Tuesday, July 18, 2006

Hungary's new tax rises - a comment

An article in todays FT (18/07/06, Hungary’s new tax rises go against the east European trend” by Christopher Condon) raises preoccupation about the proposed tax increases citing various voices that it have a negative effect on FDI inflows.

However, if we look at the situation closer – a serious decrease in FDI because of the recent rise in corporate profit tax from 16% to 20% seems rather doubtful.

First of all at 20% the corporate tax rate will remain relatively low, even in the region, comparable to neighboring Slovakia’s 19% (where there are talks of changing taxes, rather upwards), Czech Republic’s 24%, Austria’s and Slovenia’s 25% , though admittedly above the rates in Romania(16% after decrease in 2005) and Bulgaria (15%) . Thus the upward change, albeit against a trend in the region, will not make Hungary stand out among its’ neighbors.

Second, many FDI target projects, especially greenfield projects are accompanied with state-aid or tax incentives therefore the pure increase in corporate tax rate may have little actual effect on the firms’ decision where to locate its’ investment. Issues like good infrastructure and good business environment, which Hungary seems to have to a larger extent than Bulgaria and Romania (for instance, World Bank Doing Business in 2006 classifies Hungary as 52nd, while Bulgaria ranks 62nd and Romania 78th while this does not take into account crime and corruption figures) tend to be important as well.

Last, but most importantly – we must remember the context in which we judge the increase in taxes. If we take as a counterfactual Hungary without a tax increase and omit the huge double deficits the country faces – we will not be making the proper comparison. Regardless of the corporate tax rate, no country in the region has a fiscal position as negative as Hungary – and if it were to remain (or deteriorate) it would most certainly bring about a crisis, for which it is quite doubtful we would see no negative effect on FDI.

With a fiscal deficit as per cent o GDP of nearly two digits, the situation in Hungary is looked upon with attention not only by policy makers, but also by foreign investors.
As companies care for a risk weighted return (or rather flow of expected returns) a looming crisis would certainly affect their decision whether to invest in a country or not. And failing to consolidate the fiscal gap in Hungary would bring effective risks to the country (we talked about it on the TEblog here… and here... ) especially as the current situation is not only alerting but also unsustainable. Improvement of Hungary’s fiscal position would reduce the risk of crisis, and improve (or rather make realistic at all) the prospects of joining the Euro. While, an increasing prospect of the crash of the forint is certainly be an important scarecrow for foreign investors.

So can we realistically assume a corporate tax change of a couple of percentage points would be more harmful for the inflow of investment then the luring crisis, which would most probably hit if the gap between public spending and revenue was to remain? I don’t think so. And in this I do not want to say that the tax reforms will suffice to maneuver the Hungarians out of a difficult fiscal situation. A more decisive stance on the spending side of public finance would be welcome in order to achieve sustainability, but the attempts to increase corporate (among other) taxes, should have little if any negative effect on FDI.

Monday, July 03, 2006

Hungary - continuing to head for trouble?

There seems to be a recent rise in preoccupation about the large twin deficits in Hungary. The voices include last month’s IMF report(6th of June )
and today’s FT commentary by W.Munchau. Is the situation really so serious?

Figure 1. Hungarian forint against euro(left scale, red) and BUX stock market index (right scale, blue) in 2006. Dates marked by vertical lines(see text for more details) (19 April) - NBH governors comment, (6 June) - IMF report, (15 June) S&P downgrade. Source: Datastream

We have discussed the problems of Hungary already in April (Hungary – heading for trouble?) and the problems remain the same as the ones highlighted in the blog note (high current account and public deficit, high public debt ratio, more recently rapid credit expansion and a rise in inflation).

There are two main issues regarding the situation of Hungary – the first one being whether Hungary can deal with the problem and escape a crisis – and most commentators seem to suggest the answer is hardly positive.
A series of warning lights have flashed in the recent months – an April declaration from the NBH governor about forint being in ‘serious danger’ was followed by the troubling surge in yoy inflation in May, which reached 2.8%, well above the National Bank of Hungary estimates (report with estimates). Then the release of the earlier mentioned IMF report, critical of both the situation and of the governments plans to resolve it, that focus mostly on the revenue side, i.e. on tax increases. The report was also somewhat doubtful on whether there is sufficient will to implement long term reforms, and whether the proposed tightening was sufficient.
On June 15th S&P long term credit rating of Hungary was lowered (Bloomberg) from A-, where it has been since 2000, to BBB+. Not a week passed and an issue of three year government bonds failed to attract bidders (www.portfolio.hu). There are voices of asset price (mainly housing) bubbles and credit booms (especially foreign currency denominated, unhedged) – the last suggesting that a further ER deterioration would be painful.
The currency saw a depreciation in the recent weeks (see Figure) and the stock market was rather bearish, though admittedly so were the markets in Poland and Czech Republic and it was showing some signs of recovery in the last week.
But the growth forecasts have been revised downwards, and IMF foresees GDP growth to possibly fall below 3% already in 2007. This is the effect of the necessary fiscal and monetary tightening the country must go through in order to navigate away from a crisis.

The second issue is whether if the Hungarian economy were to suffer a crisis, what is the chance that it would spread to the neighboring CEE economies?
As for the rest of CEE-5 (Czech Republic, Poland, Slovakia and Slovenia) – the room for impact seems rather limited – both the fiscal and c.a. deficits are far lower in these countries, and growth prospects look much better. Czech R. and Poland show many signs of a recovery from a slowdown, and though Slovakia in the recent elections showed some discontent with reforms, the situation seems rather stable. In Poland some political turmoil regarding the (now ex-) Minister of Finance seemed a possible threat, but by now seems to have had no longer term effect. Thus in the near future the appointment process of new NBP governor – successor to Leszek Balcerowicz by the end of the year will be an important thing to watch.
Slovenia – seems by far most on the safe side, which should be confirmed once it joins the euro in a couple of months.
As for Bulgaria and Romania the first seems exposed to most risk, with credit markets booming and a large current account deficit, though EU entry expected next year should rather improve its situation.
And finally the Baltics with credit markets booming even more than in Hungary (see previous blog notes on credit booms) and very high current account deficits are suggested most vulnerable by Munchau. Their fiscal deficits lower or even in surplus (though arguably this gives them less room for maneuver) and their fixed exchange rates seem credible, having for instance survived the Russian crisis, so perhaps foreign currency loans exposure is ‘safer’ in these countries. The troubles would be resolved upon EMU entry, but this has been postponed because of (higher than entry criterion) inflation levels. The latter remains a risk, and the uncertainty related to future euro entry prospects certainly adds to it.

Overall, though there is some room for the ‘central European financial crisis’ that is a regional crisis sparking from Hungary and spreading to the whole CEEC region, this prospect should not, in my opinion, be over overvalued. These countries, albeit showing a large degree of co-movement in stock markets, are in quite different situations, their economic and trade ties to the old-EU often being higher than to each other, thus its Hungary’s problems that should be most focused on.

Sunday, July 02, 2006

Stock markets in the NMS – separately or together?

Today just a graph and small facts – but a discussion will come…

Figure 1. Stock market indices (PX – Prague; BUX – Budapest, WIG – Warsaw + FTSE London and DJ-US), all shares, home cur. index rescaled for last session in 2001 =100, dates 1994-2006.
Source: DataStream

Amid the recent falls in the three main stock markets of the NMS (Budapest, Prague and Warsaw) we can see that these markets co-move to a large degree. Regardless of issues like exchange rates and other country specific shocks (IPOs, macroeconomic factors, changes of base in the indices) there seems to be a large degree of co-movement in the markets which raises the question whether it makes sense for these markets to actually exist, or perhaps a common trading floor would be more efficient?
All three markets were setup in the early 1990s – the first trading sessions took place in June 1990 (Budapest), on the 16th of April 1991 (Warsaw), and on the 6th of April 1993 (Prague). Since their establishment, all three were expanding relatively steadily and moreover, quite similarly. They gained depth and liquidity, though are still far from most developed country levels in these respects. As for the evolution, the end of first quarter 1994 brought a first major correction (rather at the Warsaw and Budapest SE’s as the Prague one was still very young). The slump following the Russian crisis in 1998 was quickly recovered from, and the next common fall came in March 2000 – about 6 years after the previous one. This time the recovery was relatively slow (amid, among other events, the burst of the dot-com bubble), and it was not until late 2002 till all three indices picked up, gaining steadily from then on. The indices more than tripled since then, and May 2006, again 6 years after the previous slump followed with a fall of about 20% within a couple of weeks. Whether the falls mean a short term correction that has already began to pick-up is a different issue, yet as we see in Figure 1, the developments in all three stock market indexes are not very different, and moreover, do not seem to move away overtime.