On thin ice?

Hungary's prime minister is in full gear. With declining popularity and approval ratings he is convinced that it is due to his government's inability to make people understand how well they are treated. Instead they believe in the lies of the opposition. As a result Viktor Orbán appears everywhere, gives interviews (even to reporters earlier exiled to remote corners of the public media) and engages the opposition in the parliament. (Contrary to the British custom there is no informal obligation of the premier to participate on Prime Minister's Questions every week.) Additionally he visits friendly societies, in order to clarify his program for faithful followers. 

Aside from the obvious ominous signs - what to expect from people supposedly belonging to the country's business elite who are listening to Orbán's contradictio in adiecto statements without objection, moreover, taking it with applause - the prime minister made yesterday an interesting comment in one of these circles. He referred to that although it is almost impossible to introduce fixed exchange rate it is worth to contemplate the possibility. 

Given the self-proclaimed and proudly borne "unorthodox" nature of the economic policy of the government, such a hint is not necessarily as meaningless as one would be inclined to take it. There is at least one recent example that a country managed to regain competitiveness and growth with a set of measures including capital - and implicitly exchange rate - controls. Paul Krugman gladly compares the example of Iceland as a country that took a more traditional devaluation focused IMF approach in the aftermath of its crisis to the European countries taking the internal devaluation path. Iceland is an example for a country's potential to convince the IMF  that act of its own design can serve the common aim of returning to growth just as well as the IMF's proposals. According to the latest IMF report on Iceland the government insisted on capital controls in order to make devaluation (and implicitly inflating away debt) easier with pre-empting capital flight.

In the light of Iceland's performance, much praised by the IMF, even the idea that Hungary's leaders are contemplating something similar cannot be written off easily. However, some caveats should be made here concerning the viability of a possible change of strategy. Firstly, Iceland started negotiations with the EU on its accession simultaneously with its IMF program. On the one hand it means a strong pledge that capital controls and exchange rate manipulation will remain temporary, on the other hand it was free from the EU rules, something not given for Hungary, part of a joined EU-IMF credit program. It is hard to see in Hungary’s case how EU law can be eliminated, even if it allows for reintroduction of capital controls in case of economic danger. Secondly, Hungary is still following the path of classic austerity – despite the government’s insistence on the opposite –, it is “on the Greek road”, as Orbán likes to formulate. Even if it is possible to change track, the austerity already has forced its citizens to deplete their reserves, it has not strengthened its banking system (as Iceland did), rather weakened it in the last year, and the typical neo-liberal reforms (for example on the labour market) proudly passed in Parliament yesterday do not suggest the government’s willingness to take an alternative route in order to share the burdens of the crisis more fairly. Thirdly, and this point is knit the former, Orbán has a distorted vision of Hungarian society, impeding him to realize policies strengthening equality. Yesterday he also announced that his policies are aimed at strengthening the middle class. However, the latest income statistic of the Statistical Office showed that people with a monthly per capita net income of 130000 HUF (400 EUR, equivalent of 200000 HUF gross wage) in 2010 belonged to the top income decile. Fidesz’s new flat-tax in 2011 meant a tax raise for everyone with a gross wage under 290000 HUF. One can safely guess that Orbán’s policy – however strongly he is convinced of the opposite – benefits only 4-5% of the population, and certainly not the middle class, only the elite. And last, but not least, a sudden change of track would not only need approval from Hungary’s creditors (something certainly not happening without clearly formulated and well founded strategy), but a bit more capacity to act than the government has shown until today.

Disorderly devaluation?

The saga of the conversion of fx-loans in Hungary goes on. According to a report at the Hungarian website origo.hu the government's main aim is to regain freedom of exchange rate determination and practically carry out a devaluation of the forint, without hurting households with fx-loans. As I'm no friend of this government I'm sceptical a bit, no government politician or supporter used this argumentation until today. However, if it is true it is just an even stronger proof of the incompetence of the government.

I know that I was arguing – not that it would matter the slightest – on behalf of external devaluation, therefore to declare a seemingly identical argumentation could seem paradox. Nonetheless, it is hard to treat the government's proposal as fulfilling the three necessary preconditions of a successful devaluation through the conversion of fx-loans. Any attempt should be comprehensive in its extent, prompt in its execution and orderly regarding the covering of losses and managing the inevitable risks. In this case none of the above preconditions exists.

The volume of fx-loans is around 1 million households. The ration of non-performing loans is around 10%. The proposal of the government intends to cover only 300 000 at best, so, the remaining 700 000 would still make a very significant electoral base not to let the forint devalue. And this is the maximal number the government claims will have an opportunity to make the conversion. The Minister of National Economy allegedly argued that only 50 or 100 billion HUF loss will be incurred to the banks, a sum that gives only about 75 000 existing loans converted. Hardly a reduction enabling the government to devalue.

Neither is the proposal prompt enough to make a sufficient reduction for a quick devaluation. Although the prime minister told yesterday that only a limited time frame would be allowed to the debtors to make the conversion (a solution with many – albeit very different – risks), this evening the reports states that the possibility will be open indefinitely. So, even with the compulsory lending of forint based loans prescribed for the banks the process would be slow (given the practical and procedural necessities, finding the suitable new loan, preparing the documentation etc.) and without it it will only be a cherry picking of the better debtors. Meanwhile everyone will avoid the not so promising clients, effectively reducing the number of conversions and therefore postponing the restoration of freedom of exchange rate manipulation. With the process underway for months or probably even for years the economy can not have the boost hoped from the devaluation.

It is again hardly an orderly solution. Although the distribution of the losses is clearly settled at least for the time being* nothing else seems to be in place to impede the dangerous process induced by the conversion. First of all there could be a long period of risen demand for forint that will inevitably lead to higher interest rates, while the exchange rate will be depressed (but probably not depressed enough to lift the exports significantly) to compel the National Bank to raise its policy rate and simultaneously inflating the country's foreign currency denominated sovereign debt. Even at the present rate of 286-287 forint for one euro the debt grew with 800 billion forint, 26+ of the amount the government reduced it back in summer. It would effectively mean the end of the debt reduction course, up to this moment the main objective of government policy.**

Beyond the practical issues the new strategy (external devaluation) is the third one in 16 months. Initially there was an attempt for a stimulus through tax cuts that almost immediately failed due to policy constraints. The EU forbade any deviation form the agreed deficit target of 3,8% of GDP. During the autumn the government made an experiment with classic austerity and tax cuts, but the budget collapsed already in January, leading to the very typical austerity program (internal devaluation), the Széll Kálmán plan and the primary objective of forced and fast debt reduction. And now the government turned around again, this time opting for external devaluation. Albeit not in a very sensitive way. (It is worth to take a look at what happened in Iceland, where – with the assistance of the IMF – a consolidation program based on external devaluation was carried out successfully. It needed far more and far stronger cooperation and effort than the Hungarian government envisages.) And not only the sudden and unexpected turns and twists speak fro themselves, there are a lot of contradiction between these strategies. Austerity is the opposite of the stimulus, while external and internal devaluations are hardly reconcilable and the former will initially raise the debt to GDP ratio. A sensitive mixture of these approaches would still be possible (especially of the first and the third), but it would need a more complex and sensible approach, one that calculates with every possible effect and takes into account every potential risk. Unfortunately the only economic quality the government seems to possesses is a very high marginal propensity for gambling.

* However, the prime minister admitted yesterday that the EU Court would most probably declare the move illegal, order compensation and fine Hungary, but he was eager to assure the people that they do not need to fear, the state will take this burden.

** There are a numerous other risks. For example the conversion means the liquidation of Hungarian assets and payment of huge sums to foreign creditors. Reducing national wealth and handing it over to foreigners, a reduction of the capital and with it the possible base of investment, and obviously will have a negative impact on the current account.