By Nouriel Roubini, October 21, 2008
I recently spent a few days visiting Hungary, a country that is now at the center of financial pressures in emerging markets. In recent weeks the stock market has sharply fallen, interest rates have increased, the currency has weakened and financial institutions have suffered of shortages of liquidity. A fully fledged currency and financial crisis can still be avoided with appropriate and coherent policy actions but the financial pressures have intensified in the last week.
The macro, financial and policy weaknesses of Hungary – in many ways similar to those of many other countries in the Emerging Europe region – are not new; here at RGE we covered them as early as June 2006 in two analyses about vulnerabilities in
Hungary and in
Emerging Europe. But the global financial crisis has been the external trigger that has led now to a liquidity and credit crunch, the risk of a sudden stop and of a reversal of capital inflows.
The vulnerabilities of the economy include a large current account deficit, a still excessive fiscal deficit, a partially overvalued currency, serious maturity and currency mismatches in the financial system, the household sector and the corporate sector, low stock of foreign reserve and high level of short term foreign currency debt that is at risk of a roll-off.
Mary Stokes, RGE’s analyst on Emerging Europe, has recently well analyzed and summarized these vulnerabilities:
Hungary is the latest hotspot in the ongoing global financial turmoil. On October 15, the currency plunged almost 7%, the biggest daily decline in five years and stocks tumbled almost 12%. Meanwhile, demand for Hungary’s government bonds dried up.
This turmoil comes at a time when Hungary is in recovery mode. In mid-2006, after years of extremely loose fiscal policy that resulted in major imbalances, Hungary implemented a fiscal austerity package, which improved the current account and pushed down the budget deficit (from a record 9.2% of GDP in 2006 to a projected 3.4% of GDP or lower this year).
So how did Hungary become the latest target in the global financial turmoil?
While the immediate trigger seems to be a liquidity squeeze prompted by the global financial turmoil, the country has a number of vulnerabilities that contributed to the recent Hungarian asset sell-off.
High Foreign Currency Lending
Foreign currency lending in Hungary has increased by leaps and bounds in recent years as shown in the graph below. While swiss franc and euro loans appeal to companies and households because of their lower interest rates, this type of lending is particularly risky because it leaves unhedged borrowers exposed to currency swings.
Domestic Banks: Heavy Reliance On Non-Deposit, Foreign Financing
While the rapid growth in foreign currency lending in Hungary is concerning, some of Hungary’s regional peers have similarly high levels. A key problem specific to Hungary is an exceptionally high ratio of foreign currency loans to foreign currency deposits.
Over 60% of total loans to businesses and households were in foreign currencies (primarily euro, Swiss franc), while foreign currency deposits accounted for just over 20% of total deposits, according to a Fitch report from January 2008. This, combined with Hungary’s high loan-to-deposit ratio of over 140%, suggests a heavy reliance on non-deposit foreign funding, which tends to be volatile especially in the context of the current global credit crunch.
Domestic Banks: Deteriorating Maturity Structure
According to a recent report from Hungary’s central bank, the maturity profile of foreign funding has deteriorated and the domestic banking sector must be prepared to face ‘sustained tight liquidity conditions.’ This deterioration in the maturity profile increases ‘roll-over risk’ – the risk that investors are unwilling to refinance the debt coming due – and is a common feature of financial crises.
Potential Spillover From Foreign Parent Banks
In a blog post back in April, I noted that the CEE area is clearly vulnerable to any financing issues experienced by the major foreign parent banks that dominate the region’s banking systems. That is, problems in the EU banking sector could potentially impact Hungary and other Eastern European economies and vice-versa. Given the growing concerns about the stability of the EU banking sector, this potential contagion channel is a vulnerability and important to watch. (See related spotlight issue: How Safe Is the EU Banking Sector? Watch High Leverage Ratios and Derivatives Exposure) (See this UniCredit report for details on which foreign banks operate in Hungary.)
Adverse Financing Composition Of Current Account Deficit
Hungary’s current account deficit is high, but nothing compared to the double-digit deficits in Bulgaria, Romania, and the Baltics. The key issue is its financing composition.
In 2007, Hungary’s current account corrected to 5% of GDP, down from 6.1% in 2006, and the gap is projected to be even lower this year. The problem is that net FDI covered just 20% of the gap in 2007, and debt-generating inflows financed the rest, according to Pasquale Diana of Morgan Stanley, who expects some improvement this year.
Reserves Coverage of Short-term Debt
Hungary’s short-term debt (18% of GDP) is roughly covered by net international reserves, according to the IMF. The build-up of short-term debt was a key vulnerability in the run-up to the Asian financial crisis in 1997 and the Russia crisis in 1998, among others. Hungary’s foreign exchange reserves totaled EUR17 billion at end-September (less than 3 months of imports, which is normally considered a critical level for FX reserves in terms of liquidity).
Budget Deficit and Government Debt Levels Highest in the Region
Notably, Hungary still suffers from twin deficits - the current account deficit mentioned above, as well as a budget deficit. Despite Hungary’s fiscal austerity measures, Willem Buiter still described Hungary as being in a 'deep fiscal mess' earlier this year. With public debt standing around 65% of GDP, Hungary is an outlier among its regional peers. Buiter says the public debt load will turn out to be unsustainable unless there is a major change in the political equilibrium.
Political Risk
As Edward Hugh notes in a recent blog post, there is considerable political risk in Hungary. The ruling Socialist Party now governs from a minority position after the Free Democrats pulled out of coalition in April 2008. Meanwhile, the government has become unpopular in the wake of the 2006 fiscal austerity package, making it difficult for the government to pursue a reform agenda
Growth Laggard
Hungary's growth is lowest of any CEE country. Real GDP growth of 1.3% in 2007 was down from over 4.0% a year earlier, largely due to the fiscal austerity measures implemented in 2006.
However, at this point the crucial issue - beyond dissecting the macro, policy and financial vulnerabilities that have led to the recent financial pressures – is to figure out what are the possible policy actions that may restore confidence and prevent and currency and financial crisis. Such a crisis would be devastating not only for Hungary but also for the Emerging Europe region: if Hungary goes bust the risk of a domino effect – like the one that in 1997 led the East Asian crisis to spread from Thailand to Malaysia, Indonesia and Korea – would be significant as many of the Emerging Europe region economies share the same vulnerabilities as Hungary (and indeed significant financial pressures are already underway in Estonia, Latvia, Poland, Romania, Bulgaria and Turkey). A crisis in Hungary would lead to a crisis in a large part of Emerging Europe; so preventing such a crisis in Hungary is essential to prevent a broader regional financial crisis.
So what can be done to prevent such a crisis? There are several options on the table that, together, can lead to a coherent policy response that restores confidence and credibility. Let us discuss next in some detail such options…
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