Reclaiming Hungary's growth potential, an Op-Ed by Ashoka Mody, Assistant Director, European Department, IMF
October 24, 2007By Ashoka Mody, Assistant Director, European Department
International Monetary Fund
Published in The Budapest Sun
October 24, 2007
Since mid-2006, incomes in Hungary have stopped catching up with those in the richer parts of Europe.
This underperformance has been reinforced by recent data: Hungary's second quarter GDP grew at less than 1% on an annualized basis.
Domestic demand was particularly soft. On the back of subdued investment, private consumption fell.
Absent buoyant exports, the outcome would have been even worse. The disappointment is acute because, in comparison, growth in much of Europe - in the advanced and emerging economies - remained vibrant.
This weakness in income growth is due, in part, to the much needed fiscal tightening.
Since the fiscal deficits of earlier years had become untenable, the government had to impose self-discipline, and a necessary cost of that discipline is slower growth in the short-term.
Once the tightening stops, the negative impulse - the downward drag exerted on domestic demand - will also stop.
But it would be a mistake to assume that growth will automatically resume when the fiscal consolidation is completed.
Signals of deeper-rooted problems were flashing before the consolidation was initiated. In 2005, growth had slowed relative to other economies that had acceded to the European Union along with Hungary in May 2004.
In mid-2006, before the fiscal consolidation was announced, investment dipped. This was unexpected and was a warning that investors were taking a cautious future view of Hungary.
Once the fiscal consolidation commenced, Hungarian consumers initially held their spending steady, perhaps viewing the developments as temporary.
They did cut back on durable goods' purchases, especially automobiles and houses.
But they continued to dip into their savings or borrowed to maintain current expenditures.
However, such "smoothing" of consumption, or the reluctance to restrict current consumption, can persist only if consumers see light at the end of the tunnel.
They must see the prospects of stronger growth, leading to better employment opportunities and higher wages.
Absent that, prudence would require scaling back on household expenses.
And, indeed, the initial phase was followed by slowing retail sales. The particular surprise in the second quarter was an actual decline in consumption relative to the same period last year.
Looking ahead, the signs are not yet promising. Businesses have virtually stopped borrowing, implying that their investment plans remain restricted. Consumer confidence and perceptions of employment prospects remain weak.
Consumption is unlikely to keep declining, but it may be a while before it grows at a robust pace.
And, while the global environment has remained resilient despite the recent turbulence in international financial markets, the increase in downside risks clouds Hungary's export prospects.
There are two sources of continuing concern with Hungary's economic outlook.
First, although the fiscal balance has improved in response to the vigorous efforts made by the authorities, the task ahead is formidable. For now, the public debt-to-GDP ratio is likely to remain in the range of 70% of GDP, a level significantly higher than that required to meet the Maastricht criterion and hence also an impediment to eventual euro adoption.
With government liabilities to loss-making public enterprise companies still high, and the inevitable retirement and medical costs of ageing, the fiscal challenges will not go away.
Ad hoc changes to the tax code have not helped. As such, regaining the lost fiscal credibility will not be an overnight task.
Second, while the government has made efforts to improve the business environment, the bar is being continually raised as countries in the region seek to improve their investment climate.
Once again, reducing the size of the government to allow a reduction in the tax wedge will remain an ongoing goal. The actions needed to improve the outlook are not always dramatic and eye-catching: they need steady, quiet persistence.
The costs of inaction may also not be striking and visible. Instead, a loss of competitiveness may lead to a slow but increasingly irreversible shift of investor interest and, hence, to a prolonged period of low growth.
This would be an unfortunate outcome for a country with such evidently high potential.
Hungary stands at the cross-roads of Europe, benefiting from the currents of trade, people, and capital from the east and the west.
Recognizing the opportunities, a generation of Hungarian leaders prepared the nation to benefit from this exciting process.
And the promise was realized as the Hungarian economy made a rapid transition from planned to market economy and was an early "star" performer in the region.
The current generation will be judged by whether the legitimate goals of solidarity are hijacked to impose continuing burdens on the fiscal system and thereby dampen growth prospects.
The challenge is to achieve solidarity with growth - and with commitment and perseverance that surely is a goal within reach.