External shocks and limited absorption in a small open economy: the case of Hungary

Abstract

This article reflects on the shock absorption experience of a small open economy. The main questions asked are: why and how can a strong external financial orientation lead to amplified external shocks in a small open economy; and whether the shocks could have been better absorbed or dampened with some foresight? Our answer is in the affirmative as we indicate that the dangers of extended foreign currency exposure were known from the literature and from other small countries' experience. However, we argue that for Hungary a fully effective defence, let alone full absorption of the shocks, was not possible by any measure; nor was it offered by any known policy measures of standard theories. The article outlines the general world economic conditions during the crisis period and follows with Hungary-specific features and vulnerabilities in order to identify crucial points of crisis management and economic policy formation. Data series cover 2004–10, with expectations for 2011. This six-year period represents Hungary's economic development path after EU accession. We demonstrate that the capacity of a non-eurozone small open economy for external shock absorbing, and for applying standard crisis-dampening instruments, fiscal or monetary, was very limited. Successful external shock absorption, with large foreign debt exposure, is more challenging than the profession or the general public might think.