By Timothy Ash of RBS
Hungary seems to be centre stage at the moment, due to market worries of fallout from problems in the eurozone to emerging Europe.
So what is the government of Viktor Orban doing wrong, and how can it turn market sentiment in its favour?
The Hungarian forint is turning out to be something of a regional whipping boy, having weakened now by 20 per cent since July. The level of foreign exchange weakness is surprising given the following about Hungary:
- it is currently running a current account surplus (1-2 per cent of GDP)
- it is expected to post a budget surplus this year (2-3 per cent of GDP)
- will be one of the few countries in the region to see its public sector debt/GDP ratio decline – by around five percentage points of GDP, according to the European Commission’s latest projections.
But investors are clearly not impressed, and neither are the ratings agencies: both S&P and Fitch both signalled this week that the country’s investment grade status could be under threat.
The problem for the Orban administration is that current budget and debt ratios have been massaged to look better by short term fixes: the abolition of the second pillar pension system; and the imposition of sectoral taxes on big business. The government sold these as one-off measures required to buy time for the administration to pursue an aggressive structural reform programme.
The former has created large long-term unmatched pension liabilities for the state. The latter it was hoped would deliver higher rates of growth, allowing Hungary to grow itself out of debt concerns – Hungary’s public sector debt/GDP ratio is around 76 per cent, and is the highest in emerging Europe, albeit low by eurozone standards.
The problem is that the structural reform programme (the ‘Szell Kalman’ plan) has run into difficulty, with implementation being much tougher than expected. The departure of one of the programme’s architects (Andras Karman) has hardly helped the mood music surrounding the plan. And while the government can be commended for its ambition in terms of its programme – it is one of the few governments in the region actually focusing on new drivers for growth – the problem is that the radical nature of the programme risks shocking the economy, weakening growth and recovery.
Add to this government efforts to resolve the problem of household foreign exchange debt, which has put it at loggerheads with its banks – most of which are European and looking at deleveraging across the region – and the government faces a serious challenge.
The government needs to quickly turn market sentiment, which is overwhelmingly negative at the moment. The central bank could try to prop up the forint by aggressively hiking policy rates or selling some of its $52bn foreign exchange reserves – which they indicated on Tuesday may happen. But given the fact that the crux of the problem at the moment seems to be a confidence issue in terms of government policy, perhaps an alternative solution is required.
I would argue that a new precautionary arrangement with the IMF would provide assurance for the market that the Orban administration’s more unorthodox policy refluxes can be bounded. Arguably, Hungary does not need significant new official financing, but could fund itself from the market if backstopping from the Fund was provided.
This could be the sentiment changer for the market. But for Hungary’s prime minister this would be a tough pill to swallow given that he has made much of breaking from the IMF and running an independent economy policy. However, needs must – and failure to act now could see the central bank forced to aggressively hike policy rates in defence of the forint, which would kill any recovery in its tracks.
Timothy Ash is head of emerging markets research at Royal Bank of Scotland