Hungary: Staff Report for the 2002 Article IV Consultation

This 2002 Article IV Consultation highlights that although economic growth of Hungary slowed in 2001, the economy showed considerable resilience to the weaker external environment. GDP growth was a still respectable 3.8 percent, down from 5.2 percent in 2000 but higher than most other countries in the region. Although export growth decelerated as the year progressed, it nevertheless outpaced growth in Hungary’s export markets. Domestic demand was partly supported by buoyant private consumption on the back of strong real wage gains. Meanwhile, the unemployment rate edged down to 5.6 percent by the start of 2002.

Abstract

This 2002 Article IV Consultation highlights that although economic growth of Hungary slowed in 2001, the economy showed considerable resilience to the weaker external environment. GDP growth was a still respectable 3.8 percent, down from 5.2 percent in 2000 but higher than most other countries in the region. Although export growth decelerated as the year progressed, it nevertheless outpaced growth in Hungary’s export markets. Domestic demand was partly supported by buoyant private consumption on the back of strong real wage gains. Meanwhile, the unemployment rate edged down to 5.6 percent by the start of 2002.

The 2002 Article IV consultation discussions were held in Budapest during February 21–March 7, 2002. The mission met with: President Járai of the National Bank of Hungary (NBH); Finance Minister Varga; senior officials in the NBH, government ministries, and Parliament; trade unions; and representatives of financial and research institutions.

The staff team was headed by Mr. Feldman and included Ms. Wagners, and Messrs. Berger and Drummond (all EU1). A team headed by Mr. Quintyn (MAE) also visited Budapest during February 25—March 8 to update the 2001 Financial System Stability Assessment. The Regional Resident Representative, Mr. Nord, assisted both teams. Mr. Kiekcns, Executive Director for Hungary, attended the concluding policy meeting.

Hungary participated this year in the preparation of updates of the Report on Standards and Codes (ROSC) modules on the financial and fiscal sectors, and on data dissemination. Hungary meets the Special Data Dissemination Standard (SDDS) specifications.

In concluding the last Article IV consultation on May 4, 2001, Directors commended Hungary on its impressive economic performance. This included remarkable export growth, strong external competitiveness, and a narrowing external current account deficit. They urged Hungary to maintain its track record of careful macroeconomic management, while pressing ahead with remaining structural reforms. They also welcomed the decision to widen the exchange rate band, and the room it would provide monetary policy to fight inflation. But Directors emphasized that monetary policy alone could not achieve both inflation and external objectives: support from appropriate fiscal adjustment would be needed.

Parliamentary elections were completed on April 21, 2002 and a center-left coalition led by the socialist party won by a narrow margin.

Hungary is among the most advanced EU accession countries. So far, 24 chapters of the acquis communautaire have been provisionally closed. In its last Regular Report, the European Commission concluded that Hungary is a functioning market economy and, provided that it fully maintains and implements its reform program in a consistent manner, should be able to cope with competitive pressure and market forces within the EU in the near term.

I. Background

1. Hungary achieved remarkable economic success in the four years to 2000. The country maintained strong output growth, increased employment, raised the investment-to-GDP ratio, reduced inflation significantly, steadily narrowed the fiscal deficit, and lowered the current account deficit to a sustainable level (Table 1 and Figure 1). All this reflected careful macroeconomic management and significant structural reforms, including the lasting effects of the bold reform measures of the early and mid-1990s.

Table 1

Hungary: Main Economic Indicators

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Sources: Data provided by the authorities; IFS; and staff estimates.

These projections are based on the government’s budget, and planned off-budget spending.

Consists of the central budget, social security funds, extra-budgetary funds, and local governments.

This excludes net interest payments and central bank transfers from the government balance.

SNA refers to System of National Accounts.

Measured by the change in the structural primary balance.

In convertible currencies, including inter-company loans, and non-resident holdings of forint denominated assets.

Figure 1
Figure 1

Hungary: Selected Economic Indicators, 1995-2001

Citation: IMF Staff Country Reports 2002, 111; 10.5089/9781451817942.002.A001

2. Although economic growth slowed in 2001, the economy showed considerable resilience to the slowdown in the EU. GDP growth was a still respectable 3.8 percent, down from 5.2 percent in 2000 but higher than in most other countries in the region.1 While this reflected a deceleration in the growth of exports, they nevertheless outpaced growth in Hungary’s export markets (Figure 2). Demand was partly supported by buoyant private consumption on the back of strong real wage gains. Meanwhile, the unemployment rate edged down to 5.6 percent by the start of 2002 and labor market conditions remained tight in some regions—though the number of employed dropped by 1 percent.

Figure 2
Figure 2

Hungary: Export Performance, 1995-20011/

Citation: IMF Staff Country Reports 2002, 111; 10.5089/9781451817942.002.A001

Sources: Direction of trade statistics, IMF.1 January through November data for 2001.

3. With economic growth slowing and the political cycle in full swing, fiscal policy turned expansionary in 2001, also contributing to domestic demand. The sizable fiscal stimulus, estimated at about 2 percent of GDP (see text table below), contributed to public investment and growth at a time when private investment was being scaled back. But the higher level of public spending—notably on wages and pensions—has increased the challenge of attaining needed medium-term fiscal adjustment. The deficit of the general government, on an SNA basis, almost reached an estimated 5 percent of GDP.

Consolidated General Government Balance (Official and SNA Basis)1/

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Sources: Ministry of Finance and preliminary staff estimates.

As in the past, staff has made adjustments to include the fiscal activities of the privatization agency, the Hungarian Development Bank, and the motorway company, to measure more fully than the official statistics the impact of the operations of the general government.

Measured by the change in the structural primary balance on an SNA basis, assuming potential GDP growth of 4.5 percent.

Table 2a

Hungary: Consolidated General Government, 1999-2002 1/

(Official account basis)

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Sources: Ministry of Finance, and staff estimates.

Official consolidated data for central budget, social security funds, extra-budgetary funds, and local governments. While no detailed breakdown of net financing for the general government is available, the Government’s Debt Management Agency is not planning any new net issuance of foreign exchange debt in 2002.

Contributions to the Pension Insurance Fund, the National Health Fund, and the Labor Market Fund.

Includes privatization revenues of the social security funds and proceeds from the sale of concessions.

Central budget investment projects and local government capital expenditures.

Table 2b

Hungary: Adjusting the General Government Balance to an SNA Basis1/

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Sources: Ministry of Finance and preliminary staff estimates.

This table is based on available data through end-March 2002. While it aims to adjust the official fiscal accounts to make them consistent with the SNA system of accounts, there is insufficient data to ensure full consistency. The table draws on preliminary estimates of the Ministry of Finance for privatization items, net lending, accrual basis corrections, and off-budget items.

Proceeds from the sale of shares and other financial assets by the Social Security Funds and other units of government.

Net lending for non-policy purposes, principally related to Russian debt and other debt repayments in revenues. Includes dividends paid by the NBH.

Includes estimates of fiscal spending by the privatization agency, the Development Bank, debt assumption of public corporations, and road construction. The estimate for contruction expenditure by the National Motorway Company exceeds central budget appropriations of Ft 35.2 and Ft 36 billion for 2001 and 2002 respectively. Includes Ft 10 billion for spending on road maintenance not covered byroad tolls and fees.

Proceeds from the sale of concessions, including 1800 MHz spectrum and mobile phone licenses (UMTS).

Measured by the change in the structural primary balance on an SNA basis; assuming potential GDP growth of 4.5 percent.

4. The authorities successfully introduced a new monetary policy framework—widening the exchange rate band in May 2001 to ±15 percent against the euro and adopting inflation targeting in June 2001. Notwithstanding a string of interest rate cuts since the band widening, this led to a tightening of monetary conditions (Figure 3). With inflation expectations coming down—as indicated, for example, by the Reuters’ poll of financial analysts and the decline in long-term interest rates—real short-term interest rates have increased. The exchange rate is the more powerful channel of monetary policy transmission, and the forint has strengthened against the euro by some 10 percentage points since the band widening, to stand about 12 percent above its central rate.

Figure 3
Figure 3

Hungary: Components of Monetary Conditions, 1996-2002

Citation: IMF Staff Country Reports 2002, 111; 10.5089/9781451817942.002.A001

Sources: National Bank of Hungary and Bloombreg.1/ A minus(-)sign mcans apprecition.2/ Nominal rates 12-month T-bill rate adjusted for the ex-post 12-month CPI growth rate.3/ Nomonal rates deflatrd by one year ahcad CPI.

5. Inflation has come down. After peaking at 10.8 percent in May 2001, year-on-year consumer price inflation declined steadily to 6.8 in December 2001 (somewhat under the NBH1s projection), falling further to 5.9 percent in March 2002 (Figure 4). This reflected moderating growth in tradable goods inflation owing largely to the appreciation of the forint; a drop in services sector inflation to single digits, attributed to greater competition; and a decline in food and fuel prices. Core inflation, which excludes certain fuel and food prices, and administrative prices, declined by 4.2 percentage points over the same period.

Figure 4
Figure 4

Hungary: Consumer Prices and Wage Development, 1996-2002

(In percent)

Citation: IMF Staff Country Reports 2002, 111; 10.5089/9781451817942.002.A001

Source: Hungarian authirites.

6. Wage growth, though somewhat difficult to interpret, has accelerated. Year-average economy-wide nominal wage growth reached 18 percent (16 percent in the private sector) in 2001, compared with headline inflation of 9.2 percent. In contrast to the preceding few years, real wage growth outpaced productivity gains, reflecting in part faster-than-anticipated disinflation. As shown in Figure 4, in contrast to a rapid acceleration in public sector wages, wage growth in the private sector has recently been much more moderate. Moreover, while a 57 percent increase in the minimum wage, introduced in January 2001, was a contributing factor to wage increases, some minimum wage workers actually receive higher but unrecorded pay. This implies that the minimum wage hike had the effect of raising measured wages more rapidly than actual wages.2 In January 2002, the minimum wage was increased again by 25 percent: it now stands at almost 45 percent of average wages, compared with about 35 percent in Poland and the Czech Republic.

7. The external current account deficit narrowed in 2001, and external financing was unaffected by emerging market tensions over the past year. The deficit was 2.1 percent of GDP, down from 2.9 percent of GDP in 2000 (Table 3).3 In terms of the underlying current account flows: import growth moderated owing to the sharp drop in private investment growth and lower oil prices; exports, though slowing during the year, were buoyant on a year-average basis; tourism receipts were strong; and profit repatriation at year-end was unexpectedly much less than in previous years. Access to international financial markets has remained on favorable terms, even amid emerging market turmoil,4 and there has reportedly been little indication of speculative inflows, even in the aftermath of full capital account liberalization in mid-2001. At this time, vulnerability is judged to be low, as indicated, for example, by a comfortable level of international reserves (measured in terms of import cover, short-term debt, or broad money) (Table 4).

Table 3

Hungary: Balance of Payments, 1999-2004

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Sources: National Bank of Hungary, IFS, and staff estimates.

These projections are based on the government’s budget, and planned off-budget spending.

Foreign liabilities net of foreign assets, excluding equity but including intercompany loans.

Table 4

Hungary: Frequently Used Indicators of Stability and Vulnerability in the Financial and External Sectors

(In percent of GDP, unless otherwise indicated)

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Sources: National Bank of Hungary, Ministry of Finance, Bloomberg and staff estimates.

End-of-period.

Backward-looking using actual CPL

Customs based data, in current U.S. dollar prices.

Net foreign assets plus foreign exchange (FX) credit to government and banks less deposit money banks’ FX deposits at NBH. Does not include FX position arising from off-balance sheet operations.

Includes short-term loans (by remaining maturity), and nonresident holdings of domestic bonds. Reserves are net of resident foreign exchange deposits with the NBH.

Including intercompany loans.

Excluding intercompany loans.

NBH bond maturing April 2003 (US$-denominated) and a U.S. government bond with, similar maturity.

NBH bond maturing September 2003 (DM-denominated) and a German government bond with similar Maturity.

II Report on the discussions

8. In addition to the short-term outlook, the discussions centered on the medium-term macroeconomic framework and related implications for policy. With policy anchored on the overarching objective of early accession to the EU and adoption of the euro, consolidating the public finances and achieving EMU-compatible inflation were issues of particular focus. So was advancing the real convergence process through completing the structural reform agenda, maintaining growth-enhancing fiscal expenditure in the context of an appropriately restrained overall fiscal stance, and generally ensuring macroeconomic stability, including to encourage an environment conducive to investment.

9. Policies and related details will need to be fleshed out by the new government. The political cycle has meant that the fiscal effort and progress on various structural reforms had to await the completion of parliamentary elections in April. The authorities stressed that the next two years are critical ones, with the first 12 months after the elections offering the best window of opportunity to initiate work and lay the economic and political groundwork on needed reforms.

A. Economic Outlook and Objectives

10. The authorities expect economic growth to accelerate. Underpinned by an improving external environment in the second half of this year, the authorities’ baseline calls for export growth and private investment to pick up—resulting in a shift in the composition of growth away from other components of domestic demand. While, on a year-average basis, the pace of economic activity slows down modestly to about 3½ percent (notwithstanding the pick up as the year progresses), the economy is expected to gather pace in later years, with real GDP rising by about 4 percent in 2003, led by increasing export growth. The mission’s projections were broadly in line with the authorities. Downside risks were recognized, reflecting uncertainties concerning wage growth, the lagged effects of an appreciating real effective exchange rate (Figure 5), and the timing of the upturn in western Europe. But the upside was also recognized, reflecting, for example, supply-side considerations related to generally strong competitiveness and shifts from other production sites to lower-cost Hungary.5

Figure 5
Figure 5

Hungary: Exchange Rates, 1990-2001

Citation: IMF Staff Country Reports 2002, 111; 10.5089/9781451817942.002.A001

Source: Hungarian authorities.

11. Key medium-term macroeconomic targets have been set with a firm eye on early EU accession and adoption of the euro. For Hungary, a small economy that is already highly integrated with the EU, adopting the common European currency has clear medium-term benefits. This is particularly true given the important role in Hungary of FDI and foreign-owned enterprises, and their orientation mainly toward EU markets. The commitment to early EU accession and adoption of the euro not only hardens the authorities’ resolve to deliver the necessary fiscal discipline and structural reforms, but it can also serve to strengthen the credibility of the disinflation path and, by doing so, can also help to minimize short-run costs that might arise. The authorities have announced end-year targets (with tolerance bands of ± 1 percent) for headline inflation of 4.5 percent and 3.5 percent for 2002 and 2003, respectively; and the goal of narrowing the deficit of the general government (on an ESA-95 basis, consistent with the Maastricht fiscal criterion) to 2–3 percent of GDP by 2004.

B. Monetary and Exchange Rate Policy

12. All agreed that maintaining the momentum of disinflation should be the primary objective of monetary policy. The inflation targeting framework has served Hungary well in this regard.6 With the benefit of a stronger exchange rate since the widening of the band, the NBH has been successful in lowering its policy rates while maintaining broadly appropriate monetary conditions—and the fall in inflation expectations is evidence of the increasing credibility of the NBH’s disinflation strategy. At the same time, in the context of their goal of early adoption of the euro, the authorities recognized that the objective of lowering inflation to EMU-compatible levels, while real convergence advances, presents challenges for the policy framework. In this connection, in light of the expected real appreciation of the exchange rate associated with real convergence—through, for example, the Balassa-Samuelson effect—the nominal exchange rate may have to appreciate if disinflation is to continue on the envisaged path.

13. The inflation targets for both this year and next are within reach—but not without risks that inflation could be higher than targeted. The NBH projects the continuation of rapid disinflation through the first half of 2002. Owing in part to an expected rise in the oil price, this is followed by a period of stable inflation until 2003 when disinflation is projected to resume. In the NBH’s view, downside risks of lower inflation counterbalance the upside, particularly in 2002. Regarding possible downside risks, the NBH has lowered the assumed exchange rate pass-through for its central forecast, but views a higher pass-through as a possibility. This could lead to lower-than-expected inflation. Upside risks to the central projection stem from uncertainty over regulated prices (especially in 2003) and wage behavior. While considerable uncertainty surrounds the impact of this year’s minimum wage hike, the authorities clearly expected it to be more binding than last year’s. They, nevertheless, were also hopeful that labor market flexibility would mitigate its impact and other wage pressures on inflation.7 Discussions with labor unions highlighted two concerns: they argued that containing wage increases following the rise in the minimum wage would prevent wage differentiation; moreover, they were skeptical about the NBH’s inflation targets in light of the inflation overshooting in the past.

14. Staff saw greater upside risks than the authorities. In particular, staff expressed concern that private sector wages could increase by more than the NBH projected in formulating its inflation outlook.8 This was on account of the signaling effect of large wage increases for the public sector in 2001 and 2002, and the potential unwinding of wage compression caused by the increase in the minimum wage. In the staff s view, this could make it all the more difficult to meet the inflation targets, and could also weaken external competitiveness down the road.

15. The authorities and staff agreed that labor market participants’ expectations of future inflation will be heavily influenced by whether this year’s target will be met. By meeting it, monetary policy can reduce their expectations of inflation, thereby restraining future wage growth and lending strong support to meeting future inflation targets. Staff was of the view that the risk of higher inflation argued for a cautious approach in deciding on further interest rate cuts in the period ahead. In particular, with fiscal stimulus still in the works (see below) and disinflation widely expected to pause, or possibly reverse, in the second half of this year, there was considerable merit in at least maintaining the current degree of monetary tightness. The NBH saw the potential conflict between the current exchange rate band and meeting its inflation targets, but emphasized that it would stand ready to raise interest rates, if need be, to safeguard its inflation targets. More generally, the NBH has developed a broad-based communication strategy (including by providing a comprehensive and transparent assessment of inflation in its Quarterly Report on Inflation and direct outreach efforts with the social partners) to encourage more forward-oriented assessments of inflation in wage setting behavior.

16. Monetary policy cannot do it alone—the policy mix will be key. The authorities concurred with the staff’s stress on the importance of support from fiscal consolidation, as this would help to keep monetary tightening as moderate as possible and avoid too strong an appreciation of the forint, which, inter alia, could have unwanted consequences on export performance. And a strong and visible commitment by fiscal policy to support monetary policy would add to the credibility of the disinflation path, help anchor inflation expectations, and thereby moderate wage growth. Such gains in credibility would help to minimize any real cost associated with significant disinflation.

C. Fiscal Policy

17. The authorities saw several advantages of significant medium-term fiscal consolidation. Although the authorities cannot establish precise medium-term targets for the fiscal deficit until a new government is in place, a deficit of the general government—on an SNA basis—in the range of 2 to 2½ percent of GDP by 2004 would be in line with the target outlined in the Pre-Accession Economic Program (prepared in the spring of 2001). As indicated by the authorities in broad terms and demonstrated by the staffs medium-term scenario (Table 5), a deficit of this size would contribute to meeting a number of goals: supporting the disinflation effort; raising national saving to support investment; safeguarding public debt and external sustainability;9 avoiding crowding out private sector investment; and leaving room for maneuver in conducting stabilization policies, while providing a safety margin for meeting the Maastricht fiscal criterion.

Table 5

Hungary: Staff Illustrative Medium-term Scenario 1/

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Source: IMF staff estimates

Incorporates staff’s policy recommendations.

Revenues are exclusive of EU transfers as expected preaceession transfers are netted against spending for accession purposes.

18. Achieving the medium-term fiscal objective will not be easy. Without adjustment, the fiscal stimulus this year could be about 1 percent of GDP and the deficit of the general government, on an SNA basis, could reach 5¾ percent of GDP. This would imply a narrowing of the deficit by about 3 percentage points of GDP to achieve the desired fiscal deficit by 2004. The authorities noted that roughly a percentage point of this adjustment is expected to come from lower interest payments. They also noted in other discussions that another ½ percent of GDP or so might come from net transfers from the EU (after membership in early 2004). But there would obviously be a need for greater expenditure restraint by the new government.

19. Redirecting fiscal policy at the earliest opportunity would facilitate the task at hand. Staff strongly recommended aiming for a broadly neutral fiscal stance in 2002 (implying a general government deficit of 4¾ percent of GDP on an SNA basis). This would avoid adding stimulus at a time when the economy is likely to gather steam, and would give an early start to achieving the medium-term targets. However, with only part of the year remaining to bring the 2002 fiscal deficit down to the level recommended by staff, the change in government near midyear, and local elections in October, fiscal adjustment could well get delayed into 2003. But, even in these circumstances, it would be crucial to initiate the needed work on reforms once a new government is formed, in anticipation of taking decisive actions next year.

20. In a related vein, adopting medium-term expenditure limits would help secure the desired fiscal deficit targets. A workshop on the medium-term fiscal framework pointed to the importance of calibrating discretionary, lower-priority, spending to safeguard the fiscal target, after taking into account expenditures that are precommitted and defining and protecting goals for other categories of priority spending (e.g., infrastructure and EU-accession related outlays). In all of this, it would be important to identify the impact of possible reforms—for instance, in the health care and pension systems, the civil service, and better targeting of other social benefits. In some key areas, such as health care, education, and other local services, reforms will require cooperation between central and local levels of governments to ensure local services are pooled to meet needs efficiently. The Ministry of Finance has started preparing a review of public expenditure—with a view to presenting options for containing spending to the new government. Making medium-term spending targets public—which would include providing them to Parliament during the budget cycle—would help establish the political commitment to, and credibility of, the specified expenditure ceilings, as well as the medium-term fiscal adjustment path.

D. Structural Reforms

21. Critical structural reform priorities—needed to support the medium-term fiscal consolidation effort and Hungary’s long-term growth potential—remain outstanding. The discussions raised a number of issues in four key areas, which would have implications for labor supply, investment, total factor productivity, and macroeconomic stability. But the specifics of reform plans and initiatives would have to await a new government.

22. On pensions, recent changes have reversed some of the features of the earlier pension reform and the impact is yet uncertain. The comprehensive reforms of 1997 substantially improved the viability of the pension system. These reforms included both far-reaching changes in the traditional PAYG scheme and the introduction of a second pillar (mandatory for new labor market entrants, but voluntary for others) based on private pension funds. Partly reflecting the surprisingly high number of workers choosing to switch to the multi-pillar system, the authorities adopted changes in November 2001. These included: (i) making the decision to join either the traditional PAYG plan and the two-pillar pension scheme voluntary; and (ii) abolition of the minimum benefit state-guarantee for privately funded pensions. In addition, the authorities maintained the decision made during the preparation of the 2001–2002 two-year budget not to increase financing of the second pillar from 6 percentage points of participants’ pension contributions to 8 percentage points, thus reducing the importance of the privately funded pillar relative to the reforms envisaged earlier. Some of the implications of these actions are discussed in the box below.

Altering the 2nd Pillar of the Pension System: What are the Implications?

The decision to allow voluntary participation in the two-pillar scheme, even for new labor market entrants, could lead to an increase in the unfunded liabilities of the overall pension system to the extent that workers choose to participate in the traditional PAYG plan. The fiscal deficit, all else equal, would be smaller in the near-term, but only as long as the temptation to spend the extra revenues from contributions are resisted (and at some cost to the intertemporal balance overall).

The abolition of the minimum benefit state-guarantee for privately funded pensions reduced the contingent liabilities stemming from the pension system. To the extent that the recent withdrawal of the guarantee does not lead to a significant backflow into the traditional PAYG plan—which so far it has not—the intertemporal balance of the pension system would be improved.

The decision not to proceed with the planned increase in the contribution rate to the private second pillar could have some disadvantages from a long-term perspective. While, in principle, both the private and the PAYG pillar of the pension system could be used to raise the actuarial fairness and, thus, the incentives to participate officially in the labor market, strengthening the private pillar might be a more effective way to achieve this goal from the standpoint of administrative costs. In this regard, meeting the informational requirements for converting the existing PAYG pillar, as in many European countries, into one with a transparent notional defined contributions system—a plan currently under review—may need to involve a substantial effort in terms of resources and staff.

23. In all, against the background of adverse demographic prospects, policy makers will be increasingly confronted with the need to address issues related to the unfunded future liabilities of the public pension system. This will require timely, consistent and transparent decisions on a range of policies that affect the viability of the pension system, with a view to increasing the effective supply of labor and keeping benefits within prudent limits.10

24. Tackling health care reform ranks very high on the agenda. Health care costs are likely to rise significantly over the longer term due to population ageing. However, while the Health Insurance Fund has experienced large spending overruns, comprehensive health care reform has been delayed. Plans now on the table, in addition to a number of ad hoc measures to control spending, include programs that aim to allow doctors to practice on a contractual basis outside the traditional health care system, and to set the stage for further private provision of health care services, especially in hospitals. If implemented consistently by the new government, these measures—along with others in the context of a comprehensive reform, possibly including expanding the range of co-payments and limiting the range of health services covered by the public system—could help to increase the efficiency of the public health care sector and lower its reliance on general government revenues.

25. Regulatory reform of the energy sector, aimed at reducing state ownership and ending subsidization of prices at the household level, is progressing slowly. The new Electricity Act approved this year allows for a gradual opening of the electricity market to private suppliers beginning in 2003—though with full liberalization by 2010. At the same time, privatization of MVM, the large wholesaler and network operator, has been postponed, and government still plays a decisive role in price-setting, sometimes overriding pre-agreed formulas if the resulting price increase is deemed too large. Similarly, liberalization of the natural gas market will only be gradual, state-ownership in the dominant supplier MOL is still substantial (and expected to grow with the prospective renationalization of the gas unit), and natural gas price regulation keeps household prices artificially low. The government has, at times, covered a significant part of the losses arising at the supplier level through ad hoc payments.

26. The authorities noted that there is overstaffing in the public sector. While acceding to the EU implies higher staff levels in some areas, they indicated that employment in health, education, and general administration needs to be better rationalized. A rationalization program, even when combined with higher wages to retain highly qualified staff, could contribute to scaling back the size of government and the public wage bill, in line with the authorities’ objectives, help to increase labor force participation rates in the private sector of the economy, and contribute to the targeted fiscal adjustment. An assessment of public sector employment that could aid future rationalization efforts is underway.

E. Financial System Stability

27. Against the backdrop of the international economic slowdown and slower growth domestically, the financial system demonstrated its resilience. The update of the 2001 Financial System Stability Assessment revealed no serious threats to the stability of Hungary’s financial system, a view shared by the NBH as indicated in its latest Financial Stability Report11 Banks remain adequately capitalized and liquid, and asset quality remains high. Bank profitability increased significantly in 2001, supported in particular by the fast growth in lending to small- and medium-size enterprises and the household sector, which more than offset the effects of narrowing interest rate margins. Mortgage lending continued to accelerate in 2001, driven by a generous home building subsidy plan; the authorities agreed with the staffs stress on careful monitoring of this rapid pace of growth to ensure that it not lead over time to a deterioration in the quality of banks’ asset portfolios. Nonbank financial institutions continued to increase their market shares, from a very low base, within the financial system, without any systemic stability issues arising.

28. The changes to the monetary and exchange regime framework in 2001—adoption of inflation targeting, widening of the exchange rate band, and removal of the remaining capital controls—have significantly altered the operating environment for the financial system. Combined, these policy changes have stimulated the development of foreign exchange and forint money markets, facilitating risk management and, more broadly, a smoother operating environment for financial institutions. Trading volumes in both markets have grown significantly and maturities have lengthened, while interest and exchange rate volatility have not increased dramatically. Nevertheless, in this new environment, staff reiterated the importance of strengthening monitoring of the financial sector’s indirect exposure to exchange and interest rate movements (including through regular surveys of corporate exposures).

29. The significant strengthening of the legal framework governing the financial system is an additional safeguard for the financial system’s stability. In the aftermath of the 2000 Financial System Assessment Program (FSAP) effort and in the run-up to EU accession, several new acts on the financial sector have been adopted. The new act on the National Bank of Hungary further enhances the transparency of the central bank’s operations. The new credit institutions act sets the stage, among other improvements, for consolidated reporting and supervision—a most welcome enhancement of Hungary’s supervisory framework. The new capital markets act strengthens the supervisors’ enforcement power, further liberalizes the markets, and removes several legal uncertainties with respect to the use of repos and pledges. Finally, the autonomy and accountability of the Hungarian Financial Supervisory Authority (HFSA) have also been strengthened. These legal efforts bring Hungary close to international standards and practices, but fall short of granting full legislative independence for the HFSA. The mission also noted some other areas for further strengthening, including fit and proper testing (in particular, the power to remove board members or managers at later stages), and the mechanisms to instill principles of good corporate governance in the financial institutions. In addition, the lack of a gradual ladder of sanctions to address noncomplying financial institutions could hamper the effectiveness of supervisory action. New legislation for the insurance sector is still underway, which aims at EU compatibility.

30. The mission commended the authorities for adopting stricter legislation aimed at combating money laundering and terrorist financing. The assessment revealed that the new legal and regulatory framework, adopted in 2001, effectively addresses the two major issues that the Financial Action Task Force (FATF) raised regarding Hungary—the existence of anonymous savings deposits and the lack of information regarding beneficial ownership. Over the period ahead, the focus should be on taking steps to ensure robust implementation of the strengthened anti-money laundering legislation and improving the efficiency of the functioning of the Financial Intelligence Unit.

F. Transparency and International Standards

31. Hungary has made further progress in the area of economic statistics. As described in the statistical issues appendix, the authorities have addressed a number of issues of data quality noted in last year’s report—though some problems remain within government finance statistics, reflecting the growing size of off-budget fiscal activities in recent years.

32. Fiscal transparency should be strengthened. While work to compute the fiscal accounts on an ESA95 basis has been proceeding, it will be important to reduce the growing discrepancy between the cash budget approved by Parliament and monitored by government, and the more inclusive measure of the general government that includes fiscal activities now treated off budget (notably the activities of the National Motorway Company, the Hungarian Development Bank, and the privatization agency). The first priority should be to scale back off-budget fiscal spending (including by bringing such spending into the budgetary process). At the same time, a comprehensive and timely information system should be put in place, ensuring that the Ministry of Finance can keep up-to-date and accurate records of all fiscal spending, including by off-budget agencies.

III. Staff Appraisal

33. The performance of the Hungarian economy has been impressive. This reflects careful macroeconomic management and far-reaching institutional and structural reforms, including the lasting effects of the bold measures of the early- and mid-1990s. Though growth slowed in 2001 from the fast pace of the previous year, the economy weathered the recent global economic slowdown well. As long as appropriate policy adjustments are made and EU demand picks up, economic growth can be expected to accelerate and gather pace in later years—with the external current account deficit staying within safe limits.

34. The authorities’ objective of seeking early EU accession and adoption of the euro provides a key anchor for the policy framework with clear benefits. This is particularly the case as Hungary is already highly integrated with the EU. Moreover, the commitment to an early entry should underpin the authorities’ resolve to deliver needed fiscal discipline and structural reforms, and therefore also serves to strengthen the credibility of the policy framework.

35. Achieving this objective poses significant challenges. Against the background of rapid growth in public sector wages, the large hike in the minimum wage, and still tight labor market conditions, achieving the targeted disinflation path is not yet assured. In addition, fiscal adjustment has been made all the more difficult by the significantly expansionary fiscal stance last year and into this year.

36. The introduction of a new monetary policy framework—which was well managed both publicly and professionally—has contributed to putting inflation back on a downward track. Widening the exchange rate band allowed the NBH to appropriately tighten monetary conditions. And the significant fall in inflation helped to foster the credibility of the new inflation targeting regime.

37. Securing the targeted disinflation will require a determined effort. Keeping monetary policy tight will be key, as an easing of monetary conditions would risk rekindling price pressures, not least in circumstances in which real growth is expected to pick up. Support from fiscal policy is also essential. This would help to keep monetary tightening as moderate as possible and avoid too strong an appreciation of the forint.

38. It will be important to reverse the fiscal expansion underway at the earliest opportunity. Achieving a broadly neutral fiscal stance in 2002, while challenging, would eschew adding stimulus at a time when the economy is likely to gather steam. Equally as important, it would facilitate meeting medium-term fiscal consolidation objectives and avoid crowding out private sector investment. In addition, a strong, early, and visible commitment by fiscal policy to support monetary policy would add to the credibility of the disinflation path—and help anchor inflation expectations more firmly, moderate wage growth, and minimize real costs associated with disinflation. Initiating needed work on fiscal reforms as soon as a new government is formed would help to ensure that decisive fiscal actions are implemented next year.

39. Meeting fiscal deficit targets will hinge on restraining spending, underscoring the need for a well fleshed-out medium-term expenditure framework. In this context, the decision to start preparing a review of public expenditure, with a view to presenting options for greater expenditure restraint for the new government, is most welcome. Adopting medium-term expenditure ceilings and providing them to Parliament during the budget cycle would be another important step forward. This would add to the credibility of the fiscal adjustment path, including by strengthening the political commitment to the ceilings.

40. Pressing ahead with remaining structural reforms would help support fiscal consolidation, increase policy flexibility, and improve the economy’s resilience. In addition to rationalizing public sector employment, pension and health care reforms are key in light of the ageing population. Tackling the unfunded future liabilities of the public pension system will require timely, transparent, and consistent decisions on a range of policies that affect the system’s viability, with a view to increasing the effective supply of labor and keeping benefits within prudent limits. Health care reform is critical for strengthening expenditure control while delivering quality services. On public administration, the government faces the task of retaining high quality staff and expanding employment in some areas (for example, on activities related to EU accession), while raising the productivity of existing services and keeping the wage bill in check. This may require some adjustment to the wage structure, but, to be successful, it must be accompanied by strong and decisive efforts to rationalize and reduce public sector employment. Finally, moving forward with liberalizing the energy market should be a priority, and the government should refrain from ad hoc caps on regulated prices and from reversing earlier privatization.

41. The Hungarian financial system remains fundamentally sound. Hungary is at the forefront of financial sector reform among the accession countries and has one of the most developed financial systems in the region. As in the past, the continuous monitoring evident in the Financial Stability Report, and the efforts of the Hungarian Financial Supervisory Authority should help mitigate any future risks. While not an immediate concern, banks’ rapidly increasing exposure to certain market segments deserves careful monitoring and attention. And, in the current environment of more volatile exchange rates, the authorities are also encouraged to closely monitor the foreign exchange exposure of banks’ clients, with a view to ensuring that credit risks are well contained. The strengthening of the legal framework for the financial sector has continued at a significant pace, and the adoption of new legislation aimed at combating money laundering and terrorist financing is a welcome step. Over the period ahead, the emphasis should be on ensuring its robust implementation.

42. With respect to economic statistics, transparency, and standards initiatives, Hungary should build on past successes. This includes improvements in the national accounts, a recent agreement to place the balance of payments statistics on an internationally comparable basis by early 2003, and progress in computing the fiscal accounts on an ESA95 basis. In addition, the country’s participation in updating the ROSC modules as part of this year’s Article IV consultation is evidence of the country’s continued commitment to transparency and standards. Looking ahead, it will be important to reduce the discrepancy between the official fiscal accounts and a more inclusive measure of the general government that includes the fiscal activities of currently off-budget entities. In a related vein, a comprehensive and timely information system needs to be put in place to ensure that the Ministry of Finance can keep up-to-date and accurate records of all fiscal spending, and properly measure the activities of the general government.

43. The next Article IV consultation with Hungary should remain on the 12-month cycle.

APPENDIX I: Hungary: Fund Relations

(As of February 28, 2002)

I. Membership Status: Hungary became a member of the Fund on May 6, 1982; Article VIII.

II. General Resources Account:

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III. SDR Department:

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IV Outstanding Purchases and Loans: Mone

V. Financial Arrangements:

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VI. Projected Obligations to Fund: None

VII. Exchange Rate Arrangement:

Between May 16, 1994 and January 1, 1997, the exchange rate of the forint was linked to a basket of the European Currency Unit (with a weight of 70 percent) and the U.S. dollar (with a weight of 30 percent). In January 1, 1997, the NBH changed the composition of its fixing basket to a combination of deutsche mark (with a weight of 70 percent) and the U.S. dollar (with a weight of 30 percent). Since January 1, 1997, the NBH has based its official rate on the interbank spot rates. Margins for the NBH’s intervention band were widened to ±2.25 percent on December 23, 1994; and ±15 percent on May 4, 2001. Until March 13, 1995, the value of the peg to the basket was adjusted periodically, mainly on the basis of the difference between domestic and foreign inflation rates; since then and until October 1, 2001, the value of the peg was adjusted in accordance with a preannounced rate of crawl. Since then, the peg was set at 276.1 forint per euro. Between March 13 and June 30, 1995, the rate of devaluation against the basket was 1.9 percent per month, it was reduced to 1.3 percent per month as of July 1, 1995; to 1.2 percent per month as of January 1, 1996; to 1.1 percent per month from April 1, 1997; to 1.0 percent per month as of August 15, 1997; to 0.9 percent per month from Jan 1, 1998, to 0.8 percent per month from June 15, 1998; to 0.7 percent per month from October 1, 1998; to 0.6 percent per month from January 1, 1999; to 0.5 percent per month from July 1, 1999; to 0.4 percent per month from October 1, 1999; to 0.3 percent as of April 1, 2000; to 0.2 percent as of April 1, 2001; and eliminated effective October 1, 2001. As of January 1, 2000, the central parity of the intervention band has been defined solely in terms of the euro.

Hungary accepted the obligations of Article VIII as of January 1, 1996, and its exchange system is free of restrictions on payments and transfers of current international transactions. In accordance with UN Resolution 661 and Executive Board decision No.l44-(52/51), Hungary continues to maintain exchange restrictions against Iraq. The UN Security Council Resolution on food for oil was implemented in December 1996.

VIII. Article IV Consultations:

Hungary is on a 12-month consultation cycle.

The 2000 Article IV staff report was issued on April 13, 2001 (SM/01/109). The last Article IV Board discussion took place on May 4, 2001. The Public Information Notice No. 01/47 was released on May 18, 2001.

IX. Technical Assistance:

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X. Regional Resident Representative:

Mr. Roger Nord took office in Budapest in December 1998. It is expected that the regional office will be closed when Mr. Nord’s term expires in July 2002.

APPENDIX II: Hungary: Statistical Issues

1. Progress has been made in improving the timeliness, coverage, periodicity, and quality of Hungarian statistics. A number of issues of data quality, noted in the data dissemination module of the 2001 Report on the Observance of Standards and Codes, have been addressed, but some shortcomings remain.

2. Hungary has subscribed to the Special Data Dissemination Standard, and its metadata are posted on the Fund’s Dissemination Standards Bulletin Board (http://dsbb.imf.org). Hungary meets the SDDS specifications for the coverage, periodicity, and timeliness of the data, and for the dissemination of advance release calendars.

A. Real Sector Issues

National accounts

3. A persistent national accounts residual appeared in 1997, and remained in subsequent years, reported as part of changes in inventories. In 2000, the Hungarian Central Statistical Office (HCSO) first published an estimate of the statistical discrepancy between the final version of GDP by production activities and GDP by expenditure components. The HCSO publishes estimates of quarterly GDP by type of economic activity and by expenditure components beginning with the first quarter of 1996. The benchmarking of the quarterly estimates to the annual estimates has been applied from 2000. Beginning in June 2002, the HCSO will begin releasing a seasonally adjusted series of quarterly national accounts. The national accounts are also undergoing revision to incorporate a more up-to-date estimate of imputed rents.

Other real sector issues

4. The authorities have improved the reliability of industrial sales data by broadening the sample of enterprises surveyed. In addition, a new methodology for seasonal adjustment was introduced in 1997.

B. Balance of Payments

5. The Statistics Department of the National Bank of Hungary (NBH) compiles the balance of payments and international investment position of Hungary in broad conformity with the conceptual framework of the fifth edition of the IMF’s Balance of Payments Manual (BPM5). However, transactions are recorded on a cash basis, rather than on the accrual-based accounting principles of the BPM5. While resident institutional units are in accord with the BPM5’s definition of center of economic interest, the exclusion of reinvested earnings and other transactions that have no payment counterpart or banking mediation, limits the scope of BOP statistics in their coverage of all resident-nonresident transactions. No adjustments for reinvested earnings are made in the current and financial accounts. As a result, white there is no impact on the overall balance, the current account deficit has been underestimated by, perhaps, 2-3 percent of GDP in recent years.

6. In the BOP, trade data are recorded on a settlements basis, instead of using the more adequate customs data, which records the physical movement of goods across borders. Processing and repairs of goods are recorded as services (value added) in the BOP, instead of recording the gross value of exports and imports under goods as recommended in the BMP5.

7. Strengthened institutional cooperation between the NBH and the HCSO, covering methodological and technical issues, aims at replacing current ITRS goods data by customs statistics and incorporating reinvested earnings in foreign direct investment. Introducing accrual accounting for investment income also has high priority for the NBH. These steps, which are planned to be first introduced for the 2002 annual data (to be published in early 2003), will place the balance of payments statistics and Hungary’s international investment position on an internationally comparable basis.

C. Monetary Sector

8. The IFS country page for Hungary now provides timely data for the monetary authorities, banking institutions, and the banking survey. In addition, the coverage of the NBH’s analytical accounts has been extended, and Hungary now complies with the strengthened reserves standard. STA conducted a money and banking statistics mission in October 2000 to review progress in this area and to discuss recent methodological changes in the compilation of monetary statistics. The STA mission found that the framework for the compilation of monetary statistics in Hungary basically conforms to the Fund’s current methodology. A ROSC data module mission in January 2001 recommended that securities recorded on the balance sheets of depository corporations should be valued at market prices, and deposit liabilities of credit institutions in the process of liquidation should be removed from the monetary aggregates and classified as restricted deposits. The value of deposits of a credit institution in the process of liquidation is zero from November 2000. Hence, from that date, monetary aggregates Ml through M4 do not include any deposits of credit institutions under liquidation. In the future, these kinds of deposits will be excluded from monetary aggregates and will be shown under “restricted deposits.” The national definition of the monetary base still does include deposits of some credit institutions in the process of liquidation. This problem will be resolved in the first half of 2002. The introduction of new reporting forms based on the System of National Accounts (1993 SNA) in May 2001 also resolved the sectorization issues of nonprofit institutions.

D. Government Finance Statistics

9. The degree of decentralization of fiscal institutions hinders the full consolidation of government accounts, thereby leading to lags in availability of the data, possible overstatement of the size of the government in the economy, and complicating the estimation of the national accounts.

10. Significant progress in addressing several of these issues has been made with the establishment and subsequent expansion of the centralized Treasury and improved compilation of statistics at the Ministry of Finance. However, plans to report monthly expenditures classified on an economic basis have yet to come to fruition. Following a GFS mission in 1998, the authorities provided annual data for publication in the GFS Yearbook starting from 1991. The latest data published in the GFS Yearbook are for the year 2000. These data now cover the operations of the State Property Management and Privatization Company, since its inception in 1995. However, some other activities of a fiscal nature-taking place outside of the government budget, such as those of the National Motorway Company, are not included. The GFS Yearbook data, and the monthly data reported for IFS, still contain inconsistencies between the measures of the deficit and financing. The GFS Yearbook data contain significant adjustments to current expenditure in order to balance the deficit and financing.

11. Financing data provided for IFS are not published because of the significant differences between financing and the deficit. The Ministry of Finance, in cooperation with the Treasury and the Debt Management Office, is working to identify and eliminate these inconsistencies.

Hungary: Core Statistical Indicators

(As of April 15,2002)

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APPENDIX III: Hungary: Relations with the World Bank Group

1. Hungary joined the World Bank in 1982. Since then the Bank has committed about US$4.0 billion for 40 projects and programs. During the 1980s, Bank assistance focused on liberalizing the economy and modernizing and expanding its productive capacity, and infrastructure. During the 1990s, support for macroeconomic and structural adjustment became a key element of the assistance program, including structural adjustment loans in the earl 1990s, accompanied by Japan Exim co-financing and an IMF EFF Program, and sector adjustment loans in the mid-1990s supporting financial sector and pension reform. The Bank also provided support to help strengthen public institutions (e.g. in tax administration and public finance, health and social assistance).

2. Since the last Country Assistance Strategy, discussed by the Bank’s Board on January 28, 1998, Hungary has continued to establish a sustainable and robust macroeconomic environment, complete the transformation agenda, and make progress towards meeting the requirements for EU accession. A new CAS Progress Report will be discussed by the Bank’s Board on April 25, 2002. With moderate external deficits, good access to private capital and support from the EU and its financial institutions, Hungary does not envisage further borrowing from the Bank. Therefore, the Bank’s assistance program for FY03-05 outlined in the CAS Progress Report is limited to a program of advisory and analytical support in selected areas and support for implementation of two remaining Bank-financed projects in the portfolio.

3. The two ongoing Bank-financed projects are for Municipal Wastewater Management and Public Finance Management, with an undisbursed balance of about US$12.2 million as of April 1, 2002. With limited borrowing from the Bank in recent years, cancellation of portions of undisbursed loans, and pre-payment of some loans, Hungary’s outstanding obligations to the Bank amounted to about US$0.5 billion as of April 1, 2002. IFC and MIGA have not undertaken new investments and guarantees in Hungary in recent years.

1

Bearing in mind the difficulty in measuring potential output, the output gap in 2001 would be approximately -1 percent of GDP, assuming potential growth of about 4½ percent and a closed output gap in the preceding year.

2

Estimates by the NBH—adjusted for the composition of employment and the number of working days, as well as removing the impact of the minimum wage—suggest that wage growth in the private sector, on a year-average basis, could have been as much as 3½percentage points lower than the official data would indicate.

3

The deficit would be higher if retained earnings were included in the official statistics, but FDI would also be correspondingly higher. These earnings have been estimated in the range of 2 to 3 percent of GDP, but data are not yet officially available.

4

Interestingly, the government has changed its borrowing strategy for 2002 by shifting exclusively to forint-denominated bonds and lengthening the average maturity of its debt. The government floated its first 15-year bond last November at a heavily oversubscribed auction, which elicited strong investor interest.

5

Broadly speaking, staff believes that the appreciation of the forint so far has not compromised Hungary’s external competitiveness in light of the substantial gains made earlier in reducing relative unit labor costs, as shown in Figure 5.

6

An accompanying Selected Issues paper discusses in more detail the inflation targeting framework.

7

Although too soon to form firm judgments, technical discussions at the NBH suggested that December 2001 data on private sector wages may be indicative of labor markets responding flexibly to the slowdown in growth and the appreciation of the forint.

8

The NBH forecasts private sector wage inflation, on a year-average basis, of 8 to 10½ percent for 2002 and 5 to 8 percent for 2003.

9

This includes targeting an external current account deficit of under 4 percent of GDP, which would be sustainable in the staff’s view. See “Sustainability in the Hungarian Balance of Payments,” IMF Staff Country Report (SM/99/27).

10

An accompanying Selected Issues paper discusses the impact of aging and pension reform.

11

More details are provided in the Financial System Stability Assessment (FSSA) follow-up, and related documentation, which accompany this Staff Report.

Hungary: Staff Report for the 2002 Article IV Consultation
Author: International Monetary Fund