I have received a lot of E-mails overnight about developments in Hungary. The vast majority of these E-mails have suggested that these developments (sharp rise in government bond yields since November) coupled with the fact that the Hungary uses its own currency (the forint) and floats in on international markets provide problems for the Modern Monetary Theory (MMT) understanding of the monetary system. I have been digging into the data on Hungary for some months now as I learn more about the history of the nation and its political and institutional structure. I am always cautious researching foreign-language material because outside of documents published in Dutch or French my comprehension skills are weak and I know that even in English documents there are tricks in trying to come to terms with the way data is collected, compiled and disseminated. However, unlike many non-English-speaking nations, access to very detailed data for Hungary in English is reasonable. I will have more to write about their problems in the future as I accumulate and process more information. But at present what I can say is that Hungary is a very good example of what a government with its own currency should not do and the current developments reinforce the insights available from MMT rather than present us with problems. Hungary is in deep trouble exactly because it has violated some of the basic macroeconomic principles defining sound fiscal and monetary policy.
This blog is not intended to be a definitive statement about Hungary. It reflects some of the products of an on-going research effort. But it should highlight some of the key MMT issues that the mainstream media is ignoring.
Some facts about the Hungarian monetary system:
It hasn’t always done that. The Magyar Nemzet Bank (MNB) – the Hungarian central bank – reports that:
Pursuant to Act LVIII of 2001 on the Magyar Nemzeti Bank, the Government decides on the choice of exchange rate regime in agreement with the MNB. With effect from 26 February 2008, the forint exchange rate has been floating freely vis-à-vis the euro as a reference currency, with movements in the forint determined by the interaction between the forces of supply and demand.
In June 2001, the Hungarian government lifted all restrictions on citizens holding foreign currencies (see BBC report. While this allowed citizens to open foreign bank accounts etc it also marked the beginning of the private foreign-currency borrowing boom.
2. The forint is issued by the government under monopoly conditions – so it uses its own currency.
3 The central bank sets the policy interest rate.
These points would suggest that the currency is sovereign in MMT terms.
The problem is that there is one additional characteristic that is missing in the Hungarian case. The national government borrows heavily (and increasingly so) in foreign currencies. Once they do that their sovereignty is effectively lost and they become exposed to default risk on the foreign-currency debt.
But before I consider that in more detail lets see what the real economy has been doing. I note that unemployment is around 10 per cent at the moment although that is a serious underestimate given the extent of hidden unemployment. I will do a separate labour market analysis another day.
You can access national accounts data from the Hungarian Central Statistical Office. The following graph shows the quarterly growth in real GDP from March 1996 to September 2011.
The crisis was very damaging to national economic activity in Hungary. After a false start (a mild recession over three quarters from the June- to December-quarters 2007), real GDP growth collapsed in the March-quarter 2009 and plunged by 7.2 per cent, 8.1 per cent, 7.6 per cent, 4.4 percent over the next 5 quarters before resuming tepid growth in the March-2010 quarter.
Which component of expenditure were responsible for the sharp contraction in real GDP growth. The following graph shows the quarterly contributions (percentage points) of each of the main expenditure components from September-quarter 2006 to the September-quarter 2011. I should note that the data for government only relates to consumption expenditure and so gross capital formation (investment) includes both public and private investment.
With the investment contribution clearly negative as the crisis worsened and real GDP growth declined very sharply, the lack of government consumption support through this period is notable and made the crisis much worse than it should have been.
One reason for this failure of government to respond to the crisis with a appropriately-sized fiscal stimulus lies in the on-going process to meet the Maastricht criteria. Macroeconomic policy over the last several years has been dominated by the Government’s intention to move to the Euro – a process that has been suspended a few times since 2002 because the aggregate indicators are outside the dimensions permitted under the Stability and Growth Pact strait-jacket.
The next graph simplifies the previous graph by showing just the contributions to real GDP growth from domestic and external demand. It is clear that domestic expenditure collapsed while net exports continued to play a positive contribution.
Now what has been going on recently?
The UK Guardian article (January 5, 2012) – Hungary’s woes provide yet another reason to worry about European banks – stated that it was:
It’s time to get seriously worried about Hungary. Thursday’s debt auction was a disaster. The country was obliged to pay 9.96% for short-term debt and didn’t even raise the 45bn forints it was seeking via auction; it got just 35bn, presumably because it turned away bids pitched at 10% or more.
Yes, the numerical information is fact.
You can access all information regarding the public debt management in Hungary from Government Debt Management Agency Limited (ÁKK), which was formed on March 1, 2001 and is 100 per cent “owned” by the Ministry of Finance. So it is another one of these legal illusions.
It is basically an arm of the government treasury operation but claims to be an “independent corporation”. These arrangements are common around the world but ultimately have no operational significance. Just as their operations etc were created by law – Act on Public Finances (Act XXXVIII of 1992) – (a political choice) they can be changed by law as the politics dictate.
That is, there are no intrinsic financial constraints that govern the operation or existence of these types of agencies.
The following Table (compiled from AKK data) shows what the fuss is about in terms of the recent bond auctions.
The treasury bills auctions over the last few days have “failed” in the sense that the private bond investors have demanded yields (offered lower prices) that are acceptable to the Government). In the first auction (January 3, 2012) there was enough volume (that is, the private markets tendered amounts more than being sought). By the second auction, the bids were below the auction announcement overall
The Guardian article opines that:
The backdrop is well known. The Hungarian currency is in freefall (down 18% against the euro in six months) despite rate hikes designed to shore up confidence and protect mortgage borrowers who have (ridiculously) taken out loans in foreign currencies. The government needs to raise about $16bn this year and Hungary’s banks require foreign lines of credit.
I will come back to the assessment that the private borrowing in foreign currencies is deemed “ridiculous” another day. It is an important part of the story. But here is some information.
The following graph is taken from the latest Chart Pack from the MNB. You can see that as financial liberalisation caught on in Hungary foreign currency loans have dominated the private housing mortgage market.
The banks, heavily privatised when Hungary moved into its neo-liberal phase (post-Soviet) are now mostly foreign-owned and there were no controls on the source of loans for the domestic housing market.
While the majority of household debt is in the form of housing mortgages a wide range of new debt sources grew with liberalisation. The Financial Accounts of Hungary 2008 – a publication of the MNB says that:
The majority of the increase in the loan portfolio affected foreign exchange loans as the interest rates on these loan structures are significantly lower than those of forint loans. Initially, households used FX- based loans to finance vehicle purchases, and subsequently FX-based loans were granted for real estate purchases and consumption purposes also. In the period 2000-2003, forint loans gained ground in the housing loan market in state subsidised loan structures. In 2004, however, demand for forint housing loans dropped due to the tightening of subsidised housing loan conditions, and to compensate this decline, banks began to offer foreign exchange products with small instalment amounts. Currently, the stock of FX loans represents 60% of the overall loan portfolio; two thirds of consumer loans and nearly one half of real estate loans are FX-based loans, disbursed predominantly in Swiss francs.
This is a pattern we have observed in other former Soviet-satellites (including Latvia and Estonia). I provided some analysis of what happened in Latvia in this blog – When a country is wrecked by neo-liberalism.
Liberalisation saw a proliferation of international banking in these nations and those organisations (or non-bank offshoots) gained a huge presence and began to dominate mortgage origination. The financial engineers pushed credit denominated in foreign-currency at a pace thus leaving the home buyers extremely exposed to foreign exchange fluctuations (in Hungary).
Why did the government not place restrictions on the home mortgage market? Why did it allow around a huge proportion of mortgages to be written in foreign currency? Why did it not regulate the foreign banks that swamped the Hungarian financial sector?
MMT would point to the failure to regulate the financial sector appropriately (particularly the role of banks) which allowed to many households to take on ridiculous levels of foreign currency debt to maintain the real estate boom.
But the major deviation in currency sovereignty, is the large proportion of foreign currency-denominated loans held by the central government. Once a currency-issuing government borrows in a foreign currency they effectively surrender their risk-free status in bond markets and become exposed to default risk on that debt.
Then they are back in the hands, to a certain extent, of the private bond markets.
You can download very detailed government debt data from the – AKK. Data is available in annual frequency from 1990 to 2004 and then monthly from January 2004 to November 2011 (latest).
The following graph shows the proportion of total central government debt denominated in foreign currencies. In 1990, that proportion was 2.4 per cent. The proportion rose quickly once the Soviet system fell but then stabilised until 2008. After that it has accelerated quickly.
The higher is the foreign-currency denominated debt ratio the more reliant the nation becomes on expanding its net exports to pay for it. Please read my blog – Modern monetary theory in an open economy – for more discussion on this point.
If a nation has issued foreign-currency denominated debt its external risk rises. If this debt is issued by private firms (or households), then they must earn foreign currency (or borrow it) to service debt. To meet these needs they can export, attract FDI, and/or engage in short-term borrowing. If none of these is sufficient, default becomes necessary.
There is always a risk of default by private entities, and this is a “market-based” resolution of the problem.
This will become a major issue in Hungary now as the forint depreciates – adding revaluation stress to the outstanding private foreign-currency debt.
In the case of the government foreign currency-denominated debt, there are additional problems. Default becomes more difficult because there is no well delineated international method. Often, the government is forced to go to international lenders to obtain foreign reserves; the result can be a vicious cycle of indebtedness and borrowing. The IMF is already involved in Hungary and wants to impose even more ideological design on the system.
There is also a controversy concerning reports that the government wants to access central bank stocks of foreign exchange reserves. The MNB has significant foreign currency reserves.
In addition to that controversy, part of the current crisis appears to be the reaction by the private bond markets to the legislation passed on December 30, 2011 by the Hungarian parliament which increased the size of the MNB’s interest-rate setting board. Additionally, there is a debate going on to merge the central bank with the prudential regulator and reduce the position of the central bank governor.
All these developments and proposed developments are being criticised by the neo-liberals who claim they compromise the central bank independence. I will provide some specific discussion of these political moves in a later blog.
Please read my blog – Central bank independence – another faux agenda – for more discussion on the general issues here.
The problem is that these developments horrify the IMF and the EU and the bond markets are just following the trail of fear that the Troika elites are mounting.
On top of the problems that arise from having a large exposure to foreign currency denominated debt, the Hungarian government is also caught in two additional “pincer movements” of its own making.
First, its options have become constrained by its obsession with joining the Euro. Like all the previous EMU hopefuls it has started on a long journey to meet the Stability and Growth Pact (Maastricht requirements) and has been systematically constraining its discretionary net spending at the expense of the prosperity of its population..
In a sense, the crisis seems to have been a less important event for the Government than the Euro-process, which helps explain why the real GDP growth collapse has been so severe.
Second, the Government has also imposed its own “fiscal rules” guided by the non-elected “Fiscal Council” which seemingly can override the decisions of the elected government.
The MNB publishes an annual document which provides a very detailed analysis of the developments in the Hungarian and Euro economy from the angle of appraising the suitability of adopting the Euro as the national currency. According to the Analysis of the Convergence Process 2011, we learn that:
Legislated by Parliament and now in force, the so-called real debt rule prohibits the real value of the national debt from being increased from one year to the next. Furthermore, the Constitution requires that the indebtedness ratio of the central budget be decreased each year until it reaches the 50 percent threshold. Of these two provisions, the real debt rule – if the real GDP growth rate is positive – is more restrictive in nature. That said, these rules do not speak to the methods of achieving these targets, leaving these considerations up to the legislature.
The fiscal responsibility Act, adopted in 2008, not only enacted a series of fiscal rules but also set up a legally independent institution, before the entire framework was overhauled in 2010. As a result of this revision, the gdp- proportionate debt ceiling was enshrined in the Constitution, while the country’s Fiscal Council – after having also been restructured – was vested with broader powers to control fiscal processes or, as the case may be, to even block the legislative process. In contrast to the past, however, the reformed Fiscal Council no longer continuously monitors fiscal processes throughout the year, nor does it promptly assess the fiscal impact of individual amendments, since its scope of inquire is largely confined to the period covered by the prevailing Budget Bill for the upcoming year.
So the Government is deliberately constraining its fiscal capacity to service the demands of foreign elites (and its own elites) which will make the current crisis worse.
The problem is that both the private and public sector in Hungary are now very exposed to the assessment of the bond markets and exchange rate movements which follow.
In the latest edition – Analysis of the Convergence Process 2011 – the MNB say:
… higher- than-average balance sheet adjustment may be necessary due to the fact that debt is denominated in foreign currency, where changes in the exchange rate are obviously very unpredictable … Overall, the balance sheet adjustment in the private and particularly in the household sector – on a larger scale than in the core euro area countries – will constitute an asymmetric shock in the coming years, possibly further strengthened by the banking sector’s dependence on external funds and its declining capital accumulation capability.
And the problem also extends to the public sector because it has such a large exposure now to foreign currency-denominated debt.
The Analysis of Convergence Process 2011 Report referred to above says:
As a result of the high foreign currency ratio of the public debt and the relatively short average maturities, rising yields and a weakening exchange rate of the forint may trigger a substantial increase in the indebtedness ratio. At higher debt levels, the rate of indebtedness becomes more sensitive to declines in economic output and fluctuations in yields.
Put together – a very difficult situation is ahead.
Life in Hungary will get very difficult because it is now so exposed to movements in its currency. The private sector will experience significant reductions in its real standards of living as they struggle to service foreign-currency denominated debt with a declining domestic income.
The government will also be pushed towards default by a slowing economy, the massive revaluations of its foreign-currency denominated debt as the currency falls and the declining capacity of the economy to generate export growth (as the rest of Europe slows).
It is a very dire situation and the bond markets are reacting to the increased risk of default.
The lesson is that Hungary does not provide a case against the insights provided by MMT. Budget deficits in a sovereign, floating, currency never entail solvency risk. Sovereign government can always “afford” whatever is for sale in terms of its own currency. It is never subject to “market discipline”. A sovereign government spends by crediting bank accounts, and it can never “run out” of such credits.
I repeat that when analysing a specific nation there are so many aspects to draw together. I have just skimmed the surface and deliberately left a lot of interesting and relevant issues out – to allow a focus on the specific MMT issue – the loss of currency sovereignty.
The blog was just a sharing of some research effort about Hungary (which really all my blogs are meant to be). There is a lot more analysis needed of this country and its desire to join the Euro to really get to the bottom of their current dilemma.
The first Saturday Quiz for 2012 will be available some time tomorrow. I hope it is a bit of fun.
That is enough for today!