Posted by: michaeldavidpower | October 8, 2009

Hungary: ETA Euro Aeroport now unknown

Keep your seat belts fastened; turbulence still distinctly possible.

In my (overly simplistic?!) characterization of the New World Order arising, a nation can be a locomotive, a coal truck or a passenger car.

Locomotives are few in number and come in two varieties. They are either demographically rickety and slow as in the US, Japan and the EU (effectively a self-contained train made up of German, French and British locomotives followed by a posse of passenger cars). Or they are young and energetically fast as in China, the East Asian Tiger troop and, increasingly, India.

As for coal trucks and passenger cars, they are generally born, not made. Coal trucks have natural resources upon which they rely heavily for exports. Passenger cars instead hitch themselves to locomotives using their cheaper labour to do so. This labour makes and supplies lower-than-locomotive cost inputs into the supply chain of their proximate locomotive (the Mexican “maquiladora” model) or migrates into the locomotive itself (again Mexico was the pioneer here).

For the past 35 years, during which period the Western locomotive has been at the front of the global economic train, it is generally better to have been a passenger car than a coal truck. An argument could be made that ‘oil tankers’, carboniferous cousins to the coal trucks, were an exception to this rule and were particularly blessed. This was because Western locomotives were far more oil-fired whereas Eastern ones – for now – tend to be more coal-fired. But since 2000, this ranking has been changing. With the Eastern locomotive now at the front of the global economic train, many coal trucks have been promoted up the train order and an increasing number (Brazil, Indonesia) are now ahead of the passenger cars and oil tankers. (Incidentally, ranking is more a function of contribution to overall global growth momentum, not economic size; using this methodology, China is now ahead of the US.)

Some coal trucks like Australia are Western in origin but, adapting well to the new world, are still in the winners’ circle today too – truly lucky countries! Other coal trucks like South Africa are so confused about their economic identity, they seem unwilling to leave the comfort of the known yet Old World even though the still misty yet emerging New World would serve them far, far better.

There is no confusion about the status of Hungary – it is a passenger car attached to the European locomotive, pure and simple. It has little chance of changing its designation and so its destiny having no significant natural resources except perhaps its exceptional Royal Tokaji dessert wine!

Perhaps accepting its fate, Hungary has – since the Iron Curtain was first ripped apart by Hungary itself in 1989 – embraced its passenger car status with a vengeance. If exports plus imports as a percentage of GDP is the defining measure of economic openness, at over 170%, Hungary surely has one of the world’s most open economies. A secondary measure might be the share of one’s banking system owned by foreigners: at over 80%, again Hungary has one of the highest levels of openness. No one can accuse Hungary of not following the IMF’s play-book in this regard!

Indeed, Hungary’s ‘good boy status’ is further evidenced by the fact that it has put export-led growth at the centre of its economic development strategy. At its industrial core lies positioning the country as an efficient and lower cost component manufacturer supplying Western Europe’s – and especially Germany’s – capital goods sectors. In particular, it is a key supplier to the German auto giants:  Audi’s engine factory at Győr is the largest in Europe.

Around this foundation, it has riveted electronics and pharma factories, adding related R&D facilities to soak up its highly educated population. (Never have I seen so many young people in parks reading books as in Budapest!) Hungarian ‘bright young things’ – with their world-famed reputation in mathematics and mechanical engineering – have also attracted major multinationals into the country’s growing service sector.

Finally, being at the crossroads of central Europe (Austria and Slovenia to the West; Slovakia to the North; Ukraine and Romania to the East; Serbia and Croatia to the South), Hungary has exploited its geography and built up a road and rail network that has allowed it to become a regional logistics hub second to none.

So why, in 2009 when GDP growth may contract over 6%, has Hungary suffered its worst economic downturn of the post-1989 era?

If coal trucks risk catching the Dutch Disease, passenger cars risk catching the American Disease: debt-financed overconsumption often ending in the tears of a bursting property bubble. This has been Hungary’s fate and it now finds itself dealing with the consequences: a work-out period that could last over five years.

For all the good results  it achieved on its production side – manifested in exports now being over 80% of GDP – Hungary ate them all up, and more, in a consumption binge post 2000 (perhaps a reaction to the austere 1990s, a post-communist era hang-over decade). By 2008, the ‘overdoing it’ signs were everywhere to be seen but, during that era of abundant liquidity that ended the day the music died – the day Lehmans died! – no one really cared. In 2008, Hungary’s current account deficit exceeded 8% of GDP. Meanwhile Hungarians were borrowing heavily from abroad, most ill-advisedly in a Swiss Franc, Euro and Yen carry trade used to finance their home mortgages – just imagine the awful consequences now if US home-owners had done the same?! Government spending had, in a country with a highly developed welfare state, slipped to a widest point deficit of 9% of GDP in 2006.

What kept Hungary afloat was abundant liquidity in the form of inflows of foreign capital supplemented by those “cheap” foreign borrowings for home mortgages (made available largely through the 80% foreign-owned Hungarian banking system). Without such hot money and easy street IOUs, the Hungarian economy would have sunk two or three years before 2008. Even with them, it was an accident waiting to happen: the events of September 2008 torpedoed an already badly leaking and listing S.S. Magyar.

So where does the Hungarian economy stand now? Precariously. The offshore debt threatens to strangle domestic consumers if the Forint were to fall appreciably. Recognizing this, the Central Bank – haven given up exchange rate targeting for inflation targeting (3%) a few years ago – today again effectively targets the exchange rate! (The “3% in one go” rise in rates to protect the Forint a year ago is evidence of this.) By pursuing Forint stability over goosing growth through devaluation, the Central Bank is opting for the long way out: Hungary will not grow itself out of its predicament in a short term dash but, by letting the overstretched consumer gradually repair his balance sheet, over a longer term slog. So interest rates will remain higher than they should be, underpinning the currency even at the cost of making the burden of government debt financing higher than it should be. That said, two more 50bp cuts are scheduled this year and are well enough signposted so as most likely not to spook the FX markets.

The current situation puts the Socialist Government – facing elections next year – in a tight spot. Currently implementing an austerity package, they are fiscally constrained as part of an IMF programme so few pre-election goodies are likely to be handed out in coming months. (A $20bn IMF/World Bank/EU care package is what is tiding over government spending in the meantime.)

Invariably – and typically – politics threatens to intervene. But this time it is the Socialists who are trying to play by the book and keep to the IMF stipulated rules. The dieting electorate is unlikely to reward the Socialists for their good behaviour i.e. austerity! Rather the carping Right – with few clearly defined economic policies – will likely gain power next year (and most likely without having to form a coalition). What they will do them, no one really knows. It is not impossible that, having criticised the incumbent regime, they will end up adopting most of its austerity programme after all.

This is because both sides have one supreme objective in mind: Hungary joining the Eurozone. This will put an end to the bane of Hungary’s economic life today – the currency risk that straddles the higher interest cost Forint zone with the much lower cost Eurozone. Once the Euro is adopted, Hungary’s cost of capital will effectively halve and consumers will also see borrowing costs halve; moreover Hungary’s banks will see their fractured balance sheets effectively repaired overnight.

The only question is what route Hungary will take and how long will the journey last until the Maastricht criteria are fulfilled and the Eurocrats permit Hungary’s landing at the Euro Aeroport. Invariably the more populist the policies in the interim – which is to say policies designed to win elections – the longer the flight will be.

My forecast is that ETA Eurozone will be about 2015. Till then, Hungary will be in convergence mode but – as recent history has painfully illustrated – not necessarily a secure convergence trade.

So what is the bottom line on Hungary?

Destined to be a passenger car attached to the aging locomotive that is the EU, Hungary – having partied for much of this decade – is doing pretty much all the right things to get back on its flight path, a path whose destination will mean that the Forint will be replaced by the Euro and higher interest rates will be replaced with much lower ones. Criticise the Hungarians for being naughty in the Noughties if you must. Perhaps they counted their Euro chickens before they hatched, but what more could they do now to make amends?

Hungary’s Euro destiny is clearly defined – it will just take longer to get there than they once hoped it would.

But, in the back of my mind, I still wonder if being a passenger car (not that Hungary has any other option) to an increasingly rusty Euro locomotive is not the larger challenge that Hungary ultimately faces.

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