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EEMEA Intraday Comment
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F I X E D I N C O M E R E S E AR C H                                                                1 1 F E B R U AR Y 2 0 1 1

Hungary and Poland trip notes: Fundamental reassessment needed
Contributing Economist
Peter Attard Montalto
++44 20 710 28440

This report can be accessed electronically via: www.nomura.com/research or on Bloomberg (NOMR)

On a recent trip to Eastern Europe we met MNB Governor Simor and Deputy State Secretaries Natran and Banai in the
Ministry of National Economy in Hungary. In Poland we saw NBP MPC member Winiecki and Deputy Minister of Finance
Radziwill. We also saw the IMF in both countries and had a range of other meetings.

     x    Markets need to fundamentally reassess their currently short-termist views of policymaking credibility in both
          countries. We think Hungary looks much worse than Poland looking out just two years. However we can see why
          many investors have returned from Hungary positive on the short term.

     x    That said, we think Hungary’s current outperformance could continue if an active (even if ultimately unsustainable)
          economic package is implemented at the end of this month. There may well be a fiscal surplus this year of around
          +1.1% and a deficit of only -1.4% next year. However, as the 2014 election approaches together with a looming
          budget deficit, current policies may not be sustainable.

     x    The MPC shake-up may well be worse than we feared even if the inflation target is now less likely to be changed.
          Governor Simor may leave if the fundamental framework of monetary policy is changed. We now pencil in rate cuts
          to our forecast.

     x    Growth in Hungary looks set to surprise to the upside because of exports but the internal dynamic remains
          troublesome. Government measures should provide some relief but may not fully kick-start domestic demand.

     x    We see logic in the Polish fiscal plan but the market and the Ministry of Finance are not seeing eye to eye –
          something which may continue through this year. Better communication is needed. That said we still doubt the
          government’s commitment to any meaningful consolidation before the election and remedy is only likely to come
          afterwards in the form of an emergency budget if a downgrade looks to be looming.

     x    The speed of recovery has surprised policymakers. The next inflation report should be bullish reflecting this. The
          NBP seems now fixed in its hawkish stance with timing and extent of the hikes dictated by the currency.

Sentiment changed significantly in Q4 and this has been strongly evident in markets since the start of the year. Investors
have become much more bullish on Hungary, confident that the situation there is under control and happy with the country’s
small fiscal deficit (even surplus this year), ongoing fiscal consolidation and current account surplus. By contrast, on Poland,
where there has been little discernable fiscal consolidation to tackle a sizeable deficit and a widening current account deficit,
there has been much more scepticism. While we believe this market view may well continue in the short term (and have trade
recommendations based on this), one of our aims on this trip was to gain more confidence in the long-term dynamic,
especially policy credibility and sustainability. Here, based on our meetings with policymakers, we retain our long-held view
that the current market optimism on Hungary is unsustainable, while Poland’s current policy path – although not perfect – is

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Nomura | EEMEA Economics Intraday Comment                                                                          11 February 2011

more sustainable. Looking beyond the headline numbers and politics at the core issues, we think the policy narrative in
Hungary will produce only short-term results, while Poland’s could be more sustainable over the longer term and lead to
better economic outturns. However, markets cannot trade such a view because it is too far into the future. In some sense
then it is not surprising that many investors return from trips to Hungary more bullish. We therefore keep our current trades.


Fiscal policy

Our visit to Budapest left us with several interesting impressions, more important than hard facts. The first is that it is of
paramount importance to FIDESZ that it achieves a continual string of victories. Its commitment to fiscal consolidation,
although not affecting households to any great extent, flows from this. Hence, we think the current policy set-up should keep
the deficit under control this year and next, but with short-termist and ultimately unsustainable measures. This can be seen in
the forthcoming economic plan this month. The Ministry of National Economy knows it needs to fill the hole left by the fall-off
in the temporary banking and sectoral taxes in order to secure “victory” in this area, but these decisions appear to be highly
political and taken at the very heart of government. What is unclear as yet is whether the Ministry of National Economy can
keep the plan to the overall size necessary under such political strain.

For the new economic structural plan, HUF600-700bn is still the figure being mentioned although it is far from certain this is
what will come out. The measures that will be imposed are equally uncertain at the moment. We expect changes to benefits
and incentives to improve the participation rate (something begun under the previous Prime Minister Bajnai) and some wage
freezing and local spending cuts. But given the political constraints on the plan, we think the measures will be short-termist
and perhaps distortionary. The likely proportion seems to be two-thirds expenditure side one-third revenue side. These
proportions may be shifting in favour of revenue, however, with the government shying away from expenditure cuts and
instead looking at some new taxes (which would be pro-inflation). As with the budget, the government seems to be pushing
completion of the plan to the wire given the 23 February launch date. It could be late and even falling into March. The MFB
local development bank is set to become increasingly important in taking on board off-balance sheet funding of the parallel
investment programme, but the details do not appear to have been finalised. We therefore no longer think that the new
economic plan would be deficit-neutral – it looks set (on balance sheet at least) to be deficit-positive (ie, lead to a smaller
deficit) but at the expense of the MFB. This should therefore aid closing the 2013 budget gap. However, our original forecast
of the HUF600bn 2013 budget hole may well still stand. The ministry is still pushing the idea of growth at 5.5% by 2014 but,
when pressed, accepts that 3.5% may be a more realistic number. Policy seems to be based on 5.5%, so if the government
really expects growth to be lower this calls into question its credibility and shows the unsustainability of the budget and its
short-termist nature. Indeed, the government agreed that, for instance, the sectoral taxes were not the first best option, but
given the political constraints they were the least worst option available. The fiscal rules should be added to the constitution
by April will be welcome but the key test will be if they can survive the period around the next election.

What is important in the long term is how the government reacts to the likely 2013 budget hole. Will it stick to tight fiscal
policy? Some in the government seem to believe that by 2013 there will be less concentration on fiscal policy from both the
EU and markets. Because the new economic plan measures are spread pretty evenly over the coming three years, we see a
risk of slippage later on, particularly with elections in 2014. These elections will be crucial to FIDESZ and policy will likely
become very risk averse beforehand (as it did between the parliamentary and local elections last year).

The pensions reorganisation is concerning locals at the moment but there now seems an acceptance that what has
happened has happened and, given the incentive structure, around 97% of tier 2 accounts have returned to tier 1.
Interestingly, this represents around 90% of assets. In other words, only the very rich are able to withstand the loss of a tier 1
pension while still contributing to the government social security fund. The debt write-off looks set to occur late in Q2 and
should represent around 5.4% of GDP by our calculation (the AKK and the government have a similar number). The equity
proportion will be dispensed over a longer period dependent on liquidity and the AKK (and government) seems happy to hold
onto smaller stocks for some time (although, as we have mentioned before, we think this raises governance issues). Foreign
stocks should be rapidly disposed of, and when domestic stocks are sold the AKK is looking at ways to deal directly with
existing stake-holders. Overall we think the government underestimates the risks of equity market dislocation and the
thinning out of market liquidity at times of stress in particular. The AKK looks set to undertake an additional debt buy-back in
the middle of the year using some of the cash that immediately becomes available. The clear aim of policy here is to reach a
target debt level of 70% of GDP very quickly – early next year. This would accelerate the fall in interest rate expenditure costs.

Nomura | EEMEA Economics Intraday Comment                                                                           11 February 2011

Cash currently on account (EUR2.5bn) as well as bank support facilities that will be repaid (another EUR1bn) will help this
effort and provide funds for IMF repayment (on the subject of which, acceleration of repayment is often mentioned but there
appears to be no decision yet).

There seems to be a range of ways of accounting for the asset transfer. The IMF uses accrual accounting (similar to ESA 95)
and so sees all the value appearing as revenue this year. The government, looking at things on a cash basis, sees only the
sales this year. We take the latter approach which gives us a deficit of -2.3% of GDP for this year. However, the IMF’s 5.7%
surplus this year makes little sense in terms of available resources to spend. The government’s aim of reducing debt to 70%
means it is unlikely to spend any of the additional, apparent, money though borrowing against the asset in the short term.

The government is also setting up a HUF250bn fund to secure against unforeseen budget events this year. We see little point
in such a move. The government has a deficit target of -2.8% of GDP and our forecast is -2.3% of GDP; the fund looks simply
to be the difference between the two so the money could either be a PR exercise or will simply be spent while keeping the
deficit within target.

With a clear target of debt at 70% of GDP, at least the appearance of fiscal consolidation occurring and a low budget deficit,
we can see why many investors return from Hungary bullish. However, we think this totally disregards the credibility of the
policymaking process and the sustainability of policy itself. We remain very bearish on Hungary’s long-run fiscal dynamic.
Monetary policy

We went to Hungary pessimistic on the MPC handover process. We leave more worried and now more convinced the market
risks a serious surprise if it does not fully consider what is likely to occur here. In government circles the need for lower policy
rates seems clear, but they are aware of the more immediate harm that changing the inflation target could do. Hence we
think the new MPC may now not actually change the inflation target explicitly even if it does work under a different framework.
It is not clear whether the potential members under discussion are really those who would be appointed, or whether they may
not be loyal enough for the government (as opposed to necessarily outright dovish). Rate cuts seem much more probable as
a result (especially as one of the current deputy governors, who is staying, now has a more neutral stance). Although we still
believe the new MPC will probably wait until after the Q2 inflation report, there is a risk it could try to cut earlier or that
Governor Simor and the other remaining deputy governor push for hikes again in March, leading to confrontation.

Most worryingly, given the position of Governor Simor as a “guarantor” of MNB credibility and financial and currency stability
during the past three and a half years, we believe he may step down this year. Although he is committed to seeing out his
term if he can, there may be circumstances where his position becomes untenable – in particular if the new MPC totally
changes the very framework of monetary policy and shifts away from inflation targeting (even if tacitly and not through an
open change of mandate). This would be a serious blow and a significant market event. His position is also becoming more
difficult with the new MNB supervisory board which is likely to flex its muscles more with its annual report mid-year. It would
never normally comment on monetary policy, only on the corporate functions of the Bank. However, under Mr Jarai and with
closer links to FIDESZ, this could change this year.

In the short term, rates now appear to have gone far enough, and with a very split MPC (3 for a hold 3 for a hike and 1 for a
cut) we now see a much reduced probability of a 25bp hike at the February meeting. The upcoming CPI print will be key,
however, and could tip the balance again in favour of a hike. Views locally on the hiking cycle are very mixed and depend on
whether the focus is on the currency and risk premia or on inflation and growth. The MNB seems to be at an extreme then in
its inflation hawkishness (not unjustifiably in our view), citing the failed policy of the past when it looked through supply-side
shocks. In Hungary such shocks invariably lead to core inflation pressures given unanchored inflation expectations. There is
a fear within the Bank of rising inflation without growth because of government policy measures on the one hand, and on the
other rising inflation if the risks of stronger growth come through as well. The Bank is also well aware of some of the
paradoxes of policy, such as the possibility that hiking rates and strengthening the currency may actually boost credit growth
by making banks’ balance sheets more secure.

Both in the MNB and more generally a view seems to be forming – one that we increasingly share – that the EU will do
nothing about Hungary’s contravention of treaty.
In general on the economy, the recovery in headline growth appears to be progressing but is driven almost totally by exports
with domestic demand remaining lacklustre. The personal income tax changes should help stabilise demand in the economy
but there is some doubt that it will actually boost spending as it only really affects the better off in the income spectrum. Net

Nomura | EEMEA Economics Intraday Comment                                                                         11 February 2011

saving is expected to increase with household balance sheets under stress, and both banks and the MNB see fiscal policy
being broadly neutral on growth in the short term despite cuts – a sign of the government’s determination not to damp growth.

Fiscal policy

Fiscal policy is the key issue for markets because of a perceived lack of fiscal consolidation. This stems from the way the
Ministry of Finance thinks about the deficit. First, it sees few funding issues given such strong demand for its bonds
throughout the crisis and its FCL, flexible credit line, backstop (which the IMF thinks would only likely be used if there was an
actual buyers’ strike as opposed to any regional event). It looks at a “core” deficit once EU structural fund payment co-
financing (accelerated from ending in 2015 for the current tranche, to being drawn down by end-2013) and pension costs are
taken out. The structure of Poland’s pension system means that requires a future contingent liability to be monetised in the
OPF pension funds now – the government sees this as unfair and detrimental to its debt and deficit standing in the market.
Through this lens last year’s deficit would not have been 8% of GDP but closer to 5.5% and so approaching the -3% SGP
more quickly. Then when on top of this the new discretionary 1% real fiscal rule growth, the VAT hike, government wage
freeze and a number of the smaller changes being made are added the government feels they are on the right track.

With the parliamentary election coming up at the end of this year, politics are a key driver of policy. The government is
determined not to damp growth in any way beforehand, and the pension reforms were seen as the easiest cut to spending
because they would have minimal effect on growth. Headline funding needs mean the government looks at the deficit in a
different way from the market (which looks at the headline numbers of debt and deficit, not the core measures). With local
elections, the end of accelerated EU funding and a fall in pension contributions set for next year, we doubt the government is
fully committed to fiscal consolidation in any meaningful sense after the parliamentary elections because it would have an
effect on growth that it would still want to avoid. This would alarm markets, unless they started looking at the core deficit.
Interestingly, the 2012 budget may now appear this summer before the Polish EU Council presidency gets fully under way
and before October’s elections. At this point in the year we think there would be little real new policy the markets would like;
the risk is that the government goes for pre-election giveaways. There is a view in some quarters locally that the PO will
struggle to find a strong platform in the elections especially given the harm the pension reforms have done to them in the
opinion polls. The government does not seem to be worried about breaching the 55% debt level, both because it believes
(rightly in our view) that debt will fall enough this year anyway because of the pension changes, but also because even if it
did breach it this year it would likely turn around sufficiently by next year to meet the Public Finance Act requirements without
an austerity package. It is also very open about the possibility of changing the debt or deficit accounting rules though admits
that changing the headline level of the 55% ceiling would be unacceptable to the market. However, there is a risk that current
spending is allowed to slip in some areas because of the gap opened up by the pension changes vs what is in the budget law
given the elections.

There is a range of factors set against the government which may well be “unfair”. Expenditure as a percentage of GDP is set
to fall overall in the coming years thanks to the new fiscal rule, which promises also to tackle excessive overruns in local
government. For a country with strong growth, debt levels as a percentage of GDP should remain low and also fall due to the
pension reforms. It should also reach a 3% deficit in only three years’ time. These numbers may allow Poland some room for
complacency. However, markets are equally right that the volume of funding based on the headline deficit (including co-
financing and pensions) is what is important and Poland remains vulnerable to regional risk sentiment. Even if the market’s
view is too short-termist, the demand for further consolidation will likely continue. There seems some possibility of an
emergency budget after the election if necessary to keep the markets and ratings agencies on board, but this would clearly
be a credibility blow given the government’s unwillingness to undertake the measures before the election. However, we
revise our view on ratings as a result and believe the government will, if push comes to shove, avoid a downgrade through
such an emergency budget. However, we still see a risk of a downgrade after the election. The lack of fiscal drag overall
should support growth further, however.

The government is attempting to make the pension reforms equity market neutral by increasing the savings rate through tax
incentives (savers can write off additional pension contributions) and by allowing increased equity allocations by OPF funds.
This should work in part but not fully we believe. There does not appear to be enough of a saving culture to have a significant
aggregate effect in the short term and the changes are coming in over a longer period of time. As such we still believe the
pension changes will be net equity market negative, while on the bond front they should be positive with the reduction in
supply outstripping the reduction in demand. However, as for Hungary, the government is reluctant to acknowledge that the

Nomura | EEMEA Economics Intraday Comment                                                                          11 February 2011

true test will be in times of market stress when the usual stalwarts of bond buying – the pension funds – will not be about and
so risks of market dislocation are increased.

The government is attempting to change some of its debt from fixed rate to floating. It sees short-term market stress and a
profitable opportunity as the market appears to be pricing in too many rate hikes. In other words, it is receiving rates on a
belief the NBP will hike rates less than the market is currently expecting. This is our view too, and we have the trade in our
portfolio in 1y1y. However, given the poor way in which the move has been communicated market reaction is likely to remain
negative on this issue. And because it is being done during a rate hiking cycle when the profit may well be short lived, then it
could make a loss in the fixings.

Monetary Policy

On monetary policy the NBP – both the staff and MPC members – seem to have been surprised not so much by the end
point in growth terms of this recovery but the speed at which we are getting there. Investment seems to be the key driver of
the surprise, but the recovery is seen as broad-based, with consumption and exports playing their part. That said, the public
sector has responded more rapidly than the private sector. As such, although we may not be seeing tightness in the labour
market, credit market or in terms of capacity utilisation more generally, these events are now expected in the near future and
hence the need to normalise rates.

The NBP sees inflation pressures developing in both in core and headline given current commodity price pressures and
demand-side pressures likely to materialise in H2. Energy prices are considered the more significant risk, though this is partly
down to an assumption that food price pressures on the international markets will dissipate going forwards – in other words
the NBP staff at least are taking the opposite view to the market. We see risks to the next inflation report CPI forecast firmly
skewed to the upside as a result. Nevertheless, all the key indicators should look stronger in the inflation report. This may
suggest to some of the swing voters on the committee the need to continue the hiking cycle.

In the near term another hike in March looks possible and should be highly currency dependent. The MPC seems to contain
members right across the hawk-dove spectrum who are currency centric – but on balance we believe the MPC decisions will
be postmodern and be heavily influenced by the currency. Some on the MPC seem to think that rate hikes are needed
regardless of currency – so while currency strength may well affect timing, the need to move back to normal rates means it
should not halt the cycle all together. With a more hawkish inflation report as a result of updated forecasts, some MPC
members could swing over to hike but we retain our view that it will be a close call between the two meetings.

There is also a lot of interest in the NBP on the currency. Both staff and MPC members (and to some degree in the MinFin
too) are perplexed by the lack of appreciation given what markets are pricing in. The NBP seems concerned that with so
much now priced in for hikes by the market that the currency will find it difficult to appreciate any further from here. We do not
see this playing out via more rate hikes to force appreciation but the hawkish rhetoric may well accelerate in order to aid
appreciation. Part of the general underperformance of PLN is also put down to the rapidly widening current account and in
particular the very large net errors and omissions – which given a range of views where they could reside, seem to be flowing
from smaller firms underreporting imports and banks misreporting negative PLN hedging activities.

Forecast changes

Hungary: We now explicitly forecast cuts under the new MPC and see rates at 5.00% at year-end. We think the probability of
rates remaining unchanged in February has risen to 40%. We raise our GDP forecast to 1.5/2.0/2.5% for 2010-12 from
1.0/1.5/2.5% previously. We lower our debt to GDP forecast for 2012 to 69.4% given the government’s target in this area. We
shift our fiscal balance forecast for this year to a surplus (of +1.1%GDP) given a change in accounting and reduce our
projected 2013 budget hole to HUF550bn.

Poland: No significant changes.

Nomura | EEMEA Economics Intraday Comment                                                                                                             11 February 2011

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Nomura | EEMEA Economics Intraday Comment                                                                                                           11 February 2011

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