Hungary leaves the band! Will it enter rehab next?

Today the National Bank of Hungary (the country’s central bank) abandoned the currency’s ERM-style trading band (15 percentage points fluctuation margins in either direction from a central parity of 282.36 forints to the euro). At the end of the trading day, the market rate was 263,57; the abandonment of the band was from the ‘strong’ side of the band. It was meant to give the forint greater scope for appreciation than would have been possible with the band in place (the band would have ‘capped’ the forint at 240 to the euro).

The NBH was right to can the band. An exchange rate target zone or exchange rate band is the worst exchange rate regime designed by man or dog. It combines the major weaknesses of any fixed or managed exchange rate regime – lack of flexibility combined with, ultimately, lack of commitment – with those of a market-determined exchange rate regime – the exposure of producers, consumers and portfolio holders to large and sudden swings in the nominal and real exchange rate, often caused by nothing more fundamental than one of the many manifestations of foreign exchange market psychosis.

For reasons understood only by the authors of the Treaty of Maastricht (and quite possibly not even by them), membership of the ERM for a period of 2 years preceding the examination date for full (stage 3) membership in the EMU, is a prerequisite for becoming a member of the Euroclub. So for countries willing to join and with some hope of meeting all the other criteria as well (inflation, interest rate, public debt, public deficit, central bank independence, good table manners etc.) entering the ERM makes instrumental sense. The 2-year ERM purgatory remains at best, an exercise in futility and an investment without any prospect of a positive return; at worst it exposes a candidate Euroclubber to unnecessary risk of financial and macroeconomic instability.

Clearly, the Hungarian authorities have given up on joining the eurozone for the time being. Quite wisely too. They have serious economic problems on their hands; not meeting the criteria for eurozone membership is the least of these. Growth is the lowest of any CEE country (1.3% for real GDP in 2007; maybe around 1.5 in 2008 – with a global economy that is slowing down and an effective real exchange rate that may be appreciating in the short term). Inflation is high, starting off January 2008 at 7.1% (on a year earlier). Private sector unit labour costs rose by 8.0 percent in 2007. It will have to be a lot less than that if domestically generated inflation is going to be anywhere near the Bank’s target.

Public debt (probably near 70 percent of GDP at the beginning of 2008 and rising fast) and public sector deficits (around 6.5% of GDP in 2007) are high and will turn out to be unsustainable unless there is a major change in the political equilibrium – one that permits non-interest public spending to be cut by at least 10 percentage points of GDP from its Swedish-French level of 53% of GDP (in 2006). The country is in a deep fiscal mess. Gross external debt (private and public) stands at around 100 percent of GDP. The band was irrelevant.

Abandoning the band will not materially affect the policy choices open to the authorities, however. To the extent that the public debt is forint-denominated, fixed-rate nominal debt, its real value can be eroded by creating unexpectedly high rates of inflation. This will not help with debt (both private and public) that is denominated in euro, Swiss franc and other foreign currencies. In Hungary, as in most of the CEE, many private sector players (households, non-financial corporates and banks) have funded themselves increasingly abroad and in currencies other than the forint. Hungary is, of course, very open to trade (exports are around 80 percent of GDP), so a number of firms, and even some households, will have natural hedges for their financial foreign currency exposure, but many will not. Of those that don’t have natural hedges, a few may have taken out synthetic hedges, but many will not have done so. Hungarian banks and other financial institutions will discover that they have little foreign exchange risk on their balance sheets (or off it) but rather a lot of credit risk.

The monetary authorities (who did not raise the official policy rate from its excessively low 7.5 percent level) may hope that the appreciation of the forint will give them some anti-inflationary freebies without the need to raise interest rates. They are right only if the forint is undervalued in real terms and if this disequilibrium is corrected more swiftly with the band removed than with the band in place. Even if they are right in their belief that the forint is undervalued as likely to appreciate in real terms, their apparent faith that underlying inflation can be brought down to its official target of 3 percent from an actual level of over seven percent with short real interest rates barely positive, beggars belief.

Marcus Miller and I showed back in the middle ages[1] that the sacrifice ratio (the cumulative additional unemployment incurred or output lost to achieve a given sustained reduction in inflation) is not lowered by a sharp up-front real appreciation of the currency if the transitional dynamics of the economy are rather old-Keynesian. When forward-looking expectations effects dominate, it may be possible to lower the sacrifice ratio through a sharp up-front appreciation, but policy sequences that make use of this feature are not time-consistent, that is, they involve a commitment by the policy maker to future actions that are not credible: when the day comes that the future commitment has to be honoured, the incentives facing the policy maker will have changed as a result of the earlier actions.[2]

So in all likelihood, there will either be a de-facto or de-jure abandonment of/increase in the operational inflation target, or the policy rate will have to be raised quite sharply, possibly to double digits. I expect that the underlying Balassa-Samuelson pressure for gradual real exchange rate appreciation will for several years be swamped by the contractionary fiscal measures required to achieve fiscal and external sustainability. The real value of the forint should, once the need for drastic belt-tightening is recognised, fall quite significantly. The immediate appreciation that followed the death of the band should not be taken as a reliable guide to the medium term behaviour of the real exchange rate.

Will the government do enough to avoid a default on the public debt? Hungary is unique among the countries of central and eastern Europe, in that it has never received (or indeed asked for) forgiveness or rescheduling of its public debt. So its record as regards debt servicing willingness and ability is unequalled. Since the country has never had its debt rescheduled, restructured or written down, it is key to look beyond the level of the debt-to-GDP ratio (which is at about the French and German level and well below those of Italy, Greece or Belgium) and beyond the level of the general government deficit, which includes interest on the outstanding stock of debt. Instead we should look at the trend in the debt-to-GDP ratio (rising) and at the behaviour of the primary (non-interest) general government balance, which should be in or headed for a surplus (it is not). Most important, we should look at the elephant lurking behind the financial account bushes: the level of (non-interest) public spending on goods and services. At around fifty percent of GDP, this is not financeable for a country with Hungary’s level of per capita income unless Hungary discovers an, as yet unknown, much less distortionary and much less growth-discouraging way of taxing away half of every Hungarian’s income.

I fear Hungary’s economic prospects for the next few years are very challenging even if the authorities take the plunge and slash public spending drastically. Things will be even worse if sustainable and sustained spending cuts are not implemented. In that case, only the most immediate pain will be postponed, to be served up again later, mightily compounded. A default on the public sector debt then becomes a distinct possibility, despite the country’s stellar past record of meeting its public debt obligations. It would be a sad end to a remarkable story of economic and political success. I hope that the country wakes in time from its stupor and enters rehab.

[1] Buiter, W. H. and M.H. Miller (1983), “Real exchange rate overshooting and the output cost of bringing down inflation: Some further results”, in J. Frenkel (ed.) Exchange rates and international macroeconomics, University of Chicago Press.[2] See Buiter, W. H. (1986), “Policy evaluation and design for continuous time rational expectations models: some recent developments”, in M. H. Peston and R. E. Quandt (eds.) Prices, Competition and Equilibrium, Essays in honor of William Baumol, Barnes and Noble Books, pp. 84-108, reprinted in Willem H. Buiter, Macroeconomic Theory and Stabilization Policy, Manchester University Press, 1989; and Buiter, W. H. (1985), “International Monetary Policy to Promote Economic Recovery”, in C. van Ewijk and J.J. Klant (eds.), Monetary Conditions for Economic Recovery, Martinus Nijhoff, Amsterdam, reprinted in W. H. Buiter, International Macroeconomics, Clarendon Press, Oxford, 1990.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website