Hungary: 2008 Article IV Consultation Discussions
June 9, 2008
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 reductions in the fiscal deficit and the current account deficit in 2007 are welcome, but vulnerabilities are still high at a time when global financial conditions remain unsettled. Government debt and net external liabilities (relative to GDP) in Hungary are by far the largest among new EU member states. Against this background, the fall in global risk appetite over the past year has led to a relatively large widening of government bond spreads. Moreover, financial system risks have risen; if realized, these risks would have adverse effects on the economy.
A further decline in vulnerabilities is essential to promote macroeconomic stability and strong, sustainable growth. The key policy priorities are as follows:
• Further fiscal consolidation in line with the Convergence Program is needed, along with tax and spending reforms that preserve stability and promote growth.
• Monetary policy should remain firmly anchored by the 3 percent target for CPI inflation at the two-year horizon.
• Improvements in banks' risk management practices are needed, and financial authorities should review and test financial safety nets.
Failure to reduce vulnerabilities could lead to a tightening of financing conditions, including higher risk premia and lower capital inflows, which would hurt the economy.
Following the sharp fiscal consolidation in 2007, economic growth is expected to pick up in 2008-09. Private consumption is projected to rise gently, as real disposable income growth increases. Robust exports and increasing EU transfers are expected to underpin an acceleration in investment. Overall, real GDP growth is projected to increase to 2 percent in 2008 and 2¾ percent in 2009. Potential growth over the medium term is estimated at about 3-3½ percent—it would be higher if the size of government and the corresponding tax burden were reduced, and the administrative burden on business were lowered.
The current account deficit is expected to narrow in 2008-09 but then widen again over the medium term. In the short term, strong export growth is projected to improve the trade balance; net income and EU transfers are also expected to rise. Over the medium term, the pick up in domestic demand is projected to reduce the trade balance. Following its recent appreciation, the real effective exchange rate is estimated to be slightly above the value implied by fundamentals, though large uncertainties surround such assessments.
Large external liabilities present an important vulnerability. Net external liabilities amount to about 100 percent of GDP, reflecting mainly FDI, bank borrowing to finance credit growth, and government debt. With gross external debt also amounting to about 100 percent of GDP, gross external financing needs are high, especially in 2008-09. However, short-term debt is roughly covered by net international reserves. For banks, external funding from non-parent sources is potentially more volatile than funding from parent banks. A related vulnerability is the large foreign currency exposure of households.
Uncertainties surrounding the outlook for 2008-09 are significant. On the upside, better-than-projected agricultural production could spur a faster revival of growth. On the downside, a worsening of external financing conditions, precipitated by either global or domestic developments, would raise borrowing costs and dampen investment. A large depreciation of the forint could temporarily improve competitiveness but would hurt household balance sheets, given large foreign-currency denominated liabilities. Wealth effects could depress economic growth and thus worsen credit quality, potentially leading to banking system stress.
For 2008, the fiscal deficit target of 4 percent of GDP is attainable. The adjustment is mainly on the spending side, reflecting largely the one-off expenditures recorded in 2007, including the recapitalization of the state-owned railroad company, the leasing of defense equipment, and motorway projects. Given below-potential growth, the fiscal adjustment is nevertheless appreciable. Against the backdrop of cautious revenue forecasts and continued progress in tax administration, any revenue overperformance should be saved and devoted to reducing public debt.
For 2009, a further reduction in the fiscal deficit to the 3.2 percent of GDP target in the Convergence Program is essential. Achieving the target will require strict spending restraint (especially on wages and transfers, in line with the announced spending ceilings) and continued strong revenue growth (in line with the government's forecast for real GDP growth). Consequently, there is no room for tax relief unless it is offset by spending cuts.
Deficit-neutral tax and spending changes could improve work incentives, boost employment, and thus enhance economic growth over the medium term:
• Revenue. A broadening of the tax base along with a shift in the tax burden away from labor and to consumption and wealth would be desirable. For example, in the short term, a cut in labor taxes could be accompanied by a reduction of exemptions, an increase in the value-added tax rate, and a rise in excise duties. More generally, further simplification of the tax system and improvement in tax administration would cut compliance costs and limit opportunities for tax evasion. Over the medium term, a revenue-neutral introduction of a property tax along with a reduction in labor taxes should be considered.
• Expenditure. Short-term savings in social transfers could be achieved by increasing means-testing and tightening eligibility criteria. Over the medium term, durable reduction in government spending will depend on further reform of the health, education, and pension systems. In the pension system, incentives for early retirement could be curtailed and the retirement age gradually raised. In health care, the key tasks are to improve the governance of hospitals and increase efficiency by adopting a sound regulatory framework. In education, enhanced coordination between local governments, expanded performance-based financing, and greater autonomy of higher education institutions would increase efficiency.
Given the uncertainties surrounding the economic outlook and the budget impact of reforms, the 2009 budget should include sizable contingency reserves. High government debt makes debt service vulnerable to higher interest rates and exchange rate depreciation. High inflation puts upward pressure on certain spending items, such as wages, social transfers, transfers to local governments, and subsidies to state-owned enterprises. Moreover, the state-owned railroad company remains a significant source of risk. Another concern is the increasing debt of local governments.
Introducing a rules-based fiscal framework and strengthening budgetary procedures would help deliver the needed further consolidation. Enactment of the draft fiscal responsibility law, along with the proposed amendments to the constitution and to the local government act (both requiring a two-thirds majority in parliament), would signal commitment to sound public finances. The proposed parliamentary budget office would provide independent and expert scrutiny of compliance with the fiscal rules, which is essential. The law would strengthen the medium-term expenditure framework by making the currently indicative spending ceilings binding. These changes could lead to important gains in terms of lower borrowing costs for the government.
The elimination of the exchange rate band is welcome, as this removes a possible conflict between monetary policy objectives. Monetary policy is now able to focus exclusively on the inflation target. Exchange rate movements will be factored into the setting of the policy interest rate to the extent that they affect the outlook for inflation. In addition, the elimination of the band has removed the possibility of a one-way bet against the forint in a period of financial market turmoil, and may help to increase awareness of the risks associated with lending and borrowing in foreign currency.
Aiming to reduce CPI inflation to the 3 percent target over two years is essential to macroeconomic stability. Over the past year, not only have higher global prices of food and energy boosted CPI inflation, but underlying inflationary pressures have risen: declines in core inflation and wage growth first stopped and then partially reversed, and measures of inflation expectations have risen. Against this background, the central bank has appropriately tightened monetary policy.
Looking forward, the policy interest rate may need to rise further, depending in part on the impact of global developments on underlying inflationary pressures. In our baseline scenario, the appreciation of the exchange rate in recent months, along with projected below-potential growth in 2008-09, are expected to reduce inflation to the 3 percent target by the first half of 2010. However, risks to inflation are significant. On the upside, further increases in global food and energy prices would boost inflation, which could affect inflation expectations and thus wage pressures. An increase in the risk premium on forint-denominated assets would put downward pressure on the exchange rate and thereby tend to boost inflation. On the downside, a sharper-than-projected slowdown in external demand would dampen inflation.
Financial system risks have increased over the past year, reflecting both the global financial market turbulence and continued rapid credit growth. With global financial conditions still unsettled, the magnitude and timing of any additional spillover effects on Hungary are uncertain.
• Credit risk. Banks have eased lending standards for households, including by lengthening maturities, raising loan-to-value ratios, and introducing new products with higher risk profiles (such as yen-based loans).
• Liquidity risk. Robust credit growth has led to a rise in loan-to-deposit ratios and a decline in liquid asset ratios. The decline in global risk appetite has increased banks' external funding costs and shortened maturities. While Hungarian banks have no direct exposure to the U.S. subprime market, some of their foreign parent banks do, which creates a possible channel of contagion to Hungary.
Against this background, policy measures to improve banks' risk management are crucial. Regarding credit risk, the priorities are to establish a credit registry for households and to strengthen stress testing in this area, including of households' foreign currency exposures. A mandatory credit registry would not only improve banks' credit risk management but also enhance consumer protection by discouraging the build-up of excessive debt. The bottom-up stress testing exercise being planned by the central bank and the Hungarian Financial Supervisory Authority (HFSA) needs to be implemented as soon as possible. If the HFSA judges that banks are not adequately capitalized, it should not hesitate to use its supervisory tools to require increases in capital. Regarding liquidity risk, the priority is to expedite the HFSA's review of banks' liquidity management practices. This would strengthen the HFSA's capacity to supervise liquidity management. The HFSA should develop and publish explicit recommendations on banks' liquidity management as soon as possible. In the meantime, the HFSA needs to ensure that banks have effective contingency arrangements.
The review and testing of financial safety nets should be accelerated. Although the HFSA has the necessary supervisory tools, the introduction of a formal system of early remedial action could be considered. Domestic crisis management arrangements between the central bank, the HFSA, and the Ministry of Finance have been established and tested, and should be continuously enhanced. Given Hungary's important cross-border linkages, both to parent banks in western Europe and to subsidiary banks in southeastern Europe, effective communication and collaboration with financial authorities in other countries are essential.
We thank the authorities for, as always, their generous hospitality and the frank discussions, and wish them well with their endeavors.