Hungary and sovereign default

It's almost official: the government's ingenious plan is to nationalize compulsory private pension savings and spend it on current budget expenses (pensions) and debt reduction. They hope it will enable them to survive without major restructuring and action until the tax cuts will bring 7% GDP growth. (Actually many expressed doubts, how realistic this expectation could be. Some calculate that 8-10% growth would only fill the holes of the budget from 2013.) Anyhow, the government expects 90% of the mambers of such private pension schemes will return to the state run, pay-as-you-go system, eventrually transferring their portfolio to the state. The delicacy of the issue: it is nothing else than default on a part of the debt and restructuring.

Private pensions savings, although compulsory, are private property. They hold about 2800 billion HUF savings in sovereign bonds (circa 1300 billion) and other assets, mainly stocks and investment funds. It means at around 5% of the GDP is in the hands of these private as government issued bonds. As soon as they transfer it to the government they will be rewarded with a promise of a state pension and their portfolio transformed into state property. Obviously the state will never be obliged to redeem them, it will reduce the debt. It is not a straightforward way of default and debt restructuring, but in its essence it is nothing else. Government liabilities at private debtors are declared void and exchanged to another type of government liablity. At the moment it is - nominally - voluntary. However, the pirme minsiter expressed his firm conviction that as much as 90% ot the members of private pensions schemes will choose the satte run system in two months time. As this number is highly unrealistic on a voluntary basis one could expect legislation making it compulsory, transforming the process in a confiscation. Especially in the light of Fidesz's willingness to reduce the jurisdiction and competenc eof the Constitutional Court, barring it from judging the constitutionality of economic legislation.

Hungary in fact defaulted today...

White mice - Updated

After months of permanent "revolution" the prime minister, Viktor Orbán announced new measures this Wednesday aimed to bring the budget deficit under the ceiling aggreed with the EU, supposedly without austerity. It would be easy to mock him how he defines austerity (as next years budget is planned with a nominal cut in budget expenditures, obviously affecting a lot of people) but I presume it will be a popular activity in the coming weeks. It is more interesting whether this new action plan (complemeted with a modified tax system due to be announced next Monday, but a series of ideas already known) signals a dicision at last concerning the economic policy. Especially as the 29 point from June were the sign of indecision. (See my post here.)

It would be easy to dismiss yesterday's plans as the postponement of this state of agony, as it is not easy to see any coherent direction of action in the rather patchy series of new - intentionally only temporary - levies. However, considering the nature and content of the earlier internal conflict and the resulting political dilemma for Orbán, this time one should assume the decision has been made and what one can see is the backbone of the new economic strategy of Hungary's government. For years economists around and inside Fidesz fought a pitched battle whether the state has to be reduced with drastic cuts in order to make room for tax cuts in a corresponding extent or taxes should be reduced without any offsetting measures. Funnily and ironically proponents of both directions pointed out the same examples, most notably Slovakia, but in the last few years Romania and Bulgaria as well. The representatives of the former line - many of whom participated in the activity of the Reform Alliance in 2008 and 2009 - argued that the size of the state was and is too large and its extent of income redistribution - especailly with its ratio of social expenditures - is crowding out private investment and depresses initiatives. A much smaller state would enable the private sector to invest more leading to higher production and with time higher income. However, according to this line of thought, the balanced budget is a precondition of higher grwoth, because the budget deficit is just as harmful as the high redistribution ratio. If the state runs deficit it needs financing and the sivereign bonds issued attract the capital easier than investment. Those holding an opposite view in Fidesz do not deny the necessity of a smaller state. Nevertheless, their recipe is quite different, as their diagonisis focuses on the reasons of the weakness of economic growth eslwhere, finding it in the lack of sufficient internal demand. Therefore they propose a kind of shock, government measures in order to raise personal income levels creating the preconditions of rapid growth.* They presume this boost of internal demand would lead to such a growth rate that would allow a larger state expenditure in nominal and real terms and simultaneously reduce the redistribution rate as a ratio of GDP.

It is clear the latter "soultion" needs either a very benevolent attitude form those financing the diefict or a permission of the EU, the guradian of the Stability and Growth Pact, because it is usually seen as a way leading to immediate worsening of the situation of the budget. Even if faster growth would bring higher revenues with time as the proponents of this solution claim (far from being certain, but a very popular argument) someone has to finance this transitional period. The idea of a higher deficit for this year, so ferociously defended (portrayed as inevitable) during the run up to the election and afterwards served exactly this purpose. After the EU Commission reppoached Orbán and made it clear they wouldn't accept any deviation from the plans outlined by the outgoing government the circle looking for this way needed to find another soultion. For a while it seemed the former group prevailed and next years' budget will be constructed very cautiously, but meanwhile there were signs of attepmts signaling the almost desperate will for implementing the second version of economic policy. Despite these signs "analysts" and "economists" were deluded by the readily repeated promises of government officials that Hungary will stick to the deficit target both this and next year. They convinced themselves it logically means bugdet cuts, asuterity, reforms.**

Yesterday it turned out we won't see the first alternative being realized, instead Orbán Viktor opted for raising internal demand without lasting measures to offset losses. It doesn't mean the budget won't be extremely tight, but every inch of room for maneuvre will serve the purpose of a huge tax cut. (The one I sketchily characterized in my previous post.) However, the whole action has a transitory nature as the government expects a new wave of additional revenues from higher growth. New windfall taxes on telecommunication companies, on the energy sector and on retail cahins will be imposed (already due this year!) and contributions to private pesnions schemes (obligatory for at about 3 million people in Hungary) will be withhold in the budget. Whether it is the first step towards complete nationalization (a very contorversial issue under EU law) or just a necessary step to cover losses temporarily (the minister hinted to an eventual compensation, although without specifying its nature) is not clear. Anyway,for many observers it seems the government bought itself enough time to bring about its tax cut without destroying the budget and placing the country at the mercy of external financers. Doubts are only raised regarding durability of the reduction of the budget deficit when these measures expire without significant reforms.

If the informations regarding the harsh cuts in the budget (affecting sectors like health care, already drained by years of austerity) turn out to be correct one should conclude the situation is more serious than one would have thought earlier. In this case it will be clear the country is the scene of a mass experiment of supply side economics and the government is playing a gamble. Not that some of the problems they conceive would not be real. Further austerity - albeit propsed by the EU and requested and expected by the markets - could easily push Hungary to the Greek, Irish or Portuguese road. Austerity depresses growth and fails to reduce debt to GDP ratio lastingly making a new wave of cuts necessary and further depressing growth. The vicious circle is not easy to escape (I tend to think it is impossible without coordinated efforts of the EU) and the governments plans to brake it can be seen as legitimate. Although some of the doubts echoed are equally legitimate, the real problem with the proposed solution lies elsewhere. The government relies on the assumption that the only hindrance for growth in the country is the depressed internal demand and a sufficiently strong boost will give the necessary impulse to the economy, bringing new orders to local SMEs etc. In order to achieve this they will introduce a Slovak-type tax system (they even copied the abolishment of the inheritance tax) accompanied by Slovak-type social assistance system, but contrary to the Slovak model they won't prefer market-oriented reforms of systems like the health care, child benefits or pensions. A very strange version of neoliberalism (provincial and protectionist) but still supply sider neoliberalism.

This is exactly the Achiles heel of the whole plan, it focuses on one single factor and assumes a large enough change will generate substantial changes in the whole economy and society. Ironically, it would need a completely and perfectly funcitiong economy, something doesn't exist in the country to the extent the plan would presume (and the existence of which would make the whole idea obsolete). But beyond rather insignificant general observations the whole plan suffers from many important deficiencies. Firstly, there is no sign of the rowth generating effect of stronger internal demand among the present circumstances. Real wages and incomes have grwon in Hungary in this year due to not insignificant tax cuts for middle income categories. On some income levels it was almost 10% raise of net income and on an aggregate level in the first half of the year real income was 5% higher than a year earlier. (This is now fading due to base effects.) Nevertheless, retal sale were continously decreasing, an omnious sign for every attempt to use internal demand as a means of stimulus.***

An even more important factor giving way to doubts is the very uneven distribution of benefits from the proposed tax cuts either in terms of social status or georgraphy. According to preliminary calculations based on the leaked informations on the new tax system a very sognificant part of the working populatioin will not be better off or only with an insignificant ammount, probably meaning a loss of real income. It won't be offset by the child allowance fr these social groups. Moreover, even families with low income but three or more children will not benefit from the generous child allowance. The only group that will certainly enjoy a significant advance in financial terms will be the one of families with high income and three or more children, while the more people earn at the present the more positive the effects of the tax cut will be. Although it is hard to assess the distribution of the tax cuts precisely, it is safe to assume it will make better the position of those with a lower marginal propensity to consume except families with children. Moreover, while the tax cuts can serve as a stimulus via internal demand, the cuts of budget expenditure will have a negative effect on public invesment and public consumption, a factor of GDP dragging down growth already for years. Once again, I have no clue to the ratio of these conflicting effects, but it is hard to accept the planned 500-600 billion HUf tax cuts will raise grwoth with the envisaged 2%.

Of course one can say at least the demographic effect will be positive and I wouldn't be surprised to learn of a temporary positive change in the birth rate in next year. Given the number of live births just under 100000 per year 10000 additional newborn would be a very significant development. However, as I mentioned the child allowance will only mean a significant help for thosew with extremely high income (by Hungarian standards) and with three or more children. People with high income could opt for a third child, but it still won't change the picture fundamentally. Meanwhile the sate will renounce on the social infrastructure of child upbringing (kindergartens, play-scholls etc.) as it won't have the necessary funds to rebuild the instiutions lost in the last two decades. The well-to-do large families will be able to afford private kindergarten (the monthly fee of which is equal to the ammount of the entire child allowance planned!) and will be able to finance one of the parents remaining at home, while those with less children and/or lower income will still struggle to reconcile work (substantial to secure an accepatble family income) and child care. The whole complex is aggravated by the fact that in the backward regions of the country where unemployment - longterm, structural - is concentrated and where the above mentioned larger family type with low income (somteimes living on social assitance) is widespread people's burden won't really be lifted by this new tay system. The result: higher inequalities in the country, less opportunity for people in these reagions and less social mobility. The latter is especially important as under the planned tay system lasting positive developments in demography would need very strong social mobility, because the real positive effect on birth steps in at higher income levels. As long as one can not break away from poverty or the trap of mediocre income one could not really enjoy generous child allowance. (The difference is huge. The child allowance is worth 10000 HUF for the first two children each, and 33000 for each children after the third one is born!)

(Some additional thoughts.) The last - but not the slightest of problems - of the new line of action is that ironically it makes Hungary even more dependent on external factors than earlier. While the government claims to have realized economic independence with getting rid of the IMF, its plan is based on the positive development of a series of external factors. Even if one assumes a turnaround in the reatil sales (a signal of grwoing internal demand) public consumption and investment will affect GDP negatively. Therefore, Hungary will need significant export growth to make its very ambitious plans a reality and collect the revenues envisioned. However, the tax cuts has almost no effect on competitiveness and there are some ominous signs. In the first half of this year the extraordinary growth in germany did not generate enough export oriented economic activity to have offset the decrease elsewhere. If the world ecopnomy will slow down Hungary can find itself trapped again. Beyond this worrying possibility one should take into account the ongoing sovereign debt crisis in the eurozone. If in March, when Ireland will return to the financial markets its yields will still be too high to lend credibility to its claim of beginning to reduce debt as a ratio of GDP the whole edifice can collapse, bringing down Hungary as well. Meanwhile the world economy is inchoing towrads "currency war", a series of competitive devaluation, a dangerous development to the export capabilities of the EU.

As it seems although Hungary freed itself from the the IMF (but not from rules of the EU, that are much less flexible) it did not gain a larger influence on these exterenal factors. While countries had a chance to really negotiate measures with the IMF, and that way implement an economic policy - at least partially - of their own making and enjoying the safety of having the support of this institution, now the Hungarian government acts in the hope that every single external factor it can not influence will at the end contribute positively to its economic plicy. In this sense Hungary is less and not more independent at the moment, its future hinges exclusively on the positive developments in the world.

I do not want to presage an inevitable failure of this new policy, although I have not much confidence in it. But even if I try to make this generous gesture of fair play I could not escape feeling myself as a white mouse looking out of a cage juts before entering a labyrinth in a new laboratory experiment.

* Please note, the owner of this blog doesn't concur with any of these opinions, considering them very simplistic if applied to Hungary's present state of affairs and in general as well.

** One should pay respect to the few exceptions, most notably among the Peter Attard Montaldo at Nomura, who echoed suspicion from the beginning.

*** There could be many reasons for this surprising development. One of them is certainly the process of deleveraging, especially as the fx-based loans were hit by the rapid deterioration of the exchange rate of the HUF against CHF and EUR. People probably pay higher mortgage rates from their higher income, something that could easily last for years.