The context

Every third Hungarian family services a loan denominated in foreign currency, predominantly in Swiss francs (CHF), drawn either to buy a house or a car. The whole stock of foreign exchange (FX) household mortgage loans amounted approximately to CHF 22 billion, that is 18 per cent of Hungarian GDP in the autumn of 2011. Each month a million families wonder how much to pay on debt service, since the forint (HUF) floats against foreign currencies; therefore the actual sum you must pay depends on the exchange rate on a given day of the month. The household sector is not alone in this situation; companies and the Hungarian state itself are also hooked on foreign borrowed funds.

This is why the daily exchange rate is as much a common conversation topic here as the weather in England. The issue of FX loans has become, not surprisingly, highly political, which eventually made the government offer a very political answer in the autumn under the somewhat pompous name of “plan for protection of the National Economy”.

Now, for those not familiar with the particular local conditions, the whole story must sound quizzical. The situation certainly calls for explanation. Few Britons or Americans would ever think of borrowing in a currency not their own. You earn your income in dollars, why would you then borrow in, say, yen? That does not make much sense.

Still, such a case is not absurd at all in Central and Eastern Europe. In fact, using foreign currency for domestic transactions is not rare in other parts of the world, either. If you live in Latin America, you may sell and buy non-trivial items in US dollars; as saver or borrower, your currency is the US dollar. The financial jargon refers to such widespread practices as the “dollarization” of an economy.

In this part of the world, we learnt a similar practice a long time ago under another name. Dealing in hard currency – this is what you did as a tourist renting a room in Yugoslavia in the 1970s and 1980s. This was not an optional choice for the visitor: no landlord would let a room or apartment at a seaside resort for dinars, the official, and inflationary, currency of Socialist Yugoslavia. In fact, bed-and-breakfast rates were customarily quoted in Deutschmarks (DM), a sort of semi-official currency. Similarly, in Socialist Poland before the changes of 1989 you could get by only with US dollars, or DM, or even Austrian Schillings in your purse: asset and goods owners were reluctant to accept zloty, the official currency with a purchasing power that declined fast. Under the conditions of product shortage, as was the case with Socialist Poland, in a financial mess after 1980, hard currency dealing was obvious and unavoidable.

In contrast, Socialist Hungary in the 1980s did not experience physical shortages and supply frictions of comparable size. Yet here you also needed hard currency if you wished to buy imported quality products such as Scotch whisky, fine chocolate or a Western car.

Dollarization was not limited to households in certain planned economies. Their governments borrowed internationally in hard currency for the simple reason that there were not enough domestic savings, and international credit was exceptional under COMECON, the economic commonwealth of Communist regimes. General lack of savings was partly due to the fact that until the 1980s planned economies had only a quite rudimentary banking system, with no stock exchanges or other key financial institutions of market based economies. It was only under IMF tutelage that Socialist Hungary started to build a (state owned) commercial banking system in 1987. Still, domestic savings proved insufficient to meet the overall demand for funds generated by the Hungarian State, the (state owned) firms and banks, and the households put together. Thus the authorities (Ministry of Finance or the Hungarian National Bank) had to turn to foreigners for funding, and it could not be done in local currency. The Forint, the legal tender of Hungary at that time was a not-fully-convertible “local currency”.

Before the ascent of the Euro (EUR), certain states and their central banks (“sovereign borrowers”) of East European countries borrowed in DM, pound sterling, Swiss franc, and yen. Lately, sovereign and business borrowers have mostly used USD and EUR, but the Swiss franc has also remained popular. The Chinese yuan will probably become an emerging star in the international debt markets once it is fully convertible.

But whatever the currency, borrowing in a foreign currency is risky for the borrower. In an often quoted paper, Eichengreen and Hausmann (1999) analyzed a particular financial situation that emerges as a consequence of what they dubbed the “original sin”: market participants in need of funds borrow abroad not in the domestic currency but take up funds in foreign (hard) currencies. Under such circumstances, borrowers run an exchange rate risk emanating from a currency mismatch: projects that generate local currency will be financed with dollars or other foreign currencies. On top of that, borrowers face a maturity mismatch: long-term projects are financed with short-term (foreign exchange denominated) loans.

As Communist Poland, Yugoslavia, and Hungary had to learn the hard way in the 1980s: exchange rate risk is not a negligible technical term. In fact, excessive state (“sovereign”) borrowing in hard currency led eventually to international bankruptcy of Poland and Yugoslavia during the 1980s; Communist-led Hungary could only avoid defaulting on its external debt in hard currencies by swiftly entering the International Monetary Fund (IMF) and World Bank (IBRD) in 1982.

Policy mistakes and political vices

All this is past history. But past histories can come back to haunt you. Some political élites can learn from mistakes of yesteryear, but some cannot and they are destined to relive the same sad history.

Indebtedness in foreign currency has a long history in Socialist Hungary. At the very moment of the political regime change in 1989/1990, the Hungarian state was again at the brink of international default – a rough start for the Antall cabinet. Gradually, we managed to move out from the danger zone. Borrowing conditions improved a bit, and non-debt-creating forms of currency liabilities started to flow into Hungary, foreign direct investments (FDI) first of all. Later the prospect of full membership in the European Union (EU) accelerated financial flows into the region, and particularly into Hungary. In 2004, entry into the EU opened a new chapter: decades of non-convertibility of currency and of managed finance were over: as an EU member, Hungary was as open financially as older and richer member states.

Yet, EU membership in 2004 found Hungarian finance in a rather peculiar situation. Most of the banking sector was owned by foreign investors by the second half of 1990s. With easy access to foreign exchange funding, foreign-owned banks offered foreign currency-denominated loans to Hungarian customers as a matter of course. This practice was immediately copied by domestic banks. Households and corporate borrowers found the lower interest rates on foreign currency-denominated loans attractive, even though most borrowers had no income in the same funding currency, and consequently they, as clients, had no natural hedging against foreign exchange risk. Banks hedge their exposures, and the financial supervision agency makes sure that the banks have no open positions; thus their FX-positions are broadly balanced. But this also means that private and corporate domestic borrowers run all the exchange rate risk. This sort of risk is a major item in the Hungarian case: over half of bank lending to the nonfinancial sector is denominated in foreign currency (mostly Swiss francs and Euro).

Now we have the familiar pattern in a country that entered the 1990s with higher external debt than neighbouring countries in Central and Eastern Europe, due to a history of greater openness to trade and finance flows. Transformation into a market economy in the early 1990s only further increased financial openness. Accession to the EU also triggered substantial financial inflows both in the form of EU funds, and private funds. By the end of 2007, Hungary’s external debt amounted to about 100 percent of GDP – a large exposure at a time of modest economic growth even in peaceful times. But 2008 turned out to be anything but peaceful. Hungary had to request the IMF to provide financial help. Politicians, it seems, had learnt nothing from history.

Drivers of foreign currency loans

As for the IMF, it had certainly noticed the issue with FX loans, and made its concern known to the authorities. It is informative to learn about the IMF’s earlier activity now, when a parliamentary committee investigates the history of the foreign loan saga with the aim of finding the persons and institutions responsible for the hardships of “the people”. Well, one cannot claim that no policy maker was aware of the risks involved in household borrowing in foreign currencies. The Fund wrote in its 2005 report on Hungary that “although the share of foreign currency loans to households still remains relatively small (less than 15 percent of total household loans, as of December 2004), it has been growing very rapidly. The main driving factors appear to be the winding back of subsidies on forint mortgages and the resulting increased spread between effective nominal interest rates on forint loans and interest rates on foreign currency loans. The availability of foreign currency funds in the form of loans from foreign parent banks has also contributed. Of significant concern, there seems to be some lack of awareness by borrowers of the exchange rate risks, despite the steps that have been taken by the authorities to publicize these risks” (IMF, 2005).

Needless to say, these words of caution had no effect. In fact, the process of household indebtedness accelerated in earnest after 2004. But let us put the process into perspective. Hungary joined the European Union in May 2004, and expectations of both borrowers and bankers were rosy, and justifiably so. EU funds started to flow into the Hungarian economy, and private fund holders also found the country a good place to invest. All major economic factors pointed in one direction: growth. Compared to other new member states, the Hungarian economy was not even in an overheated condition: 4 to 5 per cent GDP growth was nice but far from phenomenal at a time when the Baltic countries or Slovakia experienced growth rates over 8 per cent, or even in double digits.

On the supply side: the banks, mostly foreign-owned, were happy to offer their Euro-based products – in a country that was supposed to join the Euro zone at the earliest possible date. For history’s sake: the first Orbán cabinet, back in 2000, announced the intention of an early accession to the Euro zone, as early as 2006 (which was otherwise technically impossible under the Maastricht entry conditions; Slovenia, the very fastest entrant, adopted the Euro in January 2007). Therefore, it was not unreasonable to assume that the forint would cease to exist in a not too distant future. Mortgage loans are certainly about the long term.

Obviously, Swiss franc was not, and is not, a currency of an EU state. But the exchange rate of CHF had been pretty stable vis-à-vis the Euro for a long time thus the genuine exchange rate risk that a Hungarian client borrowing in CHF was running – so went the argument – was practically similar to the EUR/HUF risk. And the latter was not regarded as serious. Moreover, convergence economies, such as Hungary’s, have had a tendency of real appreciation of their currency vis-à-vis the Euro, on the strength of their superior economic growth rate and the general tendency of asset price increase in emerging economies. All in all, there were strong arguments why the “original sin” was not really a big issue.

On the demand side: pent-up demand for new homes, new cars and consumer goods was logical in the early 2000s after a decade of hardship and austerity. People wanted to consume more; or – if you look at buying a home as an investment – to invest in real estate and durables. Being in the EU strengthened the lure of Western consumption and life style patterns in a decade that started with some tensions in 2000 but was followed by high real economic growth and a sizable increase in the standard of living. True, particularly in the case of Hungary, higher living standards were fuelled by international borrowing. Still foreign indebtedness caused less and less headaches for decision makers in new member states. Debt simply was not as hot an issue at that time all over Europe as nowadays, and Hungary was no exception. Consumers did feel better, real wage and real pension increases were visible – it is all the more weird that Fidesz in opposition built its 2006 election campaign on the slogan “We are all worse off than before”.

The less than spectacular economic growth in Hungary was soon to stop, in autumn 2006, when the Socialist-Liberal coalition led by Ferenc Gyurcsány had to announce austerity measures to stop public sector deficit from growing too much. The government was forced to implement a quick U-turn under the Excessive Deficit Procedure as determined by the EU’s Stability and Growth Pact. The “Gyurcsány Plan” with its combination of new taxes and public expenditure cuts, unfortunately, suppressed economic growth. Under such conditions, housing construction and real estate investments became even more important to add to the otherwise weak aggregate demand. Therefore the then government had no desire to kill the only booming sector – that is, housing construction driven by (foreign currency) bank loans even if distant potential foreign exchange risks were associated with it.

Then came the turbulent autumn of 2008, with deep depreciation of the forint against most Western currencies, and particularly against CHF. Unavoidably, the hard currency debt issue became highly political, and the issue remained hot, even getting more and more explosive, until it really led to the much debated government intervention of September 2011.

But that had an important antecedent: the banking community had failed to offer a concerted solution to distressed clients, in spite of the growing number of worrying signs, such as the increasing percentage of non-performing mortgage loans. The authorities are also to be blamed. The National Bank of Hungary did issue some warnings, but it had no regulatory power. The financial regulator remained rather restrained in its attitude to the foreign exchange-loan problem throughout this history, instead of restraining the banks in their business practice (that is, the one which places both the exchange rate risk and the interest rate risk on the borrower). In the absence of self-regulation or regulatory control over private interest, sheer politics will always step in. This is what happened in 2011.

When politicians set arbitrary exchange rates

The serious appreciation of CHF and, to a lesser degree, appreciation of EUR, against the forint raised the debt burden on households after the autumn of 2008. With around one million Hungarian households holding such loans, the issue is of national proportions and as such it has an impact on key economic variables. One of the victims is consumption. Families try their best to service mortgage loans even if they have to reduce current consumption and give up projects like home modernization or new car purchase. Not surprisingly, the construction business has been dying for some time, and new vehicle registration very much down. For the Orbán government with a pro-growth policy agenda, this is reason enough to intervene and to try to find funds to mobilize in order to solve the issue of lack of aggregate demand. Not surprisingly, it was the banking industry that the government pinpointed as the agent that could foot the bill.

Banks have become recently very unpopular, with reason. Many analysts feel that banks in fact mis-sold their foreign exchange-loan products, or at least failed to highlight the risks in an adequate and efficient manner when they sold their loan products. The foreign exchange-denominated mortgage, car, and consumer loan products have been until recently very profitable for banks in Hungary: return on equity in Hungary was in the period leading to the financial crisis of 2008/2009, three times what the same banks could make in Germany or Austria.

Now, with these events in the background it was a bit unexpected but not altogether surprising that the Fidesz government eventually decided to step in.

It started in early September 2011, with Fidesz politicians announcing that the government was working on a scheme to let homeowners repay foreign exchange denominated mortgages in a lump sum at government-determined exchange rates. Soon Parliament passed the proposal into law on 19 September with the votes of the government party and the opposition Jobbik party. Under the law, borrowers could repay their mortgage loans in a lump sum at a preferential exchange rate of 180 forints per Swiss franc, 250 forints per euro, and 2 forints per yen, provided they originally took out the loans at lower exchange rates. Losses out of repayment ahead of schedule and transaction costs must be assumed by banks. The exchange rates determined by laws were 20 to 25 per cent below recent market rates at the time of the announcement of the Act; later the gap between legal rate and the actual even widened as the forint, partly because of this very measure, depreciated further.

Such a wide margin between market rate and the officially set rate is so inviting that no one can reject the repayment offer. That is, no one with enough savings or with access to newer loans. The gain of the borrowers equals the expense of the banks. This expense is not trivial: banks do not have a CHF deposit base in Hungary, so they have to borrow funds abroad, typically short term, that they on-lend long term; if borrowers repay their debt at 180 HUF per CHF, banks still have to buy currency at going rates of 240 or more in the autumn of 2011.

Not many borrowers, though, can mobilize enough free funds or will be able to get new HUF loans. As we will see, some banks in the Hungarian market are short of forint funds. Consequently, forint loans are not cheap. Thus this scheme has limited relevance for all the families with foreign exchange-loans; the take-up rate is estimated at 10 to 35 per cent by analysts. The plan clearly helps some households to escape their foreign exchange liabilities; they are probably the most well-to-do families, while the really troubled borrowers who lack the funds or capacities to borrow cannot participate in this scheme. For them, the other government initiative may provide temporary relief: a previous Act allowed the temporary fixing of HUF instalments on foreign exchange mortgage loans, with rescheduling of the remaining debts.

This exercise will have macroeconomic effects since the potential stock of foreign exchange-loans is huge, the overall amount of mortgage loans outstanding denominated in the three mentioned foreign currencies exceeds to 5000 billion HUF. Even a relatively low take-up, say 10 per cent, as the Minister of National Economy Gy. Matolcsy forecast in his letter of explanation to the worried Austrian Finance Minister would result in bank losses of about 120 billion HUF – a half per cent of Hungary’s GDP. Fitch Ratings, a major credit rating agency, immediately announced that “the Hungarian parliament’s decision to allow repayment of foreign currency mortgages at below market exchange rates could put pressure on some banks’ credit profiles. The agency also has concerns that such measures could impede the long-term development of the banking system”.

These comments are rather restrained for a rating agency, not hinting at an instant downgrading of either the sovereign or of key banks. In fact, the Hungarian banking sector is, on the whole, well capitalized, and thus can absorb a shock like that, at least in the short term. But not all banks are in good shape. Recent policy events (such as the bank tax and now the prepayment of foreign exchange loans) result in what economists call an asymmetric shock. Hungarian banks differ, and the impact of such important legal changes will vary from market player to player. The largest bank that is widely seen as a Hungarian firm, that is OTP, and a small number of domestic banks and savings institutions will have a preferential starting position in the race for clients. The point is that even better-off clients would hardly be able to pay back the whole of FX loan from existing savings; such customers would probably turn to a bank (not necessarily the one with the original Swiss franc loan) for additional personal finance. Having a healthy forint deposit base gives a bank an advantage; lack of forint deposits amounts to a serious disadvantage.

Government officials are aware of the structural consequences for the banking industry of the repayment issue; Mihály Varga, State Secretary at PM Orbán’s cabinet office said in an interview in the Hungarian weekly Heti Válasz that “two or three banks leaving Hungary” would not be any problem. Certainly, some smaller banks have already considered exiting the stagnating Hungarian market. The ones with an Austrian parent are particularly unhappy about the whole scheme which causes additional losses for them without much chance of an upside in the form of future growth of business: Erste or Raiffeisen do not have the abundant forint funding needed to keep existing clients and to acquire new ones. They complain the most about lack of consultation and lack of respect for existing, valid contracts. The Austrian government is known to be considering legal remedies.


The initiative to reduce families’ exposure to foreign exchange debt through a government-sponsored one-off measure has created, obviously, heated controversy inside and outside Hungary. The interest representation of banks (Hungarian Banking Association) asked the Hungarian Constitutional Court to declare the scheme unconstitutional as an unjustified intervention into contracts between private parties. Critics of the new Hungarian government do not fail to notice that this is once again an “unorthodox” measure, like the bank levy or the de facto nationalization of private pension funds.

The banks that would be hit the hardest are those with owners in foreign countries. This is why some foreign governments expressed their concerns, particularly those whose bank had sizable operations in Hungary, and would have to swallow serious losses (Austrian, Italian, and German banks, mostly). Analysts feel that the issue will end up at the European Court of Justice – carrying a financial and reputational risk for future Hungarian governments.

Another risk factor is the success rate of the repayment scheme. If a very large number of households take part in it, bank losses may grow too big, endangering the stability of the banking sector, although it is not likely that a bigger part of the clientele will be able to take this opportunity to repay loans. But then alternatively there is a political price to pay: many families will feel category left behind, a sort of losers, unlike those with enough cash.

On the other hand, a successful reduction of Hungarian households’ exposure to foreign exchange risk would strengthen the balance sheet of many families resulting in a certain “deleveraging” of the household sector. This would be a welcome development in a country with excessive foreign debt. The government also assumes that the families relieved of financial burden and psychological stress would resume consumption; and consumption is the most important component of the aggregate demand.

We will see how this measure works. But one thing is certain: dependence on foreign borrowed funds, particularly above a certain limit, involves risks that can materialize in bad weather. Hungary has seen in recent decades too many incidents of very bad weather, thus it is high time policy makers learned the lessons about the “not that original sin”.


Eichengreen, B. – Hausmann, R (1999): Exchange Rates and Financial Fragility. NBER Working Paper No. 7418.

IMF (2005): Country Report No. 05/212.

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