## _cr1135

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### I. Context
- Hungary emerged from a severe economic crisis driven by global financial strains in late 2008, high pre-crisis vulnerabilities, and close integration into global financial and goods markets.
- Real GDP contracted by almost 7 percent in 2009.
- Key pre-crisis vulnerabilities:
  - government debt about 80 percent of GDP,
  - external debt about 140 percent of GDP,
  - low reserve coverage,
  - large-scale currency mismatches,
  - banking system dependent on external funding with large on-balance sheet currency mismatches,
  - corporations and households indebted in foreign currencies.
- IMF/EU-supported program, large upfront official financing, and easing global financial conditions contributed to stabilization from mid-2009.
- New government formed mid-2010 (Fidesz, two-thirds majority) let the IMF/EU program lapse and adopted a strategy with pillars including tax relief for households, enhanced family benefits, targeted SME support (“New Széchenyi Plan”), temporary revenue measures targeted at profitable sectors, and de facto re-nationalization of the second pillar private pension system.

### II. Macroeconomic outlook and risks
- Near-term staff projections and observations:
  - Exports increased for six consecutive quarters; employment rising since February 2010.
  - Tax cuts announced for 2011 estimated to increase disposable income by about 5 percent.
  - Staff expects real GDP growth to increase from around 1 percent in 2010 to about 2¾ percent in 2011.
  - Current account: temporarily in surplus in 2010, expected to swing into deficit starting in 2012.
  - Average inflation expected to be around 4 percent in 2011.
- Medium-term projections:
  - Staff projects potential growth of 2–2½ percent over the medium term.
  - Actual growth projected to be roughly one percentage point higher than potential in 2012–15, gradually narrowing the output gap.
  - Authorities project actual output growth reaching 5½ percent in 2015 (based on more favorable assumptions).
- Risks to the central scenario:
  - Downside risks:
    - global recovery may slow affecting exports;
    - deterioration in risk appetite could compound financing risks given high external and public debt;
    - further strengthening of the Swiss franc (CHF) would increase household debt-servicing costs;
    - high policy uncertainty could raise precautionary savings and depress consumption and investment.
  - Upside risks:
    - accommodative macro policies in advanced economies could spur global growth and stronger capital flows to emerging markets, compressing Hungary’s borrowing spreads;
    - recent policy package effects on employment and investment, if reinforced by structural reforms and business climate improvements, could outperform staff assumptions.
- Openness and spillovers:
  - High openness implies spillovers both to and from Hungary.
  - Fidesz officials’ June 2010 statements suggesting imminent government insolvency upset regional markets and temporarily impacted the euro.
  - Hungary’s risk premia have recently increased markedly; rating agencies downgraded Hungary to the lowest investment grade, with a negative outlook.

### III. Fiscal policy, composition, and staff recommendations
- Fiscal developments and composition:
  - 2010 budget deficit target of 3.8 percent of GDP proved unattainable; emergency package adopted with large special levy on financial institutions, spending cuts, reductions in corporate income tax, and elimination of small taxes.
  - Second package (October) included levies on foreign-owned retail chains, telecommunication and energy companies, and a 14-month diversion of second pillar private pension contributions to the budget.
  - Net deficit-reducing effect of the two rounds of measures amounted to 2 percent of GDP.
  - New revenue slippages in December put attainability of the deficit target (ESA95 terms) in question.
- 2011 budget and tax reform:
  - Flat-rate personal income tax to be implemented over three years, unifying and phasing marginal tax rate to 16 percent and introducing more generous child allowances.
  - Immediate revenue loss estimated at 1¾ percent of GDP (and a further 1½ percent in 2012–13).
  - Budget relies primarily on temporary measures to meet the 2.9 percent of GDP deficit target agreed with the EU:
    - continuation of temporary sectoral levies,
    - diversion of second pillar pension contributions (about 1.2 and 1.3 percent of GDP, respectively),
    - using asset transfers from the second pillar to fund spending (about 2 percent of GDP).
  - Incentives expected to lead virtually all contributors to return to the PAYG system in early 2011, implying total one-off revenues of about 11 percent of GDP in 2011.
  - Pension asset use: new supervisory body to determine assets not needed for current expenditures; at least half is expected to be used to reduce gross debt.
  - Structural measures in the 2011 budget amount to about one percent of GDP (including staff cuts of 0.5 percent of total government employment, reduced bonuses and in-kind benefits, streamlined public works, and lower capital spending by local governments).
- Staff concerns:
  - Revenues in the 2011 budget viewed as optimistic given 2010 performance (especially VAT and CIT).
  - Excluding the pension asset transfer, the deficit would be close to 5 percent of GDP.
  - Heavy reliance on temporary measures implies a substantial loosening of the underlying fiscal stance in 2010.
  - Structural weakening from tax cuts in 2011 only partly offset by expenditure cuts and redirection of pension contributions.
  - Measures could be passed to consumers, distort sectors, and—through higher risk premia—send negative signals about foreign investment.
- Staff recommendations to restore structural fiscal sustainability:
  - Focus on rationalization of current primary spending and other structural reforms.
  - Identify expenditure-reducing measures of about 4 percent of GDP to eliminate the 2011 structural deficit and set debt on a downward trajectory.
  - Suggested measures: rationalizing the public wage bill and social benefits, restructuring public transportation companies.
  - A property tax could be an additional revenue source.
  - Urged progress in public finance management to avoid spending slippages, continue tax administration compliance strategy, and merge customs and tax administrations.
  - Recommended greater budget transparency, including publishing contingent liabilities given increased prominence of state guarantees in the New Széchenyi plan and the expanded role of the state development bank MFB.

### IV. Authorities’ responses and medium-term consolidation potential
- Authorities’ stance:
  - Expect a medium-term reform plan (to be announced in February) may yield up to 2½ percent of GDP in savings via administrative reforms (local governments), public finance management changes (budget inspectors), restructuring state-owned enterprises, and a permanent (but smaller) bank levy.
  - Prefer revenue-side measures that spare households and were reluctant to commit to concrete steps immediately.
- Staff advice:
  - Frontload durable expenditure measures and postpone personal and corporate tax cuts planned for 2012–13 until fiscal space emerges.
  - Staff estimated a required cumulative adjustment of 5–5½ percent of GDP in 2013–14 to achieve authorities’ targets.
  - Public debt particularly sensitive to growth and real exchange rate shocks.
- Key quantified consolidation potential (IMF staff estimates, based on Hungarian authorities data; totals in percent of GDP):
  - Total potential consolidation from proposed measures: 4.0
  - Better targeting of social benefits 1/: 1.8
  - Active labor market policies' rationalization 2/: 0.3
  - Reduction of the public sector wage bill 3/: 1.0
  - Rationalization of state-owned transport enterprises to eliminate losses 4/: 1.0
  - (Notes reproduced from source: definitions of measures and beneficiaries.)

### V. Pension reform — fiscal implications and risks
- Mechanism and short-term effects:
  - Shift from pillar 2 (private defined-contribution) to pillar 1 (government defined-benefit) delivers an immediate stream of pension contributions to government; corresponding pension benefit payments increase only as these workers retire.
  - Transfer of pension assets is recorded as revenue under ESA95 accounting rules, creating room for expenditures while meeting headline fiscal targets; reduction in government financial debt lowers the interest bill.
- Staff concerns:
  - Despite initial debt reduction, reform raises questions about medium-term fiscal sustainability if assets moved to PAYG are used for current spending.
  - Reform reduces transparency and increases fiscal risks.
  - Reform biases terms in favor of switching to PAYG, raising concerns about business environment and property rights.
  - Implied erosion of liquidity in domestic bond and equity markets could negatively impact capital market depth.
  - Staff suggests low returns in private funds could be better addressed by improved regulation.
- Authorities’ rationale:
  - Optimistic regarding viability of expanded PAYG, citing tax reforms to increase employment and fertility; argued pensions safer with state than with private funds.
- Empirical indicators cited:
  - Government estimates indicate a negative net present value of discounted contributions and pension benefits to 2060 of about 10 percent of GDP (using optimistic assumptions about labor market participation).
  - The reform exchanges an explicit liability in government bonds for an implicit pension liability of initially about 11 percent of GDP (value of transferred pillar 2 assets).

### VI. Financial sector soundness, risks, and policy recommendations
- Banking sector performance and vulnerabilities:
  - Capital adequacy ratio: 10.2 (Q3 2008).
  - Aggregate capital cushion increased to more than 13 percent by end-September 2010.
  - Lending to the private sector contracted by almost 5 percent in 2009 and stagnated in first nine months of 2010; mortgage lending fell particularly sharply.
  - Pre-tax profitability declined; non-performing loans increased to 9.3 percent at end-September 2010, concentrated in unsecured consumer lending and commercial real estate.
  - About 60 percent of mortgages are denominated in CHF (Swiss Franc).
  - Housing prices have already dropped by 10 percent.
- Key Financial Soundness Indicators (end of period):
  - Regulatory Capital to Risk-Weighted Assets: 10.4 (2007); 11.2 (2008); 13.1 (2009); 13.2 (End-Sept 2010).
  - Liquid Assets to Total Assets: 16.4 (2007); 15.6 (2008); 22.7 (2009); 22.1 (End-Sept 2010).
  - Return on Equity (After-Tax): 18.4 (2007); 11.6 (2008); 9.4 (2009); 4.4 (End-Sept 2010).
- Staff risk assessment and recommendations:
  - Baseline: non-performing loans expected to peak around 12 percent in 2011; most banks able to finance additional provisions from income or capital cushions.
  - Key risk: forint weakness against the Swiss Franc could lead banks to restrain credit supply; higher debt servicing costs could dampen household demand.
  - Urged authorities to pre-commit to sharply reducing the financial sector levy after 2011 and align its design and size with emerging EU standards.
  - Suggested eliminating the moratorium on mortgage foreclosures (extended until end-April 2011) to restore effective mortgage portfolio management and credit discipline.
  - Welcomed targeted homeowner support in concept but stressed limiting moral hazard and budget risks.
  - Banks appear generally prepared to meet forthcoming higher Basel III capital and liquidity standards, though detailed analyses pending.
  - Called for strengthening the bank resolution regime and reviving efforts to develop longer-term funding instruments such as the mortgage bond market.
- Financial sector levy specifics:
  - Levy introduced in July 2010 is large at 0.7 percent of GDP annually (more than three times higher than the largest such tax elsewhere).
  - Total annual revenue from the levy: HUF 186 billion, about 70 percent from banks and the remainder from insurance firms and other financial intermediaries.
  - The CIT and a recently introduced special profit tax can be credited against the levy.

### VII. Monetary policy, exchange rate, and inflation dynamics
- Monetary policy constraints:
  - Policy constrained by need to avoid disorderly exchange rate depreciation due to widespread FX indebtedness.
  - In October 2008, MNB hiked interest rates by 300 basis points.
  - Policy rate cutting cycle ended in May 2010; MNB hiked policy rates from 5¼ to 5¾ percent in November–December 2010.
  - Central Bank increased the policy rate by 25 basis points to 6 percent on January 24 (press statement cited cost-push shocks and unanchored inflation expectations).
- Inflation and labor market:
  - Core inflation was 1.9 percent in November (year not restated in excerpt).
  - MNB argued tax increases, unfreezing of administered energy prices, and rising food prices would increase headline inflation above target in both 2010 and 2011 under unchanged policies.
  - Inflation rose to 4.6 percent in December (above the 4.4 percent consensus and 3 percent center target), driven largely by food and energy prices with an incipient upward trend in core inflation.
  - Unemployment high at 11 percent; real wage growth roughly flat.
  - Annual collective wage negotiation recommended a general wage increase of 4–6 percent for 2011.
- Staff view:
  - Cautioned when tightening on inflation grounds alone given low core inflation and large output gap.
  - A clear shift toward a sustainable medium-term fiscal framework would help reduce risk premia and facilitate a more accommodative monetary stance.
  - Policy discussion referenced matching implied Hungarian policy rates to foreign policy rates plus long-term spreads (with Germany and Switzerland) and a Taylor rule with weight 1/2 on output gap and inflation.

### VIII. Governance, institutional changes, and credibility concerns
- Institutional changes under the new government:
  - Constitutional change limiting powers of the Constitutional Court in assessing fiscal and pension matters.
  - Fiscal Council replaced by a consultative body (chairman of State Audit Office, MNB governor, presidential appointee) without support staff and limited to commenting on draft budget once a year.
  - Draft change to MNB law allows parliament to appoint all 4 external members of the 7-member Monetary Policy Council; new members expected to be appointed in March 2011.
- Staff and Directors’ view:
  - Actions remove checks and balances, undermine policy credibility, and could translate into higher borrowing spreads.
  - Authorities argue changes aim to improve efficiency and are not weaker than many EU countries; staff functions could be performed by MNB or State Audit Office.
- Recommendation:
  - Next Article IV Consultation with Hungary recommended to be held on the 12-month cycle.

### IX. External debt sustainability and shock scenarios (selected figures)
- Baseline external debt (percent of GDP, selected years):
  - 2005: 81.0; 2006: 96.5; 2007: 103.2; 2008: 116.0; 2009: 146.2; 2010: 144.2; 2011: 139.5; 2012: 131.2; 2013: 122.8; 2014: 117.9; 2015: 114.8.
- Annual change in external debt (2005–2015):
  - 2005: 8.8; 2006: 15.5; 2007: 6.7; 2008: 12.8; 2009: 30.2; 2010: -2.0; 2011: -4.7; 2012: -8.4; 2013: -8.4; 2014: -4.9; 2015: -3.1.
- Identified external debt-creating flows (percent of GDP):
  - 2005: -2.0; 2006: 2.8; 2007: 2.0; 2008: 0.5; 2009: 13.3; 2010: -4.1; 2011: -7.2; 2012: -6.2; 2013: -5.7; 2014: -4.3; 2015: -3.1.
- Current account deficit, excluding interest payments (percent of GDP):
  - 2005: 4.6; 2006: 4.4; 2007: 3.2; 2008: 1.9; 2009: -4.9; 2010: -5.8; 2011: -5.8; 2012: -5.1; 2013: -4.5; 2014: -3.5; 2015: -2.4.
- Exports and imports (percent of GDP, selected years):
  - Exports 2010–2015: 86.0; 90.9; 94.8; 98.5; 100.6; 102.5.
  - Imports 2010–2015: 79.5; 85.2; 89.7; 93.8; 96.6; 99.5.
- Automatic debt dynamics contributions (percent of GDP):
  - Automatic debt dynamics (2009–2015): 19.2; 3.1; 1.8; 1.8; 1.9; 2.0; 2.0.
  - Contribution from nominal interest rate (2009–2015): 5.3; 4.6; 5.7; 5.7; 5.6; 5.4; 5.3.
  - Contribution from real GDP growth (2009–2015): 8.9; -1.6; -3.9; -3.9; -3.7; -3.4; -3.3.
- Residual, including change in gross foreign assets (line 13, percent of GDP):
  - 2009: 16.9; 2010: 2.1; 2011: 2.5; 2012: -2.1; 2013: -2.7; 2014: -0.5; 2015: 0.0.
- External debt-to-exports ratio (percent):
  - 2009: 189.5; 2010: 167.7; 2011: 153.5; 2012: 138.3; 2013: 124.6; 2014: 117.3; 2015: 112.0.
- Gross external financing need (in billions of euros):
  - 2009: 35.1; 2010: 38.6; 2011: 44.0; 2012: 45.9; 2013: 47.8; 2014: 50.4; 2015: 49.3.
- Scenario shocks (selected outcomes):
  - Combined shock scenario peak value: 126 (baseline box value 115).
  - One-time real depreciation of 30 percent in 2011 yields combined shock peak 164 (baseline box value 115).
  - Debt-stabilizing non-interest current account: -7.4.

### X. Capacity to repay the Fund and repayment profile
- Hungary’s exposure to the IMF: €8.7 billion (9 percent of GDP and 26 percent of gross international reserves).
- Bulk of IMF repayment scheduled for 2012 and 2013.
- Repayments to the EU in excess of 3.5 percent of GDP are falling due in 2011 and 2014.
- Baseline envisages slow deleveraging by foreign banks and moderate net corporate financing; repayments will need partial financing through net issuance of long-term debt from 2013.
- Planned transfer of private pension assets to the budget: foreign portion about €3 billion could be used to increase reserves and repay the Fund.
- Outstanding Fund credit to Hungary exceeds the 200 percent of quota threshold for Post-Program Monitoring (PPM) and expected to remain above this threshold until August 2013 under the repurchase schedule.
- Managing Director recommends initiation of PPM; Fund mission expected in spring for PPM discussions; first PPM Board discussion envisaged in mid-2011, concurrent with Board consideration of the Ex-post Program Evaluation.

### XI. Staff appraisal — summary judgments and policy priorities
- Assessment:
  - Hungary was hit hard by the global crisis due to large underlying vulnerabilities and international integration; IMF and EU assistance helped avoid financial meltdown.
  - Recovery has begun but is fragile; vulnerabilities persist and risk premia remain elevated and volatile.
- Policy priorities to restore investor confidence and sustainable growth:
  - Reduce uncertainty and improve policy quality within a coherent medium-term macroeconomic framework.
  - Implement durable expenditure rationalization and structural reforms to put public debt on a downward trajectory.
  - Limit reliance on temporary revenue measures and avoid premature tax cuts that erode structural fiscal positions.
  - Address financial sector vulnerabilities (CHF exposure, large financial levy, mortgage foreclosure moratorium) while containing moral hazard and fiscal costs.
  - Enhance budget transparency, publish contingent liabilities, and progress public finance management reforms.
  - A sound medium-term framework could lower risk spreads, reduce financing costs, and support higher growth.

### XII. Selected economic indicators (2006–11) — key figures (as presented)
- Real GDP (change in percent): 3.3; 0.8; 0.8; -6.7; 1.1; 2.8
- Total domestic demand (contribution to growth): 0.3; -2.3; 0.7; -12.6; -2.4; 2.3
- Private consumption (change in percent): 2.1; -1.7; 0.6; -6.8; -2.3; 2.1
- Gross fixed investment (change in percent): -3.2; 1.7; 2.9; -8.0; -2.5; 0.7
- Exports (change in percent): 18.7; 16.2; 5.7; -9.6; 13.8; 8.9
- Imports (change in percent): 14.9; 13.3; 5.8; -14.6; 11.9; 9.4
- CPI (end year): 6.5; 7.4; 3.5; 5.6; 4.2; 3.9
- CPI (average): 3.9; 7.9; 6.1; 4.2; 4.9; 4.1
- Unemployment rate (average, in percent): 7.5; 7.4; 7.8; 10.1; 11.1; 11.2
- Gross domestic investment (percent of GDP): 24.0; 23.5; 23.7; 19.2; 18.3; 18.8
- Gross national saving (percent of GDP, from BOP): 16.4; 16.6; 16.4; 18.7; 19.5; 19.0
- General government overall balance (percent of GDP), ESA-95 basis: -9.3; -5.0; -3.7; -4.4; -4.0; 5.6
- General government primary balance (percent of GDP), ESA-95 basis: -5.4; -0.9; 0.4; 0.3; 0.1; 9.5
- General government primary structural balance: -6.1; -0.9; 0.2; 2.8; 0.8; -0.3
- General government debt (percent of GDP), ESA-95 basis: 65.7; 66.1; 72.3; 78.4; 79.5; 69.9
- Broad money (end-of-period, percent change): 13.6; 11.0; 8.8; 3.4; 4.1; 8.3
- Lending to the private sector, flow-based (percent change): 20.6; 18.5; 12.2; -2.3; 1.0; 5.0
- Goods and services trade balance (percent of GDP): -1.4; 0.9; 0.4; 5.1; 6.5; 5.7
- Current account (percent of GDP): -7.6; -6.9; -7.3; -0.5; 1.2; 0.1
- Reserves (in billions of euros): 16.4; 16.4; 24.0; 30.7; 33.5; 38.0
- Gross external debt (percent of GDP): 96.5; 103.2; 116.0; 146.2; 144.2; 139.5
- Exchange regime: Floating
- Present rate (December 15, 2010): Ft 207.3 = US$1;  Ft. 274.4 = €1
- Quota at the Fund: SDR 1038.4 million

*Source: IMF staff report excerpt and IMF Public Information Notice (PIN) No. 11/15, February 3, 2011 (content provided in the supplied PDF extract).*

### 1. Main Economic Indicators, 2006–11 ...........................................................................33

### 1. Main Economic Indicators, 2006–11

### I. Context
- Hungary emerged from a severe economic crisis driven by global financial strains in late 2008, high pre-crisis vulnerabilities, and close integration into global financial and goods markets.
- Real GDP contracted by almost 7 percent in 2009.
- Key pre-crisis vulnerabilities included high public and external debt, a banking system dependent on external funding with large on-balance sheet currency mismatches, and corporations and households indebted in foreign currencies.
- The IMF/EU-supported program, large upfront official financing, and easing global financial conditions contributed to stabilization from mid-2009.
- The government formed in mid-2010 (Fidesz, two-thirds parliamentary majority) let the IMF/EU-supported program lapse and stated it was not seeking a successor arrangement.
- New government strategy pillars: tax relief for households, enhanced family benefits, targeted support to SMEs (the “New Széchenyi Plan”), temporary revenue measures targeted at profitable sectors, and de facto re-nationalization of the second pillar private pension system.
- Persisting vulnerabilities as of two years after the crisis outbreak:
  - government debt about 80 percent of GDP,
  - external debt about 140 percent of GDP,
  - low reserve coverage,
  - large-scale currency mismatches,
  - growing reliance on external funding.

### II. Macroeconomic Outlook and Risks
- Near-term outlook:
  - Exports increased for six consecutive quarters; employment rising since February 2010.
  - Tax cuts announced for 2011 estimated to increase disposable income by about 5 percent.
  - Staff expects real GDP growth to increase from around 1 percent in 2010 to about 2¾ percent in 2011.
  - Current account: temporarily in surplus in 2010, expected to swing into deficit starting in 2012.
  - Average inflation expected to be around 4 percent in 2011.
- Medium-term expectations:
  - Staff projects potential growth of 2–2½ percent over the medium term.
  - Actual growth is projected to be roughly one percentage point higher than potential in 2012-15, gradually narrowing the output gap.
  - Authorities’ medium-term projections are more optimistic, with actual output growth reaching 5½ percent in 2015 (based on more favorable assumptions about labor participation and investment).
- Uncertainty and risks around the central scenario:
  - Downside risks:
    - Global recovery may slow, affecting exports.
    - Deterioration in risk appetite could compound financing risks given high external and public debt.
    - Further strengthening of the Swiss franc (CHF) would increase household debt-servicing costs.
    - High policy uncertainty could raise precautionary savings and depress consumption and investment.
  - Upside risks:
    - Accommodative macro policies in advanced economies could spur global growth and stronger capital flows to emerging markets, compressing Hungary’s borrowing spreads.
    - Recent policy package effects on employment and investment, if reinforced by structural reforms and business climate improvements, could outperform staff assumptions.
- Openness and spillovers:
  - High openness implies spillovers both to and from Hungary.
  - Statements in June 2010 by Fidesz officials suggesting imminent government insolvency upset regional markets and temporarily impacted the euro.
  - Hungary’s risk premia have recently increased markedly, especially relative to regional peers; rating agencies downgraded Hungary to the lowest investment grade, with a negative outlook.

### III. Policy Discussions
- Staff’s overall stance:
  - Advocated a more cautious approach to safeguard institutional integrity, fiscal sustainability, and financial stability.
  - Suggested phasing in economic stimulus gradually, in line with progress in fiscal consolidation.
  - Emphasized anchoring long-term market expectations to reduce risk spreads and financing costs.
- Fiscal policy developments and composition:
  - 2010 budget deficit target of 3.8 percent of GDP proved unattainable; emergency package adopted included a large special levy on financial institutions, spending cuts, reductions in corporate income tax, and elimination of small taxes.
  - Second package in October included levies on foreign-owned retail chains, telecommunication and energy companies, and a 14-month diversion of second pillar private pension contributions to the budget.
  - Net deficit-reducing effect of the two rounds of measures amounted to 2 percent of GDP.
  - New revenue slippages in December put attainability of the deficit target (ESA95 terms) in question.
- 2011 budget and tax reform:
  - 2011 budget centered on introduction of a flat-rate personal income tax, to be implemented over three years, unifying and phasing marginal tax rate to 16 percent and introducing more generous child allowances.
  - Immediate revenue loss estimated at 1¾ percent of GDP (and a further 1½ percent in 2012–13).
  - Authorities argue tax cuts will improve competitiveness, spur labor supply and investment, and be offset by greater tax compliance.
  - Staff cautioned against overestimating Laffer-curve effects and argued for a more modest tax cut as envisaged in the 2009 tax reform.
- Compensation for tax cuts and deficit target mechanics:
  - To meet the 2.9 percent of GDP deficit target agreed with the EU, the budget relies primarily on temporary measures:
    - continuation of temporary sectoral levies,
    - diversion of second pillar pension contributions (about 1.2 and 1.3 percent of GDP, respectively),
    - using asset transfers from the second pillar to fund spending (about 2 percent of GDP).
  - Incentives expected to lead virtually all contributors to return to the PAYG system in early 2011, implying total one-off revenues of about 11 percent of GDP in 2011.
  - Pension asset use: assets not needed for current expenditures will be determined by a new supervisory body; at least half is expected to be used to reduce gross debt.
  - Structural measures in the 2011 budget amount to about one percent of GDP, including staff cuts (0.5 percent of total government employment), reduced bonuses and in-kind benefits, streamlined public works, and lower capital spending by local governments.
- Staff concerns about structural fiscal position:
  - Revenues in the 2011 budget viewed as optimistic given 2010 performance (especially VAT and CIT).
  - Excluding the pension asset transfer, the deficit would be close to 5 percent of GDP.
  - Heavy reliance on temporary measures implies a substantial loosening of the underlying fiscal stance in 2010.
  - In 2011, structural weakening from tax cuts is only partly offset by expenditure cuts and redirection of pension contributions.
  - Staff argued measures could be passed to consumers, distort sectors, and—through higher risk premia—send negative signals about foreign investment.
- Staff recommendations to restore structural fiscal sustainability:
  - Focus on further rationalization of current primary spending and other structural reforms.
  - Identify expenditure-reducing measures of about 4 percent of GDP to eliminate the 2011 structural deficit and set debt on a downward trajectory.
  - Suggested measures include rationalizing the public wage bill and social benefits, restructuring public transportation companies.
  - A property tax could be an additional revenue source.
  - Urged progress in public finance management to avoid spending slippages, continued implementation of tax administration’s compliance strategy, and merger of customs and tax administrations.
  - Recommended greater budget transparency, including publishing contingent liabilities, given increased prominence of state guarantees in the New Széchenyi plan and the expanded role of the state development bank MFB.

*Source: IMF staff report excerpt (sections I–III) from the provided PDF content.*

### 15.      The authorities agreed with some measures proposed by staff, but were reluctant

### _cr1135 - 15. The authorities agreed with some measures proposed by staff, but were reluctant

### Fiscal policy and consolidation
- Authorities expect a medium-term reform plan, to be announced in February, may yield up to 2½ percent of GDP in savings.
- Envisaged measures include administrative reforms (in local governments), recent public finance management changes (introduction of budget inspectors), steps to restructure state-owned enterprises, and a permanent (but smaller) bank levy.
- Authorities prefer revenue-side measures that spare households and were reluctant to commit to concrete steps at this stage.
- Staff recommended frontloading durable expenditure measures and postponing personal and corporate tax cuts planned for 2012–13 until fiscal space emerges.
- Staff noted that the authorities’ Convergence Programme envisages a headline fiscal deficit of below 2 percent of GDP in 2014 and public debt declining towards 60 percent, but warned fiscal sustainability was not ensured under present policies given phasing out of temporary measures coinciding with further tax cuts in 2012–13.
- Staff estimated a large required cumulative adjustment of 5–5½ percent of GDP in 2013–14 to achieve the authorities’ own targets.
- Staff’s public debt sustainability analysis shows debt is particularly sensitive to growth and real exchange rate shocks.

Key quantified consolidation potential (IMF staff estimates, based on Hungarian authorities data):
- Total potential consolidation from proposed measures: 4.0 (percent of GDP)
- Better targeting of social benefits 1/: 1.8
- Active labor market policies' rationalization 2/: 0.3
- Reduction of the public sector wage bill 3/: 1.0
- Rationalization of state-owned transport enterprises to eliminate losses 4/: 1.0

(Notes from source:
1/ Decreasing the generosity of benefits, introducing means-testing to universal transfers (such as child allowances), eliminating untargeted price subsidies, consolidating the design and administration of social benefits at the central and local levels.
2/ Reduce generosity and coverage of public works programs. Narrow the scope of active labor market policies on groups most disadvantaged in the labor market.
3/ Reduce employment (rather than wages, which appear low relative to the private sector) through attrition; consolidate local governments to achieve better economies of scale.
4/ Refers to the operational annual losses of MAV, BKV and MALEV.)

### Pension reform — staff concerns and authorities' responses
- Staff concerns:
  - Despite initial debt reduction, the reform puts into question fiscal sustainability, particularly if assets moved to the PAYG system are used for current spending (as in the 2011 budget).
  - Reform reduces transparency and increases fiscal risks.
  - Reform heavily biases terms in favor of switching to the PAYG system, raising concerns about business environment and property rights.
  - Implied erosion of liquidity in domestic bond and equity markets could negatively impact capital market depth.
- Authorities’ position:
  - Optimistic regarding viability of expanded PAYG system, citing tax reforms aimed at increasing employment and fertility rates.
  - Argued pensions were safer with the state than with private pension funds, which had performed poorly.
- Staff counterpoint:
  - Low returns in private funds could be better addressed by improved regulation.

### Financial sector policies — soundness, risks, and recommendations
Findings on banking sector performance and vulnerabilities:
- Capital adequacy ratio: 10.2 (Q3 2008).
- Aggregate capital cushion increased to more than 13 percent by end-September 2010.
- Lending to the private sector contracted by almost 5 percent in 2009 and stagnated in first nine months of 2010; mortgage lending fell particularly sharply.
- Pre-tax profitability declined; non-performing loans increased to 9.3 percent at end-September 2010, concentrated in unsecured consumer lending and commercial real estate.
- Capital and profitability unevenly distributed across banks; main bank without a foreign parent particularly strong.
- About 60 percent of mortgages are denominated in CHF (Swiss Franc).
- Housing prices have already dropped by 10 percent.
- Key Financial Soundness Indicators (end of period):
  - Regulatory Capital to Risk-Weighted Assets: 10.4 (2007), 11.2 (2008), 13.1 (2009), 13.2 (End-Sept 2010).
  - Liquid Assets to Total Assets: 16.4 (2007), 15.6 (2008), 22.7 (2009), 22.1 (End-Sept 2010).
  - Return on Equity (After-Tax): 18.4 (2007), 11.6 (2008), 9.4 (2009), 4.4 (End-Sept 2010).

Staff risk assessment and recommendations:
- Baseline scenario: non-performing loans expected to peak around 12 percent in 2011, with most banks able to finance additional provisions from income or capital cushions.
- Key risk: forint weakness against the Swiss Franc could lead banks to restrain credit supply; higher debt servicing costs could dampen household demand.
- Staff urged authorities to pre-commit to sharply reducing the financial sector levy after 2011 and align its design and size with emerging EU standards.
- Staff suggested eliminating the moratorium on mortgage foreclosures (extended until end-April 2011), as it prevents effective mortgage portfolio management and risks undermining credit discipline.
- Staff welcomed targeted homeowner support in concept but stressed limiting moral hazard and budget risks.
- Staff noted banks appear generally prepared to meet forthcoming higher Basel III capital and liquidity standards, though detailed analyses remain pending.
- Staff called for progress on outstanding financial sector reforms, including strengthening the bank resolution regime and reviving efforts to develop longer-term funding instruments such as the mortgage bond market.

Specifics on the financial sector levy and related numbers:
- Financial sector levy introduced in July 2010 is large at 0.7 percent of GDP annually (more than three times higher than the largest such tax elsewhere).
- Of total annual revenue of HUF 186 billion from the levy, about 70 percent will come from banks and the remainder from insurance firms and other financial intermediaries.
- The CIT and a recently introduced special profit tax can be credited against the levy.

### Monetary and exchange rate policy constraints and outlook
- Monetary policy constrained by need to avoid disorderly exchange rate depreciation due to widespread FX indebtedness.
- In October 2008, MNB hiked interest rates by 300 basis points.
- Policy rate cutting cycle ended in May 2010; MNB hiked policy rates from 5¼ to 5¾ percent in November–December 2010.
- Staff noted core inflation was 1.9 percent in November (year not explicitly restated in this excerpt).
- MNB argued tax increases, unfreezing of administered energy prices, and rising food prices would increase headline inflation above target in both 2010 and 2011 under unchanged policies.
- Staff suggested caution when tightening on inflation grounds alone given low core inflation and large output gap, but agreed that a clear shift toward a sustainable medium-term fiscal framework would help reduce risk premia and facilitate a more accommodative monetary stance.
- Policy discussion referenced matching implied Hungarian policy rates to foreign policy rates plus long-term spreads (with Germany and Switzerland) and a Taylor rule with weight 1/2 on output gap and inflation.

### Economic governance and institutional changes
- Recent institutional changes:
  - Constitutional change limiting powers of Constitutional Court in assessing fiscal and pension matters.
  - Fiscal Council being replaced by a consultative body (chairman of State Audit Office, MNB governor, presidential appointee) without support staff; new body limited to commenting on draft budget once a year.
  - Draft change to MNB law allows parliament to appoint all 4 external members of the 7-member Monetary Policy Council; new members expected to be appointed in March 2011.
- Staff view:
  - Actions remove checks and balances, undermine policy credibility, and could translate into higher borrowing spreads.
- Authorities’ justification:
  - Changes aimed at improving efficiency of economic policy making; argued new framework not weaker than many other EU countries and staff functions could be performed by MNB or State Audit Office.

### Capacity to repay the Fund and repayment profile
- Hungary’s capacity to repay the Fund remains adequate, though modest international reserves and a challenging sovereign amortization schedule pose risks.
- Hungary’s exposure to the IMF is currently €8.7 billion (9 percent of GDP and 26 percent of gross international reserves).
- Bulk of IMF repayment scheduled for 2012 and 2013.
- Repayments to the EU in excess of 3.5 percent of GDP are falling due in 2011 and 2014.
- Baseline envisages slow deleveraging by foreign banks and moderate net corporate financing; repayments will need to be partly financed through net issuance of long-term debt from 2013.
- Planned transfer of private pension assets to the budget: foreign portion about €3 billion could be used to increase reserves and repay the Fund.
- Fund procedural action:
  - Outstanding Fund credit to Hungary exceeds the 200 percent of quota threshold for Post-Program Monitoring (PPM) and is expected to remain above this threshold until August 2013 under the repurchase schedule.
  - Managing Director recommends initiation of PPM; a Fund mission is expected in the spring for PPM discussions.
  - First PPM Board discussion envisaged in mid-2011, concurrent with Board consideration of the Ex-post Program Evaluation.

### Staff appraisal — summary judgments
- Hungary was hit hard by the global crisis due to large underlying vulnerabilities and integration in international markets; tightening of monetary and fiscal policies with IMF and EU assistance helped avoid financial meltdown.
- The economy has begun to rebound but the recovery is fragile and vulnerabilities persist; risk premia remain elevated and volatile.
- Going forward, reducing uncertainty and improving policy quality is critical; maintaining investor confidence requires sound policies within a coherent medium-term macroeconomic framework.
- Such a framework could trigger a virtuous cycle: lower risk spreads, reduced public and private financing costs, and ultimately higher growth.

*Source: IMF staff report excerpt provided in content unit _cr1135 - 15.*

### 32.      The government that took office in mid-2010 is using its considerable political

### _cr1135 - 32.      The government that took office in mid-2010 is using its considerable political

### Fiscal policy reorientation, short-term measures, and risks
- The government that took office in mid-2010 is using its considerable political mandate to fundamentally reorient fiscal and financial sector policies, including tax cuts and targeted support to small and medium-sized enterprises (SMEs).
- Much of the structural fiscal adjustment achieved in the past two years is being unwound and replaced by temporary revenue measures.
- Institutional changes reduce the capacity of the Fiscal Council, Constitutional Court, and MNB to provide independent economic analysis and governance.
- Positive aspects cited:
  - Steps towards reducing the tax wedge on labor.
  - Focus on SMEs.
  - Desire to meet headline fiscal deficit targets agreed with the EU.
- Main risks and concerns:
  - The strategy’s success relies heavily on high GDP growth which may not materialize.
  - Temporary revenue measures increase uncertainty and are distortive; once they expire in 2013, debt ratios are likely to rise again and—under unchanged policies—threaten fiscal sustainability.
  - Dissolution of the second pillar of the pension system allows headline fiscal indicators to improve without structural fiscal adjustment, replacing current obligations with unrecorded future liabilities and reducing fiscal transparency.
  - Overall deterioration in the quality, extent, and permanence of fiscal adjustment amid large vulnerabilities increases risks to the Hungarian economy.
- Recommendation for sustainable adjustment:
  - Focus on durable expenditure rationalization, including poorly targeted social benefits and price subsidies.
  - Restructure public transportation companies and pursue administrative reforms to generate savings and efficiency gains.
  - Enhance revenues via improved tax administration and a property tax.
  - Tackle structural measures quickly to free up fiscal space for growth-enhancing tax reforms.

### Fiscal program context and past adjustment (Box 1)
- IMF Stand-By Arrangement approved November 6, 2008: total SDR 10½ billion (about €12½ billion at the time); complemented by EU financial assistance of €6½ billion.
- Disbursements before mid-2010 decision not to complete remaining reviews:
  - SDR 7½ billion (€8.7 billion) disbursed.
  - €5½ billion from the EU disbursed.
- Program outcomes and actions:
  - Structural fiscal adjustment: primary structural balance improved by about 4 percent of GDP over 2008–09; when added to the 5 percent of GDP adjustment in 2007, Hungary’s structural fiscal improvement ranked among the largest in emerging Europe in recent decades.
  - Financial supervision: on-site bank inspections intensified; 2009 establishment of tri-partite Financial Stability Council (FSC) with HFSA, MNB, and Ministry of Finance; FSC and MNB were granted the right to initiate legislative and regulatory action.
  - Government bond market: non-resident sell-off of €3.5 billion Q4 2008; AKK suspended issuance in October 2008 and re-purchased significant amounts of debt; AKK drew down IMF/EU funds deposited at the MNB; MNB sterilized impact via central bank bills.
  - External funding support: March 2009 government extended FX loans of €2½ billion to three banks without a foreign parent.
  - FX swap and spot market measures: overnight FX swap facility introduced October 2008; 3- and 6-month FX swap facilities in March 2009; MNB intervened in early 2009 to prevent disorderly forint depreciation and used a 300 bps interest rate hike at the crisis’ onset.

### Pension reform fiscal implications (Box 4)
- Key effects of shifting workers from private defined-contribution (pillar 2) to government defined-benefit (pillar 1):
  - Immediate stream of pension contributions to government; corresponding pension benefit payments increase only as these workers retire.
  - Transfer of pension assets from 1st to 2nd pillar is recorded as revenue under ESA95 accounting rules, creating additional room for expenditures while still meeting headline fiscal targets.
  - Reduction in government financial debt lowers the interest bill, providing further fiscal space.
- Sustainability concerns:
  - Government’s estimates indicate a negative net present value of the discounted contributions and pension benefits to 2060 of about 10 percent of GDP (using optimistic assumptions about labor market participation).
  - Reform shifts all pension risks to the government and reduces transparency by exchanging an explicit liability in government bonds for an implicit pension liability of initially about 11 percent of GDP (the value of transferred assets, equivalent to pillar 2 pension claims).
- Staff highlights heightened need for reforms to make pillar 1 sustainable and warns sustainability could be further undermined if pension parameters are made more generous.

### Financial sector resilience and vulnerabilities
- Current status:
  - Sector-wide liquidity and capitalization are adequate.
  - Profitability has fallen amid rising non-performing loans.
- Risks:
  - A strong Swiss Franc may further impair banks’ mortgage portfolios.
  - The outsized financial sector levy will likely erode capital cushions.
  - These risks threaten to stall the resumption of credit growth.
- Policy measures:
  - Efforts to help distressed mortgage holders are welcome if moral hazard and fiscal cost are contained.
  - Government has given the HFSA the right to issue binding decrees, appropriately strengthening supervision.
  - Weakening of the Financial Stability Council erodes capacity to safeguard financial stability and contain systemic risks.

### Support scheme for distressed mortgage borrowers (Box 5)
- Structure: three “pillars”:
  - Pillar 1: banks encouraged to offer a range of restructuring options.
  - Pillar 2: state guarantee to cover incremental costs of a further loan restructuring if the loan becomes non-performing again.
  - Pillar 3: local government can acquire the property at foreclosure and may rent it back to the distressed borrower.
- Oversight: Pillars 2 and 3 will be overseen by a National Asset Management Agency (NAMA), governance structure yet to be established.
- Targeting: only low-income households who have serviced their mortgage for at least 12 consecutive months will be eligible.
- Costs and uptake:
  - Government will collect a guarantee fee to fund pillar 2, but there will be upfront costs as some households may qualify immediately for pillar 3.
  - Ultimately, up to one-third of currently distressed debtors may become eligible.
  - Tentative Ministry for National Economy estimates: budget outlays of HUF 10–11 billion for 2011–12, increasing to HUF 120–130 billion for 2013–14 (about 0.45 percent of GDP).
  - The process of pillars 1 and 2 is envisaged to delay pillar 3-related costs.

### Monetary policy stance and exchange rate vulnerabilities
- The MNB’s cautious monetary policy stance remains appropriate, balancing persistently high risk premia with ongoing slack in the economy.
- The forint’s vulnerability to changes in investor appetite will likely remain a constraint on monetary policy, given significant economy-wide currency mismatches.
- Inflation dynamics:
  - Tax hikes and global supply shocks have renewed upward pressure on headline inflation.
  - The large output gap has helped keep underlying price inertia in check thus far.
- A clear shift toward a sustainable fiscal framework would help reduce risk premia and facilitate a more accommodative monetary stance, provided underlying inflation remains muted.

### External competitiveness, REER, and growth projections (Box 2 and Box 3)
- Current account and REER:
  - The current account adjusted by 8.6 percentage points of GDP to a surplus of 1.2 percent of GDP in 2010.
  - For 2015, after a projected 6.9 percent appreciation in REER, the current account balance is expected to decrease to -2.9 percent of GDP, still above the current account norm of -3.3 percent of GDP.
  - Real exchange rate undervaluation estimated at 2 percent based on macro-balance and external stability methodologies.
  - Equilibrium Exchange Rate methodology points to a 6 percent overvaluation.
- Competitiveness notes:
  - Hungary maintains a de facto ‘floating’ exchange rate regime free of exchange restrictions and multiple currency practices.
  - Structural reforms are key to maintaining competitiveness; Hungary’s export share in world exports is quickly recovering after the global crisis.
  - Hungary improved its business environment in 2008–09, but still lags peers in quality of institutions, infrastructure and macro environment.
- Growth and potential:
  - Potential growth declined in Hungary since mid-2000; medium-term potential expected to recover but remain below regional peers.
  - Staff forecast actual growth of 3–3½ in the medium term, markedly below the authorities’ latest projections.
  - Staff estimates potential growth of 2–2½ percent; output gap over 6 percent in 2010.
  - Authorities project actual medium-term growth of 5½ percent and assume actual employment growth of 3 percent versus staff’s 1 percent per year from 2012.
  - Authorities expect investment growth rates of up to 12 percent in the medium-term, versus staff’s more moderate rates of 4 percent.
  - Staff’s more cautious views are broadly shared by the MNB, the European Commission and private analysts.

### Governance, credibility, and recommendation
- Steps that undermine economic governance—by removing important checks and balances—add to policy uncertainty, may undermine Hungary’s credibility with investors, and contribute to a further widening of risk premia compared to regional peers.
- It is recommended that the next Article IV Consultation with Hungary be held on the 12-month cycle.

*Source: IMF staff report content provided in the supplied PDF extract.*

### Box 6. Hungary’s Experience with Inflation Targeting

### Box 6. Hungary’s Experience with Inflation Targeting

### Background and institutional strengths
- Hungary adopted inflation targeting (IT) in mid-2001 to accelerate progress toward its primary objective of price stability.
- At inception, the Magyar Nemzeti Bank (MNB) had many elements needed for successful IT implementation: statutory priority placed on price stability, instrument independence, reasonable control over short term rates, well developed financial markets, and a law prohibiting government financing.

### Main challenges encountered
- Coexistence of a second nominal anchor: until 2008 Hungary had an exchange rate band which often conflicted with the inflation target.
- Recurrent fiscal shocks that frequently necessitated monetary tightening.
- Rising foreign exchange indebtedness of households and corporations (particularly in the late 2000s) increased the importance of the exchange rate as a transmission channel at the expense of domestic currency lending conditions.

### Outcomes and performance
- From the broad perspective of achieving lower average inflation, the IT regime has been a success:
  - Average inflation in the decade before adoption was 18 percent.
  - Inflation in 2001, the year of adoption, was 9.2 percent.
  - During 2002–08, headline inflation averaged 5.3 percent.
- Progress was similar in core prices (no numeric breakdown provided in the box).
- Performance relative to announced inflation targets was mixed:
  - From 2001–06, the MNB met its annual end-year target only half the time.
  - As of end-2007, the MNB started targeting a “continuous medium term target.”
  - Since end-2007, inflation was within ½ percentage point of its target during only one five-month period in early 2009.

### Key drivers of deviations from target
- Exogenous supply shocks.
- Currency sell-offs.
- Ad hoc tax increases.

*Box 6. Hungary’s Experience with Inflation Targeting.*

### Appendix Figure 1. Hungary: External Debt Sustainability: Bound Tests  1/

### Appendix Figure 1. Hungary: External Debt Sustainability: Bound Tests 1/

### Baseline external debt projections (external debt in percent of GDP)
- Baseline: External debt (2005–2015 projections, selected years)
  - 2005: 81.0
  - 2006: 96.5
  - 2007: 103.2
  - 2008: 116.0
  - 2009: 146.2
  - 2010: 144.2
  - 2011: 139.5
  - 2012: 131.2
  - 2013: 122.8
  - 2014: 117.9
  - 2015: 114.8
- Change in external debt (annual, 2005–2015)
  - 2005: 8.8
  - 2006: 15.5
  - 2007: 6.7
  - 2008: 12.8
  - 2009: 30.2
  - 2010: -2.0
  - 2011: -4.7
  - 2012: -8.4
  - 2013: -8.4
  - 2014: -4.9
  - 2015: -3.1

### Identified external debt-creating flows and components (percent of GDP)
- Identified external debt-creating flows (4+8+9)
  - 2005: -2.0
  - 2006: 2.8
  - 2007: 2.0
  - 2008: 0.5
  - 2009: 13.3
  - 2010: -4.1
  - 2011: -7.2
  - 2012: -6.2
  - 2013: -5.7
  - 2014: -4.3
  - 2015: -3.1
- Current account deficit, excluding interest payments
  - 2005: 4.6
  - 2006: 4.4
  - 2007: 3.2
  - 2008: 1.9
  - 2009: -4.9
  - 2010: -5.8
  - 2011: -5.8
  - 2012: -5.1
  - 2013: -4.5
  - 2014: -3.5
  - 2015: -2.4
- Deficit in balance of goods and services
  - 2005: 1.6
  - 2006: 1.4
  - 2007: -0.9
  - 2008: -0.4
  - 2009: -5.1
  - 2010: -6.5
  - 2011: -5.7
  - 2012: -5.1
  - 2013: -4.7
  - 2014: -3.9
  - 2015: -3.0
- Exports (percent of GDP)
  - 2005: 67.7
  - 2006: 77.1
  - 2007: 80.3
  - 2008: 81.3
  - 2009: 77.2
  - 2010: 86.0
  - 2011: 90.9
  - 2012: 94.8
  - 2013: 98.5
  - 2014: 100.6
  - 2015: 102.5
- Imports (percent of GDP)
  - 2005: 69.3
  - 2006: 78.5
  - 2007: 79.4
  - 2008: 80.9
  - 2009: 72.1
  - 2010: 79.5
  - 2011: 85.2
  - 2012: 89.7
  - 2013: 93.8
  - 2014: 96.6
  - 2015: 99.5
- Net non-debt creating capital inflows (negative)
  - 2005: -5.0
  - 2006: -2.4
  - 2007: 4.6
  - 2008: -1.3
  - 2009: -1.0
  - 2010: -1.3
  - 2011: -3.1
  - 2012: -2.9
  - 2013: -3.1
  - 2014: -2.8
  - 2015: -2.7

### Automatic debt dynamics contributions (percent of GDP)
- Automatic debt dynamics (line 9)
  - 2005: -1.7
  - 2006: 0.9
  - 2007: -5.8
  - 2008: -0.2
  - 2009: 19.2
  - 2010: 3.1
  - 2011: 1.8
  - 2012: 1.8
  - 2013: 1.9
  - 2014: 2.0
  - 2015: 2.0
- Contribution from nominal interest rate (line 10)
  - 2005: 3.2
  - 2006: 3.2
  - 2007: 3.7
  - 2008: 5.4
  - 2009: 5.3
  - 2010: 4.6
  - 2011: 5.7
  - 2012: 5.7
  - 2013: 5.6
  - 2014: 5.4
  - 2015: 5.3
- Contribution from real GDP growth (line 11)
  - 2005: -0.9
  - 2006: -2.6
  - 2007: -0.7
  - 2008: -0.8
  - 2009: 8.9
  - 2010: -1.6
  - 2011: -3.9
  - 2012: -3.9
  - 2013: -3.7
  - 2014: -3.4
  - 2015: -3.3
- Contribution from price and exchange rate changes (line 12)
  - 2005: -4.0
  - 2006: 0.3
  - 2007: -8.8
  - 2008: -4.7
  - 2009: 5.0
  - (further years truncated in source excerpt)

### Residual and financing indicators
- Residual, including change in gross foreign assets (line 13)
  - 2005: 10.8
  - 2006: 12.7
  - 2007: 4.7
  - 2008: 12.3
  - 2009: 16.9
  - 2010: 2.1
  - 2011: 2.5
  - 2012: -2.1
  - 2013: -2.7
  - 2014: -0.5
  - 2015: 0.0
- External debt-to-exports ratio (in percent)
  - 2005: 119.6
  - 2006: 125.2
  - 2007: 128.5
  - 2008: 142.7
  - 2009: 189.5
  - 2010: 167.7
  - 2011: 153.5
  - 2012: 138.3
  - 2013: 124.6
  - 2014: 117.3
  - 2015: 112.0
- Gross external financing need (in billions of euros) 6/
  - 2005: 26.5
  - 2006: 28.7
  - 2007: 30.9
  - 2008: 35.7
  - 2009: 35.1
  - 2010: 38.6
  - 2011: 44.0
  - 2012: 45.9
  - 2013: 47.8
  - 2014: 50.4
  - 2015: 49.3
- Gross external financing need (in percent of GDP)
  - 2005: 30.0
  - 2006: 32.0
  - 2007: 30.6
  - 2008: 33.5
  - 2009: 37.8
  - 2010: 39.7
  - 2011: 43.6
  - 2012: 43.0
  - 2013: 42.3
  - 2014: 42.2
  - 2015: 39.0

### Scenario and shock summaries (external debt)
- Scenario with key variables at their historical averages (2009–2015 projection)
  - 2009: 144.2
  - 2010: 143.2
  - 2011: 139.7
  - 2012: 136.1
  - 2013: 134.2
  - 2014: 132.6
  - Debt-stabilizing non-interest current account (right scale): -7.4
- Individual shocks shown in bound tests:
  - CA shock scenario: Baseline box value 115; projected shock peak value 122
  - Combined shock scenario: Baseline box value 115; projected shock peak value 126
  - Real depreciation shock (one-time real depreciation of 30 percent occurs in 2011): Combined shock with 30% depreciation shows peak 164 (baseline box value 115)
  - Growth shock scenario: Baseline box value 115; projected shock peak value 128
- Shock definitions (from figure notes)
  - Individual shocks are permanent one-half standard deviation shocks.
  - Note 2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
  - Note 3/ One-time real depreciation of 30 percent occurs in 2011.

### Key macroeconomic assumptions underlying the baseline (selected indicators)
- Real GDP growth (in percent)
  - 2005: 1.3
  - 2006: 3.3
  - 2007: 0.8
  - 2008: 0.8
  - 2009: -6.7
  - 2010: 1.1
  - 2011–2015: 2.8, 3.0, 3.0, 3.0, 3.0 (each year respectively)
- GDP deflator in euros (change in percent)
  - 2005: 6.3
  - 2006: -1.9
  - 2007: 11.3
  - 2008: 4.8
  - 2009: -6.5
  - 2010: 3.7
  - 2011: 0.9
  - 2012: 2.4
  - 2013: 2.8
  - 2014: 2.8
  - 2015: 2.7
- Nominal external interest rate (in percent)
  - 2005: 4.7
  - 2006: 4.1
  - 2007: 4.3
  - 2008: 5.5
  - 2009: 4.0
  - 2010: 3.3
  - 2011: 4.1
  - 2012: 4.3
  - 2013: 4.5
  - 2014: 4.7
  - 2015: 4.8
- Growth of exports (euro terms, in percent)
  - 2005: 12.2
  - 2006: 15.4
  - 2007: 16.9
  - 2008: 6.9
  - 2009: -17.2
  - 2010: 17.0
  - 2011: 9.6
  - 2012: 10.0
  - 2013: 10.0
  - 2014: 8.0
  - 2015: 7.8
- Growth of imports (euro terms, in percent)
  - 2005: 10.3
  - 2006: 14.7
  - 2007: 13.6
  - 2008: 7.7
  - 2009: -22.3
  - 2010: 15.7
  - 2011: 11.2
  - 2012: 11.1
  - 2013: 10.7
  - 2014: 8.9
  - 2015: 9.0
- Current account balance, excluding interest payments (table repeats baseline signs; note formatting difference in source)
  - 2005: -4.6
  - 2006: -4.4
  - 2007: -3.2
  - 2008: -1.9
  - 2009: 4.9
  - 2010: 5.8
  - 2011: 5.8
  - 2012: 5.1
  - 2013: 4.5
  - 2014: 3.5
  - 2015: 2.4
- Net non-debt creating capital inflows (sign convention differs by table; baseline listing)
  - 2005: 5.0
  - 2006: 2.4
  - 2007: -4.6
  - 2008: 1.3
  - 2009: 1.0
  - 2010: 1.3
  - 2011: 3.1
  - 2012: 2.9
  - 2013: 3.1
  - 2014: 2.8
  - 2015: 2.7

### Notes on definitions and methodology (as presented)
- Shaded areas in figures represent actual data. Figures in boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.
- Excluding Special Purpose Entities. Including inter-company loans and nonresidents' holdings of forint-denominated assets.
- Footnote 2/ (figure): Includes EU capital transfers.
- Automatic debt dynamics formula (footnote 3/):
  - Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in euro terms; g = real GDP growth rate; ε = nominal appreciation (increase in dollar value of domestic currency); and α = share of domestic-currency denominated debt in total external debt.
- Contribution from price and exchange rate changes (footnote 4/): Defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock; ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).
- Gross external financing need (footnote 6/): Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

*International Monetary Fund — Appendix Figure 1. Hungary: External Debt Sustainability: Bound Tests 1/*

### 1.      This statement provides information that has become available since the issuance

### _cr1135 - 1.      This statement provides information that has become available since the issuance

### Update since the staff report
- The new information does not alter the thrust of the staff appraisal.
- The statement provides information that has become available since issuance of the staff report (EBS/11/8).

### Fiscal developments and budget outcome
- Based on preliminary Central Government data, the authorities 2010 fiscal deficit target of 3.8 percent of GDP was just about met in cash terms.
- The budget outcome in ESA95 terms is expected to be available only in mid-2011.
- The government maintained the 2010 deficit target of 3.8 percent via:
  - temporary levies on primarily foreign-owned financial institutions, retail chains, telecommunication and energy companies;
  - diversion of second pillar private pension contributions to the budget.
- Prime Minister Orban publicly stated that the government is considering to partially repay the IMF early. Timing and amount are unclear. Technical staff indicated the government may tap foreign exchange deposits at the MNB earmarked for contingent bank funding (€3 billion or roughly one third of outstanding IMF debt) to finance the repayment.
- At present, Hungary’s official reserves stand at €33 billion, equivalent to 81 percent of short term debt.

### Pension reform: dismantling of the second pillar
- The dismantling of the second pension pillar is proceeding as planned.
- According to the law passed in December, all second pillar assets are automatically transferred to the first pillar unless the individual contributor actively opts out.
- Thus far, only some 40,000 out of a total of 3.1 million private pension fund members have opted out, suggesting that virtually all second pillar pension assets will be transferred to the state.
- Directors noted the unwinding of the defined-benefit private pension pillar increases medium-term fiscal risks while reducing transparency.

### Structural reform package
- Authorities announced elements of the structural reform package to be formally discussed by the government in February.
- Initial statements indicate the reforms could include:
  - better targeted social benefits,
  - a redesign of drug subsidies,
  - broadening of the tax base.
- Several proposals align with past IMF technical assistance and recommendations under the 2008–10 Stand-By Arrangement.
- Depending on the size and nature of these measures, the package could help address debt sustainability concerns raised in the staff report.
- Staff’s assessment will be provided as part of the first post-program monitoring report.

### Monetary policy, inflation, and labor market
- On January 24, the Central Bank increased the policy rate by 25 basis points to 6 percent.
  - The press statement cited cost-push shocks amid unanchored inflation expectations as driving the decision.
- Inflation and wages:
  - Inflation rose to 4.6 percent in December (above the 4.4 percent consensus and 3 percent center target), driven largely by food and energy prices but also an incipient upward trend in core inflation.
  - Amid still high unemployment of 11 percent, real wage growth was roughly flat.
  - The annual collective wage negotiation in December agreed to recommend a general wage increase of 4–6 percent for 2011, which could provide upward pressure going forward.
- The MNB had reduced the policy rate by over 600 basis points from a crisis high of 11.50 percent; it paused in mid-2010 and tightened by 50 basis points since November in response to a sharp rise in risk premia and higher headline inflation prints.
- Directors noted recent central bank tightening helped anchor inflation expectations and protect the financial sector, while also emphasizing substantial slack in the economy and high unemployment.

### Balance of payments and banking sector developments
- Latest balance of payments data suggest Hungary, unlike regional peers, experienced net capital outflows in both Q2 and Q3, 2010.
- This reflects, inter alia, a further decline of parent banks’ funding of their Hungarian subsidiaries.
- Preliminary data: at end-December 2010 aggregate funding of the six subsidiaries that had participated in European Bank Coordination Initiative (EBCI) stood at 120 percent of end-September 2008 level, compared to peak exposure of 140 percent at end-July 2010.
- The funding decline counterpart has been a reduction in banks’ liquid assets, especially central bank bills.
- The financial sector remained resilient through the crisis, with banks increasing liquidity and capitalization; however, profitability has begun to fall sharply amid rising non-performing loans.
- Directors welcomed efforts to support distressed mortgage holders, stressing moral hazard and fiscal cost containment.
- Directors noted bank earnings are under pressure due to the disproportionately large levy on assets, which could dampen credit growth and undermine the recovery.

### Governance, supervisory, and policy-dialogue issues
- Directors expressed concern over weakening economic governance:
  - Steps to lessen the independence of both the Fiscal and the Monetary Policy Councils and the reduced role of the Constitutional Court in assessing budgetary matters undermine checks and balances.
  - These steps run counter to authorities’ stated goal of restoring investor confidence and lowering borrowing costs.
- Directors welcomed action to strengthen the legal authority of the Hungarian Financial Supervisory Agency, but noted weakening of the Financial Stability Council reduces capacity to monitor and control systemic risk.
- Directors welcomed the use of post-program monitoring to maintain a close policy dialogue between Hungarian authorities and the Fund.

### Executive Board assessment and overarching risks
- Executive Directors commended the ongoing recovery and welcomed improvements in capital and liquidity financial indicators.
- Main challenge: establish a sustainable fiscal stance over the medium term.
- Directors stressed the need for durable expenditure rationalization in the near term, notably:
  - better targeting of social benefits,
  - restructuring of state-owned transportation companies.
- Directors underscored importance of addressing financial sector vulnerabilities, particularly losses driven by the strong Swiss Franc on household foreign-currency indebtedness.
- Directors emphasized that a sound medium-term fiscal framework would create room for monetary easing.

### Selected economic indicators (2006–11) — key figures (as presented)
- Real GDP (change in percent): 3.3; 0.8; 0.8; -6.7; 1.1; 2.8
- Total domestic demand (contribution to growth): 0.3; -2.3; 0.7; -12.6; -2.4; 2.3
- Private consumption (change in percent): 2.1; -1.7; 0.6; -6.8; -2.3; 2.1
- Gross fixed investment (change in percent): -3.2; 1.7; 2.9; -8.0; -2.5; 0.7
- Exports (change in percent): 18.7; 16.2; 5.7; -9.6; 13.8; 8.9
- Imports (change in percent): 14.9; 13.3; 5.8; -14.6; 11.9; 9.4
- CPI (end year): 6.5; 7.4; 3.5; 5.6; 4.2; 3.9
- CPI (average): 3.9; 7.9; 6.1; 4.2; 4.9; 4.1
- Unemployment rate (average, in percent): 7.5; 7.4; 7.8; 10.1; 11.1; 11.2
- Gross domestic investment (percent of GDP): 24.0; 23.5; 23.7; 19.2; 18.3; 18.8
- Gross national saving (percent of GDP, from BOP): 16.4; 16.6; 16.4; 18.7; 19.5; 19.0
- General government overall balance (percent of GDP), ESA-95 basis: -9.3; -5.0; -3.7; -4.4; -4.0; 5.6
- General government primary balance (percent of GDP), ESA-95 basis: -5.4; -0.9; 0.4; 0.3; 0.1; 9.5
- General government primary structural balance: -6.1; -0.9; 0.2; 2.8; 0.8; -0.3
- General government debt (percent of GDP), ESA-95 basis: 65.7; 66.1; 72.3; 78.4; 79.5; 69.9
- Broad money (end-of-period, percent change): 13.6; 11.0; 8.8; 3.4; 4.1; 8.3
- Lending to the private sector, flow-based (percent change): 20.6; 18.5; 12.2; -2.3; 1.0; 5.0
- Goods and services trade balance (percent of GDP): -1.4; 0.9; 0.4; 5.1; 6.5; 5.7
- Current account (percent of GDP): -7.6; -6.9; -7.3; -0.5; 1.2; 0.1
- Reserves (in billions of euros): 16.4; 16.4; 24.0; 30.7; 33.5; 38.0
- Gross external debt (percent of GDP): 96.5; 103.2; 116.0; 146.2; 144.2; 139.5
- Exchange regime: Floating
- Present rate (December 15, 2010): Ft 207.3 = US$1;  Ft. 274.4 = €1
- Quota at the Fund: SDR 1038.4 million

*Source: IMF Public Information Notice (PIN) No. 11/15, February 3, 2011.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr1135.pdf_