Hungary ought to borrow at the IMF if it offers the cheapest terms - Morgan Stanley

Portfolio.hu: What is your base case scenario for the talks between Hungarian authorities and the IMF/EU? When do you think the credit line could be secured and how smooth the negotiating process will be?

Pasquale Diana: Our base case scenario is that a deal will be done by the end of April. If the current infringement procedure with the EC moved to the next stage and it proved more complicated, we are probably looking at May.

The negotiating process is likely to be tricky, as the Hungarian side will have to make concessions on sensitive areas like the issue of the Judiciary, among others. The European Commission looks like a tougher negotiating partner than the IMF, but we do not think that it will introduce fresh new conditions at this stage.

The recent EC proposal to freeze EUR 495 million of Cohesion Fund payments for 2013 will put even more pressure on Hungary to achieve an agreement with the lenders, we think. True, these two issues are strictly speaking unrelated to each other. However, bear in mind that any EU/IMF programme would include sustainable budget cuts which would also de facto make the EC abandon its proposal to suspend Cohesion Fund payments.

P.: Do you see any risk - and if you do how big - that in view of the diminishing market pressure and favourable global investor sentiment the Hungarian government will decide that it does not need the IMF/EU credit line, or if it does ink that deal it will not meet the conditions laid down in the agreement?

P.D.: I think that the risk of the Hungarian government withdrawing from the negotiations certainly exists, but ought not to be exaggerated, for two reasons. First, the government knows that a significant part of the improvement in market sentiment is due to external factors, and has little to do with Hungary. These external factors could change very quickly if the external backdrop worsened, and having a large safety net would help.

Second, the latest opinion polls do not show a slide in support for Fidesz following its U-turn, rather a stabilization. Therefore, the more conciliatory tone from the government towards international lenders is not being seen as a sign of weakness, quite the opposite. All in all, from a pragmatic point of view signing a deal with international lenders is best course of action, in my view.

P.: Over the past month Hungarian asset prices rose considerably. In light of the aforementioned risks don’t you think the market is too much ahead with respect to pricing in the potentially positive impacts of an IMF/EU deal? Do you see it possible that the striking of a credit agreement with the lenders will lead to further asset price increases? If the answer is yes, which segments do you think will be affected?

P.D.: Probably the foreign exchange market has priced in a fair chance of an IMF/EU deal, hence while we could see some appreciation after the deal, Morgan Stanley thinks most of the move has already happened.

We do think however that the interest rate market would start to price in rate cuts more aggressively than it is doing at present, if a deal were to be signed. We believe that recent MPC commentary has made it abundantly clear than an assistance package is a necessary condition to bringing rates to a more normal level.

P.: PM Orbán said recently that Hungary will not draw from the IMF/EU credit facility even if it were much cheaper than market-based funding. Do you think this kind of strategy is right? What should be the key considerations in this matter?

P.D.: From a rational point of view, Hungary ought to borrow at the cheapest possible terms. If these are found at the IMF, then Hungary should definitely borrow at the Fund.

However, a lot of political capital has been invested on the idea that this SBA would only be used as a "safety net". Also, not drawing from the line would also make it easier for Hungarian authorities to "walk away" at some point in the future if international conditions were deemed to have improved in a durable manner.

Therefore the value of that option (ie. walking away) has to be high enough for the authorities to compensate for the extra cost of borrowing on the market instead of the IMF/EU.

P.: Key business sentiment indicators improved in the eurozone over the past few months and the ECB’s LTRO considerably reduced market tensions. Do you believe recession can be avoided in the eurozone? What are your main projections for 2012?

P.D.: Despite the improvement in the business indicators that you alluded to, our colleagues in the Euro area team remain rather pessimistic on the growth outlook for the Euro area. The continue to expect GDP to contract by 0.3% in the euro are in 2012, led by recessions in the periphery (Italy: -1.7%, Spain: -1.7%, Portugal: -3.7%, Greece: -4.5%).

P.: The Hungarian government expects the eurozone economy to pick up in the second half of the year and that this will help Hungary’s growth via the country’s export markets. How well-founded do you think this assumption is? Can Hungary avoid slipping into recession this year?

P.D.: We broadly assume a similar path, both for the euro area and for Hungary. We see Hungarian GDP growth at 0% this year but the risks are clearly tilted to the downside. True, the 4Q GDP release was a nice surprise (+0.3%Q), but we will not be able to say much until we see the details, which are out on March 9.

It is definitely possible that some expenditures were frontloaded to 4Q, ahead of the large tax increases of 2012. If that is the case, the slowdown in early 2012 could be even more severe than we forecast.

P.: What is your outlook on the Hungarian budget in 2012? Will the government need additional fiscal adjustment measures to meet its 2.5% of GDP deficit target?

P.D.: It is very difficult to say this with certainty, but the official government deficit forecast of 2.5% of GDP in 2012 may look optimistic. That said, even the National Bank expects only minor slippage, assuming that the budget reserves (1% of GDP) are saved, rather than spent.

The biggest unknown is the macro situation: the government assumes growth of 0.5% this year, which looks perhaps too optimistic. Some extra tightening is possible, though the problem is that in reality fiscal policy in Hungary is already rather tight following the tax increases in early 2012.

A 2012 deficit number around 3% of GDP or higher looks likely given the macro challenges and to be perfectly honest it would not be a disaster, given Hungary's challenging cyclical position. In any case, the real issue in our mind is 2013. The government will phase out the crisis taxes (losing revenues worth 0.9% of GDP) and still expects to hit a 2.2% deficit target, which in practice means it will find in excess of 1% of GDP of extra savings to compensate for those lost revenues. That's a rather tall order.

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