A Bold Move by Hungary
Hardly has the ink dried on the post below where I indulge on some more theoretical investigations before I am compelled to return to the real world and the daily movements in the markets. Consequently, Hungary announced today that it would scrap the trading band on the Forint vis-à-vis the Euro formerly situated between 240.01 and 324.71 per euro. For my latest in-depth note on Eastern Europe, go here.
(quotes taken from Bloomberg)
Hungary scrapped trading limits on the forint, betting a strengthening currency will help control inflation as economic growth stalls. The forint climbed as much as 2.3 percent after the central bank said in a statement that the price band in which the currency is allowed to trade against the euro will be dropped from tomorrow. The Budapest-based bank left the benchmark interest rate unchanged at 7.5 percent today. Policy makers led by Governor Andras Simor want to curb an inflation rate that's running at more than twice the central bank's target even after the economy expanded 0.8 percent in the fourth quarter last year, the slowest pace in the European Union. Annual inflation was at 7.1 percent last month.
``They are trying to pull a clever trick,'' said Nigel Rendell, an emerging-markets currency strategist at RBC Capital in London. ``They hope the currency will do their work for them instead of raising rates.''
``The ability of the bank to control inflation has increased on the back of this move,'' Janos Samu, an economist at Concorde Securities in Budapest, said in a client note. ``The central bank regained its impact on currency movements, the major determinant of inflation processes in the economy.''
As can readily be observed by the quotes above the move has widely been seen as a move to help the central bank to keep a lid on inflation. By letting the Forint flow freely they are consequently hoping that the ensuing appreciation will help the central bank in its uphill struggle to bring back inflation within target. I put emphasis on hoping here since it is far from certain I think that the Forint can be expected to stay elevated vis-à-vis the Euro. So far though the markets seem to be indulging the central bank in its move. After having been the emerging market whipping boy of this year the Forint saw a hefty appreciation on the back of the move. Yet, as noted, this may not last. Moreover, the scrapping of the trading band has also effectively opened up the door to all those unhedged liabilities which the households and cooperations and households have taken up. Clearly, the move itself will now tend to diminish the allure of these kinds of loans which may be good in itself but if you take a look at the graph Edward fielded in a recent post it becomes clear that the issue lingers. The only mental leap you need to do in order to imagine the real situation is that you consider the fact that a large part of those deposits are not denominated in the same currency as the loans. In this way, today's move has opened up a veritable abyss of downside. For those of you with financial inclinations you can imagine how all those banks having supplied the loans will have to tweak their VAR models quite a bit.
Having said all this however, I do think that this move was the only reasonable way that Hungary can begin, ever so slowly, to wriggle herself out of the wrench in which she is now situated. The problem is that the scrapping of the band in order to do something about inflation as well as to stay credible in the face of increasing market pressure may not work out as expected in the longer term. This is not an argument for not doing it though but inflation is not Hungary's own problem and what we thus need to realize is that Hungary effectively is the first economy to really have entered the malice of stagflation (and here I am maintaining an open mind as to what exactly the Fed et. al. ought to worry most about). As Edward succinctly puts it in his review of yesterday's events ...
Basically I think this is the point, when the HUF rally runs out of steam the NBH is going to be in a very difficult situation indeed, and it will run out of steam when Hungarian households let up on their frenzy to borrow money in Swiss Franc denominated loans, a decision which may be made easier for them now that the band has been removed and the currency risk is evident to all. A difficult decision, but then maintaining the band was only encouraging people to keep going on contracting the loans.
The interesting question is what happens next? Clearly, simply indicating that they want the currency to rise on its own won't get the currency to rise. It had been falling in recent weeks, and this is the tonic - in the absence of future rate rises from the bank - that we could expect to see continue. Really this decision has been taken - as I am suggesting - to avoid taking another one, which is whether to raise or lower interest rates. It seems the bank would like to give the impression that it wants to be firm on the rates front (which would imply rate rises) since otherwise talk of upward movement in the forint doesn't make sense, but that it could only get the government to agree to scrapping the band by holding fire.
On the other hand, the economy itself is headed downwards, and with more fiscal tightening on the agenda and a more difficult external environment as the eurozone economies themselves slow it is hard to see where growth can come from, and the economy seems in bad need of some sort of stimulus shot or other. So we really now move over to the political front, and need to ask ourselves how much more of this type of medicine with no tangible results is the Hungarian voter actually going to put up with without making some sort of protest. Which brings us back to the third tipping point, the proposed referendum for March 9th.
As you can see, the bind in which Hungary has fallen continues to tighten. From this point on it becomes paramount to watch the Forint. I hope that this move pays off but if it does not I am afraid that the Hungarian authorities are running out of bullets to fend off the wave of attacks which may come next.