EMERGING MARKETS RESEARCH

EEMEA | 14 April 2011

HUNGARY: COPING WITH FX DEBTS

No easy fix for CHF-mortgages, but some relief
The government seems to be closer to implementing measures to deal with the problems associated with households large share of CHF debt (15-20% of GDP). Following a long debate, recent proposals seem more limited (based on our analysis) than previous ideas predicated on mass scale mortgage conversions from CHF into HUF. Thus, policymakers appear to have acknowledged the potentially significant costs of such radical schemes, for both the government and the financial sector, ie, ultimately, underlying FX risk cannot be eliminated but just shifted from households to other sectors. Our analysis suggests that the government proposes to: limit the HUF/CHF range which feeds into CHF-linked mortgage payments fro the next 3-4 years, having the implied mortgage payment changes (credit/debits) beyond the thresholds accrue in special accounts. Potential debits would still have to be repaid by households, but would be guaranteed by the government; provide subsidies on (HUF) mortgages for homes purchased in foreclosure auctions, which would begin after the moratorium is finally lifted (scheduled for end-June); and ease the outright ban on all FX lending implemented last summer, by re-introducing some EUR-based lending. We expect further details on these schemes in the coming weeks. While some of the potential costs associated in theory are unlimited, our rough estimates indicate that the realistic fiscal burden should be controllable. Restarting the EUR-loans market implies some additional HUF support, in our view, as it would lead to fresh EUR capital inflows. Figure 1: Shouldering the legacy of CHF-denominated loans in Hungary
25% 20% 15% 10% 5% 0% Apr-05 220 210 200 190 180 170 160 150 140 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 CHF housing loans to households (% GDP) Other CHF loans to households (% GDP) HUF/CHF, RHS
Source: National Bank of Hungary, Barclays Capital

Koon Chow +44 (0) 20 7773 7572 koon.chow@barcap.com Christian Keller +44 (0) 20 7773 2031 christian.keller@barcap.com www.barcap.com

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 6

Barclays Capital | Hungary: Coping with its FX debts

Background
The main proposal limit the fluctuations due to CHF/HUF FX swings in household debt service payments

The government needs to put something in place before the moratorium on evictions and auctioning off NPL collateral lapses

Large FX debts in the household sector, in particular CHF mortgages, are one of Hungarys central legacy issues. Total domestic household debt amounts to about one-third of GDP, of which over two-thirds is denominated in FX, mainly in CHF. The current total stock of CHF loans stands at around HUF 4.4tn, HUF 2.3tn of which is defined as housing loans. The bulk of these CHF loans were taken on board before the financial crisis, at an average 160 CHF/HUF exchange rate compared with the current 205 level. Since then, the weak economy, including official unemployment of over 11%, and the HUFs 28% depreciation vs. CHF has exacerbated the burden of servicing the CHF debt. Indeed, while the CHF strength has fully passed through to households, the low CHF interest rates have not: on average, the APR on CHF loans remains just below 7%. Consequently (and because of rising FX debt), households debt servicing burden on FX debt has increased more than fourfold between 2004 and 2010, to about 8% of disposable income; in turn, this has contributed to the rise in NPLs to over 10% by end-2010, and a potentially a further rise to 14-15% by end2011 (the expected peak). Importantly, a moratorium on mortgage foreclosures has shielded the housing market, but must be lifted at some point. The associated pressures on households and banks balance sheets have wider macroeconomic implications, as they have prevented any recovery in domestic lending and household consumptions, thus keeping the growth rebound very lop-sided and extremely reliant on external demand. This situation has created a debate about potential government actions in FX household debt for some time now, particularly around how to protect households from FX swings on their CHF-linked mortgages. However, besides declaring an immediate ban on any FX lending by domestic banks last summer, the sheer size of the problem has prevented quick decisions by the government on any other proposals, including ideas of mass CHF mortgage conversions. With the recent general stabilisation of Hungarian assets, the new additional fiscal resources gained from the re-nationalization of the second pension pillar, and the need to allow the normal foreclosure process to begin in the coming months, the government now seems closer to take some decisions. The aim will be to avoid any rapid deterioration in the housing market and NPL ratios as result of the moratorium termination and some gradual recovery in domestic lending. The most recent update of the governments reform programme 1 and information provided by the Hungarian Bankers association suggests to us that a package of measures on CHF-linked loans will likely be approved in the coming weeks.

There was a ban on FX lending by domestic banks last summer but since then, nothing concrete has emerged to deal with the legacy FX-debt

(http://www.kormany.hu/en)

14 April 2011

Barclays Capital | Hungary: Coping with its FX debts

Figure 2: Household debt rose; 2/3 of it is in FX (mainly CHF)

35 30 25 20 15 10 5 0 2003 2004 2005 2006 2007 2008 2009 2010 %

Figure 3: Most loans were extended when CHF was weaker

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 140

Distribution of Swiss franc denom. mortage loans

150

160

170

180

190

200

210

Total household loans (% GDP) Household loans in FX (% GDP)

Source: NBH, Barclays Capital Source: NBH, Barclays Capital

CHF/HUF

Figure 4: A stronger CHF added to rising debt servicing costs

10 8 6 4 2 0 2004 2005 2006 2007 2008 2009 Household's FX debt burden and average CHF/HUF exchange rate 210 200 190 180 170 160 150 140 2010

Figure 5: Strong CHF, high unemployment pushed up NPLs

12% 10% 8% 6% 4% 2% 0% Jun-10 Sep-10 Dec-09 Mar-09 Mar-10 Dec-10
3

Jun-09

Debt burden (% of disposable income) FX loans CHF/HUF exchange rate (right scale)
Source: NBH, Barclays Capital

Household loans overdue on payment (31-90 days) Household loans overdue on payment (91+ days)
Source: NBH, Barclays Capital

Figure 6: Households remain net re-payer of loans

400 300 200 100 0 -100 -200 2005 2006 2007 2008 2009 2010

Figure 7: Credit conditions remain tight

Per cent 100 80 60 40 20 0 -20 Easing -40 06H1 06H2 07H1 07H2 08H1 08H2 Jan'09 Apr'09 Jul'09 Oct'09 Jan'10 Apr'10 Jul'10 Oct'10 11H1 06H1 06H2 07H1 07H2 08H1 08H2 Jan'09 Apr'09 Jul'09 Oct'09 Jan'10 Apr'10 Jul'10 Oct'10 11H1 Loans for house purchase Consumer loans Credit conditions in the household sector (Senior Loan Officer Survey)

Net flow, consumer and other nonbank loans Net flow, nonbank loans for house purchase Net flow, consumer and other bank loans Net flow, bank loans for house purchase
Source: NBH, Barclays Capital

Source: NBH, Barclays Capital

14 April 2011

Tightenining

Sep-09

Barclays Capital | Hungary: Coping with its FX debts

Most recent proposals

Based on media reports and our conversations with representatives of the financial sector, the policy proposals are shaping up around three main measures - see below. 1. Limiting the impact from CHF/HUF swings on monthly mortgage payments via a fixing exchange rate range and creation of special accounts. According to widespread media reports, the proposal is to set an exchange rate range (190-200 CHF/HUF) within which FX fluctuations can feed into changes in the forint value of the CHF-linked loan and therefore, the monthly loan repayment. If the forint weakens beyond the weaker formal threshold, the monthly payments will be capped at the level when CHF/HUF was 200 and additional monthly service charges would accrue in a special account for up to 3-4yrs. If the forint were to appreciate, monthly payments would drop up until CHF/HUF trades to 190. Thereafter a monthly service credit would feed into and run down value of the special account. According to draft plans, there is no debt forgiveness element and after the FX fixing period elapses, households are to repay the accrued charges in the special account, in a mechanism yet to be finalized. The government would guarantee the special accounts against a fee paid by the banks. 2. Provide mortgage subsidies for homes purchased via foreclosure. The moratorium on seizing collateral and evictions has been in place since last year - the longer it holds, the worse the moral hazard implications will be. It currently applies to around 100k nonperforming mortgage contracts (with the notional value of the loans summing to just under HUF 500bn). This may drop to around 75k as the moratorium will later exclude the category of mortgages loans for consumption purposes. Local bank analysts estimate that up to 20% of NPL mortgage holders can pay in principle but opt not to pay. i.e., are unwilling to pay. Removing the moratorium would recapture these mortgage holders. However, households who genuinely cannot pay would be at risk of losing their homes. Also, a sudden fire sale of foreclosed homes could weigh further on the real estate market, causing collateral values to deteriorate and the overall problems to worsen. To alleviate this risk, once the moratorium lapses, the government is considering offering subsidised mortgages to those who participate in the purchase of homes auctioned off as result of NPL-related foreclosures. This could help to support the price of the auctioned assets limiting the scope for negative equity for those households that have been evicted and had their properties auctioned off. There is no information yet about the size of the subsidies for such HUF mortgages (given the prohibition of any FX lending). We assume that such a subsidy would have to be in the form of an interest rate subsidy of several percentage points, given that APRs on HUF mortgages are still in low double-digits and households focus will continue to be the past interest rate level on FX loans. 3. Easing the ban on FX lending by allowing for some EUR loans. The regulation in June 2010 abruptly halted all domestic FX lending in Hungary. This was already less relevant for CHF loans, as these had naturally stopped as a result of exchange rate developments, but it also halted EUR lending (e.g., half of housing loans taken out in 2009 were in EUR). HUF lending has of course increased on a relative basis as a consequence of the ban; however, given the comparatively still-high HUF interest rates, lending to households has not recovered. Households remain net loan re-payers. In addition, the governments ban could be challenged as it may breach EU regulations that do not allow such general bans under the common capital market rules. The government thus seems willing to ease the ban on EUR-denominated lending, possibly killing several birds with one stone: addressing potential EU conflict, giving local banks some prospect for loan growth, and slowly resuscitating household consumption.
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Barclays Capital | Hungary: Coping with its FX debts

Policy objectives and associated risks

Limiting the pass through from FX to household service payments may support the economy. But the burden will still remain and someone needs to shoulder the cost

In principle, investors may welcome the governments aim to support households, ie, by limiting some of the negative impact of FX swings on service payments, and overall consumption in the economy. However, ultimately, the burden of the CHF debt cannot be eliminated but only shifted around within the domestic economy. Thus far, households have borne the brunt of this. Shifting the burden to the banks, while also subjecting them to special taxes, may also be difficult, and the government seems to realise that continued pressure on the banking sector could become counter-productive to reviving domestic demand. Finally, however, the governments fiscal situation limits its ability to take on any additional financial burden as well. It is therefore useful to have some estimates of the potential financial costs associated with the above schemes (although it would be unsurprisingly if more tweaks and measures were announced). Scope and potential costs of CHF/HUF fixing measures: If applied only to loans for house purchases, the stock is about HUF2.3tn. If all CHF-loans to households are included, it would mean another HUF 2.1tn. Given the average APR, the rough rule of thumb would be that, if applied to all CHF household loans, a 10% depreciation of HUF against CHF beyond the threshold would cost 0.1% of GDP per year (see figure 8). The banks would accumulate that value as an asset in the special account (which the household would later have to pay back gradually), but it appears that it would still have an impact on banks cash flow positions (as it would still need to service its own CHF liabilities at the market rate).

The cost of a further 10% permanent fall in the HUF (vs CHF) implies an additional annual debt service charge on CHF-loans equivalent to 0.1% of GDP

Figure 8: Some one has to pay The impact of additional HUF depreciation
Stock of loans APR on One-off depreciation (end Feb210) loan* beyond threshold CHF- loans for house purchases Total CHF- loans to households HUF 2,282bn HUF 4,389bn 6.8% 6.8% 10% 10% Additional annual servicing cost to hold or govt. or banks HUF 16bn / 0.06% GDP HUF 30bn / 0.1% GDP

Note: * 6.8% is the average initial APR on CHF-linked mortgages. Source: Barclays Capital

Current proposals suggest no debt forgiveness and accumulated charges in the special accounts should eventually be met by the original loan holders. The government guarantee would step in if households are ultimately not able to pay. In theory, the potential costs of the government guarantee are unlimited, depending on how much stronger CHF moves against HUF over the 3-4 year duration of the scheme, and the ability of households to later service its debt on the special accounts. However, realistically, 0.1-0.2% (HUF30-60bn) per year would seem to be the maximum. As a comparison, the bank tax imposed by the government for 2010-12 is officially estimated to yield HUF 180bn per year.
Subsidising a small class of new mortgage could help to ease the longer term effects of the foreclosure process

Potential costs of subsidizing new NPL-related mortgages. Given the absence of more concrete plans, estimates are difficult to make. However, it is possible to gauge the schemes limits: on our estimates, the notional value of non-performing housing loans is just under HUF500bn; assuming a full replacement of these loans with fresh subsidised loans, each one percentage point subsidy would thus cost HUF5bn p.a. In general, such a direct subsidy from the budget would be relatively transparent and thus, a more controllable manner with which to implement such a support scheme as opposed to for example, some form of imposed interest rate ceilings.

14 April 2011

Barclays Capital | Hungary: Coping with its FX debts

Figure 9: Allowing banks to extend EUR loans could lead to fresh foreign capital inflows
25 20 15 10 5 0 -5 -10 2005 2006 C/A 2007 FDI 2008 Portfolio 2009 2010 Some revival of foreign borrowing, if EURbased lendign is re-instroduced?

Figure 10: EUR-based loans still imply FX risk, but seem a safer choice than CHF
320 300 280 260 240 220 210 200 190 180 170 160 150 220 140 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 EUR/HUF (monthly average)

Borrowing

CHF/HUF (monthly average)

Source: NBH, Barclays Capital

Source: NBH, Barclays Capital

Market neutral, possibly HUF support from re-introduction of EUR loans

No mass conversions of CHF into HUF loans. The above measures should be broadly neutral for the markets

Based on our analysis of the proposals of the current scheme, we cannot see strong immediate market implications. This is in contrast to the potential repercussions from a mass CHF loan conversions into HUF (suggested by some ruling party MPs), ie, banks may have been forced to cover their open FX exposure. As households would probably have been resistant to such an approach given that current APRs on HUF mortgages (10%+) are significantly above the rates on CHF and EUR mortgages that households were used to pre- financial crisis (6-7% and 7-8% respectively), there were suggestions of supplementing such a mass conversion with generalized subsidies for all HUF mortgages. In our view, the FX and fiscal implications of such schemes would have been much larger and difficult to c ontrol. We think, however, that the easing of the FX lending bank and a re-introduction of EURlinked mortgages and loans could have positive effects on HUF from a technical flow perspective (ie, EUR inflows to banks, which extend credit). Certainly, it would imply exchange rate risk versus EUR rather than CHF. However, unlike CHF, the EUR is ultimately Hungarys target currency (euro adoption), its main trading partners currency, and historically has remained in a narrower range.

The government measures on the CHF-loans may be market neutral but potentially HUF positive if the measures end up supporting growth and/or allow new EURlinked loans to be offered

14 April 2011

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