HUF’s vulnerability rising

The true costs of uncertainty have not yet appeared, for two reasons. Partly due to timely risk forecasts, the market has priced in well the likely outcomes of the referendum. Second, the effects of the governing coalition's demise on the HUF and the Stock Exchange have been mitigated by external factors, including the cushioning effect of foreign investors combining Hungary with other emerging markets in their investments.

Foreign financial institutions regularly handle the HUF as a component of a combination of a number of currencies, including the Turkish lira, the South-African rand and various East-European currencies. Due to its political vulnerability, the HUF is likely to decouple from this currency package in the near future.

As a consequence of sluggish economic growth in the European Union, the international risk tolerance for emerging markets may improve. However, Hungary may very well fail to benefit from this cushioning effect, because its dependence on export to the EU, as well its idiosyncratic political environment, can lead to a decoupling from the region.

If this scenario takes place, these factors will combine to create an exponential effect, since Hungary will loose both a share of its export markets and its currency’s artificial support.

Therefore the risk of a speculative attack against the HUF has increased dramatically.

Such attack will result in a deepening political crisis. A deepening political crisis in turn will exacerbate the currency crisis. This vicious circle may have short-term, but extreme consequences.

The stability of the government is greatly bound to the exchange rate of the HUF. The weakening of the Forint may prompt a panic reaction by the markets and investors. This would have further political consequences in itself.

• First, international and domestic business may withdraw support for the government, and this can lead to a situation in which the majority of investors become interested in the PM’s removal (for further details, see our risk warning on the coalition break-up, issued on 1st April).

• Second, middle-class voters, who hold their debts mainly in Swiss Frank, can promptly feel the effects of a Forint crunch in the form of a rate hike. The political effects of this in turn will be amplified by more intense attacks by the opposition. This can lead to decreasing public support for the government.

The vicious circle is completed when the currency rate, determined by the perceptions of both international business and Hungarian voters, reacts to the deepening of the political crisis. Hence, HUF can get even weaker because of the growing risks arising from the unstable political environment. While the abolition of the trading band was a rational and smart move by the Central Bank, if this scenario actualizes it will greatly multiply its negative consequences. A potential forint crisis can also increase the risks in the credit and mortgage markets, too, as rate hikes may lead to the growing liquidity problems of the households.

Source: National Bank of Hungary

How to break the vicious circle?

As the market clears, the growing short-term political and financial instability can lead to its own solution in the mid-term. The growing pressure on the leaders of MSZP and SZDSZ may end up with the “hardliners” losing their power, and the politicians who are determined to make compromises can strengthen their base both in MSZP and SZDSZ. In this case, Political Capital believes, replacement of the Prime Minister becomes inevitable. In this situation the emergence of a “technocrat” or an economic expert as the PM candidate becomes probable. This can calm down the markets, and may reduce HUF volatility.