IMF Executive Board Concludes 2008 Article IV Consultation with HungaryPublic Information Notice (PIN) No. 08/124
September 24, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2008 Article IV Consultation with Hungary is also available.
On September 17, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.1
The current account deficit narrowed in 2007, but the net external liability position is still very large. Reflecting mainly the impact of fiscal consolidation on domestic demand, real GDP growth slowed to 1¼ percent in 2007 and the current account deficit narrowed to 5 percent of GDP. Although external financing needs declined, the composition of financing remained largely debt-creating and net external liabilities amounted to about 100 percent of GDP. Despite the economic slowdown, private sector credit growth remained robust, raising debt burdens. With most new borrowing in foreign currency, the private sector's net foreign currency liabilities increased.
Fiscal adjustment in 2007 was substantial, but the budget deficit and government debt are still high. The general government deficit narrowed from 9¼ percent of GDP in 2006 to 5½ percent of GDP in 2007, reflecting a broadly balanced mix of higher revenue—partly due to improved tax administration—and lower expenditure. However, even with the sharp decline in the fiscal deficit, government debt only stabilized at 66 percent of GDP. With substantial amortization due in 2008-09, gross financing needs are high. Indicative expenditure ceilings were introduced with the 2008 budget.
The exchange rate band was removed in early 2008, moving Hungary to a floating exchange rate regime. Monetary policy is now able to focus exclusively on the inflation target of 3 percent over two years. In response to higher inflationary pressures, the policy interest rate was raised over the past half year. Higher global prices of food and energy have prevented a decline in CPI inflation, which was 7 percent in May 2008. At the same time, underlying inflationary pressures, including core inflation and wage growth, have risen.
Financial system risks have increased over the past year, reflecting both the global financial market turbulence and continued rapid credit growth. The banking system is well-capitalized and profitable, though these indicators deteriorated in 2007. The authorities are taking measures to address risks, including further development of stress testing, publication of guidelines on foreign currency risk exposures, publication of criteria for Pillar II assessments, review of banks' liquidity management practices, and testing of financial safety nets. The authorities also aim to improve liquidity in the government bond market.
Executive Board Assessment
Executive Directors commended Hungary's substantial fiscal consolidation since mid-2006 and the associated narrowing of the current account deficit. Monetary policy has been appropriately tightened, and the elimination of the exchange rate band has removed a potential conflict between monetary policy objectives. Directors also welcomed the authorities' publication of guidelines on banks' risk management and consumer protection related to foreign currency loans.
Directors noted that risks to external stability would remain high in the period ahead. In particular, they raised concerns about the high level of government debt, the large net external liability position, and financial system risks, especially in light of unsettled global financial market conditions. Pressures on the current account deficit could intensify from 2009 if economic growth picks up as expected because of strengthening domestic demand, and if real exchange rate appreciation continues. Directors noted the assessment that the real effective exchange rate is somewhat above the value implied by fundamentals, while pointing to the uncertainties surrounding this assessment and observing that Hungary does not appear to have suffered a loss of external competitiveness. They believed that the strength of the currency may reflect in part appropriately tight monetary policy. Directors noted that Hungary's gross external financing needs in 2008-09 are high, though short-term debt is roughly covered by net international reserves.
Directors considered that the key policy priority for the authorities is to continue to reduce vulnerabilities. This will involve sustained further efforts to put the government debt-to-GDP ratio firmly on a downward path, preserve domestic stability and confidence in the currency, and strengthen the resilience of the financial sector. Continued improvements in the business environment will help to preserve Hungary's external competitiveness and attractiveness for foreign direct investment.
Directors welcomed the fiscal tightening under way in 2008 and urged further fiscal consolidation in 2009 in line with the Convergence Program. They observed that expenditure restraint and buoyant revenue made the fiscal deficit target for 2008 attainable, and supported the authorities' intention to use any revenue overperformance for public debt reduction. To achieve further consolidation in 2009, continued strict spending restraint is needed. Tax cuts should be avoided unless they are offset by specific spending cuts. Given the uncertainties in the economic outlook, it would be helpful for the 2009 budget to include sizable contingency reserves. Directors supported the planned introduction of a rules-based fiscal framework; if underpinned by credible policies, this would signal the authorities' commitment to fiscal discipline and help deliver the needed consolidation. Directors suggested reducing the size of government, and the corresponding tax burden, through further reform of pension, health, and education expenditures. They also favored improving work incentives and increasing employment by shifting the tax burden away from labor and toward consumption and by broadening the tax base.
Directors recommended that monetary policy aim to reduce inflation to the 3 percent target over two years. They noted that, in the new floating exchange rate regime, monetary policy is able to focus exclusively on the inflation target. Given the rise in inflationary pressures in the first half of 2008, Directors considered that the tightening of monetary policy had been appropriate. Looking forward, they observed that the policy interest rate would need to respond to the effects of exchange rate developments and the evolution of underlying inflationary pressures. They underscored that the central bank should be prepared to react quickly and forcefully to inflationary shocks.
Directors noted that while the banking system remains profitable and well-capitalized, financial soundness indicators have deteriorated recently. They urged further policy action to improve banks' risk management. Regarding credit risks, the priorities are to establish a credit registry for households and to strengthen stress testing, including of households' foreign currency exposures. It will also be important to ensure that banks remain adequately capitalized. Regarding liquidity risks, the priorities are to expedite the review of banks' liquidity management practices, develop liquidity management guidelines, and ensure that banks have effective contingency arrangements in place. In addition, Directors recommended that the review of financial safety nets be accelerated. They also called for enhanced collaboration with foreign supervisory authorities given Hungarian banks' close links with financial institutions abroad.