The Hungarian economy rests on cracked pillars and were it not for investments in the auto industry, the economy would probably be slipping into recession in the coming quarters, said Pasquale Diana, analyst at Morgan Stanley in London, in his trip note following a visit to Budapest last week. He reiterated his strong view that that an IMF package would be appropriate for Hungary to fortify its defences and reassure markets of access to funding and ability to support the forint.
“The view from Budapest is that there is a clear slowdown in the economy, and growth forecasts are being marked down," he said in the trip note.
Diana sees “clear downside risks" to his meagre GDP forecasts of 1.6% for 2011 and 1.2% for 2012.
“Were it not for investments in the auto industry, the economy would probably be set to experience a recession in the quarters ahead," he said.
Feeble growth = further budget tightening
The weaker growth backdrop is forcing the government to tighten the budget further, the analyst noted.
The government initially expected growth at just over 3% this year and next, but it soon became clear that these expectations would not be met. Therefore, it chose to stick to its fiscal targets (2.5% of GDP deficit in 2012) and implement tax hikes (excise and VAT), “running even more pro-cyclical policy".
Diana said the commitment to meeting the budget targets at any cost is “certainly a positive", but even so “the growth environment is so weak" that he would definitely not rule out further measures in order to cap the 2012 deficit.
Note, for instance, that in its September Inflation Report the central bank staff projected a budget deficit of 3.7% of GDP for 2012, saying that taking into account all the recent government measures, the deficit ratio could ease to 3.4%, which would still be almost 1pp higher than the government target (2.5%).
“And these forecasts assume 1.5% GDP growth for 2012, the risks to which appear clearly tilted to the downside. All in all, our impression is that a deficit of around 4% of GDP for next year looks plausible," Diana said.
Delays in the implementation of structural reforms
Diana addressed Hungary’s structural reform measures too, saying that there are some delays in its implementation, adding that he growth backdrop makes everything more difficult.
The analyst reiterated his previously voiced view that the Széll Kálmán plan of structural reforms focuses on the right areas - increasing labour force participation, reducing expenditure on disability pensions and reforming public transportation - but while the labour market reforms and the changes in local municipalities are on track, there are main delays in the reform of public transportation and disability pensions.
“The local view is that implementation is running at around 60% of total. And of course, weaker growth provides a less-than-ideal backdrop to introduce sweeping reforms to the welfare state," he said.
FX debt repayment programme does not really remedy macro vulnerabilities
About the FX mortgage conversion scheme he noted that Morgan Stanley’s visit to Budapest reinforced his conviction that “the conversion rate will be rather modest (10-20% of all loans), as banks are not going to make HUF funding available en masse."
Diana noted that the plan, which seems to have few supporters both in Hungary and abroad, looks to be driven by political considerations rather than macro thinking.
“[...] the plan earned Hungary a lot of negative publicity, and it achieves close to nothing in terms of removing key macro vulnerabilities. Further, it reminds investors of a sometimes unpredictable and centralised policy-making."
In light of recent comments from the PM indicating that more help may be in store for FX borrowers, the analyst thinks that this issue may resurface in unexpected ways in 2012.
“We came back with even greater conviction that markets overestimate the dangers of a near-term rate increase to protect the currency," Diana said.
While several investors compare the current situation to October 2008, when the NBH last hiked interest rates to support the currency, he believes that the NBH “sees the situation as very different now compared to then."
While he acknowledged that the forint is even weaker, but stressed the banks are stronger, the government bond market is functioning and the NBH has twice as many FX reserves to intervene if it has to.
“Of course, this does not mean that the NBH will not hike rates in emergency fashion under any circumstances. But a rate hike seems quite far away, and would only come after a large increase in daily volatility and a steep move in HUF, rather than when a given level of EURHUF is crossed."
Diana expects the upcoming financial stability report to reveal a new stress test that “may shed some light on dangerous levels for the forint and the banking system", but he thinks that these levels are in general weaker than people assume.
No rate cuts for sure
Diana said the risk environment is “clearly too fragile" for the NBH to even consider cutting rates at this point.
“And with a large stock of FX loans and little new credit, it is not even clear why rate cuts would be a major boost to growth."
In addition, he also noted that the inflation outlook for next year does not favour an easier stance, with headline inflation seen hovering around 5% for a lot of next year.
“True, core inflation (ex taxes) is going to be lower, but both the VAT hike and the 18% increase in the minimum wage pose risks of pass-through from headline to core. And, as we have said many times, the NBH has not (yet) established an inflation-fighting track record that allows it the luxury of ‘looking through’ one-off price shocks."
“It thus seems to us that rate stability is the only plausible scenario ahead. The curve may price rate cuts (as it did a month ago), or some tightening (as it does now), but the bar for a move either way is rather high, given the circumstances."
IMF package certainly possible but politics is the main obstacle
Diana continues to strongly believe that an IMF package, whether as a PCL (Precautionary Credit Line) or a precautionary SBA (Stand-By Arrangement), would be appropriate, “to strengthen Hungary’s defences and reassure markets of access to funding and ability to support the currency."
“That said, there seem to be very high political obstacles to calling the IMF back in, for the moment."
Should the situation deteriorate quickly and foreigners decide to sell government bonds (possibly as a consequence of a downgrade to non-investment grade in the coming weeks by one of the agencies), Diana thinks the NBH “may have to step in and support the bond market."
He noted though that this would clearly be a short-term measure, similar to what the NBH did in 2008.
“And obviously, given recent action by the ECB and other central banks, the NBH would likely feel less exposed to international criticism for intervening in the secondary bond market," Diana said adding that it would be rather easy for the NBH to argue that such intervention was made necessary to restore the normal working of the monetary transmission channel, given how far the monetary policy debate has moved on since 2008.
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