Hungary Cuts Interest Rate to Record Low

Hungary's central bank cut interest rates to a new record low of 4.75 percent on Tuesday, in an attempt to bolster the flagging economy, as inflation has eased to a record low of 2.2 percent. But the weakness of the local currency, the forint, could give policymakers reason for more caution, according to analysts.

"Investors are trigger-happy in Hungary, selling the forint on any news, because Hungary has a history of blowing up every now and then," Bartosz Pawlowski, head of CEEMEA strategy at BNP Paribas, told CNBC.

The forint–euro exchange rate is a key factor for the central European country, because in the build-up to the global financial crisis Hungarian families and corporates took out cheap loans denominated in euros and Swiss francs. That borrowing binge ended badly when the forint tumbled in 2008.

(Read More: The 'Miracles' of Hungary and Poland: European Tigers)

Bloomberg via Getty Images

The government appointed Gyorgy Matolcsy, a close ally of Prime Minister Viktor Orban, as the new central bank governor last month. As economics minister, he pioneered such policies as nationalizing the private pension funds, taxing banks and fighting the EU and the IMF.Hungary's unorthodox policies – including a fixed exchange rate for foreign loans and transaction taxes – have turned heads in the markets.

Given these unorthodox actions, Nomura analysts say "the base rate is no longer really relevant."

Covert Rate Cut

Recent comments from the governor suggest the central bank will restrict foreign investor access to the 2-week Treasury bill, which pays the benchmark interest rate of 4.75 percent. The central bank wants to exclude those foreign banks not involved in lending in Hungary in order to limit a popular carry trade whereby foreign investors raise money in euros or the dollar and place it in the Treasury bills for two weeks. "Rinse and repeat," explained Pawlowski.

"Last year, the Hungarian 10-year bond was the best performing asset in the emerging market universe on dollar terms, and yet hardly anyone owned it," he added.

Limiting foreign holdings of the 2-week bill, is like a covert rate cut, as foreign investors will only be able to roll their money in overnight central bank deposits, which pay 100 basis point less.

BNP calculated the impact would be equal to a 10 basis point rate cut, as these speculative holdings are around 400 billion forint (1.3 billion euro) and make up 10 percent of the total outstanding value of 2-week bills.