'New' Europe: Hungarian Contagion? Turmoil Rocks Eastern Europe's Burgeoning Currency Markets, Creating More Opportunities in Trading the Growth of the European Union. (Trade Trends)

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Currency traders learned a lesson 'bout messin' with the Hungarian Central Bank (HCB) in January, when a two-day, two-basis-point rate slash -- coupled with a series of interventions estimated by some to have cost an unlikely $5 billion -- left those on the long side of the country's currency, the forint, reeling.

"A lot of traders who we wouldn't normally call expert emerging market traders were drawn into the market and found themselves on the wrong side rather quickly," says Fimat FX boss Julian Knight, referring to a gaggle of mid-sized European banks believed to have taken massive hits when the rising forint abruptly reversed. "They'd been talked into the position within a very short time frame -- really just a couple of weeks before the move."

The positions -- basically long the forint and short the euro, often using money borrowed in the eurozone and to buy high-yielding Hungarian bonds -- were built as the euro fell toward Ft 234.69:1, which is 15% below Hungary's target convergence rate of Ft 276.1 to the euro, which the HCB had promised to defend in May 2001 (see "The Allure of Trading Europe," October 2002). Since then, a combination of optimism and high interest rates (two-week rates of 8.5% are estimated to have lured as much as $9 billion in hot money) had gradually lifted the forint roughly 12% against the euro and 20% against the dollar by early January, when speculators began piling into the forint to both grab the high rates and get a piece of the bull market. The key level was touched on Friday, Jan. 10, and the market priced in a 1/2-point rate cut on Monday -- only to be left in the lurch.

The market hovered around 234.80 for most of Monday, and emboldened traders bought on Tuesday, Jan. 15, pushing the euro below 234.69 -- but after the HCB had closed. So on Wednesday, the bank unleashed its two-pronged attack: slashing its key two-week rate to 7.5% from 8.5%, and selling forint for euros.

Come Thursday, papers were filled with news of trading carnage, as well as calls for rates to come down even further, but HCB governor Zsigmond Jarai, long a champion of higher rates, said there was no room for more cuts. The euro then fell to 234.90 -- just above the perceived intervention level -- and the bank unleashed a second full-point rate cut, coupled with more buying of euros and selling of forint. That kicked the euro up to Ft 250, while slashing bond yields by as much as 145 basis points on the short end and 20 on the long end.

"This may have helped the HCB achieve its goals in the short term, but Jarai's double-talk has cost them credibility," says a Deutsche Bank trader, whose trading desk was on the winning side of the move and helping to offset losses on other Deutsche desks believed to have given up more than $200 million. Smaller banks weren't so lucky, and several were forced to liquidate positions in other Eastern European currencies -- giving rise to fear of a "Hungarian Contagion" ostensibly fuelled by widespread friction among the central banks and elected governments of Eastern Europe.

Although the central bank and government of Poland both advocate policies that ultimately translate into a weak currency policy, albeit with disputes over the speed of that weakness (see "Trading European Growth," November 2002), Hungary's authorities have more to quibble about. The HCB is targeting inflation of 4.5% by year-end, down from just above 5% last year, while the government is more interested in growth and keeping the currency in line. jarai was finance minister under the previous center-right government, and some say that now that he has a job exempt 'from political meddling he wants to see the incumbents fail -- hence, cynics say, the double-talk.

To be fair, both the government and the bank face an array of challenges -- many of which will no doubt be familiar to their continental neighbors: free spending left Hungary's deficit at more than 9% of GDP last year, which has awakened inflation, which in turn has driven interest rates higher. …