Hungary cenbank ramps up rates two weeks after ending rate hike cycle - What's the deal here?
The central bank today announced extraordinary decisions. Firstly, it introduced a new deposit facility with a very high interest rate of 18%. Secondly, it agreed to provide euros to energy importing companies so that they would not exchange forint into euro on the foreign exchange market to pay their energy bills.
Let's take a couple of steps back, and look at this from a distance, so that measures that seem complicated at first glimpse can be less confusing.
Suppose there is a country with a seriously imbalanced external position, i.e. spending beyond its means. As a result, its own currency (simply because of foreign exchange transactions linked to imports and exports) comes under depreciation pressure and its exchange rate is constantly falling. As this situation is likely to be permanent, speculators will inevitably pop up to profit from the predictable change in the exchange rate, which will accelerate the sell-off. The situation is not made any easier by the fact that there is enough nervousness in the world to make investors increasingly reluctant to take their money into risky areas.
Let’s make a generous gesture here just for a little bit longer and pretend that this description does not fit Hungary. Instead, ask what we would do as economic policymakers in this country. Since this type of unaddressed problem can lead to a current account and exchange rate crisis, which is far from the ideal state of the economy, the situation must of course be addressed. In order to avoid the critical element of such crises, capital flight, the tumbling exchange rate needs to be stabilised,
- in the short term, through the central bank's operational tools such as interest rate hikes and direct intervention on the foreign exchange market,
- and, in the longer term, by overall economic policy to tackle the structural cause of the depreciation, the current account deficit.
Everything is the same, only different
What has taken place in Hungary today is part of the short-term solution.
It may be slightly confusing that instead of a straight-up interest rate hike, the central bank conjured up a previously non-existent rate in haste, quickly made it the benchmark, and raised it above the previous benchmark rate (13%). Significantly (18%).
This makes the domestic interest rate regime even slightly more complicated, and we could be in for a strong case of déjà vu. It was not so long ago that the central bank was so reluctant to raise interest rates that it preferred to decouple the base rate from the one-week deposit rate, which is the real benchmark, and instead kept raising the latter. Even then, the more or less admitted rationale was that the higher benchmark rate existed "only" to manage the jiggling on the forint market, and the base rate (which is of no real interest to anyone) is the reality of the real economy set in stone. This is how the situation looks now: the base rate remains on hold, but the forint needs to be brought back from the brink by a higher interest rate, so we plucking out a tool from thin air, which is needed once again only for the short term to keep HUF from easing further, while the base rate is not altered.
The underlying rationale is probably similar: after the cycle of interest rate hikes, which was halted a bit over two weeks ago, the central bank would have felt uncomfortable to restart the same rate hike cycle (and with a 500 basis point raise no less), so it preferred to come up with a new instrument, with a higher interest rate. The previous attempt ended up with the two types of interest rate being merged at a higher level, but not without a lot of communication hiccups and a great deal of inconvenience.
The other important instrument is also slightly different from traditional intervention when the central bank buys forints for euros on the FX market. The central bank secures the euro needed for energy imports outside the foreign exchange market, by directly approaching importers, who do not create demand for the euro. In economic terms, however, the difference between the two solutions is minimal: the central bank neutralises the debilitating effect of €1-1.5 billion of forint sales per month in the market.
In other words, the central bank did its textbook job today, using classical monetary policy tools to save the forint. It would be interesting material for alternative history courses to see how much of this could have been avoided if the central bank had not taken the ill-founded decision to demonstratively stop raising interest rates at the end of September. At that time the euro exchange rate was 407 forints at a base rate of 11.75%. Now (after a significant strengthening) the euro is 417 forints and the interest rate is 18%.
And what about the long term?
The structural problem of a high current account deficit is much more difficult. The central bank has cleverly combined intervention in the foreign exchange market with directly addressing the main cause of the deficit, the soaring energy prices, by providing euro funding. But in doing so it has not solved the deficit issue, only neutralised its direct impact on the FX market.
It is highly unlikely that it can do so in the long run.
Indeed, the foreign exchange reserve is being depleted by this operation, while the short-term debt of the Hungarian economy is rising precisely because of high energy bills in the corporate sector. In other words, the current foreign exchange reserve of around EUR 38 billion could easily fall, while the current short-term debt of EUR 32-33 billion could rise further. One of the most accepted rules is that foreign exchange reserves must exceed short external debt.
Of course, regaining access to EU funds could help. On the one hand, it would provide the central bank with a direct source of foreign exchange. On the other hand, it would open up the possibility of re-entering the foreign currency government bond market.
Logically, the following factors could help the current deficit problem:
- A significant fall in energy prices. Imports would decline through an improvement in the energy balance, and the pressure on the forint market would also let up. With prices far from being economically justified, we would say chances of this happening are not bad the geopolitical situation makes it difficult for us to see it happening in the short term.
- External financing to remain stable. There have been periods when countries with current deficits of 7-9% have been financed by the rest of the world for years. But now, with extremely high interest rates, in a much more risk-sensitive environment, and being extremely vulnerable in respect of the factors causing the energy crisis, betting on this seems a huge gamble.
- Moreover, these two solutions would come from the outside. There is little Hungary can do to make them a reality. This leaves the country with the painful internal solution of adaptation. The C/A gap means additional spending, which can be dealt with by cutting it. But if a country reduces its expenditures to this extent (the state, the population and businesses spend less, and not just on energy, but on everything), it will lead to an economic downturn. In other words, a severe recession. For now, Hungary is at the beginning of this journey, with surreal side-shows such as a fuel price cap kept in place in the midst of an energy crisis and severe external imbalances.
Cover photo: Shutterstock
