Hungary -- 2003 Article IV Consultation Discussions, Preliminary Conclusions of the IMF Mission
February 6, 2003
1. Reflecting a remarkably successful transition, Hungary is now on the verge of EU membership. Strong external competitiveness, export growth, and foreign direct investment have been at the heart of Hungary's success. This success has also been backed by careful macroeconomic management and significant structural reforms, including the lasting effects of the bold reform measures of the early and mid-1990s.
2. In 2002, developments in growth and inflation were broadly positive. Real GDP growth, while slower than its rapid average pace during 1997-2001, picked up during the year—to 3.4 percent (year-on-year) in the third quarter from 3.0 percent in the first half of the year. Headline inflation declined from its recent peak of 10.8 percent in May of 2001 to 4.8 percent at end-2002. While helped by exogenous factors, the Magyar Nemzeti Bank (MNB) has essentially met two consecutive year-end inflation targets. There was also a significant decline in core inflation.
3. However, clouds have gathered on the economic horizon.
• Recent wage growth has been extremely rapid: for example, on an economy-wide basis, it was 18 percent in the first eleven months of 2002 (year-on-year). This reflected continued strong wage growth in the private sector on the back of the sharp hike in the minimum wage early in 2002, followed by the 50 percent wage increase in September for some three-quarters of the public work force (without any reform of public employment). The carryover effect of the public wage increase is significant—contributing to an increase in the wage bill of the general government in 2003 of 20 percent, even without further wage increases. The demonstration effect on private wages could also be considerable, not to mention the potential effect on wage negotiations in the state-owned enterprises. This, along with other factors, adds significant upside risk to inflation.
• Reflecting both wage increases and nominal exchange rate appreciation (reversed to some degree recently), external competitiveness has declined significantly in the last two years—with the ULC—based real effective exchange rate having appreciated by some 20 percent during 2001-02. This would raise even more serious concerns about export prospects, and possibly foreign direct investment, if rapid wage growth were to persist.
• Buoyed by real appreciation, wage increases, and a fiscally-induced strengthening of domestic demand (see below), import growth accelerated. Along with historically low tourism receipts, the current account deficit is likely to have been in excess of 5 percent of GDP last year, at a time when FDI fell off sharply. While the 2002 current account deficit will probably be smaller when the move is made to customs data for merchandise trade, the inclusion of reinvested earnings, in line with international practice, would make the deficit larger.
4. By any standard, fiscal policy was excessively expansionary in 2002. Compared with deficits (on an ESA-95 basis) of 3.0 percent of GDP in 2000 and 4.7 percent of GDP in 2001, the estimated deficit of the general government reached a startling 9.3 percent of GDP. While one-off expenditures amounted to about 3.5 percent of GDP, there were significant permanent expenditure increases—notably on wages and pensions, as well as on health-related spending, social benefits, and some subsidies. These increases not only added to the deficit last year, but they will also complicate fiscal consolidation efforts in this and later years.
5. Fiscal laxity, alongside rapid wage increases, put monetary policy in a very difficult bind. With upside risks to inflation predominating, the speculative attack against the band in January brought to a head the conflict between inflation objectives and objectives related to the exchange rate—in the face of a widening external current account deficit and concerns over external competitiveness. While it would have been preferable if the turmoil could have been avoided, the response by the MNB at the time of the attack was, in the mission's view, appropriate. Nevertheless, the basic problem remains: monetary policy by itself cannot aim simultaneously to lower inflation and support external competitiveness and current account adjustment.
Macroeconomic Policy Issues
6. Euro adoption provides an important anchor for the macroeconomic framework. The mission sees considerable merit in early adoption of the euro, provided fiscal discipline and wage restraint are vigorously pursued. In formulating and communicating the macroeconomic policies required to meet the Maastricht criteria in a sustainable way, care must be taken to avoid the potentially disruptive effects from abrupt shifts in market expectations on the progress toward adopting the euro. In this context, the establishment of a working group of the MNB and the Ministry of Finance is a welcome and important step in promoting collaboration and progressing with needed preparatory work, and in building consensus on a euro strategy.
7. Significant fiscal adjustment is essential for meeting the challenges ahead, both on the domestic and external fronts. With wage pressures still evident, and on the heels of the speculative attack in January, the end-2003 inflation target is likely to be breached (the mission projects inflation above 5 percent). To be in a position to meet the end-2004 inflation target, a significant fiscal tightening is indispensable. Moreover, by lessening the necessary degree of monetary restraint to meet inflation objectives, a tight fiscal stance would help to avoid too strong an appreciation of the exchange rate, in circumstances in which the size of the external current account is a concern. In the mission's view, the current account needs to return to more comfortable levels, and it could become especially troublesome without action to reduce the fiscal deficit. Even with significant fiscal adjustment in 2003, the external current account deficit seems poised to widen, reflecting continued sluggish growth in Hungary's trading partners, higher oil prices, and the lagged effects of the significant appreciation of the real exchange rate. While it is tempting to assume that the current account deficit will continuously be financed on favorable terms, not least in light of the market's exuberance over EU accession, market expectations can change unexpectedly. Were sizable twin deficits to prevail, the risk of a (possibly disorderly) correction should not be overly discounted.
8. Thus, the mission strongly supports the authorities' fiscal deficit targets—which call for sizable and early consolidation. These targets are specified in the latest pre-accession economic program, which envisages deficits falling below 3 percent in 2005. The 2003-04 period offers the best opportunity to press ahead with the bulk of fiscal adjustment, ahead of the next election cycle. In addition to helping alleviate excessive upward pressure on the exchange rate (an important consideration in the run up to ERM2 and adopting the euro), achieving the fiscal targets would contribute to a number of other important macroeconomic objectives: raising national saving to support investment while avoiding crowding out private sector investment; safeguarding public debt and external viability; supporting the disinflation effort; and generally maintaining macroeconomic stability important for sustaining growth. The fiscal targets are also consistent with early adoption of the euro.
9. Achieving the deficit target as from its first budget would support the credibility of the new government and is an important first step toward medium-term fiscal adjustment. As the 2003 budget assumes that current expenditures (as a percent of GDP) will be contained at a lower level than in 2002, unwavering policy implementation will be required on this score. Upside risks to spending on subsidies, pensions, and other social transfers are present. On revenues, while the budget estimates on the whole seem reasonable, downside risks arise from the possibility of lower real growth than assumed in the budget (the mission forecasts 3.6 percent in 2003), and from optimistic projections for the base for the personal income tax and social security contributions. If slippages occur, the mission would strongly urge that corrective measures be taken, to ensure that the fiscal deficit target of 4.5 percent of GDP is met.
10. 2004 is a pivotal year in which the authorities will be confronted with a number of challenges in achieving the targeted deficit of 3 percent of GDP. With the adjustment in 2003 relying mostly on one-off factors and lower investment spending, it is important to prepare early for more durable fiscal adjustment in 2004—focusing on current expenditure. Indeed, the evidence suggests that fiscal consolidation is durable and more friendly to growth when it relies more heavily on restraining spending than increasing revenue, and tackles key issues related to the government wage bill, transfers, and subsidies. A number of considerations in 2004 strengthen the case for strong restraint on current spending. First, spending pressures arise from public investment needs. Second, EU membership entails a significant reduction in import duty revenues and increases in EU-related spending. Third, the high tax wedge on labor will be reduced. Areas for achieving greater expenditure restraint and efficiency include public employment, pensions, and various subsidies (e.g., for housing, transport, and pharmaceuticals). In addition, it will be important to limit transfers to and guarantees for state-owned enterprises.
11. Our discussions considered important principles to strengthen fiscal management and transparency.
• A framework is under consideration that would establish three-year expenditure ceilings. In the view of the mission, an essential feature would be submitting these ceilings to parliament for approval at the time of the budget, along with a statement of policy objectives. Within this framework, consideration should be given to specifying sub ceilings on the key components of public spending that need to be reined in, and to identifying measures to underpin this effort. A number of EU governments (e.g., the Netherlands and the United Kingdom) have adopted medium-term expenditure frameworks and their experience is worth tapping into.
• The mission is heartened by recent efforts to improve transparency in the fiscal area. These include: widening the coverage of the general government; eliminating some important quasi-fiscal activities of government institutions; and limiting the use of the APV Rt reserves. There are also plans to bring the activities of many non-profit government entities into the budgetary fold. The proposal to move toward performance based budgeting also has important advantages, among them facilitating greater public surveillance of fiscal activities and promoting a more efficient delivery of public services.
• There have also been notable improvements in other areas to bring data compilation and dissemination in line with international best practices. In particular, the mission welcomes the progress being made on improving balance of payments and national accounts data, and looks forward to the inclusion of reinvested earnings in the balance of payments statistics by early 2004.
12. Monetary policy, for now, has to operate in a constrained and difficult environment. In the near term, on the heels of the speculative attack, the MNB will want to reverse the increase in base money and negative short-term real interest rates at the earliest opportunity to limit the potential for dissaving and rekindling inflationary pressures. It will also want in due course to remove the limits on the two-week deposit facility and return to normal operating procedures (and transmission from official to market rates). Reversing the emergency money market measures and interest rate cuts will require, in line with current practice, caution and a pragmatic approach, to avoid triggering new speculative pressures. Looking out further, the scope to affect the inflation outturn for 2003 is limited, both in light of the lags involved in monetary transmission and because of the limited room for maneuver after the attack, which has essentially subordinated the inflation target to exchange rate considerations for now. Thus, in a process that is already underway, the monetary authorities should focus their public pronouncements on the end-2004 target and the supporting policies to achieve it. The government could help by publicly elaborating in greater detail its role and intentions in supporting the disinflation process.
13. Wage moderation is key to disinflation and supporting external competitiveness. In the first instance, the government needs to signal the importance it attaches to this objective and contribute to meeting it through its wage policy for public sector employees. Thus, on the heels of the large wage increases already granted, the mission strongly supports the wage freeze this year for the vast majority of public sector employees, and would urge the government to consider keeping wage increases in 2004 below the inflation target. The mission also sees merit in closer cooperation among the social partners—working through, say, the National Coordination Interest Council—to reach a broader consensus on, and realize, wage moderation. In this regard, the experience of some current members of the euro area is interesting. In several countries (e.g., Greece, Ireland, and Portugal), wage agreements were instrumental in bringing down inflation to meet the Maastricht criteria. In some others (e.g., Belgium and the Netherlands), wage agreements have been explicitly guided by employment and external competitiveness considerations. The mission strongly believes that wage recommendations should be made in (gross) nominal rather than real terms. This would make it easier for the various players to translate recommendations into actual wage increases. It would also discourage backward-looking indexation, which adds inertia to inflation and makes it more difficult to disinflate.
The Financial System
14. The Hungarian financial system remains fundamentally sound. In 2002, banks remained adequately capitalized and profitability was solid. While the quality of their loan portfolio deteriorated modestly, it still remained high. Potential areas of vulnerability arise from the concentration of bank credit to a handful of large borrowers, the fast growth of mortgage lending, fueled by open-ended and unsustainable government interest subsidies, rapid growth in other consumer lending, and some lingering reluctance by the corporate sector to hedge against foreign exchange risks. But the authorities are keenly aware of these areas and watch them closely—notably through the MNB's semi-annual Report on Financial Stability and the Hungarian Financial Supervisory Authorities' (HFSA) on-site inspections. While the impact on banks' profits of the recent speculative attack was neutral to positive, and their small open foreign exchange positions kept risk low, the possibility of more volatile exchange rates in the period ahead underscores the advantages of closer monitoring of corporate sector exposure to foreign exchange and related risks. In the wake of the increased liquidity the attack entailed, careful monitoring of the quality of bank lending would be prudent. On other aspects of supervision, the mission welcomes the HFSA's efforts to implement provisions of the credit institutions' act to undertake consolidated supervision, and looks forward to its full legal fortification.
15. The mission is encouraged by recent policy decisions in the areas of privatization and energy sector liberalization. Hungary has an excellent track record on privatization. Recent plans to complete the privatization process would only enhance that record, and the mission supports the goal of not using the proceeds to increase fiscal spending. With respect to the electricity market, the Energy Office estimates that the recent increase in regulated electricity prices will close the gap between costs and revenues at MVM and eliminate the need for government subsidies. On the natural gas market, proposals are in the works to eliminate preferential prices and to replace the current implicit subsidy with explicit targeted assistance from the budget. Though Hungary still has a way to go in adjusting natural gas prices to world market levels, these proposals are on the right track.
The mission would like to express its sincere appreciation for the high quality of the discussions and the cooperation received, as well as for the very skillful handling of the administrative aspects of the mission.
February 6, 2003