## cr17123 — 1. Real Sector

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### Context
- Hungary posted several consecutive years of high economic growth and debt reduction, but vulnerabilities remain.
- Growth since 2013 was supported by high utilization of EU funds, a favorable external environment (low interest rates and commodity prices and strong export growth), and accommodative monetary and fiscal policies.
- External and public debt levels and financing needs remain sizeable despite steady declines in recent years.
- Perceptions of Hungary’s business environment have worsened somewhat and parliamentary elections scheduled by Spring 2018 could increase pressure for more public spending and interventions in the economy.

### Background and Recent Developments
- 2016 growth and demand
  - Real GDP growth slowed to an estimated 2 percent in 2016, reflecting a sharp reduction in public investment due to low absorption of EU funds amid the shift to a new program period and somewhat slower export growth as major automotive manufacturers upgraded production lines.
  - Strong private sector consumption supported by rapid employment growth, a falling unemployment rate, high wage growth, and tax reductions.
- Labor market and wages
  - Unemployment rate has stayed below 4½ percent since November 2016.
  - Even excluding Public Works Schemes (PWS), employment exceeds its pre-global financial crisis level.
  - Severe shortages reported for both skilled and unskilled labor.
  - Average earnings increased by about 10 percent at end-January 2017 (y-o-y).
- Inflation and asset prices
  - In March (2017), core and headline inflation reached 1.9 and 2.7 percent y-o-y, respectively (MNB target is 3 +/-1 percent).
  - Real estate prices grew by 15 percent country-wide and by 22.8 percent in the Budapest area (y-o-y in September 2016).
  - The Budapest stock market index (BUX) increased by 19.6 percent y-o-y at end-March 2017.
  - These developments point to upside risks to inflation.
- Fiscal outcomes
  - Staff estimates that the general government deficit widened to about 1.7 percent of GDP, up from 1.6 percent a year earlier; the preliminary 2016 general government deficit has been revised to 1.8 percent of GDP in another Annex.
  - The primary structural surplus is estimated to have declined from 2.2 to 1.4 percent of GDP.
- Monetary policy and liquidity management
  - MNB base rate lowered from 1.35 percent in March 2016 to 0.90 percent in May 2016 (in three steps); interest rate corridor narrowed.
  - 3-month money market (BUBOR) rate declined by about 80 basis points since July 2016.
  - Reserve requirement ratio halved to 1 percent in December 2016.
  - MLS supported SME lending; FGS expired in March 2017; 15 of the 17 participating banks exceeded MLS commitments as of February 2017.
- Credit, banking sector, and financial stability
  - Stock of gross loans to households declined by 2.5 percent during 2016; stock of gross loans to NFCs declined by 0.2 percent during 2016.
  - Lending to SMEs performed better, partly due to FGS and MLS.
  - Average capital ratio was 16.4 percent at end-2016.
  - NPL ratio declined from 11.7 percent at end-2015 to 7.4 percent at end-2016.
  - Banks reduced CRE NPL exposures by about HUF 500 billion (1.4 percent of GDP) since November 2014 till mid-2016.
- External position and reserves
  - Net IIP nearly halved to -65 percent of GDP by end-2016 from -119 percent of GDP in 2009.
  - Gross external debt declined to around 96 percent of GDP by end-2016 from close to 150 percent of GDP in 2009.
  - Gross external financing needs declined to about 18 percent of GDP.
  - International reserves declined to €24.4 billion at end-2016, down from €30.3 billion a year earlier; reserves-to-short-term debt ratio was 132.7 percent.
  - A three-year bilateral currency swap between the MNB and the People’s Bank of China of RMB 10 billion (about €1.4 billion) was renewed in September 2016.
  - Rating agencies upgraded Hungary to investment grade in 2016.
- Competitiveness
  - Staff considers the CA regression most informative but regards its estimated current account norm (a small deficit) as too low given vulnerabilities.
  - Real exchange rate broadly in line with fundamentals, but non-price indicators suggest competitiveness challenges: export market share has not kept pace with peers and FDI prospects are projected to remain below the pre-crisis average.

### Outlook and Risks
- Short-term projection
  - Growth projected to pick up to about 2.9 percent in 2017, driven mainly by a rebound in investment as EU funds absorption recovers and planned automotive projects proceed.
  - Private consumption to remain strong due to wage increases and tax cuts; fiscal relaxation and accommodative monetary policy will also support demand.
  - Labor market projected to remain tight, with further wage pressures.
  - Inflation expected to approach the upper boundary of MNB’s tolerance band by early 2018.
- Medium-term outlook and risk factors
  - Downside risks: normalization of U.S. and euro area monetary policy and tighter global financing conditions; euro area slowdown or higher trade barriers; increased state role and frequent policy changes; rising demand and housing scheme expansion inflating asset-prices; political pressure to increase spending.
  - Upside risks: stronger-than-expected U.S. and euro area growth boosting Hungarian growth and reducing financing costs.
- Authorities’ view
  - Authorities’ growth projections are higher—3.5–4.1 percent in the short term—based on stronger consumption and EU funds absorption plus corporate tax cuts.
  - Authorities consider 2016 reserve decline temporary and adequate overall; they highlighted ongoing reduction in external liabilities and sizable share of inter-company lending in external debt.
  - A committee chaired by the Minister for National Economy established to recommend measures to boost competitiveness.

### Policy Agenda (overview)
- Rebalance macroeconomic policy mix while emphasizing structural reforms to enhance potential growth and reduce vulnerabilities.
- Maintain current account surpluses over the medium term to reduce vulnerability to external shocks.
- Continue measures to strengthen Hungary’s external position and competitiveness.

---

### Fiscal Outlook and Recommendations

### Near-term fiscal projections and measures
- 2017 budget target: general government deficit of 2.4 percent of GDP.
- New measures announced in December 2016 (after adoption of the budget):
  - Employer social contributions reduced from 27 to 20 percent.
  - Corporate income tax rate reduced from 19 percent (and 10 percent for SMEs) to a 9 percent flat rate.
  - Previously planned reductions in the VAT rate for selected items.
  - Higher spending on compensation of employees and ambitious public investment programs.
- Staff projection with these measures:
  - Overall deficit: about 2.6 percent of GDP in 2017 and 2.5 percent in 2018.
  - Overall and primary structural balances would worsen significantly.
  - Debt-to-GDP ratio would barely decline over the medium term and would remain elevated at about 70 percent (DSA).

### Staff recommendation for debt and structural balance path
- Reduce the structural deficit by about 0.4 percentage points annually on average over the medium term.
  - Consistent with reaching authorities’ medium term target of a 1.5 percent structural deficit by 2019.
  - Would lead to reduction in public debt to about 60 percent of GDP by 2022.
  - Would help guard against contingent liabilities (Government guarantees amounted to around 9 percent of GDP at end-2015).

### Growth-friendly consolidation: revenue and expenditure focus
- Revenue measures suggested:
  - Broaden tax base by reducing exemptions and preferential regimes, including eliminating excise exemptions for fuel.
  - Phase out remaining sectoral taxes (offsetting revenue loss from other measures).
  - Consider introduction of a modern real estate tax over the medium term after careful preparation.
- Expenditure measures suggested:
  - Gradually reduce the wage bill, generalized subsidies, and spending on goods and services.
  - Implement public administration reform and use targeted/rolling expenditure reviews.
  - Better-target or eliminate regressive generalized subsidies (fuels and transportation) while protecting vulnerable groups via more efficient mechanisms.

### Fiscal impact of potential measures (2017–2022 average per year)
- Total: 0.4
- Revenue: -0.1
  - Phasing out of sectoral taxes: -0.3
  - Streamlining VAT rates: 0.1
  - Elimination of excise exemptions for fuel: 0.1
- Expenditure: 0.5
  - Reduction in wage bill: 0.2
  - Rationalization of spending on non-EU-related goods and services: 0.2

### Authorities' stance and staff response
- Authorities expect to meet their budget target, believe tax and social security reductions will raise incomes and growth and thereby tax revenue, and do not plan to reduce sectoral taxes (other than the bank levy).
- Authorities may use fiscal reserves to meet deficit target if revenue shortfall occurs.
- Staff prefers keeping fiscal reserves for unforeseen developments and recommends a contingency plan including staff-recommended measures.
- Staff considers a modern real estate tax viable but contingent on reforms like enhancing land registration and the cadaster.

---

### Monetary Policy and Financial Sector

### Monetary policy stance and outlook
- Need to keep stance under review due to underlying inflationary pressures and projected loosening of structural fiscal balance.
- Headline inflation 2.7 percent in March (2017); expected to overshoot slightly but stay within the upper band in early 2018.
- Bank lending expected to pick up in 2017 due to EU funds, higher incomes, and rising real estate prices.
- Speed of withdrawal of monetary stimulus should depend on fiscal stance.
- Unconventional instruments:
  - Liquidity swaps introduced to facilitate day-to-day liquidity management.
  - Decision to let FGS expire by end-March 2017 is welcomed.
  - MLS and EU-funded schemes support SMEs.
  - As deleveraging ends and new lending picks up, unconventional policies should be phased out.

### Financial sector assessment and macroprudential framework
- Banks on average liquid, well capitalized, and profitable; improved profitability in 2016 increased willingness to lend.
- Supervision and macroprudential measures:
  - Staff welcomes MNB’s intention to enhance supervisory practices and collateral evaluation guidelines.
  - Macroprudential rules and debt cap rules introduced; MNB developed new housing price indices and pricing models.
  - Systemic risk buffer set between zero and two percent of total domestic risk-weighted exposure value (individual bank basis).
  - Regulation to finance at least 15 percent of long-term household mortgage portfolio by long-term mortgage-backed securities.
  - DTI and LTV cap rules applied since 2015 at 80 and 50 percent respectively for HUF denominated mortgages (calibration depends on household income).
- Risks and prudence:
  - Balance sheets strengthened with reduced NPLs and FX mismatches, but vigilance needed given rising real estate prices and re-leverage cycle.
  - Operational costs of many Hungarian banks seen as relatively high; cooperative credit institution consolidation expected to continue in 2017.

---

### Structural Policies and Reforms

### Priority reforms and labor market
- Upgrade vocational training to match skills demand to address labor shortages.
- Modify public works schemes to improve participants’ skills/productivity and encourage transition to the primary labor market; authorities plan to reduce number of scheme participants and set limits.
- Boost activity rates, particularly for women, including through affordable childcare; authorities intend to increase number of childcare facilities.
- Government allocated HUF 50 billion for vocational training and cash disbursements for jobseekers.

### Competitiveness, business climate, and state involvement
- Hungary has lost ranking in competitiveness indicators; challenges include getting electricity, paying taxes, and starting a business.
- Perceived corruption and frequent regulatory changes impede business; address via enhanced transparency and predictability.
- National Competitiveness Board set up in March to identify impediments; chaired by the Minister for National Economy.

---

### Staff Appraisal — Key Findings and Recommendations
- Recent achievements: boosted growth and employment and reduced vulnerabilities, though risks remain relatively high.
- Recent performance: GDP growth temporarily slowed in 2016 to an estimated 2 percent, mainly due to a decline in investment from subdued absorption of EU funds.
- Remaining vulnerabilities: external and public debt levels and financing needs remain sizeable; competitiveness concerns in non-price indicators.
- Policy recommendations summary:
  - Pursue growth-friendly consolidation focused on improving expenditure quality and revenue composition while steadily improving the structural fiscal balance.
  - Reforms to reduce elevated wage bill as part of administrative reform, better target subsidies, and enhance revenue mobilization (reduce sectoral taxes, streamline VAT rates and exemptions for fuel and tobacco excises).
  - With consolidation, monetary policy could remain accommodative longer.
  - Advance structural reforms: address skills mismatches, strengthen training for public works participants, boost female labor force participation, improve business environment by addressing perceived corruption, enhance transparency and predictability, and streamline regulations.
- Monetary policy timing: current settings can be maintained in near term, but some removal of accommodation may be needed before end-2017 if inflationary pressures rise or fiscal policy is more stimulative than warranted.
- Consultation recommendation: hold the next Article IV consultation on the standard 12-month cycle.

---

### Box 1 — Macroeconomic Policy Mix Simulation (FSGM): Scenarios and Impacts
- Staff simulation recommends fiscal measures amounting to an average annual consolidation of about 0.4 percent of GDP over the medium term.
  - Short-term: temporary moderate negative impact on growth from fiscal tightening.
  - Offset: monetary policy can be more accommodative than baseline, partially offsetting negative growth impact; combined aggregate effect on growth would be very small.
  - Longer-term: substantial positive benefits—reduced fiscal deficit and public debt, stronger trade balance, higher output beyond horizon shown.
- Second simulation: fiscal and monetary package plus structural reforms (improving public works schemes, reforming public administration, reducing red tape).
  - Structural reforms would raise potential output and support growth short- and long-term.
  - Models indicate structural measures could improve the average annual growth rate by about ½ percentage point compared to the baseline.
  - Combination of lower deficit and higher growth would reduce public debt-to-GDP ratio by about 12 percentage points over the medium term.
- Illustrative point: participants in the public works scheme constitute about 5 percent of the labor force; shifting even only 10 percent of these participants annually to the primary labor market could substantially impact productivity and growth.

---

### Box 2 — External Sustainability and Competitiveness: Findings and Policy Implications

### Current account, assets, liabilities, and reserves
- Current account surplus increased in 2016 to an estimated 4.9 percent of GDP, from 3.4 percent in 2015 and 2.1 percent in 2014.
- Net IIP estimated at -65 percent of GDP in 2016; projected to improve to -27 percent by 2022.
- Gross external debt 96 percent of GDP in 2016; gross financing needs around 18 percent of GDP.
- Reserves at €24.4 billion as of March 2017; deemed broadly adequate and above the 100 percent of short-term debt benchmark.

### External position and competitiveness assessment
- External position broadly in line with medium-term fundamentals, though EBA approaches yield mixed REER signals (overvaluation of 8 to 29 percent in some approaches; ES approach suggests undervaluation by 11.5 percent).
- Non-price indicators: unit labor costs remain attractive but post-crisis compensation compression is unwinding; perceptions of investment climate weaker than some neighbors; labor shortages persist.
- FDI has declined in contribution; medium-term FDI inflows projected to remain below historical average.

### External Balance Assessment results (selected figures)
- CA norm (percent of GDP): -0.7
- CA - stabilizing NFA at 2015 level (percent of GDP): -2.5
- CA gap (percent of GDP): 5.2, 5.1
- Exchange rate gap (percent): -12.0, 28.8, 8.1, -11.5

### Policy recommendations drawn from the box
- Advance structural reforms to raise sustainable growth and competitiveness.
- Enhance business climate perceptions to attract and retain foreign investment.
- Accelerate absorption of EU funds to support public investment and growth.
- Limit state involvement in the economy and increase policy predictability.
- Adopt growth-friendly fiscal adjustment and update macroprudential tools where relevant.
- Roll back the housing support scheme to reduce real estate bubble risks, particularly in Budapest.
- Use FX intervention to smooth excessive exchange rate volatility; tighten monetary policy if market conditions warrant; implement fiscal reforms to reduce deficit and debt.

### Risk Assessment Matrix — selected risks and policy responses
- Significant further strengthening of the US dollar and/or higher rates (Relative Likelihood: High; Impact: High/Medium): policy response includes FX intervention, tightening monetary policy if needed, and fiscal reforms.
- Retreat from cross-border integration (Relative Likelihood: High; Impact: High/Medium): allow automatic stabilizers, keep monetary policy accommodative, and advance structural reforms.
- Continued expansion of the state’s role in the economy (Relative Likelihood: Medium; Impact: Medium): accelerate structural reforms, limit state involvement, increase predictability.
- Slower absorption of EU funds (Relative Likelihood: Low; Impact: High): accelerate absorption and promote private sector–led growth.
- Further fiscal relaxation and expansion of the housing scheme (Relative Likelihood: Medium; Impact: Medium): adopt growth-friendly fiscal adjustment; update macroprudential tools; roll back housing support scheme.

---

### Debt Sustainability Analysis (DSA) — Baseline, Projections, and Stress Tests

### Baseline debt dynamics and projections
- "The primary balance will contribute only very mildly to the debt dynamics over time."
- Contribution of the interest rate-growth differential expected to be more favorable, reflecting modest growth and relatively low effective interest rates, especially in 2017–19.
- Gross financing needs-to-GDP ratio forecast to decline to less than 20 percent of GDP by the end of the projection period.

### Public gross nominal debt (selected years, percent of GDP)
- 2014: 72.9
- 2015: 75.7
- 2016: 74.7
- 2017 (projection): 74
- 2018 (projection): 73
- 2019 (projection): 72
- 2020 (projection): 70
- 2021 (projection): 70

### Gross external debt baseline path (percent of GDP)
- 2016: 96.1
- 2017 (projection): 88.2
- 2018 (projection): 79.6
- 2019 (projection): 72.7
- 2020 (projection): 65.9
- 2021 (projection): 61.3
- 2022 (projection): 54.0

### DSA baseline assumptions (selected)
- Real GDP growth (percent): 2016: 3.1; 2017: 2.0; 2018: 2.9; 2019: 3.0; 2020: 2.6; 2021: 2.4; 2022: 2.2
- Inflation (GDP deflator, percent): 2016: 1.7; 2017: 1.0; 2018: 2.2; 2019: 2.6; 2020: 2.6; 2021: 2.6; 2022: 2.6
- Primary balance (percent of GDP, baseline): 2016: -0.2; 2017: -0.1; 2018: -0.1; 2019: -0.1; 2020: -0.2
- Effective interest rate (percent, baseline): 2016: 4.9; 2017: 4.3; 2018: 4.1; 2019: 4.0; 2020: 4.1; 2021: 4.5; 2022: 4.9

### Stress-test scenarios and sensitivity
- Macro-fiscal shock: simultaneous shocks to growth, interest rate, and primary balance would raise debt-to-GDP ratio to exceed 90 percent at the end of the projection horizon; financing needs about 25 percent of GDP.
- Growth shock: decline in growth by one standard deviation for 2016 and 2017 would raise debt-to-GDP to around 85 percent and financing needs to about 25 percent of GDP.
- Contingent liabilities shock: standardized shock of 10 percent of financial sector assets would push debt-to-GDP above 80 percent and financing needs above 20 percent of GDP.
- Fan charts: symmetric fan chart width estimated at around 25 percent of GDP; asymmetric chart skews upward reflecting downside risks.

### Vulnerabilities and mitigating factors
- Vulnerabilities:
  - External financing needs above upper risk-assessment early warning benchmark for emerging markets.
  - Sizeable share of foreign liabilities related to intra-company loans.
  - Public debt in foreign currency and public debt held by non-residents remain above lower risk benchmarks.
- Mitigating factors:
  - Debt now held predominantly by domestic financial institutions; non-resident component estimated around 20 percent of total debt.
  - Public sector deposits estimated around 5 percent of GDP providing a net-debt cushion.
- External debt sensitivities:
  - An adverse permanent current account shock of ½ standard deviation would add about 13 percentage points of GDP to external debt.
  - An adverse growth shock of ½ standard deviation would add about 7 percentage points of GDP to external debt.
  - A one-time real depreciation of 30 percent would add 12 percentage points of GDP to external debt.

---

### Annex: Response to Past Fund Policy Advice and Authorities' Statements
- Authorities implemented some IMF recommendations but deviated on others.
- Implemented/adopted actions:
  - General government balance performed above 2016 target and public debt ratio declined moderately; however, 2017 budget would worsen underlying structural balance.
  - MNB continued easing monetary policy in 2016 and adjusted unconventional instruments.
  - Governance of asset management company for commercial real estate improved; MARK set up and pricing methodology approved in 2016; MARK being sold with closing envisaged end-June.
  - Number of new regulations declined since 2013 but state role remains high.
  - Plans to increase childcare facilities, enhance vocational training, and reform public work program.
- Authorities (May 10, 2017) emphasized commitment to prudent fiscal policy, compliance with EU rules, and implementation of structural reforms; cited expectation to meet budget targets and use of fiscal reserves if needed.
- Authorities project unemployment to decline to 3.6 percent in 2018; Ministry projects real GDP growth at 4.1 percent for 2017 and 4.3 percent for 2018; government foresees public debt declining to 61.2 percent of GDP at end-2021 (from 74 percent currently).

*International Monetary Fund staff summary of "1. Real Sector" (extracted from the IMF consultation document).*

### 1. Real Sector _____________________________________________________________________________________  20

### 1. Real Sector

### Context
- Hungary achieved several consecutive years of high economic growth and debt reduction, but vulnerabilities remain.
- Growth since 2013 was supported by high utilization of EU funds, a favorable external environment (low interest rates and commodity prices and strong export growth), and accommodative monetary and fiscal policies.
- External and public debt levels and financing needs remain sizeable despite steady declines in recent years.
- Perceptions of Hungary’s business environment have worsened somewhat and parliamentary elections scheduled by Spring 2018 could increase pressure for more public spending and interventions in the economy.

### Background and Recent Developments
- 2016 growth and demand
  - Real GDP growth slowed to an estimated 2 percent in 2016, reflecting a sharp reduction in public investment due to low absorption of EU funds amid the shift to a new program period and somewhat slower export growth as major automotive manufacturers upgraded production lines.
  - Strong private sector consumption was supported by rapid employment growth, a falling unemployment rate, high wage growth, and tax reductions.
- Labor market and wages
  - Unemployment rate has stayed below 4½ percent since November 2016.
  - Even excluding Public Works Schemes (PWS), employment exceeds its pre-global financial crisis level.
  - Severe shortages reported for both skilled and unskilled labor.
  - Average earnings increased by about 10 percent at end-January 2017 (y-o-y).
- Inflation and asset prices
  - In March (2017), core and headline inflation reached 1.9 and 2.7 percent y-o-y, respectively (MNB target is 3 +/-1 percent).
  - Real estate prices grew by 15 percent country-wide and by 22.8 percent in the Budapest area (y-o-y in September 2016).
  - The Budapest stock market index (BUX) increased by 19.6 percent y-o-y at end-March 2017.
  - These developments point to upside risks to inflation.
- Fiscal outcomes
  - Government outperformed its 2016 fiscal target in some respects: improved collection of social security contributions and corporate income tax; lower interest and EU funds-related outlays.
  - Other expenditures increased, including the wage bill.
  - Staff estimates that the general government deficit widened to about 1.7 percent of GDP, up from 1.6 percent a year earlier.
  - The primary structural surplus is estimated to have declined from 2.2 to 1.4 percent of GDP.
- Monetary policy and liquidity management
  - The MNB base rate was lowered from 1.35 percent in March 2016 to 0.90 percent in May 2016 (in three steps), and the interest rate corridor was narrowed.
  - The 3-month money market (BUBOR) rate declined by about 80 basis points since July 2016.
  - The MNB stopped offering interest rate swaps (IRS) as part of the self-financing program in July 2016.
  - Effective Q4 2016, the MNB capped the amount of its key instrument for the base rate; the cap was cut further in Q1 and Q2 2017.
  - The MNB began offering liquidity swaps coinciding with the cap.
  - In December (2016), the reserve requirement ratio was halved to 1 percent.
  - The MNB continued to adjust unconventional instruments: Market-Based Lending Scheme (MLS) supported SME lending; Funding for Growth Scheme (FGS) introduced in 2013 expired in March 2017.
  - MLS: 15 of the 17 participating banks exceeded their commitments to lend to SMEs as of February 2017.
- Credit, banking sector, and financial stability
  - The recovery has remained credit-less since the global financial crisis: stock of gross loans to households declined by 2.5 percent during 2016; stock of gross loans to NFCs declined by 0.2 percent during 2016.
  - Lending to SMEs performed better, partly due to FGS and MLS.
  - Bank deposits increased persistently; banks increased placements in government securities and continued to deleverage.
  - New bank lending (transaction basis) has been picking up.
  - Average capital ratio was 16.4 percent at end-2016.
  - NPL ratio declined from 11.7 percent at end-2015 to 7.4 percent at end-2016.
  - Banks with large CRE NPLs will face a systemic risk capital charge effective July 2017; since its announcement in November 2014 till mid-2016 banks reduced these exposures by about HUF 500 billion (1.4 percent of GDP).
  - State involvement: MARK governance adjusted; privatization and state/EBRD purchases of bank stakes occurred in 2016.
- External position and reserves
  - Net IIP nearly halved to -65 percent of GDP by end-2016 from -119 percent of GDP in 2009.
  - Gross external debt declined to around 96 percent of GDP by end-2016 from close to 150 percent of GDP in 2009.
  - Gross external financing needs declined to about 18 percent of GDP.
  - External public debt remained about 40 percent of GDP.
  - International reserves declined to €24.4 billion at end-2016, down from €30.3 billion a year earlier.
  - Reserves-to-short-term debt ratio was 132.7 percent.
  - A three-year bilateral currency swap between the MNB and the People’s Bank of China of RMB 10 billion (about €1.4 billion) was renewed in September 2016.
  - Market sentiment improved and the three main rating agencies upgraded Hungary to investment grade in 2016.
- Competitiveness
  - Staff considers the current account regression most informative but regards its estimated current account norm (a small deficit) as too low given vulnerabilities.
  - Real exchange rate appears broadly in line with fundamentals, but non-price indicators suggest broader competitiveness challenges: export market share has not kept pace with peers and FDI prospects are projected to remain below the pre-crisis average.

### Outlook and Risks
- Short-term projection
  - Growth is projected to pick up to about 2.9 percent in 2017, driven mainly by a rebound in investment as EU funds absorption recovers and planned automotive projects proceed.
  - Private consumption will remain strong due to wage increases and tax cuts; fiscal relaxation and accommodative monetary policy will also support demand.
  - Labor market conditions are projected to remain tight, with further wage pressures.
  - These dynamics are expected to narrow the external current account surplus and raise inflation, which is forecast to approach the upper boundary of MNB’s tolerance band by early 2018.
- Medium-term outlook and risk factors
  - Downside risks: normalization of U.S. and euro area monetary policy and tighter global financing conditions could increase capital outflows and financing costs; a slowdown in the euro area or higher trade barriers would dampen exports; further increase of the state’s role and frequent policy changes could harm business confidence; rising demand and expansion of the housing scheme could inflate asset-prices; political pressure to increase spending would push inflation higher.
  - Upside risks: stronger-than-expected U.S. and euro area growth could boost Hungarian growth and reduce financing costs.
- Authorities’ view
  - The authorities’ growth projections are higher—3.5–4.1 percent in the short term—based on stronger consumption and EU funds absorption plus corporate tax cuts.
  - Authorities broadly agreed with staff on risks but highlighted additional upside risk from higher EU funds absorption.
  - Authorities consider 2016 reserve decline temporary and adequate overall; they highlighted the ongoing reduction in external liabilities and the sizable share of inter-company lending in external debt.
  - A committee chaired by the Minister for National Economy was established to recommend measures to boost competitiveness.

### Policy Agenda (overview as presented)
- Rebalancing the macroeconomic policy mix while emphasizing structural reforms is recommended to enhance potential growth and further reduce vulnerabilities.
- Maintain current account surpluses over the medium term to reduce vulnerability to external shocks.
- Continue measures to strengthen Hungary’s external position and competitiveness (committee to recommend measures chaired by the Minister for National Economy).

*International Monetary Fund staff summary of "1. Real Sector" (extracted from the IMF consultation document).*

### 16.      An expansionary fiscal stance is projected for 2017–18. The 2017 budget targets a

### 16.      An expansionary fiscal stance is projected for 2017–18. The 2017 budget targets a 

### Fiscal outlook and near-term projections
- 2017 budget target: general government deficit of 2.4 percent of GDP.
- New measures announced in December 2016 (after adoption of the budget):
  - Employer social contributions reduced from 27 to 20 percent.
  - Corporate income tax (CIT) rate reduced from 19 percent (and 10 percent for SMEs) to a 9 percent flat rate.
  - Previously planned reductions in the VAT rate for selected items.
  - Higher spending on compensation of employees and ambitious public investment programs.
- Staff projection with these measures:
  - Overall deficit: about 2.6 percent of GDP in 2017 and 2.5 percent in 2018.
  - Overall and primary structural balances would worsen significantly.
  - Debt-to-GDP ratio would barely decline over the medium term and would remain elevated at about 70 percent (DSA).

### Staff recommendation for debt and structural balance path
- Staff view: reduce the structural deficit by about 0.4 percentage points annually on average over the medium term.
- Consistency with targets:
  - Would be consistent with meeting the authorities’ medium term target of a 1.5 percent structural deficit by 2019.
  - Would lead to a reduction in public debt to about 60 percent of GDP by 2022.
  - Would help guard against contingent liabilities (Government guarantees amounted to around 9 percent of GDP at end-2015) and reduce vulnerabilities and financing costs, progressing toward the authorities’ strategic objective of debt at 50 percent of GDP.
- Rationale: virtual closure of the output gap limits short-term negative growth impact; monetary policy can remove accommodation more slowly; structural reforms would amplify benefits (faster external vulnerability reduction and higher potential growth).

### Growth-friendly consolidation: revenue and expenditure focus
- General approach: reorient public expenditure toward physical and human capital development; rationalize less productive current expenditures; enhance revenue mobilization by reducing exemptions and improving tax administration.
- Revenue measures suggested:
  - Broaden tax base by reducing exemptions and preferential regimes, including eliminating excise exemptions for fuel.
  - Phase out remaining sectoral taxes (offsetting revenue loss from other measures).
  - Consider eventual introduction of a modern real estate tax over the medium term after careful preparation.
- Expenditure measures suggested:
  - Gradually reduce the wage bill, generalized subsidies, and spending on goods and services.
  - Implement long-awaited public administration reform to accompany wage moderation; use targeted/rolling expenditure reviews to identify priorities.
  - Better-target or eliminate regressive generalized subsidies (fuels and transportation) while protecting vulnerable groups via more efficient mechanisms building on the current system of subsidized transportation tickets to students and pensioners.

### Fiscal impact of potential measures (2017–2022 average per year)
- Total 0.4
- Revenue -0.1
  - Phasing out of sectoral taxes -0.3
  - Streamlining VAT rates 0.1
  - Elimination of excise exemptions for fuel 0.1
- Expenditure 0.5
  - Reduction in wage bill 0.2
  - Rationalization of spending on non-EU-related goods and services 0.2

### Authorities' stance and staff response
- Authorities’ view:
  - They expect to meet their budget target and cite past over-performance.
  - They expect tax and social security reductions to raise incomes and growth and thereby tax revenue.
  - Given limited fiscal space, they do not plan to reduce sectoral taxes other than the bank levy.
  - They believe lower VAT rates improve tax compliance and support the poor.
  - In case of revenue shortfall from the December tax package, they plan to use fiscal reserves to meet the deficit target.
  - They emphasized commitment to national and European fiscal rules and gradual debt reduction while providing some fiscal stimulus.
  - On real estate tax: concerned about social impact and note local governments already collect property taxes.
- Staff view:
  - Prefer keeping fiscal reserves for unforeseen developments and recommend a contingency plan including elements from staff’s recommended measures.
  - Consider a modern real estate tax to have large potential with options for preferential treatment for primary residence; prerequisite reforms include enhancing land registration and the cadaster.

### Monetary policy
- Need to keep stance under review due to underlying inflationary pressures and projected loosening of structural fiscal balance.
- MNB actions and outlook:
  - Appropriately eased monetary policy during 2016.
  - Headline inflation 2.7 percent in March.
  - Inflation expected to overshoot slightly but stay within the upper band in early 2018.
  - Bank lending expected to pick up in 2017 due to EU structural and investment funds activity, higher incomes, and rising real estate prices.
  - Speed of withdrawal of monetary stimulus should depend on fiscal stance: a smaller-than-projected fiscal deficit would permit more gradual normalization.
- Unconventional instruments:
  - Introduction of liquidity swaps facilitated banks’ day-to-day liquidity management.
  - Decision to let the FGS expire by end-March 2017 is welcome.
  - SMEs supported by Market-Based Lending Scheme of the MNB and various EU-funded schemes.
  - As deleveraging ends and new lending picks up, usual monetary transmission mechanisms likely to be restored and unconventional policies should be gradually phased out.
- MNB perspective:
  - Estimates the output gap to be still slightly negative.
  - Believes labor shortages and wage pressures will stimulate investment in advanced technology and labor-capital substitution.
  - Considers inflation expectations poised and wage share in production costs still generally low.

### Financial sector assessment
- Banks: on average liquid, well capitalized, and profitable; improved profitability in 2016 increased willingness to lend.
- Supervision and macroprudential measures:
  - Staff welcomes MNB’s intention to enhance supervisory practices and collateral evaluation guidelines.
  - Macroprudential rules introduced/strengthened in recent years have been useful; debt cap rules introduced.
  - MNB developed new housing price indices and pricing models to monitor booming housing markets.
  - Decision to rely on external funding for potential MARK non-performing loan purchases is helpful; intent to sell MARK aligns with past staff advice.
  - MNB foundations have stopped buying government securities in the primary market and now purchase in the secondary market, in line with ECB recommendations.
- Risks and prudence:
  - Balance sheets strengthened with progress in reducing NPLs and FX mismatches, but vigilance needed given rising real estate prices and re-leverage cycle.
  - Macroprudential measures should focus on systemic risks; supply bottlenecks addressed via structural reforms.
  - Operational costs of many Hungarian banks seen as relatively high; consolidation among cooperative credit institutions expected to continue in 2017 and should be market determined.

### Structural policies and reforms
- Importance: advancing structural reforms is essential to boost productivity, support growth, and broaden its base; effective utilization of EU funds is key.
- Priority reforms:
  - Labor market policies:
    - Address labor shortages by upgrading vocational training to match skills demand.
    - Modify public works schemes to improve participants’ skills/productivity and encourage transition to the primary labor market; authorities plan to reduce the number of scheme participants.
    - Boost activity rates, particularly for women, including through affordable childcare; authorities intend to increase number of childcare facilities.
  - Competitiveness:
    - Hungary has lost ranking in competitiveness indicators; challenges include getting electricity, paying taxes, and starting a business.
    - Perceived corruption and frequent regulatory changes impede business; address these via enhanced transparency and policy predictability.
    - Authorities note frequency of new rules has decreased compared to crisis years.

### Staff appraisal (key findings)
- Recent achievements:
  - Boosted growth and employment and reduced vulnerabilities, though risks remain relatively high.
  - Pick-up in growth supported by high utilization of EU funds, favorable external environment, accommodative monetary and fiscal policies.
- Recent performance:
  - GDP growth temporarily slowed in 2016 to an estimated 2 percent, mainly due to a decline in investment from subdued absorption of EU funds.
- Remaining vulnerabilities:
  - External and public debt levels and financing needs remain sizeable and global risks appreciable.
  - External position broadly in line with fundamentals but non-price indicators show competitiveness concerns.
- Policy recommendations summary:
  - Fiscal policy should pursue growth-friendly consolidation focused on improving expenditure quality and revenue composition while steadily improving the structural fiscal balance.
  - Reforms should aim to gradually reduce elevated wage bill as part of administrative reform, better target subsidies, and enhance revenue mobilization (reduce sectoral taxes, streamline VAT rates and exemptions for fuel and tobacco excises).
  - With such consolidation, monetary policy could remain accommodative longer.
  - Advance structural reforms to boost productivity: address skills mismatches, strengthen training for public works participants, boost female labor force participation, improve business environment by addressing perceived corruption, enhance transparency and predictability, and streamline regulations.
- Monetary policy timing:
  - Current settings can be maintained in near term, but some removal of accommodation may be needed before end-2017 if inflationary pressures rise or fiscal policy is more stimulative than warranted.
- Consultation recommendation:
  - Hold the next Article IV consultation on the standard 12-month cycle.

### Box 1 — Macroeconomic policy mix simulation (FSGM) — scenarios and impacts
- Staff simulation: recommend fiscal measures amounting to an average annual consolidation of about 0.4 percent of GDP over the medium term.
  - Short-term: temporary moderate negative impact on growth from fiscal tightening.
  - Offset: allows monetary policy to be more accommodative than baseline, partially offsetting negative growth impact; combined aggregate effect on growth would be very small.
  - Longer-term: substantial positive benefits—reduced fiscal deficit and public debt, stronger trade balance, higher output beyond horizon shown.
- Second simulation: fiscal and monetary package plus structural reforms (improving public works schemes, reforming public administration, reducing red tape).
  - Structural reforms would raise potential output and support growth short- and long-term.
  - Models indicate structural measures could improve the average annual growth rate by about ½ percentage point compared to the baseline.
  - Combination of lower deficit and higher growth would reduce public debt-to-GDP ratio by about 12 percentage points over the medium term.
- Additional illustrative points:
  - Participants in the public works scheme constitute about 5 percent of the labor force; shifting even only 10 percent of these participants annually to the primary labor market could substantially impact productivity and growth.

*International Monetary Fund staff report excerpt.*

### Box 2. External Sustainability and Competitiveness 1/

### Box 2. External Sustainability and Competitiveness 1/

### Current account and trade balance
- The current account surplus continued to increase in 2016 to an estimated 4.9 percent of GDP, from 3.4 percent in 2015 and 2.1 percent in 2014, reflecting buoyant exports.
- The deficit on the primary income account, which includes repatriation of earnings by foreign companies, is estimated to have narrowed slightly in 2016.
- The current account surplus is expected to moderate over the medium term as import growth picks up due to increased consumption and investment.
- Staff believes that the CA approach is the most informative for Hungary, although its CA norm may be too low given Hungary’s still-elevated vulnerabilities, and constrained policy space amid heightened external risks.
- The CA regression has had difficulty fully explaining current account swings in some countries that have gone through boom/bust episodes; this may be the case for Hungary where the model has predicted a smaller current account balance since the crisis when it moved from deficit into surplus.

### Foreign assets, liabilities, and external indebtedness
- The net International Investment position (IIP) is estimated to have been -65 percent of GDP in 2016 and is projected to improve to -27 percent by 2022.
- Gross foreign liabilities fell by 55 percentage points of GDP since 2009, while gross foreign assets remained relatively steady.
- Slightly more than half of gross foreign liabilities is related to direct investment (a 9 percentage points increase from 2009).
- Around one-quarter of gross foreign liabilities reflects portfolio investment.
- The share of short-term liabilities declined three percentage points since 2009, to 7 percent.
- In 2016, external debt declined to 96 percent of GDP (and it is expected to trend lower in the coming years).
- Gross financing needs fell to around 18 percent of GDP.

### Reserve adequacy
- Reserves, at €24.4 billion as of March 2017, remain broadly adequate according to the Fund’s metric and maintain a comfortable cushion relative to the benchmark of 100 percent of short-term debt.
- Last year’s €6 billion decline in reserves largely reflected the reduction in the government’s net external borrowing, and banks’ redemption of MNB swap contracts related to the household FX loan conversion scheme.
- Both programs are reducing external exposures, although they put some downward pressure on reserves at a time when external risks are elevated.
- With the FX conversion scheme concluding this year, reserves are expected to increase and remain in the recommended ranges.

### External position and competitiveness assessment
- Hungary’s external position appears to be broadly in line with medium-term fundamentals.
- EBA yields mixed results:
  - The two Real Effective Exchange Rate (REER) approaches suggest an overvaluation of the exchange rate of 8 to 29 percent, but these approaches leave a large residual (up to 31 percent) that is not explained by the policy variables.
  - The External Sustainability (ES) approach suggests that the exchange rate may be undervalued by 11.5 percent; this is based on stabilizing Hungary’s net borrower position (NFA/GDP) at its recent level, which would be consistent with a medium-term current account deficit of 2.5 percent of GDP.
- Staff concludes Hungary’s external position is broadly in line with medium-term fundamentals, consistent with the assessment in the 2016 Article IV.

### Non-price competitiveness indicators and structural challenges
- Unit labor costs are still attractive relative to peers, although this largely reflects the post-crisis compression in compensation, which has started to unwind.
- Perceptions of Hungary’s investment climate (reflected in indicators like the World Bank’s Doing Business report and the World Economic Forum’s Global Competitive Index) are not as favorable as those for some neighbors.
- Unpredictability of policymaking has been cited as one challenge; authorities emphasize this perception is largely a legacy of the crisis-fighting period.
- Labor shortages, particularly skilled labor, are another key challenge.

### Growth, FDI, and policy implications
- Greater export diversification and steady and sustained FDI would be supportive of medium-term growth and efforts to reduce external vulnerabilities.
- While exports continue to increase relative to GDP, their share within the EU has not grown as rapidly as that of regional competitors.
- FDI played an important role in promoting exports, but its contribution has gradually declined.
- Medium-term FDI inflows are projected to remain below their historical average despite Hungary’s relatively favorable incremental capital-output ratio.
- Efforts to expand labor participation and the pool of skilled workers, including through better vocational training and affordable childcare, will be important to bolster competitiveness and further enhance Hungary’s appeal to foreign investors.

### External Balance Assessment Results (selected figures)
- CA norm (percent of GDP): -0.7
- CA - stabilizing NFA at 2015 level (percent of GDP): -2.5
- CA gap (percent of GDP): 5.2, 5.1
- Exchange rate gap (percent): -12.0, 28.8, 8.1, -11.5
- Source: 2016 External Balance Assessment (March 2017)

*1/ Prepared by Dora Douglass Kochman (SPR).*

### Box 2. External Sustainability and Competitiveness (concluded)

### Box 2. External Sustainability and Competitiveness (concluded)

### Key findings on external competitiveness and export performance
- Despite limited forint volatility, openness to trade and foreign investment, and relatively competitive labor costs, Hungary has experienced lagging growth in export share relative to peers.
- The concurrence of:
  - limited forint volatility;
  - openness to trade and FDI; and
  - relatively competitive labor costs
  has not translated into stronger export share growth versus peers.

### Trade openness and FDI (figures referenced)
- Trade openness and stock of inward FDI are presented as averages for 2010–2015 (percent of GDP).
- Note: Trade openness defined as total exports and imports as a share of GDP.

### Labor costs and productivity
- Real compensation per employee (2010 = 100) is tracked for Hungary and peers across 2010–2016, showing increases in compensation.
- Real labor productivity per employee (2010 = 100) is tracked for Hungary and peers across 2010–2016, showing relatively stagnant labor productivity for Hungary relative to compensation growth.

### Business climate and competitiveness indicators
- Current rankings in the WEF Global Competitiveness Index (among 138 countries) and the World Bank Doing Business Index (among 199 countries) indicate scope to enhance business climate perceptions.
- The weak alignment between business climate indicators and export performance is highlighted as a constraint on external competitiveness.

### Exchange rate and export dynamics
- Real Effective Exchange Rate (REER) (2007 = 100) dynamics are shown for Hungary and peers (Jan-07 to Jan-17).  
  - Footnote: 1) Increase indicates appreciation.
- Hungary’s share in intra-EU exports (2008Q1 = 100) is tracked through 2016, showing relative underperformance versus some peers.

### Policy recommendations and staff-advised responses (drawn from box and RAM)
- To address competitiveness and external sustainability:
  - Advance structural reforms to accelerate the transition toward a higher, sustainable growth path.
  - Enhance business climate perceptions to attract and retain foreign investment.
  - Accelerate absorption of EU funds to support public investment and growth.
  - Limit the state’s involvement in the economy and increase policy predictability to reduce resource misallocation and support private investment.
  - Adopt a growth-friendly fiscal adjustment strategy and, where relevant, update macroprudential tools.
  - Roll back the housing support scheme to reduce risks of a real estate bubble, particularly in Budapest.
- To address potential external shocks and market stress:
  - Use FX intervention to smooth excessive exchange rate volatility.
  - Tighten monetary policy if market conditions warrant (for instance, in response to reversal of capital flows).
  - Implement fiscal reforms to reduce the deficit and debt; revisit public debt strategy if stresses surface in the bond market.

### Risk Assessment Matrix — selected risks, likelihoods, impacts, and policy responses
- Significant further strengthening of the US dollar and/or higher rates (short-term)
  - Relative Likelihood: High
  - Impact if Realized: High/Medium — possible non-resident sell-off of HUF securities, capital outflows, higher borrowing costs; stronger US dollar could enhance competitiveness.
  - Policy response: FX intervention to smooth volatility; tighten monetary policy if needed; implement fiscal reforms; revisit public debt strategy if bond market stress emerges.
- Retreat from cross-border integration (short to medium term)
  - Relative Likelihood: High
  - Impact if Realized: High/Medium — rising trade barriers, decline in policy coordination, weighing on activity through trade and confidence.
  - Policy response: If near-term growth slows sharply, allow automatic stabilizers, keep monetary policy accommodative or ease further, and advance structural reforms.
- Structurally weak growth in key advanced and emerging economies (medium-term)
  - Relative Likelihood: High/Medium
  - Impact if Realized: Medium — weaker external demand would weigh on Hungary’s exports and growth.
  - Policy response: Advance structural reforms to raise sustainable growth.
- Continued expansion of the state’s role in the economy (short/medium term)
  - Relative Likelihood: Medium
  - Impact if Realized: Medium — increased policy uncertainty, resource misallocation, lower potential growth, reduced FDI and credit growth.
  - Policy response: Accelerate structural reforms, limit state involvement, increase policy predictability.
- Slower absorption of EU funds
  - Relative Likelihood: Low
  - Impact if Realized: High — lower public investment and negative effects on growth.
  - Policy response: Accelerate absorption and allow structural reforms to promote private sector–led growth.
- Further fiscal relaxation and expansion of the housing scheme (short/medium term)
  - Relative Likelihood: Medium
  - Impact if Realized: Medium — worsening debt sustainability and increased risk of a real estate bubble.
  - Policy response: Adopt growth-friendly fiscal adjustment; update macroprudential tools; roll back housing support scheme.

*Sources: Eurostat; European Commission; Direction of Trade; World Economic Outlook; Hungarian Statistical Office; MNB; UNCTAD; WEF Global Competitiveness Report (2016/17); World Bank; Doing Business Report (2017); and IMF staff calculations.*

### Annex I. Response to Past Fund Policy Advice

### Annex I. Response to Past Fund Policy Advice

### Summary
- The authorities have actively engaged in a policy dialogue with the Fund and implemented a number of its recommendations, but some policies deviated from previous IMF advice.

### Key recommendations and implemented policies
- Implement a growth-friendly fiscal consolidation to help build policy space, reduce fiscal risks, and firmly place public debt on a declining path.
  - The general government balance performed above its 2016 target and the public debt ratio declined moderately. However, the 2017 budget would result in a deterioration in the underlying structural balance rather than an improvement as recommended by staff.
- Adopt a cautious monetary easing if downside risks to inflation and growth materialize, unless external financing conditions worsen unexpectedly.
  - The MNB continued to ease monetary policy in 2016 and adjust its unconventional monetary policy instruments.
- Strengthen the governance structure of the asset management company for commercial real estate and keep its operations fully transparent.
  - The authorities have improved the governance structure of the asset management company for commercial real estate, broadly in line with past staff advice as well as technical assistance recommendations.
- Limit state involvement in the economy.
  - The number of new regulations and laws has declined substantially since 2013. However, the changes are still frequent and the role of the state in the economy remains high.
- Reduce the regulatory burden, enhance policy predictability. Address weaknesses in the labor market, promote innovation and entrepreneurship, and increase the efficiency of EU funds utilization to boost competitiveness.
  - The government is putting in place plans to increase child-care facilities to boost female labor force participation. In addition, the government announced plans to enhance vocational training and encourage participants in the public works scheme to move to the primary labor market. A committee led by the Minister for National Economy has been established to recommend reforms to boost competitiveness.

*Annex I. Response to Past Fund Policy Advice — cr17123*

### 2021. Under the baseline scenario, the primary balance will contribute only very mildly to the

### cr17123 - 2021. Under the baseline scenario, the primary balance will contribute only very mildly to the

### Baseline debt dynamics and projections
- Under the baseline scenario, "the primary balance will contribute only very mildly to the debt dynamics over time."
- "The contribution of the interest rate-growth differential will be more favorable, reflecting modest growth and still relatively low effective interest rates, especially in 2017–19."
- "The gross financing needs-to-GDP ratio is forecast to decline to less than 20 percent of GDP by the end of the projection period."
- Public gross nominal debt (selected years, in percent of GDP, as shown in DSA table):
  - 2014: 72.9
  - 2015: 75.7
  - 2016: 74.7
  - 2017 (projection): 74
  - 2018 (projection): 73
  - 2019 (projection): 72
  - 2020 (projection): 70
  - 2021 (projection): 70
- Public gross financing needs (selected values in percent of GDP from DSA baseline table): 2014: 22.7; 2015: 21.3; 2016: 20.9; 2017: 17.1; 2018: 13.2; 2019: 0 (table formatting indicates projections and cumulative values).

### Stress-test scenarios and sensitivity
- The debt and financing needs projections are "particularly sensitive to combined macro-fiscal, growth, and contingent liabilities shocks":
  - Macro-fiscal shock: "If shocks to growth, interest rate, and primary balance occurred simultaneously, the debt-to-GDP ratio would exceed 90 percent at the end of the projection horizon. Financing needs would in this case reach about 25 percent of GDP."
  - Growth shock: "Assuming a decline in growth by one standard deviation for 2016 and 2017, the debt-to-GDP ratio is forecast to reach around 85 percent, and financing needs around 25 percent of GDP by the end of the projection period."
  - Contingent liabilities shock: "A standardized shock of 10 percent of financial sector assets ... In such a scenario, the debt-to-GDP ratio would exceed 80 percent at the end of the projection horizon and financing needs would exceed 20 percent of GDP."
- Fan charts and uncertainty:
  - "The width of the symmetric fan chart, estimated at around 25 percent of GDP, illustrates the degree of uncertainty for equal-probability upside and downside shocks."
  - Asymmetric fan chart: "Upside shocks to growth and primary balance are constrained to zero in the asymmetric fan chart, resulting in an upward-sloping debt path. This reflects a balance of risks skewed to the downside."

### Hungary-specific debt profile vulnerabilities and mitigating factors
- Vulnerabilities:
  - "External financing needs are above the upper risk-assessment early warning benchmark for emerging market countries."
  - "A sizeable share of foreign liabilities accounts for intra-company loans."
  - "Public debt in foreign currency and public debt held by non-residents have declined considerably in recent years, they are still above the lower risk assessment early warning benchmark."
  - These facts "suggest some non-negligible risks in case of pressures on the exchange rate and foreign exchange reserves."
- Mitigating factors:
  - Investor base: "Debt is now held predominantly by domestic financial institutions, with the non-resident component decreasing and estimated at around 20 percent of total debt."
  - Buffers: "Deposits accumulated by the public sector ... are estimated around 5 percent of GDP. This implies a lower public debt-to-GDP ratio on a net basis and some liquidity cushion that could help cover financing needs for a few months."

### External debt developments and vulnerabilities
- Gross external debt developments:
  - "Gross external debt has declined from its peak of 149 percent of GDP in 2009 to about 96 percent by end-2016."
  - "Inter-company loans related to FDI ... amount to about 28 percent of gross external debt."
- Projections and drivers:
  - External debt is expected "to continue to decline, reflecting ongoing implementation of the MNB’s self-financing program, as well as continued current account surpluses and non-debt creating capital inflows over the medium term."
- Sensitivities:
  - "External debt is particularly vulnerable to a current account shock or a real depreciation and, to a lesser extent, a growth shock."
  - Quantified impacts:
    - "An adverse permanent current account (growth) shock of ½ standard deviation of their historical variation would add about 13 (7) percentage points of GDP to external debt."
    - "A one-time real depreciation of 30 percent would add 12 percentage points of GDP to external debt."
- Gross external debt baseline path (selected baseline row from Table 1, in percent of GDP):
  - 2016: 96.1
  - 2017 (projection): 88.2
  - 2018 (projection): 79.6
  - 2019 (projection): 72.7
  - 2020 (projection): 65.9
  - 2021 (projection): 61.3
  - 2022 (projection): 54.0

### DSA baseline assumptions (selected)
- Real GDP growth (baseline projections, in percent): 2016: 3.1; 2017: 2.0; 2018: 2.9; 2019: 3.0; 2020: 2.6; 2021: 2.4; 2022: 2.2
- Inflation (GDP deflator, in percent): 2016: 1.7; 2017: 1.0; 2018: 2.2; 2019: 2.6; 2020: 2.6; 2021: 2.6; 2022: 2.6
- Primary balance (baseline, in percent of GDP): 2016: -0.2; 2017: -0.1; 2018: -0.1; 2019: -0.1; 2020: -0.2 (table presents varying rows; specific scenario tables also show Primary Balance 2016: 1.4 in alternative rows)
- Effective interest rate (in percent, baseline): 2016: 4.9; 2017: 4.3; 2018: 4.1; 2019: 4.0; 2020: 4.1; 2021: 4.5; 2022: 4.9 (DSA table entries vary by scenario; preserve shown figures)

### Policy-relevant observations and staff/authority notes
- Authorities’ views:
  - Emphasized "the importance of mitigating factors to debt sustainability risks," including "an increasing role of retail investors as public debt holders" and the role of "inter-company loans" in external financing needs.
  - Noted "recent pension reforms" that "ensure" long-term public debt sustainability (not captured by the DSA framework).
- Data and institutional recommendations from staff:
  - "It is critical to avoid undue changes to the MNB’s legal framework and to ensure that the law continues to support MNB’s operational and legal independence."
  - On statistics: "Data provision is adequate for surveillance" but "needs to be improved further" — specifically, monthly cash-basis central government accounts "do not reflect the GFS presentation and provide no information on financing" and automatic provision of arrears, local government, and state-owned enterprise financials would "facilitate the monitoring of obligations on an accrual basis."
- Other operational notes:
  - Public sector deposits are "estimated around 5 percent of GDP" providing a net-debt cushion.
  - Non-resident share of public debt is "estimated at around 20 percent of total debt."

*Italic: IMF staff report extract (Hungary), informational annex and Public DSA tables and figures as provided.*

### 1. The preliminary 2016 general government deficit has been revised slightly from 1.7

### 1. The preliminary 2016 general government deficit has been revised slightly from 1.7

### Macroeconomic developments
- The preliminary 2016 general government deficit has been revised from 1.7 percent of GDP to 1.8 percent of GDP.
- Unemployment is reported at 4.5 percent for end-March 2017.
- The Ministry for National Economy projects unemployment to decline to 3.6 percent in 2018.
- The Ministry for National Economy projects real GDP growth at 4.1 percent for 2017 and 4.3 percent for 2018.
- The authorities estimate growth in 2016 at 2 percent of GDP and project growth to be between 3.6 and 4.3 percent in 2017 owing to higher EU funds inflow and absorption and continuing recovery of consumption.
- The authorities project the current account surplus to decline by 1.8 percentage points to around 3.7 percent of GDP in 2017.
- Participation rate reached 70.1 percent in 2016.

### Fiscal outlook and government stance
- The draft 2018 budget envisages a general government deficit of 2.4 percent of GDP, slightly narrower than staff’s projection of 2.5 percent of GDP.
- The Hungarian Fiscal Council approved the 2018 budget on April 27.
- The 2018 budget was submitted to the Parliament on May 2, 2017.
- The government foresees public debt declining to 61.2 percent of GDP at the end of 2021 (from 74 percent of GDP currently, having decreased from 81 percent in 2011).
- The government is committed to achieve its 2.4 deficit target for 2018 notwithstanding the general elections in 2018.
- The government allocated HUF 50 billion for vocational training and other cash disbursements for those who seek jobs in the private market.

### Inflation, monetary policy, and central bank measures
- Headline inflation retreated to 2.7 percent in March, from 2.9 percent in February.
- The MNB forecasts inflation to 2.4 - 2.5 in mid-2017.
- The MNB projects reaching its inflation target of 3 percent sustainably by the first half of 2018.
- The central bank keeps monetary conditions loose until the underlying inflation becomes stable.
- The cost effect of dynamic wage increases will be partially offset by the reduction in the social contribution tax and the lower corporate income tax.

### Credit, non-performing loans (NPLs), and central bank programs
- The MNB’s Funding for Growth Scheme (FGS) facilitated financing for almost 40,000 micro, small- and medium-sized enterprises.
- The FGS contributed substantially to the 12 percent SME credit growth in 2016.
- The FGS has been phased out at the end of March; transition supported by the Market-Based Lending Scheme (MLS).
- Market-based new lending in Q4 2016 for non-financial corporates turned into positive territory after almost 8 years.
- When MARK started to operate in 2015, more than one fifth of the outstanding corporate loans were non-performing, while almost half of the commercial real estate loans were in default.
- At the end of 2016, corporate NPL and commercial real estate NPL ratios came down to 11 and 24 percent respectively.
- MARK is being sold with closing of the ongoing sale envisaged at end-June.
- MARK was set up with the support of IMF technical assistance and received the European Commission’s approval for its pricing methodology in 2016.

### Macroprudential and banking sector measures
- The MNB announced a systemic risk buffer requirement for banks set between zero and two percent of the total domestic risk-weighted exposure value, determined on an individual bank-by-bank basis.
- A regulation instructs banks to finance at least 15 percent of their long-term household mortgage portfolio by long-term mortgage-backed securities.
- Debt-to-income (DTI) and loan-to-value (LTV) cap rules have been applied since the beginning of 2015, at 80 and 50 percent respectively in case of a HUF denominated mortgage loan for an average income household, with calibration dependent on household income level.
- The MNB has the authority and stands ready to adjust the calibration based on credit growth developments.

### Structural reforms, competitiveness, and labor market measures
- A National Competitiveness Board was set up in March to identify impediments to economic growth and their quick resolution; chaired by the Minister for National Economy and includes private sector, chamber of commerce and academia representatives.
- Several regulatory reforms to improve Hungary’s Doing Business indicators have been formulated; some are already underway (example: reducing the number of days to get connected to the electricity network).
- The Committee will work on further reforms that might include inter alia education, raising female labor participation and increasing R&D.
- The government is reforming the public work program (PWS): a limit has been set to the number of participants and workers with certain skills are not eligible to participate any longer.
- Most of the 200,000 participants in the PWS are very low-skilled; government estimates around 30 percent have sufficient skills to get employment in the private sector.
- The general minimum wage and the guaranteed minimum wage for vocational professions increased by 15 and 25 percent respectively last year; remuneration for those participating in the PWS increased by 3 percent.
- Hungarian companies are recruiting workforce from the region; wage increases could attract some of the approximately 300,000 Hungarians who work in other EU countries.

### Policy assessments and commitments
- Authorities broadly agree with staff’s assessment and appreciate the policy dialogue and recommendations.
- Authorities concur that some unconventional measures should be phased out gradually and structural reforms implemented to foster potential growth.
- Authorities note steps already taken: extra levy on the banking sector was halved and is on a downward path; the MNB is selling MARK; the MNB stopped providing conditional financing to banks for SME lending under the Funding for Growth Scheme; improving competitiveness is high on the government’s agenda.
- The government is strongly committed to implement prudent fiscal policy to achieve fiscal consolidation and comply with EU fiscal rules.

*Statement by Michaela Erbenova, Executive Director for Hungary and Bertalan Varga, Senior Advisor to Executive Director, May 10, 2017*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17123.pdf_