Hungary in Trouble

By: Wolfgang Munchau

Between May 29 and June 29 the Hungarian forint depreciated against the euro by 8.5 per cent. The turbulence in global financial markets has hit some emerging economies particularly hard. Within Europe, no country is more vulnerable than Hungary, which runs massive twin deficits, each close to 10 per cent of gross domestic product. The troubling question for the European Union is to what extent the problems faced by Hungary are purely local or whether they might prove contagious.

It is normal for emerging economies to run current account deficits. But if these deficits become too large, the economies face risks. This risk is greater if the exchange rate is fixed, semi-fixed or subject to managed floating, as it is in many central and east European economies. It is greater still if a large current account deficit is accompanied by a large budget deficit.

The recently re-elected Hungarian centre-left coalition responded to the rise in the deficit with an austerity programme. It consisted mostly of tax increases, in particular corporate tax and value-added tax. Ferenc Gyurcsány, Hungary’s prime minister, said he hoped to cut the deficit from
8 per cent of GDP this year to 3 per cent in 2008. The International Monetary Fund recently suggested that these projections are too optimistic. Hungary needs more budgetary savings for a strategy of consolidation to be credible. A policy based so heavily on tax increases could hurt economic growth and may in turn put additional strains on public finances.

Here are some troubling facts about the Hungarian economy. The current account deficit is projected to reach 8.4 per cent of GDP this year. The rise in the deficit stems largely from a credit boom, which has led to the build-up of asset-price bubbles, especially in the housing market. The share of domestic credit to GDP has risen from 49.9 per cent in 2001 to 62.9 per cent in 2005, according to the Moody’s statistical handbook.

Hungary is also vulnerable to currency mismatch, as Hungarians have been borrowing increasingly in foreign currency, mainly euros and Swiss francs, to benefit from low borrowing rates. According to the IMF*, household borrowing in foreign currencies increased from about 10 per cent of total household loans at the end of 2002 to 25 per cent in 2004. In 2005, almost all new lending in the banking system has been foreign currency denominated. The difference in domestic and foreign interest rates was more than compensated for by the depreciation of the forint during June. A further depreciation could cause serious distress among private Hungarian borrowers and banks.

There are several measures that show a rise in Hungary’s
vulnerability on all fronts. The Moody’s external vulnerability indicator, a measure of obligations that fall due in the short term against foreign exchange reserves, shows an unsustainably high value of 240. Among countries rated by Moody’s, only Hungary, Cyprus, Estonia, Latvia, Kazakhstan, Belize and Ecuador have ratios above 200.

As this list suggests, Hungary is not the only country that may be vulnerable. Many of the other central and east European countries have better economic fundamentals, in particular healthier public finances. This is especially true of the three Baltic republics, Slovakia and Slovenia. But even these countries could be hit by turbulence in global financial markets. Latvia, for example, had
a current account deficit of more than 12 per cent of GDP last year, of which only one quarter was financed by net foreign direct investment. While Latvia is a member of the European exchange-rate mechanism, it had an annual inflation rate of 6.9 per cent in 2005, expected to improve only marginally in coming years.

A survey by Christian Menegatti and Nouriel Roubini** of 14 central and south-east European economies found that in 2005 all were running current account deficits, in most cases substantial. Some, such as Hungary, were running large twin deficits. In most, the current account deficit has been driven by private sector imbalances. Saving rates have been falling in Hungary, Bulgaria and Romania, while investment rates have been down in Hungary, the Czech Republic and Slovakia.

Among the 14 countries, 10 experienced a sharp increase in domestic credit. Especially in Turkey and Hungary, there are also signs of asset-price bubbles. The study concludes that there is a significant risk of contagion “as many of these countries share similar vulnerabilities and common creditors”. The countries most at risk are Hungary, Turkey and Serbia. Bulgaria, Croatia, Estonia, Latvia and Lithuania might be at risk if and when external imbalances continue to deteriorate.

Asia had its big financial crisis in the late 1990s. One contributor was unsustainable currency pegs. The main problem in central and south- eastern Europe is twin deficits. We cannot yet speak of a “central European financial crisis”. But there is a real possibility that such a crisis might occur within the next 12 months. If and when it comes, unpleasant economic consequences will result. They will disrupt those countries’ integration into the EU and the eurozone. This is yet another crisis the EU and its institutions are unprepared for.

Copyright The Financial Times Limited 2006