Hungarian authorities relaxed about risks - Should they be concerned?

Pasquale Diana, a London-based analyst at Morgan Stanley, said in a CEE Trip Note on Tuesday that most of their meetings in Hungary “revolved around the new direction of monetary policy, and the implications of the NBH’s ongoing efforts to flatten the curve and increase the share of fixed-rate mortgages in the economy."

Noting that steepness is an absolute, but also a relative concept, Diana reminded that the central bank explicitly wants to flatten the curve and it was clear at its November meeting that it was unhappy about how much the curve had flattened.

Since the meeting, the yield curve flattened by a further 20bp. The yield on the 10-yr benchmark bond is near 2.0% and the yield on the 5-yr bond dropped close to 1.0%, but both are still above these respective levels. (The fall has stopped in the last few days, though.)

Responding to clients’ inquiries if there is a natural limit to how much the NBH wants the curve to flatten, Diana said their sense is that “as long as the NBH can entice banks to buy the bonds via providing the right incentives (IRS), the flatter the better."

But the NBH is unlikely to want to pursue flattening at all costs. Flattening is a relative as well as an absolute concept: if the Bund or POLGB curve were to steepen from here because of an inflation surge, the NBH would try to contain the steepening in Hungary to ensure it stays muted versus peers, rather than push for more flattening. Conversely, if other European curves were to flatten, the NBH would probably want to see the Hungarian curve flatten by more.

As regards the central bank’s drive to encourage fixed-rate lending with a view to boosting financial stability, Diana noted that the “devil is in the detail" and that plenty of question marks remain even following Morgan Stanley’s trip on exactly how this will be done, but also on which products exactly fall into scope. In particular, he noted three lingering uncertainties:

• Stock or flow? First, fixed-rate mortgages make up 70% of the flow of new mortgages, but only 37% of the outstanding stock. NBH Deputy Governor Nagy in a recent interview said that he would like to see fixed-rate mortgages reaching 80% of the market. “At the current pace, this will take years. Given the NBH’s desire to lock in the current historically low levels of real rates, presumably the NBH wants this to happen fairly quickly. It is therefore reasonable to assume that the NBH will also target the stock of variable-rate loans, and encourage banks to refinance variable-rate products with attractive fixed-rate products. How it goes about encouraging banks to increase the supply of fixed-rate products remains to be seen."
• Fixed rates=rate hike: Second, it is important to realise that as far as borrowers go, borrowing at fixed rates (around 4.5-5%) is more expensive than borrowing at variable rates (3-3.5%). While flattening the curve can reduce this gap, it will still be there, Diana said. And in Poland, despite a historically flatter yield curve, this difference is precisely the reason why borrowers tend to opt for variable-rate loans: they are cheaper. “Thereby, fixing the rate exposure (again, assuming that the NBH wants to address the stock and not only the flow) would be equivalent to a rate increase. How to get borrowers to voluntarily opt for a higher rate? It is not clear. Will the NBH try to cap margins on fixed-rate products or make them compelling from a regulatory standpoint so that banks will price them more attractively? Will the NBH’s decision to become an investor in the mortgage bond market be enough to persuade banks to issue more loans?"
• What about corporates? Third, Diana highlighted that while the market tends to assume that only mortgage loans will be the target of this policy, most corporate loans are variable-rate loans. “To the extent that SMEs are not much better equipped than households at dealing with interest rate risk, corporate loans may well also be a target of this policy. If this were to be the case, obviously we would be looking at a much bigger refinancing programme. The total stock of outstanding HUF corporate loans is HUF3.6 trillion (versus HUF5.8 trillion for households, of which HUF 3 trillion are housing loans)."

Diana said that in their meetings, the worsening of the central budget cash budget deficit (almost 4% of GDP in the 12 months to October) was mentioned a few times. However, there are a few alleviating factors:

• First, the deterioration is due to pre-funding of projects which will be paid for with EU structural funds. When the funds are actually paid (in the coming months), the cash position will improve substantially.
• Second, some of this money goes to the coffers of local governments to help them fund their projects.

Therefore, on a consolidated basis, even the general government cash balance probably has not deteriorated that much. And while it is true that Hungary's fiscal stance looks set to expand over the coming couple of years, it is doing so from a good level.

Bottom line: What can go wrong?

Diana said they discussed this at length with local experts.

He added that in general, locals appear confused by the latest actions of the NBH, and believe that “Poland poses a natural limit to how much the Hungarian curve could flatten even in the most bullish of cases."

They also tend to believe, Diana said, that “the NBH will not undertake any initiatives that would undermine the health of the banking system, or push banks towards pricing loans too cheaply."

The majority of our contacts believe that the NBH is excessively dovish, given the cycle, but hardly anyone believes that the economy is overheating, inflation is about to take off or HUF is vulnerable because rates are too low. Hungary's external surplus is just too strong, and it buys the NBH degrees of freedom to be behind the curve.

In the worst-case scenario, locals think that the curve may simply stop flattening because banks stop buying local bonds, but even the most sceptical observers do not appear concerned that the NBH's stance is creating fundamental imbalances in the country, Diana added.

He thinks that “a potential catalyst for the NBH to turn less dovish may come after the April 2018 elections are out of the way, and not before the NBH is satisfied that enough refinancing at fixed rates has taken place. It seems like a tall order to expect this to happen any time soon."

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