During the 1970s, macroeconomic policies in Hungary were sufficiently balanced to prevent chronic shortages and inflationary pressures in consumer markets. Partly because of a delayed response to sharp increases in world prices for oil and other imported raw materials, however, Hungary’s convertible currency trade deficit widened steadily in the 1970s, resulting in the buildup of substantial external debt. From the late 1970s to the mid- to late 1980s, the stance of economic policies was reversed frequently, shifting between expansion and restraint, in an attempt to narrow the external imbalance (Table 2).

During the 1970s, macroeconomic policies in Hungary were sufficiently balanced to prevent chronic shortages and inflationary pressures in consumer markets. Partly because of a delayed response to sharp increases in world prices for oil and other imported raw materials, however, Hungary’s convertible currency trade deficit widened steadily in the 1970s, resulting in the buildup of substantial external debt. From the late 1970s to the mid- to late 1980s, the stance of economic policies was reversed frequently, shifting between expansion and restraint, in an attempt to narrow the external imbalance (Table 2).

Table 2.

Selected Economic and Financial Indicators

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Sources: Hungarian authorities; and IMF staff estimates and projections.

With personal consumption on a “territorial” basis through 1988, and a “national” basis thereafter. Personal consumption on a territorial (national) basis excludes (includes) consumption by Hungarians abroad and includes (excludes) consumption by foreigners in Hungary. Prior to 1989, the difference between consumption measured on, respectively, a territorial and a national basis, was relatively small.

Percent change from the beginning to the end of the year.

Based on the IMF’s Government Finance Statistics.

Including stockbuilding.

Including the use of IMF resources.

Debt service, including IMF repurchases, in percent of earnings from merchandise exports.

Against this background, the Government adopted in mid-1987 a medium-term program of economic stabilization and structural reform to address the weak supply performance of the economy, which persisted despite relatively high investment. Pending the benefits of comprehensive structural reform, a substantial share of the initial adjustment was borne by demand restraint—mainly through a reduction in the budget deficit and curtailment of excess liquidity. This resulted in sluggish GDP growth of 1/2 of 1 percent in 1988 and in a 2 percent fall in domestic demand—the largest decline recorded in the 1980s (Table 3). Consumer price inflation rose to 15 percent, mainly because of the introduction of a VAT tax on January 1, 1988. The convertible current account deficit—which reached 6.3 percent of GDP in 1986—narrowed gradually to 2.9 percent in 1988, despite a substantial increase in travel expenditures as Hungarian residents took advantage of relaxed travel and foreign exchange regulations. The external adjustment slowed the previously rapid growth of external convertible debt.

Table 3.

Sources and Uses of GDP

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Sources: CSO, Statistical Yearbook; IMF, International Financial Statistics; Hungarian authorities; and IMF staff estimates.

Annual average percent change at 1976 prices through 1975, at 1981 prices from 1976 through 1985, and at 1986 prices thereafter.

Data at constant prices for 1986 on exclude terms of trade losses on CMEA investment.

Trade, water economy, and other material sectors.

Including unallocated reserve of 0.8 percent of GDP.

Including social benefits in kind and net receipts from tourism.

Percentage contribution to GDP growth.

The foreign balance as a component of GDP does not account for factor payments (including interest) and net travel earnings, which are included in personal consumption.

The adjustment program faltered in 1989. Real output declined for the first time since 1985, and consumer price inflation increased to 19 percent. The rise in inflation reflected, in part, accommodating financial policies. Wages also increased faster than planned, particularly in the early part of the year; the rapid pace of wage increase was the result of large wage awards granted by enterprises enjoying greater freedom over wage determination and high liquidity, owing to a much weaker than planned fiscal policy and a large ruble trade surplus.

The loose financial policies led to a widening of the convertible current account deficit to $1.4 billion in 1989 (5 percent of GDP), compared with $0.8 billion in the previous year. A small improvement in the trade balance, reflecting improved terms of trade, was more than offset by a large deterioration in the services account. The latter was due primarily to large travel outflows, encouraged by an unduly favorable regime for personal imports and by an overvalued currency. It also reflected larger debt service payments and—increasingly during the course of the year—capital flight.

In response to the resulting convertible currency drain, the Hungarian authorities adopted policies in late 1989 to achieve domestic and external adjustment and to preserve Hungary’s external solvency. A stand-by arrangement with the IMF was concluded in March 1990 for approximately $200 million, equivalent to 30 percent of Hungary’s quota in the IMF. This arrangement sought to reduce the convertible current account deficit to $550 million in 1990, and to reduce the current account surplus in nonconvertible currencies to $35 million in 1990 from $800 million in 1989. It also sought to contain domestic inflation to about 20 percent and to sustain economic reform. In pursuit of these goals, the Hungarian authorities:

  • tightened fiscal policy—including lending by the State Development Institution—by roughly 2 percentage points of GDP relative to 1989;

  • limited the expansion of domestic credit to well below the rate of inflation;

  • increased domestic interest rates;

  • depreciated the forint against convertible currencies by 15 percent and tightened household access to foreign currency; and

  • lowered ruble export quotas while taking administrative measures to ensure adherence to these quotas.

The authorities, as discussed earlier, also adopted various structural reforms. These included further price and import liberalization, decentralization of the banking system, and measures to accelerate enterprise restructuring.

The Government that assumed office in May 1990 emphasized its commitment to policies supported by the stand-by arrangement. To this end, the Government adopted in July a fiscal package including reduced subsidies on agricultural exports; higher excise taxes for electricity, gasoline, cigarettes, and liquor; reduced tax allowances; increased dividend payments accruing to the State; and reduced spending in certain areas to meet the fiscal objectives of the program. It also took further measures to raise interest rates (Chart 5). Taking advantage of the better-than-planned performance in the convertible balance of payments in the early part of the year, the Government, in July, announced a lower target deficit of $400 million for 1990.

Implementation of these policies has achieved some important successes. The convertible current account recorded a surplus in 1990 for the first time since 1984. This better-than-planned performance occurred despite disruptions to Soviet oil supplies—which required the substitution of high-priced imports from the West—and the worst drought this century. It resulted from a strong export performance reflecting tight financial policies, which compressed domestic demand. The curbs on ruble exports—which achieved broad balance in ruble trade—ensured that convertible currency export markets were the only source of potential expansion. Exports of small, private firms grew substantially. Travel and transfer receipts were also much stronger than forecast, as Hungary enjoyed a boom in tourism. The convertible current account surplus permitted Hungary to preserve its external solvency, albeit with a low level of reserves. This was possible despite a much weaker capital account than forecast. A shortfall in medium-term borrowing and outflows of short-term capital resulted from spreading concerns about Hungary’s credit-worthiness. These concerns followed the announcement of a moratorium on principal payments by Bulgaria at the end of March 1990 and payments difficulties in the U.S.S.R., as well as uncertainty surrounding the elections and the new Government’s policy toward servicing the debt. The net outflows were partly offset by a doubling of receipts from inward direct foreign investment to $0.4 billion.

Domestically, results were mixed. Output is estimated to have declined by up to 6 percent. This figure may, however, be an overestimate as it is based mainly on returns from large socialized enterprises. It may not, therefore, adequately reflect the rapid growth of smaller state enterprises and the private sector. Key elements in the output decline were the drought and the large fall in the volume of ruble exports (about 30 percent). Personal consumption declined by more than 10 percent in real terms, and private saving rose to record levels. Despite depressed domestic demand, inflation rose to nearly 30 percent. The higher-than-forecast inflation resulted partly from the effects of the mid-year corrective fiscal package, from the drought, and from higher oil prices. Tight financial policies also had less impact in bringing down inflation than initially hoped.

The Government’s Medium-Term Program

In the fall of 1990, the Government adopted a comprehensive medium-term program designed to put in place the most important elements, including the institutional framework, of a contemporary market economy within three years. The Government aims to construct a modern European social market economy, integrated into the world economy and emphasizing private property. On the basis of this reform program, the IMF approved in February 1991 an extended arrangement for $1.6 billion over three years. In addition, IMF financial support (of up to $0.5 billion) was provided to cover the increased cost of oil imports. In March 1991, the Government launched a four-year Action Program for Stabilization and Convertibility.

The Government is committed to reducing the State’s role in the economy through privatization and other measures, strengthening the operation of the free market, and through the development of an adequate social safety net. Its strategic aim is to create a social market economy. The reform measures undertaken and proposed—which provided the basis of the current agreement with the IMF on an extended facility—are described in detail in earlier sections. Briefly, the Government’s goal is to achieve a decline in state-owned property to less than half total assets in the competitive sphere of the economy by 1993. Foreign investment is to be encouraged. A radical transformation of public finances—including lower subsidies—is key to reducing the State’s role in the economy. Competition will be strengthened by the major liberalization of both prices and imports, which occurred at the beginning of 1991, as well as by the establishment of a Cartel Office. Loss-making enterprises will continue to be restructured or closed, with the process accelerated by a new bankruptcy law. The banking system will be subject to prudential supervision conforming to international standards, and monetary policy will rely increasingly on market-based instruments. A major reform of social assistance is under way; the reform seeks to improve the targeting of social benefits to those in greatest need and to strengthen job retraining and unemployment compensation programs. Environmental deterioration will be checked through the promotion of greater energy efficiency, which, in turn, will entail appropriate pricing and taxation and the control of pollution through fees, fines, and other measures. The Government attaches priority to improving the education system—with emphasis on higher education and better language training—and fostering research and development as key for improving the long-term competitiveness of the economy.

A crucial element of the program is tight financial and budgetary policies aimed at regulating domestic demand. The switch, from 1991 on, to trading with CMEA partners at world prices presents Hungary with a major uncertainty. A large terms of trade loss results as export prices of manufactures decline relative to import prices of raw materials—notably oil and energy products. While Hungary and the U.S.S.R. have agreed that Hungary’s accumulated surpluses with the U.S.S.R. of about $1 billion will be converted to U.S. dollars at the exchange rate of $0.92 per transferable ruble, no agreement has been reached on when these surpluses can be used. Preliminary first-quarter results in 1991 show a sharp contraction in trade with the Soviet Union. Various other shocks are affecting the Hungarian economy in 1991—notably higher world oil prices (at least temporarily) and the continuing effects of the drought. These shocks together imply a significant worsening of the convertible current account and of the fiscal deficit. Together with industrial restructuring, they imply a further fall in output and a rise in unemployment over the medium term.

The immediate goal of policies in 1991 is to ensure that both the external and fiscal accounts adjust to one half of the shocks outlined above, while curtailing inflation. Thus, financial policies for 1991 have been designed to limit the budget deficit to 11/2 percent of GDP, allowing the flow of more financial resources to the productive sector of the economy. The growth in money supply will be tailored to limiting the rate of inflation (after corrective price adjustments) to about 30 percent, while ensuring that credit is available to the enterprise sector, particularly private enterprises. Progress in reducing inflation is expected to be slow as subsidies continue to be reduced, other economic reforms are introduced, and increases in energy costs are passed through to consumers. The forint was depreciated by 15 percent in January 1991 to preserve external competitiveness.

The Government’s medium-term objective is to reduce inflation to single digits by 1993. It also aims to maintain Hungary’s traditional access to capital markets by halting the growth of external indebtedness within three years. The Government’s approach to debt management remains guided by the principle that, given a realistic amount of external support, Hungary will fully and promptly comply with its international payment obligations. Over the medium term, the Government hopes to achieve an annual economic growth rate of at least 5 percent. The Government believes that the development of an internationally efficient economy, in the context of financial and budgetary policies effectively regulating domestic demand, represents the best prospect for attaining such a level of sustainable growth.

The Hungarian Government elected in spring 1990 inherited an onerous legacy of excessive state intervention, environmental degradation, and large external debt. It also inherited a well-educated labor force and considerable progress in certain areas of reform. The Government is seeking to tackle this legacy and build on these advantages through its medium-term reform program. The reward is clear: Hungary’s growth potential—from a relatively low base—is large.

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