ANALYST VIEW - When is excessively loose policy a problem for Hungary?

Morgan Stanley’s new growth forecasts have changed only marginally since its mid-year outlook. Pasquale Diana, a London-based analyst at MS, expects growth of 3.7%Y this year and 3.5%Y next year (3.8%Y and 3.3%Y previously). His first cut at 2019 comes in at 3.2%Y.

“In essence, we envisage a prolonged period of above-trend growth in Hungary, spurred mostly by consumption and investment growth. [... There is probably still a great deal of 'pent-up' consumer demand in Hungary that can be released, following many years of underperformance. This can easily result in a few years of above-trend growth," he said in a research note published on Sunday.

Diana noted that the Hungarian labour market continued to tighten, with the unemployment rate falling to record lows.

“And while double-digit wage growth (13.6%Y in September) is eye-catching, the rise in unit labour cost (ULC) growth has been somewhat more muted than the acceleration in wages, because of a cut in social security contributions (SSCs)."

The analyst forecasts 4.2% U-rate for this year and 3.8% for both 2018 and 2019.

Diana said that the Hungarian central bank (NBH) has started “Stage 2" of the easing cycle. Whereas a constructive view on growth is very much consensus at this stage, opinions differ on monetary policy and what the NBH's new stance means for markets, Diana noted.

Earlier this year, the bank had seemed satisfied with how much it had eased monetary conditions. However, the NBH turned progressively more dovish during the summer, in response to low inflation and some FX outperformance against peers. In September, the bank cut the O/N rate, in October it indicated a clear desire to flatten the curve and encourage borrowing at fixed rates, and in November it announced two new tools to achieve its goals.

The first tool is a new IRS programme with 5- and 10-year maturities, worth HUF 300 billion for 1Q18. Deputy Governor Márton Nagy said that IRS tenders would be held every two weeks, and the programme may total HUF 1-1.5 trillion. Unlike the programme terminated in 2016, the new facility would be unconditional; namely, banks would not have to necessarily buy government bonds but could also have other assets on their balance sheets (presumably retail and corporate fixed-rate loans).

The second tool is QE: The NBH will launch a "targeted programme aimed at purchasing mortgage bonds with maturities of three years or more". Deputy Governor Nagy mentioned that the NBH may buy up to 50% of the mortgage bond market (currently worth HUF 900 billion), both on the primary and secondary market. Its goal is to reduce the spread of mortgage bonds over government bonds in order to help banks to secure long-term funding. Presumably, banks would then feel more comfortable offering competitive fixed-term loans, funded by mortgage bonds.

How do these tools help the NBH?

The bank's objective is clear. With Hungary's real rates negative through the maturity spectrum, borrowers should be given incentives to lock in these rates and be protected from future rate hikes, Diana said.

Flattening the curve via lower long-term yields would lower the reference rate for fixed-rate loans and make them more attractive versus variable-rate loans (demand side). Offering IRS and becoming a major investor in the 3+ years mortgage bond market encourages banks to issue more fixed-rate loans (supply side).

Is it really 'easing'?

Given Hungary's promising growth and rising rates elsewhere, another bout of easing seems very late/procyclical at this point.

While the analyst would agree with this assessment, he noted that the central bank’s recent actions “seem more targeted at addressing financial stability and insulating borrowers from interest rate risk than easing per se."

Indeed, he pointed out that fixed-rate loans are more expensive than variable-rate loans, in general.

“And therefore, should the NBH succeed in engineering a significant refinancing of variable-rate products into fixed-rate products, the end result would be higher rates for consumers, not lower."

Flows or stocks? Only households or also corporates?

While the NBH's strategy appears clear, there are a lot of question marks, Diana noted. The NBH will hold discussions with banks in the coming days and hopefully some of these issues will become clearer:

• whether the central bank will be satisfied encouraging as much new lending at fixed rates as possible (flows), or
• instead will try to encourage banks to refinance those on variable rates too (stock).

In a comment last month, Nagy mentioned that the NBH would like to see the stock of fixed-rate mortgages rise from the current 37% to 80%. Depending on how ambitious the time frame for this is, a large refinancing programme may be needed, Diana added.

Moreover, while most assume that this programme is solely targeted at households, we would point out that most corporate borrowing is also done at variable rates and could therefore in theory be a target of this policy.

When is too much really too much?

Diana pondered when could excessively loose policy be a problem? He would argue that a central bank which keeps policy very stimulative for a long time runs the risk of overheating and may lose control of inflation.

“If the market were to lose faith in the central bank, the currency would sell off, inflation would accelerate and the monetary authorities would have to hike aggressively as a result," he warned.

Even with oil at USD 60+, Diana thinks that Hungary's inflation will stay within the target band.

The economy is running hot but not yet overheating. Most importantly, it is really difficult to imagine marked FX weakness in a country which runs a very large C/A surplus, which will remain in surplus through our forecast horizon (see table below).

“In essence, the strong external surplus gives the NBH leeway that other EM central banks (most notably Turkey or South Africa in this region) simply do not have."

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