## Hungary — IMF Staff Report Excerpt (_cr14155)

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### Context and Recent Developments
- Hungary reduced vulnerabilities since the 2008 crisis: current account turned into surplus, external debt declined, inflation decelerated; external and public debt remain among the highest in the region.
- Real GDP stands at about 5 percent below its pre-crisis level.
- Growth and recent performance:
  - Real GDP growth: 1.1 percent in 2013; high-frequency indicators suggest growth remained strong in 2014:Q1.
  - Current account surplus: widened to 2.9 percent of GDP in 2013 from 1 percent in 2012.
- Political context: ruling party retained a two-third majority in April 2014; platform includes debt relief for FX mortgage holders, utility price reductions, continuation of public work programs, easing tax burden on labor, and boosting industrialization via strategic agreements.

### Macroeconomic Outlook and Key Projections
- Selected staff projections (percent unless noted):
  - Real GDP Growth: 2012 -1.7; 2013 1.1; 2014 2.0; 2015 1.7; 2016 1.7; 2017 1.7; 2018 1.7; 2019 1.7.
  - Inflation (period average): 2012 5.7; 2013 1.7; 2014 0.9; 2015 3.0; 2016 3.0; 2017 3.0; 2018 3.0; 2019 3.0.
  - General government overall balance (percent of GDP): 2012 -2.0; 2013 -2.2; 2014 -2.9; 2015 -2.9; 2016 -2.9; 2017 -2.8; 2018 -2.8; 2019 -2.7.
  - General government gross debt (percent of GDP): 2012 79.8; 2013 79.2; 2014 78.9; 2015 78.9; 2016 78.8; 2017 78.6; 2018 78.4; 2019 78.2.
  - Current account (percent of GDP): 2012 0.9; 2013 3.0; 2014 2.5; 2015 2.0; 2016 1.2; 2017 0.4; 2018 -0.6; 2019 -1.7.
  - Reserves (EUR billions): 2012 33.9; 2013 33.8; 2014 34.6; 2015 35.5; 2016 36.6; 2017 37.6; 2018 38.8; 2019 39.9.
  - Gross external debt (percent of GDP, excl. SPEs): 2012 128.8; 2013 118.7; 2014 116.8; 2015 107.8; 2016 100.2; 2017 94.2; 2018 89.9; 2019 87.1.
- Risks:
  - Tilted to the downside: adverse external shocks, deleveraging, exchange-rate channels, geopolitical tensions.
  - Domestic policy uncertainty and continued government interference could worsen deleveraging, undermine competitiveness, and hurt investment and growth.
  - Upside: expansion of FGS and stronger euro-area growth could boost activity temporarily.

### Inflation, Labor Market, and Monetary Policy
- Inflation and expectations:
  - Headline inflation decelerated sharply to 0.4 percent at end-2013 and has remained around zero more recently.
  - Core inflation and inflation expectations have decelerated more gradually and have remained around the MNB’s 3 percent inflation target.
- Labor market:
  - Labor force participation: increased by about one percentage point to 65.1 percent at end-2013.
  - Public works: registered individuals exceeded 400,000 (about 10 percent of total employment) at end-2013.
  - Unemployment: declined to 9½ percent in 2013:Q4 from 11 percent (seasonally-adjusted) in 2012:Q4.
  - Private sector: job creation weak; private sector real wage growth moderated to about 3 percent at end-2013.
- Monetary policy:
  - Policy rate cut to a record-low level of 2.5 percent.
  - Pass-through estimate: a 1 percent exchange rate depreciation raises prices by about 0.3 percent over one year.
  - Staff recommendation: keep policy rate on hold, adopt a monetary policy tightening bias, maintain accommodative stance until signs of inflationary pressures, be ready to tighten if external conditions deteriorate, and emphasize clear communication.
  - Forward rate agreements pricing: policy rate hike of 40 basis points by end-2014 (market pricing).

### Fiscal Developments, Outlook, and Staff Consolidation Strategy
- Recent fiscal outcomes:
  - 2013 fiscal deficit: 2.2 percent of GDP (over-performing 2.7 percent target).
  - Public debt: declined only slightly to just above 79 percent of GDP.
  - 2012 adjustment: substantial (3½ percent of GDP).
  - Hungary exited the EU Excessive Deficit Procedure in June 2013.
- Near-term fiscal outlook:
  - Fiscal stance projected to relax in 2014; deficit target increased to 2.9 percent of GDP mainly due to increases in health, education, and EU co-financed projects.
  - Structural deficit set to widen by about one percentage point of GDP; public debt roughly unchanged at about 79 percent of GDP.
  - Staff assesses budget likely over-estimates revenues; meeting the deficit target depends on saving all budget reserves (0.7 percent of GDP).
- Staff recommended medium-term consolidation:
  - Contain fiscal impulse in 2014 to ½ percent of GDP (about ½ percent of GDP adjustment vs. approved budget).
  - Follow-up structural tightening of about ½ percent of GDP annually through 2015–19.
  - Expected outcome: structural deficit about zero by 2019; public debt just below 70 percent of GDP by 2019. Under current growth path, maintaining that structural deficit beyond 2019 could lower public debt below 60 percent of GDP by 2022.
- Composition and priorities:
  - Core principles: durable expenditure consolidation, better composition of expenditure, gradual elimination of distortionary taxes.
  - Staff sees scope for better targeting social benefits, rationalizing loss-making SOEs, containing discretionary goods and services spending, rationalizing the wage bill.
  - Growth-enhancing reallocation: redirect public works spending to individualized employment services and training; redirect family benefit savings to childcare.
  - Tax reforms: reduce exemptions and special regimes; eliminate distortionary sectoral taxes; reduce high tax wedge for low-income workers; tackle VAT fraud in basic food sector.

### Fiscal Impact of Potential Measures (percent of GDP; staff table)
- Total 1/ 4.8
- Nominal freeze of spending on non-EU-related goods and services 1.2
- Reduction in public sector employment 2/ 0.5
- Reduction in public transport tariff subsidies 0.2
- Elimination of operational subsidies to transport enterprises 0.9
- Streamlining of VAT rates from 3 to 2 0.3
- Elimination of selected CIT exemptions (e.g., sports and entertainment) 0.2
- Elimination of excise exemptions for diesel fuel and tobacco 0.4
- Reduction of VAT fraud 3/ 1.3
- Notes:
  - Total reflects needed adjustment to compensate for elimination of sectoral taxes and recommended consolidation; individual impacts do not add to total due to rounding.
  - Reduce employment through attrition; rationalize local government employment further.
  - Assumes measures eliminate 75 percent of estimated total fraud.

### Banking Sector, FGS, and Financial Intermediation
- Banking sector stress and indicators:
  - NPLs: 16.9 percent, 2013:Q4.
  - Many banks posted losses for a third year in a row.
  - Credit contraction in 2013: credit to households contracted by 3 percent; credit to corporates contracted by 2 percent.
  - Loan-to-deposit ratio: 102 percent in 2013:Q4 (down from about 150 percent in early 2009).
  - Key financial soundness indicators (2009–13, end period shown): Regulatory capital to RWA: 13.9, 13.9, 13.8, 16.3, 17.4; NPLs to gross loans: 6.7, 9.8, 13.4, 15.8, 16.9; ROA: 0.6, 0.0, -0.7, -0.1, 0.3; ROE: 8.4, 0.4, -7.7, -1.4, 2.7; Net open FX position to regulatory capital: 17.8, 15.9, 23.9, 20.5, 15.5.
- Funding for Growth Scheme (FGS) — design and utilization:
  - First phase pillars and amounts:
    - Pillar I: MNB zero-interest funding to banks for on-lending to SMEs at max 2½ percent. Initially HUF 250 billion, later HUF 425 billion (1½ percent of GDP). Max loan maturity 10 years; banks bear credit risk.
    - Pillar II: allocated HUF 325 billion to facilitate conversion of SMEs’ FX loans into forint at same refinancing terms.
    - Pillar III: HUF 1,150 billion (4 percent of GDP) aimed at reducing FX liabilities of banks and MNB interest expenses.
  - Second phase:
    - Envisaged up to HUF 2,000 billion (6.6 percent of GDP); only HUF 500 billion initially allocated, operational until end-2014.
    - Financing terms same; 90 percent for new loans, 10 percent for refinancing; participation requirements relaxed; individual borrower limit raised to HUF 10 billion from HUF 3 billion.
  - Utilization (first phase and overall):
    - About 93½ percent of overall amount (HUF 701 billion) disbursed to credit institutions.
    - Majority to pillar I (HUF 472 billion).
    - Central bank data: second phase utilization in first six months (Oct 2013–Mar 2014) about 18½ percent (HUF 92.7 billion); 11 percent of allocated amount utilized for new investment loans.
  - Staff judgment:
    - Full utilization up to HUF 2,000 billion unlikely; staff assumes up to HUF 500 billion will be utilized.
  - Estimated growth impact (GIMF, Hungary calibration):
    - Real GDP increase of approximately 0.1 percentage point on impact; up to 0.2 percentage points in subsequent periods.
- Staff priorities to restore intermediation:
  - Reduce heavy tax burden on banks and increase predictability.
  - Faster cleanup of banks’ asset portfolios by removing legal, regulatory, and tax impediments.
  - Swift adoption and implementation of a personal insolvency framework in line with best international practice.
  - Any new FX mortgage debt relief should envisage appropriate burden sharing among stakeholders.
  - FGS guidance: limit, target, time-bound; link lending rate to policy rate; keep fiscal costs transparent; focus on SMEs.

### External Sector, Competitiveness, and Export Developments
- External metrics and vulnerabilities:
  - External debt: 119 percent of GDP (end-2013).
  - Net international position: -93 percent of GDP.
  - Open FX positions on private sector balance sheets: about 21 percent of GDP.
  - Gross external financing needs: average 26 percent of GDP per year over the medium term.
  - Nonresident holdings of forint government securities: 32 percent of end-March 2014 outstanding stock.
- Competitiveness assessments:
  - Real exchange rate: staff assessment broadly in line with fundamentals; methodologies yield mixed signals (Current Account Balance suggests undervaluation; REER approach suggests overvaluation by about 20 percent; External Sustainability finds REER undervalued by just under 10 percent).
  - Non-price indicators show erosion in export market share and FDI attractiveness: FDI stock in manufacturing peaked at 23 percent of GDP in 2007 and declined sharply thereafter; Hungary’s global competitiveness ranking slipped 11 places since 2010/11 (63 out of 148 in 2013/14).
- Export developments and GCESC integration:
  - Hungary’s export volume quadrupled during 1995–2009; domestic value added in exports increased by 14 percent of GDP during 1995–2009.
  - Since 2009, export growth moderated and world export share declined; no strong evidence of exchange rate misalignment—decline reflects declining competitiveness.
  - Investment declined from 23 percent of GDP in late 1990s to record-low 17 percent in 2012.
- Staff recommendations to bolster competitiveness and growth:
  - Move up the value chain: upgrade labor force skills, promote entrepreneurship and innovation, reduce tax burden, and improve business climate.
  - Boost labor demand by differentiating minimum wage and linking increases to productivity; strengthen training in active labor market policies.
  - Restructure remaining loss-making transport SOEs; avoid further utility price reductions that compromise service quality and investment.
  - Comprehensive reform package could lift potential growth substantially (increase labor participation; improve fiscal policy quality; enhance business environment); model simulations suggest potential growth could return to pre-crisis rates over the medium term.

### Structural Policies, Labor Market, and Public Works Program
- Potential output and constraints:
  - Potential output growth currently estimated at around 1 percent; projected to increase modestly to around 1½– 1¾ percent over the medium term.
  - Subdued potential driven by low investment and total factor productivity; labor market weaknesses also weigh on long-term growth.
- Public Works Program (facts and assessment):
  - Registered participants: 271,600 in 2011–12 to 402,700 in 2013; program size reached 10 percent of total employment at end-2013.
  - Fiscal cost: almost tripled to about 0.6 percent of GDP in 2013; spending on training 0.1 percent of GDP.
  - Effectiveness: 13.3 percent of participants find primary labor market jobs within 180 days of leaving program.
  - Staff view: program has questionable long-term effectiveness and resembles social assistance; recommend shifting resources toward vocational training and new skills development to address horizontal skills mismatch.

### Debt Sustainability and External Debt Stress Tests (Appendix I)
- Public debt outlook (baseline):
  - Public debt projected to remain around 80 percent of GDP under baseline; elsewhere described as "just under 80 percent of GDP."
  - Gross financing needs forecast to hover above 20 percent of GDP.
  - Baseline assumptions: net lending/borrowing near 3 percent of GDP; interest rates rise in line with global WEO; medium-term output growth 1¾ percent; markets accessible with no large spread spikes.
- Probabilistic risks:
  - Public debt could enter an increasing trajectory with probability of 50 percent.
  - If policy rigidities prevent improving the primary balance by more than 2 percent of GDP in a single year, probability that public debt increases rises to 75 percent.
- External debt stress sensitivity:
  - A one-time real depreciation of 30 percent would add nearly 35 percentage points of GDP to external debt.
  - An adverse permanent growth or current account shock of ½ standard deviation would add about 12 to 15 percentage points of GDP to external debt, respectively.
- Policy-relevant observation: vulnerabilities stem from high public and external debt and large annual gross financing needs with significant nonresident financing reliance; limited fiscal space due to high tax burden.

### Executive Board Assessment and Policy Priorities
- Executive Directors welcomed recovery supported by accommodative policies but flagged risks: uncertain global environment, high public debt, large financing needs, reliance on non-resident funding.
- Directors’ policy priorities:
  - Rebuild policy buffers via recalibrated macroeconomic policies.
  - Ambitious structural reforms to improve medium-term growth and competitiveness.
  - Strengthen institutions and increase policy predictability.
  - Promote private sector participation and restore financial intermediation.
- Fiscal and financial recommendations reiterated:
  - Focus on expenditure retrenchment, elimination of distortionary taxes, reduction of tax exemptions, address VAT fraud, better targeting of social benefits, restructure loss-making SOEs, streamline public sector employment, introduce multi-year budget framework, and strengthen Fiscal Council independence and resourcing.
  - Restore intermediation by facilitating NPL resolution, reducing taxes on banks, removing legal/regulatory impediments, and refining FGS modalities.

*Source: IMF staff report excerpt (cr14155).*

### 1. Response to Past Fund Policy Advice ___________________________________________________________ 5

### 1. Response to Past Fund Policy Advice

### Context and recent developments
- Hungary reduced vulnerabilities since the 2008 crisis (current account turned into surplus, external debt declined, inflation decelerated), but external and public debt remain among the highest in the region and the economy is still susceptible to shocks.
- Real GDP stands at about 5 percent below its pre-crisis level.
- Growth drivers and recent performance:
  - GDP growth: 1.1 percent in 2013, with domestic demand as main driver.
  - Current account surplus widened to 2.9 percent of GDP in 2013 from 1 percent in 2012.
  - High-frequency indicators suggest growth remained strong in 2014:Q1.
- Political context: The ruling party retained a two-third majority in April 2014 elections; platform includes debt relief for FX mortgage holders, utility price reductions, continuation of public work programs, easing tax burden on labor, and boosting industrialization via strategic agreements with large multinationals.

### Inflation, labor market, and monetary policy
- Inflation:
  - Headline inflation decelerated sharply to 0.4 percent at end-2013 and has remained around zero more recently.
  - Core inflation and inflation expectations have decelerated more gradually and have remained around the National Bank of Hungary’s (MNB) 3 percent inflation target.
- Labor market:
  - Labor market participation: increased by about one percentage point to 65.1 percent at end-2013.
  - Public works programs: registered individuals exceeded 400,000 (or about 10 percent of total employment) at end-2013.
  - Unemployment: declined to 9½ percent in 2013:Q4 from 11 percent (both seasonally-adjusted) in 2012:Q4.
  - Private sector: job creation weak; real wage growth in private sector moderated to about 3 percent at end-2013.
- Monetary policy:
  - Policy rate cut to a record-low level of 2.5 percent.
  - MNB introduced the Funding for Growth Scheme (FGS).
    - First phase: equivalent of 2.4 percent of GDP lent by commercial banks.
    - Scheme extended with possible increase in allocated amount to up to 6.6 percent of GDP.

### Fiscal developments
- Fiscal outcomes:
  - 2013 fiscal deficit: 2.2 percent of GDP (over-performed the 2.7 percent target).
  - Public debt declined only slightly to just above 79 percent of GDP.
- 2012 adjustment: substantial (3½ percent of GDP).
- Hungary exited EU’s Excessive Deficit Procedure in June 2013.

### Banking sector and financial intermediation
- Banking sector stress:
  - Nonperforming loans (NPLs): 16.9 percent, 2013:Q4.
  - Many banks posted losses for a third year in a row.
  - Credit contraction in 2013: credit to households contracted by 3 percent; credit to corporates contracted by 2 percent.
  - Loan-to-deposit ratio: 102 percent in 2013:Q4 (down from about 150 percent in early 2009).
- Sectoral measures:
  - Tax burden on banks increased after bank transaction tax rate hike in June 2013.
  - Government integrated cooperative credit institutions into a single body under state-owned Development Bank; total assets of cooperative credit institutions amounted to €7.2 billion at end-2013; current loan-to-deposit ratio of cooperatives 60 percent; integration expected to be completed by end-2014.

### External sector and vulnerabilities
- Key external metrics:
  - External debt: 119 percent of GDP.
  - Net international position: -93 percent of GDP.
  - Open FX positions on private sector balance sheets: about 21 percent of GDP.
  - Gross external financing needs: average 26 percent of GDP per year over the medium term.
  - Nonresident holdings of forint-denominated government securities: 32 percent of the end-March 2014 outstanding stock (high investor concentration).
- Exchange rate and competitiveness:
  - Staff assessment: real exchange rate broadly in line with medium-term fundamentals; different methodologies yield mixed signals (Current Account Balance approach suggests undervaluation; REER approach suggests overvaluation by about 20 percent; External Sustainability approach finds REER undervalued by just under 10 percent).
  - Non-price indicators show erosion in export market share and FDI attractiveness: FDI stock in manufacturing peaked at 23 percent of GDP in 2007 and declined sharply thereafter; Hungary’s global competitiveness ranking slipped 11 places since 2010/11 (63 out of 148 in 2013/14).

### Outlook and risks
- Staff projections (selected rows from macro table; percentages are as presented):
  - Real GDP Growth (percent): 2012 -1.7; 2013 1.1; 2014 2.0; 2015 1.7; 2016 1.7; 2017 1.7; 2018 1.7; 2019 1.7.
  - Inflation (period average, percent): 2012 5.7; 2013 1.7; 2014 0.9; 2015 3.0; 2016 3.0; 2017 3.0; 2018 3.0; 2019 3.0.
  - General government overall balance (percent of GDP): 2012 -2.0; 2013 -2.2; 2014 -2.9; 2015 -2.9; 2016 -2.9; 2017 -2.8; 2018 -2.8; 2019 -2.7.
  - General government gross debt (percent of GDP): 2012 79.8; 2013 79.2; 2014 78.9; 2015 78.9; 2016 78.8; 2017 78.6; 2018 78.4; 2019 78.2.
  - Current account (percent of GDP): 2012 0.9; 2013 3.0; 2014 2.5; 2015 2.0; 2016 1.2; 2017 0.4; 2018 -0.6; 2019 -1.7.
  - Reserves (in billions of Euros): 2012 33.9; 2013 33.8; 2014 34.6; 2015 35.5; 2016 36.6; 2017 37.6; 2018 38.8; 2019 39.9.
  - Gross external debt (percent of GDP, excluding special purpose entities): 2012 128.8; 2013 118.7; 2014 116.8; 2015 107.8; 2016 100.2; 2017 94.2; 2018 89.9; 2019 87.1.
- Risks:
  - Tilted to the downside: adverse external shocks could erode demand for Hungarian assets, affect banking sector through deleveraging and exchange-rate channels, and be exacerbated by geopolitical tensions in the region.
  - Domestic policy uncertainty and continued government interference could worsen deleveraging, undermine competitiveness, and hurt investment and growth.
  - Upside risks: potential expansion of FGS and stronger euro-area growth could boost activity temporarily.

### Response to past IMF advice (Box 1)
- IMF key recommendations and implemented policies (as presented):
  - Recommendation: Implement a more balanced and growth-friendly fiscal adjustment to durably reduce the public debt-to-GDP ratio.
    - Implemented policies: Fiscal restraint continued and the 2013 fiscal deficit over-performed the target, but the composition of the budget remained largely unchanged as additional ad-hoc revenue measures were taken. The public debt ratio declined only slightly.
  - Recommendation: Improve the operating environment for banks—including by reducing the tax burden and putting in place conditions to facilitate a cleanup of balance sheets—to help repair financial intermediation.
    - Implemented policies: The Funding for Growth Scheme has improved credit conditions for small and medium enterprises (SMEs). However, the tax burden on banks has increased further following the hike of the bank transaction tax rate in June 2013.
  - Recommendation: Pursue a broader structural reform agenda, including by promoting competition in the product markets, and restructuring loss-making state-owned enterprises (SOEs).
    - Implemented policies: Some tax incentives were introduced to boost labor demand and supply, including the Job Protection Plan and an extension of the family tax allowance. Implementation of structural reforms in other areas largely stalled.

### Authorities’ views and policy priorities
- Authorities broadly agree with near-term outlook and acknowledge persistent external vulnerabilities; they consider risks broadly balanced and see low likelihood of capital outflows due to a more stable investor base.
- Authorities emphasize improved fundamentals (current account surplus, fiscal consolidation, low inflation), recent decline in sovereign CDS spreads, oversubscribed government paper auctions, and see upside risks to growth from corporate lending pickup and the FGS.
- Policy discussion focus: boost potential growth and reduce public and external debts via building policy buffers, adopting a comprehensive growth strategy that includes growth-friendly fiscal adjustment, revival of financial intermediation, and structural reforms to reduce risk premia and raise investment.

*HUNGARY — INTERNATIONAL MONETARY FUND*

### 17.      Staff welcomed the authorities’ commitment to fiscal consolidation, but noted that

### _cr14155 - 17.      Staff welcomed the authorities’ commitment to fiscal consolidation, but noted that 

### Fiscal outlook and near-term assessment
- The fiscal stance is projected to relax in 2014.
- Deficit target for 2014 increased to 2.9 percent of GDP, mainly due to increases in expenditure on health, education and projects co-financed with the EU.
- Structural deficit is set to widen by about one percentage point of GDP, leaving public debt roughly unchanged at about 79 percent of GDP.
- Staff assesses the budget over-estimates potential revenue collection; the deficit target is likely to be met only if all budget reserves (0.7 percent of GDP) are saved.
- Over the medium term, staff projects the fiscal deficit to come down only modestly:
  - Government’s updated convergence program targets a reduction in the deficit to 1.9 percent of GDP by 2017.
  - Staff’s baseline macro scenario, given current policies and the authorities’ ambitious investment agenda, projects the fiscal deficit would decline only slightly to 2¾ percent of GDP.
  - Public debt would remain around 78 percent of GDP and be a significant vulnerability.

### Need for a clear medium-term consolidation strategy (staff recommendation)
- Staff recommended:
  - Containing the fiscal impulse in 2014 to ½ percent of GDP (an adjustment of about ½ percent of GDP compared with the approved budget).
  - Follow-up with a structural tightening of about ½ percent of GDP annually throughout 2015–19.
- Expected outcomes of this strategy:
  - Bring the structural deficit to about zero by 2019.
  - Reduce public debt to just below 70 percent of GDP by 2019.
- Note: Under the current GDP growth path, if the structural deficit were maintained at this level beyond 2019, public debt would decline to below 60 percent of GDP by 2022.

### Composition of adjustment and policy priorities
- Core principles: durable expenditure consolidation, enhanced composition of expenditure, and gradual elimination of distortionary taxes.
- Observations:
  - Government spending is over 50 percent of GDP.
  - Revenues from sectoral taxes were about 2.3 percent of GDP in 2013, of which 1.2 percent of GDP was collected from the banking system (bank transaction taxes and the special bank levy).
- Staff sees scope for:
  - Better targeting of social benefits, employer tax breaks, and price subsidies.
  - Rationalizing remaining loss-making SOEs.
  - Containing discretionary spending on goods and services.
  - Rationalizing the wage bill.
- Growth-enhancing reallocation suggestions:
  - Redirect spending on public works to individualized employment services and training.
  - Redirect savings in family benefits towards the provision of child-care.
- Tax policy recommendations:
  - Streamline the tax regime through a reduction of exemptions, special regimes, and elimination of distortionary sectoral taxes.
  - Reduce the high tax wedge for low-income workers.
  - Decisively tackle VAT fraud, particularly in the basic food sector.

### Fiscal impact of potential measures (in percent of GDP)
- Total 1/ 4.8
- Nominal freeze of spending on non-EU-related goods and services 1.2
- Reduction in public sector employment 2/ 0.5
- Reduction in public transport tariff subsidies 0.2
- Elimination of operational subsidies to transport enterprises 0.9
- Streamlining of VAT rates from 3 to 2 0.3
- Elimination of selected CIT exemptions (e.g., sports and entertainment) 0.2
- Elimination of excise exemptions for diesel fuel and tobacco 0.4
- Reduction of VAT fraud 3/ 1.3
- Sources/notes:
  - The total reflects the needed adjustment to compensate for the elimination of sectoral taxes and the staff's recommended structural consolidation. The individual impacts do not add to the total due to rounding.
  - Reduce employment (rather than wages) through attrition; rationalize local government employment further.
  - Assumes measures to eliminate 75 percent of the estimated total fraud.

### Fiscal institutions and governance
- Frequent changes in fiscal targets and ad-hoc measures weaken policy predictability.
- Current fiscal rules broadly in line with the Stability and Growth Pact but domestic fiscal rules exhibit design flaws.
- Staff recommendations:
  - Simplify the fiscal rules system.
  - Set rules in structural terms to avoid pro-cyclicality.
  - Adopt a binding multi-year budget framework to anchor expectations and contain spending pressures.
  - Provide the Fiscal Council adequate resources and greater operational independence to assess fiscal sustainability and risks ahead.

### Authorities’ views on fiscal policy
- Authorities reaffirmed commitment to fiscal consolidation.
- Acknowledged risks to the 2014 budget (including inclusion of substantive gains in tax collection through administrative improvements) but believe saving only part of the budget reserves will be sufficient to meet the deficit target.
- Over the medium term, expect deficits to fall mainly via partial freezes in government wages and spending on goods and services and past reforms to restrict eligibility and reduce generosity of social transfers.
- Differences with staff on structural policies:
  - Authorities support the public works program and targeted reductions in employer contributions under the Job Protection Act.
  - Hesitant about interventions based on reported income, such as lowering the tax-wedge for low income workers.
  - Progress claimed on rationalizing loss-making SOEs and strengthening the pension system.
  - Do not intend to phase out sectoral taxes in the near future; dispute characterization of some taxes as distortionary sectoral taxes, arguing taxes like the financial transactions tax or the telecom levy are relatively broad-based consumption taxes.

### Monetary and exchange rate policy highlights
- Under the baseline, inflationary pressures set to build gradually; headline inflation projected to revert towards the MNB’s inflation target of 3 percent as the output gap narrows and one-off effects wane.
- Pass-through estimate: the pass-through from exchange rate depreciation of 1 percent to prices is estimated at about 0.3 percent over a period of one year.
- Risks:
  - Considerable uncertainty in the external environment.
  - Hungary’s interest rate differentials reached a record low; further compression could reduce attractiveness of Hungarian securities.
  - Potential for disorderly capital flow movements amid emerging market repricing and geopolitical tensions.
  - Forward rate agreements pricing a policy rate hike of 40 basis points by end-2014.
- Staff recommendation:
  - Keep the policy rate on hold and adopt a monetary policy tightening bias.
  - Maintain accommodative stance until signs of building inflationary pressures; be ready to tighten if external conditions deteriorate sharply.
  - Emphasize clear communication strategy to guide market expectations.
- Reserves:
  - Maintain sufficient reserves to support financial stability; Hungary’s reserve position projected to remain within the Fund’s adequacy range over the medium term.
  - Large financial sector vulnerabilities (heavy reliance on FX swaps with nonresidents, risk of market volatility) imply elevated reserve needs.

### Financial sector — repairing financial intermediation
- Credit outlook:
  - Credit projected to contract further in 2014 despite economic improvement.
  - High level of restructured loans (~18 percent of total loans) and high NPLs hinder credit growth.
- Staff priorities to restore intermediation:
  - Sustainable improvement in banks’ operating environment, including reduction in heavy tax burden on banks and higher policy predictability.
  - Faster cleanup of banks’ asset portfolios by removing legal, regulatory, and tax impediments.
  - Swift adoption and implementation of a personal insolvency framework in line with best international practice.
  - Any new FX mortgage debt relief scheme should envisage appropriate burden sharing among all stakeholders.
- FGS (Funding for Growth Scheme) guidance:
  - Lending under the FGS should be limited, targeted, and time-bound, with fiscal costs clearly recognized.
  - Link lending rate to the policy rate to remove monetary policy easing bias in the scheme while compensating banks for SME risk.
  - Scheme should remain time-bound and limited to SMEs; fiscal costs should be transparently reported.
- Co-operative credit institutions:
  - Integration aims to improve financial standing, risk management, and lending capacity; safeguards needed to prevent state interference.
- Financial stability framework:
  - New MNB Act integrated the Hungarian Financial Supervisory Authority into the MNB and equipped it with micro-prudential instruments.
  - MNB’s macro-prudential tool kit reinforced; some instruments transferred from government to MNB (minimum liquidity levels, regulation of maturity and currency mismatches, LTV and limits on lending (DTI and PTI)).
  - Staff stressed need for adequate checks and balances so financial stability concerns do not override price stability.
  - Establishment of the Financial Stability Council is welcomed; staff encouraged strengthening supervisory framework further, including adopting a bank resolution framework.
- Authorities’ views on financial sector:
  - Emphasized role of FGS in repairing intermediation; did not share staff concerns about its modalities.
  - See FGS as a useful monetary tool to boost SME lending and expect demand to pick up later in the year.
  - Consider bank levy and bank transaction tax necessary given limited fiscal space.
  - Task force to submit recommendations on faster portfolio cleaning to the Financial Stability Council in coming months.
  - Drafting a new law to implement the Bank Recovery and Resolution Directive, with full implementation envisaged early next year.

### Structural policies and growth prospects
- Potential output growth currently estimated at around 1 percent.
- Projected to increase modestly to around 1½– 1¾ percent over the medium term.
- Subdued growth potential driven by low investment and total factor productivity.
- Weaknesses in the labor market (low participation and employment rates) also weigh on long-term growth.

*Source: IMF staff report (chapter excerpt)._cr14155 - 17.*

### 34.      The erosion in market share and the drop in FDI undermine Hungary’s growth

### The erosion in market share and the drop in FDI undermine Hungary’s growth

### Erosion in market share, FDI, and implications
- Staff assessment: the erosion in market share and drop in FDI mainly reflects structural factors rather than exchange rate developments, and could undermine Hungary’s current role in the German-Central European Supply Chain.
- Staff recommendation: move up in the value chain through measures to upgrade labor force skills, promote entrepreneurship and innovation, reduce the tax burden, and improve the business climate to support investment and growth.

### Structural reform needs and specific policy ideas
- Renewed structural reform momentum is needed to remove obstacles to growth; past reforms helped but further steps are required.
- Policy options and measures identified by staff:
  - Boost labor demand by differentiating the minimum wage across different groups and linking future increases to productivity growth.
  - Reduce labor market skills mismatches by strengthening the training component of active labor market policies.
  - Increase policy predictability and reduce regulatory and tax compliance burden on businesses.
  - Restructure the remaining loss-making transport SOEs.
  - Avoid further measures to reduce utility prices as part of a strategy to make the energy sector non-profit, because they may compromise service quality and undermine investment plans.

### Potential gains from a comprehensive reform package
- Staff analysis suggests a comprehensive and ambitious structural reform package could lift Hungary’s potential growth substantially by:
  - (i) increasing labor participation;
  - (ii) improving the quality of fiscal policy, including by eliminating distortionary sectoral taxes;
  - (iii) enhancing the business environment.
- Model simulations (see Selected Issues Paper): in such a reform scenario, potential growth could return to its pre-crisis rates over the medium term.

### Authorities’ views
- Authorities’ medium-term potential growth view: about 2½ percent, attributed to higher investment from increased EU funds, more favorable financing conditions for SMEs, and labor market reforms.
- Authorities’ interpretation of export performance:
  - They viewed the recent decline in Hungary’s export market share as linked mainly to the changing structure in manufacturing (particularly telecom) and peers’ catching-up.
  - They expect diversification of export destinations (including trade links with Asian countries), expansion of Eximbank operations, and planned increases in automobile industry production capacity to boost exports.
- Authorities’ view on utility price cuts: part of strategy to develop a non-profit energy sector to reduce high energy costs and enhance competitiveness.

### Macro policy recommendations (staff appraisal)
- Recalibrate macroeconomic policies to build policy buffers and reduce vulnerabilities.
- Growth-friendly fiscal consolidation to put the public debt ratio on a downward path; supportive measures could include:
  - Better targeting of social benefits;
  - Restructuring remaining loss-making SOEs;
  - Streamlining public sector employment;
  - Reducing tax exemptions and addressing VAT fraud.
- Support a binding multi-year budget framework (planned with the 2015 budget) to bolster fiscal predictability.
- Strengthen the fiscal council: more independence and adequate resourcing to monitor risks and ensure sustainability.
- Monetary policy stance:
  - Monetary easing should end and a tightening bias adopted.
  - Policy rate should be kept on hold while the economy recovers; precise timing of tightening depends on signs of building inflationary pressures.
  - Central bank should be ready to tighten if external conditions deteriorate sharply.
  - Maintain adequate international reserves to mitigate excessive exchange rate volatility.
- Financial sector / credit market:
  - Remove regulatory, legal, and tax impediments and introduce a personal insolvency framework to accelerate bank balance-sheet cleanup.
  - Reduce tax burden on banks and improve policy predictability to support lending.
  - Ensure future FX debt relief schemes entail appropriate burden sharing.
  - Funding for Growth Scheme (FGS) should remain time-bound and limited to SMEs, with fiscal costs clearly recognized.
- Structural reforms to boost potential growth and competitiveness:
  - Improve business climate, promote entrepreneurship and innovation, reduce regulatory burden, rationalize taxes.
  - Boost productivity in services, restructure remaining loss-making SOEs.
  - Increase policy predictability and limit government interference.
  - Continue efforts to increase labor supply and demand, mitigate skill mismatches, invest in knowledge industries, adjust the tax wedge on low income earners, and ensure minimum wage increases align with productivity growth.

### Risk Assessment Matrix — selected domestic and global risks
- Global risks highlighted:
  - Surges in global financial market volatility — Relative Likelihood: High; Impact if Realized: High.
  - Protracted slower growth in advanced and emerging economies — Relative Likelihood: High; Impact if Realized: Medium.
  - A sharp increase in geopolitical tensions surrounding Russia/Ukraine — Relative Likelihood: Medium; Impact if Realized: Medium.
  - Bond market stress from reassessment in sovereign risk — Relative Likelihood: Low; Impact if Realized: High.
- Domestic risks highlighted:
  - Unconventional policies undermining credibility — Relative Likelihood: Medium; Impact if Realized: High.
  - Stalling fiscal consolidation and slippage in structural reforms — Relative Likelihood: Medium; Impact if Realized: Medium.
- Policy response in episodes of sharp deterioration: tighten monetary stance, use FX intervention to smooth exchange rate volatility, adopt growth-friendly fiscal adjustment, increase policy predictability, accelerate structural reforms while limiting government interference.

### Box: Public Works Program — facts and assessment
- Program objective: facilitate return of discouraged workers to the labor market via temporary employment with public agencies (mainly agricultural and construction).
- Participation and scale:
  - Number of registered individuals grew from 271,600 in 2011–12 to 402,700 in 2013.
  - Size of program reached 10 percent of total employment at end-2013.
- Fiscal cost and composition:
  - Cost to the budget almost tripled (to about 0.6 percent of GDP in 2013).
  - Spending on training constituted 0.1 percent of GDP.
- Effectiveness:
  - Share of participants finding jobs on the primary labor market within 180 days of leaving the program was 13.3 percent.
  - Staff view: program has questionable long-term effectiveness and resembles social assistance; recommend shifting resources toward vocational training and new skills development to address horizontal skills mismatch.
- Context: Hungary is among countries with relatively high horizontal skills mismatch (a mismatch of field of education).

### Box: Funding for Growth Scheme (FGS) — design, utilization, and growth impact
- First phase pillars and amounts:
  - Pillar I: MNB provided zero-interest funding to banks for on-lending to SMEs at a maximum rate of 2½ percent. Amount initially set at HUF 250 billion, later raised to HUF 425 billion (1½ percent of GDP). Maximum loan maturity 10 years; participating banks fully bear credit risk.
  - Pillar II: allocated HUF 325 billion to facilitate conversion of SMEs’ FX loans into forint at same refinancing terms.
  - Pillar III: HUF 1,150 billion (equivalent to 4 percent of GDP) aimed at reducing foreign currency liabilities of banks and MNB interest expenses.
- Second phase:
  - Envisaged increase up to HUF 2,000 billion (6.6 percent of GDP), though only HUF 500 billion initially allocated, operational until end-2014.
  - Financing terms same, but 90 percent of additional funds required for new loans, 10 percent for refinancing.
  - Participation requirements relaxed to include real estate companies, individual farmers, leasing companies, and non-bank financial intermediaries.
  - Limit of financing for an individual borrower raised to HUF 10 billion from HUF 3 billion.
- Utilization data (first phase and overall):
  - About 93½ percent of the overall amount (HUF 701 billion) was disbursed to credit institutions.
  - Majority disbursed to pillar I (HUF 472 billion), divided between:
    - Investment loans: 3,679 177 41.6
    - Working capital: 2,285 113 26.6
    - Refinancing: 2,167 182 42.8
  - Pillar II: 325 1,713 229 70.5
  - Total: 750 9,844 701 93.4
  - Note: As of August 1, 2013 credit institutions were allowed to use allocation under pillar II for pillar I.
- Second phase utilization and staff judgment:
  - Staff view: full utilization of second phase up to HUF 2,000 billion unlikely; staff assumes up to HUF 500 billion will be utilized.
  - Central bank data: utilization of the second phase in the first six months (October, 2013–March, 2014) stood at about 18½ percent (HUF 92.7 billion), of which 11 percent of the allocated amount was utilized for new investment loans.
- Potential growth impact (model-based, using the GIMF calibrated for Hungary):
  - Provision of FGS funds modeled as temporary decrease in riskiness of corporate borrowers, reducing external financing premium and cost of capital.
  - Estimated impact: Real GDP would increase by approximately 0.1 percentage point compared to the baseline on impact; in subsequent periods, real GDP would be higher by up to 0.2 percentage points.

*Source: IMF staff report excerpt.*

### Box 4. Export Developments and External Competitiveness

### Box 4. Export Developments and External Competitiveness

### Integration with the German-Central European Supply Chain (GCESC)
- Hungary’s integration into the GCESC drove its impressive export performance until 2009.
- Starting in the mid-1990s, many German firms outsourced or relocated part of the production process to the CE4 countries, starting with Hungary, drawn to lower unit labor costs, high-quality human capital, and proximity to markets.
- The CE4 group comprises the Czech Republic, Hungary, Slovakia, and Poland.

### Quantitative outcomes of integration (1995–2009)
- Hungary’s export volume quadrupled during 1995–2009.
- Domestic value added in Hungary’s exports increased by 14 percent of GDP during 1995–2009, most of this in the knowledge-intensive sectors.
- Integration raised intermediate goods imports, particularly in the knowledge-intensive sectors such as the automotive industry.
- Hungary received substantial foreign direct investment from Germany during that period, bringing technology transfers, raising external competitiveness in the knowledge-intensive sectors and domestic value added, creating jobs and supporting income convergence.
- Close economic ties with Germany served as a shock absorber during the global financial crisis.

### Risks, exposures, and structural challenges
- Increased trade dependency on Germany has been reflected in higher business cycle co-movement and increased exposure to global shocks.
- The CE4 countries are more exposed to spillovers from the rest of the world, and concentration of exports in knowledge-intensive industries (e.g., machinery and transport equipment) increases vulnerability.
- Since 2009, Hungary’s export growth moderated significantly and its share in world exports has been declining.
- There is no strong evidence of exchange rate misalignment; the decline also reflects declining competitiveness.
- Investment declined sharply from 23 percent of GDP in the late 1990s to a record-low 17 percent in 2012.
- Hungary’s ranking in the Global Competitiveness report slipped by 11 places in the past 3 years.
- As unit labor cost differentials with Germany narrow, Hungary may face difficulties in sustaining its role in the GCESC, particularly as other CESEE countries remove impediments to trade and become potential GCESC candidates.

### Policy implications highlighted in the text
- Hungary needs to maintain sufficient policy buffers to cope with external shocks.  

*International Monetary Fund — Box 4. Export Developments and External Competitiveness*

### 2.6 percent (as of March 2014), the MNB launched the Funding for Growth Scheme in June 2013,

### _cr14155 - 2.6 percent (as of March 2014), the MNB launched the Funding for Growth Scheme in June 2013,

### Funding for Growth Scheme and SME financing
- MNB launched the Funding for Growth Scheme in June 2013; reference participation rate cited as 2.6 percent (as of March 2014).
- Program aims to boost lending to SMEs by providing loans with preferential interest rates.
- Assessment of impact:
  - The program "has provided some relief and shifted credit growth to SMEs to a positive territory."
  - Likely limited impact on overall growth absent complementary measures to restore banks’ financial intermediation role.
- Complementary measures highlighted as imperative:
  - Steps to facilitate faster NPL resolution.
  - Measures to reduce the tax burden.
- Additional SME financing mechanisms noted:
  - (i) state-owned guarantees provided by Garantiqa,
  - (ii) guarantees and direct lending by the Hungarian Development Bank,
  - (iii) government’s subsidized-short-term lending program (“Szechenyi Card”).

### Banking sector: performance, vulnerabilities, and structural issues
- Cross-border funding and balance-sheet trends:
  - "Cross border funding declined sharply" and banks continue to deleverage.
  - Banks' reliance on FX swaps remains high.
- Profitability and capital/liquidity:
  - "Banks continued to register losses."
  - "Capital and liquidity positions remain comfortable."
- Asset quality:
  - NPLs are high and provisioning is low (chart label: "NPLs are high and provisioning is low").
- Key financial soundness indicators (2009–13, end of period):
  - Regulatory capital to risk-weighted assets: 13.9, 13.9, 13.8, 16.3, 17.4 (years sequence as presented).
  - NPLs to gross loans: 6.7, 9.8, 13.4, 15.8, 16.9.
  - NPLs net of provisions to capital: 33.0, 49.3, 59.0, 52.9, 46.3.
  - ROA: 0.6, 0.0, -0.7, -0.1, 0.3.
  - ROE: 8.4, 0.4, -7.7, -1.4, 2.7.
  - Net open FX position to regulatory capital: 17.8, 15.9, 23.9, 20.5, 15.5.

### Real sector, labor market, and potential growth
- Real activity:
  - Real GDP growth series (select): -6.8 (2009), 1.1 (2010), 1.6 (2011), -1.7 (2012), 1.1 (2013), 2.0 (2014), 1.7 (2015), 1.7 (2016).
- Demand composition:
  - Total domestic demand contributions and components show recovery of domestic demand shifting GDP growth to positive territory recently.
  - Investment remains weak: Investment-to-GDP ratio and change in investment-to-GDP ratio indicate low level and decline (figures presented visually).
- Labor market:
  - Unemployment rate declined despite an increase in participation rate.
  - Employment growth has been driven mainly by public work programs.
- Potential growth:
  - "Potential growth is projected to remain subdued."
  - Potential output growth in projections: 0.5, 1.2, 1.3, 1.4, 1.5, 1.7 (medium-term sequence shown).

### Fiscal sector: balance, debt, and financing needs
- Fiscal position and projections:
  - General government overall balance (GFSM basis): -4.6 (2009), -4.4 (2010), 4.2 (2011), -2.0 (2012), -2.3 (2013), -2.9 (2014), -2.9 (2015), -2.9 (2016).
  - Primary balance: -0.5 (2009), -0.5 (2010), 8.0 (2011), 2.0 (2012), 1.8 (2013), 0.6 (2014), 0.5 (2015), 0.6 (2016).
  - Gross debt: 79.8 (2009), 82.1 (2010), 82.1 (2011), 79.8 (2012), 79.2 (2013), 79.0 (2014), 79.0 (2015), 78.9 (2016) — all in percent of GDP.
- Revenue and expenditure composition (2013, 2014 context):
  - Revenue about 46.9 percent of GDP (2009), and remains in mid-40s in projections.
  - Tax revenue around 26.6 percent of GDP (2009) with taxes on goods and services ~16.6 percent of GDP (2009).
  - Tax burden described as "one of the highest in the region."
- Financing needs:
  - Gross financing needs projected: 0 (year sequence): 2013 onward figures in charts show large financing needs; explicit projections show Gross financing needs (percent of GDP) rising and remaining large.
  - Table highlights Gross financing needs: 16.7, 19.6, 16.3, 20.9, 24.9, 19.8, 24.8 (selected years sequence).
  - Central government cash deficit examples: 3.3, 1.7, 1.9, 2.6, 3.1, 2.9, 2.9.

### Monetary policy, inflation, and real interest rates
- Inflation:
  - CPI inflation (average) series: 4.2, 4.9, 3.9, 5.7, 1.7, 0.9, 3.0, 3.0 (select years).
  - CPI inflation (end year): 5.6, 4.7, 4.1, 5.0, 0.4, 2.9, 3.0, 3.0.
  - Headline inflation declined sharply in 2013; core inflation decline was more moderate.
- Monetary policy stance and rates:
  - Policy rate cuts accompanied by a decline in risk premia.
  - Real interest rates (policy rate deflated by core inflation) "brought the real interest rate significantly below its historical average."
  - 5-year sovereign CDS (December 31, 2013) values include 335, 282, 379, 450, 260 (chart labels by country comparisons).
- Labor and wages:
  - Nominal wage growth and inflation expectations moderated but remain elevated; target inflation rate at 3 percent.

### External vulnerabilities and financing
- External position:
  - Gross external debt: 150.1, 143.7, 134.6, 128.8, 118.7, 116.8, 107.8, 100.2 (percent of GDP sequence 2009–16).
  - Net international reserves and reserve coverage: Gross official reserves (in billions of euros): 30.7, 33.7, 37.8, 33.9, 33.8, 34.6, 35.5, 36.6 (select years).
  - Gross official reserves (percent of short-term debt at remaining maturity) examples: 83.6, 74.9, 88.9, 96.0, 98.3, 117.2, 116.0, 126.2.
- Recent market turmoil:
  - "The recent financial market turmoil had a moderate impact on Hungary."
  - Exchange rate and bond yield changes were relatively less than in other EMs.
- External financing needs:
  - Table shows Total financing requirements (in millions of euros) for selected years: 38,379; 44,370; 37,814; 27,504; 28,871; 24,331; 26,322; 25,735; 25,860; 25,156 (multi-year sequence).
  - Net external vulnerabilities include high external liabilities and large open FX positions across sectors, leaving Hungary vulnerable to external shocks.

### Key medium-term projections (select series from tables)
- Real GDP growth (2009–19 sequence, select): -6.8, 1.1, 1.6, -1.7, 1.1, 2.0, 1.7, 1.7, 1.7, 1.7, 1.7.
- Unemployment rate (average): 10.1, 11.2, 11.0, 11.0, 10.3, 9.4, 9.2, 9.0, 8.7, 8.5, 8.3.
- Lending to the private sector, flow-based (current prices, e.o.p.): -2.3, -2.4, -6.9, -7.4, -3.2, 0.0, 3.0, 3.5, 4.0, 4.0, 4.0.
- Gross domestic investment (percent of GDP): 20.7, 18.6, 17.9, 17.4, 18.1, 18.9, 19.2, 19.6, 20.1, 20.6, 21.1.
- Gross national saving (percent of GDP, from BOP): 20.5, 18.8, 18.3, 18.3, 21.1, 21.4, 21.2, 20.9, 20.5, 20.0, 19.4.
- Gross external debt (percent of GDP) projection path noted above under External vulnerabilities.

*Source: IMF staff estimates and projections.*

### Appendix I. Hungary: Debt Sustainability Analysis

### Appendix I. Hungary: Debt Sustainability Analysis

### Public debt outlook (baseline)
- Hungary’s public debt is projected to remain at around 80 percent of GDP under the baseline scenario; elsewhere described as "just under 80 percent of GDP."
- Gross financing needs are forecast to hover above 20 percent of GDP.
- Baseline scenario assumptions:
  - Net lending/borrowing balance of near 3 percent of GDP.
  - Interest rates on sovereign bonds and loans gradually increase in line with global WEO assumptions.
  - Medium-term output growth of 1¾ percent.
  - Financial markets remain accessible with no significant interest rate spikes; sovereign and maturity spreads remain at near 2014 levels.

### Risks to public debt dynamics and probabilistic analysis
- With public debt at around 80 percent of GDP, relatively small negative shocks can trigger adverse market reactions, amplified by annual gross financing needs hovering above 20 percent of GDP and large reliance on non-resident financing.
- Possible shocks identified:
  - Increase in sovereign spreads through contagion from other emerging economies.
  - Depreciation pressure on the exchange rate.
  - Reduced appetite by international investors.
  - Increase in global interest rates in line with U.S. monetary policy normalization.
  - Domestic shocks to the primary fiscal balance from recurrent needs to restore service provision by SOEs, public wage pressures, and revenue uncertainty driven by new tax schemes and volatile VAT and corporate tax collection.
- Probabilistic outcomes based on historical volatility:
  - Public debt could enter an increasing trajectory with a probability of 50 percent.
  - Assuming policy rigidities that do not allow improving the primary balance by more than 2 percent of GDP in a single year, the probability that public debt enters an increasing trajectory increases to 75 percent.
- Constraint driving the elevated probability: an already high tax burden that leaves virtually no room for significant revenue-raising measures, and the typically slow implementation of expenditure-based consolidations.

### External debt dynamics and vulnerabilities
- Gross external debt declined from its peak of about 150 percent of GDP in 2009 to 119 percent by end-2013.
- The improvement mainly reflects heavy bank deleveraging that began during the global financial crisis, partly offset by higher external government debt.
- Intra-company loans related to FDI remained broadly stable, amounting to just above 20 percent of gross debt throughout the period.
- Going forward, external debt is expected to continue to decline, with all sectors except for the government continuing to make net repayments.
- External bond issuances and continued purchases of HUF-denominated securities by nonresidents are expected to keep government external debt elevated, albeit declining in percent of GDP over the medium term.

### Stress tests and shock sensitivity (external debt)
- Exchange rate shocks are the main source of risk to external debt dynamics, reflecting high external liabilities.
- External debt remains sustainable under a range of shocks, but is particularly vulnerable to exchange rate shocks and, to a lesser extent, growth or current account shocks.
- Quantified stress impacts:
  - A one-time real depreciation of 30 percent would add nearly 35 percentage points of GDP to external debt.
  - An adverse permanent growth or current account shock of ½ standard deviation of their historical variation would add about 12 to 15 percentage points of GDP to external debt, respectively.

### Debt sustainability indicators and model outputs (high-level)
- Historical and projected indicators highlighted in the DSA:
  - Public gross financing needs: examples shown in the DSA include 23.2 percent (2012), 16.5 percent (2013), 20.1 percent (2014) in tabulated projections.
  - Nominal gross public debt projections shown around 70.0–79.8 percent in early rows and projected in charts to remain in the high-70s to low-80s percent of GDP range.
  - Real GDP growth baseline paths include 1.7 percent in the medium term (and tabulated annual projections with repeated 1.7 values).
  - Effective interest rate examples in the projections: 5.0, 4.7, 4.7, 4.9, 5.2, 5.4 (percent) across projection years in the tables.
- Scenario exercises presented: baseline, historical, constant primary balance, primary balance shock, real GDP growth shock, real interest rate shock, real exchange rate shock, combined macro-fiscal shock, contingent liability shock.
- Heat-map and predictive-density charts illustrate considerable tail risk: predictive densities of gross nominal public debt show substantial probability mass above the 70 percent benchmark under adverse scenarios.

### Policy-relevant observations from the analysis
- Vulnerabilities stem from high public and external debt and large annual gross financing needs with significant nonresident financing reliance.
- The DSA highlights limited fiscal space: high tax burden constrains immediate revenue-raising options and expenditure-based consolidations typically require time to implement.
- Institutional note (from safeguards assessment): it is critical to avoid undue changes to the MNB’s legal framework and to ensure that the law continues to support MNB’s operational and legal independence.

*Source: IMF staff — Appendix I. Hungary: Debt Sustainability Analysis (As of May 8, 2014).*

### 2.9 percent of GDP implies a structural relaxation of about one percent of GDP leaving

### _cr14155 - 2.9 percent of GDP implies a structural relaxation of about one percent of GDP leaving

### Executive Board assessment and macroeconomic stance
- A structural relaxation of about one percent of GDP, with an overall deficit target of 2.9 percent of GDP, is assessed to leave public debt broadly unchanged at about 79 percent of GDP.
- Executive Directors welcomed the economic recovery supported by accommodative policies but flagged significant risks from an uncertain global environment, still high public debt, large financing needs, and extensive reliance on non-resident funding.
- Policy priorities identified by Directors:
  - Recalibration of macroeconomic policies to rebuild policy buffers.
  - Ambitious structural reforms to improve medium-term growth.
  - Strengthening institutions and increasing policy predictability.
  - Promoting private sector participation in the economy.

### Fiscal policy, consolidation, and recommendations
- Authorities’ fiscal stance and targets:
  - Deficit target of 2.9 percent of GDP.
  - A countercyclical structural impulse of about 1 percentage point is allowed in the 2014 budget; a broadly neutral stance is envisaged thereafter.
  - Budgeted contingency reserves for 2014 intended to meet the 2.9 percent deficit target at a comfortable margin.
- Measures and outcomes:
  - Fiscal discipline preserved stable fiscal balance and moderately declining public debt.
  - The public debt-to-GDP ratio declined 3 percentage points by end-2013.
  - Spending on non-EU related goods and services to remain under strict nominal control and decline as a share of GDP.
  - Public nominal wages remain frozen except in education and healthcare; social transfers decline as a share of GDP (pensions indexed to inflation; other benefits frozen).
- Directors’ recommendations for durable adjustment and growth-friendly reform:
  - Focus on expenditure retrenchment and elimination of distortionary taxes.
  - Reduce tax exemptions and address VAT fraud.
  - Better targeting of social benefits.
  - Restructure remaining loss-making SOEs.
  - Streamline public sector employment.
  - Introduce a multi-year budget framework and an independent, adequately-resourced fiscal council.

### Monetary policy, liquidity measures, and financial stability
- Monetary stance and instruments:
  - Magyar Nemzeti Bank (MNB) reduced the policy rate to a record-low level of 2.5 percent (as of April 2014).
  - Given decelerating inflation, low risk premia, and a negative output gap, the accommodative stance supports activity; Directors saw merit in halting further easing absent inflationary pressures.
  - Adequate international reserves were highlighted as mitigating exchange rate volatility and supporting financial stability.
- Funding for Growth Scheme and results:
  - First phase (June–September 2013) disbursed about 2.5 percent of GDP; strengthened SME credit competition and alleviated firms’ interest burden.
  - Second phase (running until end-2014) emphasizes new loans for new investments.
  - As of April, 60 percent of the 126 bn HUF (about 0.4 percent of GDP) of already contracted loans were new investment loans.
- Upcoming instrument changes (planned from August 2014):
  - Two-week MNB bill to be replaced by a two-week deposit facility, excluded from eligible collateral, to incentivize banks to support domestic financing of government debt.
  - Introduction of interest rate swap, long-term repo operation, and asset swap to encourage banks to buy long-term HUF government bonds and improve the maturity profile of public debt.
- Financial supervision and stability:
  - Integration of the financial supervisory authority into the central bank and establishment of the Financial Stability Board to coordinate micro- and macro-prudential oversight.
  - Revision of the Act on Credit Institutions to transpose Basel III (CRD IV) strengthened the supervisory toolbox.

### Financial sector vulnerabilities and debt composition
- Key developments:
  - Public debt broadly unchanged at about 79 percent of GDP under the current policy mix.
  - The share of FX-denominated debt declined by more than 10 percentage points over the past three years.
  - Nonresident holdings of government paper are on a declining trend; composition shifted toward more stable, real-money investors.
  - Retail bond program (started 2012) led to domestic households holding 10 percent of total government securities stock.
  - Domestic institutional demand for government securities increased; changes in monetary instruments expected to raise demand from banks.
- Directors’ calls:
  - Restore financial intermediation and facilitate resolution of non-performing loans by reducing taxes on banks and removing legal/regulatory impediments to bank portfolio clean-ups.
  - Refine modalities of the Funding for Growth Scheme to improve targeting and effectiveness.

### Growth outlook and structural constraints
- Growth outlook and drivers:
  - Economic activity picked up in the past 1.5 years; output growth reached 3.5 percent in Q1 2014.
  - Authorities more optimistic than staff, expecting GDP growth rates exceeding 2.5 percent for current and next year.
  - Rising exports expected to remain an important driver, supported by increasing FDI in manufacturing and new automobile industry capacities.
  - Investment likely to pick up with easing credit constraints and increased EU funding use.
  - Consumption recovery gradual due to ongoing household deleveraging.
  - Inflation expected to return to the price stability range of 3 percent as the output gap narrows and one-off effects phase out.
- Structural challenges:
  - Private consumption hampered by household balance sheet repair; private investment weighed by weak business environment.
  - Banks under stress from heavy tax burden, high non-performing loans, and weak growth outlook.
  - Labor participation remains low despite some increases.
  - Competitiveness pressures reflected in loss of export market share due to deterioration in the business climate, particularly institutional framework and tax policy.
- Structural reform measures and labor market policies:
  - Diversification of export destinations supported by Eximbank financing and insurance facilities.
  - Steps to develop a non-profit energy sector and reduce high energy costs to international levels.
  - Labor market reforms: changes to the Labor Code for flexible employment, Job Protection Act (2013) reduced tax wedge for disadvantaged groups, extension of family tax allowance further reduced tax wedge for lower-income families.
  - Transformation of unemployment, disability benefits, and early retirement to encourage return to work; mobility benefits to alleviate geographic mismatches.
  - Labor market reforms aim at a workfare state and work-based social-security system; reflected in rising labor force participation, private employment, public work scheme employment, and declining unemployment.

*Source: Hungarian authorities; IMF, International Financial Statistics; Bloomberg; and IMF staff estimates.*

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