Public Information Notice No. 00/23

Public Information Notice: IMF Concludes Article IV Consultation with Hungary

March 17, 2000

On March 8, 2000, the Executive Board concluded the Article IV consultation with Hungary.¹

Background

Hungary remains in the vanguard of the transition economies, reflecting the pace and comprehensiveness of structural reforms. As growth in Hungary's export markets slowed in early 1999, and fiscal pressures emerged, concerns grew about a renewed "twin deficits" problem. Over the year, however, exports proved resilient, and, partly with the benefit of some exceptional receipts, the fiscal deficit was brought in slightly ahead of target:

• With an acceleration of activity in the latter part of the year, underpinned by stronger EU demand, real GDP growth in 1999 is estimated by Fund staff at just over 4 percent and is projected at 4½ percent or greater in 2000.

• Domestic demand eased, as lower capacity utilization and cutbacks in public investment slowed fixed investment growth, although improved access to credit supported private consumption.

• The strong export performance relative to other regional economies reflected high shares of final consumer goods and FDI-based trade, as well as favorable competitiveness—evidenced by the recent depreciation of the ULC-based real effective exchange rate, solid export sector profits, and a rising share in EU markets.

Labor market conditions improved over the year, although incipient regional bottlenecks for skilled labor have emerged. Total employment rose by more than 3 percent in 1999, while the unemployment rate stood at 7 percent in December. Labor productivity rose by 10½  percent in manufacturing during 1999.

Core inflation continued on a downward trend, although disinflation in headline CPI terms stalled in 1999—largely reflecting supply shocks and sharp increases in regulated prices. After reaching single digit levels in January 1999 for the first time since transition began, a 4-year downtrend in headline CPI inflation was broken in July. The 12-month CPI reached a peak of 11.2 percent in December, up from less than 9 percent in May, but returned to single digit levels in February 2000.

The external current account deficit narrowed to about 4¼ percent of GDP in 1999, more than ½ percentage point of GDP lower than in 1998. Through the first half of 1999, the deficit for the year appeared set to exceed 5 percent of GDP, but—with EU markets recovering, competitiveness strong, and domestic demand slowing—exports began to outpace imports by the latter half.

Hungary emerged fairly unscathed from global market turbulence and retains access to financial markets on excellent terms. Moreover, nondebt-creating flows significantly exceeded the external current account deficit in 1999, with FDI alone covering two-thirds of the deficit. Meanwhile, the forint yield curve has shifted downward significantly in recent months, reflecting the positive macroeconomic fundamentals and the prospects for EU accession.

Monetary policy, within the constraints of the forint's narrow band, sought to restrain demand, in a setting where market concerns about the current account and the budget took time to abate. Against a setting of high real interest rates, capital inflows kept the exchange rate close to the top of the band from mid-1999. As external and fiscal trends improved, however, the NBH was able to reduce policy interest rates—by 25 basis points in mid-November and mid-December. As market interest rates fell further in early 2000 amid growing enthusiasm for Hungarian instruments, the NBH again cut interest rates—by 50 basis points in early January and—as inflows continued—by an unprecedented 150 basis points in mid-January and another 50 basis points in February, with the crawl-adjusted interest rate differential reaching its level prior to the Russian crisis.

Despite slippages in revenue and current expenditure in early 1999, the general government deficit came in at 3.8 percent of GDP, just below the 4 percent target. After a freeze of expenditure reserves (of 0.4 percent of GDP) in early 1999, the deficit target was held through (1) spending restraint—falling heavily on investment, and (2) exceptional receipts—which helped counterbalance cyclical weakness and exceptional costs. The 2000 budget aims for further fiscal consolidation, envisaging a general government deficit of 3½ percent of GDP.

Executive Board Assessment

Executive Directors commended the authorities' recent conduct of macroeconomic policy which, together with far-reaching structural reforms implemented over the past decade, had fostered increasing economic growth, sustained confidence, and helped put Hungary in the vanguard of the economies that are candidates for EU membership.

Directors noted, however, that significant structural challenges remain, in particular in reforming the public administration and health care, as well as completing pension reform. They observed that the present upswing presented a favorable opportunity to press ahead with such structural reforms, as they would greatly enhance the longer-run outlook for growth, employment, and the public finances.

Directors agreed that fiscal policy remains crucial in containing domestic and external imbalances. They commended the authorities for keeping the 1999 budget deficit within the target, despite weaker than expected growth and serious flooding. Directors regretted, however, that the burden of expenditure restraint had fallen so heavily on capital spending.

Directors considered that the stance of the 2000 budget was appropriate, but noted that it would be crucial to lock in a lower deficit if growth proved stronger than projected. They were concerned about execution risk in the budget, and in this respect underscored the importance of controlling current expenditure. Directors also stressed the importance of firm resolve in slimming down public sector employment. A few Directors were of the view that early identification of contingency expenditure savings plans could further facilitate the implementation of the budget. Directors also urged early action to initiate health care reforms.

Directors welcomed the introduction of a medium-term fiscal framework as a major step in developing an effective strategy for the public finances. For consolidation to be durable, they noted, the authorities would need to press ahead with public sector structural reforms. In this regard, Directors encouraged the authorities to broaden the tax base and improve tax administration, so as to provide some room for reducing tax rates in the near future, especially the tax wedge on labor. In view of the extent of fiscal decentralization, a cooperative yet firm approach to local authority finances would be crucial to ensure more effective use of resources, particularly in the areas of health care and education. Directors also advised pressing ahead with the remaining elements of the pension reform.

Viewing the medium-term outlook as very favorable, reflecting Hungary's strong competitiveness, Directors stressed the role of policies in managing the possible consequences of success—including potential capital inflows in the run-up to EU accession. It would be crucial for fiscal policy to ensure the availability of adequate domestic savings so that the expansion of private investment does not put undue pressures on the external current account. Directors observed that a prudent fiscal policy stance would also help minimize the potential adverse effects of short-term inflows on the economy, in terms of variability of the exchange rate or a potential reversal of confidence. Directors thus advised aiming for a more ambitious fiscal deficit target, toward the low end of the government's medium-term range for 2000-02.

With regard to monetary policy, Directors considered that the crawling peg and narrow band, combined with controls on short-term inflows, had served the economy very well—facilitating gradual disinflation, without jeopardizing competitiveness. Moreover, Hungary's supportive fiscal policies, together with structural reforms and its labor market flexibility, had underpinned this regime, whose resilience had been evident during the Russian crisis. Recent experience with heavy capital inflows, however, illustrated the scope for tension between domestic and external goals of policy. Many Directors saw grounds for caution about further interest rate cuts, pending confirmation that disinflation remains firmly on track. They agreed that the overriding goal of monetary policy is to bring inflation down to low single levels.

For the future, Directors suggested that capital inflows, rather than outflows, were likely to pose a major challenge for the exchange regime. In this connection, they welcomed the tentative plan to widen the exchange rate band in due course. Directors considered the authorities' recourse to controls on short-term capital inflows to reduce speculative pressures as prudent. They endorsed the authorities' intention to maintain these controls until Hungary moved closer to EU membership.

Directors urged the authorities to press forward with key structural reforms to maintain Hungary's impressive track record in this field. It remains a priority to complete the privatization process and cut the number of enterprises in which the state plans to keep a permanent stake. It is also important to restructure the railway authority, and to address its persistent debt problem. Directors welcomed the authorities' heightened attention to regional development, and the expansion of small- and medium-sized firms. Noting the regional inequalities, they remarked that balanced regional development would spread higher living standards more widely, and mitigate the risk of overheating. The role of public infrastructure in this regard underscores the need for restraint over current spending. The authorities were also encouraged to design a comprehensive regional development strategy and to take advantage of all the available external resources for this purpose.

Directors welcomed Hungary's progress in implementing international standards. They welcomed the authorities' plan to proceed with a fiscal transparency self-assessment, but they warned that it was important to avoid any reversals in the trend of moving off-budget items into the budget. Directors noted Hungary's major achievements in banking reform and the decision to merge the three supervisory authorities. They underscored the importance of further enhancing the capacity of the supervisory body and welcomed Hungary's participation in the pilot Financial Sector Assessment Program. Directors viewed Hungary's economic statistics as adequate for surveillance, but urged continuing progress, for example in national income data.