Fiscal policy switched to emergency mode
It was only a month ago that we raised our end-2022 consumer inflation forecast to the upper teens, simultaneously improving the outlook for growth, predicting robust annual GDP growth for this year. But forecasts do not have a long life these days. We now see CPI-inflation even higher, right around 20% in December and GDP in recession in H2, the latter leading to full-year growth of 2.5-3% only. Given the exceptionally fast movement of energy prices now and prospectively in the coming months, it seems way too early to call the peak of the current inflation cycle. We still see next year’s GDP growth around "negative zero", affirming our previous relatively pessimistic view.
The reason for this change is the unexpected aggressiveness of fiscal adjustment. The government is pushing the emergency brake hard indeed. It clawed back to the central budget a massive amount of previously disbursed but still unused funds rather quickly, and more recently it sharply reduced energy subsidies to retail consumers. In the first case, it was mainly the speed of action we found surprising, whereas the second set of measures we had not expected at all. It looks like the government sees a considerable chance that it will not be able to get a big chunk of budgeted development funds from the EU, and it also sees serious risks as to the availability but mainly the prices of energy imports. The current energetic efforts to put the budget in order appear to us as a series of precautionary measures, should negative scenarios in these two areas indeed materialize.
We think this official precaution is well justified. It is hard to see a scenario in which Hungary could escape losing a significant part of its EU funds quotas under the RRF and the new budget in the coming year. Similarly, major negative events around Russian gas shipments and European energy prices represent a serious threat. In view of these two risks, S&P just lowered its BBB rating outlook to negative in early August. Previously, Fitch Ratings affirmed its stable outlook for a similar rating in July, assuming EU funds could still become available in the end. But Moody’s could also lower its Baa2 outlook to negative at its second and final review this year, due in September.
The forced return of previously disbursed funds to the central budget should depress both current and development spending by government institutions, whereas the reduction of energy subsidies will greatly accelerate inflation and eat massively into real consumer demand. The first impact of the former could already be seen in domestic sales by industry and in construction output in June. Q2 GDP growth still looked quite impressive, but the MNB’s weekly activity index clearly showed a steep decline of the estimated yoy growth rate in the last few weeks of the quarter.
The cuts of energy subsidies started in early August, and they should almost automatically add some 4%-points to the yoy CPI-inflation rate starting from this month. The resulting inflation rate should exceed the otherwise very high rate of nominal wage growth. The MNB has expressly confirmed this outlook recently, adding that inflation may indeed peak at end-2022 or in early 2023, although admitting that "we are still quite far away" from having a clear view on the further shape of the cycle. The next time the MNB is scheduled to formally update its inflation forecast is in late September.
On the positive side, the central government’s cash budget has shown rapid improvement over the last four months, so that the cumulative cash deficit had come quite close by July to where it is supposed to be for the year as a whole. In addition, the Q2 BOP data looked more friendly than the Q1 results, even though the fundamental deficit was still quite large, mainly because of the continuation of large terms-of-trade losses on energy imports.
A special factor affecting the whole of output, the BOP and inflation quite negatively is the worst drought on record, hitting the country in the current year. Even though Hungary traditionally produces a substantial food surplus, this year’s agricultural results are just too poor to allow any compensation for high energy import prices, and they are even contributing to rising prices, representing a major driving factor behind inflation.
There can be no doubt that the MNB will continue tightening in the coming months, as promised. But we do not expect it to lose its temper and jump after rapidly rising inflation with interest rates, trying to keep pace with the former all the time. Instead, the MNB is more likely to continue its focus on the EURHUF exchange rate, trying to defend the current 400 line in the short term and to maintain relative stability in longer term. The base case for now should be a 100bps interest rate hike per month, flexibly adjusted upwards as and when required by currency market volatility.
Talks on Hungary’s access to EU funds reportedly have continued but there has been no proof of any progress reached lately. One negative event has been the recent news story in the British press on how the government puts pressure on the judicial system, trying to influence judges and controlling their appointment, in addition to directing politically sensitive cases to courts believed to be "friendly". Anyway, the ongoing rule-of-law procedure is coming to a conclusion soon, with the EU Commission scheduled to present its proposal to EU decision-makers before end-September.
In July, a few opinion polls on party preferences were published again, following no surveys at all in June, with rather mixed results. Essentially, there has been no evidence of any serious shift away from Fidesz so far. The real test in this regard will be the polls to be taken in autumn, by which time the first of the higher gas and electricity bills will have reached customers, in addition to the impact of higher fuel prices and the bad news about the rising inflation rate.
Despite Hungary's being highly exposed to energy imports from Russia, the current situation regarding gas storage for winter seems much better than the European average. In part, this is due to the fact that the bulk of gas imports arrives in Hungary through Turkstream, rather than through the troubled Nordstream 1 pipeline. The fact that Hungary has more extensive storage capacities than most other countries in Europe is also important. Fuel supply, on the other hand, is below appropriate, due to limitations on MOL’s refining capacity now that other wholesalers are kept away from the domestic market by the government’s forced price cap on a great part of retail fuel sales. The ongoing regular summer maintenance at MOL’s refinery and also at a part of the Paks nuclear power plant is also a problem. Hungary imports a considerable portion of its electricity needs, and it is hit by the current extreme high electricity prices as well.
Finally, it is good news that Covid infections have apparently been retreating over the past two weeks.
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