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Statement by the Monetary Council (7 June 2004)

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In 2004, the structure of growth in Hungary is expected to become more favourable in terms of economic balance. The rate of household consumption growth may reach a level that is sustainable over the longer term, and corporate investment may become the engine of growth, consistent with increasing demand for Hungarian exports of goods. A slower growth rate of household and government expenditure may improve the external balance as well. This, however, is likely to be a slow process. Given the high initial level of the current account deficit, any break or reversal in the improvement in external balance may be seen by foreign investors as a negative signal, thereby adding to risks to stability. Therefore, a consistent reduction in the fiscal deficit is key to restoring external equilibrium and reducing risks to stability. Fast and massive rises in yields in developed-country markets, exceeding expectations, may raise risk premia and affect financial stability adversely in emerging countries.

Currently, the improved outlook for risks can be experienced primarily over short maturities in domestic financial markets, which reflects the volatility of the market’s assessment of the fiscal deficit and external balance. Developments in longer yields and the shorter average maturity of foreign investors’ government securities holdings are evidence of the fact that uncertainties surrounding investors’ assessment of the Hungarian economy’s medium and longer-term outlook have barely eased.

The banking system, providing the basis for the domestic financial intermediary system, is stable. The characteristics of the banking sector include a marked expansion of activity, an improvement in portfolio quality, high profitability, ability to accumulate capital, a satisfactory level of liquidity and low market risks despite financial market volatility. However, cost effectiveness of the domestic banking system remains low at approximately half the European Union average.

The improved outlook for manufacturing firms and high profitability in the service sector affected banks’ exposures to the corporate sector positively last year. Investment-related foreign currency lending to the corporate sector, sensitive to fluctuations in external demand, increased significantly. Simultaneously with this, banks’ forint-based lending to SMEs, which carry higher risks, also increased strongly.

Cyclical conditions and, presumably, high forint interest rates have led to a higher share of foreign currency loans within domestic bank’s outstanding claims. This may contribute to the risks that banks run if companies without natural or artificial coverage step up borrowing in foreign currency. An unfavourable trend is that the impact of the economic downturn in the market of offices and retail outlets is reflected to a lesser degree in commercial property lending, which may point to higher risk taking by banks. Nevertheless, for the time being, this does not imply increased risks in corporate lending, since the negative effects may be offset by the improved earnings prospects and better loan quality of manufacturing firms.

Household indebtedness has grown, with its level approximating the Western European average, but the sector’s propensity to save has remained relatively low. Housing loans account for the larger part of the increase in outstanding household loans. Furthermore, the outstanding claims of financial enterprises and consumer credit provided by banks have also risen substantially. A higher level of indebtedness, more moderate household income growth, the tightening of the subsidised housing loan scheme and a high rate of forint interest, encouraging financial savings, may slow the increase in household demand for credit in 2004. This trend may contribute to the required improvement in the household saving rate.

Owing to the interest rate differential between forint and foreign currency-based credit facilities, the latter are likely to gain further ground, adding to risks. As regards the credit facilities currently available, both exchange rate and interest rate risks are borne by customers. Instalment amounts of foreign currency-based loans may change to a larger extent and more frequently than those of forint loans, owing mainly to the short repricing periods and banks immediately passing the arising exchange rate risk on to borrowers. Many debtors may have no foreign currency revenues and take their borrowing decisions on the basis of the exchange rates and interest rates prevailing at the time of borrowing. This may carry further risks in respect of foreign currency-based loans with maturity of 15 to 20 years. Consequently, the growing popularity of foreign currency-based housing loans may expose the banking system to significant additional risks.

In the earlier issues of its Report on Financial Stability, the Bank pointed out that relaxing creditworthiness standards and loosening the terms and conditions of lending, the underlying reason for both being sharp competition, set a risky trend. This trend, i.e. the increase in market risks, persisted last year. Risks were clearly reflected in the slight deterioration in the quality of non-bank financial intermediaries’ outstanding loans in 2003. The majority of credit risks facing banks caused actual losses to their financial enterprises, and particularly to leasing companies, which underscores the importance of the consolidated assessment of risks.