Hot spots: Hungary.(economy)

Worried about the danger that a falling forint and rising taxes will push inflation far above what the monetary authorities deem acceptable, the Central Bank has yanked up its key lending rate. This does not reduce the country's vulnerability to wider troubles, however, which have to do with its huge twin deficits and its substantial exposure to exchange rate risk.

Most observers had expected the Central Bank to raise interest rates in late-July, after the institution had repeatedly voiced concern that the persisting softness of the forint in the exchange market, coupled with the corporate tax hikes and the VAT increase which the government had imposed in an effort to get the fiscal and current-account BoP deficits under control, would drive up inflation. Monetary erosion in June was just 2.8 percent year-on-year and, thus, below the 3.0 percent target set by the government, but the CB thinks it will be as high as 7 percent by the end of this year.

While some interest rate hike was widely anticipated, the consensus view was that it would be by 25 basis points, like one the Bank had announced in June. Instead, the July increase was by 50 basis points. It raised the Central Bank's key lending rate to 6.75 percent. As a result, it is now virtually certain that economic growth, which was on the order of 4.5 percent last year, will slow sharply in the months ahead. The country will do well to register a real GDP gain of 3.0 percent in the current year and around 2 percent in 2007. For the moment, it appears that the Bank's aggressive action has been effective in shoring-up the forint's exchange rate. Unfortunately, it does not address the main problem facing the country.

Hungary is not alone as an emerging market running very large current-account balance-of-payments and budget deficits. This is true also for countries such as Turkey, Serbia, Bulgaria, Croatia, and all three of the Baltic states, Estonia, Latvia and Lithuania. Where the big red-ink are have been the result of credit booms, which led to asset bubbles (for instance, in housing).

According to the International Monetary Fund, Hungarians have been borrowing increasingly in foreign currencies to benefit from relatively low interest rates abroad. Borrowing in foreign currencies increased from about 10 percent of total household loans at the end of 2002 to 25 percent in 2004. In 2005, almost all the new lending in the banking system was foreign-currency denominated. The depreciation of the forint during June against both the EUR and the CHF, however, more than ate up the interest rate advantage, and there continues to be a distinct risk that, if the HUF fails much further, many private Hungarian borrowers and banks could get into serious trouble.

This is something that not only financial institutions but also exporters shipping to Hungary on credit should keep an eye on. Carry trades going sour were among the principal causes behind the Asian financial crisis, and they've played a growing role in Hungary. The fiscal austerity plan introduced by the Socialist-led ...