## 1. Europe and Hungary: GDP Growth and Bank Credit to the Private sector

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### A. Introduction and high-level conclusions
- Reviews relationship between real GDP growth and domestic bank lending to the private sector in Hungary after the GFC, using cross-country analysis of European countries.
- Key conclusions:
  - Both credit demand and supply were adversely affected by the GFC.
  - Key factors influencing credit developments: loan quality, deposit funding, and bank capital, as well as the macroeconomic environment.
  - Lending by Hungarian banks to the private sector seems to be finally beginning to pick up.

### B. Pre- and post-GFC context and recovery timing
- Pre-GFC drivers:
  - Rapid economic and domestic bank credit growth across many European and CESEE countries driven by convergence expectations, EU membership prospects, FDI, and substantial inflows of EU funds.
  - Domestic bank lending often channeled into real estate and boosted by banks’ easy access to foreign funding.
- Post-GFC outcomes:
  - CESEE countries as a group required five years on average to return to pre-GFC real GDP per capita; Hungary required six years.
  - Domestic bank lending in Hungary only began to recover despite low nominal interest rates.
  - Hungary’s recession was deeper due to exposure to the European sovereign debt crisis and high public debt; Hungary caught up with peers in 2015.
  - Private consumption per capita declined more in Hungary than in peers; investment per capita outperformed CESEE average, supported by FDIs and EU structural and cohesion funds (absorption accelerated toward end-2015).

### C. Credit recovery specifics and counterfactuals
- Lending to the private sector by Hungarian banks remained more subdued than in other CESEE countries and worse than in countries recovering from a financial crisis.
- Contributing adverse factors:
  - Rapid increase in NPLs; disputes and court cases between banks and household clients; global discussions about tighter prudential regulation; resolution of MKB bank (initiated December 2014, finalized mid-2016).
  - Some banks faced challenges accessing global markets prompting an IMF arrangement in November 2008 (expired October 2010).
- Counterfactual controlling for external demand:
  - Rescaled external demand to reflect European post-GFC external demand: under this counterfactual Hungarian real GDP growth per capita recovered faster than other CESEE countries and better than the typical recovery after a non-financial recession.
  - Private consumption per capita performed better than peers and mostly within the confidence interval of a normal recovery.
  - Investment still outperformed peers.
  - Domestic bank lending remained subdued under the counterfactual.

### D. Implications
- Subdued domestic bank lending had less impact on growth because large reputable companies—particularly foreign subsidiaries and Hungarian-owned companies—financed themselves abroad.
- Mitigating factors for growth despite subdued credit: FDIs, integration into regional supply chains (notably Hungary’s linkages to the German supply chain), and accelerated absorption of EU funds.

---

### 2. Cross-country bank-level analysis and key correlates of credit growth

### Data and methodology
- Bank-level cross-country panel (1999–2015) with up to almost 8,000 banks across 37 countries plus Hungary; system GMM estimations.
- Annual macro data from WEO; individual bank data from FitchConnect. Unconsolidated balance sheets used when available.

### Main correlates of credit growth (Europe-wide, standardized one-standard-deviation effects)
- NPL ratio: negative effect on credit growth (important).
- Customer deposits (flows/assets): positive effect (important).
- Bank equity price index: positive effect.
- Regulatory capital ratio: negative effect (noted in regressions).
- Real GDP growth: positive and significant (proxying demand and debt-servicing ability).
- Inflation: positive although insignificant.
- Interaction terms included (e.g., regulatory capital*recession D, bank equity index*recession D, NPL ratio*recovery D, deposit flow/assets*recovery D).

### Interpretation for CESEE and Hungary
- Presence of large foreign-owned banks in many CESEE countries may explain why regulatory capital and funding seemed less crucial for credit growth in these countries.
- Hungary: insufficient observations for a country-specific regression; Hungarian banks’ real credit growth lies within the model’s confidence interval but is moderately lower than peers after the GFC.

### Empirical magnitudes (Europe-wide)
- For 39 European countries (1999–2015), a 10 percent increase in domestic bank credit to the private sector correlates with real GDP increasing by about 0.6-0.7 percent.
- A 10 percent credit growth raises investment by 2 percent.
- The credit impulse influenced GDP growth strongly and significantly during post-GFC recessions and recoveries.

---

### 3. NPLs, bank funding, capital, and policy implications

### NPLs and bank lending: cross-country findings
- NPL ratio was significant and negatively correlated with credit growth, but its impact diminished during the recovery (NPL coefficient much less negative during recoveries).
- Mechanisms linking NPLs to reduced lending:
  - Change in risk perception and more conservative credit policies.
  - Provisions absorb profits and perhaps even equity, hampering lending capacity.
  - Adverse effects on funding costs, collateral evaluation concerns, adverse market sentiment, and managerial focus on NPLs instead of new business.
- Empirical note: if NPLs are appropriately and timely priced and provisioned, the NPL ratio should in principle not affect new lending.

### Policy recommendations on NPLs
- Timely provisions of NPLs is critical to not restrain future credit growth, including prudent conservative evaluation of collateral.
- A credible strategy to resolve the stock of NPLs is important to remove real or perceived lingering uncertainties.
- Strengthen the debt recovery framework by making it more timely, efficient, predictable, and less costly for both borrowers and lenders to reduce risk premia and perceived risks.

### Hungarian experience and policy actions
- Trend reversal:
  - NPL ratio trend in Hungary has been successfully reversed since 2014; new lending reportedly has very low NPL ratios.
  - During 2016, NPL ratios of both households and non-financial corporations declined, and shares of un-provisioned loans also declined.
- Selected measures and facts:
  - Conversion of FX denominated loans during 2015 reduced uncertainty for many borrowers.
  - Personal Bankruptcy Law: effective September 2015 for mortgages and October 2016 for all household loans; about 650 cases were in process at end-February 2017.
  - In 2014, the MNB established an asset management company for non-performing project loans to commercial real estate (MARK); it has been sold to the private sector (transaction expected to be finalized in June 2017).
  - Effective July 1, 2017, a special capital charge (systemic risk buffer) will be applied to banks with an extraordinary large share of non-performing commercial real estate loans.
  - Numerous legal and prudential initiatives strengthened debt recovery frameworks and encouraged out-of-court settlements.
- Result: banks cleaned up NPL portfolios by selling or writing off loans; real estate prices improved substantially since 2014, permitting revoking provisions and boosting bank profitability in 2016.

### Deposits, capital, and funding
- Customer deposits support lending: deposit variable significant with positive sign in cross-country analysis, though smaller during recessions.
- Less dependence on volatile wholesale funding reduces vulnerabilities.
- Hungary specifics:
  - Deposit growth of households and non-financial companies decelerated after the GFC, with new lending less than amortizations.
  - Loan-to-deposit ratio of firms and households declined from 140 at end-2008 to 83 percent at end-2016.
  - Bank regulatory capital (as percent of total assets) associated with negative bank lending in cross-country analysis, especially during recessions.
  - Hungarian banks increased capital adequacy ratios since the GFC largely by reducing risk-weighted assets.

---

### 4. Hungary-specific credit dynamics, alternative funding, and recent lending developments

### Creditless recovery and alternative funding sources
- Hungary experienced a creditless recovery; large non-financial manufacturing companies often accessed foreign or intra-group financing.
- EU funds, including generous advance payments and grants, may have eased dependence on domestic bank credit.
- Funding for Growth Scheme (FGS):
  - Introduced in 2013: MNB provided inexpensive liquidity to banks to on-lend to SMEs with an interest cap.
  - MNB let the FGS expire at end-March 2016.
  - Market-Based Lending Scheme introduced January 2016 offers incentives to banks that commit to increase lending to micro companies and SMEs.
  - At end-March 2017, nearly 40,000 micro and SMEs had received loans during various phases of the FGS.
- EIB survey (Hungary, July–October 2016, 476 companies):
  - Bank financing was the most important external financing for investments, but the share of Hungarian firms relying on internal financing was higher than EU average.
  - Share of surveyed Hungarian companies reporting being finance-constrained: 13 percent on average, 17 percent for SMEs, compared with EU average 5 percent.

### Balance sheet recession and net financial assets
- Households and non-financial companies reduced debt and built up savings after the GFC (balance sheet recession).
- Net-financial assets of households:
  - Declined to about 41 percent of GDP in 2008.
  - Increased to almost 87 percent of GDP (estimated, Q3 2016).
- Net-financial assets of non-financial companies declined around the GFC and sovereign debt crisis but improved thereafter.

### Recent lending developments and measurement notes
- Both credit demand and supply contracted immediately after the GFC and sovereign debt crisis and have only gradually recovered.
- Measurement caveats: change in stock of credit deflated by CPI inflation can be misleading because it does not consider amortization flows, sales of NPLs to non-banks, write-offs, closure of banks, or exchange rate effects.
- Transaction-based bank credit growth (adjusted for exchange rate changes) shows a pickup in new lending in recent months, particularly to non-financial companies and also to households.
- Anecdotal reports: reduced vulnerabilities and debt levels, and improved macroeconomic prospects underpin expectations many banks will increase lending during 2017.

---

### 5. Grey economy, VAT mobilization, and taxation measures

### Grey economy: size, determinants, and impacts
- Definition: legal activities performed outside reach of legal authorities (undeclared work and underreporting).
- Estimated grey economy in Hungary: about 22 percent of GDP (Schneider, 2015); EU average 18 percent of GDP (Schneider, 2015).
- Main determinants: high tax and social security contribution burdens, poor quality of public institutions, excessive regulation, low tax morale, low penalties/probability of getting caught, lack of financial development and prevalence of cash transactions.
- Impacts: forgone revenue, negative effects on access to credit, lower quality output and working conditions, distortions in statistical data.

### VAT context and tax administration reforms
- VAT revenue amounts to almost 10 percent of GDP in Hungary.
- Standard VAT rate: 27 percent.
- Effective rate lower due to reduced rates for selected items; "The items subject to reduced rates were increased in 2016 and 2017."
- Key tax administration reforms and measures:
  - Creation of the National Tax and Customs Administration (NTCA) in 2011.
  - Strengthening of the General Criminal Directorate.
  - Enhanced tax registration procedure introduced in 2012: around 90 percent of registrations identified as having no impediments; around 5 percent denied; around 5 percent resulted in deregistration (NTCA, 2017).
  - Online cash registers implemented (around 250 thousand connected by end of 2016).
  - Electronic Trade and Transport Control System (EKAER) introduced in 2015: since 2015 more than 60 thousand taxpayers and around 6.5 thousand transporters registered on EKAER, accounting for more than 60 percent of domestic registrations (NTCA, 2017).
  - Other measures: reduced threshold for itemized VAT in 2015, increased VAT returns reporting frequency for newly established taxpayers, reporting VAT declaration quarterly if sales exceed a threshold.

### VAT outcomes and fiscal simulations
- VAT collection:
  - Increased from 8.9 percent of GDP in 2013 to 9.7 percent of GDP in 2015.
  - Footnote: "VAT is estimated to have slightly reversed to around 9.5 percent in 2016, which can be attributed to lower absorption of the EU funds and the introduction of reduced rates on selected items."
  - Increase in VAT collection exceeded the estimated increase of the tax base, implying improved compliance was the main driver.
- VAT gap dynamics:
  - European Commission (2016): VAT gap stable at around 22 percent of the theoretical liability between 2010 and 2013; shrank by 4 percentage points in 2014, and most likely shrunk further in 2015 (MfNE, 2016).
  - Current VAT gap estimated at above 15 percent, higher than the 10 percent EU average but lower than many regional peers.
- Staff simulation: gradual elimination of the VAT compliance gap over next five years would:
  - Strengthen primary balance from around 0 percent to around 2 percent of GDP.
  - Improve overall balance from around -2.5 percent to almost a balanced budget.
  - Reduce public debt to around 62 percent of GDP.

### Conclusions on tax compliance and the grey economy
- Improving tax compliance is key to shifting segments of the grey economy into the formal sector.
- The grey economy in Hungary has been shrinking and is at par with peers, but remains sizeable.
- The comprehensive post-crisis strategy to improve tax compliance has yielded sizeable gains; VAT collection improved with implementation of online cash registers (introduced 2014, expanded 2015) and EKAER (2015).

---

### 6. Public Works Schemes (PWS): scale, fiscal implications, and recommendations

### Scale, costs, and participant profile
- 2016 figures:
  - PWS employed about 223,000 workers (5.0 percent of the labor force).
  - Cost of PWS amounted to HUF 340 billion in 2016 (1 percent of GDP).
  - PWS constituted 70 percent of the cost for all active labor market measures.
  - Fiscal cost per participant (annual) ranged from 788.8 thousand HUF to 1559.6 thousand HUF during 2011–2016 (source tables).
- Participant characteristics:
  - Around 83 percent of PWS workers have low or no professional skills.
  - Average monthly PWS wage about €160—less than the minimum wage but above the welfare entitlement.
  - Initial 12-month contract can be extended by an additional 6-month contract with same public employer; workers may remain in PWS for years.

### Outcomes and transitions
- Transition statistics:
  - 11-13 percent of PWS workers exit every year and get a regular work contract.
  - About a quarter of PWS workers receive some form of training.
  - Some studies found continuous participation reduces odds of finding primary market work.
- Fiscal and social protection trade-offs:
  - PWS workers contribute to state pay-as-you-go pension at same rate as regular workers, but contributions based on lower incomes imply potential future pension liabilities.
  - In absence of PWS, estimated fiscal cost of offering social support to these participants would be about 1.2 percent of GDP (estimate noted).

### Policy challenges and recent adjustments
- Challenges:
  - Labor market distortions and misallocation; potential to discourage human capital formation and reinforce polarization.
  - Upward wage pressures: removing 5 percent of labor force from bottom pay scale could add wage pressure.
  - Management and governance risks: misallocation of participants into redundant programs; unclear relevance for return to primary job market.
  - Long-term fiscal liabilities if pension funding gaps are not addressed.
- Recent policy moves:
  - Authorities plan to gradually reduce participants to 150,000 (about 3.4 percent of labor force) by 2020.
  - Limit total participation period to 12 months.
  - January 2016: new allowance for active job searching; fostered workers moving to private sector continue to receive allowance for remaining term of PWS contract.
  - 2017: 15 percent increases in minimum wage for unskilled workers accompanied by only 3 percent increase in PWS wages to raise incentive to find private-sector job.

### Policy recommendations to accelerate transitions
- Enhance training: increase vocational and basic education (in 2015 around 53 percent of PWS workers had education at or below primary school).
- Ease transitions through portable social benefits: extend some social transfers to offset relocation, housing, and transportation costs.
- Create joint ventures and private-sector linkages: develop work experience, internships, and apprenticeship programs to increase employability.

### Conclusion on PWS
- PWS have lowered unemployment, supported domestic demand, targeted the poor, and maintained public infrastructure.
- Given severe labor shortages, PWS need to adapt by better training participants and incentivizing transitions to the primary labor market to raise supply, improve potential growth, reduce fiscal cost, raise productivity, and enhance competitiveness.

*Source: cr17124 — IMF content unit (excerpts).*

### 1. Europe and Hungary: GDP Growth and Bank Credit to the Private sector ____________ 4

### 1. Europe and Hungary: GDP Growth and Bank Credit to the Private sector ____________ 4

### A. Introduction
- The paper reviews the relationship between real GDP growth and domestic bank lending to the private sector in Hungary after the global financial crisis (GFC), drawing on a cross-country analysis of European countries.
- Key high-level conclusions:
  - Both credit demand and supply were adversely affected by the GFC.
  - Key factors influencing credit developments include loan quality, deposit funding, and bank capital, as well as the macroeconomic environment.
  - Lending by Hungarian banks to the private sector seems to be finally beginning to pick up.
- Context and drivers before the GFC:
  - Rapid economic and domestic bank credit growth across many European and CESEE countries, fueled by convergence expectations, EU membership prospects, FDI, and substantial inflows of EU funds.
  - Domestic bank lending was often channeled into real estate and was boosted by banks’ easy access to foreign funding.
- Post-GFC outcomes:
  - It took five years for CESEE countries, as a group, and six years for Hungary to reach pre-GFC real GDP per capita levels, as the private sector deleveraged.
  - Domestic bank lending in Hungary only began to recover despite low nominal interest rates.

### B. Was the Post GFC-Recovery in Hungary Different?
- Methodology:
  - Local projection method (Jordà (2005)) used to project recession and recovery paths for cumulative changes in real GDP per capita, real private-sector consumption per capita, real investment (GFCF) per capita, and real bank credit to the private sector per capita from the beginning of each recession and recovery.
  - Sample: 57 countries (Appendix I), using a set of 79 recession and recovery episodes across 35 advanced and large emerging-market countries from 1971–2006 to construct projection paths.
  - Distinction between financial and non-financial recessions using Laeven and Valencia (2012) definition; sample includes 64 non-financial and 15 financial recession episodes.
- Comparative outcomes:
  - Hungary’s real GDP per capita since the GFC broadly followed CESEE peers, but Hungary’s recession was deeper due to exposure to the European sovereign debt crisis and high public debt.
  - Hungary caught up with peers in 2015.
  - Private consumption per capita declined more in Hungary than in peers.
  - Investment per capita performed better than average for CESEE countries, likely supported by FDIs and EU structural and cohesion funds; absorption accelerated toward end-2015 due to the 2007–2013 program period ending.
  - Hungary’s current account improved after the GFC due to import compression and stronger exports.
- Credit recovery specifics:
  - Lending to the private sector by Hungarian banks remained much more subdued than in other CESEE countries and performed worse than in countries recovering from a financial crisis.
  - Hungary was a borderline case for having a systemic banking crisis per Laeven and Valencia (2012); shortly after the GFC, some Hungarian banks faced challenges accessing global markets, prompting an IMF arrangement in November 2008 (expired October 2010).
  - Contributing adverse factors: rapid increase in NPLs, disputes and court cases between banks and household clients, global discussions about tighter prudential regulation, and the resolution (initiated December 2014, finalized mid-2016) of MKB bank.
  - Subdued domestic bank lending had less impact on growth because large reputable companies—particularly foreign subsidiaries and Hungarian-owned companies—financed themselves abroad.
- Counterfactual controlling for external demand:
  - A counterfactual analysis rescaled an external demand variable to reflect European post-GFC external demand and replotted projection paths.
  - Under this counterfactual, since the European sovereign debt crisis Hungarian real GDP growth per capita recovered faster than other CESEE countries and better than the typical recovery after a non-financial recession.
  - Private consumption per capita performed better than peers and was largely within the confidence interval of a normal recovery.
  - Investment still outperformed peers (FDIs and EU funds likely explanations).
  - Domestic bank lending remained subdued under these assumptions.

### C. Factors Influencing Bank Credit in Europe and Hungary
- Data and empirical approach:
  - Bank-level cross-country panel (1999–2015) with up to almost 8,000 banks across 37 countries plus Hungary; different specifications estimated using system generalized method of moments (GMM).
  - Annual macro data from WEO; individual bank data from FitchConnect. Unconsolidated balance sheets used when available. Extreme values removed.
- Main correlates of credit growth (Europe-wide results, standardized one-standard-deviation effects):
  - NPL ratio: negative effect on credit growth (important).
  - Customer deposits (flows/assets): positive effect (important).
  - Bank equity price index: positive effect.
  - Regulatory capital ratio: negative effect (noted in regressions).
  - Interaction terms (e.g., regulatory capital*recession D, bank equity index*recession D, NPL ratio*recovery D, deposit flow/assets*recovery D) were included in specifications.
  - Real GDP growth: positive and significant—proxying demand and debt-servicing ability.
  - Inflation: positive although insignificant.
- Interpretation for CESEE and Hungary:
  - Presence of large foreign-owned banks in many CESEE countries may explain why regulatory capital and funding seemed less crucial for credit growth in these countries.
  - For Hungary, available observations in the sample were insufficient for a country-specific regression, but the real credit growth of Hungarian banks in the sample lies within the model’s confidence interval.
  - Lending by Hungarian banks in the sample is moderately lower than for peers after the GFC, but within the confidence interval—suggesting similar explanatory factors may apply to Hungary.
- Bank-level developments in Hungary (2000–2016, as presented in figure/description):
  - Pre-GFC: lending boom, in part foreign funded.
  - Post-GFC: sharp increase in NPLs and decrease in lending.
  - Recovery period: provisions increased and cushions strengthened as banks deleveraged.

### D. Key Findings and Implications
- Timing and magnitude:
  - CESEE countries as a group required five years on average to return to pre-GFC real GDP per capita; Hungary required six years.
  - Lending to the private sector in Hungary remained subdued relative to CESEE peers and to typical non-financial-recession recoveries.
- Drivers of subdued credit growth:
  - Elevated NPLs and legal/dispute uncertainty.
  - Bank funding challenges and access to global markets in the immediate post-GFC period.
  - Macro environment including weak external demand post-GFC.
- Mitigating factors for growth despite subdued credit:
  - FDIs, integration into regional supply chains (notably Hungary’s linkages to the German supply chain), and accelerated absorption of EU funds helped sustain investment and growth.
  - Large non-financial firms had access to foreign financing, reducing dependence on domestic bank credit.
- Empirical correlations (from cross-country bank-level panel):
  - NPL ratio and customer deposits are the most important bank fundamentals correlated with credit growth.
  - Real GDP growth is a key macro driver of credit growth.
  - Regulatory capital ratios, bank equity indices, and deposit flows also exhibit measurable associations with credit dynamics in the panel.

*Prepared by Tonny Lybek; draws on the cross-country analysis by an EUR team led by Sergei Antoshin, Marco Arena, Tonny Lybek, John Ralyea, and Etienne Yehoue under the supervision of Nikolay Gueorguiev.*

### 12.      As expected, the NPL ratio was significant and negatively correlated with credit

### 12.      As expected, the NPL ratio was significant and negatively correlated with credit

### NPLs and bank lending: cross-country findings
- The NPL ratio was significant and negatively correlated with credit growth in the cross-country analysis, but its impact diminished during the recovery.
- Mechanisms linking NPLs to reduced lending:
  - A rising NPL ratio may trigger a change in risk perception and more conservative credit policies, reducing willingness to lend.
  - Provisions absorb profits and perhaps even equity, hampering banks’ ability to lend.
  - If NPLs are appropriately and timely priced and provisioned, the NPL ratio should in principle not affect new lending because new lending decisions should be forward-looking and based on expected net present value.
- Additional ways high NPLs may hamper lending even if fully provisioned:
  - Adverse effects on funding costs.
  - Concerns about collateral evaluation and thus inadequate provisions.
  - Adverse market sentiment.
  - Bank management pre-occupation with NPLs rather than new business.
- Empirical note: the NPL coefficient becomes much less negative during recoveries, suggesting improved credit demand reduces the NPL-related constraint on lending.
- Data limitation noted: sufficient data were not available to use the un-provisioned part of NPLs instead of the gross NPL ratio (analogous to the Texas ratio).

### Policy recommendations on NPLs
- Timely provisions of NPLs is critical to not restrain future credit growth, including prudent conservative evaluation of collateral.
- A credible strategy to resolve the stock of NPLs is important to remove real or perceived lingering uncertainties.
- Strengthen the debt recovery framework by making it more timely, efficient, predictable, and less costly for both borrowers and lenders to reduce risk premia and perceived risks.

### Hungarian experience and policy actions
- Since the GFC, Hungarian authorities have taken numerous initiatives to address the high NPL ratio; a major challenge was non-performing commercial real estate loans, with consumer loans particularly contentious.
- The NPL ratio trend in Hungary has been successfully reversed since 2014; new lending reportedly has very low NPL ratios.
- Selected measures and facts:
  - Conversion of FX denominated loans during 2015 reduced uncertainty for many borrowers.
  - A Personal Bankruptcy Law: effective September 2015 for mortgages and October 2016 for all household loans; about 650 cases were in process at end-February 2017.
  - In 2014, the MNB established an asset management company for non-performing project loans to commercial real estate (MARK); it has been sold to the private sector (transaction expected to be finalized in June 2017).
  - Effective July 1, 2017, a special capital charge (systemic risk buffer) will be applied to banks with an extraordinary large share of non-performing commercial real estate loans.
  - Numerous legal and prudential initiatives strengthened debt recovery frameworks and encouraged out-of-court settlements.

### Deposits, capital, and funding
- Increasing customer deposits appears to facilitate bank lending; customer deposit variable is significant with a positive sign in bank-level cross-country analysis, although smaller during recessions.
- Less dependence on volatile wholesale funding reduces vulnerabilities.
- Hungary: deposit growth of households and non-financial companies decelerated after the GFC, with new lending less than amortizations. Loan-to-deposit ratio of firms and households declined from 140 at end-2008 to 83 percent at end-2016.
- Bank regulatory capital (as percent of total assets) is associated with negative bank lending in cross-country analysis, especially during recessions, implying higher capital requirements or perceived risks can make banks less able or willing to lend.
- Hungarian banks increased capital adequacy ratios since the GFC largely by reducing risk-weighted assets.

### Credit and GDP relationships (Europe-wide and Hungary)
- For 39 European countries (1999–2015), a 10 percent increase in domestic bank credit to the private sector correlates with real GDP increasing by about 0.6-0.7 percent.
- A 10 percent credit growth raises investment by 2 percent.
- These relationships did not change much during recession and recovery periods.
- The credit impulse (change in credit growth) influenced GDP growth strongly and significantly during post-GFC recessions and recoveries.

### Hungary-specific credit dynamics and alternative funding
- Hungary experienced a creditless recovery; alternative funding alleviated strain:
  - Large non-financial manufacturing companies often accessed foreign or intra-group financing.
  - EU funds, including generous advance payments and grants, may have eased dependence on domestic bank credit.
- EIB survey findings (Hungary, July–October 2016, 476 companies):
  - Bank financing was the most important external financing for investments, but the share of Hungarian firms relying on internal financing was higher than EU average.
  - Share of surveyed Hungarian companies reporting being finance-constrained was 13 percent on average, 17 percent for SMEs, compared with EU average 5 percent.

### Balance sheet recession and net financial assets
- After the GFC, Hungarian households and non-financial companies reduced debt and built up savings, deepening the recession and slowing recovery (balance sheet recession).
- Net-financial assets of households:
  - Declined to about 41 percent of GDP in 2008.
  - Increased to almost 87 percent of GDP (estimated, Q3 2016).
- Net-financial assets of non-financial companies declined around the GFC and sovereign debt crisis but improved thereafter, consistent with better earnings.

### Household and corporate credit structure and policy measures
- Household debt:
  - Both total credit and domestic bank loans to households declined since the sovereign debt crisis.
  - Domestic bank loans now account for about 70 percent of total household debt.
  - Debt-cap rules became effective January 1, 2015.
  - Emerging mortgage bond market supported by recent legal and regulatory changes.
- Non-financial companies:
  - Share of domestic bank loans as share of total financial debt declined from almost 25 percent in 2000 to about 15 percent at end-2016.
  - Funding for Growth Scheme (FGS) introduced in 2013: MNB provided inexpensive liquidity to banks to on-lend to SMEs with an interest cap; it helped many SMEs with working capital and new investments.
  - The MNB let the FGS expire at end-March 2016.
  - Market-Based Lending Scheme introduced January 2016 offers incentives to banks that commit to increase lending to micro companies and SMEs.
  - At end-March 2017, nearly 40,000 micro and SMEs had received loans during various phases of the FGS.

### Recent trends in NPLs and lending (Hungary)
- Hungarian banks’ lending to households and non-financial companies contracted after the GFC as NPLs increased; NPL ratios have since reversed first for firms and then for households.
- During 2016, NPL ratios of both households and non-financial corporations declined, and shares of un-provisioned loans also declined.
- Banks cleaned up NPL portfolios by selling or writing off loans.
- Real estate prices improved substantially since 2014, permitting revoking provisions and boosting bank profitability in 2016.

*Source: cr17124 — section 12 (excerpt) from IMF material on Hungary.*

### 25.      It is intrinsically difficult to disentangle whether lending has been subdued due to lack

### 25.      It is intrinsically difficult to disentangle whether lending has been subdued due to lack

### Lending dynamics and survey evidence
- Both the demand for credit and the supply of credit contracted immediately after the GFC and the sovereign debt crisis, and have only gradually recovered.
- Lending surveys indicate:
  - Supply appears to have recovered before demand, at least for loans to households.
  - Distributional differences matter: different households and companies had different degrees of cushions to withstand the GFC.
- Notes on measurement:
  - Bank lending data used for cross-country analysis are the change in stock of credit deflated by CPI inflation. This measure can be misleading because it does not consider:
    - changes in amortization flows,
    - sales of NPLs to non-banks,
    - write-offs,
    - closure of banks,
    - exchange rate effects.
  - Transaction-based bank credit growth (adjusted for exchange rate changes) shows a pickup in new lending in recent months, particularly to non-financial companies and also to households.

### Recent lending developments
- New bank lending to households and particularly non-financial corporations seems to finally be picking up (as reflected in transaction data).
- Reduced vulnerabilities and debt levels, and improved macroeconomic prospects underpin anecdotal reports that many banks are expecting to increase their lending during 2017.
- Measures that likely helped reduce uncertainties or substitute them with more manageable ones include numerous actions to address NPLs, including the conversion of FX denominated household loans during 2015.

### Hungary’s recession and recovery (summary of findings)
- Hungary experienced a deeper and longer recession following the GFC than historical experience would have suggested, but has recovered since 2013.
- The GFC triggered a deleveraging of private balance sheets, which suppressed the marginal propensity to consume and invest; Hungary experienced hallmarks of a “balance sheet recession.”
- Hungary faced a double-dip recession related to the European sovereign debt crisis and compounded policy challenges due to the global nature of the GFC.
- Real GDP recuperated and in 2014 was at par with the 2008 output level, benefiting from being part of the German supply chain as well as EU funds.
- Employment has also exceeded the pre-crisis level—even excluding those participating in the public work scheme—and companies are increasingly reporting labor shortages.

### Creditless recovery and financing sources
- Hungary’s recovery has so far been creditless.
- Historical context:
  - Creditless recoveries are not uncommon, particularly after periods of rapid credit growth.
  - The study notes that real growth and job creation can happen without rapid domestic bank credit growth under special conditions.
- Alternative financing and policy support that helped the recovery:
  - Large reputable companies had access to foreign financing.
  - Relatively generous advance payments related to partially EU funded projects may have alleviated financial strains as the private sector deleveraged.
  - The MNB took initiatives to support SMEs (Funding for Growth Scheme), which seem to have had some positive impact.
- Caveats:
  - Such programs entail risks that must be carefully managed.
  - Domestic bank lending to the Hungarian private sector remained subdued and only recently begun to recover as reflected in transaction data.

### Empirical findings on credit and growth
- The study found a significant positive correlation between real growth and bank lending, but the correlation is modest and could occasionally be overstated.
- Key lesson: not all credit automatically provides sustainable growth and job creation; credit-fueled booms based on exuberant expectations will later be followed by painful adjustments.

### Policy recommendations and priorities
- The study underpins that the following are critical for a sustainable recovery supported by new viable bank lending:
  - (i) timely provisioning;
  - (ii) resolving the inherited stock of NPLs;
  - (iii) strengthening the debt recovery frameworks.
- Implementation notes:
  - In principle, fully provisioned NPLs should not hamper new lending.
  - Lingering uncertainty about the evaluation of collateral can still hamper credit supply.
  - In Hungary, the recent recovery of the real estate market and banks’ revocation of provisions may be an opportune time to review and bolster prudently conservative collateral evaluation policies.

*International Monetary Fund. Content unit: cr17124 (excerpts).*

### 1.      The reduction in Hungary’s grey economy coincided with improvement in the tax

### 1.      The reduction in Hungary’s grey economy coincided with improvement in the tax

### B. The Grey Economy
- Definition used in this note: the grey economy comprises legal activities, such as undeclared work and underreporting, that are performed outside the reach of legal authorities; specifically, all economic activities that would be legal and generally taxable if they were reported.
- Main determinants of a large grey economy:
  - High tax and social security contribution burdens, particularly when informal sector salaries are relatively low and minimum wages in the formal sector do not match productivity.
  - Poor quality of public institutions, inefficient provision of public goods and services, bureaucracies that complicate doing business, and corruption.
  - Excessive regulation leading to high costs in the formal economy.
  - Low tax morale and social norms that normalize nonreporting.
  - Low penalties and/or low probability of getting caught.
  - Lack of financial development and prevalence of cash transactions that are difficult to trace.
- Impacts and challenges for policymakers:
  - Forgone revenue due to under-reporting of wages and unregistered business activity.
  - Negative effects on access to credit from the banking sector.
  - Lower quality output and poorer working conditions due to lack of regulation and protection.
  - Distortions in statistical data, misleading economic policymaking.
- Potential mitigating benefits of the grey economy (contextual):
  - Acts as a safety net providing employment and income for those unable to find formal opportunities.
  - Some goods and services may be cheaper and more accessible.
  - Provides opportunities for micro and small firms that would otherwise struggle under heavy regulation.
- Size and drivers in Hungary:
  - Estimated grey economy in Hungary is about 22 percent of GDP (Schneider, 2015).
  - EU average is 18 percent of GDP (Schneider, 2015); Hungary’s level is larger than the EU average but in line with regional peers.
  - The most important factor identified for Hungary: indirect taxes.
  - Historical determinants highlighted:
    - Until 2010, the marginal tax wedge was a high 64 percent, incentivizing employers and employees to underreport wages (Balog, 2015).
    - Consumption tax rates and the level of corruption are noted determinants (Lacko, 2007).
    - Improvements in tax morale—stemming from reduced unemployment and enhanced quality of public services—can curb tax evasion (Toth et al, 2015).
    - Measures to tighten monitoring and increase the cost of evasion (increasing audit frequency and precision, publishing names of payers in arrears) are recommended.

### C. Tax Compliance
- VAT context and importance:
  - VAT revenue amounts to almost 10 percent of GDP in Hungary.
  - VAT is considered one of the least distortive taxes compared to income taxes.
  - High domestic consumption (and imports) implies significant potential gains from mobilizing VAT revenue.
- Hungary’s VAT rates:
  - Standard VAT rate is 27 percent (noted as very high compared to the OECD average and the highest among regional peers).
  - Effective rate is lower due to reduced rates for selected items.
  - Note: "The items subject to reduced rates were increased in 2016 and 2017."
- Strength of tax administration (relative assessment):
  - Hungary ranks strongly in CESEE on organizational structure, strategic management, operational performance, and IT/online services (drawing on IMF (2016) and OECD (2015)).
  - Reforms since the 1990s and renewed after the global financial crisis improved enforcement.
- Key tax administration reforms and measures:
  - Creation of the National Tax and Customs Administration (NTCA) in 2011 by merger of Hungarian Tax and Financial Control Administration and Hungarian Customs and Finance Guard.
  - Strengthening of the General Criminal Directorate with greater autonomy and resources; performs fiscal investigative tasks and investigations related to crimes endangering revenue and intellectual property violations.
  - Enhanced tax registration procedure introduced in 2012:
    - Around 90 percent of registrations identified as having no impediments.
    - Around 5 percent of registration requests denied.
    - Around 5 percent of cases resulted in deregistration of taxpayers (NTCA, 2017).
  - Online cash registers (electronic connection of cash registers to tax authorities) implemented to monitor turnover in real time:
    - Number of cash registers connected reached around 250 thousand by end of 2016 (MfNE, 2016).
    - Initially covered selected activities; expansion planned.
  - Electronic Trade and Transport Control System (EKAER) introduced in 2015 to monitor road transport of goods:
    - Purpose: curb VAT fraud, strengthen law-abiding businesses, ensure transparency of goods traffic, exclude food fraud, and screen tax evaders.
    - Default penalty up to 40 percent of the value of goods of uncertified origin can be imposed for irregularities.
    - Since 2015, more than 60 thousand taxpayers and around 6.5 thousand transporters registered on EKAER interface, accounting for more than 60 percent of domestic registrations (NTCA, 2017).
  - Other measures:
    - Reduced threshold for itemized VAT in 2015 to detect risky invoicing networks (made possible by increased data-handling capacity).
    - Increased VAT returns reporting frequency for newly established taxpayers without a predecessor for the first two years of activity.
    - Requirement to report VAT declaration on a quarterly basis if sales exceed a certain amount in the second year preceding the tax year (NTCA, 2017).
  - 2017 measures:
    - Extension of online cash registers to services sectors including taxi services, foreign exchange bureaus, repair and maintenance of vehicles and spare parts sales, laundry services, and activities improving physical well-being.
    - Planned introduction of online invoicing to make invoice data reporting real-time and enhance collection of overdue tax liabilities.
- Outcomes and VAT performance:
  - VAT collection increased from 8.9 percent of GDP in 2013 to 9.7 percent of GDP in 2015.
    - Footnote: "VAT is estimated to have slightly reversed to around 9.5 percent in 2016, which can be attributed to lower absorption of the EU funds and the introduction of reduced rates on selected items."
  - The increase in VAT collection exceeded the estimated increase of the tax base, implying improved compliance was the main driver (MNB, 2015).
  - Implementation timing aligns: improved VAT performance coincided with online cash registers (introduced 2014, expanded 2015) and EKAER (2015) (MfNE, 2016).
- VAT gap dynamics:
  - VAT gap defined as the difference between theoretical tax liability and actual VAT revenue.
  - European Commission (2016) assessment:
    - VAT gap was stable at around 22 percent of the theoretical liability between 2010 and 2013.
    - It then shrank by 4 percentage points in 2014, and most likely shrunk further in 2015 (MfNE, 2016).
  - Current level remains significant:
    - Estimated at above 15 percent, markedly higher than the 10 percent EU average, but lower than many regional peers.
- Policy simulations (staff simulations) — scenario: gradual elimination of the VAT compliance gap over next five years:
  - Primary balance would strengthen from around 0 percent to around 2 percent of GDP.
  - Overall balance would improve from around -2.5 percent to almost a balanced budget.
  - Public debt would decline to around 62 percent of GDP.
  - Narrative: Higher VAT revenue leads to lower deficits, lower debt stock and cost of financing; increase in VAT revenue reduces the stock of debt more than proportionally in the steady state.

### D. Conclusions
- Improving tax compliance is key to shifting segments of the grey economy into the formal sector.
- The grey economy in Hungary has been shrinking and is at par with peers, but remains sizeable.
- Tax noncompliance and undeclared work are main drivers of Hungary’s grey economy.
- The comprehensive post-crisis strategy to improve tax compliance has yielded sizeable gains and VAT collection improved in recent years.
- VAT gap estimates point to a reduction in the gap, coinciding particularly with:
  - Implementation of online cash registers.
  - Implementation of the electronic system monitoring the road transport of goods movement (EKAER).

*Prepared by Mariusz Jarmuzek and Borislava Mircheva.*

### 23.      Mobilizing additional VAT collection would help lower the fiscal deficits, which would

### cr17124 - 23.      Mobilizing additional VAT collection would help lower the fiscal deficits, which would

### VAT mobilization and the grey economy
- Eliminating the VAT gap would:
  - reduce the overall deficit by around 2 percentage points.
  - reduce public debt by around 8 percentage points.
  - reduce exposure to shocks and create fiscal space for other initiatives.
- Efforts to shift more of the grey economy to the formal sector should be multi-faceted:
  - Strengthen tax administration.
  - Streamline regulations and improve the business environment to increase tax compliance, facilitate productivity gains, and boost growth and job creation.

### Public Works Schemes (PWS): scale and fiscal implications
- Magnitude and costs:
  - In 2016 PWS employed about 223,000 workers (5.0 percent of the labor force).
  - The cost of PWS amounted to HUF 340 billion in 2016 (1 percent of GDP).
  - PWS constituted 70 percent of the cost for all active labor market measures.
  - During 2011-16, the fiscal cost increased fivefold, while the number of participants more than doubled.
  - Fiscal cost per participant (annual) figures shown in the source for 2011–2016 range from 788.8 thousand HUF to 1559.6 thousand HUF (see table in source).
- Participant characteristics and contracts:
  - Around 83 percent of PWS workers have low or no professional skills.
  - The average monthly PWS wage is about €160—less than the minimum wage but above the welfare entitlement.
  - The initial 12-month contract can be extended with an additional 6-month contract with the same public employer; workers may change employers and remain in PWS for years.
  - PWS workers usually perform labor-intensive low-skilled physical labor in public infrastructure and maintenance—construction, drainage, agriculture and farm work, and street cleaning.
- Transitions and training:
  - Statistics show that 11-13 percent of PWS workers exit every year and get a regular work contract.
  - About a quarter of PWS workers receive some form of training.
  - Some studies found that continuous participation in PWS tends to reduce the odds of finding work on the primary job market.
- Fiscal and social protection trade-offs:
  - PWS workers contribute to the state pay-as you go pension at the same rate as regular workers, but contributions are based on lower incomes, implying potential future pension liabilities for the state.
  - In the absence of PWS, the fiscal costs associated with offering social support to these participants would be significantly higher, reaching about 1.2 percent of GDP (estimate noted in the source), though that estimate does not include eventual future fiscal cost to fill any pension funding gap for PWS workers.
- Aggregate contribution to growth:
  - PWS support incomes and domestic demand because PWS workers have a high propensity to consume.
  - PWS workers are three times more numerous than those receiving unemployment benefits and their income is 2½ times higher than those on unemployment benefits.

### Policy challenges associated with large PWS
- Labor market distortions and misallocation:
  - Large PWS could encourage labor-intensive activities and discourage human capital formation (e.g., encourage school dropouts).
  - Could reinforce labor market polarization and entrench rigidities and hysteresis.
  - Could discourage labor mobility and sustain shortages in booming regions.
- Upward wage pressures:
  - Removing about 5 percent of the labor force from the primary job market’s bottom pay scale could add to wage rate pressure and contribute to rapid increases in minimum wages, with adverse implications for unit labor costs (ULC) and competitiveness.
- Management and governance risks:
  - Reports of misallocation of participants into redundant programs; criticism that PWS do not produce significant value added or adequate training.
  - EU reviews conclude that the relevance of PWS in facilitating return to the primary job market is not yet demonstrated.
- Long-term fiscal liabilities:
  - Large-scale PWS could increase fiscal liabilities over the long term if pension funding gaps are not addressed.

### Recent policy moves and targets
- Authorities’ actions in response to labor shortages:
  - Plan to gradually reduce the number of participants to 150,000 (about 3.4 percent of labor force) by 2020.
  - Limit the total period of participation for workers to 12 months.
  - In January 2016, a new allowance was introduced for active job searching; fostered workers who move to the private sector would continue to receive this allowance for the remaining normal term of their PWS contract.
  - In 2017, the 15 percent increases in the minimum wage for unskilled workers was accompanied by only 3 percent increase in PWS wages to raise the incentive to find a job in the private sector.
  - Note: Hungary has two types of minimum wages; the national minimum wage and the guaranteed minimum wage (see source).

### Policy recommendations to accelerate transition to the primary job market
- Enhance training:
  - Increase vocational and basic education; in 2015 around 53 percent of all PWS workers had an education at or below primary school.
- Ease transitions through portable social benefits:
  - Extend some social transfers to partially offset additional costs associated with relocating, housing, and transportation to improve incentives to move to the primary labor market.
- Create joint ventures and private-sector linkages:
  - Develop work experience, internships, and apprenticeship programs with the private sector to increase employability and facilitate transitions.

### Conclusion
- PWS have been successful in lowering unemployment, supporting domestic demand during the recovery, targeting the poor, and maintaining public infrastructure.
- Given Hungary’s current severe labor shortages, PWS need to adapt by better training participants and incentivizing transitions to the primary labor market to raise supply, improve potential growth, reduce fiscal cost, raise productivity, and enhance competitiveness.
- The recent reorientation of PWS toward these objectives is a positive development.

*Source: Excerpts from the supplied IMF content unit (cr17124).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17124.pdf_