Economy 14 November 2012, 1:50pm

Markets too sanguine on Hungarian municipality debt risk

Portfolio

A restructuring of local government debt in Hungary is by no means certain and, even if it did occur, would entail smaller losses for the banking sector than a similar restructuring of private sector debt late last year. But even so, the very fact that it has been mooted illustrates that the government will continue to seek creative ways out of the country’s debt problem, Capital Economics said in a research note. With this in mind, CDS premia look too low, it added.

Developments over the past few weeks have shifted the focus from Hungary’s debt-laden households to its debt-laden municipal governments. This began with an announcement by Prime Minister Viktor Orbán last month that the central government would take control of part of the local authorities’ debt burden (which is included in the general government debt figures but serviced by municipal authorities).

As things stand, local government debt totals around HUF 1.1 trillion (3.9% of GDP). Media reports suggest that around half of this could be taken over by the central government.

Orbán did not elaborate as to what might happen to the debts once they have been assumed by the central government but he did offer an ominous warning that “those who think ahead will have a bad hunch or two" which would not be “unjustified".Local daily Népszabadság has since reported that the government will ask the local banks that own the municipal debt to take a 20-25% haircut on their holdings. According to Portfolio.hu’s estimates, this would put a HUF 122-153 billion burden on banks.

“All of this has echoes of last year’s mortgage repayment scheme, in which the government permitted households to repay foreign-currency mortgages at preferential exchange rates and forced banks to take a 25% haircut on these loans. The scheme severely dented confidence in local policymaking and the losses imposed on banks contributed to a further contraction in domestic credit," said Neil Shearing, Chief Emerging Markets Economist at Capital Economics in London, in a research note published on Tuesday.

He suspects that a restructuring of local government debt would result in smaller losses being imposed on banks than was the case under the mortgage repayment scheme.

“After all, local government debt is much smaller than FX mortgage debt," he argues.

On the basis that banks are forced to take a 25% haircut on the portion of local authority debt assumed by the central government, losses could amount to HUF 125-150bn (0.4% of GDP), in Shearing’s view.

He estimates that this would reduce the aggregate Tier 1 capital ratio of banks to 12.0% from 12.5%. (By contrast, banks faced much larger losses of around HUF 260 bn (0.9% of GDP) under the mortgage repayment scheme.)

Shearing also highlighted that “any restructuring of local authority debt would probably constitute a sovereign default in the eyes of the ratings agencies", which means that “the government is likely to think twice before pursuing such a course of action."“Even so, the very fact that the government appears to be considering such a course of action illustrates [...] that austerity alone is unlikely to resolve Hungary’s debt problems, and default (or “restructuring") will continue to form part of the solution."

Shearing added that “second-guessing an increasingly unpredictable government is difficult," but he thinks investors “may be too sanguine on the risks."

He pointed out that the sharp fall in CDS premia in recent months has left the market pricing in a 15% chance of default over the next two years based on a 75% recovery rate (or 25% haircut).

“Given the size of Hungary’s debt burden and the extent of its economic malaise, this seems too low," he concluded.