(Richard H. Schweizer is the pseudonym of a Swiss banker with more than 25 years of experience managing money and trading markets.)
Spreads of Irish government bond yields over German bunds exploded to new highs for the Euro era on Friday. It was enough to draw a statement from the IMF denying rumours that they were preparing an Irish rescue package; a harsh reminder that the European periphery remains fragile.
Morgan Stanley had already noted that concerns about economic growth and the availability of external funding have been pushing CDS spreads higher in recent weeks for both the PIIGS and Central/East European countries.
The chart below suggests a correlated credit tsunami in the making. The welter of austerity programs being imposed on the PIIGS and CEE economies are unlikely to be growth boosters in the short term.
Photo: Morgan Stanley
And there’s that little problem which won’t go away. How do the PIIGS return to competitiveness so long as they are locked into the Euro ? It’s as if the PIIGS are being crucified on a sort of Eurotrash gold standard. Does anyone believe the Germans – scarred by memories of Weimer Republic hyperinflation – will really go along with ideas of printing money and a weak Euro in order to save their profligate brothers on the periphery. If not, labour prices need to be cut dramatically in the PIIGS.
Photo: Sanford Bernstein
While CEE countries are in the shadows of new worries about the PIIGS, it may be the capacity of the average Budapest cabbie to service and repay the CHF loan on his taxi which turns out to be the tipping point for the health of the European banking system.
Cheuvreux, part of Paris-based Credit Agricole, recounted the following anecdote in a recent report aptly christened the Swiss Franc Curse.
A taxi driver in Budapest took a Hungarian Forint equivalent loan for HUF 2.5mio in Swiss Franc to buy his taxi a little over two and half year ago. Then he was paying HUF 70,000 monthly but is now paying almost 30% more while his revenues have fallen 20% and this in a country where his auto monthly payment now represents more than 50% of average net wages. How long can he keep it up ? Like Poland, 60% of Hungary’s mortgage loans are denominated in Swiss Francs so likely the same taxi driver probably has a Swiss Franc mortgage. Extrapolate the monthly instalments for CHF denominated mortgage loans on the chart below, up the rising curve of the strengthening Swiss Franc and it’s clear the average Budapest taxi driver is on a stairway to hell.
Foreign exchange debt as a percentage of GDP is at horrific levels in several CEE economies. Hungary (mostly CHF loans) and Bulgaria (Euro loans) might represent the extreme, but Romania (also Euro) and Poland (CHF) also have substantial foreign debt exposure, their private sectors addicted to foreign debt. The Baltic nations are not much better.
Hungarians borrowed heavily in CHF because CHF interest rates were so much lower than HUF interest rates. Partly this was simply due to massive demand for mortgage and consumer credit in the CEE amidst a lack of savings, a situation not unlike the U.S. in the same period. However, Americans could still borrow in dollars. In Hungary, neither the unsophisticated borrowers nor the banks appear to have accounted for the risk of a surging Swiss Franc.
Photo: Morgan Stanley
Photo: Morgan Stanley
The Swiss Franc loan binge in Hungary from 2003-08 has left Hungary burdened with debt denominated in the one of the world’s two strongest currencies, a situation which might temporarily ease, but is sure medium term to simply increase in pressure given the Swiss dislike for printing money together with their sounder banking system and economy.
Interestingly, it’s not Swiss banks who loaned those francs. Credit Suisse data from 2009 indicated that less than 2% of the total loan book of both UBS and CS were exposed. The big lenders in Swiss Francs in the CEE were other European banks. For example, Austrian banks provided about 40% of CHF loans in the Eurozone. Between 15-25% of the balance sheets of the top four Greek banks are exposed to SE Europe, including almost 40% and 30% of loans to the private sector in Bulgaria and Romania respectively, according to Macquarie Bank. In turn, German, French and other northern European banks are heavily exposed to Greece. The Baltics were the province of the Swedish banks.
Thus, the proverbial Hungarian taxi driver may yet trigger a financial tsunami amongst European banks. Of course, the ECB and IMF have put in place support mechanisms, but Hungary stands out in terms of its vulnerability to any future growth shock or lack of foreign funding because its foreign debt to GDP ratio is already 136%.
Of course, Swiss Franc lending and new loans of any kind have collapsed in the past 18 months and the Hungarian government is doing a good job despite the surprise halt to IMF talks in July. There’s mounting evidence, says Merrill Lynch this week, that the government will achieve its budget deficit goal of 3.8% of GDP, an outcome which would deemed a miracle in the U.S.
Photo: Morgan Stanley
But prudent fiscal management from the Fidesz government in Budapest might not be enough. The strengthening Swiss franc is increasing risk on non-performing loans according to Cheuvreux, and mathematically the foreign debt burden, in HUF, is worsening.
Nomura believes the potential for a debt spiral is very real under any downside economic shock, where public debt/GDP could surge from the current 78% to 110% in certain scenarios. This will be something the markets will be watching carefully with another peak in gross government re-financing coming next year amounting to about 20% of Hungarian GDP.
In such a scenario, with Government debt / GDP at or above 100%, the temptation to print money would be enormous. Economic history tells us that currencies in such situations usually choose the devaluation route. The Hungarian Forint would suffer again, creating a negative feedback loop with Swiss Franc loans and further deterioration in NPLs both amongst domestic and foreign banks.
Cheuvreux estimate that the pain threshold for the Budapest taxi driver is another 15-20,000 HUF in monthly financing costs. This would seem to require a repeat of the moves in the HUF/CHF exchange rate and sovereign CDS spreads, an outcome which might be plausible in the downside economic shock scenario outlined by Nomura. Other CEE economies would likely experience something similar.
Before that Budapest taxi driver takes to vodka thinking about Nomura’s growth shock scenarios, he might want to read up about the thousands of Swiss Franc loans made to Australian businesses, particularly farmers, from 1983-86, which resulted in heavy capital losses after the floating of the then sinking Australian dollar as currency fluctuations caused million dollar loans to double in size creating an impossible burden for borrowers. By 1995 there were several hundred foreign currency loan litigation cases in Australia in which the lack of sophistication of the borrower in foreign currency borrowing played a central role. The courts ruled in favour of borrowers only in the minority, but perhaps times have changed.
Either way, the Nomura scenario would mean the Hungarian Forint might still turn into goulasch. It would create a bad case of indigestion for European banks.