Unconventional monetary instruments in the current crisis: the case of Hungary Péter Tabák Head of Financial Stability Magyar Nemzeti Bank (the central bank of Hungary) „The Modern Role of Central Banks in Small Open Economies” June 26-27, 2009 Tbilisi

Outline Initial conditions: the landscape in October 2008 The immediate challenge: FX liquidity provision Mitigating the costs for the real economy Domestic currency liquidity provision Some lessons from the Hungarian experiences

Initial conditions: the landscape in October 2008 Weak fundamentals – large adjustment in the fiscal deficit but still high public and external debt High share of foreign currency lending (CHF-based mortgages)– the primary concern for banks is foreign currency liquidity Bank’s strong reliance on foreign funding – but major role of parent banks Structural domestic liquidity surplus – there is more than sufficient HUF liquidity in the system, but unevenly distributed Strong pressure on the exchange rate – monetary easing (rate cut) is not an option for financial stability reasons

High public indebtedness Source: Eurostat Public debt in percentage of GDP, 2007

High external indebtedness Source: Eurostat Net foreign debt in percentage of GDP, 2007

Strong reliance on foreign funds in the past - expected adjustment in the near future Loan-to-deposit ratio in the banking sector Source: MNB

Funding from parent banks has been important Source: MNB

Recurring pressure on the exchange rate Implied HUF yields from FX swaps Source: MNB

The immediate challenge: FX liquidity provision I FX back-up facilities for the banking system Two-way overnight EUR/HUF FX-swap –The central bank steps in as intermediary between counterparties –Mitigates counterparty risk –No extra liquidity - saves foreign reserves –From October 2008 One-way overnight EUR/HUF FX-swap –End-of-the-day back-up instrument at a penalty rate –Additional FX liquidity –Backed by a repo agreement between the MNB and ECB –From October 2008

The immediate challenge: FX liquidity provision II Due to the prevalence of CHF-based mortgages: CHF liquidity is also key 1-week CHF/EUR FX-swap –Backed by a CHF/EUR swap agreement between the MNB and the SNB –Provides CHF liquidity for commercial banks at a small surcharge –Widely used by some banks –From February 2009

Mitigating the costs for the real economy Strong decline in corporate credit: banks needed longer- term, more predictable foreign-currency liquidity to provide working capital financing to the corporate sector 6-month and 3-month EUR/HUF FX-swap facilities: –Backed by the IMF standby agreement –Aim is to avoid a credit crunch in the corporate sector –The 6-month swap is cheaper, but only available for banks who agreed to maintain corporate lending, and bring in additional long- term foreign funding as well –No bidding, each bank has an agreed swap limit –The 3-month swap is more expensive, but available to all registered banks –Competitive bidding –Both facilities operate from March 2009

Contraction in corporate credit: potential „financial decelerator” effect Source: MNB

The use of the MNB’s foreign currency liquidity instruments Source: MNB

Domestic currency liquidity provision Periods of HUF liquidity shortage despite aggregate surplus Almost 25% HUF depreciation between July and October 2008  margin callls, extra collateral at rollovers  need for extra HUF liquidity Uneven distribution of HUF liquidity surplus and tightened counterparty limits  individual banks faced HUF liquidity problems HUF liquidity provision –2-week and 6-month collateralised lending facilities –Lower reserve ratio –Outright government bond purchases –Conversion of the IMF and EU funds at the central bank –Extension of the range of eligible collateral

Large drop in foreign investors’ demand for HUF T- bonds after Lehman Source: MNB

Liquidity of the government bond market improved but still not normalised Source: MNB

Some lessons from the Hungarian experiences

First lesson: beware of the latent liquidity risk in open FX positions Funding markets that seem very liquid for a long time can dry out completely (FX swaps) Local authorities' LOLR capacity in FX is limited In case of a liquidity crisis, effective help from parent banks' LOLR authorities (in our case the ECB) is far from guaranteed (no FX swap lines, CEE subsidiaries' assets not accepted as collateral by ECB) Funding from international institutions (IMF, EU) is the last resort Hedging by swaps requires domestic liquidity in case of the weakening of the domestic currency These risk should be taken into account in prudential regulation (e.g. requiring larger liquidity buffers for FX funding)

Second lesson: enhance resilience with external help IMF-EU-WB package of USD 25 bn –higher international reserves –bank support package of USD 2.5 bn –continued fiscal adjustment –structural measures (new indexation of pensions, higher retirement age) Central banks –ECB facility of EUR 5 bn –EUR-CHF swap facility with the Swiss National Bank

Third lesson: avoid international repercussions High exposure of several developed EU countries in the region Home countries can be negatively affected by host country problems –financial stability should be a joint responsibility –a soft landing in FX lending would be desirable –continued support by parent banks is essential –level playing field in liquidity provision in and outside the eurozone needed –much more intensive information exchange, coordination of liquidity management, regulation and supervision

Fourth lesson: look forward in regulation and supervision Intervene proactively based on micro- and macroprudential risk assessment –top-down and bottom-up stress tests based on fat-tail assumptions –enhanced on-site inspections –earlier intervention triggers for supervisory action –power to intervene based on risk assessment –more emphasis on communicating the risks and desirable actions