Hungary--Concluding Statement of the 2010 Article IV Mission
October 25, 2010
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.
With a stabilizing economy and a strong political mandate, the new Hungarian government has an historic opportunity to create the conditions for sustainable growth and sound public finances. The economic program proposed in recent days includes several encouraging elements, notably the determination to adhere to fiscal targets agreed with the European Union and to reduce the taxation of labor. But, amid large underlying vulnerabilities, it relies to a substantial extent on temporary and distortive measures that may jeopardize medium-term fiscal sustainability, increase uncertainty, and ultimately harm growth. To enhance the plan’s chances for success, we encourage the authorities to spell out elements that are in our view still incomplete, notably additional measures to permanently reduce government spending and to improve the efficiency of public services. In addition, a cautious monetary stance, preservation of current financial stability arrangements, and progress on financial sector reform are warranted to support stability.
Macroeconomic Outlook and Risks
1. Hungary has emerged from a severe crisis, but the recovery is fragile. Due to its high integration in global trade and financial markets, elevated pre-crisis vulnerabilities, and weak structural foundations for growth, Hungary was more immediately and profoundly affected by the Great Recession than other countries in the region. The combination of improved policies and significant adjustment in the context of the IMF/EU-supported program, availability of large and upfront official financing, and an easing of global financial conditions brought a faster-than-expected stabilization. After a deep initial slump, an export-led recovery is underway, but domestic demand remains sluggish as the private sector continues to adjust balance sheets. Output is expected to grow slightly less than 1 percent in 2010, with inflation slowly declining to 3¾ percent by year-end. The external current account is temporarily in surplus.
2. Going forward, we expect the economy to recover gradually. In line with developments in the EU, import demand growth of trading partners is projected to be well below pre-crisis levels, contributing to robust but moderate export growth. While the recently announced personal income tax cuts will boost disposable income, we expect the underlying trend of increasing precautionary savings to continue in face of increased uncertainties and double-digit unemployment. Taken together, this suggests real GDP growth of 2½ percent in 2011, rising to about 3 percent in the medium term. Recent policy changes may boost labor participation but discourage investment. The output gap will close only slowly. Despite this large slack and a real exchange rate close to equilibrium, tax increases and other supply side shocks will keep average inflation above 3½ percent in 2011.
3. The uncertainty around this central scenario is considerable.
• On the upside, accommodative monetary policy in advanced economies may spur global growth and induce stronger capital inflows to emerging markets, potentially compressing Hungary’s borrowing spreads. In the long term, the effects of the recent policy package on employment and investment, if supplemented by structural reforms and tangible improvements in the business climate, may also turn out stronger than assumed in our baseline.
• On the downside, the global recovery and the recent increase of global risk appetite may well prove temporary. Amid Hungary’s high external and public debt, a change in investor sentiment would compound financing risks as large sovereign redemptions fall due in 2011-14. Domestic demand will suffer if the Swiss Franc, whose value directly impacts households’ debt servicing costs, strengthens further. Finally, there is a risk that the authorities will not take the necessary measures to restore fiscal sustainability. The associated policy uncertainty could lead to a more cautious behavior by households and both domestic and foreign investors.
The Policy Agenda
4. The challenge is to solidify hard-earned stability gains, head off downside risks, and create the conditions for putting growth on a permanently higher trajectory. The government’s strong political mandate presents an historic opportunity to address fundamental constraints to Hungary’s growth and to bring fiscal policy sustainably back on track. For now, the markets have welcomed the authorities’ renewed commitment to the fiscal targets agreed with the EU. However, scrutiny of sovereigns with perceived weak policies or significant vulnerabilities remains. Articulating a coherent policy framework that goes beyond the 2011 budget, incorporates high quality measures, and is based on conservative medium-term assumptions could set off a virtuous cycle where a permanent reduction of fiscal and financial vulnerabilities increases confidence, lowers risk premia, and fosters growth.
5. The recently announced elements of the government’s economic program are by themselves unlikely to achieve these objectives. The government’s strategy to increase tax compliance and competitiveness through steep cuts in personal and corporate income tax rates is bold but risky, as it counts on a profound but uncertain response by the economy. While we support efforts to increase labor participation, we recommend a more cautious approach that safeguards fiscal sustainability and financial stability—preconditions for growth—while the economy is being restructured. At a minimum, this calls for thorough contingency planning. The program itself can be improved by (i) including well-specified structural measures to replace the recently introduced temporary taxes; (ii) reversing as soon as possible distortive measures that disregard Hungary’s dependence on foreign trade and investment; (iii) ensuring that household pension savings are not used as a substitute for structural fiscal adjustment; and (iv) completing the financial sector reform agenda. The MNB can support these efforts by continuing to maintain a cautious monetary policy stance.
6. The temporary measures recently adopted appear sufficient to limit the fiscal deficit to 3.8 percent of GDP in 2010. To compensate for significant revenue shortfalls and spending slippages in 2010, the government is relying mainly on temporary measures, such as levies on financial institutions, energy, telecommunication, and retailers, and on the redirection of pension contributions from the second to the first pillar of the pension system. These measures, along with the expenditures cuts announced in July, appear sufficient for the government to meet its fiscal deficit target, while financing additional spending on state-owned enterprises and outlays related to recent floods and environmental damage.
7. Additional measures need to be taken to meet the fiscal deficit target of 2.9 percent of GDP in 2011, upon which the authorities have agreed with the EU. The government submitted to Parliament on October 16 a tax package, which, in addition to the aforementioned levies and the temporary redirection of pension contributions, notably included the phased introduction of a flat-rate PIT and a reduction of the CIT rate in 2013. As these reforms are expected to result in substantially reduced revenues, our assessment is that the recently announced expenditure cuts (reductions in staff and material costs) will not suffice to bring the headline fiscal deficit below 3 percent of GDP.
8. While the government’s determination to meet headline fiscal targets is commendable, the quality of the measures adopted to meet these targets is questionable. The PIT reform comes at a sizeable cost to the budget (at least 3 percent of GDP over the medium term). As many of the measures adopted so far to compensate for this tax cut are temporary, the improvement in headline deficits will coincide with a deterioration of the underlying fiscal situation. In structural terms, the primary fiscal deficit is expected to widen by slightly more than 1 percent of GDP in 2010 and to further increase in 2011. The levies are difficult to justify on economic grounds as they discriminate among sectors and send negative signals about the government’s attitude towards foreign investment, which is critical for Hungary. Meanwhile, the taxes will be partly passed on to consumers via higher prices. Finally, the redirection of pension contributions may undermine confidence in the pension system, especially as the government has yet to announce how contributors will be compensated.
9. To make fiscal adjustment sustainable, a focus on durable expenditure rationalization is necessary. The size of government, at about half of GDP, remains large compared to regional peers. While significant progress has been made over the last few years in a number of areas (including education, public wages and employment, pensions, and subsidies), we see room for further rationalizing current primary spending. In particular, reforms to the social benefit system could focus on decreasing the generosity of benefits, introducing means-testing to universal transfers (e.g. child benefits, especially in view of new child allowances in the PIT), and eliminating untargeted price subsidies (e.g., for gas). Further, there appears to be room to scale down public works programs (pathway to work). Restructuring the main public transportation companies could generate substantial budgetary savings and efficiency gains; this is particularly true for MAV, which has been a growing drain on the budget. Administrative reforms, including at the local government level, would contribute to lower operational expenditures. In this context, we welcome the authorities' intention to reduce bureaucracy, although precise steps need to be specified. Implementation of all these measures should start in 2011 to close the remaining fiscal gap, and continue over the medium term to contribute to the required structural adjustment.
10. These efforts should be supplemented by additional structural measures. Over the medium term, the introduction of a property tax and mobilization of more EU transfers could be significant sources of additional revenue. We also see scope for further strengthening public finance management, to avoid a recurrence of the spending slippages observed in the past. Finally, revenue collection could be improved, including through the continued implementation of the tax administration’s compliance strategy and the planned merger of the customs and tax administrations.
11. The envisaged winding down of the second pillar of the pension system raises a number of concerns. The government recently announced that all contributors to the second pillar will be allowed to switch back to the first pillar. This reform would allow the authorities to improve headline fiscal indicators (as the assets transferred from the second to the first pillar would be recorded as revenue) without undertaking the necessary structural fiscal adjustment. Moreover, this measure would constitute a significant step back in the pension reform process initiated in the late 1990s, which has contributed to making Hungary’s pension system one of the most sustainable in Europe. By replacing explicit with contingent liabilities, it will reduce fiscal transparency while increasing fiscal risks. Furthermore, it could negatively impact the development of the domestic capital market, notably by eroding its liquidity, one of Hungary’s strengths compared to other CEE countries. Lastly, this measure may hinder long-term growth, if it reduces needed national savings and thus investment. Regulatory measures could be considered to address the issue of relatively low second pillar pension fund returns.
12. The growth and fiscal impact of PIT reform should not be overestimated. The substantially reduced taxation of labor will improve Hungary’s competitiveness by allowing a significant decline in the tax wedge, which, despite progress over the last two years, has remained one of the highest among OECD countries. However, international experience suggests that the impact of the reform on labor supply might be limited, especially because it is not accompanied by a reduction in still generous and largely universal social benefits. In the short term, the reform may have a lower-than-anticipated impact on consumption because it primarily benefits high income earners who have a lower propensity to consume. Finally, compliance gains are more likely to materialize in the medium term and will depend crucially on improving tax administration.
13. The MNB’s cautious monetary policy stance remains appropriate. At present, the substantial fall in aggregate demand has opened a large output gap suggesting downward pressure on prices. However, even amid such weak growth dynamics, inflation forecasts over the policy horizon are above target, limiting the room for monetary policy to provide stimulus to the economy. More broadly, inflation remains highly sensitive to developments in the exchange rate, leaving price changes exposed to risk premia going forward. As a result, credibility of the government’s medium term-adjustment program, level of risk premia and outlook on inflation are key considerations ahead of any change in the monetary stance.
Safeguarding Financial Stability
14. The banking system has displayed resilience in a difficult environment, but challenges remain, particularly given a wide variation among banks. Non-performing loans (MNB definition) increased to 8½ percent by end-June 2010 and are now expected to peak in 2011 at around 12 percent. The recent deterioration in credit quality reflects intensifying weakness in commercial real estate, an increase in household defaults amid recent Swiss franc strength, and the moratorium on foreclosures that prevents banks from managing their mortgage portfolios effectively. However, in aggregate, the sector’s pre-tax profitability has remained relatively sound and existing capital cushions for most banks provide ample stress-absorbing capacity. Stress tests prepared by the Hungarian central bank (MNB) suggest that only modest recapitalization needs would arise in the event of a further sharp deterioration in the economic environment and an additional large depreciation against the Swiss franc. On the basis of system-wide stress tests, banks seem well prepared to meet the forthcoming higher Basel III capital standards, although detailed analysis has yet to be carried out. Finally, the sector is generally well placed to meet the expected Basel standards for liquidity, although the lack of quantitative domestic liquidity requirements poses risks in the event that there are sudden demands on liquidity from parent companies or subsidiary holdings.
15. We support measures to help households facing difficulties in servicing their mortgages. While the appreciation of the Swiss franc poses only limited risks to the stability of the banking system, mitigating the social repercussions of a surge in mortgage defaults is a legitimate public policy objective. The support scheme recently developed by the Ministry for the National Economy (MfNE) responds to this challenge. Appropriate attention has been paid to identifying areas of need while at the same time limiting explicit and contingent fiscal liabilities, minimizing moral hazard for borrowers and banks through appropriately tight eligibility criteria, and safeguarding the proper operation of market mechanisms. Importantly, it avoids creation of a national asset management company which could have been open to abuse. Once the new scheme is introduced, the moratorium on mortgage foreclosures should be immediately ended to help restore a functioning mortgage market and remove one of the obstacles to covered bond market development, especially important in light of recent de facto ban of foreign currency mortgage lending. Furthermore, we welcome initiatives to enhance the predictability and transparency of terms and conditions of loan contracts, provided that proposals do not violate existing contracts or impose arbitrary penalties on financial institutions. The Hungarian Financial Supervisory Authority’s (HFSA) new responsibilities in the area of consumer protection and the MNB’s focus on financial stability will be important to promote good practices in this area.
16. Distortive policies such as Hungary’s outsized financial sector levy are harmful to the economy. The levy is large at 0.7 percent of GDP (more than three times the largest such tax elsewhere), serves exclusively fiscal purposes, and for less profitable banks amounts to a de-facto expropriation of capital. Its design places a disproportionate payment burden on foreign banks. At this juncture, the payment obligation across institutions has been fixed for 2010 and 2011 but remains undetermined for 2012 and beyond. The risk is that uncertainty about the future design of the tax leads banks to reduce their balance sheet size over time, with negative repercussions for credit supply and economic growth. To minimize the prospect for adverse reactions from banks, we suggest that the government send a clear and credible signal that the levy will be substantially reduced and/or aligned with emerging EU standards after 2011.
17. The institutional framework for financial supervision and financial stability has been strengthened, but the task is not yet complete. The HFSA has been upgraded to an autonomous institution accountable to Parliament and, additionally, a tri-partite Financial Stability Council (FSC) composed of the MfNE, the HFSA, and the MNB has been established. The goal of the FSC is to maintain a transparent safeguard for the coordination and integration of macro- and micro-prudential aspects of financial supervision. The FSC and the MNB have been given the right to make regulatory and legislative proposals on a “comply or explain” basis, i.e., the government needs to declare within 15 days that it accepts the proposal, or explain why it disagrees. It is important that both institutions maintain the right to use this mechanism and the FSC continues to meet regularly with participation at the highest level and publishes the minutes of its meetings. Going forward, the HFSA should obtain the authority to issue regulations in its own right. Work should also continue on draft legislation to strengthen the framework for bank resolution that was submitted to Parliament earlier in the year. This work can be informed by the parallel European Commission initiative to enhance cross border crisis management and resolution in the EU.
18. Important progress has been made in the area of on-site banking supervision and international supervisory cooperation. In the past two years, the HFSA has worked to continually enhance its on-site inspection capacity and has conducted comprehensive inspections of Hungary’s eight largest banking groups with follow-up targeted inspections on credit quality. A series of thematic inspections is underway. Based on current legislation, the HFSA’s on-site inspection program now requires regular mandatory inspections of all banking groups, credit cooperatives and other financial enterprises. Continued close cooperation between on-site and off-site supervisors will be needed to maximize the efficiency of the HFSA’s inspections. Progress is being made in the program to inspect the foreign subsidiaries of domestically incorporated banks where the HFSA is the home state supervisor, and the HFSA is developing its relationships with home and host state supervisors.