Chapter

I Introduction

Author(s):
János Somogyi, and Anthony Boote
Published Date:
March 1991
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Hungary was the first centrally planned economy to introduce a broad market-oriented reform, in 1968. It has been undertaking economic reforms ever since. And yet, the first freely elected government in forty yearswhich took office in May 1990inherited a poorly performing, over-centralized economy with low external reserves and the highest per capita debt in Eastern Europe. What went wrong? This paper examines Hungary’s experience with reform up to mid-1990, which is essential to understanding the reform measures recently introduced by the new Government and which may also be instructive for other formerly planned economies implementing their own reform programs.

Many positive elements emerge from a detailed review of Hungarian reforms between 1968 and mid-1990. The authorities implemented price reform early and avoided the major distortions common in other centrally planned economies. Queues were uncommon. Trade with western economies was significantly liberalized. Important institutional reforms were carried out in the areas of banking and taxation. In the 1980s, small private enterprises were the principal source of economic growth. The economy became more flexible and adaptable.

The overall results, however, were clearly unsatisfactory. The authorities continued to maintain substantial formal and informal central control. Reform measures were often partial, inconsistent, and subsequently reversed. The checkered history of wage regulation provides a classic example; the persistence of widespread enterprise tax allowances undermined the effectiveness of tax reform. The goal was to stimulate marketssuch as by raising the administered price of raw materials to world market levelsrather than to provide scope for the interaction of market forces. There was a fundamental reluctance to permit competition between domestic enterprises and to close down chronic loss makers. The relationship between the State and state enterprises remained fatally flawed, and the representation of ownership interests remained unresolved in the dominant socialized sector of the economy. As Prime Minister Jozsef Antall stated in his inaugural address in May 1990, “In the economy, too, everything was upside down. The State embraced all activities in the direction and operation of the economy; the state enterprises were not real enterprises; state redistribution had pushed its way into the place of the market.”

The State’s domination of economic activity and its control over resource allocation reflected the fusion of economic and political power in the Hungarian Socialist Workers’ Party. This fusion led many to conclude that political reform was necessary for the successful transformation of the economic system. As the Government stated in its March 1991 Program of Stabilization and Convertibility, “Political change and economic transformation: two processes that presuppose each other.” The lesson of the Hungarian reform experience up to mid-1990 was, in the words of a senior official of the previous Government, that halfway does not work.

The new Government formed in mid-1990 has put in place a comprehensive reform program designed to complete the creation of the most important elementsincluding the institutional frameworkof a contemporary market economy within three years. The Government, drawing on Hungary’s earlier reform experience, is placing great emphasis on reducing the State’s role in the economy through privatization and other measures, strengthening the operation of the free market, and developing an adequate social safety net.

The earliest example of a broad market-oriented reform program to be implemented in a centrally planned economy is Hungary’s New Economic Mechanism (NEM), introduced in 1968. The NEM freed enterprises from mandatory plan directives and relaxed controls, which permitted a revival of small-scale cooperative and private activities. As a result, Hungary’s economy improved in the first four to five years of the NEM, but not without the emergence of tensions. In particular, opposition to the decentralization of decision making proved to be stronger than anticipated, and contradictions between the requirements of the plan and the market appeared. The reform left intact most of the traditional institutional system of economic management. Moreover, it did not fundamentally alter the economic development strategy established during central planning.

After 1968, the authorities attempted periodically to improve the NEM and to rejuvenate the reform process. Although the system that evolved was no longer characterized by pervasive direct administrative controls, enterprises remained subject to informal direct controls; in addition, substantial indirect controls governed entry, exit, and the selection of lines of activity. The authorities were able to affect enterprises’ financial results through price and wage regulations, taxes, and subsidies; throughout the period, they had a pervasive influence on enterprise activity. The instruments of indirect control were, however, applied with sufficient flexibility and supported by macroeconomic policies sufficiently balanced to avoid major disequilibria in the domestic economy, and especially chronic shortages and inflationary pressures in consumer markets. Macroeconomic policies were not sufficiently tight to avoid growing indebtedness vis-à-vis the convertible currency area and the frequent subordination of price and wage liberalization to anti-inflationary objectives.

One reason for inconsistencies in the reform process was that it foresaw the initiation of a fundamental reform of the institutional system only at a late stage. A key issue of institutional reform—the establishment of an effective representation of ownership interests in the state sector—was not resolved. This limited the extent to which management could be held accountable for the results of enterprise operations and the authorities could be freed from microeconomic responsibilities. These conditions tended to undermine financial discipline. They also complicated the enforcement of tight fiscal and monetary policies, which in turn limited the scope for further liberalization of the price and wage systems. The liberalization of private and small-scale cooperative economic activities, including in agriculture, contributed to a strengthening of supply. These operations, however, were frequently motivated mainly by a desire for quick results, given the past ambivalence of the authorities toward private undertakings.

Until recently, the scope and effectiveness of economic reform in Hungary were limited by the prevailing social-political model based on the Party’s dominance of both political and economic activity. The omnipresence of the Party imposed limits on the reform blueprints and hampered their implementation. As a result, political reform was considered necessary for the successful transformation of the economic system. A crucial step in this direction was the conduct of the first free elections for more than forty years in March-April 1990. The coalition Government that assumed office in May 1990 has formulated a comprehensive program of economic reform aimed at moving to a market economy based on private ownership with a social safety net for the needy.

This paper describes the reform efforts undertaken prior to 1968, which were aimed at moving away from the traditional system of central planning through partial decentralization. It outlines the comprehensive blueprint of the NEM introduced in 1968. The paper then describes in detail the reforms undertaken between 1968 and mid-1990 with respect to (i) the system of macro-economic decision making; (ii) the price system; (iii) the foreign trade and the exchange system; (iv) the wage system and labor market policies; (v) the fiscal system; (vi) the banking system and capital market; and (vii) agriculture. Each section concludes with an assessment of the position as of mid-1990 and with a summary of the new Government’s subsequent policies and plans. Some of these reforms have benefited from IMF technical assistance since Hungary joined the IMF in 1982. This assistance has included advice on decentralizing the banking system; on developing monetary and credit policy instruments; on reforming the budgetary, tax, and social security systems; and on improving statistics.

The paper concludes with a review of recent economic developments and of the current economic situation in the context of the 1990 standby arrangement from the IMF. It outlines the Government’s medium-term program, supported by an extended arrangement approved by the IMF’s Executive Board in February 1991, as well as the Government’s four-year Program of Stabilization and Convertibility unveiled in March 1991.

Hungary at a Glance

Population

Hungary is a relatively small country with a population of 10.5 million, which declined in the 1980s, Three fifths of the population lives in towns. The average life expectancy is seventy years.

Political System

From the late 1940s until 1990, political and economic power was monopolized by the Hungarian Socialist Workers’ Party. Following the first free Parliamentary elections for forty years in the spring of 1990, a coalition government led by the Hungarian Democratic Forum assumed office.

Economy

Hungary’s economic system is dominated by the state and cooperative sectors (the socialist sector), which accounted for 94 percent of gross domestic product (GDP) in 1988. The private sector, however, was the most dynamic sector in the 1980s. The economy is highly open: exports and imports together constitute about 80 percent of GDP. Until 1991, a major part of this trade was with partner countries of the Council for Mutual Economic Assistance (CMEA) at administered prices.

Past policies favoring extensive industrialization have transformed Hungary from an agricultural society to one in which industry accounted for about 35 percent of both GDP and employment in 1989. Almost all industry is in the socialist sector. Energy and basic materials accounted for approximately 20 percent of industrial production, with the remainder split between the manufacturing sub-sectors—machinery and engineering products, building materials, chemicals, light industry, and food processing.

Agriculture

Cooperatives own about three fifths of agricultural land, with some one quarter owned by state enterprises and one tenth by small-scale producers. Approximately one half of agricultural production derives from cooperatives, one sixth from state enterprises, and nearly two fifths from small-scale producers. About 18 percent of the labor force is engaged in agriculture and forestry. The major products are pork, wheat, corn, poultry, milk, beef, fruit, and vegetables.

Foreign Debt

Hungary has a relatively high convertible currency debt, equivalent to approximately three quarter of GDP. This largely reflects borrowing to finance domestic consumption associated with delayed adjustments to higher world prices, notably of energy and raw materials.

Selected Social and Demographic indicators1
GDP per capita (current U.S. dollars)2,781
External debt/GDP2 (percent)75
Area
Total land area (sq. km.)93,030
Agricultural land (in percent of total)70
Forest and woodland (in percent of total)18
Population and vital statatistics
Total population (in millions)10.5
Urban population (in percent of total)62
Population growth rate (annual percent)-1.3
Population density (per sq. km.)112
Population age structure (in percent)
0-14 years20
15-59 years61
60 and above19
Infant mortality rate (per thousand)16
Life expectancy at birth (years)70
Males66
Females74
Birth rate (per thousand)11
Death rate (per thousand)13
Labor force
Total active labor force (in millions)4.8
Participation rate (in percent)46
In agriculture and forestry (in percent)18
In industry (in percent)30
Average monthly earnings (U.S. dollars)
Gross179
Net138
Health and nutrition
Proteins (grams per day)106
Population per physician287
Population per hospital bed101
Housing
Population per hundred dwellings271
Owner occupied (in percent)73
Dwellings with internal plumbing (in percent)68
Education
Enrollment rate (in percent)
Primary99
Secondary76
Pupil-teacher ratio
Primary13
Other
TV license holders (in percent)28
Private cars (per thousand)173
Telephone (per thousand)167
Sources: Statistical Pocket Book of Hungary; Monthly Bulletin of Statistics; and IMF staff calculations.

Estimates refer to the latest available year; generally 1989.

Convertible currency, gross debt.

Sources: Statistical Pocket Book of Hungary; Monthly Bulletin of Statistics; and IMF staff calculations.

Estimates refer to the latest available year; generally 1989.

Convertible currency, gross debt.

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