Politics of bank rates
 

The Magyar Nemzeti Bank (MNB), the Hungarian National Bank, raised the policy rate in January 2011, the third time since the change in government that took place in May 2010. The rate increase drew a rebuke from the growth-focused government, which called it “unjustified” in a public statement of the Ministry of National Economy, roughly corresponding to a ministry of finance (MinFin) in the European practice. In fact, the ministry issued the third official statement condemning a rate hike. Differences of views between the central bank (CB) and the MinFin are customary in most countries. Ministers frequently complain in private, sometimes even publicly, about bank rates; but to lecture a central bank on the proper level of interest rates in official communication is a sign of bad education in high offices. The purists’ view on this particular issue would probably be that the Hungarian ministry’s comments were three too many. Those analysts who are more sympathetic to the government position might find the number of public statements two too many: the MNB’case for the latest increase from 5.75 to 6 per cent in January 2011 was not fully convincing (this is a case I consider in more detail below).

Political analysts, of course, notice that the Hungarian central bank reduced the rate to 5.25 per cent on 27th April, 2010, just two days after the landslide victory of Fidesz that put an end to political uncertainties in Hungary. To the politically minded public, the rate reduction looked like a vote of confidence for the new government; by the same logic, however, the series of recent interest rate hikes amounts to withdrawal of the Bank’s support for the Orbán cabinet.

Yet, the motives and calculations behind a central bank interest rate change do not fit into simple political patterns. Central banks are responsible for a narrow set of goals: the overriding mandate of modern central banks is to protect the purchasing power of the currency; on the other hand, a government pursues a variety of overlapping and sometimes conflicting goals. This is why it is next to impossible for a government and a central bank to agree on every major policy item, and least of all on the central banking rate. A central banking rate that monetary policy makers regard as high enough to deflate the inflationary pressures building up in the economy and mitigate inflationary expectations would certainly be too high for the treasury that deals with huge public debts. Ask an economics or finance minister about the going interest rate in his or her country and you always get the same answer: rates are too high.

A charged relationship
 

So far, nothing has been particularly Hungarian about the case, except perhaps for the publicity of the complaints of the government and the occasional acidic Bank remarks about government policy style and content. But this is Hungary, where policy making has become a pretty noisy exercise; politicians here are not known for expressing themselves in understatements.

Conflicts between the two major players in monetary policy making – that is the central bank and the government (MinFin) – go back decades in Hungary. The Magyar Nemzeti Bank, created in 1924 with intellectual and funding support from the Bank of England, has experienced crisis periods and various regime changes during its history. The bank lost its high prestige in the decades of central planning, became rather influential right before and during the hectic transition from plan to market, and regained its independence in 1991 through the Act on Central Banking presented by the centre right government of Prime Minister József Antall to the first freely elected multiparty Parliament. While Antall’s concept of an independent central bank, modelled somewhat on the German pattern, was widely supported by all sides in politics, when Antall chose his economics minister as the president of the Bank (modesty forbids me to name the first president of the independent MNB), the Socialists and left-leaning Free Democrats cried foul, and Fidesz, also in opposition at the time, raised concerns about the impartiality of the central bank under a former cabinet minister. Once the Socialists came back to power with a bang in May 1994, gaining a two thirds parliamentary majority together with the Free Democrats, they immediately launched attacks on the president of the central bank, who had been appointed for six years and had another three to serve. The “cohabitation” between the central banks president and the leftist coalition government was anything but smooth; after months of tension, the MNB president decided to resign.

It is important to add that at that time Hungary was not a member state of the EU. Indeed it did not even have candidate country status, thus the position of the MNB president was not yet protected by EU treaty. Having forced the president out of office, the Socialist-led coalition gave the job to their own candidate for a period of six years. Three years later, in 1998, the Left lost the elections and the incoming Fidesz-led centre-right coalition inherited the MNB president chosen by the Socialists. The inter-institutional collaboration was again far from amicable: the central bank president was criticized for the conduct of the monetary policy and also for mismanaging the Vienna-based commercial operations of the MNB. But the clashes did not result in his resignation. The centre-right coalition at the time, in contrast to what had been the case between 1994 and 1998 and was to be the case after May 2010, did not have the two-thirds majority in Parliament that would be needed to change central banking law and fire the “left-over” banker.

After his term expired, Fidesz simply replaced him with their minister of finance in 2001.

Now, history somewhat repeated itself: the political pendulum came back and swept the Socialist-Free Democrat coalition into power in 2002. The coalition partners therefore had a central bank president whom they did not like. But by that time, the country had a Europe-compatible central banking law with strong guarantees of the personal, financial, and institutional independence of the Bank. A minor issue that later gained significance: the remuneration of the top bank management was put into law with a formula according to which the president and the vice presidents of the Hungarian National Bank earn much more than the president of the FED of the United States.

The Socialist-led government had to live with the “left-over” president, but it put him under pressure, criticising his exchange rate and interest rate policies. The parliamentary majority changed various points of the central banking law to make the life of the conservative central bank president harder. More seriously, the PM “diluted” the rate setting Council by sending in additional members who shared his lax monetary policy views – a trick not much appreciated by the European Central Bank (ECB).

Despite the pressures, the MNB president managed to keep his job and serve out the full mandate of six years. Moreover, he did not keep quiet about his criticism of the Socialist government’s economic programs. Also, being a hawk rather than an inflation dove, he tended to keep interest rates rather high – something the Socialists never liked. Then, not surprisingly, his contract was not renewed at the end of the six year mandate, and the Socialist Prime Minister chose a left-leaning businessman to become the next president of the Bank in 2007. At the moment he is still president.

One can easily guess the next turn: the pendulum swung back like a demolition hammer in 2010. Fidesz got an exceptionally large majority in Parliament, and the party has used it to reduce legal and institutional constraints. But the independence of the central bank governor is something very much protected by EU law and is under ECB scrutiny.

Conflicts have been brewing around three issues. One has roots in the personal past of the incumbent governor: it was reported some time ago that he kept his personal investments somewhere off-shore. He first dismissed the charges by claiming that Cyprus is an EU member state, not an off-shore market, but later declared that he would transfer his funds to Hungarian jurisdiction. Still, he earned the title of “off-shore knight” – a term used several times by Viktor Orbán, the head of the opposition and now Prime Minister.

The second issue emerged right after the election victory of Fidesz in April 2010; on the face of it, this was about the applicability of a general public sector salary cut to the particular case of the Hungarian National Bank. The Bank said that the remuneration of the president and vice presidents was fixed in the central banking act: the Bank, being a non-government public institution, should not be subjected to government sector regulation. The case went to the ECB: Frankfurt did not support the pay cut applied to the present bank leadership, though it would not mind applying it in the future; the issue is not over yet, but the president gets one fourth of his previous remuneration.

But the most serious issue is the yawning gap between the attitudes of the two players toward monetary policy. The new government (as described in various articles in preceding issues of this Review) embarked on a particular version of a growth-rate centred economic policy course underpinned by unorthodox policy measures. The MNB was rather critical of the content (and probably of the style) of the first measures of the Orbán government. Certainly, a central bank has to be alert to financial risks inherent in non-mainstream policy course. It is not surprising that MNB president Simor entertained a certain scepticism concerning the policies of the Orbán cabinet.

But the tone and the public nature of the split between the central bank and the government and other policy noises added to Hungary’s recent financial problems. President Simor warned in an interview with the Wall Street Journal that government measures that he termed “unconventional” (designed to shore up the budget in the short term) could end up contributing to inflation and crimping credit. In other statements he complained about lack of communication from the government side and about its attempts to curb the independence of the national bank. The WS Journal added that the tension between Hungary’s key institutions has come under intense scrutiny by money markets suspicious of any deviation from the belt-tightening orthodoxy now taking hold across Europe.

Responsibility for foreign exchange loans

So far, apart from the tone, the split between the Central Bank and the government could be regarded simply as a local variation on a recurring theme. Or if one is inclined to trust central bankers more than politicians, one may side with the position of a non-political, professional public figure like the MNB president. Alternatively, critics of “democratic deficit in central banking” may support the new government’s position as a brave defiance of financial fat cats. Unfortunately, the professional record of the MNB is far from spotless. A major source of Hungary’s vulnerability stems from the very high size of the indebtedness of the households in foreign currency – and the responsibility of the Central Bank in allowing this vulnerability to develop is eminent.

True, the MNB had to keep forint (HUF) rates high during the profligate years of the Socialist governments to counter inflationary pressures and to fend off potential weakening of the domestic currency. But high forint rates triggered a process of “euroization,” that is the use of external currencies (the Euro at first, but also increasingly Swiss francs, and occasionally yen). Since the process was driven by both the lenders and the banks, it quickly grew out of proportion. On the credit demand side, households and small businesses had been encouraged for years to borrow in Euro and Swiss franc by the persistently significant difference between high interest rates in Hungary and low rates in Western European countries. When you have a relatively stable currency and the expectation of convergence, borrowing in other currency makes sense for the families and businesses involved; but from a macro-prudential point of view, concomitant risks should be always monitored and assessed by national authorities. You cannot rely on the caution of bankers, particularly in the Hungarian (East and Central European) context, where most banks are owned by foreign banking groups: for them, the Euro or even Swiss francs were the natural choice. These banks also favoured foreign currency lending owing to the lack of domestic forint savings.

As a result of all of these factors, Hungarian households and enterprises had become highly indebted in foreign currency, especially in SFR, by late 2008. Total external debt reached about 120% of GDP at the end of 2008, compared to less than 50% in Poland and 40% in the Czech Republic. And here another policy mistake enters the picture: at the climax of the financial crisis in October 2008, international reserves kept at the MNB proved to fall short of covering short-term foreign currency debt.

Party politics is also responsible for the crucial macroeconomic risk Hungary has been running for some time. The increase in foreign exchange lending accelerated in Hungary in 2003 when the incoming Socialist government abolished a subsidy on forint-denominated household loans, claiming the subsidy was a costly pet project of the (first) Fidesz government between 1998 and 2002. True, the house ownership scheme under the conservative administration weighed heavily on the public budget. Supporters of the scheme argue that the spread of private residential property adds to the potential tax base and provides impetus to an otherwise sluggish economy.

The Socialists may not really have bothered about the budget; they just did not like the previously much publicized (and subsidized) home ownership project that the Fidesz government made a flagship policy act of its own.

The problem was not that the Socialist brought it to an end, but rather that they did not offer a viable housing option instead. The banks, directed and funded mostly from their headquarters in Western Europe, immediately sensed an opportunity to grab: they started powerful campaigns to offer foreign currency (FX)-denominated mortgage, car-finance and general consumption loans. This is why, by end of 2008, the share of FX loans in Hungary had become the highest among the new EU member states outside the Baltics.

Where to go from here
 

This, then, is the past. By 2010, the problem of the indebtedness of (mostly middle and low-middle class) households emerged as a major policy issue, and also as a time bomb for the incoming Fidesz government, which had strong support among the same social strata. Non-performing loans increased to over 8 percent of all bank loans by end of June 2010, and the increase in household defaults was accelerated by recent Swiss franc strength, and a high unemployment rate. The Fidesz government installed a moratorium on foreclosures: this measure is popular but it prevents banks from managing their mortgage portfolios effectively and cannot be maintained for good in a market based economy.

Thus a slightly stronger exchange rate would help the indebted public. The MNB keeps its central rate high partly by taking care of the forint rate. But it immediately clashes with the government, which would love to see lower rates to boost economic growth and would not mind some further depreciation of the forint to support export activity (ideally, of course, without aggravating the conditions of the indebted middle classes). There is no quick monetary policy cure for that. Moreover, inflation is far from insignificant. The MNB noted that the introduction of “crisis taxes” and unfreezing of administered energy prices, plus rising food prices (worldwide and in particular in Hungary due to unfavourable weather conditions in both 2010 and early 2011) would increase headline inflation well above target. Moreover, inflationary expectations are not fully anchored: which means in plain language that the Hungarian public, given the country’s history, expects higher prices. Seen from this angle, it is not surprising that the rate setting council decided in January to increase the policy rate further.

Two things would help the macroeconomic conditions. One is Hungary being upgraded by major rating agencies. Investor confidence is important for exchange rate stability in view of the high foreign currency exposure on domestic balance sheets, and for making sovereign and private borrowing a bit less expensive. But an upgrade is just a wish in early 2011, shortly after the Fitch downgrade in December 2010, despite the improvement in Hungary’s current account, and some important pieces of good news in foreign direct investment (FDI) flows.

Second, what Hungary needs is solid economic growth supported by a clear economic policy and the atmosphere of trust between the government and businesses. In keeping with the upturn in German exports, Hungary’s export sales keep growing dynamically. Real wages have become lower than in most neighbouring countries due to nominal wage restraints and relatively high inflation in recent years; thus unit labour costs are not high. Taxation is meant to be simpler and less burdensome (except for the sectors hit by “crisis taxes”); it remains to be seen how major investors judge the legal and administrative conditions they think they will be facing in coming years.

If trust is restored, Hungary may well benefit from growing demand and improving supply side conditions. Then it will be easier for the central bank to look after the value of currency without having to keep domestic rates too high. Politicians will probably complain anyway about interest rates, even at a much lower rate, but then one can only nod: this is a recurring motif.