Special Report – July 29, 2010

Hungary: Breakdown of negotiations with IMF

Is 3-4% deficit low enough for Hungary?

Hungary much closer to bringing deficit below 3%

than majority of EU countries

Short-term refinancing not that concerning,

2011-12 could be more challenging

Sustainable debt path can be assured even

with slightly higher than 3% deficit in 2011

More measures on expenditure side needed

to keep deficit sufficiently low and
its financing less vulnerable

Erste Group – Special Report July 2010 Page 1

Special Report – Hungary: Breakdown of negotiations with IMF

Analysts: Zoltan Arokszallasi, Erste Bank Hungary

zoltan.arokszallasi@erstebank.hu
Juraj Kotian, Erste Group Bank
juraj.kotian@erstegroup.com

Introduction:

During the last weekend, negotiation between the IMF and EU delegations and the
new government broke down. Thus, the remaining amount of the financing funds is
not available to be drawn down. Later in the week, the government signaled that it will
not be seeking to make a further, precautionary deal with the IMF. However, this was
announced by cabinet officials earlier.

Since September 2009, Hungary has not drawn down funds from the IMF package,
but without the Fund’s support, financing of the government from markets is expected
to be more expensive and difficult, especially in times of heavy sell-offs of government
bonds held by non-residents (like in 2008). The forint and government bonds
plummeted last week on the news, while demand for T-bills at last week’s auctions
was muted.

What could have been the rationale behind the government’s decision? To answer
that, we need to realize that Hungarian economic fundamentals have changed
(improved) since autumn 2008, when the emergency stand-by agreement was signed
in order to keep the country afloat.

Erste Group – Special Report July 2010 Page 2

Special Report – Hungary: Breakdown of negotiations with IMF

What has changed since 2008?

Much more consolidated fiscal situation: Already since 2006, Hungary has been
delivering a reasonable amount of budget consolidation. The headline budget shortfall
figure was decreased from above 9% in 2006 to 4% in 2009 – taking into account the
serious recession of Hungary in the crisis, this performance is even more remarkable
(the cyclically-adjusted net lending position [w/o interest payments] of the government
improved from -7.0% in 2006 to +2.5% in 2009). With these consolidation efforts,
Hungary managed to become the best performer in terms of structural deficit in the
EU.

Cyclically-adjusted net lending w/o interest*, % of GDP (2006 & 2010e)

6
4
2
0
-2
-4
-6
-8 -7.0
-10

Denmark
Romania

Portugal

Germany

Belgium
Czech

Slovakia
United

Poland

Greece
France
Estonia

Luxembourg

Malta

Ireland

Finland
Hungary

Italy

Cyprus

Netherlands
Latvia

Lithuania

Slovenia

Bulgaria
Spain
Austria

Sweden
2006

4 2.4
2
0
-2
-4
-6
-8 -7.6
-10
Denmark
Romania

Germany
Portugal
United
Ireland

France
Slovakia
Poland

Czech
Greece

Luxembourg

Malta

Finland
Belgium
Estonia
Cyprus

Italy
Netherlands

Hungary
Spain

Lithuania

Latvia

Slovenia

Bulgaria
Austria

Sweden

2010
Source: AMECO

Even if Hungary does not bring its deficit below 3% by 2011, it is much closer to
bringing its deficit below the 3% ceiling no later than 2013, which was set as the
deadline for the correction of excessive deficits for a majority of EU countries in which
the consolidation has just started.

Erste Group – Special Report July 2010 Page 3

Special Report – Hungary: Breakdown of negotiations with IMF

Fiscal deficit in 2009 and revised consolidation path (according to Excessive

Deficit Procedure), % of GDP
16

14
2009
12 2010
2010
2011
10 2011 2012
2010 one of the lowest deficit 2013
in 2010 and 2011 2014
8 2010
2011
2010
2012 2010
2012 2010
6 2011 2011
2010 2010 2010
2013 2013 2010 2011 2010 2011
2011
2012 2012 2012 2010 2011
2012
2011 2012
4 2011 2011 2010 2011
2012 2012
2014 2013 2013 2013 2012 2012 2013 2013
2014 2012 2013
2

Slovakia
Ireland

Italy
Greece

Spain

France

Poland

Czech Rep

Austria
Portugal

Belgium

Netherlands

Hungary

Germany
Source: Stability Programs of countries

Balanced Current Account: The Current Account Balance shows a spectacular

improvement since the outbreak of the crisis. Mainly on the back of the plummeting
internal demand, the fall of imports outpaced the decrease of exports in 2009.
Moreover, since the start of the recovery, the export figures have shown considerable
increases, and it was only in May 2010 when import dynamics outpaced those of
exports. This translates into substantial amounts of trade surpluses, which is not
completely counterbalanced by the outflow of incomes from Hungary. Taking into
account the funds from the EU, the net financing position of Hungary has become
positive, a huge contrast compared to the pre-crisis period. This means that the FX
level does not cause any imbalances and the real exchange rate has not been
significantly overvalued/undervalued.

Current Account Balance (% of GDP)

0.2
0
-0.2
-1.0
-2

-4

-6 -6.5
-7.2 -7.1
-7.2

-8
2005 2006 2007 2008 2009 2010e 2011e

Source: Erste Group Research

Higher FX reserves: CB FX reserves have increased significantly since the outbreak

of the crisis and start of the IMF stand-by agreement. A considerable part of the
amount already drawn down from the international lenders was transferred into the
CB’s reserves. The amount has roughly doubled since autumn 2008 and now exceeds
Erste Group – Special Report July 2010 Page 4
Special Report – Hungary: Breakdown of negotiations with IMF

six times the amount of imports per month (before the crisis, it was below three times
the amount of imports per month). The amount of reserves now also considerably
exceeds short-term external rollover needs (so the so-called Guidotti-Greenspan rule
is also not violated). The maturing external debt of the Hungarian economy in the
remainder of 2010 and FY11 amounts to about EUR 20.8bn.

FX reserves of the central bank (EUR mn)

40,000 USD bonds
EUR bonds issued
issued
35,000
2nd
30,000 drawdown

Drawdown of 1st
25,000 tranche of
international loan FX reserves
20,000 doubled

15,000

10,000

5,000

0
Jan-06 Nov-06 Sep-07 Jul-08 May-09 Mar-10

Source Central bank of Hungary

Refinancing needs and government debt sustainability

In order to analyze whether Hungary can go without the IMF loan, we need to
scrutinize the external debt redemption profile and the refinancing needs of the
government (both short- and long-term) and check the sustainability of the debt path.

External debt redemption profile: Within the maturing external debt, we have to
distinguish between the debt that can be attributed to the private sector and that of the
public sector. The total maturities in 2010-11 are as follows:

External debt redemption profile (EUR mn)

10,000

8,000

6,000

4,000

2,000

0
Q2 Q3 Q4 Q1 Q2 Q3 Q4
2010 2010 2010 2011 2011 2011 2011
Central Bank Gen. govt. - other than HUF bonds
Gen. govt. - HUF bonds Banks (other than CB)
Rest of economy

Erste Group – Special Report July 2010 Page 5

Special Report – Hungary: Breakdown of negotiations with IMF

Redemption profile of LCY bonds held by foreigners (EUR mn)

10,000

8,000
Remaining

6,000 4097 2014

2013
4,000
939
2012
947
2,000
959 2011
473
546
0 2010
Gen. govt. - HUF bonds

Source: Central bank of Hungary (2010 reflects only 2H)

From the above charts, one can see that LCY bonds held by non-residents amount to
EUR 1.7bn in 2010-11. The total amount of LCY bonds held by non-residents sums up
to EUR 7.8bn (7.9% of GDP). The roll-over of maturing government debt held by non-
residents is not as big a risk factor as sudden sell-offs. During the massive sell-off at
the end of 2008, foreigners shunned around HUF 1000bn (EUR 3.5bn at current FX
rates) worth of bonds (the highest volume before the November 2008 panic was
around EUR 12bn, 12.2% of GDP). Given the current environment and improved
fundamentals of the Hungarian economy, we do not see reasons for a sell-off of such
a magnitude, even in the case of severe market deterioration. However, this remains
the main threat to the Hungarian bond market, although the central bank and
government have strengthened their positions to counteract this effect.

Foreign investors’ holdings of LCY government bonds (HUF bn)

4.8 3,500

4.6
3,000

4.4

2,500

4.2

2,000
4.0

3.8 1,500
Sep-08 Mar-09 Aug-09 Feb-10 Jul-10

Volume Average remaining maturity (left scale, yrs)

Source: Hungarian Government Debt Management Agency

Local demand for government papers: Currently, banks have huge liquidity
reserves held in the central bank on top of their positions in Hungarian government
bonds and T-bills. In May 2010, liquid assets of financial institutions accounted for
23% of their balance sheet total (11% of government bonds and T-bills, 12% in CB
deposits and 2W bonds – respective percentages are 14% and 16% of expected 2010
GDP). This means that domestic banks should be able to finance government debt
from their liquidity surplus, if yields and maturities are attractive to them. In the case of
Erste Group – Special Report July 2010 Page 6
Special Report – Hungary: Breakdown of negotiations with IMF

a massive sell-off, the liquidity held in 2W CB bonds at banks can provide a good
cushion against yield increases, as banks may be more willing to buy government
bonds sold by foreigners from this amount, as lending to the real economy still poses
risks in the current economic environment.

Short-term and long-term refinancing needs: In 2010, the Hungarian government

seems to be able to pay for maturing debt. This year, Eurobonds worth EUR 1.1bn will
mature in October. Regarding HUF-denominated debt, EUR 2.3bn worth of bonds is
also maturing this year. In January, the Debt Management Agency issued USD 2bn in
debt, while in the meantime the government has EUR 3.7bn in funds at the CB in FX.
Thus, short-term refinancing does not seem to be threatened, at least in short-term
accounts for 2010.

As for 2011-12, refinancing could be much more challenging. In these two years,
EUR 9.2bn in HUF debt and EUR 9.1bn in EUR debt will mature and needs to be dealt
with. However, one needs to take into account the increased amount of CB reserves,
although it is doubtful that the authorities would start to use these funds, or if this is
even legally acceptable.

Redemption profile of government debt (EUR mn, at current exchange rate)

15

12

0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Rest

HUF Bonds HUF T-bills HUF Loans FX Bonds FX Loans

Source: Hungarian Government Debt Management Agency (2010 reflects only 2H)

Maintaining sustainable debt path: Due to the breakdown of negotiations between

the government and the IMF, and the intention of the cabinet not to meet the below
3% deficit target for next year, questions emerged from the market on whether the
sustainability of the debt course has been damaged by this step. Assuming nominal
GDP growth of 4.5-5.0% for 2011 and 6.0-6.5% for the following years (3.0-3.5% real
growth and 3% deflator), the debt path can be sustainable if some small amounts of
primary surpluses are maintained. This means that the deficit can be up to 3.5-3.8% in
2011 to have roughly the same debt-to-GDP levels in 2011 as in 2010. Primary
surpluses grant decreasing debt-to-GDP ratios under this scenario, if the interest
payments of the government do not go over by too much. However, risks have
increased that interest rates will eventually grow, due to the lack of assurance
conferred by IMF loans in the background, thus increasing refinancing risks (mainly
looking at 2011-12).

Erste Group – Special Report July 2010 Page 7

Special Report – Hungary: Breakdown of negotiations with IMF

Problems with plans of new government, alternative methods of consolidating budget

We see the main concern not in the current level of the deficit, but in the measures
that have been adopted. Naturally, the measures introduced by the new government
are not very investor-friendly, while the banking tax (as a temporary levy) will surely
not decrease the need for long-term structural reforms; it will only delay their
implementation for some time. At the same time, it has an adverse effect on economic
growth and the business environment. However, after 2011-12, the lack of sustainable
measures will surely resurface and structural reforms need to be implemented in order
to maintain a balanced deficit and healthy, sustainable growth for Hungary. Given the
already stretched situation on the revenue side (Hungary has one of the highest
taxation levels in the region, with VAT already at 25%), it is obvious that Hungary still
has to do more homework on the expenditure side.

Government spending structure, % of GDP, YE09

60% 56% 52% 52% 51% 50% 50%

48%
50% 46% 46%
45%
42% 41% 40%
40%
11.3%
30% 9.0%
10.3% 10.8% 9.3% 6.54%
10.0% 12.3% 14.0% 8.2%
13.2% 6.7% 12.1% 7.0%
20% 13.7% 10.44%
11.3% 9.8% 11.2% 11.8%
7.4% 8.1% 10.2% 10.6%
12.4% 7.8%
10%
15.9% 12.6%
11.6% 13.2% 12.0% 11.6% 12.4% 10.5% 10.7% 14.64% 9.3% 9.9%
7.4%
0%

Slovakia
Italy
France

Austria

Greece

Spain

Poland

United

Romania
Portugal

Hungary

Germany

Republic

States
Czech

Social benefits Wages Other consumption

Investments Interest Expenditures Other expenditures
Source: AMECO, Erste Group Research

Looking at the chart, one can see that Hungary spends considerably larger amounts
on social benefits and wages than its regional peers. Hungary’s 12% social spending
is 1.9% points greater than the regional peer average (average of Czech, Slovak,
Romanian and Polish figures), while wages also stand 2.0% points higher than the
regional average (percentages of GDP). The higher amount paid for social necessities
may be justified by the high number of old age pensioners and disabled working age
populace, but it seems obvious that, in the long run, even less consolidation in social
spending than the potential (described above) could bring the budget onto a long-term
sustainable path. Even more important is to buy the confidence of the markets through
reasonable policy measures, which would trigger a reduction of interest expenditures.
This could bring potential for savings in expenditures of more than 1pp of GDP. This
could even be sufficient to deliver tax cuts that could stimulate the economy in the
longer run, increasing the potential growth of the country.

Erste Group – Special Report July 2010 Page 8

Special Report – Hungary: Breakdown of negotiations with IMF

Concluding remarks:

After the breakdown of negotiations with the IMF, it became a significant concern on
the market that Hungary might not be able to go it alone without the help of the IMF to
roll over debt, while the sustainability of the debt course cannot be maintained if the
deficit is not decreased to below 3% next year. The other concern was that
consolidating the budget with temporary levies (like the banking tax) should not be
preferred to structural reforms, while the financial sector tax also has an adverse effect
on the Hungarian economy and could erode the reputation of Hungary as a country
with a stable/predictable business environment.

Based on the reasons described in this report, we can say that, regarding the first
concern, Hungary may indeed go without the IMF by itself, at least in the short run, to
finance debt. We can also say that some percentage points of excess deficit above
3% would not hurt the debt sustainability significantly. However, we must note that,
without the IMF agreement, the government has to deliver an even more strict fiscal
policy. Also, without the IMF funds serving as a safety net in the background, a
deterioration in global investor sentiment would be expected to more intensively affect
the risk assessment of Hungary. Regarding the other concern, we share the view that
the need for structural reforms may resurface soon, while the consolidation should be
based on social spending cuts instead of temporary levies that hamper investor
sentiment and harm the growth outlook for Hungary.

Assessment on market outlook:

Regarding the EUR/HUF rate, we believe that the forint may remain at the current
weaker levels until the end of September (perhaps even strengthening somewhat). By
the year-end, some appreciation should come. Regarding bond yields, we believe in a
similar trajectory. In the next few months, 10-year bonds may remain at similar levels
to those seen currently. However, by the year-end, some muted yield decreases might
come.

Exchange Rate vs EUR 10y Govt. Yield

HUF Fwd HU
Spot 284.3 Spot 7.22
Sep-10 280.0 287.93 Sep-10 7.30
Dec-10 270.0 290.25 Dec-10 7.10
Mar-11 265.0 292.38 Mar-11 6.70
Jun-11 262.0 294.43 Jun-11 6.30

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Erste Group – Special Report July 2010 Page 9

Special Report – Hungary: Breakdown of negotiations with IMF

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