Rebalancing in a low growth environment

1. Rebalancing in a low growth environment András Simor OMFIF Golden Series On World Money 6th October 2011

2. Main messages • Deleveraging is a painful and long but inevitable process, • The external adjustment in Hungary (and in most Central- and East European countries) is remarkable • Fiscal adjustment in a low growth environment requires stamina • Consolidation fatigue results in unnecessary detours but market reaction exerts discipline • In addition to smooth deleveraging policymakers should focus on improving the competitiveness of the economy

3. The roots of imbalances in Europe and Hungary Low real interest rates lead to excessive risk taking • Two coincident factors compressed real interest rates: • Eurozone accession and accession expectations: • Interest rate convergence • Underestimation of exchange risk • „Europhoria” (high income expectations related to rapid convergence) • Global imbalances, abundant liquidity, high risk appetite • Different manifestations of attractive borrowing conditions: • Private sector debt overhang: credit + asset price boom • Ireland, Portugal, Spain, Baltic countries • Hungary: unhegded household debt in foreign currency • Fiscal indulgence: • Greece, Hungary • Financial markets didn’t pay adequate attention to vulnerabilities András Simor - Rebalancing in a low growth environment

4. The original sin #1: high external liabilities and debt (2009) András Simor - Rebalancing in a low growth environment

5. The original sin #2: high public debt compared to our peers (2009) András Simor - Rebalancing in a low growth environment

6. Original sin(#3) : Households took unhedged FX positions András Simor - Rebalancing in a low growth environment

7. The way out: deleveraging + rebalancing • Deleveraging can be enhanced by different factors, but not all of them are under the control of domestic policymakers • Adjustment in primary balance • Changes in funding costs • Growth • Deleveraging for Hungary seems to be a slow and painful process and equivalent to slow domestic demand growth for a prolonged period • Rebalanced growth should be based more on export and less on domestic demand • Export driven growth depends on: • External demand: supportive so far, and ahead? • Competitiveness András Simor - Rebalancing in a low growth environment

8. Crisis triggered fast and large scale external adjustment • Temporary and permanent factors contributed to the shift in externalfinancing requirement: • Cyclical factors decreased consumption and import • Balance sheet deterioration triggered deleveraging • Fx denominated loans • Falling asset prices • Bank lending channel: • Normal procyclical behavior (temporary) • Scarce, more expensive, shorter maturity funding • Shift towards a business model relying more extensively on domestic savings • Fiscal adjustment András Simor - Rebalancing in a low growth environment

9. Spectacular adjustment in external imbalances (in flows) 2012-13: MNB’sforecast András Simor - Rebalancing in a low growth environment

10. Deleveraging is accelerated by the adjustment of commercial banks’ balance sheet (low credit supply) Net credit flow to households by denomination Net credit flow to non-financial corporations Source: MNB Source: MNB András Simor - Rebalancing in a low growth environment

11. Underperforming lending in regional comparison Stock of corporate loansin the CEE region (Oct. 2008 = 100 per cent, adjusted with exchange rate) Stock of household loansin the CEE region (Oct. 2008 = 100 per cent, adjusted with exchange rate) Source: National central banks Source: National central banks András Simor - Rebalancing in a low growth environment

12. Corporate lending and net external debt András Simor - Rebalancing in a low growth environment

13. Banking sector deleveragingGradual adjustment, but still high Loan-to-Deposit ratio Loan-to-Deposit ratio in international comparison Loan-to-Deposit ratio in the Hungarian banking sector Source: MNB Source: ECB, National central banks András Simor - Rebalancing in a low growth environment

14. From current account adjustment to rebalanced growth • In order to restore growth while preventing current account deterioration it is necessary to: • Return to fiscal sustainability • Ensure smooth deleveraging • Improve external competitiveness • Fiscal policy: • Sustainable improvement • Budgetary measures to improve long-term competitiveness • Monetary policy: • Safeguarde nominal stability and support smooth deleveraging of the financial sector András Simor - Rebalancing in a low growth environment

15. So far private sector financing requirement has produced the bulk of the adjustment András Simor - Rebalancing in a low growth environment

16. Negative cyclical position hides significant improvements in fiscal positions Structural deterioration in 2011… … but further improvement is expected in 2012, taking into account the announced government measures András Simor - Rebalancing in a low growth environment

17. Government’s efforts contained debt dynamics Decomposition of 2007−2010 debt dynamics András Simor - Rebalancing in a low growth environment

18. Rebalancing should be supported by fiscal measures • Competitiveness friendly fiscal consolidation can induce long term growth • A significant part of fiscal consolidation was based on expenditure cuts • Tax restructuring: switch from PIT to VAT • But flat tax, and minimum wage increase deteriorates employment chances for the low skills • Labor market reforms: • Tighter eligibility conditions for social transfers • Further relaxation of employment protection laws • Government measures increase labour supply, further efforts needed to support the demand for labour András Simor - Rebalancing in a low growth environment

19. Participation rate is on the rise as a result of significant tightening of the eligibility conditions András Simor - Rebalancing in a low growth environment

20. Sluggish recovery with ongoing re-balancing ofeconomic growth from domestic demand to net exports GDP decomposition András Simor - Rebalancing in a low growth environment

21. A few large FDI projects support export dynamics amid slowing global growth András Simor - Rebalancing in a low growth environment

22. Gains in competitiveness support more balanced external position Evolution of Real Unit Labor Cost From 2007 Source: Ameco András Simor - Rebalancing in a low growth environment

23. Despite slow growth vulnerabilities are decreasing: gradual decline in external and government debt levels (percentage of GDP) András Simor - Rebalancing in a low growth environment

24. Government commited to decrease vulnerabilities but some measures are controversial • Government is committed to decrease public debt, increase employment and decrease the households’ burden due to foreign exchange loans. These goals are respectable, but some measures are controversial. • One off measures need to be replaced by sustainable cost reduction: • Repossessing of the private pillar of the pension system • Taxes on financial institutions, energy-, telecom- and retail companies • Early repayment scheme of retail debt at below market rate: • Deteriorates bank balance sheet • MNB provides the FX liquidity in order to contain spillovers András Simor - Rebalancing in a low growth environment

25. Monetary policy’s dilemma: Weak domestic demand Indirect tax increases keep inflation above the target Deteriorating risk perception András Simor - Rebalancing in a low growth environment

26. Uncertainty in financial markets warrants a wait-and-see policy stance. • Inflation is raised by cost shocks in 2010-11 and by indirect taxes in 2012 • However, the negative output gap is disinflationary • Thus, inflation may fall back to the 3% target in the first half of 2013 • Volatility has increased in financial markets, global risk appetite has fallen • The option for households to repay their foreign currency debt at below-market rate represents a significant source of uncertainty • Volatility in financial markets may persist for some time • At some point monetary easing would have adverse effect on the real economy because of the FX-risk at the households’ and the corresponding credit risk at the banks’ balance sheet András Simor - Rebalancing in a low growth environment

27. Summary • Hungary made significant advances in the deleveraging process • It is accompanied with sluggish but rebalanced growth • The worsening external environment makes this process more painful • Despite some controversial measures the government is clearly committed to decrease vulnerabilities and increase competitiveness • Monetary policy is safeguarding nominal stability and supporting the smooth deleveraging of the financial sector András Simor - Rebalancing in a low growth environment