The Hungarian central bank has been the target of fierce media attention. The Wall Street Journal, Reuters, The Economist, and lately Bloomberg, have suggested that the central bank “funnels one billion dollars to friends and family”. While vigilance is good, allegations seem to be quite distorted and biased.
Before we get to the actual topic of the article, it is worth to briefly go through the modern monetary history of the country.
I. Pre-2010 era: The financial system works against the country
Hungary had been a big loser in monetary affairs throughout the last few decades. Although the country gained independence in 1989, no political forces before 2010 had the combination of loyalty, intellectual capabilities, and political strength to stop the financial system from directing huge funds away from the country.
Interest groups (including foreign creditors, local banks, and other countries issuing reserve assets) with the assistance of local mainstream economists, politicians, and mainstream media outlets were in the position to set the rules of the game. The rules, until recently, had been favorable for interest groups, and, as a side effect, unfavorable for the country. Huge funds had been funneled away through different channels:
1. High public debt service cost
2. Shortage of liquidity for local economy, inflation
3. Power abuse of banks
4. Giving up sovereign money creation, over-reserving
Let’s go through these points one by one.
1.) High public debt service cost
Hungary had spent to the extent of 8% of GDP in the 90s, and 5% of GDP in 2000s on public debt service costs. Mainstream economists suggest that this public debt is the result of “chronic overspending”. True, the country had been running a deficit, but this deficit was not the result of negative primary balances, but rather of interest payments. More importantly, the majority, about 75% of the debt stock, was born as result of “mistaken” decisions in the area of finance and the occurring interests of those losses. Those “mistakes” included:
Bad currency denomination of public debt
The country’s foreign debt exploded from USD 2 billion to over USD 20 billion from 1973 to 1989. The key driver of the increase was the worst possible choice of the denomination of debt. The Swiss franc was the main denomination in 1973, which appreciated 250% against the dollar in few years’ time. The dollar became the new choice in 1980, just when it bounced back by 40%. The Yen was favored in 1985, but doubled its value within two years.
Bad third party loans
The socialist central bank (in charge of debt management) was not only an incredibly unlucky forex trader, but also a bad banker. It lost USD 3 billion with bad lending practices to exotic countries and banks.
A poor regulatory environment and high corruption resulted in “bad lending” practices and ensuing huge losses in the banking system in the 90’s. The country spent over 10% of GDP on recapitalizing commercial banks.
2.) Shortage of liquidity for local economy, inflation
Liquidity had been scarce for the local economy and plenty for reserve asset issuers and banks in the last several decades.
During socialism, the central bank created money for the government whenever the party asked to do so. At the same time, prices were fixed. As too much money was printed, too much money was chasing a finite amount of goods, hence shortages prevailed. The ending of this fix price regime caused exploding prices as the market sought a new equilibrium.
The central bank, instead of letting the market do its job, fought against inflation by draining money out of the local economy. The central bank raised interest rates to the level of 25% and sold its forint denominated assets, causing a dry-up of liquidity in the local economy. Thousands of local business went bankrupt, and the unemployment rate surged from 2% to 12% within a few years. (Clearly, the economy needed reform, but such a liquidity shock also killed companies that could have potentially adapted to new circumstances.)
At the same time, the central bank created fresh money against dollar “reserves”, effectively giving the new base money to the foreign banking system, which then presented itself as a new “capital investor” in the country. Privatization took place in time, when money was extremely tight for the local economy and available for dollar holders.
The new price level was more or less reached by around 2001 when the central bank introduced an inflation-targeting regime and wished to continue to fight against inflation through high interest rates. Higher rates, in theory, cause tighter money supply and thus a decrease in prices. However, this mechanism only works if the debt that backs the money is private and in the local currency denomination. None of those caveats existed.
Most of the Hungarian money supply was backed by public debt. Although yields on public debt followed the central bank rate, a higher rate did not cause tightening, as politicians disregarded yields in budget planning and overspent anyway. All that the high yield caused was higher rates on the public bonds, thus increasing money supply and leading to higher inflation. Not only did the government disregard the central bank’s supposedly anti-inflationary policy, but households and businesses circumvented the central bank by moving towards Swiss franc denomination financing.
The result of this mistaken monetary policy was liquidity being funneled away from local actors to foreign creditors. Public debt grew quickly, the local private sector suffered a lack of a reasonable level of funding in the local denomination, and thus moved towards Swiss franc denomination funding. Nevertheless, the inflation target was never reached.
3.) Power abuse of banks
Consumer protection in banking had been quite poor. No supervisory authority halted banks from luring households into the Swiss franc denominated debt. Banks were in the position to change contract conditions unilaterally. For example, banks increased interest payment terms with the excuse that their own risk increased. Banks were also able to apply hidden fees. For example, when disbursing foreign currency denomination loans, up to 4% wide bid-ask ratios were used for conversion. Clearly, consumers were too naive and ill-equipped with necessary legal and financial skills, but it’s fair to say that banks had misused their power, and consumers were losing in multiple ways.
4.) Giving away sovereign money creation, over-reserving
As introduced earlier, money was printed by the central bank for the government during socialism. Clearly, that is a wealth transfer from money holders to the government. It is also clear, that if the money creation level is higher than the growth of the economy, then money printing causes a price increase in the long run.
Nevertheless, it is still more sensible for a country to print money for itself than print money to other states, the US, or Eurozone countries. The country gave up its money creation power by 1996 following IMF advice and started to print central bank money against dollar reserves. The Euro became the new reserve of choice after the country joined the EU in 2004. Until recently, holdings of reserve assets, and thus money printing for reserve asset issuer countries, were on the rising trend.
II. Media coverage of the pre-2010 era
As introduced, there had been a very rich variety of abuses, or anomalies, to be politically correct, in the modern monetary history of the country, where dollar billions were funneled out of the country. Interesting topics could have been investigated, such as:
- Why did the socialist central bank take such unfortunate forex bets? What institutions were on the winning side of those trades? Why did János Fekete (head of the central bank, the “forex guru”) have offshore accounts in the Bahamas? Why did the IMF protect him?
- What role did George Soros play in the Hungarian bond market at the time of the regime change? How did Soros, whose foundations were allowed to operate as early as 1985, potentially influence local mainstream economists and decision makers? Why did local mainstream economists lobby against debt relief, while Poland negotiated a 40% cut?
- Why and how were gold reserves accumulating about 60 tons sold?
- How did half of the total assets of the second largest commercial bank (Posta Bank) evaporate in the mid-90s?
- Why did the central bank hold rates high when the intended goal was never reached and while it had a devastating effect on public and private finances?
Unfortunately for global readers interested in Hungarian financial affairs, these stories barely caught the mainstream media’s attention. Instead, some of the figures involved in the introduced events were hailed as heroes. János Fekete, for example, was called “a master at using western financial methods” by Time Magazine. Soros was portrayed by Western media as a “philanthropist” to Hungary. György Surányi and Lajos Boros, two emblematic names of the restructuring, austerity, and privatization process, were celebrated as the “dream team”.
III. Post-2010 era: rules of the game start to be reset
New leadership took office in 2010 and overtook control of the central bank in 2012. Its room for maneuvering was initially very tight, as the country was on a brink of a financial disaster.
Local demand was collapsing, 30’s style deflationary collapse was in full front. Neither classic monetary nor fiscal easing appeared to be possible due to a high percentage of foreign currency denominated private and public debt. Monetary or fiscal easing risked the ignition of self-reinforcing cycles. The weaker forint had caused higher monthly installments, less disposable income, decreased local demand, more unemployment and bankruptcies, higher NPL ratios, higher bank and country risk, which then again had caused an even weaker forint, etc. feeding the cycle.
In a series of remarkable moves (and supportive internal and external factors such as the private sector showing huge flexibility to adjustment and easy Eurozone monetary policy), finances were stabilized.
Step 1: The budget was balanced. Classic spending cuts and tax increases caused a further collapse of local demand. Instead, the tax increases were placed largely on those monopolies (utilities, telecom companies, banks), which did not change their business behaviors despite higher taxes. Clearly, those corporations weren’t particularly happy about higher taxes and strongly lobbied against the government internally and externally.
However, from a macroeconomic perspective, the measures reached their intended goal. Revenue was found for the budget, while, in most cases, all that the higher tax caused was less profit repatriation. Also note, that corporations were typically the very same that had been sold at undervalued prices during privatization, and which were powerful enough to avoid paying taxes, and, in the case of utilities, to constantly raise prices to levels which became curiously high in international comparison. On the other hand, taxes on companies in competitive areas, such as car manufacturing, fabrication, business support services, and small and mid-size businesses, were typically reduced.
Step 2. Once the budget was balanced and the risk of immediate collapse was reduced, leadership started to convert foreign denominations into forint loans step-by-step. One of the most emblematic moves was saving households from the Swiss franc bloodbath. In November 2014, just two months away from SNB leaving the peg, the Hungarian central bank forced local banks to convert households’ mortgage debt into forint denomination, and, at the same time, provided commercial banks with the necessary foreign currency for the conversion from its reserves. Good timing saved about 350 billion forints (USD 1.3 billion), about 1.1% of GDP for the households.
The government started to move away from foreign currency denomination debt as well. The forint started to dominate new public bond issuances. The share of foreign currency denomination in total public debt stock decreased from 50% to 30%.
Step 3: Paralleling the foreign debt being converted into forint denomination, the central bank could start to decrease interest rates at a gradual pace. The central bank cut the rate from 7% to 0.9%. Bond yields followed suit, the 10-year sovereign yield decreased from 10% to a 3% level.
Rate cuts resulted in large savings through two channels:
- Public debt: The country is on course to save over 1,000 billion forint (USD 3.6 billion) 3% of GDP per annum, once the entire stock of 25,000 (USD 90 billion), around 77% of GDP, is repriced. Total of 1,000 billion forint (USD 3.6 billion), 3% of GDP has already been saved in the past few years.
- Unneeded central bank money (“sterilized amount”): The central bank saves 250 billion forints (USD 0.9 billion) 0.8% of GDP per annum. 4,000 billion forints (USD 14 billion), 12% of GDP worth of unneeded central bank money was created by the former central bank management against the same amount of forex reserves. The central bank paid a base rate, i.e. 7% on the “sterilized volume”, while earning 1% on the reserves. Thus, the central bank lost 6% of the rate-difference, about 250 billion forints (USD 0.9 billion), or 0.9% of GDP every year.
A total of 2000 billion forints (USD 7 billion), 6% of GDP is projected to be saved by the end of 2016 and the country is on course to save further over 1000 billion forints (USD 3.6 billion), 3% of GDP per annum once the entire stock is repriced. (Yes, the rate hike, just like everywhere else, will be difficult. However the forint at this level seems to be well supported by a huge current account surplus, still positive carry, relatively low private debt to GDP ratios, and relative asset undervaluation compared to regional peers.)
Although country is building down its debt at a quick pace, it has still been a net debtor. The rate cut thus not only caused a change in the flow of funds within internal savers and debtors, but largely decreased the flow of funds from the budget and the central bank to foreign creditors.
The central bank has also started to reduce its foreign reserves, and thus withdraw unneeded central bank money through buying forints in exchange for euros from its reserves step-by-step. As foreign denominated debt ratio has been decreased and on course to be decreased further, lower reserve stock doesn’t seem to increase vulnerability in a meaningful way.
Commercial banks that unilaterally changed interest terms and used wide bid-ask ratios during Swiss franc loan conversions were forced to pay back those losses to customers with interests. About 1,000 billion forints (USD 3.6 billion), 3% of GDP was paid back to households.
Hungary took some additional actions to strengthen its financial stability and to increase diversification. Measures included:
- Bilateral swap agreement with China,
- Issuance of yuan denominated debt,
- Loan negotiation with Russia,
- Purchase of local interbank clearing system operator, GIRO,
- Purchase of facility (“luxury rale estate”) of potential host to gold reserves.
To sum up the results of the measures so far:
- Rate cut is to result in 2,000 billion forints (USD 7 billion), 6% GDP savings by the end of 2016, and the country is on course of saving over 1,000 billion forints (USD 3.6 billion), 3% GDP per annum.
- The central bank saved households from further increase of debt by 350 billion forints (USD 1.3 billion), 1.1% GDP, through good timing of the Swiss franc loan conversion.
- The central bank has diversified and reduced the vulnerability of the financial system.
Other achievements of the country since 2010 (as result of a combination of the above measures and favorable external and internal forces and hard work) include:
- Public debt decreased from 82% to 77% of GDP;
- Budget balance improved from 4.5% to 1.9% of GDP deficit;
- Current account balance increased from 0.3% into 5% of GDP surplus;
- Trade balance increased from 4% to 9% of GDP surplus;
- Households built down 35% of former debt stocks;
- Businesses built down 40% of former debt stocks;
- Unemployment rate decreased from 11% to 6%;
- Inflation decreased from 4% to close to zero;
- Net external debt decreased from 60% to 30% of GDP.
To sum up the process: the country became a huge net exporter and saver. Households and businesses used savings to deleverage over a third of their former loans and to buy back public debt from foreign creditors. Healthier macro flows and improving balances supported rate cuts, and lower rates improved flows and thus balances further.
It’s not all rosy. Great challenges lie ahead of the country. But things had been stabilized, financial flows are positive, and balances are improving quickly.
IV. Post-2010 era media coverage (incl. “Hungarian central bank funneling one billion dollar to friends and family”)
Just again, unfortunately for global readers interested in Hungarian financial affairs, few of the recent achievements caught any mainstream media attention.
Instead, local and international mainstream media have been loud recently about the “Hungarian central bank funneling one billion dollars to friends and family”. The Wall Street Journal, Reuters, The Economist, and Bloomberg were eager to report on the topic. Let’s start with some fact checks.
The Hungarian central bank set aside 266 billion forints (USD 1 billion), 0.8% of GDP from its reserves/profit and put these funds to different foundations in 2014. These foundations can be interpreted as sovereign wealth funds. The foundations were designed to invest their assets in safe holdings and to spend their proceeds on economics and finance education-related purposes.
Based on the 2016 release, foundations, following two years of “funneling funds to friends and family”, hold 267 billion forints worth of assets, i.e. slightly more than initially. Assets include mostly Hungarian government bonds (74%), bank deposits, real estate, and shares. (Real estate and share valuations could be a fluid issue, but these valuations were not topic of criticism, thus, I suggest, these are at fair valuations).
The amount that is spent and thus under scrutiny, is part of the proceeds of the foundations, about 5 billion forints (USD 18 million) in two years. This sum was not stolen, it was spent in line with the stated ambition of the foundations, for example on high-schools, the education of central bank staff, scholarships, media appearances, etc.
Let’s spot some of the key criticized areas:
“The central bank through its foundation participates in monetary financing, which is strictly prohibited under EU treaties.”
Yes, obviously this is indeed monetary financing. The central bank, instead of keeping its reserves in French, Italian, Portugal etc. bonds, places capital in its foundations (sovereign wealth funds), and those foundations buy Hungarian bonds. Thus the central bank indirectly holds 0.6% of GDP’s worth of local government bonds instead of holding Eurozone bonds. If, however, any EU official is worried about the prohibition of monetary financing, then maybe it is first worth to take a look at ECB and its member banks’ balance sheets, or investigate the setup of ESM, EFSF, EFSM, before it criticizes the MNB.
“The Central bank weakened the forint in order to profit and this profit is the loss of the people whose Swiss franc denominated debt was converted into forint denomination.”
Households typically took Swiss franc denominated loans at a 140-160 CHFHUF level in the mid-2000s. In November 2014 when the central bank converted their franc denomination loan into forint, the market price was 256. 256 is better than today’s price of 285, but clearly that is still a loss of 65% compared to the initial level.
Stating that households lost because of the recent central bank leadership is politically quite an effective lie. Everybody understands that monthly installments have increased and been fixed at a high level. But not everybody understands that most of the CHFHUF rate move had little to do with the current central bank leadership’s actions.
First of all, part of the CHFHUF move was a result of the appreciation of the franc against the euro from 1.60 in 2008 to 1.10 now. Clearly the MNB has little, if any, impact on the EURCHF cross.
Although the EURHUF exchange rate is relatively weak, currently trading around 315, a similar level was reached in 2009 or 2011. When comparing the forint to its regional peers, no extraordinary underperformance is to be noticed. Zloty for instance has been trading in the 62 to 75 range in the last 10 years, now it is at 71. The Romanian lei has been trading in the 60 to 80 range in the last 10 years, now it is at 70.
“The Central bank organized luxury receptions for themselves for unnecessary presentations.”
The central bank organized a series of educational events for its staff, where they invited internationally regarded economists such as John Gerzema or Arjun Appadurai. Following the presentations, a reception was held, and foods and beverages were served. In about 10 events, a total of 200 million forints (USD 0.7 million) was spent, where costs included presentation fees, travel and accommodation costs of the presenters, hiring the hall, foods, and beverages.
One could argue that it’s a waste of resources to organize such events, or different presenters should have been invited. Nevertheless, the discussion is irrelevant as the sum under scrutiny is meaningless in the grand scheme of things.
“The Central bank bought 200,000 bullets and 112 handguns.”
The central bank owns several buildings such as its head buildings that include some strategically important objects to its function – a workplace for their staff, hosts to key financial infrastructures, printing-press, mint, gold safe, etc. Clearly these facilities need some protection. Suppose the amount of bullets cover exercise purposes as well, the amounts don’t seem to be extraordinarily large. Let’s say bullets cost 1 dollar each and guns 2,000 dollars each. A total of half a million dollars was spent. Again one could argue that instead of 112 pieces of handguns, 52 or even 32 pieces would have been enough. Possibly. But again, the discussion is totally irrelevant.
“Why does the central bank promote its own ideas at all?"
It’s safe to say that there is a divergence of ideas between local mainstream economists and the central bank’s leadership on what economic principles are good for the country. The central bank wishes to hear its voice and hence wishes to invest in new faculties and media appearances. It’s up to readers to judge whether the central bank’s use of controlled funds for its own ambition is justifiable and acceptable or not.
About 18 million dollars are under scrutiny. Part of that sum could have been spent differently or better. The level of vigilance of the mainstream media is noteworthy. What, however, many wonder is why similar levels of vigilance were not projected when billions of dollars had actually been funneled away from country. Also many don’t understand why the mainstream media is so shy reporting on the country’s recent achievements.
Some believe that the answer is somehow related to the fact that many of the introduced actions constitute zero sum games. What is a win for the country is a loss (reduction of profit) for other actors involved.
- Foreign creditors need to familiarize themselves with lower interest payment incomes.
- Local banks need to adapt to lower rates and a stricter regulatory environment, and thus envision lower profitability.
- Reserve asset issuer countries, i.e. Eurozone countries, need to accept less demand for their bonds. (Not as if Hungary was a big player in the Eurozone bond markets, but reserve asset issuers are presumably unhappy to see reserve asset holders waning away.)
- Some local mainstream economists need to expect less demand for their advice.