Non-Conventional Economic Policy Measures - Hungarian Style

In this essay I attempt to draw a preliminary balance of recent non-orthodox economic policy practice in Europe and, in particular, in Hungary even if the essayist lacks historical perspective. It would be good to wait until data and hard facts are available but this is rarely the case in real life: policy makers, business executives, market analysts, and rating agencies act on whatever fragmented information they may have about ongoing processes. This cannot be otherwise: navigare necesse est. Financial markets are notoriously hectic and short-sighted as many market players take positions on impulse and react to the “news”; rating agencies announce their verdicts on risks before they actually materialize; even institutional investors act under time pressure. This is a reality of the modern era but year 2011 will probably go down in European economic history as a unique period of high tensions in financing debt-stricken states (the “sovereigns”). The EU leaders met many times, most recently in December 2011, but they could not claim to have found a convincing and sustainable solution to the accumulated problems; market analysts sound pessimistic, financial markets remain extremely volatile.

The Hungarian economic and financial story is also hard to read; events follow events. After only one year and a half, it is hard to do justice to the economic policy course of the Orbán cabinet. Still the calendar year in our case closes a period in Hungary. The fourth quarter of 2011 produced important market developments in the Hungarian economy, and unexpected government decisions were taken – all indicating that a certain period ends with the year-end. It is enough to mention that quarterly GDP figures indicated a much slower economic growth than hoped for; a surprise decision of the government in September to make banks accept lump sum repayment of foreign exchange mortgage loans at non-market rates; drying up of investors’ demand for Hungarian government bonds in October; a new turn in government policy toward international financial institutions, namely the International Monetary Fund (IMF or Fund); downgrade of Hungarian sovereign risk by a major rating agency in November. The financial landscape thus changed a lot, and for the worse, in the second half of the year. There is life, as politicians tend to repeat, after a risk downgrade, and turning to the IMF for funds is not something unheard-of on the periphery of Europe. But changes like that will always have a strong impact on the direction and style of economic policy making – and perhaps even on the policy makers themselves. At such a turning point, the reader is justified in expecting some preliminary evaluation of the events, processes and results of the closing period.

But first, let us see some important news items. On 17 November 2011, György Matolcsy, minister responsible for the national economy, made a surprise statement about the Hungarian government’s intention to request financial support from the IMF. Such an event should not come as a big surprise on the Old Continent which has emerged by now as the main borrowing client of the IMF, were it not for a country whose government declared in a self-assured manner some time before that (in June 2010) its decision to sever ties with the Fund and vowed to finance its debt solely through financial markets, without having any recourse to official sources. The U-turn came out of the blue; only three days earlier the same minister proclaimed that Hungary had no business whatsoever with that “three letter institution” which was party to the then Socialist government in implanting an ineffective policy plan on Hungary in 2008.

Rumour has it that the announcement was hastily issued in order to stop Fitch, a major rating agency from publishing its decision to downgrade Hungary’s sovereign debt from investment grade rating to BB+ which is already junk bond rate (more politely: non-investment grade). What is certain is that Mr Matolcsy’s press release on reopening negotiations with the Fund took the IMF itself unprepared: the resident representative of the IMF to Hungary issued a statement in the afternoon of the same day reiterating that the Fund team that happened to be in Budapest was conducting a regular economic surveillance that the IMF performs for all member countries, and she added: “The IMF has not received a request from the authorities to initiate negotiations on a Fund-supported program.” It took a day or two for the proper documents to reach the IMF and simultaneously the European Commission about the government’s initiative to start the negotiation procedure. Weeks later it is still unclear what type of financial assistance the Hungarian authorities are aiming at and what loan type would be feasible under the particular Hungarian economic situation.

If fear of an imminent downgrade was the motive behind this sudden policy turn, it seemed to work at first but – as we learnt soon – not for too long: Fitch did not issue a new rating; it made known instead that any future rating event was now conditional on the contents of Hungary’s new IMF program. The forint appreciated somewhat against the euro.

Only days after that, however, the positive reactions to the announcement about the IMF negotiations gave way to doubts. Events followed each other pretty fast: Moody’s Investors Service, another rating agency, soon stripped Hungary of its investment-grade sovereign bond rating for the first time in 15 years, reducing it to junk status (Ba1 from Baa3, with negative outlook). As a business analyst put it: Moody’s downgrade was unlikely to surprise many in the market. If the bid for an IMF deal was an attempt to forestall such rating actions, then it came too late, and doubts lingered on whether the Hungarian authorities would offer the concessions needed to get the IMF easily on board.

At present, not much is known about the contents and the schedule of the IMF loan negotiations. Interestingly enough, the IMF decided to communicate directly with the Prime Minister concerning the negotiations rather than to the mentioned minister who nominally represents Hungary at the Fund on policy level; the PM named another minister to coordinate the Hungarian side during the negotiations.

As for the other heavy-weight financial players, the rating agencies, that is, their intentions concerning the future rating of European sovereigns, whether of core or non-core countries, are anybody’s guess. The very last weeks of the year were abundant in twists and turns in market processes as well as in European policy initiatives; thousands of influential market players, rating firms included, try to assess the seriousness of the highly visible, hotly disputed but only partly understood European financial crisis. In this case, it is certainly not easy to separate perception from reality: in spite of the obvious financial stresses the euro, the common European currency remains as strong and stable vis-à-vis the dollar and other major currencies as ever. Inflation in the eurozone is under control, the average European public sector debt ratio is lower than that of the US, UK, and particularly Japan. The sad reality is, however, that fund holders perceive many European states as vulnerable and less than fully reliable debtors on longer terms.

Hungary, similarly, can show up improving indicators of economic fundamentals: trade and current account surplus, moderate (though, for my taste, still high) inflation, some economic growth. What happens, obviously, that Europe has a direct impact on the Hungarian economy and on the government’s future margin of manoeuvre; and the second half of 2011 turned out to be worse in this respect than expected by Hungarian policy makers. Still, the downgrade came as a surprise for the authorities; the spokesmen’s first reactions were to cry foul and blame financial speculators and the rating agencies. Perception and reality, credit risk rating versus economic fundamentals – these are hopelessly interwoven these days. The blame game has not ended; those with strong imagination and/or strong views smell here some conspiracy against the country, others believe that downgrade is a form of revenge for the unconventional policies of the Hungarian government.

Now, we certainly have here a controversial issue: do recent events such as the downgrade of Hungarian sovereign debt and the return of IMF to Hungary have to do with the non-orthodox policy line of the new Hungarian government? Have the non-orthodox (non-conventional) methods failed? What has been actually downgraded: the fundamentals of the Hungarian economy or the policy course? Many Hungarian newspaper editorials and media commentators have opined that the junk bond rating was first and foremost a sort of punishment meted out for the unconventional measures of the government of Mr Orbán.

In fact, the press communiqué of Moody’s (24 November) did not directly mention policy aspects. It named two key drivers for the downgrade: “the rising uncertainty surrounding the country’s ability to meet its medium-term targets for fiscal consolidation and public sector debt reduction, particularly given Hungary’s increasingly constrained medium-term growth prospects; and second: the increased susceptibility to event risk stemming from the government’s high debt burden, heavy reliance on external investors and large financing needs as the country enters a period of heightened external market volatility”. To put it into simpler language: the rating agency worried about the indebted country’s growth outlook, as well as about its exposure to international trade and finance events.

The future of the Hungarian economy looks rather gloomy if the concluding section of the rating decision, wrapped in technocratic language, is true: “Moody’s believes that the combined impact of these factors will adversely impact the government’s financial strength and erode its shock-absorption capacity. The rating agency’s decision to maintain a negative outlook on Hungary’s ratings is driven by the uncertainty surrounding the country’s ability to withstand potential event risks emanating from the European sovereign debt crisis.”

There is no direct mention here of the most controversial policy measures such as the de-facto nationalization of the compulsory private pension funds, levying extraordinary industry taxes and a program forcing banks to swallow exchange-rate losses on the early repayment of foreign-currency mortgages (see my analyses in September 2011 and November 2011 issues of the present Review). Still, some foreign papers do point out that link. The columnist of the influential weekly Economist called the design behind the non-conventional policy measures a gamble, adding that when the government walked away from the IMF in 2010, it was because the Fund disagreed with the particular policy approach of the new government: “Mr Matolcsy and Viktor Orbán, the Prime Minister, wanted to add to demand by instituting a flat tax, plugging the revenue gap with a windfall tax on banks. The IMF thought both ideas very risky.” T. E. the columnist believes that the decision to return to the IMF appears to signal that the government has abandoned its experiment in what it has variously called a “struggle for economic independence” (when addressing certain domestic audiences) or, before a broader public, “unorthodox economic policy” (The Economist, 21 November). The Economist is not alone in this respect; many others express similar opinions in the Western press commenting on Hungary’s return to the IMF.

Rating agencies, interestingly, have not emphasized non-conventional policies as sources for their concern, with one exception: the foreign exchange repayment initiative of the government. Fitch’s pointed out in a November 2011 communiqué that the “government’s policies to tackle the large stock of Swiss franc denominated household debt may turn out to be fairly ineffective and have negative consequences”. Certainly, this recent government measure has provoked the sharpest criticism from abroad and also in domestic economics circles, mostly on the strength of the argument that this sort of government intervention into private contracts has a shaky legal basis, plus the fact that the ensuing bank losses weaken the financial intermediation system at a time when Europe agrees on strengthening the banking sector’s capabilities to absorb shocks.

The European aspect of crisis management places the whole Hungarian story in the context of a more general issue: is there any room at all for non-conventional or non-orthodox policy measures in highly integrated European economies? Or even more broadly: do governments have genuine policy options during crisis times?

Let us put the particular Hungarian policy steps in a more general framework of policy choices in turbulent times. There is a fast growing body of knowledge about this subject. One of the lessons of the recent financial crisis has been the big variety of government policies reacting to steep output decline in most advanced economies. Governments have applied a gamut of “non conventional” economic policy measures when confronted with the spectre of deep recession. Nationalization of important banks and insurance companies in the US, UK, Ireland; consumption-prodding government incentives (such as the “junk car” programs in many countries, including the otherwise fiscally conservative Germany under the Abwrackprämie initiative); bailing out construction firms (also in Germany, for example); subsidies paid directly to selected sectors and firms – these are some of the measures that do not fit at all into the received policy mainstream. That is, the mainstream until the crisis. Looking back to the year 2009 and early 2010, government policies seemed to work inasmuch the recession remained within manageable proportions and was over soon. Again, a second look at events and figures would justify a much more critical opinion since the same crisis mitigating policy measures paved the way for the sovereign debt problems of 2010 and after.

If one unorthodox measure is to be singled out, this is undoubtedly the Greek debt restructuring scheme euphemistically known as “private sector involvement”. It is also referred to in financial circles as the 50 per cent “haircut”: commercial banks and brokerage firms holding Greek government securities had to accept a “voluntary” contribution of that size to a debt reduction plan, as a precondition for the new assistance package to Greece the outline of wich was announced in July 2011. The non-standard debt restructuring scheme looked nice at first glance: the extremely high Greek debt figures were reduced significantly this way without a formal declaration of sovereign default. Those who masterminded the scheme (in Germany) probably thought that this formula saved a eurozone country from clear legal default, but still helped reduce the Greek debt to a manageable level. It had an appealing logic: investors who had taken excessive risks should pay a price for their mistakes, without the taxpayers having to bear the sad results of the reckless behaviour of lenders (and borrowers).

As so often in life, this unorthodox measure has gradually proved a very costly failure. Bond holders started to think seriously not about the capability but the willingness of one or numerous European states to honour outstanding debt obligations to the letter. Greece was not in default when the European authorities made concerned banks join in sharing the costs of Greece’s near bankruptcy. The obvious question in such a case: who will be next debtor (Ireland? Portugal?) with an EU backed initiative to make private investors lose half of their invested assets.

It is important to reckon with this July 2011 European financial episode for the simple reason that investors and rating agencies became from that moment on increasingly concerned not only about the capabilities of sovereign debtors to honour that obligation to the letter but their determination to do so. With Hungary, this credibility issue emerged after a series of non-conventional government decisions. What made the headlines about Hungary first was the “bank tax”. Not that this measure is particularly Hungarian: Sweden had it before Hungary, and Austria, the United Kingdom, Belgium, France, Germany, Slovakia, and Slovenia introduced some sort of financial sector levy. The motives, tax incidents, and the use of the levy differ a lot; certainly the Hungarian measure stands out for its size. But it is also known that financial institutions had enjoyed a pretty high return on their equities for a long time before the crisis here, with a light profit tax rate, therefore the government felt justified to mete out a serious one-off levy on cash-rich businesses.

Having said that, one must also add that the Hungarian authorities have been less than consistent in their statements about the actual time horizon and scale of the “crisis taxes” and therefore businesses could not be sure whether such an additional tax measure would truly remain a one-off episode. But if the surtax is a genuinely one-time measure, than another issue can be raised: what would happen to the Hungarian budget once such transitory revenue-enhancing measures peter out? And this is probably the question that concerned the rating agencies about Hungary’s public finance more than the bank tax being a “non-standard” policy measure.

Mind you, some so-called “new” or “non-conventional” measures are nothing other than old solutions applied again. Let us take the policy of “cheap money”, a quite general monetary policy measure taken by many a central bank in advanced countries: in response to the credit freeze of end-2008, they acted in a profoundly customary fashion, following textbook recommendations to the letter (Keynesian or neo-Keynesian textbooks, that is) when they reduced the central bank policy rates close to zero. When the customary techniques of easing the monetary conditions aimed at curbing the credit crunch turned out to be ineffective near zero interest rates, central banks decided to react to the lack of liquidity (and lack of trust) by resorting to “non-conventional” solutions: they accepted less than risk-free collaterals for discounting, or provided loans directly to business actors.

Acceptance of corporate bonds as loan collateral or direct central bank financing of public sector entities and private ventures are anything but new measures: that was the common practice in the 1950s throughout the world – only to disappear altogether by the 1980s. Providing subsidies to car manufacturers, airlines, construction firms, banks and insurance companies is far from being novel – some industrialized states and most developing nations practiced that two generations ago.

History, thus, seems to have repeated itself in some ways, at least in advanced countries: in Europe and even more in the USA. Interestingly enough, governments outside the global core areas tended to behave in a more conservative manner during and after the 2007–2009 crises. Emerging countries, in a sharp contrast to the policy course taken by advanced countries, were not eager to reduce their interest rates when the turbulences erupted. Some rather increased the rates at first; therefore at a later stage they did not have to resort to non-conventional methods of monetary easing. Central banks in emerging economies, again in contrast to the practice of the advanced countries, decided not to take part in selective financing of particular sectors and firms; they instead left growth-promoting and microeconomic crisis-managing financial activities to governments. The motives behind central bank orthodoxy must have been that they as institutions lacked the credibility that is needed to apply not fully transparent policy measures. Also, they did not wish to risk their hard gained institutional independence, knowing that the so-called non-conventional measures only work when governments and central banks cooperate closely.

The above description is mostly valid for the Hungarian case. The Hungarian central bank (Magyar Nemzeti Bank – MNB) took certain measures to provide liquidity to banks during the crisis, utilizing its links to other central banks and to the European Central Bank (ECB) but tried to remain outside the policy battles. It is everybody’s guess whether the low level of international reserves was a critical factor responsible for the country’s near-bankruptcy situation in October 2008. Certain responsibility also rests with the MNB for tolerating the spread of foreign exchange lending in Hungary for a long time before the crisis hit the country, and the many indebted households. Still, on the whole, monetary policy in Hungary remained quite conventional during crisis years.

This is not so with fiscal and budgetary policies after the change of government in the spring of 2010. There is not much doubt that previous policies had to be changed, and not only for domestic reasons, to satisfy voters’ demands. The eight years of Socialist rule left behind it a sad legacy: the combination of near stagnation and burgeoning public sector indebtedness. The outgoing Socialist government of Mr Bajnai in 2009 set for itself a limited goal in terms of economic policy: to fulfil the loan conditions of the IMF/EU duo that saved the country from an even bigger crisis in 2008. Yet, the “minimalist” policy aspiration resulted in a very deep contraction of close to 7 per cent of GDP in 2009, much worse than the European average. Budget deficit was reduced as promised to lenders, but employment remained very poor, investments shrinking, business sentiments low. The incoming Orbán team had always been and remained convinced that this sort of austerity policy would lead to nowhere and, instead, what was needed was the “restart of the engines of the economy” through verbal and financial injection of dynamism.

Unfortunately, the season of massive fiscal stimulus was about to end in Europe by the time the new Hungarian government put together its policies. European countries already embarked on their exit from the previous period of fiscal expansionism as its drawbacks started to appear in the form of ballooning sovereign indebtedness. Official lenders (IMF and the European Commission) made it known to PM Orbán that his growth-oriented policy direction must stay within the strict deficit limit as agreed upon by the previous government and the lenders, and that further fiscal slippages would not be tolerated. In fact, this is not fully so: the official Hungarian public sector deficit of year 2010 turned out to be 4.3 per cent of the GDP; this is 0.5 per cent more than the 3.8 per cent original target that was said to be “carved in stone”; the slippage was due to overspending by Hungarian local authorities, not fully controlled by central authorities. But what turned out to be crucial: the incoming cabinet of Mr Orbán justly felt that European leaders and the Fund did not allow the new government to follow its proper policies by denying Hungary a policy course that other nations could take in preceding years. Hence the search for new solutions, some admittedly non-standard, to mobilize resources for the original grand design of “restarting the engines of the Hungarian economy”.

Now, some time later it is obvious that certain measures had their side effects. The reduction of the rate of personal income tax did leave more money in the pockets but the hoped-for consumption increase did not fully materialize: families saved instead. Second: the sectoral taxes (on banking, telecoms, energy, retail) did generate additional income to the government but led to some decline in the investment activity of the sectors concerned (and not only in those sectors: some profitable foreign ventures became increasingly concerned about the calculability and transparency of the Hungarian tax regime.

But the paramount external criticism of the policy of the government that has been in place since June 2010 is lack of coherence: it is hard to read why the government takes this and that measure. Domestic analysts may figure out a bit better what the measures are aiming at; still the government has been launching too many plans and initiatives to follow and digest. There is a strong doubt in town whether the government measures are really well calibrated and whether the decision-makers have really taken into account the time and resource requirements of their actions.

Also, as we could see, the government has been in critical instances behind the curve: fiscal stimulus plan in 2009 would have been compatible with the “new normal” but became no-no in spring 2010; walloping domestic banks with levies and forcing them to swallow customers’ losses on foreign exchange housing loans sound different before and after the Europe-wide decision to build additional capital cushion at banks. The foreign exchange loan initiative was in itself a high risk measure in good times, but the European mood was far from good in September when the government enshrined it into law (without much consultation with the banks concerned).

Now, it may well be too early to announce an authoritative verdict on the phase of non-standard measures in Europe, and in particular in Hungary. What seems to be a safe statement is that member states will all have to take determined (and convincing) measures to reduce financial uncertainties. Smaller nations are doubly exposed to external forces, and can hardly afford to be misunderstood concerning their policy course. If this is the new environment from 2012 on, Hungary also needs a convincing policy line and easy-to-read measures.