Is Hungary Set To Become The New Iceland?

Iceland, why on earth Iceland? Well, the issue I have in mind concerns the independence and viability of central bank monetary policy (especially in a small open economy like Hungary’s) and the role interest rates, and investor sentiment, and yield differentials, and oh yes, I almost forgot, that notorious vehicle so beloved by investors the “carry trade” in producing a situation where financial dynamics get really out of hand.

In a visionary paper given at the International Conference of Commercial Bank Economists (held in Madrid, July 2007) – entitled The Global Financial Accelerator and the role of International Credit Agencies – the Danish economist Carsten Valgreen argued the following:

The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.

Interestingly enough, Valgreen chose as his paradigmatic examples of central bank loss of control over monetary policy the cases of Iceland and Latvia. Equally today we could add the name of Hungary to our list. As Valgreen argued (and this remember, before the sub prime blow-out):

It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. A country such as Iceland will be the first to notice that the agenda for monetary policy has changed, as the current and capital accounts are naturally very large and important for the economy. However, this is more of a reason to study its experiences carefully, as they might show something of what is in store for larger economies over the next decade.

So the issue really is, does the Hungarian National Bank continue to control monetary policy in any meaningful sense, or is it reduced to responding to events elsewhere? And does the Hungarian government have any effective tool left with which to fight this crisis? But getting ahead of ourselves and going too far into all this, let’s step back a bit, and take a longer look at the Hungarian economy, just to set the scene.

The IMF and the EU Agree To A Larger Deficit

The International Monetary Fund and the European Union has now approved Hungary’s request for a larger budget deficit this year, thus giving the government marginally more room for manoeuvre in the face of the very severe contraction in GDP. The government is now going to be authorised to aim for a 3.9 percent of gross domestic product shortfall, as compared with the earlier 2.9 percent objective, according to Finance Minister Peter Oszko. The government have also revised their forecasts, and expects the Hungarian economy to shrink by 6.7 percent this year, the most since 1991, a revision from the earlier 6 percent forecast. Hungary was the first EU member to arrange a 20 billion IMF-led bailout last year, lining up 20 billion euros in a bid to avert a default after investment and credit to eastern Europe dried up. The country then pledged to keep its budget deficit under control to qualify for the loan.

The question is, is this good news or bad news? Evidently the decision not to strangle the government budget is welcome (we are in danger of a contraction that feed on itself here, since with external demand at very low levels, applying 9.5% interest rates and fiscal tightening means the economy can simply fall into a downward spiral). But in the braoder context the news is not good. The IMF and the EU have cut Hungary some more slack simply because the ferocity of the slump in output is worse then any previously imagined, and things are now going to get worse, not better. Which made it rather strange to read in Bloomberg this morning that Finance Minister Peter Oszko has announced the government is to consider selling foreign-currency denominated bonds this year in order to take advantage of rising investor confidence. We are on very dangerous gound indeed here gentlemen! I mean, whatever happened to once bitten twice shy. According to Bloomberg:

Foreign-currency borrowing, along with slower growth, a wider budget deficit and higher government debt than elsewhere in eastern Europeraised concern about Hungary’s ability to repay its debt lastyear……IMF and EU officials this week approved Hungary’s plan torun a wider budget deficit this year and next than earlier targeted….

So what exactly has changed? According to the latest data growth is now even slower than before (or rather the contraction is sharper), the budget deficit and gross government debt are both pointing up again, and the only (vaguely) “good” news is that living standards are falling so fast that the trade balance is improving, and with it the current account deficit. But the government debt dynamics are not the same as the external trade one, and things are getting worse, not better, which makes you wonder what all the optimisim is about? In their recent stress testing exercise the Hungarian Government Debt Management Agency suggested the debt path was sustainable (see much more below on this), but in order to offer this assurance they assumed an average growth rate of GDP of 3% 2013 – 2020 even in their worst case scenario! . My estimate is a much more sobre one, and that is, with declining and ageing population to think about – the Hungarian ecenomy will be lucky to average 1% growth over the above time horizon (more justification on this below). So as far as I can see Hungary’s public debt dynamics are still set on a clearly unsustainable path.

Then you need to take into account how you have a 9.5% central bank benchmark interest rate going into a 6% percent plus GDPcontraction (with inflation around 3%), so what are people thinking about? This policy mix doesn’t work, and it won’t. If you lower the interest rates to support the economy, the forint crashes, and with it the balance sheet of all those households still holding CHF denominated mortgages in their portfolio. Hungary is clearly caught between the proverbial rock and the hard place.

And what’s more, this policy mix is leading to all sorts of distortions. Hence the reference in the title of this post to Iceland, since Iceland’s problems precisely got out of hand, due to the “juiciness” of the trade their domestic interest rate yield differential offered. Viz a recent Deustche Bank report which specifically recommended buying HUF denominated assets, due to the yield differential.

Currency deals that profit from the difference in interest rates globally are returning to favor on speculation the worst of the creditcrisis may be over, spurring investors to buy eastern European assets,Deutsche Bank AG said.The Russian ruble, Hungarian forint and Turkish lira offer investorsthe best returns in the next two to three months thanks to the highestrates in the region, said Angus Halkett, a strategist at Deutsche Bankin London.The so-called carry trade, in which investors borrow in currencieswith low interest rates to buy higher-yielding assets, helped theforint and lira surge to record highs last year before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets.

Perhaps people should reflect a little more on the significance of those final few words: “before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets”.

This is what is known as the “carry” trade, and it works like this. Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations with interest rates which are often in double figures.Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like Brazil, Hungary,Indonesia, South Africa, New Zealand and Australia which collectively rosee around 8% from March 20 to April 10, the biggest three-week gain since atleast 1999 for such carry trades, according to data compiled by Bloomberg . A straightforward carry-trade transaction would be to borrow U.S. dollars at the three-month London interbank offered rate of 1.13% and use the proceeds to buy Brazilian real and earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% – as long as both currencies remain stable, but the real, of course, is appreciating. Now all of this can present a big problem for a number of CEE economies, because:

Turkey’s key interest rate is 9.25 percent, Hungary’s is 9.5 percent and Russia’s 12 percent. The cost of borrowing in euros overnightbetween banks reached 0.56 percent yesterday from 3.05 percent sixmonths ago as the European Central Bank began cutting interest rates and pledges of international aid allayed concern the global slowdownwould worsen. The London interbank offered rate, or Libor, forovernight loans in dollars fell to 0.22 percent from 0.4 percent inNovember as the U.S. government and the Federal Reserve spent, lentorcommitted $12.8 trillion to stem the longest recession since the1930s.

So basically, “Big Ben’s” US bailout is fuelling specualtion on Hungarian debt!

And don’t miss this point from the Bloomberg article:

Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months from 286.55 today. Investors should also sell the dollar against the lira and buy the ruble against the dollar-euro basket, the bank said.

And it isn’t only Deutsche Bank, Goldman Sachs recommended on April 3 that investors use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles.

We can see some of this impact in the German ZEW investor sentiment index. As can be seen, something interesting is happening somewhere, even if it is not immediately evident where. As Solow would have said, “I can see evidence for improved investor sentiment everywhere, except in the real economies”.

So, come on everyone, off you go to Monte Carlo, and place your bets. But meanwhile, remember, in Hungary at least, the most notable phenomena are the growing unemployment and the way the bad loans pile up, even as the Hungarian economy tanks! Basically, the all the evidence now points to the fact that IMF and the EU urgently need a rethink about how they are going about things, but this is beyond the scope of the present post.

“Hungarian lenders face an increase in non-performing loans, which will contribute to “substantially deteriorating” profits for the country’s financial system, central bank Vice President Julia Kiraly said. The whole banking system, which is stable with adequate liquidity, may end up with “negative profit” this year and some lenders need to strengthen their capacity to resist shocks, Kiraly said at a conference in Budapest today.”

The Fundamentals, All The Fundamentals, And Only The Fundamentals

Horrid GDP Data

The decision to widen the deficit allowance slightly is not that surprising when you take into account that Hungary’s gross domestic product dropped by 5.8% year on year in the first quarter of 2009. The figure was announced by the statistics office last Friday and followed a decline of 2.6% in the last three months of 2008.

Quarter on quarter there was a 2.3% GDP decline, (down from 1.5% contraction in the fourth quarter) which means the economy was shrinking at a 9.2 percent annualised rate, quite sharp, but far from being one of the worst cases in the EU. What makes the Hungarian recession rather different is the way it has been lingering in the air since the initial “correction” in 2006, and is now becoming protracted since this was the fourth consecutive quarter when quarter on quarter growth was negative, and it is hardly likely to be the last.

Household consumption is in continuos decline (see retail sales data below), real wages are falling, and the lack of internal and external demand growth means that investment remains weak. Further, this dynamic is not likely to change rapidly. Exports have plunged – even though since imports have slumped even further we have the ironic detail that net trade is still mildly positive for GDP. However, with interest rates at such a high level and fiscal policy being continually tightened there is little chance of a ‘V’ shaped recovery in Hungary, and the recession has all the hallmarks of becoming an ‘L’ shaped” one.

Even the agricultural sector due to the high base effect of last years bumper harvest. So basically, it’s back and back in time we go at the moment.

Retail Sales In Continuous Decline

Hungarian retail sales fell for the 25th consecutive month in February as rising unemployment falling wages and a generally deepening recession sapped consumer spending. Retail sales were down an annual 3.2 percent following a 2.8 percent decline in January, according to national statistics office data. Prime Minister Gordon Bajnai, who replaced Ferenc Gyurcsany last month as differences over how to handle the recession boiled over, has indicated he plans to raise the value-added tax as the recession cuts into budget revenue. This will surely push sales down even lower, and household consumption is now expected to decline by as much as 8 percent this year, according to the most recent government estimates.

Consumers started finding themselves with less to spend following the introduction of the government austerity programme in 2006 which raised taxes and utility prices.

Unemployment On the Up and Up

Hungary’s jobless rate rose to 9.7% in March, up sharply from the 8% level recorded in December. Hungary’s unemployment rate has been howevering continuously in the 7%-8% range for more or les 4 years now, so the current spike (with the prospect of more to come) suggests something important has changed. Between Q4 2008 and Q1 2009, unemployment claims rose by 66,000.

Of the country’s 402,800 registered unemployed, 42.5 percent have been out of work for at least a year, now. The number of Hungarians employed averaged 3.76 million in the first quarter, compared with 3.88 million in the previous three months. It is hard to see a resurgence in the number of Hungarian’s employed, even after this recession is past and forgotten, since the working age population is falling steadily, and has been for some time now.

Alongside the increase in unemployment the activity rate has declined even more rapidly. Of the 117,000 laid off during the last quarter some 40,000 chose to remain inactive rather than looking for employment elsewhere. Hungary’s already languishing job market received a major blow from the global economic crisis in the form of layoffs and bankruptcies, meanwhile, companies may have been more cautious in hiring new staffers. These job market trends were only to be expected, however downsizing is on a higher scale compared with forecasts. Hungary’s economy is in a state of deep recession, with predictable consequences for employment, real wages, and demand.

One consequence of the sharpnesss of the recession has been that Hungarian aggregate wages are falling much more rapidly than anticipated, and this, in turn, has put a major dent in the new government’s fiscal adjustment plans. The Finance Ministry had originally anticipated an additional HUF 50 billion in tax revenue. However, the new unemployment figures suggest that the decrease in wage costs may surpass the government’s most recent 2% forecast. In a worst-case scenario, the drop in aggregate earnings may be as high as 4%, with a HUF 100 billion-HUF 150 billion negative impact on the budget.

Exports Continue To Fall

Hungary posted a foreign trade surplus of EUR 492.8 million in March, the largest in the past decade, according to the Central Statistics Office (KSH). Still exports were down by nearly 20% year on year, and the improved balance was the result of imports falling even more – by over 23%.

In fact Hungary’s exports came in at EUR 5,173 million in March – an 18.2% year on year decline, a considerably slower rate of decline than that registered a month ago (-29.7%). Imports came in at EUR 4,680 million , a staggering 23.4% drop, following a plunge of 32.3% in February.

The gap between export and import growth (5.2 percentage points) has not been as wide as this this wide September 2007 (5.9 percentage points). The March balance shows a record high, a surplus of EUR 492.8 million, which compares with a surplus of EUR 213.9 million in March last year. Exports in the first quarter as a whole amounted to EUR 13,843 million, a decline of 26.3% in annual terms. Imports in Q1 amounted to EUR 13,233 million, down 28.5% year on year. Hungary’s Q1 foreign trade balance showed a surplus of EUR 609.3 million, another record, which compares with a surplus of EUR 282.1 million for the same period of 2008.

And Industrial Output Slumps

With exports slumping in this way it is not surprising to find that Hungary’s industrial production dropped by 19.6% in March, according to working day adjusted data. Over the first quarter Hungarian industrial output declined by 22.3% year on year, but – although it rose 4.3% month on month, according to data adjusted for calender and working day changes.

And activity in Hungary’s manufacturing sector continued to contract in April according to the PMI reading, although the pace of contraction is now down slightly from January’s all-time low.

The headline manufacturing PMI stood at a seasonally adjusted 40.4 in April, up slightly from the 39.5 registered in March, according to the release from the Hungarian association of logistics. This was the seventh consecutive month of contraction, following the all-time low of 38.5 hit in January. The Hungarian government currently forecasts that GDP will contract by as much as 6% this year as the German economy, Hungary’s chief export market, also faces a similar decline in GDP. Hungarian manufacturing output contracted even more in April than in March, to 37.1 from 37.6. The export index showed a further decline to 35.6 from 36.5 in March. The only positive development came from the new orders index which showed a marginal increase to 37.5 from a reading of 35.0 in March.

Only Inflation Rebounds

Hungary’s inflation rate unexpectedly rose in April for the first time in 11 months, after a weaker forint made imports more expensive, with prices of fuel, medicine, clothing and new cars leading the rise. The annual rate was 3.4 percent, rising from 2.9 percent in March to what is its highest level so far this year. Core inflation, which filters out food and energy prices, was 3.2 percent on the year and 0.5 percent on the month. The annual rate had returned to the central bank’s 3 percent target in February for the first time in more than two years.

The prices of consumer durables, including cars, rose 1.4 percent in a month, while fuel costs climbed 2.9 percent and medicines by 1.9 percent. The price of clothing increased 3.7 percent, the statistics office said. With Hungary’s recession damping demand, consumer prices are set to increase “only moderately,” according to the central bank. Policy makers now expect the inflation rate to average 3.7 percent this year and 2.8 percent next year. The bank raised its estimate from an earlier forecast of between 3.1 percent and 3.4 percent for 2009 and 1.5 to 1.9 percent for 2010.

One factor which will influence future inflation is the new government’s decision to raise the main value-added tax rate to 25 percent from 20 percent, as of July 1 in an attempt to offset declines in state revenue and narrow the budget gap. Raising the rate of consumption tax is deeply problematic in the sort of double-bind situation which Hungary faces. Germany raised VAT by 3 percentage points on 1st January 2007, and look what happened to consumption (see chart below) in December 2006, and then subsequently. This is doubly relevant to the Hungarian case since the Hungarian economy is more than likely set on the German path of becoming an export dependent economy. Weakening domestic consumption further could well prove to be a “lethal dose”.

Magyar Nemzeti Bank policy makers expect the annual inflation rate to be “near” their 3 percent goal “on the monetary policy horizon” of five to eight months, they said on May 8.

“The NBH would clearly like to cut interest rates, which at 9.5% look far to high for an economy that will contract by 5-6% this year, but this is more dependent on global financial stability and declining risk aversion than the latest CPI release.” Nigel Rendell, Royal Bank of Canada

And So The NBH Keeps Rates On Hold

Hungarian monetary policy makers left the benchmark interest rate unchanged at their April meeting for a third month as concern over the forint’s decline outweighed the outlook for slowing inflation and growth. The Magyar Nemzeti Bank kept the two-week deposit rate at 9.5 percent.
Policy makers didn’t consider cutting the interest rate in March based on stability concerns (according to the minutes) and even rejected a proposal, backed by Governor Andreas Simor and his two deputies, to raise the key rate to 10.5 percent. In April the rate-setting Monetary Council considered the recession, the outlook for inflation and economic stability when setting the key rate. The annual inflation rate may be near the bank’s 3 percent target on the 18-month monetary policy horizon, according to the statement.

Much Ado About Debt

Zsuzsa Mosolygó and Lajos Deli, of the Hungarian Government Debt Management Agency recently published what they call ” a first a simple model to analyze the impact of the international credit line on debt ratio trends as well as to demonstrate the importance of calibrating reasonable values for decisive macroeconomic parameters”.

Read stress tests.

Below you will find the chart showing their basic assumptions, and giving the outcomes for the various scenarios. The whole idea of the process was to show that Hungarian debt to GDP will not necessarily rise in the future as some analysts had been predicting. I don’t want to go into all of this in too much, but if you click on the chart and take a look at the assmptions for GDP growth (which is actually the key parameter), you will find that on both the basic and the pessimistic scenarios average growth of 3% is assumed (this is impossible to attain on my view), while the “optimistic” scenario even assumes 4% (incredible). Remember these are average growth rates and over seven years (2013 – 2020). This is like selling Spanish property pre 2007 with a splendid photo of the sun and the beach.

And this comes from two apparently serious analysts, analysts who are supposed to be committed to taking a serious stab at putting the country’s longer term finances on a stable footing. All they actually acheive is offering a confirmation of the worst fears of those of us who feel that the debt dynamics in Hungary are totally unstable in the mid term, and illustrate just how out of balance most of Eastern Europe now is as we move forward.

They justify their decision in the following way:

Market analysts tend to assume in their debt models a 2% economic growth for the
Hungarian economy. The National Bank of Hungary estimates currently a 2%
potential GDP growth rate, however, it does not mean necessarily the long-term
economic growth. A few years ago the estimates were higher and it seems to be
possible that adequate reforms to encourage employment would result in a 3-4% or
even higher potential GDP growth rate.

(Please Click On Image For Better Viewing)

In fact the objective of the study was not to seriously stress test Hungarian debt dynamics, but to try to argue that those analysts arguing for unsustainable dynamics have it wrong. The end product isn’t very convincing. Not surprsingly the debt to GDP ratio diminishes gradually after 2009 both in the “optimistic” and “basic” version. The authors even underline that debt development does not appear to be unsustainable under very pessimistic macroeconomic conditions, either. In the “pessimistic” scenario debt ratio peaks at about 80% in 2020 and descends slowly afterwards (which is due to the assumed 6% interest rates). Of course, “pessimistic” here means Hungarian GDP rising by 3% a year every year from 2013 to 2020. To put this in perspective, using current Hungarian government forecasts average GDP in the ten years up to 2010 is something like 1.8% per annum. And this has been a pretty good decade by Hungarian standards (see chart for long term growth).

In fact, with a declining and ageing workforce, together with decline domestic consumption (see retail sales chart above), even a 1% per annum growth rate may be optimistic. In any event we won’t see 3%, and nothing produced by the Hungarian government to date substantiates the claim that longer term debt is NOT on an unsustainable path. “To sleep, perchance to dream-ay, there’s the rub.”

This entry was posted in A Fistful Of Euros, Economics: Country briefings, Economics: Currencies by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

17 thoughts on “Is Hungary Set To Become The New Iceland?

  1. Hi Edward,

    although I tend to agree with you that the picture is not very rosy, I think you were not really fair with the guys from the National Debt Management Agency. It is good that at last someone takes the challange (nobody dared to answer them from those to whom it were directed), but otherwise your view is a very simplistic one, especially reagrding your counterarguments. Moreover you were omitting some important details and parts of the context. It was not a stress test in the proper sense, and never was it intended to be, just an argumentative article providing the reader at least with the basic methodology. It was written beracuse the view they were contesting had nothing to do with methodologically sound analysis, those were hysterical opinions expressed in interviews (just google Heim Péter who envisioned an inevitable default in months and filled with this the Hungarian media landscape) without any argumentation and proofs being put forward. But it is also important, that Mosolygó and her companion pointed out that every so called serious analysis took gross debt as equal with net one, calculating as if the IMF loan would be a lasting burden and not a means to replace outgoing ones. Even though the contraction will raise the level of debt/GDP ratio it is not unimportant whether the starting point is 65-70-75% or more than 80% as almost everyone calculates.

    But the real problem is that you tries to “ridiciule” the pessimistic scenario with the argument that 3% growth rate is unrealistic. It is perhaps true, but as the table provides some more information it is clear that the pessimistic scenario is based not solely on this assumption but on a whole set of paramters, many of them similarly pessimistic concerning the past or the possibilities. For example the assumed long term average exchange rate of the forint, or the central bank rates or the primary budget balance. As Mosolygó and her companion gave the basic calculus as well, you can run simulations with your assumed 1 or 2% long term growth rate and judge whether the necessary modification of other parameters in order to ensure the same path for the long term change in debt is realistic, possible or impossible.

    As far as I understand you simply took the other parameters ceteris paribus and decided that the prediction for growth is problematic. (It can be.) I don’t think that it is a methodologically sound approach, especially as it is aimed at the future and therefore we can only have some basic assumptions and no certainty about those data. For example why isn’t it possible that a government – the composition of which in 2016 is completely unpredictable – will run a 2 or 3% primary budget deficit instead of one percent? And why would it be disastrous, as even the original budget for this year, with the 2,6% deficit was based on primary surplus, not deficit? I would say that it is somehow revealing the main deficiency of the use of such models for forcasting: you have so many parameters to decide deliberately, that you will almost certainly make a mistake and it is not impossible that this mistake will completely ruin the efficiency compared to the “real” data.

    You are completely right when you put forward the issue of demographics especially as this is a factor not to be changed easily, as it is harder to raise the fertility rate lastingly than to eliminate budget deificit. But it has nothing to do with the calculus described in Mosolygó’s article. And I would be more inclined to take seriously those, who at least know the difference between net and gross debt, then those who are not capable to grasp it, be the latter even S&P and its team.

  2. Hello Wolff,

    First thanks very much for taking the trouble to right such a lengthy response.

    Before getting into the debt sustainability issue – which is the meat of what you talk about – I would like to make a counple of points.

    1) The thrust of what I am saying here is not especially about the side dish of Hungarian debt. What is happening in Hungary raises questions about difficulties which face a number of countries in the east of Europe whether inside (Romania and Hungary) or outside (Russia, Serbia, Ukraine) the EU. And that is they are trapped, since the high interest rates they are offering is attracting “carry” and this is making the operation of normal monetary policy impossible, and makes the future very difficult. So my first point is that the current IMF bailout strategy doesn’t take account of this, and the whole situation is very precarious.

    Read the Valgreen paper, it is, as I say, visionary in this sense.

    2) Secondly, I would like to suggest that many of the arguments coming from Eastern Europe at the moment are really rather counter productive, since they tend to suggest that things aren’t as bad as they seem, when really they may well be worse than they seem. Thus, arguments which are advanced due to issues of national sentiment and pride really don’t help, since if the IMF programmes aren’t working – and they aren’t – then this needs to be addressed, and the sooner the better.

    Now for your main points.

    “It was written beracuse the view they were contesting had nothing to do with methodologically sound analysis, those were hysterical opinions expressed in interviews”

    Basically I understand this, but I simply want to go to the heart of the matter. Basically I would argue that GDP growth is the main and important indicator, since everything else depends on this. You can adjust government spending, you can redistribute income, you can do whatever you want, but if you don’t have sufficient cake, then you can’t pay the pensions, you can’t pay the health, and you can’t pay the debt.

    This is a methodology Claus and I have been developing by looking at other ageing societies – Italy and Japan – and has lead us in both cases to the conclusion that the debt simply is not sustainable in the longer run. That is, both these countries are liable to be forced into default at some point. They will be forced into default because the numbers simply don’t add up. Hungary is simply the first case of a new batch of countries with unsustainable debts who are about to arrive in Eastern Europe – although ultimately this will become a global problem.

    The issue is how you can get fast enough GDP growth to stop debt (whether net or gross) from rising as a proportion of GDP as you try to support ever higher elderly dependent populations. This is the first time in human history that any societies have tried to run on these proportions, and I don’t think they can. So we have a problem. But the sooner we start to talk about the problem the better.

    Basically, you can cut spending on older people. But then those older people have families, so the family members support them. This simply tranfers the liabilities from the state to the family. This raises all sorts of social and political issues, but it is the economic ones which interest me. Basically the economic consequence of this transfer is that domestic consumption gets weaker and weaker as younger people, instead of borrowing try to save. We ahve already considerable evidence of this dynamic in societies like Germany and Japan. It leads to a brutal export dependence, which is fine as long as world trade grows, but as we can see now, as soon as it doesn’t these economies implode, and it is this implosion that puts all the pressure on the debt. Look what is happening to Italy debt to GDP now.

    OK, all this is out of mainstream thinking, but not taking this possibility into account seems foolish to me, since evidence to support the hyothesis is mounting.

    “As Mosolygó and her companion gave the basic calculus as well, you can run simulations with your assumed 1 or 2% long term growth rate and judge whether the necessary modification of other parameter”

    This is what I am saying, on a back of the envelope calculation of 1% or lower trend growth Hungary is bust before 2020. All the other parameters – exchange rate, inflation, interest rates depend on this. This is the problem with a lot of models, variables do not behave in linear fashion, they are interconnected and their are feedback processes. It is the kind of test Mosolygó was carrying out which is rather naieve, I am afraid.

    “as it is aimed at the future and therefore we can only have some basic assumptions and no certainty about those data.”

    Well, we can apply levels of probability, and then calibrate and adapt. Up to now Hungarian policy since 2006 has been driven by a “this year was bad so next year will be better” theory of probability. I have plausible theoretical assumptions, and the empirical data has been backing me up since 2006 (when I started my Hungary blog, and started saying this). A lot of people are being asked to make sacrifices, this is not something we should take likely.

    “it is harder to raise the fertility rate lastingly than to eliminate budget deificit. But it has nothing to do with the calculus described in Mosolygó’s article.”

    I’m sorry, I don’t follow. As I see things it has everything to do with it. What conditions sustainability and non sustainability in public debt is shifting median age (in the longer run) this is what conditions the ability of a society to generate wealth, and the liabilities it has to meet from the wealth it creates.

    Societies with high populations under 15 are unstable due to the need to support so many unproductive people, and societies top heavy with people over retirement age the same.

    “For example why isn’t it possible that a government – the composition of which in 2016 is completely unpredictable – will run a 2 or 3% primary budget deficit instead of one percent?”

    Basically because, the level fo the deficit influences the level of growth – that is, logically more deficit more growth, since deficit is demand expansionary, as I say these things are inter-related. If you get no deficit, you get low growth and you need to cut back on services, which increases saving and so on. This is a negative feedabck spiral. And I don’t think it matters at all who is in the goverment, since the IMF will be overseeing – or rather the IMF and the EU.

    “I would be more inclined to take seriously those, who at least know the difference between net and gross debt,”

    I think this difference is a red herring (I have been having this debate over Japan for years), and also I have a lot of respecyt for S&P, if people in the CEE had been listening to them to some extent you wouldn’t be in this mess.

    Basically gross debt is the best number to work from (and it the one the OECD and Eurostat use), quite simply because the net debt elements are not priced on a mark to market basis (they are at best priced on a held to maturity basis), and we quite simply do not know what some of these things are worth.

    But this is beside the point, what matters isn’t any given number, but the underlying dynamic. Japan has gross debt of around 190% of GDP right now, Italy around 107%, Hungary between 65 and 70%. All these are unsustainable, because they are climbing without the possibility of changing course – due to the difficulty that trend growth is gradually moving towards and then below zero. What we would need to see is a “balck swan” (or empirical counter example) – that is a society which enters this dynamic and manages to bring the level down permanently.

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  4. Hi Edward,

    thanks for taking the the time an energy for replying for such a lay as I am. I won’t say we agree on many points but at the same time our views are not quite far from each other, rather they adress different problems. I would like to stress again that I tend to agree with you on the lasting and disastrous effects of population ageing, but neither Mosolygó, nor the others prophesizing the inevitble take into account this factor and base their conclusions on it. Mosolygó and her companion wrot an article using the same parameter and same basic assumptions reagrding what is influencing the cahnge of debt to GDP ratio as it is used by others and they reasults should be interpreted and contested in the same model and framwork in order to judge whether they are “right” or “wrong”. It is possible of course that the others reached a right conclusion from wrong premises with wrong reasoning but it won’t make their work better and more than a classical fallacy in their reasoning, isn’t it? There is simply no place for the effects of demographics in those models, otherwise the guys predicting the catastrophe won’t sell the story that a simple change in the tax system would raise the potential GDP grwoth rate with two points as high as 4% a year. (Well, Mosolygó’s assumption regarding the 3% has to be interpreted against this background.) Your approach is seemingly different, while your primary basis is the demographic change, others – either at S&P or in Hungary or at the National Debt Management Office – do not really bother themselves with such issues, otherwise they won’t be so sure in their ideas regading the possibilit of long and sustainable growth in Hungary.

    Only one additional point should be raised here, the issue of net debt. At the moment it is a bit different from the situation you suggested, when the assets of the country can be in government loans from Iceland etc. The other analysts simply added the IMF loan to the sovereign debt, even though for example a large chunck of it – at about 6 billion dollars (?) – is simply a deposit at the HNB. I wouldn’t dare to predict that 6 billion dollars is not worth of 6 billion dollars, because of pricing problems. (I know that the HNB can buy bonds from it and have losses but it is not really realistic that they will lose it.)

    But to sum up carefully although I’m inclined to buy your reasoning regarding the demography and its effects, the problems arising from those processes etc. Mosolygó and her companion wrote an article in using premises and assumptions equally accepted by those whose views they contested while neither of them regards demography important enough to be built in in their models. But that should mean, as a consequence, that you have problems even with models predicting default, because those are not fortelling its real reason.

    Otherwise, there is a factor that can cushion the transition in Hungary (in the medium term, as the dependency on export won’t really change) the low employment rate. It can signall the existence of some reserves in the system, even though its mobiliziation is not so easy as it is preceived by many, via the tax system.

  5. Ed – this form is fucking awful.

    I just typed out a post, missed the spam protection and hit submit. It tells me to go back and fill in spam protection; BUT IT HAS WIPED MY POST.

    If that’s the back behaviour, you need to change it so it doesn’t let you submit in the first place.

  6. Wolff,

    “Otherwise, there is a factor that can cushion the transition in Hungary (in the medium term, as the dependency on export won’t really change) the low employment rate. It can signall the existence of some reserves in the system, even though its mobiliziation is not so easy as it is preceived by many, via the tax system.”

    Oh I agree. I’m not saying nothing can be done, its just we need to be realistic about the difficulties, and we need a policy on an EU level to all help each other. I am sure participation rates can be raised in Hungary, and this is important, although I agree with your scepticism: it won’t be as easy as many seem to think.

    And I am not pessimistic, as I have indicated before, about Hungary’s potential export prowess in the future. I would put Hungary second to the Czech Republic in this regard.

    But first we need to break out of this dreadful contraction.

  7. But I still want to stress that all this is simply a side plate at the moment. The big danger is that investor enthusiasm for “carry” trades acn distort everything completely.

    And it isn’t only Hungary who have a problem, Renaissance Economics, in a research report out today, make the very valid point that the 14 percent rebound in the ruble against the dollar since January is once more eroding the competitiveness of non-energy businesses in Russia and risks pushing the country directly back into a “boom-bust cycle,”. Roland Nash, chief strategist at Renaissance Capital says:

    “The danger for Russia is a stronger ruble, not a weaker one,” Nash said in an interview from Moscow today. “A weaker ruble definitely helps the non-oil economy and a stronger ruble definitely hurts them.”

    The other key point about this would be the way the high interest rates on offer to maintain ruble liquidity attract carry trade plays from investors, which artificially sustain the ruble. My own feeling is that the high interest rates have encouraged ruble liquidity, and this is supporting the currency and stabilising the reserves. But, as Renaissance Capital point out, things can’t go on like this, since Russia’s economy will only keep contracting internally, especially as we get into next year, and they can’t keep pumping in fiscal stimulus. So, even though we won’t see violent contractions everywhere like we just saw in Q1, 2010 could well be a generally tougher year than 2009, since there will nothing like the same room for fiscal stimulus. Russia’s leaders are obviously gambling that oil prices will rebound, but if they don’t……….

  8. I liked this profound and critical analysis, however, as a co-author of the cited analysis at Hunagarian Government Debt Management Agency I would like to hereby make a correction. We assumed 2 per cent economic growth in the pessimistic scenario but the translater made a “copy-paste” mistake when translating the analysis. Mr Hughes cannot help it, either, of course. We have already made the English version correct and one can found it here:

    In addition, I would like to add that it is not the economic growth that determines life and death about debt paths, though it is an important factor. And it is not the best to calculate an avergae 1.8 per cent economic growth between 2000 and 2010 for Hungary and to derive from this a bad growth outlook for the next decade. In 2008-2010 we are just experiencing a huge world recession not seen long-long ago and there hardly were structural reforms in Hungary in this decade… Economic growth, however, was around 3-4 per cent before authority measures in 2006-2007. In Hungary everyone would argue that this decade was pretty good for us… Just take a look at Slovakia, for example, where Dzurinda-reforms made the economy grow like hell until the crisis.

    All in all, debt path is not unsustainable even with 1 per cent growth in the next decade. One should take a look at the USA or UK since it is fiscal deficit that makes debt unsustainable and Hungary performs in the next few years one of the best in Europe and in the world. That is what counts and what should be monitored and enforced. Now IMF terms and conditions helps to carry out a responsible fiscal policy in the following years and this positive fact should be underlined, I think.
    Lajos Deli

  9. Mr. Deli makes a good point, but the key for turning around a fiscal deficit is obviously either by cutting spending and/or increasing tax income – if a country is in decline and you increase taxes, especially taxes on consumption, then there is no guarantee those taxes will increase receipts in the medium or long-term because the overall level of consumption may decrease disproportionately – you may argue the Laffer curve is not completely true; however, it is not completely false.

    A debt path for a country depends on expectations of how much support (and hence spending) will be required to make a turnaround, so I feel a comparison of the UK to Hungary is unfair as our economy is far less exposed than yours, not to mention our credit rating puts us far behind you in a race to a sovereign debt crisis.

    Whether GDP growth is projected at 2% or 3% is irrelevant, I think both are unrealistic unless radical measures to support the economy are taken by 2012 and quite possibly, Euro Membership which I would wager is perhaps something you are betting on – if that is the case, please enlighten us.

    The crux of the matter is clearly the stability of the currency – the MNB is evidently acutely aware of the exposure of the economy (and the government) to foreign currency debt and hence, the ability to service that debt is crucial to preventing a free-fall in both GDP and the Forint.

    Sadly, the government lacks any sort of credibility to assist the MNB in keeping the currency supported in the face of interest rate cuts and I would not be at all surprised if a shadow-economy transacting in Euros has sprung up, stemming from a lack of faith in the Forint. The result net effect is that the MNB has indeed essentially lost control of monetary policy

    Additionally, the commercial banks themselves are very much part of the problem and steps should already have been taken to address this, especially with regard to their treatment of FX borrowers and otherwise – the public sector needs to learn that the private sector will happily hold a cap out and hoarde liquidty till the cows come home unless threatened with measures that bite at the heels of executive management.

    The ideal solution would be to allow Hungary an early entry into the Euro – this would lift a huge weight from the shoulders of many, however, the odds of that are as likely as Jobbik convincing the population that they’re not Nazis.

    So, in the absence of any such relief, the only hope for Hungary is for it to try and maintain exports and hopefully make itself more competitive for industry to consider the country as a viable manufacturing base.

    The population will very likely continue to languish until there are either improvements in the standard of living, or perhaps cutbacks in education spending that kills off sex education.

    If (When) Fidesz win the elections, I can foresee a reversal of Bajnai’s programme (to what extent I can’t be sure) and some maneuvering to begin a process of spending that will aim to support the economy – the success of which will largely depend on their ability to convince the rest of the world that the country can indeed make a stable recovery and hence maintain the stability of the currency.

    It is entirely possible in my eyes that in order to satisfy political goals Fidesz may simply restrict capital movement in order to provide support, though this would be rather extreme to say the least and repercussions with regard to joining the Euro also make such a move unlikely, but nonetheless, possible.

    That said, with a foreign currency borrowing of just under 50% of gross debt, maenuverability is extremely tight – the ultimate saviour will be taming the banks, and then, foreign investment; be it direct private input or more from the IMF, though in the latter case, more flexible terms will be crucial to a proper sustained recovery.

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  11. Hello Deli,

    Thanks for taking the time to make the lengthy comment. Basically, we are in the very grey and muddy area of “methodolocial issues”.

    In part, the answer one gives to the sort of questions you are asking depends on whether or not you think economies are path dependent entities. This is important, since it conditions whether or not you believe there is some variant or other of steady state growth to which to which economies tend to revert in the long run. Your argument, at least in some loose informal sense, seems to depend on such a view. If not, it is hard to see the relevance of reference to the US and the UK in comparative terms, since what are we comparing, apples and pears, or two entities which are inherently comparable? In the latter case, economies would not seem to be path dependent.

    Since beyond the fact that they are all economies there are such vast differences between the UK and the US economies between themselves, and between the two of them and Hungary that I find it hard to see where we are.

    I have serious difficulties with any view that ignores path dependence. I think economies to depend with some degree of sensitivity on their previous time path, and in this sense I find what is happening to the current value of the forint rather disturbing, as it may condition the evolution of several other key variables for some time to come. The presence of all those CHF loan’s is another item – indeed I see the resolution of this issue as the key to progress, since if Hungary is to be an export driven economy then you need a parity well below 270 to the euro, unless of course you go for drastic wage deflation, although I see recent evidence of this in the earnings data.

    Frankly I find the whole idea of convergence to a theoretical steady state to be completely metaphysical, like the Holy Trinity (you know, god is three, and god is one) you either believe in it or you don’t.

    So since I am a great admirer of one well known Hungarian thinker – Imre Lakatos – and his version of Popper’s falsification process, I would simply ask you: what would it take for you to change your view that the longer term growth potential of the Hungarian economy is as you believe it to be – other than by waiting till 2020 and checking of course, since by that time the horse will be well gone and bolted (at least if I am right, and economies are path dependent entitities). In my opinion this is the only way we can get a serious rational debate started.

    In the second place I don’t accept that Solow’s original “plausible assumption” that population change was egogenous to economic growth is as plausible as it seemed to him to be, once you start scratching around below the surface and dig into some facts.

    I haven’t published on this yet, but you can find a blog post to the topic here.

    Now just because the neo-classical version of growth theory seems to be not without problems doesn’t mean we have to thow all the procedures of neo classical economics straight out of the window. The marginal idea seems to me to be a good one, which is why I am not sure how you have become so convinced that drawing marginal labour into the labour force is going to revolutionise Hungarian economic growth.

    Don’t get me wrong, I am more or less in sure the measures the Bajnai administration is introducing to reduce the tax wedge are positive, its just that having studied this process in some depth (in relation to ageing population) in Germany, I’m not sure you are going to get the bang per forint you are expecting.

    Also, while bringing prematurely retired workers back into employment (and off the state payments system) is surely beneficial, it is only one half of the short term solution being offered for ageing and declining workforces (the long term answer is of course to attack those ultra low fertility levels).

    The other half of the policy reponse is to promote immigration – as outlined in the World Bank report “From Red To Grey” – and I find the almost complete absence of any plan to stem the rate of invesrion in the population pyramid in the whole rescue programme pretty pre-occupying. If the root of your unsustainability is the drop in population, and its relative ageing, then it would see, to be convincing, that this topic at least needs to be addressed.

    The bottom line is that the whole current programme of IMF CEE rescue’s worries me, and I suspect we are going to see a presence from the fund in the region for a long long time to come.

  12. Incidentally Deli,

    “And it is not the best to calculate an avergae 1.8 per cent economic growth between 2000 and 2010 for Hungary and to derive from this a bad growth outlook for the next decade.”

    Look, I thought quite carefully about this. Of course we are in the midst of a huge crisis. But this is why I take ten year moving averages, since to some extent this irons out these ups and down.

    What I mean is that as well as the crisis you need to take the excesses which preceded it (everywhere) into account. Prior to 2007, Hungary had an artificially high growth rate, boosted by current account and fiscal deficits. So to some extent the sharp contraction is logical (on the steady state way of looking at things), and it is what it is (on the path dependent approach). In either case it exists, and the ten year average gives us an idea of just how fast Hungary was capable of growing.

    Also, look at the long term chart. Before the 1990s there was a clear decline. Of course you can argue this was artificially low (due to state planned economy etc), and I would agree weith you. But what we have between 1990 and 2010 is a lot of “noise” in the data, a huge down and a surge up. I doubt we can extrapolate anything meaningful from that. So I look at other ageing societies, and I find a similar pattern of losing momentum (Germany, Japan).

    The tragedy is (from my perspective) that the CEE is currently going through a huge metamorphosis (nice Kafkerian expression this), from having consumer driven to export driven economies. The driving force behind this transition is rising population median ages, yet almost no one in Eastern Europe seems to notice (or care).

    “it is fiscal deficit that makes debt unsustainable and Hungary performs in the next few years one of the best in Europe and in the world”

    I think you are not taking sufficient account of the danger of self perpetuating (via deflation) contractions. Obviously you are right in the evident sense that if you don’t run growth plus low enough deficits/primary surpluses, you can’t reduce debt to GDP. But if you apply a very rigid fiscal objective, tight monetary policy and provoke ongoing deflation, then with falling nominal GDP values the tendency is towards higher debt to GDP levels.

    This is the key point.

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  14. Dear Edward,
    I really liked your blog entry and also the comments. As a Hungarian i find it really bad that you can’t find susch an article in hungarian press, or better sad really rairly. If people are not aware of these problems i find it impossible to run such policies which could fix these.
    I would just mention immigration: the society is simply not accepting it but this is the only way to keep economical standards – what people don’t want to give up.

    About the export and import: if you look at data what is the value added to export you can understand why IM and EX are moving so much together – most of the import is input for export (find data in IDR 2009).

    Since at least the a decade the potential growth rate is overestimated, i rember at times of fidesz gov. back in 90s everyone was speaking about 4 percent, Tibor ErdÅ‘s was then telling also 2 percent. To belive that hungary’s potential growth rate is higher is not wise – not just because of ageing population, the education of working age population is also pretty bad, there is a significant portion of the working age population wich has no useful education – for these people no jobs can be created.

    about the possible structural reforms: if it was impossible to do some deeper wise decisions in these gloomy days, i can’t belive something will happen if global happyness will come back.

    now the joining of euro zone should be first priority because deliberated capital flows, huge dept, small country, big current account deficit is not a cool combination to stay alone and fear also the exchange rate volatility.


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