But little global impact: However, despite the rate hikes in many EM countries and in advanced economies such as Canada, Australia, Sweden, New Zealand and Norway, the global monetary policy stance remains extremely expansionary. This becomes obvious by looking at the GDP-weighted global policy rate, which has barely moved up from its low of 2.4% in 1Q10 to 2.5% right now. To some extent this is because, as mentioned above, some central banks were still cutting rates earlier this year, counterbalancing the hikes in other countries. Moreover, central banks in the big hitters in term of GDP - the US, euro area, Japan and China (with a combined weight of more than 50% of global PPP-weighted GDP) - have simply been sitting on their hands and kept rates at rock-bottom levels so far.
Global policy stance still super-expansionary: The story becomes even more interesting if we adjust the (weighted) nominal global policy rate of 2.5% for inflation to get to the real policy rate. Global CPI inflation (again using GDP weights) is currently running at a little over 3%, implying that the global real policy rate is negative to the tune of around -0.6%. Moreover, as inflation has risen by more than nominal policy rates over the past 6-12 months, real short rates have actually eased further well into this economic recovery. Hence, there is now a very wide gap between the growth rate of global GDP - 4.8% in the year to 2Q - and the real short-term interest rate - around -0.6% - signalling an extremely expansionary monetary policy stance despite the hikes in nominal interest rates by many central banks over the past 6-9 months.
AAA liquidity cycle still in full swing: Against the backdrop of super-expansionary monetary policies, it is hardly surprising that global excess liquidity has continued to rise until recently. Recall that our favourite measure of excess liquidity is the ratio of cash and sight deposits held by non-banks (M1) to nominal GDP. We focus on M1 - rather than a narrower aggregate such as excess reserves held in the banking system or broader aggregates such as M2 and M3 which also include savings and time deposits - because this is a measure of money which has already found its way into the hands of households, companies and investors (as opposed to excess reserves, which are gathering dust in the central banks' vaults) and which is most directly correlated with spending on goods, services and assets. By adjusting M1 for nominal GDP (and thus spending on goods and services), we focus on excess liquidity that is available to churn asset prices. When excess liquidity surged from early 2009, we were looking for asset prices to rally and, eventually, economies to recover. Excess liquidity has continued to expand until recently on the back of easy monetary policies. In other words, global M1 growth has continued to exceed nominal GDP growth despite the rebound in the latter, putting ever more excess liquidity in the hands of households, investors and companies.
What tightening? Looking ahead, global monetary policy looks set to remain very accommodative throughout the remainder of this year, on our forecasts. In fact, a few countries already seem to be nearing a peak, or at least a prolonged pause in their tightening cycle. In Australia, where the latest CPI was lower than expected, Gerard Minack thinks that the next move may well be down (though not before next year), following 150bp of rate increases since last year. In China, Qing Wang expects the PBoC to ease credit later this year as the soft landing of the economy unfolds. And in Brazil, Gray Newman now thinks that the central bank, after slowing the pace of rate hikes to 50bp last week, has only one last rate hike of 25bp this year up its sleeve. And while some other central banks are still likely to raise rates further this year, big hitters such as the US Federal Reserve, the European Central Bank and the Bank of England are likely to keep official rates unchanged throughout the remainder of this year, while our Japan team even expects the Bank of Japan to ease further later this year.
Just what the doctor ordered? Most investors and central bankers seem to believe that the extreme monetary policy accommodation in the US and Europe is exactly what the doctor ordered in an environment where fears about double-dips, deflation and massive fiscal tightening abound, and where the banking sector, especially in Europe, is still struggling. However, we believe that these fears are overdone: we continue to say ‘no' to the double-dip, we continue to worry more about the longer-term inflationary risks associated with extreme monetary accommodation, and we doubt that governments in the US and in the large euro area member states have the resolve to tighten fiscal policy drastically.
Or rather overmedication? If we are right, then central bankers and investors may be in for a rude awakening once it becomes clear that monetary policy has remained too expansionary for too long. Then, monetary policy will face an awkward choice between allowing inflation to run its course and raising interest rates aggressively despite high debt levels. Our suspicion is, as we have explained in the past, that they would opt for the former - allow higher inflation for some time in order to help reduce the debt burden. Of course, such a policy would not be pre-announced because inflation has to come as a surprise to have real effects. And if the inflation appears, central banks would have a natural tendency to claim that it is caused by one-off factors and won't last. For a script, just look at the Bank of England's response to above-target inflation this year. This may well become a blueprint for other central banks in the foreseeable future.
One of the distinguishing features of the new Hungarian government thus far has been its unorthodox approach to communication. Far from being an isolated example, this is developing into a trend. A series of unfortunate comments by Fidesz policymakers had already rattled markets back in June (see also our views in Budapest Trip Notes, July 1, 2010). On July 17, the IMF announced that it would conclude its mission without an agreement, as no common ground could be found with the authorities. And more recently, the PM has repeatedly suggested that Hungary plans to deal with the EU in the future, rather than the IMF. Moreover, Orban signaled that he thinks the EU should treat all countries equally, i.e., Hungary should not have to bring its deficit to GDP below 3% faster than any other country. During this time, the authorities have continued to promote legislation to cap the NBH governor's salary, a move criticised by the ECB on the grounds that it threatens the NBH's independence. The criticism was brushed aside. In this note, we look at why this change in rhetoric by the new administration took place, why we think it is dangerous, and what it entails for the central bank.
The IMF: From Poster-Child to Problem?
The IMF/EU package, approved in October 2008, provided some much-needed relief for Hungary, reassuring markets and allowing the NBH to take rates lower. Hungary's compliance with the plan had been impeccable until recently, so much so that it became commonplace among investors to ‘rank' IMF programmes in CEE and contrast the successful ones (Hungary) with more problematic ones (Romania, Ukraine). Therefore, the sudden departure of the IMF from Budapest raised a few eyebrows. While the Hungarian authorities did not plan to draw any tranches for now, this also means that €3.4 billion of financing from the IMF and €1 billion from the EC are held up pending further reviews. The timing of such reviews is unclear, however, and the IMF would have to be invited to Budapest by the authorities. This would imply a change in attitude on the part of PM Orban and his cabinet, which looks unlikely, at least until the October local elections.
There were basically two points over which the IMF and the Hungarian authorities could not find enough common ground. First, the nature of the measures to be taken in order to keep the deficit at 3.8% of GDP this year: the IMF thinks that the government relies excessively on the bank tax (worth around 0.7% of GDP, for this year and next at least), which is detrimental to growth and distortionary. Also, as the central bank has also pointed out, the bank tax is, as a share of GDP, much higher than we saw in almost any other country. Instead, more attention should be paid to the spending side. Second, the IMF wanted more reassurance that the 2011 fiscal targets would be met (2.8% of GDP), whereas Economy Minister Matolcsy had hinted that the government would try to negotiate a higher deficit for 2011 (around 3.8% of GDP).
The Hungarian response to these two points has been fairly direct. On the first point, the PM has stated that, provided Hungary sticks to the 2010 target (which it will, he says), it should have as much leeway as it wants in order to decide how it meets that target. On the second point, Orban noted that, given that the IMF deal is effectively coming to an end, the relationship that really matters is with the EU, not the IMF. This implies that the new 2011 deficit target will be agreed with the EU, and the risks are clearly that Orban, who can point to Hungary's very strong primary fiscal position, will seek to negotiate a higher 2011 deficit, which would allow Hungary to go ahead with its planned tax cuts. This would be consistent with recent statements by the PM arguing in favour of a unified timeframe for all EU countries to bring their deficits below 3% of GDP. In other words, he thinks Hungary should not be asked to get there ahead of others.
There are at least three conclusions to be drawn from all this. First, the general attitude of the Fidesz administration seems to be to escalate confrontation, rather than seek compromise. This is proving popular with voters, according to opinion polls: Fidesz leads with a huge 64% of preferences, ahead of 16% for the Socialists and 10% for far-right extremist Jobbik. Second, PM Orban is not interested in securing a ‘precautionary lending facility' with the IMF that would start in 2011. During our last trip to Budapest, it seemed highly likely to us that the government would seek to extend its relationship with the IMF by turning the SBA into a credit line. But given the conditionality attached to this credit line, it now seems unlikely that Orban wants to go ahead. Second, the PM is banking on being able to build a ‘special relationship' with the EU, having just ditched the IMF. But it is far from clear than the EU will prove more lenient, and any such calculations are costly and could prove wrong. Hungary has so far had two anchors (the EU and the IMF), which served it well during turbulent times. The PM thinks it can live with just one (the EU). Soon, however, it may be left with none.
Agencies were quick to pick up on the news, and quite critical on the whole bank tax issue. S&P revised its Hungary outlook from neutral to negative, leaving the rating stable at BBB- (one notch above non-investment grade). S&P argues that without an EU/IMF programme to anchor policy, Hungary faces higher funding costs and lower growth. In addition, the financial institutions tax could impede the effective functioning of the financial system and threaten Western parent banks' commitment to the Hungarian banking system. Separately, Moody's placed Hungary on review for a possible downgrade, using a very similar line of reasoning. We think that a downgrade looks likely later this year, and note that Moody's rates Hungary Baa1 (two notches higher than S&P), with a negative outlook already.
Improved, but Still Vulnerable
As we have stressed a number of times (see, among others, The Virtues of Prudence, July 17, 2009), the improvement in macro fundamentals in Hungary over recent years has been truly impressive. Its primary position is among the best in the EU, its C/A deficit has vanished and its loan-to-deposit ratio has come down. That said, Hungary still faces, as a result of previous excesses, serious stock issues of external (public and private) debt which continue to make it vulnerable in a CEE context. In addition, its relative underperformance of its CEE peers, coupled with an ongoing credit crunch, has raised concerns that the country may be stuck in a low growth rut for years to come. One way of putting this all together is to run a debt-sustainability analysis (for more details, see An Exercise in Debt Sustainability, July 19, 2010) This exercise showed that only by keeping its current ultra-tight fiscal stance can Hungary stabilise its debt ratio at around 80% of GDP. Any loosening, however small, could drive the debt ratio much higher over the next ten years. This is one of the reasons why investors react to tax-cutting plans with concerns, especially if it is not clear how they are funded: at present, they focus much more on the fiscal implications, rather than the possible boost to growth.
Also, the notion that Hungary does not need the IMF and it can fund itself from the market is a dangerous one, and applies only if inflows into EM and risk appetite both remain good. Note that Hungary faces redemptions of €5.8 billion (6% of GDP) of bonds and €3 billion (3%) of external debt between now and end-2011. Also, T-bills worth €4.3 billion (4.4%) mature over the coming six months. True, these are perhaps less volatile, but note that some of the last T-bill auctions have not been good. And of course, unless Hungary renegotiates an agreement with the IMF, it will have to start paying back its loan in 2012. There is no definite schedule, but Hungary will also have to return the €5.5 billion drawn under the EU's BoP facility. Given all of the above, the government's conviction that Hungary can ‘go it alone' without an external backstop facility looks odd to us. True, reserves are high and we estimate that the Min Fin maintains about €5 billion in its account at the National Bank, which it can use to reduce issuance needs if market conditions are negative. Even so, surely an IMF precautionary facility with funds charged at a rate of around 4.5% (albeit with conditionality) is an attractive ‘safety net' to have? The government seems to have decided otherwise.
What Does All This Mean for the NBH?
Some of the recent comments by policymakers may be for domestic consumption ahead of the October local elections. It is certainly possible that the government abandons its belligerent tone after the vote, and rebuilds its relationship with the IMF. That, however, is far from certain, and we would caution against being so complacent: it is possible that a true break from the past has taken place, and this administration chooses to take a much harder line against markets and international lenders. Given how quickly the currency reacts and that there are serious prospects of Hungarian debt being downgraded to non-investment grade, we still think that the authorities will eventually soften their tone. But the path may be much more tortuous than people assume.
The NBH in its July statement noted with regret the suspension of talks, and explicitly said that it will "make efforts to stem any effective fluctuations in the forint exchange rate" - a not-so-veiled threat of FX intervention, in our view. It also added that it will continue converting EU funds on the market, and that it would raise rates if a rise in risk premia made it necessary. We have been warning about risks of a more hawkish tone by the NBH for a while, and that is what the government's rhetoric brought about.
Another factor which is worth looking into is the likely shape of the new CPI projection, which will be available to the NBH at the August meeting (August 23). In May, the bank revised the CPI forecast higher (to around the 3% target in 2011-12), on the back of higher imported inflation and a recovery in activity which would prevent further falls in core inflation. The NBH also observed "strong" upside risks to CPI. Since then, the external assumptions suggest somewhat higher inflation - the forint is 7% weaker than in the May forecast, which (using standard pass-through coefficients) points to inflation 0.8-1.0% higher than previously across the horizon. Oil prices in USD are lower than in May, but due to the changes in the HUF exchange rate, the oil profile in local currency is broadly unchanged. Food prices are higher than previously thought in the near term, due to the effects of the recent floods. Overall, therefore, the external factors could easily push CPI above target. Offsetting this, the NBH could revise down GDP due to the recent fiscal measures (the bank tax), which the Fiscal Council estimates will shave off nearly half a percentage point from GDP growth in 2011-12, thus prompting a downgrade to the currency GDP trajectory and a wider output gap. Overall, however, we think that the odds are that the August CPI projection shows an inflation trajectory which is at least as high as in May, if not higher. A rate hike is not our central case yet, but overall it seems to us more likely than a rate cut, especially if HUF is biased to weaken from here, which seems likely to us.
Read Full Article »