Economy 30 October 2012, 2:00pm

Hungary cenbank proceeds with rate cuts (3)

Portfolio

In agreement with the analyst consensus, the National Bank of Hungary has continued the easing cycle with another 25 bp rate cut on Tuesday, lowering the benchmark interest rate to 6.25% as of tomorrow. What happened behind the scenes is likely to have been similar to the past two months when the 4 external members of the rate-setting Monetary Council in favor of a rate cut outvoted the 3 more conservative central bank delegates, while the inflation outlook as well as uncertainty surrounding the outcome of credit talks with the EU/IMF would have promted a more cautious approach.

Pros and cons

The analysts polled by Portfolio.hu before the vote were unanimously expecting the rate-setting Monetary Council to proceed with its recent series of rate cuts despite a mixed message of macro reports and market signals. Among these were an unexpectedly high September headline CPI figure of 6.6%, released after the September rate decision, as well as the two fiscal consolidation packages announced by the government in early and mid-October, respectively, both of which consist of measures with an impact on tax and consequently boosting inflation. Meanwhile, withdrawn plans to reduce the amount of bank tax to half the earlier amount in 2013, as well as the newly announced consolidation of local government debt (if warning signals from Prime Minister Viktor Orbán are realized) once again pose new threats to the stability of the banking system.

Market perception improved

In addition, government decisions with an impact on bank tax and other fiscal consolidation measures may have seriously changed Hungary's 2013 GDP outlook for the worse, providing one more argument in favor of assisting the economy through easing the benchmark rate.

Another consideration that dovishly-inclined rate-setters may have taken into account is that the government is apparently seeking to keep budget deficit under control, and Hungary's financial market indicators have clearly improved since the previous rate decision. Although the EUR/HUF exchange rate has remained unchanged (around 285), Hungary's sovereign credit default spread has declined by a remarkable 120 bp, and so did the risk premium of 5-year Hungarian eurobonds over those issued by Germany, by approximately 80 bp.

Plunge not specific to Hungary

It should be noted, however, that the marked decline of CDS premium has not been specific to Hungary; practically all CEE countries witnessed a similar trend recently. This is predominantly due to a technical factor, namely that as of 1st November the EU has banned open CDS positions without government bond collateral, thus the closure of un-collateralized open positions caused CDS premia to decline.

Urged by Monetary Council

Another factor that may have played a role in the decline of Hungary's CDS is a market insight that by repealing the law that would have imposed a financial transactions tax on the National Bank of Hungary, and by adopting a series of fiscal consolidation packages, Hungary's government is clearly manifesting a serious intention to reach agreement with the EU and the IMF and that a standby loan agreement could be put in place in the short run. However, the past one or two weeks have seen a swathe of news that have raised major concerns over deteriorating relations between the government and the international organizations, as well as of the IMF frowning on the government's ad hoc decisions.

In addition to launching a media campaign against the IMF, government statements may have also given rise to market concerns as to whether the government is honestly committed to reaching agreement with the international lenders. These doubts cast a shadow over the performance of the forint yesterday and caused a hike in government bonds yields; however these were apparently not seen as sufficient watning signs by the Monetary Council to pause the easing cycle. Over the past 6 months, the statements of the rate-setting body have consistently emphasized the need for a credit line agreement as soon as possible, as well as the expected increase in room for interest rate policy maneouver (i.e. rate cuts) once the deal is put in place. Should, however, the Monetary Council persist in rate cuts even if no agreement is reached with the EU and the IMF, Hungary's financial vulnerability may become further increased. This argument is likely to have been mentioned at the meeting today by the hawkish, prudent internal members of the Monetary Council.