Hungary -- 2004 Article IV Consultation, Preliminary Conclusions
January 30, 2004
1. On the eve of EU accession, Hungary's impressive accomplishments need to be recognized. Its successes were based on the long-lasting effects of significant structural reforms and privatization, which also facilitated Hungary's outward orientation, FDI inflows, strong export performance, and sound banking system. Periods of particular success were rooted in the willingness and ability to institute macroeconomic adjustment measures when needed, and in maintaining an adequate level of international competitiveness. Privatization is in its final stage, and structural reforms continue with the liberalization of the energy sector and adjustment of electricity and natural gas prices to cost recovery levels.
2. However, economic developments and policies in recent years have disappointed in a number of respects. Huge wage increases in the public sector spilled into the private sector and, combined with the forint's appreciation, worsened external competitiveness. While GDP growth stayed positive in 2003 despite the global slowdown, it was largely led by consumption, fueled by fiscal expansion and associated excessive wage increases. The external current account deficit widened significantly, reflecting surging imports, the lagged effects of the decline in competitiveness, and a sharp drop in household saving stemming partly from the unsustainable housing subsidy scheme. The downward trend in inflation was reversed. And, the past jump in wages also made it all the more difficult to contain the deficit of the general government which, according to the preliminary data, was a bit under 6 percent of GDP in 2003 (ESA-95 basis), compared with an original target of 4½ percent.
3. Looking ahead, there is reason for optimism concerning economic growth. Competitiveness has improved and signs of a turnaround are evident in recent data on industrial production, exports, and domestic investment. As a result, the composition of growth can be expected to become more balanced, with export and investment growth taking the lead. With the right policies and a favorable external environment, Hungary is poised for a period of strong economic growth.
4. However, unsustainably large fiscal and current account deficits impair economic prospects—and the concerns they raise are only exacerbated by the loss of policy credibility. The large current account deficit is being financed by debt-creating inflows that can be especially volatile in the face of the loss of confidence in the authorities' willingness to deal with macroeconomic imbalances. Thus, if the twin deficits are not reined in, not only will debt levels rise imprudently, but Hungary will continue to be vulnerable to heavy exchange rate and interest rate risks. The loss of policy credibility makes the financing of these deficits all the more precarious, because markets have become less inclined to give Hungary the benefit of the doubt, and because of the greater risk, in these circumstances, of contagion from an unexpected shock outside of Hungary. This credibility loss reflects several factors: the pursuit of exchange rate targets in the face of inconsistent policies; conflicting statements by policymakers; and the announcement of targets and estimates that went unfulfilled. With household saving expected, at best, to increase only moderately, and the movement in overall private saving expected to be insufficient to finance the rise in private investment, lower fiscal deficits are the only way to ensure that the excessive current account deficit is reduced. Lower fiscal deficits would also support disinflation and competitiveness, particularly when backed by firm wage restraint.
5. Re-establishing policy credibility, and putting in place policies that provide greater assurances that the necessary fiscal adjustment and disinflation will materialize, are essential for establishing a time frame for euro adoption. Shifts in market expectations about progress with nominal convergence will be an ever-present potential source of pressure on exchange and interest rates. At the same time, the advantages of euro adoption are clear, and a credible target date would surely help to anchor expectations and minimize the output costs of bringing about the necessary disinflation. With the heavily polarized political climate constraining economic policy making, the importance of achieving greater national consensus for the policies required for euro adoption is clear.
6. At this fragile juncture, taking decisive and concrete actions in support of fiscal adjustment is the only way to restore policy credibility and improve the monetary-fiscal policy mix. Such actions would allow risk premia and therefore interest rates to come down and limit vulnerability to shifts in market sentiment—all of which would strengthen prospects for sustainable economic growth. But until confidence is re-established, it would be counterproductive to lower policy interest rates. Indeed, doing so prematurely could well lead to higher interest rates at longer maturities by raising inflation expectation. The recent practice of allowing greater exchange rate flexibility makes good sense, not least because it provides a degree of "insurance"—albeit probably at some cost to inflation—against fiscal slippages.
7. Fiscal policy has embarked on an appropriately ambitious course. The revised deficit target for the general government in 2004 is in line with macroeconomic objectives. Moreover, although the deficit target has been raised to 4.6 percent of GDP, the mission agrees, taking into account the slippages in 2003, that the original target became increasingly unrealistic.
8. While achieving a deficit of 4.6 percent still poses serious challenges, important measures have been announced in general terms and specifics are under preparation. These specifics will need to be made public in a timely manner, with a view to enhancing the credibility of, and market response to, the fiscal effort.
• Measures worth HUF 80 billion—equivalent to 0.4 percent of GDP—have been in the public domain. The mission understands that HUF 55 billion in expenditures of ministries and other budgetary institutions have been suspended (including HUF 20 billion at the Ministry of Defense), and another HUF 25 billion will come from reductions in transfers to agencies with unspent appropriations. Also important were changes to the housing subsidy scheme. While the immediate budgetary saving is relatively small, these changes will contribute to substantial fiscal savings in the coming years and slow the growth in household consumption. A further scaling back, if not elimination, of housing subsidies is warranted.
• Further saving of HUF 120 billion (0.6 percent of GDP) has also been announced. This saving is slated, in general terms, to come from reducing ministries' operational spending, from restraining transfers from the ministries to various other institutions, and from a scaling back of some project and investment spending (excluding highways and EU-related spending).
• Assuming the HUF 120 billion in saving is achieved, the mission still sees the potential for falling short of the deficit target by as much as 0.7 percent of GDP, largely due to lower projected tax revenue. After the rapid increases in previous years, nominal wage restraint in the general government would be sensible: a wage freeze could deliver as much as 0.5 percent of GDP in saving.
• In view of the importance of re-establishing credibility, and taking into account the risks posed by the current account deficit and the election cycle, the mission fully supports the authorities' intention of making timely corrections should the fiscal deficit target be threatened (these corrections could also include measures in the areas mentioned below). The mission would urge the authorities to quickly identify contingency spending measures, while also preparing early for permanent structural spending measures for medium-term adjustment.
9. Further fiscal consolidation, centered on expenditure restraint, is needed in the medium term. It would improve the saving-investment balance in the economy and safeguard public debt and external viability. Backed by wage moderation, it would also lessen the degree of monetary restraint needed to meet inflation targets and enhance external competitiveness. Given the high tax incidence, particularly on labor, adjustment should concentrate on the expenditure side. As evidenced by the experience in other countries, expenditure-based adjustment tends to be more durable, friendly to growth, and credible. At the same time, to leave room for spending pressures arising from public investment needs and EU accession, focusing on current expenditure will be key. In this connection, the mission sees scope for saving in the areas of government employment, pensions, social benefits, subsidies, education, and health care. Since substantial savings would materialize only over time, reforms should start quickly. In this regard, steps toward health care reform are encouraging. Increasing the labor force participation rate—including by leaving room for labor tax cuts (and phasing out the lump-sum health care contribution from employers as planned) and reducing disincentive to work stemming from the structure of benefits—would raise potential output and help mitigate pressures on the public finances over the medium term.
10. Policy credibility and performance would be enhanced by a well-defined fiscal strategy, spelled out in a clear statement of policy and backed by expenditure ceilings. The three-year rolling framework under consideration last year, which included a ceiling on overall expenditure and sub ceilings on key components, would be an important step in this direction. Such a framework would need to be submitted to parliament as part of the budgetary process. Moreover, in circumstances in which fiscal adjustment is crucial, assumptions should be realistic but conservative, with a view to erring on the side of fiscal over performance. On the revenue side, casting changes in the tax system within a coherent medium-term strategy would not only enhance the predictability and quality of fiscal policy, but also the business climate. The recent initiatives to increase transparency in the spending of public funds by strengthening interim audits, financial control and management, and information dissemination are encouraging. However, the 2002 amendment to the organic budget law, which allowed the government to undertake additional spending without supplementary appropriations and parliamentary approval, weakens fiscal discipline and the practice should be discontinued.
11. Monetary policy is severely constrained in the short run. While it would be counterproductive to lower policy interest rates until confidence is re-established, raising rates, to safeguard the inflation target, should be guided by the following considerations. First, the lagged effects from the sizable 600 basis point rate hikes since June are still in the pipeline and argue for a "wait-and-see" approach. Second, the current account deficit is a concern. Thus, raising interest rates could appreciate the forint and prevent a narrowing of the current account deficit. In the best of circumstances, a return of confidence backed by fiscal determination would allow interest rate cuts over time, consistent with disinflation, the return to a viable path for the current account as investment picks up, and nominal convergence in a broader sense.
12. Monetary policy, more generally, will need to deal with a number of issues.
• While one-off factors significantly raise the price level in 2004, the inflation target for 2005 seems within reach. Thus, the authorities are rightly focusing their public pronouncements on medium-term inflation objectives, and the supporting policies to achieve them. Moreover, they are communicating clearly that the impact of the one-off factors is not expected to be repeated.
• Disinflation, over the medium term, will increasingly need to take place in circumstances in which the exchange rate variability against the euro will be limited, consistent with the interpretation of the exchange rate stability criterion within ERM2. Thus, in effect, inflation targeting will need to be operated in a qualified way—putting increasing emphasis on exchange rate stability. Such stability has advantages in keeping tradable good inflation in line with inflation for the anchor currency, and can therefore be part of a reasonable disinflation strategy.
• However, the full use of policy tools will also be required, including incomes policy. To moderate wage growth, the public sector will have to take the lead by signaling the importance it attaches to this goal through its public sector wage policy. Drawing on the experience of current members of the euro area, closer cooperation between the social partners to achieve private sector wage agreement to help bring inflation down to the Maastricht criterion appears necessary.
The Financial Sector
13. Available indicators show that Hungary's financial sector is basically sound—but it is important to keep an eye on the vulnerabilities that have surfaced. Banks have remained adequately capitalized and liquid; profitability has been solid; and the quality of banks' loan portfolios has remained broadly stable, with the quality of corporate lending deteriorating only slightly in the wake of the slowdown in economic growth. However, as recognized by the authorities, potential vulnerabilities arise from rapidly growing consumer lending, and the increase in credit risk as a result of exchange rate volatility. Also of concern is the growing share of commercial property loans in overall corporate lending, its high concentration within a few banks, and, in less developed parts of the country, risks from less liquid collateral. These risks, while manageable now, warrant careful monitoring, with a view to taking timely corrective action if needed. Moreover, during the run-up to euro adoption and afterward, a credit boom may be expected due to the convergence of interest rates. This should be closely watched. In any event, there is no substitute for strong supervision of banks and a close monitoring of their internal risk management systems.
14. Important issues have arisen with respect to the Hungarian Financial Supervisory Authority (HFSA). In this context, it is important to maintain the independence of the supervisory authority, while ensuring its accountability. Outside recent legislative concerns, granting the supervisory authority the legal power to issue binding rules and regulations would move Hungary closer to international best practices. The mission also sees room for better cooperation between the HFSA and Finance Ministry in exchanging information.
The mission would like to thank the authorities for the time they made available during this very busy period, for the high quality of the discussions, the gracious hospitality extended to us, and the skillful handling of the administrative aspects of the mission.
January 30, 2004