Hungary -- 2005 Staff Visit, Concluding Statement of the IMF Mission
September 21, 2005
Though the private sector has demonstrated flexibility and resourcefulness, fiscal policy weaknesses are raising risk levels — procrastination is no longer a policy option. Over the last decade, the economy has dealt successfully with global competition, engineering a commendable shift to a more high-tech production structure. However, Hungary has moved from being a "star" performer to one of the slower growing economies among the new EU member states. Significant policy weaknesses have emerged in recent years — in particular, the lack of predictability of the fiscal budget and the persistence of high fiscal and current account deficits. A benign international financial environment has ensured the financing of these deficits. But Hungary's domestic currency risk premium remains high relative to other countries in the region. With the 2005 fiscal deficit target to be imminently missed and the substantial challenges for 2006, the risks have increased.
Short-run macro developments have been welcome, though vulnerabilities remain. Following weak performance in the previous three quarters, growth finally picked up in the second quarter this year. Export growth remained solid. The composition of growth has become more balanced. Inflation reached historical lows. Downside risks to GDP growth arise from the increase in the price of oil, continued slow growth in the euro area, and the planned increases in the minimum wage. We expect growth to be 3.4 percent in 2005, increasing to 3.6 percent in 2006. The current account deficit, projected at about 8 percent of GDP in 2005, could be larger if accession-related procedural changes led to a underreporting of imports. The financing of this deficit will be helped by the increased availability of EU funds, but remains crucially dependent on continued investor confidence in Hungarian economic prospects. And with almost all new net domestic lending to the private sector occurring in foreign currencies, the macroeconomic risks from an exchange rate correction have increased. The strong financial system, however, can withstand such a correction.
Three factors highlight the continued erosion of fiscal discipline. First, revisions reveal that the fiscal consolidation in 2004 was smaller than originally thought. Second, reflecting the difficult political environment, even the modest momentum for fiscal reform in 2004 was not continued in 2005, and the focus, unfortunately, shifted towards accounting measures to achieve budgetary targets. This shift was reinforced in June to deal with the slippages in the earlier part of the year. Despite that, the government's 2005 fiscal deficit target under the Convergence Program will not be met, especially in light of Eurostat's recent rejection of the underlying accounting approach to reach that goal. Containing the fiscal stimulus, which is not directly influenced by the Eurostat decision, will depend crucially on the realization of the unusually large projected surplus in December. Third, the announced 2006 budget plans, which propose a 1½ percent of GDP expenditure consolidation, do not appear to come to grips with the seriousness of the problem, either in the extent of the consolidation needed or in the quality of the adjustment proposed.
Even if politically difficult, an appropriately ambitious and consciously transparent budget framework must be reestablished. With the fiscal challenge set to increase next year, debt dynamics could turn adverse. To prevent this unfortunate outcome, urgent action is needed, accompanied by the setting of a realistic fiscal deficit trajectory for the Convergence Program and euro adoption. Transparency and candid communication, based on realistic targets, will help avoid destabilizing surprises, while improving budgetary controls.
A new strategy for durable and credible consolidation in 2006 requires sizable expenditure cuts, in part to make room for the planned tax reduction. Bold steps are necessary to limit and rationalize public expenditures, in the areas of public employment, health, education, pensions, the housing subsidy scheme, and subsidies to enterprises. While the proposed tax reduction initiative can be a spur to investment and growth, it could be ill-timed if it is not accompanied by expenditure reduction to achieve revenue neutrality. Further tax reform possibilities should be based on a comprehensive assessment to ensure long-term gains — reforms driven by short-term political competition could prove counterproductive. Broadening the tax base by reducing exemptions should be a priority. In this context, a tax expenditure budget, which assesses revenue losses due to all current tax exemptions, is an important first step.
Greater transparency and accountability are needed to increase fiscal control. We welcome the Eurostat decision uncovering the recourse to accounting measures for reducing the deficit, which was becoming endemic. Greater transparency in fiscal reporting is required in light of the still large divergence between cash and accrual budgets. Also of concern is the limited effectiveness of internal controls to contain the deficit. Independent review of budget projections through, for example, the State Audit Office, can enhance accountability, if the remit of this office were appropriately extended. A full accounting of the various Public Private Partnerships, with a ready basis to determine their operational status and the government's direct and contingent liabilities, has now become essential. A system is urgently needed for predicting and managing expenditures that do not have nominal caps. Similarly, when reserves are set aside to manage budgetary contingencies, they should be freed only in line with clear expenditure priorities.
This is an opportune moment to consider a move to a floating exchange rate regime. The authorities have remained committed to the exchange rate band even in adverse circumstances — and remain so committed. However, a risk management perspective suggests that this is a good time to consider a move towards exchange rate flexibility. First, with favorable market conditions and strong investor confidence in Hungary, the forint has held steady in a narrow range for the past 18 months, with no evident pressure either upwards or downwards. A move towards exchange rate flexibility now, in times of calm global markets, would be desirable. While short-term upward or downward pressures may ensue, exit from the current position of strength is likely to limit prolonged destabilization. Instead, if global imbalances unwind, Hungary could get caught in the tailwinds of that adjustment, as currencies and interest rates are realigned. These external developments would interact with domestic vulnerabilities in important and potentially unpredictable ways. Second, with the decline in inflation, the current exchange rate band is no longer relevant as a monetary policy anchor; if anything, its presence interferes with the operation of the inflation targeting anchor. Moreover, the possibility of euro adoption by 2010 appears remote and, hence, the ERM-II like framework will not be relevant for some years. Finally, the perception of greater exchange rate volatility will help stem unhedged foreign currency borrowing.
Overall, the stance of interest rate policy seems appropriate. Since the VAT-induced decline in the 2006 inflation rate is expected to be temporary, further interest rate reductions should be guided by inflation projections for 2007. The authorities recognize this — as reflected also in their adoption of a medium-term framework that targets inflation 5 to 8 quarters ahead. However, market commentary has been more aggressively projecting interest rate cuts to match the temporary decline in inflation in 2006. While disinflation may continue, this cannot be presumed. Further interest rate reductions should be based on the medium-term evolution of inflation projections and expectations.
The Hungarian economy has many real strengths. Consistent and predictable policies will enhance these strengths. Decisions taken now will determine if the full potential is realized. The mission wishes the authorities well in their endeavors and thanks them and many others for their warm hospitality and candid discussions.