Tuesday, January 17, 2012

Hungary on Brink of Default

ISRIA: Hungary - Fellegi Started Negotiations with IMF
MarketWatch: Hungary Won't be Last to Make Bondholders Pay
WSJ: Hungary, IMF meet on Loan Conditions
WSJ: Hungarian Forint Strengthens; Euro Falls Below HUF309
Trading Economics: Government Bond Yields - 10 Year Notes - List by Country

Hungary, a country with a total population of 10 million and a GDP of less than $200 million, is not normally the focus of international investors due to its relatively small size. However, Hungary is running out of money and may, within the next few weeks, be the first country in Europe to default as a result of the sovereign debt crisis. A Hungarian default by itself would not likely be catastrophic, due to the country’s relatively small economy, but it could be a precursor to additional European defaults.

Hungary is currently facing default due to a number of factors. Before the recent financial collapse, Hungary’s government and citizens used the availability of cheap credit to grow the economy at unsustainable levels, but after the recent credit crunch the country was unable to obtain the credit necessary to continue fueling that growth. Additionally, many Hungarian citizens incurred significant amounts of debt, most notably on personal mortgages, that many can no longer afford and are unable to refinance. When the Hungarian economy slowed, the country’s debt became a large burden. For example, Hungary’s personal and corporate incomes fell, which lowered government tax revenues and decreased Hungary’s ability to pay its debts. Also, with lower personal incomes, Hungarians had to spend a larger portion of their income on mortgage payments, leaving less income for other purchases, thus lowering consumption and economic growth further. In response to these economic issues, rating agencies have reduced the country’s bond rating to junk status (as a result, the country’s ten-year bond yields are around 10%—as compared to 1.85% in Germany, 3.37% in France, and 1.96% in the United States) and the Hungarian stock market has suffered greatly.

International financial markets want the IMF to step in with a loan of approximately €20 billion, which is enough for Hungary to meet its current debt obligations while the country’s economy recovers. Without IMF assistance Hungary will likely default on its loans, resulting in losses for Hungarian debt holders. The IMF loan would prevent a default, which would assure international investors recover their investments. However, recent talks have broken down based on disagreements about the independence of the Hungarian Central Bank from the Hungarian government and the implementation of austerity measures.

Based on these disagreements, the prime minister of Hungary may decide that a deal with the IMF is not the best option and the country could instead default on its financial obligations. This belief is based, in part, on a comparison of Greece and Iceland. Greece accepted IMF assistance and saw its economy shrink by 5% in one year. Iceland entered a financial crisis in 2008, did not accept IMF assistance, and instead defaulted on certain obligations. While this resulted in a shrinking economy from 2008-2010, the economy is now growing. While defaulting may be a good decision for Hungary, investors are worried that Hungary’s example will lead other countries to reach the same conclusion. Investors fear this outcome because when a country decides to default it will result in debt holders receiving less than the full value of their original investment. Investor confidence in the region would decline, which would negatively affect the amount of money invested and increase countries’ borrowing costs, both of which would harm the European economy. Even though a Hungarian default is possible, most believe Hungary and IMF will reach an agreement.

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