## _cr06379 (IMF staff report excerpts)

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### Executive summary — background and recent performance
- GDP growth slowed from 5.2 percent in 2004 to 4.1 percent in 2005; economy’s potential estimated at 4-5 percent.
- Hungary and Poland were the only two NMS whose growth decelerated in 2005; Hungary continued to lag into 2006.
- Employment ratio “remains low”; consumption growth moderated in 2005.
- Fixed investment growth in 2005 largely reflected government-sponsored motorway construction.
- Net exports’ strong contribution in 2005 likely exaggerated by changed import estimation and large inventory drawdown.
- Corporate sector:
  - Average pretax return on corporate assets “about 5½ percent in 2004”.
  - Profitability uneven; about two-fifths of SMEs unprofitable.
  - Since May 2006 the stock market experienced a significant correction.
- Inflation:
  - Headline CPI inflation fell in May to 2.8 percent, year on year.
  - Core inflation fell to 1.0 percent.
  - Absent the VAT cut in January 2006, year-on-year headline inflation would have been 4.5 percent.
  - VAT cut had larger effect on non-traded goods.
- Exchange rate and competitiveness:
  - CPI-based real exchange rate appreciated 36 percent from 1997 to 2005.
  - Real exchange rate became overvalued around mid-2001; by end-2005 overvalued by “about 5 percent”.
  - Since start-2006 the exchange rate has depreciated significantly; “no obvious overvaluation, for now.”
  - Competitive pressures from Asia, notably China; Hungary’s market share plateaued.
- Debt and external vulnerabilities (end-2005):
  - Fiscal deficit: 7.6 percent of GDP.
  - Current account deficit: 7.4 percent of GDP (possibly underestimated by up to 2 percent of GDP).
  - Public debt: 62 percent of GDP.
  - External debt: 75 percent of GDP.
  - Public debt has relatively long maturities and low FX exposure; ratio of reserves to external short-term debt at or above 100 percent.

### Policy findings and risks
- Central task: “progress in containing its runaway budget deficit.”
- New government’s consolidation program “ambitious in intent and speed.”
- Risks:
  - Tax increases may not deliver anticipated revenues and may undermine growth and competitiveness.
  - If market sentiment weakens, “serious consequences could follow.”
  - Existing buffers provide protection but could be worn down if adverse trends continue.
- Market differentiation began as early as September 2005 and worsened with global volatility.

### Fiscal policy — recommendations, scenarios, and staff projections
- Recommended consolidation:
  - “A fiscal consolidation matching the intent of the authorities’ program but extended over another two years would reverse the trend increase in the public debt-to-GDP ratio and bring it below the Maastricht limit by 2010.”
  - Emphasize expenditure reforms and revenue enhancement by broadening the tax base.
  - Stronger budgetary controls, greater transparency and accountability to stem endemic overruns.
  - “Allowing for the exclusion of the cost of pension reform would lower the deficit by approximately 1½ percent of GDP.”
- Authorities’ consolidation plan (commencing H2 2006 through 2008):
  - Projected savings of over 10 percent of GDP (about three-fifths relying on higher taxes).
  - Measures include limiting baseline deterioration (about 3 percent of GDP) and known additional obligations; cumulative deficit reduction about 7 percent of GDP.
  - Authorities’ projected deficits: 2006 = 9.5 percent of GDP; 2007 = 5 percent of GDP; 2008 ≈ 3 percent of GDP.
  - Authorities’ GDP growth projection: 2006 = 4½ percent; 2007 = 2½ percent.
  - Authorities expect inflation to rise to about 6 percent in 2007 (one-off effects).
- Staff assessment (more conservative implementation):
  - Staff estimates fiscal deficit 2006 = 10 percent of GDP.
  - Staff projects deficits: 2007 = 7½ percent of GDP; 2008 = 6½ percent of GDP.
  - Staff baseline macro projections (in percent unless noted):
    - Real GDP growth: 2006 = 4.5, 2007 = 3.5, 2008 = 3.7, 2009 = 3.7, 2010 = 3.8
    - Consumption: 2006 = 3.5, 2007 = 2.2, 2008 = 2.9, 2009 = 3.0, 2010 = 3.5
    - Investment: 2006 = 7.3, 2007 = 6.2, 2008 = 5.8, 2009 = 5.5, 2010 = 5.8
    - Exports: 2006 = 12.2, 2007 = 7.7, 2008 = 6.6, 2009 = 6.3, 2010 = 6.6
    - Imports: 2006 = 11.9, 2007 = 7.5, 2008 = 6.6, 2009 = 6.3, 2010 = 7.0
    - Inflation: 2006 = 3.5, 2007 = 5.8, 2008 = 4.4, 2009 = 3.5, 2010 = 3.0
    - Fiscal deficit: 2006 = 10.1, 2007 = 7.6, 2008 = 6.4, 2009 = 5.8, 2010 = 5.5
    - Primary deficit: 2006 = 6.2, 2007 = 3.7, 2008 = 2.5, 2009 = 2.1, 2010 = 1.9
    - Current account deficit: 2006 = 9.1, 2007 = 8.0, 2008 = 7.6, 2009 = 7.4, 2010 = 7.1
    - Public debt: 2006 = 67.8, 2007 = 69.5, 2008 = 70.6, 2009 = 71.6, 2010 = 72.5
    - External debt: 2006 = 81.8, 2007 = 82.2, 2008 = 82.5, 2009 = 83.2, 2010 = 84.0
- Staff’s principal concern: under baseline, public debt continues to rise, exceeding 70 percent of GDP by 2008.
- Alternative consolidation scenario:
  - A cumulative fiscal consolidation of 10 percent of GDP over 2006-10 focused on expenditure reduction would raise growth potential and lower debt-to-GDP ratio to below 60 percent by 2010.
  - Primary surplus scenarios (2006-2010) shown:
    - Baseline scenario: -6.2 -3.7 -2.5 -2.1 -1.9
    - Authorities' program: -5.6 -1.3 0.5 0.6 0.7
    - Staff's preferred scenario: -6.1 -2.6 0.7 2.4 3.9
- Staff’s reform menu and estimated budgetary savings (2006-10, percent of GDP):
  - Expenditure reforms total: 8.9
    - Government employment and wages, public administration: 1.5
    - Health care (co-payments, pharmaceuticals reform): 0.9
    - Education (economies of scale): 1.0
    - Government subsidies (housing, transport, energy): 1.5
    - Pensions (revisions to formulas and eligibility): 2.1
    - Social benefits (better targeting): 0.6
    - Caps on carryover funds and open-ended items: 1.2
  - Tax reforms total: 4.9
    - Delay in pending items of 2005 tax reform: 2.8
    - Tax pensions under personal income tax: 0.1
    - Tax interest income and capital gains: 0.1
    - Increase VAT from 15 to 20 percent: 0.5
    - Eliminate exemptions: 0.8
    - Strengthen real estate tax: 0.5
  - Total potential savings: 13.8

### Monetary policy and exchange rate regime
- Interest rate policy: “While interest rate policy is on a sound course, the forint should float.”
- Recent monetary actions:
  - Recent increase of the policy rate by 25 basis points (June 19) judged appropriate.
  - MNB raised policy rate by a cumulative 175 basis points in four steps since June (context: later excerpts).
- Inflation outlook and pass-through:
  - Staff expects inflation: 2006 = 3.6 percent; 2007 = 6.1 percent; 2008 = 3.8 percent (staff central projections revised in supplementary material).
  - Exchange rate pass-through declined to about 20 percent over a 24-month span.
- Exchange regime:
  - Current arrangement: Peg against euro, with band +/-15 percent; central parity Ft 282.36 per euro (effective June 4, 2003).
  - Staff view: “From a risk-management perspective, a floating exchange rate regime is best suited to Hungary’s present needs,” to reduce incentives to borrow in foreign currency and strengthen inflation-targeting anchor.
  - Authorities argued the band is wide and does not constrain inflation targeting.

### Financial sector stability — foreign-currency lending and stress tests
- Foreign-currency lending:
  - FX share of outstanding bank loans increased from about 43 percent in December 2004 to 53 percent in March 2006.
  - Text Table 2 — Share of Foreign Currency Loans (percent of loans in category):
    - All loans: 2002 = 36.5, 2003 = 40.0, 2004 = 43.2, 2005 = 50.5, Mar-06 = 53.0
    - Private sector: 2002 = 26.7, 2003 = 29.2, 2004 = 34.0, 2005 = 41.8, Mar-06 = 44.6
    - Nonfinancial companies: 2002 = 35.0, 2003 = 40.7, 2004 = 44.5, 2005 = 47.5, Mar-06 = 49.6
    - Households: 2002 = 3.0, 2003 = 5.0, 2004 = 14.6, 2005 = 32.6, Mar-06 = 36.9
    - Other loans: 2002 = 61.7, 2003 = 69.3, 2004 = 70.3, 2005 = 75.9, Mar-06 = 76.4
  - Hungarian banks’ FX lending exposure highest among CE-4.
  - Banks are fully hedged against currency risk; credit risk increases if large currency correction occurs.
- Banking buffers and indicators:
  - System capital adequacy ratio around 11 percent.
  - ROA (after tax): 2004 = 2.0; 2005 = 2.0.
  - ROE (after tax): 2004 = 25.3; 2005 = 24.6.
  - NPLs to gross loans around 2½ percent in 2005.
  - Loans to deposits: 2005 = 107.7.
  - Currency composition of corporate FX loans (percent of FX corporate loans): CHF share rose to 19.3 in 2005.
- Stress-test results (impact on Tier I capital; number of banks whose CAR falls below 8 percent out of 32):
  - Parallel upward shift in forint yield curve of 500bps: -5.62 (out of 32)
  - Depreciation of 40 percent: -2.60 (out of 32)
  - Increase in nonperforming assets of 100 percent: -15.29 (out of 32)
  - Scenario: 30 percent depreciation, upward shift in forint yield curve of 200bps, and deterioration in 30 percent of unhedged FX loans: -14.57 (out of 32)
  - Loss given default assumed at 50 percent.
- Staff recommendations for supervision:
  - Strengthen supervision with regular stress tests of individual banks.
  - More intensive on-site assessment of risk-management practices.
  - Consider requiring higher provisioning or increased risk weights for FX lending.
  - Monitor aggressive lending practices, especially via nonbank affiliates.
- Differentiation by financial markets and funding risks:
  - Likelihood of a sudden stop in capital inflows estimated in the 3-5 percent range.
  - Large portfolio investor withdrawals estimated by MNB; commercial banks became important suppliers of FX financing (largely Swiss francs) for on-lending.
  - If commercial bank credit lines are not rolled over, current account and output would contract.

### External vulnerabilities, financing, and projections
- Current account and external debt:
  - Current account deficit: 2005 = -9.1 percent (four-quarter rolling basis in some tables); other references 2005 = 7.4 percent of GDP.
  - Current account could rise to about 9 percent of GDP in the year if underreporting reversed and decline gradually to about 7 percent by 2010.
  - External debt likely to rise to about 82 percent of GDP by end-2006 and maintain upward trajectory.
  - Gross foreign debt (percent of GDP): 2005 = 81.8; 2006 = 82.2.
  - Net foreign debt (percent of GDP): 2005 = 40.6; 2006 = 41.6.
- Financing needs and reserves:
  - Gross reserves (US$ billions): 2002 = 12.8; 2003 = 16.0; 2004 = 18.6; 2005 = 18.9; 2006 = 19.5.
  - Gross financing need under baseline (US$ billions): 2005 = 26.6; 2006 = 26.9; 2007 = 24.3; 2008 = 25.2; 2009 = 24.6; 2010 = 24.4; 2011 = 24.5.
- Staff warning:
  - During the forint’s slide financing of the current account has been sufficient and balance-sheet effects minimal to date, but political unwillingness to consolidate or fading consolidation could lead to significant exchange rate correction, higher interest rates, reduced confidence, retrenchment of consumption and investment, and contraction of the current account.

### Labor markets, competitiveness, and EU funds
- Employment:
  - Employment-working-age population ratio about 57 percent; employment remains low, especially among workers with primary education.
  - Unemployment rate (percent): 2002 = 5.9; 2003 = 6.1; 2004 = 7.2; 2005 = 7.4; 2006 proj = 8.1 (selected table) and other projections show variations (e.g., PIN figures).
- Policy recommendations to raise employment:
  - Reduce the tax wedge.
  - More effectively target social welfare programs, especially disability pension and early retirement.
  - Rationalize child care benefits to enable temporary and part-time work.
- Competitiveness and EU funds:
  - Market shares flattened; need technological upgrading and productivity growth.
  - Absorption of EU funds expected to rise from about 2 percent of GDP in 2006 to 2.7 percent of GDP in 2008 (net inflows about 1 percentage point less).
  - Staff and authorities agree on need for cost-benefit analysis and linking EU funds deployment to fiscal structural reforms.

### Data provision, statistics, and IMF relations
- Hungary subscribes to SDDS; metadata posted on Fund’s DSBB.
- National accounts:
  - Statistical discrepancy between GDP by production and by expenditure emerged in 1997; reduced to about 1 percent of GDP in 2001 and ½ percent in 2002.
  - HCSO publishes seasonally adjusted quarterly GDP from Q1 2002 with retrospective coverage from 1995.
- Balance of payments moved to accrual-based BPM5; revisions and methodological improvements implemented in 2004.
- Monetary statistics moved to ECB framework since January 2003; market valuation of securities progressively encouraged and partially required.
- Government Finance Statistics updated (January 2004) with data from 2000 onwards on accrual basis and GFS 2001 format.
- IMF relations and Article IV:
  - IMF membership: Joined May 6, 1982; Article VIII.
  - Quota: SDR 1,038.40 million.
  - Hungary on 12-month Article IV cycle; 2005 Article IV staff report issued May 20, 2005.
  - Supplement prepared by European Department approved October 4, 2006; Convergence Programme submitted September 1.
- Selected macro projections and key indicators (staff and current projections where shown):
  - Real GDP growth: 2002 = 3.8; 2003 = 3.4; 2004 = 5.2; 2005 = 4.1; 2006 staff = 4.5 / current = 3.6; 2007 staff = 3.5 / current = 2.8.
  - Inflation (average): 2005 = 3.6; 2006 staff = 3.5 / current = 3.6; 2007 staff = 5.8 / current = 6.1.
  - General government overall balance (ESA-95): 2005 = -10.1 (alternative table shows 2005 general government balance reached 7.5 percent of GDP deficit in some excerpts); staff projections vary with revisions.
  - Gross foreign debt: 2005 = 81.8 percent of GDP; 2006 = 82.2 percent of GDP (staff report).
  - Public sector debt (percent of GDP): 2001 = 53.5; 2002 = 56.6; 2003 = 58.9; 2004 = 60.2; 2005 = 62.4; 2006 baseline = 67.8; 2011 baseline = 72.5.

*Source: _cr06379 — IMF staff report excerpts and Executive Summary (IMF country report content).*

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

### Executive Summary

### Background and recent performance
- Hungary's growth was robust between 1997 and 2001 but has recently been "respectable but at the low end among the New Member States of the European Union."  
- GDP growth slowed from 5.2 percent in 2004 to 4.1 percent in 2005—the lower end of the economy’s potential, which is estimated at 4-5 percent.
- Hungary and Poland were the only two NMS whose growth decelerated in 2005; Hungary continued to lag into 2006.
- The ratio of employment to working-age population "remains low."
- Consumption growth moderated in 2005 with restrained wage growth and weak employment trends.
- Fixed investment growth in 2005 largely reflected government-sponsored motorway construction.
- The strong contribution of net exports in 2005 was likely exaggerated by a changed method for estimating imports; unusually slow import growth was statistically balanced by a large drawdown of inventories.
- Corporate sector: average pretax return on corporate assets was "about 5½ percent in 2004"; profitability uneven with about two-fifths of SMEs unprofitable; since May 2006 the stock market experienced a significant correction.
- Inflation developments:
  - Headline CPI inflation fell in May to 2.8 percent, year on year.
  - Core inflation fell to 1.0 percent.
  - Absent the cut in the value-added tax (VAT) rate in January 2006, year-on-year headline inflation would have been 4.5 percent, still within the ±1 percentage point band around the 3.5 percent end-2006 inflation target.
  - The VAT rate cut appears to have had a bigger effect on non-traded goods.
- Exchange rate and competitiveness:
  - The CPI-based real exchange rate appreciated by 36 percent from 1997 to 2005.
  - The real exchange rate became overvalued sometime around mid-2001 and by end-2005 was overvalued by "about 5 percent," reflecting principally the accumulation of net external liabilities.
  - Since the start of 2006 the exchange rate has depreciated significantly, suggesting "no obvious overvaluation, for now."
  - Competitive pressures from Asian economies, notably China, are increasing while Hungary’s market share has plateaued.
- Debt and external vulnerabilities:
  - Hungary had the largest fiscal and current account deficits among sizable emerging markets in 2005.
  - The 2005 fiscal deficit was 7.6 percent of GDP.
  - The 2005 current account deficit was 7.4 percent of GDP; it "is possibly underestimated by up to 2 percent of GDP" due to likely underreporting of imports.
  - Public debt was 62 percent of GDP at end-2005.
  - External debt was 75 percent of GDP at end-2005.
  - Public debt has relatively long maturities and low foreign currency exposure; the ratio of reserves to external short-term debt has remained at or above 100 percent.

### Policy findings and risks
- Central to the outlook is "progress in containing its runaway budget deficit."
- The new government's consolidation program is "ambitious in intent and speed."
- Some measures in the package "take the long view," but tax increases "may not deliver the anticipated revenues and undermine growth and competitiveness."
- Financial markets have signaled concern; "If market sentiment weakens, serious consequences could follow."
- Existing economic and financial buffers provide some protection but could be worn down if trends continue.
- Market differentiation of Hungary began as early as September 2005 and worsened with global market volatility.

### Fiscal policy: recommendations and scenarios
- A recommended fiscal consolidation: "A fiscal consolidation matching the intent of the authorities’ program but extended over another two years would reverse the trend increase in the public debt-to-GDP ratio and bring it below the Maastricht limit by 2010, allowing euro entry from a position of strength."
- Emphasize expenditure reforms and revenue enhancement by broadening the tax base to achieve sustainable consolidation.
- Stem endemic overruns in the budget deficit through stronger controls, and greater transparency and accountability.
- Note: "Allowing for the exclusion of the cost of pension reform would lower the deficit by approximately 1½ percent of GDP."

### Monetary policy and exchange rate regime
- Interest rate policy: "While interest rate policy is on a sound course, the forint should float."
- Recent action: "The recent increase of the policy rate by 25 basis points and the signal of a measured tightening cycle are appropriate in light of the risks to inflation."
- The existing exchange rate band is wide and "does not presently pose a constraint to the pursuit of inflation targeting."
- Given that "euro adoption [is] some distance away and the band serv[es] no useful purpose," a "risk-management perspective suggests that a floating exchange rate regime should be adopted."

### Financial sector stability: assessment and recommendations
- The banking system’s profitability and capitalization "remain robust."
- Concerns:
  - Increase in foreign currency lending.
  - Signs of worsening credit quality.
- Recommended supervisory and regulatory actions:
  - Strengthen supervision with regular stress tests of individual banks.
  - More intensive on-site assessment of risk-management practices.
  - Consider requiring higher provisioning against foreign-currency loans.

### Labor markets and competitiveness: structural policy links
- Needed reforms to increase employment and enhance competitiveness are "linked to structural fiscal measures."
- Policy measures to raise employment:
  - Reduce the tax wedge.
  - More effectively target social welfare programs, "especially the disability pension and early retirement programs."
- Productivity enhancement is crucial to maintain competitiveness; ensure EU funds are effectively used to raise productivity by "linking their deployment to fiscal structural reforms."

### Overall assessment
- Hungary faces important challenges despite many strengths: slowing growth relative to peers, low employment, rising public and external debt ratios, and growing currency mismatches.
- Financial markets have sounded warning signals that warrant prompt and comprehensive policy action across fiscal consolidation, monetary regime settings, financial sector supervision, and structural reforms to labor markets and public spending.

*Source: Executive Summary (IMF country report content).*

### 7.      For now, banks retain cushions against the rising risks from foreign currency

### _cr06379 - 7.      For now, banks retain cushions against the rising risks from foreign currency

### Foreign-currency lending and banking-sector buffers
- Foreign currency share of outstanding bank loans increased from about 43 percent in December 2004 to 53 percent in March 2006.
- Text Table 2 — Hungary: Share of Foreign Currency Loans, 2002-06 (In percent of loans in category)
  - 2002 / 2003 / 2004 / 2005 / Mar-06
  - All loans: 36.5, 40.0, 43.2, 50.5, 53.0
  - Private sector: 26.7, 29.2, 34.0, 41.8, 44.6
  - Nonfinancial companies: 35.0, 40.7, 44.5, 47.5, 49.6
  - Households: 3.0, 5.0, 14.6, 32.6, 36.9
  - Other loans: 61.7, 69.3, 70.3, 75.9, 76.4
- Hungarian banks’ exposure to foreign currency lending is the highest among the four central European economies (CE-4).
- Banks are fully hedged against currency risk and therefore primarily face increasing credit risk (borrower default if large currency correction occurs).
- Banking-sector capacity to absorb losses:
  - Declining operating costs and strong profitability noted.
  - System capital adequacy ratio of around 11 percent (Figure 3 and Table 5).
  - However, buffers could prove inadequate for some banks if currency depreciation weakens borrowers and aggressive lending weakens banks.

### Banking-sector stress tests and balance-sheet risks
- Likelihood of a sudden stop in capital inflows—or involuntary contraction in the current account—estimated in the 3-5 percent range.
- Box Table 3.2 — Summary Results of Banking Sector Stress Tests (Impact on Tier I Capital; Number of Banks whose CAR falls below 8 percent)
  - Parallel upward shift in forint yield curve of 500bps: -5.62 (out of 32)
  - Depreciation of 40 percent: -2.60 (out of 32)
  - Increase in nonperforming assets of 100 percent: -15.29 (out of 32)
  - Scenario: 30 percent depreciation, upward shift in forint yield curve of 200bps, and a deterioration in 30 percent of unhedged foreign currency loans: -14.57 (out of 32)
  - Loss given default is assumed to be 50 percent (note in source).
- Public debt stress: public debt dynamics more sensitive to a sharp rise in interest rates than to currency depreciation; Hungary’s gradual shift toward long-term, fixed-rate local currency borrowing reduces exposure relative to some crisis cases.
- Private sector: large firms have significant natural hedges; weak SMEs may not withstand a sharp currency correction. Households have buffers in forint-denominated financial assets, but some households with large foreign currency liabilities may lack significant financial assets (information fragmentary).
- Overall private sector exposure to currency risk is significantly less than in Thailand in 1996 (Box Figure 3.2).

### Differentiation by financial markets and funding risks
- Since March (year context in source), “convergence play” unwound and emerging market sentiment waned; Hungary has experienced rating downgrades relative to other CEECs.
- MNB estimates large portfolio investor withdrawals from Hungary; commercial banks have become important suppliers of foreign currency financing (largely Swiss francs) to domestic subsidiaries for on-lending to businesses and households.
- If commercial bank credit lines are not rolled over, the current account and output would contract.

### Fiscal position, authorities’ consolidation plan, and staff assessment
- Authorities’ baseline (absent new measures): budget deficit in 2006 projected at 11.1 percent of GDP (in ESA’95 terms, without the credit for the pension adjustment).
- Authorities’ fiscal consolidation plan (commencing second half of 2006 through 2008):
  - Projected to achieve savings of over 10 percent of GDP, about three-fifths relying on higher taxes.
  - Because measures include limiting anticipated baseline deterioration (about 3 percent of GDP) and known additional obligations, cumulative deficit reduction would be about 7 percent of GDP.
  - Authorities project deficits: 2006 = 9.5 percent of GDP; 2007 = 5 percent of GDP; 2008 = around 3 percent of GDP.
  - Authorities project GDP growth: 2006 = 4½ percent; 2007 = 2½ percent.
  - Authorities expect inflation to rise to about 6 percent in 2007 due to additional taxes and reduction in subsidies (one-off effects expected to subside quickly).
  - Authorities see principal gain as reversing recent trend rise in public debt (estimates not completed by authorities).
- Staff assessment and projections:
  - Staff view that consolidation package will deliver less than authorities expect due to political, legal, and administrative delays.
  - Staff estimates fiscal deficit in 2006 is 10 percent of GDP.
  - Staff projects deficits: 2007 = 7½ percent of GDP; 2008 = 6½ percent of GDP.
  - Staff expects lower yields from solidarity taxes on personal and corporate income, health and social security contributions, and public administration and health reform.
  - Staff baseline macro projections (Text Table 4; In percent unless otherwise noted):
    - Real GDP growth: 2006 = 4.5, 2007 = 3.5, 2008 = 3.7, 2009 = 3.7, 2010 = 3.8
    - Consumption: 2006 = 3.5, 2007 = 2.2, 2008 = 2.9, 2009 = 3.0, 2010 = 3.5
    - Investment: 2006 = 7.3, 2007 = 6.2, 2008 = 5.8, 2009 = 5.5, 2010 = 5.8
    - Exports: 2006 = 12.2, 2007 = 7.7, 2008 = 6.6, 2009 = 6.3, 2010 = 6.6
    - Imports: 2006 = 11.9, 2007 = 7.5, 2008 = 6.6, 2009 = 6.3, 2010 = 7.0
    - Inflation: 2006 = 3.5, 2007 = 5.8, 2008 = 4.4, 2009 = 3.5, 2010 = 3.0
    - Fiscal deficit: 2006 = 10.1, 2007 = 7.6, 2008 = 6.4, 2009 = 5.8, 2010 = 5.5
    - Primary deficit: 2006 = 6.2, 2007 = 3.7, 2008 = 2.5, 2009 = 2.1, 2010 = 1.9
    - Current account deficit: 2006 = 9.1, 2007 = 8.0, 2008 = 7.6, 2009 = 7.4, 2010 = 7.1
    - Public debt: 2006 = 67.8, 2007 = 69.5, 2008 = 70.6, 2009 = 71.6, 2010 = 72.5
    - External debt: 2006 = 81.8, 2007 = 82.2, 2008 = 82.5, 2009 = 83.2, 2010 = 84.0
  - Staff’s principal concern: public debt under the baseline will continue to rise, exceeding 70 percent of GDP by 2008.
  - Staff estimates deficit fall to only 7½ percent in 2007 and to 6½ percent in 2008 under more conservative implementation assumptions.

### External vulnerabilities and financing
- Current account deficit could rise to about 9 percent of GDP this year (if suspected underreporting is reversed) and decline gradually to about 7 percent of GDP by 2010.
- External financing requirement remains high (arising either from underrecorded imports or inflows recorded in errors and omissions).
- External debt likely to rise to about 82 percent of GDP by end-2006 and maintain an upward trajectory.
- During the forint’s slide, financing of the current account has been sufficient and balance-sheet effects minimal to date, but this cannot be presumed if political willingness to consolidate fades—then a significant exchange rate correction could be accompanied by higher interest rates, reduced confidence, retrenchment of consumption and investment, and contraction of the current account.

### Policy implications and recommendations reflected in the text
- Use the current political window of opportunity to:
  - Cut spending more aggressively and implement budgetary controls.
  - Prioritize expenditure reduction to achieve sustainable consolidation rather than relying principally on ad hoc or tax measures that could hurt competitiveness and require reversal.
- Monetary policy:
  - Continue inflation-targeting orientation and transparent communications strategy; authorities have resisted moving to a floating exchange rate (source notes authorities’ view).
- Financial sector safeguards:
  - Strengthen monitoring and evaluation of credit risks from foreign-currency borrowing, especially unhedged household and SME exposures.
  - Continue implementation of FSAP recommendations (strengthened bankruptcy regime, pension regulation, consumer awareness), and accelerate evaluation of unhedged borrower credit risks.
- Fiscal strategy risks:
  - Be wary of high and persistent public debt; delays or partial implementation of consolidation measures would lead to continued debt buildup.
  - Staff cautioned that tax increases that reduce incentives to work and invest could hurt competitiveness and may need reversal, creating policy variability that would harm credibility.

*Source: _cr06379 - 7.      For now, banks retain cushions against the rising risks from foreign currency*

### 16.      A cumulative fiscal consolidation of 10 percent of GDP over 2006-10, based on a

### _cr06379 - 16.      A cumulative fiscal consolidation of 10 percent of GDP over 2006-10, based on a

### Fiscal consolidation and debt dynamics
- A cumulative fiscal consolidation of 10 percent of GDP over 2006-10, based on a more far-reaching expenditure reduction than currently contemplated, would raise Hungary’s growth potential.
- This consolidation would stretch to 2010 and would lower the debt-to-GDP ratio to below 60 percent (Text Figure 13).
- Recent research shows that the deficit and debt reduction complement each other to raise the growth potential.
- Primary Surplus (in percent of GDP) scenarios (2006-2010) as presented:
  - Baseline scenario-6.2-3.7-2.5-2.1-1.9
  - Authorities' program-5.6-1.30.50.60.7
  - Staff's preferred scenario-6.1-2.60.72.43.9
- Public debt dynamics (2005-2010) depicted using a fan-chart approach with 1,000 simulations; figures show the median debt and the probability of debt-to-GDP ratio exceeding 75 percent.

### Composition of adjustment and public spending efficiency
- Staff proposes greater reliance on expenditure-based consolidation to reduce the large size of the government, which is not commensurate with Hungary’s per capita income (Text Figure 14).
- Delivery of public services can be better targeted and the efficiency of social spending increased (Text Figure 15).
- A smaller, more efficient government will help immediate consolidation needs and raise growth potential (Box 4).
- Text Figure 15 indicators (efficiency of public spending) examples:
  - Public education spending per tertiary student (as a percent of per capita GDP) and resulting total graduates of school aged population, tertiary (country indices shown, e.g., LBN 1.00, HUN 0.42, SVK 0.37, etc.).
  - Social protection spending (as a percent of GDP) and reduction in percent at-risk-of-poverty (country indices shown, e.g., IRE 1.00, DNK 1.00, HUN 0.59, etc.).
  - Public health spending (as a percent of GDP) and child mortality, per 1,000 (country indices shown, e.g., HUN 0.78, LUX 1.00, NLD 1.00, etc.).

### Evidence on composition of fiscal adjustment (Box 4)
- Expenditure cuts have proved more sustainable than adjustments relying heavily on tax increases.
- IMF research shows expenditure-based adjustments work particularly well when focused on reduction of subsidies, wages, and transfers, supported by structural reforms; revenue-based consolidations have often been reversed except when emphasizing broadening the tax base and strengthening tax administration.
- Following large expenditure-based fiscal adjustments, GDP growth recovered to its trend during the first two years of the adjustment, driven by private investment and gains in consumption and trade balances.
- European examples:
  - Spain reduced primary spending by over 6½ percent of GDP during 1994–97, mainly through cuts in subsidies and transfers.
  - Finland consolidated social security and welfare payments by 8 percent of GDP during the 1990s through reforms of the pension system and unemployment benefits.
- Box Table 4.1. Growth Performance in Spain and Finland:
  - Spain: 1980-1993 Growth2.53.7 ; Std. Dev.2.01.0
  - Finland: 1980-1993 Growth1.53.6 ; Std. Dev.3.41.4

### Staff’s reform menu and estimated budgetary savings (Text Table 5)
- Reform Options and Estimates of Their Potential Budgetary Savings in 2006-10 (In percent of GDP):
  - Expenditure reforms total:8.9
    - Government employment and wages, and public administration (employment cuts, wage freeze and abolition of unusual benefits)1.5
    - Health care 0.9 (mainly introduction of co-payments and pharmaceuticals reform)
    - Education (notably to obtain economies of scale)1.0
    - Government subsidies (housing, transport, energy)1.5
    - Pensions (including revisions to formulas and eligibility)2.1
    - Social benefits (reduction and better targeting of benefits)0.6
    - Caps on expenditures from carryover funds and open-ended items 1.2
  - Tax reforms total:4.9
    - Delay in pending items of 2005 tax reform2.8
    - Tax pensions under personal income tax0.1
    - Tax interest income and capital gains0.1
    - Increase in VAT rate from 15 to 20 percent0.5
    - Elimination of exemptions0.8
    - Strengthening of real estate tax0.5
  - Total13.8
- Staff’s proposal includes needed revenue enhancements through a broadening of the tax base.

### Specific policy recommendations (pensions, welfare, taxation)
- Pension reforms recommended:
  - Indexing pension benefits to inflation;
  - Gradually increasing the retirement age;
  - Eliminating the thirteenth-month pension for new retirees;
  - Introducing more stringent rules for the disability pension;
  - Phasing out early retirement schemes.
- Welfare and subsidy reforms:
  - Reform the welfare system, redirecting budget support to families to the poor;
  - Eliminate the house subsidy scheme.
- Revenue-base broadening:
  - Tax pension benefits under personal income tax;
  - Unify the VAT rate;
  - Tax all income from fixed-income securities;
  - Eliminate tax exemptions;
  - Introduce a more far-reaching real estate tax;
  - Strengthen tax administration.
- Authorities viewed some measures as medium-term objectives and noted political difficulty in eliminating exemptions.

### Budgetary controls, fiscal credibility, and institutional measures
- Fiscal slippages would continue if consolidation measures are not accompanied by tighter budgetary controls.
- Persistent deficit overshooting has become characteristic of Hungarian public finances, with the projected 2006 excess a new high (Text Figure 16).
- Staff recommended:
  - Establishing an independent body (budgetary council or broadened State Audit Office mandate) to assess the budget’s time consistency and risks, with a required response before parliamentary approval of the budget.
  - Implementing a medium-term budget framework with multiyear expenditure ceilings.
  - Implementing new rules for budgeting open-ended expenditures and holding line ministries responsible for meeting targets.
  - Discontinuing the practice of allowing budgetary spending without appropriations and parliamentary approval.
  - Accounting for quasi-fiscal activities associated with public enterprises and PPPs when setting fiscal deficit targets for the general government.
  - Undertaking quarterly reviews on an ESA’95 basis to aid monitoring and ensure timely responses to slippages.
- Authorities were receptive to proposals but had not formulated concrete plans; they did not favor a budgetary council but could contemplate broadening the State Audit Office mandate.

### Monetary policy stance and inflation risks
- Staff commended the authorities for strengthening the credibility of inflation targeting through policy actions and communications; commitment to inflation targeting helped price stability.
- With projected reduction of subsidies and tax increases, inflation will exceed the MNB’s 3 percent target in 2007 and possibly also in 2008; tax changes will likely have one-off effects on inflation.
- Staff estimates that, absent the recent fiscal measures, inflation would stay within the target band.
- Authorities noted inflationary expectations had recently turned up after a substantial decline (Text Figure 17) and concluded a tightening cycle in small step increases of the policy rate may be required if second-round effects appear.
- A 25-basis-point increase in the policy rate on June 19 was judged appropriate.
- Exchange rate considerations:
  - A continued steady depreciation or a sharp depreciation beyond the central parity of Ft 282.36 per euro would require clarity on implications for inflation and monetary tightening (Text Figure 18).
  - The exchange rate pass-through has declined to about 20 percent over a 24-month span.
- Authorities rejected calls to shift to a floating exchange rate regime, arguing the band is wide and does not constrain inflation targeting; staff noted risks if fundamentals weaken and suggested greater exchange rate variability would reduce incentives to borrow in foreign currency.

### Financial sector stability and supervision
- Key developments to watch:
  - Foreign currency lending was 53 percent of outstanding loans and, on current trends, could increase by about 5 percentage points a year.
  - Senior Loan Officer Survey identifies more aggressive bank lending activities and practices (often through nonbank financial affiliates), raising credit risks.
  - Financial fragility of SMEs appears to have increased (increase in share of loans on banks’ “watch list”).
  - Ratio of nonperforming to outstanding loans remained relatively steady at about 2½ percent, but riskier lending and SME fragility imply more nonperforming loans may be in the pipeline.
- Authorities assess the banking sector as able to withstand substantial shocks; staff recommended more sophisticated supervisory and precautionary regulatory measures:
  - More proactive supervision and more intensive on-site supervision of risk-management practices to ensure banks factor in potential declines in collateral values coincident with heightened credit risk.
  - Stress tests of individual banks should become an integral part of supervision; none had been undertaken since the 2005 FSAP update.
  - Consideration of increased risk weights or additional provisioning requirements for foreign currency lending.
- Authorities were receptive to stepped-up supervision but did not favor further regulatory measures, fearing circumvention in open capital markets; staff noted such measures exist in other countries.

### Labor markets and competitiveness
- Raising employment rates remains a priority.
- Staff analysis shows a sharp decrease in employee compensation after 1995 stimulated employment generation, increasing the employment-working age population ratio over the past decade (Figure 6).
- At about 57 percent, the employment ratio remains relatively low (Text Figure 21).

*Source: _cr06379 (IMF staff).*

### 27.      The discussions identified three

### 27.      The discussions identified three

### Labor market and social-welfare issues
- The tax wedge is wide; in the currently weak labor market situation, lowering the tax wedge should reduce employee costs and help generate employment.
- The welfare system can be rationalized:
  - Both men and women drop out of the labor force to take advantage of the generous disability benefits (Text Figure 22).
  - Child care benefits can be rationalized to allow for greater scope for temporary and part-time work.
- Employment ratio is particularly low among workers with primary education (Text Figure 23).
  - The rapid shift of the Hungarian output structure to relatively skill-intensive activities has implied a low demand for unskilled workers.
  - Policy priority: greater effort to raise the productivity of unskilled workers and to maintain the economic relevance of higher education.

### Competitiveness, productivity, and EU funds
- During exchange rate appreciation, export strength was maintained through a counteracting shift from “low-” to “medium-” skilled export products; technological upgrading has become necessary but not sufficient for further world-market penetration.
- Market shares have flattened (see Text Figure 9); continued emphasis on raising productivity growth and the savings rate remains crucial for long-term external sustainability.
- The authorities view the expected step-up in the use of EU funds as an opportunity to raise productivity and improve infrastructure:
  - Absorption of EU funds has been growing and is likely to increase further, from about 2 percent of GDP in 2006 to 2.7 percent of GDP in 2008 (net inflows will be about 1 percentage point less, reflecting Hungary’s payments to the EU) (Text Table 6).
  - Projects related to small and medium-sized enterprises’ technology upgrading, the road network, and education and training are moving ahead and are linked to productivity growth.
  - Staff and authorities agree that continued efforts based on cost-benefit analysis are needed to utilize the remaining structural funds by end-2008 and administer a threefold increase in new commitments for 2007-13.
  - Absent fiscal structural reforms, the effectiveness of these resources will likely be diminished.

### Macroeconomic risks and policy recommendations (Staff appraisal)
- Growth and risks:
  - Growth owes much to a strong fiscal stimulus; with a needed fiscal contraction planned for 2007, growth can be expected to slow.
  - A largely tax-based consolidation risks reducing competitiveness and increasing policy uncertainty, since some of the new taxes will eventually need to be reversed.
  - Greater short-term risk stems from failure to implement significant consolidation, which could undermine investor confidence and force an involuntary contraction in the current account and output.
- Fiscal policy priorities:
  - Principal task: place public finances on a sound footing via a fiscal consolidation, sustained over a longer period and somewhat more sizable than envisaged by the authorities.
  - Aim to lower the debt ratio to below the Maastricht limit to allow euro entry from a position of strength.
  - Emphasize expenditure reforms, improved expenditure targeting and efficiency, and revenue enhancement through broadening the tax base (including instituting a more far-reaching property tax), rather than surcharges on capital and labor.
  - Endemic overruns in the budget deficit must be stemmed through stronger controls, greater transparency, and accountability.
- Monetary policy guidance:
  - Identify one-off inflationary influences, communicate them to the public and financial markets, and address potential second-round effects.
  - Progress has been made in establishing credibility of the inflation-targeting framework; continued consistent actions and communications are needed.
  - If second-round effects increase, anticipatory policy tightening will be required; a measured course of tightening is preferred to sharp changes in policy rates.
  - The June policy rate increase and the prospect of a tightening cycle represent the right stance.
- Exchange rate and financial stability:
  - From a risk-management perspective, a floating exchange rate regime is best suited to Hungary’s present needs; an ERM II-like band is not currently relevant and may interfere with the inflation-targeting anchor.
  - Greater perceived exchange rate variability will help reduce incentives to borrow in foreign currency.
- Banking supervision:
  - Banking profitability and capitalization remain robust, but the steady increase in foreign currency lending and signs of worsening credit quality are causes for concern.
  - Recommendations: institute regular stress tests of individual banks; intensify on-site supervision of banks’ risk-management practices, especially foreign currency lending; consider requiring higher provisioning against foreign currency loans.
- Linkages between fiscal reform, labor markets, and competitiveness:
  - Reducing the overall cost of labor is important for increasing employment; this requires reducing the tax wedge, a goal rendered difficult by the current fiscal position.
  - Raising the employment rate requires targeting social welfare programs more effectively, especially disability pension and early retirement programs.
  - Productivity enhancement is crucial for maintaining competitiveness; effective use of EU funds will require linking their deployment to fiscal structural reforms.

*III. STAFF APPRAISAL (excerpt).*

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

### _cr06379 - 36.      The next Article IV consultation with Hungary is expected to be conducted under the

### Macroeconomic outlook and staff projections
- Real GDP growth (annual projections, percent): 2002: 3.8; 2003: 3.4; 2004: 5.2; 2005: 4.1; 2006: 4.5; 2007: 3.5; 2008: 3.7; 2009: 3.7; 2010: 3.8; 2011: 3.9.
- CPI (end year): 2002: 5.7; 2003: 5.5; 2004: 3.3; 2005: 5.4; 2006: 5.5.
- CPI (average): 2002: 4.7; 2003: 6.8; 2004: 3.6; 2005: 3.5; 2006: 5.8.
- Unemployment rate (percent): 2002: 5.9; 2003: 6.1; 2004: 7.2; 2005: 7.4; 2006: 8.1.
- Gross domestic investment (percent of GDP): 2002: 24.4; 2003: 25.4; 2004: 23.7; 2005: 25.5; 2006: 26.4.
- Gross national saving (percent of GDP, from BOP): 2002: 15.8; 2003: 16.8; 2004: 16.3; 2005: 16.3; 2006: 18.4.

### External sector: deficits, financing, and vulnerabilities
- Current account (percent of GDP, four-quarter rolling basis and projections):
  - 2002: -8.7 percent; 2003: -8.6 percent; 2004: -7.4 percent; 2005: -9.1 percent; 2006: -8.0 percent.
- Trade and goods:
  - Exports goods (percent of GDP): 2002: 43.3; 2003: 56.0; 2004: 61.9; 2005: 71.3; 2006: 77.3.
  - Imports goods (percent of GDP): 2002: 46.6; 2003: 59.0; 2004: 63.9; 2005: 74.8; 2006: 80.2.
  - Trade balance (percent of GDP): 2002: -3.9; 2003: -3.0; 2004: -1.8; 2005: -3.3; 2006: -2.7.
- Financial flows and reserves:
  - Net direct investment (percent of GDP): 2002: 0.5; 2003: 3.6; 2004: 5.2; 2005: 2.3; 2006: 2.7.
  - Gross reserves (US$ billions): 2002: 12.8; 2003: 16.0; 2004: 18.6; 2005: 18.9; 2006: 19.5.
  - Gross foreign debt (percent of GDP): 2002: 62.7; 2003: 67.9; 2004: 75.2; 2005: 81.8; 2006: 82.2.
  - Net foreign debt (percent of GDP): 2002: 29.1; 2003: 32.7; 2004: 34.6; 2005: 40.6; 2006: 41.6.
- External-debt stress tests and bound tests (selected scenario results):
  - Baseline external debt (percent of GDP): 2005: 81.7; projected 2011: 84.4.
  - Combined shock scenario external debt peaks around 91–99 percent depending on shock (figures shown in bound tests).

### Public finances and debt sustainability
- General government (ESA-95, percent of GDP):
  - Overall balance: 2002: -7.3; 2003: -6.5; 2004: -7.6; 2005: -10.1; 2006: -7.6; 2007 proj: -9.5.
  - Primary balance: 2002: -3.5; 2003: -2.5; 2004: -3.7; 2005: -6.2; 2006: -3.7; 2007 proj: -5.6.
  - Gross debt (including costs of pension reform, percent of GDP): 2002: 58.9; 2003: 60.2; 2004: 62.4; 2005: 67.8; 2006: 69.5.
- Consolidated general government (2002–06, percent of GDP, selected lines):
  - Total revenues: 2002: 43.0; 2003: 42.5; 2004: 43.1; 2005: 43.2; 2006: 42.2.
  - Total expenditures: 2002: 52.1; 2003: 49.8; 2004: 49.5; 2005: 50.7; 2006: 48.6.
  - Net interest (percent of GDP): 2002: -3.7; 2003: -3.8; 2004: -4.0; 2005: -3.9; 2006: -3.3.
- Public sector debt sustainability framework (Table 7, selected):
  - Public sector debt (percent of GDP): 2001: 53.5; 2002: 56.6; 2003: 58.9; 2004: 60.2; 2005: 62.4; 2006 baseline: 67.8; 2011 baseline: 72.5.
  - Debt-stabilizing primary balance (percent of GDP): indicated as "1" in table header (methodology context).
  - Gross financing need under baseline (US$ billions): 2001: 9.0; 2002: 17.6; 2003: 15.6; 2004: 23.5; 2005: 26.6; 2006: 26.9; 2007: 24.3; 2008: 25.2; 2009: 24.6; 2010: 24.4; 2011: 24.5.

### Banking sector soundness and financial indicators
- Profitability and costs (2000–05):
  - Return on assets (after tax, ROA): 2000: 1.1; 2001: 1.3; 2002: 1.4; 2003: 1.5; 2004: 2.0; 2005: 2.0.
  - Return on equity (after tax, ROE): 2000: 13.5; 2001: 15.8; 2002: 16.2; 2003: 19.3; 2004: 25.3; 2005: 24.6.
  - Operating costs/total assets showed declining costs in the banking sector across 2000–2005 (figures in charts).
- Asset quality and composition (2000–05):
  - NPLs to gross loans: 2000: 3.0; 2001: 2.7; 2002: 2.9; 2003: 2.6; 2004: 2.7; 2005: 2.5.
  - Provisions to NPLs: 2000: 57.0; 2001: 57.9; 2002: 50.8; 2003: 47.3; 2004: 51.3; 2005: 54.4.
  - NPLs net of provisions to capital: 2000: 7.3; 2001: 10.0; 2002: 10.7; 2003: 10.0; 2004: 8.9.
- Currency composition of corporate foreign-currency loans (percent of FX corporate loans):
  - EUR: 2000: 61.9; 2001: 69.5; 2002: 77.6; 2003: 84.8; 2004: 79.3; 2005: 74.8.
  - USD: 2000: 35.6; 2001: 27.8; 2002: 19.3; 2003: 9.8; 2004: 6.7; 2005: 5.7.
  - CHF: 2000: 1.7; 2001: 2.6; 2002: 2.8; 2003: 5.3; 2004: 13.9; 2005: 19.3.
- Liquidity and leverage (2000–05):
  - Loans to deposits: 2000: 74.7; 2001: 77.0; 2002: 84.6; 2003: 99.7; 2004: 103.7; 2005: 107.7.
  - Liquid assets to total assets: 2000: 31.8; 2001: 29.9; 2002: 24.3; 2003: 19.5; 2004: 21.1; 2005: 21.0.
- Financial soundness indicators highlight adequate capital and strong profitability alongside rising foreign-currency lending to households and corporates.

### Debt and external vulnerability stress testing (selected scenario outcomes)
- Public debt bound tests (Figure 4) and external debt bound tests (Figure 5) present multiple scenarios:
  - Public sector: baseline public debt around 72 percent of GDP in the mid-2000s with scenario outcomes increasing debt ratios under combined shocks (e.g., combined shock values shown in figures around mid-80s to high-80s percent of GDP).
  - External debt: baseline external debt around mid-80s percent of GDP with combined and current-account shocks pushing ratios into the 90s (selected box figures: current account shock 92; combined shock 91; real depreciation shock up to 99 in one figure).
- Growth shock, interest-rate shock, combined shock, real depreciation and contingent-liabilities shocks are modeled; gross financing need under baseline is shown on right scales in figures.

### Fiscal composition and policy-relevant fiscal details
- Revenues and expenditure composition (2002–06, percent of GDP):
  - Tax revenues total: 2002: 38.4; 2003: 38.2; 2004: 38.0; 2005: 37.7; 2006: 36.2; 2007 staff proj: 36.7; 2008 auth.: 37.2.
  - Social security contributions: 2002: 13.1; 2003: 12.7; 2004: 12.5; 2005: 12.8; 2006: 12.6; 2007 staff proj: 12.5; 2008 auth.: 12.7.
  - Interest payments (percent of GDP): 2002: 4.1; 2003: 4.1; 2004: 4.4; 2005: 4.1; 2006: 3.5; 2007 proj: 4.1.
  - Capital expenditures (percent of GDP): 2002: 4.9; 2003: 3.3; 2004: 3.3; 2005: 3.3; 2006: 3.1; 2007 proj: 4.2.
- Memorandum fiscal items:
  - GDP, in current prices (forint billions): 2002: 16,915; 2003: 18,651; 2004: 20,429; 2005: 21,802; 2006: 23,270; 2007 proj: 23,590; 2008 auth.: 23,140.
  - Ft 222.72 = US$1 (exchange rate reference shown).

### Monetary policy, exchange rate arrangement, and interest rates
- Exchange regime: Peg against euro, with band +/-15 percent; central parity fixed to the euro at Ft 282.36 per euro, effective June 4, 2003.
- Interest rates (T-bill 90-day, average): 2002: 8.9; 2003: 8.2; 2004: 11.1; 2005: 6.8.
- Government bond yield (5-year, average): 2002: 7.8; 2003: 7.3; 2004: 9.2; 2005: 6.8.
- Nominal effective rate (1990=100): 2002: 38.9; 2003: 38.8; 2004: 39.6; 2005: 39.2.

### Fund relations, Article IV cycle, and technical assistance
- IMF membership: Joined on May 6, 1982; Article VIII.
- Quota and Fund positions (as of May 31, 2006):
  - Quota: SDR 1,038.40 million (100.00 percent of quota).
  - Fund holdings of currency: 917.15 (88.32 percent).
  - Reserve position in Fund: 121.25 (11.68 percent).
  - SDR holdings: 47.01 (N/A).
- Financial arrangements (historical):
  - Stand-by approved 3/15/96–2/14/98: SDR 264.18 approved, drawn 0.00.
  - Stand-by approved 9/15/93–12/14/94: SDR 340.00 approved, drawn 56.70.
  - EFF approved 2/20/91–9/15/93: SDR 1,114.00 approved, drawn 557.24.
- Article IV consultations:
  - Hungary is on a 12-month consultation cycle.
  - The 2005 Article IV staff report was issued on May 20, 2005 (IMF Country Report No. 05/213).
  - The last Article IV Board discussion took place on June 15, 2005 (EBM/05/52).
  - Public Information Notice No. 05/82 was released on June 29, 2005.
- Technical assistance history (selected entries, years and purposes):
  - 1991 FAD: Tax reform (April; June; November); Budget reform (May; November).
  - 1992 STA: Money and banking statistics seminar (March).
  - 1994 FAD/EU1: Treasury/debt management (February); Tax administration (March).
  - 2002 FAD: Expenditure rationalization (November).
- Regional Resident Representative for Central And Eastern Europe: The regional office was opened in February 2005.

*Source: IMF staff report content extracted from the provided PDF content unit.*

### 1. Data provision to the Fund is timely and facilitates effective surveillance. Significant

### _cr06379 - 1. Data provision to the Fund is timely and facilitates effective surveillance. Significant

### Data provision and metadata
- Hungary subscribes to the Special Data Dissemination Standard (SDDS), and its metadata are posted on the Fund’s Dissemination Standards Bulletin Board.
- Hungary meets the SDDS specifications for the coverage, periodicity, and timeliness of the data, and for the dissemination of advance release calendars.
- Most data quality issues noted in the data module of the 2001 Report on the Observance of Standards and Codes (ROSC) have been satisfactorily addressed, but some still remain.

### Real Sector Statistics — National accounts
- A statistical discrepancy between the final version of GDP by production activities and GDP by expenditure components emerged 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.
- Methodological refinements and a change in the base year trimmed the magnitude of the discrepancy to about 1 percent of GDP, based on 2001 current price data, and ½ percent in 2002.
- From June 2002, the HCSO began publishing seasonally adjusted estimates of quarterly GDP by type of economic activity and by expenditure components beginning with the first quarter of 2002, with retrospective coverage from 1995.
- Benchmarking of quarterly estimates to annual estimates applied from 2000.
- Beginning with annual data for 2000, methodology for imputed owner-occupied rent was changed in line with recommendations of Eurostat.
- Series of quarterly GDP at constant 2000 prices extend back to 2000.
- Methodological changes in 2001–2002 annual national accounts advanced transition to accrual basis accounting.
- Change in accounting method of re-export and net base accounting was calculated for 1998 going backwards.
- Full set of non-financial accounts of the general government sector compiled for 2001–02.
- Revision of Gross Fixed Capital Formation (GFCF) data facilitated by improved data collection, estimation of previously missing items, and application of ESA95 methodology; important GFCF items estimated consistently for 2000–02.
- The weights of the monthly consumer price index (CPI) and the producer price index (PPI) are updated each year; the weight reference period used in for the CPI is two years prior to the current year.

### External Sector Statistics
- A work plan with clear timetables implemented to replace cash-based balance of payments (compiled by the Magyar Nemzeti Bank, MNB) with accrual-based accounting consistent with IMF’s BPM5.
- Improvements implemented:
  - Exports and imports of goods derived from foreign trade data; from May 2004 based on the Intrastat/Extrastat system.
  - Balance of payments statistics now record goods under processing and repair on goods, and financial lease arrangements according to BPM5.
  - In 2004, estimates of reinvested earnings were included in the balance of payments statistics, raising the current account deficit with an offsetting impact on the financial accounts.
  - In 2004, investment income recorded on an accrual basis.
- These modifications completed the shift of Hungary’s balance of payments statistics to accrual-based accounting consistent with BPM5.
- Release of revised quarterly series by MNB in 2004 covered the period 1995–2003.
- MNB and HCSO reconciled data sources and methodologies for travel receipts and payments, eliminating a prior discrepancy.
- Since 2002, improved cooperation between HCSO and MNB has been formalized through memoranda of understanding signed each year.

### Monetary and Financial Statistics
- IFS country page for Hungary provides timely data for monetary authorities, banking institutions, and the banking survey.
- Since January 2003, MNB has collected and compiled monetary data using the ECB methodological framework. Changes include:
  - Monetary financial institutions sector includes money market funds (MMFs).
  - Credit is classified on a gross basis.
  - Fixed assets classified at acquisition cost.
  - Deposits at face value (without interest accrued).
  - Zero coupon bonds recorded at their discounted values.
- Valuation of securities is an area not fully aligned with international standards: securities on depository corporations’ balance sheets are not always valued at market prices.
- Progress on market valuation:
  - Since 2004, MNB encouraged depository corporations to use market valuation for securities in trading portfolios.
  - In 2005, MNB made market valuation compulsory for depository corporations that are listed on the stock exchange.
  - Securities of all companies listed on the stock exchange and held by depository corporations in their trading portfolio must be market valued.
  - Depository corporations are required to revalue their securities at least quarterly.
  - At present 12 banks (out of 40) apply market valuation for securities in their portfolios.
- In September 2001, a study summarized revision practice of monetary statistical publications; new monetary accounts and interest rate data first published per advance release calendar can be considered preliminary and subject to cross-checks and subsequent revisions; methodological changes are made public in advance and applied retroactively where possible.

### Government Finance Statistics (GFS)
- In January 2004, STA conducted a substantive update of the GFS dataset using the July 2003 Data Quality Assessment Framework.
- Significant progress made in 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 have not yet been realized.
- Latest data reported for publication in the 2005 GFS Yearbook refer to 2003.
- Data now cover consolidated central government and consolidated general government operations and corresponding subsectors.
- Data for 2000 onwards compiled on an accrual basis and reported in the Government Finance Statistics Manual 2001 format.

### Staff Report Supplement — Developments since 2006 Article IV and updated projections
- Supplement prepared by the European Department; approved October 4, 2006.
- Authorities’ Convergence Programme (CP) submitted to the European Commission on September 1 sets out a slower but more realistic consolidation path than envisaged in June.
- Financial markets cautiously endorsed the resolve to reduce the fiscal deficit; task of mitigating short-term risks and achieving long-term fiscal sustainability has just begun.
- With the economy weakening earlier than anticipated, staff reiterates caution on speed of monetary tightening.
- Political developments: demonstrations after leakage of Prime Minister Gyurcsány’s speech; Prime Minister retained party and coalition support; October 1 municipal elections saw opposition gains though governing coalition held Budapest mayoralty and retains a safe majority in parliament.

Key fiscal and macro projections and comparisons (Staff Report vs Current projections), 2006–10 (in percent or as noted)
- Real GDP growth (in percent)
  - Staff Report: 4.5 3.5 3.7 3.7 3.8
  - Current: 3.6 2.8 3.4 3.7 3.8
- Inflation (average, in percent)
  - Staff Report: 3.5 5.8 4.4 3.5 3.0
  - Current: 3.6 6.1 3.8 3.3 3.0
- External current account balance
  - Staff Report: -9.1 -8.0 -7.6 -7.4 -7.1
  - Current: -8.6 -7.2 -6.2 -5.4 -5.0
- General government balance 1/ (incl. PPPs)
  - Staff Report: -10.7 -8.5 -6.5 -5.8 -5.5
  - Current (incl. PPPs): -10.7 -7.9 -5.6 -4.2 -3.7
- Gross external debt 2/
  - Staff Report: 81.8 82.2 82.5 83.2 84.0
  - Current: 82.8 82.5 82.6 82.5 82.2
- General government debt 2/
  - Staff Report: 67.2 68.9 70.1 71.1 72.0
  - Current: 70.1 72.9 73.6 73.2 72.4

Additional staff assessments and notes
- Staff lowered its projections for the fiscal deficits given actions taken and required tax legislation now in effect.
- Staff estimates fiscal deficit will decline from 10.7 percent of GDP in 2006 to 7.9 percent of GDP in 2007, and further to 5.6 percent of GDP in 2008.
- Staff now projects additional consolidation of 0.6 and 0.9 percent of GDP in 2007 and 2008, respectively, relative to the staff report.
- Authorities have raised their deficit projections; differences in deficit projections are about 0.6 percent of GDP in 2006 and about 1 percent of GDP a year thereafter, reflecting uncertainty in implementation.
- Both staff and authorities’ estimates point to a rising debt ratio through 2008, when it is expected to peak at about 73 percent of GDP.
- In staff’s central scenario, the debt ratio’s decline in the outer years would be noticeably less than that projected by the authorities.
- Important pension and social welfare reforms, and steps to broaden the tax base, have yet to be detailed and remain crucial for more rapid and durable deficit and debt reduction.

1/ Deficit numbers now include the budget of motorway construction-related expenditures, a practice adopted by the authorities in their September 2006 Convergence Programme.
2/ The higher 2006 debt figures reflects revisions to the end-2005 debt ratio and valuation effects.

*Source: IMF staff report excerpt and supplementary information prepared by the European Department (October 4, 2006).*

### 4.      Financial markets continued to differentiate Hungary through the summer but

### _cr06379 - 4.      Financial markets continued to differentiate Hungary through the summer but

### Financial markets and sovereign risk
- Financial markets differentiated Hungary from peers through the summer, but differentiation has been cautiously reduced as international markets calmed.
- The forint traded in a very narrow range; yields on local currency bonds increased by about 25 basis points.
- Rating actions and reviews:
  - Fitch changed its outlook from stable to negative (within the rating category BBB+) on September 20.
  - Moody’s placed Hungary on review for a possible downgrade on September 25.
  - These rating actions had limited impact on market functioning.
- Market sentiment appeared to view the prospects of fiscal consolidation favorably, as indicated by a mild reaction to recent demonstrations.

### Growth and external balance revisions
- Staff revised down GDP growth projections:
  - GDP growth projection revised from 4.5 to 3.6 percent for 2006.
  - GDP growth projection revised from 3.5 to 2.8 percent for 2007.
- Reasons for slower growth:
  - Slowdown in Q2 reflecting a pullback in publicly-sponsored motorway investment and a fall in corporate and residential investment.
  - Import growth decelerated.
  - Since the June fiscal consolidation announcement, retail sales weakened and consumer and business confidence indices fell.
  - Anticipated higher personal income taxes, public sector layoffs, and a wage freeze may have restrained spending earlier than projected.
- Current account:
  - Current account deficit projected for 2007 is now 7.2 percent of GDP, 0.8 percent of GDP lower than in the staff report.
  - Lower expected current account deficits over the next few years will reduce the pace of external debt accumulation.

### Inflation outlook and monetary policy
- Inflation developments and projections:
  - Inflation has risen modestly since the staff report was issued.
  - Staff expects inflation at 3.6 percent in 2006.
  - Staff expects inflation at 6.1 percent in 2007, when one-time effects of tax and administered price increases will kick in.
  - Staff projects inflation to fall to 3.8 percent in 2008, just inside the ±1 percent range around the 3 percent inflation target.
  - The Magyar Nemzeti Bank (MNB) is forecasting a slightly higher 4.2 percent inflation rate for 2008.
- Monetary policy actions:
  - The MNB has raised the policy rate by a cumulative 175 basis points in four steps since June.
  - Staff recommends measured tightening that responds to second-round effects if they emerge, or a pause if inflationary effects are mitigated by the growth deceleration and the expected fiscally-induced slowdown.
  - Staff urges continued communication that interest rate policy will be guided by the inflation target (not by an exchange rate target) and that further rate increases will respond to second-round effects from tax and subsidy changes.

### Fiscal consolidation, structural reform, and risks
- Assessment of the Convergence Programme (CP):
  - The CP is a significant step toward needed fiscal consolidation and has alleviated short-term vulnerabilities.
  - Firm implementation of structural reforms and high transparency remain essential for durable consolidation.
- Risks from current consolidation strategy:
  - Reliance initially on tax increases on personal and corporate incomes and one-off measures (wage freezes) entails risks:
    - Tax hikes could produce less revenue than anticipated due to evasion or slower than projected growth.
    - The 2009 budget will face pressure to raise frozen public sector wages; the high tax wedge cannot be sustained.
  - If more durable measures are not in place by 2009, financial turbulence could recur.
- Medium-term fiscal outlook and concerns:
  - Even if plans proceed, the deficit will still be sizable (3½-4 percent of GDP) in 2009.
  - Government expenditure is 45 percent of GDP, disproportionate to Hungary’s per capita income.
  - Public debt-to-GDP ratio would remain above 70 percent under current trajectories.
  - These features could cause a prolonged period of below-potential economic performance.
- Recommendations for fiscal policy:
  - Implement structural reforms and maintain high transparency and accountability to contain budget overruns.
  - Implement a medium-term budget framework with multi-year expenditure ceilings.
  - Emphasize expenditure-based consolidation to enhance growth and efficiency, while avoiding undue reliance on revenue measures.
  - Institute more forceful reforms of pensions and social welfare transfers, improve targeting and efficiency.
  - Broaden the tax base (including a more far-reaching property tax) rather than surcharges on already high taxes on capital and labor.

### Financial sector and exchange rate considerations
- Banking sector:
  - Banking sector remains robust in profitability and capitalization, but increasing risks stem from rapid growth in foreign currency lending.
  - Risks amplified by aggressive lending practices and financial fragility of small and medium-sized enterprises.
  - Directors emphasized need for more proactive supervision and regulation, including regular stress tests and more intensive on-site supervision of banks’ risk management.
- Exchange rate regime debate:
  - Several Directors considered a floating exchange rate regime appropriate from a risk-management perspective and to strengthen the inflation-targeting anchor and reduce incentives to borrow in foreign currency.
  - Other Directors noted the existing fluctuation band (Peg against euro, with band +/-15 percent) already provides room for inflation targeting.
  - Timing issues are crucial; a formal switch in the exchange rate regime in present circumstances could send a mixed signal to markets.

### Labor market, competitiveness, and EU funds
- To raise employment and competitiveness:
  - Reduce the overall cost of labor and better target social welfare programs.
  - Increase productivity to maintain competitiveness.
  - Improve pace of absorption of EU funds in productivity-enhancing activities and link their deployment to fiscal structural reforms.

### Key statistics and indicators (as reported)
- Staff GDP growth revisions:
  - Revised from 4.5 to 3.6 percent for 2006.
  - Revised from 3.5 to 2.8 percent for 2007.
- Inflation projections:
  - Staff: 3.6 percent in 2006; 6.1 percent in 2007; 3.8 percent in 2008.
  - MNB: 4.2 percent in 2008.
- Forint and bond market:
  - Yields on local currency bonds increased by about 25 basis points.
- Public finances and external balances:
  - 2005 general government balance reached 7.5 percent of GDP (deficit).
  - 2005 current account deficit 7.4 percent of GDP.
  - 2005 general government debt 62.4 percent of GDP; projected 2006 debt 70.1 percent of GDP (as reported in Selected Economic Indicators).
  - Current account projected for 2007 is 7.2 percent of GDP (0.8 percent of GDP lower than in the staff report).
- Selected indicators (from tables and PIN):
  - Real GDP (change in percent): 2005 = 4.1; 2006 (Proj.) = 3.6.
  - CPI (average): 2005 = 3.6; 2006 (Proj.) = 3.6.
  - Unemployment rate (in percent): 2002 = 5.8; 2003 = 5.9; 2004 = 6.1; 2005 = 7.2; 2006 (Proj.) = 7.4.
  - Gross national saving (in percent of GDP): 2002 = 18.0; 2003 = 15.8; 2004 = 16.8; 2005 = 16.3; 2006 (Proj.) = 16.9.
  - Gross domestic investment (in percent of GDP): 2002 = 25.0; 2003 = 24.4; 2004 = 25.4; 2005 = 23.7; 2006 (Proj.) = 25.5.
  - Exchange regime: Peg against euro, with band +/-15 percent.
  - Present rate (September 30, 2006): Ft 215.74 = US$1.

*Source: IMF staff report and Public Information Notice (PIN) on Hungary, October 11 and October 20, 2006.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06379.pdf_