Hungary Country Update

Orban’s Dangerous Game

Recent data showing that the economy officially fell into recession in the second quarter of 2012 has brought an added sense of urgency to the government’s effort to obtain an emergency loan package from the IMF. The currency has firmed and the cost of insuring Hungarian debt has fallen on expectations that Prime Minister Viktor Orban will contain his populist impulses sufficiently to secure the backing of the IMF, but recent negotiations have highlighted persistent sticking points, particularly in the area of tax policy.
Orban’s government first signaled its desire to open negotiations with the IMF and the EU for a three-year, $20 billion loan package back in November 2011, but the European Commission conditioned its blessing for loan talks on the repeal or revision of numerous pieces of legislation approved by the Parliament since late 2011 that did not conform to EU standards. Negotiations finally commenced in July 2012, triggering a rally in Hungarian assets.
However, the scheduling of a second round of talks was contingent upon the government’s response to the long list of demands presented by the IMF and the EU during their week-long discussions in July. Orban indicated that he would wait until the lenders had a chance to review the 2013 budget before giving a response, which he promised would come in early September.
On September 7, just one day after the prime minister had expressed confidence that a deal would be concluded when talks resumed in the autumn, Orban, communicating via a video posted to Facebook, declared that after consulting with members of his Fidesz party, he could not accept the terms presented by the IMF and the EU. Specifically, the government rejected demands to cancel a $1.3 billion payroll tax cut planned for 2013 and to abandon plans to extend a 0.1% financial transactions tax to the central bank, a move that the EC sees as a threat to the independence of monetary authorities.
Orban also voiced objections to cuts in pension and family benefits, as well as deeper reforms of the tax system, although there is no concrete evidence that these were among the demands of either the EU or the IMF. The IMF has called on Hungary to stop relying on ad hoc measures to contain the fiscal deficit, and instead pursue broader reforms aimed at establishing a basis for long-term fiscal stability, but public documents issued by the Fund on that topic have been short on specifics.
Significantly, the IMF claims that local press coverage of the negotiations, which has mentioned pressure on the government to cut spending on pensions, is inaccurate, without getting into specifics. The apparent discrepancy between the conditions that Orban claims the IMF and the EU have presented to Hungary and what the lenders have revealed to the public has fueled speculation that the prime minister is overstating the demands so that he can claim to have wrested concessions from the IMF and the EU once the threat of currency collapse and a debt crisis ultimately forces him to accept whatever terms are attached to the loan.
The government’s budget forecasts for 2013, including a projected deficit equivalent to 2.2% of GDP, are based on assumed real GDP growth of 1.6%. The European Commission has dismissed the growth forecast as unrealistic, and has stated that the budget as currently formulated would produce a deficit in the neighborhood of 4% of GDP. On that basis, neither the IMF nor the EU will be inclined to make concessions.
Hungary’s need for the loan is not really debatable. The country faces a large debt service burden over the next several quarters, including payments on previous loans from the IMF and the EU totaling slightly more than $6 billion. Owing to the downgrading of Hungary’s credit rating to junk status in late 2011, loans obtained in global credit markets would carry a very high interest rate.
However, Orban appears to be intent on holding out as long as possible, for purely political reasons. Currently available liquid reserves are sufficient to enable the government to meet its financing needs through the end of March 2013 without need for an IMF loan. However, a loss of confidence in Hungary’s ability to reach a deal with the IMF would send the forint plummeting, and the financial buffer would shrink accordingly.
In short, the prime minister is playing a very dangerous game. Investors have tolerated Orban’s adversarial approach to multilateral lenders so far, but their stomach for the risks inherent in his game of financial chicken will weaken as the day of reckoning draws closer, and a miscalculation on the prime minister’s part could produce disastrous results.
Political Gamble
Orban’s rather schizophrenic approach to loan negotiations is guided largely by consideration of political appearances. Fidesz romped to victory at the 2010 elections, winning a two-thirds majority of seats in the Parliament, on the strength of Orban’s populist platform, a central plank of which was a pledge to end austerity.
The prime minister’s unorthodox policies left Hungary particularly vulnerable to a negative turn in investor sentiment. The value of the forint fell steeply in mid-2011, amid fears that the euro-zone debt crisis would not be contained, putting heavy pressure on Hungarian households who took out mortgages denominated in Swiss francs. The approval in September 2011 of an extremely controversial scheme under which local banks were forced to absorb the cost of what amounted to a massive write-off of mortgage-related household debt stirred fears of an exodus by foreign-owned banks, one of the factors that prompted international credit rating agencies to downgrade Hungary’s debt to junk status, resulting in a sharp rise in the cost of new debt.
As a result, averting a full-blown crisis now hinges on obtaining assistance from the IMF, which, at a minimum, will require Orban to break his no-austerity pledge. Fully cognizant of the political damage he stands to incur when he does so, the prime minister wants to be able to claim that he put off signing a deal with the IMF as long as he could without bringing economic ruin upon Hungary, and that he fought for—and won—significant concessions from lenders, thereby sparing his countrymen unnecessary pain.
The success of that strategy thus far is debatable. On the one hand, an August poll put support for Fidesz at just 17%, or less than one-third of the 52.7% vote share won by the party in April 2010. On the other hand, that marks a one-point improvement over its poll showing in July, and Fidesz is still the most popular party, as its main rival, the Hungarian Socialist Party (MSZP), was favored by just 14% of respondents.
Moreover, none of the other parties currently represented in the Parliament has gained at Fidesz’s expense. In fact, support for every party is currently running below their respective share of the vote won at the last election, suggesting that the overwhelming response to the current economic troubles and disappointment with Fidesz is disgust with party politics in general, rather a shift in party allegiances. It will arguably be easier for Fidesz to revive the enthusiasm of disenchanted former supporters who have retreated to the sidelines than to convince them to renounce their new-found allegiance to another party.
In that regard, it is worth noting that Fidesz’s fall in popularity does not appear to have strained party unity. In early May, the National Assembly voted to elect a new president to replace Pal Schmitt, who resigned in April 2012, amid allegations that he plagiarized his doctoral dissertation. Fidesz nominated its co-founder, Janos Ader, who was quickly approved with the backing of all 262 of the governing party’s representatives.
Significantly, Ader will serve a full five-year term (to May 2017), rather than completing the remainder of Schmitt’s term. As a result, Fidesz is assured of retaining some measure of influence, regardless of the outcome of the 2014 elections.
Stagflation Threat
According to preliminary estimates released by the Central Statistics Office, the GDP contracted by 0.2% (quarter-on-quarter) in the April–June 2012 period, following a 1% decline in the first quarter of the year. The economy shrunk by 1.3% in real terms compared to the second quarter of 2011, and various indicators suggest that performance will not improve to any significant degree in the third quarter.
Year-on-year, industrial output contracted in every industry except information and communications in the second quarter of 2012, with construction and agricultural production recording double-digit declines. Industrial output fell by a 2.2% (year-on-year) in July, compared to a 1.2% drop in June, reflected a slowdown in automobile production. Based on the current trajectory, the economy is forecast to contract by 1.1% in 2012.
Adding to Hungary’s economic woes, inflation accelerated to 6% (year-on-year) in August, raising the specter of “stagflation,” the combination of weak or negative growth and relatively high inflation. Stagflation creates an obstacle to reviving a moribund economy or containing inflation because the monetary and fiscal tools typically used to deal with one of those problems tends to exacerbate the other.
However, the central bank signaled that putting a floor under the economic downturn is its top priority in late August, when it announced an unexpected quarter-point reduction in the main interest rate to 6.75%. The yield on Hungarian debt fell to 9.732%, the lowest in a year, ahead of a bond auction in early September, on expectations of additional rate cuts in the coming months. The central bank’s loosening bias points to persistent inflation that, despite slowing economic activity, will push the annual increase in consumer prices up to near 6% in 2012.

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