Turnaround in monetary policy in developed markets, dynamic growth in the Hungarian economy

Executive summary

 

In the first half of 2014, the focus of growth increasingly shifted to developed regions, while global economic growth slowed down: the expansion in developed countries could only partially offset the stagnation of growth in emerging countries struggling with structural problems. This is reflected in both a decline in the expansion of world trade and a deteriorating outlook (the World Bank reduced the expected growth rate of the world economy from 3.2% to 2.8% in its latest forecast for this year). The optimistic start to the year was followed by a somewhat bleaker spring in developed countries. The United States saw a significant fall in economic performance in the first quarter owing to the bad weather, but prospects remain favourable thanks to the strong fundamentals, and employment increased dynamically in the spring months. In the eurozone, however, the year-on-year growth of a modest 0.9% recorded for the first quarter is not expected to accelerate due to the external downturn, the strong euro hindering exports, the sustained contraction in corporate lending and the invariably large differences in the growth potential of member states. Fears over an overvalued euro and worsening growth prospects made the European Central Bank decide on a further base rate cut (to 0.15%) in June, simultaneously with reducing its earlier annual growth forecast for the eurozone from 1.2% to 1.0%, and is planning to launch refinancing operations of EUR 1,000 billion targeted at businesses in the autumn.

 

Following an upturn in the US economy, the Fed started to taper the third round of its quantitative easing programme (QE3) by USD 10 billion per month in January 2014, causing merely a temporary deterioration in sentiment on the international financial markets: major equity markets declined in February, US and German government bond yields slumped about 50 basis points in the spring, the demand for the assets of emerging countries dropped, and their currencies weakened, even leading to base rate hikes by the central banks of India, Brazil and Turkey. However, the abundance of liquidity in money and capital markets brought investors’ risk appetite back soon, so stock indices began to grow dynamically again and capital inflow to the money and capital markets of emerging countries resumed in the second quarter. Meanwhile, the dollar to euro exchange rate remained stable, fluctuating between 1.35 and 1.40 USD/EUR, with the euro depreciating approximately 1.0% over the entire six-month period. Since the announced monetary loosening in Europe will counterbalance the impact of the tapering of quantitative easing under way in the US, liquidity is expected to remain abundant in international financial markets, and the euro is likely to weaken further.

 

Nevertheless, this abundance of liquidity in the financial system coupled with falling yields and interest rates has not yet resulted in a sustained improvement in private sector lending, which fact indicates the fragility of growth prospects. In the US, 2014 will see a further expansion of corporate and consumer lending, a trend which started three years ago, while the volume of property loans has been stagnating since late 2009. The situation is gloomier in the eurozone, where corporate and consumer loans have been showing a sharp decline for three years, while real estate loans are stagnating. In both the US and the eurozone, there is a persistent downward slide in the interest rates on loans provided by commercial banks, the level of which was between 3% and 4% this spring.

 

Private sector lending also seems to be a bottleneck for growth in Hungary. The Hungarian economy entered a lasting growth path in the middle of 2013, and grew by 3.5% on a year-on-year basis in the first quarter of 2014, which is not only considerably faster than expected but also considered to be outstanding on a European scale. Thanks to this turnaround in the growth trend, the Hungarian GDP has reached the level of Q4 2008, and the Hungarian economy resumed the process of catching up to the EU average early last year following a period of standstill after 2005: owing to the increasingly dynamic pace of expansion, Hungarian growth surpassed that of the EU-28 by 1.6 to 1.9 percentage points in the previous quarter. Moreover, the structure of growth was balanced on both the expenditure side and the production side of GDP. As a result of the long-awaited upswing in domestic consumption, in particular the growth in investments creating a high need for imports, the year-on-year expansion of imports was somewhat higher than that of exports, reducing the impact of net exports on growth. Investments played a leading role in fuelling growth: due to community infrastructure developments financed from EU funds and reviving investments in the manufacturing industry, gross fixed capital formation increased by 13.3% on a year-on-year basis in the first quarter of 2014. As a result of improving labour market conditions (increasing employment and a drop to 8% in the unemployment rate), as well as an accelerating wage outflow and inflation sinking to a multi-decade low, household consumption expenditure rose by 1.5% in the first quarter, and government transfers also grew. On the production side of GDP, all sectors, except agriculture, made a positive contribution to growth in the period between January and March: industry grew by 6.7% (y/y), including a growth by 9.6% (y/y) in the manufacturing industry due to European demand gaining momentum, a growth by 25.2% (y/y) in construction thanks to investments in infrastructure financed from EU funds and a growth by 1.5% (y/y) in services resulting from an increase in domestic demand. Although the pace of growth may slow down in the second half of the year due to partly the base effect and partly the phasing out of EU funds, the better-than-expected growth dynamics of the first quarters have already caused both market actors and analysts to gradually adjust their GDP forecasts for 2014 upward.

 

The favourable growth, labour market and inflation figures were accompanied by further improvement in the financial balance. According to the balance of payment statistics, the Hungarian economy’s net financing capacity increased to 7.6% of GDP in the first quarter of 2014, attributable to firstly an increase in the aggregate balance on goods and services and secondly the still intense inflow of EU transfers. Although the data of financial accounts show that the net savings position of non-financial corporations has declined for the second quarter running, which indicates a slight strengthening of the willingness to borrow loans and to make investments, the persistent corporate savings position implies that Hungarian companies still postpone developments and borrowing. The financing capacity of households continued to increase, while the financing requirement of general government reached 2.7% of GDP over the one-year period ending with the first quarter of 2014. Although the budget deficit amounted to HUF 682 billion in the first five months, which is 69% of the projection for the whole year, the development of revenues and expenditures during the year, coupled with the government’s determination to keep the deficit below the target, is expected to enable the achievement of the year-end target of 2.9% relative to GDP.

 

Decelerating inflation and a supportive external money and capital market environment (strong global risk appetite), leading to a falling risk premium and a strengthening demand for Hungarian financial assets on the part of investors, created favourable conditions for the Central Bank of Hungary (MNB) to continue in the first half of 2014 the monetary easing commenced in the summer of 2012. The Monetary Council reduced the base rate from the historic low of 3.00% early this year to 2.30% in late June by implementing monthly interest rate cuts of 15 and then, from March onwards, 10 basis points, which may be followed by additional interest rate cuts in the second half of the year, provided that the international financial environment remains supportive. The exchange rate of the forint reflected the changing international risk appetite: it weakened significantly when “tapering” began and regained strength during the spring. In June another phase of depreciation  started, which may have been caused by the government’s plans to phase out foreign currency loans, as well as the expected loss of the banking system, therefore the Hungarian currency depreciated by 3.6% over six months.

 

The continued downward trend in interest rates and the solution to the problem of foreign currency loans are not likely to allow the exchange rate of the forint to strengthen considerably before the end of the year, although the favourable development of economic fundamentals would justify it. The supportive external money and capital market environment, as well as the stable fundamentals of the Hungarian economy drove down yields on discount treasury bills by 60-80 basis points, which is roughly equal with the 70 basis-point cut of the base rate by the central bank, while the yields on 5 and 10-year government bonds fell at a much higher rate of 120-130 basis points, and the interest rates on corporate and home loans denominated in the domestic currency became lower by nearly 50 and 60 basis points, respectively. Having dropped below 5%, the interest rates on corporate loans in Hungary are much more competitive than one year earlier, even by international and regional standards. The interest rate descent was also attributable to the interest rate cap of 2.5% applied in the Funding for Growth Scheme launched by the MNB. At the same time, corporate lending in Hungary reflects the eurozone trend: despite the falling interest rates, the volume of corporate loans is shrinking steadily. In the first five months of 2014, loan repayments by Hungarian companies exceeded their borrowings by HUF 57 billion. This phenomenon is an indication of fragile economic growth, considering that a dynamic expansion of corporate lending is essential for the economy to grow in a sustained and sustainable manner, which can be fostered – but cannot be replaced over the long term – by programmes such as the FGS in Hungary, launched by the central bank in order to promote lending to the corporate sector.