Hungary: Value zone - short duration HUF bonds

We maintain our positive investment view on Hungarian local
currency bonds as a trend to disinflation and still high interest rates should provide the NBH with opportunities to soften its monetary
policy stance. The pace of fiscal consolidation, however, remains
slow and the currency is vulnerable to short-term capital flows,
which makes us more cautious in our recommendations for Q4 2004.

Investment summary

For investors looking at Hungary’s three main markets – foreign exchange,
local currency bonds and hard currency bonds –
in the short term we see
best value on the short end of the local currency debt curve (1-3Y) and
money market instruments and recommend an Overweight position.
The HUF should continue to be supported by the highest interest rate
differential in the region and should move sideways over the next couple of
months at /HUF 248-252, before weakening toward 260 by year-end.
Over the longer term we remain cautious on Hungary’s pace of fiscal
consolidation and the currency’s vulnerability to speculative flows, and
would recommend investors reduce their exposure to the local bond market
in Q4. We also keep our Underweight recommendation on the external debt.

Political and economic update

The Hungarian political scene remains the most stable in the region and
despite the poor EP election outcome we expect the current government to
remain in office for the rest of its term, i.e. until spring 2006.
The economy is accelerating and adjusting to more balanced growth this
year as investments and exports increasingly take over as key drivers of
the economy. Inflation uncertainty has also decreased and we project CPI
to slow to 6%-6.5% by end-2004.
The fiscal position remains a key concern as the 2005 budget is likely to
be moderately restrictive at best, and substantial risks still remain for the
achievement of budget deficit targets for both this year and next year – 4.6%
and 4.1% of GDP respectively.
The current account deficit is improving slowly, but the sources of the
financing are larger and better. Net local bond issuance in H2 2004 is likely
to be negative, which should provide some support to the local market.