This is why Hungary's public debt remains high

Hungary's public debt rate stood at 66% of GDP in mid-2008. Admittedly, not a low figure - but then it had barely risen for two years in a row. And yet, in late 2008, a massive surge followed, with the rate up to 80% and above in just a few quarters. Since then, government debt has been hovering in the range of 80% to 85%. In what follows below, we are trying to clarify a few facts about government debt, which could help us see more clearly regarding the future debt trajectory as well.

The following chart shows Hungary's post-Communist government debt history in a nutshell. Economic collapse and public sector overspending propeled the public debt rate from 70% to 90% in the first half of the 1990s, followed by relatively quick decline in the debt rate that lasted until the early 2000s. During this period, several factors were supportive of debt reduction, such as the use of privatisation revenues toward debt repayment, a narrowing fiscal gap, economic recovery, and last but not least, persistently high inflation. The positive trend was halted by overspending in the public sector. From 2001 to 2008, Hungary's government debt rate increased from 53% to 66% of GDP despite continual fiscal consolidation attempts in the last few years of that period. And then the worldwide crisis struck, bringing with it a massive jump in the debt rate as discussed above.

What caused the surge in public debt in 2008, and why was the rate stuck at a permanently high level afterwards? Occasionally, you hear the argument that it was all due to the IMF loan. That explanation is obviously utter nonsense, as the loan, extended in several tranches, has been already fully repaid (actually, Hungary has also repaid a significant part of the EU assistance package). Even if the first major loan tranches did actually raise Hungary's debt index, in a baseline scenario the debt rate should have by now returned to its earlier level as debt financing gradually readjusted after the Lehman bankruptcy. Neither is it any more convincing that the increase in the debt rate could be the result of topping up foreign currency reserves; in fact, currency reserves are replenished by borrowing in foreign currency, with the funds converted by the central bank into forints, something the government is then free to spend. Therefore, all it takes to increase foreign currency reserves is to readjust the ratio of FX vs forint instruments within the public debt issue plan - that is, no (significant) increase in the amount of debt issuance is necessary.

Whilst this is seemingly a tired old story, it is in fact still relevant today, because Hungary's government debt rate was boosted and kept permanently high by the combined impact of several shock-like, and several permanent changes. (So much so that midway through the year 2014 the rate was close to the all-time high.) These factors are still having some impact; the question is, how much longer they will continue to do so.

Denominator effect #1: The economic recession

The first shock of the global financial crisis triggered a gigantic economic setback in Hungary: the year 2009 saw real GDP plummet 6.7%. This alone boosted the government debt rate, expressed as a percentage of GDP, by more than 5 percentage points. Of course, this is a rather one-sided calculation - in reality, the economic recession impacted a wide range of factors that affect public debt (exchange rates and inflation, just to name a few). Even so, it was a major one-off impact.

Denominator effect #2: Permanently low economic growth

A drawn-out financial crisis kept the national economy on a permanently low growth path even after deep recession was over; in fact, Hungary experienced a second, minor bout of recession. As a result, GDP growth remained consistently below the pre-crisis rate year after year - or rather, below the growth rate the government was hoping to see. A case in point: Had the dynamic growth path projected by the government back in 2011 been realised, Hungary's GDP would be HUF 3,700 billion higher today than it actually is; which would mean 8 or 9 percentage points lower government debt rate even at the same nominal amount. In light of these figures, it is little wonder that in 2011 the government projected 2014 public debt would fall between 65% and 70%, as opposed to the current reality of 80% to 85%.

A more comprehensive picture of post-2008 debt management issues can be gained if you consider how the size of Hungary's national economy grew in terms of nominal GDP (estimate at current prices). This index is rising in parallel with economic growth and inflation. In the four years preceding the crisis, average per annum growth was 6.5%, vs. 3.2% between 2010 and 2013. It is obvious that such a slow increase in the denominator makes it very difficult to lower the debt rate.

Fiscal slips

Little did it help to keep Hungary's debt on track that budget gaps were not uncommon during the recession either. Fiscal balance remained fragile for several years: in 2009 due to deep recession, in 2010 due to bad planning, in 2011 due to lack of fiscal discipline, conveniently covered up by the nationalisation of private pension funds. Only since 2012 has the budget gap narrowed consistently to less than 3%. Moreover, due to the factors listed above, near-3% deficit is considered much less impressive now than it would have been in the pre-crisis years.

Weakened forint

Ever since the onset of the global crisis, the Hungarian forint has been losing value, which boosts the amount of foreign currency debt. Between end-2007 and end-2013, the currency lost 17% (rise in EUR/HUF rate from 253 to 297), followed by further loss in value. Currency weakening has boosted Hungary's debt rate by approximately 5 percentage points.

Increased need for liquidity

Rising debt is due to one more characteristic factors. To put it simply, the crisis has increased the amount of liquid funds Hungary needs to keep ready for unforeseen situations. A higher level of treasury funds is required to ensure, for instance, that maturing government debt is promptly paid even if difficulties arise in the government bond market. While an amount of approximately HUF 300 was sufficient before the global crisis, the latter has prompted the government to boost the amount of readily available funds, which are now typically in the range of HUF 1,000 billion to 1,500 billion.

Of course, raising the level of liquid funds would not have been possible without borrowing more than the amount of maturing debt, and keeping the surplus amount in the state coffers. It could be a startling figure at first sight, but this higher need for liquidity alone boosted Hungary's debt rate by as much as 3 to 4 percentage points.

In manner of a virtual history experiment, we have prepared a hypothetical debt rate chart based on the assumption that the amount of liquid treasury funds has remained at the pre-crisis level for the past six years (assuming a fixed HUF 300 billion deposit). The chart below represents that scenario, and leads to two conclusions. First, it is apparent that without a need for more liquidity, Hungary's public debt rate could have remained below 80%. Second, the chart "exposes" the true nature of last year's government debt reduction: it can be clearly seen that without the the government bringing the level of liquid treasury funds down to a 5-year low, a rise in the public debt rate would have occurred. That the aim of reducing the level of liquid treasury funds was only to cover up a spike in government debt is evident from the fact that the government once again saw a need to replenish liquid funds in early 2014, boosting the level of government deposits to HUF 2,200 billion (which explains how the public debt rate could rise above 85%).

The conclusion

With the 2008/2009 spike in government debt being the combined outcome of several shock-like and several permanent changes, the question arises as to whether the easing of the economic difficulties could make a swift decline in debt possible for Hungary. To answer that question in a nutshell: while certain factors could change for the better, these are unlikely to result in a major breakthrough on the public debt front. Let us see how the factors listed above might be expected to change in the near future:

1. Quick correction after a major economic setback?

There are several reasons why it would not be realistic to expect Hungary's national economy to swing back to growth just as quickly as it collapsed five years ago. For one thing, back then Hungary's economy was in a state of a credit bubble - therefore, for the most part the collapse can be seen as a return to potential output levels. History has taught us anyway that financial crises are typically followed by slow recovery (especially as a result of a slow re-start in lending); moreover, the output gap is closing as well. Thus, a spectacular rise in GDP would be only possible in the event of another bubble - which is unlikely considering the current slow ease in reluctance to lend.

2. An accelerating economy?

As you may have noticed in the second chart above, Hungary has seen a spectacular rise in GDP in Q1 2014, breaking away from the prevalent trend in the past four years. Without doubt, the debt path would be greatly improved if the inflation rate returned to near the 3% target and the economy could permanently grow at a similar rate. At 6% nominal GDP growth, it would be much easier to reduce public debt as a percentage of GDP. However, there are several downside risks to this path (for instance, Hungary's potential GDP growth is less than 3%), however the denominator of the public debt rate (i.e. nominal GDP) can be reasonably expected to grow at a moderately faster pace compared with that witnessed since 2010.

3. Budget deficit: divorcing the 3% gap?

The past few years have seen conflicting fiscal trends in Hungary. On the one hand, deficit stabilised below the 3% Maastricht criterion. On the other hand, efforts to cut deficit further have proved a bumpy road - not to mention the 2014 budget, which is clearly a stimulus package. Narrowing the budget gap to 1% or 2% of GDP would probably be more reassuring from the point of view of public debt reduction than a deficit permanently gravitating towards 3%. In their efforts to do so, economic policymakers may be assisted by a projected steady decline in the average interest rate on public debt. However, governments have been known to utilise any room for fiscal policy manoeuvre to the greatest possible extent, with a tendency for expenditures to swell and fill the new added space. Considering Hungary's ambitions to buy new assets and launch the Paks 2 nuclear plant expansion project, we would not be surprised to see gains from lower interest rates to be spent rather than used to lower public debt in the coming years.

4. Forint firming ahead?

The easiest way for Hungary to reverse the public debt increase resulting from a weaker forint would be to restore the EUR/HUF rate to a (definitely not unattainable) level of 290, which would lower the debt rate by 2 to 3 percentage points. On the other hand, the exchange rate - as an economic policy tool - serves multiple purposes including inflation and competitiveness. Although it has been argued that a swift forint appreciation near the end of last year may have been "encouraged" by economic policymakers in order to achieve a lower debt rate at the end of the year 2013.

5. Less ready cash?

Hungary's significantly increased government deposit can be used directly to reduce public debt by paying maturing debt from that source, as opposed to issuing new government securities. The question is, now that Hungary is recovering from the crisis, to what extent is it prudent to shrink emergency funds back to earlier levels? The very reason they had to be increased was to reduce the refinancing risk of Hungary's high public debt, however now that the crisis has abated, risks are lower than before.

On the other hand, we should make it clear that it would take shrinking government bond issuance by several hundred thousand forints even just to set amount of emergency funds back to the end-2013 level. That is, with the end-2013 level used as a statistical base for year-on-year comparison, the question we should be asking is whether there is any chance of achieving a significantly lower level of ready cash than last December's HUF 752 billion. At best, Hungary could make a further 1 or 2 percentage point cut beyond that point, and even that would take a temporary deep reduction in the volume of ready money. But that would be likely seen as a sleight of hand rather than actual debt reduction.

As it should be obvious from the above, Hungary has not much room for manoeuvre that could allow it to reduce government debt in an easy and effortless way. This is a battle that can be only won by keeping the budget deficit low and achieving sustainable, fast-paced economic growth.

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