This Selected Issues paper analyzes empirically the main determinants of Hungary’s inflation rate during 1990–96. Although there exist a number of possible methodologies to analyze this issue, the one proposed in the paper takes explicit account of the time-series properties of the variables that are potential candidates for explaining Hungary’s inflation performance. This leads to the specification of a long-term equation, linking consumer prices to a number of macroeconomic variables as well as to proxies for relative price shocks. The paper also examines the external current account and net foreign assets in Hungary.

Abstract

This Selected Issues paper analyzes empirically the main determinants of Hungary’s inflation rate during 1990–96. Although there exist a number of possible methodologies to analyze this issue, the one proposed in the paper takes explicit account of the time-series properties of the variables that are potential candidates for explaining Hungary’s inflation performance. This leads to the specification of a long-term equation, linking consumer prices to a number of macroeconomic variables as well as to proxies for relative price shocks. The paper also examines the external current account and net foreign assets in Hungary.

IV. Improving the Long-Term Viability of the National Bank of Hungary 1/

1. Introduction

Owing to prevailing regulations and agreements between the Ministry of Finance and the National Bank of Hungary (NBH), a large share of NBH assets pays no or below-market interest rates. Despite the low average yield on its claims, the NBH has achieved modest profits in recent years because the interest rate paid on required reserves has been low. 2/ However, reflecting the growing share of zero-yielding assets in its portfolio, and the increasing costs of sterilizing capital inflows, the NBH just broke even in 1995 and is projected to incur a loss equivalent to some 0.7 percent of GDP in 1996. 3/ Moreover, the underlying financial position of the NBH is expected to weaken in the medium term owing to a reduction in seignorage revenue resulting from a decline in inflation, and the need to lessen the burden of reserve requirements in the face of increased foreign competition within the domestic banking system.

This chapter examines the factors underlying the deterioration in the NBH’s profit account and the various measures already implemented or under consideration to improve its financial position. The next two sections discuss, respectively, the factors responsible for the erosion of the net worth of the central bank, and the measures adopted in 1993 to address this deteriorating financial position. Section 4 discusses the effect on the NBH’s 1996 balance sheet of the successful privatization program in the previous year. The final section examines recent proposals to eliminate the zero-interest bearing component of NBH assets and to reform the accounting relationship between the government and the NBH.

2. How the NBH got into this position?

Two separate claims of the NBH on the government are primarily responsible for the underlying weakness of the central bank’s financial position. First, the cumulative stock of valuation losses incurred by the NBH on its net foreign-currency liabilities; and second, the stock of NBH credits to the government outstanding at December 1991. At end-1995, these accounted for 37 percent and 13 percent, respectively, of total NBH assets and 37 percent and 13 percent of GDP, respectively (see Tables 11 and 12). As a result, the effective interest rate on NBH claims on government in 1995 was about 7½ percent, compared with an NBH base rate of 28 percent.

Table 11.

Structure of the Balance Sheet of the NBH, 1990-96

(Billions of forint: end of period)

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Sources: Data provided by the National Bank of Hungary; and staff estimates.
Table 12.

Structure of the Balance Sheet of the NBH, 1990-96

(As share of total NBH assets/liabilities; end of period)

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Sources: Data provided by the National Bank of Hungary and staff estimates.

a. Foreign exchange valuation losses

As a result of lackluster external sector performance during the previous decade, the NBH entered the 1990s with net foreign liabilities of $16.2 billion (some 44 percent of GDP), as the proceeds from foreign loans were used to finance shortfalls in the balance of payments. 1/ External sector weakness persisted into the 1990s, creating the need for additional foreign currency financing. As a result, the buildup in external debt continued during the first half of the 1990s. In addition, the NBH acquired large amounts of foreign exchange from domestic banks, primarily in the form of foreign-currency denominated deposits. Rapid growth in these bank deposits—from 7.8 percent of GDP in 1990 to 12.6 percent of GDP in 1994—resulted mainly from increased demand by households for foreign-currency savings in a period of moderately high inflation, and from reserve regulations that induced banks to retain the foreign exchange at the central bank. 2/ As a result of these factors, by end-1994, the NBH’s net foreign-currency liabilities had risen to US$19.6 billion.

Reflecting this large net foreign-exchange liability position, the NBH is exposed to substantial losses whenever the forint depreciates. 3/ Valuation changes are measured monthly on an accrual basis and, as a result, include both realized and unrealized capital losses. These losses are not recorded in the NBH’s profit account but, reflecting the government’s responsibility as NBH shareholder, are shown as a (nonmaturing) zero yielding claim on the government. 4/ The volume of these claims on government increased very sharply between 1990 and 1994, from Ft 519.2 billion (23 percent of GDP) to Ft 1440.1 billion (33 percent of GDP).

b. Stock of pre-1992 loans to the government

Since 1992, direct lending to the government by the NBH for deficit-financing purposes has taken place at the NBH’s basic refinancing (base) rate, which is broadly in line with market interest rates. However, credits issued prior to December 1991 would pay only 40 percent of the base rate. The stock of these credits, which was equivalent to 34 percent of GDP in 1991, has declined gradually over time (to 13 percent of GDP in 1995), according to a predetermined amortization schedule.

3. Securitization of valuation losses

In order to slow the weakening of the NBH’s profit position stemming from the nonpayment of interest on the valuation account, an amendment to the NBH Law (December 22, 1993) introduced rules for the gradual conversion of the stock of valuation losses into market-interest-bearing government securities. According to the revised Law, the amount to be securitized in a given year is the greater of: (i) 5 percent of the stock of valuation claims outstanding at the end of the previous year; and (ii) the forint-equivalent of the reduction in net foreign exchange liabilities of the NBH, less the sum of securitizations in the years since the previous reduction in net foreign exchange liabilities. Based on the 1993 “5 percent rule,” the stock of valuation losses was reduced by Ft 59 billion in 1994 and Ft 72 billion in 1995. 1/ This regular securitization was insufficient to offset the build-up of new valuation losses in each of these years, however.

4. Developments in 1996

The stock of zero interest-bearing valuation losses declined markedly in 1996 primarily as a result of strong foreign direct investment, including privatization-related inflows, in the previous year (see Chapter VI). These inflows contributed to a decline in the net foreign exchange liabilities of the NBH of Ft 570 billion in 1995. As a result, about Ft 440 billion of zero-interest debt was converted between March and Hay 1996 into market interest bearing securities 2/—consistent with alternative (ii) under the amended NBH Law—an amount which represented nearly 22 percent of the total outstanding stock of valuation losses at end-1995. 1/ In contrast with earlier securitizations under the 1993 “5 percent rule,” the 1996 issues will pay interest only once a year, beginning in 1997.

In addition to the exceptional conversion of non- interest-bearing debt, the success of the 1995 privatization program improved the position of the NBH because privatization proceeds were mandated by Parliament to be used to reduce government debt. On this account, the Government and the NBH agreed that the privatization receipts transferred to the budget through January 1996 would be used to retire government debt to the NBH in proportion to the debt stocks outstanding at end-1995. Accordingly, in early April 1996, the stock of valuation losses was reduced by Ft 167 billion, while the stock of pre-1992 preferential rate government credits was reduced by Ft 101 billion. 2/

Whereas the retirement of government debt will substantially improve the profitability of the NBH in 1996, its effect on profitability in subsequent years will be mitigated by a clause in the amended NBH Law which stipulates that the amount of valuation losses retired with privatization receipts is to be deducted from the volume of securitization in the subsequent year. Therefore, it is unlikely that any securitization of valuation losses would take place in 1997 under the 1993 amendment to the NBH Law.

5. Recent proposals to reform the treatment of valuation losses

The gradual conversion of valuation losses into market interest-bearing securities under the 1993 amendment to the NBH Law was intended to strengthen the NBH’s profit account. However, as was evident in 1994 and 1995, a major shortcoming of the Law is that conversion at the rate of 5 percent per year is not sufficient to offset the accumulation of new valuation losses. Barring any further sharp declines in the net foreign currency liabilities of the NBH, the Law would therefore not lead to a reduction in the outstanding stock of these zero interest-bearing claims.

In order to increase the transparency of relations between the NBH and the fiscal accounts, and to improve the long-term viability of the NBH, the authorities intend to securitize by end-1996 the entire outstanding stock of valuation losses (projected at Ft 1,950 billion or 29 percent of GDP at end-1996). While the precise mechanism has not yet been decided, two main proposals are currently under review, each requiring the government to issue to the NBH foreign-currency denominated bonds. 1/

Under the first option, the amount of foreign-currency bonds to be issued would equal the net foreign-exchange (both domestic and foreign) liabilities of the NBH so as to, in effect, transfer the foreign-currency obligations to the government. Moreover, the currency, interest payments, and maturity structure of the bonds would closely match the foreign exchange obligations of the NBH, thereby hedging the NBH against foreign exchange risks on its existing liabilities. The alternative proposal is to issue foreign-currency denominated debt in an amount equal to the outstanding stock of valuation losses, converted at current exchange rates. The difference in the amount of bonds issued (and the corresponding interest cost to the budget) under these two alternatives is likely to be relatively small since, on current forecasts, net foreign exchange liabilities of the NBH are projected to be roughly equal to the valuation account at end-1996.

While these alternative mechanisms would largely eliminate the outstanding stock of valuation losses and hedge the NBH against foreign exchange risks on its existing foreign currency liabilities, they would not address the issue of valuation gains and losses arising from future changes in the NBH’s net foreign exchange position. 2/ In response, the authorities are also considering modifying the accounting treatment of future valuation changes. In particular, in order for the profit account of the NBH to reflect more closely the true economic gains and losses on its foreign exchange transactions, valuation changes should be incorporated explicitly in its profit and loss account. Consideration is also being given to accumulate net foreign-exchange valuation gains into a reserve account prior to profit distribution, to be drawn down only to cover subsequent net valuation losses. Should this reserve account be insufficient to cover the valuation losses, budgetary support in the form of cash transfers or marketable securities would be provided.

1/

Prepared by Rachel van Elkan.

2/

Another contributing factor has been the comparatively strong demand for currency, which boosts seignorage revenue.

3/

As residual claimant on the NBH, the government is legally obliged to cover NBH losses from budgetary sources.

1/

Historically, and continuing into the present, the NBH has been the primary sovereign borrower for Hungary. While no direct on-lending to the government of foreign loans has taken place in recent years, prior to 1988 the proceeds from foreign loans were used to finance forint-denominated lending to the government and state-owned banks.

2/

Prior to February 1996, banks’ foreign currency deposits at the NBH were deducted from their mandatory reserve obligations. Since these deposits earned (foreign) market interest rates—while mandatory reserves against banks’ foreign currency liabilities (which are held in forint) were remunerated at below market rates—banks had an incentive to retain their foreign exchange at the NBH. This inducement was most pronounced prior to 1995 when interest arbitrage considerations favored foreign-currency denominated assets.

3/

Between January 1, 1990 and December 31, 1994, the forint depreciated by more than 220 percent against the U.S. dollar.

4/

Moreover, these valuation losses are not recorded in the government’s budget. As a result, the true fiscal balance is understated by the annual increase in these losses.

1/

The securities issued to replace the valuation losses have an original maturity of between 10 and 30 years. Interest on these securities, which is paid twice yearly, is linked to yields on discount treasury bills.

2/

The Ft 440 billion of valuation losses converted in 1996 is equal to the decline in 1995 in the net foreign exchange liabilities of the NBH measured at end-1995 exchange rates (Ft 570 billion), less the amount securitized in 1994 and 1995 (about Ft 130 billion).

1/

Moreover, it was agreed in January 1996 that the NBH would receive 5 percent of regular bi-weekly issues of 6-month and 12-month discount Treasury Bills and issues of government bonds in exchange for non-interest bearing debt. During the first half of 1996, the amount securitized under this facility was about Ft 30 billion.

2/

In addition, Ft 11 billion in market-interest bearing securitization bonds were also retired.

1/

Under both proposals, valuation losses incurred by the government on the foreign-currency bonds issued to the NBH will be budgeted below the line, rather than as an expenditure item.

2/

If the amount of foreign currency bonds issued to the NBH in exchange for valuation losses exceeds (falls short of) its stock of net foreign exchange liabilities, depreciation of the forint will result in valuation gains (losses) to the NBH on its existing foreign exchange obligations.