Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Hungary Struggles as Growth Slows, Investors Retreat

January 25, 2012

  • Domestic policies, euro zone crisis drag on economy
  • Country needs to attract more investment
  • Improved economic governance, fiscal policy mix can help recovery

Hungary’s government needs to improve its economic governance and fiscal policy mix as the euro zone crisis creates uncertainty for one of Europe’s key emerging markets, the IMF said in its latest annual assessment of the Hungarian economy.

Hungary Struggles as Growth Slows, Investors Retreat

A woman in Budapest, Hungary: the country should improve economic stability and governance (photo: Pascal Deloche/Newscom)


In an interview with IMF Survey online, Christoph Rosenberg, IMF mission chief for Hungary, discusses the challenges faced by Hungary’s economy and describes the IMF’s policy recommendations for the country.

IMF Survey online: Hungary’s debt was recently downgraded to junk status, and growth has slowed considerably. In light of these developments and the ongoing crisis in the eurozone, what is the outlook for the economy?

Rosenberg: Hungary never really recovered from the last crisis, so growth in the last years has been relatively modest, particularly compared to regional peers. We now expect the economy to stagnate in 2012 due to both external and domestic factors, and to only slowly recover thereafter.

In the long term, supply side measures taken under the Széll Kálmán Plan may have positive effects, but it will take time for those to take hold. And in the meantime, there are a number of headwinds externally and internally.

IMF Survey online: Describe the headwinds Hungary is leaning against.

Much like the rest of Europe, Hungary faces the difficult task of addressing large debt burdens in an increasingly difficult growth environment. At the same time, traditional economic options such as loosening fiscal or monetary policy are more constrained than in many other countries in the region.

Because Hungary is a small open economy, it is very exposed to what happens in Europe and emerging markets world wide through trade and financial channels. Hungary has one of the highest export-to-GDP ratios in the region, and is strongly integrated with the German economy, which has been a plus in the last two years. But growth in the euro zone is predicted to slow down and that will affect Hungary as well, especially since exports have been the only source of growth since the crisis.

Equally important is financial integration. Hungary’s public sector is highly dependent on foreign financing. Almost two-thirds of Hungary’s public sector debt, which stands at about 80 percent of GDP, is held by foreigners, both foreign currency-denominated debt and domestic currency-denominated debt.

Similarly, the financial system depends heavily on foreign funding. Those investors, who roll over their exposures to the tune of €35–40 billion annually, are at times concerned by the policies pursued in Hungary. They are also, of course, also highly influenced by what happens in financial markets elsewhere.

In this difficult external environment, a key challenge is to support growth. As I said, external demand is weakening, but at the same time domestic consumption and investment have been extremely weak. There are many headwinds here: low real wage growth, rising debt service, unemployment, a credit crunch. Importantly, confidence has suffered in a policy environment that is perceived by many investors and consumers as unpredictable and discriminatory.

Unfortunately, there is no easy way to jumpstart growth in the short run. Fiscal stimulus is not an option for Hungary. The budget deficit needs to be reduced to ensure that debt remains sustainable, financing needs are contained, and European Union deficit targets are met. Lowering the central banks’ interest rate is not an option either, as this would lead to a weaker exchange rate and increase the debt burden of both the public and private sector, which are heavily indebted in foreign currency.

IMF Survey online: What are the key policy solutions to these challenges?

Rosenberg: First, maintain economic stability. Here, Hungary has taken some positive steps. The budget this year is very ambitious. It includes a structural fiscal adjustment that is large by any country’s standards. It is, of course, procyclical: the government is raising taxes and cutting spending at the same time as the economy is slowing. But after two years of structural loosening this is necessary to ensure that the debt-to-GDP ratio remains on a downward trajectory and does not continue to burden the economy forever. This is also important to maintain investor confidence and keep financing costs in check. Monetary policy has also been appropriately tight, to prevent further destabilizing depreciation of the forint.

The second is to improve the design of fiscal policy, to make it less regressive and more growth friendly.

One example is the introduction of the flat tax, which a number of countries in the region use. The specific design in Hungary, along with some of the accompanying policies, have led to less than optimal economic outcomes, added to bureaucracy, and overly burdened the most vulnerable. These include

• the elimination of the basic tax allowance; under the new regime people pay taxes from the first forint they earn

• a steep 18 percent hike in the minimum wage

• a complicated system of wage recommendations and compensations for employers, and

• a sharp increase of the standard VAT rate to 27 percent and excise tax hikes across the board.

Our concern is that all this will lead to real income losses and reduced employment opportunities for lower-skilled workers. And it will make doing business in Hungary more complicated and less attractive.

Another example is the special taxes on sectors such as retail, energy, communication, and banking, which are predominantly foreign owned. These so-called “crisis levies”, as well as measures that interfered with existing loan contracts, have negatively affected the business climate. But Hungary urgently needs new investment, including from abroad.

When it comes to attracting new investments into the economy, which is crucial for growth, Hungary has lagged behind regional peers and its own good performance earlier in the last decade.

And the third area is about improving economic governance, which is also about increasing the predictability of policies. The most visible example is the debate about the independence of the central bank. The legislation passed at the end of 2011 has given the impression that the government is trying to exert influence on the decision making of the central bank. The government should do everything possible to dispel that impression by changing the law so it is in line with international best practices. They should be clear: monetary policy is conducted by those who are charged with it, not by the government.

Another area where checks and balances need to be reestablished is the Fiscal Council, which was transformed into a much weaker entity in late 2010. We are concerned that in its current form it does not have the resources or the independence to provide an outside objective view of the budgetary developments.

IMF Survey online: How affected is Hungary by the current deleveraging that’s taking place across Europe right now?

Rosenberg: In Hungary, the banking system is in large part owned by Austrian, Italian, German, and Belgian banks, which are affected by what’s happening in the euro zone and by the new capital requirements being introduced in Europe. This has led to a structural deleveraging throughout the region.

The business environment for banks has been, however, much more adverse in Hungary than elsewhere—I’m thinking of the extraordinarily high bank levy that has been imposed since 2010, but also the forced early mortgage repayment scheme that was introduced recently. This has led these banks to deleverage faster in Hungary, and that has created additional balance of payments pressures and a credit crunch. Hungary has been experiencing negative credit growth for several years in a row, which is of great concern because it constitutes an additional drag on growth.

Our view is that deleveraging is best addressed by changing the business environment itself. And in the meantime financial supervisors should keep a close eye on banks’ capital and liquidity levels.

Question: What is the status of negotiations on Hungary’s request for a loan?

Last week Christine Lagarde, IMF Managing Director, met with a country delegation to discuss when and whether to negotiate a new loan arrangement for Hungary. As the Managing Director said, we will need to see tangible steps that show the authorities’ strong commitment to engage on all the policy issues that are relevant to economic stability before.