Should Hungary brace itself for shock therapy if Fidesz wins? - Morgan Stanley

Fidesz poised to win two-thirds majority

Most observers think that Fidesz will get its two-thirds majority. “Even if it should be a few votes short, it should not be a major issue to gather enough votes in parliament," Morgan Stanley’s CEE economist Pasquale Diana and CEEMEA rate strategist Chuan Lim said.

The ‘supermajority’ would allow Fidesz to adopt sweeping structural reform, for example suppress part of the 3,200 local governments to save money, amend the media law, grant citizenships to Hungarians living abroad (this may raise tensions with neighbouring countries).

“Support for far-right xenophobic Jobbik at 17% looks high (particularly among young people), but besides the odd negative headline that will raise eyebrows in the international press, there will be no consequences on policy or governance," the analysts said.They noted that with the Socialist party “in disarray" and an electorate “hungry for change" after eight years of Socialist rule, Fidesz could establish a “very solid and long-lasting hold on power".

Fiscal policy: Lots of question marks remain

By far the issue which we found the most controversy around was the fiscal deficit picture after Fidesz gets into office (June-July) and implements a fiscal audit, Morgan Stanley said.

Diana and Lim found “broad-based confirmation" of their view that Fidesz “understands the importance of the IMF framework."

For that reason, any upside revision to this year’s deficit target (3.8% of GDP) will be the outcome of a negotiation with the Fund. Essentially, Fidesz will deliver reform plans in return for a deficit target which is less detrimental to the growth outlook. This is very different from outright fiscal easing," the analysts added.As a result of the aforementioned, Morgan Stanley sees a “high probability" that later this year Fidesz will choose to revise the deficit target up to around 5% of GDP.

This does not include the possible inclusion of extra-budgetary items, such as the debt of the Budapest Transport Company (BKV), the railway company (MÁV) and the debt of local governments, the analysts underlined.

These, the NBH estimates, could add another 1.5% to the deficit. “They would of course be a one-off, even if all paid in 2010, but they may not affect issuance at all, as the Min Fin could simply pay off this debt out of its cash pile, according to the Government Debt Management Agency (ÁKK)."

Controversial info

All in all, there is not a great deal of clarity, the analysts noted.

While they think that a revised 5% of GDP target (with IMF approval) would not rock sentiment, they also heard more bearish views.

“These argue that the budget for 2010 and the spending allocations to some key areas (such as healthcare) are unrealistically low, and Fidesz will put an end to underfunding of hospitals, accept a higher deficit in the short term and implement sweeping expenditure reform for the coming years," Diana and Lim said.

Senior economists close to Fidesz envision a ‘Slovak-style’ adjustment that will bring revenue to GDP (now the highest in the region) down by 10 percentage points, in line with the rest of the region, they added.

“Of course, this would imply radical suppression of local governments, unproductive state agencies and whitening of the underground economy. This ‘shock therapy’ may eventually yield great results, but we think that the market’s initial reaction to a much wider deficit in 2010 (7% of GDP was mentioned as a possibility, ex one-offs) would be definitely negative."

C.bank intervention possible

The meetings Morgan Stanley held at the central bank (NBH) had far more clear-cut conclusions, the analysts said.

“The bank remains firmly in easing mode: its modus operandi is the following:"

• the CPI and GDP outlook still suggest cuts ahead;
• these will be delivered (at least 50bp more in Morgan Stanley’s base case, to 5%) as long as the risk environment is supportive;
• the central bank’s assessment of risk is, in the words of a policymaker, “more an art than a science";
• the NBH does not perceive itself as swimming against the tide, even though some EM peers have started hiking rates.

The central banks that matter to the NBH are its regional neighbours (CNB, NBP) and the ECB. None of these banks appears in any way in a rush to tighten policy. On the contrary, the NBH stressed how some on the CNB are considering more cuts, and that the NBP is busy stemming PLN gains, rather than considering rate increases.

“A number of metrics are monitored, including CDS spreads, the currency, liquidity indicators, banks’ funding conditions and bond yields. The NBH believes that the recent news on Greece, which has avoided a near-term liquidity crisis, represented a concrete step which lessened the risk of contagion to CEE," Diana and Lim said.

“Logically, it follows that failure to disburse aid to Greece should Greece request it would have a material adverse impact on the NBH’s risk assessment," they added.

The economists detected “some frustration" at the fact that, despite the undeniable improvements in fundamentals, markets remain rather sceptical and still tend to put Hungary with the ‘weak’ credits.

Dim CPI outlook

The NBH noted with some surprise that the higher-than-expected March CPI had been wrongly interpreted by some commentators, and that the underlying structure is benign. Morgan Stanley agrees. The central bank noted that the growth in services wages, another valuable indicator of inflation expectations, has slowed dramatically (see chart below).

“We remain sceptical on the extent of the disinflation the bank sees in 2011, and believe that ultimately the NBH will be disappointed. Too much faith is being placed on slack driving down inflation, which seems risky given that the impact of slack (however measured) on inflation has historically been unstable," Diana and Lim said.

Looking at CPI risks to the forecast, they appear “all tilted to the upside": oil prices, a weaker EUR (i.e., higher oil and commodity prices, priced in USD), and sticky CPI expectations, the added, noting that these upside risks “may not materialise for a while."

“And as a consequence, a stronger HUF is not needed from a disinflationary point of view. On the contrary, given how reliant the economy is on exports at the current macro juncture, we think the NBH would react much like the CNB or the NBP to pronounced currency gains, i.e., by trying to stem its rise, either verbally or by intervention."

The analysts said it was interesting in this respect that the NBH’s Deputy Governor Ferenc Karvalits said in a recent interview that there is no need for tighter monetary conditions via FX, and although the NBH would rather refrain from intervention, it cannot categorically rule it out.Euro in 2014? Well...

While some local economists see a real window for Hungary to adopt the euro as soon as 2014, Morgan Stanley does not believe chances of that scenario are high. This implies ERM-2 entry early next year.

While Diana and Lim do not rule this out, they doubt it, for two main reasons.

First, “the odds are that Fidesz will want to assess scope for an upward revision to the deficit first, then assess scope for structural reform, while at the same time negotiating room for manoeuvre with the IMF: such a time of profound change seems hardly the most ideal time to enter a commitment to adopt the euro, especially as we think growth is unlikely to rebound to 3-4% for some time, which will make meeting the criteria on deficit that much more difficult."

The analysts recalled a recent interview with György Matolcsy (candidate for Econ Ministry), saying he sounded quite cautious on the whole EMU issue.

Second “the current appetite for euro area expansion from within the ‘core’ EU appears limited, in the light of the current troubles with Greece. The argument that ultimately Hungary has to adopt the euro like every other accession country and therefore the EU will have to accept a euro-zone expansion is weak. The EC/ECB still have plenty of leeway on the timing of that accession. And we think they will be inclined to use that flexibility. So, the door is definitely not shut, but especially at the time of ERM II entry, the scrutiny will be severe."

When thinking ahead to euro area entry, Morgan Stanley believes the biggest obstacle might be meeting the inflation criterion, rather than the deficit. While Diana and Lim think Hungary has a “golden opportunity" to move to a lower inflation environment, they noted that it has been effectively stagnating or in recession for three years and yet it still does not meet the Maastricht inflation criterion (true, partly due to administered prices and tax changes).

“Realistically, Hungary needs to target CPI in a 1.5-2.0% range to ensure compliance, a very tall order indeed. On the deficit, the numbers look better: the cyclically adjusted budget deficit stands at 2.6% of GDP, according to the European Commission - one of the best in the whole of the EU (of course, with all the caveats mentioned above)."

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