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So The Bank Of England And The UK Government Cannot Default On Its Bonds – Is It?

Always start macroeconomics with balance of payments :-)


Moody’s Investors Service has today downgraded the domestic- and foreign-currency government bond ratings of the United Kingdom by one notch to Aa1 from Aaa.

It also downgraded the Bank of England:

In a related rating action, Moody’s has today also downgraded the ratings of the Bank of England to Aa1 from Aaa.

This has seen a lot of reactions – such as quoted here in an FT Alphaville blog post ‘This downgrade is nonsense!’

So let us get straight to scenarios which lead to defaults – in addition to ones purely voluntary.

Scenario 1.

The easiest is to think of a scenario where the Euro Area forms a political union and the UK is invited to join it and it joins it – such as in 2027. The UK government then gives up the power to make drafts on its central bank and becomes a state level government. UK government bonds will be redenominated in Euro and hence a possibility of default exists – including on debts in existence in 2013.

Scenario 2.

Suppose the UK pegs GBP to some currency such as the Euro or the dollar in 2024. Then surely the government and the central bank can default on debts in existence in 2013 and denominated in GBP in say 2037 isn’t it (like Russia in 1998)?

Now you may complain that it was the government’s mistake to have pegged its exchange rate – but whatever said, an investor holding a bond in 2013 would have been hurt in 2037.

Scenario 3.

Suppose the UK has a balance of payments crisis in 2030. It needs foreign exchanges and needs an international lender such as the IMF. Now suppose the IMF insists that the UK government and the Bank of England default on foreigners holding GBP denominated bonds including those in existence in 2013. Voluntary default?


Moody’s can be criticized for playing political games but a good critique cannot be that default is not possible.

You can come up qualifiers but won’t prove Moody’s rating change wrong.

Don’t get me wrong. I am trying to convince to come up with stronger arguments for critiquing the rating agencies instead of simple ridiculing. Usually the rating actions are defended by people arguing for fiscal contraction. Paradoxically the recovery of the world economy cannot come about easily with without at least a worldwide fiscal expansion.

The Monetary Economics Of Sovereign Government Rating

If a government (outside monetary unions) can make a draft at the central bank, why do rating agencies rate governments’ creditworthiness?

In this post, I will attempt to describe the dynamics of defaults and restructurings by going through some monetary economics of open economies.

Carmen Reinhart and Kenneth Rogoff wrote a book in 2009 titled This Time Is Different: Eight Centuries Of Financial Folly or simply This Time Is Different arguing that governments do indeed default – both in debt denominated in the domestic and foreign currencies. They blame the public debt and the government for the public debt – hence giving the innuendo that governments across the planet should attempt to cut public debt by tight fiscal policies. This is an illegitimate conclusion – on which I will say more below.

At another extreme are the Chartalists who argue that the government cannot “run out of money” and hence fiscal policy has no monetary constraints. Sometimes they qualify this statement by saying that the currency they are discussing are “sovereign currencies”. Now, there are various definitions of what a sovereign currency is but it is frequently pointed out by them that nations who have seen restructuring of government debt did not have a “sovereign currency” – because the currency is either pegged or fixed or it is the case that the government had a lot of debt in foreign currency which presumably allows defaults/restructuring of government debt in the domestic currency as well. The motivation behind this is Milton Friedman’s idea that nations should freely float their currencies in international markets and that markets will clear and that the State intervention in the currency markets can only make things worse. Hence Reinhart/Rogoff don’t prove them wrong – according to them – since the situations are supposedly different.

We will see that while there is some truth to it, the notion of a “sovereign currency” is highly misleading. Such intuitions are coincident with the incorrect notion that indebtedness to foreigners (in domestic currency) is just a technical liability and there’s nothing more to that!

Here’s S&P’s article on the methodology it uses to assign ratings on governments: Standard & Poor’s – Sovereign Government Rating And Methodology. One can see the importance it gives to the external sector. However, S&P does not provide a mechanism on how a government will finally end up defaulting. The purpose of this post is to look into this.

Before this let us make a connection between the public debt and the net indebtedness of a nation. Most people in the planet confuse the two. The former is the debt of the government whereas the latter is the (net) indebtedness of the nation as a whole. This is the net international investment position (adjusting for traditional settlement assets such as gold) with the sign reversed. This can be obtained by consolidating all the sectors of an economy and the consolidation involves (for example) netting of the assets of the domestic private sector held abroad and also its gross indebtedness to the rest of the world.

So one can think of two extremes:

  1. Japan – with a high public debt of about 195% of gdp (includes just the central government debt),  while being a net creditor of the world. It’s NIIP is about 50% of gdp (data source: IMF)
  2. Australia – with a low public debt of 18% of gdp and NIIP of minus 59% of gdp.

So in the case of Japan, while the government is a huge debtor, the nation as a whole is a creditor, whereas in the case of Australia, it is the opposite. So the rating agencies get it wrong or opposite!

Let us first assume a closed economy. The greatest starting point in analyzing economies is the sectoral balances approach. For a closed economy it is:


where NAFA is the Net Accumulation of Financial Assets of the private sector and DEF is the government’s budget deficit. If the private sector wants to accumulate a lot of financial assets, and the government wants to run the economy near full employment, the public debt will be higher, the higher the propensity to save, for example. (This is not as straightforward as presented here but can be shown in a simple stock-flow consistent model). So unlike what neoclassical economists think, the level of public debt is somewhat irrelevant. Neither does the government has too much trouble in financing its debt because the public debt is the mirror image of the private sector net financial asset position.

Now let us take the case of an open economy. The sectoral balances identity now is


A deficit in the current account implies an increase in the net indebtedness to foreigners. Unless the markets miraculously clear with the exchange rate adjusting to bring the CAB in balance, a deficit in the current account implies the nation as a whole has to attract foreigners to finance this deficit i.e., via a lower NAFA or higher DEF. In the long run, the private sector is accumulating financial assets (or has small positive NAFA) and the whole of the current account balance is reflected in the public sector balance.

So the debate fixed vs floating doesn’t help too much. A relaxation of fiscal policy may spill over into higher imports with the public debt and the net indebtedness to foreigners keeps rising forever to gdp. Hence nations typically have to curb growth to bring the current account into balance.

An excellent reference for this is New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, by Martin Fetherston and Wynne Godley.

This is theory. So let’s look at an open economy mechanism of an event of default by the government as a story.

In the following, I will use the phrase “pure float” instead of the dubious terminology “sovereign currency”.

Here’s the simplest model:

In the above, a nation with its currency on a pure float and with zero official sector liabilities in foreign currencies has a somewhat weak external position in 2012. Now, according to some of the Neochartalist arguments this nation can’t default on its government debt. However this is a wrong conclusion as the scenario above hightlights. In the scenario constructed, the balance of payments position weakens over the years (and I have mentioned that roughly in 2020 it weakens). In 2022, foreigners are no longer willing to finance the debt. This may be due to a capital flight or due to the inability of the banking system to maintain a low net open position in foreign currency. The depreciation of the domestic currency isn’t sufficient to clear the fx markets and the official sector (either the central bank or the government’s treasury) necessarily has to intervene in the foreign exchange markets by issuing debt denominated in foreign currency. The government is then acting as the borrower of the last resort and the objective is to use the proceeds to partially have more foreign exchange reserves and/or to sell the foreign currency proceeds from the debt issuance to clear the fx markets. The government is then left with a net liability position in the foreign currency. Soon the external situation worsens to the point requiring official foreign help – such as from the IMF – which promises to help and requires a restructuring of the debt both in domestic and foreign currencies.

Free marketers have a blind belief in the markets and the theories are built on the assumption that markets always clear. The recent crisis has highlighted that this isn’t the case. Even for the case of Australia – whose currency can be considered closed to being pure float – has had issues in the external sector and the Reserve Bank of Australia had to borrow in US dollars from the Federal Reserve (via swap lines) to help Australian banks meet their foreign currency funding needs during the crisis.

Of course the above is not typical but to prevent the external vulnerability to go out of control, governments keep domestic demand low and a lot of times, they over-do this.

The point of the exercise is to prove that it is not meaningless to think of nations becoming bankrupt in whichever situation one can think of and it doesn’t help to laugh at the rating agencies and make fun of them – possibly with the exception for the case of Japan. Statements such as “government with a sovereign currency cannot become bankrupt” are simply misleading. In the above, the Chartalists would argue that the currency was not sovereign and they were not wrong about the default but the currency was sovereign in their own definition in 2012!

Here are some comments on some nations.

Japan: As mentioned above, Japan is a net creditor of the rest of the world and partially as a consequence of that, most of the Japanese government’s debt is held internally. The rating agencies are aware of this but in spite of this continue to make comments on the creditworthiness of the Japanese government. It is possible that residents may transfer funds abroad for unknown reasons (which the raters for some reason suspect) but it may require just a minor interest rate hike to prevent this from happening. Japan has a relatively strong external situation and hence has no issues in financing its government debt.

Canada: Nick Rowe of WCI mentioned to me on his blog that worrying about the balance of payments constraint is like “beating a dead horse” – citing the example of Canada which has floated its currency and it seems has no trouble with its external sector. But this ignores other things in the formulation of the problem. Canada is an advanced nation and an external situation which is not weak. However, a growth of the nation much faster than the rest of the world will lead to a worsening of the external situation. To some extent the nation’s external situation has been the result of its relatively better competitiveness of exporters compared to its propensity to import and a demand situation which either as a conscious attempt of demand management of the government or by pure fluke has helped its external situation remain non-vulnerable.

United States: The US dollar is the reserve currency of the world and slowly over time, the United States has turned from being a creditor of the rest of the world to becoming the world’s largest debtor nation. (Again not due to its public debt but because of its net indebtedness to foreigners). The US external sector is a great imbalance and any attempt to get out of the recession by fiscal policy alone will worsen its external situation leading to a crash at some point. S&P is right! So to come out of the depressed state, the nation has to complement fiscal expansion with improvement of the external situation such as by (and not restricted to) asking trading partners to not revalue their currencies. Still for some reasons bloggers at the “New Economic Perspectives” think that

… Bernanke also knows that the US has infinite ability to finance these fiscal components, that there is no solvency issue and that the policy rate and both ends of the yield curve are under the direct control of the Fed.

Back to This Time Is Different. While Reinhart and Rogoff’s analysis of government debt may be useful, their conclusions can be destructive for the world as a whole. The domestic private sector of a nation needs continuous injection from outside so that it can run surpluses in general and tightening of fiscal policies will lead to a depression. Global imbalances is crucial in understanding the nature of this crisis (and not public debt alone) and even coordinated attempts to reflate economies may provide only a temporary relief. Since failure in international trade restricts the growth of nations and their attempts to reach full employment, what the world needs is an entirely different way to run the economies under managed trade with fiscal expansion. Ideas of “free trade” such as that outlined here by Alan Blinder simply help some classes of society at the expense of others because it relies on the “market mechanism” which has failed over and over again.

This brings me to “sovereignty”. As argued, the concept “sovereign currency” is almost vacuous (except highlighting the problems of the Euro Area) but sovereignty as argued by Wynne Godley in his great 1992 article Maastricht And All That and by Anthony Thirlwall in the same year on FT (my post on it here Martin Wolf Pays A Generous Tribute To Anthony Thirlwall) definitely have great importance. Some of Thirwall’s concepts of economic sovereignty in the article were: the ability to protect and encourage strategic industries, the possibility of designing systems of managed trade to even out payments imbalances, the ability to protect against certain countries with persistent surpluses, differential taxes which discriminate in favour of the tradeable goods sector.

Updated: 5 May 2012 at 11:07am GMT – typos corrected

S&P’s FAQs On EA Rating Actions

S&P released another document yesterday in connection with the rating action of Eurozone governments yesterday which you can get via it’s Tweet:

On the political agreements, the release says:

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.

Two points.

First – yes, fiscal profligacy is not the only source of the crisis. It is typical to give the example of Spain and Ireland – and done by S&P itself – to justify this:

This to us is supported by the examples of Spain and Ireland, which ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, during the period 1999-2007 (versus a deficit of 2.3% of GDP in the case of Germany), while reducing significantly their public debt ratio during that period.

There is a risk in making such an argument and even progressives sometimes do so. The error is assuming that the public sector deficit is a proxy for the fiscal stance of the government! Macroeconomists using stock flow coherent macro modeling have shown that the budget balance is just an endogenous outcome and the more appropriate proxy for the fiscal stance is G/θ, where G is the government expenditure and θ is the average tax rate.

To me it seems both Spain and Ireland governments (and local governments) were actually lavish in their spending. The private sector was even more lavish in its expenditure and rising incomes led to higher tax revenues which improved the government’s budget balance before the crisis. The whole process was allowed to continue by market forces, domestic and foreign lenders who (not surprisingly) underpriced risk. Needless to say the lack of a central government overseeing demand management and the ignorance of Keynesian principles contributed to the haphazardness.

Second, most commentators – including the S&P – pay too much attention to price competitiveness. So typically one sees a graph of unit labour costs of individual nations in almost all analysis. One even does not need to take innovations in the export sector to explain the crisis.

The EA17 nations had different levels of non-price competitiveness to begin with and faster growth of income/expenditure in the “periphery” as a result of the boom as compared to slower growth in the “core” nations led to exploding current account deficits. Here’s the data from the IMF’s latest World Economic Outlook published in September 2011 on the current account balances:

With different non-price competitiveness (or income elasticity of imports) (to begin with at the formation of the monetary union rather than innovations during the last ten years) combined with fast rising income/expenditure in the periphery, this led to a dramatic increase in net indebtedness of the periphery as a straightforward consequence. To emphasize the point, even if non-price competitiveness was similar between the core and the periphery, this would have resulted in rising net indebtedness.

It is surprising how international finance contributes to unsustainable processes from continuing as if they can continue forever!


Paul Krugman has a new post on his NY Times Blog on the same comment from S&P from its FAQs but with a different viewpoint.

S&P Takes Rating Actions On Euro Area Governments

On 5 December 2011, S&P put ratings of EA17 governments on rating watch negative. See my post S&P And EA17 National Governments for link to the S&P report. Today it concluded its review and downgraded several governments.


According to the report, which can be obtained from S&P’s Tweet:

We have lowered the long-term ratings on Cyprus, Italy, Portugal, and Spain by two notches; lowered the long-term ratings on Austria, France, Malta, Slovakia, and Slovenia, by one notch; and affirmed the long-term ratings on Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the Netherlands. All ratings have been removed from CreditWatch, where they were placed with negative implications on Dec. 5, 2011 (except for Cyprus, which was first placed on CreditWatch on Aug. 12, 2011).

The outlooks on the long-term ratings on Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain are negative, indicating that we believe that there is at least a one-in-three chance that the rating will be lowered in 2012 or 2013. The outlook horizon for issuers with investment-grade ratings is up to two years, and for issuers with speculative-grade ratings up to one year. The outlooks on the long-term ratings on Germany and Slovakia are stable.

We assigned recovery ratings of `4′ to both Cyprus and Portugal, in accordance with our practice to assign recovery ratings to issuers rated in the speculative-grade category, indicating an expected recovery of 30%-50% should a default occur in the future.

S&P also cites that “an open and prolonged dispute among European policymakers over the proper approach to address challenges” as one of the reasons to take the rating actions.

How can the Euro Area solve its problems?

One of my favourite papers is A Simple Model Of Three Economies With Two Currencies (link) written by Wynne Godley and Marc Lavoie. The paper was written about 7-8 years back and was published in 2006 in the Cambridge Journal of Economics.

The paper’s abstract:

This paper presents a Keynesian model which describes three countries trading merchandise and financial assets with one another. It is initially assumed that all three countries have independent fiscal policies but that two of the countries share a currency, hence the model can be used to make a preliminary analysis of the conduct of economic policy in ‘the eurozone’ vis-a`-vis the rest of the world—‘the USA’. The main conclusion will be that, if all three countries do indeed operate independent fiscal policies, the system will work under a floating currency regime, but only so long as the European central bank is prepared to modify the structure of its assets by accumulating an ever rising proportion of bills issued by any ‘weak’ euro country.

G&L make an interesting remark about a possible ECB behaviour:

… If the ECB is forbidden from accommodating market-driven changes in the composition of its assets, or if the ECB rules that it will not accumulate additional stocks of securities issued by governments that have excessively large debts according to rating agencies, then fiscal policy in the ‘weak’ countries must be endogenous for stability to prevail, for otherwise it would seem that the only alternative is to let interest rates on euro bills to diverge from country to country in an unsustainable way.

Now this would seem to be a rather dismal state of affairs, from a progressive standpoint. However, it should be noted that balanced fiscal and external positions for all could as well be reached if the euro country benefiting from a (quasi) twin surplus as a result of the negative external shock on the other euro country decided to increase its government expenditures, in an effort to get rid of its budget surplus …

i.e., Euro Area nations with a weak external sector will have to deflate fiscal policy to attempt to keep the external deficit, net indebtedness to the rest of the world and interest rate in check, if surplus nations in the Euro Area do not wish to engage in fiscal expansion. Else, as G&L conclude:

Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.

In my opinion, this is the only way the Euro Area can come out of the mess because it is the only way the net indebtedness of an EA nation (or a group of nations) can be prevented from exploding relative to its domestic output .

For an earlier take on the Maastricht Treaty by Wynne Godley see the article Maastricht And All That published in the London Review of Books in 1992.

S&P Again

Yesterday S&P put 15 of the EA17 governments on CreditWatch negative (comments and links here). It later came out with Credit FAQ: Factors Behind Our Placement Of Eurozone Governments On CreditWatch which gives the rationale for the action. According to the S&P

For countries in net external liability positions, including the eurozone’s peripheral economies, we see growing risks to the funding of their external requirements. In our view, financial institutions located in countries in net external asset positions (such as Germany) also face pressure where the quality of those assets is deteriorating.

So it seems to understand that the problem of the Euro Area is severe internal imbalances leading to high net external debt.

S&P also wrote an article titled Why Trade Imbalances For Creditors As Well As Debtors In The Eurozone Are Weighing On Growth, a few days back. Available through S&P’s Twitter update

A wisecrack:

More fundamentally, large imbalances between the 17 member economies remain; after many years of high current account deficits in net debtor eurozone countries, these economies have built up substantial levels of net external debt. Such high levels of external leverage will weigh on economic growth prospects–in both net debtor and net creditor eurozone countries–over the next several years. How imbalances between them are unwound, and under what conditions, could determine the success or failure of policymakers in addressing the European debt crisis.


More on net indebtedness. Australia’s ABS released its Balance of Payments and International Investment Position, September 2011. It has this chart on Australia’s Net International Investment Position (with sign reversed in their convention):

So around 60% of GDP. Highly indebted nation!

Australia’s debt is both in domestic and foreign currencies and banks have hedged most of the foreign currency exposure hedged using foreign exchange derivatives. Australia’s government has almost zero liabilities in foreign currency.

Some people claim that as long as the debt to foreigners is in domestic currency, it doesn’t matter for some kind of “intuitive” reasons. My view is that while it is true that it is advantageous to incur liabilities to foreigners in domestic currency, my reasons are entirely different. A liability in domestic currency prevents revaluation losses if the exchange rate depreciates. A net indebtedness to foreigners is still a burden.  A point rarely understood.

S&P And EA17 National Governments

First, there was a leak from FT S&P ratings warning to top euro nations and then it really happened:

Pdf uploaded by S&P here

Does it matter? Yes and No. Will have to wait for the markets to open tomorrow, although SPX and EURUSD moved a bit after FT put out the news.

The Euro Area monetary union has designed itself to be dependent on rating agencies. For example, the “Eurosystem Credit Assessment Framework” outlines what kind of collateral are acceptable for borrowing (by banks) from their home National Central Bank. So eligibility and “haircuts” depend on ratings. If a national government’s rating gets downgraded, most private sector securities issued by the nation can be impacted. It is true that for a while, some issuers had their ratings higher than their sovereigns (possible!), time has arrived when they will be impacted too. With a general shortage of collateral, this will make the situation worse.

And of course, if markets start pricing a higher credit risk based on S&P’s opinion, there needn’t be an explanation of how things can go wrong.

Hungary Again

I had two previous posts on Hungary here and here. Initially I thought of writing more on this, but today Fitch came out with a rating action and I guess explains most stuff on the deterioration of the economy – so enough of Hungary for now. Find below Fitch’s release. I quoted two comments highlighting CHF mortgages (equivalent of 16% of GDP) while my first post was on deteriorating external finance – both highlighted by Fitch.

Full report below

Fitch Ratings
Fitch Revises Hungary’s Outlook to Negative; Affirms at ‘BBB-‘ Ratings 

11 Nov 2011 11:06 AM (EST)


Fitch Ratings-London-11 November 2011: Fitch Ratings has revised the Outlooks on the Republic of Hungary’s Long-term foreign and local currency Issuer Default Ratings (IDR) to Negative from Stable and affirmed the ratings at ‘BBB-‘ and ‘BBB’, respectively. The agency has also affirmed Hungary’s Short-term IDR at ‘F3’ and Country Ceiling at ‘A-‘.
“The revision in Hungary’s Outlook to Negative reflects a sharp deterioration in the external growth and financing environment facing Hungary’s small, open and relatively heavily indebted economy,” says Matteo Napolitano, Director in Fitch’s Sovereign Group. “Moreover, various fiscal policy measures and the scheme to allow the repayment of household foreign currency mortgages at below market exchange rates have dented foreign investor confidence, on which medium-term growth prospects depend.”

Hungary is particularly exposed to any deterioration in the economic and financial conditions in the eurozone, owing to its open economy, mainly Western European-owned banking sector, relatively high levels of public and external debt and financing ratios, sizeable stock of portfolio investment (including a 40% non-resident share of domestically issued government debt) and Swiss Franc (CHF) mortgages debt.

Heightened risk aversion has increased refinancing risks on external sovereign maturities. Hungary needs to refinance around EUR4.6bn in 2012, and EUR5bn-EUR5.6bn annually in 2013-14, of foreign exchange denominated debt. Any potential selling of HUF-denominated debt by non-resident investors could add to financing pressures. The government’s EUR1.6bn cash deposit at the central bank provides a moderate buffer against refinancing risks.

Growth prospects have weakened sharply both in Hungary and in its main Western European trading partners in recent months. In October, Fitch revised its forecast for 2012 eurozone GDP growth down to 0.8% from 1.8% previously, and to 1.6% from 1.7% previously for 2011. Against this backdrop, with domestic demand weighed down by fiscal tightening and private-sector de-leveraging, Fitch expects Hungary’s economy to grow by only 0.5% in 2012, down sharply from the agency’s projection of 3.2% in June 2011.

The government appears committed to fiscal consolidation and through the course of 2011, has set out an array of measures in the Szell Kalman plan in March, the Convergence Programme in April and the new measures announced in September. Despite some widening in the structural budget deficit in 2011, it will run a general government surplus in 2011 of around 3.5% of GDP, driven by large one-off factors such as the return of private pension assets to the public sector. Fitch forecasts that government debt will decline to around 76% of GDP at end-2011, from 80% at end-2010.

For 2012, the government intends to reduce the structural budget deficit by over 2 percentage points of GDP to bring the headline deficit to 2.5% of GDP, thus taking Hungary out of the EU’s Excessive Deficit Procedure (EDP). However, the weak growth outlook, the uncertain costing and implementation of some measures and potential reform fatigue make this challenging. Fitch forecasts a 2012 budget deficit of 3.3% of GDP.

Over the course of 2011 the Hungarian forint (HUF) has depreciated by 13%-14% against both the euro and the CHF, thus increasing further heavy public- and private-sector debt repayment burdens. The government’s policies to tackle the large stock of CHF-denominated household debt (equivalent to 16% of GDP in mid-2011) may turn out to be fairly ineffective and have negative consequences. Credit constraints and a lack of sufficient savings will likely prevent the share of CHF loans that are repaid early at a preferential exchange rate from rising above 20%-25% of the total (see ‘Hungary: Risks from Swiss Franc Debt Exposure’, dated 5 October 2011 at www.fitchratings.com).

However, this will still place further pressure on the HUF and on the banking sector’s balance sheet, which is already beset by an exceptional levy, rising non-performing loans and several years of sluggish economic activity. Although the system average Tier 1 capital adequacy ratio (CAR), at 10.9% in September 2011, looks reasonable, a number of banks are already making losses and will require re-capitalisation – which is likely to be forthcoming from foreign parents. Nevertheless, foreign parent banks are likely to continue to cut their exposure to Hungary and the supply of credit is likely to continue to contract, weighing on GDP growth.

Some of Hungary’s fundamental rating strengths such as a rich and diverse economy, and underlying political stability remain in place. Moreover, it is running a large current account surplus, which Fitch forecasts at an annual average of 2.4% in 2011-12, helped by resilient export performance and weak domestic demand. It should also attract around USD2bn in non-debt financing in 2012 from EU transfers and other sources.

Foreign direct investment (FDI) registered a net outflow of EUR1bn in H111. Aside from a handful of large investments in the automotive sector, there are few significant FDI projects in the pipeline. Potential investors appear to be either delaying decisions, or investing elsewhere, as government policies have eroded Hungary’s business climate – a traditional rating strength and key part of the growth model.

When Fitch affirmed Hungary’s rating at ‘BBB-‘ and revised the Outlook to Stable on 6 June 2011, it noted that “negative pressure on the rating could also emerge from the anaemic growth, private sector capital outflows, increased problems in the banking sector or a significant shift in investor sentiment that adversely affected Hungary’s public and external financing capacity”.

Hungary is exposed to an intensification of financial instability and recession in the euro area. A significantly worse than currently anticipated slowdown, evidence of private sector capital outflows or problems in the banking sector, a rise in the risk premium or fiscal financing pressure could lead to a downgrade. A material weakening in the government’s commitment to fiscal consolidation could also lead to a downgrade.

Conversely, the government meeting its budget deficit targets and a return to healthy growth, particularly in the context of significant structural reforms and declining external debt ratios, could lead to positive rating action.


Primary Analyst
Matteo Napolitano
+44 20 3530 1189
Fitch Ratings Limited
30 North Colonnade
London, E14 5GN

Secondary Analyst
Ed Parker
Managing Director
+44 20 3530 1176

Committee Chairperson
Shelly Shetty
Senior Director
+1 212-908-0324

Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com.

Additional information is available at www.fitchratings.com.

The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

Applicable criteria, ‘Sovereign Rating Methodology’, dated 15 August 2011, are available at www.fitchratings.com.

Applicable Criteria and Related Research:
Sovereign Rating Methodology


Copyright © 2011 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries.