Compared to its European neighbours, Hungary finds itself in dire financial straights. John Dawe explains
The mantle of the sick man of Europe has been passed around over the years, having first been applied to what is now Turkey way back in the 19th century. Since then, most of the major European economies, including Germany, France and the UK, have been referred to in this way at one time or another, but now the description seems to fall most aptly upon Hungary's shoulders, even if the sickness does appear to be largely self-induced.
The Hungarian economy is currently suffering from both a severe budgetary problem, with the government deficit at more than 9% of GDP in 2006, and a balance of payments current account deficit in excess of 6% of GDP. This has prompted a series of actions on the part of the government designed to bring the government deficit down to 3% of GDP by 2010, keeping open the possibility of joining the single European currency in 2012. Thus public spending has been cut and taxes have been raised. A number of much needed public sector reforms, not least to the healthcare system, are also underway. The immediate, and unfortunate, consequence of this is that economic activity has stalled. GDP grew by just 1% over the year to the third quarter of 2007 according to preliminary figures - an 11-year low. Consumer spending is actually falling.
At the same time, inflation has risen and now stands at 6.7%. Some part of this increase (inflation was below 3% early in 2006) can be attributed to rises in regulated prices, part of the government's programme to reduce the budget deficit. But the latest figures were higher than expected and other factors, including higher food prices, may now be at play. This in turn means that the Hungarian Central Bank may find it harder to justify further cuts in interest rates, with the base rate standing at 7.5% since September, and lower interest rates are sorely needed to spark the economy back into life.
Cause and effect
To perhaps make matters worse, this predicament is almost entirely of Hungary's own making. In the run-up to last year's general election, the political parties were falling over themselves to promise the electorate all manner of inducements to secure their votes. And the ruling Hungarian Socialist Party (MSZP), having promised most, and having control of public expenditure, was duly returned to power, in coalition with the Alliance of Free Democrats (SZDSZ). This is not a new phenomenon. Apparently, it is difficult for an incumbent government, unsure of re-election, to resist the temptation to target increased public spending and lower taxes on the electorate.
It is perhaps therefore no surprise that, at a time when politicians almost everywhere seem to be held in contempt, Hungary's politicians seem to be held in more contempt than most, and rightly so. A recording in which the prime minister, Ferenc Gyurcsny, admitted lying in the run-up to last year's election was made public and led to protests on the streets of Budapest. His popularity has in consequence slumped with the latest opinion polls, indicating that only around 15% of the electorate would now vote for his party.
A cyclical situation
Hungary has been in a very similar economic situation before, in the mid 1990s, requiring an austerity programme which is no doubt still relatively fresh in many people's minds. This programme, again designed to bring public finances under control and reduce the current account deficit, was accompanied by an aggressive privatisation programme, which saw many state-owned enterprises sold to foreign multi-nationals, as well as changes to the exchange rate regime to boost exports. Given its relative lack of natural resources, Hungary has always tended to rely upon foreign trade to a significant extent, and these measures have resulted in Hungary becoming a very open economy with much of its output geared towards exports. Its main market is the EU, and within this Germany takes the lion's share. It also helped promote a surge in foreign direct investment (FDI) which saw Hungary take over one third of all FDI coming into the region, with US investment to the fore. This in turn helped finance the current account deficit. Foreign capital is attracted to Hungary by its modern infrastructure, including telecommunications, its skilled and relatively cheap labour market and also tax incentives.
One consequence of the openness of Hungary's economy and the way in which state assets were sold in the aftermath of the economic troubles of the 1990s is the domestic stock market is very limited in its scope. Unlike the thriving Polish stock market, which benefits from significant popular participation with its roots in the privatisation programme of the 1990s as well as the requirement for pension funds to hold a significant portion of their assets in Polish equity, the Hungarian stock market appears to some to be in a state of terminal decay, surrounded by rumours it may eventually be subsumed into a regional exchange. Hungarians, be they individuals or institutions, have not caught the "equity bug"; pension fund participation is at very low levels with the overwhelming majority of their assets in fixed income investments. Daily turnover on the Budapest stock exchange is currently a paltry €120m .
Indeed, there are only four companies represented in the MSCI Hungary Index: OTP, HungaryÕs largest bank with significant operations across central and eastern Europe; MOL, the oil and gas company currently in the eye of OMV, its Austrian peer; Magyar Telekom, the telecommunications group, a subsidiary of Deutsche Telekom; and Gedeon Richter, the independent pharmaceuticals company with a strong regional footprint. Between them, these four companies dominate the local market, representing more than 90% of the entire market capitalisation of the Budapest stock exchange, which in any event is only capitalised at around €34bn. In addition, these companies are also listed and trade on other exchanges.
Any equity investor seeking direct exposure to just the Hungarian economy is therefore liable to be disappointed. Such an investor is, however, a dying breed. And this is not necessarily a reflection of the current state of the Hungarian economy, though this by itself would be sufficient to deter many people. Rather, given the increasing openness of the world economy in general and, in this case, the free movement of capital within the European Union in particular, the distinction of where a company has its headquarters, its listing, its operations or its sales has become increasingly blurred and irrelevant. Investors have instead adopted a regional or an industry basis for their decisions if they have a top-down bias, whilst bottom-up investors of course continue to focus on the merits of the company itself regardless of whatever national flag some people may wish to attach to it.
This is perhaps just as well as it would come as no surprise if the number of significant purely Hungarian companies were reduced even further over the years ahead. OTP Bank has gained many plaudits for the way in which it has expanded its operations into neighbouring countries. In so doing, it has reduced its dependency upon the Hungarian economy itself and bought into faster growth elsewhere; a policy which has seen its earnings, and share price, rise dramatically over recent years. Its management may have delivered the goods but, as significant shareholders in the firm, there is a suspicion that they are positioning the company for a takeover. This may be further good news for all shareholders but it would result in the removal of the largest company from the Budapest stock exchange. At the same time, the second largest company on the exchange, MOL, is already under hostile attack from OMV, the Austrian energy company, which wishes to create a central European champion big enough to challenge the mighty Russians. OMV is the largest single shareholder in MOL, but the Hungarian government has come to the defence of MOL and rushed through legislation which would make it much harder for foreigners to buy Hungarian companies. This legislation would appear to go against EU principles and indeed the EU has told the Hungarian government as much; the battle continues.
A silver lining?
In contrast to the stock market, the Hungarian bond market is in much better shape and perhaps offers more opportunities to investors. The available yields may be attractive, but to an extent future returns are reliant upon a belief in both the effectiveness of the government's current reform process and, more importantly, the prospect of the forint joining the euro in the not too distant future being a realistic one. Currency considerations also play their part of course; the forint may be showing a slight fall against the euro over the year to date, but there is little doubt that without the carrot of the European single currency, the forint would be trading at significantly lower levels still, given the current state of the economy.
But although the Hungarian economy may be sick, the prognosis is far from terminal. The cure of fiscal responsibility and reform has been applied and there is every chance of recovery, albeit over the medium term. This time around, there really could be a different outcome, the 1990s need not be repeated. This is because the government is now so unpopular it stands to lose little by pushing through the necessary reforms. Indeed, it stands to gain a place in history as the government that laid the way for full participation in the European single currency. The immediate period ahead will not be easy but as long as the government sticks to its guns, an end to Hungary's vicious economic circle may be in sight.
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