THE GLOBAL FINANCIAL CRISIS HITS HUNGARY

C O N F I D E N T I A L SECTION 01 OF 03 BUDAPEST 001006

SIPDIS

DEPARTMENT FOR EUR/CE, EB/OMA, INR/EC
TREASURY FOR ERIC MEYER, JEFF BAKER, LARRY NORTON

E.O. 12958: DECL: 10/16/2013
TAGS: EFIN ECON PREL HU
SUBJECT: THE GLOBAL FINANCIAL CRISIS HITS HUNGARY

REF: BUDAPEST 874

Classified By: P/E COUNSELOR ERIC V. GAUDIOSI; REASONS 1.4 (B) AND (D)


1. (SBU) Following years of high budget deficits and other
economic policy mistakes, together with a high reliance on
foreign currency-denominated loans, Hungary finds itself
particularly vulnerable to the secondary effects of the
financial crisis - the increasing cost and drying up of
credit, lower investor risk tolerance, and a shrinking of
export markets in Western Europe.


2. (U) Ever since the cloud of the U.S. mortgage crisis began
to loom over Europe, GOH officials and economic analysts
maintained that the Hungarian banking sector had little
exposure to toxic assets, and would not be impacted by the
primary effects of the mortgage crisis, as the financial
sector held little toxic debt. Eighty percent of the banking
sector in Hungary, however, is made up of local subsidiaries
of foreign (mostly European) banks. These banks, while
generally profitable in Hungary, are subject to the liquidity
and capitalization problems of their parents.

CURRENT MACROECONOMIC SITUATION


3. (U) Over the past two years, the government has narrowed
its fiscal and current account deficits. Years of high
fiscal and current account deficits, however, have left
Hungary with the largest government debt (over 67 percent)
and net external liability position (relative to GDP) among
the new EU member states. These macroeconomic risks
contributed to a widening in government bond spreads and a
reduction in demand for government securities as global risk
tolerance continues to fall.

FOREIGN CURRENCY-DENOMINATED LOANS


4. (U) Additionally, an increase in foreign currency
borrowing has raised both household and the corporate
sectors' net foreign currency liabilities. The mortgage
market, in particular, is largely comprised of
foreign-currency denominated loans. Merrill Lynch analysts
note that within the Hungarian banking sector, only 44
percent of private credit is in local currency, with foreign
exchange lending split between Euros (18 percent) and Swiss
Francs (37 percent). These high foreign currency liabilities
continue to raise indirect credit risk to the banking system.
The financial sector's external funding has become
particularly vulnerable as banks have less access to external
funding.

EXPORTS IMPACTED BY LACK OF EU GROWTH


5. (U) A recession in Western Europe will impact growth in
Hungary, which relies on European markets (particularly
Germany) as a destination for exports. This was one reason
cited by the government for revising its 2009 budget, which
was originally based on an optimistic growth forecast of 3
percent. Shrinking exports also result in a higher current
account deficit and external financing requirements.

CURRENCY AND STOCK MARKET IMPACT


6. (U) Last week Hungary experienced a sharp currency
depreciation and decline in the stock market. Bond yields
have increased significantly as demand for Hungarian
government securities has dried up, causing the Debt
Management Agency to cut back issuances. In addition, a
growing number of banks have announced they are stopping or
reducing their foreign exchange-based lending, particularly
in the Swiss Franc, due to increased concerns about
counterparty risk in the European interbank markets.


7. (SBU) Panic, rumors about the health of the Hungarian
financial sector, and fear that Hungary would become another
Iceland has contributed to the negative impact on markets and
exchange rates. In addition, although initially favorably
received, news of possible IMF assistance has caused some to
fear that the situation in Hungary is even more serious than
initially believed. Hungary's vulnerabilities came to light
on Wednesday, when the stock market experienced its largest
one-day point decline ever, and the forint weakened to 266 to
the Euro. S&P today put Hungary, which currently has a
BBB /A-2 Sovereign credit rating, on "CreditWatch" due to
"concerns over mounting financial sector pressures and their
potential to raise general government debt materially from
its current level of 67 percent of GDP."


BUDAPEST 00001006 002 OF 003


GOVERNMENT RESPONSE


8. (SBU) Although perhaps underestimating the speed and the
severity in which the economic crisis would hit Hungary, the
government has been taking it seriously, and has begun taking
steps to address it. By Hungarian standards, the discussion
over what actions to take has been reasonably constructive
and not dominated by partisan squabbling (septel).


9. (U) In addition to reassurances about the health of the
Hungarian financial sector, last week the government
announced a 12-point plan to address the effects of the
financial crisis in Hungary, which included the withdrawal
and revision of the 2009 proposed budget and tax bill, and a
package of "Measures to Strengthen the Safety of Deposits".
The GOH announced an increase guarantee on bank deposits to
EUR 50,000 in line with EU decisions, and also announced the
following actions:

--it would begin offering state guarantees for interbank
loans;

--it would repeal investment regulations of pension funds
requiring stock holdings of 40 percent;

--the National Bank would introduce one-day forint-euro
currency swap tenders to help optimize capital flows between
banks, and indicated it stands ready to help banks meet their
forint liquidity requirements.


10. (U) Subsequently, Hungary began a dialogue with the IMF
on possible financial assistance as "a measure of last
resort." On Wednesday, the National Bank announced that they
are working on a package of measures to help the government
securities market, and that the Debt Management Agency (AKK)
and the IMF would all likely play a role.


11. (U) In addition to working with the IMF, the Hungarian
National Bank and the ECB reached an agreement today on
repurchase transactions, allowing the National Bank to borrow
up to EUR 5 billion to provide additional support to its
operations. This facility would support the new announced
open market operations announced last week to support
liquidity in the domestic foreign exchange swap market. The
Finance Minister said further measures could be announced as
early as this afternoon.


12. (U) On Wednesday, Prime Minister Gyurcsany made several
proposals at the EU summit, including: Granting SME,s
faster access to EU funds; broadening the authority of the
European Central Bank to use monetary policy tools to
intervene in any EU Member State (not just those within the
Eurozone); suspending 3 percent deficit caps for member
states during recessions; and establishing a unified EU
financial markets authority.


13. (U) Today, the Finance Minister announced that the
government plans to further tighten 2008 and 2009 budgets,
and that an IMF delegation is in Hungary monitoring the
situation, and may stay through Saturday. Any assistance
plan would not be announced until after the delegation makes
a proposal to the Board next week. Observers believe IMF
assistance may not come in the form of a stand-by loan, but
technical and other financial assistance instead.


14. (U) Minister Veres also announced that the government is
reducing its deficit target for 2008 to 3.4 percent,
decreasing the financing requirements for the rest of the
year. The GOH announced that it plans to meet the Maastricht
deficit criterion in 2009 and set a budget deficit goal of
2.9 percent (below 3.2 percent Convergence Program target).
Details, including macroeconomic assumptions of growth and
inflation will be released this Saturday. Prime Minister
Gyurcsany has reportedly stated that this could make it
possible for Hungary to join the ERM II by 2010.


15. (C) Comment: The GOH is taking the economic crisis
seriously, and seems to be casting a wide net in exploring
policy responses. We see the GOH's willingness to seek
assistance from the IMF and Brussels as a positive sign that
Budapest is not in denial. Indeed, the government may see
the crisis as a way to revive its political fortunes
(septel). The involvement of the IMF or the ECB may also
assist Hungary in undertaking politically difficult long-term
reforms, the key to economic prosperity. Publicly, the
government has not directed blame at the U.S., but portrays
its policy response as an attempt to not only avoid becoming
a victim of the global financial turmoil which began abroad,

BUDAPEST 00001006 003 OF 003


but also to fend off attacks from unscrupulous market
speculators at home.
Foley