Hungary now Europe's austerity test case after IMF row

The collapse of Hungary's deal with international lenders marks the greatest challenge by a government so far to the Europe-wide orthodoxy of austerity, with markets and other nations watching closely.

Talks between the International Monetary Fund (IMF) and European Union and Hungary's recently elected center-right Fidesz government fell through over the weekend over deficit targets, hitting the currency and raising bond yields.

Analysts say governments in the EU's core, particularly Germany, are in no mood to be flexible on deficit reduction and want to send a b signal beyond emerging Europe to troubled euro zone fringe states including Spain and Greece.

"The real driver here is the EU," said Preston Keat, head of research for political risk consultancy Eurasia Group. "They are the ones who are pushing so hard for austerity -- more so than the IMF. They are trying to signal to other EU countries that this is a new era regarding budgets and public finances."

German voters in particular loath the idea of bailing out more profligate euro zone nations, with support for Greece being partly blamed for Chancellor Angela Merkel's defeat in local elections this year. That is seen driving broader EU policy.

Emerging European nations began trying to balance their budgets much earlier in the crisis to qualify for essential IMF and EU support, with populations generally broadly accepting of the measures and unrest and dissent so far generally limited.

Poland has proved particularly reluctant to cut spending, but as one of Europe's better placed economies this has prompted much less concern. Hungary, in contrast, is central Europe's most indebted economy with public debt at around 80 percent of GDP.

In Western Europe, opposition to the cuts has so far been highly fragmented, mainly limited to groups lobbying against the axe falling on them. Investors would likely worry if any government looks to be wobbling on austerity.

Fidesz had said before its election that it would aim to renegotiate deficit targets with the IMF and also wants to impose tough tax rises on banks, worrying large European banks with a presence in the country.

Market Reaction Key

Most analysts had assumed an agreement would be struck, but many now believe there will be little movement until the IMF returns in September or local elections on October 3 -- unless dramatic market pressure forces action faster.

Analysts say that in many ways the situation in Hungary is something of a one-off. Investors were already concerned over confused signals from the new government, particularly after officials overtly compared its situation to that of Greece.

But some worry they might see similar problems in Romania if the fragile government collapses, as well as potentially in Latvia if the opposition Harmony win elections scheduled for October 2. Harmony has opposed Latvia's IMF/EU package as too harsh, although it helped the government win a parliamentary vote on the measures in January by abstaining.

Whether markets choose to punish Hungary badly may be key to what happens next. The forint lost over 2.5 percent against the euro and bond yields rose by 25-30 basis points on Monday, boosting borrowing costs. Analysts say it is too soon to say how serious or prolonged the market reaction will be.

"The key is the market reaction -- if Hungary is seen as having got away with it that will have much wider implications," said Nomura emerging markets economist Peter Attard Montalto.

"It's hard to tell today because we're still seeing hot money moving out -- people who had bet on successful IMF talks -- but we should have more of an idea by the end of the week."

Hungary would not face financing pressure itself until the fourth quarter, he said, but its banks could come under pressure earlier. A currency slump would boost import costs and hurt local borrowers with debts in foreign currency.

Hungary, EU Playing Politics

Markets have so far been dogged in their pressure on countries investors worry might be remiss in rebalancing public finances, but might also become nervous that cutting spending too fast might further imperil growth and also tax revenues.

The knock-on market reaction on the rest of the region so far seemed limited, Montalto said, but the Hungary dispute had much broader potential regional impact than the prolonged troubles over Ukraine's IMF deal.

That collapsed because pre-election politics made it impossible to pass a budget, but policymakers continued to engage with the IMF and it was seen as a more unique situation.

The new government bowed to IMF pressure and negotiated a new $14.9 billion loan pushing through painful measures including gas price rises.

For Hungary, keeping communications channels open between the government and EU/IMF negotiators will be key -- although possibly far from easy if politics get in the way.

"This may be good politics and political signaling both from the Fidesz government -- 'we will not cave in to the IMF, and we will punish the evil banks' -- and the EU -- 'after the Greece debacle, fiscal austerity and transparency are non-negotiable'," said Eurasia Group's Keat. "This may not translate into good economic policies or market reactions."

[Source: By Peter Apps, Political Risk Correspondent, Reuters, London, 19Jul10]

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