Last week the Hungarian government, led by the prime minister’s Fidesz party, passed changes to the constitution. These amendments sparked warnings from European leaders that the new regulations risk contravening EU law as well as European democratic values.
As expected, things are currently strained between the Hungarian government and both the International Monetary Fund and the European Commission. To get a better understanding of the situation and its potential economic impact, I visited Budapest this week. It was very telling that one of my meetings with the Hungarian central bank was cancelled by the governor, and this is a perfect illustration of the present political and economic tensions. Country visits are a vital piece of our emerging market debt team’s investment process and provide a unique perspective on the country’s fundamentals, political environment, leading economic indicators and business sentiment. Particularly effective in times of political transition, these research trips can provide a heightened level of analysis and understanding of the country’s markets and are very effective in shaping our investment views.
Adding to the rising tensions, the changes to the Hungarian constitution were announced shortly after the replacement of Hungary’s central bank governor, Andras Simor, as his six-year term expired. Simor was viewed as having the integrity to make decisions that were best for the country’s economy and was not easily swayed by the prime minister’s wishes. As broadly expected, economy minister György Matolcsy was appointed to step into the role. This unsettling change sees a widely respected and credible governor replaced by one of the prime minister’s associates, in what is considered to be another move by the prime minister to firmly establish his power across major institutions in Hungary. Just two weeks into his term, there have already been significant and aggressive changes within the central bank that show that Matolcsy is not shy to show his hand.
With elections slated for early 2014, the Hungarian prime minister Viktor Orban’s focus is on re-election. He wants growth. Therefore, fears of unorthodox monetary policy on the horizon, with no possibility of protection from the ‘Simor Backstop’, have led to weakness in the Hungarian forint (although overall risk premium has so far remained low). This is a country that still carries considerable exposure to foreign currency debt and, as such, is vulnerable to a depreciating currency. Policies to absorb the cost of the currency loans are likely and could encourage the leadership to maintain favourable exchange rates in the near term. However, the details of such policies are not yet clear.
The first Monetary Policy Council meeting with Matolcsy at the helm is scheduled for 26 March 2013. The recent weakening of the forint has sent a warning message, highlighting that it will be hard for the central bank to embark on an aggressive cutting path without exacerbating a rapid currency selloff. Furthermore, a volatile and uncertain environment is undesirable in a pre-election year and thus the market expects a continuation of the steady 25 basis point easing cycle rather than anything more drastic at this stage.
In previous episodes of rapid currency depreciation, the central bank had to implement emergency rate hike measures to defend the currency, thus pushing rates and bond yields higher. With new bank leadership in place, this reaction is now less likely. However, other measures, including intervention using currency reserves, are possible. Any such developments are likely to push investors to re-price Hungarian credit risk, which would then weigh on the fixed income markets.
The currency move is still contained and Hungary maintains good access to financing, meaning this is not a credit risk event. However, all of these developments, unless managed rationally, pose risks for the bond market. We will continue to keep a close eye on this situation.