IMF Executive Board Concludes 2007 Article IV Consultation with HungaryPublic Information Notice (PIN) No. 07/87
July 26, 2007
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. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2007 Article IV Consultation with Hungary is also available.
On July 18, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.1
Investor sentiment towards Hungary improved after intense financial market pressure in mid-2006. The improvement was helped by the government's announcement of a fiscal consolidation package to contain the runaway fiscal deficit. The measures helped contain the 2006 fiscal deficit, which rose to 9.1 percent of GDP. Since mid-2006, the exchange rate, which had weakened to a low of F285 per euro in June, has appreciated and its volatility has come down. About one-half of the appreciation reflected renewed bullishness for central European economies, while the other half was attributable to a more benign view of Hungary.
However, vulnerabilities remain. The public debt is about 66 percent of GDP. Although the current account deficit fell to 5.8 percent of GDP in 2006, net financing needs remained at about 9 percent of GDP and the external debt reached 91 percent of GDP.
Growth deceleration from early 2005 brought GDP growth to 3.9 percent in 2006 and 2.7 percent in the first quarter of 2007. Consumption growth weakened further after the announcement of the fiscal consolidation package in mid-2006; gross domestic capital formation has fallen in the past year. Export growth, which has maintained its strength, was sustained by a shift from European and U.S. markets to fast-growing emerging European markets. Inflation surged to 6.5 percent year-on-year in the last quarter of 2006 primarily owing to the one-off effects of the hikes in taxes and regulated prices to support fiscal consolidation. After reaching 9 percent in March 2007, inflation fell to 8.5 percent in May, as the one-off effects apparently peaked.
Bank borrowing, especially in foreign currencies, decelerated in 2006 with the weakening domestic demand. Although the unhedged exposure of borrowers to foreign currency loans generates credit risks for banks, the share of foreign currency loans in total loans stabilized in the second half of 2006 at 54 percent of all loans. Banks appear capable of managing new stresses and challenges with significant financial buffers, as capital adequacy ratio is at a healthy level and profitability remains high. Furthermore, the Financial Supervisory Authority has used its market-risk stress tests to require strengthened capitalization and risk management practices in major banks.
Executive Board Assessment
Executive Directors congratulated the Hungarian authorities for their resolute efforts to rein in the budget deficit and rebuild fiscal credibility. Markets have responded favorably to the deficit-reduction measures and access to funds has eased.
Directors stressed, however, that the task ahead is formidable and that vulnerabilities remain. Fiscal and external deficits are still large, and public and external debt ratios are likely to remain high. Favorable market sentiment could reverse, especially if fiscal and external accounts deteriorate.
Directors noted that Hungary's GDP growth performance has deteriorated relative to the rest of Europe since early 2005, and more since the onset of the fiscal package in mid-2006. Domestic consumption and investment are expected to recover only gradually. Directors encouraged the authorities to continue to persevere with structural reforms to improve competitiveness and spur growth.
Directors cautioned that prolonged low growth would set back income convergence and aggravate vulnerabilities. While the easy access to Europe's product, financial, and labor markets provides the basis for a return to rapid growth with stability, realizing the full potential of that opportunity will require continued pursuit of sound public finances and a competitive business environment.
Directors welcomed the structural content of some of the fiscal consolidation measures, and urged the authorities to outline further such measures so as to extend deficit reduction beyond 2009. They welcomed the measures to strengthen tax administration, to downsize public employment, to increase efficiency in health and education, and to reform the disability and early retirement schemes. However, much remains to be done, particularly in light of the government's contingent liabilities from loss-making public enterprises and pressures from age-related expenditures. Directors recommended further rationalization of budget support to families, housing subsidies, and local governments. A revenue-neutral tax reform that simplifies and rebalances direct and indirect taxes, and budget rules and procedures that promote fiscal discipline, should also be priorities.
Directors saw the recent easing of the policy interest rate as appropriate, with inflation having apparently peaked and likely to return to the target range over the forecast horizon. They encouraged the authorities to undertake further policy rate reductions gradually, mindful of inflation expectations. Following such an approach, they envisaged a cumulative reduction of the policy rate that could bring greater convergence with rates in the region. They highlighted that enhanced fiscal policy credibility would help dampen pronounced swings in the policy interest rate, as would increased reliance on statements of monetary policy inclinations.
In view of the wide exchange rate band for the forint, many Directors supported the current exchange rate regime, which was working well and seemed not to constrain monetary policy. Other Directors, however, considered that an eventual move to a more flexible system would be desirable, as it would be more consistent with the inflation targeting framework. The reconsideration of the exchange rate framework should take place in the context of the medium-term strategy concerning fiscal policy and euro adoption. Directors viewed the exchange rate as falling within a broadly acceptable range, but cautioned that competition from economies with lower wages and better business environments poses a threat to foreign direct investment inflows and export buoyancy, which are needed to support growth.
Directors stressed the need to improve the business climate and increase productivity to enhance economic growth. They therefore welcomed the simplification of regulatory requirements and public procurement procedures. Effective deployment of European Union funds in infrastructure, human capital, and the innovation system would also help raise productivity and growth.
Directors noted that the financial sector appears generally sound, with banks profitable and well capitalized. At the same time, with financial deepening, banks are financing riskier activities, the ongoing economic slowdown is creating more corporate distress, and foreign currency borrowing (especially by households) remains a source of balance sheet risk. Directors therefore welcomed the recent measures to contain risks by requiring some banks to strengthen their risk management procedures and capitalization. In this context, Basel II regulations should be put in place, and risk-based consolidated supervision across financial institutions should keep pace with ongoing developments.