Chapter 6. Hungary: Placing the First Call to the IMF from Emerging Europe
- Bas Bakker, and Christoph Klingen
- Published Date:
- August 2012
Hungary was immediately and significantly affected by global deleveraging because of its high external and public debt in conjunction with its close international financial integration. These vulnerabilities had built up over many years, rather than in the context of a precrisis boom of domestic demand, and fiscal consolidation efforts came too late to redress them. Just three weeks after the collapse of Lehman Brothers, Hungary became the first country in emerging Europe to request financial assistance from the IMF when it found its gross financing needs impossible to meet on its own. A strong policy response, together with significant official support from the IMF and the EU, restored financial stability and mitigated the economic downturn. A change of government led to the premature lapse of the program in July 2010 and partial policy reversals. Consequently, Hungary came under renewed pressure as the euro area crisis intensified in the second half of 2011.
Hungary embraced the economic transition to a market-based economy but inherited large debts from the pretransition period. Quasi-market elements were introduced from the late 1960s, and legislation on foreign direct investment and the transformation of state enterprises into shareholding companies was put in place in 1988–89. Hungary bolstered this head start with a major austerity, stabilization, and privatization package in the mid-1990s to acquire a leading position as a reformer in the region. The early entry of foreign investors helped build a largely modern and efficient industry and an open economy firmly integrated into Europe’s cross-border production chains more generally. The banking system became dominated by subsidiaries of western European banks, but the large former national savings bank, OTP, remained independent and established its own subsidiaries in neighboring countries.
With early success, a degree of complacency set in. The economy began to grow again in 1994 and was particularly vibrant during 1997–2000. Inflation was brought down in the second half of the 1990s under a crawling-peg exchange rate regime. An inflation targeting framework with exchange rate bands was introduced in 2001 (the bands were removed in 2008). However, efforts to reign in government and external debt were never sufficiently decisive. A persistent current account deficit kept external debt high relative to GDP. On the fiscal front, relatively well-off Hungary kept social benefits generous. Fiscal deficits fluctuated with the political cycle but were on average too large to ever bring the debt-to-GDP ratio below 50 percent of GDP.
The Run-Up to the Global Financial Crisis
The period of 2003-08 was marked by mediocre economic growth and a further buildup of vulnerabilities. At a time when most of emerging Europe went through a domestic-demand-driven boom, Hungary’s real GDP expanded by a rate of only 2.9 percent a year. With current account and fiscal deficits persisting and foreign financing readily available, external and public debt kept growing. Foreign investors became important players in the government bond market (Figure 6.1). The entry and subsequent aggressive expansion of foreign banks helped fuel the growth of private debt. In particular, foreign currency denominated lending, especially in Swiss francs, was highly profitable.
Figure 6.1New EU Member States: Portfolio Investments by Nonresidents
Sources: IMF, Balance of Payments and International Investment Position Statistics Database; and IMF staff calculations.
The fiscal deficit widened sharply in the run-up to the 2006 election, and the subsequent major fiscal adjustment effort came late. After the fiscal deficit had risen to 9.4 percent of GDP in 2006, the government embarked on fiscal consolidation and focused on cuts to the government wage bill and subsidies, improvements in tax collection, and a pro-growth shift from direct taxation to indirect taxation. In mid-2008, the fiscal deficit for the year was expected to be about 3½ percent of GDP, although gross financing needs (which include maturing debt) remained large at about 17 percent of GDP.
Thus, on the eve of the global financial crisis, Hungary was in a precarious position: (i) despite consolidation efforts, public debt was about 70 percent of GDP and its rollover depended on the whim of foreign investors; (ii) banks’ loan-to-deposit ratios had risen to 150 percent, exposing them to significant liquidity risk; (iii) almost two-thirds of all bank loans were foreign currency denominated to mostly unhedged borrowers; and (iv) official foreign currency reserves covered little more than half of short-term foreign debt.
Impact of the Global Financial Crisis
When global liquidity froze in the days after the collapse of Lehman Brothers, funding pressures emerged quickly for Hungary’s government and banks:
- Government funding. In early October 2008, auctions in the primary government bond market failed. In the secondary market, foreign investors sold more than one quarter (€3.5 billion) of their holdings of domestic-currency denominated government bonds between mid-September and end-November 2008. The sell-off put severe downward pressure on the exchange rate.
- Bank funding. Banks hedged their foreign-currency lending in the foreign-exchange swap market, with the typical counterpart being a nonresident who needed domestic currency to purchase high-yielding domestic-currency denominated assets, especially government bonds (Barkbu and Ong, 2010). When global funding markets froze, foreigners’ interest in holding domestic currency assets declined, which reduced the supply of swaps. As a result, banks’ cost of hedging increased sharply and maturities in the swap market shortened. Moreover, the depreciation of the exchange rate triggered margin calls on swap positions, which caused severe liquidity shortages in some banks. In addition, banks without a foreign parent lost critical direct foreign-currency funding.
The Hungarian authorities called the IMF on Thursday, October 9, 2008. It was the central bank governor, who told the IMF, “all hell has broken loose” after an unsuccessful government bond auction in the morning: primary dealers of government securities had stopped quoting prices; the swap spread (an indicator of foreign exchange market pressure) had spiked; the currency was weakening; and the stock market price of OTP was under pressure. Such a rapid and severe impact on Hungary of the global financial market turbulence did not come as a surprise, given Hungary’s well-known vulnerabilities. The speed with which the Hungarian authorities asked for assistance was welcome.
The phone call was met by a quick response, leading to IMF Executive Board approval of a stand-by arrangement on November 6, 2008.1 On October 9, a staff team was organized, IMF management informed the IMF Executive Board that it was invoking emergency procedures, and the European Commission was consulted. The next day, a briefing paper was written and approved, and the team left for Budapest on October 11.
The program comprised three main elements: efforts to build fiscal credibility, steps to maintain financial stability, and large front-loaded official financial assistance.
Given high government debt and the low credibility of fiscal policy, it was critical to improve fiscal sustainability and limit government financing needs in the short term. Adjustment focused on the expenditure side because weak spending control had led to a relatively high level of government spending compared to regional peers, leaving ample room for rationalization and restructuring. In contrast, already high tax rates precluded a significant role for revenue measures. While the initial adjustment package announced in October 2008 relied largely on front-loaded spending freezes, entitlement reforms with a durable impact on future spending were subsequently enacted, including an acceleration in the planned increase of the statutory retirement age, incentives to discourage early retirement, a more limited role for wage inflation in pension indexation, and reductions in relatively generous universal transfer programs, such as maternity leave (Figure 6.2). Cuts in the wage bill—mainly through an extension of nominal freezes—were also introduced. To minimize the impact on the poor, safety nets were preserved by expanding means-testing and sheltering the purchasing power of low-income civil servants and retirees. Spending measures were accompanied by a pro-growth, revenue-neutral shift from labor taxation to consumption taxation.
Figure 6.2Hungary: Composition of Fiscal Adjustment Plans under the IMF-Supported Program
Source: IMF staff calculations.
The government’s commitment to fiscal sustainability was buttressed by institutional reforms aimed at focusing budget preparation and execution on the need for debt reduction. A fiscal responsibility law (adopted in late 2008) mandated a decline in the budget deficit over the next two years and an annual reduction in debt in real terms thereafter (a requirement that ensures a fall in the debt to GDP ratio as long as real GDP growth is positive). Along with these numerical ceilings, the law sought to enhance the transparency of the budget process through specific disclosure requirements and the creation of a nonpartisan fiscal council to monitor and assess budgetary developments against the objectives of the law. Finally, procedural rules (in particular, the obligation that any new spending or tax initiative be deficit-neutral) were introduced to avoid slippages during the budget year.
As economic activity contracted more sharply than initially expected during the first half of 2009, the fiscal targets were modified to preserve an appropriate balance between the necessity to enhance fiscal credibility and the need to minimize the adverse effect on aggregate demand. The initial consolidation path was adjusted twice (at the first and second reviews of the program) to accommodate roughly half of the expected revenue shortfall. To avoid jeopardizing the medium-term objective of reducing public debt, the government strengthened the initial adjustment measures with structural reductions in future commitments, mainly by rationalizing social transfers (including pensions) and subsidies.
The second element of the program—maintaining financial stability—required preventing excessive exchange rate depreciation, assuring bank liquidity and solvency, and strengthening financial supervision and macro-prudential oversight, as follows.
- Monetary and exchange rate policies. A sharp currency depreciation would have had significant adverse effects on household and corporate balance sheets. Interest rate policy was the main tool used to defend the exchange rate, with the central bank raising its policy rate by 300 basis points in October 2008. To prevent an intensification of depreciation expectations, the central bank’s strategy was to keep its policy interest rate in line with the European Central Bank’s policy rate plus a risk premium (the yield spread on long-term bonds). In addition, the central bank intervened directly in the foreign exchange spot market in February and March 2009.
- Liquidity. The central bank quickly established a two-week domestic currency lending facility and an overnight foreign-exchange swap facility. Longer-term (3- and 6-month) swap facilities were added in March 2009. For domestic banks, the government initially granted foreign currency funding guarantees; however, these proved ineffective in light of the government’s low credit rating. The government then fell back on extending foreign-currency loans of €2.3 billion directly to three banks without a foreign parent. An interagency group (comprising the central bank, the financial supervisor, and the Ministry of Finance) was established to continuously monitor these banks’ financial standing.
- Bank solvency. Hungary’s banks entered the financial crisis with generally solid capital positions. Nevertheless, as a safeguard against the possible impact of deteriorating economic conditions on bank solvency, a capitalization fund was established. The fund was used only once in a small amount (a temporary injection of €100 million in March 2009 into one bank without a foreign parent). Most banks remained profitable throughout the crisis.
- Financial supervision. The authorities put in place a comprehensive program to enhance the quality of financial supervision, with a view to strengthening confidence in the good financial standing of Hungary’s financial institutions. In 2009 and early 2010, the Hungarian Financial Supervisory Agency (HFSA) conducted comprehensive on-site inspections of Hungary’s eight largest banking groups, and followed up in 2010 with targeted inspections focusing on credit quality. Cooperation between home and host supervisors was strengthened, both in cases where the HFSA is the host supervisor (for subsidiaries of western European parent banks), and where it is the home supervisor (for foreign subsidiaries of OTP).
- Remedial action and resolution framework. The remedial action regime was improved, including strengthening legal protection for the supervisory commissioner and establishing an additional mandatory threshold for the appointment of a supervisory commissioner. A legislative proposal to broaden bank resolution tools was developed but not enacted.
- Macro-prudential oversight. A Financial Stability Council was established, consisting of the HFSA, the central bank, and the Ministry of Finance, with the task of integrating micro- and macroprudential aspects of financial supervision, thus enhancing the capacity to identify and prevent the buildup of systemic risks within the financial system. The Financial Stability Council and the central bank were granted the right to initiate legislative and regulatory action. However, the HFSA’s full regulatory independence was not established, because the government lacked the two-thirds majority in parliament to make the necessary constitutional change.
- Foreign banks. Continued commitment of foreign banks to their local subsidiaries was indispensible to the program’s success. Disengagement could have easily triggered a large-scale exodus of foreign capital, which in turn would have undermined financial stability and the exchange rate. In October 2008, parent banks provided assurances to the central bank that they would maintain their exposure to subsidiaries and recapitalize them as needed. Indeed, the parent banks of the six largest Hungarian subsidiaries increased their funding by more than a quarter (or €6 billion) in the last quarter of 2008 and the first quarter of 2009. Parent banks formalized their commitments in writing under the European Bank Coordination Initiative (EBCI) arm of the Vienna Initiative in May 2009.
The third element of the program was large and front-loaded financial support from the IMF and the European Union. The economic policies under the program were intended to restore investor confidence in Hungary’s external sustainability. However, it was difficult to predict the speed with which investor confidence would return, so sufficiently large and up-front official financial support was essential to convince investors that the country could meet its external obligations for the foreseeable future.
Hungary’s external financing need was potentially very large. The gross need was projected to be about €39 billion from 2008:Q4 through end-2009 (it was calculated as the sum of the projected current account deficit, maturing debt obligations, and the needed increase in official reserves to cover about 80 percent of short-term debt). Financial inflows of about €19 billion were expected, including capital transfers from the European Union, foreign direct investment, and other private inflows, leaving a financing gap of about €20 billion. This gap was filled by commitments from the IMF (€12½ billion), the European Commission (€6½ billion), and the World Bank (€1 billion). Of this amount, €7 billion was provided immediately, €4½ billion in 2009:Q1, €1½ billion in 2009:Q2, and €1½ billion in 2009:Q3.
Economic Outcomes in 2009–11
Financial strains eased and the economy stabilized in less than a year. Financial markets responded positively to the program, as suggested by the behavior of the sovereign credit default swap (CDS) spread (Figure 6.3). The CDS spread fell after the announcement of the program, especially relative to the sovereign CDS spreads of other EU emerging economies. Investor concerns about banking system health in central and eastern Europe led to an increase in financial market pressures in early 2009, but these started to ease after the G20 announced a sharp increase of IMF resources in March 2009. Hungary’s CDS spread fell substantially and durably in the late spring of 2009. By July 2009, the central bank began a series of interest rate cuts and the government began to issue bonds at a pace sufficient to meet its financing needs. The successful issuance of a foreign-currency bond in July 2009 strongly signaled that global investor confidence had returned.
Figure 6.3CDS Spreads: Hungary Compared with Other New EU Member States, June 2008–October 2009
Sources: Bloomberg L.P., and IMF staff calculations.
Hungary’s economic downturn was severe, but it was mostly driven by the shock to global trade. Real GDP contracted by 7¾ percent in seasonally adjusted terms from peak (2008:Q1) to trough (2009:Q4), and the unemployment rate rose by more than 4 percentage points from mid-2008 to early 2010. However, the severity of the downturn was largely due to Hungary’s high degree of integration into the global trading system, with exports amounting to about 80 percent of GDP and consisting mostly of machinery and equipment. About two-thirds of Hungary’s decline in GDP can be explained by the decline of domestic demand in its advanced-economy trading partners.2 The depreciation of the nominal exchange rate in Hungary was much less than the depreciation during the Asia crisis. As a result, balance sheet adjustment was more orderly and a banking crisis was avoided.
As global trade rebounded, the economy returned to growth in the third quarter of 2009 on the back of a pickup in exports. The pace of real economic expansion rebounded modestly to about 1½ percent in 2010 and 2011, after an almost 7 percent contraction in 2009. Despite the recession, the fiscal deficit deteriorated by a modest ¾ percent of GDP in 2009, to 4.5 percent of GDP. The external sector has been a particularly bright spot, with the current account swinging into surplus for the first time in more than 15 years. While the slump in domestic demand is partly responsible, exports remain the key driver of the recovery.
Program disbursements stopped in the fourth quarter of 2009. Although the fourth and the fifth program reviews were completed in December 2009 and March 2010, the authorities decided not to draw on IMF or EU resources in light of regained access to market financing. The new government that was formed in mid-2010 took a new direction in economic policies, and the program expired in October 2010 without any additional reviews being completed. Fiscal policy turned sharply expansionary, with the structural deficit widening by 3 percentage points in 2010-11. The de facto nationalization of second-pillar pension funds, institutional changes that weakened economic governance, regressive and complex changes to the tax system, special levies on selected industries, and heavy-handed schemes to convert CHF-denominated mortgages into local currency proved controversial and likely contributed to high risk premiums and low investor and consumer confidence. Although the government subsequently adjusted its fiscal policy stance with the announcement of a program of structural reforms and an ambitious 2012 budget, Hungary came under substantial financial market pressure in the second half of 2011 and requested financial support from the IMF and the European Commission in November.
Hungary paid a high price for its many vulnerabilities during the global financial crisis, but the worst was avoided through a quick policy reaction and substantial official financial support. Hungary initially made important progress toward improving its resilience, with banks’ liquid assets now much higher, international reserves having doubled, and the current account in surplus.
It will take much longer to make substantial inroads into other vulnerabilities. High external and public debt and a large stock of foreign currency loans—along with the accompanying dependency on nonresident holders of government paper and foreign-exchange swaps—can only be corrected by pursuing corrective policies over many years. Fiscal discipline, the development of domestic currency markets, the strengthening of external competitiveness, and structural reform for more growth all need to become permanent features of policymaking in Hungary. The renewed pressures in late 2011 underscore the fact that Hungary has little leeway to deviate from such a reform path, especially in an external environment that is bound to remain volatile for some time.
|Real Sector Indicators|
|GDP (real growth in percent)||3.9||4.8||4.0||3.9||0.1||0.9||−6.8||1.3||1.7|
|Domestic demand (real growth in percent)||6.0||4.6||1.4||1.6||−1.4||0.7||−10.9||−0.5||−0.6|
|Net exports (real growth contribution in percent)||−2.1||−0.1||2.5||2.3||1.6||0.2||3.6||1.8||2.2|
|Exports of goods and services (real growth in percent)||6.2||15.0||11.3||19.1||15.0||5.7||−10.3||14.3||8.4|
|CPI (end-of-period change in percent)||5.7||5.5||3.3||6.5||7.4||3.5||5.6||4.7||4.1|
|Employment (growth in percent)||1.2||−0.6||0.1||0.7||−0.2||−1.2||−2.5||0.0||0.8|
|Unemployment rate (percent)||5.5||6.3||7.3||7.5||7.7||8.0||10.1||11.2||11.0|
|Fiscal balance (percent of GDP)||−7.2||−6.4||−7.8||−9.4||−5.1||−3.7||−4.5||−4.3||4.0|
|Government revenue (percent of GDP)||42.5||42.7||42.2||42.8||45.6||45.5||46.9||45.2||52.4|
|Government expenditure (percent of GDP)||49.6||49.1||50.0||52.2||50.6||49.2||51.4||49.5||48.4|
|Government primary expenditure (percent of GDP)||45.5||44.7||45.9||48.2||46.5||45.1||46.8||45.3||44.5|
|Government primary expenditure (real growth in percent)||−0.2||2.9||6.9||9.1||−3.4||−2.2||−3.3||−1.9||−0.1|
|Public debt (percent of GDP)||58.5||59.4||61.7||65.9||67.0||72.9||79.7||81.3||80.4|
|Of which foreign held||24.0||28.3||26.9||33.8||34.8||29.3||39.3||37.6||…|
|Current account balance (percent of GDP)||−8.0||−8.4||−7.5||−7.4||−7.3||−7.4||−0.2||1.1||1.6|
|Net capital inflows (percent of GDP)1||8.2||12.1||13.7||9.7||5.9||10.6||−4.4||1.1||2.9|
|Exports (percent of GDP)||62.2||65.3||67.8||77.3||81.0||82.0||77.7||86.3||91.4|
|Exports (€, growth in percent)||3.3||16.3||12.2||15.4||16.1||6.9||−17.7||18.3||10.2|
|Global export market share (basis points)||56.5||60.0||60.4||62.7||68.9||67.6||67.3||64.1||…|
|Remittances (percent of GDP)||0.05||0.04||0.06||0.05||0.04||0.03||0.04||0.04||0.04|
|Imports (percent of GDP)||66.1||68.0||69.3||78.4||80.3||81.7||73.0||79.9||84.5|
|Imports (€, growth in percent)||5.9||14.1||10.1||14.6||13.5||7.4||−22.5||16.8||10.0|
|External debt (percent of GDP)||62.3||67.3||77.1||101.8||111.4||109.0||157.8||141.4||131.3|
|Gross international reserves (€ billions)||10.1||11.7||15.7||16.3||16.3||24.3||30.6||36.0||41.6|
|Gross international reserves (percent of GDP)||15.3||15.6||16.8||19.1||17.6||21.9||34.8||37.4||38.3|
|Reserve coverage (GIR in percent of short-term debt)||84.6||88.8||74.4||76.8||52.0||79.2||105.0||88.6||93.8|
|Broad money (end of period, growth in percent)||12.0||11.6||14.7||13.7||11.0||7.7||4.4||3.0||5.9|
|Monetary base (end of period, growth in percent)||18.6||−3.7||19.4||13.8||11.4||19.5||−23.2||14.4||11.3|
|Private sector credit (end of period, percent of GDP)||43.4||46.8||62.7||57.1||64.7||72.6||72.6||72.6||68.5|
|Of which foreign currency denominated||11.8||14.9||24.9||25.4||34.4||45.3||45.1||45.5||42.6|
|Of which foreign currency indexed||…||…||…||…||…||…||…||…||…|
|Cross-border loans to nonbanks (Q4, percent of GDP)||18.2||19.7||21.4||25.2||27.9||28.6||36.1||24.8||18.6|
|Private sector credit (end of period, real growth in percent)||26.1||12.6||38.3||−8.0||11.4||15.1||−8.5||−0.3||−4.6|
|Assets (percent of GDP)||66.1||69.7||76.0||87.0||94.8||109.6||115.9||113.0||109.9|
|CAR (percent of risk-weighted assets)||11.8||12.4||11.6||11.0||10.4||12.3||13.9||13.9||14.2|
|NPLs (percent of total loans)||…||…||2.3||2.6||2.3||3.0||6.7||9.8||12.3|
|Cross-border claims by foreign banks (all sectors, percent of GDP)||34.4||37.3||39.8||51.2||56.8||60.9||73.2||57.2||42.8|
|Interest rates (end of period, one-year government bond, percent)||11.2||8.6||6.4||8.0||7.5||8.8||6.1||6.3||8.0|
|CDS spreads (sovereign, end of period, basis points)||32||16||27||21||49||430||242||384||623|
|EMBIG spread (sovereign, end of period, basis points)||28||32||74||58||84||504||186||345||578|
|Exchange rate (end of period, domestic currency/€)||262.5||246.0||252.9||251.8||253.7||266.7||270.4||278.0||314.6|
|NEER (index, 2003 = 100)||100.0||102.1||102.9||96.7||102.5||103.9||94.5||94.0||93.2|
|REER (CPI-based, 2003 = 100)||100.0||106.7||108.9||103.9||115.8||120.0||113.0||115.5||115.6|
|REER (ULC-based, 2003 = 100)||100.0||105.4||107.5||102.3||112.5||113.3||102.6||99.4||…|
|GDP (nominal, in billions of domestic currency)||18,738||20,665||22,019||23,676||24,991||26,546||25,623||26,748||28,154|
|GDP (nominal, in billions of €)||73.9||82.0||88.6||89.6||99.3||104.8||90.9||96.9||105.7|
Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.
Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.
The main authors of this chapter are Alina Carare, Xavier Debrun, James Morsink, and Johannes Wiegand.
The program was initially for 17 months. It was subsequently extended by 6 months through October 2010.