Hungary turns to IMF as stress mounts in Eastern Europe

Hungary has returned cap in hand to the International Monetary Fund after kicking out inspectors last year, becoming the first country in Eastern Europe to succumb to contagion from eurozone debt stress.

By Ambrose Evans-Pritchard, International business editor

the Telegraph,

21 November, 2011, 9:03PM GMT 

Rising bond yields and a weakening forint has forced the country's Fidesz government to swallow its pride and request a "precautionary" credit from both the International Monetary Fund and Europe, reportedly of €4bn b(£3.4bn).

The growing likelihood that Hungary's debt will be downgraded has accelerated capital flight, causing two-year debt yields to jump from 5.5pc to 7.5pc since September.

"Hungary is a warning sign," said Neil Shearing from Capital Economics. "It is the country where the risks are most acute in the region, so this is where you would expect to trouble to start. We fear this may spread to Ukraine and the Balkans. Eastern Europe has enormous external financing needs for the banking system. They won't be able to roll over debts if there is a credit freeze in Western Europe." Mr Shearing said Hungary has to raise external finance equal to 18pc of GDP over the next year. The figures are 14pc for Croatia, and 13pc for Bulgaria.

Eastern Europe is dependent on eurozone lenders and their subsidiaries for about 80pc of its banking system. This leaves the region vulnerable to a credit crunch as foreign groups slash loan books – by €2 trillion over 18 months, according to a Deutsche Bank study – to meet the EU's requirement for 9pc core tier 1 capital.

Western regulators have already begun to lean on their banks to cut loan books abroad to head off a squeeze at home. Austria's central bank has ordered Erste Bank, Raiffeisen and Unicredit Austria to restrict lending in Eastern Europe to what they can raise in local deposits, perhaps a move by Vienna to safeguard its own AAA rating amid the EMU storm. Austria's exposure to Eastern Europe is near $270bn (£173bn), or 70pc of GDP. Its banks make up 40pc of lending in Croatia, 30pc in Romania and 25pc in Hungary.

Fitch Ratings warned on Monday that West European banks may pull back if the eurozone debt crisis escalates. "Stress could spread from the eurozone to Central and Eastern Europe banks. Although eurozone banks' subsidiaries would be able to sustain some reduction in funding from their parents, they could be forced to cut credit provision and shrink their balance sheets further, with an adverse effect on GDP growth," it said.

Lars Christensen from Danske Bank said Balkan states are in the firing line as Greek lenders batten down the hatches. "Bulgaria faces a significant squeeze because Greek and Italian banks make up 60pc of loans," he said.

The story in Hungary is complicated by an erratic government accused of violating EU principles across the board, from confiscating private pensions and imposing an ad hoc bank tax, to judicial abuse and curbing press freedoms.

"They are not following the rule of law," said Mr Christensen. "This latest move of going back to the IMF smells of desperation. They have done a volte face."

It is unclear how the IMF will respond given that Hungarian leaders vow to resist foreign demands for policy changes. "The IMF is not simply going to roll over and create new facilities for Hungary when it sees policies that it disagrees with, " said Peter Attard Montalto from Nomura.

Hard reality may dictate events. Public debt is near 80pc of GDP, high for an economy with near zero growth and 7pc to 8pc borrowing costs. Hungary must repay €5.9bn in EU-IMF loans, starting early next year. Gross external finance needs for 2012 are 34pc of GDP, including banks.

Almost two-thirds of mortgages and household debt are in the uber-strong Swiss franc, creating a lethal currency mismatch with the tumbling forint. The central bank may have to raise rates to shore up the currency, even though recession threatens. Hungary is in a classic foreign debt vice.