Mission Concluding Statement 

May 7, 2007

The sizeable ongoing fiscal consolidation effort has reassured markets. In spring 2006, adverse sentiment toward emerging markets had put Hungarian financial assets under special pressure. The pressure intensified when the fiscal deficit threatened to reach over 11 percent of GDP. Market sentiment improved in the second half of the year, helped by the announcement of consolidation measures to contain the runaway deficit. The authorities recognize that even the 9.2 percent of GDP deficit achieved in 2006 remains unacceptably high and their Convergence Program promises continued improvements through 2010.

The authorities must act to retain the confidence of markets and counteract the possibility of a low growth trap. The fortuitous parallel improvement in global markets' risk appetite has helped. Another adverse shift in sentiment and surprises in Hungary's fiscal and external accounts could reverse the markets' reprieve. Importantly, despite vibrant exports, Hungary's overall growth relative to the rest of Europe deteriorated in early 2005 and that divergence was accentuated in 2006. The policy challenge is to lower domestic and external vulnerabilities and to ensure a strong recovery from the current adjustment process.

To fully benefit from a historically powerful integration into Europe, a new generation of fiscal and structural reforms is needed. Access to Europe's product, financial, and labor markets has created the foundation for rapid growth with stability, a process from which Hungary has already achieved substantial gains. But realizing the continuing potential of this opportunity requires sound public finances and the business environment for firms to operate competitively in the euro zone. The political window of reform could close prematurely. It remains imperative that this window-and the space provided by the markets' goodwill-be used now to fundamentally reorient fiscal affairs and ensure continued competitiveness.

Economic Risks and Outlook

External vulnerabilities need continued vigilance. The current account deficit is expected to decline to 5 percent of GDP in 2007. The overall financial account is also projected to decline but may remain closer to 7 percent of GDP if increased unclassified outflows in the balance of payments (net errors and omissions) reflect genuine obligations to foreigners. Debt creating flows should fall to 3½ percent of GDP. The external debt-to-GDP ratio (including inter-company loans) is expected to decline from 94 percent in 2006, mainly due to the stronger currency. The size of external reserves and the conservative structure of public debt provide good buffers.

Much has been achieved on fiscal consolidation, but the vulnerabilities remain and the challenges are formidable. The impressive achievements in tax administration have contributed to higher than expected revenues. However, the fiscal deficit will be about 6¼ percent of GDP in 2007 and 4½ percent of GDP in 2008. Moreover, uncertainties remain with respect to the future of wage freezes and the nature of certain expenditure overruns (worth about ¾ percent of GDP) in 2006. Beyond 2008, detailed measures for a further reduction of the deficit to 3¼ of GDP have not yet been outlined. The task ahead remains formidable also because of the government's liabilities arising from loss-making public enterprises and increasing pressures from age-related expenditures. Public debt is currently about 66 percent of GDP and is expected to remain in that range for the next few years.

A rapid growth recovery from the ongoing fiscal adjustment is far from assured. GDP growth is projected to fall to 2.7 percent in 2007 before rising to 3 percent in 2008. Recent investment trends have not been favorable, and the virtual standstill in corporate borrowing implies that investment is likely to remain weak. Together with the deceleration since early 2005, these developments suggest Hungary's growth potential may have fallen to 3½ percent a year. A drop in public financing needs, however, may improve corporate financing conditions and contribute to a better investment environment. Favoring higher growth would be forceful implementation of initiatives to improve the business environment to foster continued high export performance in a demanding environment, productive deployment of EU funds, and importantly, sustained fiscal action. Recovery to a 4 percent growth rate may well occur gradually.

The inflation target range appears within reach in the 18-month forecasting horizon. Inflation rose to an annual rate of 9 percent in March mainly due to higher indirect taxes and regulated prices, but is projected to decline to within the target range of 3 ±1 percent in the 18-month forecasting horizon. There is no clear evidence of labor market tightening and recent wage increases apparently reflect advances in bonus payments and higher reported earnings because of stronger tax compliance. More generally, following the introduction of inflation targeting, inflation persistence has declined. However, the risk of short-term persistence remains if negotiated wages were to compensate for higher prices.

Public Finances

Sustained fiscal consolidation will reduce vulnerabilities and stimulate growth. Even if the Convergence Program is fully implemented, the sizable 2009 fiscal deficit, the high public debt-to-GDP ratio, and a large government and tax wedge will continue to undermine stability and growth. The uncertainties with respect to the future of the ad hoc taxes and the pace of reform could dampen incentives for employment and investment. Continued consolidation in 2009 and beyond-relying on durable expenditure restraint and broadening of the tax base-would put the debt-to-GDP ratio on a sustainable downward trend, raise potential growth, and help adopt the euro early in the next decade.

Recognizing that the needed measures will bear fruit over time, a concrete vision and roadmap is required now to guide the reform process. The emergency steps in the second half of 2006 were intended to deal with the threat of a fiscally-induced crisis. While reliant on tax increases and the freeze of public wages, some expenditure measures with a longer view have been undertaken and others are under active discussion. However, even with these initiatives, the size of government expenditure (or the "redistribution") will remain close to 50 percent of GDP. As such, an important benchmark for fiscal reform should be to bring the expenditure-to-GDP ratio to between 40 and 45 percent.

Implicit in the ongoing debate on fiscal reform is the future role of the state in delivering public services and social security. Much can be gained from more efficient government and better targeting of expenditures. In addition, as reflected in the discussions on the more far reaching measures being contemplated, the goals of solidarity will need to be preserved in the context of greater private responsibility.

This debate is most evident in the reform of the health care sector, which has become the symbol of the reform process. Important progress has been made in instituting co-payments by patients, rationalizing hospital beds, and scaling back pharmaceutical subsidies. The next step requires a more fundamental view of the state's role in providing services and a safety net. The public debate has, as yet, focused on competition in the supply of health insurance. A more wide-ranging discussion is needed on the boundaries of public supply of services and the scope for a greater private role and patient responsibility. This broader discussion would determine the degree of competition in health services and ensure quality and accountability to patients. The restructuring and corporate governance of hospitals is, therefore, crucial to further progress. Success of this process is important not only for the health care sector but also for achieving legitimacy for further reform.

Ongoing progress in other areas will bring valuable benefits, but the scope of change should be broadened and its pace stepped up. Reforms of subsidies and of disability and early retirement pensions, reductions in the replacement rate of pensions for new retirees, and restructuring of central public administration are under way. Under active discussion are the changes to indexation of pension benefits and a gradual increase in the retirement age. Also under discussion are more far reaching reforms of pensions and education (through the mechanism of consensus-seeking roundtables) to draw the boundaries between public and private responsibility. All these proposals are welcome and should be implemented swiftly. Reforms of budget support to families, housing subsidies, and, in particular, local governments have not yet moved, but remain key for equity and efficiency.

Tax reform with a clear commitment to revenue neutrality should aim to increase efficiency, fairness, and stability. The welcome effort to institute a property tax needs to be backed by early measures to establish a property registry based on market valuation and simple rate structures. The personal income tax should be greatly streamlined, while maintaining the principle of progressivity. The base of the corporate income tax should be broadened by phasing out exemptions and simplifying deductions. Keeping pace with benefit consolidation and consistent with the long-term sustainability of the social security system, a measured reduction in contributions could be achieved. To rebalance the tax composition, consumption taxes may need to be increased. These efforts could be a prelude to reducing the tax wedge once the fiscal space has been created through expenditure rationalization.

Enhancing fiscal predictability and transparency remain paramount to sustainable fiscal consolidation. Additional reserves and quarterly reporting have permitted better control of budget execution. In that spirit, overperformance of revenues should continue to be used for faster deficit reduction. The authorities have signaled their intent to institute stronger defenses against fiscal indiscipline through new fiscal rules, a medium-term expenditure targeting framework, and stronger budget monitoring. These new rules should be suitably ambitious and be supported by appropriately sequenced complementary reforms in public financial management systems and budget processes to credibly deliver on fiscal goals. As stressed in the past, strengthening the external scrutiny of fiscal policy by an independent council would promote transparency and accountability, and it is encouraging that the authorities are now open to this possibility.

Monetary Policy

An easing interest rate cycle could commence once inflation is on a downward trend. Market participants are beginning to anticipate policy rate reductions. Factors favoring a rate cut include tightening monetary conditions, output growth likely to remain below potential, significant fiscal consolidation under way, and no evident signs of inflation being embedded in wage contracts. Nevertheless, one-time price increases generated by the fiscal measures may not have peaked, and the risk of inflation persistence cannot be ruled out. It would be best to start an easing cycle once the downward movement of inflation has commenced. This could be followed by further easing if inflation expectations permit.

With this gradual approach, the cumulative reduction during the forthcoming easing cycle could bring real short-term rates within the range of regional peers. Such a decline could also influence a downward shift in the yield curve, inducing a further move to forint-based borrowing and with that a more effective monetary policy transmission. Greater reliance on statements of policy inclinations could also substitute for the traditionally sharp movements in policy rates; and effectiveness of the inflation targeting framework would be helped by a more refined analysis of the dynamic interactions between interest rates and prices.

We reiterate our recommendation of moving to a floating rate regime. The discussion of such a move has recently reemerged in the Hungarian policy debate. This debate has focused on short-term risks of harmful currency appreciation. While such a risk does exist, a more medium-term perspective should guide the decision, and its timing. While the band is large, it has on occasion constrained policymaking. Since the band is not otherwise useful, from a risk-management perspective, its elimination would be desirable.

Financial Sector

Banks have significant buffers, and the supervisory authority has responded to cautionary signals. With financial deepening, banks have increasingly financed riskier activities. Profitability remains high but is likely to come under increasing pressure due to higher funding costs and decreasing interest margins. Credit growth has increasingly been financed by interbank deposits and debt securities that are more subject to liquidity or rollover risks than traditional deposits. The unhedged exposure of borrowers to foreign currency loans generates credit risks for banks. Bankruptcies and liquidations are up following the economic slowdown in the second half of 2006, and the macroeconomic adjustment could further strain parts of the banking system. The supervisor has used bank-by-bank stress tests for market risk to induce strengthening of risk management and capitalization. Similar tests for credit risks would allow identifying additional capitalization needs; the aggregate credit risk tests being developed by the authorities are a welcome first step. Ensuring that Basel II regulations are placed on track remains important.

Structural Policies

Hungary may be falling behind regional peers in maintaining its overall business climate. Within central and eastern Europe, Hungary has been at the lower end of the international competitiveness rankings. These rankings show Hungary to be falling behind: business indicators are not necessarily becoming worse; other countries have made a more proactive effort to improve their business operating conditions. The administrative burden adds to the disadvantaged position of Hungarian firms on account of high labor taxes. In this context, the government's recent initiative, "In tune with business," takes the right steps. These include simplification of regulatory requirements and public procurement procedures.

EU funds have been rapidly absorbed and effective deployment would help raise productivity and growth. Expenditures financed from the EU budget are to reach 2.6 percent of GDP this year, almost a 1 percentage point increase over 2006. The National Development Agency appears well positioned to organize the utilization of structural and cohesion funds. The authorities recognize the important need to coordinate the use of EU moneys with ongoing structural reforms, including to strengthen human capital and Hungary's innovation system, and to ensure, especially for private sector development, transparency and competition in the award of grants.

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We wish the authorities well in their pursuit of growth with equity. We thank them for, as always, their generous hospitality and candid discussions.