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

Financial Interdependence in the World’s Post-Crisis Capital Markets: Lessons from Hungary Ferenc Karvalits Deputy 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 0 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

-1 Maastricht reference value

-2 -3 -4 -5 -6 -7 -8 -9 -10

Election years

Czech Republic

Hungary

Poland

4

Unsustainable debt dynamics, tolerated by the market during the „global savings glut�, but punished after Lehman Government debt, % of GDP 80

70

60

Maastricht reference value 50

40

30

20

10

0 1998

1999

2000

Hungary

2001

2002

Czech Republic

2003

2004

Poland

2005

Slovakia

2006

2007

2008

EA-15

5

Overly optimistic convergence expectations Households’ consumption as a percentage of disposable income 95%

90%

85%

80%

75%

2009:Q1

2008:Q1

2007:Q1

2006:Q1

2005:Q1

2004:Q1

2003:Q1

2002:Q1

2001:Q1

2000:Q1

1999:Q1

1999:Q1

1997:Q1

1996:Q1

1995:Q1

70%

6

...all this contributed to significant external imbalances and currency mismatch Loose fiscal policy

Large public debt 1. Government risk

Constrained monetary policy

High HUF yields

Integrated banking system with developed countries Overoptimistic expectations the households Low FX volatility

Lending in foreign currency

External debt

High inflation

150% loan to deposit ratio 2. Banking sector risk

Liberalised balance of capital Excess global liquidity 7

It is not just a twin deficit Net external debt as a percentage of GDP 70

%

%

70 60

50

50

40

40

30

30

20

20

10

10

0

0 02 Q1 02 Q2 02 Q3 02 Q4 03 Q1 03 Q2 03 Q3 03 Q4 04 Q1 04 Q2 04 Q3 04 Q4 05 Q1 05 Q2 05 Q3 05 Q4 06 Q1 06 Q2 06 Q3 06 Q4 07 Q1 07 Q2 07 Q3 07 Q4 08 Q1 08 Q2 08 Q3 08 Q4 09 Q1 09 Q2 09 Q3 09 Q4

60

Banking sector

Corporate sector

General government

Net external debt

8

The currency mismatch of the private sector amounts to 40% of the GDP 70

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

%

%

70

60

60

50

50

40

40

30

30

20

20

10

10

0

0 -10

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

Household sector

Corporate sector

General government

Non-residents

Net external debt

Source:Â MNB 9

Policy Response to the Crisis I Firefighting: 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 II Inevitably 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 III Some 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 credit conditions 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 Net financing capacity of individual sectors and net external financing position (as a percentage of GDP) 8

%

%

6

4 2

4 0 2 -2

0 -2

-4

-4

-6

-6 Forecast

-8

-8 -10

-10 -12

-12

2003

2004 Private sector

2005

2006

Public budget

2007

2008

2009

2010

2011

Net external financing position (right-hand scale)

Source: MNB. Note: Based on SNA, not ESA. The SNA public budget includes municipalities, quasifiscal duties (Hungarian State Railways [MĂ V] and the Budapest Public Transport Company [BKV]), the MNB and PPP schemes.

16

Private sector credit growth has slowed significantly, and tilted towards HUF denominated loans New loan contracts and loan stocks

Nov 2009

Sep 2009

Jul 2009

May 2009

Mar 2009

Jan 2009

Nov 2008

Sep 2008

Jul 2008

May 2008

Mar 2008

0 Jan 2008

0

HUF CHF EUR JPY Proportion of HUF denominated loans (right-hand scale) Proportion of HUF denominated mortgage loans (right-hand scale)

5 000

25

4 000

20

3 000

15

2 000

10

1 000

5

0

0 Nov 2009

15

30

Sep 2009

50

6 000

Jul 2009

30

35

May 2009

100

7 000

Mar 2009

45

40

Jan 2009

150

45

8 000

Nov 2008

60

%

Outstanding amount

bn HUF

Sep 2008

200

9 000

Jul 2008

75

May 2008

%

Mar 2008

New loan agreements

bn HUF

Jan 2008

250

HUF CHF EUR JPY The proportion of HUF loans (right-hand scale)

Source:Â MNB.

17

80

Greece Portugal Spain New Zealand Hungary Latvia Australia United States Sweden Denmark Estonia Croatia Italy Lithuania Slovenia France Austria Netherlands Canada Poland Turkey United Kingdom Romania Bulgaria Slovak Republic Finland Mexico Brazil Ukraine Chile Norway Czech Republic Belgium Germany Israel Argentine Cyprus Japan

External debt stock still remains high in international comparison Net external debt as a proportion of GDP (2008)

%

60

40

20

0

-20

-40

-60

-80

-100

Source: IFS, Eurostat.

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 100

%

90

80

70

60

50

2019

2017

2015

2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

40 1991

– Public debt ratio is expected to peak slightly below 80% in 2010 – Beyond 2010: slowly decreasing debt ratio, reaching 60% around 2018 – Relatively high level compared to our peer group (CZ, SK, PL, RO, BG), but favourable position and dynamics compared to EU-average – Further structural reforms are needed at the areas of health care, public administration, state-owned enterprises and tax system, which can have costs

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

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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

Weak domestic demand is still a drag on growth Quarterly change in Hungarian GDP

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

Inflation persistence seems to be broken Trend inflation indicators (m/m)

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.

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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.

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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

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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

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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.

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Thank you for your attention!

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