Economy 30 November 2015, 2:41pm

Could 2016 be the year banks in Hungary return to normal?

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The Hungarian economy is experiencing a domestic demand-led recovery against a relatively benign inflation backdrop, but inflation is set to accelerate sharply in the near term, due to energy-related base effects. This will mean that although the central bank (NBH) will likely resume easing, it will wait until the second quarter of 2016, when inflation eases again, projects Pasquale Diana, a London-based economist at Morgan Stanley, in a recently published CEEMEA Economic Outlook. In 2016, he expects to see continued normalisation in the banking environment after years of deleveraging. On the rating front, he expects Hungary to regain investment grade status next year.

Recovery led by domestic demand

Diana noted that his macro forecasts have not changed much compared to the Autumn Outlook and that he still expects the Hungarian economy to grow by 2.6%Y this year, 2.2%Y in 2016 and 2.5%Y in 2017. These forecasts are a few tenths lower than Morgan Stanley’s previous ones (2.9%Y, 2.4%Y and 2.6%Y, respectively).

“The overall macro story is still that the recovery in domestic demand will continue, particularly in household spending. However, a slower absorption of EU funds will mean investment growth slows down," Diana said.

He pointed out that at Morgan Stanley they are already seeing signs of sequential slowdown, with the economy running at a 2% annualised pace in the first three quarters of the year, a far cry from the 3%+ pace that has characterised the post-2013 period.

Economic slowdown, accelerating inflation widens room for rate cut

Morgan Stanley’s view on inflation has moderated further, and they now expect CPI to average 1.7%Y in 2016 and 2.6%Y in 2017, down from 2.3%Y and 2.7%Y, respectively in the Autumn Outlook. Lower oil prices and weaker incoming CPI data explain the downgrade for 2016 inflation, Diana said.

“In terms of policy, with the economy slowing, inflation rising on base effects but staying well below target and the ECB set to administer more QE,

the NBH seems to have another window to ease policy further. It seems to be a matter of how the NBH will ease policy, rather than if

," the analyst added.

He has reminded that in recent statements, the central bank decided to extend its forward guidance, indicating that its policy rate would remain “on hold over the entire forecast horizon". Moreover, the bank recently approved a new package of measures aimed at helping to restore credit to SMEs, called GSP (Growth-Supportive Programme).

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Could the NBH cut the policy rate again, after indicating that it would remain on hold for some time?

“We think it is certainly possible, especially if the Fed rate hike has a limited impact on Hungarian assets (as we expect), and if the bank feels that the market is able to digest negative real rates, something that NBH management has flagged to the market for some time," Diana said.

Note that economists at Morgan Stanley expect Hungarian inflation to rise sharply in the coming months, entirely on the back of base effects. In their forecast, inflation could exceed 2%Y in January, which would mean a 200bp move from current levels.

“With the real policy rate moving into negative territory, the NBH will likely sit and wait to see how markets react," Diana added.

But if, as we expect, inflation then slows down in 2Q, the NBH could easily revert to an easing stance and cut rates to around 1% later in the year. This is the reason why we pencil in easing in 2Q rather than 1Q.

On the broader issue of easing, Diana again pointed out that the unorthodox nature of Hungarian monetary policy and the NBH’s broad interpretation of its mandate suggest that the policy rate gives only a very narrow window on the overall policy stance.

“In the past, initiatives such as the Funding for Growth Scheme (FGS), the Self-Financing Scheme and the recently announced GSP have all contributed to loosening policy by either lowering borrowing costs for the state or trying to push credit into the real economy," the analyst noted.

He strongly suspects that this will remain the NBH’s modus operandi in 2016 as well, and therefore he would not overemphasise his call for the 3m policy rate to fall to 1%.

Other options for the c.bank

“Cancelling the two-week deposit facility, offering more IR swaps, changing the LCR requirement again, implementing a negative O/N rate or tweaking the GSP to make it even more attractive for banks to lend are all possible ways in which the NBH could seek to loosen financial conditions for the economy," Diana said.

Is a normalisation of banking relations on the cards?

In Diana’s view, the most important macro story of 2016 may be to see whether banks return to a more normal credit environment.

In the recently published Financial Stability Report, the NBH estimates that the banking sector has been a drag on growth since 2010, and that it is currently subtracting around 0.4pp from Hungary’s growth rate.

“This explains why re-engaging with the banks is a priority for the government in 2016: With temporary supports to growth (EU funds, FGS) fading, it will be difficult for Hungary to grow much above 2%Y without the support of its banks. Hence, the government is keen to improve the relationship and, despite its occasionally harsh rhetoric, the NBH is probably on the same page."

Diana also noted that extra fiscal incentives (e.g., an even larger bank tax reduction) are on the cards for those banks who expand their balance sheet in the coming years, according to recent government legislation.

2016 to be the year of the return to investment grade

Diana believes that credit upgrades are overdue and Hungary will regain its IG rating with at least one, but more likely at least two agencies.

“The ongoing sharp fall in external and FX-denominated government debt, together with a more predictable operating environment for banks and an ongoing solid fiscal position, should be enough to warrant upgrades," he concluded.