Escaping Original Sin in Hungary?
According to the well known textbook in international economics by Maurice Obstfeld and Paul Krugman [1] the notion of original sin refers to the fact that many developing economies are not able to borrow in their own currencies but are forced to denominate large parts of their sovereign debt in foreign currency in order to attract capital from foreign investors. The argument then goes that if and when the goings get tough those countries will face difficulties paying off their liabilities and once the dust have settled the sin, as it were, has only become more binding when these same economies yet again venture onto international capital markets.
It is interesting to ponder this story in relation to Eastern Europe where far from being a sin the ability to denominate liabilities in foreign currencies such as Euros and Swiss Francs was almost seen as a virtue of modern capital markets during the boom years which followed the famous meeting in Copenhagen which saw the European family expand to 25 countries, a number which now has risen to 27. On the face of it, it is not difficult to see where this virtue came from. Aggressive expansion by western European banks into the CEE and a low volatility environment ultimately driven by the notion of a road map towards convergence bound to bring forth an equalization in living standards and, in the case of many CE economies, a certain membership into the Eurozone underpinned the fact that the ability to shop foreign currency loans was hardly a sin, but a natural counter product of the newly formed European community.
Now, all this has capsized and those economies who where so busy raising rates going into crisis in order to quell the massive inflationary pressures, which further intensified the flow of foreign currency loans, are now effectively stuck with no ability to tweak monetary policy since the low rates which are needed are either impossible (in the case of the Baltics and their Euro pegs) or de-facto impossible in the context of e.g. Hungary and Romania. Moreover, and in a world where major central banks are stuck at the zero bound and where the level of volatility may itself be volatile as we move from optimism to pessimism all that liquidity may yet again prove to be a destabilising factor in the context of Eastern Europe where we were all, I am sure, amazed, to learn a couple of months ago how some analysts were advising clients to play the carry trade with Eastern European economies as designated targets, for more on this see this post.
So what does all this has to do specifically with Hungary? Well, today we learned from Finance Minister Peter Oszko that Hungary would certainly prefer to issue local currency debt in the future, but given the fact that the IMF loan is not, by nature of it being a loan, permanent Hungary also need to find a viable way to make its policy tools work most effectively. The following excerpt is from Bloomberg;
Hungary doesn’t plan to raise foreign-currency debt in the “near future” and will increase sales of forint-denominated bonds to finance the budget, Finance Minister Peter Oszko told Nepszabadsag. “In the short term, the budget doesn’t need foreign- currency denominated financing sources,” Oszko said in an interview with the Budapest-based newspaper. The Finance Ministry has confirmed the comments to Bloomberg. “Increasing forint-based issuance is more worthwhile.”
Hungary sold 1 billion euros ($1.42 billion) of debt last week in its first offering since the flight of investors forced it to take a 20 billion-euro bailout from the International Monetary Fund, the European Union and World Bank in October. The country is working to wean itself off emergency financing. The IMF-led loan, which “secures a comfortable situation,” runs out in March 2010 and the government must work to ensure the country can finance itself from the market at lower rates by then, Oszko said.
“The July auction’s primary importance wasn’t to secure financing but rather to strengthen confidence in the country,” Oszko said. A “smaller” foreign debt sale is possible in the future as “it’s our basic interest to be active in the market.” Hungary could next target U.S. investors with the sale of dollar-based bonds, the newspaper Napi Gazdasag reported today, citing Laszlo Balassy, a Budapest-based executive at Citigroup Inc., which helped organize last week’s sale.
It should immediately be clear that this represents the original sin issue in full vigour although somewhat in reverse one could argue. Consequently and notwithstanding the obvious problems facing Hungary in the context of lowering rates, the country needs to balance the between issuing debt in foreign currency which would mean further currency translation risk and an even further entrenchment of the high domestic interest rates or issuing in domestic currency which might not be possible at current rates (i.e. rates would need to go up further) or simply not viable given the future financing needs.
To put all this in the context of a solid macroeconomic analysis I am in luck since Edward has just dished out an up to date look at Hungary's economy. As Edward notes straight away, Hungary has now embarked on the great experiment also currently being tested in Latvia of internal devaluation and the long hard climb, through deflation, towards the competitiveness Hungary so badly needs. Now, I know that I tend to move closely together with Edward on many accounts but I dare anyone not to share the sentiment expressed by Edward as he points to the obvious point. The current strategy taken in Hungary to battle the crisis is not working and at some point one really has to stop to ask why.
One striking data point is the fact that while the real economy seems in absolute free fall real wages are still rising and given the inevitable point that Hungary needs wages to fall, and a lot, absent devaluation one wonders silently what kind of contractory jolt the real economy needs in order to engender this effect. Meanwhile, Hungary has also recently pulled out the good old trick of raising the VAT something which will surely to push up the main inflation index, once again pulling in the wrong direction.
As usual Edward is thorough, very thorough, and I can only suggest to spend the 20 minutes it takes to superficially digest his points. Especially the point about a monetary policy trap is mandatory reading. In terms of a summary of the situation the following gets to the heart of the matter;
And in case you had forgotten, here is what is happening to Hungarian GDP: while wages and prices are rising steadily, GDP is in free fall. Year on year it was down 4.7% in Q1 and Hungary’s government currently expects the economy to contract 6.7 percent this year, the most since 1991. My view is a total policy trap is in operation here, since neither monetary (interest rates are currently 9.5%) or fiscal policy are available, so there is little support to put under the economy at this point. The only way to break the circle in my opinion is to let the forint drop, bring down rates, and restructure the CHF loans.
As will no doubt come as a big surprise, I completely agree. Hungary needs to address the already existing asymmetry inherent in the economic edifice which should entail a strategy on how to deal with the stock of CHF loans on the households' and corporates' balance sheet. This also gives a final spin on the actual topic of this entry.
In all probability the difficulties facing the Hungarian treasury in terms of constructing a viable and solid platform on which to finance its operations is greatly dependent on the issue with the already existing fx denominated loans. If Hungary were to construct a credible and realistic solution to the issue of how to write down/pay off the stock of CHF loans my guess is that the original sin would be a little easier to escape even if not all together.
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[1] Who follow the lead of Eichengreen and Hausmann.