Hungary–2013 Article IV Consultation and Third Post-Program Monitoring Concluding Statement of the IMF Mission
January 28, 2013
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
Favorable global market conditions have eased government funding pressures, but the economic outlook remains difficult. The economy is in the midst of a second recession in four years with consumption and investment falling and unemployment remaining stubbornly high. While the fiscal deficit was reduced significantly in 2012, partly to offset an earlier loosening, policies to achieve this worsened the investment climate. A new policy course is needed to deliver the required medium-term fiscal adjustment in a sustainable way to support growth and confidence, repair the financial sector, and promote structural reforms to boost the potential of the Hungarian economy.
1. The economy is in recession and prospects for a quick recovery have weakened. GDP is estimated to have declined by around 1½ percent in 2012 on the back of contracting private consumption and investment, and a large fiscal consolidation. Except for part of the export oriented manufacturing sector, the rest of the economy is sputtering. Job creation in the private sector is anemic and unemployment remained roughly unchanged despite the support from the government’s public works program. Corporate and household bank lending continued to contract. On the basis of current policies, economic activity is expected to stagnate in 2013, with a modest positive contribution from net exports likely to be offset by continued weak domestic demand. The government believes that higher eurozone growth, strategic agreements with selected companies in the manufacturing sector, and faster absorption of EU funds would spur growth in the coming years. However, unless investment recovers from the current historically low level and with unit labor costs slowly increasing, competitiveness, exports, and growth would suffer over time and keep the medium-term growth outlook subdued.
2. This weak performance is due partly to structural factors, but also to specific domestic policies. The needed deleveraging of the household and public sectors has inevitably had a negative impact on growth. And although imbalances have improved, the adjustment process is still not complete and will pose a further drag on activity. Government policies have sought to cushion the impact of the downturn on households, including through minimum wage hikes, mortgage relief schemes, and utility tariff cuts. However, increased state interference in the economy and frequent and unpredictable tax policy changes, particularly on the corporate sector, undermined private sector activity. This contributed to a negative feedback loop between slow growth, weak investment, bank disintermediation, and high public debt.
3. The current favorable external market conditions provide a propitious moment for corrective action. The intense market pressures seen in early 2012 dissipated recently following actions taken by major foreign central banks but also boosted by the government’s commitment to fiscal consolidation. Surging private flows into government debt, especially by non-residents, are now helping Hungary to cover its large fiscal financing needs. While this is a welcome development, it also underscores the most immediate vulnerability. The gross external and public financing needs remain very large and a sudden change in investors’ behavior could undermine financial stability. Under these circumstances, strong policies are crucial to sustain confidence and market access.
4. In the period ahead, Hungary needs to urgently address three interconnected challenges: (i) sustain fiscal consolidation to decrease public debt but with measures that strengthen incentives to invest and work; (ii) repair the financial system to ensure that savings are effectively intermediated to the economy; and (iii) advance structural reforms to raise potential growth.
5. In 2012 the government demonstrated a strong commitment to fiscal consolidation. After eight years with sizable structural deficits, the government’s priority was to reduce the overall deficit to around 2½-2¾ percent of GDP in 2012-13 with a view to exit the EU’s Excessive Deficit Procedure (which Hungary entered into shortly after its accession in 2004). While fiscal consolidation was necessary, the government has relied excessively on ad-hoc measures (VAT hikes, sectoral taxes including a new banking transactions tax (BTT), and across the board spending cuts) to cover emerging fiscal gaps, caused by slower-than-planned growth, underlying spending pressures, and costly policy initiatives, like the introduction of a new PIT system at a time it was not affordable. The high frequency of new and often discriminatory measures together with the erosion of domestic fiscal institutions has dented public confidence in policy making.
6. Based on current policies, the general government deficit is expected to increase in 2013-15. Assuming that the Country Protection Fund reserves are saved, the deficit is likely to reach 3¼ percent of GDP in 2013. The bulk of the overrun is caused by possible revenue shortfalls, including from tax administration and the BTT, delays in launching the electronic toll system, and higher spending on education and copayments to EU funds. The deficit is projected to remain above 3 percent of GDP in 2014-15. As a result, public debt would continue to hover around 78 percent of GDP—some 10 percentage points higher than its pre-crisis level, despite the notable consolidation effort in 2012 and the one-off effect from the transfer of assets from the private pension funds in 2011.
7. A different fiscal policy mix can deliver the needed adjustment in a more growth friendly and sustainable way. The original Szell-Kalman plan rightly put the emphasis on spending consolidation through structural reforms. However, three years after its conception, public expenditure remains high (even adjusting for the planned acceleration in the absorption of EU funds)—and among the highest in the region—increasingly financed through distortive taxes. Streamlining spending while protecting the most vulnerable would open room for the needed rationalization of the tax system which, in turn, would support investment, labor participation, and growth. Possible actions include: (i) streamlining the cost of government bureaucracy, including by implementing recently announced measures aimed at reducing central government employment, and containing spending at the local government level where savings can be found after the centralization of health and education spending; (ii) restructuring loss making transport SOEs to reduce state transfers; (iii) better targeting social benefits to vulnerable groups; (iv) gradually eliminating sectoral taxes while streamlining the corporate tax regime; (v) reducing disincentives to labor participation embedded in the personal income tax to complement measures in the job protection plan boosting labor demand; (vi) reducing tax expenditures; and (vii) in addition to measures already taken, adopting a more comprehensive approach to tackle VAT fraud, particularly in the basic food sector. The goal should be to reduce public spending while phasing out distortive taxes, and bring the deficit to well below 2 percent by 2015, which is important to set public debt firmly on a downward path.
Monetary and exchange rate policies
8. After several consecutive policy rate cuts, further monetary easing should be considered very cautiously. Inflation is still not well anchored and its projected decline to 3.5 percent in 2013 is partly the consequence of the reduction in utility tariffs. While the desire to help rekindle domestic demand is understandable, lower policy rates are unlikely to have a material impact on credit and aggregate demand at the current juncture given the difficult operational environment for banks. Moreover, the foreign currency exposure of private and public balance sheets, albeit reduced, is still significant and further rapid rate cuts, if they result in sizable currency depreciation, could be destabilizing. A strong policy framework, including maintaining the independence of the MNB and the credibility of the inflation targeting regime would support a durable improvement in business and market sentiment. In this regard, in an environment of continued capital inflows, the MNB should maintain adequately high level of reserves to provide buffers against shocks.
Financial sector policy
9. The banking system is facing great challenges as it seeks to redefine its role in an uncertain environment. Banks are generally liquid and most appear well capitalized but they continue to experience losses resulting from high non-performing loans (NPLs) and related provisioning, a heavy tax burden, and the mortgage pre-payment scheme. The share of corporate and household NPLs increased significantly in 2012 to 21 and 15 percent, respectively, and is expected to rise further in 2013. Restructured loans continue to grow and now make up a significant part of banks’ portfolios. Portfolio cleaning remains sluggish reflecting a frozen real estate market and banks’ unwillingness to realize losses, as well as legal and regulatory obstacles to debt collection. Banks’ loan portfolio is contracting, unlike in most regional countries, against a depressed economic environment and a sharp reduction in external funding. Unless bank lending recovers, the economy will struggle to grow.
10. A turnaround of bank lending requires improving the banking system’s operational environment. Key steps would include increasing the predictability of government policies, scaling down the tax burden, including the retroactive levies, and facilitating conditions to help banks clean up their asset portfolio, including by removing tax, legal, and regulatory obstacles. These would be a more effective, and less costly and distortive, way to restore credit growth, as opposed to government initiatives to stimulate credit through tax incentives for specific bank lending and direct lending by state-controlled banks. The government’s intention to reach a new agreement with banks is encouraging, but tangible steps would be needed to address the underlying problems that undermine lending activity.
11. Prudential norms could contribute to reducing still-large FX swap exposures. The stock of FX swaps of the banking sector has declined by nearly one third since end-2011, in tandem with the reduction of FX-denominated assets. However, it still poses liquidity and rollover risks and banks should be encouraged to turn to more stable sources of external funding.
12. The crisis management and resolution frameworks need to be upgraded in key areas. A clear framework, outlining the powers and responsibilities of the resolution authority, the triggers, and the financing arrangements, would improve the timeliness and cost-effectiveness of remedial action, if and when, needed. The authorities are working in this direction and legislation is being drafted.
13. There are important concerns about Hungary’s potential growth. Potential GDP growth is estimated to be currently close to zero and projected to remain around 1-1½ percent in the medium term. The decline of Hungary’s productive capacity in recent years has been deeper than in peer countries; Hungary’s ranking has deteriorated in the Global Competitiveness Report; investment is at record lows; and labor participation, although improving as a result of recent government measures, remains low by regional standards.
14. Increased policy predictability, a level playing field for all business, and structural reforms are critically needed to generate higher growth and raise living-standards. While some important steps were taken during 2009-11, including the adoption of more flexible labor market regulations and parametric pension reform, the reform process has lost momentum recently and policies have been directed at piecemeal solutions. Efforts to stimulate growth through isolated measures (including by temporarily raising disposable income through utility tariff cuts and minimum wage hikes) are unlikely to provide the boost the economy needs as while supporting consumption in the short-term, they undermine competitiveness and investment. The job protection plan is a step in the right direction and the public works program has provided some temporary reprieve, but unemployment cannot be durably reduced without a robust private sector recovery. Policies should therefore focus on facilitating the expansion of private activity and raising productivity. In this regard, efforts are needed to increase competition in the product markets, address the persistent weak condition of state-owned enterprises (especially in the transportation sector), further encourage labor participation, and improve the business climate, including through a more balanced and sustainable composition of fiscal adjustment.
The mission team is grateful to the authorities and other counterparts met during our stay in Budapest for their hospitality and frank discussions. The mission collaborated closely with a parallel mission from the European Commission.