The Case of the New Government with International Finance

Mark Weisbrot, a fervent critique of the IMF, the gendarme of the financial world, stood behind Prime Minister Viktor Orbán in this conflict with the Fund and the European Union (EU), lenders to the Hungarian government (“To Viktor go the spoils: how Hungary blazes a trail in Europe” (Guardian, 9 August 2010). The Economist, the influential business and economics weekly, on the other hand, was very critical in its 5 August, 2010 piece: “Orbán out on a limb. Hungary’s new prime minister takes on the world”.
First, what happened? The joint IMF and EU team left Budapest on 17 July without successfully closing the fifth review of the loan contract with the incoming Hungarian government. Because of this, the government could not draw on what was left from the stand-by loan. In addition, the premature departure meant that talks could not start on a new precautionary loan from the IMF. PM Orbán and National Economy Minister György Matolcsy had expressed Hungary’s intention to seek such a loan once the stand-by arrangement expires in October 2010.
The mood changed immediately after 17 July. Viktor Orbán said the government would, reluctantly, meet the 2010 budget deficit target of 3.8% of GDP, the inherited obligation under the current financing plan with the IMF/EU duo, adding that the Fund had no say in how the government was to accomplish it. He also declared that the government would not negotiate a new IMF agreement once the loan expired. Hungary would talk to the EU alone about the 2011 budget – this is, in fact, a must under the Stability and Growth Pact of the EU. The PM noted that the country was able to meet its borrowing requirement through financial markets without an IMF safety net.
As we will see, neither event itself (no access to remaining funds, and no new precautionary loan) should have material consequences in 2010 or the year after. Still, emotions erupted: some journalists rallied behind the government claiming it was waging an economic freedom fight against big finance. Exaggeration as it is, some policy makers did talk in public about regaining “financial independence”. “Hungary will not ‘break its back’ to reduce its budget deficit to 2.8% of GDP in 2011 just to please a few financial experts in distant offices”, said Minister Matolcsy, on Hungarian TV. Certain foreign supporters (some of them embarrassingly on the extreme left) congratulated the new government for standing up to high finance and Brussels bureaucrats.
Other foreign commentators forecast a financial meltdown without the Fund. Heated passions. What happened meanwhile in the economy was a further weakening of the currency. The forint (HUF) took a blow already in June, a couple of weeks after the general elections when an office holder of the governing party Fidesz mentioned Hungary in the same breath as Greece – the latter hovering on the verge of financial collapse at that time. The prime minister’s spokesman added fuel to the fire by standing by the above statement, sending the currency into freefall for a while. But the incident was soon left behind when the new government published an adjustment package of 29 measures.
Then in July, news of the abrupt departure of the international lenders shook the forint again. Major credit rating agencies noted that the Hungarian sovereign risk increased due to the suspension of talks with the IMF. Hungary’s risk downgrading looked imminent.
Only some weeks later in August, the story lost its heat as it became clear that the Hungarian state had managed to finance the public debt in the financial markets, and no further draw-down from the IMF would be needed this year due to high international reserves. Market players heard what PM Orbán had to say when he declared the IMF unnecessary: his government was to accept the recommendation of the EU institutions to keep this year’s and next year’s budget deficit as low as set in the loan contract, even though the contract is a legacy of the previous Socialist (minority) government of Mr. Bajnai – who liked to refer to his administration, somewhat inaccurately, as a caretaker government of experts.
Thus the piece of news that the IMF/EU had suspended talks with the incoming Hungarian
government in July suddenly sounded less important. Markets reacted: bond yields declined, the
forint recovered a lot. The improvement of the markets’ mood, however, had a political price tag:
the new government of Viktor Orbán had to promise in Brussels to give up, at least temporarily,
its plan to restart economic growth through a one-off fiscal stimulus.
So was “taking on the world” nothing but a tempest in a teacup? Or did the summer conflict with the IMF and the EU indicate a paradigm change in economic policy making in Hungary? Even if lenders declined to support the election programme of the incoming Hungarian government, its efforts to stand up against the present mainstream elicited strong echoes in certain corners of European policy making and in the media. Others did not see a clash of philosophies behind the skirmishes, and described the incident as simply a futile attempt of the incoming government to broaden its room for manoeuvre against the strict lending conditions of the IMF/EU loan.
Tactics or strategy, manoeuvering or signals of paradigm change?

 

THE ROAD TO FINANCIAL TENSIONS

To answer these questions, we have to look first to the antecedents. Hungary, once a star in transition from plan to market, lost some of her shine around the mid-2000s: economic growth was less impressive than in other emerging markets of the region, public sector deficit remained stubbornly high, the employment rate stagnated. Such lacklustre results came as a surprise as entry into the European Union positively helped accelerate growth in the whole region stretching from Estonia to Slovenia. The eight former planned economies which were eventually admitted to the EU in 2004 (and later, in 2007, Bulgaria and Romania) profited healthily from membership, Hungary was a spectacular exception.
In spite of a sizeable public sector debt and the growing indebtedness of households and businesses, the country’s sovereign risk rating had improved to A-level in the early 2000s. A country at the doorstep of EU membership, and then a new member state and net receiver of EU funds: a safe bet for cash-rich investors. Then came the hot summer of 2008. The shocking news about the meltdown of Icelandic finance made investors wonder about sovereign (country) risks in general. The Economist in its 23rd October 2008 piece entitled “Who will be the next one”, that is which country would follow Iceland in going bankrupt, did mention Hungary, as one obvious candidate, and pointed out “Hungarians’ troubling penchant for loans in Swiss francs”. With the collapse of top class American and British financial institutions in 2008, domestic and foreign fund holders grew tired of running Hungarian risks, particularly when high debt and deficit figures triggered sovereign risk downgrading by major rating agencies to BBB, and then to BBB- that summer.
The news about the bankruptcy of Lehman Brothers immediately changed the attitude of financial market players in mid-September 2008. Given the high public and private foreign exchange exposure, Hungary became an obvious target for speculation after the downfall of Iceland. As a consequence, the secondary market for Hungarian government bonds froze in October, the national currency depreciated deeply; trading was suspended in the Budapest stock exchange because of a steep price fall. Government bond auctions had to be cancelled for lack of bidders. The price of insurance against sovereign default (the socalled CDS spread) jumped to a historic high. The message was clear: the financial markets felt that the Republic of Hungary was on the verge of insolvency.
The Socialist-Liberal coalition was still in office under Mr. Gyurcsány, who as PM and chairman of the Socialist Party had by that time used up his political capital and personal credibility as a consequence of a series of blatant political lies, broken election promises, use of brutal police force against opposition rallies, shady party finance and unclear privatisation deals. Looking back to the summer and autumn of 2008, one can see that Gyurcsány and his team were on the verge of panic. They contacted leaders of major EU member states for financial support. No money was offered, just advice: turn to the IMF for emergency finance if the case is urgent; the EU is not good at acting fast.
The IMF swiftly put together a package with the European Commission. In just two weeks, the Hungarian government obtained a i12.5 billion emergency stand-by loan from the IMF, together with a matching loan of i6.5 billion from the EU, and a i1 billion loan facility for the financial sector from the World Bank.
IMF loan conditions are never soft. In this case, the request letter set out the government’s promises concerning budgetary and tax policy: “The 2009 budget will be amended to further reduce the government’s borrowing requirement. The revised budget envisages a general government deficit of 2½ per cent of GDP. The tax cuts previously envisaged for 2009 will be cancelled and we will not make any changes in the tax code that could lead to lower net revenues.”
Budget cuts and maintaining high taxes during a recession? This goes against common sense, and particularly the recommendation of John M. Keynes who saw during the Great Crash of 1929–1933 what damage pro-cyclic policies can cause to the economy and society.
In fact, the Gyurcsány government did sacrifice fiscal and tax policy room for manoeuvre in return for a huge foreign loan designed to keep the Hungarian state out of the default danger zone until the expected date of the general elections, April 2010. The social and economic price was, not surprisingly, high: with high taxes and declining public sector expenditures during recession, the Hungarian economy shrank more in 2009 than the German economy and many others in the euro-zone.
European governments spent huge sums of public money to counterbalance, at least partly, the
contraction of the aggregate demand. Large government deficits were recorded by Ireland (-14.3%), Greece (-13.6%), the United Kingdom (-11.5%), Spain (-11.2%), France (-7.5%) and Poland (-7.1%) in 2009, as a percentage of GDP. Compared to them the Hungarian figure (-4.4%) looked moderate. In fact, Hungary did just the opposite of what Keynes would recommend by applying a strict fiscal and monetary stance in spite of deep output contraction.
The Hungarian unemployment rate swiftly moved over 10%, higher than the EU average, and
personal consumption and housing construction declined. The centre-right party Fidesz, still in
opposition in 2009, strongly criticized the government for choking the economy, and revealed its
massive tax reduction plan to invigorate the shrinking economy.
Once in office in June 2010, the Fidesz government set out to correct things, trying to break the
downward cycle of “fiscal restrictions-decline-restriction-decline”. In order to restart the economy, the new government promised to reduce the tax burden on those who work and employ, even if
initial tax cuts first increase, rather than decrease, public sector debt: a sort of investment into the
future in the form of a slight increase of government debt. Orbán’s cabinet must have thought that
such a calculated move would be tolerated by lenders. The sudden end of IMF talks in Budapest,
and parallel meetings with EU officials in Brussels in July proved this forecast wrong.

ON MANOEUVRES AND STRATEGIES

Wasn’t it a bit naïve to expect the IMF and the EU to accept an easing of the loan conditions?
Not at all! This is what happened to Hungary and to Romania in 2009: the deeper than expected
contraction rewrote the original conditionality. The lenders gave Hungary waivers on certain key
issues, including the size of budget deficit in 2009: in light of the deep recession, the target deficit
was allowed to be a bit higher than originally planned. The incoming government therefore had
reason to believe that the lenders could be convinced by good arguments.
But that was before the Greek financial blues. The spring of 2010 shook the whole Euro-zone since Greece, unlike Hungary or Romania or Latvia, was a member of the currency zone. This is why the zone members put together a huge sum to support Greece (and indirectly, of course, the French and German banks which held chunks of Greek government bonds in their portfolios). At first, the financial markets felt satisfied and stopped worrying about Greek insolvency, but then they had second thoughts about the sustainability of overall European finance. It was now Europe’s turn to impress international markets. During 2010, most European governments decided to take fiscal measures to reduce borrowing requirements: not only Greece but Spain, Portugal, Italy and Ireland as well. Even the most creditworthy nations joined in: Angela Merkel announced a package of measures and said that Germany was setting an example of budgetary discipline to other euro-zone countries.
Therefore, the mood changed in the summer of 2010 in the EU, partly because of parallel attitude changes on the financial markets. There remained no room of manoeuvre for the incoming Hungarian government, however logical and justified it would have been to apply a dose of Keynesian anti-cyclical spending to kickstart a stagnating economy. Yet neither fellow politicians, nor financial market players felt sympathy for the Hungarian administration in its endeavours.

WHERE TO GO NOW?

In fact, there remained numerous frictions with the IMF/EU team at the time of their departure. The Orbán cabinet wanted to negotiate a higher, 3.8% of GDP deficit for 2011 (rather than below 3%) in exchange for structural reforms in the public sector such as the restructuring of the state railways – not granted by the lenders. Second, the lenders did not like the planned financial sector levy (“bank tax”) either, designed to raise 200 billion forints (nearly one per cent of GDP) in 2010 and for unspecified years after. The IMF/EU noted that this measure would help reduce the budget deficit but at the cost of hurting economic growth through reduced financial intermediation. The lenders’ team was also concerned about the independence of the central bank (the Hungarian National Bank), after a proposed public sector pay ceiling which reduced the central bank governor’s pay.
The new Hungarian government, backed by a large Parliamentary majority, and with strong support from the general public on talking tough with international financial institutions, on the “bank tax”, as well as on limiting the salary of the Hungarian National Bank governor, would not yield.
As Mr. Matolcsy phrased it in a television programme: “the cabinet remains intent on maintaining the country’s financial independence and regaining economic selfdetermination”. This is, of course, a political statement rather than a the proper analysis of the situation. Borrowing from international institutions does involve the borrower’s concessions in terms of economic policy sovereignty: the government is bound by contracts, and exposes itself to regular reviews. But with a debt like that of Hungary, you have only one other choice left: market finance. That does not appear to infringe sovereignty – yet, it does reduce the room of manoeuvre of an indebted government, since these days international investors expect limited public sector deficit, and clear and positive stories
about the growth potential of the economy. Deep down, there are fewer differences between the two sets of lenders.
The question is, therefore, whether the Hungarian economy can move out of recession in a financially sustainable manner. The eight years of Socialist-Liberal rule was a story full of grave policy mistakes (high government expenditures on non-selective social benefits; a tax regime to weaken incentives to work; encouraging families and small businesses to borrow in foreign currency) and of numerous omissions in structural reform issues. As the new government took office in June, PM Orbán vowed to create a million jobs in a decade. Let us not take such a statement at face value, but still it is clear the he means to bring back as many as possible into the labour market.
Dependence for growth solely on imported capital is also something that proved to be a policy failure in previous years, particularly if in the meantime domestic firms remained uncompetitive and undercapitalized. Orbán’s call for a patriotic policy aims at correction again, and does not mean any desire to look inward. This would not be in the interest of the country, particularly when a new Mercedes assembly plant is just about to open in the town of Kecskemét, Opel has committed itself to double its manufacturing capacity in Szentgotthárd, and the enlargement of the existing Audi motor engine plant in Gyõr is under way. True, further support to medium and small domestic firms is vital if hundreds of thousands are to be employed, as giant transnational businesses would not be able to absorb labour in an economic crisis.
Without a vibrant domestic economy (and a healthy middle class) such an open country as Hungary is much too dependent on occasional external factors, and cannot contribute significantly to European competitiveness and dynamism figures. In that sense, a brand new economic policy is justified, even if its particular measures do not fit into the existing mainstream. One is tempted to call the much needed new policy a “social market economy” – one that proved so efficient in Germany in the decades after World War II. Under the present fast changing conditions, it is too early to tell what feasible models may emerge in Europe. But that will be another story.