Given the acute challenges that Hungary is facing in the fifth year of the financial disturbances in Europe, one could argue that it is not topical to discuss the whys, ifs and hows of Hungary’s entry into the eurozone.

The last time Hungary comfortably met even one entry condition of the notorious set of five Maastricht criteria was back in 2001, when we were not yet even in the European Union and thus were not able to apply to enter the third phase of Economic and Monetary Union (ERM 3): the one that involves the final, irrevocable fixing of the exchange rate of the national currency and consequent surrendering of sovereign monetary policy. It is hard to believe now that this economic variable was public sector debt per GDP – nowadays the hottest policy indicator both inside and outside the eurozone; and the one that rating agencies scrutinise the most keenly before declaring their verdict on a country’s sovereign risk.

The relative size of public debt has justifiably become the focus of policy debates in recent years in over-leveraged Europe, particularly in the “South”: Greece, Italy, Portugal, Spain – and Ireland (the so-called GIIPS countries). The reference value of debt/GDP was set at 60 percent when the founding fathers conceived the Maastricht tests in 1991; but few Western nations passed the test at that time and even fewer have done so since. Ironically, in the early 2000s, Hungary’s figure was just over 50 per cent – albeit higher than those of all the other new member states of Central and Eastern Europe (the EU10), but at the same time safely within the Maastricht limit. The debt sustainability outlook looked promising with the country’s limited annual deficit and strong economic growth at the time. That is all ancient history now, however. The Hungarian figure is currently the highest among the EU10 countries at around 80 per cent. The exact figure depends on the actual exchange rate of the national currency (HUF) against the funding currencies, half of Hungary’s stock of national debt being denominated in currencies of others.

Thus, for Hungary, meeting that particular entry condition looks like a long term issue only, which is bad news for those of us who would rather see Hungary in the eurozone in the foreseeable future. We do stand a good chance of meeting the public sector deficit criterion this year though. According to Maastricht, this should not exceed 3 per cent of GDP. Analysts expect the annual deficit in 2012 to be between 2 to 3 per cent, while the planned budget deficit for 2013 also remains below the limit. This is good news; yet passing one entry test is unfortunately not enough to be considered a candidate for euro entry. Hungary’s inflation rate is much too high for entry, and the same goes for interest rates. The remaining criterion of currency stability for 24 months within the Exchange Rate Mechanism (ERM) does not apply for Hungary of course, since the country has not even applied for entry into the ERM.

Enough of the technicalities of how a nation enters ERM 3: Hungary is not, and will not be for years, in a condition to even contemplate joining. So why even bother discussing our relationship with the euro? Well, it is hard to avoid. The problems of the euro, the eurozone, and the travails of some of the eurozone nations are undoubtedly critical issues and hot topics today. Another issue, perhaps less talked about, is how having the euro can create problems for a country’s economy. These problems are miniscule, however, compared with the challenge of running a currency of your own. Not being in the eurozone is not an answer to a nation’s dilemma of how to choose a currency regime that best suits your economy.

Our exchange rate regime is far from ideal, and in fact now seems to suit no one at all. The forint is nominally in a free float regime vis-à-vis the euro, the currency, let us not forget, of our most important trade and financial partners. If the HUF floats too freely and begins oscillating too wildly as can often happen with a smallish currency serving a limited market, the monetary authorities are forced to intervene in one way or another to stabilise the exchange rate.

Exchange rate volatility is a headache in any economy, but is a particular problem in one like Hungary with its extreme currency exposure, as was discussed in an earlier issue of this Review (HR Vol. II, No. 6). The National Bank may keep declaring that the paramount monetary policy goal is containing inflation and that the Bank does not have an exchange rate target, but in reality policy practice will be otherwise when society is so indebted in Swiss francs, euros or other hard currencies. Central bankers have to take into consideration the interests and probable reactions of large segments of Hungarian society with significant or critical foreign exchange exposures, from families to small businesses to local administrations. The government is particularly concerned about the situation of indebted households (who are, of course, also potential voters) and of the viability of domestic businesses under debt burden.

Managing a floating exchange rate is neither easy nor cheap. To protect the HUF from depreciation, you have to pay a price in the form of higher domestic interest rates. While most central banks (from the European Central Bank to the Bank of England to the Czech National Bank) can all keep their policy rate at or below 1 per cent a year, the Hungarian central bank’s base rate is 7 per cent. You can imagine what sort of competitiveness handicap this entails for market players in this country who have to borrow expensively in domestic currency in contrast to competitors in countries with access to much cheaper funding.

While too much depreciation of the national currency is undoubtedly a problem, appreciation can cause just as much a headache. Exporters justifiably protest that their profit margins are squeezed by too strong a forint. Business leaders repeatedly call for the forint to be weakened in order to protect domestic producers from unfairly cheap competitors.

Such demands are increasingly supported by observing the economic and financial problems of the “South” of Europe. These peripheral eurozone states that suffer from poor competitiveness vis-à-vis the “North” and the rest of the world claim that they are economically hamstringed because of the lack of option to devalue. Overindebted and uncompetitive nations from a price point of view find the adjustment process extremely difficult: authorities cannot change the nominal exchange rate, that is, devalue the currency and make tradable products cheaper.

Hungary is not a member of the monetary union and thus our situation looks different from those of the GIIPS countries but certain parallels prevail as long as the forint is informally pegged to the euro. Some southern nations may also suffer from exchange rate misalignment: they joined the common European currency at too high an exchange rate for their cost and productivity level. Similarly, Hungarian producers may also feel that the forint rate is too strong for them. We also share the unpleasant restraint of a heavy government debt burden.

It should come as no surprise then that debates about exchange rate policy are back. Some feel that the whole euro enterprise is too risky for us, and we should not contemplate entering the zone until our level of development is much closer to the eurozone average. This view seems to be shared by at least some in government circles.

Others, including myself, feel that growth through currency devaluation is not the winning ticket for us. Hungary has already posted massive trade surpluses in the last five years – an indication that the forint cannot be too strong. Net exports have lately been our only dynamic growth sector, while consumption and particularly investments have performed dismally since 2007. Without robust fixed capital formation and an invigoration of the labour market, Hungary cannot restart economic growth, and without growth we cannot comfortably service our high public sector and private sector debts. Cheaper exports (and cheaper Hungarian assets) via devaluation will not be an answer to our problems.

Labour market reforms have started under the second Orbán government, and some measures to tie social welfare to willingness to take up jobs are welcome from a competitiveness viewpoint. But capital injections and markets are also needed if employment is to be increased: it would be naïve to think that people forced to re-enter the labour market will easily find jobs on their own. Demand for labour is unfortunately and notoriously low today, which is hardly surprising given the poor levels of investment in the last five to six years.

The causes of the meagre investment levels are many, but high funding costs and a lack of policy stability are probably the two biggest reasons. A managed devaluation would not help much in this instance, while a random devaluation shock emanating from any government-induced policy initiative to make Hungary “price competitive” would almost certainly make things worse. Here one can see some similarities with the “southern” eurozone members. Structural reforms in labour and capital markets, increased efficiency in government services (and less corruption), abroad taxbase and strict budgetary regimes are the essential components of a successful adjustment rather than exchange rate realignment.

The parallels end here: the fundamentals of the Hungarian economy are better in several respects than many of the troubled eurozone economies. This is in spite of the poor output records in recent years – weak growth in 2011 and mild recession in the first half of 2012 – which has been aggravated by high inflation (5.8 per cent annualised consumer price index in July 2012). Labour costs in Hungary are (unfortunately) much lower than in most European countries, while labour markets are perhaps more flexible here as well. The geographical closeness and good infrastructural links to the industrial engines of Europe (southern Germany, northern Italy) are also valuable assets. On the other hand, capital inflows have been less dynamic than in previous periods, while many domestic businesses are dormant, waiting for an upturn in sentiment and an increase in purchasing power.

For investors, domestic and foreign alike, public policy consistency is a key driver. Consumers also like to know where things are going in the medium term. One of the sensitive policy areas is the exchange rate regime; it is no wonder that both market players and the general public would like to see the government take a clear stance on the future of the forint. There are numerous options but no obvious models to adopt. The Swedish formula – that is, staying indefinitely outside the eurozone but shadowing the euro and running a balanced budget, supported by an internationally competitive advanced economy – is not suitable for Hungary of the 2010s. What about Czech exceptionalism? Prague has a relatively low public sector debt level, the savings propensity of the population is adequate, inflation expectations are low and anchored, while interest rates are also low – borrowings in Swiss francs or other foreign currencies are practically nonexistent. The Czechs can afford to stay outside the eurozone indefinitely without provoking a speculative attack on the Czech koruna.

What Hungary needs, hence, is some kind of anchor in financial affairs, such as a publically announced schedule to fulfil the eurozone entry conditions. Sceptics may say that this club will probably no longer exist by the time we are “eligible” to enter; but this is not how events generally unfold. Core Europe will always demand a strong and stable currency; think of the Deutschmark of the 1970s and 1980s or the ERM of the 1990s. Such a zone will always exist to serve the interests of the mainly North European trade dependent nations. Such a core currency will also always have a strong appeal for market players and the general public in small, open and indebted countries such as Hungary. Our authorities may not particularly like the eurozone entry conditions and will point out good reasons for not fulfilling them, but you cannot stop “euroisation”. Businesses and households will also invariably follow their own well-understood interests: they prefer stable currencies for saving and making transactions.

Let us face it, real estate, trade and industrial contracts are settled predominantly in euros (or in dollars in particular sectors like oil and gas). Hungarian families that borrowed in other currencies than the forint have learnt a painful lesson amidst our recent financial turmoil; but the lesson is not that it would be better to make transactions in forints. No, they feel, and they are right, that exchange rate stability above all is what they want.

It is difficult for floating exchange rate regimes to provide such stability. Entry into the eurozone, on the other hand, can provide it. It may seem a long shot to even contemplate Hungary’s entry into the eurozone but long term thinking is what is missing most in contemporary Hungary.

Trade dependent open economies require a stable and low interest rate currency, and the euro has been such a unit, at least in the first decade of its existence. Following the financial and economic shocks in 2008 and the weaknesses in the euro’s institutional foundations that were revealed, it can now also be seen that the euro is highly sensitive to how well its members play by the policy rules. But the same external shocks have also delivered a brutal message to financially exposed nations outside the eurozone: you may be vulnerable to becoming a plaything of both speculative forces and your own nervous citizens. There exist no easy choices; those who promise simple and easy solutions such as a sudden devaluation of your national currency (“funny money”, as it was once referred to by an American financial economist) will not do their society a service. Detours can only hinder the hard adjustment process we all have to perform to make European nations truly competitive.

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