Risk On/Off?

Before I left for my summer break in Greece I asked, among other things, whether Hungary was trying to escape original sin or more specifically (and implicitly) whether Hungary is using the current relatively favorable market environment to claw back control over monetary policy. Recent comments from central bank Deputy Governor Ferenc Karvalits suggest that this may very well be the case (quote below from Bloomberg);

Investors see Hungary becoming “significantly” less risky, allowing for further reductions in interest rates, central bank Deputy Governor Ferenc Karvalits said. “Over the past few months, international risk appetite has improved significantly, the risk assessment of the region and Hungary has stabilized, and this allows for further easing of monetary conditions,” Karvalits said in an interview on Kossuth Radio today.

The Magyar Nemzeti Bank lowered its benchmark interest rate by half a percentage point to 8 percent on Aug. 24 as it works to jolt the economy out of its worst recession in 18 years. The bank has shaved 1.5 points off the key rate since July as confidence rises in the first European Union nation to get a bailout. Hungary received 20 billion euros ($28.5 billion) in an emergency loan from the International Monetary Fund, the EU and the World Bank.

The country has a “good chance” to finance its budget deficit from the market and may not need the next installment of the IMF loan, Karvalits said. The forint weakened 0.3 percent against the euro and was trading at 268.82 at 7:48 a.m. in Budapest.

You see, one of the principal reason why Hungary is in such a mess is that as inflation shot up in the months leading up to the crisis Hungary chose to loosen its peg against the Euro. At the time, the rationale seemed wise albeit very bold. In an environment where investors were willing to take risk (i.e. hunting for yield) their objectives could be aligned with that of public authorities in the sense that the former got their yield whereas the latter got the nominal appreciation needed to keep inflation in check.

It did not work quite like that.

As the crisis hastened its grip on global markets and as its locus steadily moved to Eastern Europe the Hungarian Forint plummeted and lay bare the country's vulnerabilities in the context of balance sheet (on the liability) side denominated in Swiss Francs. The result was that Hungary crashed into a recession unable to tweak monetary policy downwards because of a fear that this would scythe the Forint and thus essentially bankrupt scores of households and companies. On the other, the government also had (and has) difficulties raising funds on international capital markets.

Now however things appear to have changed at least for a moment and Hungary's central seem poised to take advantage of the relatively benign market conditions to lower interest rates to support its ailing economy. The underlying idea is simple. If you believe that risk aversion is to stay low, the Forint should not be sensitive towards the lowering of nominal interest rates since after all the carry remains plentiful. In this way, my view is that Hungary's central bank is trying to claw back the control over monetary policy by locking in a lower interest rate for the Forint. The key question which we should be asking ourselves however is of course whether Hungary could actually be forced to raise rates further down the road to defend the Forint. Clearly, bets are being made inside Hungary at the moment that this is not the case.

This is very interesting in a practical as well as a theoretical sense as I have discussed for example in this post about carry trade and global monetary policy. More recently, Edward Hugh mused on the same topic (more or less) invoking the idea of the (eternal) triangle of monetary policy in an open economy context.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

Edward's account here is important since it alerts us to the fact that it was only at the very end that e.g. Hungary opted for float because it was believed that it would make the inflation problem go away. At that point however, the structural imbalances and essentially damage were already embedded in the system of course. Nevertheless, it is unequivocally the fact that Hungary, at the moment, is attempting to benefit from the relative benign market conditions which means that risk aversion remains relatively subdued.

Elsewhere in Market Land ...

If our little trip to Hungary suggests that risk is on, if only a little bit and potentially in the case of Hungary news elsewhere suggest that the waters are more choppy. Of course, none of this is earth shattering by any means of the word, but since much, if not everything, seems to be revolving around China at the moment it seems worthwhile to dwell at recent news on how China are expected to "tweak" its hitherto lax lending policies to skim the worst of the mounting bubble (quote below from Bloomberg).

China’s banking regulators are “tweaking” lending policies to remove “froth” from the system while growth remains the top priority for policymakers, according to Royal Bank of Scotland Group Plc. The goal is to manage risk exposure among banks and asset quality by checking lending from going into A-shares traded on the mainland and properties, Wendy Liu, Hong Kong-based head of China research at RBS ABN Amro, said in a report dated yesterday.

(...)

The banking regulator sent draft rule changes to banks on Aug. 19 that would require lenders to deduct all existing holdings of subordinated and hybrid debt sold by other lenders from supplementary capital, said the people, who have seen the document and declined to be named as the matter is private. This may cut lending by as much as 700 billion yuan ($102 billion), China International Capital Corp. said Aug. 24.

Of course, the main bias of the Chinese stimulus program and thus the authorities' objective remain one of promoting growth through the expansion of domestic investment and, one would assume, consumption. As RBS ABN Amro's Wendy Liu is quoted of saying; "policymakers have a far greater tolerance for asset-price appreciation over the medium term than before". That sounds about right to me even if I am no sage, at all, on China.

What is interesting in the case of the recent news from China was also the following piece by Bloomberg whose headline (Yen Strengthens as China Policy Concern Spurs Demand for Safety) makes a direct link between policies in China and risk sentiment in the market and thus also the movement of the Yen and the USD (remembering of course the narrative that repatriation of profits may ultimately be the main driver of the Yen at the moment).

The yen rose for a third day against the euro in the longest stretch of gains since July on concern Chinese production curbs would slow economic recovery, fanning demand for the relative safety of Japan’s currency. The currency gained versus major counterparts including the pound on speculation Japan’s exporters are repatriating earnings to take advantage of a new tax law. A government report today may show a faster contraction in the U.S. economy than previously estimated.

“We have talks from China cutting back expanding, trying to sort out the balance sheet and prevent too much reckless lending,” said Peter Frank, a London-based currency strategist at Societe Generale SA. “But domestic factors, like capital repatriation, are driving yen’s strength right now.”

Whether there is a history to be made here is debatable, but one thing is certain. China seems to have decidedly taken center stage in the global market discourse. Finally and essentially as a small footnote, yours truly took notice of the fact that despite the decidedly positive sentiment in the core of Europe at the moment on the back of the Q2 GDP print and upbeat confidence readings in Germany, aggregate retail sales continued their steady decline.

Whether all this signifies that risk is "on" or "off" I will allow the reader to decide for themselves. Personally, I am still bearish, but it is difficult to deny that the relative calm and positive environment that has prevailed since spring seems rather strong. I would expect sentiment to change once we return to "normal" in Q4 once the elections in Germany and Japan have been resolved and, more importantly, once OECD stimulus packages start to wane. Most importantly however, there is the situation in Southern and Eastern Europe still loom as the most likely harbringers of, if you will, black swans in which case risk almost surely would be off.

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.