IV. Political Developments
2. The recent political disturbances have served as a wake-up call on the need for greater transparency. Street demonstrations followed the leakage of Prime Minister Gyurcsány’s speech, in which he acknowledged that the government had concealed the seriousness of the fiscal situation prior to the April parliamentary elections. The Prime Minister, however, retained the strong support of his party and coalition, and reiterated the need for dealing with the critical fiscal challenges. Markets remained calm and asset prices moved in a small range. In the October 1 municipal elections, the government’s popular support eroded and the opposition party, Fidesz, made strong gains. However, the governing coalition held on to the Budapest mayoral position, and with its safe majority in parliament, the government should be in a position to win the upcoming vote of confidence and pursue the goals articulated in the CP.
V. Implications of Recent Developments for the Outlook
3. Recognizing the significant actions taken, staff has lowered its projections for the fiscal deficits. The required tax legislation has been passed and the higher rates are in effect. Steps have been taken to reduce central government employment, freeze public wages, lower energy price subsidies, and implement measures in healthcare and education. With these in place, along with some budgetary control measures, staff estimates the fiscal deficit will decline from 10.7 percent of GDP in 2006 to 7.9 percent of GDP in 2007, and further to 5.6 percent of GDP in 2008 (Text Table 1 and Table 1). 2 On this basis, staff now projects additional consolidation of 0.6 and 0.9 percent of GDP in 2007 and 2008, respectively, relative to the staff report. At the same time, the authorities have raised their deficit projections, which now present a more realistic assessment of the likely fiscal consolidation path (Table 2). The continuing differences in deficit projections—of 0.6 percent of GDP in 2006 and about 1 percent of GDP a year thereafter—reflect staff’s caution in light of the uncertainties associated with implementation. Both the staff and authorities’ estimates point to a rising debt ratio through 2008, when it is expected to peak at about 73 percent of GDP. However, in staff’s central scenario, the debt ratio’s decline in the outer years would be noticeably less than that projected by the authorities. Important pension and social welfare reforms, as well as steps to broaden the tax base, have yet to be detailed and remain crucial for more rapid and durable deficit and debt reduction.
|Real GDP growth (in percent)||Staff Report||4.5||3.5||3.7||3.7||3.8|
|Inflation (average, in percent)||Staff Report||3.5||5.8||4.4||3.5||3.0|
|In percent of GDP|
|External current account balance||Staff Report||−9.1||−8.0||−7.6||−7.4||−7.1|
|General government balance 1/||Staff Report (excl. PPPs)||−10.1||−7.6||−6.4||−5.8||−5.5|
|Staff Report (incl. PPPs)||−10.7||−8.5||−6.5||−5.8||−5.5|
|Current (incl. PPPs)||−10.7||−7.9||−5.6||−4.2||−3.7|
|Gross external debt 2/||Staff Report||81.8||82.2||82.5||83.2||84.0|
|General government debt 2/||Staff Report||67.2||68.9||70.1||71.1||72.0|
|(In percent, unless otherwise indicated)|
|Real GDP growth||3.8||3.4||5.2||4.1||3.6||2.8||3.4||3.7||3.8|
|Nominal GDP, forint billions||16,915||18,651||20,429||21,802||23,418||25,55327,435||29,374||31,405|
|Inflation (CPI; year average basis)||5.3||4.6||6.8||3.6||3.6||6.1||3.8||3.3||3.0|
|Inflation (CPI; end-year basis)||4.8||5.7||5.5||3.3||6.3||5.5||3.5||3.0||3.0|
|(Annual percentage change, constant prices)|
|Gross fixed capital formation||10.2||2.9||8.0||6.6||4.4||4.1||5.5||5.8||5.8|
|Exports of GNFS||3.9||6.1||15.8||10.813.3||7.5||7.1||6.4||6.5|
|Imports of GNFS||6.6||9.3||13.5||6.5||11.9||5.3||6.3||6.3||6.8|
|(In percent of GDP)|
|External current account balance||−7.1||−8.7||−8.6||−7.4||−8.6||−7.2||−6.2||−5.4||−5.0|
|Gross national saving||18.0||15.8||16.8||16.3||16.9||19.1||20.6||21.8||22.6|
|Gross national investment 1/||25.0||24.4||25.4||23.7||25.5||26.4||26.8||27.2||27.5|
|Gross external debt 1/||55.5||62.7||67.9||75.6||82.8||82.5||82.6||82.5||82.2|
|Private sector savings-investment balance 3/||−1.6||−1.9||−2.1||0.1||2.1||0.6||−0.6||−1.2||−1.3|
|Gross private savings||20.0||17.8||20.0||20.4||22.9||22.3||22.1||22.0||22.3|
|Gross private investment||21.6||19.7||22.1||20.4||20.8||21.7||22.7||23.2||23.5|
|General government (ESA-95)|
|General government balance (including the costs of pension reform) 4/||−9.1||−7.3||−6.5||−7.5||−10.7||−7.9||−5.6||−4.2||−3.7|
|General government balance (excluding the costs of pension reform) 4/5/||−8.4||−6.4||−5.4||−6.2||−9.3||…||…||…||…|
|General government debt||56.6||58.9||60.2||62.4||70.1||72.9||73.6||73.2||72.4|
|General government debt (excluding the costs of pension reform) 5/||55.0||56.7||57.1||58.464.0||…||…||…||…|
|Structural general government balance||−9.0||−7.0||−6.4||−7.4||−10.5||−7.3||−4.8||−3.3||−2.7|
|Structural primary balance||−5.3||−3.2||−2.4||−3.6||−6.5||−3.0||−0.9||0.6||1.1|
|Real GDP growth (in percent)||4.1||2.2||2.6||4.1||4.2–4.5||4.5|
|Inflation (CPI: year average basis, in percent)||3.5||6.2||3.3||3.0||2.5–3.0||2.5–3.0|
|In percent of GDP|
|External current account balance||−7.9||−5.9||−4.4||−3.6||−3.0||−2.0|
|General government balance||−10.1||−6.8||−4.3||−3.2||−2.7||−2.2|
|General government primary balance||−6.3||−2.4||−0.2||0.8||1.0||1.5|
|General government debt||68.5||71.3||72.3||70.4||68–69||65–67|
4. Financial markets continued to differentiate Hungary through the summer but have since cautiously reduced this differentiation. Calmer international markets, which saw the Icelandic krona and the Turkish lira regaining part of their sharp losses, also benefited the forint, though with a lag. Markets appear to be viewing the prospects of consolidation favorably, as indicated by the mild reaction to the recent demonstrations. The forint has traded in a very narrow range and yields on local currency bonds have increased by about 25 basis points. The rating agencies, however, have taken a more cautious view of the political disturbances. Fitch changed its outlook from stable to negative (within the rating category BBB+) on September 20 and Moody’s placed Hungary on review for a possible downgrade on September 25. These actions had limited impact.
5. Reflecting an earlier than anticipated slowdown, staff has lowered its projection of GDP growth and current account deficit estimates. A slowdown in the second quarter (going against the trend of accelerating growth elsewhere in the region) reflected a pullback in publicly-sponsored motorway investment and a fall in corporate and residential investment. Import growth, which tends to be a forward-looking indicator, also decelerated. Since the announcement of the fiscal consolidation package in June, retail sales have been weaker than expected and indices of consumer and business confidence have been falling. The anticipated higher personal income taxes and public sector lay offs and the wage freeze may have begun to restrain spending earlier than had been projected. Accordingly, staff’s GDP growth projection has been revised down from 4.5 to 3.6 percent for 2006 and from 3.5 to 2.8 percent for 2007.3 As a consequence, import growth is also expect to slow, and the current account deficit projected for 2007 is now 7.2 percent of GDP, 0.8 percent of GDP lower than in the staff report. The trajectory of lower expected current account deficits over the next few years will reduce the pace of external debt accumulation.
6. Inflation is expected to recede close to the target range over the medium term. Inflation has risen modestly since the staff report was issued. While inflation is expected to increase further in the next twelve months due to tax and administered price increases, the slowing economy should keep inflation contained. The authorities and the staff have revised upwards their inflation projections for 2006 and 2007. Staff is now expecting inflation at 3.6 percent in 2006 and 6.1 percent in 2007, when the one-time effects of the tax and administered price increases will kick in. Reflecting the expected slowdown in growth, staff projects inflation to fall to 3.8 percent in 2008, just inside the ±1 percent range around the 3 percent inflation target, while the Magyar Nemzeti Bank (MNB) is forecasting a slightly higher 4.2 percent inflation rate. The MNB has raised the policy rate by a cumulative 175 basis points in four steps since June. With the projected 2008 inflation rate either within or just outside the target band, staff continues to recommend measured tightening that responds to second-round effects if they do emerge, or a pause if these inflationary effects are mitigated by the recent growth deceleration and the expected fiscally-induced slowdown.
VI. Staff Assessment
7. The CP marks a significant step forward towards needed fiscal consolidation, but, if this objective is to be durably achieved, firm implementation of structural reforms and a high level of transparency remain essential. The CP has been successful in alleviating short-term vulnerabilities. Risks, however, are inherent to the strategy of relying initially on tax increases on personal and corporate incomes and on one-off measures such as wage freezes. First, the tax hikes could produce less revenue than anticipated due to evasion or slower than projected growth. Second, the 2009 budget will need to address the pressure to raise the frozen public sector wages. Also, the high tax wedge cannot be sustained. If the more durable measures (of the type emphasized in the staff report) are not in place by then, the financial turbulence of this spring and summer may repeat. Even if everything goes as planned, the deficit will still be sizable (3½-4 percent of GDP) in 2009, government expenditure (45 percent of GDP) disproportionate to Hungary’s per capita income, the tax wedge high, and the public debt-to-GDP ratio above 70 percent. These features could cause a prolonged period of below-potential economic performance. Finally, though the government successfully navigated the recent political disturbances, transparent communication of the risks and sacrifices that lie ahead will prevent more disruptive reactions in the future.
8. Policy interest rates should remain focused on achieving the inflation target 18 to 24 months ahead. Short-term inflation tendencies are currently characterized by considerable uncertainty in view of the many changes to taxes and subsidies. Thus, it is difficult to infer inflationary trends from the recent rise in inflation. Both the authorities and staff see inflation declining to close to or within the target range by 2008 and, hence, over the horizon relevant for monetary policy decisions. The recent increases in policy interest rates appear to have been at the higher end of the range of interest rate hikes needed under current circumstances to bring inflation two years out within the target range. Staff urges continued communication that the interest rate policy will be guided by the inflation target (and not by an exchange rate target) and that further rate increases will respond to the strength of second-round effects from the tax and subsidy changes.
On September 26, the EC endorsed the CP, highlighting continuing risks and calling for strict implementation. The Council of Economics and Finance Ministers of the European Union will make its decision on October 10.
These deficit numbers include for the first time the budget of motorway construction-related expenditures, a practice adopted by the authorities in their September CP (as recommended by recent staff reports and the fiscal ROSC). These expenditures amount to 0.6, 0.9, and 0.1 percent of GDP through 2006 to 2008.
The authorities’ growth estimates have not yet incorporated the recent deceleration. Their growth projections and that of staff are broadly similar—slower growth in 2007 and 2008 relative to 2006 and a rise thereafter.