Mission Concluding Statements
Hungary and the IMF
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INTERNATIONAL MONETARY FUND
Hungary—2005 Article IV Consultation
March 11, 2005
1. Hungary's macroeconomic performance and policies made valuable gains in 2004. Growth and its structure improved and inflation was lower. The reduction of the budget deficit and declining policy interest rates were welcome developments. The government's efforts to institute more controls on expenditures should help contain the 2005 deficit.
2. To raise Hungary's medium-term growth—and, more seriously, to prevent its erosion—the authorities now need to reestablish a track record of consistent and predictable policies. Growth requires a stable policy environment. Deficit reduction is being achieved, but the legacy of repeatedly missed ambitious targets continues to generate policy uncertainty. Monetary policy, though more predictable in the past year, remains burdened by the memories of large policy swings, which were inadequately communicated to the market. An extensive agenda of structural reforms needs to be tackled to raise savings, reduce external vulnerabilities, and increase employment.
3. This is an important moment in directing the long-term course of the economy. Following Hungary's successful accession to the European Union on May 1, 2004, the government has committed to adopt the euro by 2010. A forceful policy agenda of sustainable reforms is key to successful euro adoption and to vibrant economic performance thereafter. If euro adoption is achieved largely by ad hoc measures, the scope for future policy maneuver will be reduced and anemic long-term growth will likely result. As the authorities recognize, policy slippages would add to the uncertainties and vulnerabilities.
4. An IMF mission team visited Budapest between March 2 and 11 to discuss recent economic developments, policy priorities for 2005, and longer-term strategies. The team is grateful to the authorities for the preparatory work they undertook, for their warm hospitality, and for the cordial and candid discussions.
Recent Economic Developments and Outlook
5. After robust growth in 2004, a modest slowing down is expected in 2005. Real GDP grew by a preliminary 4 percent in 2004, with the balance of growth shifting away from consumption and toward investment and exports. However, growth slowed in the second half of the year, with investment affected by domestic cyclical factors. These recent developments and the expected lower EU growth in 2005 suggest that GDP growth will moderate in 2005 to around 3.7 percent, as investment and export growth decelerate and consumption remains restrained. Meanwhile employment declined in 2004, contributing to slower wage growth. Employment is expected to increase marginally in 2005, but because labor supply is forecast to increase faster than demand, the unemployment rate is projected to rise.
6. Inflation fell sharply in the last quarter and disinflation can be expected to continue. Price increases decelerated rapidly in the second half of 2004, as the inflation of traded goods moderated due to a strengthening exchange rate, foreign competition, and declining wage growth. The inflation rate of non-traded goods and services, however, declined more modestly. Disinflation is expected to continue, led by intensified competition in traded-goods markets, and assuming stable oil prices, further wage moderation, and a broadly stable exchange rate.
7. The current account deficit remained high, reflecting a persistent savings-investment imbalance. The current account deficit is estimated at about 9 percent of GDP in 2004. Importantly, more than half of the resulting capital inflow is, in effect, financing the government's budget deficit. Declining domestic savings also contribute to keeping the deficit high. The current account deficit is expected to narrow somewhat in 2005 and 2006, helped by fiscal consolidation. With increased EU transfers, the external financing needs will also decline.
8. While the large current account deficit is partly explained by a long-run process of income convergence, it also exposes Hungary to vulnerabilities. Recent trends in the appreciation of the real exchange rate raise concerns of a building competitiveness problem. The FDI-to-GDP ratio, despite a slight recovery in 2004, has fallen below levels achieved up to 2002. Reliance on debt-financing flows has, therefore, increased, though at current interest and growth rates, the external debt-to-GDP ratio is expected to gradually decline. Hungary also has access to international foreign currency borrowing at low spreads. However, adverse shocks and a reversal of market sentiment remain serious risks. Vulnerabilities are also being generated by the trend, especially since April 2004, towards unhedged foreign currency borrowing, induced by the exchange rate stability and high domestic interest rates.
9. The significant challenges to managing public finances were evident during 2004. The budget deficit was brought down to a preliminary 4.2 percent of GDP when including contributions to second-pillar pension funds, or 5.1 percent without their inclusion (ESA-95 terms). Based on preliminary information, the consolidation was achieved mainly by a cut in primary expenditures, reflecting strong wage restraint. However, as in previous years, deficit targets were revised upwards during the year. In May 2004, the European Commission started the Excessive Deficit Procedure for Hungary, urging the authorities to take effective action for sustainable deficit reduction.
10. Going forward, adhering to the targets set in the government's Convergence Program (CP) is crucial to regaining policy credibility. While lowering the deficit below the Maastricht limit is important, of equal importance is the possibility that fiscal tightening—by improving macroeconomic stability—will deliver higher growth and will lower the public debt-to-GDP ratio from its present level of around 60 percent. Consolidation in line with the CP, if achieved with high-quality sustainable measures, seems adequate to address macroeconomic imbalances and debt sustainability issues. However, in addition to spelling out the details of the proposed consolidation measures, the authorities should remain watchful with respect to debt dynamics and be prepared for more ambitious consolidation if that becomes necessary. Future expenditure increases connected with public-private partnership projects should be carefully planned to avoid creating contingent liabilities. It is important to guard against reported deficit reduction without commensurate withdrawal of fiscal stimulus.
11. Risks remain to achieving the 2005 budget deficit target of 3.8 percent of GDP with the second-pillar pension contributions, or 4.7 percent without their inclusion. Past commitments (such as the 13th month pension and the reduction of employer contributions to health care costs) have added to budgetary pressures and rigidities, further reducing budgetary flexibility and the ability to deal with unexpected revenue shortfalls or urgent expenditure requirements. As such, vigilance will be needed to ensure that the recently instituted expenditure controls—through the operation of reserve funds and expenditure caps—are maintained. This applies, as the authorities recognize, especially to open-ended expenditure obligations (including transfers to non-profit organizations, pharmaceutical subsidies, and interest subsidies for housing). Of concern also are possible overruns in local government spending. On the revenue side, the long-standing downside risk to the realization of projected VAT revenues remains. Finally, growth and inflation could turn out to be lower than in the government's macroeconomic framework, resulting in a more general revenue shortfall. Timely identification of spending priorities must guide the measured release of reserves to ensure that the achievement of the deficit target is not endangered.
12. To be sustainable, further reductions of the deficit will require structural measures. Bolder steps on structural spending measures are needed than those envisaged in the 2005 budget. The further reduction/removal of the house subsidy scheme will not only ease the pressure on the budget but will also increase the incentives of households to save. Expenditure reforms—through a reduced involvement of the government in such areas as health and education—are required to modernize the delivery of public services and to induce household savings for the private acquisition of these services. Further initiatives to reduce the costs of the first-pillar pension and social support systems are also needed. Lowering subsidies to state-owned enterprises and completing the privatization process will enhance economic efficiency. These reduced commitments would then create space for a wide-ranging tax reform—based on lower rates and a broader base—without endangering the fiscal consolidation plans. However, the phasing out of the local business tax in a revenue neutral manner may be a matter of some urgency.
13. Though attractive in accelerating needed infrastructure development—while deferring budgetary capital expenditures—the use of public-private partnerships (PPPs) should proceed with great caution. PPPs do not reduce the fiscal stimulus. They represent a burden for future fiscal budgets, reducing their flexibility. When used primarily as a financing tool, they add to public costs because of the premium typically required on private returns and value for money is not ensured. PPPs also render difficult the evolution of public debt and the interpretation of budget trends and their macroeconomic impact.
14. Sustainable consolidation will also require strengthening the rules and procedures for budget formulation and implementation. In international comparisons, Hungary ranks low in the quality of rules and procedures for containing overruns of expenditures that are not nominally anchored. The introduction of stricter rules for the carry-over of unused funds from the previous fiscal year is welcome. More, however, needs to be done. Recent limitations to allowing additional budgetary spending without supplementary appropriations and parliamentary approval is a step in the right direction; the practice is best discontinued. The government recognizes the importance of creating a medium-term budget framework to impose fiscal discipline while also achieving greater budgetary transparency and predictability. In this context, the authorities should reconsider the three-year rolling framework under consideration in 2003, which included ceilings on overall expenditure and sub-ceilings on key components. Further checks and balances in the expenditure management system are also important. Finally, it would be worth considering if more extensive use of scrutiny through the State Audit Office would enhance transparency and credibility.
15. Following the recent reduction of policy interest rates, a calibrated lowering of rates should be guided by the market's inflation expectations. A welcome decline in inflation expectations has allowed steady reduction in interest rates. Current market expectations of further interest rate reductions are consistent with achieving the 2005 inflation target. A gradual easing of rates in line with these expectations is appropriate. A gradual approach is desirable for two reasons. First, markets must learn to interpret changes in the policy interest rate as being motivated primarily by inflation targeting considerations, and a cautious reduction in rates, with appropriate communication, is likely to facilitate the necessary learning. Second, the rate of inflation of non-traded goods prices and private sector wages is still high and the recent decline could be reversed.
16. In the medium term, the inflation target could be lowered to 3 percent a year, which the authorities assess as providing price stability, though meeting the Maastricht inflation criterion may require further reduction. The current practice of setting a new target every year for December inflation could be replaced by a single target, such as 3 percent, to be achieved over a constant targeting horizon, such as 8 quarters. Such an approach would make policy more predictable, help to anchor inflation expectations, and bring policies closer in line with international best practice.
17. In the period before euro adoption, the conduct of monetary policy requires clearer objectives and strong support from fiscal policy. Since the introduction of the inflation targeting framework in 2001, the Monetary Council, in setting policy interest rates, has appropriately considered the implications of exchange rate movements for inflation developments. But using interest rate policy to keep the exchange rate within the band and to achieve an inflation target necessitates strong fiscal support, particularly in the context of an open capital market. In an environment of large and volatile capital flows, the focus of monetary policy on containing domestic inflationary pressures should be reemphasized.
Financial Sector and Structural Policies
18. Although the financial sector remains sound, the growing share of foreign currency debt held by the private sector could be a potential source of vulnerability in the future. The banking sector remains profitable, is well capitalized, and the rapid pace of credit growth has so far not led to a deterioration in portfolio quality. However, in 2004, foreign currency denominated loans accounted for a substantial portion of new borrowing. While still low as a share of the total stock of private sector debt, the expansion of such borrowing—especially by households and small and medium-sized firms who are not naturally hedged—should be closely monitored to prevent it from becoming a source of macroeconomic vulnerability. Stronger disclosure requirements and additional provisioning for foreign currency loans could help. The recently concluded FSAP update found substantial improvements in supervision since the first assessment in 2000. It recommended initiatives in the pension and insurance sectors, which the authorities welcomed.
19. Further structural reforms are needed to increase Hungary's flexibility and competitiveness, which will be important in ensuring gains from euro adoption. The possibility of a reduction in the high tax wedge on labor income is constrained by the current budgetary situation. Labor market flexibility can be increased by facilitating geographic and occupational mobility, reducing the impediments to part-time employment, and through educational reforms that decrease the extent of skills mismatches. These reforms will allow the labor market to respond to shocks, and will also improve the business climate. Empirical evidence shows that raising the minimum wage has ill-served Hungary suggesting that further increases should be contained. The efficient use of EU funds can stimulate valuable infrastructure development, increase the quality of education, and raise the productivity of small and medium-sized firms. However, fiscal structural reforms are an essential prerequisite to limit the risk that available funds are channeled merely into new spending programs without achieving long-lasting gains.
IMF EXTERNAL RELATIONS DEPARTMENT