One factor which has been troubling investors for a while, namely the state of the US recovery returned to haunt equity market investors on Friday afternoon. After another set of weak economic figures the Dow Jones Industrial Average fell 261 points and took with it the worlds equity markets. This represented quite a turn-around for some as Europe was rallying in its own time and the UK FTSE 100 went from being over 60 points higher to a close of 52 lower. One thought I do have which relates to my recent discussion on probability and probability tails I notice that the whole debate on the US is now concentrating on whether her economy will “double-dip” or not. Please remember that other alternatives are possible and her economy could simply grow slowly for a while, slowdown does not have to mean collapse.
The Euro and its exchange rate
As this weekend has seen more examples of financial and economic illiteracy I would just like to repeat a point I made in my article on Friday. From the euro zone’s perspective the fall in the Euro exchange rate was a good thing. Over time the fall would be likely to improve the balance of payments and hence economic growth in the euro zone. This economic reality rather contrasts with the view of the euro zones elected leaders who accused a “wolf pack” of driving the Euro down. The recent rally from 1.20 against the US dollar to 1.293 now is not good for the euro zone.
I notice that Iam supported by the head of Spain’s Exporter’s Club (hardly surprising really) but also notice that according to Bloomberg he called Spain’s domestic economy ” paralysed”.
Hungary and the EU/IMF suspend negotiations over a loan package
Over the weekend talks between the EU/IMF and Hungary’s government were suspended. When a country is in the middle of an IMF rescue programme such behaviour is relatively rare. Even if a country is not in desperate need of funds at that moment in time the boost in credibility provided by an explicit backing of a countries economic plan by the IMF is often very valuable in three main areas. The exchange rate is likely to settle down and be supported, government bond yields are likely to be at the least stabilised, and perhaps most important of all then banks are likely to lend to the country concerned again. Seeing as one asks for IMF help if you have serious trouble in one or all of these areas this is a valuable tool.
The story of how we have got here has implications for Hungary, the EU and particularly the euro zone and the IMF. If we look at Hungary’s recent economic experience then we see that economic growth peaked bank in 2004. Her government responded to the slowdown with a fiscal stimulus programme but quite quickly expansion in the fiscal deficit became important.So the fiscal expansion which was in response to a decline in economic growth led to fiscal deficits and problems. So Hungary did this way before it became “fashionable” although you could say that Japan and Italy travelled this particular road before her. Hungary then found herself in a position where she felt that she had to reverse her fiscal stimulus as her fiscal deficit reached 6.2% but that in terms of growth from it there had been very little. There was also the building problem of the number of mortgages taken out in Swiss Francs that I have written about before partly because her central bank was holding her interest rates at 7.5%. This was to help fight inflation and also to try to hold a “currency peg” against the Euro.
As Hungary entered 2008 she found herself in what I call stagflation where her inflation rate exceeded 7% but her economic growth was low at less than 1% particularly if you allow for her fiscal stimulus. (As an aside for UK readers stimulus measures can create this and there is food for thought for us…). Bad timing or luck now intervened as the credit crunch was hitting the world just as Hungary needed a fair wind. Imagine you were at the Hungarian Central Bank would you cut rates to aid growth and let inflation rip or raise them to cut inflation? This is the sort of dilemma that may well from time to time give any central banker nightmares. One policy tool and two contrasting and opposite objectives. Oh and actually there was a third as of course the Central Bank felt she had to maintain the Forint exchange rate or face the effects of all the Swiss Franc mortgages starting to go wrong. In a familiar trend government bond yields rose to 10%. By now an intelligent central banker would know that he/she was trapped with no way out.
So as 2008 progressed Hungary saw stock market falls, drops in retail sales, and foreign banks started to refuse to lend to her and her nationals. The European Central Bank stepped in and offered 5 billion Euros of loans to help. The Central Bank had edged rates higher to 8.5% to try to defeat inflation and this was working but what about output?
In the end Hungary had to call in the IMF and the European Union.
The Aid package of late 2008
Hungary secured a 20 billion Euro loan which came from three institutions: the IMF, the EU and the World Bank. The International Monetary Fund contributed 12.5 billion Euros, the European Union provided another 6.5 billion Euros, and the World Bank is chipped in with a mostly symbolic 1 billion Euros. The fact that other bodies also helped was because the IMF was short of resources and I have written on this subject before, indeed in spite of a big boost to its resources it claims it is short of liquidity right now.
As will be familiar to regular readers the IMF got out its playbook and suggested that fiscal austerity was the way forward, Conditions were imposed for the loans in terms of public expenditure and taxation targets. The EU Commission chimed in with three conditions of its own. Hungary must tame and cut public expenditure, continue fiscal reform measures and continue structural reforms.
Unfortunately the playbook did not appear to have a section which also covered world recession and a country with a large amount of loans/mortgages in another currency (Swiss Franc).
Hungary today: Has the IMF failed?
If we leap into Doctor Who’s TARDIS and come to the present day then one can see that the IMF plan is in danger of failing. Nothing has been done about the Swiss Franc mortgages and they just sit there as a big drag on the Hungarian economy. She hasn’t really got her fiscal deficit under control as it is likely to exceed her 3.8% target this year. Worst of all she has not found anyway of sustaining economic growth which is the most vital factor going forward. The only real hope is improved exports and one might think of depreciation of her currency as a way out but then think again of the impact of that on her Swiss Franc loans. A fall in economic output of 7% last year was just about the last thing Hungary needed and she may not grow this year.
There have been several mistakes made by the new Hungarian government. For example the statement “Hungary is like Greece” which appeared in early June was quite an aberration for a country with a lot of foreign debt. However I do not think that they are being completely foolish in challenging the IMF’s austerity mantra. As they point out Hungary has in effect been following this since 2006. Rather than more austerity measures Hungary will impose a bank tax. As to the numbers then she was not currently borrowing from the IMF but there was another 5.5 billion Euros available if she needed them. She has not spent all of what she has borrowed so she has up to 5 billion Euros tucked away.
The big danger in such a move is a fall in the Forint. This would impact on the cost of the Swiss Franc mortgages which are held by 1.7 million people out of a population of 10 million. So far today the Forint has fallen by just under 3% to 289.7 versus the Euro. So until we see the scale of the move it is hard to say how unwise this mostly politically motivated act is. In the end Hungary will probably return to the table and do a deal.
Implications for the IMF and the euro zone
I feel that there is one very important one. Everybody is being reminded that the IMF and its plans are far from foolproof. There is almost a cult around it which bears in my view very little resemblance to reality. I have discussed before how her plans have helped lead to something of an economic catastrophe in Latvia and now Hungary looks in serious trouble. The idea of countries leaving an IMF programme is usually ignored.
At this time the IMF is looking for (yet) more resources. Before I let it have it I would want a review of its performance as if nothing else some modesty would not come amiss, as considering its recently track record some modesty is appropriate.
As more and more countries in the euro zones “sphere of influence” appear to have deteriorating economic circumstances this does not bode well for it in 2010 and 2011. As I pointed out above the currency rally does not help either. Austerity is spreading around Europe.
I keep reading how well things are going for Greece and yet if one looks at the evidence there are clear issues. Firstly other countries in IMF/EU inspired austerity programmes have tended to spiral downwards in terms of economic growth as a price for controlling fiscal deficits. Secondly many other governments in Europe are also embracing austerity which will reduce prospects overall. Thirdly as I pointed out last week Greece appears to have cut her public expenditure mostly by simply not paying her bills.
This morning Moodys have downgraded Ireland’s sovereign rating by one notch to Aa2 with a stable outlook. There are three main reasons quoted for this which are: loss of financial strength: weakened growth prospects: and the crystallization of contingent liabilities by which they mean that Ireland’s bad bank or NAMA is getting lower quality debt than expected when it was incepted. A lot of this has come from Anglo-Irish bank’s property portfolio whose performance was known to be poor but is in fact now looking even more dire than that. One should be careful not to over-emphasis the importance of this as it puts Moodys rating in line with S&P at AA and one notch ahead of Fitch at AA-. The Irish debt agency may not be quite so sanguine however as she has 1.5 billion Euros of 6 and 10 year debt to issue tomorrow!
I have been asked on here about Ireland and on that subject find one area where I do agree with Moodys. The rescue of Anglo-Irish bank is looking ever more expensive. Her property portfolio looks worse and worse and for Irish taxpayers there is a chilling phrase in Moodys report “Moody’s expects that Anglo-Irish Bank may need further support” as so much has been poured in already.
This has to have knock-on effects on the Irish property market particularly the commercial one. On a day when I am discussing the wider implications of things here is a big issue for the euro zone. Apart from issues on her borders we now see internal property market issues again hitting banks. Whilst much of this will be domestic for Ireland overseas banks were much in evidence in Dublin’s riverside “tax-free” zone and these include UK banks some of whom did pre-crisis appear to like a property loan.
There is a further implication to my mind. To its credit Ireland is trying to deal with its commercial property market whereas Spain and to an extent the UK have tried to stick their head in the sand. All of the factors I have discussed today will be turning up in some banks balance sheet, please remember that when this weeks “stress tests” tell us everything is okay.