## _cr05213

## Source details

**Canonical URL:** [_cr05213](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05213.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05213.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05213.pdf.json)

---

### Executive Summary
- GDP growth was 4 percent in 2004.
- The current account deficit stabilized at about 9 percent of GDP in 2004.
- The 2004 average inflation rate was just under 7 percent (excluding the direct effect of the 2004 VAT increase, average inflation was 4.8 percent).
- Some fiscal consolidation was achieved in 2004, but underlying consolidation was limited.
- Financial markets maintained a generally optimistic view of Hungary.

### Outlook
- Real GDP growth is expected to slow to 3.4 percent in 2005.
- Disinflation is expected to continue.
- The current account deficit is projected to decline in 2004 and in the medium term, but the trajectory of the external deficit and debt remains crucially linked to the extent of fiscal consolidation.
- Medium-term growth is expected to be in the range of 3½ to 4 percent a year, with movements reflecting euro area growth.

### Key macroeconomic developments (recent)
- Growth dynamics:
  - Strong export and investment performance supported brisk growth in early 2004; growth slowed in the second half of 2004.
  - Hungary’s growth performance was influenced by developments in the euro area.
- Labor market:
  - The unemployment rate rose from 5.5 percent in the last quarter of 2003 to 6.3 percent in October–December 2004.
  - Labor force participation remained low at 60.5 percent in 2004, compared with 68 percent in the euro area.
- Wages and consumption:
  - Real wages were relatively flat in 2004 after earlier rapid increases.
  - Slower wage growth and a weaker labor market moderated consumption growth.
- Inflation:
  - An encouraging fall in inflation started in June 2004.
  - Month-on-month inflation was down to an annualized rate of 3.5 percent by year’s end.
  - Prices of traded goods are rising at about the same rate as imported goods; nontraded goods and services inflation declined more slowly.
- Fiscal outcomes:
  - When second-pillar pension contributions are added to government revenues (ESA 1995 basis), the general government deficit fell from 6.2 percent in 2003 to 4.4 percent of GDP in 2004.
  - Excluding these notional revenues, the budget deficit declined from 7.2 percent to 5.4 percent of GDP.
  - The cash-based (GFS 1986) deficit actually rose in 2004 despite the accrual deficit decline.
  - The wage bill was reduced by 1 percent of GDP (about half reflecting an accounting convention change regarding bonus payments).
- External sector and financing:
  - Low savings (15 percent of GDP) and stable investment (24 percent of GDP) help explain the large current account deficit.
  - FDI averaged 8 percent of GDP in the late 1990s, fell to 2.6 percent of GDP in 2003, and recovered to 4.2 percent of GDP in 2004; nevertheless, the large current account deficit required significant debt-creating financing.

### Policy discussions — main points and recommendations
- Euro adoption:
  - Authorities’ target to adopt the euro by 2010 has not been supported by an active structural reform agenda.
  - Meeting the Maastricht fiscal limits will require substantial effort.
  - Staff emphasized sustainable structural reforms, particularly fiscal reforms, are essential for euro adoption and stronger subsequent economic performance.
- Public finances:
  - Meeting the 2005 fiscal deficit target will require strong discipline through use of reserves and expenditure controls.
  - Adherence to the fiscal consolidation path in the Convergence Program is critical and needs support from structural expenditure measures.
  - Structural measures—such as raising households’ incentives to save and modernizing public services—have durable benefits.
  - Increased checks and balances in the budget process are necessary to improve accountability and discipline.
- Monetary policy:
  - Further reductions in the policy interest rate should be undertaken cautiously and based on market inflation expectations.
  - Markets must learn to interpret policy rate changes as driven primarily by inflation-targeting considerations.
  - Adopt a constant inflation goal targeted over a moving horizon, and reduce the role of exchange rate considerations in setting interest rates.
- Financial sector:
  - The financial system is generally sound and well supervised.
  - The growing share of foreign currency debt, particularly among households and SMEs that likely are not hedged, could become a source of vulnerability and should be monitored closely.
- Structural reforms:
  - Raising labor force participation and increasing labor market flexibility are priorities.
  - Further efforts are needed to raise productivity.
  - Appropriate use of EU funds will be crucial for fostering the knowledge economy, promoting small business, and improving infrastructure.

### Financial markets and exchange rate
- The forint strengthened by 7 percent against the euro in 2004.
- The exchange rate has been close to the strong edge of its band (a 15 percent range around a central parity of 282.36 forint per euro).
- Risk premiums on both domestic and foreign currency bonds have fallen with improved sentiment toward the region.
- Market differentiation and concerns:
  - Fitch downgraded Hungary’s local currency rating in January 2005 in response to concerns about the twin deficits.
  - Magnitudes of exchange rate appreciation and spread compression have been smaller than those of other countries in the region.
  - Forward spreads on local currency bonds have not narrowed, reflecting greater uncertainty regarding the timing of euro adoption.

### Short-term outlook and risks
- Economic activity:
  - Industrial production and indices of business sentiment are down in early 2005.
  - The unemployment rate reached 7.1 percent in the first quarter of 2005.
- Growth projections:
  - Staff expects real GDP to grow at 3.4 percent in 2005.
  - Authorities’ projection: 3.5–3.8 percent.
  - Consensus forecast: 3.6 percent.
- Current account:
  - Staff projects the current account deficit will decline to 8.6 percent of GDP as the trade balance stabilizes in GDP terms and net current transfers through EU funds increase.
- Inflation and risks:
  - Average inflation in 2005 is projected at 4 percent.
  - Upside inflation risks: movements in oil, other commodity, and unprocessed food prices; a reacceleration of wage growth; and a hike in the tobacco excise duty in 2006 (expected to affect the core CPI).
- Budget risks and fiscal management:
  - Authorities acknowledge significant risks to meeting the 2005 budget deficit target of 3.6 percent of GDP (or 4.7 percent of GDP excluding the second-pillar pension contributions).
  - The 2005 budget assumed GDP growth and inflation at 4 and 4½ percent, respectively—higher than currently projected outcomes.
  - Staff estimates slower growth and lower inflation could cause a revenue shortfall of about 0.6 percent of GDP.
  - Administrative problems may cause VAT revenue shortfalls; risks of overspending are serious.
  - Between January and April, the cash deficit reached about 70 percent of the annual target.
  - Staff emphasized careful release of reserves (overall 1.3 percent of GDP), timely identification of priority spending, and strict enforcement of measures to limit overspending and carryover of unused funds.
  - If restraints prove infeasible, staff project a deficit overshoot of 0.6 percent of GDP, raising risks of a larger current account deficit, increased debt and slower growth in the medium-term.

### Medium-term trends and competitiveness
- Growth performance and potential:
  - Hungary’s average growth slowed from 4.7 percent between 1997 and 2000 to 3.6 percent a year between 2001 and 2004.
  - Staff estimates potential growth declined from just under 5 percent a year in the late 1990s to about 3½ percent in 2004.
  - A staff analysis places Hungary’s long-run growth potential in the 3.8–5.8 percent range.
  - If potential growth remains at the lower end, growth beyond 2005 will stay in the range of 3½ to 4 percent a year.
  - Raising potential growth will require structural reforms to achieve higher productivity growth and greater labor force participation.
- External sustainability and debt dynamics:
  - With the effective real interest rate on external debt expected to be lower than the growth rate, at the current exchange rate the external debt-to-GDP ratio is projected to decline from 63 percent in 2004 to 56 percent in 2010.
  - Increased EU resources will reduce reliance on external borrowing.
  - A setback to fiscal tightening and shocks to growth and FDI could reverse the projected decline in the external debt ratio.
- Competitiveness and tradables:
  - CPI- and unit labor cost (ULC)-based real exchange rates have appreciated in recent years.
  - Authorities focus on measures to raise productivity growth and the savings rate rather than exchange-rate adjustment alone.
  - Staff cautioned that technological upgrading may have slowed and Hungary faces increasing competition from other industrializing countries.

### Public finances, PPPs, and off-budget risks
- Convergence Program commitments:
  - The authorities reiterated commitment to targets in the government’s Convergence Program.
  - A fiscal consolidation relative to GDP of 0.6 percentage point per year is targeted over the next three years.
  - Staff urged minimizing changes in accounting conventions and emphasized lowering the deficit below the Maastricht limit is important for euro adoption.
- Debt levels and vulnerability:
  - The public debt-to-GDP ratio is at 60 percent.
  - Stress tests show that a slowdown in real growth could raise the debt ratio well above the Maastricht ceiling by 2010.
  - Staff stressed preparedness to respond quickly with more ambitious fiscal consolidation should debt dynamics turn adverse.
- PPPs and off-budget operations:
  - PPP-based investment spending for highways is estimated at 1.2 percent of GDP in 2005 and contributes to a fiscal stimulus.
  - Spending based on privatization receipts is expected to reach 0.5 percent of GDP in 2005.
  - Table 1 fiscal operations (in percent of GDP): fiscal deficit 2004 = 5.4; 2005 = 4.7. Primary fiscal deficit 2004 = 1.2; 2005 = 0.9. Capital expenditures under PPPs 2004 = 0.0; 2005 = 1.2. Privatization receipts spending 2004 = 0.4; 2005 = 0.5. Adjusted fiscal deficit 2004 = 5.8; 2005 = 6.4. Adjusted primary fiscal deficit 2004 = 1.6; 2005 = 2.6. Fiscal stimulus...1.0.
- Staff cautioned against the use of extrabudgetary mechanisms primarily to achieve on-budget consolidation; PPPs may obscure public debt and reduce fiscal flexibility.

### Fiscal consolidation: central message and recommended reforms
- Central message:
  - Fiscal consolidation is central to policy objectives; risks to achieving the government’s 2005 fiscal deficit target are evident from early trends.
  - To meet the 2005 target it will be necessary to enforce the system of reserves and expenditure controls and to ensure timely identification of spending priorities.
  - Beyond 2005, adherence to at least the fiscal targets in the Convergence Program is essential for euro adoption by 2010 and for preserving macroeconomic stability and debt sustainability.
- Structural expenditure reforms recommended:
  - Pension sector reform.
  - Health sector reform.
  - Education sector reform.
  - Phasing out of interest rate subsidies.
- Tax policy:
  - Wide-ranging tax reform based on lower rates and a broader base.
  - Improvements in tax administration.
  - Tax reductions must be linked to expenditure reforms to ensure fiscal consolidation.
- Budget institutions:
  - Strengthen rules and procedures for budget formulation and implementation.
  - Adopt a medium-term fiscal budget framework: a three-year rolling framework including ceilings on overall expenditure and subceilings on key components.
  - Strengthen checks and balances and oversight by the State Audit Office.
  - Limit carryover of unused funds and additional budgetary spending without parliamentary approval.

### Monetary policy and inflation targeting
- Inflation context:
  - Inflation was 3.9 percent year on year as of April 2005.
  - MNB’s estimated optimal inflation rate: 3 percent.
  - Risks to inflation arise from possible supply shocks and a reversal of recent wage trends.
- Policy interest rate developments:
  - Policy interest rate had been rapidly reduced in the past year to 7.5 percent.
  - Market expectations of further interest rate reductions are consistent with achievement of the 2005 and 2006 inflation targets of 4 and 3.5 percent (±1 percent), respectively.
  - A gradual easing of rates in line with these expectations is likely to be appropriate.
- Recommendations:
  - Any further lowering of rates should be guided by the market’s inflation expectations.
  - Markets must learn to interpret policy rate changes as motivated primarily by inflation-targeting considerations.
  - Authorities plan to strengthen the inflation-targeting framework and expect to replace year-end targets with a constant inflation objective targeted over a rolling horizon.
- Exchange rate role:
  - Staff recommended that exchange rate considerations play a smaller role in setting interest rates and urged greater flexibility within the exchange rate band to avoid market confusion.

### Financial sector stability and vulnerabilities
- Financial sector performance:
  - Regulation and supervision have significantly improved; the system is well-capitalized and recently exceptionally profitable.
  - FSAP update recommended clarifying the Finance Minister’s role in overseeing the HFSA and cautioned the regulatory framework for the pension payout phase was deficient.
- Foreign currency borrowing concerns:
  - Household foreign currency borrowing increased from about 10 percent of total household loans at end-2002 to 25 percent in September 2004.
  - In 2005, almost all new lending of the banking system has been foreign currency denominated.
  - Households and small businesses are unlikely to be naturally hedged, generating credit risks for banks.
  - Staff reiterated FSAP recommendation to better inform borrowers of their foreign exchange risk; authorities agreed lenders should be required to provide detailed information to customers.
  - Regarding additional provisioning for foreign currency borrowing, the MNB cautioned such measures should not distort competition and must be in line with EU prudential directives.
- Key financial soundness indicators (selected):
  - Regulatory capital-to-risk-weighted assets: 2000 13.7; 2001 13.9; 2002 13.0; 2003 11.8; 2004 11.2.
  - Nonperforming loans (in percent of total loans): 2000 3.0; 2001 2.7; 2002 2.9; 2003 2.6; 2004 2.7.
  - Return on equity (after tax): 2000 13.5; 2001 17.7; 2002 16.2; 2003 19.5; 2004 25.2.

### Structural issues and labor market
- Priorities:
  - Raise Hungary’s low labor participation rate and increase labor market flexibility.
- National Action Plan for Employment reforms highlighted:
  - Gradual increase of retirement age to 62 years.
  - Better targeting of income replacement benefits (almost 60 percent of the inactive population not in school receive some form of pension).
  - Overhaul of vocational training with greater employer involvement.
  - Improve geographic mobility by addressing transport infrastructure deficiencies and rigidities in the housing market.
  - Phase out by 2006 the fixed component of employers’ contributions to health care to reduce disincentives to part-time work.
  - Future wage developments should be balanced, predictable, and in line with productivity growth.

### Business climate and competitiveness
- Hungary ranks about 39 (WEF) and 42 (IMD) in selected global competitiveness indicators (2004).
- Strengths: efficient contract enforcement.
- Weaknesses: more days to register a new business, high registration and legal costs, underdeveloped credit information systems, weak insolvency regime with low recovery rates.
- Authorities’ strategy: use EU funds in three interlinked areas—fostering the knowledge economy, promoting small businesses, and developing infrastructure.

### Staff appraisal and policy priorities
- Recent performance:
  - Hungary’s economy showed resilience in its first year as an EU member.
  - Exporters largely held their own; macroeconomic imbalances were contained; foreign investors remained confident.
- Policy priorities to raise potential growth and reduce vulnerabilities:
  - Achieve fiscal consolidation at least as ambitious as the Convergence Program.
  - Strengthen the inflation-targeting framework.
  - Reduce financial sector vulnerabilities, notably foreign currency exposure.
  - Undertake a more ambitious agenda of structural reforms.

### Key indicators and projections (selected figures preserved verbatim)
- Real GDP (change in percent): 2004: 4.0; 2005: 3.4; 2006: 3.6.
- CPI (average): 2004: 6.8; 2005: 4.0; 2006: 3.6.
- Unemployment rate (in percent): 2004: 5.9; 2005: 6.4; 2006: 6.2.
- General government balance (percent of GDP), ESA-95 basis: 2004: -5.4; 2005: -4.7; 2006 (proj): -4.1.
- Gross public debt (percent of GDP): 2004: 60.7; 2005: 59.9; 2006 (proj): 59.9.
- Current account (percent of GDP): 2004: -8.9; 2005 (proj): -8.6; 2006 (proj): -8.1.
- Reserves (months of imports): 2004: 2.6; 2005 (proj): 2.4; 2006 (proj): 2.3.
- Net external debt (percent of GDP): 2004: 31.7; 2005 (proj): 32.1; 2006 (proj): 31.0.
- Exchange regime: Peg against euro, with band +/-15 percent; Ft 196.0 = US$1 (present rate indicated).

### Staff illustrative medium-term scenario (table highlights)
- Real GDP growth (annual): 2005: 3.4; 2006: 3.6; 2007: 3.9; 2008: 4.0.
- Inflation (CPI; end-year basis): 2005: 4.0; 2006: 3.2; 2007: 3.0; 2008: 2.6.
- General government (ESA-95) primary balance (percent of GDP): 2005: -0.9; 2006: -0.5; 2007: 0.0; 2008: 0.4.
- General government debt (percent of GDP): 2005: 59.9; 2006: 59.9; 2007: 59.4; 2008: 58.4.

### External sustainability and stress tests (selected outcomes)
- External debt-to-GDP ratio projections (public sector debt, percent of GDP): 2004: 60.7; 2005: 59.9; 2006: 59.9; 2007: 59.4; 2008: 58.4; 2009: 57.6; 2010: 56.7.
- Stress test scenarios (selected outcomes):
  - Nominal interest rate shock (baseline + two standard deviation in 2005–06): 2005: 65.5; 2006: 65.6; 2007: 63.6.
  - Real GDP growth shock (baseline − two standard deviation in 2005–06): 2005: 65.0; 2006: 64.6; 2007: 62.6.
  - One-time 30 percent nominal depreciation in 2005: 2005: 81.6; 2006: 79.8; 2007: 77.5.
  - Combination of one-standard-deviation shocks (2–5): 2005: 75.3; 2006: 86.6; 2007: 84.2.
- Debt-stress scenario (Scenario 2) real interest rate shock (baseline + two standard deviation in 2005 and 2006) sample values:
  - 62.3; 64.7; 64.1; 63.1; 62.3; 61.4.

### Monetary, fiscal, and data-quality notes
- Monetary statistics and classification changes implemented to align with ECB and IMF manuals; MMFs included in monetary financial institutions from January 2003.
- Government Finance Statistics: data for 2000 onwards compiled on an accrual basis and reported in the Government Finance Statistics Manual 2001 format.
- Significant progress made in coverage, periodicity, and other aspects of Hungarian economic and financial statistics; Hungary meets SDDS specifications.

### Executive Board outcome and procedural note
- IMF Executive Board concluded the 2005 Article IV consultation with Hungary on June 15, 2005.
- The next Article IV consultation with Hungary is expected to be conducted under the standard 12-month cycle.

*Source: IMF staff report text provided in the content unit.*

### Executive Summary ......................................................................................................

### Executive Summary

### Background and headline findings
- GDP growth was 4 percent in 2004, with especially brisk growth in the first half of the year.
- The current account deficit stabilized at about 9 percent of GDP in 2004.
- Inflation fell through much of 2004; the 2004 average inflation rate was just under 7 percent (excluding the direct effect of the 2004 VAT increase, average inflation was 4.8 percent).
- Some fiscal consolidation was achieved in 2004, but underlying consolidation was limited.
- Financial markets maintained a generally optimistic view of Hungary.

### Outlook
- Real GDP growth is expected to slow to 3.4 percent in 2005.
- Disinflation is expected to continue.
- The current account deficit is projected to decline in 2004 and in the medium term, but the trajectory of the external deficit and debt remains crucially linked to the extent of fiscal consolidation.
- Medium-term growth is expected to be in the range of 3½ to 4 percent a year, with movements reflecting euro area growth.

### Key macroeconomic developments (recent)
- Growth dynamics:
  - Strong export and investment performance supported brisk growth in early 2004; growth slowed in the second half of 2004.
  - Hungary’s growth performance was influenced by developments in the euro area.
- Labor market:
  - The unemployment rate rose from 5.5 percent in the last quarter of 2003 to 6.3 percent in October–December 2004.
  - Labor force participation remained low at 60.5 percent in 2004, compared with 68 percent in the euro area.
- Wages and consumption:
  - Real wages were relatively flat in 2004 after earlier rapid increases.
  - Slower wage growth and a weaker labor market moderated consumption growth.
- Inflation:
  - An encouraging fall in inflation started in June 2004.
  - Month-on-month inflation was down to an annualized rate of 3.5 percent by year’s end.
  - Prices of traded goods are rising at about the same rate as imported goods; nontraded goods and services inflation declined more slowly, leaving Hungary’s inflation relatively high regionally.
- Fiscal outcomes:
  - When second-pillar pension contributions are added to government revenues (ESA 1995 basis), the general government deficit fell from 6.2 percent in 2003 to 4.4 percent of GDP in 2004.
  - Excluding these notional revenues, the budget deficit declined from 7.2 percent to 5.4 percent of GDP.
  - The trend in VAT refunds remains unclear; deficits for 2003 and 2004 may be revised further.
  - The cash-based (GFS 1986) deficit actually rose in 2004 despite the accrual deficit decline.
  - Consolidation was supported by restraint in the wage bill and capital expenditures; the wage bill was reduced by 1 percent of GDP (about half of which reflected an accounting convention change regarding bonus payments).
- External sector and financing:
  - Low savings (15 percent of GDP) and stable investment (24 percent of GDP) help explain the large current account deficit.
  - FDI averaged 8 percent of GDP in the late 1990s, fell to 2.6 percent of GDP in 2003, and recovered to 4.2 percent of GDP in 2004; nevertheless, the large current account deficit required significant debt-creating financing.

### Policy discussions — main points and recommendations
- Euro adoption:
  - Authorities’ target to adopt the euro by 2010 has not been supported by an active structural reform agenda.
  - Meeting the Maastricht fiscal limits will require substantial effort.
  - Staff emphasized that sustainable structural reforms, particularly fiscal reforms, are essential both for successful euro adoption and for stronger subsequent economic performance.
- Public finances:
  - Meeting the 2005 fiscal deficit target will require strong discipline through use of reserves and expenditure controls.
  - In the medium term, adhering to the fiscal consolidation path in the Convergence Program is critical and needs support from structural expenditure measures.
  - Staff and authorities agreed that structural measures—such as raising households’ incentives to save and modernizing public services—have durable benefits.
  - Increased checks and balances in the budget process were identified as necessary to improve accountability and discipline.
- Monetary policy:
  - Following the rapid decline in the policy interest rate, further reductions should be undertaken cautiously and based on market inflation expectations.
  - Staff suggested, and the authorities agreed, that markets must learn to interpret policy rate changes as driven primarily by inflation-targeting considerations.
  - This implies adopting a constant inflation goal, targeted over a moving horizon, and a smaller role for exchange rate considerations in setting interest rates.
- Financial sector:
  - The financial system is generally sound and well supervised.
  - The growing share of foreign currency debt, particularly among households and SMEs that likely are not hedged, could become a source of vulnerability and should be monitored closely.
- Structural reforms:
  - Raising labor force participation and increasing labor market flexibility are priorities.
  - Further efforts are needed to raise productivity.
  - Appropriate use of EU funds will be crucial for fostering the knowledge economy, promoting small business, and improving infrastructure.

### Governance and policy implementation issues
- Regaining durable control over fiscal policy is the key challenge given a legacy of missed deficit targets and declining fiscal transparency.
- Election years have historically been unfavorable for fiscal reform; the government has committed to further fiscal consolidation before the April 2006 elections.
- The authorities generally concurred with Fund advice on fiscal consolidation and structural reform but domestic political considerations have limited implementation.
- Specific Fund advice uptake:
  - Public wages were restrained in 2004, but only modest steps were implemented on government employment, pensions, social benefits, subsidies, education, and health care.
  - A three-year rolling fiscal framework suggested by staff has not been adopted.
  - Interest rate policy in 2004 broadly followed Fund recommendations, but authorities continue to signal an exchange-rate range to markets despite an inflation-targeting framework.
  - The Financial Sector Assessment Program (FSAP) update concluded the regulatory and supervisory framework had significantly improved over the previous four years.

*Source: IMF staff Executive Summary (page excerpts).*

### 8.      Financial markets remain generally optimistic about Hungarian prospects. In

### 8.      Financial markets remain generally optimistic about Hungarian prospects. In

### Financial markets and exchange rate
- The forint strengthened by 7 percent against the euro in 2004.
- The exchange rate has been close to the strong edge of its band (a 15 percent range around a central parity of 282.36 forint per euro).
- Risk premiums on both domestic and foreign currency bonds have fallen with improved sentiment toward the region.
- Market differentiation and concerns:
  - Fitch downgraded Hungary’s local currency rating in January 2005 in response to concerns about the twin deficits.
  - Magnitudes of exchange rate appreciation and spread compression have been smaller than those of other countries in the region.
  - Forward spreads on local currency bonds have not narrowed, reflecting greater uncertainty regarding the timing of euro adoption.

### Short-Term Outlook
- Economic activity:
  - Industrial production and indices of business sentiment are down in early 2005, mirroring the weakening euro area economy.
  - The unemployment rate reached 7.1 percent in the first quarter of 2005.
- Growth projections:
  - Staff expects real GDP to grow at 3.4 percent in 2005.
  - Authorities’ projection: 3.5–3.8 percent.
  - Consensus forecast: 3.6 percent.
- Current account:
  - Staff projects the current account deficit will decline to 8.6 percent of GDP as the trade balance stabilizes in GDP terms and net current transfers through EU funds increase.
- Inflation and risks:
  - Average inflation in 2005 is projected at 4 percent.
  - Authorities attribute recent disinflation to intensified import competition after EU accession and to an appreciating exchange rate.
  - Upside inflation risks: movements in oil, other commodity, and unprocessed food prices; a reacceleration of wage growth; and a hike in the tobacco excise duty in 2006 (expected to affect the core CPI).
- Budget risks and fiscal management:
  - Authorities acknowledge significant risks to meeting the 2005 budget deficit target of 3.6 percent of GDP (or 4.7 percent of GDP excluding the second-pillar pension contributions).
  - The 2005 budget assumed GDP growth and inflation at 4 and 4½ percent, respectively—higher than currently projected outcomes.
  - Staff estimates slower growth and lower inflation could cause a revenue shortfall of about 0.6 percent of GDP.
  - Administrative problems may cause VAT revenue shortfalls; risks of overspending are serious (municipal overspending, open-ended spending obligations, pharmaceutical and housing subsidies).
  - Between January and April, the cash deficit reached about 70 percent of the annual target.
  - Staff emphasized careful release of reserves (overall 1.3 percent of GDP), timely identification of priority spending, and strict enforcement of measures to limit overspending and carryover of unused funds.
  - If restraints prove infeasible, staff project a deficit overshoot of 0.6 percent of GDP, raising risks of a larger current account deficit, increased debt and slower growth in the medium-term.

### Medium-Term Trends
- Growth performance and potential:
  - Hungary’s average growth slowed from 4.7 percent between 1997 and 2000 to 3.6 percent a year between 2001 and 2004.
  - Staff estimates potential growth declined from just under 5 percent a year in the late 1990s to about 3½ percent in 2004.
  - A staff analysis of European growth experience places Hungary’s long-run growth potential in the 3.8–5.8 percent range.
  - If potential growth remains at the lower end of this range, growth beyond 2005 will stay in the range of 3½ to 4 percent a year.
  - Raising potential growth will require structural reforms to achieve higher productivity growth and greater labor force participation.
- External sustainability and debt dynamics:
  - With the effective real interest rate on external debt expected to be lower than the growth rate, at the current exchange rate the external debt-to-GDP ratio is projected to decline from 63 percent in 2004 to 56 percent in 2010.
  - Increased EU resources will reduce reliance on external borrowing.
  - A setback to fiscal tightening and shocks to growth and FDI could reverse the projected decline in the external debt ratio.
- Competitiveness and tradables:
  - CPI- and unit labor cost (ULC)-based real exchange rates have appreciated in recent years.
  - Authorities do not regard the exchange rate as the main mechanism for maintaining competitive exports; focus should be on measures to raise productivity growth and the savings rate.
  - Staff cautioned that technological upgrading may have slowed and Hungary faces increasing competition from other industrializing countries.
  - Real appreciation appears weakly associated with slower domestic production of traded goods in the short run.
- Catch-up and current account (Box 3 summary):
  - Hungary’s GDP growth averaged about 3½ percent a year between 2002 and 2004, while its current account deficit was around 9 percent of GDP.
  - A cross-country catch-up model suggests Hungary’s current account deficit of 9 percent of GDP was about 2½ percent of GDP larger than the central prediction of the model (though within the statistical confidence band).
  - Growth of 4 percent in 2004 was about 1 percentage point less than the central prediction of the model.

### Public Finances
- Convergence Program commitments:
  - The authorities reiterated commitment to targets in the government’s Convergence Program.
  - A fiscal consolidation relative to GDP of 0.6 percentage point per year is targeted over the next three years.
  - Staff urged minimizing changes in accounting conventions and emphasized that lowering the deficit below the Maastricht limit is important for euro adoption and for macroeconomic stability and growth.
- Debt levels and vulnerability:
  - The public debt-to-GDP ratio is at 60 percent.
  - Stress tests show that a slowdown in real growth could raise the debt ratio well above the Maastricht ceiling by 2010.
  - Staff stressed preparedness to respond quickly with more ambitious fiscal consolidation should debt dynamics turn adverse; further consolidation is desirable to make room for automatic stabilizers.
- Fiscal stimulus and off-budget operations (Box 4 summary):
  - PPP-based investment spending for highways is estimated at 1.2 percent of GDP in 2005 and contributes to a fiscal stimulus.
  - Spending based on privatization receipts is expected to reach 0.5 percent of GDP in 2005.
  - Table 1 fiscal operations (in percent of GDP): fiscal deficit 2004 = 5.4; 2005 = 4.7. Primary fiscal deficit 2004 = 1.2; 2005 = 0.9. Capital expenditures under PPPs 2004 = 0.0; 2005 = 1.2. Privatization receipts spending 2004 = 0.4; 2005 = 0.5. Adjusted fiscal deficit 2004 = 5.8; 2005 = 6.4. Adjusted primary fiscal deficit 2004 = 1.6; 2005 = 2.6. Fiscal stimulus...1.0.

*IMF staff report text*

### 19.      Staff cautioned against the use of extrabudgetary mechanisms primarily to

### _cr05213 - 19.      Staff cautioned against the use of extrabudgetary mechanisms primarily to

### Fiscal consolidation and extrabudgetary mechanisms
- Staff cautioned against the use of extrabudgetary mechanisms primarily to achieve consolidation of the on-budget balance.
- Authorities noted that off-budget financing through public-private partnerships (PPPs) can accelerate infrastructure development, but:
  - Staff argued the Hungarian experience and that of other countries suggested PPPs did not have a good track record of producing value for money.
  - PPPs provide a fiscal stimulus (Box 4) and represent a burden for future fiscal budgets, reducing fiscal flexibility.
  - Absent careful disclosure and accounting, PPPs render difficult the interpretation of public debt, budget trends, and their macroeconomic impact.

### Structural measures to limit and rationalize public expenditures
- Authorities acknowledged specific structural measures had yet to be formulated.
- Staff urged bolder steps to achieve durable and credible consolidation; authorities recognized structural measures would:
  - increase household incentives to save;
  - modernize the delivery of public services.
- Sectoral reform priorities noted:
  - Health and education: recent modest reforms need to proceed further with reduced direct government involvement in provision of services.
  - First-pillar pension and social support systems: costs should be contained.
  - Housing subsidy scheme: further reductions in, or preferably, removal of, the current housing subsidy scheme could help raise household savings.
  - State-owned enterprises: phasing out subsidies and completing privatization would enhance economic efficiency.

### Tax reform and the tax burden
- Expenditure-based consolidation was considered critical to create space for needed tax reform.
- Hungary’s heavy tax burden creates disincentives for employment and investment (Text Figure 8); the tax wedge on labor is particularly onerous (Text Table 2).
- Options under consideration for comprehensive tax reform: lower rates, a broader base, and greater ease of administration.
- Authorities agreed tax reductions could temporarily reduce revenues and must be linked to expenditure reforms to ensure fiscal consolidation.
- The envisaged early elimination of the local business tax, which the EU is likely to require, could be achieved on a revenue-neutral basis through a surcharge on the corporate tax or a real estate tax.

Key statistics from Text Table 2. Tax Wedge, 2003 1/
- Hungary: Income Tax plus Employee Contributions (in percent of gross wage) 13.0; Income Tax plus Employee Contributions less Cash Benefits (in percent of gross wage) 25.5; Income Tax plus Employee and Employer Contributions less Cash Benefits (in percent of labor costs) 45.7
- Czech Republic: 11.6; 24.1; 43.8
- Poland: 6.2; 31.2; 42.9
- Slovak Republic: 6.3; 19.1; 41.4
- Ireland: 11.4; 16.4; 24.5
- Korea: 2.3; 6.8; 14.1
- Mexico: 2.9; 4.4; 17.3
- Euro-area: 13.4; 26.7; 41.1
- Source note: 1 / Single person without children at 100 percent of average earnings.

### Budget rules, procedures, and fiscal institutions
- Sustainable consolidation requires strengthening rules and procedures for budget formulation and implementation.
- Despite some consolidation in accrual terms, there has been persistent overshooting of deficit targets, which have been gradually revised upward (Text Figure 9).
- In international comparisons, Hungary ranks low in the quality of its rules and budgetary procedures.
- Staff emphasized strengthening fiscal institutions to provide checks and balances to restore credibility to policy targets.
- Recent Public Finances Law measures were welcomed, but much remained to be done:
  - Stricter rules for carryover of unused funds from the previous fiscal year will help in 2005.
  - Limiting additional budgetary spending without supplementary appropriations and parliamentary approval was a step in the right direction; staff suggested discontinuing the practice altogether.
  - Staff urged adoption of a medium-term fiscal budget framework: the three-year rolling framework under consideration in 2003 (included ceilings on overall expenditure and subceilings on key components), further checks and balances in expenditure management, and more extensive oversight by the State Audit Office.

### Monetary policy and inflation targeting
- Inflation context:
  - Inflation was 3.9 percent year on year as of April 2005.
  - MNB’s estimated optimal inflation rate: 3 percent.
  - Risks to inflation arise from possible supply shocks and a reversal of recent wage trends.
- Policy interest rate developments:
  - Policy interest rate had been rapidly reduced in the past year to 7.5 percent (Text Figure 10).
  - Current market expectations of further interest rate reductions are consistent with achievement of the 2005 and 2006 inflation targets of 4 and 3.5 percent (±1 percent), respectively.
  - A gradual easing of rates in line with these expectations is likely to be appropriate.
- Recommendations:
  - Any further lowering of rates should be guided by the market’s inflation expectations.
  - Markets must learn to interpret policy rate changes as motivated primarily by inflation-targeting considerations; cautious reduction communicated appropriately will facilitate learning.
  - Authorities plan to strengthen the inflation-targeting framework and expect to replace year-end targets with a constant inflation objective targeted over a rolling horizon.
- Exchange rate role:
  - Importance of exchange rates for forecasting inflation has declined; staff recommended that exchange rate considerations play a smaller role in setting interest rates.
  - Staff reiterated that greater flexibility within the exchange rate band was desirable to avoid confusion in markets about the central bank’s objectives.
- Box 5: Inflation Persistence and Inflation Targeting
  - Since year-end inflation targets have not been consistently met, credibility of inflation targeting is not strongly established.
  - Analysis finds substantial forward-looking component in Hungarian inflation and low inflation persistence.
  - Achieving credibility will require a more consistent focus on inflation targeting; on occasion, changes in policy rates have been greater than can be rationalized by inflation-targeting considerations alone.
- Central Bank governance:
  - Following changes to the Central Bank Act in February 2004 allowing nominations to the Monetary Council by the Prime Minister, the Council was temporarily expanded to thirteen members; even after scaling back to eleven members in September 2006, the Council will remain large.
  - Staff noted vigilance is required to ensure effective functioning of the Monetary Council for central bank independence.

### Financial sector stability and vulnerabilities
- Financial sector performance, regulation, and supervision have continued to improve.
- An FSAP update confirmed a well-capitalized financial system that had recently been exceptionally profitable.
- Recommendations from the update included clarifying the Finance Minister’s role in overseeing the Hungarian Financial Supervisory Authority (HFSA).
- The update cautioned that the regulatory framework for the pension payout phase was deficient and could lead to future vulnerabilities.
- Foreign currency borrowing concerns:
  - Household foreign currency borrowing (mainly euro and Swiss franc) increased from about 10 percent of total household loans at end-2002 to 25 percent in September 2004 (Text Figure 11).
  - In 2005, almost all new lending of the banking system has been foreign currency denominated.
  - Households and small businesses are unlikely to be naturally hedged, generating credit risks for banks; foreign currency loans typically carry a shorter fixed-rate period than domestic currency loans.
  - Staff reiterated FSAP recommendation to better inform borrowers of their foreign exchange risk; authorities agreed lenders should be required to provide detailed information to customers regarding the effect of exchange and interest rate movements on debt-servicing expenses.
  - Regarding additional provisioning for foreign currency borrowing, the MNB cautioned such measures should not distort competition and must be in line with EU prudential directives.

Key statistics from Text Table 3. Hungary: Financial Soundness Indicators for Commercial Banks
- Regulatory capital-to-risk-weighted assets: 2000 13.7; 2001 13.9; 2002 13.0; 2003 11.8; 2004 11.2
- Nonperforming loans (in percent of total loans): 2000 3.0; 2001 2.7; 2002 2.9; 2003 2.6; 2004 2.7
- Loan-loss provisions (in percent of NPLs): 2000 57.0; 2001 42.6; 2002 50.8; 2003 47.3; 2004 51.1
- Return on equity (after tax): 2000 13.5; 2001 17.7; 2002 16.2; 2003 19.5; 2004 25.2
- Liquid assets (in percent of total assets): 2000 31.3; 2001 29.9; 2002 24.3; 2003 19.5; 2004 21.1
- Source: National Bank of Hungary.

### Structural issues and labor market
- Priorities: raising Hungary’s low labor participation rate and increasing labor market flexibility.
- National Action Plan for Employment reforms highlighted:
  - Gradual increase of retirement age to 62 years.
  - Better targeting of income replacement benefits (currently, almost 60 percent of the inactive population not in school receive some form of pension).
  - Overhaul of vocational training with greater employer involvement.
  - Improve geographic mobility by addressing transport infrastructure deficiencies (upgrading bypass roads, developing suburban community transportation and intermodal transport connection centers) and rigidities in the housing market.
  - Phase out by 2006 the fixed component of employers’ contributions to health care, which creates a disincentive to hiring part-time workers (only 5 percent of total employment, compared with almost 20 percent in the euro area).
  - Acknowledgement that large minimum wage hikes of 2001–02 hurt employment, especially for SMEs and low-skilled workers; future wage developments should be well balanced, predictable, and in line with productivity growth.

### Business climate and competitiveness
- Hungary has made considerable progress improving its business climate but needs further effort to reach standards of more advanced economies.
- In international competitiveness rankings, Hungary ranks about in the middle of the new EU members.
- World Bank Doing Business survey: strengths include efficient contract enforcement; weaknesses include more days to register a new business, high registration and legal costs, underdeveloped credit information systems, and a weak insolvency regime with low recovery rates.
- Authorities’ strategy tied to the National Development Plan using EU funds in three interlinked areas: fostering the knowledge economy, promoting small businesses, and developing infrastructure.
- Accession to the EU reduced the average tariff level (from 3.5 percent to 8.9 percent); accession is not expected to have a major immediate impact on trade due to gradual changes in the trade regime.

Selected entries from Text Table 4. Global Competitiveness Indicators, 2004 1/
- Finland rank: 18 (WEF)
- USA rank: 21 (IMD)
- Estonia rank: 20 (WEF) / 28 (IMD)
- Germany rank: 13 (WEF) / 21 (IMD)
- Korea rank: 29 (WEF) / 35 (IMD)
- Ireland rank: 30 (WEF) / 10 (IMD)
- Slovenia rank: 33 (WEF) / 45 (IMD)
- Hungary rank: 39 (WEF) / 42 (IMD)
- Czech Republic rank: 40 (WEF) / 43 (IMD)
- Slovak Republic rank: 43 (WEF) / 40 (IMD)
- Poland rank: 60 (WEF) / 57 (IMD)
- Source note: 1/ These survey-based indicators take into account a broad range of factors related to national economic performance.

### Staff appraisal and policy priorities
- Recent performance:
  - Hungary’s economy showed resilience in its first year as an EU member; accession created administrative challenges in tax collection and temporary inflationary pressures, which were navigated.
  - Exporters largely held their own; macroeconomic imbalances were contained; foreign investors remained confident.
- Need for raising potential growth to dampen vulnerabilities and retain financial market confidence.
  - Under current baseline projections of interest and growth rates, public and external debt as a proportion of GDP will decline modestly, but remain susceptible to shocks.
  - Growth-enhancing policies and policies to increase the savings rate are necessary given the large appreciation of the real exchange rate in recent years.
- The authorities need to reestablish a track record of consistent and predictable policies to raise growth in the short term and prevent medium-term erosion.
- Policy efforts needed in four broad areas:
  - achieving fiscal consolidation, at least as ambitious as that spelled out in the authorities’ Convergence Program;
  - strengthening the inflation-targeting framework;
  - reducing financial sector vulnerabilities;
  - undertaking a more ambitious agenda of structural reforms.

*Source: _cr05213 - 19.      Staff cautioned against the use of extrabudgetary mechanisms primarily to*

### 36.      Fiscal consolidation is central. The risks to achieving the government’s 2005 fiscal

### _cr05213 - 36.      Fiscal consolidation is central. The risks to achieving the government’s 2005 fiscal

### Fiscal consolidation: central message and near-term risks
- Fiscal consolidation is central to policy objectives; risks to achieving the government’s 2005 fiscal deficit target are evident from early trends.
- To meet the 2005 target it will be necessary to enforce the system of reserves and expenditure controls and to ensure timely identification of spending priorities.
- Another missed target would set back debt reduction and further damage policy credibility.
- Beyond 2005, adherence to at least the fiscal targets in the Convergence Program is essential for:
  - euro adoption by 2010, and
  - preserving macroeconomic stability and debt sustainability.
- A more ambitious consolidation trajectory would:
  - reduce the risk from shocks to public debt, and
  - create space for automatic stabilizers.

### Ad hoc measures, PPPs, and budgetary transparency
- Ad hoc fiscal measures obscure budgetary trends and will likely damage long-term growth.
- Recent differences in accrual and cash deficits reflect:
  - one-off VAT effects due to EU accession, and
  - changes in accounting practices that increase the difficulty of interpreting budgetary trends.
- In 2005, off-budget PPPs will finance needed infrastructure expenditures.
- International experience cautions that PPPs:
  - do not always produce value for money, and
  - further obscure budgetary trends.
- Ad hoc accounting and expenditure reduction measures may help meet the Maastricht criteria but will likely reduce economic flexibility, create structural distortions, and harm long-term growth prospects.

### Structural expenditure reforms and tax policy
- Durable fiscal consolidation requires a focus on structural improvements in expenditures and in the budget process.
- Fundamental expenditure reforms recommended:
  - pension sector reform,
  - health sector reform,
  - education sector reform,
  - phasing out of interest rate subsidies.
- Expected benefits of these reforms:
  - reduce the budget deficit,
  - improve the delivery of public services,
  - help raise private savings.
- Tax reform recommendations:
  - wide-ranging tax reform based on lower rates and a broader base,
  - improvements in tax administration.
- Caution: tax reform without structural spending reductions would endanger fiscal consolidation plans.
- To restrain competing claims on fiscal resources and overcome the tendency to miss targets, stronger checks and balances are needed in budgetary processes.

### Inflation outlook and monetary policy
- Inflation outlook improved in late 2004 and early 2005; monetary policy responded by reducing interest rates.
- Current market expectations suggest inflation will meet the 2005 and 2006 targets:
  - 2005: 4 percent (±1 percent),
  - 2006: 3.5 percent (±1 percent).
- Given risks of a reversal of recent disinflation, a cautious approach to future interest rate changes is warranted.
- Strengthening the inflation-targeting framework would help lower and stabilize inflation expectations.
- Authorities intend to lower the inflation target to 3 percent a year in the medium term; meeting the Maastricht inflation criterion may require an even lower target.
- Policy recommendations for the monetary framework:
  - introduce a constant target achieved over a rolling targeting horizon to increase predictability and anchor expectations,
  - reemphasize focus on containing domestic inflationary pressures rather than stabilizing the exchange rate, within the scope of maintaining the exchange rate band.

### Financial sector vulnerabilities and regulation
- The financial sector remains sound, but the growing share of foreign currency debt held by the private sector could become a vulnerability.
- Particular concern: expansion of foreign currency-denominated borrowing by households and small and medium-sized firms that likely are not naturally hedged.
- Recommended actions:
  - closely monitor foreign currency borrowing,
  - stronger disclosure requirements,
  - appropriately formulated additional provisioning for foreign currency loans,
  - adopt regulatory initiatives in the pension and insurance sectors as recommended by the recent FSAP update.

### Structural reforms to promote employment and productivity
- Further structural reforms are needed to promote employment and productivity growth.
- Labor market flexibility can be increased by:
  - facilitating geographic and occupational mobility,
  - reducing impediments to part-time employment,
  - implementing vocational educational reforms to reduce skills mismatches.
- Minimum wage policy:
  - sizable increases in the minimum wage in 2001–02 ill served employment generation; further increases should be contained.
- EU funds strategy:
  - authorities’ strategy to use EU funds to build a knowledge economy, raise productivity of small and medium-sized firms, and develop infrastructure is welcome,
  - fiscal structural reforms are necessary to ensure EU funds produce long-lasting gains.

### Key indicators and projections (selected figures preserved verbatim)
- Real GDP (change in percent): 2004: 4.0; 2005: 3.4; 2006: 3.6.
- CPI (average): 2004: 6.8; 2005: 4.0; 2006: 3.6.
- Unemployment rate (in percent): 2004: 5.9; 2005: 6.4; 2006: 6.2.
- General government balance (percent of GDP), ESA-95 basis: 2004: -5.4; 2005: -4.7; 2006 (proj): -4.1.
- Gross public debt (percent of GDP): 2004: 60.7; 2005: 59.9; 2006 (proj): 59.9.
- Current account (percent of GDP): 2004: -8.9; 2005 (proj): -8.6; 2006 (proj): -8.1.
- Reserves (months of imports): 2004: 2.6; 2005 (proj): 2.4; 2006 (proj): 2.3.
- Net external debt (percent of GDP): 2004: 31.7; 2005 (proj): 32.1; 2006 (proj): 31.0.
- Exchange regime: Peg against euro, with band +/-15 percent; Ft 196.0 = US$1 (present rate indicated).
- Table highlights (staff illustrative medium-term scenario):
  - Real GDP growth (annual): 2005: 3.4; 2006: 3.6; 2007: 3.9; 2008: 4.0.
  - Inflation (CPI; end-year basis): 2005: 4.0; 2006: 3.2; 2007: 3.0; 2008: 2.6.
  - General government (ESA-95) primary balance (percent of GDP): 2005: -0.9; 2006: -0.5; 2007: 0.0; 2008: 0.4.
  - General government debt (percent of GDP): 2005: 59.9; 2006: 59.9; 2007: 59.4; 2008: 58.4.
- External sustainability framework (baseline projections, public sector debt in percent of GDP):
  - 2004: 60.7; 2005: 59.9; 2006: 59.9; 2007: 59.4; 2008: 58.4; 2009: 57.6; 2010: 56.7.
- Stress test scenarios for external debt ratio (selected outcomes):
  - Nominal interest rate shock (baseline + two standard deviation in 2005–06): 2005: 65.5; 2006: 65.6; 2007: 63.6.
  - Real GDP growth shock (baseline − two standard deviation in 2005–06): 2005: 65.0; 2006: 64.6; 2007: 62.6.
  - One-time 30 percent nominal depreciation in 2005: 2005: 81.6; 2006: 79.8; 2007: 77.5.
  - Combination of one-standard-deviation shocks (2–5): 2005: 75.3; 2006: 86.6; 2007: 84.2.

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

*Source: IMF staff report text provided in the content unit.*

### 2. Real interest rate is at baseline level plus a two standard deviation shock in 2005 and 2006.

### _cr05213 - 2. Real interest rate is at baseline level plus a two standard deviation shock in 2005 and 2006.

### Debt-stress scenario results (selected scenarios)
- Scenario 2. Real interest rate is at baseline level plus a two standard deviation shock in 2005 and 2006.
  - 62.3
  - 64.7
  - 64.1
  - 63.1
  - 62.3
  - 61.4
- Scenario 3. Real GDP growth is at baseline level minus a two standard deviation shock in 2005 and 2006.
  - 61.4
  - 63.6
  - 64.3
  - 64.6
  - 63.7
  - 62.8
- Scenario 4. Primary balance is at baseline level plus a two standard deviation shock in 2005 and 2006.
  - 66.5
  - 73.1
  - 72.5
  - 71.5
  - 70.6
  - 69.6
- Scenario 5. Combination of 2-3 using one standard deviation shocks.
  - 64.8
  - 69.9
  - 69.3
  - 68.2
  - 67.4
  - 66.4
- Scenario 6. One time 30 percent real depreciation in 2005. 10/
  - 68.5
  - 68.5
  - 68.0
  - 66.9
  - 66.1
  - 65.1
- Scenario 7. Combination of 2 and 6: a two standard deviation interest rate shock and a one time 30 percent depreciation.
  - 71.2
  - 74.0
  - 73.4
  - 72.3
  - 71.4
  - 70.5

### Methodology and variable definitions (as provided)
- Consolidated general government debt, gross debt, ESA-95 basis.1/
- Debt dynamics derivation: Derived as [(r - π (1+g) - g + αε (1+r) ]/(1+g+ π + g π)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).
- Real interest rate contribution: derived from the denominator in footnote 2/ as r - π (1+g).
- Real growth contribution: derived from the denominator in footnote 2/ as -g.
- Exchange rate contribution: derived from the numerator in footnote 2/ as α ε (1+r).
- Primary balance and flow definitions: Defined as public sector deficit, plus amortization of medium- and long-term public sector debt, plus short-term debt at end of previous period.
- Interest expenditure measure: Derived as nominal interest expenditure divided by previous period debt stock.
- Key variables in scenarios: real GDP growth; real interest rate; and primary balance in percent of GDP.
- Real depreciation definition (footnote 10/): Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

### Selected financial and external indicators (reported values)
- Public sector debt: 55.4 53.4 57.1 59.1 60.8
- Broad money (M3, percent change, 12-month basis): 18.2 17.1 9.3 12.0 11.6
- Private sector credit (percent change, 12-month basis): 41.3 15.9 15.9 30.5 17.8
  - Credit to non financial corporations: 37.8 10.9 3.5 19.2 12.8
  - Credit to households: 64.3 44.5 69.7 60.7 27.7
- Total domestic credit (percent change, 12-month basis): 15.2 2.8 23.5 19.2 11.6
- 3-month T-bill yield: 11.6 9.7 7.9 11.8 9.3
- 3-month T-bill yield (real) 1/: 1.3 2.7 3.0 5.8 3.1
- Non performing loans as a percent of total loans 2/: 3.0 2.7 2.9 2.6 2.7
- Capital adequacy ratio (in percent): 13.7 13.9 13.0 11.8 11.2
- Foreign exchange loans as a percent of total loans: 42.0 36.3 30.3 30.8 34.1
- Exports of goods & services (percent change, 12-month basis in U.S. dollars) 3/: 11.6 9.8 10.7 23.4 29.2
- Imports of goods & services (percent change, 12-month basis in U.S. dollars) 3/: 12.6 6.5 12.6 27.8 26.0
- Current account balance 3/: -8.6 -6.2 -7.2 -8.7 -8.9
- Gross official reserves (in billions of US dollars): 11.2 10.8 10.4 12.8 16.0
- Official reserves in months of imports of goods and services: 3.7 3.4 2.9 2.8 2.9
- Total external debt 5/: 64.5 64.6 56.1 63.6 63.4
  - Of which: Public sector debt: 31.9 28.9 25.5 26.9 29.0
- Exchange rate (per US$, period average): 282.2 286.5 257.9 224.3 202.6
- REER depreciation (-) (12 month basis; CPI-based): 0.7 8.1 11.2 -3.6 11.5
- Stock market index (end of period): 7,850 7,131 77 989 89,380 14,743
- Foreign currency debt rating (Moody's): A3 A3 A1 A1 A1

### Statistical and data-quality notes (selected)
- Significant progress made in coverage, periodicity, and other aspects of Hungarian economic and financial statistics; most data quality issues from the 2001 ROSC data module 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 advance release calendars.
- National accounts:
  - A statistical discrepancy between GDP by production and GDP by expenditure emerged in 1997 and persisted; by 2001 the discrepancy trimmed to about 1 percent of GDP and to ½ percent in 2002.
  - From June 2002, seasonally adjusted quarterly GDP by activity and by expenditure components published with retrospective coverage from 1995; benchmarking to annual estimates applied from 2000.
  - Methodological changes in 2001–2002 included change in accounting method of re-export, net base accounting for 1998 backward, compilation of full non-financial accounts of general government for 2001–02, and revisions to Gross Fixed Capital Formation (GFCF) data applied for 2000–02 using ESA95 methodology.
- Balance of payments:
  - Work plan implemented to replace cash-based BOP statistics with accrual-based BPM5 principles.
  - Improvements: use of customs data for trade in goods; recording of goods under processing and repair and financial lease arrangements per BPM5; inclusion in 2004 of reinvested earnings raising the current account deficit with offsetting impact on financial accounts; recording of investment income on an accrual basis.
  - Revised quarterly BOP series released in 2004 covered 1995–2003.
  - Cooperation between MNB and HCSO formalized through annual memoranda of understanding since 2002 to harmonize data sources and methodologies.

*Sources: Hungarian authorities; and IMF staff estimates.*

### 8. The International Financial Statistics (IFS) country page for Hungary now provides

### 8. The International Financial Statistics (IFS) country page for Hungary now provides

### Monetary and banking statistics: coverage and classification changes
- The IFS country page for Hungary provides timely data for the monetary authorities, banking institutions, and the banking survey.
- The coverage of the MNB’s analytical accounts has been extended, and Hungary now complies with the strengthened reserves standard.
- The framework for the compilation of monetary statistics in Hungary conforms, with three exceptions, to international standards for monetary statistics.
- Two STA missions (STA staff visit on monetary and financial statistics (October 2000) and the ROSC data module (May 2001)) addressed issues including the treatment of deposit liabilities of credit institutions under liquidation.
- The MNB reclassified credit institutions under liquidation from Monetary Financial Institutions (depository corporations) to “nonfinancial enterprises”; as a result, deposits of these institutions held with the MNB and with other credit institutions are excluded from the monetary aggregates as of January 2003.
- STA and the ECB advice: such institutions should be reclassified as other financial intermediaries (per the IMF’s Monetary and Financial Statistics Manual and ECB advice).

### Valuation of securities and related reforms
- STA recommended that securities on depository corporations’ balance sheets be valued at market prices; current practice was partial market valuation.
- Reforms and timetables:
  - From 2004, depository corporations are encouraged to use market valuation for securities in their trading portfolio.
  - From 2005, market valuation is compulsory for those depository corporations that are listed on the stock exchange.
  - Securities of all companies that are listed on the stock exchange and are held by depository corporations in their trading portfolio should be based on market valuation.
- Depository corporations are required to revalue their securities at least quarterly, and more frequently if possible.
- Valuation guidance for unlisted companies’ securities:
  - Price on the basis of secondary market values when available.
  - In the absence of a secondary market, valuation will be: (i) on the basis of company profitability using the last two annual company reports, or (ii) by calculating the present value of securities using acquisition prices.
  - If no other information is available, acquisition prices could be used for the valuation.

### Monetary aggregates and inclusion of MMFs
- Starting with the release of data for January 2003, the MNB has compiled and published monetary aggregates using a methodology consistent with the ECB.
- Monetary financial institutions (beyond the central bank and credit institutions) now include money market funds (MMFs); MMFs’ investment units are treated as having characteristics similar to bank deposits.
- MMFs’ balance sheet data are included in the consolidated balance sheet of the banking system (depository corporations survey).
- Other classifications aligned with ECB guidelines:
  - Credit extended classified 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.

### Data compilation and quality practices
- The ROSC mission of 2001 noted that the MNB’s statistical practices are not guided by revisions studies.
- The ROSC updates of 2002–04 do not indicate any further developments on the restricted deposits issue.

### Government Finance Statistics (GFS): updates and coverage
- In January 2004, STA conducted a substantive update of the GFS dataset using the July 2003 Data Quality Assessment Framework.
- The mission reported significant progress addressing shortcomings of budget execution data and GFS identified in the original ROSC Data Module, notably:
  - Institutional coverage of general government.
  - Consolidation of data and reconciliation of deficit and financing.
- Plans to report monthly expenditures classified on an economic basis had not yet been implemented.
- Latest data reported for publication in the 2004 GFS Yearbook cover 2003.
- These data cover operations of the consolidated central government and consolidated general government sectors and their subsectors.
- Data for 2000 onwards have been compiled on an accrual basis and reported in the Government Finance Statistics Manual 2001 format.

### IMF staff assessment and fiscal policy recommendations (Staff statement, June 15, 2005)
- Overall thrust of staff appraisal unchanged; case for fiscal restraint strengthened by recent information suggesting risks of revenue shortfalls and expenditure overruns are more imminent.
- To achieve the authorities’ fiscal target for 2005, staff considers it important to:
  - Freeze all remaining reserves.
  - Take additional measures consistent with durable fiscal consolidation.
- Key macroeconomic projections and recent developments:
  - Authorities are revising their 2005 GDP growth forecasts downwards, close to the staff’s projection of 3.4 percent.
  - 2004 revised GDP growth: 4.2 percent.
  - GDP growth in Q1 2005: 2.9 percent.
  - Unemployment rose to 7.2 percent.
  - Central Bank’s May 23 Inflation Report lowered its 2005 forecast to 3.3 percent, from 3.8 percent.
  - Finance Ministry projection band: between 3.5 and 4.0 percent (authorities expect growth closer to the lower end).
  - Downward risks to 2005 projections if euro area recovery fails to materialize.
- Credit rating actions and risks:
  - Standard and Poor’s downgraded long-term local currency debt from A to A- and short-term debt from A1 to A2, following Fitch.
  - S&P cited concerns about the government’s ability to meet fiscal targets, lack of flexibility in fiscal accounts, risks from sharply higher interest rates and significant depreciation of the forint.
- Fiscal slippage assessment and recommendations:
  - Staff projects a revenue shortfall amounting to about 0.6 percent of GDP.
  - Expenditure overshooting likely by about half a percent of GDP.
  - Authorities estimate remaining reserves at around 0.6–0.7 percent of GDP out of the original 1.3 percent of GDP.
  - Staff view: freeze all remaining reserves and implement additional measures; seek durable consolidation through expenditure reduction, avoiding one-off measures that do not reduce fiscal stimulus (e.g., sales of assets to public sector companies).
- Structural reform program:
  - Government began rolling out its “100 Steps” program in May.
  - Program covers labor market, healthcare, pensions, education and the tax system; measures announced incrementally.
  - Revenue and cost implications not known; bulk of changes will enter into force only in 2006, with little impact on the 2005 fiscal outcome.

### Executive Board and Public Information Notice
- Public Information Notice (PIN) No. 05/82, FOR IMMEDIATE RELEASE, June 29, 2005.
- IMF Executive Board concluded the 2005 Article IV consultation with Hungary on June 15, 2005.
- Background summary excerpt:
  - Hungary entered the European Union on May 1, 2004.
  - After mid-2001 the country experienced slower growth and large budget and current account deficits.
  - 2004: Real GDP growth recovered to 4 percent, supported by strong investment and robust export growth; consumption slowed in response to rising unemployment, moderation in wage growth and tightening of the housing subsidy scheme; wage deceleration supported disinflation.

*Source: _cr05213 - 8. The International Financial Statistics (IFS) country page for Hungary now provides*

### 3.5 percent by year-end. The current account deficit stabilized, albeit at a still high level of

### _cr05213 - 3.5 percent by year-end. The current account deficit stabilized, albeit at a still high level of

### Economic performance and outlook
- Real GDP growth: 3.4 percent (2005, Proj.), with slowdown in the second half of 2004 and early 2005; growth slowed with weakening industrial production and rising unemployment.
- Inflation: CPI (average) 4.0 percent (2005, Proj.); disinflation in late 2004 and early 2005 welcomed by Directors.
- Unemployment: 6.4 percent (2005, Proj.); unemployment increased through late 2004 and early 2005.
- Wage growth (gross wages): 8.0 (2005, value in table listed as "...", but table shows preceding years including 12.1 and 8.0).
- External balances: current account around -8.6 percent of GDP (2005, Proj.); current account deficit stabilized but remained high at 9 percent of GDP (text).
- Financial markets: policy interest rates declined, the forint appreciated modestly against the euro, and risk premiums fell; forward spreads on local currency bonds remained wide reflecting uncertainty on euro adoption timing.

### Fiscal position and policy recommendations
- Fiscal deficit (ESA-95 basis, percent of GDP): -4.7 (2005, Proj.); Directors considered regaining control over fiscal policy the key challenge.
- General government debt: 60.2 percent of GDP (2005, Proj.).
- Directors' findings and recommendations:
  - Missing the 2005 fiscal deficit target would set back debt reduction and damage policy credibility.
  - Adherence to at least the fiscal targets in the Convergence Program is essential for euro adoption by 2010 and for macroeconomic stability, debt sustainability, and medium-term growth.
  - Authorities committed not to use remaining budgetary reserves; Directors urged prompt additional deficit-reducing measures.
  - Cautioned against actions that lower the reported deficit while maintaining fiscal stimulus.
  - Recommended expenditure-reducing reforms—particularly in health and education—and phasing out interest rate subsidies to reduce the budget deficit and improve public service delivery.
  - Urged a wide-ranging tax reform focused on lower rates and a broader base, to be taken alongside structural spending reductions.
  - Welcomed intention to request a fiscal Report on the Observance of Standards and Codes (ROSC) in 2006.

- Fiscal institutions and budget process:
  - Recommended strengthening fiscal institutions and the budgetary process.
  - Welcomed the recently approved Public Finances Law, but stressed much remains to be done.
  - Urged adoption of a three-year rolling framework, further checks and balances in expenditure management, and more extensive budgetary oversight by the State Audit Office.
  - Advised against frequent changes in fiscal accounting practices and urged transparent reporting on private-public partnerships.
  - Warned that relying on ad hoc accounting and expenditure reduction measures to meet Maastricht criteria risks entering the euro area with a large underlying deficit.

### Monetary policy and financial sector
- Interest rate indicators: T-bill (90-day, average) series in table includes 10.9, 10.6, 8.9, 8.8, 11.0 (earlier years shown); Government bond yield (5-year, average) 9.1 (2004).
- Directors' guidance on monetary policy:
  - Supported the reduction in interest rates as appropriate.
  - Recommended future interest rate policy be cautious and guided by market inflation expectations.
  - Emphasized focusing monetary policy on containing domestic inflationary pressures rather than stabilizing the exchange rate, and clear communication to markets.
  - Supported planned reduction in the inflation target to 3 percent a year in the medium term, to be achieved over a rolling horizon.
- Financial sector soundness:
  - Directors commended continuing soundness and increased profitability of the financial sector.
  - Concerned about growing share of foreign currency debt in the private sector as a vulnerability.
  - Urged close monitoring of foreign currency-denominated borrowing—especially by households and small- and medium-sized firms likely not naturally hedged.
  - Encouraged stronger disclosure requirements, additional provisioning for foreign currency loans, and development of market-oriented risk-hedging instruments.
  - Urged regulatory initiatives in pension funds and insurance sectors, and changes to safeguard independence of the Hungarian Financial Supervisory Authority (as recommended by the FSAP update).

### Structural policies and labor market
- Directors prioritized raising labor participation, enhancing labor market flexibility, and increasing productivity.
- Welcomed the National Action Plan for Employment aiming to facilitate geographic and occupational mobility, reduce impediments to part-time employment, and implement vocational educational reforms.
- Recommended that further increases in the minimum wage be limited to productivity growth.
- Supported authorities’ strategy to use EU funds to raise productivity of small- and medium-sized firms and improve the business environment, while stressing fiscal structural reforms to ensure long-lasting gains.

### Key numeric indicators (as reported)
- Real GDP (change in percent): 5.2 (2000), 3.8 (2001), 3.5 (2002), 3.0 (2003), 4.0 (2004), 3.4 (2005, Proj.)
- CPI (average): 9.8 (2000), 9.2 (2001), 5.3 (2002), 4.7 (2003), 6.8 (2004), 4.0 (2005, Proj.)
- Unemployment rate (in percent): 6.4 (2000), 5.7 (2001), 5.8 (2002), 5.9 (2003), 6.1 (2004), 6.4 (2005, Proj.)
- Gross national saving (percent of GDP): 22.3 (2000), 20.6 (2001), 18.1 (2002), 16.6 (2003), 15.3 (2004), 15.9 (2005, Proj.)
- Gross domestic investment (percent of GDP): 30.9 (2000), 26.8 (2001), 25.2 (2002), 25.3 (2003), 24.1 (2004), 24.5 (2005, Proj.)
- General government balance (percent of GDP, ESA-95 basis): -3.0 (2000), -4.7 (2001), -9.4 (2002), -7.2 (2003), -5.4 (2004), -4.7 (2005, Proj.)
- General government debt (percent of GDP, ESA-95 basis): 55.4 (2000), 53.5 (2001), 57.1 (2002), 59.1 (2003), 60.8 (2004), 60.2 (2005, Proj.)
- M3 (end-of-period, percent change): 18.1 (2000), 17.1 (2001), 9.5 (2002), 11.9 (2003), 11.1 (2004)
- Credit to nongovernment (end-of-period, percent change): 34.8 (2000), 18.2 (2001), 22.2 (2002), 35.2 (2003), 18.5 (2004)
- Trade balance (percent of GDP): -6.2 (2000), -4.3 (2001), -3.3 (2002), -4.0 (2003), -3.0 (2004), -3.0 (2005, Proj.)
- Current account (percent of GDP): -8.6 (2000), -6.2 (2001), -7.2 (2002), -8.7 (2003), -8.9 (2004), -8.6 (2005, Proj.)
- Reserves (months of imports of goods and services): 3.7 (2000), 3.3 (2001), 2.9 (2002), 2.8 (2003), 2.6 (2004), 2.4 (2005, Proj.)
- Net external debt (percent of GDP): 26.0 (2000), 23.9 (2001), 23.5 (2002), 29.1 (2003), 31.7 (2004), 32.1 (2005, Proj.)
- Exchange regime: Peg against euro, with band +/-15 percent
- Present rate (May 2, 2005): Ft 196.1 = US$1
- Nominal effective rate (1990=100): 35.5 (2000), 36.2 (2001), 38.9 (2002), 38.8 (2003), 39.6 (2004)
- Real effective rate, CPI basis (1990=100): 138.4, 149.6, 166.2, 170.1, 181.3 (series shown in table)

*International Monetary Fund*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05213.pdf_