Currency Devaluation and Hungary's Accession to the Eurozone

The question of whether currency devaluation could or should be used as a tool to improve the competitiveness of the Hungarian economy crops up in public policy discussions in Hungary from time to time. In a broader context, the same issue also arises when considering whether an eventual accession to the eurozone might overly restrict Hungary’s leeway in the domain of monetary policy.

The common European currency zone, whose foundations were laid at Maastricht, is commonly criticised on several fronts, namely: the negative effects of the uniform interest rate¹ on the sub-optimal currency zone;² the impossibility of a Keynesian counter-cyclical economic policy; and that it eliminates the possibility of using devaluation to increase competitiveness.

Since the beginning in 1979 of the neo-liberal era often referred to as the “Washington consensus”, devaluation as a tool has become a taboo topic. Neo-liberalism, a school which considers itself mainstream, disparaged devaluation as an “out of date” tool, even though it had served for decades as an integral part of European states’ toolkits for adjusting to changes in the international environment. Devaluation was used successfully by adherents of the developmentist model (France, Spain, Greece, and even Latin America), and also by the developing states of the Far East, as well as by countries following the Scandinavian “northern model”. To this day, it remains an option in all the Scandinavian countries apart from Finland. The decision by Sweden and Denmark to remain outside the eurozone was made in no small part in order to retain this option. Notably, even the greatest proponent of the Washington consensus, the United States, regularly and extensively operated a weak-dollar policy.³ True, the United States did not avow this policy openly, and has even denied using it as a strategy, just as China today denies US accusations (no doubt well-founded) that it is pursuing a course of devaluation.

It is obvious, therefore, that devaluation can be a legitimate and effective tool for countries to restore short-term competitiveness in the case of a high current account deficit, if the exchange rate is overvalued and internal demand is overheated. In the long term, however, a country’s competitiveness is determined by structural factors: availability of capital, a well-educated workforce, and a well-calibrated and stable system of incentives (taxes, regulatory framework, legal environment). Nevertheless, one might still raise the question of whether, in joining the eurozone, Hungary might lose too much by relinquishing the devaluation option. Here, we will ignore the oft-repeated counterclaim that Hungary, when it joined the EU, pledged to join the eurozone as soon as possible. In practice, joining the eurozone can be delayed indefinitely if there is good reason for it.

Unfortunately, in the case of Hungary, the question is not so much whether devaluation is useful or not, but more: is devaluation possible at all? For countries bearing heavy foreign debt burdens and requiring a high level of debt financing, devaluation is not only impossible, but also potentially destructive. As of mid-2011, Hungary’s gross foreign debt, not counting the debt owed to parent companies, amounted to 104 billion euros. This debt, given the EUR–HUF exchange rate of 266.8 at that time, amounted to 100 per cent of Hungary’s GDP. Calculated according to the end-of-year exchange rate, which skyrocketed to nearly 320,⁴ this debt would amount to 120 per cent of GDP.

To ease exposure to foreign-denominated debts, the government introduced an option for fixed-rate repayments. However, for the most part, this was feasible only for households with sufficient capital, or capacity to quickly mobilise capital. As this only applied for relatively affluent people, in other words a minority of the debtors, the problem remains unsolved. Since most of the loan agreements will be in effect for decades, the problem of foreign-denominated debt will likely dog the economy for a long time to come.

Many have suggested that monetary policy options could be increased by administratively converting the foreign-denominated loans into forints. This way, the foreign-exchange risk accumulated over the years by households and firms would be shifted to the banking sector. The banks, however, could not take this debt on for prudential reasons, and would immediately close their positions by purchasing foreign currency instruments. The conversion of just the households’ foreign-denominated loans into forints would cause, in this scenario, the immediate sale of forints worth approximately 24 billion euros. Since this amounts to 24 per cent of GDP, such a move would cause an immediate exchange rate collapse. Moreover, the interest burden of the households’ foreign-currency debts would increase considerably, due to the higher interest rates on the forint.

The winners in such a devaluation scenario would be for the most part the foreign- owned, export-oriented companies. At the same time, the cost of imported goods would rise, drastically affecting the population’s standard of living. Those making foreign-currency loan repayments, already in dire straits, would suffer large losses due to the higher monthly payments.

In addition to all this, experience shows that among the new EU members in East Central Europe, devaluation has not produced the favourable outcome predicted in textbooks. If we look at the data for the Visegrád 4 countries (Hungary, Czech Republic, Slovakia and Poland), plus Romania and Bulgaria between 2004 and 2011, we see a strong correlation between the nominal currency rate and GDP level. This correlation is just the opposite of what one would expect, however: countries whose currency appreciated (Slovakia, Czech Republic, Poland and Romania between 2004–2008) experienced greater growth. In contrast, countries whose currencies did not appreciate, or indeed saw significant depreciation, experienced lower growth rates (Romania and Hungary between 2009–2011). No negative relationship can be seen between an appreciating currency and exports, or between a depreciating currency and imports. Moreover, in countries where the currency appreciated, inflation rates were lower.

In the period after the summer of 2011, the euro–forint exchange rate rose from a long-term median of 250 to around 300; this amounted to a de facto devaluation. In other words, we cannot say today that the forint is overvalued. In summary, in Hungary, none of the basic conditions for using devaluation to increase competitiveness is currently met: 1) the currency is not overvalued; 2) the current account balance and trade balance both show strong surpluses; and 3) the country has high levels of foreign-denominated debt. Of the three devaluations carried out by governments since the change of regime, only the devaluation of 1994 (carried out by Lajos Bokros and György Surányi) was successful. At that time, however, households and firms did not have significant foreign-denominated debts, and the devaluation succeeded in bringing the external and internal imbalances (current account and budget deficits) back into line. Still, it should be noted that this policy also led to rising inflation and falling real wages.

The 2003 currency band adjustment downwards came in response to strong speculative attacks which were a result of the high deficits in the budget and the current account. Long-term bond yields immediately rose, and the National Bank of Hungary was only able to halt these unfavourable developments by raising interest rates by 600 basis points.

The third attempt at devaluation came in early 2009, after the government reached a credit agreement with the IMF. Shortly afterwards, in an effort to mitigate the effects of the enforced 300-point interest rate hike in a recessionary environment, the National Bank began to lower interest rates and devalue the exchange rate, moves which were also supported by verbal interventions. As a result, the forint depreciated to 316 against the euro; in a departure from regional trends, long-term bond rates began to rise (from the year-end 8 per cent to 12.5 per cent); and private sector lending dried up.

Thus, devaluation can theoretically be a useful economic policy tool under certain circumstances. In Hungary’s case, however, these circumstances currently do not prevail. In the medium term, a situation might arise in which devaluation might be necessary as a short-term tool to remedy an external imbalance. However, long-term competitiveness can be achieved only through the above-mentioned structural factors. Even in the medium term, as long as the Hungarian economy’s exposure to foreign-denominated debt remains high, we must unfortunately abandon the idea of devaluation as a component of our economic policy toolkit.

Translation by Katica Avvakumovits

NOTES: