Halfway down the Danube

The Forint in the Storm

A few days ago, in this post, I discussed Romania's economy and the shaky situation of Romania's currency, the leu.

Well, when I arrived in Hungary, I was surprised to find that Hungary is in almost exactly the same situation!

In Hungary, also, people and businesses have been very hungry for foreign goods. So the country has been importing much more than it has been exporting. Thus, Hungary has a current account deficit that is even bigger than Romania's. And so Hungary's currency -- the "forint" -- has begun to fall.

But Hungary's situation is actually even worse than Romania's. Romania's leu is starting to look vulnerable, like a possible target for currency speculators. Hungary's forint is, right now, under attack by currency speculators. The forint has fallen by about 5% in the last ten days or so. It would probably have fallen by more, but last Friday the Hungarian National Bank raised the interest rates to defend the forint.

They raised interest rates by three percent -- from 9.5% to 12.5%. That's a very big increase. And if interest rates stay high for more than a few weeks, this will cause serious problems. "The 3% interest rate increase is the Hungarian economy's obituary," said one opposition party. While that's probably an exaggeration, it's certainly not a good thing.

Still, it should have stopped the speculation. After all, raising interest rates means that forint-denominated investments are more attractive now. So people should start rushing to convert dollars and euros into forints, which should make the forint rise. (I'm simplifying again, but this is more or less how it works.)

And yet, after a short pause, the speculative attacks have started again, and the forint has fallen another percentage point or two.

This was the biggest story in Hungary while I was there. "Markets Tense As Forint Takes Another Nosedive", said the English-language Budapest Times. "Forint Unter Druck" snapped the Budapest Zeitung. "Le Forint Dans La Tourment!" cried Francophonie. And "Gobkeszerlyokabsacsuk Forint Yuk!" said the Hungarian papers. (Or something like that. Hungarian is an extremely opaque language to me.)

Why is the forint still falling? Well, it seems that the government may have a "credibility gap". Based on its past record, international investors -- and speculators -- don't believe that the government will take long-term effective action to defend the forint. Partly this is because the National Bank waited a long time to raise interest rates; partly also, this is because the government has never made clear what is more important, low inflation or a strong forint. (When there's a big trade deficit, it's very hard to have both. And Hungary's government has been very proud of its low inflation -- 5% last year, target of 4% next year.)

And mostly, it's because the speculators don't believe that the National Bank of Hungary is really independent. Yes, it is officially. But the speculators know that soon the government will feel the pain of high interest rates. Businesses -- including big businesses -- will be unable to borrow money, or will have to pay much more for their borrowing. Some businesses will close; others will see bankruptcy getting closer. They will demand that the government do something.

By betting against the forint, the speculators are betting that the government will put pressure on the National Bank to lower interest rates. When interest rates go down, forint-denominated investments will become less attractive, people will stop converting euros and dollars into forints to buy them, and the forint will fall.

It's already clear that the Hungarian government and the National Bank are divided. The Finance Minister said that he agreed with the Bank's action... as long as it was temporary. But the Bank has said that it will keep interest rates high "for as long as necessary". And, after all, the Bank has an additional responsibility: it has to convince investors -- and speculators -- that it will defend the forint, so that future attacks are deterred before they start.

Will the Bank succeed? Or will it be forced to cut interest rates after a few weeks? I don't know, but it should be interesting.

Meanwhile, here in Romania, I really hope that the folks at the National Bank of Romania are watching this closely. After all, if the forint can be attacked, so can the leu. Hungary's present could be Romania's future -- and maybe a future that's not so distant.

My personal opinion is that the Bank and the government need to pick a policy and stick with it: either decide to let the leu float freely, or decide to defend it very strongly. If the latter, then (I hate to say this) they should probably raise interest rates by at least half a point pretty soon, to show that they mean what they say.

But somehow I really doubt that they're going to do that. Which means that, as 2003 turns into 2004, the leu might be walking into a forest full of tigers.

Currencies, interest rates, trade deficits, wow. Have I bored everyone into running away yet?

Posted by douglas at December 12, 2003 10:42 PM