One of the hottest issues for Hungary in the past few weeks and months was whether the country can stay afloat without an IMF-led loan programme. Could it be able to keep funding itself? Would investors still consider the country’s debt path sustainable? By using a few simple calculations we can very easily get to the bottom of the simplest scenario, as its likely impacts have been forecasted so many times.
If without an IMF backstop Hungary’s debt issuance gets hindered - either as a consequence of an international shock or because confidence in the Hungarian economy goes up in smoke - the liquid funds of the budget will run dry sooner or later. The speed of this depletion, of course, depends on the extent of the market freeze. The most frequently cited version, in which forint instruments would still sell, but raising FX funds would be already difficult, there would certainly be serious problems around the end of this year.
So the foremost risk of "being without an IMF loan" is the drying up of funds. This is not a new risk for countries that run high public debts, but investors did not pay much attention to these scenarios when there was ample liquidity before the crisis. In the era of deleveraging, however, this carries substantial risks, as the developments on Italy’s fixed-income market in the spring of 2011 attest.
We have some more interesting scenarios; those that examine what happens when refinancing funds remain available even without an IMF backstop. At first glimpse we can say that this wouldn’t mean too big of a trouble either. In order to put the 80% of debt on a downward trend path (assuming a 3% annual inflation and 1.5% potential growth) Hungary would need to have a budget deficit smaller than 3.6% of GDP. The cabinet set its targets well below this number, aiming for a 2.5% of GDP gap this year and a 2.2% shortfall in 2013.
Adopting a bit more complex coherence of debt dynamics we find a not so appealing picture. If we assume that the current high-yield environment persists then the average interest rate burden during the refinancing process will rise continuously. This is presently at around 5.5%, but a part of the stock (about 14%) is the previous IMF/EU credit with 3% interest; and according to the cabinet’s indications the whole will be replaced by FX bonds of market yield (7-8%) in two to three years. But the same repricing is taking place slowly but surely at government securities, the yields on which are currently at 8.5-9.0%. If the average interest burden climbed in two to three years to 7%, the current fiscal path would not be sufficient to ensure a descending debt path anymore.
Of course, the cabinet would still have the option respond to such changes and implement further fiscal adjustment measures to improve the primary balance (that exclude interest expenses). But we should take into consideration that fiscal policy is already rather restrictive this year and in order to reach the targets additional adjustment steps will need to be taken. And these per se have a dampening impact on economic growth. If the stabilisation of state debt required an even better primary balance, growth would be muted further. And from then on a lot will depend on how the adjustment takes place; how the interest rate environment turns out and how the forint exchange rate reacts.
The chart below depicts the trends in an illustrative way, and although debt paths are highly sensitive to the framework conditions, it is still clear that without an IMF backstop Hungary’s public debt could hardly be set on a declining path.
Under the "nothing happens" scenario we assumed a gradual increase in the average interest rate burden to 7.5% (which would not even mean a total pass-through of the current interest rate environment); a 1.5% surplus in the primary budget balance; a 2.5-3.0% annual inflation and a stable forint exchange rate.
In this case the sustainability of the debt path cannot be ensured. If Hungary’s risk premium climbs higher due to a failure to ink a deal with the IMF (and rates follow suit) and the forint starts to depreciate as a response, then the current fiscal rigour would not do the trick and pubic debt would still rise. The expanding gap between the real interest rate and economic growth may be offset by bigger fiscal rigour - a very austere fiscal policy indeed in this case. The primary surplus should be boosted to 3.0-3.5% of GDP, which seems to be an impossible undertaking at this point.
Looking at that scary-looking debt path above the question comes naturally: how come the situation is so bad? In an economy with such a nice primary surplus and palpable potential growth it shouldn’t be this way, right? The explanation lies in the high debt and the high risk premium. Of course, it should also be worth examining how this high premium came to pass. On one hand, in an era of debt crises this is apparently a natural phenomenon. On the other hand it was caused by the serious erosion in the credibility of Hungary’s economic policy.
If this credibility was recovered only to the level in Hungary’s neighbouring countries and the risk premium could drop we could draw up much nicer debt paths. But in this respect we have an endogeneity problem: after the cabinet had committed so unexpectedly and so unwaveringly to the IMF last November, back-pedalling on the deal would not improve but - quite the contrary - further weaken its credibility. This means Hungary needs that credit agreement not because it would improve the country’s situation, but also because without it there is a fat chance that the situation will go from bad to worse. This is why we maintain our view, that the announcement on going back to the IMF for financial assistance had been totally unprepared.
The same calculations have been applied also on a scenario when Hungary reaches a deal with the IMF/EU. Although we have not assumed a breathtaking GDP growth even in this case (1.5-2.5%), but the stabilisation or decline of the interest rate burden could be enough in itself for a descending debt path, while no further adjustment in the deficit path is needed.
In this case we have drawn up two possible scenarios. In the first the government asks "only" for a "safety net" from the IMF, in line with its original announcement. This would keep the exchange rate stable and the average interest rate burden on public debt and the economy could also pick up to some extent. In the other scenario we assumed undisturbed refinancing at persistently low costs, as the IMF credit would be drawn and the expiring foreign currency debt would be renewed from this source. The declining risk premium would further improve the debt path and so there would be a marked drop in the debt-to-GDP ratio.
Needless to say, there could be a number of external factors besides the aforementioned ones that could improve the situation or make things worse. The global environment is highly uncertain and there could be serious changes in the credibility of Hungary’s economic policy too. If the cabinet managed to improve its credibility somehow, the outlook would be better even without an IMF credit line. But, as we have said before, there is only a very small chance of that happening. And in that case a no deal scenario carries substantial macroeconomic risks.
Last Updated on Wednesday, 11 April 2012 21:23