The biggest financial news story out of the Europe this summer is getting very little play in the U.S. mainstream press. However, it has the potential to torpedo the European Union (EU), and has disastrous implications for borrowing costs worldwide.
Basically, a miniature banking crisis is festering in Hungary. If it isn't contained, it could grow into a genuine crisis that infects the secondary lending markets around the world.
Hungary is supposed to have about $30 billion in domestic liquidity for exchange, the equivalent of about five months of capital in its national account. But it won't be getting additional funds from the EU machine in Brussels, or the International Monetary Fund (IMF), anytime soon.
That's because Hungary, which has been on financial austerity programs since 2006, in April elected a new government. The center-right Fidesz government was given two key mandates:
- Stand up to the bankers of the EU.
- And demand a change to the IMF's standard formula of inducing near-term pain for future gain.
The Fidesz government listened, telling the IMF that they will not impose additional financial austerity measures on Hungary's people - which entails forgoing additional bailout-stimulus funds.
The IMF and the EU left Hungary Sunday night, after refusing to release this quarter's funding package. They also didn't book a return trip, which in diplomatic terms is very telling.
A Sovereign Power Tug of War?
The EU has decided to make Hungary the poster child for who controls the economic destiny of a sovereign state. The bankers have tossed Hungary to the credit-default-swap-trading hedge-fund wolves, figuring that would scare the rest of the European states and bring them into line. These funds will "short" the Hungary's government bonds, raising its borrowing costs.
"The real driver here is the EU," Preston Keat, head of research for political risk consultancy Eurasia Group told Reuters. "They are the ones who are pushing so hard for austerity - more so than the IMF. They are trying to signal to other EU countries that this is a new era regarding budgets and public finances."
Indeed, what we have now is a European Union "state" taking on the European Union.
"This may be good politics and political signaling both from the [Hungarian] government - 'we will not cave in to the IMF, and we will punish the evil banks' - and the EU - 'after the Greece debacle, fiscal austerity and transparency are non-negotiable'," said the Eurasia Group's Keat. But "this may not translate into good economic policies or market reactions."
"If you have a large debt/gross-domestic-product ratio you are susceptible to an increase in financing costs," Dietmar Hornung, Moody's lead analyst for Hungary, told Bloomberg in a telephone interview from Frankfurt.
The ratings company maintains a Baa1 grade on Hungary's sovereign debt, three levels above "junk," with a negative outlook, which appropriately reflects "economic and political uncertainties," said Hornung. "The assessment that government finances are lastingly impaired"would result in a rating downgrade.
Meanwhile, the EU can scarcely afford another sovereign-debt crisis to occur on the heels of those in Greece and Spain. And history has shown that economic crises have a habit of popping up where people least expect them.
An Early Warning System
In 1931, Austria experienced a banking liquidity event that grew into a European banking crisis that didn't end until it shattered the gold standard of the time.
The Creditanstalt crisis of 1931, as it is known today, was the signal that Europe was broke and could no longer fake the credit transfers.
Today, Austrian banks have lent out a significant percent of their national yearly gross domestic product (GDP) in loans to Central Europe states like Hungary, so they will show the first signs of stress. Irregular funding flows also could signal a crisis, so keep an eye on Bank for International Settlements (BIS).
If Austrian banks are crushed by a Hungary funding crisis, you will see knock-on effects in core European bank fund rates. That's why we should closely monitor the status of Austrian banks, going forward.
Call to Action: You should consider reducing your exposure to Eurozone banks, and Eastern European emerging markets equity and debt.
You can build a Eurozone Tracker on your quote list, if you have an online trading account and track this new liquidity crisis as it unfolds. Simply include the CAC 40, DAX, FTSE 100 indices and add these exchange-traded funds (ETFs):
- The ProShares UltraShort Euro ETF (NYSE: EUO)
- The Market Vectors Double Long Euro ETN (NYSE: URR)
- The Market Vectors Double Short Euro ETN (NYSE: DRR)
- The ProShares Ultra Euro ProShares ETF (NYSE: ULE)
- The Currency Shares Euo Trust ETF (NYSE: FXE)
- The WisdomTree Dryfus Euro ETF (NYSE: EU)
- The PowerShares DB USD Index Bullish Fund (NYSE: UUP)
The next real crisis will be a banking crisis in Europe - and it's not a matter of "if," but is a matter of "when."
I am preparing accordingly.
News and Related Story Links:
- Financial Times:
IMF seeks $250bn boost to resources
- Money Morning Special Report:
The Baltic Dry Index is Shouting "Danger, Will Robinson!" But Are Investors Listening?
- Radio New Zealand News:
Hungary Told by IMF to Stop Spending.
- Money Morning:
Hungary is the Latest European Domino to Fall
- Money Morning:
Why Investors Must Keep an Eye on Spain
- International Monetary Fund:
- Eurasia Group:
- The Free Dictionary: