Hungary: 2008 Article IV Consultation Discussions
IMF News, June 9, 2008
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- Published: June 9, 2008
Mission summary and key vulnerabilities
- Reductions in the fiscal deficit and the current account deficit in 2007 are welcome, but vulnerabilities are still high amid unsettled global financial conditions.
- Government debt and net external liabilities (relative to GDP) in Hungary are by far the largest among new EU member states.
- The fall in global risk appetite over the past year has led to a relatively large widening of government bond spreads.
- Financial system risks have risen; if realized, these risks would have adverse effects on the economy.
- Key policy priorities:
- Further fiscal consolidation in line with the Convergence Program, along with tax and spending reforms that preserve stability and promote growth.
- Monetary policy should remain firmly anchored by the 3 percent target for CPI inflation at the two-year horizon.
- Improvements in banks' risk management practices are needed, and financial authorities should review and test financial safety nets.
- Failure to reduce vulnerabilities could lead to a tightening of financing conditions, including higher risk premia and lower capital inflows, which would hurt the economy.
Economic outlook
- Real GDP growth projections:
- 2008: 2 percent
- 2009: 2¾ percent
- Potential growth over the medium term: about 3-3½ percent (would be higher if the size of government and the corresponding tax burden were reduced, and the administrative burden on business lowered).
- Drivers and risks:
- Private consumption: projected to rise gently as real disposable income growth increases.
- Investment: expected to accelerate underpinned by robust exports and increasing EU transfers.
- Current account: expected to narrow in 2008-09 but widen again over the medium term as domestic demand picks up.
- Real effective exchange rate: following its recent appreciation, estimated to be slightly above the value implied by fundamentals, with large assessment uncertainties.
- External vulnerability:
- Net external liabilities amount to about 100 percent of GDP, reflecting mainly FDI, bank borrowing to finance credit growth, and government debt.
- Gross external debt also amounts to about 100 percent of GDP, making gross external financing needs high, especially in 2008-09.
- Short-term debt is roughly covered by net international reserves.
- For banks, external funding from non-parent sources is potentially more volatile than funding from parent banks.
- Large foreign currency exposure of households is a related vulnerability.
- Uncertainties for 2008-09:
- Upside: better-than-projected agricultural production could spur faster growth revival.
- Downside: worsening external financing conditions could raise borrowing costs and dampen investment; large depreciation of the forint could temporarily improve competitiveness but would hurt household balance sheets because of large foreign-currency denominated liabilities, possibly depressing growth and worsening credit quality.
Fiscal policy
- 2008:
- Fiscal deficit target of 4 percent of GDP is attainable.
- Adjustment mainly on the spending side, reflecting one-off 2007 expenditures (recapitalization of the state-owned railroad company, leasing of defense equipment, motorway projects).
- Given below-potential growth, the fiscal adjustment is nevertheless appreciable.
- Any revenue overperformance should be saved and devoted to reducing public debt.
- 2009:
- Further reduction to the 3.2 percent of GDP target in the Convergence Program is essential.
- Achieving the target will require strict spending restraint (especially on wages and transfers, in line with announced spending ceilings) and continued strong revenue growth (in line with the government's forecast for real GDP growth).
- No room for tax relief unless offset by spending cuts.
- Deficit-neutral tax and spending changes that could improve incentives and growth:
- Revenue:
- Broadening the tax base and shifting the tax burden away from labor and to consumption and wealth is desirable.
- Short-term example: a cut in labor taxes could be accompanied by a reduction of exemptions, an increase in the value-added tax rate, and a rise in excise duties.
- Further simplification of the tax system and improvement in tax administration to cut compliance costs and limit opportunities for tax evasion.
- Over the medium term, consider a revenue-neutral introduction of a property tax along with a reduction in labor taxes.
- Expenditure:
- Short-term savings in social transfers via increased means-testing and tightened eligibility criteria.
- Medium-term durable reduction in government spending depends on further reform of health, education, and pension systems.
- Pension reforms: curtail incentives for early retirement and gradually raise the retirement age.
- Health care: improve governance of hospitals and increase efficiency by adopting a sound regulatory framework.
- Education: enhance coordination between local governments, expand performance-based financing, and grant greater autonomy to higher education institutions.
- Budgetary recommendations and risks:
- Given uncertainties and budget impact of reforms, the 2009 budget should include sizable contingency reserves.
- High government debt makes debt service vulnerable to higher interest rates and exchange rate depreciation.
- High inflation puts upward pressure on spending items such as wages, social transfers, transfers to local governments, and subsidies to state-owned enterprises.
- The state-owned railroad company remains a significant source of risk; increasing local government debt is also a concern.
- Introducing a rules-based fiscal framework and strengthening budgetary procedures would help deliver consolidation:
- Enact the draft fiscal responsibility law and proposed amendments to the constitution and to the local government act (both requiring a two-thirds majority in parliament).
- Proposed parliamentary budget office would provide independent scrutiny of compliance with fiscal rules.
- Law would strengthen the medium-term expenditure framework by making currently indicative spending ceilings binding, potentially lowering government borrowing costs.
Monetary policy
- Elimination of the exchange rate band is welcome; monetary policy can focus exclusively on the inflation target.
- Exchange rate movements will be factored into policy interest rate decisions to the extent they affect the inflation outlook.
- Elimination of the band removed the possibility of a one-way bet against the forint and may increase awareness of foreign-currency lending and borrowing risks.
- Inflation objective:
- Aim to reduce CPI inflation to the 3 percent target over two years to ensure macroeconomic stability.
- Over the past year, higher global food and energy prices boosted CPI inflation and underlying inflationary pressures rose: declines in core inflation and wage growth stopped and then partially reversed, and measures of inflation expectations rose.
- The central bank has appropriately tightened monetary policy.
- Outlook and risks:
- Policy interest rate may need to rise further depending on global developments' impact on underlying inflationary pressures.
- Baseline scenario: appreciation of the exchange rate in recent months, along with projected below-potential growth in 2008-09, are expected to reduce inflation to the 3 percent target by the first half of 2010.
- Upside inflation risks: further increases in global food and energy prices; an increase in the risk premium on forint-denominated assets (which would tend to boost inflation via exchange rate depreciation).
- Downside inflation risk: a sharper-than-projected slowdown in external demand would dampen inflation.
Financial stability
- Financial system risks have increased over the past year due to global financial turbulence and continued rapid credit growth.
- Credit risk:
- Banks have eased lending standards for households by lengthening maturities, raising loan-to-value ratios, and introducing new higher-risk products (such as yen-based loans).
- Liquidity risk:
- Robust credit growth has raised loan-to-deposit ratios and lowered liquid asset ratios.
- Decline in global risk appetite has increased banks' external funding costs and shortened maturities.
- Hungarian banks have no direct exposure to the U.S. subprime market, but some foreign parent banks do, creating a possible contagion channel.
- Policy measures recommended:
- Improve banks' risk management:
- Establish a mandatory credit registry for households to improve credit risk management and enhance consumer protection by discouraging excessive debt.
- Strengthen stress testing of household foreign currency exposures; implement the planned bottom-up stress testing exercise by the central bank and the HFSA as soon as possible.
- If HFSA judges banks are not adequately capitalized, it should use supervisory tools to require capital increases.
- Address liquidity risk:
- Expedite HFSA's review of banks' liquidity management practices.
- HFSA should develop and publish explicit recommendations on banks' liquidity management as soon as possible.
- Ensure banks have effective contingency arrangements in the meantime.
- Review and test financial safety nets:
- Consider introducing a formal system of early remedial action.
- Continuously enhance domestic crisis management arrangements between the central bank, the HFSA, and the Ministry of Finance.
- Given cross-border linkages to parent banks in western Europe and subsidiary banks in southeastern Europe, maintain effective communication and collaboration with foreign financial authorities.
Hungary: 2008 Article IV Consultation Discussions — June 9, 2008.