July 29, 2010
“Take your package and shove it!”
This was the tone set by Hungary’s new Prime Minister Viktor Orban last week as he engaged EU and IMF officials about his country’s bailout package.
Back in the early days of the financial crisis, Hungary’s economy was one of the hardest hit in the European Union. The EU and IMF moved quickly to stave off a total collapse by promising a 20 billion euro standby bailout package to back the country’s finances.
This package is enormous by any standards, comprising over 15% of the country’s GDP.
As in common in these sorts of deals, though, the IMF likes to dish out a lot of cash and then tell the recipients exactly what they should be doing with it. This was all fine and well in the last administration, but earlier this year, Hungary elected a new Prime Minister in Victor Orban.
Oban is apparently the sort of individual to look a gift horse in the mouth; Hungary’s most recent talks with the IMF disintegrated into a macroeconomic punch line, and Orban has made one thing perfectly clear to the IMF:
“I run this country, not you.”
As a populist by nature, Orban has ruled out the possibility of any further austerity budget cuts and is instead shifting the burden to the financial sector. The IMF, bond creditors, investors, and financial markets are just going to have to take their lumps under Orban’s administration.
This sentiment has made Hungary a particularly unattractive place for bondholders to hang out. Rating agencies Moody’s and S&P, always the last to show up to the party, are now threatening to cut Hungary’s credit rating to junk; just yesterday, Hungary’s PM acknowledged that their rating would suffer.
All of this adds up to a situation that is as bad, if not worse than what is happening in Greece: no one will lend to them, and they’re just about out of cash. Unlike Greece, though, Hungary looks like it may have to deal with its debt problems alone.
That would leave only a handful of strategies:
1) Inflate. Hungary is not part of the eurozone, so it can print as much as it wants of its own currency to pay off local currency debt, EU inflation targets be damned. As the forint is not exactly a global reserve currency, however, this would lead to substantial inflation in the country, and decimate the exchange rate against the dollar and euro.
2) Tax. Foreign currency debt can only be paid by generating actual revenue, not conjuring it out of thin air. Therefore, Hungary’s government must raise taxes in order to close its budget gap and pay the interest on its debt. This, however, is unlikely to happen with this populist government considering that income taxes are already at 40% at VAT at 25%.
3) Default. This is the ultimate option, and may in fact be their most logical choice. With their sovereign debt likely to be rated at ‘junk status’ shortly, Hungary’s leadership would have little to lose by defaulting… or threatening to default.
This would force the EU and IMF to either back Hungary at all costs, or sit by and watch the country go bankrupt. Either way, it’s going to be costly for both Europe and Hungary… and here’s why it matters:
Back during the good times when their currency was strong, many Hungarian borrowers took out loans in euro and Swiss francs because those interest rates were lower.
Because the loan balances and monthly payments are denominated in a foreign currency, however, if the forint depreciates then suddenly the borrowers have to come up with more forint each month to meet the minimum payment. This increases the risk of loan default dramatically.
This wouldn’t be a big deal if it were just a few loans here and there… but the total amount of exposure that western European banks have to the Hungarian market actually exceeds the entire GDP of Hungary.
If Hungary breaks and sets off this chain reaction, the markets will experience European Financial Crisis 3.0. I would expect the dollar and yen to surge again in this case as the ‘least worst’ of the major currencies, and all world markets to fall on the standard line of risk aversion.
Stay tuned for more.