IMF Executive Board Concludes 2006 Article IV Consultation with HungaryPublic Information Notice (PIN) No. 06/118
October 20, 2006
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On October 11, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.1
Economic performance was respectable in 2005, though with mixed signals. GDP growth slowed to 4.1 percent in 2005, the lower end of the economy's potential estimated at between 4 and 5 percent a year. Consumption moderated, while investment and exports were sources of strength. Fixed investment growth reflected largely government-sponsored motorway construction. While business profitability was maintained overall, about two-fifths of small-and medium-sized enterprises were reported to be unprofitable. Inflation declined significantly, helped by globalization and one-off domestic factors.
Despite the relatively good macroeconomic performance, a loss of fiscal discipline has created a twin deficit problem and worrisome debt dynamics. The series of missed fiscal deficit targets continued in 2005, with the deficit reaching 7.5 percent of GDP, compared with a budgeted deficit of 4.7 percent of GDP. The current account deficit remained high, at 7.4 percent of GDP. Reflecting these developments, fiscal and external debt levels have risen to worrisome levels over the last few years. The continuing sharp increase in foreign currency lending to small businesses and households has created a further source of vulnerability. The risks were, however, somewhat mitigated by the presence of buffers. The reserves-to-short-term debt ratio remained above 100 percent, and public debt had long maturities and low foreign currency exposure, minimizing the government's rollover risk and the costs of a large depreciation.
The vulnerabilities caused financial markets to differentiate Hungary from the rest of the region. The differentiation of the forint started in late 2005 and increased thereafter, as did its volatility. Yields on local currency bonds increased along with spreads on foreign currency credit default swaps. Two major rating agencies downgraded Hungary and the third has put its rating on review, pointing to persistent twin deficits and rising debt ratios, while the ratings of other new member states of the EU have either remained unchanged or have been raised. However, financial markets have been calmed by the fiscal consolidation package laid out in the Convergence Programme submitted by the authorities to the European Commission on September 1, and market reaction to recent political disturbances has been relatively mild.
Executive Board Assessment
Executive Directors noted that Hungary has benefited greatly over the past decade from significant economic reforms, and commended the performance of Hungary's private sector and its resilience despite macroeconomic uncertainties. Directors noted, however, that the persistently large fiscal deficits and weak budget execution of recent years have led to unsustainable increases in public debt, and economic growth, while respectable, has lagged behind the performance of the New Member States of the European Union. While inflation has fallen to historic lows, vulnerabilities relating to large fiscal and current account deficits have weakened the forint and local currency bond prices. Against this background, Directors stressed that urgent actions are needed to restore policy credibility and redress the fiscal and current account balances in order to strengthen the groundwork for sustained high growth.
Directors welcomed the authorities' EU Convergence Programme and the associated multi-year fiscal consolidation package, which they viewed as a significant effort to address Hungary's difficult challenges. They underscored that steadfast implementation of the proposed adjustment will be crucial, along with the authorities' readiness to take any additional measures that may be required to signal to markets and partners the authorities' strong commitment to achieving Hungary's goal of rapid nominal and real convergence. Equally, continued resolve will be needed in carrying forward structural reforms to strengthen budgetary processes and increase the flexibility and competitiveness of the economy.
Directors emphasized that the principal policy task is to place public finances on a sound footing. They were encouraged by the significant steps reported in the authorities' Convergence Programme, which they felt is based on a realistic reassessment of the fiscal challenges facing Hungary. The expected fiscal consolidation would lower the current account deficit and alleviate short-term vulnerabilities. Directors noted, however, that reaching the targets in the program would require detailing further measures. Moreover, they emphasized that a fiscal consolidation that is sustained over a longer period will be needed to lower progressively the public debt-to-GDP ratio to a safer level. Directors urged the authorities to implement a medium-term budget framework with multi-year expenditure ceilings to guide fiscal policy.
Directors stressed that the composition of fiscal adjustment will have an important influence in shaping the medium-term economic outlook going forward. Hungary will benefit from greater reliance on expenditure-based consolidation that can enhance growth and efficiency, while avoiding the growth dampening effects of undue reliance on revenue measures. In this context, Directors welcomed the expenditure reduction measures in the Convergence Programme. They urged more forceful reforms of pensions and social welfare transfers, while noting that improved targeting and efficiency will contribute to lasting consolidation. Directors stressed the continuing importance of containing overruns in the budget deficit through greater transparency and accountability, and in this context supported recent efforts to institute budgetary controls. Strengthening budgetary management was seen as a priority to engender confidence that the envisaged fiscal consolidation will be successfully implemented. Directors considered that any gains in revenues would best be achieved through broadening the tax base, including by instituting a more far-reaching property tax, rather than through surcharges on already high taxes on capital and labor.
Directors commended the National Bank of Hungary for its success in establishing the inflation targeting regime, highlighting the important role played by timely communication of policy actions. Directors considered that a measured monetary policy tightening may be needed in the event of price increases in the coming months due to recent tax hikes and subsidy reductions. However, given the one-off nature of the envisaged pressures and with a weakening economy, inflation is expected to fall back close to the target in 2008. The challenge, Directors observed, is to identify one-off inflationary influences, communicate them to the public and financial markets, and fine-tune interest rate policy to deal with second-round effects.
While acknowledging the robustness of the banking sector, including its profitability and capitalization, Directors highlighted the increasing risks stemming from the rapid growth in foreign currency lending. They noted that those risks are amplified by recent aggressive lending practices and financial fragility of small and medium-sized enterprises. Directors emphasized the need for more proactive supervision and regulation, including by instituting regular stress tests of individual banks and more intensive on-site supervision of banks' risk management practices.
Directors had a wide-ranging discussion of the view that a floating exchange rate regime may be best suited to Hungary's circumstances. A number of Directors considered that a floating exchange rate regime would be appropriate from a risk-management perspective and would strengthen the inflation-targeting anchor. They also felt that increasing the perception of greater exchange rate variability could reduce incentives to borrow in foreign currency. Some other Directors, however, noted that the fluctuation band already provides adequate room for maneuver in the conduct of inflation targeting. In any event, it was recognized that timing issues will be crucial, and many Directors expressed concern that a formal switch in the exchange rate regime in present circumstances could send a mixed signal to markets.
Directors stressed the need for actions to enhance labor market performance and competitiveness. Raising employment will require reducing the overall cost of labor and better targeting social welfare programs. Directors emphasized that productivity enhancement will be crucial for maintaining competitiveness. In this context, they encouraged the authorities to improve the pace of absorption of EU funds in productivity-enhancing activities, while linking their deployment to fiscal structural reforms.