Péter Ákos Bod: the government is chasing a mirage, and the whole of Hungary will pay the price

The debate between ministry officials and central bank executives in the pages of Portfolio.hu provides a fresh illustration of the topic. The debate article, which was co-authored by the competent Deputy State Secretary and Head of Department of the Ministry of National Economy (Bence Gerlaki, Tamás Balás), came up with a proposal that seemed to be a technical one. According to this proposal, the interbank lending rate in forint (BUBOR) should be replaced by the yield on discount Treasury bills as the basis for market interest rates in the case of variable-rate loan products in corporate lending. At present, discount T-bill yields are much lower than BUBOR, hence the conclusion of the polemic: "in the current interest rate environment, a shift to the yield on the discount T-bill as the benchmark rate could lead to lower lending rates for corporate lending, provided banks do not increase their spreads by the same amount. This process would improve the profitability of the corporate sector through profit transfers and contribute to achieving the target of economic growth in 2024, i.e. keeping the investment rate above 25%".

The debate on interest rate techniques in corporate lending is intellectually interesting but relatively unpopular in academic or banking circles, but in this particular case the polemic that started the debate has caused a stir and had practical consequences. The Standard & Poor's analyst dismissed the idea that very noon as another unconventional (in Hungarian political language: unorthodox) proposal. In an email to Reuters, they mention that investor sentiment has just begun to recover after a series of populist measures affecting the Hungarian financial sector, and such a move would again increase the risk to Hungarian assets.

For this or other reasons, the forint has subsequently weakened sharply, although it has been reassuringly stable in recent months.

The relative calm in the second half of 2023, after the previous large wave of devaluation, was good for the inflation process, as the economy did not face import-side cost pressures through the exchange rate, while world energy prices also turned favourable.

The National Bank of Hungary (MNB) joined the professional debate; in their response article, their officials explained why they consider the idea to be flawed (Ádám Banai - Zsolt Kuti). According to their article, BUBOR transparently tracks market processes, eliminating it would increase uncertainty and it is not at all certain that borrowers would be well off. Indeed, the customer is ultimately interested in the final interest rate and its predictability. The total interest rate is made up of two items:

• one is the interest rate base (which the ministry's proposal would reduce),
• the other is the bank's interest rate spread per customer or transaction, which reflects the riskiness of the transaction.

For the bank taking the risk of granting the loan, the total interest rate is also important. Therefore, if a lower benchmark were to be set administratively, the bank would be forced to increase the individual interest rate premium. Furthermore, there could be many problems with the benchmark rate to which the proposal would replace the current interest rate base.

It is uncertain how yields in this particular market will evolve in response to the supply of short-term government bonds, which is dependent on the government, and the market demand for such bonds.

A possible large discount T-bill yield increase would drag up corporate lending rates. And then - and this is my own comment on the matter - the government would be able to interfere again in private contracts with interest rate caps and other unconventional instruments, which is exactly what the international rating agency's expert has warned against.

The MNB's response article also argues that the discount T-bill yield, unlike the BUBOR, is much less under the control of the central bank. This could be an institutional special interest, but it is not: if the ministerial proposal were adopted, the transmission capacity of monetary policy would be reduced. In other words, an important anti-inflationary tool would be weakened by the formally methodological change proposal.

There is no need to go into the choice of index for floating-rate bank loans here, just look at the evolution of yields over the past year. In the period just passed, the gap between the yields of discount T-bill, which are in principle risk-free (or more precisely, carry only sovereign risk), and those of money market products of the same duration (BUBOR, currency swaps) has indeed widened. Otherwise, the yield on the discount T-bill has apparently been quite volatile, which is a disadvantage for a benchmark. There is also the troubled central bank base rate, but that would not be any better as a benchmark than the current one.

As for the proposal of the officials of the Ministry of National Economy (NGM): if the only change would be to replace the three-month BUBOR by the discount T-bill's yield rate as the basis for banking operations, then, assuming all other conditions remain unchanged, the interest rate would immediately fall by 2% or 3% under the current - otherwise exceptional - conditions. Unless the banks would think of charging a higher mark-up on specific transactions than before, to compensate themselves for the loss of revenue due to the new basis of calculation.

Obviously they thought of it, but in the meantime the benchmark yield dispute is over: the BUBOR remains. But something happened at the meeting between the banks and the ministry. Following the meeting, the Banking Association issued a statement: "Accepting the proposal of the Ministry of National Economy, the Hungarian Banking Association calls the attention of its members to the initiative aimed at increasing corporate lending. In the course of the action, individual lenders can waive the interest rate premium above BUBOR for 6 months on market corporate loans with BUBOR-linked interest rates contracted between 1 February and 30 April 2024 and disbursed this year in the case of investment loans. Commercial banks may join this call on a voluntary basis, at their own discretion, in accordance with their own business policy objectives."

In the contentious case, life took another, shall we say, typically "Hungarian" turn. It is not quite what the central bankers, with paternal benevolence, had been telling the government people: we should not try to invent the best way to restart economic growth, but rather a stable environment where inflation is falling, economic confidence is growing, and the perception of Hungarian financial instruments is improving. Instead of misguided measures and ad-hoc ideas, they wrote, positive trends should be patiently allowed to unfold.

But patience is a rare commodity in our country. Before the end of the methodological debate, the ministry sent a quick reply - now from the level of the state secretary - in which the benchmark interest rate issue took on a new dimension: "The root of the problem is that the central bank is not capable of dealing with the disturbances in the transmission channels" (Máté Lóga). For the reader's understanding, he repeatedly states that the divergence between the BUBOR and the 3-month discount T-bill yield is "a blatant example of monetary policy failure". In the short piece, there is room for wording such as "the central bank failed to deal with the matter", even that very article would not have needed to be written if "the problem had been dealt with in a timely and appropriate manner by monetary policy".

I have cited a case of an apparently methodological nature, but there is more to it.

It is worth returning to the original debate article by ministry officials, which starts with the statement that the government has "actively taken measures to contain inflation". This would be the analysis of the past, followed by the authors' vision for the future: "after crisis management, the government's primary goal this year is to return the economy to a dynamic growth rate of around 4%. In the new phase of economic growth, the focus will be on restoring household consumption, increasing labour market activity and, last but not least, keeping domestic output and, with it, the investment rate above 25%".

It is not worth going into the details of the active economic protection measures that have been taken to bring down inflation in our country. By the way, according to the central bankers' response, "the combined actions of the central bank and the government, together with the fall in world commodity prices" have brought down the rate. Rather more remarkable is the message, which has been repeatedly delivered from the highest government posts, that inflation has been eliminated in 2023 and that there will be strong growth in 2024.

But the threat of inflation is far from over.

The painfully energy-intensive structure of the Hungarian economy makes the country particularly vulnerable to changes in the raw materials markets. Government debt has remained uncomfortably high as a result of the large budget deficits of the previous four years. The burden of financing it will weigh on public finances, implying high taxation in the coming years, especially if the debt ratio is to be brought down to close to EU norms this year. These are all upside risks - even with a stable exchange rate.

However, relative exchange rate stability does not happen by itself.

But relative exchange rate stability does not happen by itself. It requires higher interest rates relative to the region and that the country's assessment of risk does not deteriorate. The latter is very difficult, and not only because of the volatility of the situation described by macroeconomic data: country risk calibrators are very much aware of the additional risks due to Hungary's geopolitical eccentricity. But maintaining the central bank's interest rate differential with the region is indeed a matter of choice. The Monetary Council - rightly, I think - did not give in to the voices calling for a larger base rate cut at its last meeting, paying attention to both the interest rate channel and the exchange rate channel of monetary policy.

Yes, domestic interest rates are high. This is exactly what the ministerial discussion paper was written against. Furthermore, it is for a "primary government objective" which, in my judgement, cannot be achieved in a sustainable manner (longer than six months to a year) given the external conditions and the internal circumstances. It is pointless, what is more, a mistake to chase the mirage of rapid growth.

It is incomprehensible why it has become fixed in the minds of people in top positions that a high investment rate is a good thing worth subordinating the balance of the national economy to achieve.

As well as family consumption, whose weakness is increasingly striking in comparison with the region. But it should not come as a surprise that the Hungarian consumption rate is low, with a high investment ratio, especially if the present structure of the country's economy means that it can only operate and grow with a high capital, material and energy input. Consumption and investment - the two major components of domestic use - can only grow together under external indebtedness in any impatient attempt at acceleration, given the income-generating capacity of the country's economy. This should come as no surprise to us either, as Hungarian society has already experienced episodes of indebtedness - only to struggle for years with the task of restoring the severely disturbed external balance.

So there is more at stake here than methodological disputes or inter-institutional tensions and jurisdictional sensitivities. One half of the government sees a different past, a different present and a rather different future than the other half, as does the outside world, the analytical community. It is not optimism and realism that clash, but voluntarism and reality. And one cannot build a realistic policy on a false assessment of the situation. Government pomposity cannot be used to make economic actors dynamic.

The debate is now seemingly about economic policy instruments, but in fact, the recurring clash between forced growth and equilibrium is being reproduced in government policy.

Meanwhile, the trade-off between them is worsening. Output growth forced above our capacity ("potential GDP") is now associated with a greater imbalance than during the "golden age" of 2016-2020. Today's risks, including the risk of a slide back into inflation, balance of payments backsliding and sovereign risk, are much greater than in the previous long business cycle that lasted until spring 2020.

Developments after 2022 should be a warning to the proponents of the high-pressure economy thesis: last year, Hungary was one of the few countries in recession, and still set a European record for annual inflation. A worse trade-off implies that any further disinflation will require an even greater sacrifice in growth. Then some people, institutions and individuals, will have to debate not the extent of the contribution to success, but the distribution of responsibility for failure.

Cover photo: Portfolio