Economy
This is why more and more investors fall in love with Hungary
Pasquale Diana will also attend Portfolio’s Budapest Economic Forum conference this Thursday. Register today!
Hungary’s economic growth decelerated in the second quarter, which surprised on the downside. Analysts have already started to revise even their 2016 growth estimates downwardly. What do you expect for next year? What growth rate do you think would be sustainable in the medium term?
That’s true. The Hungarian economy had less momentum than we anticipated in 2Q, growing by a mere 0.5%Q, after 0.6%Q in 1Q. Our previous forecasts for 3.5%Y GDP growth this year and 2.5%Y next year now look out of reach. That’s why we revised our GDP forecasts to 2.9%Y in 2015 and 2.4%Y in 2016 in our recent Autumn Outlook.
That said, let me add something: slower growth than expected does not really change the underlying macro story. Hungary is enjoying a recovery in domestic demand from depressed levels. Fiscal policy is turning expansionary after years of austerity, interest rates are at record lows, consumers got a large wealth transfer from the banks following FX loan conversion earlier this year, and face a debt-service burden of sub-8% of disposable GDP, the lowest in over ten years.
Corporates have access to easy funding via FGS (Funding for Growth Scheme), which expires at end-2016 and has so far disbursed HUF 1.5 trillion of credit (around 4.5% of GDP) to SMEs. True, there are areas of weakness, such as broader credit creation outside of FGS. The ongoing clean-up of the banking system bad assets should pave the way for a better credit environment next year, in our view. Note that MARK (the asset management company) will start buying commercial real estate loans starting in the coming weeks. Over the medium-term, Hungary can probably manage growth rates of around 2.5%, which should still lead to continued convergence with the Euro area.
Non-residents have been withdrawing a lot of capital from Hungary’s bond market over the last few months. How long do you think this process can last? Could the central bank’s self-financing programme boost Hungarian banks’ demand sufficiently to offset the outflow of foreign capital?
It is clearly very difficult to tell, and it will be a function of several factors, including broader risk appetite for EM assets, the speed of Fed interest rate hikes, the health of the large economies (US, Euro area, China). And these factors are obviously related. But let me also add that there is not much that seems specific to Hungary in these dynamics. They reflect a broader shift towards a more cautious stance on the part of investors. Hungary used to be seen as a particularly risky country within the CEEMEA region, but I do not think that is true any more. The strong external surplus (as high as 9% of GDP on a combined current+capital account measure) has truly changed investors’ perceptions about Hungary’s underlying vulnerabilities.
As to the central bank’s self-financing scheme, we have already seen for a few months a steady change in ownership from non-residents to local banks. If you look at AKK data, in July this year local banks’ ownership of HGBs exceeded foreign investors’ for the first time since 2011. To this, we should add that households have been increasing their ownership of HGBs to above 8% of the total. Of course, greater domestic ownership of Hungarian debt is what the self-financing scheme is all about.
Whether this transformation can continue in a relatively smooth way will be a function of many things. At the most basic level, it depends on how fast the outflows will be relative to the local market’s absorption capacity. Given that there are around 3.5 trillion HUF that will flow out of the two-week deposit facility and that the NBH is keen to provide incentives for a lot of this money to move to government paper, we at Morgan Stanley hold on to our view that this process is likely to be successful. Our strategists are overweight Hungarian local currency bonds.
Let me say upfront that I think an upgrade is probably overdue from a macro standpoint. That said, a move to IG tends to attract a comparatively larger amount of scrutiny so this is why it may take slightly longer for this to happen, which is understandable. When you look at the market, it is fair to say that Hungary already trades like an Investment Grade (IG) country, sometimes even tighter.
More specifically, our strategists show that Hungary has historically traded between BBB and BB credits, and since 2015 Hungary has traded tighter than the average of BBB credits, which suggests an upgrade is already ’in the price’. That said, a formal move to IG would probably still be important from Hungary’s standpoint. For example, the entry into IG indices could increase interest in Hungarian bonds from non-dedicated EM investors, though we probably need two rating agencies to upgrade Hungary to IG for this to happen. This could lead to some additional outperformance of Hungarian bonds.
How long do you think Hungary’s key policy rate remain at 1.35%? How long could the MNB tolerate a possible forint depreciation?
We think that the National Bank of Hungary will keep the policy rate at 1.35% well into 2017. If anything, risks in the near-term are tilted towards rate cuts. Let me add though that I think the policy rate offers only a very narrow window on the monetary policy stance in Hungary.
In a big picture way, the NBH’s policy tool has already gone far beyond the policy rate: Funding for Growth, the Self-Financing Scheme, the use of FX reserves for FX loan conversion, the incentives to support HGB market and lower bond yields, are all examples in which NBH employed different shades of ‘unorthodox’ policies to achieve its goals. A strong external surplus and a much healthier economy have allowed the NBH to become less focused on the global risk backdrop (though not indifferent to it), and experiment a lot more.
As far as the FX is concerned, there are no ‘magic’ levels of EURHUF that would trigger a response. The economy is clearly much better able to deal with a weaker HUF now, given low inflation, and a much lower FX mismatch. That said, I am personally very skeptical of those views that argue that the NBH’s grand plan is to push rates as low as possible to weaken the currency.
If the HUF were to weaken very fast, and non-resident investors were to accelerate their sales of local bonds, yields would spike higher and the country risk premium would rise. I have no doubt that in such a situation the NBH would conclude that the benefits of a weaker HUF would be far outweighed by the costs, in terms of higher interest costs and uncertainty. This alone would make the central bank much more cautious, especially if HUF were to underperform its CEE peers (like PLN). But I believe it is difficult to envisage scenarios under which HUF depreciates sharply, given the size of the external surplus. That’s one of the reasons why our strategists are constructive on the medium-term outlook for the forint.
