## 1. Transition and Export Performance, 1993–2003

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### Background: recent developments and imbalances
- Hungary’s EU entry followed structural reforms and privatization during the 1990s that supported outward orientation, FDI inflows, strong export performance, flexible labor and product markets, and a sound banking system.
- Recent imbalances and developments:
  - Most public sector employees received a 50 percent increase in wages in the fall of 2002.
  - Minimum wage increases: over 90 percent during 2001–02.
  - Year-average real wages surged by some 13 percent in 2002; real wage growth slowed in 2003 but remained high at about 7½ percent.
  - 2003 general government deficit (ESA-95 basis), preliminary: 6 percent of GDP (original target: 4½ percent).
  - Real GDP growth in 2003: 2.9 percent; Q4 year-on-year real GDP growth: 3.6 percent.
  - Consumption drivers: wage increases, sharp drop in household savings, rapid credit growth, expanded housing subsidy scheme.
  - Headline inflation (year-on-year): 5.7 percent in December 2003; MNB target: 3½ ± 1 percent.
  - External current account deficit widened to 5.5 percent of GDP in 2003.
  - Net FDI turned negative in 2003; large current account deficit financed mainly by debt-creating inflows.
- Financial market volatility and policy credibility:
  - Policy inconsistencies and pursuit/announcement of a Ft 250–260 per euro target contributed to volatility.
  - Forint weakened to almost Ft 275 per euro in early December 2003.
  - Main short-term policy interest rate increased by 300 basis points in November 2003 to 12½ percent, total increase 600 basis points since June 2003.
- Positive signs by end-2003:
  - Competitiveness deterioration in 2001–02 reversed during 2003, aided by about an 11 percent depreciation of the forint against the euro and wage moderation.
  - Industrial production and export growth began accelerating in H2 2003.
  - Investment growth rising; share of investment goods in imports increased.
- Government fiscal stance for 2004:
  - Authorities announced revised general government deficit target for 2004: 4.6 percent of GDP (2003 outturn: 6 percent).
  - Expenditures slated to drop by 1.2 percentage point of GDP vs 2003; revenues expected to rise by 0.1 percentage point of GDP, with increases in VAT and social security taxes (of 1 percentage point of GDP) nearly offset by declines in other revenues.

### Report on the discussions — overarching objective
- Priority: address macroeconomic imbalances and re-establish policy credibility while minimizing vulnerabilities en route to euro adoption.
- Risks highlighted:
  - Large fiscal and current account deficits could impair prospects and raise financing risks.
  - Loss of policy credibility would increase exchange rate and interest rate risk exposure.
  - Market focus on euro adoption timing could trigger financial market pressure if nominal convergence expectations shift.
- Recommendation: develop and communicate a consistent policy strategy with euro adoption in mind; a credible target date would help anchor expectations.

### A. Economic outlook and objectives
- Short-term consensus:
  - Growth pickup, temporary acceleration of inflation, narrowing of current account deficit.
  - Stronger foreign demand and 2003 forint depreciation expected to boost external sector and business investment contributions to real GDP growth.
  - Private consumption expected to slow with slower real wage gains and higher taxes.
- Wage developments and projections:
  - NIRC recommendation: increase in gross nominal wages for the private sector of 7–8 percent.
  - Government agreement after mission: average nominal increase in public sector wage rate of 6 percent (late-February).
  - Staff and official GDP growth projections: 3.1 to 3.5 percent; finance ministry based budget on 3.5 percent.
- Inflation outlook and estimates:
  - One-off effects: VAT and excise adjustments; MNB estimates direct price-level boost of 1.9 percent from these changes.
  - MNB projects headline inflation of 6.9 percent at end-2004 (target: 3½ ± 1 percent).
  - Staff projection for end-2004 inflation: 6½ percent.
  - Finance ministry projects inflation might be below 6½ percent, relying on lower pass-through.
- Current account projections:
  - Staff projects current account deficit of 5¼ percent of GDP for 2004 (2003: 5.5 percent; sustainable level roughly 4 percent).
  - MNB projects deficit of 5.2 percent.
- Key risks to the outlook:
  - Weaker-than-expected recovery abroad could lower growth and widen current account deficit.
  - Persistent consumption growth could keep current account deficit larger than projected.
  - Upside inflation risks from pass-through and exchange rate weakening; downside risk from lower-than-expected pass-through.
- Medium-term considerations:
  - Authorities revising macro framework given difficulties meeting original 2005–06 fiscal targets in last PEP (2.8 and 2.5 percent of GDP).
  - Emphasis on fiscal consolidation and containing current account deficit independently of euro-timing; wage moderation needed to support investment growth and disinflation.
- ERM2 entry timing:
  - Government sees advantages to entering ERM2 soon after EU accession, but wants macro framework detail and clearer twin-deficit narrowing.
  - Staff stresses need to re-establish policy credibility and assure fiscal adjustment and disinflation before setting ERM2/euro adoption timeframe.
- Staff medium-term scenario (baseline highlights):
  - Baseline assumes authorities meet 2004 general government deficit target and later-year adjustment in line with last PEP (though at larger deficit levels).
  - Maastricht fiscal deficit criterion (3 percent of GDP) met in 2007 under baseline.
  - Baseline projects current account deficit contracting to about 3.5 percent of GDP by 2007; government and external debt decline relative to GDP; interest rates gradually fall.
  - Alternative scenario: fiscal slippage in 2004 and less adjustment later implies higher current account deficit and debt, higher interest rates and interest payments, and lower medium-term growth.
  - Stress tests show downside risks or shocks could make external and public debt dynamics problematic without policy response.
  - Conclusion: projections strengthen the case for fiscal adjustment given a large current account deficit.
- External competitiveness assessment:
  - Competitiveness judged broadly adequate; deteriorated in 2001–02 but improved in 2003.
  - Hungary continued to gain market share and export growth accelerated; exporters not recently complaining anecdotally.
  - With wage moderation and declining inflation, external competitiveness expected to continue improving.

### B. Fiscal policy: diagnosis and measures
- Consensus: decisive fiscal action only way to restore policy credibility and improve monetary-fiscal mix.
- Assessment of 2004 target:
  - Given 2003 slippages, original 2004 fiscal deficit target viewed as unrealistic.
  - Revised 2004 deficit target of 4.6 percent of GDP (a reduction of almost 1½ percentage points vs 2003) seen as sufficiently ambitious by staff.
  - Significant fiscal tightening expected to lower risk premia and interest rates and limit vulnerability to market sentiment shifts.
- Early implementation:
  - Benefits of early implementation of credible fiscal measures emphasized to reassure markets about hitting 2004 target.
- Measures adopted/announced (equivalent to about 1 percent of GDP):
  - Reduce ministries’ operational spending, including suspension of certain expenditures and cuts in maintenance, renovation, IT, and vehicles.
  - Restrain transfers from ministries to institutions under their purview.
  - Scale back project and investment spending (excluding EU-related spending on highways and other items).
  - Changes in the housing subsidy scheme expected to imply relatively small budgetary savings in 2004 but substantial savings in coming years.

### Fiscal outlook and 2004 deficit target (staff concerns)
- Staff estimated the deficit would exceed the target by about ¾ percent of GDP, largely due to lower projected tax revenue.
- Staff judged finance ministry’s assumptions too optimistic:
  - Personal income taxes: rise in tax base of over 13 percent appears inconsistent with projections of wages and employment.
  - VAT: assumed Ft 40 billion efficiency gain (about 0.2 percent of GDP) seemed unlikely absent concrete measures.
- Authorities indicated readiness to make timely corrections; as last resort, room to further delay nonpriority investment spending (unrelated to EU funding).
- Staff urged rapid identification of specific contingency measures given risks from current account deficit and election cycle.
- Authorities targeted general government deficit of 4.6 percent of GDP in 2004 (narrowing by almost 1½ percentage points of GDP from previous year).

### Structural fiscal reforms, political constraints, and recommended expenditure measures
- Limited overall progress on prior structural fiscal reforms due to a heavily polarized political climate.
- Wage policy:
  - Authorities agreed 6 percent increase in most public sector wages.
  - Staff recommended nominal wage freeze in general government (worth up to 0.5 percent of GDP in saving).
  - Staff suggested wage moderation in the public sector—possibly a nominal wage freeze in 2005.
- Staff emphasized early preparation of structural spending measures for durable medium-term adjustment and service quality improvement.
  - Starting health care reform in 2005 viewed as encouraging; implementation is key.
- Menu of expenditure reform options and estimated potential budgetary savings (In Percent of GDP):
  - Government employment and wages (hiring freeze and abolition of unusual benefits): 0.30
  - Health care (mainly introduction of co-payments): 0.5
  - Education (notably to obtain economies of scale): >0.7
  - Pension reform (including revisions to formulas and eligibility): 0.8-1.1
  - Social benefits (reduction and better targeting of benefits): 0.50
  - Reform of government subsidies (housing, transport, and pharmaceuticals): 0.8-1.0
  - Total: >3.6-4.1
- Staff welcomed plans to reduce public employment in 2003–04 (by 10 percent in ministries and 6 percent in public administration) but called for further civil service reform.
- Recommended adoption of a well-defined medium-term fiscal strategy backed by expenditure ceilings (three-year rolling framework with overall expenditure ceiling and sub-ceilings), to be submitted to parliament with a clear policy statement as part of the budget process.
- Encouraged use of realistic but conservative assumptions and framing tax changes within a coherent medium-term strategy.
- Noted benefits of increasing labor force participation—including room for labor tax cuts and phasing out lump-sum health care contribution from employers as planned—to raise potential output and mitigate public finance pressures.

### Monetary and exchange rate policy
- After significant interest rate hikes in 2003, monetary policy on hold during discussions.
- Inflation and outlook:
  - MNB forecast: 4.3 percent at end-2005 (assuming agents view 2004 spike as temporary).
  - Staff agreed end-2005 inflation target (4.0 ± 1 percent) was in reach, aided by subdued oil and import prices.
- Interest rates and policy actions:
  - Staff did not see compelling reason to raise interest rates further, considering lagged effects of mid-2003 hikes.
  - Conditions for lowering rates: re-established confidence through convincing fiscal adjustment and limited second-round effects from transitory inflation.
  - On March 22, MNB reduced key policy rate by 25 basis points to 12¼ percent, citing cabinet approval of spending measures, appreciating exchange rate during March (to Ft 250–255 per euro), and favorable economic data.
- Exchange rate regime:
  - Authorities abandoned public targeting of Ft 250–260 per euro around start of 2004; staff welcomed greater exchange rate flexibility to absorb unanticipated shocks (at some likely cost to inflation).
- Key questions ahead for monetary policy:
  - In ERM2, exchange rate variability vs euro limited; inflation targeting will be operated in a qualified way with limited monetary policy flexibility.
  - MNB economists estimate Balassa-Samuelson effects to date at about 1 percent or less.
  - Supporting policies: fiscal consolidation essential for market confidence; wage discipline in public sector and cooperation among social partners to achieve private sector wage agreement highlighted.
  - Importance of getting the central parity right and developing consistent policy strategy.

### Financial sector soundness and vulnerabilities
- Overall assessment: supervisory authorities judged financial system basically sound—banks adequately capitalized and liquid; profitability solid; loan portfolio quality broadly stable.
- Identified vulnerabilities and monitoring needs:
  - Rapid consumer lending growth:
    - Consumer loans increased by some 4 percentage points of GDP (to about 12½ percent) in 2003; housing loans accounted for more than 40 percent of this increase.
    - Increase expected to subside after housing subsidy revisions in December 2003, but potential for higher risk-taking amid scaled-back subsidy scheme and competitive banking market.
  - Exchange rate volatility and credit risk:
    - Households’ foreign currency borrowing from banks small (3 percent of total bank lending to households) but highly concentrated within a few banks.
    - Lending to households by bank-owned financial enterprises (roughly 10 percent of households’ total liabilities) mainly denominated in foreign currency.
    - Staff encouraged strengthening monitoring of indirect exposure to exchange rate movements (including borrower exposure surveys).
  - Commercial property lending:
    - Growing share in corporate lending, high concentration within a few banks, risks from less liquid collateral in less developed regions.
    - Commercial property lending mainly denominated in foreign currency.
  - Near euro adoption: interest rate convergence expected to contribute to credit expansion; HFSA and MNB agreed to watch closely for a credit boom, with strong fiscal policy and bank supervision as main defenses.
- HFSA issues:
  - Authorities requested technical assistance to align HFSA legal and institutional changes with best practices.
  - Staff stressed importance of maintaining independence of supervisory authority while ensuring accountability.

### Structural reforms, transparency, and international standards
- Privatization in final stage; sector reforms include energy liberalization and adjustment of electricity and natural gas prices to cost recovery levels.
  - Electricity market liberalization progressing; subsidies eliminated following regulated price increases of over 18 percent in 2003, closing gap between costs and revenues at state-owned grid-operator and public wholesaler (Energy Office estimates).
  - Natural gas prices moved close to world market levels.
- Competition legislation, enforcement, and market regulation compare favorably with advanced countries.
- Modest progress in reforming rail transport and postal services; scope for increased efficiency.
- Labor market generally flexible; authorities could explore differentiating minimum wages and social benefits across regions.
- Trade policy: adoption of EU common policy not expected to have significant negative impact; negative effects from elimination of some existing free-trade agreements expected to be offset by EU agreements.
- Standards, codes, transparency:
  - Progress in fiscal and data dissemination standards; BOP statistics moved to full accrual basis; reinvested earnings incorporated at end-March 2004.
  - Initiatives to increase transparency in public spending by strengthening interim audits, financial control and management, and information dissemination.
  - Note: 2002 amendment to organic budget law allowed additional spending without supplementary appropriations and parliamentary approval as long as deficit does not exceed budgeted amount by more than 5 percent of total expenditure.

### Staff appraisal and policy implications
- Historic context: EU entry reflects over a decade of reforms; recently large macro imbalances re-emerged.
- Loss of policy credibility increases financing risks and vulnerability to external shocks.
- Short-term optimism: momentum in GDP, industrial production, exports, and investment; competitiveness reversal; further improvements expected with productivity growth and wage moderation.
- Policy prescription:
  - Decisive, concrete fiscal adjustment required to restore credibility and improve monetary-fiscal mix.
  - Adjustment would help lower risk premia, facilitate interest rate reductions, and limit vulnerability to market sentiment shifts—strengthening prospects for sustainable growth.
  - Fiscal policy on appropriately ambitious course targeting 4.6 percent of GDP general government deficit in 2004 to support return of current account toward sustainable path.

### Fiscal risks and near-term policy priorities (sections 33–41)
- Fiscal risks: risk of falling short of deficit target "significant" and "potentially by some ¾ percent of GDP."
- Timely corrections likely needed soon because of:
  - Importance of re-establishing policy credibility;
  - Risk posed by current account deficit;
  - Election cycle with parliamentary elections in 2006.
- Authorities urged to quickly identify contingent spending measures.
- Medium-term expenditure reform priorities:
  - Fundamental expenditure reforms needed for durable medium-term adjustment; difficult to implement in one year, so preparation for 2005 implementation necessary.
  - Consolidation should focus on current expenditure given high tax incidence on labor and public investment/EU accession spending pressures.
  - Areas for reform: government employment; pensions; social benefits; subsidies; education; health care.
  - Specific recommendation: further scaling back, if not elimination, of housing subsidy scheme warranted.
  - Greater public sector wage restraint warranted after lack of a freeze in 2004.
- Fiscal discipline mechanisms and governance:
  - Authorities considering three-year rolling framework with overall spending ceiling and sub-ceilings; submission to parliament with clear policy statement recommended.
  - The 2002 amendment to organic budget law allowing considerable leeway for additional spending without supplementary appropriations and parliamentary approval should be discontinued.
- Interest rate policy and inflation management:
  - Official interest rates broadly appropriate; room to reduce them as confidence re-established.
  - Mistake to try to bring inflation within target by raising interest rates immediately given one-off 2004 factors and lagged effects of 2003 hikes.
  - Room for further rate reductions exists after convincing fiscal adjustment and absence of second-round effects.
- Exchange rate flexibility and euro adoption strategy:
  - Greater exchange rate flexibility welcome as insurance against unanticipated shocks (at some cost to inflation).
  - Hungary "stacks up well on optimal currency area criteria"; essential preconditions for euro adoption: fiscal adjustment and disinflation assurances.
  - Avoid public communication implying hard commitment to specific exchange rate level or range as ERM2 approaches.
  - In ERM2, monetary independence significantly lower; full use of fiscal consolidation and wage moderation needed for sustainable disinflation.
  - Importance of getting central parity right and strong incomes policy; government should lead with public sector wage policies, including in state-owned enterprises.
- Financial system soundness and supervision:
  - Financial system healthy but vulnerabilities from strong credit growth and credit risk warrant monitoring.
  - Legal changes to supervisory framework must preserve HFSA independence while ensuring accountability.
- Product market and pricing reforms:
  - Product market reforms encouraging; completion of privatization and gas/electricity price increases to cost recovery levels welcome.

### Stress tests and external sustainability (selected results)
- Staff illustrative medium-term baseline projections (selected):
  - Real GDP growth: 2003 2.9; 2004 3.2; 2005 3.4; 2006 4.0; 2007 4.0.
  - Inflation (CPI, end-year): 2003 5.7; 2004 6.5; 2005 4.2; 2006 3.0; 2007 2.3.
  - External current account balance: 2003 -5.5; 2004 -5.3; 2005 -4.3; 2006 -3.9; 2007 -3.6.
  - Primary balance: 2003 -1.9; 2004 -0.5; 2005 0.3; 2006 0.4; 2007 0.5.
  - General government debt: 2003 59.1; 2004 58.8; 2005 57.8; 2006 57.8; 2007 57.1.
- Stress-test scenarios (external debt ratios, percent of GDP, selected rows preserved):
  - Scenario 1 (historical averages): 2004-08 external debt series: 69.5, 67.0, 66.3, 64.7, 62.0, 59.1.
  - Scenario 2 (nominal interest rate at historical average + 2 s.d. in 2004–05): 69.5, 69.6, 71.7, 69.7, 66.9, 64.0.
  - Scenario 3 (real GDP growth at historical average − 2 s.d. in 2004–05): 69.5, 68.0, 68.6, 66.6, 63.9, 61.1.
  - Scenario 4 (U.S. dollar GDP deflator at historical average − 2 s.d. in 2004–05): 69.5, 86.0, 106.8, 103.6, 99.9, 96.3.
  - Scenario 5 (non-interest current account at historical average − 2 s.d. in 2004–05): 69.5, 68.9, 71.1, 69.1, 66.3, 63.4.
  - Scenario 6 (combination of 2–5 using one s.d. shocks): 69.5, 79.2, 92.1, 89.3, 86.1, 82.8.
  - Scenario 7 (one-time 30 percent nominal depreciation in 2004): 69.5, 72.4, 71.5, 69.5, 66.7, 63.8.
- Public sector debt trajectory (selected): 1998 61.1; 1999 61.2; 2000 55.8; 2001 53.5; 2002 57.1; 2003 59.1; baseline projects decline to 56.6 by 2008.
- Stress-test bound tests show severe shocks could push debt to much higher levels (example: B2 severe growth shock debt rising to 76.2 by 2008).
- Gross external financing need 2003: US$14.7 billion, 17.8 percent of GDP (baseline medium-term projections show decline to 58.8 percent external debt by 2008).

### Key statistics and recent datapoints (selected)
- Main economic indicators (selected years):
  - Real GDP: 1999 4.2; 2000 5.2; 2001 3.8; 2002 3.5; 2003 2.9; 2004 3.2.
  - CPI (average): 1999 10.0; 2000 9.8; 2001 9.2; 2002 5.3; 2003 4.7; 2004 7.1.
  - Unemployment rate: 1999 7.0; 2000 6.4; 2001 5.7; 2002 5.8; 2003 5.9; 2004 6.2.
  - Gross national saving (percent of GDP): 1999 23.5; 2000 24.3; 2001 23.5; 2002 21.2; 2003 19.5; 2004 20.1.
  - Gross domestic investment (percent of GDP): 1999 28.6; 2000 30.5; 2001 26.8; 2002 25.2; 2003 25.0; 2004 25.4.
- Consolidated general government (ESA-95), 2003 (revised) / 2004 (revised budget), percent of GDP:
  - Total revenues: 44.9 / 43.7.
  - VAT: 9.2 / 9.7.
  - Total expenditures: 50.8 / 48.3.
  - Wages and salaries: 12.4 / 11.9.
  - General government balance: -5.9 / -4.6.
  - Gross debt: 59.0 / 59.5.
  - GDP in current prices (forint billions): 18,574 / 20,380.
- Exchange rate and reserves:
  - Ft 204.83 = US$1 (table entries vary by series; alternative: Ft 204.48 = US$1 appears in PIN section).
  - Exchange regime: Peg against euro, with band +/-15 percent (official description; practices shifted toward greater flexibility).
- Monetary and market indicators:
  - Main policy interest rate: increased by 600 basis points in 2003; March 22 reduction by 25 basis points to 12¼ percent; subsequent cuts in 2004 (April 5: 25 basis points; May 3: 50 basis points to 11½ percent noted in supplementary information).
  - T-bill (90-day, average) 2003: 8.8 (series in table varies by period).
  - 3-month T-bill yield (Feb '04 examples): 12.4, 11.6, 9.7, 7.9, 11.8, 12.4.
- Balance of payments and external indicators:
  - Trade balance (percent of GDP): 1999 -4.5; 2000 -6.3; 2001 -4.3; 2002 -3.3; 2003 -4.1; 2004 -4.0.
  - Current account (percent of GDP): 1999 -5.0; 2000 -6.2; 2001 -3.3; 2002 -4.1; 2003 -5.5; 2004 -5.3.
  - Net external debt (percent of GDP), Q3 2003: 24.0 (table note).
  - Gross international reserves (Billions of U.S. dollars): 1999 11.0; 2000 11.2; 2001 10.8; 2002 10.4; 2003 12.8; 2004 14.2 (PIN).
- Banking indicators (selected):
  - Non-performing loans as percent of total loans (Sep '03): 4.2, 3.0, 2.2, 2.0, 1.7 (series by institution type).
  - Capital adequacy ratio (Jun '03): 14.2, 13.7, 13.9, 13.0, 11.6 (series by group).
  - Foreign exchange loans as percent of total loans (Jun '03): 41.6, 37.4, 36.5, 39.9 (series by group).

### Appendices highlights (selected)
- Data and statistical improvements:
  - Work plan to shift BOP to accrual-based BPM5; reinvested earnings included end-March 2004.
  - HCSO publishing seasonally adjusted quarterly GDP from Q1 2002 with retrospective coverage from 1995.
  - HCSO–MNB formalized cooperation through annual memoranda of understanding since 2002.
  - STA recommendations on monetary statistics valuation and classification being implemented (market valuation of trading securities from 2004; compulsory for listed depository corporations from 2005).
- Housing subsidy scheme (Appendix IV):
  - Introduced 2001; subsidy spending boosted to 0.7 percent of GDP in 2003 due to market interest increases.
  - June 2003: maximum credit limit reduced from Ft 30 million to Ft 15 million; December 2003: further decreased to Ft 5 million for used homes.
  - MNB estimates fiscal savings to increase to 0.3–0.4 percent of GDP in 2006/7; impact on current account deficit to rise from 0.1–0.3 percent of GDP in 2005 to 0.45–0.75 percent of GDP in 2006/7.
  - Because changes apply only to new contracts, immediate impact modest; expenditures expected to rise to 0.9 percent of GDP in 2004 due to December 2003 grace-period contract spurt.
- Estimation Error Correction Model for CPI inflation (Appendix V):
  - Long-run estimated: LCPIXR = 0.69 * LULCEP + 0.43 * LCPIGF – 2.86 + seasonality (std. errors: (0.022), (0.025), (0.142)).
  - Dynamic ECM: DLCPIXR = 0.374 * DLCPIXR_1 + 0.236 * DLCPIXR_3 + 0.231 * DLCPIXR_4 – 0.069 * ECM_1 + 0.0597 * OPG + 0.002 + seasonality (std. errors shown).
  - ECM coefficient suggests 60 percent of disequilibrium closed in one year; output gap significant.
- Supplementary information (post-report developments):
  - Merchandise exports in euro terms up 13.1 percent in Jan–Feb 2004 vs year earlier (about 20 percent in volume).
  - Imports in euros up 8.4 percent (about 15 percent in volume).
  - Trade deficit €270 million in Jan–Feb 2004 vs €467 million in Jan–Feb 2003.
  - 12-month rolling current account deficit (including reinvested earnings): 9 percent of GDP in February 2004 (peak 9.2 percent in Aug–Oct 2003).
  - Industrial output up 10.8 percent in Q1 2004 year-on-year.
  - Headline CPI declined to 6.7 percent in March 2004 from 7.1 percent in February; core inflation 6.1 percent.
  - Gross monthly private sector wage growth Jan–Feb 2004: 10.1 percent year-on-year (3.3 percent real); public sector wage growth Jan–Feb 2004: 5.5 percent (−1.4 percent real).
  - Forint stabilized in Ft 250–255 per euro range since staff report.
  - MNB policy rate cuts: 25 basis points on April 5; 50 basis points on May 3 to 11½ percent.
  - Preliminary general government deficit about 2.1 percent of estimated annual GDP in Q1 2004 vs 1.6 percent in Q1 2003 (excluding local governments).
  - Tax revenues up 8.3 percent year-on-year to Q1 2004; total expenditures up 17.3 percent year-on-year (7.8 percent increase excluding certain early transfers).
  - Ministry of Finance expects deficit to increase through Q2 2004, then be very low in H2 2004.

*Source: IMF staff report text, "1. Transition and Export Performance, 1993–2003" (IMF staff report and supplementary materials as presented).*

### 1. Transition and Export Performance, 1993–2003 ....................................................17

### 1. Transition and Export Performance, 1993–2003

### Background: recent developments and imbalances
- Hungary’s entry into the EU followed significant structural reforms and privatization during the 1990s that supported outward orientation, FDI inflows, strong export performance, flexible labor and product markets, and a sound banking system.
- Recent developments pointed to significant macroeconomic imbalances despite sustained growth:
  - Public sector wage increases: most public sector employees received a 50 percent increase in wages in the fall of 2002.
  - Minimum wage increases: over 90 percent during 2001–02.
  - Year-average real wages surged by some 13 percent in 2002; real wage growth slowed in 2003 but remained high at about 7½ percent.
  - Fiscal impact: the 2003 general government deficit (ESA-95 basis), according to preliminary data, was 6 percent of GDP, compared with an original target of 4½ percent.
  - Real GDP growth in 2003 was 2.9 percent; fourth-quarter year-on-year real GDP growth reached 3.6 percent.
  - Consumption drivers: consumption—fueled by wage increases, a sharp drop in household savings, rapid credit growth, and an expanded housing subsidy scheme—was the leading factor behind growth.
  - Inflation: year-on-year headline inflation reached 5.7 percent in December 2003, compared with the MNB target of 3½ ± 1 percent; core inflation picked up and wage and price growth in services remained stubbornly high.
  - External sector: the external current account deficit widened to 5.5 percent of GDP in 2003.
  - Net FDI turned negative in 2003; the large current account deficit was financed mainly by debt-creating inflows.
- Financial market volatility and policy credibility:
  - Policy inconsistencies and conflicting statements, including pursuit and announcement of a Ft 250–260 per euro target, contributed to volatility.
  - The forint weakened to almost Ft 275 per euro in early December 2003.
  - Monetary response: the main short-term policy interest rate was increased by 300 basis points in November 2003 to 12½ percent, bringing the total increase to 600 basis points since June.
- Some positive signs by end-2003:
  - Competitiveness: deterioration in 2001–02 reversed during 2003, partly from about an 11 percent depreciation of the forint against the euro and wage moderation.
  - Industrial production and export growth began accelerating in the second half of 2003.
  - Investment growth was rising and the share of investment goods in imports increased.
- Government fiscal stance for 2004:
  - Authorities announced a revised general government deficit target in 2004 of 4.6 percent of GDP, compared with an outturn of 6 percent in 2003.
  - Planned fiscal posture: expenditures slated to drop by 1.2 percentage point of GDP compared with 2003; revenues expected to rise by 0.1 percentage point of GDP, with increases in VAT and social security taxes (of 1 percentage point of GDP) almost offset by declines in other revenues (mostly non-tax receipts).

### Report on the discussions — overarching objective
- Priority: deal with macroeconomic imbalances and re-establish policy credibility while minimizing vulnerabilities on the road to euro adoption.
- Risks highlighted:
  - Large fiscal and current account deficits, if unattended, would impair prospects and raise financing risks.
  - Loss of policy credibility would increase exposure to exchange rate and interest rate risk.
  - Market focus on timing of euro adoption implies shifts in expectations on nominal convergence could trigger financial market pressure.
- Recommendation: develop and communicate a consistent policy strategy with euro adoption in mind; a credible target date would help anchor expectations.

### A. Economic outlook and objectives
- Short-term outlook consensus:
  - Growth pickup, temporary acceleration of inflation, and a narrowing of the current account deficit.
  - With stronger foreign demand and the 2003 forint depreciation, external sector and business investment expected to contribute increasingly to real GDP growth.
  - Private consumption expected to slow in response to slower real wage gains and higher taxes.
- Wage developments and projections:
  - NIRC recommendation: increase in gross nominal wages for the private sector of 7–8 percent.
  - Government agreement after the mission: average nominal increase in the public sector wage rate of 6 percent (late-February).
  - Staff and official GDP growth projections ranged from 3.1 to 3.5 percent; the finance ministry based the budget on 3.5 percent growth.
- Inflation outlook and estimates:
  - One-off effects: VAT and excise adjustments; MNB estimates a direct price-level boost of 1.9 percent from these changes.
  - MNB projects headline inflation of 6.9 percent at end-2004 (target is 3½ ±1 percent).
  - Staff projection for end-2004 inflation: 6½ percent.
  - Finance ministry projections suggest inflation might be below 6½ percent, relying on lower pass-through.
- Current account projections:
  - Staff projects a current account deficit of 5¼ percent of GDP for 2004, compared with 5.5 percent in 2003 and a sustainable level of roughly 4 percent.
  - MNB projects a deficit of 5.2 percent.
- Key risks to the outlook:
  - Weaker-than-expected recovery abroad would lower growth and widen the current account deficit.
  - Persistent consumption growth could keep the current account deficit larger than projected.
  - Upside risks to inflation from pass-through and exchange rate weakening.
  - Downside possibility: lower-than-expected pass-through from VAT and excise adjustments.
- Medium-term considerations:
  - Authorities revising macroeconomic framework given difficulties in meeting original 2005–06 fiscal targets in the last PEP (2.8 and 2.5 percent of GDP, respectively).
  - Authorities emphasize fiscal consolidation and containing the current account deficit independently of euro-timing decisions; wage moderation needed to support investment growth and disinflation.
- ERM2 entry timing:
  - Government sees advantages to entering ERM2 soon after EU accession for disciplining credibility, but also wants macro framework details and clearer twin-deficit narrowing.
  - Staff emphasizes need to re-establish policy credibility and have policies assuring fiscal adjustment and disinflation before setting ERM2/euro adoption timeframe.
- Staff medium-term scenario highlights:
  - Baseline (Table 4) assumes authorities meet the 2004 general government deficit target and later-year adjustment in line with the last PEP (though at larger deficit levels).
  - Under the baseline, the Maastricht fiscal deficit criterion (3 percent of GDP) is met in 2007.
  - Baseline projects the current account deficit contracting to about 3.5 percent of GDP by 2007; government and external debt decline relative to GDP; interest rates gradually fall.
  - Alternative scenario: assumes fiscal slippage in 2004 and less adjustment later; implies higher current account deficit and debt, higher interest rates and interest payments, and lower medium-term growth.
  - Stress tests (Tables 5 and 6) show that downside risks or shocks could make external and public debt dynamics problematic without policy response.
  - Conclusion: these projections strengthen the case for fiscal adjustment given a large current account deficit.
- External competitiveness assessment:
  - Competitiveness judged broadly adequate.
  - Points noted: (i) competitiveness deteriorated earlier but improved during 2003; (ii) Hungary continued to gain market share and export growth accelerated; (iii) exporters were not recently complaining anecdotally.
  - Staff view: with wage moderation and declining inflation, external competitiveness would continue to improve.

### B. Fiscal policy: diagnosis and measures
- Consensus: decisive fiscal action is the only way to restore policy credibility and improve the monetary-fiscal mix.
- Assessment of 2004 target:
  - Given 2003 slippages, staff concurred the original 2004 fiscal deficit target was unrealistic.
  - The revised deficit target of 4.6 percent of GDP for 2004 (a reduction of almost 1½ percentage points with respect to 2003) was seen as sufficiently ambitious.
  - Significant fiscal tightening expected to lower risk premia and interest rates and limit vulnerability to market sentiment shifts.
- Early implementation:
  - Benefits of early implementation of credible fiscal measures were emphasized to reassure markets about hitting the 2004 target.
- Measures adopted/announced (equivalent to about 1 percent of GDP):
  - Reduce ministries’ operational spending, including suspension of certain expenditures and cuts in maintenance, renovation, IT, and vehicles.
  - Restrain transfers from ministries to institutions under their purview.
  - Scale back project and investment spending (excluding EU-related spending on highways and other items).
  - Changes in the housing subsidy scheme expected to imply relatively small budgetary savings in 2004 but contribute to substantial savings in coming years.

*Source: IMF staff report text, "1. Transition and Export Performance, 1993–2003."*

### 14.      Notwithstanding these actions, achieving the 2004 deficit target will likely pose

### _cr04145 - 14.      Notwithstanding these actions, achieving the 2004 deficit target will likely pose

### Fiscal outlook and 2004 deficit target
- Staff estimated the deficit would exceed the target by about ¾ percent of GDP, largely due to lower projected tax revenue.
- Staff judged the finance ministry’s assumptions as too optimistic:
  - Personal income taxes: rise in the tax base of over 13 percent appears inconsistent with projections of wages and employment.
  - VAT: assumed Ft 40 billion efficiency gain (about 0.2 percent of GDP) seemed unlikely absent concrete measures.
- Authorities indicated readiness to make timely corrections; as a last resort, they saw room to further delay nonpriority investment spending (unrelated to EU funding).
- Staff urged rapid identification of specific contingency measures, given risks from the current account deficit and the election cycle.
- Authorities targeted a general government deficit of 4.6 percent of GDP in 2004.
  - This implies a narrowing of the deficit by almost 1½ percentage points of GDP from the previous year.

### Structural fiscal reforms, political constraints, and recommended expenditure measures
- Staff regretted limited overall progress on prior structural fiscal reforms, noting difficulties from a heavily polarized political climate.
- Wage policy:
  - Authorities agreed a 6 percent increase in most public sector wages.
  - Staff had recommended a nominal wage freeze in general government (worth up to 0.5 percent of GDP in saving).
  - Staff suggested wage moderation in the public sector—possibly a nominal wage freeze in 2005.
- Staff emphasized beginning early preparation of structural spending measures to support durable medium-term adjustment and improve service quality.
  - Steps to start health care reform in 2005 were viewed as encouraging; implementation is key.
- Menu of expenditure reform options and estimated potential budgetary savings (In Percent of GDP):
  - Government employment and wages (hiring freeze and abolition of unusual benefits): 0.30
  - Health care (mainly introduction of co-payments): 0.5
  - Education (notably to obtain economies of scale): >0.7
  - Pension reform (including revisions to formulas and eligibility): 0.8-1.1
  - Social benefits (reduction and better targeting of benefits): 0.50
  - Reform of government subsidies (housing, transport, and pharmaceuticals): 0.8-1.0
  - Total: >3.6-4.1
- Staff welcomed plans to reduce public employment in 2003–04 (by 10 percent in ministries and 6 percent in public administration) but called for further civil service reform.
- Staff advised adopting a well-defined medium-term fiscal strategy backed by expenditure ceilings (three-year rolling framework with overall expenditure ceiling and sub-ceilings), submitted to parliament with a clear policy statement as part of the budget process.
- Staff encouraged the use of realistic but conservative assumptions and casting tax changes within a coherent medium-term strategy to enhance predictability and quality of fiscal policy.
- Noted potential benefits of increasing labor force participation—including room for labor tax cuts and phasing out the lump-sum health care contribution from employers as planned—to raise potential output and mitigate public finance pressures.

### Monetary and exchange rate policy
- After significant interest rate hikes in 2003, monetary policy was on hold during the discussions.
- Inflation and outlook:
  - MNB forecast: 4.3 percent at end-2005 (assuming agents view the spike in inflation in 2004 as temporary).
  - Staff agreed end-2005 inflation target (4.0 ± 1 percent) was in reach, aided by subdued oil and other import prices.
- Interest rates and policy actions:
  - Staff did not see a compelling reason to raise interest rates further, taking into account lagged effects of mid-2003 hikes.
  - Staff noted conditions for lowering rates included re-establishing confidence through convincing fiscal adjustment and limited second-round effects from transitory inflation.
  - On March 22, the MNB reduced its key policy rate by 25 basis points to 12¼ percent, citing cabinet approval of spending measures, an appreciating exchange rate during March (to Ft 250–255 per euro), and favorable economic data (including smaller-than-expected general government and trade deficits for February).
- Exchange rate regime:
  - Authorities abandoned public targeting of Ft 250–260 per euro around the start of 2004; staff welcomed greater exchange rate flexibility to absorb unanticipated shocks (at some likely cost to inflation).
- Key questions ahead for monetary policy:
  - Adapting to ERM2: in ERM2, exchange rate variability against the euro will be limited; inflation targeting will be operated in a qualified way with limited monetary policy flexibility.
    - MNB economists estimate Balassa-Samuelson effects to date at about 1 percent or less.
  - Supporting policies: fiscal consolidation is essential for market confidence, containing demand pressures, and avoiding upward pressure on the currency; wage discipline in the public sector and cooperation among social partners to achieve private sector wage agreement were highlighted.
  - Importance of getting the central parity right and developing a consistent policy strategy.

### Financial sector soundness and vulnerabilities
- Overall assessment:
  - Supervisory authorities judged the Hungarian financial system basically sound: banks adequately capitalized and liquid; profitability solid; loan portfolio quality broadly stable.
- Identified vulnerabilities and monitoring needs:
  - Rapidly growing consumer lending:
    - Consumer loans increased by some 4 percentage points of GDP (to about 12½ percent) in 2003, with housing loans accounting for more than 40 percent of this increase.
    - Increase expected to subside after revisions to the housing subsidy scheme in December 2003, but potential for higher risk-taking amid a scaled-back subsidy scheme and competitive banking market.
  - Exchange rate volatility and credit risk:
    - Households’ foreign currency borrowing from banks is small (3 percent of total bank lending to households) but highly concentrated within a few banks.
    - Lending to households by bank-owned financial enterprises (amounting to roughly 10 percent of households’ total liabilities) is mainly denominated in foreign currency.
    - Staff encouraged strengthening monitoring of indirect exposure to exchange rate movements (including borrower exposure surveys).
  - Commercial property lending:
    - Growing share in overall corporate lending, high concentration within a few banks, and risks from less liquid collateral in less developed regions.
    - Commercial property lending is mainly denominated in foreign currency.
  - Near euro adoption and afterward: interest rate convergence expected to contribute to credit expansion; HFSA and MNB agreed to watch closely for a credit boom, with strong fiscal policy and supervision of banks’ internal risk management as main defenses.
- HFSA issues:
  - Authorities requested technical assistance to align legal and institutional changes governing the HFSA with best practices.
  - Staff stressed importance of maintaining independence of the supervisory authority while ensuring accountability.

### Structural reforms, transparency, and international standards
- Privatization and sector reforms:
  - Privatization in its final stage; structural reforms include liberalization of the energy sector and adjustment of electricity and natural gas prices to cost recovery levels.
  - Further privatization expected to help increase FDI.
  - Electricity market liberalization progressing; subsidies eliminated following regulated price increases of over 18 percent in 2003, which closed the gap between costs and revenues at the state-owned grid-operator and public wholesaler (Energy Office estimates).
  - Natural gas prices moved close to world market levels.
  - Competition legislation, enforcement, and market regulation compare favorably with advanced countries.
  - Modest progress in reforming rail transport and postal services leaves scope for increased efficiency.
  - Labor market generally flexible; authorities could explore differentiating minimum wages and social benefits across regions to alleviate regional imbalances.
- Trade policy:
  - Hungary’s trade policy will soon be guided by the common EU policy; authorities did not foresee significant negative impact from adopting the EU import duty structure.
  - Negative effects from elimination of some existing free-trade agreements (e.g., with Serbia and Montenegro) expected to be offset by current EU trade agreements with third countries.
- Standards, codes, and transparency:
  - Progress in observing standards and codes in the fiscal and data dissemination areas.
  - BOP statistics being moved to a full accrual basis; reinvested earnings incorporated at end-March 2004.
  - Initiatives to increase transparency in public spending by strengthening interim audits, financial control and management, and information dissemination.
  - Note: the 2002 amendment to the organic budget law allowed additional spending without supplementary appropriations and parliamentary approval as long as the deficit does not exceed what is budgeted by more than 5 percent of total expenditure.

### Staff appraisal and policy implications
- Historic context: Hungary’s EU entry reflects over a decade of institutional and structural reforms; more recently, large macroeconomic imbalances (large fiscal and current account deficits) have re-emerged.
- Loss of policy credibility increases financing risks for the deficits and vulnerability to contagion from external shocks.
- Short-term outlook: reasons for optimism—momentum in GDP, industrial production, exports, and investment; reversal of competitiveness deterioration in 2001–02; further improvements expected with productivity growth and wage moderation.
- Policy prescription:
  - Decisive, concrete fiscal adjustment is required to restore policy credibility and improve the monetary-fiscal mix.
  - Such adjustment would help lower risk premia, facilitate interest rate reductions, and limit vulnerability to shifts in market sentiment—strengthening prospects for sustainable growth.
  - Fiscal policy is on an appropriately ambitious course targeting a 4.6 percent of GDP general government deficit in 2004, which would support a return of the current account toward a sustainable path.

*Source: IMF staff report content (text provided).*

### 33.      But the fiscal deficit target is again at risk. Based on announced policies, the risks of

### _cr04145 - 33.      But the fiscal deficit target is again at risk. Based on announced policies, the risks of

### Fiscal risks and near-term policy priorities
- Risks of falling short of the fiscal deficit target are "significant" and could be "potentially by some ¾ percent of GDP."
- Timely corrections are likely to be needed soon given:
  - the importance of re-establishing policy credibility;
  - the risk posed by the current account deficit;
  - the election cycle with parliamentary elections in 2006.
- Authorities have announced an intention to make corrections and are urged to "quickly identify contingent spending measures."

### Medium-term expenditure reform priorities
- Fundamental expenditure reforms are needed for durable fiscal adjustment over the medium term.
- Constraints and timing:
  - Fundamental expenditure reforms "would be difficult in the short time frame of one year," so authorities must prepare early for permanent structural spending measures to begin implementing them in 2005.
- Policy guidance:
  - Given "the high tax incidence, particularly on labor," and public investment and EU accession spending pressures, consolidating current expenditure is key.
  - Consolidation focused on spending, when spending is high, tends to be more durable, growth-friendly, and credible.
- Areas identified for potential savings with reforms:
  - government employment;
  - pensions;
  - social benefits;
  - subsidies;
  - education;
  - health care (where "recently developed plans are encouraging").
- Specific programmatic recommendation:
  - "A further scaling back, if not elimination, of the housing subsidy scheme is warranted."
  - "Greater public sector wage restraint is also warranted in the period ahead, after the lamentable lack of a freeze in 2004."

### Fiscal discipline mechanisms and governance
- Authorities had been considering a three-year rolling framework including:
  - a ceiling on overall spending;
  - sub-ceilings on key components.
- Introducing such a framework "would be beneficial" and, to garner broad political support, "should be submitted to parliament along with a clear policy statement."
- The amendment to the organic budget law that "allowed considerable leeway in undertaking additional spending without supplementary appropriations and parliamentary approval should be discontinued."

### Interest rate policy and inflation management
- Current assessment: "The level of official interest rates is broadly appropriate, but there could be room to reduce them as confidence is re-established."
- Guidance:
  - Given one-off factors affecting inflation in 2004 and lagged effects of sizable interest rate hikes of last year, it would be a mistake to try to bring inflation within the target range by raising interest rates in the immediate future.
  - Authorities are focusing on medium-term inflation objectives and communicating that one-off factors are not expected to be repeated.
  - Room for further interest rate reductions exists (following "the recent small cut") if policy credibility is re-established through convincing fiscal adjustment and if temporary inflation does not ignite second-round effects that would threaten the 2005 inflation target.

### Exchange rate flexibility and euro adoption strategy
- Recent practice allowing greater exchange rate flexibility is "welcome."
  - Greater flexibility provides insurance—"albeit at some cost to inflation"—against unanticipated shocks, including fiscal slippage, when faced with a large current account deficit.
- Medium-term challenge: adapt the policy framework to the goal of and requirements for adopting the euro.
  - Hungary "stacks up well on optimal currency area criteria" and advantages of euro adoption are clear.
  - Essential preconditions: policies that provide greater assurances that necessary fiscal adjustment and disinflation will materialize to establish a time frame for ERM2 entry and euro adoption.
  - Communication risks: as ERM2 approaches, avoid public communication implying a hard commitment to a particular exchange rate level or range that could prompt another speculative attack.
  - Once in ERM2, monetary independence will be significantly lower, increasing the importance of full use of all policy tools for sustainable disinflation, including fiscal consolidation and wage moderation.
  - To minimize exchange rate vulnerabilities, "it will also be important to get the central parity right."
  - A strong incomes policy is particularly needed; government should lead with public sector wage policies, including in state-owned enterprises.

### Financial system soundness and supervision
- Available information indicates "a healthy financial system," but vulnerabilities have arisen that warrant monitoring:
  - Mostly reflect strong credit growth and increasing credit risk.
  - While manageable now, these warrant careful monitoring with a view to taking timely corrective action if needed.
- Supervisory governance recommendation:
  - Any legal changes to the supervisory framework must preserve the independence of the HFSA while ensuring its accountability.

### Product market reform and pricing reforms
- Recent product market reforms are "encouraging."
  - Plans to complete the final stage of privatization are welcome.
  - Increases in gas and electricity prices are welcome, as they take prices "to cost recovery levels and eliminate implicit subsidies."

*Source: IMF staff report text (sections 33–41).*

### 42.      The next Article IV consultation with Hungary is expected to be conducted under the

### _cr04145 - 42. The next Article IV consultation with Hungary is expected to be conducted under the standard 12-month cycle.

### Transition and export performance (1993–2003)
- Hungary's GDP per capita as a percent of the euro area tracked alongside CECs; data for 2003 based on the first three quarters.
- EBRD Transition Index, 2003 values shown (scale: 3.0–4.0 in figure).
- Market share in EU imports plotted 1993–2003; Hungary compared with CECs without Hungary.
- Unemployment rate series (1999q1–2003q3) indicates relatively low unemployment supported by competitive export sector and structural reforms.

### Recent economic indicators (2000–04)
- GDP growth contributions in 2003: net exports contribution negative; domestic demand contribution positive.
- Private consumption and gross fixed investment:
  - Consumption "boomed" in 2003 with large wage increases.
  - Investment growth began to rise recently, especially manufacturing investment.
- Wages and inflation:
  - Real net public wage, real net private wage, and real economy-wide wage with large upward public sector adjustments.
  - Inflation reversed its downward trend: series for inflation total, core inflation, inflation services (3-month moving average).
- Fiscal outcomes:
  - General government balance (12-month rolling, percent of GDP) showed large fiscal deficits in 2003.
- External sector:
  - Imports of goods & services growth boomed; exports started accelerating in H2 2003 and now exceed import growth.
  - Current account deficit widened sharply and only recently started to narrow.
  - Current account increasingly financed by debt-creating flows; FDI and other flows plotted (12-month rolling percent of GDP).

### Financial indicators and market perceptions (2003–04)
- Interest rate differential (vs Germany, basis points) increased significantly during 2003.
- Main policy interest rate:
  - Hiked by 600 basis points in 2003 (monthly series through 2004m3 shown).
- Exchange rate vs euro:
  - Loss of policy credibility affected the exchange rate; HUF/euro series (daily points shown through Jan 2004).
- Policy rates across the region:
  - Official interest rates are much higher in Hungary than in peer countries (Czech Republic, Poland, Slovak Republic, Slovenia).
- Euro-denominated bond differentials indicate that default risk appears to remain low.
- Yield curve (March 3, 2004 vs earlier dates) moved up across all maturities (3-month to 10-year).

### Real effective exchange rates (1993–2003)
- REER indexes (2000=100) shown using ULC-based and CPI-based series (quarterly through 2003q3).
- Competitiveness deteriorated in 2001–02 due to large wage increases and nominal appreciation; improved in 2003 as the forint depreciated.

### Main economic indicators (1999–2004)
- Real economy (change in percent):
  - Real GDP: 1999 4.2; 2000 5.2; 2001 3.8; 2002 3.5; 2003 2.9; 2004 3.2 (table shows "4.25.23.83.52.93.2" formatting).
  - CPI (average): 1999 10.0; 2000 9.8; 2001 9.2; 2002 5.3; 2003 4.7; 2004 7.1.
  - Unemployment rate (in percent): 1999 7.0; 2000 6.4; 2001 5.7; 2002 5.8; 2003 5.9; 2004 6.2.
- Wage growth (gross wages) — economy-wide, private, public (selected years shown).
- Gross national saving (percent of GDP): 1999 23.5; 2000 24.3; 2001 23.5; 2002 21.2; 2003 19.5; 2004 20.1.
- Gross domestic investment (percent of GDP): 1999 28.6; 2000 30.5; 2001 26.8; 2002 25.2; 2003 25.0; 2004 25.4.
- General government (ESA-95 basis):
  - Balance: 1999 ... ; 2000 -3.0; 2001 -4.7; 2002 -9.4; 2003 -6.0; 2004 -4.6.
  - Debt: 1999 61.0; 2000 55.4; 2001 53.5; 2002 57.1; 2003 59.1; 2004 59.5.
- Money and credit (end-of-period percent change): M3 and Credit to nongovernment series (samples shown).
- Interest rates:
  - T-bill (90-day, average): 2003 8.8 (table shows broader series including 14.5,10.9,10.6,8.9,8.8,12.5).
  - Government bond yield (5-year, average): 2003 7.4 (series includes 11.8,9.1,8.5,7.8,7.4,9.6).
- Balance of payments:
  - Trade balance (percent of GDP): 1999 -4.5; 2000 -6.3; 2001 -4.3; 2002 -3.3; 2003 -4.1; 2004 -4.0.
  - Current account (percent of GDP): 1999 -5.0; 2000 -6.2; 2001 -3.3; 2002 -4.1; 2003 -5.5; 2004 -5.3.
  - Reserves (months of imports): 1999 4.1; 2000 3.7; 2001 3.4; 2002 2.9; 2003 2.8; 2004 2.7.
  - Net external debt (percent of GDP): 2003 (Q3) 24.0 (table notes third-quarter reference).
- Fund relations (February 29, 2004):
  - Fund holding of currency (in percent of quota) 58.8.
  - Quota (SDR million) 1,038.4.
- Exchange rate:
  - Ft 204.83 = US$1.
  - Exchange regime: Peg against euro, with band +/-15 percent.
  - Nominal effective rate (1990=100) series includes 37.6,35.5,36.2,38.9,38.8.
  - Real effective rate, CPI basis (1990=100) includes 135.0,135.8,146.5,162.9,166.4.

### Consolidated general government (ESA-95), 2000–04 (selected percent of GDP)
- Total revenues: 2000 46.4; 2001 45.4; 2002 44.7; 2003 43.7; 2004 43.8 (est./revised/alternative formatting present).
- Tax revenues total: 2000 39.7; 2001 38.7; 2002 38.6; 2003 38.2; 2004 38.8.
- Of which VAT: 2000 8.9; 2001 8.4; 2002 8.2; 2003 9.1; 2004 9.6.
- Total expenditures: 2000 49.4; 2001 50.1; 2002 54.0; 2003 49.6; 2004 48.4.
- Of which wages and salaries: 2000 10.5; 2001 10.4; 2002 12.0; 2003 12.5; 2004 12.3.
- General government balance: 2000 -3.0; 2001 -4.7; 2002 -9.4; 2003 -6.0; 2004 -4.6.
- Gross debt (percent of GDP): 2000 55.8; 2001 53.5; 2002 57.1; 2003 59.1; 2004 59.5.
- GDP in current prices (forint billions): 2003 18,574; 2004 20,380.

### Balance of payments (selected series, 1999–2007 projections)
- Table 3a (in percent of GDP):
  - Current account balance: 1999 -5.0; 2000 -6.2; 2001 -3.3; 2002 -4.1; 2003 -5.5; 2004 -5.3; projections through 2007 included.
  - Merchandise trade balance and goods exports/imports levels and volume percentage changes provided (exports goods 2003 43.2 percent of GDP; imports goods 2003 46.6 percent of GDP).
  - Net income and net transfers series and net travel contributions noted.
- Table 3b (alternate presentation, in billions of U.S. dollars):
  - Current account balance (US$): 1999 -3.8; 2000 -4.0; 2001 -3.2; 2002 -4.7; 2003 -7.4; 2004 -7.8; projections through 2007 included.
  - Net income deteriorated: 1999 -2.9; 2000 -2.6; 2001 -2.9; 2002 -3.6; 2003 -4.5; 2004 -4.8; 2005 -5.2; 2006 -5.5; 2007 -5.7 (percent of GDP series provided).

### Staff illustrative medium-term scenario and alternative scenario (Table 4)
- Staff projections (2000–07, selected entries):
  - Real GDP growth: 2000 5.2; 2001 3.8; 2002 3.5; 2003 2.9; 2004 3.2; 2005 3.4; 2006 4.0; 2007 4.0.
  - Inflation (CPI, end-year basis): 2003 5.7; 2004 6.5; 2005 4.2; 2006 3.0; 2007 2.3.
  - External current account balance: 2000 -6.2; 2001 -3.3; 2002 -4.1; 2003 -5.5; 2004 -5.3; 2005 -4.3; 2006 -3.9; 2007 -3.6.
  - General government (ESA-95) primary balance and debt:
    - Primary balance: 2000 1.8; 2001 -0.5; 2002 -5.6; 2003 -1.9; 2004 -0.5; 2005 0.3; 2006 0.4; 2007 0.5.
    - General government debt: 2000 55.8; 2001 53.5; 2002 57.1; 2003 59.1; 2004 58.8; 2005 57.8; 2006 57.8; 2007 57.1.
- Alternative scenario deviations (2003–07, Table 4 Continued):
  - Deviations from baseline (in percentage points) for general government balance and debt shown for an alternative scenario; example: general government debt deviation 2004 0.0; 2005 0.7; 2006 1.3; 2007 2.0; 2008 3.0.
  - Alternative nominal GDP (forint billions) scenario: 2004 20,412; 2005 22,022; 2006 23,678; 2007 25,175.

### Public sector debt sustainability and stress tests (Table 5)
- Public sector debt trajectory (percent of GDP):
  - Public sector debt: 1998 61.1; 1999 61.2; 2000 55.8; 2001 53.5; 2002 57.1; 2003 59.1; projections through 2008 provided (2008 56.6).
  - Identified debt-creating flows and decomposition (primary deficit, automatic debt dynamics, contribution from interest/growth differentials, exchange rate effects, privatization receipts).
- Key macro-fiscal assumptions (selected):
  - Average nominal interest rate on public debt series: historical values and projected declines to mid single digits in later years.
  - Real GDP growth: historical and projected averages around 4.0 percent in medium term.
  - Inflation (GDP deflator) and growth of real primary spending series included.
- Stress tests (alternative scenarios and bound tests):
  - A1 Key variables at historical averages in 2004-08 shows public debt declining to 38.4 (percent of GDP) by 2008 in that scenario.
  - A2 Primary balance under no policy change in 2004-08 shows slower debt reduction.
  - A3 Country-specific shock with less fiscal adjustment in 2004-08 results in higher debt (up to 61.3 in 2008).
  - Bound tests include shocks to real interest rate, real GDP growth, primary balance, combination shocks, one-time 30 percent real depreciation in 2004, and 10 percent of GDP increase in other debt-creating flows; resulting debt paths presented (e.g., B2 shows debt rising to 76.2 by 2008 under severe growth shock).
- External debt (baseline medium-term projections, percent of GDP):
  - External debt: 1999 64.3; 2000 64.7; 2001 64.9; 2002 62.4; 2003 69.5; projections decline to 58.8 by 2008.
  - Gross external financing need in US$ and percent of GDP provided (e.g., 2003 gross external financing need US$14.7 billion, 17.8 percent of GDP).

*Source: IMF staff report and tables as contained in the provided content unit.*

### 1. Real GDP growth, nominal interest rate, dollar deflator, non interest current account, and non debt inflows at histor

### 1. Real GDP growth, nominal interest rate, dollar deflator, non interest current account, and non debt inflows at histor

### Stress-test scenarios and resulting external debt ratios (percent of GDP)
- Scenario labels (rows) preserved in source:
  - 1. Real GDP growth, nominal interest rate, dollar deflator, non interest current account, and non debt inflows at historical av
    - 2004-08: 69.5, 67.0, 66.3, 64.7, 62.0, 59.1
  - 2. Nominal interest rate is at historical average plus two standard deviations in 2004 and 2005
    - 2004-08: 69.5, 69.6, 71.7, 69.7, 66.9, 64.0
  - 3. Real GDP growth is at historical average minus two standard deviations in 2004 and 2005
    - 2004-08: 69.5, 68.0, 68.6, 66.6, 63.9, 61.1
  - 4. Change in U.S. dollar GDP deflator is at historical average minus two standard deviations in 2004 and 2005
    - 2004-08: 69.5, 86.0, 106.8, 103.6, 99.9, 96.3
  - 5. Non interest current account is at historical average minus two standard deviations in 2004 and 2005
    - 2004-08: 69.5, 68.9, 71.1, 69.1, 66.3, 63.4
  - 6. Combination of 2-5 using one standard deviation shocks
    - 2004-08: 69.5, 79.2, 92.1, 89.3, 86.1, 82.8
  - 7. One time 30 percent nominal depreciation in 2004
    - 2004-08: 69.5, 72.4, 71.5, 69.5, 66.7, 63.8

### Historical statistics for key variables (past 7 years)
- Historical average and standard deviation (as presented):
  - Current account deficit, excluding interest payments
    - Historical Average: 2.7
    - Standard Deviation: 2.6
  - Net non debt creating capital inflows
    - Historical Average: 2.4
    - Standard Deviation: 1.1
  - Nominal interest rate (in percent)
    - Historical Average: 6.4
    - Standard Deviation: 1.3
  - Real GDP growth (in percent)
    - Historical Average: 3.9
    - Standard Deviation: 1.3
  - GDP deflator in U.S. dollars (change in percent)
    - Historical Average: 1.9
    - Standard Deviation: 9.7

### Formulae and definitions used in the stress-test framework
- Debt dynamics contribution (as given):
  - 1/ Derived as [r - g - ρ(1+ g) + εα(1+r)]/(1+g+ ρ + g ρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.
- Contribution from price and exchange rate changes:
  - 2/ Defined as [- ρ(1+ g ) + εα(1+ r )]/(1+g+ ρ + g ρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).
- Non interest current account and debt-service definition:
  - 3/ Defined as non interest current account deficit, plus interest and amortization on medium- and long-term debt, plus short-term debt at end of previous period.
- Data coverage:
  - 4/ Includes preliminary data as well as projections.

### External Sustainability Framework context (Table 6 highlights, selected indicators)
- Public sector debt (year-end observations)
  - 1999: 61.0
  - 2000: 55.4
  - 2001: 53.4
  - 2002: 57.1
  - 2003: 59.1
  - 2004: 59.5 (Dec '03 observation)
- Broad money (M3, percent change, 12-month basis)
  - Jan '04 values: 13.1 (Mar), 18.1 (Jun), 17.7 (Sep), 9.5 (Dec), 12.0 (Mar), 12.0 (Jun)
- Private sector credit (percent change, 12-month basis)
  - Jan '04 values include 21.5, 34.8, 18.4, 22.2, 35.2, 38.4
- 3-month T-bill yield
  - Feb '04 values shown include 12.4, 11.6, 9.7, 7.9, 11.8, 12.4
- Current account balance 3/
  - Observations: -5.7, -6.2, -3.4, -4.1, -5.7, -5.6 (Jan '04)
- Capital and financial account balance 3/
  - Observations (Dec '03): 13.5, 11.2, 5.9, 3.9, 8.8
  - Of which: Inward portfolio investment (debt securities etc.)
    - Values include 2.5, -1.8, 2.1, -0.4, 0.1 (Dec '03)
  - Other investment (loans, trade credits etc.)
    - Values include 3.0, 6.8, -4.5, -2.7, 4.1 (Dec '03)
  - Inward foreign direct investment (other than equity)
    - Values include 1.4, 0.7, 3.1, -0.1, -1.7 (Dec '03)
- Net foreign assets (NFA) of commercial banks (in billions of U.S. dollars)
  - Jan '04 values: 0.6, 0.2, 2.3, 1.8, 2.1, 3.3
- Gross official reserves (in billions of US dollars)
  - Feb '04 values: 11.0, 11.2, 10.8, 10.4, 12.8, 13.1
- Official reserves in months of imports of goods and services
  - Jan '04 values: 4.1, 3.7, 3.4, 2.9, 2.8, 2.8
- Total external debt (two series noted)
  - 7/ Total external debt: 64.2, 64.3, 64.3, 55.3, 47.0 (2003 Q2)
  - 8/ Total external debt (excluding intercompany loans): 58.0, 59.9, 55.4, 46.4, 51.7 (2003 Q3)
  - Total external debt as a percent of exports of goods & services (8/): 85.8, 80.5, 76.3, 81.5, 89.2 (2003 Q3)
- Exchange rate (per US$, period average)
  - Jan '04 values: 237.1, 282.2, 286.5, 257.9, 224.3, 209.8

### Financial indicators, banking sector and markets (selected series)
- Non performing loans as a percent of total loans (Sep '03): 4.2, 3.0, 2.2, 2.0, 1.7
- Capital adequacy ratio (in percent) (Jun '03): 14.2, 13.7, 13.9, 13.0, 11.6
- Foreign exchange loans as a percent of total loans (Jun '03): ... ,41.6, 37.4, 36.5, 39.9
- Exports and imports (percent change, 12-month basis in U.S. dollars) (Jan '04)
  - Exports: 35.8, 11.6, 9.8, 10.5, 22.9, 23.0
  - Imports: 37.8, 12.6, 6.5, 12.3, 26.7, 27.1
- Financial market indicators (selected)
  - Stock market index (end of period) examples: 10,101; 7,850; 7,131; 77,989; 89,380; 10,644 (23-Mar-04)
  - Foreign currency debt rating (Moody's) (23-Mar-04): Baa1, A3, A3, A1, A1, A1
  - Spread of dollar-denominated benchmark bond (basis points, end of period): 107.0, 116.0, 78.0, 59.5, ...
  - Spread of DM-denominated benchmark bond (basis points, end of period): ... , 91.4, 110.7, 53.3, 32.5, 28.5 (23-Mar-04)

### Monetary and domestic credit aggregates (selected table excerpts)
- Domestic claims (quarterly series shown)
  - Example levels: 8,302; 8,585; 8,995; 9,284; 9,862; 10,511; 10,648; 11,085
- Claims on non-financial corporations (quarterly series)
  - Levels: 3,850; 3,961; 4,142; 3,880; 4,011; 4,272; 4,425; 4,615
  - Of which securities: 293; 285; 306; 187; 188; 182; 190; 197
  - Credits (total): 3,557; 3,676; 3,835; 3,693; 3,823; 4,091; 4,235; 4,418
    - Forint credits: 2,361; 2,454; 2,547; 2,482; 2,469; 2,539; 2,671; 2,690
    - Foreign currency credits: 1,196; 1,220; 1,289; 1,211; 1,354; 1,552; 1,565; 1,728
- Claims on other financial corporations
  - Levels: 441; 520; 579; 652; 722; 862; 912; 1,020
  - Of which credits: 400; 479; 540; 602; 675; 818; 857; 961
    - Forint: 154; 163; 175; 175; 180; 214; 203; 197
    - Foreign currency: 246; 316; 365; 427; 495; 603; 653; 765
- Claims on the Consolidated Central Government
  - Levels: 2,995; 2,921; 2,875; 3,162; 3,401; 3,386; 3,047; 2,935
  - Of which securities: 1,704; 1,717; 1,700; 1,818; 2,123; 2,153; 2,061; 2,086
  - Credits: 1,290; 1,204; 1,175; 1,344; 1,279; 1,233; 987; 849
- Households (claims)
  - Levels: 932; 1,086; 1,298; 1,459; 1,605; 1,855; 2,121; 2,349
    - Forint: 906; 1,055; 1,263; 1,424; 1,563; 1,800; 2,059; 2,269
    - Foreign currency: 26; 30; 34; 36; 42; 55; 62; 80
- Net foreign assets (quarterly series): 653; 438; 420; 516; 539; 406; 539; 445
- Broad money (M3) series: 6,818; 6,945; 7,145; 7,859; 7,785; 8,114; 8,287; 8,792
  - M2 series: 6,468; 6,704; 6,870; 7,547; 7,450; 7,775; 7,996; 8,576
  - Currency outside monetary institutions: 1,005; 1,101; 1,149; 1,182; 1,198; 1,287; 1,306; 1,346
  - Deposits: 5,762; 5,886; 5,994; 6,652; 6,554; 6,791; 6,994; 7,538
    - Of which households deposits: 3,397; 3,407; 3,477; 3,729; 3,757; 3,840; 3,935; 4,324
      - Forint: 2,672; 2,729; 2,813; 3,102; 3,137; 3,202; 3,332; 3,737
      - Foreign currency: 725; 678; 665; 627; 620; 638; 603; 587
- Memorandum item: Domestic Credit levels: 6,264; 6,542; 6,950; 7,229; 7,505; 8,133; 8,342; 8,743

### Millennium Development Goals (selected indicators, 1990-2015)
- Social and human development indicators as presented:
  - Population (millions of persons): 10.4, 10.2, 10.2, 10.2, ...
  - Gross national income (billions of USD): 29.8, 42.4, 49.2, 53.7, ...
  - GNI per capita ($): 2,880; 4,140; 4,830; 5,280; ...
  - Net primary enrollment ratio (% of relevant age group): 91.3, 96.6, 90.2, ...,[100]
  - Percentage of cohort reaching grade 5 (%): 97.6
  - Youth literacy rate (% ages 15-24): 99.7, 99.8, 99.8, 99.8, ...
  - Ratio of girls to boys in primary and secondary education (%): 95.5, 97.9, 100.0, ... ,100.0
  - Under 5 mortality rate (per 1,000): 16.8, 12.5, 9.0, 9.6, [5.5]
  - Infant mortality rate (per 1,000 live births): 14.8, 10.7, 8.0, 7.5, ...
  - Immunization, measles (% of children under 12 months): 99.0, 99.0, 99.0, ...
  - Access to an improved water source (% of population): 99.0, ..., 99.0, ...
  - Aid (% of GNI): 0.2, -, 0.6, 0.8, ...
  - External debt (%GNI): 67.1, 73.8, 60.2, ...
  - Investment (% of GDP) 1/: 25.4, 23.9, 27.1, ...
  - Trade (% GDP): 59.7, 75.8, 123.3, ...
- Note: "The data shown are for the closest available year." and "1/ Different concept than IMF staff calculations."

### IMF relations, financial position and technical assistance (Appendix I highlights)
- Membership and quota (as of February 29, 2004)
  - Quota: 1,038.40 (SDR Million) — 100.00 percent of quota
  - Fund holdings of currency: 610.89 — 58.83 percent of quota
  - Reserve position in Fund: 427.51 — 41.17 percent of quota
  - SDR holdings: 32.95 (Million)
- Outstanding purchases and loans: None
- Recent financial arrangements (historical)
  - Stand-by approval 3/15/96–2/14/98: Approved 264.18 (SDR Million); Drawn 0.00
  - Stand-by approval 9/15/93–12/14/94: Approved 340.00; Drawn 56.70
  - EFF approval 2/20/91–9/15/93: Approved 1,114.00; Drawn 557.24
- Exchange rate arrangement summary:
  - Hungary accepted the obligations of Article VIII as of January 1, 1996.
  - Central parity set at 276.1 forint per euro as of October 1, 2001.
  - Intervention band margins history: ±2.25 percent on December 23, 1994; ±15 percent on May 4, 2001.
  - The peg crawl rates by period are listed explicitly in the source (monthly percentage rates and elimination effective October 1, 2001).
  - Hungary maintains exchange restrictions against Iraq (UN Resolution 661) and financial restrictions against organizations and individuals suspected of terrorism, as confirmed on March 23, 2004.
- Article IV consultations:
  - Hungary is on a 12-month consultation cycle.
  - The 2003 Article IV staff report was issued on April 2, 2003 (IMF Country Report No. 03/24).
  - Last Article IV Board discussion: May 2, 2003. Public Information Notice No. 03/58 released on May 9, 2003.
- Technical assistance (selected entries, year and purpose)
  - 1991: FAD — Tax reform; EU/IMF Institute seminar on financial programming; FAD — Budget reform; FAD — Tax administration reform; MAE/PDR — Development of a foreign exchange interbank market.
  - 1992: STA — Money and banking statistics seminar; FAD — Design and implementation of a "flash" fiscal reporting system; FAD — Revenue forecasting.
  - 1993–1997: Multiple FAD/MAE assignments on restructuring, central bank reorganization, treasury/debt management, tax administration, expenditure management, debt management, central bank auditing, monetary analysis.
  - 2000–2002: FAD/STA technical assistance on tax legislation, money and banking statistics, and expenditure rationalization.
- Regional Resident Representative:
  - The regional office was closed in July 2002.

*Source: IMF staff report excerpts and tables as presented in the supplied PDF content.*

### APPENDIX II

### APPENDIX II

### Significant progress and overall assessment
- Significant progress has been made in improving the coverage, periodicity, and quality of Hungarian economic and financial statistics.
- Most data quality issues noted in the data dissemination module of the 2001 Report on the Observance of Standards and Codes (ROSC) have been satisfactorily addressed, but some still remain.
- Hungary subscribes to the Special Data Dissemination Standard (SDDS) and meets SDDS specifications for coverage, periodicity, timeliness, and dissemination of advance release calendars.

### A. Real Sector Issues — National accounts
- A statistical discrepancy between the final version of GDP by production activities and GDP by expenditure components appeared in 1997 and has persisted.
- From 2000, the Hungarian Central Statistical Office (HCSO) has been regularly publishing an estimate of this discrepancy for final annual data.
- Subsequent methodological refinements and a change in the base year trimmed the magnitude of the discrepancy to about 1¼ percent of GDP, based on 2001 current price data.
- From June 2002, the HCSO began publishing seasonally adjusted estimates of quarterly GDP by type of economic activity and by expenditure components beginning with Q1 2002, with retrospective coverage from 1995.
- Benchmarking of quarterly estimates to annual estimates has been applied from 2000.
- Beginning with annual data for 2000, the methodology for estimation of imputed owner-occupied rent was changed in line with Eurostat recommendations (previously based on 1993 benchmarks).

### B. Balance of Payments
- A work plan with clear timetables is being implemented to replace cash-based balance of payments statistics (compiled by the Magyar Nemzeti Bank, MNB) with accrual-based BPM5 principles.
- Implemented improvements:
  - Use of customs data to derive trade in goods.
  - Recording goods under processing and repair as goods.
  - Recording financial lease arrangements according to BPM5.
  - Inclusion of estimates of reinvested earnings in balance of payments statistics (raising the current account deficit with offsetting impact on financial accounts).
- Further improvement expected in 2004: investment income to be recorded on an accrual basis; these modifications will complete the shift to accrual accounting consistent with BPM5.
- Release of revised quarterly series scheduled by the MNB for end-March 2004 covering 1995–2003.
- MNB and HCSO reconciled data sources and methodologies for travel receipts and payments, eliminating a prior discrepancy with national accounts.
- Since 2002, HCSO–MNB cooperation has been formalized through annual memoranda of understanding identifying areas to improve statistics and harmonize data sources and methodologies.

### C. Monetary Sector
- The International Financial Statistics (IFS) country page for Hungary provides timely data for monetary authorities, banking institutions, and the banking survey.
- Coverage of MNB’s analytical accounts has been extended; Hungary complies with the strengthened reserves standard.
- The compilation framework for monetary statistics in Hungary basically conforms to the Fund's current methodology.
- STA recommendation: exclude deposit liabilities of credit institutions under liquidation from monetary aggregates by reclassifying them as “restricted deposits.”
  - MNB decision (from beginning 2003): such credit institutions no longer classified as Monetary Financial Institutions (depository corporations); deposits held with them are excluded from monetary aggregates.
  - Deposits of these credit institutions held with the MNB and with other credit institutions reclassified as deposits of “nonfinancial enterprises,” thus excluding them from base money.
  - Note: in line with the IMF’s Monetary and Financial Statistics Manual and ECB advice, such institutions should be reclassified as other financial intermediaries.
- STA recommendation: value securities on depository corporations’ balance sheets at market prices; current practice is partial market valuation. Work in progress.
  - From 2004, depository corporations encouraged to use market valuation for securities in trading portfolio.
  - From 2005, market valuation compulsory for depository corporations listed on the stock exchange.
  - Securities of all companies listed on the stock exchange and held by depository corporations in trading portfolio should be based on market valuation.
  - Depository corporations required to revalue their securities at least quarterly, and more frequently if possible.
  - Note on valuation of nonlisted companies’ securities: secondary market values; if none, (i) company profitability using last two annual reports, or (ii) present value using acquisition prices; if no information, acquisition prices may be used.
- From January 2003, MNB compiles and publishes monetary aggregates adopting ECB-consistent methodology:
  - Monetary financial institutions now include money market funds (MMFs); MMFs’ balance sheet data are included in consolidated banking system balance sheet (depository corporations survey).
  - Conformity with ECB guidelines includes: classification of credit extended on a gross basis (excluding interest accrued); fixed assets at acquisition cost; deposits at face value (without interest accrued); debt securities not reported at market value recorded at face value and zero coupon bonds at discounted value.

### D. Government Finance Statistics (GFS)
- January 2004: STA conducted a substantive update of the GFS dataset using the July 2003 Data Quality Assessment Framework.
- Mission reported significant progress in addressing shortcomings of budget execution data and GFS identified in the original ROSC Data Module.
  - Improvements mainly relate to institutional coverage of general government, consolidation of data, and reconciliation of deficit and financing.
  - Plans to report monthly expenditures classified on an economic basis have yet to be implemented.
- Following a GFS mission in 1998, authorities provided annual data for GFS Yearbook starting from 1991; latest data reported for 2003 edition are for 2002.
  - These data cover operations of State Property Management and Privatization Company (since 1995), National Road Construction Company, State Debt Management Co., CASA Co., and Participation Management Co.
  - Data for 2000–2002 compiled on an accrual basis, in accordance with the 2001 Government Finance Statistics Manual methodology.
  - GFS Yearbook data and monthly data reported for IFS still contain inconsistencies between deficit and financing measures.

### Core Statistical Indicators (As of March 3, 2004) — selected metadata
- Date of latest observation examples:
  - Exchange Rates: Feb. 2004 (received 5-Mar; frequency Daily; source: National Bank of Hungary; mode Internet; public)
  - International Reserves: Jan. 2004 (received 5-Mar; frequency Monthly; source: National Bank of Hungary; mode Internet; public)
  - Central Bank Balance Sheet: Nov. 2003 (received Jan. 7, 2004; frequency Monthly; source: National Bank of Hungary; mode Internet; public)
  - Broad Money: Nov. 2003 (received Jan. 7, 2004; frequency Monthly; source: National Bank of Hungary; mode Internet; public)
  - Consumer Price Index: 31-Jan (received 17-Feb; frequency Monthly; source: Central Statistical Office of Hungary; mode Internet; public)
  - GDP: 2003 Q4 (received 15-Feb; frequency Quarterly; source: Central Statistical Office of Hungary; mode Email; public)
- Frequency of publication shown as Daily, Monthly, or Quarterly depending on series.

### APPENDIX III — Relations with the World Bank Group (summary)
- Hungary joined the World Bank in 1982; Bank commitments total some US$4.3 billion for 40 projects and programs.
- 1980s: assistance focused on liberalization, modernization, productive capacity, and infrastructure.
- 1990s: support for macroeconomic and structural adjustment, including structural adjustment loans and sector adjustment loans supporting financial sector and pension reform; support to strengthen public institutions (tax administration, public finance, health, social assistance).
- Hungary has access to private capital at highly competitive sovereign terms and significant European institutional financing; consequently Hungary has ceased borrowing from the World Bank and does not envisage further borrowing.
- The Bank provides analytical and advisory services as part of a pre-graduation assistance program.
- Ongoing Bank-financed project: Municipal Wastewater Management with an undisbursed balance of about US$12 million as of mid-November 2003.
- Additional ongoing activities: GEF Project Development Facility grant (Nutrient Reduction Project preparation); IDF grants (Center of Excellence for Property Rights and Land Market Development; Office of Roma Affairs); advisory work on health, pensions, energy reform; sub-national development policy and institutional advice; participation in “Cities of Change” initiative.
- Hungary has started to pre-pay some loans; outstanding obligations to the Bank amount to about US$253 million as of end-October 2003.
- IFC has not undertaken new investments and guarantees in Hungary in recent years.

### APPENDIX IV — The Housing Subsidy Scheme
- Scheme introduced in 2001 has had significant impact on general government deficit and external current account.
- Households obtain mortgage loans from commercial banks at below-market rates; banks are compensated with a government subsidy.
- March 2002: subsidies extended to purchase or reconstruction of used houses (previously only for new houses), increasing scheme use.
- Increases in market interest rates in 2003 boosted subsidy spending to 0.7 percent of GDP in 2003.
- Impact on domestic demand and external balances is difficult to quantify; fungibility implies subsidized loans—particularly for used houses—are partly used for consumption.
  - MNB estimates that 15–30 percent of loans granted towards used houses are used for consumption.
- Recent amendments intended to reduce fiscal cost and impact on private consumption over the medium term:
  - June 2003: maximum credit limit reduced from Ft 30 million to Ft 15  million (still almost 10 times the average annual wage); number of subsidized mortgage loans per household restricted to one.
  - December 2003: maximum credit limit for purchase/reconstruction of used homes further decreased to F5 5 million.
  - Interest subsidy reduced by making customer interest partly dependent on market rates.
- Expected impacts of changes:
  - MNB estimates fiscal savings to increase to 0.3–0.4 percent of GDP in 2006/7.
  - MNB estimates impact on current account deficit to rise from 0.1–0.3 percent of GDP in 2005 to 0.45–0.75 percent of GDP in 2006/7.
- Because changes apply only to new contracts, immediate impact expected to be modest; high market rates and a spurt of new contracts arranged during the December 2003 grace period are expected to boost expenditures in 2004 to 0.9 percent of GDP in 2004.

### APPENDIX V — Estimation Error Correction Model for CPI Inflation
- Method: Engle-Granger two-step error correction method used to assess relative importance of wage costs and import prices for inflation determination.
- Long-term relationship estimated for log CPI excluding regulated prices (LCPIXR) using unit labor costs in enterprise sector (LULCEP) and German CPI denominated in forint (LCPIGF).
- Estimated long-run equation (coefficients and standard errors in parentheses):
  - LCPIXR = 0.69 * LULCEP + 0.43 * LCPIGF – 2.86 + seasonality
    - (0.022)            (0.025)            (0.142)
- Interpretation: suggested weights for wages and productivity around 0.7 and somewhat over 0.4 for import prices; sum close to 1.
- Dynamic error-correction equation for CPI (D = first difference, ECM = long-run residual):
  - DLCPIXR = 0.374 * DLCPIXR_1 + 0.236 * DLCPIXR_3 + 0.231 * DLCPIXR_4
    - (0.089)                   (0.093)                    (0.095)
    - 0.069 * ECM_1 + 0.0597 * OPG + 0.002 + seasonality
      - (0.021)          (0.0298)             (0.002)
- Findings:
  - ECM coefficient suggests that 60 percent of a disequilibrium would be closed in one year.
  - Output gap (OPG) has a significant coefficient, indicating price pressures increase when activity becomes more buoyant.
- Key test results: standard error 0.0039; Durban-Watson statistic 2.11; equation passed a number of specification tests.

### Supplementary Information — Recent Economic Developments and Data Revisions (since staff report preparation)
- Merchandise exports in euro terms were 13.1 higher in January-February 2004 than a year earlier (about 20 percent in volume terms).
- Imports in euros higher by 8.4 percent during that period (about 15 percent in volume terms).
- Trade deficit totaled € 270 million in January-February 2004, compared with € 467 million in January-February 2003.
- The 12-month rolling current account deficit (including reinvested earnings) was 9 percent of GDP in February, down from its peak of 9.2 percent in August-October 2003.
- Industrial output was up 10.8 percent in Q1 2004 from a year earlier.
- Year-on-year headline CPI inflation declined to 6.7 percent in March from 7.1 percent in February; core inflation (excludes food and fuel) remained at 6.1 percent.
- Gross monthly wage growth in the private sector was 10.1 percent year-on-year in January-February 2004 (3.3 percent in real—CPI deflated—terms), compared with year-average growth of 9.0 percent in 2003 (4.3 percent in real terms).
- Public sector wage growth fell to 5.5 percent in January-February 2004 (-1.4 percent in real terms), compared with 17.8 percent in 2003 (13.2 percent in real terms).
- Since the staff report, the forint stabilized in the Ft 250-255 per euro range.
- MNB policy rate cuts: 25 basis points on April 5; 50 basis points on May 3 to 11½ percent.
- Preliminary general government deficit about 2.1 percent of estimated annual GDP in Q1 2004, compared with 1.6 percent in Q1 2003 (excluding local governments).
  - Tax revenues increased by 8.3 percent year-on-year to Q1 2004.
  - Total expenditures increased by 17.3 percent year-on-year (7.8 percent increase excluding “chapter administered professional appropriations” which include early transfers to central budgetary institutions).
- Ministry of Finance expects general government deficit to continue to increase through Q2 2004, then be very low in H2 2004.

*International Monetary Fund — Staff Report for the 2004 Article IV Consultation Supplementary Information (Prepared by the European Department; Approved by Carlo Cottarelli and Liam P. Ebrill; May 7, 2004).*

### 3. Fiscal data have been revised:

### _cr04145 - 3. Fiscal data have been revised:

### Fiscal data revision (April 5 update)
- Ministry of Finance provided revised estimates of the allocation within the 2004 budget, partly reflecting revised estimates of the 2003 fiscal outcome.
- Revisions incorporated information on local governments and consolidation among different parts of the general government, previously unavailable.
- Revisions increased both consolidated revenues and expenditures by about 1.2 percent of GDP, while changing the balance by only a very small amount:
  - General government balance: revised to 5.9 percent of GDP from the preliminary estimate of 6.0 percent mentioned in the staff report.
- Revised projections for 2004 show roughly unchanged total revenues and expenditures—and therefore an unchanged deficit—relative to the staff report, though the composition of these components differs from the budget projections in the staff report.
- Staff continues to see risks to achieving the 2004 fiscal deficit target, consistent with risks elaborated in the staff report.

### Consolidated General Government (ESA-95 Basis) — Table highlights (2003–04, In percent of GDP unless noted)
- 2003 (Revised) / 2004 (Revised budget):
  - Total revenues: 44.9 / 43.7
  - Current revenues and current grants: 43.2 / 42.3
  - Tax revenues total: 39.3 / 39.0
    - Taxes on income: 9.3 / 9.0
      - Personal income tax: 7.1 / 6.9
      - Corporate income tax: 2.2 / 2.1
    - Social security contributions: 12.6 / 12.4
    - Taxes on goods and services: 15.9 / 15.6
      - of which: VAT: 9.2 / 9.7
    - Other taxes: 1.5 / 2.0
  - Current non tax revenues total: 3.7 / 2.8
    - Of which: interest: 0.2 / 0.3
  - Current grants: 0.2 / 0.5
  - Capital revenues and capital grants: 1.1 / 1.4
    - Capital revenues: 0.9 / 0.8
    - Capital grants: 0.2 / 0.5
  - Non-allocable revenues: 0.6 / 0.0
  - Total expenditures: 50.8 / 48.3
  - Current expenditures and current transfers: 44.9 / 42.2
    - Goods and services: 19.6 / 17.3
      - Of which: wages and salaries 1/: 12.4 / 11.9
    - Transfers: 21.2 / 20.5
      - Of which: to households: 16.5 / 15.9
    - Interest payments: 4.1 / 4.4
  - Capital expenditures and capital transfers: 5.6 / 6.0
    - Capital expenditures: 3.8 / 3.7
    - Capital transfers: 1.8 / 2.3
  - Unallocable expenditures: 0.3 / 0.2
    - Of which: General government reserves: 0.0 / 0.2
  - General government balance: -5.9 / -4.6
  - Net interest: -3.9 / -4.1
  - Primary balance: -2.1 / -0.5
- Memorandum items:
  - GDP, in current prices (forint billions): 18,574 / 20,380
  - Gross debt (in percent of GDP): 59.0 / 59.5
- Source: Hungarian authorites.
- 1/ Including social security contributions.

### AML/CFT developments
- June 2003: new AML Act came into force. Key features include:
  - (i) bringing rules for lawyers and public notaries fully in line with the second AML Directive of the European Union;
  - (ii) introducing re-identification and verification of identification documents of existing customers of financial sector institutions.
- Other developments:
  - Increase in the number of suspicion reports.
  - Increase in the number of staff of the Financial Intelligence Unit.
  - Hungary was removed from the FATF monitoring list in June 2003.

### Executive Board Assessment — Key findings and policy recommendations
- Context and concerns:
  - Recognized Hungary’s successful transition and EU entry, but noted large fiscal and current account deficits and continued inflationary pressures.
  - Highlighted loss of policy credibility and volatility in financial markets due to policy inconsistencies in 2003.
- Macroeconomic conditions:
  - Real GDP growth: 2.9 percent in 2003; fourth quarter 2003 real GDP growth reached 3.5 percent year-on-year.
  - Economy-wide real wages surged: about 14 percent in 2002 and another 10 percent in 2003.
  - Headline inflation: 5.7 percent (year-on-year) in December 2003.
  - Current account deficit widened to 5.5 percent of GDP in 2003 (excluding reinvested earnings), financed mainly by debt-creating inflows.
  - Main short-term policy interest rate increased by 300 basis points in November 2003 to 12.5 percent; total increase 600 basis points since June.
- Fiscal targets:
  - Authorities announced revised target for the general government deficit in 2004 of 4.6 percent of GDP (compared with outturn of 5.9 percent in 2003 and original target of 3.8 percent).
  - Directors considered the fiscal adjustment envisaged by the authorities in 2004 appropriately ambitious but noted risks of falling short and cautioned that further fiscal corrections could be needed soon.
  - Encouraged authorities to quickly identify specific contingent spending cutbacks.
- Recommended expenditure reforms to ensure durable medium-term adjustment:
  - Consolidate current expenditure given high tax incidence, particularly on labor, and spending pressures from public investment needs and EU accession.
  - Areas for reform to achieve significant savings and improve efficiency: rationalizing government employment; continuing pension reform; improving targeting and structure of social benefits and subsidies; reforms in education and health care.
  - Further scaling back of the housing subsidy scheme.
  - Greater public sector wage restraint.
  - Follow through on plans to introduce a rolling medium-term fiscal framework with expenditure ceilings and integrate it in the annual budget process.
- Monetary and exchange rate policy:
  - Welcomed focus on medium-term inflation objectives.
  - Some Directors saw room to reduce official interest rates further after recent cuts; others saw the stance as appropriate pending fiscal adjustment.
  - Agreed that room for significant cuts would be created once demonstrated fiscal adjustment re-establishes policy credibility.
  - Welcomed shift to greater exchange rate flexibility to cushion unanticipated shocks; cautioned against public communication implying a rigid commitment to a particular exchange rate level or range as ERM2 approaches.
  - Emphasized use of all policy tools for sustainable disinflation, including fiscal consolidation and wage moderation; importance of getting central parity right for ERM2.
  - Suggested potential benefits from an incomes policy to alleviate tensions between inflation and current account objectives; government should lead on restraining wages.
- Financial sector and structural policies:
  - Financial system judged healthy; vulnerabilities manageable but reflected strong credit growth and increasing credit risk—authorities urged to monitor and act timely.
  - Emphasized ensuring an independent and accountable financial supervisory authority.
  - Commended compliance efforts on AML/CFT and encouraged implementation of the new AML law.
  - Welcomed product market reforms, plans to complete final stage of privatization, and increases in gas and electricity prices to cost recovery levels to eliminate implicit subsidies.
  - Encouraged actions to raise the current low labor participation rate.
- Transparency and budgetary discipline:
  - Commended commitment to transparency and standards (continued participation in Report on the Observance of Standards and Codes updates).
  - Noted that authorities’ leeway to undertake government spending above budgeted levels without supplementary appropriations and parliamentary approval threatens fiscal discipline and needs to be rectified.

### Hungary: Selected macroeconomic indicators (selected rows, from table)
- Real GDP (change in percent): 1999: 4.2; 2000: 5.2; 2001: 3.8; 2002: 3.3; 2003: 2.9; 2004: 3.2 (projection).
- CPI (end-year): 1999: 11.2; 2000: 10.1; 2001: 6.8; 2002: 4.8; 2003: 5.7; 2004: 6.5 (projection).
- Unemployment rate (percent): 1999: 7.0; 2000: 6.4; 2001: 5.7; 2002: 5.8; 2003: 5.9; 2004: 6.2 (projection).
- Gross national saving (percent of GDP): 1999: 23.4; 2000: 24.6; 2001: 23.8; 2002: 20.0; 2003: 18.2; 2004: 19.0 (projection).
- General government balance (percent of GDP, ESA-95): 1999: ...; 2000: -3.0; 2001: -4.7; 2002: -9.4; 2003: -5.9; 2004: -4.6 (projection).
- General government debt (percent of GDP): 1999: 61.0; 2000: 55.4; 2001: 53.4; 2002: 57.1; 2003: 59.1; 2004: 59.5 (projection).
- Credit to non-government (end-year, percent change): 1999: 21.5; 2000: 34.8; 2001: 18.4; 2002: 22.2; 2003: 35.2; 2004: ...
- T-bill (90-day, average) (percent): 1999: 14.5; 2000: 10.9; 2001: 10.6; 2002: 8.8; 2003: 8.5; 2004: 12.5 (average of January–February).
- Trade balance (percent of GDP): 1999: -5.1; 2000: -6.3; 2001: -4.3; 2002: -3.3; 2003: -4.1; 2004: -4.0 (projection).
- Current account (percent of GDP): 1999: -5.0; 2000: -6.2; 2001: -3.3; 2002: -4.1; 2003: -5.5; 2004: -5.3 (projection).
- Gross international reserves (Billions of U.S. dollars): 1999: 11.0; 2000: 11.2; 2001: 10.8; 2002: 10.4; 2003: 12.8; 2004: 14.2.
- Gross international reserves (In months of imports of goods and services): 1999: 4.1; 2000: 3.7; 2001: 3.4; 2002: 2.9; 2003: 2.8; 2004: 2.7.
- Net external debt (percent of GDP): 1999: 22.5; 2000: 25.4; 2001: 23.4; 2002: 26.4; 2003: 29.4; 2004: ...
- Exchange regime: Peg against euro with band +/- 15 percent.
- Exchange rate: forint 204.48 = US$1.

*Public Information Notice (PIN) No.04/59 — May 24, 2004. Source: IMF staff report and Hungarian authorities as presented in the provided material.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04145.pdf_