Interest rates rise in Kenya, Uganda. Hungary next

November 2, 2011

Recent weeks have witnessed an interesting  split between countries that are raising interest rates to fend off runs on their currencies, and those cutting rates to spur on growth — check out my colleague Carolyn Cohn’s recent piece on this topic (http://tinyurl.com/4x58ny6) .The frontier economies of Africa fall into the first category — Kenya this week jacked up rates by an unprecedented 550 basis points to ward off a currency collapse, while Uganda’s benchmark rate was increased by 300 bps.  

Big stable economies such as Australia, Brazil and Indonesia have cut interest rates. On Wednesday, Romania became the latest  country to do so.  But an exception is investment grade Hungary, which may soon join the ranks of  frontier markets in currency-defensive rate hikes.

It may also soon lose its investment grade status –at least one of the three big rating agencies is expected to soon announce a cut to the sovereign credit rating.  That fear has triggered flight from the forint and short-dated bonds, pushing the currency to 2-1/2 year lows and causing significant flattening in the yield curve. The situation hasn’t been helped by signs the government is cooking up another sceme to subsidise indebted small businesses. More is to come, many predict –a ratings downgrade could see investors pull at least $1.2 billion euros from local bond markets. ING Bank estimates. That would be 10 percent of foreigners’ Hungarian bond holdings and would send the currency into a fresh tailspin.

The forint is down 9 percent this year to the euro, and Hungarians, holding a vast stock of euro- and Swiss franc-denominated mortgages, cannot really tolerate a much weaker currency. A rate rise seems like the only way out, says Societe Generale analyst Benoit Anne who predicts the Hungarian central bank will be sufficiently alarmed by the pace and scope of the forint’s fall to raise rates by 200-300 basis points. That rekindles memories of the October 2008 crisis when the bank was forced into a 300 bps rate rise to support the forint.  Swaps markets are currently pricing a 100 bps rate rise — most analysts say that is too conservative.

The fact is investors have turned their attention to Hungary away from Turkey, where the central bank has stabilised the lira via a stealthy policy tightening exercise that boosted implied yields on the lira to around 9 percent, the highest in emerging markets. Hungary will have to do the same, says Anne who advises investors to sell the forint and buy lira instead.

True, Hungary’s position is a bit different from Turkey’s. Turkey has a massive balance of payments deficit but Hungary has a small surplus, equating to about 2 percent of its gross domestic product.  Central bank reserves cover seven months of imports, a comfortable position compared to Turkey which had enough cash to pay for just over three months of imports. All this means the central bank has the option of intervening in FX markets first to support the forint, according to  HSBC analyst Murat Toprak, who says Hungary’s moribund economy simply cannot cope with higher interest rates.   But Hungary’s central bank tends to avoid intervention – other analysts point out that even in 2008, it resorted to rate hikes rather than digging into its reserves to defend the currency.

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