## _cr16107

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---

### Fiscal outlook and public debt
- Overall balance: projected to meet the 2 percent of GDP target in 2016.
- Structural fiscal stance: implies a structural fiscal relaxation of about 1 percentage point of GDP for 2016.
- Debt trajectory:
  - Gross debt was 76.2 percent in 2014.
  - Debt is expected to decline to 74.25 percent of GDP.
- Staff recommendation:
  - Growth-friendly fiscal consolidation to build policy space, reduce fiscal risks, and firmly put public debt on a downward path.
  - Consolidation strategy should rely on durable expenditure retrenchment and a rationalization of the tax system.
  - Priority to improving the composition and efficiency of public spending, broadening the tax base and rationalizing the tax system to allow further reduction in sectoral taxes and higher infrastructure spending.

### Monetary policy and financial conditions
- Policy rate actions:
  - MNB resumed its easing cycle in March 2015.
  - Policy rate cut by 75 basis points in five equal steps to 1.35 percent in July 2015.
  - Policy rate cut further to 1.20 percent in March 2016.
- Rationale: subdued inflationary pressures, low risk premia, and a negative output gap.
- Monetary instruments: refinements of traditional and unconventional instruments introduced to strengthen transmission, reduce vulnerabilities, promote lending to small- and medium-sized enterprises, and ensure cheap government financing.
- Staff view:
  - Monetary policy has been appropriately accommodative.
  - Monetary easing may be required if downside risks to inflation and growth materialize, unless external financing conditions worsen unexpectedly.
  - Need to maintain adequate foreign exchange reserves to support financial stability.
- Unconventional instruments and risks:
  - Unconventional instruments have eased the monetary stance more than base rate cuts.
  - Some measures shifted risks between balance sheets (e.g., FX risk of households largely eliminated; official reserves are now lower).
  - Issuing interest rate swaps by the MNB may be sensible when private sector risk aversion is high but less appropriate as activity and inflation normalize.
  - Pausing easing in July 2015 was warranted given accommodative conditions and uncertainty over unconventional measures.
- Reserves:
  - Reserves are broadly adequate at 114 percent of the IMF’s reserve adequacy metric.
  - Projected to fall in 2016–17 but remain within the Fund’s adequacy range, albeit close to the lower bound.

### Near-term outlook and macroeconomic projections
- Output growth:
  - Projected to decelerate to 2.3 percent in 2016.
  - Over the medium-term, growth prospects remain subdued due to an adverse business climate, weak private investment (including from abroad), and labor market weaknesses (low labor participation, particularly among women and low-skilled workers).
- Demand composition:
  - Private consumption expected to remain robust reflecting higher disposable income and employment.
  - Favorable terms-of-trade expected to underpin a further increase in the current account surplus.
- Inflation:
  - Headline inflation expected to remain low on account of low import prices and a still negative—albeit closing—output gap.
- Risks:
  - Still elevated debt levels and financing needs leave the economy prone to shocks.
  - Expanded role of the state in the economy has shifted risks to the public sector.
  - Frequent and unpredictable policy changes and a still-high level of sectoral taxes weaken the business climate and weigh on private investment.

### Financial sector and credit
- Progress and concerns:
  - Steps to improve financial intermediation including reducing the tax burden on banks were welcomed.
  - Efforts to clean up banks’ balance sheets should be complemented with increased focus on addressing impediments to credit demand.
- Recommendations:
  - Reviving private credit requires addressing credit-demand impediments.
  - Additional measures to promote lending should consider risks and be time-bound.
  - Authorities encouraged to follow through with commitment to reduce state presence in the banking sector.
  - Asset management company for commercial real estate (MARK): operations should be voluntary, at market-related prices, governance strengthened, and operations fully transparent.
- Banking soundness and NPLs:
  - Banks are on average very liquid and well-capitalized, but bank lending to the private sector remains subdued.
  - Initiatives to reduce legacy NPLs include the new Personal Bankruptcy Law and MARK.
  - Macro-prudential measures for new loans tightened effective January 2015 but not yet binding.
  - State ownership in banking increased with acquisition of Budapest Bank; purchase of a stake in Erste’s Hungarian subsidiary delayed.

### Structural reform priorities
- Main objectives:
  - Improve the business climate and increase potential growth.
  - Reduce regulatory burden, enhance policy predictability, and limit state involvement in the economy.
  - Upgrade labor skills, promote innovation and entrepreneurship, and increase the efficiency of EU funds utilization to boost competitiveness.
  - Further reforms to increase labor force participation and address skill mismatches.
- Rationale: structural reforms are needed to boost medium-term, private sector-led growth and reduce vulnerabilities.
- Specific reform measures recommended:
  - Improve transparency and predictability of policymaking; strengthen anti-corruption efforts; ease regulatory burden.
  - Streamline tax system; broaden tax base by reducing exemptions and preferential regimes; cut remaining sectoral taxes.
  - Enhance vocational training, R&D, entrepreneurship; improve SOE efficiency.
  - Renew efforts to increase labor force participation, particularly for the young, old, low-skilled, and women; reshape family benefits to support affordable child care.

### Labor market, wages, and social measures
- Labor market outcomes:
  - Unemployment rate reduced to 6.2 percent in 2015:Q4.
  - Labor participation rate averaged 68½ percent in 2015 (up from 67 percent in 2014) but remains well-below the EU average.
  - Solid employment growth led by the private sector; continued expansion of public works contributed to employment gains.
- Wages and inflation:
  - Headline inflation hovered at zero; core inflation reached 1.4 percent y-o-y in February 2016.
  - Average monthly gross earnings grew by 5¼ percent y-o-y in 2015:Q4.
- Job Protection Action Plan (JPAP) outcomes:
  - Employer’s SSC cuts targeted to young, old, low-skilled and other groups; around 25 percent of the workforce eligible.
  - Short-term fiscal cost estimated by authorities at 0.4 percent of GDP annually.
  - JPAP associated with strong youth and older-worker employment gains; limited impact on female employment and long-term unemployed.
- Policy refinements suggested:
  - Narrow eligibility to groups with high employment response; redirect savings to active labor market policies; complementary measures such as apprenticeships, vocational education, differentiated minimum wages, and better monitoring of benefit systems.

### Selected key statistics (from the report)
- Real GDP (percentage change): 2011: 1.8; 2012: -1.7; 2013: 1.9; 2014: 3.7; 2015 Prel.: 2.9; 2016 Proj.: 2.3; 2017 Proj.: 2.5; 2018 Proj.: 2.4.
- CPI inflation (average): 2011: 3.9; 2012: 5.7; 2013: 1.7; 2014: -0.2; 2015 Prel.: -0.1; 2016 Proj.: 0.5; 2017 Proj.: 2.4; 2018 Proj.: 2.5.
- Unemployment rate (average, ages 15-64): 2011: 11.1; 2012: 11.1; 2013: 10.2; 2014: 7.8; 2015 Prel.: 6.8; 2016 Proj.: 6.6; 2017 Proj.: 6.4; 2018 Proj.: 6.2.
- Gross domestic investment (percent of GDP): 2011: 19.8; 2012: 19.4; 2013: 20.5; 2014: 21.7; 2015 Prel.: 21.3; 2016 Proj.: 20.8; 2017 Proj.: 21.2; 2018 Proj.: 21.5.
- Gross national saving (percent of GDP, from BOP): 2011: 20.5; 2012: 21.1; 2013: 24.5; 2014: 23.7; 2015 Prel.: 25.7; 2016 Proj.: 25.7; 2017 Proj.: 25.8; 2018 Proj.: 25.4.
- General government overall balance: 2011: -5.5; 2012: -2.3; 2013: -2.5; 2014: -2.5; 2015 Prel.: -1.9; 2016 Proj.: -2.0; 2017 Proj.: -2.1; 2018 Proj.: -2.1.
- Primary balance: 2011: -1.7; 2012: 1.9; 2013: 1.8; 2014: 1.3; 2015 Prel.: 1.6; 2016 Proj.: 1.2; 2017 Proj.: 0.9; 2018 Proj.: 0.8.
- Primary structural balance (percent of potential GDP): 2011: -0.6; 2012: 4.4; 2013: 3.6; 2014: 2.1; 2015 Prel.: 2.3; 2016 Proj.: 1.1; 2017 Proj.: 1.1; 2018 Proj.: 0.8.
- Gross debt (table): 2011: 80.8; 2012: 78.3; 2013: 76.8; 2014: 76.2; 2015 Prel.: 75.3; 2016 Proj.: 74.2; 2017 Proj.: 73.7; 2018 Proj.: 72.6.
- Lending to the private sector, flow-based: 2011: -6.8; 2012: -7.4; 2013: -3.3; 2014: -0.9; 2015 Prel.: -10.9; 2016 Proj.: -2.0; 2017 Proj.: 1.5; 2018 Proj.: 2.5.
- Goods and services trade balance: 2011: 6.2; 2012: 6.8; 2013: 7.3; 2014: 7.1; 2015 Prel.: 8.6; 2016 Proj.: 9.5; 2017 Proj.: 8.9; 2018 Proj.: 8.0.
- Current account (percent of GDP): 2011: 0.7; 2012: 1.8; 2013: 4.0; 2014: 2.0; 2015 Prel.: 4.4; 2016 Proj.: 4.9; 2017 Proj.: 4.6; 2018 Proj.: 4.0.
- Reserves (billions of Euros): 2011: 37.8; 2012: 33.9; 2013: 33.8; 2014: 34.6; 2015 Prel.: 30.3; 2016 Proj.: 25.4; 2017 Proj.: 24.0; 2018 Proj.: 27.4.
- Gross external debt: 2011: 134.4; 2012: 129.0; 2013: 118.4; 2014: 114.8; 2015 Prel.: 108.8; 2016 Proj.: 103.4; 2017 Proj.: 96.3; 2018 Proj.: 86.4.
- Exchange rate (March 2016, eop): Ft. 314.16 = €1; Ft. 287.25 = CHF1.
- Nominal GDP (billions of Forints): 2011: 28,134; 2012: 28,628; 2013: 30,065; 2014: 32,180; 2015 Prel.: 33,712; 2016 Proj.: 35,211; 2017 Proj.: 36,976; 2018 Proj.: 38,886.

### Executive Board Assessment and policy summary
- Directors welcomed favorable near-term performance: strong growth, decline in unemployment, and continued reduction in external vulnerabilities.
- Directors cautioned that elevated debt levels and financing needs leave the economy prone to shocks and that medium-term growth prospects appear subdued.
- Directors emphasized the need to further reduce vulnerabilities and boost medium-term, private sector-led growth through:
  - Growth-friendly fiscal consolidation and tax system rationalization.
  - Continued accommodative monetary policy as needed, and adequate reserves.
  - Measures to improve financial intermediation while limiting state presence in banking and ensuring transparency and sound governance for asset transfers.
  - Structural reforms to improve business climate, enhance predictability, limit state involvement, upgrade skills, promote innovation, and improve EU funds utilization.

### Boxes and special topics
- Box 1 — The Recent Refugee Crisis:
  - Arrivals in 2015: almost 174,400 asylum seekers; close to 14 percent of all first-time asylum seeker applications in the EU.
  - Syrians: close to 37 percent of first-time asylum applications; Afghanistan: 26 percent.
  - Fiscal response in 2015: government allocated HUF 83.9 billion (about ¼ percent of GDP); about HUF 45.7 billion spent in 2015.
- Box 4 — Is the Post-Crisis Decline in Investment Permanent?:
  - Hungary’s post-crisis investment decline concentrated in construction.
  - Pre-crisis investment exceeded the closed-economy “golden-rule”; post-crisis rate undershot it, suggesting scope to boost investment.
  - EU funds have supported investment but weak business climate limited private-sector contribution.

### EU funds, absorption, and procurement
- ESIF allocation over two program periods amounts to 45 percent of 2015 GDP (excluding agricultural subsidies and the Rural Development Fund).
- Hungary’s absolute allocation: €47 billion; per capita allocation: €4,700.
- Effective co-financing in 2015: around 32 percent, or about 2¾ percent of GDP.
- Absorption dynamics:
  - In 2015, Hungary is estimated to have absorbed almost 20 percent of all ESIF funds available for the past program period, resulting in expected inflow of about 5¾ percent of GDP, of which 3½ percent of GDP were received in 2015.
  - Risks from rushed absorption include potential irregularities and fiscal costs; government in talks with EC regarding reimbursement of around HUF 500 billion (approximately 1½ percent of GDP).

### Debt Sustainability Analysis — Annex V (key findings)
- Baseline: public debt projected to decline but remain around 70 percent of GDP; gross financing needs forecast to decline to around 11 percent of GDP.
- Baseline assumptions:
  - Primary surplus of around 1 percent of GDP.
  - Effective interest rate declining in 2016 and 2017 then gradually rising.
  - Medium-term output growth at 2 percent.
- Specific projections (selected):
  - Nominal gross public debt (percent of GDP): 2014: 73.0; 2015: 76.2; 2016: 75.3; 2017: 74.2; 2018: 73.7; 2019: 72.6; 2020: 71.3; 2021: 70.2.
  - Public gross financing needs (percent of GDP): 2014: 22.7; 2015: 21.9; 2016: 21.4; 2017: 17.8; 2018: 14.3; 2019: 18.1; 2020: 17.9; 2021: 21.5.
  - Real GDP growth (percent): 2014: 0.6; 2015: 3.7; 2016: 2.9; 2017: 2.3; 2018: 2.5; 2019: 2.4; 2020: 2.2; 2021: 2.1.
  - Inflation (GDP deflator, percent): 2014: 3.5; 2015: 3.2; 2016: 2.0; 2017: 2.3; 2018–2021: 2.7 each year.
  - Effective interest rate (percent): 2014: 6.2; 2015: 5.6; 2016: 4.9; 2017: 4.7; 2018: 4.6; 2019: 4.6; 2020: 4.7; 2021: 5.0.
  - Cumulative projected change in gross public sector debt over 2014–2021: -6.2 (in percent of GDP).
- External debt path (baseline, percent of GDP): 2010: 143.1; 2011: 134.4; 2012: 129.0; 2013: 118.4; 2014: 114.8; 2015: 108.8; 2016: 103.4; 2017: 96.3; 2018: 86.4; 2019: 79.4; 2020: 72.2; 2021: 68.1.
- External financing needs (selected): 2015: €26.2 billion (24.1 percent of GDP); 2016: €19.6 billion (18.5 percent of GDP); 2017: €14.6 billion (13.6 percent of GDP); 2018: €13.6 billion (12.1 percent of GDP); 2019: €12.1 billion (10.3 percent of GDP); 2020: €15.8 billion (13.1 percent of GDP); 2021: €13.8 billion (11.1 percent of GDP).
- Vulnerabilities and stress tests:
  - External debt is most sensitive to current account shocks (an adverse permanent current account shock of ½ standard deviation would add about 14 percentage points of GDP to external debt).
  - Other shocks: adverse permanent growth shock of ½ standard deviation would add about 7 percentage points; a one-time real depreciation of 30 percent would add 7 percentage points.
  - Probabilistic analysis indicates a 20 percent probability that public debt could enter an increasing trajectory based on historical volatility.
- Policy implications:
  - Credible fiscal reforms and growth-enhancing policies are critical to put public debt on a downward path and reduce vulnerabilities.
  - Continued prudent fiscal policies, adherence to fiscal rules, and rationalization/prioritization of public expenditure recommended.
  - Maintain adequate international reserves and manage external financing risks.

### Risk Assessment — main risks and policy responses
- Global risks:
  - Tighter or more volatile global financial conditions — Relative likelihood: High; Impact if realized: High.
    - Policy response: FX intervention to smooth volatility; fiscal stabilizers; possible monetary tightening; revisit public debt strategy if bond market stresses occur.
  - Heightened risk of fragmentation/security dislocation in part of Europe — Relative likelihood: High; Impact if realized: Medium.
    - Policy response: Allow automatic stabilizers; keep monetary policy accommodative or ease; if near-term growth slows sharply, allow stabilizers and maintain accommodative/easing stance.
  - Structurally weak growth in key advanced/emerging economies — Relative likelihood: High/Medium; Impact if realized: Medium.
    - Policy response: Advance structural reforms; adopt growth-friendly fiscal consolidation.
  - Persistently low energy prices — Relative likelihood: High; Impact if realized: Medium.
    - Policy response: If inflation expectations un-anchored and second-round effects occur, ease policy and use forward guidance; if expectations well-anchored, enhance communication.
- Domestic risks:
  - Increased state role in the economy — Relative likelihood: Medium; Impact if realized: Medium.
    - Policy response: Accelerate structural reforms and limit state involvement.
  - Continued fiscal relaxation and slippages in structural reforms — Relative likelihood: Medium; Impact if realized: Medium.
    - Policy response: Adopt growth-friendly fiscal adjustment strategy and accelerate structural reforms.

*Source: HUNGARY STAFF REPORT FOR THE 2016 ARTICLE IV CONSULTATION (April 6, 2016).*

### 76.2 percent in 2014. For 2016, the deficit is projected to meet the 2 percent of GDP target,

### _cr16107 - 76.2 percent in 2014. For 2016, the deficit is projected to meet the 2 percent of GDP target,

### Fiscal outlook and public debt
- Overall balance: projected to meet the 2 percent of GDP target in 2016.
- Structural fiscal stance: implies a structural fiscal relaxation of about 1 percentage point of GDP for 2016.
- Debt trajectory:
  - Gross debt was 76.2 percent in 2014.
  - Debt is expected to decline to 74.25 percent of GDP.
- Staff recommendation:
  - Growth-friendly fiscal consolidation to build policy space, reduce fiscal risks, and firmly put public debt on a downward path.
  - Consolidation strategy should rely on durable expenditure retrenchment and a rationalization of the tax system.
  - Priority to improving the composition and efficiency of public spending, broadening the tax base and rationalizing the tax system to allow further reduction in sectoral taxes and higher infrastructure spending.

### Monetary policy and financial conditions
- Policy rate actions:
  - MNB resumed its easing cycle in March 2015.
  - Policy rate cut by 75 basis points in five equal steps to 1.35 percent in July 2015.
  - Policy rate cut further to 1.20 percent in March 2016.
- Rationale: subdued inflationary pressures, low risk premia, and a negative output gap.
- Monetary instruments: refinements of traditional and unconventional instruments introduced to strengthen transmission, reduce vulnerabilities, promote lending to small- and medium-sized enterprises, and ensure cheap government financing.
- Staff view:
  - Monetary policy has been appropriately accommodative.
  - Monetary easing may be required if downside risks to inflation and growth materialize, unless external financing conditions worsen unexpectedly.
  - Need to maintain adequate foreign exchange reserves to support financial stability.

### Near-term outlook and macroeconomic projections
- Output growth:
  - Projected to decelerate to 2.3 percent in 2016.
  - Over the medium-term, growth prospects remain subdued due to an adverse business climate, weak private investment (including from abroad), and labor market weaknesses (low labor participation, particularly among women and low-skilled workers).
- Demand composition:
  - Private consumption expected to remain robust reflecting higher disposable income and employment.
  - Favorable terms-of-trade expected to underpin a further increase in the current account surplus.
- Inflation:
  - Headline inflation expected to remain low on account of low import prices and a still negative—albeit closing—output gap.
- Risks:
  - Still elevated debt levels and financing needs leave the economy prone to shocks.
  - Expanded role of the state in the economy has shifted risks to the public sector.
  - Frequent and unpredictable policy changes and a still-high level of sectoral taxes weaken the business climate and weigh on private investment.

### Financial sector and credit
- Progress and concerns:
  - Steps to improve financial intermediation including reducing the tax burden on banks were welcomed.
  - Efforts to clean up banks’ balance sheets should be complemented with increased focus on addressing impediments to credit demand.
- Recommendations:
  - Reviving private credit requires addressing credit-demand impediments.
  - Additional measures to promote lending should consider risks and be time-bound.
  - Authorities encouraged to follow through with commitment to reduce state presence in the banking sector.
  - Asset management company for commercial real estate: operations should be voluntary, at market-related prices, governance strengthened, and operations fully transparent.

### Structural reform priorities
- Main objectives:
  - Improve the business climate and increase potential growth.
  - Reduce regulatory burden, enhance policy predictability, and limit state involvement in the economy.
  - Upgrade labor skills, promote innovation and entrepreneurship, and increase the efficiency of EU funds utilization to boost competitiveness.
  - Further reforms to increase labor force participation and address skill mismatches.
- Rationale: structural reforms are needed to boost medium-term, private sector-led growth and reduce vulnerabilities.

### Selected key statistics (from the report)
- Real GDP (percentage change): 2011: 1.8; 2012: -1.7; 2013: 1.9; 2014: 3.7; 2015 Prel.: 2.9; 2016 Proj.: 2.3; 2017 Proj.: 2.5; 2018 Proj.: 2.4.
- CPI inflation (average): 2011: 3.9; 2012: 5.7; 2013: 1.7; 2014: -0.2; 2015 Prel.: -0.1; 2016 Proj.: 0.5; 2017 Proj.: 2.4; 2018 Proj.: 2.5.
- Unemployment rate (average, ages 15-64): 2011: 11.1; 2012: 11.1; 2013: 10.2; 2014: 7.8; 2015 Prel.: 6.8; 2016 Proj.: 6.6; 2017 Proj.: 6.4; 2018 Proj.: 6.2.
- Gross domestic investment (percent of GDP): 2011: 19.8; 2012: 19.4; 2013: 20.5; 2014: 21.7; 2015 Prel.: 21.3; 2016 Proj.: 20.8; 2017 Proj.: 21.2; 2018 Proj.: 21.5.
- Gross national saving (percent of GDP, from BOP): 2011: 20.5; 2012: 21.1; 2013: 24.5; 2014: 23.7; 2015 Prel.: 25.7; 2016 Proj.: 25.7; 2017 Proj.: 25.8; 2018 Proj.: 25.4.
- General government overall balance: 2011: -5.5; 2012: -2.3; 2013: -2.5; 2014: -2.5; 2015 Prel.: -1.9; 2016 Proj.: -2.0; 2017 Proj.: -2.1; 2018 Proj.: -2.1.
- Primary balance: 2011: -1.7; 2012: 1.9; 2013: 1.8; 2014: 1.3; 2015 Prel.: 1.6; 2016 Proj.: 1.2; 2017 Proj.: 0.9; 2018 Proj.: 0.8.
- Primary structural balance (percent of potential GDP): 2011: -0.6; 2012: 4.4; 2013: 3.6; 2014: 2.1; 2015 Prel.: 2.3; 2016 Proj.: 1.1; 2017 Proj.: 1.1; 2018 Proj.: 0.8.
- Gross debt (table): 2011: 80.8; 2012: 78.3; 2013: 76.8; 2014: 76.2; 2015 Prel.: 75.3; 2016 Proj.: 74.2; 2017 Proj.: 73.7; 2018 Proj.: 72.6.
- Lending to the private sector, flow-based: 2011: -6.8; 2012: -7.4; 2013: -3.3; 2014: -0.9; 2015 Prel.: -10.9; 2016 Proj.: -2.0; 2017 Proj.: 1.5; 2018 Proj.: 2.5.
- Goods and services trade balance: 2011: 6.2; 2012: 6.8; 2013: 7.3; 2014: 7.1; 2015 Prel.: 8.6; 2016 Proj.: 9.5; 2017 Proj.: 8.9; 2018 Proj.: 8.0.
- Current account (percent of GDP): 2011: 0.7; 2012: 1.8; 2013: 4.0; 2014: 2.0; 2015 Prel.: 4.4; 2016 Proj.: 4.9; 2017 Proj.: 4.6; 2018 Proj.: 4.0.
- Reserves (billions of Euros): 2011: 37.8; 2012: 33.9; 2013: 33.8; 2014: 34.6; 2015 Prel.: 30.3; 2016 Proj.: 25.4; 2017 Proj.: 24.0; 2018 Proj.: 27.4.
- Gross external debt: 2011: 134.4; 2012: 129.0; 2013: 118.4; 2014: 114.8; 2015 Prel.: 108.8; 2016 Proj.: 103.4; 2017 Proj.: 96.3; 2018 Proj.: 86.4.
- Exchange rate (March 2016, eop): Ft. 314.16 = €1; Ft. 287.25 = CHF1.
- Nominal GDP (billions of Forints): 2011: 28,134; 2012: 28,628; 2013: 30,065; 2014: 32,180; 2015 Prel.: 33,712; 2016 Proj.: 35,211; 2017 Proj.: 36,976; 2018 Proj.: 38,886.

### Executive Board Assessment and policy summary
- Directors welcomed favorable near-term performance: strong growth, decline in unemployment, and continued reduction in external vulnerabilities.
- Directors cautioned that elevated debt levels and financing needs leave the economy prone to shocks and that medium-term growth prospects appear subdued.
- Directors emphasized the need to further reduce vulnerabilities and boost medium-term, private sector-led growth through:
  - Growth-friendly fiscal consolidation and tax system rationalization.
  - Continued accommodative monetary policy as needed, and adequate reserves.
  - Measures to improve financial intermediation while limiting state presence in banking and ensuring transparency and sound governance for asset transfers.
  - Structural reforms to improve business climate, enhance predictability, limit state involvement, upgrade skills, promote innovation, and improve EU funds utilization.

*Source: HUNGARY STAFF REPORT FOR THE 2016 ARTICLE IV CONSULTATION (April 6, 2016).*

### 3.      Unemployment declined sharply, amid a continuous rise in labor participation. Solid

### _cr16107 - 3.      Unemployment declined sharply, amid a continuous rise in labor participation. Solid

### Labor market
- Unemployment rate reduced to 6.2 percent in 2015:Q4, below pre-crisis levels.
- Labor participation rate averaged 68½ percent in 2015 (up from 67 percent in 2014) but remains well-below the EU average.
- Solid employment growth led by the private sector; continued expansion of public works contributed to employment gains.

### Inflation and wages
- Headline inflation hovered at zero due to declining oil and initially low food prices.
- Core inflation reached 1.4 percent y-o-y in February 2016.
- Average monthly gross earnings grew by 5¼ percent y-o-y in 2015:Q4.
- Asset (stock market and real estate) prices picked up.
- Inflation expectations appear anchored around the lower end of the Central Bank’s (MNB) inflation band (2 percent).

### Fiscal performance and public debt
- Overall deficit estimated at 1.9 percent of GDP against the 2.4 percent target.
- Revenues over-performed due to the strong economy, improvements in tax administration, and sizable one-off corporate income tax and excise revenues.
- Partially offsetting higher expenditures: wages, co-financing of EU projects, and refugee-related outlays.
- Gross public debt declined to 75.3 percent of GDP from 76.2 percent in 2014.
- Net public debt has plateaued since 2013.
- Total positive impact from a primary surplus was mitigated by government asset purchases and delayed EU funds transfers.
- MNB’s self-financing program reduced shares of FX-denominated public debt and of non-resident holdings.

### Monetary policy and MNB actions
- MNB resumed its easing cycle in March 2015 and cut the policy rate by 75 basis points in five equal steps to 1.35 percent in July.
- Refinements to traditional and unconventional monetary instruments aimed at: strengthening interest rate, credit, and expectations channels; reducing vulnerabilities; promoting lending to SMEs; and ensuring cheap government financing.
- Monetary stance described as accommodative; further easing may be warranted if downside risks materialize, while tightening could be needed if capital outflows lead to exchange rate overshooting and inflation pressure.

### Credit, banking sector, and financial vulnerabilities
- Recovery described as “credit less”: bank lending to the private sector continued to contract.
- Sharp decline in household indebtedness due to compensation paid by banks and conversion of FX-denominated loans; associated reduction in household FX risk.
- Bank lending to non-financial companies continued to decline; partly masked by (i) a few large companies switching to foreign financing and (ii) the Funding for Growth Scheme (FGS) increasing lending to SMEs.
- Some risks shifted to the MNB through policy operations.
- Banking soundness indicators improving: loan-to-deposit ratio declined, liquidity ample, capital adequacy comfortable.
- Profitability recovering after large losses in 2014.
- NPL ratios have declined, though some improvement for household loans is temporary; post-crisis loans typically have lower NPL ratios.
- Initiatives to reduce legacy NPLs include the new Personal Bankruptcy Law and the asset management company for commercial real estate (MARK).
- Macro-prudential measures for new loans tightened effective January 2015 but not yet binding.
- State ownership in banking increased with acquisition of Budapest Bank; purchase of a stake in Erste’s Hungarian subsidiary delayed.

### External sector and competitiveness
- Large and persistent current account surpluses and cross-border deleveraging substantially reduced gross external debt and improved the IIP.
- Share of FX-denominated public debt dropped from 52 percent in 2011 to 35 percent in 2015.
- Markets responded with lower five-year CDS rates and bond yields.
- Remaining external concerns: gross external financing needs of 20 percent of GDP; reliance on non-resident funding of domestic public debt at 26 percent; highly negative IIP of -79 percent.
- Real exchange rate broadly in line with fundamentals, but non-price indicators and export performance point to competitiveness challenges; low FDI weighs on future export performance.
- Hungary’s export market share had stagnated until recently compared to peers; global competitiveness ranking slipped with business and regulatory environment as a drag.

### Outlook and risks
- Economic activity expected to decelerate in 2016; private consumption to remain robust due to higher disposable income and employment.
- Projected slowdown in EU fund absorption to weigh on growth.
- Medium-term output growth set to stabilize at around 2 percent.
- Favorable terms-of-trade to support current account improvement; current account to remain in surplus over the medium term but decline due to slowing deleveraging and an aging population, contributing to a sharp IIP decline.
- Headline inflation to remain low in 2016 and reach the 3 percent target in late-2018 as the output gap closes and energy prices recover.
- Balance of risks tilted to the downside: potential sharp deterioration in global or EM risk perceptions, weak external demand (notably from the euro area and China), escalation of the refugee crisis, domestic policy uncertainty, and expansion of the state’s role could harm confidence and investment.
- Upside risks: persistently lower energy prices, initiatives to boost housing construction, and policies to stimulate credit.

### Policy agenda — overview
- Staff advocated a policy mix of growth-friendly fiscal consolidation, accommodative monetary policy, and structural reforms to improve the investment climate, competitiveness, and labor market weaknesses.
- Under this strategy, growth could accelerate to more than 3 percent over the medium term, the investment ratio could reach pre-crisis levels, and the public debt ratio could fall gradually to around 60 percent.

### Policy agenda — fiscal recommendations and risks
- Fiscal policy turning expansionary; staff projects the 2016 headline deficit to meet the government’s target of 2 percent.
- Budget relies on sizeable one-off revenues from land sales and includes tax reductions: 1 percentage point reduction in PIT rate; cut in VAT on pork products and on new housing construction; higher tax allowances for families with two children; reduction in the bank levy.
- New open-ended housing support scheme and public works and career model programs will increase expenditure; significant savings expected in the interest bill.
- Envisaged fiscal stance implies a structural relaxation of about 1 percentage point of GDP.
- Authorities’ medium-term plans target deficit reduction to 1.5 percent of GDP by 2019; however, fiscal cost of housing support scheme and under-budgeting in health and education pose risks.
- Staff baseline: structural deficit to hover around 2 percent of GDP over the medium term; public debt ratio decline to just below 70 percent but exposed to risks from lower GDP growth, higher interest rates, and contingent liabilities.
- Public guarantees increased by 1.7 percentage points of GDP in 2015 to 9.5 percent of GDP.
- Staff recommended:
  - A moderate average annual structural fiscal tightening of about ⅓ percent of GDP during 2016–21, complemented with growth-enhancing reforms to reduce public debt to below 60 percent of GDP by 2022.
  - Streamline public expenditure and rationalize the tax system in a growth-friendly manner.
  - Broaden the tax base by reducing exemptions and preferential regimes; further cut remaining sectoral taxes.
  - Lower the tax wedge, particularly for low-income earners; consider progressive in-work tax credits as a targeted instrument.
  - Eliminate generalized subsidies, improve SOE efficiency, increase efficiency of public spending in health and education, and rationalize the wage bill.
  - Complement intentions to downsize public administration with a public expenditure review to identify priorities.
  - Closely monitor the housing support program to ensure it is appropriately targeted, time-bound, and eliminates loopholes; be ready to modify eligibility criteria and parameters.

### Policy agenda — monetary guidance
- Monetary policy appropriate as accommodative; may need further easing if downside risks to activity and inflation materialize.
- If inflation fails to pick up and downside risks materialize, monetary easing should be primary defense, especially if fiscal policy tightens.
- If wage increases outpace productivity gains or output gap closes faster amid fiscal easing, further monetary easing should be put on hold.
- If large capital outflows occur with exchange rate overshooting and inflation pressures, monetary tightening may be needed.

*HUNGARY  INTERNATIONAL MONETARY FUND*

### 20.      The use of unconventional monetary policy instruments has eased the monetary

### 20.      The use of unconventional monetary policy instruments has eased the monetary

### Monetary policy stance and unconventional instruments
- Unconventional monetary policy instruments have eased the monetary stance more than indicated by the base rate cuts.
- MNB view: reduction of vulnerabilities has effectively eased the monetary policy stance.
- Staff observation: many measures reduced risks but shifted part of the risks between balance sheets.
  - Example: FX risk of households largely eliminated, but most refinancing is now at variable interest rates, making households sensitive to domestic interest rate hikes.
  - Official reserves are now lower, though still broadly adequate.
  - The self-financing program increased bank-sovereign links.
  - Part of the self-financing program and the initiative to promote bank lending involve the MNB accepting interest rate risk by issuing interest rate swaps.
- Staff judgment: issuing interest rate swaps may be sensible when the private sector is very risk averse, but becomes less appropriate as activity and inflation normalize.
- MNB officials signaled a higher likelihood of easing using unconventional instruments rather than lowering the base rate, subject to inflation.
  - The pausing in the easing cycle in July 2015 was warranted given already accommodative monetary conditions, absence of underlying deflationary pressures, and substantial uncertainty about impacts of recent unconventional measures.
  - MNB view: could pursue additional unconventional measures while keeping the policy rate at the current rate because the base rate deflated with inflation expectations is already negative.
- Subsequent to the mission, MNB cut the policy rate by 15 basis points to 1.20 percent (in the context of a downward revision in inflation projections and further easing by the ECB).

### Reserves and adequacy
- Staff welcomed MNB’s commitment to maintain adequate reserves to help safeguard financial stability.
- Reserves are broadly adequate at 114 percent of the IMF’s reserve adequacy metric and above standard rules-of-thumb.
- Projected path:
  - Reserves would fall in 2016–17 as MNB provides FX liquidity to help banks close open FX positions emerging from loan conversion, but would remain within the Fund’s adequacy range, albeit close to the lower bound.
  - Authorities noted the envisaged decline will be accompanied by a reduction in short-term external debt, keeping reserves above the adequacy range in the medium term.
- Agreement on importance of maintaining adequate reserve coverage because of still elevated risks and volatile global conditions.

### Financial sector: liquidity, lending, and NPLs
- Banks are on average very liquid and well-capitalized, but bank lending to the private sector remains subdued.
- Drivers of subdued lending:
  - MNB officials: relatively high costs and legacy NPLs impede willingness to lend.
  - Market observers and staff: primary driver is still insufficient demand from borrowers with credible projects, reflecting volatile external demand, relatively-low potential growth, a weak business climate, sudden regulatory changes, and uncertainty about the future banking sector landscape.
- Policy guidance on measures to promote lending:
  - Additional measures should properly consider risks and be time bound.
  - Staff argued MNB should not share credit risk from banks’ lending; welcomed expiration of FGS+.
  - Staff recommended not lowering risk-weights for certain more risky lending.
  - Consider further reducing perils and costs of debt recovery by refining insolvency legislation and its implementation.
- On resolving legacy NPLs:
  - Staff supported efforts and emphasized keeping MARK fully transparent.
  - Personal Insolvency Law is a good step; improvements to make procedures less cumbersome are underway.
  - MARK operations entail voluntary transfer of assets at market-related prices; staff urged strengthening MARK’s governance per IMF technical assistance recommendations.
  - Staff welcomed considerations to transition MARK to private sector funding and revisiting ownership structure once a track record is established.
- State presence in banking:
  - Improving financial intermediation should entail lower state presence in the banking sector.
  - Authorities noted recent expansion in state ownership was necessitated by market failure as some foreign parent banks exited Hungary, and reiterated commitment to privatize the restructured MKB Bank and later Budapest Bank.
  - Staff stressed importance of lifting uncertainty regarding the banking sector landscape, including by letting the number of credit institutions be market determined.

### Structural policies and growth
- Current and projected potential growth:
  - Potential growth currently estimated at 1½ percent and projected to reach 2 percent over the medium term as investment increases—still below regional peers.
- Staff diagnosis of low potential growth:
  - Adverse business climate due to frequent and unpredictable policy changes and a still-high level of sectoral taxes.
  - Low productivity and continued labor market weaknesses.
  - Labor participation and employment rates still low, particularly among the low-skilled, who face substantially higher unemployment.
  - Female labor participation increased to 62¼ percent (2015) but remains below the EU-average of 66½ percent (2014).
  - Demographic headwinds: proportion of the working age population projected to fall substantially.
  - Expanding role of the state could adversely affect investment prospects; gap between post-crisis and “optimal” investment rates suggests scope for boosting investment.
- Staff priorities and reform recommendations:
  - Give priority to reforms with an increased role for the private sector as unconventional measures are phased out.
  - Business environment:
    - Increase investment and promote private-sector activity by improving transparency and predictability of policymaking, strengthening anti-corruption efforts, easing regulatory burden, and limiting the state’s role in the economy.
    - Enhance ease of paying taxes; streamline tax system; further improve tax compliance; persevere on tackling VAT fraud.
    - Strengthen anti-money laundering and combating the financing of terrorism framework to help detect corruption and VAT fraud.
  - Competitiveness:
    - Emphasize non-price factors: move up the value chain, increase export diversification, improve productivity in labor and services markets, upgrade labor skills, and improve SOE efficiency.
    - Boost innovation and R&D, enhance vocational training, promote entrepreneurship.
    - Ensure efficient EU fund utilization to maximize growth impact.
  - Labor market:
    - Renew efforts to increase labor force participation, particularly for the young, old, and low-skilled.
    - Reiterate previous recommendations: reshuffle spending on family benefits to provide affordable child care; reduce the gender wage gap to boost female labor participation.
    - Upgrade labor force skills, address skill mismatches, increase employment of low-skilled.
    - Active labor market policies should strengthen training components and job-matching services; reform tax-benefit systems.

### Authorities’ views
- Authorities confident recent policy measures bode well for higher potential growth over the medium-term.
  - Agreed on need to increase competitiveness, enhance productivity, improve education quality, and foster innovation and R&D (as in the MNB Growth Report).
  - Framed the state’s increasing role as temporary and necessary to address market failures; in energy sector, aim to secure and diversify supply to enhance competitiveness.
  - Noted scope for improving efficiency of EU funds utilization with greater private-sector participation in the next programming period.
  - Emphasized ongoing labor market reforms and the role of the public works scheme in activating and providing temporary jobs for the low-skilled, with efforts to promote transition to the primary labor market.

### Staff appraisal: macroeconomic performance and remaining priorities
- Positive developments:
  - Economy performing very well; vulnerability to shocks has declined substantially.
  - Supportive macroeconomic policies, favorable external environment, and high EU fund utilization led to strong growth rebound and drop in unemployment.
  - Decline in vulnerability due to persistent current account surpluses, sharp reduction in external debt (especially FX-denominated), and improved market sentiment.
- Remaining concerns and priorities:
  - Still-elevated debt levels, high financing needs, and subdued medium-term growth leave the economy prone to shocks.
  - Strategy has expanded the role of the state and shifted risks to the public sector.
  - Priority actions: gradual, growth-friendly fiscal consolidation; revival of private credit by addressing impediments to credit demand; structural reforms to improve business environment, enhance competitiveness, and address labor market challenges.
- Fiscal policy recommendations:
  - Growth-friendly fiscal consolidation to build policy space, reduce fiscal risks, and place public debt on a downward path.
  - Suggested measures: rationalize the wage bill via public administration reform; increase efficiency of public spending on health and education; eliminate generalized subsidies.
  - Broaden the tax base to free up fiscal space for reducing sectoral taxes and higher infrastructure spending.
- Monetary policy recommendations:
  - Monetary policy has been appropriately accommodative; may need to ease further if downside risks to growth and/or inflation materialize.
  - Continued accommodation justified while inflationary pressures remain subdued given stable inflation expectations, oil price dynamics, and negative but closing output gap.
  - If inflation fails to pick up or downside activity risks materialize, monetary easing should be primary defense.
  - Conversely, if a sharp deterioration in risk perception causes large capital outflows, FX intervention to smooth volatility and monetary tightening could be needed.
  - Adequate international reserves are necessary to support financial stability.
- Financial sector and lending:
  - Balance-sheet clean-up should be complemented by focus on impediments to credit demand.
  - Despite strong bank capital, recovering profitability, and ample liquidity, bank lending to private sector continued to contract.
  - Additional lending-promoting measures should consider risks and be time-bound.
  - Ensure MARK transfers assets voluntarily and at market-related prices; strengthen MARK governance.
  - Improve financial intermediation by addressing credit demand impediments, enhancing business climate, increasing potential growth, and removing uncertainty about banking sector landscape.
  - Authorities should maintain commitment to reducing state presence in the banking sector over time.
- Structural reforms:
  - Sustained progress on wide-ranging reforms is key to unleashing full growth potential.
  - Reforms include easing regulatory burden, enhancing policy predictability, improving tax payment ease, limiting state involvement, moving up value chain, upgrading skills, boosting innovation and R&D, promoting entrepreneurship, and improving EU funds efficiency.
  - Labor market improvements: address skills mismatches, strengthen training and job-matching services, increase female labor participation.
- Consultation cycle:
  - It is recommended to hold the next Article IV consultation on the standard 12-month cycle.

### Risk Assessment (summary of main risks and policy responses)
- Global risks:
  - Tighter or more volatile global financial conditions — Relative likelihood: High; Impact if realized: High.
    - Possible non-resident sell-off of HUF securities, reversal of capital flows, higher borrowing costs, pressure on reserves, financing pressures.
    - Policy response: FX intervention to smooth excess volatility; fiscal stabilizers; possible monetary tightening; revisit public debt strategy if bond market stresses occur.
  - Heightened risk of fragmentation/security dislocation in part of Europe — Relative likelihood: High; Impact if realized: Medium.
    - Border closures/restrictions could weigh on trade and confidence.
    - Policy response: Allow automatic stabilizers; keep monetary policy accommodative or ease; if near-term growth slows sharply, allow stabilizers and maintain accommodative/easing stance.
  - Structurally weak growth in key advanced/emerging economies — Relative likelihood: High/Medium; Impact if realized: Medium.
    - Weaker external demand would weigh on exports and growth.
    - Policy response: Advance structural reforms; adopt growth-friendly fiscal consolidation.
  - Persistently low energy prices — Relative likelihood: High; Impact if realized: Medium.
    - Domestic demand would accelerate, inflation would decline, current account surplus widen.
    - Policy response: If inflation expectations un-anchored and second-round effects occur, ease policy and use forward guidance; if expectations well-anchored, enhance communication.
- Domestic risks:
  - Increased state role in the economy — Relative likelihood: Medium; Impact if realized: Medium.
    - Could increase policy uncertainty, weaken institutions, undermine credibility, erode confidence, cause resource misallocation and TFP slowdown, lower potential growth, reduce financing and FDI, slow credit and investment growth.
    - Policy response: Accelerate structural reforms and limit state involvement.
  - Continued fiscal relaxation and slippages in structural reforms — Relative likelihood: Medium; Impact if realized: Medium.
    - Could delay reforms needed to boost potential growth, result in expenditure overruns, contingent liabilities shock.
    - Policy response: Adopt growth-friendly fiscal adjustment strategy and accelerate structural reforms.

*Source: IMF staff report excerpt contained in the supplied content unit.*

### Box 1. The Recent Refugee Crisis

### Box 1. The Recent Refugee Crisis

### Arrivals and applicant composition
- The number of asylum seekers arriving in Hungary in 2015 reached almost 174,400.
- This represented close to 14 percent of all first-time asylum seeker applications in the EU—the largest share following that of Germany.
- Relative to its population, in 2015, Hungary received the largest number of asylum applications in the EU.
- Syrians accounted for close to 37 percent of all first-time asylum applications.
- Applicants from Afghanistan accounted for 26 percent of all first-time asylum applications.

### Transit dynamics and labor market implications
- Hungary is a transit point to other European countries, particularly Germany, Austria, and Sweden.
- Refugees typically make their way to other destinations quickly and before completion of the asylum application process.
- Due to their transit nature, migrant inflows are not expected to have an impact on labor market conditions.
- The rising numbers of arrivals required an expansion of capacities in reception facilities.

### Fiscal cost and government response
- In 2015, the government allocated HUF 83.9 billion (about ¼ percent of GDP) to cover security and humanitarian expenses.
- Of this allocation, about HUF 45.7 billion was spent in 2015, with the majority of spending directed to strengthening border control and security.
- Future fiscal costs will critically depend on the number of new arrivals, which is highly uncertain.
- The remaining amount of the initial allocation would be expected to be spent in 2016.

*Source: IMF staff calculations and Eurostat as presented in Box 1. The Recent Refugee Crisis.*

### Box 4. Is the Post-Crisis Decline in Investment Permanent?

### Box 4. Is the Post-Crisis Decline in Investment Permanent?

### Post-crisis investment dynamics in the EU and Hungary
- Investment rates fell in most EU countries in the aftermath of the crisis, with steeper declines in new member states.
- Despite a subsequent recovery and easing of financial conditions, private investment rates remain below pre-crisis levels.
- For Hungary specifically:
  - Pre-crisis average investment rate had been higher than its closed-economy steady-state (“golden-rule”) value.
  - In the post-crisis period, Hungary’s investment rate appears to have undershot the “golden rule”, suggesting scope for boosting investment.
  - The decline in investment was to a large degree concentrated in construction.

### Model and methodology
- The neo-classical (Ramsey-Cass-Koopmans) growth model is calibrated for EU countries using national accounts data and European Commission estimates of capital stocks and TFP.
- Model implications:
  - An economy converges to a steady-state equilibrium where consumption is maximized and the saving/investment rate is constant at its “golden-rule” value.
  - Income, consumption, and capital grow at a fixed rate equal to the sum of exogenous labor force growth and labor-augmenting productivity growth.
  - The investment rate falls monotonically toward the “golden-rule” as the economy converges to its steady state.
  - The closed-economy “golden-rule” saving/investment can be interpreted as a lower bound for the investment rate in Hungary along its path of convergence to euro area income levels.

### Interpretations and sectoral evidence
- Two interpretations of Hungary’s pre-crisis higher-than–steady-state investment rate:
  - Convergence from above toward the “golden rule” (consistent with model dynamics).
  - Over-investment in specific sectors (an alternative, empirical explanation).
- Sectoral evidence supports the over-investment interpretation:
  - The decline in investment post-crisis was concentrated largely in construction.

### Role of EU funds and private sector response
- EU funds have contributed to supporting investment in Hungary.
- Weak business climate appears to have limited the private-sector contribution to investment recovery.

*Prepared by P. Iossifov.*

### Annex I. Response to Past Fund Policy Advice

### Annex I. Response to Past Fund Policy Advice

### Implementation of past IMF recommendations and main policy actions
- Authorities actively engaged in policy dialogue and implemented a number of IMF recommendations, but some policies deviated from previous IMF advice.
- Fiscal policy
  - 2015 fiscal deficit came in below target and the public debt ratio declined moderately.
  - Budget composition remains a concern: sectoral taxes and the public wage bill are still high, while allocations to health and education are inadequate.
- Monetary policy
  - The MNB resumed the easing cycle in March 2015 and cut the policy rate by 75 basis points in five equal steps to 1.35 percent in July 2015.
  - In March 2016, the MNB cut the policy rate further to 1.20 percent.
  - Refinements to monetary policy instruments were implemented to strengthen transmission, provide cheap funding for SMEs, ensure cheap financing for the government, and reduce vulnerabilities.
- External vulnerabilities
  - The FX mortgage conversion significantly reduced households’ exposure to exchange rate risk.
  - The MNB’s self-financing program helped reduce reliance on non-resident funding and on FX-denominated public debt.
- Financial sector / banking system
  - Initiatives to reduce NPLs are proceeding, including the setup of an asset management company and the new Personal Bankruptcy Law.
  - The bank levy was reduced in 2016 and further reductions are expected.
  - State ownership of banks has increased despite policy advice to limit the role of the state in the banking system.
- Labor market, competitiveness, and business climate
  - Affordable child-care facilities, flexible child-care services, and flexible employment opportunities are gradually expanding to help increase female labor participation.
  - The public works scheme continued to expand to support activation and employment of disadvantaged groups, particularly the low-skilled and long-term unemployed.
  - The role of the state in the economy remained high.

### Debt and Non-Performing Loans — Non-Financial Corporations (NFCs)
- NPL stock and coverage
  - The share of loans overdue more than 90 days (old NPL definition) granted by banks to NFCs has declined but a substantial overhang remains.
  - At end-June 2015, the old NPL ratio for NFC loans was 14 percent, but the new (broader EU) definition stood at 24 percent. The new definition mainly affects project loans.
  - The average loan-loss coverage ratio of project loans is reportedly around 71 percent.
- Sectoral developments and balance-sheet repair
  - Most non-performing project loans have already been restructured; many relate to commercial real estate in the Budapest area.
  - Construction and market services were the worst sectors affected by the global recession.
  - NFCs have been reducing debt (unconsolidated loans and issued securities) but debt levels remain high compared to peers.
  - NFCs built up deposits with domestic banks: 17.8 percent of GDP at end-2015 compared to 14.5 percent at end-2009.
- Bank lending dynamics
  - Domestic bank lending to NFCs remained subdued: -12.2 percent y-o-y, end-2015.
  - Two distinct factors mask lending dynamics:
    - Large reputable companies substituted domestic bank lending with less expensive foreign funding; loans from abroad account for almost 59 percent of their total debt (end-June 2015), compared to around 43½ percent at end-2009.
    - Bank lending to riskier SMEs increased: 3.6 percent (y-o-y, end-2015), mainly due to the Funding for Growth Scheme.
  - One-off factors include write-offs by MKB Bank, which is under resolution.
- MARK (asset management company) and related measures
  - In November 2014, MARK was established as a fully-owned subsidiary of the MNB and funded by almost €1 billion to purchase non-performing commercial real estate loans from banks.
  - Operations began on March 21, 2016, after DGCOMP (February 10, 2016) was assured transactions would be voluntary and based on market prices using a rule-based approach to avoid state-aid issues.
  - MARK will operate over a 10 year time horizon and will sell assets for profit; MARK is not envisaged to become a developer but may improve assets based on case-by-case cost-benefit analysis.
  - The MNB has taken measures to encourage banks to use MARK and has hinted at openness to seek external funding on market terms and pursue a broader ownership structure later.
  - Fund staff encouraged transparency and strengthened governance in line with IMF technical assistance recommendations.
  - In October 2015, the MNB decided to introduce a systemic risk buffer, effective January 2017, to encourage banks to eliminate large non-performing project loans; the additional capital buffer will range from 0 to 2 percentage points depending on the share of problematic project exposures relative to domestic pillar I capital requirement.

### Debt and Non-Performing Loans — Households
- Compensation and NPL effects
  - In 2015, following 2014 legislation on unfair banking practices, significant compensations were paid to indebted natural persons, which lowered outstanding debt and temporarily reduced household NPLs.
  - Banks reportedly strengthened loan-loss coverage from almost 59 percent at end-2014 to around 64 percent by mid-2015.
  - When compensations were no longer adequate to cover overdue payments, the NPL ratio increased again.
- FX mortgage conversion and other measures
  - Conversion of foreign-currency denominated mortgages in Q1:2015, and car and personal loans in Q4:2015, significantly reduced households’ exchange rate risk.
  - The share of foreign currency denominated lending to households declined from 52.8 percent at end-2014 to below 1 percent at end-2015.
  - The smaller conversion of FX denominated car and personal loans (about 242,000 contracts) at a preferential exchange rate is estimated to have cost HUF 31 billion; losses will be shared between banks and the government since banks can deduct these losses from future profits.
  - Effective January 1, 2015, a payment-to-income ratio was introduced and the loan-to-value ratio was strengthened to prevent future excesses; these ratios have not yet been binding.
- Social programs and insolvency framework
  - NAFA (asset management agency for non-performing residential loans of vulnerable households) was established in 2011, began operations in mid-2012, and purchases residences of vulnerable and delinquent households taking social aspects into account.
  - Initially resources covered 5,000 households, later increased to 25,000, and 35,000 in 2015.
  - The new Personal Insolvency Law:
    - First phase became effective September 2, 2015, and applies to households whose dwelling would be subject to enforcement and sale.
    - Other over-indebted persons will be covered effective October 1, 2016.
    - Natural persons with debt between HUF 2 and 60 million (about €6,500 to almost €200,000) can under certain circumstances apply.
    - Out-of-court debt settlement can be initiated under coordination of the main creditor; “Family Bankruptcy Services” check legal conditions and register initiation and settlement.
    - If no agreement within 120 days (90 days if single creditor), court mediation (“in-court” first phase) or court decision (“in-court” second phase) follows.
    - In the second phase a minimum recovery is guaranteed; repayment plan covers five years (extendable by up to two years in exceptional cases); remaining debt is discharged after the plan.
    - If repayment plan is not observed, creditors may ask the court to terminate the debt resolution procedure; a debtor cannot file again before 10 years after termination.
  - Eligibility and restrictions:
    - Settlement may not be initiated if the debtor has significant public debt, properties locked due to criminal proceedings, unlimited liability due to unlawful treatment of joint stock, or legal dispute among debtors.
    - Other requirements include: overdue debt must exceed HUF 0.5 million (approximately €1,600); be over 90 days overdue; total debt must exceed the combined value of assets and income for the next five years, but debt may not exceed twice the value of assets and projected income during the settlement period; at least 80 percent of the debt is not disputed by the debtor; and there are no more than five creditors.
    - Socially disadvantaged debtors whose insolvency may not be restored may sell property to NAFA; more complicated cases go directly to court.

### EU Structural and Investment Funds (ESIF)
- Allocation and scale
  - ESIF allocation for Hungary over two program periods amounts to 45 percent of 2015 GDP (excluding agricultural subsidies and the Rural Development Fund).
  - Hungary has the third largest allocation in absolute terms (€47 billion) after Poland and the Czech Republic; and second after Estonia in per capita terms (€4,700).
- Administration, co-financing, and effective cost
  - ESIF allocations come from three funds administered by national authorities under monitoring by the European Commission (EC); national authorities select projects in line with “operational programs” and “priority axes”.
  - Reimbursements are made upon presentation of invoices vetted and certified initially by the national certifying authority and ultimately by the EC.
  - ESIF grants require national co-financing—typically around 15 percent.
  - Certain costs (most land purchases and VAT on certain inputs) must be fully covered by national authorities, raising effective co-financing sometimes to 30–50 percent.
  - In Hungary, the effective co-financing in 2015 constituted around 32 percent, or equivalent to about 2¾ percent of GDP.
  - Most projects require maintenance, translating into permanent increases in budget spending.
- Use, absorption, and fiscal implications
  - Three quarters of EU transfers received by Hungary were spent on investment, with significant focus on infrastructure.
  - For the 2007–13 program period, Hungary used a bigger share of funds on infrastructure and environmental projects but lagged peers in R&D investment.
  - The share of investment projects financed by ESIF increased from 20 percent in 2007 to around 70 percent in 2015 of total public investment; together with private investment projects ESIF-financed investments amounted to about a third of total investments in 2015.
  - Absorption dynamics:
    - The rate of absorption is uneven with significant acceleration toward the end of the program period.
    - Grants not drawn within deadlines (i.e., 2015 for the 2007–13 program period) are lost.
    - In 2015, Hungary is estimated to have absorbed almost 20 percent of all ESIF funds available for the past program period, resulting in expected inflow of about 5¾ percent of GDP, of which 3½ percent of GDP were received in 2015.
    - Many countries in the region followed similar back-loaded patterns; Czech Republic and Slovakia preliminary figures suggest increases of 21 and 25 percent of available funds, respectively, in 2015.
  - Risks and potential fiscal costs:
    - The rushed spending of EU funds may compromise efficacy and could adversely affect the fiscal position.
    - Hungary is likely to reach almost a 100 percent absorption rate for the 2007–13 program period through an “oversubscription” practice (about 5–6 percent of submitted invoices typically rejected in subsequent checks).
    - Hastened absorption may have caused more irregularities in project certification by the EC, resulting in potential additional fiscal costs since the EC will not reimburse these costs.
    - The Hungarian government has been in talks with the EC regarding reimbursement of around HUF 500 billion (approximately 1½ percent of GDP) of EU funding.

*Source: Annex I, Annex II, and Annex III of the IMF staff report content unit _cr16107 - Annex I. Response to Past Fund Policy Advice.*

### 6.      The disbursements for the 2014–20 program period are proceeding. The Partnership

### _cr16107 - 6.      The disbursements for the 2014–20 program period are proceeding. The Partnership

### Disbursements and absorption of 2014–20 EU program funds
- The Partnership Agreement and all operational programs have been approved and disbursements have started.
- Final decisions on competing projects are made by the Office of the Prime Minister.
- Allocation shift compared with previous program period:
  - Previous period: roughly 70/30 percent allocated to the public/private sector.
  - Current program period: 60/40.
- Slightly more funding will be allocated to research and development.
- Projected risks and developments:
  - The projected slowdown in absorption in 2016 is subject to downside risks.
  - The government announced that all tenders of this period should be finalized by mid-2017 to boost early absorption.
  - Risks include: shift in administrative focus, absorption fatigue, and limited pool of potential projects.
  - The Hungarian National Bank projects that EU grants (without agricultural subsidies) could decline by over HUF 1000 billion (about 3 percent of GDP) from 2015 to 2016.
  - The Ministry for National Economy hopes some of the “absorption energy” from 2015 will be carried over to 2016.
- Procurement and administrative context:
  - Irregularities of absorption of EU funds in many EU countries are related to poor procurement practices.
  - A new Hungarian procurement law became effective in November 2015.

### Recommendations to improve utilization and efficiency of EU funds
- Suggested measures to enhance utilization of EU funds:
  - Better planning of public investment.
  - Improved costing and prioritization of public investment plans.
  - Employing a standard methodology for cost-benefit analysis and project appraisal.
  - Taking account of potential risks to projects.
  - Establishing a central review process of major projects.
  - More efficient and open procurement processes.
- Supporting references within the source:
  - The text cites "Making Public Investment More Efficient, 2015, International Monetary Fund, Washington, D.C." for further detail.

### Annex IV — The impact of labor cost reduction on employment of vulnerable groups (Overview)
- Objective and literature context:
  - Literature shows a reduction in the tax wedge has a positive effect on employment; targeted social security contribution (SSC) cuts recommended as cost-efficient.
  - Employment effects vary by country depending on market competition, elasticities of demand and supply, and labor market institutions.
  - Across-the-board tax cuts are costly; targeted cuts toward groups with higher labor supply elasticity are more efficient.
- General lessons on SSC cuts design:
  - Minimizing new distortions and employment substitution is crucial.
  - Targeting broad characteristics (low-skilled, youth) is more effective than narrowly-defined groups (long-term unemployed, new hires).
  - Phased reduction of employer SSC by wage level helps avoid a “low-pay” trap.
  - Good communication and limited paperwork aid successful implementation.

### Hungary’s SSC policy and labor market developments
- Policy implemented:
  - Job Protection Action Plan (JPAP), effective January 2013:
    - Employer’s SSC permanently cut in half for employees under 25 and over 55, and employees in elementary occupations.
    - 100 percent cut for:
      - Long-term unemployed re-entering the labor market,
      - Those returning to work after child-care leave,
      - Career starters for the first two years of employment.
    - Followed by a 50 percent cut in the third year for the groups above.
  - Since July 2015, eligibility extended to agricultural workers between the ages of 25 and 55, potentially affecting a further 30,000-35,000 employees.
- Stylized labor market facts and outcomes:
  - Overall labor market improvement:
    - Unemployment rate dropped from 11 percent at end-2012 to 6.2 percent in 2015:Q4.
    - Labor force participation increased by 4.9 percentage points to 69.1 percent.
  - Youth (15–24 years):
    - Youth unemployment declined from 28 percent at end-2012 to 16.7 percent in 2015:Q4.
    - Participation rates increased by 4.2 percentage points.
    - Cumulative growth in youth employment amounted to 26 percent since end-2012.
    - Public works accounted for about 40 percent of youth employment growth; youth employment outside public works was still two times higher than that of a non-targeted group.
    - In absolute terms, unemployment for low-skilled young workers fell from 52 percent to 26 percent; for high-skilled young employees it was reduced to 10 percent.
  - Older workers (above 55):
    - Employment grew significantly faster than the non-targeted comparator group.
    - Participation rate for this group rose by 9.5 percentage points since end-2012.
  - Low-skilled 25–54 years:
    - Unemployment declined from 23 percent at end-2012 to 16 percent in 2015:Q4.
    - Participation increased by 8 percentage points to 71 percent during the same period.
    - Cumulative employment growth since end-2012 was 19.2 percent, largely due to expansion of public works from 92,000 to 230,000 employees (adding 78,600 new low-skill jobs).
    - Outside public works, cumulative employment growth was 3.1 percent, significantly lower than comparator groups.
  - Women and long-term unemployed:
    - Impact of tax cuts on female return-to-work and long-term unemployed was limited.
    - Improvements for women 25–45 were subpar or similar to untargeted group.
    - No visible change in the declining trend of long-term unemployment relative to short-term unemployed after the tax cuts.
- Fiscal and eligibility notes:
  - Around 25 percent of the workforce is eligible for an SSC cut under the JPAP.
  - Authorities estimate the short-term fiscal costs (reduction in wage costs in the private sector) at 0.4 percent of GDP annually.
  - Net costs could be lower due to increased employment; medium-term fiscal costs depend on balances of social security funds.

### Policy considerations and recommended refinements
- Effectiveness observations:
  - Targeted tax cuts in Hungary appear more effective for the young and the elderly.
  - Impact on female employment and long-term unemployed is less pronounced.
  - Employment impact on low-skilled is biased by public works expansion.
- Recommendations to improve cost-efficiency and outcomes:
  - Narrow eligibility to groups with high employment responses to tax cuts; redirect savings to active labor market policies.
  - Consider complementary measures:
    - Introducing differentiated minimum wages.
    - Broadening the definition of eligible skilled workers from the currently narrowly defined group.
    - Better monitoring of the disability system and eligibility criteria for unemployment and social benefits.
    - Demand-pull measures: apprenticeship programs, vocational education, strengthened training components.
    - For long-term unemployed: prioritize training and placement services over tax cuts.
    - For youth: improve skills matching via enhanced cooperation between universities and employers.

*Italicized source attribution: IMF staff report excerpt as provided in the supplied content.*

### Annex V. Hungary: Debt Sustainability Analysis

### Annex V. Hungary: Debt Sustainability Analysis

### Overview
- Hungary has high public and external debt and financing needs; reliance on nonresident funding remains heavy though declining.
- Under the baseline scenario:
  - Public debt is projected to decline but will remain around 70 percent of GDP.
  - Gross financing needs are forecast to decline to around 11 percent of GDP.
- Public debt sustainability is subject to considerable risks, particularly from lower GDP growth.
- External debt is expected to continue to decline, with all sectors except the government continuing to make net repayments.
- The projected downward path of external debt is sensitive mainly to current account shocks.

### Baseline scenario and key assumptions
- Baseline elements:
  - Primary surplus of around 1 percent of GDP.
  - Effective interest rate declining in 2016 and 2017 and gradually rising afterwards in line with global WEO assumptions.
  - Decline in the share of short-term debt in line with the authorities’ debt strategy.
  - Medium-term output growth at 2 percent.
  - Financial markets remain accessible and there are no significant interest rate spikes.
- Specific projections (selected, as of March 07, 2016 table):
  - Nominal gross public debt: 2014: 73.0; 2015: 76.2; 2016: 75.3; 2017: 74.2; 2018: 73.7; 2019: 72.6; 2020: 71.3; 2021: 70.2 (in percent of GDP).
  - Public gross financing needs: 2014: 22.7; 2015: 21.9; 2016: 21.4; 2017: 17.8; 2018: 14.3; 2019: 18.1; 2020: 17.9; 2021: 21.5 (in percent of GDP).
  - Real GDP growth (in percent): 2014: 0.6; 2015: 3.7; 2016: 2.9; 2017: 2.3; 2018: 2.5; 2019: 2.4; 2020: 2.2; 2021: 2.1.
  - Inflation (GDP deflator, in percent): 2014: 3.5; 2015: 3.2; 2016: 2.0; 2017: 2.3; 2018–2021: 2.7 each year.
  - Effective interest rate (in percent): 2014: 6.2; 2015: 5.6; 2016: 4.9; 2017: 4.7; 2018: 4.6; 2019: 4.6; 2020: 4.7; 2021: 5.0.
- Cumulative projected change in gross public sector debt over 2014–2021: -6.2 (in percent of GDP).

### Public debt vulnerabilities and risks
- Debt profile improvements:
  - Share of public debt held by non-residents and share denominated in foreign currency declined due to the "self-financing" program and are expected to decline further.
  - Self-financing program did not have adverse impact on average debt maturity or effective interest rates; debt maturity increased slightly in 2015.
  - Domestic interest rates remain at historical lows at levels close to yields on Hungarian Eurobonds.
- Remaining vulnerabilities:
  - Public debt stock at 75.3 percent of GDP and gross financing needs at around 20 percent of GDP (levels cited as a vulnerability).
  - Possible shocks: increase in sovereign spreads through contagion, exchange rate depreciation, reduced appetite by international investors, increase in global interest rates, growing contingent liabilities, deterioration in the primary fiscal balance from expenditure overruns, inefficient SOEs, and delays in public administration reform.
  - Probabilistic analysis indicates a 20 percent probability that public debt could enter an increasing trajectory based on historical volatility.

### External debt dynamics and vulnerabilities
- Historical and projected trends:
  - Gross external debt declined from a peak of 149 percent of GDP in 2009 to about 109 percent by end-2015.
  - Improvement reflects heavy bank deleveraging and FX household loan conversion.
  - Intra-company loans related to FDI remained broadly stable, amounting to about 24 percent of gross debt (trend upward from 25 percent in 2013 to 31 percent in 2015 — note: percentage points as reported).
  - FX conversion and MNB’s self-financing program expected to keep external debt on a declining path over the medium term.
- External debt vulnerability to shocks:
  - An adverse permanent current account shock of ½ standard deviation of historical variation would add about 14 percentage points of GDP to external debt.
  - An adverse permanent growth shock of ½ standard deviation would add about 7 percentage points of GDP to external debt.
  - A one-time real depreciation of 30 percent would add 7 percentage points of GDP to external debt.
- External debt path remains sustainable under a range of shocks but is most sensitive to current account shocks.

### Stress tests and alternative scenarios (public DSA)
- Stress tests performed include:
  - Primary balance shock.
  - Real GDP growth shock.
  - Real interest rate shock.
  - Real exchange rate shock (including a one-time real depreciation of 30 percent).
  - Combined macro-fiscal shock.
  - Contingent liability shock.
- Selected scenario outcomes (chart summaries and tables):
  - Baseline gross nominal public debt around 68–75 percent of GDP across projections (varies by chart and scenario).
  - Historical scenario: higher debt outcomes (example box values: Historical: 96 percent for one test vs Baseline 68 percent).
  - Combined shocks and current account shocks increase external debt markedly (examples in bound tests: CA shock baseline 68 -> scenario 82; combined shock baseline 68 -> 79; 30% depreciation baseline 68 -> 75).
- Realism and forecast track record:
  - Hungary’s median forecast errors (2006–2014) reported for Real GDP growth: -1.54 (actual-projection), Primary Balance: 0.82 (in percent of GDP), Inflation (Deflator): 0.34 (in percent).
  - Assessments of projected fiscal adjustment and CAPB adjustments are included (plots and percentile information shown in source).

### Debt-stabilizing metrics and external debt framework
- External debt (baseline, percent of GDP): 2010: 143.1; 2011: 134.4; 2012: 129.0; 2013: 118.4; 2014: 114.8; 2015: 108.8; 2016: 103.4; 2017: 96.3; 2018: 86.4; 2019: 79.4; 2020: 72.2; 2021: 68.1.
- Change in external debt (percent of GDP): 2015: -5.9; 2016: -5.4; 2017: -7.1; 2018: -9.9; 2019: -7.0; 2020: -7.2; 2021: -4.1.
- Gross external financing need (in billions of Euros and percent of GDP):
  - 2015: €26.2 billion (24.1 percent of GDP).
  - 2016: €19.6 billion (18.5 percent of GDP).
  - 2017: €14.6 billion (13.6 percent of GDP).
  - 2018: €13.6 billion (12.1 percent of GDP).
  - 2019: €12.1 billion (10.3 percent of GDP).
  - 2020: €15.8 billion (13.1 percent of GDP).
  - 2021: €13.8 billion (11.1 percent of GDP).
- Debt-stabilizing non-interest current account (long-run constant balance): 2.7 (in percent of GDP) for 2021.

### Policy-relevant observations (from the analysis and authorities’ statement)
- Credible fiscal reforms are critical; absent such reforms public debt-to-GDP would decline only modestly to just below 70 percent of GDP over the medium term.
- Authorities’ debt strategy and MNB self-financing program have contributed to reducing FX-denominated debt and non-resident holdings, improving the debt profile.
- Key domestic policy vulnerabilities to monitor: contingent liabilities, primary balance slippages from expenditure overruns, inefficiencies in state-owned enterprises, and delays in public administration reform.
- Continued prudent fiscal policies, adherence to national and European fiscal rules, and rationalization/prioritization of public expenditure are emphasized to support sustainable debt reduction.
- Monetary policy has been accommodative and the MNB stands ready to use instruments to contain second-round inflation effects and support credit conditions; the Self-Financing Program has aided reduction of external vulnerabilities while easing monetary conditions.

*Source: IMF staff — Annex V. Hungary: Debt Sustainability Analysis (as provided in the source content)._*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16107.pdf_