Hungary -- 2006 Article IV Consultation, Concluding Statement of the IMF Mission
June 6, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
The state of public finances—epitomized by endemic deficit overshooting—is undermining economic stability and growth prospects. Persistently large fiscal and current account deficits, rising public and external debt, and increasing foreign-currency mismatches are the warning signals. By differentiating Hungary from other Central European countries, financial markets have spotlighted these vulnerabilities. Real economic strengths and financial buffers, assiduously built over the last decade, offer some protection from a further slide in the currency and higher interest rates. If these cushions wear thinner and, especially, if global sentiment worsens, serious consequences cannot be ruled out.
Responding to this threat, the government's program includes welcome initiatives. The impressive speed of the response acknowledges the seriousness of the problem and demonstrates the new government's commitment to restore the health of public finances. Noteworthy also is the recognition of the scale of the needed consolidation. And while the tax measures under consideration are intended to quickly raise revenues—and will need to be rethought or integrated into a more comprehensive reform—some spending cut proposals are based on the long view. The momentum must be extended to the implementation phase.
But, in addition, the risk of a fiscally induced crisis has opened a political window of opportunity that can, and should, be used to more fundamentally reorient fiscal affairs. Front loaded into the budget and the convergence program should be binding commitments to sustained reduction in the high government expenditure-to-GDP ratio and to broadening the tax base. Crucially, new budgetary controls must be a priority. Thus, the needed adjustment can be the instrument for aggressively pursuing long-term structural reforms while also achieving greater equity and fairness. Absent, for example, an effort now to better target sensitive social welfare programs to those most in need, that agenda may have to be revisited at a less opportune moment. If temporary solutions are the expedient compromise, financial markets may, as sometimes in the past, be temporarily satisfied. But the challenges will remain. And, in our view, the vulnerabilities will not go away.
To dampen vulnerabilities, boost growth, and achieve euro adoption, interrelated measures are needed. For public finances to be placed on a sound footing may require even greater consolidation than the authorities are contemplating, along with a reduction of policy variability and reestablishment of fiscal credibility. With strengthened inflation targeting, the exchange rate band should now be removed. Active steps should be considered to contain foreign-currency lending by banks. Improved labor absorption and enhanced competitiveness will require fiscal reform and effective use of European Union (EU) funds.
Economic Outlook and Risks
Growth, though respectable and with a balanced composition, is trailing that of other countries in the region. After falling behind regional growth trends in the third quarter of 2005, Hungary's GDP growth in 2006 is expected to be 4¾ percent despite a large fiscal stimulus. We estimate that the 2006 budget deficit will reach 10 percent of GDP (in ESA'95 terms, or 8½ percent of GDP without the credit for the pension adjustment). And, if the cost of some recent public-private partnerships (PPPs) is included, as it arguably should be, the deficit would be close to 11 percent of GDP. Consumption growth will remain moderate, with investment (particularly motorway construction) and exports driving growth.
The growth and inflation outlook for 2007 depend crucially on the extent and nature of fiscal consolidation. For 2007, a substantial deficit reduction is targeted. Given, however, the complexity of the proposed measures as currently known—and the likely political, legal, and administrative delays—feasible consolidation, in our view, could be 2—2½ percent of GDP. Under that scenario, GDP growth and inflation in 2007 would each be around 3½ percent. If a larger and primarily tax-based consolidation is, in fact, achieved, growth could slow to below 3 percent, and remain low on account of the reduced incentives for investment and employment generation. If, at the other extreme, despite the current momentum, the political willingness to consolidate were to fade, a significant correction in the exchange rate would likely be accompanied by higher interest rates, causing a retrenchment of consumption and investment, and, once again, a more lasting fall in the economy's growth potential.
The key metrics in assessing Hungary's vulnerabilities to external shocks are its rising public and external debt ratios. The current account deficit is expected to increase to above 9 percent of GDP this year and gradually decline to about 7 percent of GDP by 2010. By end-2006, the public debt is projected to be about 65 percent of GDP (without the credit for the pension adjustment), not including the debt of some highly indebted public enterprises, publicly-guaranteed debt, and that of the recent PPPs, some part of which may eventually belong on the government's books. Total external debt, including that of private multinational companies and banks, would rise to 81 percent of GDP and remain on an upward trajectory.
The extent of needed fiscal consolidation may be larger than the authorities are contemplating. To reach the Maastricht fiscal deficit limit of 3 percent of GDP within the new government's term, a fiscal consolidation of 7 percent of GDP will be required. However, to reverse the upward trend of public debt and bring the debt-to-GDP ratio down to under 60 percent, a more ambitious fiscal consolidation in the primary balance of 10 percent of GDP will likely be necessary. If accompanied by a significant reduction in government expenditure, the consolidation will elevate the long-term growth potential by restoring macroeconomic balance, improving economic efficiency, and encouraging private savings—and hence allow euro adoption from a position of strength.
The spending-reduction measures in the government program are welcome, but much remains to be done. The international evidence is clear: large fiscal adjustments are more successful and durable when they rely primarily on expenditure reduction. Spending cuts are necessary not only to ease the pressure on the budget but also to modernize and better target the delivery of public services. The steps under consideration in such areas as public administration, government employment, health, education, and subsidies go in the right direction and the task there is to rapidly establish supporting legislation and administrative procedures, including moving ahead with individual health accounts. However, bolder measures are needed to reform the welfare system, including indexing pension benefits to inflation; gradually increasing the retirement age; eliminating the 13th-month pension for new retirees; introducing more stringent rules for the disability pension; and phasing out early retirement schemes. In addition, budget support to families should be redirected to the poor. Finally, eliminating the house subsidy scheme would not only help restore public finances but also increase households' incentives to save.
Because the fiscal consolidation needs are so large, revenues will have to be enhanced, using the opportunity to achieve a fairer and more stable system. Broadening the tax base, by eliminating tax exemptions and strengthening tax administration, must be the principal mechanism to increase revenues. We favor a broad-based real estate tax, taxing pension benefits under the personal income tax, and taxing all income from securities. We see scope for unifying the VAT rate and also agree that, for now, even the desirable elements of the 2005 tax reform need to be postponed. In contrast, a strategy of ad hoc measures that raise labor and capital taxes carries several risks. Tax administration would be further complicated, reducing the reliability of tax revenues. More seriously, these taxes may not be sustainable if they slow down economic growth and worsen employment prospects. Fiscal consolidation efforts would, in that case, be undermined, requiring the undoing of the tax increases without a permanent solution for the stabilization of the public finances. Frequent changes in the tax code can only hurt.
However well-intentioned the consolidation measures, fiscal slippages will continue absent binding commitments, transparency, and accountability. An independent body that reports to parliament and reviews the time consistency and transparency of budgets is called for, whether this is through a budgetary council or broadening the mandate of the State Audit Office. Needed in this context are an assessment of the budget quality and risks, and a requirement of a response to that assessment before parliamentary approval of the budget. A medium-term budget framework, with multiyear expenditure ceilings, would provide the necessary road-map and benchmarks for guiding policy. The practice of allowing budgetary spending without appropriations and parliamentary approval should be discontinued. Stricter rules are needed for limiting the carryover of unused funds from the previous fiscal year. Quasi-fiscal activities associated with public enterprises and PPPs should be accounted for when setting fiscal deficit targets for the general government. The budget should follow ESA'95 coverage, accounting principles, and practices. To aid monitoring and to ensure timely responses to slippages, quarterly reviews on an ESA'95 basis should be undertaken.
The current interest rate stance appears appropriate, given inflation expectations. A growing track record of inflation targeting, alongside better anchoring of inflationary expectations, has helped price stability. The response to the recent weakening of the forint appropriately considered the context of overall inflationary pressures, and the decisions were transparently communicated. To the extent that the tax changes being contemplated have one-off effects on inflation, a policy response may not be needed. If second-round effects from energy price increases and a further depreciation of the forint were to raise inflationary expectations, small step increases may be required. Consistent communication with the public and financial markets remains crucial to maintain confidence and credibility.
From a risk management perspective, it remains our view that a floating exchange rate regime is best suited to Hungary's present needs. With euro adoption some distance away, an ERM II-like framework is not relevant at the present time. If anything, its presence interferes with the operation of the inflation targeting anchor. If global imbalances unwind, they may interact with domestic vulnerabilities in unpredictable ways, creating additional policy challenges. Finally, the perception of greater exchange rate variability will help reduce incentives to borrow in foreign currency.
Financial Sector Stability
The banking sector remains sound but the need for greater vigilance has increased. In line with the 2005 Financial Sector Assessment Program Update, banking profitability and capitalization have remained strong. Three trends bear close watching. First, foreign-currency lending has continued to rise. Second, more aggressive bank lending activities and practices have raised credit risks. Finally, the financial fragility of small- and medium-sized enterprises appears to have increased. Regular stress tests of individual banks and increased cross-border supervisory cooperation should become part of the authorities' surveillance processes. More intensive on-site supervision of bank risk management practices, especially with respect to their foreign-currency lending, is needed. Consideration should also be given to requiring higher provisioning against foreign-currency loans.
Labor Markets and Competitiveness
Raising employment rates remains a priority. Hungary's production structure and labor market have allowed for modest employment growth in the past decade. However, raising the employment rate will require more effectively targeted social welfare programs, especially the disability pension and early retirement programs. In addition, a greater effort to raise the productivity of unskilled workers must be a priority.
Hungary faces continuing competitiveness pressures. In the past decade, export strength has been the result of an impressive shift from low- to medium-skilled export products, counteracting the appreciation of the real exchange rate. However, while the technological shift is ongoing, competitive pressures are also rising. Market shares of Hungarian exporters flattened in 2005. Low-wage Asian economies are exerting pressure at the low and medium end of the technology spectrum. The accumulation of net external liabilities raises questions about real exchange rate misalignments. Continued moderation in wages should help competitiveness. For long-term external sustainability, measures should focus on raising productivity growth.
The expected step up in the use of EU funds is an opportunity to raise productivity and improve infrastructure. Absorption of the EU funds is growing. Projects related to small- and medium-sized enterprises' technology upgrading, the road network, and education and training are moving fast. These are encouragingly linked to much-needed productivity growth. At the same time, measures to improve employment adaptability and increase access to the global information network are lagging. Continued efforts, based on cost-benefit analysis, are needed to utilize the remaining structural funds by end-2008 and administer a threefold increase in new commitments for 2007-13. Absent fiscal structural reforms, the effectiveness of these resources will likely be diminished.
Much hinges on farsighted decisions at this important juncture. We wish the authorities well in their pursuit of growth with equity. We thank them for, as always, their warm hospitality and spirited and candid discussions.