## Hungary—Stand-By Arrangement—Interim Review Under the Emergency Financing Mechanism (_cr0921)

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---

### Summary and Mission
- Financial market stress has moderated since the announcement of the program, though external financing remains difficult and could deteriorate again.
- Economic indicators confirm that the downturn envisaged in the program is already underway.
- Policies are being implemented in line with the program, with end-December targets expected to be met.
- The recently-enacted budget for 2009 should deliver the size of fiscal adjustment envisaged under the program, though risks to the wage bill exist.
- New bank support law provides banks with access to capital enhancement and borrowing guarantee facilities.
- Gradual reductions in the policy interest rate have been appropriate given moderation in financial market stress and decline in projected inflation.
- Continued implementation of policies in line with the program is essential to maintain investor confidence and minimize the depth of the economic downturn.
- Mission dates: December 9–15, 2008. Mission follow-up: team plans to return in early February to conduct the first review.

### Program and Introduction
- On November 6, 2008 the Executive Board approved a 17-month Stand-By Arrangement (SBA) for Hungary under the Emergency Financing Mechanism (EFM) in the amount of SDR 10.5 billion (€12.5 billion, US$15.7 billion, 1015 percent of Hungary's quota).
- The first purchase of SDR 4.2 billion was made following the Board meeting.
- The EFM calls for a review within two months of approval; the December mission was undertaken to meet this requirement.

### Financial Markets and Banks
- Exchange rate and reserves
  - Exchange rate broadly stable; stabilization reflects broadly offsetting actions by residents and non-residents.
  - In the two months to end-November, non-residents reduced holdings of government securities by around €4 billion (30 percent) and of equities by about €½ billion.
  - Households switched deposits from foreign exchange to HUF; corporates switched borrowing from HUF to foreign exchange.
  - Foreign exchange swap market recovering: rollover costs falling and maturities lengthening.
  - Gross international reserves of the MNB have increased in line with Fund and EU disbursements.
  - The first tranche (€2 billion) of the EU’s balance of payment support package was disbursed on December 9.
    - Note: remaining tranches tentatively expected in 2009Q1, 2009Q2, and 2009Q4 (as indicated in the staff report assumptions).

- Bank funding and markets
  - Major banks’ external funding has increased somewhat; external funding from parent banks rose through mid-November and since stabilized.
  - Other external funding remained stable.
  - Conditions in government securities market improved, though bond issuance remains suspended.
    - Government relied on short-term government bills with high bid-to-cover ratios and sharply falling bid spreads.
    - Government financing plan for 2009 envisages negative net issuance in the domestic market, with no regular bond auction in 2009Q1 and increased reliance on official external financing.
    - In the secondary market, government bond yields dropped considerably since October.

- Bank lending outlook
  - Lending growth expected to decline due to weaker demand and tighter supply.
  - Foreign parent banks committed to maintaining exposures but reluctant to increase funding further.
  - Banks reducing foreign currency mismatch, including halting lending to households in Swiss francs.
  - Banks raising deposit rates; most plan to focus on lending to households and be more selective toward corporates.

### Economic Developments
- Growth and activity
  - 2008Q3 GDP: year-on-year real growth of only ¾ percent, with a slight contraction relative to the previous quarter.
  - Slowdown broad-based: decelerating consumption growth, drop in investment, weak net exports.
  - High-frequency indicators point to a sharper slowdown in 2008Q4; industrial output fell 7¼ percent in October, led by a decline of 12 percent in the car industry.

- Labor market and wages
  - Unemployment increased slightly to 7¾ percent for the three months ending in September.
  - Anecdotal evidence of sharply increased pace of layoffs in recent weeks.
  - Private sector wage growth (ex-bonuses) fell to 8 percent in October.
  - Tripartite labor council recommended private sector wage growth of 3-5 percent in 2009.

- Inflation and external sector
  - CPI inflation fell from 5.7 percent in September to 4.2 percent in November, mainly reflecting declines in food and energy prices.
  - Sharp decline in inflation suggests possibility of breaching the lower inner band (4.1 percent) under the program in December.
  - Preliminary 2008Q3 balance of payments: higher current account deficit than expected, largely due to a worse income balance.
    - Export and import growth rates in euro terms fell sharply from the previous quarter.
    - Large deficit on net income due to high reinvested earnings from FDI and high dividend outflows related to non-resident holdings of equities and government bonds.

- Central bank projections
  - MNB updated projections: main assumption changes include a stronger exchange rate and smaller capital outflows relative to the program.
  - These changes have broadly offsetting effects on projected real GDP growth but suggest lower inflation and a larger current account deficit.
  - Macroeconomic framework underlying the program to be revised as needed at the time of the first review.

### Fiscal Policy: Performance, 2009 Budget, and Reforms
- Recent performance and end-December target
  - Fiscal performance continues to strengthen; monthly path of the primary balance in 2008 shows substantial improvement versus 2007 and 2006.
  - Some weakness in VAT collection, but overall revenue resilient due to progress in tax compliance and lagged labor market effects.
  - Expenditure under control; authorities committed to freeze contingency reserves though earmarked reserves used to cover operating losses in rail transportation company.
  - Assuming strict expenditure control, the primary balance at end-December is expected to meet the program target.

- 2009 budget (adopted December 15)
  - Budget consistent with the size of fiscal adjustment envisaged under the program, but recent agreement on public sector wages puts this adjustment at risk.
  - Overall deficit of general government expected to decline from a projected 3.4 percent of GDP in 2008 to 2½ percent of GDP in 2009.
  - Revenue side: no noteworthy tax policy changes except tax simplification.
  - Expenditure side: budgeted decline in nominal wage bill lower than envisaged under the program (¶10, LOI, Country Report No. 08/361), reflecting an ad-hoc allowance that fully offsets the loss of the 13th month salary for about 70 percent of civil servants and provides a partial offset for the remainder.
    - The allowance amounts to 0.4 percent of GDP and will be financed mainly by reducing reserves and by unidentified cuts in defense and education spending.
  - Staff concerns: negative signal regarding government commitment; reduction in reserves raises risk of not achieving targeted fiscal adjustment; staff suggested need for compensating measures to protect fiscal reserves and reduce fiscal risk.

- EU-funded measures to mitigate downturn
  - Measures aimed at SMEs: investment subsidies, credit guarantees, refinancing facilities for commercial bank lending to SMEs.
  - Infrastructure projects (railroad and school refurbishment) to boost demand.
  - Wage subsidies for SMEs that maintain or create jobs.
  - These measures are mostly previously announced and not expected to affect achievement of program targets.
  - Authorities and staff agreed on importance of communicating consistency between initiatives and program targets.

- Fiscal Responsibility Law (adopted November 17)
  - Introduces numerical and procedural rules: obligation to achieve a decline in public debt in real terms; prohibition of primary deficits; compliance with medium-term expenditure ceilings; requirement to offset budget impact of legislative initiatives.
  - Transitory period for budgets 2010-12: projected growth of real expenditure cannot exceed half projected growth of real GDP.
  - Establishes a fiscal council of three wise persons and a secretariat; council should be operational by end-2009.
    - Council responsibilities: prepare macroeconomic forecasts and budgetary projections, assess budget impact of draft legislation (scoring), make recommendations on corrective actions, provide advisory information and assessments to all branches of government upon request.
  - Authorities and staff agreed on importance of medium-term budget planning and providing the fiscal council with an appropriation commensurate to its mandate.

### Financial Sector Policies and Bank Support
- Bank support law and design
  - Recently-approved law establishes a Capital Base Enhancement Fund and a Refinancing Guarantee Fund, incorporating European Commission guidance and remaining in line with the program.
  - Quantitative criterion for eligibility (own funds above HUF 200 billion) removed so all banks may apply.
  - Refinancing guarantees available even for banks that do not apply for a capital increase.
  - Preservation of banking system stability will be key in reviewing applications.
  - Triggers for possible authority takeover of a beneficiary bank in case of deterioration are appropriate.

- Size and modalities
  - Total size of support package remains HUF 600 billion, divided equally between capital enhancement and refinancing guarantees (HUF 300 billion each).
  - Any fraction of the HUF 300 billion earmarked for capital enhancement not used by March 2009 will be transferred to the Refinancing Guarantee Fund.
  - Detailed features and modalities of guarantees to be determined soon; pricing (in line with European Commission recommendations) will be important for bank interest.
  - Authorities and staff agreed need to revisit size of guarantee fund in a few months based on experience.

- Supervisory and resolution powers
  - Authorities preparing separate legislation to strengthen remedial powers of the financial supervisory agency; draft legislation to be submitted to parliament by end-2008 in line with the structural benchmark.
  - Fund and Bank staff consider the draft would benefit from additional review and outside inputs, including on range of bank resolution options.
  - With parliament in winter recess, consideration will not occur before March 2009; staff will use delay to further coordinate with authorities and the World Bank.

- Household foreign currency loan measures
  - Authorities and banks signed a public agreement on voluntary measures: extension of maturity, temporary easing of repayment, conversion of loans into domestic currency.
  - Given exchange rate stability since October, very few borrowers have used these measures; they provide a safety net if household balance sheets deteriorate.
  - Authorities and staff agreed existing measures would be insufficient if deterioration is sufficiently large.
  - Mission encouraged acceleration of consideration of a personal bankruptcy regime.

### Monetary and Exchange Rate Policy; Liquidity
- Policy rate actions
  - MNB raised policy rate by 300 bps on October 22 at a time of intense financial market stress.
  - Policy rate was cut on November 22, December 8, and December 22, by 50 bps each time, reflecting the moderation in financial market stress, the fall in projected inflation to below target, and policy rate reductions by the major central banks.
  - Staff appraisal: "The reductions in the policy interest rate have been appropriate, in light of the fall in projected inflation and the moderation of financial market stress."
  - Staff view: "As inflation is likely to fall below the 3 percent target at the two-year horizon, a prudent easing bias appears appropriate, as long as financial markets remain supportive."
  - Any further rate cuts should be gradual and cautious, and commensurate with improvements in investor confidence.
  - Financial markets reacted positively to these rate cuts, with the exchange rate appreciating modestly and long-term government bond yields falling somewhat.
  - Financial markets expect further easing in the first half of 2009.
  - Authorities have publicly noted that further rate cuts will depend on the evolution of the markets’ risk assessment of Hungary.

- Liquidity provision and facilities
  - Liquidity provision by the central bank has stabilized in recent weeks.
  - Reduction in the reserve requirement ratio from 5 to 2 percent (in line with the EU norm) has reduced the use of the central bank’s 2-week lending facility, though demand for term liquidity supplied through the 6-month facility has remained robust.
  - Overnight deposits at the central bank have continued to increase, indicating an increase in banks’ precautionary balances and the perception of high counterparty risk.
  - The central bank has broadened eligible collateral by accepting bonds of mortgage lenders associated with banks, and is prepared to take further steps, if necessary.
  - While demand for the central bank’s overnight foreign exchange swap facility has fallen, foreign exchange liquidity generally remains tight; authorities and staff agreed that extending the maturity of the facility could be considered.
  - "The central bank’s readiness to modify or expand its liquidity-providing facilities as needed is welcome."

### Economic Outlook, Risks, and Policy Recommendations
- Economic outlook and risks
  - Economic indicators confirm that the downturn envisaged under the program is already underway.
  - External creditors are reluctant to increase funding, so credit growth in Hungary is likely to slow sharply.
  - Wage restraint is critical to contain employment losses.
  - Continued implementation of economic policies consistent with the program is essential to maintain investor confidence and minimize the depth of the economic downturn.
  - With global deleveraging expected to continue in 2009, financial market stress could increase again.

- Fiscal stance and recommendations
  - Vigilance is needed to minimize the risk of fiscal underperformance vis-à-vis the program targets in 2009.
  - The fiscal program target for end-December 2008 are likely to be met.
  - The budget for 2009 is consistent with the size of the fiscal adjustment envisaged under the program, though the smaller-than-expected decline in the wage bill (mainly offset by smaller reserves) puts this adjustment at risk.
  - It will be important that budget execution delivers the envisaged expenditure restraint.
  - The new Fiscal Responsibility Law is welcome.
  - Given the importance of independent scrutiny of budget preparation and execution, it is essential that the fiscal council’s secretariat have adequate staffing and funding.

- Banking sector assessment and recommendation
  - Recently-enacted bank support law provides Hungarian banks with access to capital enhancement and borrowing guarantee facilities similar to those available to banks in other EU countries.
  - Banks currently have strong solvency positions and stable funding.
  - Going forward, external funding is likely to be tight given ongoing global deleveraging, and banks’ asset quality will deteriorate in the economic downturn.
  - Staff suggested revisiting the size of the guarantee fund based on experience and ensuring pricing of guarantees follows European Commission recommendations.

### Key Statistics (Hungary: Main Economic Indicators, 2005–09)
- Real GDP (change in percent): 2005 4.1; 2006 3.9; 2007 1.1; 2008 1.8; 2009 -1.0
- Private consumption (change in percent): 2005 3.6; 2006 1.9; 2007 -1.9; 2008 0.9; 2009 -3.9
- Gross fixed investment (change in percent): 2005 5.3; 2006 -2.5; 2007 0.1; 2008 1.0; 2009 -0.9
- Exports (change in percent): 2005 11.5; 2006 19.0; 2007 14.2; 2008 7.6; 2009 2.1
- Imports (change in percent): 2005 6.8; 2006 14.7; 2007 12.0; 2008 8.1; 2009 0.7
- CPI (end year): 2005 3.3; 2006 6.5; 2007 7.4; 2008 5.1; 2009 4.2
- CPI (average): 2005 3.6; 2006 3.9; 2007 7.9; 2008 6.3; 2009 4.5
- Unemployment rate (average, in percent): 2005 7.2; 2006 7.5; 2007 7.4; 2008 7.8; 2009 8.5
- Gross domestic investment (percent of GDP) 1/: 2005 23.6; 2006 23.1; 2007 23.0; 2008 22.8; 2009 20.0
- Gross national saving (percent of GDP, from BOP): 2005 16.1; 2006 15.6; 2007 16.6; 2008 16.5; 2009 18.0
- Overall balance (general government, percent of GDP, ESA-95 basis) 2/: 2005 -7.8; 2006 -9.3; 2007 -4.9; 2008 -3.4; 2009 -2.5
- Primary balance (percent of GDP): 2005 -3.7; 2006 -5.4; 2007 -0.9; 2008 0.6; 2009 1.9
- Debt (percent of GDP): 2005 61.6; 2006 65.5; 2007 65.8; 2008 67.4; 2009 70.1
- M3 (end-of-period, percent change): 2005 14.6; 2006 13.8; 2007 11.0; 2008 4.1; 2009 1.3
- Credit to nongovernment (end-of-period, percent change): 2005 18.9; 2006 17.1; 2007 17.3; 2008 7.2; 2009 -6.2
- T-bill (90-day, average) (percent): 2005 6.8; 2006 7.0; 2007 7.6
- Government bond yield (5-year, average) (percent): 2005 8.0; 2006 6.9; 2007 7.0
- Goods and services trade balance (percent of GDP): 2005 -1.2; 2006 -0.9; 2007 1.4; 2008 1.8; 2009 7.5
- Current account (percent of GDP): 2005 -7.5; 2006 -7.5; 2007 -6.4; 2008 -6.2; 2009 -2.0
- Reserves (in billions of euros): 2005 15.7; 2006 16.4; 2007 16.4; 2008 19.5; 2009 19.8
- Gross external debt (percent of GDP) 3/: 2005 75.0; 2006 90.4; 2007 97.2; 2008 106.4; 2009 115.8
- Exchange regime: Floating
- Present rate (December 18, 2008): Ft 182.6.4 = US$1;  Ft. 267.0 = €1
- Nominal effective rate (2000=100): 2005 111.6; 2006 105.1; 2007 111.8
- Real effective rate, CPI basis (2000=100): 2005 132.6; 2006 127.0; 2007 142.5
- Quota at the Fund: SDR 1038.4 million

*Prepared by IMF staff based on information available as of December 22, 2008. IMF staff appraisal and data as presented in Section 2 of the source document.*

### Section 1

### Hungary—Stand-By Arrangement—Interim Review Under the Emergency Financing Mechanism

### Summary
- Financial market stress has moderated since the announcement of the program, though external financing remains difficult and could deteriorate again.
- Economic indicators confirm that the downturn envisaged in the program is already underway.
- Policies are being implemented in line with the program, with end-December targets expected to be met.
- The recently-enacted budget for 2009 should deliver the size of fiscal adjustment envisaged under the program.
- The new bank support law provides Hungarian banks with access to capital enhancement and borrowing guarantee facilities.
- Gradual reductions in the policy interest rate have been appropriate, given the moderation in financial market stress and the decline in projected inflation.
- Continued implementation of policies in line with the program is essential to maintain investor confidence and minimize the depth of the economic downturn.

*Prepared by IMF staff based on information available as of December 22, 2008.*

### Discussions and Mission
- Mission dates: December 9–15, 2008.
- Officials and stakeholders met: Minister of Finance Veres; Minister of National Development and Economy Bajnai; central bank Governor Simor; senior officials; representatives of banking and business communities; senior representatives of the main opposition party.
- Mission follow-up: team plans to return in early February to conduct the first review.
- Staff composition: Mr. Morsink (head), Messrs. Wiegand and Joshi (EUR); Mr. Frécaut (MCM); Mr. Debrun (FAD); Ms. Barkbu (SPR). A European Commission staff team joined many meetings. Coordination with a concurrent World Bank team on financial sector issues.

### I. Introduction
- On November 6, 2008 the Executive Board approved a 17-month Stand-By Arrangement (SBA) for Hungary under the Emergency Financing Mechanism (EFM) in the amount of SDR 10.5 billion (€12.5 billion, US$15.7 billion, 1015 percent of Hungary's quota).
- The first purchase of SDR 4.2 billion was made following the Board meeting.
- The EFM calls for a review within two months of approval; the December mission was undertaken to meet this requirement.

### II. Recent Financial Market and Economic Developments

#### A. Financial Markets and Banks
- Exchange rate and reserves:
  - Exchange rate broadly stable; stabilization reflects broadly offsetting actions by residents and non-residents.
  - In the two months to end-November, non-residents reduced holdings of government securities by around €4 billion (30 percent) and of equities by about €½ billion.
  - Households switched deposits from foreign exchange to HUF; corporates switched borrowing from HUF to foreign exchange.
  - Foreign exchange swap market recovering: rollover costs falling and maturities lengthening.
  - Gross international reserves of the MNB have increased in line with Fund and EU disbursements.
  - The first tranche (€2 billion) of the EU’s balance of payment support package was disbursed on December 9.
    - Note: remaining tranches tentatively expected in 2009Q1, 2009Q2, and 2009Q4 (as indicated in the staff report assumptions).

- Bank funding and markets:
  - Major banks’ external funding has increased somewhat; external funding from parent banks rose through mid-November and since stabilized.
  - Other external funding remained stable.
  - Conditions in government securities market improved, though bond issuance remains suspended.
    - Government relied on short-term government bills with high bid-to-cover ratios and sharply falling bid spreads.
    - Government financing plan for 2009 envisages negative net issuance in the domestic market, with no regular bond auction in 2009Q1 and increased reliance on official external financing.
    - In the secondary market, government bond yields dropped considerably since October.

- Bank lending outlook:
  - Lending growth expected to decline due to weaker demand and tighter supply.
  - Foreign parent banks committed to maintaining exposures but reluctant to increase funding further.
  - Banks reducing foreign currency mismatch, including halting lending to households in Swiss francs.
  - Banks raising deposit rates; most plan to focus on lending to households and be more selective toward corporates.

#### B. Economic Developments
- Growth and activity:
  - 2008Q3 GDP: year-on-year real growth of only ¾ percent, with a slight contraction relative to the previous quarter.
  - Slowdown broad-based: decelerating consumption growth, drop in investment, weak net exports.
  - High-frequency indicators point to a sharper slowdown in 2008Q4; industrial output fell 7¼ percent in October, led by a decline of 12 percent in the car industry.

- Labor market and wages:
  - Unemployment increased slightly to 7¾ percent for the three months ending in September.
  - Anecdotal evidence of sharply increased pace of layoffs in recent weeks.
  - Private sector wage growth (ex-bonuses) fell to 8 percent in October.
  - Tripartite labor council recommended private sector wage growth of 3-5 percent in 2009.

- Inflation and external sector:
  - CPI inflation fell from 5.7 percent in September to 4.2 percent in November, mainly reflecting declines in food and energy prices.
  - Sharp decline in inflation suggests possibility of breaching the lower inner band (4.1 percent) under the program in December.
  - Preliminary 2008Q3 balance of payments: higher current account deficit than expected, largely due to a worse income balance.
    - Export and import growth rates in euro terms fell sharply from the previous quarter.
    - Large deficit on net income due to high reinvested earnings from FDI and high dividend outflows related to non-resident holdings of equities and government bonds.

- Central bank projections:
  - MNB updated projections: main assumption changes include a stronger exchange rate and smaller capital outflows relative to the program.
  - These changes have broadly offsetting effects on projected real GDP growth but suggest lower inflation and a larger current account deficit.
  - Macroeconomic framework underlying the program to be revised as needed at the time of the first review.

### III. Policy Developments

#### A. Fiscal Policy
- Recent performance and targets:
  - Fiscal performance continues to strengthen; monthly path of the primary balance in 2008 shows substantial improvement versus 2007 and 2006.
  - Some weakness in VAT collection, but overall revenue resilient due to progress in tax compliance and lagged labor market effects.
  - Expenditure under control; authorities committed to freeze contingency reserves though earmarked reserves used to cover operating losses in rail transportation company.
  - Assuming strict expenditure control, the primary balance at end-December is expected to meet the program target.

- 2009 budget (adopted December 15):
  - Budget consistent with the size of fiscal adjustment envisaged under the program, but recent agreement on public sector wages puts this adjustment at risk.
  - Overall deficit of general government expected to decline from a projected 3.4 percent of GDP in 2008 to 2½ percent of GDP in 2009.
  - Revenue side: no noteworthy tax policy changes except tax simplification.
  - Expenditure side: budgeted decline in nominal wage bill lower than envisaged under the program (¶10, LOI, Country Report No. 08/361), reflecting an ad-hoc allowance that fully offsets the loss of the 13th month salary for about 70 percent of civil servants and provides a partial offset for the remainder.
    - The allowance amounts to 0.4 percent of GDP and will be financed mainly by reducing reserves and by unidentified cuts in defense and education spending.
  - Staff concerns: negative signal regarding government commitment; reduction in reserves raises risk of not achieving targeted fiscal adjustment; staff suggested need for compensating measures to protect fiscal reserves and reduce fiscal risk.

- EU-funded measures to mitigate downturn:
  - Measures aimed at SMEs: investment subsidies, credit guarantees, refinancing facilities for commercial bank lending to SMEs.
  - Infrastructure projects (railroad and school refurbishment) to boost demand.
  - Wage subsidies for SMEs that maintain or create jobs.
  - These measures are mostly previously announced and not expected to affect achievement of program targets.
  - Authorities and staff agreed on importance of communicating consistency between initiatives and program targets.

- Fiscal Responsibility Law (adopted November 17):
  - Introduces numerical and procedural rules: obligation to achieve a decline in public debt in real terms; prohibition of primary deficits; compliance with medium-term expenditure ceilings; requirement to offset budget impact of legislative initiatives.
  - Transitory period for budgets 2010-12: projected growth of real expenditure cannot exceed half projected growth of real GDP.
  - Establishes a fiscal council of three wise persons and a secretariat; council should be operational by end-2009.
    - Council responsibilities: prepare macroeconomic forecasts and budgetary projections, assess budget impact of draft legislation (scoring), make recommendations on corrective actions, provide advisory information and assessments to all branches of government upon request.
  - Authorities and staff agreed on importance of medium-term budget planning and providing the fiscal council with an appropriation commensurate to its mandate.

#### B. Financial Sector Policies
- Bank support law:
  - Recently-approved law establishes a Capital Base Enhancement Fund and a Refinancing Guarantee Fund, incorporating European Commission guidance and remaining in line with the program.
  - Quantitative criterion for eligibility (own funds above HUF 200 billion) removed so all banks may apply.
  - Refinancing guarantees available even for banks that do not apply for a capital increase.
  - Preservation of banking system stability will be key in reviewing applications.
  - Triggers for possible authority takeover of a beneficiary bank in case of deterioration are appropriate.

- Size and design of support:
  - Total size of support package remains HUF 600 billion, divided equally between capital enhancement and refinancing guarantees (HUF 300 billion each).
  - Any fraction of the HUF 300 billion earmarked for capital enhancement not used by March 2009 will be transferred to the Refinancing Guarantee Fund.
  - Detailed features and modalities of guarantees to be determined soon; pricing (in line with European Commission recommendations) will be important for bank interest.
  - Authorities and staff agreed need to revisit size of guarantee fund in a few months based on experience.

- Financial supervisory and resolution powers:
  - Authorities preparing separate legislation to strengthen remedial powers of the financial supervisory agency; draft legislation to be submitted to parliament by end-2008 in line with the structural benchmark.
  - Fund and Bank staff consider the draft would benefit from additional review and outside inputs, including on range of bank resolution options.
  - With parliament in winter recess, consideration will not occur before March 2009; staff will use delay to further coordinate with authorities and the World Bank.

- Measures to mitigate household foreign currency loan risks:
  - Authorities and banks signed a public agreement on voluntary measures: extension of maturity, temporary easing of repayment, conversion of loans into domestic currency.
  - Given exchange rate stability since October, very few borrowers have used these measures; they provide a safety net if household balance sheets deteriorate.
  - Authorities and staff agreed existing measures would be insufficient if deterioration is sufficiently large.
  - Mission encouraged acceleration of consideration of a personal bankruptcy regime.

#### C. Monetary and Exchange Rate Policy
- Policy rate actions:
  - Central bank (MNB) gradually reduced the policy interest rate, partly reversing the sharp rate hike in October.
  - Policy rate was raised by 300 bps on October 22 at a time of intense financial market stress.

*International Monetary Fund staff report prepared December 22, 2008.*

### Section 2

### _cr0921 - Section 2

### Monetary policy actions and market reaction
- Policy rate was cut on November 22, December 8, and December 22, by 50 bps each time, reflecting the moderation in financial market stress, the fall in projected inflation to below target, and policy rate reductions by the major central banks.
- Financial markets reacted positively to these rate cuts, with the exchange rate appreciating modestly and long-term government bond yields falling somewhat.
- Financial markets expect further easing in the first half of 2009.
- The authorities have publicly noted that further rate cuts will depend on the evolution of the markets’ risk assessment of Hungary.
- "The reductions in the policy interest rate have been appropriate, in light of the fall in projected inflation and the moderation of financial market stress." (staff appraisal)
- "As inflation is likely to fall below the 3 percent target at the two-year horizon, a prudent easing bias appears appropriate, as long as financial markets remain supportive."
- Any further rate cuts should be gradual and cautious, and commensurate with improvements in investor confidence.

### Liquidity provision and central bank facilities
- Liquidity provision by the central bank has stabilized in recent weeks.
- Reduction in the reserve requirement ratio from 5 to 2 percent (in line with the EU norm) has reduced the use of the central bank’s 2-week lending facility, though demand for term liquidity supplied through the 6-month facility has remained robust.
- Overnight deposits at the central bank have continued to increase, indicating an increase in banks’ precautionary balances and the perception of high counterparty risk.
- The central bank has broadened eligible collateral by accepting bonds of mortgage lenders associated with banks, and is prepared to take further steps, if necessary.
- While demand for the central bank’s overnight foreign exchange swap facility has fallen, foreign exchange liquidity generally remains tight; authorities and staff agreed that extending the maturity of the facility could be considered.
- "The central bank’s readiness to modify or expand its liquidity-providing facilities as needed is welcome."

### Financial market conditions and external financing
- Financial market stress has moderated since the announcement of a program, though external financing remains difficult.
- The exchange rate has been broadly stable, government bond yields have declined, foreign parent banks have continued to support their subsidiaries in Hungary, and international reserves have increased.
- With global deleveraging expected to continue in 2009, financial market stress could increase again.

### Economic outlook and risks
- Economic indicators confirm that the downturn envisaged under the program is already underway.
- External creditors are reluctant to increase funding, so credit growth in Hungary is likely to slow sharply.
- Wage restraint is critical to contain employment losses.
- Continued implementation of economic policies consistent with the program is essential to maintain investor confidence and minimize the depth of the economic downturn.

### Fiscal stance and public finance risks
- Vigilance is needed to minimize the risk of fiscal underperformance vis-à-vis the program targets in 2009.
- The fiscal program target for end-December 2008 are likely to be met.
- The budget for 2009 is consistent with the size of the fiscal adjustment envisaged under the program, though the smaller-than-expected decline in the wage bill (mainly offset by smaller reserves) puts this adjustment at risk.
- It will be important that budget execution delivers the envisaged expenditure restraint.
- The new Fiscal Responsibility Law is welcome.
- Given the importance of independent scrutiny of budget preparation and execution, it is essential that the fiscal council’s secretariat have adequate staffing and funding.

### Banking sector assessment
- The recently-enacted bank support law provides Hungarian banks with access to capital enhancement and borrowing guarantee facilities similar to those available to banks in other EU countries.
- Banks currently have strong solvency positions and stable funding.
- Going forward, external funding is likely to be tight given ongoing global deleveraging, and banks’ asset quality will deteriorate in the economic downturn.

### Key statistics (Hungary: Main Economic Indicators, 2005–09)
- Real GDP: 2005 4.1; 2006 3.9; 2007 1.1; 2008 1.8; 2009 -1.0 (change in percent)
- Private consumption: 2005 3.6; 2006 1.9; 2007 -1.9; 2008 0.9; 2009 -3.9
- Gross fixed investment: 2005 5.3; 2006 -2.5; 2007 0.1; 2008 1.0; 2009 -0.9
- Exports: 2005 11.5; 2006 19.0; 2007 14.2; 2008 7.6; 2009 2.1
- Imports: 2005 6.8; 2006 14.7; 2007 12.0; 2008 8.1; 2009 0.7
- CPI (end year): 2005 3.3; 2006 6.5; 2007 7.4; 2008 5.1; 2009 4.2
- CPI (average): 2005 3.6; 2006 3.9; 2007 7.9; 2008 6.3; 2009 4.5
- Unemployment rate (average, in percent): 2005 7.2; 2006 7.5; 2007 7.4; 2008 7.8; 2009 8.5
- Gross domestic investment (percent of GDP) 1/: 2005 23.6; 2006 23.1; 2007 23.0; 2008 22.8; 2009 20.0
- Gross national saving (percent of GDP, from BOP): 2005 16.1; 2006 15.6; 2007 16.6; 2008 16.5; 2009 18.0
- Overall balance (general government, percent of GDP, ESA-95 basis) 2/: 2005 -7.8; 2006 -9.3; 2007 -4.9; 2008 -3.4; 2009 -2.5
- Primary balance (percent of GDP): 2005 -3.7; 2006 -5.4; 2007 -0.9; 2008 0.6; 2009 1.9
- Debt (percent of GDP): 2005 61.6; 2006 65.5; 2007 65.8; 2008 67.4; 2009 70.1
- M3 (end-of-period, percent change): 2005 14.6; 2006 13.8; 2007 11.0; 2008 4.1; 2009 1.3
- Credit to nongovernment (end-of-period, percent change): 2005 18.9; 2006 17.1; 2007 17.3; 2008 7.2; 2009 -6.2
- T-bill (90-day, average) (percent): 2005 6.8; 2006 7.0; 2007 7.6
- Government bond yield (5-year, average) (percent): 2005 8.0; 2006 6.9; 2007 7.0
- Goods and services trade balance (percent of GDP): 2005 -1.2; 2006 -0.9; 2007 1.4; 2008 1.8; 2009 7.5
- Current account (percent of GDP): 2005 -7.5; 2006 -7.5; 2007 -6.4; 2008 -6.2; 2009 -2.0
- Reserves (in billions of euros): 2005 15.7; 2006 16.4; 2007 16.4; 2008 19.5; 2009 19.8
- Gross external debt (percent of GDP) 3/: 2005 75.0; 2006 90.4; 2007 97.2; 2008 106.4; 2009 115.8
- Exchange regime: Floating
- Present rate (December 18, 2008): Ft 182.6.4 = US$1;  Ft. 267.0 = €1
- Nominal effective rate (2000=100): 2005 111.6; 2006 105.1; 2007 111.8
- Real effective rate, CPI basis (2000=100): 2005 132.6; 2006 127.0; 2007 142.5
- Quota at the Fund: SDR 1038.4 million

*IMF staff appraisal and data as presented in Section 2 of the source document.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0921.pdf_