What will the Matolcsy-Patai plan be good for in Hungary?

Mihály Patai, President of the Hungarian Banking Association, noted already after the announcement of the central bank’s new Lending for Growth Scheme on 4 April that credit institutions not active in Hungary may be barred from depositing funds in 2-w MNB bills. He said they invest in this instrument a few hundreds of billions of forints while not taking any risk in the country.

MNB Governor György Matolcsy said in an interview on 18 April that he agrees with Patai’s proposal to replace 2w bills with 2w deposits and restrict the access of certain credit institutions to the MNB facility. He added that it was "set in stone" that the central bank will strive to lower Hungary’s external financial dependence, including its exposure to short external funds by any means necessary. Matolcsy also said there was no question that two-week deposits will be reduced by HUF 900 bn.

The MNB replaced its 2w deposits with 2w bills because the latter are tradable, i.e. they can be sold and bought freely on the secondary market therefore it is accessible also for those credit institutions that may no take part directly at MNB auctions (e.g. foreign banks). The chart below depicts among other things that the stock of 2w bills grew dramatically when the state converted the massive foreign currency funds received as EU/IMF credit to forint at the MNB. This has also led to a jump in the central bank’s FX reserves. The MNB drained out the excess HUF liquidity from the financial system via the 2w bill (sterilization.)

As the 2w bill stock has been steadily around HUF 4.0-4.5 trillion over the past few years, the MNB lost a lot more on the interest paid on it (base rate) than what it has gained on the interest received on investing FX reserves abroad. The difference between the two has been hovering around HUF 50-160 billion in the past few years, i.e. this is how much interest losses the MNB suffered on the aforementioned sterilisation.

What is the objective and how large a stock can it affect?

The aforementioned characteristic of the bank’s operating result and the economic policy objective mentioned in the lead (i.e. to mitigate the bailout need of the central bank in 2014) logically led to the need for the MNB to try and reduce its 2w bills while not causing serious financial disturbance. As we have described above: free trading on the secondary market gives access to the 2w bill for credit institutions that merely want to benefit from the interest that is relatively attractive even in international comparison and which are thus partly responsible for the losses of the MNB.

By transforming the MNB benchmark facility back to deposit the bank abolishes its tradability, effectively its secondary market, which means the primary objective (to improve results) could be achieved.

Non-residents’ holding of the 2w MNB bill has been hovering around HUF 400-600 billion recently. This is in harmony with what Patai said about a few hundred billion stock.

Who could be affected?

In view of the comments made so far by economic policy makers; the members of the Hungarian Banking Association and who are primary bond dealers we believe the following foreign banks could be affected (note that this is merely guessing at this point): Goldman Sachs, Jefferies International, JP Morgan Securities, The Royal Bank of Scotland.

Where could the funds go?

From the market’s perspective one of the most vital questions is what will happen to the (presumably) cc. HUF 400 billion that could be squeezed out of the 2w bills. One of the obvious directions could be that the funds remain in MNB tools, i.e. they go into overnight deposits, although its interest is 1ppt below the base rate. Should this be the case, the improvement in the bank’s operating result would be smaller than indicated above.

Another obvious destination for the funds would be short market instruments (e.g. discount Treasury bills), which would further lower the yield environment and interest expenditures arising in relation to the state’s debt financing. An interesting side effect of that would be that it would be cheaper to go HUF short for those betting against the forint.

A third possible destination for the funds squeezed out of 2w bills could be out of the country (if the short yields are not found attractive enough), which would create FX demand and thus HUF weakening (unless the MNB provided - via some tool - foreign currency for those barred from the 2w bills).

We can assume with a fair amount of certainty that the most likely scenario will be a combination of these three possible channels therefore we cannot estimate more precisely how much the bank’s interest results will improve.

Crowding out would not help

By the transformation of 2w bills to 2w deposits the central bank could indeed crowd out certain foreign banks from the MNB’s benchmark facility, but there is a loophole and the move would not even reduce the volume of 2w deposits on the market. Therefore the central bank’s interest losses would not decline, i.e. its operating results would not improve and subsequently this move in itself would not help Hungary achieve the abrogation of the EDP.

MNB executive director Márton Nagy explained last Friday that the restriction of certain foreign players from buying the 2w MNB facility does not mean the volume of the 2w bills (or later deposits) will decrease since forint liquidity in circulation will remain unchanged and through some channel it will eventually “land" in 2w bills anyhow. For that reason the interest paid on 2w MNB bills as a sterilisation tool will not decrease either so the bank’s operating result will not improve either (thus this is no help either for the state when it comes to bailout out the central bank’s 2013 losses next year or for the EDP exit).

Nagy said that if the crowded out players bought discount T-bills from their funds squeezed out from the 2w bills they would probably do that via local banks, but then these banks would reinvest the forint funds received into the (future) 2w deposit.

Secondly, if the freed funds were to be placed at local banks as deposits they would equally end up in 2w deposits.

Thirdly, if the foreign banks decided to take their freed forint funds out of the country they would convert these into foreign currency at the local banks which then would place their forint proceeds at the central bank.

The only way to save

The central bank’s operating result would improve this year only if the MNB “meddled with" the financial system by reaching into its own pocket when the barred foreign credit institutions needed foreign currency. This way it would simultaneously reduce forint liquidity in the financial system (i.e. it would not find its way into 2w bills or more precisely 2w deposits).

In that case, however, the MNB’s operating result would already improve via not one but two channels. Firstly, it would need to pay interest on a smaller volume of 2w deposits. Secondly, it would even post a gain on the foreign currency sold (it was accumulating FX reserves at average EUR/HUF of around 275 and now it could sell at around 295). According to Portfolio.hu’s estimates, the latter would shore up the MNB’s operating result by some HUF 30 billion.

The third leg would help only this way

The operating result of the MNB could improve via the third leg of the Lending for Growth Scheme only if the central bank “intervened" in the financial system in the aforementioned way. In this case it would supply foreign currency to commercial banks by a tender similar to the euro sale tenders used for the early FX mortgage repayment scheme. The banks would use these funds to repay their short foreign liabilities. This way the 2w benchmark facility would not be used that much and FX reserves would also be “let alone" (and of course the MNB could post FX gains here as well).

So if Matolcsy was serious about the HUF 900 bn reduction of the 2w MNB facility being “set in stone", the announced programme should be modified, simply because the improvement in the operating result cannot be achieved via the FX swap solution.

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