Public Information Notice No. 04/59

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Hungary

May 24, 2004

On May 10, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.¹

Background

Hungary's entry into the EU comes on the heels of impressive accomplishments. Its successes were based on the long-lasting effects of significant structural reforms and privatization during the 1990s, which also facilitated Hungary's outward orientation, foreign direct investment (FDI) inflows, strong export performance, flexible labor and product markets, and sound banking system. The success was also rooted in undertaking macroeconomic adjustment measures when needed, and in maintaining an adequate level of international competitiveness.

However, while growth held up well in recent years despite the global slowdown, significant macroeconomic imbalances have emerged. Reflecting huge increases in public sector and minimum wages, economy-wide real wages surged by some 14 percent in 2002 and grew by another 10 percent in 2003. Such rapid wage growth had adverse consequences for fiscal policy, inflation, and the current account. And, while real GDP growth stayed significantly positive (at 2.9 percent) in 2003, consumption was a leading factor—fueled by the large wage increases, and a sharp drop in household savings and rapid credit growth (partly reflecting an expanded housing subsidy scheme). The general government deficit in 2003, according to preliminary data, was 5.9 percent of GDP (ESA-95 basis), compared with an original target of 4.5 percent. In addition to the carryover effect of large public sector wage increases and its impact on pensions, the deficit outturn resulted from overruns in spending on health, housing subsidies, and interest payments. Core inflation has recently picked up and, in the face of rapid consumption demand, price growth in the services sector has been stubbornly high. Meanwhile, year-on-year headline inflation was above target at 5.7 percent in December 2003. Rapid consumption growth also spilled over into imports and the current account deficit, influenced additionally by the lagged effects of declining competitiveness in 2001-02, widened to 5.5 percent of GDP in 2003 (excluding reinvested earnings). This deficit was financed mainly by debt-creating inflows.

Over the course of the past year or so, the imbalances together with policy inconsistencies weakened policy credibility—contributing to volatility in financial markets. Several factors were at play: in the second half of 2003, the pursuit and announcement of a Ft 250-260 per euro target (within Hungary's ERM2-like exchange rate regime) when policies were inconsistent; conflicting statements by policymakers about the appropriate exchange rate level; and targets and estimates that went unfulfilled (including revisions to the 2003 fiscal deficit target and the mid-December estimate of the 2003 fiscal outcome). As markets became increasingly concerned about external and fiscal developments (and policy credibility generally), Hungary experienced significant bouts of volatility. Interest rates were increased to support the currency. The main short-term policy interest rate was increased by 300 basis points in November 2003 to 12.5 percent, bringing the total increase to 600 basis points since June.

Recent data have, however, included some bright spots that give rise to optimism on the prospects for economic growth. The significant deterioration in external competitiveness in 2001-02 was reversed in 2003. This reflected forint depreciation against the euro, and wage moderation, alongside steady improvements in productivity, in manufacturing. Industrial production and export growth began accelerating in the second half of 2003, while investment growth was also rising. In all, the fourth quarter saw year-on-year real GDP growth continuing to gather pace, reaching 3.5 percent.

The authorities announced a revised target for the general government deficit in 2004 of 4.6 percent of GDP, compared with an outturn of 5.9 percent in 2003. While the new target is larger than the original one of 3.8 percent, it reflected the slippages in 2003. With a view to enhancing transparency and credibility, the government decided on a revised but more realistic target, rather than risking another miss by a wide margin.

Executive Board Assessment

Executive Directors saw Hungary's entry into the EU as a fitting tribute to a successful transition to a market economy, based on more than a decade of far-reaching institutional and structural reforms. However, Directors were concerned about the emergence of large fiscal and current account deficits, as well as continued inflationary pressures, and saw important benefits to strengthening policy credibility.

Looking to the period immediately ahead, most Directors welcomed recent indications that growth prospects have improved. They observed that continued productivity growth and wage moderation would support further competitiveness gains. Overall, Directors felt that, with the right policies, Hungary is well poised to take advantage of a strengthening external environment to achieve more balanced economic growth. However, they stressed that a lasting improvement in economic prospects and a reduction in Hungary's vulnerability to exchange rate and interest rate volatility will require reining in the macroeconomic imbalances.

Directors called upon the authorities to move ahead forcefully in taking decisive and concrete actions in support of fiscal adjustment to improve the monetary-fiscal policy mix. Credible fiscal policy measures will help strengthen the external current account, lower risk premia, facilitate a reduction in interest rates, and limit vulnerability to shifts in market sentiment.

Directors generally considered that the fiscal adjustment envisaged by the authorities in 2004 is appropriately ambitious. However, Directors noted the risks of falling short of the 2004 deficit target, and cautioned that further fiscal corrections could be needed soon. They were encouraged by the authorities' intention to stand ready to introduce such corrections, and urged them to quickly identify specific contingent spending cutbacks.

Directors considered that more fundamental expenditure reforms are needed to ensure durable fiscal adjustment over the medium term. They noted that, given the high tax incidence, particularly on labor, and the need to leave room for spending pressures arising from public investment needs and EU accession, priority should be given to consolidating current expenditure. In this connection, Directors identified a number of areas in which reforms can achieve significant savings, also with a view to improving the efficiency and delivery of public services. These include rationalizing government employment, continuing pension reform, improving the targeting and structure of social benefits and subsidies, and reforms in education and health care. In a related vein, Directors recommended a further scaling back of the housing subsidy scheme and called for greater public sector wage restraint in the period ahead. In addition, as a way to enhance fiscal discipline, Directors encouraged the authorities to follow through on plans to introduce a rolling medium-term fiscal framework with expenditure ceilings, and to integrate it in the annual budget process.

Directors welcomed the authorities' focus on medium-term inflation objectives. Several Directors noted that official interest rates remain high, and some saw room, after the cuts in official rates of the last few months, to reduce them somewhat further in light of the recent strength of the currency. Several other Directors, however, considered that the stance of monetary policy remains appropriate for the time being. Directors agreed that room for more significant cuts would be created once demonstrated fiscal adjustment is undertaken to firmly re-establish policy credibility.

Directors noted that in the face of inconsistent policies, the authorities' focus on keeping the exchange rate within a narrow range in 2003 had become problematic. In light of the large current account deficit, they welcomed the recent shift to greater exchange rate flexibility, which, they felt, will provide a welcome cushion against unanticipated shocks.

Directors noted that the overarching challenge in the medium term will be to adapt the policy framework to the requirements for adopting the euro. In this context, they underlined that there will need to be greater assurance that the necessary fiscal adjustment and disinflation will materialize before the authorities proceed to establish a definitive time frame for ERM2 entry and euro adoption. Directors added that, as ERM2 approaches, it will be important to avoid public communication that implies a rigid commitment to a particular exchange rate level or range, which could prompt another speculative attack.

Recalling that ERM2 will reduce monetary flexibility, Directors stressed that the authorities should ensure that they make full use of all policy tools for sustainable disinflation, including fiscal consolidation and wage moderation. To minimize exchange rate vulnerabilities, they also emphasized the importance of getting the central parity right. Several Directors also underscored the benefits that could derive from an incomes policy aimed at alleviating tensions between the inflation and current account objectives, adding that the government should take the lead on restraining wages.

Available information indicates that the Hungarian financial system is healthy and that the vulnerabilities that have arisen appear manageable. Directors noted that some of these reflect strong credit growth and increasing credit risk. Directors recommended that the authorities carefully monitor these vulnerabilities, with a view to taking timely corrective action if needed. Moreover, they emphasized the importance of ensuring an independent and accountable financial supervisory authority. Directors commended the authorities' effort to comply with international standards on Anti-Money Laundering/Combating The Financing of Terrorism, and encouraged the implementation of the new AML law.

Directors were encouraged by recent product market reforms. They welcomed plans to complete the final stage of privatization, as well as the increases in gas and electricity prices to cost recovery levels, which will eliminate implicit subsidies. As regards the labor market, Directors encouraged actions to help raise the current low labor participation rate.

Directors commended Hungary's commitment to transparency and standards, through its continued participation in Report on the Observance of Standards and Codes updates. While welcoming the further improvements made recently, Directors suggested that the authorities' considerable leeway to undertake government spending above budgeted levels without supplementary appropriations and parliamentary approval threatens fiscal discipline and needs to be rectified.