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Hungary: Selected Issues

Author(s):
International Monetary Fund
Published Date:
May 1999
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VIII. Sustainability in the Hungarian Balance of Payments87

A. Introduction

198. Hungary is well placed for a long period of strong growth to catch-up toward the per capita incomes of the EU countries. Investment opportunities will likely exceed domestic savings, attracting foreign capital and implying a deficit on the current account.88 However, financial markets can lose confidence in a country running high current account deficits. This chapter aims to estimate the current account position that is sustainable in the sense of limiting Hungary’s exposure to external crises or pressures in the medium–term, while allowing a sufficient contribution of external savings to growth. The international investment position of Hungary is described in Section B. Section C notes some aspects of Hungary’s economy that are relevant when considering the prudent external position. Sustainable current account and trade deficits under various scenarios for growth, foreign direct investment (FDI), and interest rates are estimated in Section D. Section E concludes.

B. Hungary’s International Investment Position89

199. In response to wide current account deficits in 1993–94, Table 18, the Hungarian government announced a medium-term economic strategy in Ministry of Finance (1995), which included the goal of reducing the current account deficit to a level not exceeding the inflows of FDI. It was projected that achieving this goal would lower net foreign debt-to-GDP a few percentage points by end 1997. In the event, Hungary’s net foreign debt actually fell from US$18.9 billion (45 percent of GDP) at end 1994 to US$11.2 billion (25 percent of GDP) at end 1997, Table 19. Valuation effects contributed only US$0.4 billion to this net debt reduction of US$7.8 billion.90

Table 18.Hungary—Balance of Payments 1991–97 1/(In millions of U.S. dollars; unless otherwise specified)
1991199219931994199519961997
Goods and services, net790717-2,996-3,377-1,763-1,146-558
Exports, GNFS11,62113,33210,88610,67117,02819,18924,508
Imports, GNFS-10,831-12,615-13,882-14,048-18,791-20,335-25,066
Income, net-1,383-1,251-1,192-1,446-1,845-1,454-1,421
Interest income, net-1,331-1,215-1,130-1,286-1,599-1,198-952
Equity income, net 2/-32-44-56-117-194-237-468
Employee compensation, net-209-5-43-53-21-1
Transfers, net 3/8618597329081,127922996
Current account balance267325-3,457-3,915-2,480-1,678-982
-1,539398
Capital and financial account2,4534365,3603,0655,786-1,383515
Capital account156117
Portfolio and other investment, net994-1,0353,0311,9681,376-3,525-2,225
Assets, net84-29875238128-1,286-691
Liabilities, net910-7372,9561,7301,248-2,239-1,533
Short-term, net 4/-758157-109581196509859
Long-term, net1,668-8943,0651,1491,052-2,748-2,393
Of which: Equity securities4622435834
Direct investment, net 2/1,4591,4712,3291,0974,4101,9862,622
Abroad, net00-11-49-433-431
Of which: Equity capital, net-11-49-433-286
In Hungary, net1,4591,4712,3391,1464,4531,9833,054
Of which: Equity capital, net1,4591,4712,3391,1464,4531,7882,780
Privatization receipts 5/3305191,2041043,0255781,241
Net errors and omissions7331891,2251,410296
Overall balance2,7207612,636-6614,531-1,650-170
Reserve change (increase -)-2,720-761-2,635661-4,5321,650170
Memorandum items:(In percent of GDP)
Current account balance0.80.9-9.0-9.4-5.6-3.7-2.2
Equity capital inflows, net4.43.96.02.710.44.85.5
Excluding privatization receipts3.42.62.92.53.63.52.8
Debt-creating capital inflows, net 6/-5.2-4.81.06.2-7.6-4.5-4.3
E&0 plus capital account1.90.52.73.50.9
Net foreign debt, change 7/-1,383-1,5031,8754,010-2,601-2,107-3,072
Net debt creating inflows 6/-1,726-1,7963972,583-3,380-2,023-1,929
Valuation changes, other errors3432931,4781,427779-84-1,143
Sources: Data provided by the Hungarian authorities; and staff estimates.
Table 19.Hungary—International Investment Position
19901991199219931994199519961997
(In billions of U.S. dollars)
Foreign assets5.38.18.49.99.915.813.913.3
International reserves1.24.04.46.76.812.09.78.4
Other non-equity assets4.24.14.02.92.83.33.74.2
Equity assets0.20.30.50.50.8
Outward FDI0.20.30.50.50.7
Equity securities0.00.00.0
Foreign liabilities21.824.824.930.135.643.641.940.5
Foreign debt 2/21.322.721.424.628.531.427.623.7
Equity liabilities0.62.13.45.67.112.114.216.8
Inward FDI0.62.13.45.67.111.913.314.2
Equity securities0.21.02.6
Net foreign liabilities16.516.716.520.325.727.828.027.2
Net foreign debt15.914.613.114.918.916.114.211.2
Net equity liabilities0.62.13.45.46.811.613.816.0
(In percent of GDP)
Net foreign liabilities49.949.944.252.661.862.262.460.2
Net foreign debt48.243.635.038.745.436.131.724.7
Net equity liabilities1.76.39.213.916.326.130.735.5
Foreign liabilities66.174.266.778.285.597.693.389.7
Gross foreign debt64.367.857.663.768.470.461.652.6
Equity, direct+portfoilio1.76.39.214.517.027.231.837.2
(Change in billions of U.S. dollars)
Net foreign liabilities0.2-0.23.85.52.00.2-0.8
Foreign debt1.4-1.23.14.02.9-3.8-3.9
Net equity liabilities1.51.31.91.44.82.12.3
Reserves, other assets (=increase)-2.8-0.3-1.20.0-5.71.90.8
(Change in percent of GDP)
Net foreign liabilities0.5-0.59.913.14.60.5-1.8
Foreign debt4.2-3.38.19.56.6-8.5-8.6
Net equity liabilities4.63.55.03.510.84.85.0
Reserves, other assets (=increase)-8.3-0.8-3.20.1-12.84.31.8
Memorandum items:(In billions of U.S. dollars)
GDP33.133.437.238.641.744.744.945.2
Exports, GNFS12.012.213.511.010.817.119.224.5
Imports, GNFS11.011.312.714.814.318.920.325.1
Openess, percent3535353330404455
Sources: National Bank of Hungary, and staff estimates.

200. This rapid debt reduction was made possible by high inflows of foreign equity investment, with the broader net foreign liability position remaining quite stable at just over 60 percent of GDP, Figure 25. Net equity liabilities rose by a total of US$9.2 billion from end 1994 to reach 36 percent of GDP at end 1997, primarily driven by US$8.1 billion of inward FDI over 1995 to 1997, including US$3.9 billion in privatization receipts from nonresidents. The remaining increase in equity liabilities reflects portfolio equity investment of US$1.6 billion over 1995–97, of which US$1.0 billion were privatization receipts. Thus privatization receipts of US$4.8 billion account for 62 percent of the reduction in net debt. Capital gains on foreign held portfolio equity—officially calculated using the BU X index—raised portfolio equity liabilities by US$1.0 billion in 1996–97, but exchange rate related revaluations reduced the stock of direct equity capital liabilities by a similar magnitude.91

Figure 25.Net External Liabilities: Debt and Equity

(In percent of GDP)

201. By analogy with the financial theory of the firm, it might be argued that this shift in the composition of Hungary’s external financing from debt to equity was not relevant to the net value of its external position, so that sustainability was not improved.92 However, at the level of the firm the degree of leverage does affect the risk of illiquidity/insolvency. Similarly, the switch from debt to equity has enhanced sustainability in Hungary by reducing the risk of financial difficulties in response to shocks. The following factors are relevant:

  • While foreign debt is usually foreign exchange denominated, and a fixed payment in foreign currency is required regardless of the state of the economy, nonresident equity investors share in all the currency and other risks of the Hungarian company. Thus a negative shock is partly absorbed by a reduction in profits to foreign investors.

  • Debt service is linked to foreign interest rates, a source of risk that may be negatively correlated with economic performance, as higher EU interest rates will likely reduce EU demand for Hungarian exports. In contrast, income payments on equity liabilities are positively correlated with Hungarian economic performance.

  • While nonresidents can sell portfolio investments and refuse to rollover credit, transnational corporations cannot quickly liquidate direct investments, so pressures on the foreign exchange market from a loss in confidence will be lessened the greater the share of FDI in external financing.93 Nevertheless, the fixed capital associated with FDI could provide collateral for loans to speculate against the exchange rate peg.

  • Foreign holdings of equity involve a lower potential claim on foreign reserves in the event of a crisis, as equity prices will likely fall more than the price of bonds.

  • Equity investment supports the health of the domestic financial system, as corporate balance sheets are strengthened, making them safer borrowers.

  • FDI may ameliorate asymmetric information problems, as foreign portfolio investors learn from direct investors, and as the quality of information provision is likely enhanced, including for banks and companies without foreign investment.

202. Finally, the direct and external benefits of FDI inflows have improved Hungarian growth prospects. However, the reduction in the risk of limited access to international credit markets or of currency crises is not costless. Foreign direct investors have taken additional risk in the expectation of a higher returns, and the risk premia on equity investments will be substantially above those on credit. The higher income stream to foreign equity investors implies that Hungary must run a larger trade balance to achieve the same current account balance. Appendix I discusses the FDI experience and outlook of Hungary, as FDI will remain key to the sustainability of Hungary’s current account deficits.

Hungary’s foreign debt burden

203. Hungary was classified by the World Bank (1997) as a moderately-indebted middle-income (MIMI) country, based on data for 1993 to 1995.94 The EBRD (1997) also classifies Hungary as having medium levels of debt in 1996.95 Hungary’s exports of goods and services in 1997 were 128 percent higher than in 1994, helping cut gross debt-to-exports very sharply from a peak of 265 percent in 1994 to 97 percent by 1997, below the moderately-indebted range for both the World Bank and the EBRD, Table 20. Nevertheless, Hungary would still be classified as moderately-indebted as gross external debt-to-GDP is 53 percent at end 1997, though down from a peak of 70 percent at end 1995. What does this foreign debt burden imply for Hungary’s ability to manage external shocks?

Table 20.Hungary—Debt and Debt Service Indicators
19901991199219931994199519961997
(In billions of U.S. dollars)
Foreign debt 1/21.322.721.424.628.531.427.623.7
o/w Short-term 2/2.92.22.32.02.43.23.83.9
Government and NBH 3/18.219.417.720.422.523.218.313.8
Non-government3.13.23.84.26.18.29.310.0
Credit institutions2.93.74.5
Enterprise and other5.45.75.4
o/w Intercompany0.91.41.7
Net foreign debt15.914.613.114.918.916.114.211.2
Foreign debt - reserves20.118.617.117.821.819.417.915.3
Total debt service4.24.04.74.96.28.49.811.3
excl. prepayments 4/4.13.74.24.25.27.58.19.7
o/w foreign currency 5/7.77.5
Gross interest payments1.61.61.61.61.92.42.32.3
Amortization, MLT total 6/2.52.43.13.34.36.17.49.0
Net interest payments1.41.31.21.11.31.61.21.0
(In percent of GDP)
Gross foreign debt64.367.857.663.768.470.461.652.6
Net foreign debt48.243.635.038.745.436.131.724.7
Foreign debt - reserves60.855.845.846.252.243.539.933.9
Total debt service12.712.112.712.714.918.821.725.0
excl. prepayments 4/12.511.211.210.912.516.718.021.4
o/w foreign currency 5/17.116.6
Gross interest payments5.04.94.44.14.75.35.25.0
Net interest payments4.34.03.32.93.13.62.62.1
(In percent of Exports, GNFS)
Gross foreign debt176.7185.5158.8224.2264.9183.5143.996.9
Net foreign debt132.4119.296.7136.3175.994.274.245.5
Foreign debt - reserves167.0152.6126.3162.7202.1113.493.362.5
Total debt service34.833.135.144.857.749.150.846.1
excl. prepayments 4/34.530.630.838.448.343.542.039.5
o/w foreign currency 5/39.930.6
Gross interest payments13.713.312.114.518.113.812.19.2
Net interest payments11.710.99.010.311.99.36.13.9
(In percent)
External debt, share in percent
Short-term 2/13.89.610.78.28.410.113.616.3
Government and NBH 3/85.685.882.482.978.773.866.258.1
Non-government14.414.217.617.121.326.233.841.9
Credit institutions9.113.319.1
Enterprise and other17.020.622.8
Sources: National Bank of Hungary, and staff estimates.

204. Empirical research provides support to the conventional wisdom that higher external current account deficits and debt ratios increase the likelihood of an external crisis. Kaminsky et al (1997) survey 25 empirical studies on currency crises, together exploring a wide range of potential indicators for crises. They conclude that indicators of both domestic and external imbalances are useful, including international reserves, the real exchange rate, credit and money growth, export growth, inflation, and equity prices. The current account deficit and external debt profile did not receive much support as useful indicators of currency crises. However, Milesi–Ferretti and Razin (1998) found that for middle-income countries (with per-capita income above US$1,500 and population above one million) the risk of a currency crisis rises the wider the current account deficit, and the higher the level of foreign debt relative to GDP. The “event study methodology” analysis of currency crashes by Frankel and Rose (1996) confirms Milesi-Ferretti and Razin’s conclusion on the connection between deficits, debt, and external crises. This connection is illustrated with charts showing the difference between the behavior of a range of variables in tranquil times and at times of a currency crisis. These charts suggest that crises are typically preceded by higher than normal current account deficits, high and rising external debt–to–GDP, as well as by an overvalued real exchange rate, low reserves, smaller than normal FDI inflows, higher than normal foreign interest rates, and slow foreign growth. Similarly, a set of case studies by Milesi-Ferretti and Razin (1996) found that persistent deficits are more likely to result in an external crisis when the external debt or interest payments are high relative to exports, the real exchange rate is above historical averages, the financial system is weak, and the level of domestic savings is low.

205. While the above literature points at the risk implicit in high external debt ratios, its usefulness is limited by the fact that it does not control for factors that may affect the appropriate levels of external debt and deficits across countries and time. Low-income countries, where investment opportunities are likely to be higher than in developed countries, while domestic saving is likely to be lower, may optimally run higher external deficits and debt.96 Thus, in order to assess Hungary’s level of external debt, it is useful to compare Hungary’s foreign debt position with groups of broadly similar countries.97

206. Hungary’s debt–to–GDP is now broadly in line with the average of the MIMI country group, but with a more open economy, debt is lower relative to exports, Table 21. However, the MIMI countries are not an appropriate forward-looking benchmark for Hungary.98 A more relevant comparison is to middle-income countries with credit ratings that are “investment grade” (IGMI), see Table 22. The debt indicators for these countries provide information on financial market willingness to extend funds with less risk of interruption than speculative grade borrowers.

Table 21.Sovereign Ratings, Long-term Foreign Currency Debt

At November 1998 1/

Moody’s RatingStandard & Poors Rating
Investment Grade
A1A+Cyprus, Iceland, Malta
A2Cyprus, United Arab EmiratesASlovenia, Kuwait, Hong Kong
A3Slovenia, China, Israel, Hong Kong, Malta, BahamasA-Czech Republic, Chile, Israel
BaalCzech Republic, Estonia, Greece, Chile, Panama, KuwaitBBB+Estonia, China
Baa2Hungary, Latvia, Qatar, Oman, MauritiusBBBHungary, Lativia, Greece, Qatar
Baa3Poland, Croatia, Tunisia, Columbia, Malaysia,BBB-Poland, Croatia, Lithuania, Malaysia, Columbia,
Saudi Arabia, South Africa, Uruguay, El SalvadorTunisia, Eqypt, Oman, Uruguay, Thailand
Speculative Grade
Ba1Slovakia, Lithuania, Phillipines, Bahrain, Thailand, KoreaBB+Slovakia, Korea, Phillipines, South Africa, Panama
Egypt, Morocco, Barbados, Trinidad & Tobago, Costa RicaTrinidad & Tobago
Ba2Mexico, Guatemala, IndiaBBArgentina, Mexico, India, El Salvador, Morocco, Peru, Costa Rica
Ba3Argentina, Jordan, Kazakhstan, Peru, JamaicaBB-Brazil, Lebanon, Jordan, Bolivia, Paraguay
Table 22.Comparitive Debt and Debt Service Indicators
HungaryInvestment Grade Middle-Income Countries 1997 1/Manufactures Exporting CEEMIMI 3/ Average
1997MedianAverage1997 2/1996
(In percent of GDP)
Gross foreign debt52.631.730.335.147.4
Foreign debt - reserves33.915.317.219.133.0
Total debt service 4/16.65.25.84.68.6
Gross interest payments5.01.82.11.82.9
(In percent of Exports, GNFS)
Gross foreign debt96.975.287.589.4116.6
Foreign debt - reserves62.548.952.348.681.2
Total debt service 4/30.611.016.311.721.2
Gross interest payments9.25.56.24.57.1
External debt, share in percent Short-term16.315.623.718.523.0
Long-term external debt, share in percent Public and guaranteed76.772.7
Reserves in percent of short-term debt2172753155/247117
Sources: National Bank of Hungary, and staff estimates.

207. Hungary’s 1997 debt position relative to the estimated positions of the 17 other IGMI countries is illustrated in Figure 26, for both gross debt and gross debt net of official reserves.99 The polynomial trend lines show the expected pattern of falling debt ratios as per capita GDP rises, though this effect starts beyond per capita income levels of US$7,000 to US$8,000 on a PPP basis. It seems likely that countries with a lower per capita income attained an investment grade rating largely due to their low debt levels. Hungary has among the highest debt ratios to GDP of the IGMI group, exceeded only by Tunisia and Panama, with net foreign debt about 10 percentage points of GDP above trend for its income level. More IGMI countries have higher debt ratios to exports, particularly the less open Latin American economies. However, Chile is a primary goods exporter, and Columbia, Uruguay, and Tunisia are diversified exporters, so they likely require lower imported inputs per unit of exports, making the debt-to-exports comparison less informative.

Figure 26.Investment Grade Middle-Income Countries: External Debt Ratios, 1997 Estimates

Source: World Economic Outlook database

208. The manufactures exporters of Central and Eastern Europe (CEE) are the most relevant benchmark in terms of exposure to shocks, Table 23, and the greater similarity of trade composition also makes comparisons of debt-to-exports ratios more reliable. Hungary’s net foreign debt is substantially higher than the average of 9 percent of GDP in the other CEE countries, and though gross debt-to-exports is broadly in line with the 89 percent CEE average, net foreign debt-to-exports is twice the level in this group.

Table 23.Foreign Debt Indicators of Central and Eastern Europe, 1997 1/
Czech Rep.Slovak Rep.PolandSloveniaCroatiaTotal 2/Hungary
(In billions of U.S. dollars)
Foreign debt22.411.644.04.23.986.023.7
Of which: Short-term7.35.32.90.00.315.93.9
Foreign assets21.57.425.94.45.264.412.6
International reserves9.73.520.13.42.739.38.4
Other assets in convertible currencies11.83.95.81.12.525.24.2
Foreign debt - reserves12.78.123.90.81.246.715.3
Net foreign debt0.94.218.1-0.2-1.321.611.2
Total debt service5.81.22.30.91.011.211.9
Interest payments, gross2.00.51.30.20.34.32.3
Amortization, MLT debt3.80.71.00.70.76.99.7
Economy and trade
GDP52.019.2134.518.920.4245.045.2
Exports (GNFS)29.311.137.310.48.296.324.5
Imports (GNFS)32.012.642.110.610.6107.925.1
Openess, percent 3/59623056464255
(In percent of GDP)
Foreign debt40.960.432.722.118.935.152.6
Foreign debt - reserves24.442.217.84.35.919.133.9
Net foreign debt1.721.913.4-1.3-6.48.824.7
Total debt service11.26.31.74.94.84.626.4
Interest payments, gross3.82.61.01.21.51.85.0
Amortization, MLT debt7.43.60.83.73.32.821.4
(In percent of Exports, GNFS)
Foreign debt72.7104.5117.940.047.389.496.9
Foreign debt - reserves43.473.064.27.814.748.662.5
Net foreign debt3.037.848.5-2.4-16.122.445.5
Total debt service19.810.86.28.812.011.748.7
Interest payments, gross6.84.53.52.23.74.59.2
Amortization, MLT debt13.16.32.76.68.37.239.5
(In percent)
Short-term debt in total debt32.645.76.60.98.518.516.3
Reserves to short-term debt133666899030815247217
Sovereign Credit Rating: 4/
Moody’sBaalBalBaa3A3Baa3Baa2
Standard and PoorsA-BB+BBB-ABBB-BBB
IBCABBB+BBB-BBB+A-BBB-BBB

209. In summary, although Hungary’s debt burden is much reduced from the high levels reached in 1994, its debt relative to GDP remains higher than in the group of investment-grade middle-income countries. Relative to exports, Hungary’s net foreign debt is also above that of the manufactures exporters of CEE. Hungary also appears to be approaching the income level where investment-grade countries typically start to reduce net foreign debt.

Other external indicators

210. External financial crises may reflect an underlying concern about solvency, but vulnerability to crisis also reflects the liquidity and foreign exchange exposures of an economy. The following suggests that Hungary appears adequately liquid, but is reasonably reliant on continued access to international financial markets due to relatively high debt service ratios and significant nonresident investments in domestic securities.

211. In spite of the fall in Hungary’s debt stock indicators, total debt service has risen to 25 percent of GDP in 1997, from 11–13 percent over 1990–94, Table 20. This rise reflects higher amortization payments, as gross interest payments have remained relatively stable at 4 percent to 5 percent of GDP. However, amortization data is distorted by debt prepayments, and also by the inclusion of payments related to secondary market transactions in domestic government securities. Excluding these items—though not prepayments by the private sector—the debt service ratio is about 17 percent of GDP over 1996–1997, still high compared to the benchmarks in Table 22. At end 1997 Hungary’s short-term debt was 16.3 percent of the total, similar to the benchmarks in Table 22.

212. Some commonly used external liquidity indicators are provided in Table 24. While foreign reserves strengthened in the first half of 1998, there was some reduction in liquidity by November 1998, following the impact of the Russian crisis. However, foreign reserves remained strong at 4.1 months of imports of goods and nonfactor services (GNFS), and more than twice the level of short-term foreign liabilities. It is notable that credit institutions account for most short-term liabilities, but a majority of these are covered by their own short-term foreign assets. Foreign debt falling due in the next year is estimated at US$6.7 billion in November 1998, and was more that fully covered by foreign reserves. Foreign holdings of Hungarian domestic bonds increased sharply in the first half of 1998, but there were significant outflows (US$0.5 billion) by November 1998. Nonresident investors also hold substantial portfolio equities, together with bonds accounting for about one-third of reserves in November 1998, so Hungary is significantly exposed to portfolio outflows. To the extent permitted by capital controls, capital outflows could reflect the transactions of residents as well as nonresidents, so in principle the adequacy of international liquidity should be assessed relative to a broad measure of financial sector liabilities. Foreign reserves covered 44 percent of M3 at November 1998, which appears relatively high, but there are as yet no norms for this ratio akin those for the reserves-to-imports ratio.

Table 24.Hungary: Indicators of External Liquidity, 1996–98(In billions of U.S. dollars at end of period, unless otherwise indicated)
1996199719981998
Dec.Dec.JuneNov.
Total foreign debt of Hungarian residents27.623.724.624.9
Medium- and long-term debt23.819.919.821.2
Government and NBH17.813.313.013.0
Credit institutions1.41.61.82.4
Enterprises and other (inc. intercompany loans)4.75.05.05.8
Short-term foreign liabilities 1/3.83.94.83.7
Government and NBH0.50.50.70.5
Credit institutions2.23.03.72.8
Enterprises and other1.00.40.40.4
Domestic security holdings of non-residents1.22.94.13.1
Government bonds0.30.41.61.1
Equity securities, portfolio 2/0.92.62.52.0
Foreign debt falling due in the next 12-months 3/6.46.77.56.7
Short-term foreign liabilities 1/3.83.94.83.7
Amortization of medium and long-term debt2.62.82.73.0
Public and publicly guaranteed2.22.22.12.1
Other, estimated 4/0.40.60.60.8
Foreign assets, excluding equity13.412.613.913.6
Gross official reserves9.78.49.68.7
Other short-term foreign assets 1/2.42.62.63.2
Credit institutions1.62.11.92.3
Enterprises and other0.80.50.70.9
Reserve-related domestic liabilities of NBH5.74.14.02.9
Foreign exchange deposits, resident banks3.11.60.82.3
Forint deposits (non-required), resident banks2.62.53.20.6
Memorandum items:
Official foreign reserves of NBH
In months of imports, GNFS5.74.04.64.1
In percent of:
Short-term foreign liabilities 1/258217200233
Foreign debt falling due152127128130
M348435244
Net foreign debt, including intercompany loans14.211.210.811.3
In percent of GDP31.724.722.523.8
Source: Statistics Department, National Bank of Hungary.

213. Borrowing conditions on international financial markets are fairly good for Hungary. In early 1998, Hungarian eurobond issues were accepted on similar terms to the less advanced members of the EU, at a time when many other emerging market countries had delayed bond issues. By late 1998, Hungary still had good access to international credit markets, but spreads had widened following events in Russia.100 In contrast, credit ratings agencies place Hungary towards the bottom of investment grade countries, Table 21. Analysis based on research by Cantor and Packer (1996) is suggestive that the agencies may be under-rating Hungary relative to its fundamentals. Their estimated equation for the average of Moody’s and Standard and Poor’s ratings (on a scale where 1-Be/B- and 16=Aaa/AAA) with statistically insignificant variables omitted is:

Average Rating= 1.442+1.242 ln[Per-capita GDP]+0.151 GDP growth Rating
- 0.611 In [CPI Inflation]- 0.013 External debt-to-exports
+ 2.776 IMF industrial country- 2.042 Default since 1970

This equation predicts that Hungary would have a Baa1/BBB+ rating, two grades above the actual ratings in early 1998.101 Nevertheless, both Moody’s and Standard and Poor’s upgraded Hungary in 1998, and Standard and Poor’s maintains a positive rating outlook, suggesting that any potential under-rating may not long remain.

C. Economic and Financial Structure of Hungary

214. This section briefly notes some features of Hungary’s economic and financial structure that bear on how exposed Hungary is to balance of payments pressures, focusing on Hungarian savings behavior, the composition of trade, and financial sector health.

215. A key factor underpinning the swings in the current account balance seen in the 1990s was the volatility of nongovernment savings, which collapsed from 23.8 percent of GDP in 1990 to 11.6 percent of GDP in 1993, before recovering to 21.1 percent of GDP in 1995.102 While these developments partly reflect transition-related factors affecting enterprise profitability, volatility in household saving was also significant, with the household saving rate falling from over 16 percent in 1992 to 9.5 percent in 1993.103 The current account deficit can quickly rise to unsustainable levels with such savings shocks, so some caution is warranted until a record of greater stability in savings is established.

216. Hungary was classified as a diversified exporter in World Bank (1997) based on 1993–95 data. However, recent export growth has focused on manufactures, which accounted for 63 percent of goods and services exports in 1997, Table 25. Of manufactures exports, 77 percent went to the EU in 1997, thus the key risk to exports is the EU durable goods cycle. The volatility of manufactures imports by the EU has been high recently, as imports of key EU members104 from all other countries fell 7 percent in 1993, but rose 11 percent and 19 percent in 1994 and 1995, respectively.

Table 25.Structure of Hungarian Trade, 1997
Food, beverages, tobaccoRaw materialsFuelsManufactured goods, inc. machineryTotal goodsTotal services and otherTotal goods and services
(In millions of U.S. dollars)
Exports24617285071537319069543924508
EU10054163251183713583
CEFTA341109878501387
CIS50810287571375
Other6071018719302724
Imports89669521091740721106395925065
EU3482812271234713203
CEFTA64902919321378
CIS917315636342379
Other4761512734934146
(In percent of total goods and services)
Exports10.03.02.162.777.822.2100.0
Imports3.62.88.469.484.215.8100.0
(In percent of goods category)
Exports100.0100.0100.0100.0100.0
EU40.857.164.277.071.2
CEFTA13.915.017.25.57.3
CIS20.614.01.54.97.2
Other24.713.817.112.614.3
Imports100.0100.0100.0100.0100.0
EU38.840.410.8170.962.6
CEFTA7.113.013.85.46.5
CIS1.024.974.13.611.3
Other53.121.71.3 120.119.6
Source: National Bank of Hungary, Monthly Report Table III/V, preliminary data.

217. The Asian crisis has re-emphasized the importance of a sound financial system for international financial market confidence. Hungary has privatized most of the banking system to strategic investors, with foreigners owning 61 percent of banking sector capital at end 1997.105 The relatively good health of the banking sector, and the progressive development of other financial markets, see Van Elkan (1998), suggests that with the vigilance of authorities, Hungary’s financial system should be able to effectively allocate debt-creating capital inflows of a reasonable magnitude.

D. Current Account Deficits in the Medium-Term

Two paths for net foreign debt

218. This section seeks to analyze the volume of capital inflows and thus the current account deficit that would be sustainable. The analysis in Sections B and C suggests that an increase in Hungary’s debt ratios could prevent significant further improvements in Hungary’s credit worthiness, thus current account deficits that would increase Hungary’s debt ratios can be considered inappropriate. Should the authorities aim at a further reduction in external debt ratios? Hungary’s openness, high inflows of FDI, and the falling share of public foreign debt tends to reduce its exposure to external crisis.106 However, the volatile savings record and the less diversified export structure urge greater caution with respect to the external position. The relatively high level of Hungary’s net foreign debt-to-GDP compared to the IGMI countries, also suggests that a further debt reduction over time would be helpful.107 A modest reduction could be realized by targeting no increase in net foreign debt in foreign currency terms, allowing growth and real exchange rate appreciation to erode the debt ratios. The following compares the implications or this strategy against that of stabilizing net foreign debt relative to GDP.

219. The current account deficit (CAD) that would stabilize net foreign debt-to-GDP (NFD), is given by the sum of equity capital inflows (ECI) and the level of debt-creating capital inflows (DCI) that is debt-stabilizing (variables in percent of GDP);

CAD* = ECI + DCI*; DCI*;[g/(1+g)] NFD

The debt–stabilizing level of DCI is a proportion of the outstanding debt that is increasing with the medium-term growth rate (g). Note that the growth rate is defined in terms of the currency composition of net foreign debt, and is the sum of real GDP growth, foreign GDP deflator inflation, and the real exchange rate appreciation of Hungary on a GDP deflator basis. Assuming a medium-term real GDP growth outlook of 4 percent to 5 percent, foreign inflation of 1 percent to 2 percent, and real appreciation of the forint on a GDP deflator basis between 0.5 percent and 1.5 percent, a feasible medium-term range for g is 5.5 percent to 8.5 percent.108

220. With GDP growth 6 to 8 percent in foreign currency terms, the end 1997 level of net foreign debt of 24.7 percent of GDP could be maintained with net DCI of 1.4 percent to 1.8 percent of GDP, or about US$0.7 to US$0.85 billion in 1998, Table 26. Further external debt reduction by government and outflows of foreign investment by Hungarian residents would be consistent with larger gross DCI to the private sector. Under the strategy of targeting zero net DCI, net foreign debt–to–GDP would be cut by between 6 and 8 percentage points of GDP by 2002 with growth between 6 percent and 8 percent, Table 27, similar to the reduction estimated by Krueger (1996). Under the conservative expectation that exports grow with GDP, net external debt-to-exports would be cut by 11 percentage to 15 percentage points, implying foreign debt net of reserves broadly consistent with the average 50 percent ratio to exports in the IGMI countries.

Table 26.Debt Stabilizing Debt-creating Capital Inflows(In percent of GDP)
GDP Growth Rate 1/
Long-run

net foreign

debt target
5.05.56.06.57.07.58.08.59.0
30.01.41.61.71.82.02.12.22.42.5
24.71.21.31.41.51.61.71.81.92.0
20.01.01.01.11.21.31.41.51.61.7
15.00.70.80.80.91.01.01.11.21.2
10.00.50.50.60.60.70.70.70.80.8
5.00.20.30.30.30.30.30.40.40.4
0.00.00.00.00.00.00.00.00.00.0
Table 27.Net foreign debt, projections for 2002
Stable net foreign debt to GDP 2/Stable net foreign debt in FX 3/
GDP growth(In percent of GDP)
rate, percent1/
524.719.4
624.718.5
724.717.6
824.716.8
924.716.1
(In percent of exports GNFS)
GDP growth, percent 1/
Export growth56789
rate, percent1/
545.535.7
643.445.534.0
741.443.445.532.4
839.541.443.445.531.0
937.739.541.443.445.529.6

221. Net equity inflows must also be estimated to calculate the current account deficit implied by each strategy. Given the already high participation of foreign investors in the equity market, further portfolio inflows will be constrained by new equity issues, and portfolio equity outflows may rise, suggesting that net portfolio equity inflows may be small. The potential FDI inflow is discussed in Appendix I, finding that 3 percent of GDP on a cash basis would be a reasonable expectation in the next few years (1998–2000), allowing for some outward direct investment. This FDI inflow implies debt-stabilizing current account deficits on a cash basis of 4.4 percent to 4.8 percent of GDP for growth rates in foreign currency terms of 6 percent to 8 percent, respectively, and 3 percent of GDP to freeze net foreign debt in foreign currency terms.109

Trade balance and foreign interest rates

222. This section reports estimates for the path of the trade balance in goods and nonfactor services (GNFS) that would be consistent with a sustainable current account position, by deriving the GNFS balance as the residual between the current account deficit and the estimated path for international investment income and current transfers. The current account deficit remains constant on an accrual rather than cash basis, reflecting a stable gap between investment and savings, and a stable total FDI inflow. The simulations are not projections, they merely illustrate the implications of running certain deficits on average, under the following assumptions:

  • Current BOP transfers: these are significant a source of Hungary’s disposable income at 2.2 percent of GDP in 1997. Transfers are assumed to grow at the 2.6 percent rate observed in the 1990s, so this inflow declines as a share of Hungarian GDP over time, which is to be expected as Hungarian per capita income converges.

  • Reserves and other nonequity foreign assets: these are assumed to be stable at 27.9 percent of GDP, which likely underestimates the potential expansion in foreign assets as pension and investment funds diversify from Hungarian securities.

  • Net equity liabilities: the official data is adjusted upwards by US$1.8 billion, reflecting cumulative retained earnings of foreign owners not recorded in the BOP estimates of FDI, as discussed in Appendix 1. Depreciation of the capital owned by nonresidents at an annual rate of 5 percent is assumed in estimating equity income.

  • Exports of GNFS: are assumed to grow 2 percent faster than GDP in the medium-term, which seems conservative relative to recent growth rates.

  • Interest payments: official BOP data include the marking-to-market of debt swaps in both interest payments and receipts, as reflected in the high implied interest rates on foreign assets and debt in 1997, at 9.8 percent and 8.2 percent respectively. The gross interest data for 1997 was adjusted down by US$0.5 billion, producing implied interest rates with a spread of 1.0 percent. This spread is assumed to be stable over time; though the spread paid on sovereign loans may decline, the share of nongovernment loans with higher spreads may rise.

  • Equity returns to foreign investors: are estimated at 8.4 percent in 1997, including retained earnings. The rate of return is assumed to rise linearly to 3 percent above the cost of foreign debt by 2002, as the full benefits of earlier investments are realized.

  • Repatriated equity incomes: were 43 percent of the total estimated level of equity income to foreign owners of US$1.0 billion in 1997. It is assumed that this repatriation rate is unchanged, so that as total equity earnings increase a larger part of total FDI is funded by retained earnings.

  • Total FDI including retained earnings: is assumed constant at 5 percent of GDP, consistent with FDI on a cash basis at just over 3 percent of GDP over 1998–2000, but cash FDI declines to 2.8 percent of GDP by 2007.

223. The simulation in Table 28 is for stabilizing net foreign debt-to-GDP, while Table 29 is for freezing debt in foreign currency terms. Each assumes 6 percent growth (in foreign currency terms) and 5 percent foreign interest rates. As expected, net interest costs are stable in Table 28, but total investment income deteriorates as earnings on foreign owned equity rise.110 By 2007 an improvement of 1.2 percent of GDP is needed in the GNFS balance from 1998, reflecting a 0.4 percent of GDP reduction in cash FDI, a 0.5 percent of GDP reduction in current transfers, and a 0.3 percent of GDP increase in repatriated equity incomes to nonresidents.111Table 29 shows similar trends, but as net interest costs decline by 0.6 percent of GDP, the required improvement in the GNFS balance is reduced to 0.6 percent of GDP.

Table 28.Medium-Term Balance of Payments Simulation: Stable Net Foreign Debt to GDP
1997199819992000200120022007
Act.Adj. 1/
(In percent of GDP)
Current account, cash basis-2.2-2.2-4.6-4.5-4.5-4.4-4.4-4.2
Accrual basis 2/-3.5-6.4-6.4-6.4-6.4-6.4-6.4
Trade balance, GNFS-1.2-1.2-3.7-3.5-3.3-3.2-3.0-2.5
Current transfers 3/2.22.22.12.12.01.91.91.6
Investment income, cash-3.1-3.1-3.0-3.1-3.1-3.2-3.2-3.3
Net interest-2.1-2.1-1.7-1.7-1.7-1.7-1.7-1.7
Net equity, cash-1.0-1.0-1.4-1.4-1.5-1.5-1.6-1.7
Financial account1.32.66.46.46.46.46.46.4
Debt-creating, net 4/-4.3-4.31.41.41.41.41.41.4
Gross foreign debt-6.0-6.03.03.03.03.03.03.0
Reserves&other assets1.81.8-1.6-1.6-1.6-1.6-1.6-1.6
Net equity inflows5.56.95.05.05.05.05.05.0
Recorded cash5.55.53.23.13.13.03.02.8
Retained earnings1.31.81.91.92.02.02.2
E&O, capital account0.90.90.00.00.00.00.00.0
Net foreign liabilities60.264.267.069.672.174.476.685.8
Net foreign debt24.724.724.724.724.724.724.724.7
Gross foreign debt52.652.652.652.652.652.652.652.6
Reserves&other assets27.927.927.927.927.927.927.927.9
Net foreign equity35.539.542.344.947.449.751.961.1
(In percent of Exports, GNFS)
Net foreign debt45.545.544.743.943.042.241.537.8
Gross foreign debt96.996.995.193.391.689.988.280.4
(In percent per annum)
Rates of return:
Reserves&other assets9.86.45.05.05.05.05.05.0
Foreign debt8.27.46.06.06.06.06.06.0
Foreign equity3.48.48.58.68.78.99.09.0
(In billions of U.S. dollars)
Gross domestic product45.245.247.950.753.857.060.480.9
Exports, GNFS24.524.526.528.630.933.336.052.9
Imports, GNFS25.125.128.230.432.735.237.855.0
Gross disposable income44.744.146.649.352.255.258.477.8
GDP-GDI, percent0.92.32.72.93.13.23.43.9
Assumptions(In percent)Simulation summary(In percent of GDP)
GDP growth in foreign currency 5/6.0Current account, accruals-6.4
Export growth relative to GDP2.0Cash basis (1998-2002)-4.5
Foreign interest rate, average5.0Trade balance, GNFS (1998-2002)-3.4
Current transfers growth2.6Net equity inflows to GDP, accrual5.0
Equity premium, long-run3.0Reserves&other assets in percent of GDP27.9
Table 29.Medium-Term Balance of Payments Simulation: Stable Net Debt in Foreign Currency
1997199819992000200120022007
Act.Adj. 1/
(In percent of GDP)
Current account, cash basis-2.2-2.2-3.2-3.1-3.1-3.0-3.0-2.8
Accrual basis 2/-3.5-5.0-5.0-5.0-5.0-5.0-5.0
Trade balance, GNFS-1.2-1.2-2.3-2.2-2.1-2.0-1.9-1.7
Current transfers 3/2.22.22.12.12.01.91.91.6
Investment income, cash-3.1-3.1-3.0-3.0-3.0-3.0-2.9-2.7
Net interest-2.1-2.1-1.7-1.6-1.5-1.4-1.4-1.1
Net equity, cash-1.0-1.0-1.4-1.4-1.5-1.5-1.6-1.7
Financial account1.32.65.05.05.05.05.05.0
Debt-creating, net 4/-4.3-4.30.00.00.00.00.00.0
Gross foreign debt-6.0-6.01.61.61.61.61.61.6
Reserves&other assets1.81.8-1.6-1.6-1.6-1.6-1.6-1.6
Net equity inflows5.56.95.05.05.05.05.05.0
Recorded cash5.55.53.23.13.13.03.02.8
Retained earnings1.31.81.91.92.02.02.2
E&O, capital account0.90.90.00.00.00.00.00.0
Net foreign liabilities60.264.265.666.968.169.370.374.9
Net foreign debt24.724.723.322.020.719.618.513.8
Gross foreign debt52.652.651.249.948.647.446.341.7
Reserves&other assets27.927.927.927.927.927.927.927.9
Net foreign equity35.539.542.344.947.449.751.961.1
(In percent of Exports, GNFS)
Net foreign debt45.545.542.239.036.133.531.021.1
Gross foreign debt96.996.992.688.584.781.177.863.7
(In percent per annum)
Rates of return:
Reserves&other assets9.86.45.05.05.05.05.05.0
Foreign debt8.27.46.06.06.06.06.06.0
Foreign equity3.48.48.58.68.78.99.09.0
(In billions of U.S. dollars)
Gross domestic product45.245.247.950.753.857.060.480.9
Exports, GNFS24.524.526.528.630.933.336.052.9
Imports, GNFS25.125.127.629.732.034.537.254.3
Gross disposable income44.744.146.649.352.255.358.678.2
GDP-GDI, percent0.92.32.72.82.93.03.13.3
Assumptions(In percent)Simulation summary(In percent of GDP)
GDP growth in foreign currency 5/6.0Current account, accruals-5.0
Export growth relative to GDP2.0Cash basis (1998-2002)-3.1
Foreign interest rate, average5.0Trade balance, GNFS (1998-2002)-2.1
Current transfers growth2.6Net equity inflows to GDP, accrual5.0
Equity premium, long-run3.0Reserves&other assets in percent of GDP27.9

224. The results of simulations across a range of interest rate and growth rate scenarios, focusing on the average GNFS balance in the next five years, are reported in Table 30. Relative to the GNFS deficit of 1.2 percent in 1997, stabilizing net foreign debt-to-GDP would allow a significant increase (1¼ percent to 2¾ percent of GDP) in the GNFS deficit over 1998–2002 for plausible interest rates and growth rates, while stabilizing net debt in foreign currency would allow a modest increase in the GNFS deficit (0 percent to 1 percent of GDP).

Table 30.Estimated GNFS Balances Consistent with Current Account Sustainability
GDP in foreign currency, annual growth in percent 1/
56789
I. Stable Net Debt to GDP
Foreign Interest Rate
Percent
4-3.6-3.8-3.9-4.3-4.6
5-3.1-3.4-3.4-3.9-4.1
6-2.6-2.9-3.0-3.4-3.7
7-2.1-2.4-2.5-3.0-3.2
8-1.7-1.9-2.0-2.5-2.8
II. Stable Net Debt in Foreign Currency
Foreign Interest Rate
Percent
4-2.5-2.5-2.6-2.6-2.7
5-2.0-2.1-2.2-2.2-2.3
6-1.6-1.7-1.7-1.8-1.9
7-1.1-1.2-1.3-1.4-1.5
8-0.7-0.8-0.9-1.0-1.1

225. Each percentage point rise in foreign interest rates is found to reduce international investment income by 0.4 percent to 0.5 percent of GDP on average over five years, implying that the GNFS deficit and thus domestic spending must be cut by this amount to retain a sustainable current account deficit. The responsiveness is greater than the¼ of a percent of GDP that would be implied by net foreign debt at 24.7 percent of GDP, as a partial response in net equity income is allowed. The full response—of about 0.7 percent of GDP—cannot be expected until the capital stock held by foreigners reflects the new level of required returns. While the long-run required adjustment in the GNFS trade balance and domestic spending has not been reduced by the switch from debt to equity financing, the short-run impact of changes in foreign interest rates has been significantly reduced from 1994.

E. Conclusion

226. Hungary’s foreign debt burden is much reduced from the high levels of the mid-1990s, and the reduction in vulnerability from this and other factors has proven valuable during the turmoil stemming from the Asian and Russian crises. Recent research on currency crises finds statistical evidence on the risks posed by large foreign debt and current account deficits, and country experiences and event studies support this relationship. Thus ensuring that current account deficits do not remain significantly above sustainable levels will contribute to avoiding excessive risk of currency crisis. Nevertheless, many factors may underlie capital outflow pressures, so support in other policy areas is also needed.

227. While Hungary’s debt ratios are now at more moderate levels, they remain above the average of investment grade middle-income countries, suggesting that a return to higher debt levels might prevent Hungary realizing the gains in creditworthiness that would appear to be warranted by its improved fundamentals. Further reduction in net foreign debt would be consistent with the expected rise in Hungarian per capita GDP, and the expected decline in total public debt as Hungary approaches entry to the EU. Therefore the sustainability analysis focused on current account deficits implying either no rise in net foreign debt relative to GDP, or deficits that would be required to prevent debt rising in foreign currency terms, thereby generating a further modest reduction in net foreign debt-to-GDP over time.

228. The latter strategy would limit the current account deficit to net equity inflows, which could be reasonably projected at 3 percent in the next few years. This would reduce net foreign debt-to-GDP by 6 to 8 percentage points of GDP by 2002, for growth rates in foreign currency terms ranging from 6 percent to 8 percent (4 percent to 5 percent in real terms). The debt ratio stabilizing strategy would allow a wider deficit reflecting net debt-creating capital inflows of about 1½ percent of GDP for the same growth range (yielding a total current account deficit of some 4½ percent of GDP).112 In both cases, resource flows to the private sector could be higher to the extent that the public sector reduces its net external debt.

229. Estimates of the GNFS trade deficits that would be consistent with these current account deficits were made, though these depend on a number of assumptions. These estimates suggested that a debt ratio stabilizing strategy would be consistent with a 1¼ percent to 2¾ percent of GDP increase in the average GNFS trade deficit over the next five years from the 1.2 percent of GDP level in 1997. Freezing foreign debt in foreign currency would allow a more modest rise in the GNFS deficit, of up to 1 percent of GDP. Under either approach, the average GNFS deficit would need to narrow in the long run to offset the expected growth in equity incomes to nonresidents, and the likely decline in current transfers relative to GDP. The eventual reduction needed in the average trade deficit would be smaller if net foreign debt-to-GDP continued to decline in the near-term, due to lower net interest payments.

References
APPENDIX I: Foreign direct investment in Hungary: Status and prospects

1. Foreign direct investment was a key factor in Hungary’s external debt reduction, and in the transition more generally. The following sections compare the FDI position of Hungary with other countries, describe the nature of FDI in Hungary, discuss issues regarding BOP data on FDI, and consider the outlook for both inward and outward FDI.

Where Does Hungary Stand?

2. At end 1997 the BOP estimates the stock of FDI capital received by Hungary at US$14.2 billion, though this is likely an underestimate, see below. With the stock of outward FDI by Hungary at US$0.7 billion, net FDI liabilities are 30 percent of GDP. Table 31 reports FDI stocks by region, and within each region those countries making most use of FDI. Even by 1995 Hungary is in the top league of net recipients of FDI relative to the size of its economy, with Malaysia, New Zealand, and Singapore the only countries in a comparable net FDI position. Among CEE countries the next most significant FDI recipient is Estonia, but Poland and others will have increased FDI as their privatization programs are implemented.

Table 31.Foreign Direct Investment Stocks and Flows
Stock of FDI in 1995 (Percent of GDP)Inward Direct Investment (Percent of Gross Fixed Capital Formation)
InwardOutwardNet Stock1985-901991-95
Central and Eastern Europe4.90.3-4.63.9
Hungary31.51.2-30.329.5
Czech Republic8.70.5-8.211.2
Estonia17.61.4-16.232.8
Poland7.20.2-7.010.0
European Union13.214.61.49.15.7
Austria8.05.5-2.53.01.8
Belgium&Luxemborg31.123.0-8.137.023.9
Greece16.90.0-16.99.05.2
Ireland20.26.5-13.723.116.8
Portugal7.43.3-4.117.78.0
Spain17.66.0-11.614.88.8
Sweden15.931.215.316.018.8
Other developed countries2.96.43.51.30.7
Australia30.811.9-18.911.29.3
New Zealand43.912.0-31.927.725.5
South America18.41.7-16.77.46.3
Argentina8.70.2-8.513.017.6
Bolivia22.30.2-22.125.019.6
Brazil17.81.2-16.63.12.7
Chile23.14.1-19.021.59.2
Columbia14.81.7-13.117.011.0
Eucador14.10.0-14.114.612.3
Peru9.30.2-9.115.514.7
Uruguay8.10.1-8.011.14.9
South, East and South-East Asia15.17.0-8.19.76.7
China18.22.3-15.914.516.3
Indonesia25.20.3-24.97.64.3
Malaysia52.112.6-39.543.721.3
Singapore67.438.4-29.059.323.3

3. Hungary is also in the leading group of FDI relative to fixed investment over 1991–95. Of the entire group of European transition economies Hungary received almost a third of FDI inflows to end 1996, though it had just under one-twentieth of regional GDP. The EU is overall a net provider of FDI, but it is notable that countries with below EU-average incomes (Ireland, Greece, and Spain) are significant net users of FDI, suggesting that FDI is closely entwined with the convergence process.

Nature of FDI in Hungary

4. A detailed picture of FDI in Hungary is provided by CSO (1997), with a summary in Table 32. Foreign investment enterprises (FIE) are enterprises with some proportion of share capital in foreign ownership, and they accounted for 45.6 percent of the paid in capital of all Hungarian enterprises at end 1996, employing 25.1 percent of business sector workers. Companies with foreign participation are focused on trade-intensive activities, producing 62 percent of goods exports in 1996, and importing two-thirds of goods imports. FIEs have been investing very actively, accounting for over half of business sector investment, and two-thirds of investment by the manufacturing sector in 1996.

Table 32.Foreign Participation in the Hungarian Economy, 1996
Business sector, totalForeign investment enterprises 1/Share of FIEs Percent
Paid in capital, Ft billion5004228045.6
Manufacturing121985269.9
Employment, thousands224856525.1
Manufacturing83529735.6
Investment, Ft billion88548855.2
Manufacturing31321568.6
Exports, goods, Ft billion2002124962.4
Imports, goods, Ft billion 2/2468164566.7
Source: CSO (1997), and Statistical Yearbook of Hungary, 1996, CSO.

5. Direct investment in Hungary has become quite diversified across the economy by end 1996, Table 33. Manufacturing (especially machinery, food and beverages, and chemicals) attracted both acquisitions and green-field investments by multinationals like General Electric, Audi, Suzuki, Phillips, Electrolux etc. FIEs accounted for 69.9 percent of the paid in capital of all manufacturing enterprises, and 75.1 percent of paid in capital was foreign owned, so 52.5 percent of paid in capital in the manufacturing sector was foreign owned in 1996.113 Electricity, gas, and water received substantial FDI when various utilities were privatized, with FIEs accounting for 40.7 percent of paid in capital in this sector, though foreign ownership was only 21.7 percent of capital in this sector at end 1996. The privatization of MATAV accounts for the high level of FDI in telecommunications, and the privatization of the state banks along with the earlier entry of foreign banks is reflected in two-thirds of paid in capital of financial services being held by foreign owners. New companies with foreign participation continue to be established, but data for 1997 suggests a shift in emphasis towards services.

Table 33.Foreign Direct Investment by Industry, end 1996
Number of enterprisesPaid in capital, Ft billionIndustry share (percent)FDI capital share (percent)
TotalFIE Enterprises 1/TotalFIE Enterprises 1/ValueTotal paidTotalTotal paidPaid in capital of
EnterprisesNumberPercentEnterprisesTotalo/w FDIAddedin capitalFDIin capitalFIE Enterprises
Agriculture and forestry9,0128409.3307.328.918.87.16.11.26.165.1
Mining and quarrying2907726.655.227.319.90.41.11.236.172.9
Manufacturing33,6434,31212.81218.7851.7639.924.524.439.652.575.1
Food, beverages, tobacco3,88554414.0286.3190.3147.24.35.79.151.477.4
Textiles, apparel3,95360115.266.937.632.02.21.32.047.885.1
Wood, paper, publishing7,39074510.1101.650.043.22.12.02.742.586.4
Chemical products2,23340218.0273.5247.5139.85.95.58.751.156.5
Non-metallic minerals1,04817817.064.952.844.91.21.32.869.285.0
Metal products4,48351811.6115.749.840.52.62.32.535.081.3
Machinery8,7481,12012.8286.3215.9185.75.55.711.564.986.0
Other1,90320410.723.57.86.60.60.50.428.184.6
Electricity, gas, water4214210.01058.6431.3229.23.521.214.221.753.1
Construction17,9201,2196.8147.268.160.24.52.93.740.988.4
Trade, wholesale and retail72,19012,77217.7525.0234.2191.412.110.511.936.581.7
Hotels and restaurants8,3831,12513.4103.356.339.92.12.12.538.670.9
Transport, telecommunications8,2928059.7614.5203.2141.89.612.38.823.169.8
Financial services1,47715410.4309.8215.9144.45.86.28.946.666.9
Real estate, business services51,9043,8867.5529.8149.5118.617.110.67.322.479.3
Education2,5911445.62.70.80.44.90.10.014.850.0
Health6,7141692.54.62.82.44.80.10.152.285.7
Other services9,4555856.2127.710.17.33.52.60.55.772.3
Total222,29226,13011.85004.42280.11614.2100.0100.0100.032.370.8

What is the Outlook for FDI into Hungary?

6. Clearly foreign direct investors have an important stake in the Hungarian economy. Though the privatization phase of FDI is largely concluded, the privatizations will pave the way for modernization investment. For example, in 1995 minority stakes in regional gas and electricity distributors and two electric power stations were sold for about US$1.7 billion, with pledges to make further investments of about US$3 billion in the following years. Furthermore, Hungary is emerging as a significant location for export-oriented investment projects, primarily in manufacturing. Established FDI will attract further investment to expand existing capacity, and as related companies and industries are attracted to the region. Thus it appears likely that Hungary will continue to receive substantial inward FDI.

7. Excluding privatization receipts, recorded inflows of FDI equity capital have averaged US$1.2 billion over 1991 to 1997, a flow equal to 3.0 percent of GDP, or 17.2 percent of fixed investment by nongovernment, Table 34. The inflows have been relatively stable, at around US$1.0 billion over 1991 to 1994, then rising in recent years, with FDI excluding privatization receipts and intercompany loans averaging US$1.4 billion in 1995 to 1997, or 3.2 percent of GDP. This recent increase in FDI moves broadly in line with a more general acceleration in investment. Given the relatively stable track-record for FDI an estimate of further inflows (net of outward direct investment) in the order of 3 percent of GDP is reasonable in the near-term, largely consistent with the assumptions in Ministry of Finance (1997) when intercompany loans are excluded.

Table 34.Foreign Direct Investment Flows in Hungary
19901991199219931994199519961997
(In millions of U.S. dollars)
Direct investment, net3111,4591,4712,3281,0974,5001,9861,654
Direct investment in Hungary3111,4591,4712,3391,1464,5431,9832,085
Equity capital3111,4591,4712,3391,1464,5431,7881,811
o/w privatization 1/83305191,2041043,025578272
other3031,1299521,1351,0421,5181,2101,539
Intercompany loans 2/000000195274
Direct investment abroad000-11-49-433-431
Equity capital000-11-49-433-286
Intercompany loans0000000-145
(In percent of GDP)
Direct investment, net0.94.43.96.02.610.14.43.7
Direct investment in Hungary0.94.43.96.12.810.24.44.6
Equity capital0.94.43.96.12.810.24.04.0
o/w privatization 1/0.01.01.43.10.26.81.30.6
other0.93.42.62.92.53.42.73.4
Intercompany loans0.00.00.00.00.00.00.40.6
Direct investment abroad0.00.00.00.0-0.1-0.10.0-1.0
Equity capital0.00.00.00.0-0.1-0.10.0-0.6
Intercompany loans0.00.00.00.00.00.00.0-0.3
(In percent of Non-government GFCF)
Direct investment, net4.724.323.937.515.561.023.718.3
Direct investment in Hungary4.724.323.937.716.261.623.623.0
Equity capital4.724.323.937.716.261.621.320.0
o/w privatization 1/0.15.58.419.41.541.06.93.0
other4.518.815.518.314.720.614.417.0
Intercompany loans0.00.00.00.00.00.02.33.0
Direct investment abroad0.00.00.0-0.2-0.7-0.60.0-4.8
Equity capital0.00.00.0-0.2-0.7-0.60.0-3.2
Intercompany loans0.00.00.00.00.00.00.0-1.6
Memorandum items:(In billions of U.S. dollars)
Gross Fixed Capital Formation8.07.47.97.78.99.09.610.4
Non-government6.76.06.16.27.17.48.49.1
Government1.31.41.71.51.81.61.21.3
GDP33.133.437.238.641.744.744.945.2
Source: National Bank of Hungary and the State Privatization Company.

Outward Direct Investment by Hungary

8. Over 1994 to 1995 Hungarian companies made outward foreign direct investments of about US$50 million per annum, but outward FDI in equity capital surged to US$286 million in 1997, with cumulative outward direct investment reaching US$0.7 billion or 1.6 percent of GDP. As discussed in UNCTAD (1997), the most favored locations were Romania, the United States, Slovakia, and Austria. Hungary’s FDI in CEE countries has been focused on manufacturing while FDI in advanced economies is geared towards distribution. The oil and gas company MOL has become the most active outward investor, but FDI activity also includes Pharmaceuticals and ceramics. The knowledge of Hungarian enterprises of markets in other transition economies may place them in an advantageous position in acquisitions when these countries implement cash privatization programs. In particular, foreign-owned companies resident in Hungary may become important direct foreign investors, though these outflows could be funded by higher direct investment inflows. It is expected that outward FDI net of such “intermediation” activity will remain modest compared to inward FDI in the medium–term.

Measurement Issues in the Current Account and FDI

9. As in many countries the BOP in Hungary is on a cash rather than accrual basis, which is problematic with respect to the stocks and flows of FDI as there are often no related cash payments, as retained earnings of foreign investors are a form of FDI and FDI capital is sometimes provided in kind. From 1999, the National Bank of Hungary plans to survey enterprises for supplementary information to improve the BOP information on FDI.

10. The Hungarian BOP data on FDI records cash flows related to equity purchases and sales where the nonresident party holds more that 10 percent of paid in capital in an enterprise. FDI financed by retained earnings is not captured, though retained earnings are an important source of FDI in other countries. For example, in New Zealand of the NZ$15.5 billion in total income on FDI in equity over 1992 to 1996, NZ$7.0 billion were reinvested. Table 35 presents estimates of the cumulative retained earnings of foreign investors in Hungary, where “paid dividends.” are used to proxy earnings.114 The profit accruing to the foreign investor is calculated using the share of foreign capital participation at the end of the previous year. Retained earnings accruing to the foreign owner are then calculated by subtracting repatriated dividends. Cumulating these estimates of retained earnings over 1990 to 1997 gives an estimate of US$1.8 billion of FDI from retained earnings.

Table 35.Estimate of Retained Earnings of Foreign Owners of Hungarian Companies 1/
19901991199219931994199519961997
(In billions of Forint)
1. Paid dividends by FDI enterprises12.415.425.134.359.774.9143.5262
(In U.S. dollar millions)
2. Paid dividends by FDI enterprises1962063183735685969401403
3. Repatriated dividends, BOP24324456117194257437
4. Net dividend to foreign owners (2*7)67931792223383956661031
5. Retained earnings, estimate (4-3)4361135166221201409594
6. Cumulative retained earnings4310423940562682812361830
(In percent)
7. Foreign share in total capital34.045.156.359.559.666.370.873.5
Sources: Central Statistical Office, National Bank of Hungary.

11. The estimate of US$0.6 billion in retained earnings of foreign owners in 1997 is 1.3 percent of GDP. The omission of these income flows to nonresidents from the BOP international investment income account means that the reported current account balance may understate the deficit on an accrual basis by about 1.3 percent of GDP, though this should be considered a rough estimate only.

APPENDIX II: Evaluating Hungary’s External Debt Burden

Debt Definition

1. External debt data in this chapter is intended to cover all nonequity claims of nonresidents on residents of Hungary. Thus nonresident holdings of Hungarian forint denominated securities are included, as these holdings could become a claim on foreign reserves if they were sold, as happened in August-September 1998. Intercompany loans (nonequity claims on Hungarian companies by a direct investor in that company) are also included in gross foreign debt.115 These loans have risen as a share of enterprise foreign debt, from 17 percent at end 1995 to 31 percent at end 1997. These “loans” range from being close to equity, e.g. long-term debt to the majority foreign owners of a company, through to standard trade credits except that the lender has a small—though at least 10 percent—equity participation in the borrower. The recorded maturities on these liabilities, of US$127 million in 1996 and US$322 million in 1997, were only 14 percent and 23 percent respectively of intercompany loans outstanding at the end of the previous year, implying a long-term average maturity. While some of these liabilities may be readily rescheduled, others could be a source of demand for foreign currency in the event of external pressures, so the most prudent treatment is to include intercompany loans in foreign debt.

Debt Data Quality

2. The official BOP data on debt is advanced, with International Investment Position (IIP) data provided on a monthly basis with a sectoral break-down.116 The BIS International Banking Statistics provide a basis for evaluating the official IIP debt data, as it should be the case that the survey of BIS banks covers a significant subset of the debt of a country. Table 36 provides a comparison of BIS data with the IIP data, finding that foreign parties not covered by the BIS survey hold more than half of Hungary’s foreign debt. Nevertheless, the BIS surveyed institutions hold the majority of short-term non-intercompany debt claims on Hungary.117 The BIS data on claims on the public sector slightly exceed the IIP data on government foreign debt, but this may reflect the inclusion of government guaranteed debt in the BIS data. The BIS data on holdings of Hungarian bonds and notes is significantly above the IIP data on debt in bonds and notes by almost US$1 billion, but this may reflect some differences in debt instrument classification. Overall, the BIS data in mid-1997 do not provide clear evidence of weaknesses in the official data on Hungarian foreign debt.

Table 36.Debt statistics comparison, at end-June 1997(In millions of U.S. dollars)
International Investment Position (NBH)International Banking Statistics (BIS)Deviation
Gross foreign debt, ex. intercompany loans23447Total claims1085112596
Short-term plus maturities5663Up to one year 1/40181645
Short-term3396
Maturities on public MLT debt 2/2268
By sector:By sector:
NBH and credit institutions17439Banks548111958
Government2241Public sector2400-159
Enterprises and other3767Non-bank private sector2968799
By instrument:By instrument:
Other foreign liabilities11415External loans and deposits53196096
Bonds and notes11943Bonds and notes12900-957
Sources: NBH Statistics Department, and International Banking Statistics, BIS.

Debt Ratios

3. Debt ratios to both GDP and exports are commonly used when evaluating the burden of foreign debt. Many papers suggest that ratios to exports are the more informative indicators, including Milesi-Ferretti and Razin (1996). Manzocchi (1997) argues that the attractiveness of Hungary as a destination for capital inflows despite its relatively high initial foreign debt was related to the rapid growth in the export base.118 These studies would suggest giving most weight to the sharp reduction in Hungary’s debt-to-exports in evaluating its debt burden. However, the recent expansion in Hungarian exports includes a change in export composition towards manufactures which have a high share of imported inputs. Thus the improvement in the net capacity of Hungary to generate foreign exchange through trade is overstated by the 128 percent rise in gross exports in U.S. dollar terms from 1994 to 1997, as imports also rose by 75 percent in this period.119 For comparisons of Hungary’s debt burden over time this chapter uses ratios to GDP to avoid this export composition distortion. Net rather than gross debt is the focus of the analysis, as net debt is most clearly linked to the current account deficit and it also indicates income sensitivity to foreign interest rates. Gross debt data can also be distorted by transactions that result in offsetting assets and liabilities.

4. Debt ratios are static comparisons, but it may be the case that some countries are more able to manage a certain debt ratio if their GDP or export growth will be higher than other countries. Various indicators that allow for these dynamics have been proposed, for example Manzocchi (1997) encourages use of the growth-adjusted debt–to–export ratio:

Growth-adjusted debt–to–export ratio = debt / exports [1–(export growth / interest rate) ]

A similar growth adjustment can be made for ratios to GDP. This type of adjustment was not made, as the countries of most relevance to Hungary face broadly similar potential GDP growth rates and interest rates, see for example EBRD (1997).

Prepared by Craig Beaumont.

Knight and Scacciavillani (1998) provide an overview of models of the current account.

This section uses the official BOP data, though Appendix 1 notes that FDI inflows and the current account deficit are underestimated due to the omission of retained earnings by foreign owned companies. As official direct equity liabilities are based on cumulative FDI inflows, these liabilities are becoming increasingly understated.

Cottarelli (1998) notes that the sizeable errors and omissions in the BOP in 1995 to 1997, of US$2.9 billion, may partly reflect unrecorded debt financing so that the fall in net foreign debt may be somewhat overstated.

The official stock of FDI liabilities is treated as being denominated 70 percent in German marks and 30 percent in U.S. dollars. The Fifth BOP Manual recommends market valuations of direct investment assets and liabilities. Milesi-Ferretti (1998) adjusts recorded FDI using the stockmarket index when analyzing sustainability in Chile, but this approach was not used, as the composition the Budapest Stock Exchange is not likely representative of FDI capital.

The value of a firm that shifts from debt to equity financing is unchanged under the zero taxation and zero transactions cost conditions of the Modigliani-Miller (1958) theorem.

Frankel and Rose (1996) find that a higher ratio of FDI to external debt reduces the risk of a currency crash controlling for other risk factors.

Moderately–indebted countries have either the debt-to-exports ratio between 132 percent and 220 percent or the debt-to-GDP ratio between 48 percent and 80 percent.

Medium ratios are gross external debt to current account receipts between 100 percent and 200 percent, and external debt net of reserves between 30 percent and 40 percent of GDP.

In standard models, e.g. Bandari et al (1990) and Van der Ploeg (1996), countries facing a positive productivity shock would initially have high investment partly financed by foreign debt. Hungary faces a transition-related productivity shock, suggesting that higher net foreign liabilities (NFL) would be optimal in the start of the catch-up process. However, Hungary “also faces demographic changes that affect optimal savings behavior, that could imply a reduction of NFL ahead of a rising retired population.

Technical issues regarding cross-country comparisons of Hungary’s external debt are discussed in Appendix II, which concludes that; external debt should include forint as well as foreign exchange denominated liabilities and also intercompany loans; no evidence of unreliability in the official debt data was found; debt ratios to both exports and GDP are useful, though the ratio to exports is best compared to countries with a similar trade composition; and finally, growth-adjusted debt ratios are not used as the medium-term growth prospects of comparator countries do not appear to be sufficiently different.

The MIMI group is: Chile, Colombia, Georgia, Hungary, Macedonia, Malaysia, Mexico, Morocco, Panama, Phillippines, St. Vincent, Thailand, Tunisia, Turkey, Uruguay, Venezuela.

The omission of foreign assets besides official reserves does not distort the analysis of net debt significantly, as Hungary appears to have somewhat below average holdings of these assets, at 49 percent of reserves at end 1997 while the CEE group in Table 23 held other convertible currency assets of 64 percent of their official reserves.

Five-year floating rate notes were issued by the National Bank of Hungary (NBH) in January 1998 at a spread of 37.5 basis points over three-month DM Libor, while a fixed coupon eurobond yielded 81 basis points over 5-year U.S. Treasury notes when issued in April 1998, compared to issue spreads of 230 to 250 basis points in 1993 to 1995. In late 1998, after the Russian crisis of August, the NBH twice increased the issue of the five-year DM Libor bonds by DM 250 million, at a 73 basis point spread, and also expanded the eurobond by US$200 million, at a 160 basis point spread.

Based on the following 1997 data: per capita GDP of US$4,460, external debt of 97 percent of exports, CPI inflation of 18.3 percent, overall fiscal deficit of 4.6 percent of GDP, GDP growth of 4.4 percent, not an IMF industrial country, and no default since 1970.

Further analysis of Hungarian savings behavior is provided in IMF (1995).

Germany, France, Italy, UK, Netherlands, Belgium and Spain.

As discussed in Appendix 1, nonresidents own a significant part of the nonfinancial business sector as well as the banks, and these ownership links likely reduce the extent to which creditors treat these enterprises and banks as purely Hungarian risks.

A lower share of public debt in foreign debt was found to reduce the risk of a currency crash in Frankel and Rose (1996). The fall in total foreign debt over 1994 to 1997 reflected a cut in public sector foreign debt of US$8.7 billion, while private foreign debt rose by US$3.9 billion, shifting the composition of debt sharply, from 79 percent owed by the government and NBH at end 1994 to 58 percent at end 1997, Table 20.

Krueger (1996)—based on the econometric estimates of the relationship between external deficits and demographic, fiscal, and development indicators in Debelle and Farquee (1996)—also concludes that a further decline of the external debt ratio would be appropriate.

This estimate for real exchange rate appreciation applies the Balassa-Samuelson effect, with the traded goods sector equal to half of GDP, productivity growth in the traded goods sector at 2 to 4 percent faster than the nontraded goods sector, and foreign traded goods prices falling 0.5 to 1.0 percent per annum relative to the price of foreign GDP due to traded goods sector productivity rising faster than nontraded goods in foreign economies. Simon and Kovacs (1998) find that the real appreciation that can be expected is quite uncertain, being sensitive to the treatment of agriculture among other factors.

There is however significant uncertainty about the FDI outlook, suggesting that estimates of the sustainable current account deficit be updated periodically.

These projected equity income levels are subject to significant uncertainty. In 1999 the introduction a survey of foreign investment enterprises will allow the incorporation of retained earnings into the current account, and also provide a firmerbasis for projections.

If repatriated equity incomes did not increase, retained earnings would be higher so that FDI in cash could be lower for the same total FDI, therefore requiring the same improvement in the GNFS trade balance to prevent a higher need for debt-creating capital inflows.

The current account deficit on an accrual basis would be larger to the extent that earnings of foreign equity owners-estimated at 1.3 percent of GDP in 1997-were retained in Hungary.

There may be an accounting bias where paid-in capital is higher relative to physical capital where the capital subscription is more recent, due to inflation.

While dividends are typically only a fraction of earnings, some FDI enterprises made losses, so the estimate is not overly conservative, but is only approximate.

Desk economists report that the Czech Republic includes intercompany loans in gross foreign debt, but the treatment in Poland and Slovenia is uncertain.

At this stage in the implementation of the Fifth Balance of Payments manual, 37 countries are publishing IIP data, many on an annual basis only, but some on a quarterly basis.

The comparison must allow for scheduled maturity payments on medium and long-term debt as the BIS classification is on a residual maturity basis.

The IBCA upgrade of Hungary’s long-term foreign currency debt to BBB from BBB- in June 1997 described the fall in net foreign debt relative to exports since 1994 as “unparalled in any rated emerging market in recent times.”

It is not possible to calculate the contribution of manufactures, especially machinery and transport equipment, to overall export and import growth, as CSO data on the commodity composition of trade covers trade in the free-trade zones in 1997, but not in previous years. One approach to correcting the debt-to-export ratios was prevented by the lack of trade data on a Broad Economic Category basis, i.e. consumption, capital, and intermediate goods.

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