## _cr1592

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---

### Context and Recent Developments
- Expansionary macroeconomic policies contributed to strong output growth in 2014; real GDP is about to reach its pre-crisis level.
- Output expanded by 3½ percent in 2014 driven by strong domestic demand, higher investment from increased utilization of EU funds, and a boost to consumption from utility price cuts.
- Headline and core inflation decelerated sharply to -1 and 1 percent, respectively, in February; inflation expectations fell to 2.2 percent (below the MNB’s 3 percent target).
- Unemployment rate was 7.2 percent in 2014:Q4; private sector nominal wage growth moderated to about 3½ percent in 2014:Q4; labor participation rose by 2 percentage points to 67 percent.
- Preliminary 2014 fiscal deficit estimated at 2.6 percent of GDP against a 2.9 percent target; fiscal impulse estimated at 1⅓ percent of GDP; public debt-to-GDP ratio declined moderately to just below 77 percent.
- MNB policy rate held at a record low 2.1 percent since July 2014 (later cut to 1.95 percent in March); forward rate agreements price a 30 bps policy rate cut in the next 12 months.
- MNB doubled the second phase allocation of the Funding for Growth Scheme (FGS) to the equivalent of 3¼ percent of GDP and extended the program to end-2015.
- Private sector credit contraction continues; loan-to-deposit ratio dropped to 95 percent. NPL ratio at 16 percent.
- MNB set up Asset Management Company (MARK) to buy up to the equivalent of 1.3 percent of GDP in distressed commercial real estate loans.
- External indicators: external debt fell to 116 percent of GDP in 2014; gross external financing needs of 21 percent of GDP in 2015; about 30 percent of GDP open FX position on private balance sheets; international investment position of -76 percent of GDP.
- Conversion of FX mortgage stock (25 percent of household loans, almost all in Swiss francs) to local currency loans will reduce bank foreign liabilities and lower official reserves.
- Real exchange rate broadly in line with fundamentals; non-price indicators point to competitiveness challenges (stagnating export market share, low share of products in top-quality quartile, skill mismatches, deteriorating foreign investment environment, slipping global competitiveness ranking).

### Outlook and Risks
- Staff growth projections:
  - 2015: growth decelerates to 2¾ percent.
  - Medium term: output growth projected to stabilize at around 2 percent.
- Current account and IIP:
  - Improved terms-of-trade (notably lower oil prices) forecast to increase the current account surplus in the short run; continued cross-border deleveraging expected to further improve the IIP.
  - Medium term: current account surplus expected to gradually decline due to slowing deleveraging and aging population dynamics.
- Inflation:
  - Headline inflation projected to remain very low in coming months; expected to gradually return to target provided monetary policy anchors expectations.
- Balance of risks tilted somewhat to the downside:
  - Key downside risks: abrupt change in risk perception (sovereign stress in Europe), geopolitical tensions, emerging market financial stress, protracted weak external demand from euro area, domestic state interference eroding competitiveness and provoking cross-border deleveraging.
  - Upside risks: Settlement Act and sustained lower oil prices boosting purchasing power and investment; government measures to improve banks’ operating environment accelerating repair of financial intermediation and credit growth.
- Authorities’ view: more optimistic on medium-term growth (assess medium-term potential growth at 2½ percent); consider capital outflow risk low due to higher share of institutional investors and shift to domestic financing; view balance sheet exchange rate vulnerability as significantly reduced after FX mortgage conversion.

### Fiscal Policy — Assessment and Recommendations
- Staff view: current strategy insufficient to reduce public debt significantly over the medium term.
- 2015 budget stance:
  - Staff projects the 2015 deficit at 2.7 percent of GDP versus a budget target of 2.4 percent.
  - Expenditure-to-GDP ratio expected to remain high; spending close to 50 percent of GDP.
- Staff medium-term debt outlook:
  - Under staff’s baseline, deficit would hover around 2½ percent of GDP and public debt around 72 percent.
- Recommended fiscal consolidation:
  - Moderate annual structural fiscal tightening by about ½ percent of potential GDP starting in 2015, consistent with reducing public debt to below 60 percent of GDP by 2022.
  - Anchor adjustment in a medium-term budget framework that enhances human and physical capital and accounts for equity considerations.
- Priority: sustainable expenditure retrenchment and improved composition of spending; create room to gradually rationalize the tax system.
- Recommended measures for 2015–20 (menu and fiscal impact in percent of GDP):
  - Total 1/: 4.2
  - Reduction in public sector employment 2/: 0.6
  - Rationalization of spending on non-EU-related goods and services 3/: 1.5
  - Scaled-down public works program and improved ALMPs and targeted transfers: 0.3
  - Reduction of public transport tariff subsidies by 50 percent: 0.2
  - Reduction of operational subsidies to transport enterprises by 50 percent: 0.4
  - Streamlining of VAT rates from 3 to 2: 0.2
  - Elimination of selected CIT exemptions (sports, entertainment): 0.3
  - Elimination of excise exemptions for diesel fuel and tobacco: 0.4
  - Reduction of VAT fraud 4/: 0.9
- Notes:
  - 1/ Total adjustment exceeds recommended net adjustment due to the need to eliminate distortions in the tax system.
  - 2/ Reduce employment (rather than wages) through consolidation of institutions and responsibilities, attrition; and rationalization of local government employment.
  - 3/ Savings largely associated with the proposed public sector consolidation and limiting discretionary spending of the central government.
  - 4/ Assumes implementation of measures focusing on preventing fraud at registration and enhancing detection by mobilizing the AML/CFT framework.
- Authorities’ stance:
  - Reaffirmed commitment to fiscal consolidation; defended public works program and plan to expand it.
  - Disagreed with re-introducing some element of progressivity in the tax system.
  - See scope to improve efficiency of public investment and spending on health and education; would consider reducing corporate income tax and cutting the flat income tax if fiscal space materializes.

### Monetary Policy
- Staff projections and advice:
  - Headline inflation likely to remain below target for an extended period; projected to moderately pick up later in the year as administered price cuts’ effect wanes.
  - The still negative output gap would exert downward pressure on consumer prices, keeping inflation below target throughout 2016.
  - Further cautious monetary easing recommended to guard against persistent disinflationary pressures; readiness to tighten if sharp deterioration in risk perception and capital outflows occur.
  - Effective communication about the future trajectory of the policy rate critical to avoid adverse market reactions.
- Reserves:
  - At about €34½ billion, Hungary’s level of reserves is estimated at slightly below the upper limit of the Fund’s adequacy range.
  - Reserves are projected to fall gradually by 2017 as MNB would provide FX liquidity to help banks close the on-balance sheet open FX position from the conversion of FX mortgages and the Settlement Act.
  - Decline in reserves accompanied by reduction in short-term external debt, keeping reserves comfortably within the adequacy range.
- Authorities’ stance:
  - Intent to maintain accommodative monetary conditions for an extended period; acknowledged weaker-than-expected inflation dynamics.
  - Recent ECB steps and FX mortgage conversion provided greater room for maneuver; further easing would be considered if disinflationary pressures persist.
  - Recent changes in FGS modalities, where MNB assumes part of credit risk, likely to increase its utilization.

### Financial Sector — Conditions and Policy Advice
- Current vulnerabilities and outlook:
  - Banking sector remains under pressure; aggregate capital and liquidity positions are adequate but balance sheets contracting and profitability curtailed.
  - MNB stress tests: in an unfavorable macro scenario nearly one-fifth of the banking system could need substantial capital injections.
  - FX mortgage conversion has significantly reduced private sector exposure to exchange rate risk; will likely improve asset quality and reduce reliance on FX swaps.
- Repairing financial intermediation — staff recommendations:
  - Improve operating environment for banks by removing impediments to portfolio cleanup and reducing the tax burden.
  - Keep FGS limited, targeted, and time bound; consider linking lending rate to policy rate to better support SME lending while compensating banks for credit risk.
  - Remove legal, tax, and regulatory impediments to accelerate portfolio cleanup, including:
    - Streamlining the liquidation process, increasing out-of-court framework use.
    - Provision of tax incentives for write offs.
    - Introduction of a personal insolvency law.
- MARK (Asset Management Company):
  - Would help banks clean portfolios in absence of private demand for distressed commercial real estate loans.
  - Important to keep MARK independent and transparent; objective should be maximizing value of purchased assets with voluntary transfers and consistent valuation criteria.
- State involvement:
  - Staff cautioned against increasing role of the state in the banking system; limit state role given limited fiscal space and contingent liabilities.
  - Authorities optimistic Settlement and Fair Banking Acts, FGS extension, and MARK will boost credit demand and portfolio cleaning; view government role as necessary but transitory.
- Authorities–EBRD memorandum commitments:
  - (i) create a framework for stable and predictable economic policy;
  - (ii) decrease the bank tax to the EU standards by 2019, starting in 2016;
  - (iii) refrain from measures that may negatively impact bank profitability;
  - (iv) transfer direct and indirect majority equity stakes in local banks to the private sector within the next three years.

### Structural Policies and Competitiveness
- Potential growth:
  - Potential growth currently estimated at about 1 percent and projected to increase to around 2 percent over the medium term.
  - Authorities estimate medium-term potential growth at 2½ percent.
- Constraints: difficult business climate, increased state role, demographic headwinds, low productivity, labor market weaknesses, weak SME internationalization.
- Staff reform agenda to raise growth:
  - Improve business climate: increase predictability and transparency; strengthen anti-corruption efforts; reduce regulatory burden; gradually eliminate distortionary sectoral taxes; enhance ease of paying taxes.
  - Enhance competitiveness: move up the value chain; increase export diversification; improve productivity in labor and services markets; strengthen R&D; alleviate SME-internationalization impediments; restructure loss-making transport SOEs.
  - Labor market reforms: strengthen incentives for women to enter the labor market (reform parental benefits, provide affordable child care); phase out the early retirement scheme for women; reduce the gender wage gap; upgrade labor skills and reduce skill mismatches.
- SME internationalization (Box 5) — policy priorities:
  - Develop infrastructure to improve SMEs’ exporting capacity and simplify procedures.
  - Promote innovation and reduce skill mismatches.
  - Foster cooperation between SMEs and large multinationals.
  - Improve SME access to finance: reduce bank tax burden, accelerate portfolio cleanup, develop non-bank financing (venture capital).

### Staff Appraisal — Key Findings and Recommended Strategy
- Current assessment:
  - Hungarian economy growing at a strong pace with reduced vulnerabilities; upturn driven by domestic demand and expansionary macro policies.
- Remaining risks:
  - Vulnerabilities remain elevated: external and public debt levels high; heavy reliance on nonresident financing; large open FX position; subdued medium-term growth prospects.
  - State’s increased role and sectoral taxes weaken business environment and contribute to contingent liabilities.
- Recommended comprehensive strategy:
  - Growth-friendly fiscal consolidation, revival of financial intermediation, and structural reforms to strengthen institutions and policy predictability.
  - Reduce state interference to support private sector-led growth and reduce risk premia.
- Specific priorities:
  - Fiscal: put public debt ratio on a firm downward path; enhance tax and spending efficiency; tackle VAT fraud; improve targeting of social benefits; scale down inefficient programs.
  - Monetary: further cautious easing to guard against disinflationary pressures; maintain adequate international reserves.
  - Financial intermediation: remove impediments to NPL resolution; introduce personal insolvency framework; contain state role in banking; refine FGS modalities to be targeted, time-bound, and SME-focused.
  - Structural reforms: improve business climate, competitiveness, labor participation (women and older workers), SME internationalization, and productivity.

### Risk Assessment Matrix (RAM) — Major Risks and Policy Response
- Global risks (likelihood / impact if realized):
  - Abrupt surge in global financial market volatility — Relative Likelihood: High; Impact if Realized: High.
  - Geo-political fragmentation — Relative Likelihood: Medium; Impact if Realized: Medium.
  - Protracted slower growth in advanced and emerging economies — Relative Likelihood: High; Impact if Realized: Medium.
  - Bond market stress from reassessment in sovereign risk — Relative Likelihood: Low; Impact if Realized: High.
- Domestic risks:
  - Unconventional policies — Relative Likelihood: Medium; Impact if Realized: High.
  - No fiscal consolidation and slippages in structural reforms — Relative Likelihood: Medium; Impact if Realized: Medium.
- Policy response to sharp deterioration and large capital outflows:
  - Tighten the monetary stance.
  - Use FX intervention to smooth excessive exchange rate volatility.
  - Adopt a growth-friendly fiscal adjustment.
  - Increase policy predictability.
  - Accelerate structural reforms while limiting government interference.
- RAM likelihood definitions:
  - "Low" indicates a probability below 10 percent.
  - "Medium" indicates a probability between 10 and 30 percent.
  - "High" indicates a probability of 30 percent or more.

### Appendix I — Recent Legislation Affecting Household Debt
- Settlement Act (adopted September 2014):
  - Scope: applies to all loans disbursed after May 1, 2004 and not terminated before July 26, 2009; compensation deadline is end-March 2015.
  - MNB impact estimate: HUF900–1000 billion (3–3¼ percent of GDP); of which HUF800 billion will be incurred by banks and non-resident credit institutions.
  - Distributional impact: 16 percent decline, on average, in the indebtedness of FX mortgage borrowers; together with the Fair Banking Act, monthly installments of FX mortgages would decline by 20–25 percent.
- Fair Banking Act (adopted November 2014):
  - Restricts unilateral interest rate and cost hikes by banks; regulates borrower information; allows borrowers to terminate a loan under certain conditions.
  - Interest rate rules: changes only in line with the reference rate for floating-rate loans with less than three-year maturity; for longer maturity loans, hikes allowed in reference rate and interest rate margin; margin hikes must be fixed at least three years in advance.
- FX mortgage conversion (early November 2014 agreement):
  - MNB allocated about € 9 billion to banks to help close open FX positions via euro sale instruments at the spot exchange rate at the day of the agreement (November 7).
  - Amount provided gradually over 2015–17 according to maturity of banks’ foreign liabilities.
  - On conversion, households could transfer their HUF mortgage to another bank; new loans pegged to the 3-month interbank rate with margins not exceeding original FX loans.

### Appendix II — Debt Sustainability Analysis (selected numeric findings)
- Baseline public debt projections and assumptions:
  - Public debt projected to diminish only marginally, to about 72percent of GDP over the medium term under current policies.
  - Baseline underpinnings: net lending/borrowing around 2½percent of GDP; medium-term output growth about 2 percent; interest rates on sovereign bonds and loans gradually increasing in line with global WEO assumptions.
- Selected public debt trajectory (nominal gross public debt):
  - 2013: 71.2
  - 2014: 77.3
  - 2015: 76.9
  - 2016: 75.5
  - 2017: 74.7
  - 2018: 73.9
  - 2019: 73.2
  - 2020: 72.4
  - Projection horizon: 71.8
- Public gross financing needs (percent of GDP):
  - 2013: 18.4
  - 2014: 19.4
  - 2015: 22.1
  - 2016: 21.4
  - 2017: 16.2
  - 2018: 21.1
  - 2019: 22.4
  - 2020: 22.7
  - Later projection: 23.3
- Key macro assumptions (selected):
  - Real GDP growth (percent): 1.6 (2013), 1.5 (2014), 3.6 (2015), 2.7 (2016), 2.3 (2017), 2.2 (2018), 2.1 (2019), 2.1 (2020), 2.1 (long-run).
  - Inflation (GDP deflator, percent): 4.3 (2013), 3.0 (2014), 3.1 (2015), 2.7 (2016–2020).
  - Nominal GDP growth (percent): 6.0 (2013), 4.5 (2014), 6.8 (2015), 5.5 (2016), 5.1 (2017), 5.0 (2018), 4.9 (2019–2020).
  - Effective interest rate (percent): 6.4 (2013), 6.1 (2014), 5.7 (2015), 4.5 (2016–2018), 4.6 (2019), 5.0 (2020), 5.1 (later).
- Probabilistic analysis:
  - Public debt could enter an increasing trajectory with a probability of 50 percent based on historical volatility.
  - If policy rigidities prevent improving the primary balance by more than 2 percent of GDP in a single year, probability of an increasing debt trajectory rises to approximately 60 percent.
- External debt dynamics:
  - Gross external debt declined from about 150 percent of GDP in 2009 to 116 percent by end-2014.
  - Baseline external debt (percent of GDP): 149.1 (2009), 143.6 (2010), 134.8 (2011), 128.9 (2012), 118.6 (2013), 115.8 (2014), 106.5 (2015), 89.8 (2016), 80.2 (2017), 73.6 (2018), 67.9 (2019), 63.5 (2020).
  - A one-time real depreciation of 30 percent would add 15 percentage points of GDP to external debt.
  - An adverse permanent growth or current account shock of ½ standard deviation would add about 8 to 15 percentage points of GDP to external debt, respectively.
- Market perception indicators:
  - EMBIG (bp) average over last 3 months (19-Nov-14 through 19-Feb-15): 180.
  - 5Y CDS (bp): 135.
  - Public debt held by non-residents: around 35 percent (text reference).
  - Gross financing needs upper warning benchmark: 15 percent of GDP; Hungary’s gross financing needs hover above 20 percent of GDP under baseline.

### Debt Composition and Financing Strategy (excerpted)
- Public debt reached 76.9 percent by the end of 2014, notwithstanding a weaker exchange rate.
- Financing strategy shifted debt composition toward a more healthy structure, with a declining share of FX-denominated securities.
- Central bank self-financing scheme shifted incentive of holding government securities from foreign banks to domestic banks, aiding decline of nonresident holdings.
- First and second phases of FGS provided financing amounting to about HUF 1325 billion (over 4 percent of GDP), predominantly new investment loans to more than twenty-thousand SMEs.
- FGS+ launched in March with MNB assuming 50 percent of credit risk for eligible loans, limited to up to a five-year period and capped at a maximum of 2.5 percent of the outstanding FGS+ loan stock of the individual credit institution.
- MARK expected to begin operations in the second half of 2015.
- MNB cut policy rate by 15 basis points to 1.95 percent in its March meeting.
- Authorities plan early adoption of the 2016 budget and a new Tax Code under preparation.
- Authorities commit to substantially lower the bank levy starting from 2016 and to keep public work programs in operation to integrate inactive groups into the active labor force.

*IMF staff report excerpt from the source document _cr1592.*

### 1. Response to Past Fund Policy Advice __________________________________________________________ 17

### 1. Response to Past Fund Policy Advice

### Context and Recent Developments
- Expansionary macroeconomic policies contributed to strong output growth in 2014; real GDP is about to reach its pre-crisis level.
- Vulnerabilities have declined, but debt levels remain elevated and financing needs pose significant risks given heavy reliance on non-resident funding and a large concentration of the investor base.
- The role of the state in the economy has been increasing, including acquisition of energy companies and foreign bank subsidiaries, increased sectoral taxes, expanded public works, administered utility price cuts, and the Settlement Act requiring bank compensation to borrowers (Appendix I).
- Output expanded by 3½ percent in 2014 driven by strong domestic demand, higher investment from increased utilization of EU funds, and a boost to consumption from utility price cuts; net exports’ contribution was largely driven by rapid import growth.
- Headline and core inflation decelerated sharply to -1 and 1 percent, respectively, in February; inflation expectations fell to 2.2 percent (below the MNB’s 3 percent target).
- Unemployment rate was 7.2 percent in 2014:Q4; private sector nominal wage growth moderated to about 3½ percent in 2014:Q4; labor participation rose by 2 percentage points to 67 percent.
- Preliminary 2014 fiscal deficit estimated at 2.6 percent of GDP against a 2.9 percent target; fiscal impulse estimated at 1⅓ percent of GDP; public debt-to-GDP ratio declined moderately to just below 77 percent.
- MNB policy rate held at a record low 2.1 percent since July 2014; forward rate agreements price a 30 bps policy rate cut in the next 12 months. MNB doubled the second phase allocation of the Funding for Growth Scheme (FGS) to the equivalent of 3¼ percent of GDP and extended the program to end-2015.
- Private sector credit contraction continues; loan-to-deposit ratio dropped to 95 percent. NPL ratio at 16 percent. MNB set up Asset Management Company (MARK) to buy up to the equivalent of 1.3 percent of GDP in distressed commercial real estate loans. State continued acquisitions in the banking sector (MKB acquired in 2014; purchase of Budapest Bank near finalization; announced acquisition of a 15 percent stake in Erste’s subsidiary).
- External indicators: external debt fell to 116 percent of GDP in 2014; gross external financing needs of 21 percent of GDP in 2015; about 30 percent of GDP open FX position on private balance sheets; international investment position of -76 percent of GDP. Conversion of FX mortgage stock (25 percent of household loans, almost all in Swiss francs) to local currency loans will reduce bank foreign liabilities and lower official reserves (Appendix I).
- Real exchange rate broadly in line with fundamentals, but non-price indicators point to competitiveness challenges: stagnating export market share relative to peers, low share of products in top-quality quartile, skill mismatches, deteriorating foreign investment environment, and slipping global competitiveness ranking due to institutional framework and transparency issues.

### Outlook and Risks
- Staff projects growth to decelerate to 2¾ percent in 2015 due to smaller domestic-demand impetus from a less supportive fiscal stance and lower investment growth given projected decline in EU funds.
- Private consumption expected to continue growing supported by lower household indebtedness, accommodative monetary conditions, and higher employment.
- Medium-term output growth projected to stabilize at around 2 percent.
- Improved terms-of-trade (notably lower oil prices) forecast to increase the current account surplus in the short run; continued cross-border deleveraging expected to further improve the IIP. Over the medium term, the current account surplus expected to gradually decline due to slowing deleveraging and aging population dynamics.
- Headline inflation projected to remain very low in coming months; inflation expected to gradually return to target provided monetary policy anchors expectations.
- Balance of risks tilted somewhat to the downside: abrupt change in risk perception (sovereign stress in Europe), geopolitical tensions, emerging market financial stress, protracted weak external demand from euro area, and domestic state interference eroding competitiveness and provoking cross-border deleveraging are key downside risks.
- Upside risks include the Settlement Act and sustained lower oil prices boosting purchasing power and investment, and government measures to improve banks’ operating environment accelerating repair of financial intermediation and credit growth.
- Authorities broadly agreed on near-term outlook and risks but were more optimistic on medium-term growth; they consider capital outflow risk low due to higher share of institutional investors and shift to domestic financing, and view balance sheet exchange rate vulnerability as significantly reduced after FX mortgage conversion.

### Policy Discussions — Fiscal Policy
- Staff view: current strategy insufficient to reduce public debt significantly over the medium term.
- 2015 budget implies a broadly neutral fiscal stance; staff projects the 2015 deficit at 2.7 percent of GDP versus a budget target of 2.4 percent, citing sizeable unidentified revenue sources and less optimistic expenditure restraint and tax administration gains.
- Expenditure-to-GDP ratio expected to remain high; large allocations to discretionary programs compromise spending quality; inefficiencies significant, particularly in the health sector (Box 3). Budget continues to rely on sectoral taxes.
- Staff projects public debt ratio to decline only modestly under current policies; authorities’ medium-term fiscal target of 1.7 percent of GDP structural deficit judged by staff as not ambitious and not backed by well-specified policies. Under staff’s baseline, deficit would hover around 2½ percent of GDP and public debt around 72 percent.
- Staff recommended a growth-friendly fiscal consolidation: a moderate annual structural fiscal tightening by about ½ percent of potential GDP starting in 2015, consistent with reducing public debt to below 60 percent of GDP by 2022; the adjustment to be anchored in a medium-term budget framework that enhances human and physical capital and accounts for equity considerations.
- Priority: sustainable expenditure retrenchment and improved composition of spending (expenditure close to 50 percent of GDP), creating room to gradually rationalize the tax system.
- Recommended menu of measures for 2015–20 includes:
  - Enhance efficiency and progressivity of tax system by reducing exemptions and gradually eliminating distortionary sectoral taxes; streamline financial taxation to restore financial intermediation and credit growth.
  - Tackle VAT fraud through a comprehensive approach focusing on preventing fraud at registration and enhancing detection by mobilizing the AML/CFT framework.
  - Reform social welfare toward targeted, conditional transfers linked to revamped active labor market policies emphasizing individualized skills-training and job-search assistance.
  - Scale down costly and inefficient programs such as the public works program; reduce public sector employment as envisaged; improve spending efficiency in education and health.
- Authorities reaffirmed commitment to fiscal consolidation, agreed in principle on weaknesses of the 2015 budget (e.g., unidentified revenue sources), and saw scope to improve efficiency of public investment and spending on health and education. They project a substantial medium-term deficit reduction based on past social transfer adjustments and discretionary spending freezes and would consider reducing corporate income tax and cutting the flat income tax should fiscal space materialize.

*IMF staff summary of "1. Response to Past Fund Policy Advice" (from the source content provided).*

### 17.      Differences in views centered on the efficiency and desirability of select fiscal policy

### 17.      Differences in views centered on the efficiency and desirability of select fiscal policy instruments

### Fiscal impact of potential measures (2015-2020)
- Total 1/: 4.2 (in percent of GDP)
- Reduction in public sector employment 2/: 0.6
- Rationalization of spending on non-EU-related goods and services 3/: 1.5
- Scaled-down public works program and improved ALMPs and targeted transfers: 0.3
- Reduction of public transport tariff subsidies by 50 percent: 0.2
- Reduction of operational subsidies to transport enterprises by 50 percent: 0.4
- Streamlining of VAT rates from 3 to 2: 0.2
- Elimination of selected CIT exemptions (sports, entertainment): 0.3
- Elimination of excise exemptions for diesel fuel and tobacco: 0.4
- Reduction of VAT fraud 4/: 0.9

Notes from source table:
- 1/ Total adjustment exceeds recommended net adjustment due to the need to eliminate distortions in the tax system.
- 2/ Reduce employment (rather than wages) through consolidation of institutions and responsibilities, attrition; and rationalization of local government employment.
- 3/ Savings largely associated with the proposed public sector consolidation and limiting discretionary spending of the central government.
- 4/ Assumes implementation of measures, which focus on preventing fraud by identifying fraudulent companies at the registration stage and enhancing detection by further mobilizing the AML/CFT framework.
- Sources: IMF staff estimates, based on data provided by the authorities, and FAD and LEG TA reports.

### Fiscal policy discussion and authorities' stance
- Authorities strongly defended the public works program and plan to expand and include all able-bodied welfare recipients, despite:
  - recovery of private employment; and
  - scheme’s uncertain benefits with regard to helping participants re-enter the primary job market.
- Authorities disagreed with re-introducing some element of progressivity in the tax system (to counter rising inequality and create fiscal space).
- Authorities saw a need to improve the targeting of the Job Protection Act.

### Monetary Policy
- Staff projections:
  - Headline inflation likely to remain below target for an extended period.
  - Inflation projected to moderately pick up later in the year as the effect of last year’s administered price cuts wanes and the effect of oil price declines peters out.
  - The still negative output gap would exert downward pressure on consumer prices, keeping inflation below target throughout 2016.
  - Weakness in the external environment and oil price dynamics pose downside risks to inflation, particularly if they continue to feed into inflation expectations.
- Policy recommendations and risks:
  - Further cautious monetary easing would help guard against persistent disinflationary pressures.
  - With policy rate at a record-low level and increased utilization of the FGS, monetary policy has been supportive, though with inflation falling, the real policy rate has increased.
  - Scope for further easing exists, given improved resilience of household balance sheets to exchange rate risk and potential pressure for capital inflows from easing in the euro area.
  - Recommended fiscal policy stance would provide further scope for monetary easing.
  - A sharp deterioration in risk perception and capital outflows (perhaps triggered by a sudden jump of the term premium on U.S. long-term interest rates) would require monetary tightening to preserve financial stability.
  - Effective communication about the future trajectory of the policy rate would be critical to avoid adverse market reactions.
- Reserves:
  - At about €34½ billion, Hungary’s level of reserves is estimated at slightly below the upper limit of the Fund’s adequacy range.
  - Reserves are projected to fall gradually by 2017 as MNB would provide FX liquidity to help banks close the on-balance sheet open FX position from the conversion of FX mortgages and the Settlement Act.
  - The envisaged decline in reserves will be accompanied by a reduction in short-term external debt, keeping reserves comfortably within the adequacy range.
  - Staff underscored the importance of maintaining adequate reserves for safeguarding financial stability.
- Authorities’ stance:
  - Intent to maintain accommodative monetary conditions for an extended period.
  - Acknowledged inflation dynamics were weaker-than-expected, reflecting low imported inflation.
  - Noted recent ECB steps and FX mortgage conversion provided greater room for maneuver; further monetary easing would be considered if disinflationary pressures persist.
  - Recent changes in FGS modalities, where MNB assumes part of credit risk, likely to increase its utilization.
  - Reiterated commitment to maintain sufficient reserves as a buffer against shocks.

### Financial Sector
- Current conditions and vulnerabilities:
  - Banking sector remains under pressure, though vulnerability to exchange rate risk has declined.
  - Banks face contraction in balance sheets; aggregate capital and liquidity positions are adequate.
  - MNB stress tests suggest that in an unfavorable macroeconomic scenario nearly one-fifth of the banking system could need substantial capital injections.
  - FX mortgage conversion has significantly reduced private sector’s exposure to exchange rate risk, will likely improve asset quality, and reduce reliance on FX swaps.
- Repairing financial intermediation:
  - With strained balance sheets, banks’ willingness to lend is projected to remain limited.
  - Staff called for improving the operating environment for banks by removing impediments to portfolio cleanup and reducing the tax burden.
  - Staff welcomes government’s commitment to gradually reduce the bank levy and to refrain from steps that could harm bank profitability.
  - FGS has improved SME access to finance; scope exists to modify the scheme to better support monetary transmission and enhance impact on growth, possibly by linking the lending rate to the policy rate in a manner that adequately compensates banks for lending to riskier SMEs.
  - Staff called to keep the FGS limited, targeted, and time bound.
- Nonperforming loans (NPLs) and cleanup:
  - Absent efforts to accelerate cleanup, NPLs are projected to remain elevated for a protracted period, undermining lending activity.
  - Staff recommended removing legal, tax, and regulatory impediments to accelerate portfolio cleanup and refocus banks on core business, including:
    - Streamlining the liquidation process, including increased out-of-court framework use.
    - Provision of tax incentives for write offs.
    - Introduction of a personal insolvency law.
  - MARK (Asset Management Company):
    - Establishment of the MARK would help banks clean portfolios in absence of private demand for distressed commercial real estate loans.
    - Important to keep MARK’s operations fully independent and transparent to avoid potential conflict with MNB’s price and stability objectives.
    - MARK should be given an exclusive objective of maximizing the value of purchased assets while ensuring transfers are voluntary and based on a clear and consistent set of valuation criteria (per MCM technical assistance recommendations).
- State involvement in banking:
  - Recent measures likely to improve private sector balance sheets and could re-invigorate credit growth.
  - Staff cautioned against an increasing role of the state in the banking system.
  - Announcements favoring consolidation and state purchases of banks increased uncertainty, despite government’s stated intention to divest stakes within three years.
  - Staff stressed lending should be based on adequate risk-management and recommended limiting the state’s role, given limited fiscal space and no room to build up further contingent liabilities.
- Regulatory and supervisory framework:
  - Integration of the Hungarian Financial Supervisory Authority into the MNB in 2013 equipped it with micro-prudential instruments and reinforced macro-prudential tool kit.
  - Staff welcomed authorities’ commitment to strengthen the framework, including adoption of a new macro-prudential regulation introducing more stringent LTV and PTI ratios, especially for FX loans, to prevent excessive household indebtedness.
- Authorities’ view:
  - Optimistic that Settlement and Fair Banking Acts will boost households’ demand for credit and that extension of the FGS will continue to support SME lending.
  - Working with the EBRD to identify ways to expedite NPL resolution; believe MARK will induce more dynamic portfolio cleaning.
  - Stress that consolidation in the banking sector is warranted to foster competition and improve efficiency through economies of scale.
  - View government’s increased role as necessary but transitory to facilitate consolidation and restructuring.

### Structural Policies
- Growth potential and constraints:
  - Potential growth currently estimated at about 1 percent and projected to increase to around 2 percent over the medium term as investment increases.
  - These rates are below Hungary’s regional peers, suggesting slow convergence.
  - Constraints include difficult business climate, state’s increased role in the economy, demographic headwinds, low productivity, and labor market weaknesses (notably low labor participation among women and older workers).
  - Weak SME performance, partly reflecting low internationalization, weighs on growth.
- Staff recommendations for an ambitious structural reform agenda:
  - Improving the business climate:
    - Increase policy predictability and transparency.
    - Strengthen anti-corruption efforts.
    - Reduce regulatory burden.
    - Gradually eliminate distortionary sectoral taxes.
    - Enhance ease of paying taxes.
    - Staff cautioned against government’s interventionist strategy that could weigh on private investment and growth.
  - Enhancing competitiveness:
    - Move up the value chain.
    - Increase export diversification.
    - Improve productivity in labor and services markets.
    - Strengthen R&D.
    - Alleviate SME-internationalization impediments.
    - Restructure loss-making transport SOEs.
  - Addressing structural weaknesses in the labor market:
    - Strengthen incentives for women to enter the labor market, including by reforming parental benefits.
    - Re-shuffle spending on family benefits to also provide affordable child care.
    - Phase out the early retirement scheme for women.
    - Reduce the gender wage gap.
    - Upgrade labor skills and reduce skill mismatches, including by strengthening the training component of active labor market programs.
- Authorities’ outlook:
  - Optimistic: assessed medium-term potential growth at 2½ percent, owing to higher investment (increased EU fund utilization), more favorable financing conditions for SMEs, and increased labor participation from ongoing labor market reforms.
  - See scope for moving up the value chain via innovation and better integrating SMEs into supply chains.
  - Ongoing efforts to diversify export destinations and increased automobile industry production capacity expected to boost export performance.
  - Agreed on the need to improve level and predictability of taxation, insolvency procedures, and access to finance.
  - Energy strategy (creation of a state-owned utility company and acquisition of energy companies) aimed at securing and diversifying energy supply to enhance competitiveness.

### Staff Appraisal — key findings and recommendations
- Current assessment:
  - Hungarian economy growing at a strong pace with a welcome reduction in vulnerabilities; upturn driven by pickup in domestic demand on the back of expansionary macroeconomic policies.
  - Vulnerabilities declined due to large and persistent current account surpluses, recent policy measures, and improved market sentiment.
- Remaining risks:
  - Vulnerabilities remain elevated; external and public debt levels high.
  - Associated financing needs, heavy reliance on nonresident financing, large concentration of investor base, and large open FX position continue to pose risks.
  - Subdued medium-term growth prospects exacerbate vulnerabilities.
  - State’s increased role in the economy and sectoral taxes weaken the business environment; state acquisitions in banking and energy contribute to buildup of contingent liabilities.
- Recommended comprehensive strategy:
  - Emphasis on growth-friendly fiscal consolidation, revival of financial intermediation, and reforms addressing structural impediments, strengthening institutions, and increasing policy predictability.
  - Reduced state interference to support strong, private sector-led growth and further reduction in risk premia.
- Fiscal priorities:
  - Put the public debt ratio firmly on a downward path while supporting growth.
  - More ambitious efforts needed to significantly reduce high public debt ratio.
  - Strategy should include growth-friendly fiscal reforms: enhance efficiency of the tax system and public spending, tackle VAT fraud, improve targeting of social benefits, and scale down inefficient programs.
  - These reforms can enhance human and physical capital.
- Monetary priorities:
  - Further cautious monetary policy easing to guard against disinflationary pressures, with readiness to tighten if external conditions deteriorate sharply.
  - Maintain adequate international reserves to mitigate exchange rate volatility and support financial stability.
- Financial intermediation priorities:
  - Repair financial intermediation by removing impediments to portfolio cleanup, reducing tax burden, and enhancing policy predictability.
  - Remove regulatory, legal, and tax impediments to NPL resolution; mitigate potential institutional and operational risks associated with the Asset Management Company.
  - Promptly introduce a personal insolvency framework.
  - Contain the role of the state in the banking sector.
  - Refine the FGS modalities to enhance impact while avoiding risk to the central bank; keep the scheme targeted, time-bound, and limited to SMEs.
- Structural reform priorities:
  - Ambitious reforms to improve business climate, enhance competitiveness, and reform the labor market are essential for higher investment and private sector-led growth.
  - Priorities include promoting entrepreneurship and innovation, reducing regulatory and tax burden, alleviating impediments to SME internationalization, boosting productivity in services, increasing labor participation (particularly women and older workers), and mitigating skill mismatches.

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

### 38.      It is recommended to hold the next Article IV consultation on the standard 12-month

### It is recommended to hold the next Article IV consultation on the standard 12-month cycle.

### Risk Assessment Matrix (RAM) — Major Risks and Policy Response
- Global risks (sources, relative likelihood, and impact if realized):
  - An abrupt surge in global financial market volatility
    - Relative Likelihood: High
    - Impact if Realized: High
    - Impact details: Nonresident sell-off of HUF securities and deposit withdrawals; reversal would sharply raise borrowing costs, put pressure on reserves, and depreciation would impair banks’ balance sheets given large foreign currency risk exposures.
  - Geo-political fragmentation that erodes the globalization process and fosters inefficiency
    - Relative Likelihood: Medium
    - Impact if Realized: Medium
    - Impact details: Sharp increase in tensions surrounding Russia/Ukraine may lead to re-pricing of risks and spillovers through trade, financial and confidence channels; a shift in risk perception would increase borrowing costs, lower external demand, and put pressure on reserves; disruption of gas supply and increase in gas prices would adversely affect production.
  - Protracted period of slower growth in advanced and emerging economies
    - Relative Likelihood: High
    - Impact if Realized: Medium
    - Impact details: External demand would wane, weighing on Hungary’s growth; weaker export growth would weigh on the recovery and perpetuate macroeconomic vulnerabilities.
  - Bond market stress from reassessment in sovereign risk
    - Relative Likelihood: Low
    - Impact if Realized: High
    - Impact details: Sovereign stress re-emerges due to incomplete delivery of policy commitments at the national or euro area level; through strong trade and financial ties with Europe, could lead to sharp reversal of capital flows, credit crunch, economic slowdown, and financing pressures.

- Domestic risks:
  - Unconventional policies
    - Relative Likelihood: Medium
    - Impact if Realized: High
    - Impact details: Unconventional fiscal policies and weakening institutions would undermine policy credibility, erode confidence, limit availability of financing, foster sharper cross-border deleveraging, lower FDI flows, contract credit and investment, and put pressure on reserves.
  - No fiscal consolidation, and slippages in structural reforms
    - Relative Likelihood: Medium
    - Impact if Realized: Medium
    - Impact details: Delay in fiscal and structural reforms would raise borrowing costs, worsen debt dynamics, put reserves under pressure, erode competitiveness, and worsen Hungary’s economic prospects.

- Policy response (recommended if sharp deterioration in risk perception and large capital outflows occur):
  - Tighten the monetary stance.
  - Use FX intervention to smooth excessive exchange rate volatility.
  - Adopt a growth-friendly fiscal adjustment.
  - Increase policy predictability.
  - Accelerate structural reforms while limiting government interference in the economy.

- RAM footnote on likelihood definitions:
  - "Low" indicates a probability below 10 percent.
  - "Medium" indicates a probability between 10 and 30 percent.
  - "High" indicates a probability of 30 percent or more.

### Response to Past Fund Policy Advice — Assessment of Implemented Policies
- Key recommendation: Implement a durable, growth-friendly fiscal adjustment to sustainably reduce the public debt-to-GDP ratio.
  - Outcome: The 2014 fiscal deficit came in below target, but budget composition remains a concern with increased scope of sectoral taxes and allocations to discretionary programs. The public debt ratio remained unchanged.
- Key recommendation: Reduce external vulnerabilities.
  - Outcome: FX mortgage conversion significantly reduced household exposure to exchange rate risk. Steps taken to reduce reliance on FX-denominated public debt.
- Key recommendation: Improve the operating environment for banks, reduce tax burden, facilitate balance sheet cleanup, and improve effectiveness of the FGS.
  - Outcome: Bank portfolio cleaning remains sluggish and the tax burden on banks is high. An asset management company was set up to facilitate cleanup. The FGS was extended to end-2015 and expanded to include riskier companies with the MNB assuming half of the credit risk. Government recently announced commitment to gradually reduce bank taxes.
- Key recommendation: Address labor market weaknesses, promote competition, restructure loss-making SOEs, and improve business climate by limiting the state's role.
  - Outcome: Flexible child-care benefits and compulsory early childhood education were introduced to boost female labor participation. The role of the state in the economy increased (including acquisitions of banks and energy companies), while reforms in other areas were largely stalled.

### External Sustainability and Competitiveness — Staff Assessment and Findings
- Staff view: The real exchange rate is broadly in line with medium-term fundamentals.
- EBA (External Balance Assessment) results are mixed for Hungary:
  - REER (Real Effective Exchange Rate) approach: indicates an overvaluation of the exchange rate by 15 percent.
  - External Sustainability approach: finds the REER undervalued by 12 percent.
  - Current Account Balance approach: suggests Hungary’s REER appears undervalued.
  - Staff caveat: The current-account norm should be adjusted upward to reflect the need for elevated savings to reduce Hungary’s still-large external liabilities.
- Other indicators:
  - Unit labor costs do not point to price pressure on exchange rates.
  - Non-price factors have undermined competitiveness: Hungary’s export market share has stagnated since 2008 compared to peers, reflecting sharp moderation in export growth from pre-crisis rates.
  - Competitiveness rankings: Hungary’s ranking in the Global Competitiveness Report slipped by 12 places in the past 3 years with institutional framework dragging overall competitiveness.
- FDI and medium-term prospects:
  - Low levels of foreign direct investment may detract from medium-term growth.
  - Medium-term FDI inflows are projected to remain significantly below their historical average while Hungary’s incremental capital-output ratio is relatively favorable.
  - Staff analysis: Gains from the EU single market going forward depend on reversing the deteriorating foreign investment environment and addressing structural bottlenecks.
- Policy implications to boost exports and competitiveness:
  - Improve export quality and diversify products and markets.
  - Focus on increasing innovation, enhancing vocational training and post-graduate education, scientific research, effective cooperation between science and industry, and R&D.

- Specific numeric and comparative points preserved from staff analysis:
  - EBA REER overvaluation: 15 percent.
  - EBA External Sustainability undervaluation: 12 percent.

### Efficiency of Public Spending on Health and Education — Findings and Potential Gains
- Overall observation:
  - Hungary’s public spending on health and education is not high by international standards and related outcomes lag behind.
  - Public spending on health: 5 percent (2012) of GDP.
  - Public spending on education: 4½ percent (2011) of GDP.
  - Outcomes: Life expectancy and infant mortality remain below the OECD average despite improvement; PISA performance is low compared to the OECD average and has deteriorated recently.
- Health sector efficiency:
  - Data envelopment analysis efficiency score: 0.45 (frontier = 1).
  - OECD average efficiency score: 0.57.
  - Average OECD efficiency for countries with similar per capita public spending on health: 0.68.
  - Potential efficiency gains in health if Hungary operated at frontier OECD efficiency: up to 2¾ percentage points of GDP over the medium-term.
  - Potential gains if Hungary matched average OECD or average OECD with similar per capita spending: range between 2/3–1¼ percentage points of GDP.
  - Potential savings could be channeled to improving health outcomes.
- Education sector efficiency:
  - Hungary’s efficiency score: 0.90.
  - OECD average efficiency score: 0.61.
  - Average for countries with similar per student spending on primary and secondary education: 0.79.
  - Potential gains if Hungary operated at frontier OECD efficiency: up to ⅓ percentage point of GDP over the medium-term while achieving the same education outcomes.
  - After closing efficiency gaps, consideration could be given to increasing spending to further enhance outcomes and strengthen access for disadvantaged groups.
- Additional numeric outcome:
  - First-time graduation rate at upper secondary school: 94 percent in 2012 (OECD average: 84 percent).

### Gender Gaps in the Labor Market — Constraints and Potential Gains
- Current participation and trends:
  - Female labor market participation (FLMP) is very low relative to EU and OECD averages and lags regional peers.
  - Employment of mothers with children under 2: 10 percent in 2008 (the lowest in the OECD).
  - Aggregate female labor force participation rate (FLFPR) increased by 2.8 pp during 2008-13 to 50.6 percent in 2013.
- Long-term demographic challenge:
  - Hungary’s labor force projected to shrink by around 10 percent by 2030 given current trends.
  - OECD estimate: full convergence in participation rates by 2030 can increase annual per capita growth rates in Hungary by 0.6 percent, on average.
- Factors depressing FLMP:
  - Parental leave policies and cultural pressures favor mothers staying at home.
  - Shortage of affordable child care options.
  - Limited availability of long-term care forces older women to care for elderly relatives.
  - A new early retirement program for women was established in 2011, counteracting participation incentives.
  - Growing wage gap between men and women; tax policies raise marginal tax rates for second earners.
- Impact of activation policies (2008–13):
  - Increase in participation primarily among women with primary education or less.
  - Decrease in participation among women with tertiary education when controlling for compositional effects, calling into question efficacy of activation policies aimed at higher income groups (including tax incentives and flexible parental leave efforts).

*IMF staff summary as presented in the chapter.*

### Box 5. Internationalization of Small and Medium Sized Enterprises (SMEs)

### Box 5. Internationalization of Small and Medium Sized Enterprises (SMEs)

### Role and recent performance
- SMEs remain an important driver for Hungary’s economic activity and employment creation.
- Since the outset of the crisis, SME performance has been particularly weak and below that of the EU average, reflecting limited access to credit for riskier SMEs, sharp deleveraging, and a deteriorating business environment.
- The low level of Hungarian SME internationalization, which is below the EU average, together with the collapse of domestic demand in 2009 and the weak recovery thereafter also played an important role.

### Evidence on internationalization
- The EC’s 2014 Small Business Factsheet shows that apart from the cost required to export/import, Hungary scores well below the EU’s average in all internationalization criteria.
- The share of SMEs exporting and importing outside the EU is significantly below the EU average, and the bureaucracy—the time and number of documents required to export/import—is poorer than the EU average.
- Staff analysis finds a positive correlation between an increase in SMEs’ export-to-operating revenue ratio and growth of revenue and employment, suggesting greater internationalization may generate positive spillovers through technology and knowledge transfer, and ultimately productivity and competitiveness gains.

### Determinants and correlates of SME internationalization
- Larger firms with high share of fixed tangible assets are more likely to increase internationalization.
- Higher labor productivity, more favorable liquidity position, and higher leverage are associated with higher internationalization, though the positive effect of the leverage ratio disappears when its level is “excessive”.

### Policy recommendations to alleviate barriers
- Develop stronger infrastructure to improve SMEs’ exporting capacity, including by simplifying pertinent procedures, and help SMEs obtain greater information about foreign markets.
- Promote innovation and reduce skill mismatches to enhance factor productivity and facilitate faster penetration to foreign markets.
- Foster higher degree of cooperation between SMEs and large multi-national companies to facilitate positive spillovers through knowledge and technology transfer.
- Improve SME access to finance by repairing financial intermediation:
  - Create a better operating environment for banks through a reduction in their tax burden and accelerated portfolio cleanup.
  - Develop an infrastructure for non-bank financing, including by increasing the availability of venture capital.

*Source: IMF staff summary of "Box 5. Internationalization of Small and Medium Sized Enterprises (SMEs)".*

### Appendix I. Recent Legislation Affecting Household Debt

### Appendix I. Recent Legislation Affecting Household Debt

### Settlement Act (adopted September 2014)
- Scope and timing:
  - Applies to all loans disbursed after May 1, 2004 and not terminated before July 26, 2009.
  - Compensation deadline is end-March 2015.
- MNB impact estimate:
  - HUF900–1000 billion (3–3¼ percent of GDP).
  - Of which HUF800 billion will be incurred by banks and non-resident credit institutions.
  - Net effect on banks will be somewhat smaller because of previous loan-loss provisioning.
- Compensation mechanics:
  - Compensation will take the form of a principal reduction of ongoing contracts, and a cash transfer to borrowers with expired contracts.
- Distributional/borrower impact:
  - The Settlement Act would result in a 16 percent decline, on average, in the indebtedness of FX mortgage borrowers.
  - Together with the Fair Banking Act, monthly installments of FX mortgages would decline by 20–25 percent.

### Fair Banking Act (adopted November 2014)
- Key provisions:
  - Restricts unilateral interest rate and cost hikes by banks.
  - Regulates the information provided to borrowers.
  - Allows borrowers to terminate a loan contract under certain conditions.
- Interest rate rules:
  - The interest rate could change only in line with the reference rate, without any change in the interest margin for loans based on a floating rate with less than three-year maturity.
  - For loans with longer maturity, the Act allows hikes both in the reference rate and the interest rate margin.
  - Banks will need to fix the margin hike at least three years in advance.

### FX mortgage conversion (early November 2014 agreement)
- Purpose:
  - Fast and orderly conversion of FX mortgage loans to local currency to reduce household balance sheet exposure to exchange rate risk.
- MNB support and mechanics:
  - To avoid strong pressure on the exchange rate, the MNB used its reserves to allocate to the banks about € 9 billion to help them close their open FX position that emerged from the conversion through euro sale instruments at the spot exchange rate at day of the agreement (November 7).
  - The scheme is designed so it does not jeopardize the MNB’s reserve adequacy given that the amount of foreign currency made available will reduce short-term external debt and consequently the MNB’s foreign exchange reserve needs.
  - The amount will be provided gradually over 2015–17 according to maturity of banks’ foreign liabilities.
- Borrower options and loan terms after conversion:
  - On conversion, households had the option to transfer their HUF mortgage to another bank.
  - The new loans were pegged to the 3-month interbank rate, with interest rate margins not exceeding those in the original FX loans.

*Appendix I. Recent Legislation Affecting Household Debt — INTERNATIONAL MONETARY FUND*

### Appendix II. Hungary: Debt Sustainability Analysis

### Appendix II. Hungary: Debt Sustainability Analysis

### Overview and key vulnerabilities
- Hungary’s high public and external debt and financing needs, together with heavy reliance on non-resident funding, remain important sources of vulnerability.
- Under the baseline scenario:
  - Public debt is projected to remain at around 72percent of GDP.
  - Gross financing needs are forecast to hover above 20 percent of GDP.
- External debt is expected to continue to decline, with all sectors except for the government continuing to make net repayments.
- The projected downward path of external debt is sensitive mainly to exchange rate and current account shocks.

### Baseline public debt projections and assumptions
- Under current policies, public debt is projected to diminish only marginally, to about 72 percent of GDP over the medium term.
- Baseline scenario underpinnings:
  - Net lending/borrowing balance around 2½percent of GDP.
  - Interest rates on sovereign bonds and loans gradually increasing in line with global WEO assumptions.
  - Medium-term output growth of about 2 percent.
  - Financial markets remain accessible with no significant interest rate spikes; sovereign and maturity spreads remaining at near 2014 levels.
- Table excerpts (selected trajectory and indicators, as of February 19, 2015):
  - Nominal gross public debt: 71.2 (2013), 77.3 (2014), 76.9 (2015), 75.5 (2016), 74.7 (2017), 73.9 (2018), 73.2 (2019), 72.4 (2020), 71.8 (projection horizon).
  - Public gross financing needs: 18.4 (2013), 19.4 (2014), 22.1 (2015), 21.4 (2016), 16.2 (2017), 21.1 (2018), 22.4 (2019), 22.7 (2020), 23.3 (later projection).
  - Real GDP growth (percent): 1.6 (2013), 1.5 (2014), 3.6 (2015), 2.7 (2016), 2.3 (2017), 2.2 (2018), 2.1 (2019), 2.1 (2020), 2.1 (long-run).
  - Inflation (GDP deflator, percent): 4.3 (2013), 3.0 (2014), 3.1 (2015), 2.7 (2016–2020).
  - Nominal GDP growth (percent): 6.0 (2013), 4.5 (2014), 6.8 (2015), 5.5 (2016), 5.1 (2017), 5.0 (2018), 4.9 (2019–2020).
  - Effective interest rate (percent): 6.4 (2013), 6.1 (2014), 5.7 (2015), 4.5 (2016–2018), 4.6 (2019), 5.0 (2020), 5.1 (later).
  - Cumulative change in gross public sector debt (2013–2020): -5.1 (total change over projection period).
  - Identified debt-creating flows (cumulative): -6.7.
  - Primary (noninterest) revenue and grants (percent of GDP): 43.8 (2013), 47.0 (2014), 46.8 (2015), 46.1 (2016), 44.0 (2017), 44.4 (2018), 44.9 (2019), 45.6 (2020), 46.6 (later years).
  - Primary (noninterest) expenditure (percent of GDP): 45.6 (2013), 45.1 (2014), 45.5 (2015), 45.2 (2016), 43.1 (2017), 43.5 (2018), 44.2 (2019), 44.7 (2020), 45.5 (later).
  - Primary deficit (percent of GDP): 1.8 (2013), -1.9 (2014), -1.4 (2015), -0.9 (2016–2018), -1.1 (2020).

### Probabilistic analysis and risk of debt trajectory reversal
- Based on historical volatility, probabilistic analysis indicates:
  - Public debt could enter an increasing trajectory with a probability of 50 percent.
  - If policy rigidities prevent improving the primary balance by more than 2 percent of GDP in a single year, the probability of an increasing debt trajectory rises to approximately 60 percent.
- Rationale for the constraint on large fiscal adjustment in a single year:
  - Already high tax burden leaves virtually no room for significant revenue-raising measures.
  - Expenditure-based consolidations typically take more time to design and implement.

### External debt dynamics and vulnerabilities
- Gross external debt path:
  - Declined from about 150 percent of GDP in 2009 to 116 percent by end-2014.
  - Improvement mainly reflects heavy bank deleveraging begun during the global financial crisis; partly offset by higher external government debt.
  - Intra-company loans related to FDI remained broadly stable at about 15 percent of gross debt.
- Prospects:
  - External debt is expected to continue to decline, with all sectors except for the government continuing to make net repayments.
  - FX conversion and the government’s self-financing program (to reduce purchases of HUF-denominated securities by nonresidents) are expected to keep external debt on a declining path over the medium term.
- Sensitivities:
  - External debt is particularly vulnerable to exchange rate and current account shocks, and to a lesser extent to growth and interest rate shocks.
  - A one-time real depreciation of 30 percent would add 15 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 8 to 15 percentage points of GDP to external debt, respectively.

### External DSA historical trajectory and indicators (selected)
- Baseline external debt (percent of GDP): 149.1 (2009), 143.6 (2010), 134.8 (2011), 128.9 (2012), 118.6 (2013), 115.8 (2014), 106.5 (2015), 89.8 (2016), 80.2 (2017), 73.6 (2018), 67.9 (2019), 63.5 (2020).
- Change in external debt (percent of GDP): 33.4 (2009), -5.5 (2010), -8.8 (2011), -5.9 (2012), -10.4 (2013), -2.7 (2014), -9.4 (2015), -16.7 (2016), -9.6 (2017), -6.6 (2018), -5.7 (2019), -4.5 (2020).
- Identified external debt-creating flows (percent of GDP): 22.1 (2009), -7.8 (2010), -2.4 (2011), 0.0 (2012), -6.4 (2013), -8.9 (2014), -6.1 (2015), -5.5 (2016), -4.7 (2017), -3.6 (2018), -2.1 (2019), -1.6 (2020).
- Current account deficit, excluding interest payments (percent of GDP): -4.6 (2009), -5.3 (2010), -6.2 (2011), -7.4 (2012), -8.5 (2013), -7.1 (2014), -6.4 (2015), -5.7 (2016), -4.9 (2017), -3.9 (2018), -3.3 (2019), -2.5 (2020).
- Exports (percent of GDP): 75.2 (2009), 82.5 (2010), 87.5 (2011), 87.6 (2012), 88.8 (2013), 92.8 (2014), 93.2 (2015), 94.7 (2016), 93.8 (2017), 93.5 (2018), 93.3 (2019), 94.8 (2020).
- Imports (percent of GDP): 71.1 (2009), 77.2 (2010), 81.3 (2011), 80.7 (2012), 81.2 (2013), 85.4 (2014), 84.4 (2015), 86.4 (2016), 86.5 (2017), 86.3 (2018), 86.6 (2019), 87.1 (2020).
- External debt–to-exports ratio (percent): 198.3 (2009), 174.0 (2010), 154.1 (2011), 147.2 (2012), 133.6 (2013), 124.8 (2014), 114.3 (2015), 94.8 (2016), 85.6 (2017), 78.7 (2018), 72.8 (2019), 66.9 (2020).
- Gross external financing need (in billions of US dollars): 54.7 (2009), 58.9 (2010), 68.8 (2011), 65.0 (2012), 48.5 (2013), 41.2 (2014), 37.4 (2015), 35.1 (2016), 22.8 (2017), 17.5 (2018), 17.1 (2019), 17.0 (2020).
- Gross external financing need (percent of GDP): 58.7 (2009), 60.2 (2010), 68.5 (2011), 65.8 (2012), 48.3 (2013), 39.9 (2014), 35.4 (2015), 31.9 (2016), 19.7 (2017), 14.6 (2018), 13.6 (2019), 13.0 (2020).

### Stress tests and scenario results (selected)
- Stress-test scenarios (public DSA):
  - Primary Balance Shock, Real GDP Growth Shock, Real Interest Rate Shock, Real Exchange Rate Shock, Combined Shock, Contingent Liability Shock.
- Selected scenario assumptions and outcomes (examples shown in the material):
  - Real GDP Growth Shock example (2015–2020): Real GDP growth sequence 2.7, -2.0, -2.1, 2.1, 2.1, 2.1; Primary balance sequence 0.9, -1.5, -4.0, 0.8, 0.9, 1.1; Effective interest rate 4.5, 4.6, 4.6, 5.0, 5.2, 5.3.
  - Real Exchange Rate Shock example (2015–2020): Inflation sequence 2.7, 6.6, 2.7, 2.7, 2.7, 2.7; Effective interest rate 4.5, 4.7, 4.4, 4.6, 4.9, 5.1.
  - Real Interest Rate Shock example (2015–2020): Effective interest rate 4.5, 4.5, 4.8, 5.3, 5.9, 6.2.
- Stress-test implications:
  - Debt and gross financing needs remain vulnerable to sudden realization of contingent liabilities; while contingent liabilities are not a principal vulnerability at this stage, fiscal risks have been rising with the expansion of quasi-fiscal activities.
  - External debt-sensitivity tests: individual shocks (permanent one-half standard deviation) and combined shocks can increase external debt significantly above baseline; for example, combined shock outcomes and a 30 percent one-time real depreciation notably raise external debt ratios in scenario charts.

### Risk assessment and market perception indicators (selected)
- Market perception and risk indicators (as presented):
  - EMBIG (bp) average over last 3 months (19-Nov-14 through 19-Feb-15): 180 (noted in table).
  - 5Y CDS (bp): 135 (in one table).
  - Public debt held by non-residents: around 35 percent (text reference to reliance on non-resident financing).
  - Gross financing needs upper warning benchmark: 15 percent of GDP; Hungary’s gross financing needs hover above 20 percent of GDP under baseline.
  - Summary heat map and risk flags indicate elevated risks from gross financing needs, public debt held by non-residents, and external financing requirements.

### Selected implications for policy (drawn from analysis in the text)
- The baseline is subject to considerable risks; materialization of shocks would likely set public debt on an increasing trajectory.
- Key domestic risks identified:
  - Public wage pressures, large allocations to projects in the investment fund, pressures in sectors with increased public sector ownership.
  - Risks on the revenue side: unidentified revenue sources, VAT fraud and evasion of social contribution payments.
  - Rising fiscal risks through expansion of quasi-fiscal activities and contingent liabilities.
- Market and external risks:
  - Exchange rate depreciation pressure, increase in sovereign spreads through contagion, reduced appetite by international investors, increase in global interest rates.
- Areas implied for policy focus (consistent with risks identified in the analysis):
  - Reduce vulnerability to exchange rate and current account shocks.
  - Address VAT fraud and social contribution evasion to secure revenues.
  - Limit buildup of contingent liabilities and quasi-fiscal activities; ensure transparency and governance where state role expands.
  - Strengthen investor base and reduce reliance on nonresident financing.

*Source: IMF staff — Appendix II. Hungary: Debt Sustainability Analysis (as presented in the staff report materials).*

### 76.9 percent by the end of 2014, notwithstanding a weaker exchange rate. The financing strategy

### _cr1592 - 76.9 percent by the end of 2014, notwithstanding a weaker exchange rate. The financing strategy

### Debt composition and financing strategy
- Public debt reached 76.9 percent by the end of 2014, notwithstanding a weaker exchange rate.
- Financing strategy shifted debt composition toward a more healthy structure, with a firmly declining share of FX-denominated securities.
- The central bank’s self-financing scheme shifted the incentive of holding government securities from foreign banks to domestic banks, aiding the decline of nonresident holdings of public debt.
- Domestic households continued to increase their bond holdings.

### Fiscal policy performance and plans
- Authorities are fully committed to prudent fiscal policies compatible with sustainable debt reduction and building buffers for countercyclical policies.
- Deficit outcomes:
  - 2012, 2013, and 2014 deficits over-performed relative to initial targets.
  - The 2014 deficit is estimated at 2.6 percent on the background of an accelerating economy and significant improvements in tax administration.
- Revenue administration measures:
  - Increased VAT collection and tackling fraud, including installation of online cash registers.
  - Recent implementation of the Electronic Trade and Transport Control System expected to yield positive results.
- 2015 budget:
  - Targets a 2.4 percent deficit, planning a broadly neutral fiscal stance for the current and subsequent years.
  - Intended convergence to the medium-term structural deficit target of 1.7 percent and a steadily declining public debt trajectory.
- Fiscal framework changes planned:
  - Intended early adoption of the 2016 budget to enhance predictability and harmonize with the European Semester.
  - A new Tax Code under preparation to develop a more customer-friendly system and ease taxpayers’ administrative burden.
- Policy considerations and actions:
  - Some staff recommendations on medium-term fiscal adjustment are being implemented or considered.
  - Measures addressing VAT compliance and fraud are already yielding promising results (online cash registers) or are in early implementation (road control system).
  - Spending on non-EU related goods and services will remain under close monitoring.
  - Government committed to substantially lower the bank levy starting from 2016.
  - Authorities wish to keep public work programs in operation to integrate inactive groups into the active labor force.

### Monetary policy and reserves
- The central bank (MNB) cut the policy rate by 15 basis points to 1.95 percent in its March meeting, re-launching its easing cycle after an eight-month stall.
- MNB committed to maintaining accommodative monetary conditions for an extended period.
- Inflation developments:
  - Inflationary pressures assessed to stay moderate in the medium term.
  - Headline inflation stayed in the negative territory in the past months.
  - Households’ inflation expectations adjusted and declined continuously during the last year.
- International context:
  - ECB’s asset purchase program and ongoing regional monetary easing point to easier monetary conditions.
- Reserves:
  - Current level of international reserves is adequate by a variety of metrics.
  - Reserves expected to stay within a comfortable range even after supplying the banking sector with the necessary foreign exchange for the conversion of mortgage loans.
  - No compelling evidence showing that the exchange rate is misaligned.

### Financial system developments and measures
- Banking system:
  - Aggregate capital and liquidity positions are adequate, though most banks’ balance sheets continued to shrink and profitability remained curtailed.
  - Nonperforming loans stabilized but remained high in both corporate and household segments.
- Funding for Growth Scheme (FGS):
  - Launched in 2013 to provide liquidity to credit institutions at a preferential rate, alleviating disruptions in lending to SMEs.
  - First and second phases provided financing to more than twenty-thousand SMEs, amounting to about HUF 1325 billion (over 4 percent of GDP), predominantly new investment loans.
  - Lending outside of the FGS has yet to recover due to excessive risk aversion by banks and tight credit conditions in the riskier but viable SME segment.
- FGS+ (launched in March):
  - Targets SMEs with medium risk spreads that exceed the FGS’ 2.5 percent cap.
  - Under the FGS+, the MNB will assume 50 percent of the credit risk from credit institutions, limited to only up to a five-year period, and capped at a maximum of 2.5 percent of the outstanding FGS+ loan stock of the individual credit institution.
- Asset management vehicle (MARK):
  - Established to clean nonperforming commercial real estate loan portfolio as a voluntary option for banks to remove distressed assets and catalyze the market.
  - Following consultations with the European Commission and the ECB and Fund TA recommendations, MARK’s market-based characteristics were improved and shifted to market pricing.
  - Implementation of further safeguards to ensure the financial independence of the central bank is being examined.
  - MARK is expected to begin operations in the second half of 2015.
  - MNB highly appreciates the prompt technical assistance provided by the Fund in the set-up of MARK.
- FX mortgage measures:
  - Settlement Act ensured settlement of non-justified interest rate, fee increases, and exchange rate spreads, setting the stage for transition to a “fair banking system”.
  - Conversion Act stipulated conversion of the FX-denominated mortgage stock at the market exchange rate.
  - Fair Banking Act ensures transparency in pricing going forward, fostering competition.
  - Immediate effect will reduce banking sector profitability for this year; longer term effects expected to increase households’ repayment ability, ease balance sheet pressures, increase predictability, and reduce banks’ exposure to foreign funding.
  - MNB active in macroprudential regulation, consumer protection, and supplying foreign exchange for the conversion.
- Government–EBRD memorandum of understanding to increase banking sector profitability and lending capacity commits to:
  - (i) create a framework that ensures the long-term sustainability of a stable and predictable economic policy;
  - (ii) decrease the bank tax to the EU standards by 2019, starting in 2016;
  - (iii) refrain from any measure that may have a negative impact on the profitability of the banking sector;
  - (iv) transfer all direct and indirect majority equity stakes it currently holds in local banks to the private sector within the next three years.

### Structural reforms and competitiveness
- Regulatory and administrative reforms implemented to improve the business environment:
  - New Labor Code facilitating a shift towards more flexible employment types.
  - New Civil Code with reforms in corporate law and contract law.
  - Cutting Red Tape program to reduce entrepreneurial administrative burdens, reduce timeframes for administrative procedures, and simplify the tax system by abolishing several minor taxes.
  - One-stop-shop government windows for administrative matters.
  - New Tax Code under preparation to be more customer-friendly with less administrative burden.
- Labor market reforms toward a workfare state:
  - Job Protection Act reduced the tax wedge for disadvantaged groups (low-skilled, young, old, long-term unemployed, returning mothers, career starters).
  - Results reflected in continuously rising labor force participation alongside declining unemployment.
  - Measures to transform primary and higher education and vocational training to enhance human capital.
- Other structural efforts:
  - Efforts stepped up to diversify export destinations.
  - Energy strategy focused on developing a non-profit energy sector to reduce high energy costs for investors to international levels to enhance competitiveness.

### Final remarks
- Authorities thank staff for thorough and constructive discussions during the Article IV mission and for valuable advice on macroeconomic policies.
- Authorities remain committed to prudent policies, focusing strategy on sustainable debt reduction, increasing labor participation, improving competitiveness, and reducing financial vulnerabilities.

*From IMF staff report excerpt.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1592.pdf_