Wednesday, September 20, 2006

Hungary - high time to act

In the past months, many voices have raised the fact of unsustainability of the twin deficits troubling Hungary. Among others, we expressed preoccupation about the build up of the fiscal and current account deficits (fiscal deficit for the year was recently predicted to exceed 10% of GDP, for an overview of the developments see: Hungary - heading for trouble? , Hungary - continuing to head for trouble? , Hungary's new tax increases - a comment). The need for an extensive fiscal reform, especially on the expenditure, but also on the revenue side was emphasized by international organizations (IMF, EU) and by economists and commentators (among others, Zsigmond Járai, the head of the Hungarian National Bank, MNB, FT, The Economist and this blog). We focused on the fact that tax reductions and increases in social spending promised during the recent elections were totally unrealistic. But it still seems some people believed the campaign slogans. Now the government admitted lying about the situation of the economy, and backed out on its promises, but as mentioned above the actual state of the economy was visible for quite some time - the development has hardly come as a surprise.

The need for reform is obvious and urgent. Yesterday (19/09/06) the forint dropped slightly against the euro (1% initially but only 0.7% on closure) and the stock market fell (by 1.2%). A relatively modest downturn, even if we take into account the developments since the beginning of the year (forint down against euro by almost 10% since January, BUX down by 10% since April/May levels), which signals there is hope in the turn around, and that despite the protesters on the street, honest, immediate and complex handling of the situation can steer the country into safe waters. Surely the situation is not simple - the current government openly caught on lying to the public has, many claim, lost legitimacy. On the other hand, it would take substantial time for another one to get elected. The decisions to cut spending and not to reduce (but even increase) taxes, will certainly be highly unpopular – especially after the high-blown promises of the recent election, but are absolutely necessary, though will not guarantee a safe exit. In the medium term, I don’t think a further fall in the forint and the BUX can be avoided, however, there seems to be room to escape a crash. The falls from the beginning of the year suggest investors may have been more reasonable with their expectations than the voters – expecting that the fiscal cuts must come, and therefore perhaps being also more ready to welcome them.

The developments in Hungary had limited effect on the markets in the region – the Czech Korona and the Polish Zloty barely moved (albeit downwards) closing respectively -0.2% and -0.4% against the euro. The PX and WIG also tipped downward, but again, not spectacularly.

Generally, I think the effect of contagion should be rather modest, albeit negative – Poland and the Czech Republic have budget deficits, which ought to be reduced, have pending campaign promised spending, but all of a more reasonable order.
The Baltics, despite their strong external exposure through current account deficits, contrary to Hungary have sound fiscal policy. They would be hurt by a flight of capital from the region, but this seems rather unlikely, as the situation in Hungary was bold and identified some time ago, and its troubles were more evident and in many cases different than in the other CEECs. However, the sooner the situation in Hungary is resolved, the better for the region.

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