GOVT BOND MARKET WAITING TO BOUNCE BACK

C O N F I D E N T I A L SECTION 01 OF 02 BUDAPEST 000042

SIPDIS

DEPT FOR EUR/CE, EB/OMA, INR/EC; USDOC FOR SAVICH; TREASURY
FOR IRS, ERIC MEYER, JEFF BAKER, LARRY NORTON; USEU FOR
HAARSAGER

E.O. 12958: DECL: 01/14/2014
TAGS: EFIN ECON PGOV HU
SUBJECT: GOVT BOND MARKET WAITING TO BOUNCE BACK

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


1. (C) Summary. The situation in the Hungarian government
securities market improved only slightly in recent weeks
following a tumultuous autumn that saw yields of 13-14
percent and massive sell-offs by non-resident investors. The
government has sought to stabilize the market by suspending
regular bond auctions to reduce supply pressure, cutting
government expenditures to lower the country's net financing
needs, and relying on EU and IMF loans to eliminate the need
to go to international capital markets. Despite these
actions, investors have yet to return, and non-resident
investors remain net sellers. There is growing concern that
excessively high FX exposure in Hungary's debt portfolio or a
failure to meet deficit reduction or other commitments made
under the terms of its IMF loan could result in further
downgrades in Hungary's rating by international credit rating
agencies, thus further delaying the recovery of Hungary's
financial markets. End summary.

AUTUMN TURMOIL IN THE BOND MARKET


2. (SBU) Global deleveraging, investor risk aversion, and a
lack of confidence in Hungarian macroeconomic fundamentals
created a crisis in the government securities market in
October, as the market virtually froze from a lack of demand
that pushed yields as high as 13-14 percent. Following a
decade of annual increases in non-resident holdings of
Hungarian government securities, the sell-off in October and
November was particularly dramatic - the volume of
foreign-owned Hungarian government securities decreased by
approximately USD 4 billion, a decline of over 25 percent.
Non-residents hold about 30 percent of Hungary's
forint-denominated debt (about 8 percent of treasury bills
and 35 percent of treasury bonds). Hungarian Debt Management
Agency (AKK) Managing Director Laszlo Buzas also notes that
Hungary's downgrade by international credit rating agencies
this fall contributed to the sell-off by making Hungarian
government securities less attractive to a number of
institutional investors.

GOVERNMENT RESPONDS


3. (SBU) In response, AKK revised its debt financing plan to
reduce supply pressure on the government bond market,
suspending remaining 2008 issuances. In mid-December the
agency released its 2009 debt financing plan, which calls for
a further decrease in the supply of bonds and schedules no
regular government bond auctions during the first quarter of

2009. In addition, in October the Hungarian National Bank
(MNB) began purchasing government bonds with 1-3 year
maturity dates, but discontinued doing so in early December
as Hungary's financial market environment improved.


4. (SBU) The government is also reducing its 2009 financing
needs through deficit reduction. Under the terms of the
international stabilization package, Hungary agreed to
accelerate its fiscal consolidation and reduce its deficit to
2.6 percent, which should reduce Hungary's net financing
needs for 2009 by nearly USD 400 million. Subsequent
predictions of a significant economic contraction, however,
will increase the pressure on the GoH to revisit these
targets.


5. (SBU) Moreover, in 2008 Hungary has made use of EUR 1
billion of the IMF and EU stand-by arrangements to redeem
expired debts and finance repurchase auctions, thereby
reducing the amount of bond issuances required. It expects
to use another EUR 5 billion (HUF 1,430 billion) in 2009.

BUT INCREASES FOREIGN CURRENCY EXPOSURE IN THE PROCESS


6. (SBU) This use of the IMF and EU credit lines will
increase AKK's foreign currency exposure. The agency's
current debt management guidelines call for a maximum HUF-FX
debt ratio of 32 percent. AKK expects to use approximately
EUR 5 billion from the credit line in 2009, which would
increase the FX ratio in Hungary's debt portfolio to over 35
percent. AKK CEO Laszlo Szarvas cautions that this would
create a risk of possible downgrades of Hungary's sovereign
debt rating, but expressed the hope that the credit rating
agencies would understand the extraordinary situation.


7. (C) In addition, AKK's Buzas tells us that they are in
discussions with the MNB about the possibility of swapping
euros for forints, which would reduce AKK's foreign currency
exposure and could enable the MNB to put additional medium

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term foreign exchange in the market. Buzas notes, however,
that discussions are ongoing and the MNB has not yet agreed
to such an arrangement.

SLIGHT THAW, BUT WHEN COMES THE MELT?


8. (U) The situation improved somewhat in December, as yields
declined to 8-9.5 percent. AKK Senior Managing Director
Laszlo Borbely points to increased domestic demand and higher
demand at auctions as a sign that markets are beginning to
normalize. Analysts caution, however, that this may not be
the case, noting that non-resident investors remain net
sellers, and that AKK is keeping supply artificially low to
help stabilize the market.


9. (C) Considerable uncertainty remains regarding when
foreign investors will return to Hungary's financial markets.
AKK's Buzas believes that foreign investor deleveraging has
not come to an end, estimating that there may be as much as
HUF 800 - 1 trillion (USD 4-5 billion) yet to come. Some are
concerned that if demand for government securities does not
pick up in 2009 - or if the Hungarian economy faces some new
crisis - AKK will be forced to once again revise its debt
financing plan and the GoH may look to use more of the IMF
and EU credit lines for government financing.


10. (SBU) When asked when they plan to resume regular
auctions, AKK officials express the hope to resume regular
auctions during the second quarter of 2009, but tell us they
are trying to remain flexible, and have been in discussions
with market participants.

THE RISK OF A DOWNGRADE


11. (C) Comment. There is a risk that excessively high FX
exposure in Hungary's debt portfolio, or a failure to meet
deficit reduction or other commitments made under the terms
of its IMF loan could result in further downgrades in
Hungary's rating. All three major international credit
rating agencies have already issued a negative outlook
following November and December downgrades. S&P, for
example, noted that Hungary's ratings could be lowered
further "if political support for fiscal consolidation were
to falter." Further downgrades by credit rating agencies
could delay investors' return to Hungary, or even cause many
remaining investors to close their positions here in search
of lower-risk investments. This would exacerbate Hungary's
problems in restoring investor confidence, and possibly delay
the return of normally functioning markets. End comment.

Foley