Capital Markets in Communist Hungary

When Hungarian industry was struggling to secure enough capital to maintain its efficiency, the communist government was looking for ways to raise investment capital. Freeing up financial markets became a priority and before the end of the 1980s, a socialist economy in Central Europe had a bond market and a stock market. They started off small but grew over the decade. In the end though, this reform was not enough to decisively turn the economy around and save what was still at its core, a socialist economy.

Hungarian Economy to 1983-4

Like other Eastern Bloc economies, that of Hungary specialized in heavy industry and had only a small sector producing consumer goods or services. Hungary’s heavy industry saw large amounts of labor and capital deployed in areas like metallurgy, chemicals, and the manufacturing of machinery and vehicles. Mining, light industry, and agriculture were also important, but smaller parts of the economy.

Industry requires large amounts of capital investment to remain efficient and produce quality products. Unfortunately, investment peaked in the late 1970s and went into decline. In the early 1980s, the economy slowed and the country was briefly on the verge of a government default in 1982. Indeed, Hungary had relied on credit, and this was being withdrawn. The reason was an even worse crisis in neighboring countries. Poland faced financial difficulties as did Romania, prompting Western banks to cut off credit to Hungary, credit upon which Hungary relied in order to finance its imports.

Fairly quickly, restrictions on new investment and imports restored a surplus in the country’s current account. This was important in stabilizing the situation, but the reforms went still further. Industrial decision-making was decentralized and private and cooperative ventures were permitted in a wider range of areas. During the early stages of the economic recovery, essentially over 1983-4, the current account was in much better shape and with that, access to foreign credit was restored. However, real wages were still falling. Whatever its problems though, Hungary still had a freer economy than that of other Eastern Bloc countries, the product of its softer implementation of socialism, dubbed ‘goulash communism’.

Moszkva tér (Moscow Square) in 1989, Budapest (Source: budapestretro.weebly.com). The city was home to the first McDonalds in a Warsaw Pact country (opened in 1988). This location (which was not the first) is still open in Budapest.

Bond Market

To push the economic recovery along, financial markets were liberalized somewhat, allowing the emergence of a bond market. Public utilities began to issue bonds linked to specific projects in 1981 and general government bonds were issued the following year. Initial experiments were slow going; only about half of bonds due to be issued were actually subscribed to. Still, the bond market was opened up further in 1983, the first such market in an Eastern Bloc country.

The government authorized bond issuances by municipal governments, companies, and banks. This was an effort to raise private capital for investment from both individuals and companies with surplus resources. Bonds could reallocate these surpluses into productive projects more quickly than the state could. The effort was also designed to encourage firms to become more mindful of the economic merit of their decisions, since they would now count private bondholders among their stakeholders. Optimists believed the reform would require firms to measure and publish accurate statistics about their operations as well.

If bonds were issued to private individuals, they had to be approved by the Ministry of Finance; if they were offered only to firms, then this step could be skipped. Regulation may have been light, but adoption of bonds was still slow. By early 1985, two dozen issues had raised just $30 million or about 1.5 billion Hungarian forints. In the early years, the amount raised in the bond market was less than 1% of annual investment in Hungary.

These few offerings were primarily issued by municipalities financing improvements and were issued with terms of seven to ten years. Some investors were even given extra inducements, beyond interest rates of between 9% and 14%, namely benefits-in-kind, things like telephone installations or a guaranteed place in a day care facility, often related to the project being financed. As another example, two IT firms offered bonds that gave investors free or discounted software. State-run banks assisted in arranging bond offerings. In a socialist economy with some problems producing sufficient goods or services to meet demand, the banks may have suggested such perks to help get the bonds sold.

After humble beginnings, bond issuance grew quickly in the mid-to-late 1980s. A total of 142 bond issues in 1987 raised 17.3 billion forints; the total just four years earlier was a mere 750 million forints. Yields generally rose over the decade, attracting some of this extra money. Also, in this period, individuals, rather than enterprises, became the primary investors in the new bond market and the primary issuers were no longer local governments but private firms and banks.

A secondary market for bonds, where initial investors could resell their securities, was formed in 1984. Banks assisted in trading bonds among firms and individuals simply exchanged them directly among each other. For firms they counted as clients, the banks acted as brokers and market-makers, connecting buyers and sellers and acting as a buyer or seller of last resort to maintain liquidity in the market. Newspapers began to publish data on bond prices and the yields they implied. Commercial banks in Hungary were formed starting in 1987 and they became large bond issuers that same year. They were also permitted to raise funds from deposits and lend to individuals. Also in 1987, a stock market was developed.

Stock Market

A stock exchange was established in Budapest in December 1987. No such exchange had operated in the country since 1948. Up to this point there was no venue in Hungary to raise funds for higher-risk ventures; some private shares had been issued as early as 1982-83 but only on an experimental basis. Initially, shares listed on the new exchange could only be invested in by firms but at the end of 1988, participation in the stock market was extended to individuals.

Many initial public offerings in the early days were for the newly formed banks. New joint stock companies issued shares worth approximately twenty billion forints by the end of the decade. These funds were raised with fairly limited disclosure. Prospectuses for new issuances were usually very short and lacked meaningful detail. Limiting participation by foreigners, local accounting practices did not conform to international norms. Despite some early success with new initial public offerings, secondary market trading on the primitive stock exchange was light. The stock market had difficulty attracting investment since dividends, though commonly as high as 10-15%, still had to compete with high inflation and high interest rates on bonds and bank deposits. Insider trading scandals, which technically broke no laws, along with price volatility didn’t help.

In May 1989, laws were passed allowing for the privatization of state-owned firms by converting them into stock companies and permitting them to sell majority control to new shareholders. However, the stock market was still too small to place large volumes of shares with the investing public, so most of the stock of state-owned firms remained with quasi-public institutions like social security funds, insurance companies, and municipal governments. In 1989 though, George Soros, the Hungarian-born hedge fund manager, helped establish the First Hungary Fund, the first mutual fund in the country.

1980s

During the 1980s, Hungary’s economy grew slowly. The capital invested in industry became obsolete with time and whatever money could be raised in the bond market was insufficient to change this. This obsolescence meant Hungarian exports became uncompetitive. Bad weather stunted agricultural output, adding further pressure to the balance of trade as deficits returned. The Hungarian forint depreciated and inflation remained high.

The government’s fiscal policies did not help the economy as poor productivity growth was complemented by austerity measures. A broad array of subsidies, which made up about 26% to 29% of the public budget, were cut. Taxes were introduced or raised, including the Eastern Bloc’s first value added tax. Despite this, Hungary’s foreign debt grew.

While it was not enough to turn the economy around decisively, private economic activity was blossoming. By 1989, about three-quarters of Hungarians did at least some private sector work, albeit in most cases with only a small minority of their time. Private firms were permitted to employ up to five hundred workers. Housing construction, agriculture, and consumer services like auto repair and restaurant dining were most dependent on private firms. Foreigners were also permitted to buy local companies. Despite all this, the still mostly socialist economy was stuck until the system was dispensed with altogether.

Lesson

From Hungary to China, the transition to a market economy was a process rather than an event. Those who in hindsight look like pro-market reformers often had more modest objectives early on (typically the objective was to save socialism) and changes in policy, though quick, still took some time. So, there was a period of perhaps a decade at least, in each of these countries, where elements of a socialist and capitalist economy co-existed. In Hungary, a bond and stock market existed in a time and place when the economy was still dominated by large state-owned industrial firms. When the government was withdrawing from certain roles in what had been a planned economy, private capital markets filled some of the gap.

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Read about the privatization of state-owned firms in 1990s Russia. The communist world did interact with Western finance, in the case of the Soviet Union through the Moscow Narodny Bank. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.