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Hungary: The Greece of Eastern Europe
It used to be Greece that was the canary in the coal mine, these days it’s Hungary. The new year got off to a bad start for the Eastern European nation after it experienced a failed bond auction, causing its bond yields to surge.

This caused major jitters across global financial markets and once again a small, relatively unknown economy is dominating the headlines and causing a massive headache for the European authorities.

But while there are many similarities, the reasons for the panic in Hungary’s debt markets are different from Greece’s problems. Athens borrowed too much and public spending spiralled out of control. However, Hungary’s problems were not based on the size of its budget deficit, which was a fairly manageable 4.2 percent of GDP at the end of 2010, but the amount of debt in its public and private sector that was denominated in foreign-currency.

While the post-Communist era in Hungary helped to modernise the state, its capital markets did not keep up to date. Borrowing costs were lower in the euro zone and other parts of Europe where banks were willing to lend relatively cheaply across the Eastern European bloc, especially to Hungary. While the Hungarian forint was strong it was fine to have liabilities in euro and Swiss franc, however, since the start of 2011 the forint has deteriorated at a rapid pace. Since August alone the forint has lost more than 17 percent of its value against the euro.

Here is the problem: when your liabilities are in euro but you earn forint, all of a sudden servicing your debts becomes much more expensive and bad debts start to rise.
That’s where the similarities with Greece start. If bad debts start to rise then Austria and Italy could be on the hook. Austrian banks hold a whopping $40 billion of Hungarian liabilities, while Italian banks have a slightly more manageable $20 billion.

But problems in Hungarian loan books could further erode the integrity of the banks’ balance sheets, putting further strain on the ECB, which has essentially thrown everything but the kitchen sink at Europe’s banks to ensure they continue to have a healthy flow of liquidity. One of the reasons that banks are depositing so much money on a daily basis with the ECB rather than lend it to their peers is that banks are afraid of losses from Eastern Europe.

This problem can also aggravate sovereign concerns. Bad debts in Hungary can hurt banks in Austria and weigh on Austria’s national finances if its banking sector needs to be bailed out. However, the trail of destruction doesn’t stop there. Banks across Europe need to raise more than 110 billion euros of fresh capital this year, which means they will lend less to economies outside of the euro zone such as Hungary. Since Hungary has relied on European credit for so long, if banks fail to lend then the Hungarian economy will suffer making further bailouts necessary. Hungary was first bailed out in 2008; it is now in discussions for another, much needed, cash injection as its economy nose-dives. Since Hungary is a member of the EU, a Hungarian bailout chips away at the pile of money available to solve the euro zone’s own problems with bad debts.

So, what seems like a small problem in a country no one knows much about has the potential to cause a major fire. Hungary’s problems have spiralled quickly and ferociously out of control and it’s political situation also shares some of the same traits as Greece.

Just as former Greek PM George Papandreou asked the Greek people to decide whether or not to take another bailout, the Hungarian government decided to vote for a motion that would take away independence from the National Bank of Hungary, in defiance of the EU, IMF and the U.S. thus threatening its negotiations to secure another bailout. Just like with Greece, the Hungarian PM Viktor Orban has back-pedalled and promised to cooperate with the head of the NBH so that he can help secure funding.
However, it highlights the unpredictable things that politicians can do when economic stress reaches fever pitch. Orban’s retraction of his threats to NBH independence wasn’t rewarded by the markets; credit rating agency Fitch was the third agency to downgrade Hungary to junk, saying that there remain doubts about whether it will submit to conditions attached to new bailout funds. Likewise, although Papandreou retracted his offer to the Greek people, this didn’t halt market jitters.

A few months later and Papandreou was replaced by an unelected technocratic government, which is ironic since Greece is the birth place of democracy. But, worryingly, when financial situations become critical democratic principles can come under threat. Hungary is also coming under attack for the government’s plans to overhaul its Media Act, which could lead to greater censorship, and its Church Act that would only legally recognise 14 Christian and Jewish congregations forcing all other religions to formally seek recognition from the government.

Although these changes were thrown out by Hungary’s Constitutional Court before Christmas, the problem is that Orban’s conservative Fidesz party holds a two-thirds majority and in its rush to pass through legislative change, some policies that have the potential to limit democratic freedoms could slip through the net.

This is where the situation in Hungary turns darker than that in Greece. However, it highlights a major, but often silent, fear of the euro zone debt crisis: that financial stress erodes democratic principles and causes unsavoury political changes with long-term repercussions.

So as Europe’s debt crisis spreads beyond the currency bloc’s boarders, Hungary has become the latest small, but important, troubled economy that investors need to watch