The Hungary Nation State Loses Its Sovereignty And Seigniorage

I perceive the death of the sovereignty and seigniorage of the Hungary nation state by carry trade investing.  This is more evidence that the world has passed through a tipping point  …. the world passed from the age of  leveraging and economic expansion that came by Milton Friedman neoliberalism, Free To Choose, carry trades, and Alan Greenspan credit liquidity economic policies,  …. and into the age of deleveraging, and economic contraction.

A … Shaun Richards in article The Exchange-Rate Carry Trade which affected Japan,Switzerland and Eastern Europe reports:

The countries whose currency was most borrowed for this purpose Japan and switzerland had low interest-rates in the middle of the last decade whereas many parts of Eastern Europe had high single figure interest-rates. Accordingly each year there is an interest-rate or carry profit and in some cases this was fairly substantial.

To put this into numbers you could borrow in Swiss Francs at just over 2% for ten years at the beginning of 2005. In comparison the Hungarian official  short-term interest-rate was 9.5% and she had various ten-year government bond auctions mostly yielding over 7%. So the attraction is obvious for all the players in this. The margins are so wide that the banks arranging the transaction can pocket quite substantial fees and yet still offer what on the face of them are attractive products. For the borrower the attractions of lower monthly payments and is some cases substantially lower are plain.

The Dangers

1. There was an insidious danger in all this which was not thought through except perhaps sadly by the unscrupulous. This carry trade became very popular in Eastern Europe and in fact became such a feature that it began to become so large that it affected the Swiss Franc exchange rate. This then fell due to the weight of money and it began to appear that not only were there interest-rate profits available but capital gains. I think we can imagine without too much effort the unscrupulous advising individuals and companies that both types of profit were available.

The obvious problem is that as even more were attracted to the scheme the problem of an exit strategy got worse. How could this ever be reversed without having the effect of raising the value of the Swiss Franc ? The answer is that it could not and in fact has been taking place recently when the Swiss Franc has been strong due to its safe haven status and a period where gold has done well. The error was the size of the trade which was much too large for the size of the Swiss Franc exchange rate market.

2. I am sure that some were encouraged to borrow more as monthly repayments under such a scheme would be much lower than before. If you think of a mortgage affordability calculation under the new lower interest-rates the possible implications become plain. I guess by now you will not be surprised there was something of a house price boom in Hungary.

3. There are considerable implications for the countries whose exchange-rate has been borrowed and the smaller the economy the more likely it is that it will be swamped. I have concentrated on Switzerland here but different flows of money also swamped Japan and the Yen which is a much bigger economy. They find that their currency is artificially depreciated at one phase of the arrangement and later artificially appreciated at the final stages.

Where we stand now.

In 2010 both the Swiss National Bank and the Bank of Japan have tried to fight such tendencies and so far they have failed. Actually my opinion is that they never stood a chance. I expressed my views on currency intervention back in late August and am intrigued to notice that Union Bank of Switzerland now agree with me,perhaps they still follow ex-employees!

Added to this is a theory that I have developed which goes as follows, talk of official exchange rate intervention seems to encourage markets to take the proposed intervention on and I think that we saw some of this yesterday. Sometimes they get bored easily and move onto other matters.

So there are real dangers to my mind in foreign currency intervention and it usually does not work. You might not get that impression from the media who like such news stories but it is true. Politicians like to be seen to do something and so the Bank of Japan may come under increasing pressure but it should hold fire in my view.Markets may concentrate on something else in the short-term which would help and if this is a long-term move then there is little it can do anyway. Accumulating more unrealised losses improves nothing. Sometimes you have to accept the limits of what can be achieved.

In practice the Bank of Japan tried various measures to restrain the Yen and certainly directly intervened once when the exchange-rate was at 83 versus the US dollar and maybe once or twice more. With the exchange rate at 82.89 as I type this is hardly a success but of course we never know how event would have unfolded otherwise.

The Swiss National Bank intervened much harder in 2010 and has lost heavily. At the end of the first half of 2010 it had lost some 14.3 billion Swiss Francs and at an exchange rate of 1.26 as I type the situation is worse now. It looks as though she may have tried again yesterday but why she thinks it will succeed now I do not know. Either way trapped between a possible exchange-rate inspired deflation and exchange-rate losses I would imagine it will not be a very happy Christmas at the SNB. If she keeps this up she may well become another central bank whose financial position becomes questioned.

One of the reasons I wanted to discuss this issue today is that it is topical and relevant as the Swiss Franc has been strong this week and the economic problems surrounding Hungary have led to her being downgraded by Fitch to BBB-. But there are two points of further news. Earlier in the week I saw that one of the ratings agencies had reaffirmed Austria’s AAA credit rating.Yes the same Austria whose banks were so heavily involved in the carry trade.

B … Markus Salzmann and Peter Schwarz of in article The Demolition Of Press Freedom In Hungary report: To reduce the budgetary deficit, Orban’s government raided private pension funds, unceremoniously incorporating them into the state budget. Approximately 3 million Hungarians with reserves totalling some €3.3 billion were affected. Critics have spoken of “cold-blooded expropriation”.

However, this was not enough for the international financial markets. They are demanding aggressive measures to permanently and definitively reduce workers’ income and state social spending. An analyst at the Vienna Raiffeisen International Bank was convinced that the Orban government would do everything to prevent a further downgrading of his bank’s creditworthiness. He was expecting a comprehensive reform package of drastic austerity measures in the spring of 2011.

The EU wants to avoid conflict with the Hungarian government, which takes over the EU presidency for half a year on January 1. Furthermore, Orban’s Fidesz party is a member of the European People’s Party, to which numerous other European ruling parties belong―including German Chancellor Angela Merkel’s Christian Democratic Union. Ultimately, all these parties consider it inevitable that authoritarian measures be implemented to enforce the austerity diktats of the banks against the working population.

C. Stephen Koptis remarks in Econobrowser: The customers wanted to borrow in SFr, and either the bank–one of Hungary’s largest–was issuing loans, or it wasn’t. It was.

Could the government of Hungary have intervened? Did the government of Hungary have the sophistication to institute capital controls without causing even greater harm? I have my doubts.

The best the government could have done was to bring the national deficit under control in timely fashion. The socialist government instead spent eight years laying the foundations of a fascist reaction.

The new Media Law was just passed this week. One paper greeted the news with the following loosely-translated headline today: “What Progress! From Today, Only Good News”. Hungarians know censorship when they see it. All of which has really nothing to do with capital controls.

D … Hugh Edwards in The Price Of Power: After a sweeping victory in April’s elections, which saw the victorious FIDESZ party elected with a two-thirds majority, the incoming government unveiled a program which departed dramatically from that of the previous caretaker Socialist cabinet that had been following the outline of an IMF Programme introduced after the country narrowly avoided economic meltdown in 2008. Initially the party had pledged to cut taxes and create jobs in an attempt to stimulate the growth the country evidently badly needs to tackle its heavy debt burden, although such moves would obviously threaten targets agreed under the country’s 20 billion euro European Union/International Monetary Fund bailout.

In fact Hungary has – for anyone who looked hard enough – been in an unsustainable fiscal position for some time now (try this article of mine in January, Is Hungary Another Greece?). It was obvious that the deficit was going to be higher than the 3.8% objective – indeed I personally clashed publicly with the Finance Minister (see his reply to me here) on exactly this issue back in January – and that the provisional figures coming out for growth from the statistics office were just a bit too good to be true. Furthermore, the underlying “cashflow” deficit (as in Spain, see charts below) was in fact higher because of the need to fund the losses of state companies and others (like the hospitals and other public entities where the previous government was simply funding the losses by classifying them as unpaid short term debts). Hungary had been lucky until the election in that the financial markets had been too busy with Greece, Southern Europe and the Eurozone to pay the country too much attention. Now that state of grace is well and truly over.

But beyond the immediate, headline-catching, story there lurk a number of issues with implications which stretch well beyond the frontiers of the small central European country. The first of these is the high preponderance of forex loans which have been taken out by Hungarian families (largely in CHF, they constitute over 85% of total mortgages). The presence of these loans has been a massive aggravating factor in Hungary’s ability to conduct an effective monetary policy in a context of high inflation and low growth. Swiss franc loans are attractive in Hungary, since they are much cheaper than forint denominated ones, since while interest rates determined by the National Bank of Hungary are still over 5%, at the Swiss National Bank they are effectively near to zero.

The second issue is the failure of the current IMF programme to return the economy to a sustainable growth path. The Hungarian economy contracted by 7% last year, and even while it grew slightly in the first three months of this year, the level of Hungarian PIB is still likely to fall again in 2010. A 5% increase in VAT last July, and increasing reluctance to take out more loans means that domestic consumption is still contracting, while the public sector has been in an ongoing adjustment process since 2006. This leaves the economy – like its Spanish equivalent – completely dependent on exports to obtain growth. Yet while Hungary now has both a trade and current account surplus, the heavy level of international indebtedness means that the burden of interest payments is heavy, and the capacity to generate export lead growth insufficient.

Finally, we have the political lessons. Having seen the experience of Greece, and now that of Hungary, it must be very clear to all that the traditional ploy of those who win elections against unpopular governments – of blaming their predecessors for the disastrous state of public finances – is now no longer open. The financial markets are indifferent to who is responsible, they simply want to know how the extra debt being made public is going to be paid. So the lions share of their anger inevitably falls on the incoming government.

Also, this kind of situation demands a high level of responsibility from opposition parties. This responsibility was not shown by the FIDESZ party. Indeed in 2008 they organised a succesful referendum against the constitutionality of a number of cost saving measures in the health system (see my post on this at the time), only to find that they themselves will have to introduce similar (if not identical) measures. The only casualty here is democracy. Countries facing problems which can lead to national bankruptcy need the maximum political unity and consensus in seeking a way out, and not short term political gests which can only bring more problems in the longer run. If pensions need to be cut, they need to be cut, if the only way to finance them is to issue more debt at a time when markets are tired of buying so much of it. The sooner politicians find the courage to recognise this the better, whether we are talking about Hungary, or other (let them be nameless) countries on Europe’s periphery in similar difficulties.


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