Policy makers continue to expect inflation to come off well into next year but the local private sector is less convinced. Net exports remain the only real hope for growth, UBS said.

In early May UBS recommended taking profits on long duration positions in EM, but it a note published on Tuesday it said it will look to get back into Polish bonds and the zloty as global sentiment improves.

"For now, we are paying the spread between 2y Hungarian and Polish swaps from 82 bp. The spread has already widened out to 109 bp. We are looking for another 20bp in this carry positive trade. We will look to buy protection in 5y HU CDS at levels below 200 bp. Lastly, we have hit our target level on our short CZK vs. long TRY recommendation," said György Kovacs and Bhanu Baweja, analyst at UBS in London. They said a separate note will be published on this later.

Inflation on track

The analysts noted that both the Hungarian central bank (NBH) and the International Monetary Fund (IMF) remain convinced that the inflation trajectory remains southwards for the coming 12 -18 months.

They were expecting CPI to decline towards 3% yr/yr by the end of 2010, and to 2.5% yr/yr by the end of next year.

"Local fund managers were less optimistic about inflation coming lower. They feared that price growth would display inertia even as economic growth remained extremely subdued. High prices in utilities such as electricity and water were seen responsible, as was the slow pace of adjustment in nominal wages (both are related, of course). Microstructure problems in utilities (lack of freely competitive markets) was suggested as the main reason behind price inertia," Kovács and Baweja said.

Monetary policy and risk assessment

The analysts said local policy makers seemed "pleasantly surprised" by the market’s risk assessment of Hungary.

"Given growth remains fairly narrowly based, the central bank did see room for further accommodation but pointed out that, based on its view that a risk premium would still be demanded on Hungarian assets, it would be difficult to see Hungarian policy rates converging to Polish rates (Hungarian and Polish policy rates are presently at 5.25% and 3.5% respectively)."

Given the external debt of the household sector, it should not come as a surprise that the NBH considers risk assessment at least as important as the state of the real economy, the analysts added.

New deficit target in the making

Until recently Hungary was seen as the poster child for IMF’s fiscal consolidation programmes, but UBS highlighted that there has been "very little guidance" from the new government. And multilateral organisations also have "as little visibility as observers in the market do," they added.

UBS was reminded by locals that owing to a large vote against the Socialist Party (MSZP), Fidesz came to power without having to elaborate on its economic priorities.

"Their policy programme is likely still being debated within the party," the analysts noted.

Kovács and Baweja called some recent statements by Fidesz officials "populist", noting that this has worried a small section of the locals.

"However, most observers have shrugged these off as mere posturing, and are waiting to see what Fidesz will do rather than what Fidesz say," they added.

The analysts take for granted that the 2010 budget deficit target (3.8% of GDP) will be revised upwards, adding the key focus now shifts to the 2011 budget.

"Most observers pointed out that the European Commission is unlikely to tolerate too much fiscal laxity and hence the scope for fiscal manoeuvre of the new government looks rather limited."

The new government is to take office at the end of May. First round negotiations with the IMF could start in June once the results of the party’s fact-finding committee are out.

The next important period is October when both the current IMF programme lapses and local elections take place.

"Most observers agreed that the government does not have time to wait until the local elections to shape policy," the analysts said.

Debt sustainability a key concern

The IMF, which has the most conservative growth assumptions, did believe that IF Hungary continued with its fiscal consolidation, debt to GDP could fall towards 65% by 2015.

Kovács and Baweja stressed, however, that the IMF’s base case growth forecast does not take into account the possibility of a double dip in Europe.

"Most observers agreed that debt sustainability is one of the top concerns. Hungary faces a big problem if potential growth fails to accelerate," the analysts said.

Key reform areas

There was consensus that Hungary has labour supply problems as "the labour markets in Hungary should be better aligned with the needs of businesses," the analysts said.

"Concerns were voiced both about the flexibility of the wage structure and skill adaptability of the labour force. Additional steps needed to tackle issues related to early retirement, disability pension or education. Deregulation needs to be pushed forward. Improving business activity by reducing the size of and bureaucracy in the public sector is key," they concluded."

Source: Portfolio Online Financial Journal