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Hungary and the IMF
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On May 2, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.1
Reflecting a remarkably successful transition, Hungary is now on the verge of European Union membership. Strong external competitiveness, export growth, and foreign direct investment (FDI) have been at the heart of Hungary's success. This success has also been backed by careful macroeconomic management and significant structural reforms. However, with elections in 2002, fiscal policy was highly politically-charged and turned very expansionary, contributing to macroeconomic imbalances and an inordinate burden on monetary policy.
Developments in growth and inflation were broadly positive in 2002. Buoyed by domestic demand, real GDP growth increased to 3.5 percent (year-on-year) in the second half of this year from 3.0 percent in the first half. Headline inflation declined from its recent peak of 10.8 percent in May of 2001 (when the exchange rate band was widened) to 4.8 percent at end-2002 (and 4.5 percent at end-February 2003). Core inflation also declined significantly, and the central bank has essentially met two consecutive year-end inflation targets.
However, recent wage growth has been extremely rapid. On an economy-wide basis, year-average wage growth was 18.3 percent in 2002. This reflected continued strong wage growth in the private sector on the back of a 25 percent hike in the minimum wage early in 2002, which not only increased wages on its own but also compressed the wage scale leading to further upward wage pressure. Rapid wage growth in the public sector also reflected the 50 percent wage increase in September for some three-quarters of the public work force (without any reform of public employment). The carryover effect of the public wage increase is significant, while the demonstration effect on private wages could also be considerable.
Reflecting both wage increases and nominal exchange rate appreciation, external competitiveness declined significantly during 2001-02. The Unit Labor Costs-based real effective exchange rate appreciated by some 20 percent during this period, reflecting both exchange rate appreciation and, to a greater extent, rising relative unit labor costs. The resulting loss of external competitiveness dampens export performance now and with a lag, and may also be adversely affecting FDI. Moreover, the loss of competitiveness would raise even more serious concerns about export prospects and FDI if rapid wage growth were to persist.
The external current account deficit widened in 2002 while FDI fell off sharply. Thus, the deficit was mostly financed by debt and a decrease in official reserves. Buoyed by real appreciation, wage increases, and a fiscally-induced strengthening of domestic demand, import growth was strong. At the same time, tourism receipts fell sharply. This resulted in a current account deficit of 4.1 percent of GDP, compared with 3.4 percent in 2001. The year-on-year growth of exports of goods and services slowed down considerably in the second half of the year. The deficit would perhaps be some 2-3 percent of GDP larger if data on reinvested earnings were available and included in the official statistics.
By any standard, fiscal policy was highly expansionary in 2002. Compared with deficits (on an European System of Accounts-95 basis) of 3.0 percent of GDP in 2000 and 4.7 percent of GDP in 2001, the estimated deficit of the general government reached 9.5 percent of GDP. While one-off expenditures were sizable and their fading out will lower the fiscal deficit in 2003, there were significant permanent expenditure increases—notably on wages and pensions, as well as on health-related spending, social benefits, and subsidies. These increases not only added to the deficit last year, but they will also complicate fiscal consolidation efforts in this and later years.
Fiscal laxity, alongside rapid wage increases, put monetary policy in a difficult bind. With upside risks to inflation predominating, a speculative attack against the strong edge of the exchange rate band in January brought to a head the conflict between inflation and external objectives—in the face of a widening current account deficit and concerns over the external competitiveness. To fend off the attack, the central bank cut interest rates, undertook major foreign exchange intervention, and limited access to its two-week deposit facility. With the inflation target subordinated to exchange rate considerations in the near term, the central bank's scope to affect the inflation outturn in 2003 is limited, and inflation is likely to exceed its end-2003 target of 3½ percent ± 1 percent.
Executive Board Assessment
Executive Directors commended the Hungarian authorities for their track record of far-reaching institutional and structural reforms, and their successes in macroeconomic management. Hungary has almost completely emerged from the transition from a planned to a market-based economy, and has become highly integrated with the EU. Thus, if supported by the necessary vigorous fiscal adjustment, wage restraint, and continued structural reform, this integration will provide a good basis for progress in the direction of the adoption of the euro. Directors welcomed in this regard the strongly positive outcome of the national referendum on Hungary's accession to the EU, and Hungary's signature of the Accession Treaty in Athens.
Notwithstanding these economic achievements, Directors were concerned that a drastic increase in wages in excess of productivity growth, and an expansionary fiscal policy had contributed to weakening Hungary's external competitiveness and widening the current account deficit. They also observed that the authorities' inflation target for 2003 is at risk, making it even more important to ensure that the target for 2004 is met.
Directors observed that the speculative attack in January 2003 against the upper end of the exchange rate band of the forint highlighted the conflict between the authorities' inflation and external objectives, and clearly pointed to the need to adjust the policy mix by shifting the focus to fiscal consolidation and wage moderation. They emphasized that, notwithstanding the market's recent exuberance about Hungary's accession to the EU, market expectations can change unexpectedly, and avoiding sizable fiscal and current account deficits would help sustain market confidence. These considerations reinforce the need for vigorous fiscal consolidation at an early juncture and into the medium term.
Directors encouraged the authorities to press ahead with the bulk of fiscal adjustment in 2003-04—ahead of the next election cycle. They supported the authorities' fiscal deficit targets, and emphasized the need for corrective actions if slippages occur. To secure durable fiscal adjustment and satisfactory economic growth, fiscal consolidation in 2004 should focus on structural elements aimed at restraining current expenditure, including in the areas of public employment, health care, pensions, social benefits, and subsidies. A number of Directors pointed to the advisability of safeguarding capital investment given the need to develop Hungary's infrastructure in the context of coming EU accession. In light of the magnitude of the fiscal adjustment required, a few Directors recommended considering the postponement of the envisaged tax reductions.
Given the importance of expenditure restraint for meeting fiscal deficit targets, Directors welcomed the authorities' intention to introduce three-year rolling fiscal frameworks with expenditure ceilings. They recommended that the ceilings be submitted to parliament for approval along with the budget and a supporting policy statement, and urged the authorities to adopt subceilings on key expenditure areas where restraint is especially needed.
Directors saw wage moderation as a key component of further disinflation and external competitiveness, especially in light of the significant wage increases granted last year. They urged the authorities to signal the importance they now attach to wage moderation by implementing the planned public sector wage freeze this year strictly, and by keeping public sector wage increases below the inflation target next year. Directors observed at the same time that greater emphasis might be placed on reducing the number of noncritical public employees. A few Directors considered that an undifferentiated wage containment could risk the exit of highly skilled and valuable workers from public service. Pointing to the positive experience of some current members of the euro area, and while emphasizing the value of preserving the traditional flexibility of the Hungarian labor market, Directors highlighted the benefits of closer cooperation between the social partners, with a view to achieving wage agreements that would help to bring inflation down to the Maastricht criterion level in due course. Directors recommended that wage guidelines be set in nominal rather than real terms, for simplicity and to discourage backward-looking indexation.
On monetary policy, Directors considered that the central bank had responded appropriately to difficult challenges. At the same time, Directors were concerned that the credibility of the inflation targeting framework had been weakened by its subordination to exchange rate considerations in the near term. However, Directors viewed the end-2004 inflation target as achievable, and welcomed the authorities' focus on the necessary supporting policies. Nevertheless, they cautioned that deviating from a tight incomes policy and the envisaged fiscal deficit path would clearly make it difficult to meet the inflation objectives without compromising external competitiveness.
In considering more specifically Hungary's plans for joining the European Monetary Union and while recognizing that decisions on EMU membership are taken in the context of the competent European fora, Directors pointed to the importance of formulating a clear strategy for the objective of joining ERM II and eventually adopting the euro, which should include consideration given to how to target monetary policy in the ERM II framework. They therefore welcomed the establishment of a working group to build consensus for such a strategy. Most Directors called attention to the advisability of achieving durable and broad convergence with euro area countries in advance of the currency conversion.
Directors were encouraged by the fundamental soundness of Hungary's financial system and the continued progress in the regulatory and supervisory frameworks. They referred, however, to the potential risks, such as the rapid growth in consumer, business property, and mortgage lending—the latter being fueled by open-ended and unsustainable government interest subsidies. Directors urged the authorities to continue to monitor these risks carefully, including through the work of the central bank's Financial Stability Report and the activities of the Financial Supervisory Agency.
Directors commended recent structural reform initiatives, including plans to complete privatization and the recent increase in the regulated price of electricity and corresponding elimination of subsidies, and encouraged them to continue their efforts. While noting that the price of natural gas for some users is still considerably below world market levels, they welcomed recent plans to lessen gas pricing distortions.
Directors welcomed the steps taken by the authorities to increase the efficiency of the fight against money laundering, through an amendment of the anti-money laundering law. They also welcomed the strengthening of anti-terrorism financing efforts, with the improvement in operations and authority of the Financial Intelligence Unit.
Directors observed that Hungary's continued participation in updating Reports on the Observance of Standards and Codes modules is testament to its commitment to adopting international best practices. They welcomed the authorities' additional efforts to improve fiscal transparency and the quality of economic statistics.
Directors warmly welcomed the authorities' decision, in the context of the Heavily Indebted Poor Countries Initiative, to provide debt relief on all of Hungary's claims on a number of heavily-indebted less developed countries.
Hungary: Main Economic Indicators
IMF EXTERNAL RELATIONS DEPARTMENT