Opinion
Learning Hungarian
By: Dana Gabor
Romania and Hungary have been hit hard by the global financial crisis, but now only Hungary can look to the future with confidence
Posted: 26/12/2009
Except for an 11-month stint as prime minister, Mugur Isarescu has headed Romania's central bank since September 1990, and was recently reappointed to another term as governor.
A year later, it all looked very different. A bond market rally saw Hungary foregoing IMF and EU assistance. In turn, the Romanian government was struggling to finance its expenditure through domestic commercial banks, paying interest rates nearly twice above Hungary's. This situation, it is commonly agreed, reflects a failure of politics: while Hungary maintained its initial budget deficit (at 3.8 per cent of GDP), Romania nearly doubled its 2009 target (to 8.1 per cent of GDP) amid increased political tensions since September 2009.
Such different trajectories are the consequence of central bank policies. Hungary provides a good example of a central bank (the MNB) that assumes, albeit not overtly, responsibility for public debt dynamics, while the Romanian experience testifies to the chaos that ensues when the central bank refuses such responsibility.
To start with, central banks faced similar challenges during October 2008. The NBR announced the successful defeat of a speculative attack on the currency, but at the expense of high interest rates on the interbank market (where banks trade liquidity with each other). The MNB responded to similar pressures on its currency markets by raising its policy interest rate by three per cent. Afterwards, the two banks' crisis management policies became increasingly different.
Since October 2008, the NBR's frayed relationship with commercial banks meant that a tight lid was kept on liquidity, as it worried that liquidity injection might fuel renewed currency pressures. Before the April 2009 IMF agreement, it would only lend to banks against collateral and at interest rates four per cent above its (already high) policy rate. Afterwards, it stepped up liquidity injections, varying maturity and volume in line with its perceptions of potential pressures on the domestic currency. The public sector has been the undisputed loser of this strategy.
With revenues plummeting and scarce access to international financial markets, Romania's government was forced to borrow in domestic currency from commercial banks, whose willingness to commit their own resources deteriorated due to parent bank problems and the NBR's uncertain policies. Indeed, when the NBR eventually stepped in, it chose a highly discretionary mechanism: through repo operations, it provided commercial banks with the liquidity necessary to finance government debt issues. While the repo rate became the lower limit for the government's borrowing costs, the NBR maintained it at levels warranted by an overheating rather than a freefalling economy. As a result, deficit financing concentrated on short-term maturities and high interest rates.
That the NBR preferred exchange rate stability to stabilising public debt costs was also clear from its reluctance to act as the government's foreign exchange agent. As the government finally decided to borrow in foreign currency (a long overdue decision given the NBR's liquidity policies) after July 2009, the ensuing EUR 3bn entries plus $1.36bn of the IMF's second tranche should have increased domestic liquidity by RON 15bn (or less if foreign currency loans were used for external debt repayment). Yet by September Romania was again experiencing liquidity shortages, driving banks to borrow record high volumes from the NBR's expensive Lombard facility. Concerned that the political crisis would ignite speculative behaviour, the NBR tightened liquidity even further: it reduced the maturity of its liquidity injections to two days, seeking to increase banks' dependency on its liquidity operations. Confronted with such uncertainties, commercial banks refused to lend to the government for less than an interest rate of ten per cent - two per cent above the policy rate. In contrast, the Hungarian government's short-term financing rate (around 6.4 per cent) was below the central bank's policy rate (seven per cent) during the same period.
The explanation? After October 2008, the MNB monetised government debt directly by purchasing government paper from primary dealers, and indirectly, by exchanging the governments' foreign borrowing for forint liquidity. Since Hungary successfully convinced the IMF to direct the first two loan tranches to the government and also issued foreign currency bonds, the MNB's willingness to act as the foreign exchange agent for the government produced a substantial excess of liquidity on the interbank market. Second, the MNB developed a systematic and transparent approach to liquidity management: banks can now deposit all excess liquidity at weekly auctions, remunerated at the policy rate. As a result, interbank interest rates stabilised, closely tracking the cuts in the policy rate after May 2009. This approach restored non-resident interest in forint-denominated assets despite narrowing interest rate differentials, and lowered the government's costs of borrowing.
Hungary demonstrated that the central bank, and not the market, ultimately shapes public debt dynamics. There, the government's increasing financing needs were harnessed to restore banks' liquidity without fuelling a speculative attack because investors were offered alternative avenues for making profit. What explains the NBR's reluctance to try the Hungarian way? Most likely eagerness to preserve its public image: it is easier to deny responsibility for public debt dynamics than exchange rate volatility.
Simple maths shows how the NBR has worsened public welfare. A very rough estimate puts the interest rate costs of the RON 55.5bn issued during the first nine months of 2009 somewhere above RON 3.5bn (assuming a 10 per cent return). With different central bank policies, the government could have used this money to avoid the massive RON 2.57bn cut in the public sector wage bill.
The policy implication is simple: the NBR's policies ensure that the burden of this crisis is shared. If trade unions, farmers, public sector employees want a less onerous share, they should be gently knocking at Mr Isarescu's door rather than protesting in front of a powerless, misguided Ministry of Finance.
Dana Gabor is a Senior Lecturer in Economics at Bristol Business School
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