Hungary's Economic Achievements and ProspectsSpeech by John Lipsky, First Deputy Managing Director of the International Monetary Fund, at Hungary's Social and Economic Council
Budapest, June 4, 2007
Ladies and Gentlemen, I am honored to be able to discuss Hungary's economic achievements and prospects with a group of experts. My purpose in these opening remarks is to offer some perspectives that I hope will stimulate a good discussion.
Hungary's integration into the European economy
Hungary was a leader in the transition from planned to market economies. Thus, Hungary's integration with the European community began well before the formal entry into the European Union in May 2004. Privatization of state-owned enterprises attracted foreign investment, generating productivity gains and trade links to Europe and the world. These gains have proved enduring and are reflected in still-deepening investment and trade linkages.
The continued strength of Hungary's exports is in no small measure due to the ties that its industrial base has established with the production networks of Europe. The ratio of exports-to-GDP has risen from less than 45 percent of GDP in 1995 to the current figure of almost 80 percent. During this process, the quality and sophistication of Hungary's exports has increased impressively. This improvement has played a crucial role in maintaining Hungary's competitiveness.
Integration with Europe has brought another important benefit: access to international capital on favorable financial terms. At a seminar that the Fund sponsored here last fall we presented an analysis of financial market perceptions of the EU's new member states. As we noted at that time, spreads on foreign currency borrowing by this group of countries consistently have been lower than in other emerging markets with similar underlying fundamentals. Hungary has shared in this advantage—with spreads on dollar-denominated bonds—at about 65 basis points—almost 100 basis points less than in other, similar emerging markets. The most likely explanation of this advantage is European Union membership, including the prospect of euro adoption.
That this advantage has persisted despite the delay in euro adoption is a testimony to the confidence with which market participants view Hungary's medium-term prospects. Access to foreign capital has allowed Hungarian consumers to raise their standard of living at a faster rate than would have been possible otherwise. The resulting gap between saving and investment has been reflected in significant current account deficits and the associated accumulation of external debt.
Under current market conditions—based on the apparently favorable consensus outlook for global economic conditions—international capital markets have been fairly tolerant of variations in fiscal discipline. In particular, international markets in recent years remained relatively patient, even as Hungary's fiscal deficit continued to exceed targets. Nonetheless, the situation shifted notably during the spring and summer of 2006. As you remember vividly, investor attitudes began to sour when the already-high deficit seemed at risk of rising to double digits as a percent of GDP. As market risk aversion heightened, the threat of a crisis loomed.
The subsequent steps taken to contain the deficit helped to calm financial turbulence. However, the forint and bond prices also have been strengthened by the fortuitous and parallel improvement in global markets' risk appetite. But there should be no illusions. If doubts re-emerge about the commitment to sustained fiscal consolidation—or if the current consensus optimism about the global outlook were to weaken—financial pressures could reappear rapidly.
The Fiscal Challenge
In these circumstances, dealing with the fiscal challenge will remain the key policy priority. Budgetary policy is central because it influences virtually every aspect of the Hungarian economy. Lower deficits and public debt reduce financial vulnerabilities. Spending control and a more efficient tax system are necessary in order to provide space for strengthened private initiative. A more consistent and predictable fiscal policy is an important underpinning for the predictability of monetary policy.
In this regard, it is clear to all that the ongoing fiscal consolidation, while painful, was necessary. Much remains to be done, however. not only is sustained deficit control needed, but the moment is appropriate to lay the foundation for a fundamental reorientation of budget policy. Reliable fiscal discipline, together with more effective spending and a more efficient tax system will pay dividends in fostering faster growth and greater economic flexibility. Both of these elements are needed to put the Hungarian economy on a successful path that will open the option of eventual admission into the euro area.
The measures taken in the second half of 2006, embodied in the Convergence Program, were decisive and necessary first steps to turn the fiscal situation around. Important measures have been taken in the healthcare sector, in the reduction of subsidies, and in central government administration. The government recognizes, however, that even with these steps, the deficit remains unacceptably high. At the present time, it appears that with the measures already in the pipeline, the deficit should decline to about 4½ percent of GDP by 2008. This would be a substantial achievement. But there are short-term risks, and more importantly, the question will still remain regarding policy plans beyond 2008.
While the goals of the Convergence Program are a critical anchor today, it is important to consider more ambitious objectives. Under present projections, the size of government expenditure (or the "redistribution") will remain close to 50 percent of GDP. This is large in relation to the size of the government in other countries at similar levels of development. Experience elsewhere suggests that an expenditure-to-GDP ratio of between 40 and 45 percent is associated with stronger growth.
The task of future fiscal policy reform should not be underestimated. Achieving such a restructuring would require:
• Far-reaching reforms that will draw new boundaries between public and private responsibility in pensions, health, and education.
• Better targeting of the welfare system and administrative reforms of local governments for greater equity and efficiency.
• Greater transparency and predictability of fiscal policy through tighter procedures. In this context, I welcome the government's recent receptivity to external scrutiny of fiscal policy by an independent council.
I recognize also that there is considerable pressure to reduce tax rates. But I would urge caution. Any rate reductions should await clear signs that durable and credible expenditure control has been achieved. In the interim, however, much remains to be accomplished. For example, international experience suggests that the introduction of a broad-based property tax could increase revenues while improving the efficiency of local administration. In addition, a higher percentage of Hungarians should be paying their share of taxes. At present, however, legal exemptions abound, while tax evasion appears to be all too common. The combination of high tax rates and the complexity of the tax code together create opportunities and incentives for non-compliance. Simplification of the code would help to broaden the tax base while tending to shrink the black economy. Tax reform also would improve incentives for employment and growth. In this regard, lowering labor taxes while raising consumption taxes would improve the tax system balance.
In short, despite the welcome recent fiscal improvements, fundamental changes will be required in order to achieve the goals. Inevitably, greatly—and broadly shared—prosperity reforms will be opposed by those who suspect that they will lose existing privileges. However, broader social goals can be underpinned by new fiscal reforms even in a context of increasing the scope for private initiative and responsibility.
A Vision for Hungary
My vision for a Hungary's future is of a vibrant, innovative economy, one that draws on the widely-recognized Hungarian traits of independence, originality, ingenuity, intellectual attainment and high energy to generate the skilled employment that will generate a convergence with the living standards in the advanced European countries. It is a vision of inclusion, and of effective social safety nets as well as of increased scope for individual initiative.
I am confident that this vision is feasible and realistic. Although difficult choices will be necessary to secure these advances, the task and direction are clear. With the global environment exceptionally favorable, and with international markets newly optimistic about Hungary's prospects, this is the moment to seize the opportunity for new advances. Such a positive environment can't be counted on to last forever, and the roadmap to reform is open before us.