Financial Interdependence in the World’s Post-Crisis Capital Markets:

Lessons from Hungary

Ferenc KarvalitsDeputy Governor

Magyar Nemzeti Bank (the central bank of Hungary)

Prague, June 14, 2010

Outline

1. Pre-crisis period: build-up of macro-imbalances

2. Policy responses to the crisis

3. Current economic conditions and outlook

4. Lessons from the crisis

2

The pre-crisis period in Hungary: build-up of macro-imbalances

• Institutional flaws– Fiscal policy: weak fiscal institutions unsustainable debt

dynamics– Monetary policy constrained by the ER band unable to

sufficiently counterbalance fiscal expansion– Overly optimistic expectations of convergence low savings

contribute to large CA deficits

• All this made possible by abundant global liquidity (cheap financing) lack of disciplining power of financial markets

3

Chronically large budget deficits, „political business cycle”

budget balance, % of GDP

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

01998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Czech Republic Hungary Poland

Maastricht reference value

Election years

4

Unsustainable debt dynamics, tolerated by the market during the „global savings glut”, but punished after Lehman

Government debt, % of GDP

0

10

20

30

40

50

60

70

80

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Hungary Czech Republic Poland Slovakia EA-15

Maastricht reference value

5

Overly optimistic convergence expectationsHouseholds’ consumption as a percentage of disposable income

70%

75%

80%

85%

90%

95%

1995

:Q1

1996

:Q1

1997

:Q1

1999

:Q1

1999

:Q1

2000

:Q1

2001

:Q1

2002

:Q1

2003

:Q1

2004

:Q1

2005

:Q1

2006

:Q1

2007

:Q1

2008

:Q1

2009

:Q1

6

...all this contributed to significant external imbalances and currency mismatch

Integrated banking system with developed countries

Overoptimistic expectations the households

Low FX volatility

Loose fiscal policy Large public debt

Lending in foreign currency

Liberalised balance of capitalExcess global liquidity

External debt

High HUF yields

2. Banking sector risk

1. Government risk

150% loan to deposit ratio

Constrained monetary policy

High inflation

7

It is not just a twin deficitNet external debt as a percentage of GDP

0

10

20

30

40

50

60

70

0

10

20

30

40

50

60

7002

Q1

02 Q

202

Q3

02 Q

403

Q1

03 Q

203

Q3

03 Q

404

Q1

04 Q

204

Q3

04 Q

405

Q1

05 Q

205

Q3

05 Q

406

Q1

06 Q

206

Q3

06 Q

407

Q1

07 Q

207

Q3

07 Q

408

Q1

08 Q

208

Q3

08 Q

409

Q1

09 Q

209

Q3

09 Q

4

% %

Banking sector Corporate sector General government Net external debt

8

The currency mismatch of the private sector amounts to 40% of the GDP

Source: MNB

Open FX position of the main sectors as a percentage of GDP

-10

0

10

20

30

40

50

60

70

2000

Q1

Q2

Q3

Q4

2001

Q1

Q2

Q3

Q4

2002

Q1

Q2

Q3

Q4

2003

Q1

Q2

Q3

Q4

2004

Q1

Q2

Q3

Q4

2005

Q1

Q2

Q3

Q4

2006

Q1

Q2

Q3

Q4

2007

Q1

Q2

Q3

Q4

2008

Q1

Q2

Q3

Q4

2009

Q1

Q2

%

-10

0

10

20

30

40

50

60

70%

Household sector Corporate sector General government Non-residents Net external debt

9

Policy Response to the Crisis IFirefighting: sorting out the liquidity crisis

• Domestic currency liquidity provision– 2-week and 6-month credit tender facilities– Lower required reserve ratio– Extension of eligible collateral range (mortgage securities, municipal

bonds)• The immediate response in October 2008: FX liquidity provision

after the FX swap market dried out• The challenge: LOLR capacity in FX is limited • Started with short horizons: overnight FX swaps• Horizon gradually lengthened after various forms of backing

from international community was secured:– ECB credit facility– Loan agreement with the IMF, European Union and the World Bank – EUR/CHF swap line with the Swiss National Bank

10

Policy Response to the Crisis IIInevitably procyclical fiscal and monetary policies

• Because of the unsustainable level of public debt countercyclical fiscal easing is out of question in Hungary

• A sizeable and largely structural fiscal adjustment is being implemented supported by an IMF programme

– In the midst of the crisis this is pro-cyclical and painful…

• …but inevitable and hopefully will increase long-term growth potential

• Monetary policy constrained by financial stability and exchange rate transmission concerns (unhedged FX debt)

• Initially had to tighten substantially to prevent a full-blown currency crisis

11

Hungary has become a „world champion” in structural deficit

Cyclically adjusted primary deficits excluding one-off items

Source: Convergence and Stability Programmes’ assessment by the European Commission

12

Policy Response to the Crisis IIISome fiscal steps also enhance growth prospects

• Restricting eligibility for transfers– Reduction in child care time – Increase in the retirement age – Tightening the criteria for disability retirement (current 11%

share to the regional average 7%);

• Financial incentives to work:– 8,3% reduction in pension replacement rate;– significantly lower tax wedge for the low income workers;

– stringent malus system for early retirees

• Change in pension indexation

13

Fast adjustment in private and banking sector

• In 2009 companies adjusted wages, work force and investment

• Households reduced spending, demand for loans

• Banks deleveraged their balance-sheets and tighten creditconditions with procyclical effect

14

Adjustment of the economy refleceted in a sharp improvement in external balance

Components of the external financing capacity (seasonally adjusted data, per cent of GDP)

15

Both the private and public sector have increased their financing capacity

Source: MNB.

Note: Based on SNA, not ESA. The SNA public budget includes municipalities, quasi-fiscal duties (Hungarian State Railways [MÁV] and the Budapest Public TransportCompany [BKV]), the MNB and PPP schemes.

Net financing capacity of individual sectors and net external financing position (as a percentage of GDP)

-12

-10

-8

-6

-4

-2

0

2

4

-12

-10

-8

-6

-4

-2

0

2

4

6

8

2003 2004 2005 2006 2007 2008 2009 2010 2011

%%

Private sector Public budget Net external financing position (right-hand scale)

Forecast

16

Private sector credit growth has slowed significantly, and tilted towards HUF denominated loans

New loan contracts and loan stocks

Source: MNB.

0

15

30

45

60

75

0

50

100

150

200

250

Jan

2008

Mar

200

8

May

200

8

Jul 2

008

Sep

2008

Nov

200

8

Jan

2009

Mar

200

9

May

200

9

Jul 2

009

Sep

2009

Nov

200

9

%bn HUF

HUFCHFEURJPYProportion of HUF denominated loans (right-hand scale)Proportion of HUF denominated mortgage loans (right-hand scale)

New loan agreements

0

5

10

15

20

25

30

35

40

45

0

1 000

2 000

3 000

4 000

5 000

6 000

7 000

8 000

9 000

Jan

2008

Mar

200

8

May

200

8

Jul 2

008

Sep

2008

Nov

200

8

Jan

2009

Mar

200

9

May

200

9

Jul 2

009

Sep

2009

Nov

200

9

%bn HUF

HUFCHFEURJPYThe proportion of HUF loans (right-hand scale)

Outstanding amount

17

External debt stock still remains high in international comparison

Net external debt as a proportion of GDP (2008)

Source: IFS, Eurostat.

-100

-80

-60

-40

-20

0

20

40

60

80G

reec

ePo

rtug

alSp

ain

New

Zea

land

Hun

gary

Latv

iaA

ustr

alia

Uni

ted

Stat

esSw

eden

Den

mar

kE

ston

iaC

roat

iaIt

aly

Lith

uani

aSl

oven

iaFr

ance

Aus

tria

Net

herla

nds

Can

ada

Pola

ndTu

rkey

Uni

ted

Kin

gdom

Rom

ania

Bul

garia

Slov

ak R

epub

licFi

nlan

dM

exic

oB

razi

lU

krai

neC

hile

Nor

way

Cze

ch R

epub

licB

elgi

umG

erm

any

Isra

elA

rgen

tine

Cyp

rus

Japa

n

%

18

We expect a gradual further decrease of the external debt ratios in the coming years

• Due to the external adjustment the „flows”(i.e. external financing capacity) can contribute the decrease both of the net external debt and the net external liabilities

• But the „heritage of the past” will decelerate the fall of debt ratios. The combined effect of – Higher financing costs,– Slow growth,– Sluggish real convergence and hence

moderate real appreciation

will have an increasing effect on GDP-proportionate stock ratios.

19

As a result of the pro-cyclical fiscal policy of recent years the public debt ratio is expected to decrease

– Public debt ratio is expected to peakslightly below 80% in 2010

– Beyond 2010: slowly decreasing debtratio, reaching 60% around 2018

– Relatively high level compared to ourpeer group (CZ, SK, PL, RO, BG),but favourable position and dynamicscompared to EU-average

– Further structural reforms are neededat the areas of health care, publicadministration, state-ownedenterprises and tax system, which canhave costs

40

50

60

70

80

90

100

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

2019

%

Improvement in debt sustainability and external balance helped to restore investors’confidence

• Regained credibility along with consolidation in international financial markets enabled a gradual, but significant reduction in the base rate – Decreasing to historic low levels in May 2010

• Stability of the banking sector has strengthened, improvement in capital adequacy and decrease in liquidity risks

• Due to sharp reduction in domestic demand, prospect for achieving price stability in the medium term

21

Economic outlook

• Growth– Stronger external demand has helped Hungarian exports to

recover.– The fall in domestic demand is impeding the overall economic

recovery.– Recovery lags behind the region

• Labour market– Earnings growth in market services has slowed markedly in

response to the downturn; manufacturing wage growth reflects cyclical developments.

– Weak corporate profits will force further adjustment in the labour market on the forecast horizon.

22

Quarterly change in Hungarian GDP

Weak domestic demand is still a drag on growth

23

Nominal wages has been adjusting significantly

24

Economic outlook

• Inflation– Increases in administered prices and indirect taxes are likely to

raise inflation in the short term, higher commodity prices exert more permanent upward pressure on inflation

– Weak domestic demand and unused capacities restrain domestic price increases, as reflected in movements in service sector prices adjusted for the effects of changes in taxes.

– Core inflation remains well below the medium-term target on the forecast horizon

25

Trend inflation indicators (m/m)

Inflation persistence seems to be broken

26

The main policy dilemmas

• The deep recession triggered by the financial crisis and the medium term projection for inflation call for further policy easing.

• Hungary’s external balance has improved and risks to external sustainability have decreased significantly.– However, concerns about the sustainability of Greek fiscal policy and

potential contagion to other high debt, high current account deficit countries may become a key source of uncertainty in the region.

27

The main policy dilemmas

• Uncertainty surrounding global risk appetite has left less room for manoeuvre for monetary policy.– Further considerable monetary easing would entail a growing risk of

exchange rate depreciation.

– An adverse external shock would increase the probability of sudden large exchange rate depreciation.

28

What we have learned- bleak medium term outlook

• Historical evidence suggests that the financial crisis causes prolonged adjustment, detrimental for growth

• A persistent fall in risk appetite causes– A fall in the investment ratio– A prolonged deleveraging in highly leveraged sectors– Prolonged slow down in bank lending

• Problems in the financial sector hinders TFP growth– Reduced risk appetite and increasing bankruptcy rates might

reduce financial access of otherwise creative and profitable companies

• Job losses result in higher long term unemployment rate

29

What we have learned- need for a new convergence model

• In the past, a pick up in growth has always been associated with widening current account deficit

• Given the permanent fall in risk appetite, markets presumably will not tolerate substantial current account deficits, especially for countries that already have large external debt stocks

• Further rapid and credible consolidation of public finances has a leading role in adjustment

• …but fiscal discipline isn’t sufficient in itself• Structural measures will help to bust potential growth and

support debt sustainability

30

What we have learned- inside or outside the Euro area?

• Recent evidence suggests, that EA membership gives a shelter for small open economies against the volatility of capital flows

• We should enter eurozone as soon as possible, because outside the country is more vulnerable

• Serious financial imbalances should be averted, because it may cause asymmetric response or financial fragility to shocks even within the Eurozone

• EA membership is not a panacea– The shelter might mask for a while underlying fundamental

weakness in the economies and the adjustment later on can be very painful

31

What we have learned- monetary policy

• IT provides an appropriate framework for maintaining price stability and financial stability…

• …but in implementation more emphasis sould be laid on financial indicators, showing build-up of financial and hence macro-imbalances

• Macroprudential regulation should be strengthened • No need to raise our inflation target

– Still sufficient room for maneuver– Risk of higher and instable expectations

• We all have to have robust reserve strategy

32

What we have learned- reserve strategy

• Short term debt can increase faster than reserves.

• Investors and rating agencies require the fulfillment of the Guidotti rule even at the trough of the crisis.

• Liabilities from parent banks were rolled over, even in the most critical periods.

• Besides spot markets, central bank intervention might be necessary on derivative (swap) markets as well.

• Alternative sources of foreign currency played an important role alongside „classical” reserves.

• Replenishing the reserves in a global crisis may become impossible.

33

Thank you for your attention!

34