’s budget plan was to fail, the inevitable devaluation would do enormous harm to households needing to pay euro or franc debts with forint income. Furthermore, many members of the elite have been able to finance mortgages with subsidised interest rates, which makes them less vulnerable to any monetary tightening.

The government’s previous games with the budget are being disclosed and unwound. According to its economic “convergence” plan filed with Brussels, “methodological and acc­ounting changes have increased this year’s deficit by 1.4 percentage points”. Were that scale of adjustment required in the US government accounts, it would have increased the budget deficit by more than $180bn.

I met Janos Koka, minister of the economy, during his visit to New York last week. He had had a series of wearing meetings with American bond investors. “They’re more difficult than the European Commission or European Central Bank officials,” he said. “They do not want to just hear promises from the Hungarian government.”

He plans to give quarterly reports in person to the main capital markets. “When I come back, I will be able to speak not only about principles but about the outcome of key figures in the budget, which is the only way to justify that we are on the right track,” Mr Koka said.

The coalition government led by the Socialist party (Mr Koka is a Liberal) had been in open conflict with the central bank. HNB people had formed alliances with international investors to oppose government policies. Now, though, they are on the government’s side.

For its part, the government seems to have implicitly conceded the HNB clan was basically right for the past several years. Mr Járai will be retiring but the probable new governor, and the new members of the bank’s monetary council, will, it seems, be able to maintain the culture of the HNB.

Mr Koka says: “My party will be pushing for an independent central bank. Neither hostile nor dependent behaviour on the part of the HNB is welcome.”

What is the pay-off for investors? Hungarian government bonds live on an inverted yield curve. The sweet spot on the curve is probably five years, where the recent yields are about 7.5 per cent. To that you could probably add some capital gains, say one and a half percentage points over the next year, if yields come down by 50bp on a rise in investor faith. If the currency stays flat, that would mean a total return of 9 per cent. With a 2 per cent devaluation, if you are more pessimistic, that is still 7 per cent.

Foreign investors actually should do better on purchasing power than domestic investors. With inflation close to the current five-year yield, the Hungary-based holder will not get much, if anything, in real yield. But the tight monetary policies, along with strong direct investment flows and EU transfers, should maintain the exchange rate. So dollar or euro-based investors will do better than the locals.

It is not a bad bet. Budapest was shocked by its ratings downgrades, European Commission warnings that transfers could be cut and by the sudden unfriendliness of capital markets. It could be facing another, rather belated, downgrade from Moody’s. That would keep the pressure on the government. It should be sticking to its plan.

johndizard@hotmail.com

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