Hungary: Staff Report for the 2003 Article IV Consultation
Author: International Monetary Fund
Publication Date:
09 May 2003
eISBN:
9781451817874
Language:
English
Keywords:
ISCR; CR; deficit; GDP; export volume growth; government; private sector employment; foreign currency; inflation target; balance of payments; central bank; broad money
Download PDF (1.6 MB)

This 2003 Article IV Consultation for Hungary highlights that developments in growth and inflation were broadly positive in 2002. Buoyed by domestic demand, real GDP growth increased to 3.5 percent (year-over-year) in the second half of 2002 from 3.0 percent in the first half. Headline inflation declined from its recent peak of 10.8 percent in May of 2001 to 4.8 percent at end-2002. The external current account deficit widened in 2002, although foreign direct investment fell off sharply.

Abstract

This 2003 Article IV Consultation for Hungary highlights that developments in growth and inflation were broadly positive in 2002. Buoyed by domestic demand, real GDP growth increased to 3.5 percent (year-over-year) in the second half of 2002 from 3.0 percent in the first half. Headline inflation declined from its recent peak of 10.8 percent in May of 2001 to 4.8 percent at end-2002. The external current account deficit widened in 2002, although foreign direct investment fell off sharply.

I. Background

1. Reflecting a remarkably successful transition, Hungary is now on the verge of EU membership. Strong external competitiveness, export growth, and foreign direct investment (FDI) have been at the heart of Hungary’s success (Figure 1). This success has also been backed by careful macroeconomic management and significant structural reforms, including the lasting effects of the bold reform measures of the early and mid-1990s (see text figure). However, with elections in 2002, fiscal policy was highly politically-charged and turned very expansionary, contributing to macroeconomic imbalances and an inordinate burden on monetary policy.

Figure 1.
Figure 1.

Hungary: Transition and Export Performance, 1992–2002

Citation: IMF Staff Country Reports 2003, 124; 10.5089/9781451817874.002.A001

Source: IMF World Economic Outlook; IMF Direction of Trade Statistics; and staff calculations.1/ Data for 2002 are based on the first three quarters of the year
A01ufig01

Hungary’s record on structural reforms compares favorably

Citation: IMF Staff Country Reports 2003, 124; 10.5089/9781451817874.002.A001

2. Developments in growth and inflation were broadly positive in 2002 (Table 1; Figure 2, panels A-F). Real GDP growth, while slower than its rapid average pace during 1997-2001, picked up during the year. Buoyed by domestic demand, it increased to 3.6 percent (year-on-year) in the second half of last year from 3.0 percent in the first half. Headline inflation declined from its recent peak of 10.8 percent in May of 2001 (when the exchange rate band was widened) to 4.8 percent at end-2002.1 As a result, the Magyar Nemzeti Bank (MNB or the National Bank) has essentially met two consecutive year-end inflation targets. Exogenous factors contributed to the decline in inflation, including lower food and fuels prices during this period. Core inflation also declined significantly.

Table 1.

Hungary: Main Economic Indicators

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Sources: Hungarian authorities, IFS, and staff estimates.

These projections assume the government achieves its fiscal deficit target for 2003.

Consists of the central budget, social security funds, extrabudgetary funds, and local governments.

For more details on monetary developments, see Table 8.

Data for 2003 are as of end-February.

Data for 2003 are as of end-February and expressed in terms of imports in 2002.

Including inter-company loans, and nonresident holdings of forint denominated assets.

Figure 2.
Figure 2.

Hungary: Recent Developments, 1999–2002

(year-on-year growth, in percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2003, 124; 10.5089/9781451817874.002.A001

Source: Hungarian authorities and staff estimates.
A01fig02a
Source: Hungarian authorities; IMF Direction of Trade Statistics; and Staff calculations.1/ Includes short-term loans (by remaining maturity), and nonresident holdings of domestic bond. Reserves are net of resident foreign exchange deposits with the MNB2/ ULC based on manufacturing sector (1995=100)

3. However, recent wage growth has been extremely rapid. On an economy-wide basis, year-average wage growth was 18.3 percent in 2002 (Figure 2, panel C). This reflected continued strong wage growth in the private sector on the back of a 25 percent hike in the minimum wage early in 2002, which not only increased wages on its own but also compressed the wage scale leading to further upward wage pressure.2 Rapid wage growth in the public sector also reflected the 50 percent wage increase in September for some three-quarters of the public work force (without any reform of public employment). The carryover effect of the public wage increase is significant—contributing to an increase in the wage bill of the general government in 2003 of 20 percent, even with the announced wage freeze for most public employees.3 The demonstration effect on private wages and on wages in state-owned enterprises could also be considerable.

4. Reflecting both wage increases and nominal exchange rate appreciation, external competitiveness declined significantly during 2001-02. The ULC-based real effective exchange rate appreciated by some 20 percent during this period (Figure 2, panel I). About one-third of this appreciation was the result of the stronger nominal effective exchange rate. Some two-thirds of the appreciation reflected nominal wage growth in excess of the growth in productivity, and the resulting rise in Hungarian relative unit labor costs. Hungary has clearly lost some of its competitive edge as a result, and the loss of competitiveness associated with real exchange rate appreciation dampens export performance now and with a lag, and may also be adversely affecting FDI. Moreover, the loss of competitiveness would raise even more serious concerns about export prospects and FDI if rapid wage growth were to persist.

5. The external current account deficit widened in 2002 while FDI fell off sharply. Thus, the deficit was mostly financed by debt and a decrease in official reserves. Buoyed by real appreciation, wage increases, and a fiscally-induced strengthening of domestic demand, import growth was strong. At the same time, tourism receipts fell sharply. This resulted in a current account deficit of 4.1 percent of GDP, compared with 3.4 percent in 2001 (Table 2). These data reflect methodological changes to the balance of payments statistics that were introduced in late February (after the Article IV discussions) to bring them more in line with international best practices.4 While these changes lowered the current account deficit by about one percent of GDP in 2002, the deficit would perhaps be some 2-3 percent of GDP larger if data on reinvested earnings were available and included in the official statistics. Moreover, the year-on-year growth of exports of goods and services slowed down considerably in the second half, and export volume actually may have turned negative in the fourth quarter.

Table 2.

Hungary: Balance of Payments, 1998–2005 1/

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Sources: National Bank of Hungary and staff estimates.

These data reflect the methodological changes to the BOP statistics (described in the statistical issues appendix and the data ROSC update) that were introduced in late February 2003. Note that data on reinvested earnings are unavailable and therefore excluded tor now from the official BOP statistics and the projections in this table. Incorporating these earnings, when the relevant data becomes available (expected in early 2004), would raise the current account deficit, and an offsetting entry would be made in the financial account leaving the overall balance of payments unchanged.

Including intercompany loans.

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

Table 3a.

Hungary; Consolidated General Government, 2000–2003 1/

(Official Account Basis)

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

Official consolidated data for central budget, social security funds, extra-budgetary funds, and local governments (GPS basis).

For 2003 onwards, includes the introduction of the simplified business tax.

To the Pension Insurance Fund, the National Health Fund, and the Labor Market Fund.

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

Extraordinary expenditure on debt assumption and take over, recapitalization, purchase of shares and other one-off transactions.

Include wages and salaries, and other goods and services of the general government, and investment not undertaken by the central and/or local government, for which a separate breakdown is not available.

Central budget investment projects, local government capital expenditures, and housing grants.

ESA-95 basis.

Table 3b.

Hungary: Consolidated General Government, 2002–2003

(ESA-95 basis, in percent of GDP)

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Source: Hungarian authorities and staff estimates.

Estimates as of late 2002.

6. By any standard, fiscal policy was highly expansionary in 2002. Compared with deficits (on an ESA-95 basis) of 3.0 percent of GDP in 2000 and 4.7 percent of GDP in 2001, the estimated deficit of the general government reached a startling 9.5 percent of GDP (Table 3).5 While one-off expenditures amounted to about 3¾ percent of GDP,6 there were significant permanent expenditure increases—notably on wages and pensions, as well as on health-related spending, social benefits, and subsidies. These increases not only added to the deficit last year, but they will also complicate fiscal consolidation efforts in this and later years.

7. Fiscal laxity, alongside rapid wage increases, put monetary policy in a very difficult bind. The MNB had set an end-2003 inflation target of 3.5 ± 1 percent, but rapid wage growth and fiscal expansion contributed to an increase in its baseline projection to above-target inflation, with upside risks predominating.7 Against this background, and in the face of a widening external current account deficit and concerns over external competitiveness, the speculative attack against the exchange rate band in January (Box 1) brought to a head the conflict between inflation and external objectives, and the inconsistency in earlier macroeconomic policies.

The Speculative Attack

  • With the forint at the strong end of its ±15 percent band against the euro, it came under a massive speculative attack during January 15-16, 2003. With considerable stimulus from an expanding fiscal deficit and wages, speculators bet that the central bank (with needed legal consent from the government) would revalue the central rate to a stronger level or, absent a band, allow the exchange rate to appreciate, to meet the inflation target.

  • To fend off the attack the MNB: lowered the base rate (i.e., the interest rate on two-week deposits) by 200 basis points to 6½ percent; undertook major intervention, accumulating large amounts of foreign exchange; widened the overnight interest rate corridor from the base rate ±100 basis points to ±300 basis points, thereby reducing the rate on overnight deposits from 7½ percent before the attack to 3½ percent; and imposed quantity limits on the two-week deposit facility, which forced funds to be shifted to the overnight facility and caused actual money market rates to fall significantly below the base rate.

  • In the aftermath, the MNB has sold foreign exchange to mop up liquidity and help to unwind long forint positions; and, effective February 24, removed the limit on the two-week deposit facility and narrowed the interest rate corridor back to 100 basis points (while keeping the base rate at 6½ percent).

  • The forint traded between 245 and 248 per euro in the last ten business days in March, compared with 245-250 before the monetary measures in mid-February and 234 at the strong edge of the band. (Figure 3 shows movements in exchange rates, interest rates, and reserves).

  • The authorities noted that the impact of the recent speculative attack on banks’ profits in Hungary was neutral to positive, and their small open foreign exchange positions kept risks low.

Figure 3.
Figure 3.

Hungary: Interest Rates, Exchange Rate and Foreign Reserves, 2001–2003

Citation: IMF Staff Country Reports 2003, 124; 10.5089/9781451817874.002.A001

Source: National Bank of Hungary and Bloomberg.

II. Report on the Discussions

8. The discussions covered a number of issues. These included the short-term outlook and the appropriate near-term setting of macroeconomic policies, as well as medium-term goals and the strategy for adoption of the euro. All agreed on the need to rebalance the policy mix—that is tighten fiscal policy with a view to unburdening monetary policy, thereby avoiding excessive monetary tightening, unwanted currency appreciation, and the inconsistent monetary/fiscal policy mix that was an important element leading up to the speculative attack on the strong edge of the currency band. An important aspect of the discussion on joining ERM-2 (upon acceding to the EU) and adopting the euro was the challenges faced by the authorities, particularly on the fiscal front, in progressing toward meeting the Maastricht criteria. The need for fiscal consolidation, and the associated policies to achieve it, have been a key feature of previous consultations.

A. Economic Outlook and Objectives

9. For the most part, the outlook for this year was not a point of contention—though uncertainties were recognized.

  • Growth. The MNB’s baseline real GDP forecast for 2003 is 3.5 percent (revised down from the 3.9 percent forecast made in November). This is similar to the staff’s projection (and the consensus) of 3.6 percent. The figures of both the MNB and staff reflect a projected pick up in EU activity and exports, which also has a growing positive effect on private investment throughout the year. Private consumption, while strong, is projected to moderate in response to a slower pace of real wage gains than the torrid pace witnessed in 2002. These growth forecasts are below the 4.4 percent used by the Finance Ministry in preparing the budget (the latter being made in the fall of 2002), and estimates of potential output growth of about 4½ percent.8

  • Inflation. With wage pressures still evident and the exchange rate having depreciated since the speculative attack, there was general agreement that inflation at end-2003 would be above the of 3½ ± 1 percent target. For this and other reasons, the MNB, in its latest Quarterly Report on Inflation (February 2003), projects inflation of 5.2 percent. This is in line with the staff’s projection.

  • External current account. Pressures that are expected to widen the current account deficit include continued sluggish growth in Hungary’s trading partners, higher oil prices, and the lagged effects of the significant appreciation of the real exchange rate. The latest projection of the MNB foresees a widening of the deficit (using the old data methodology) of one-half percentage point of GDP.9 Staff projects a widening of a similar magnitude, to a deficit of 4.8 percent of GDP using the new data methodology. A further increase in later years, or a sustained deficit of this size, would raise warning flags from a sustainability point of view, including because of the potential for unfavorable debt dynamics.10 However, such problems are not expected to arise with the projected current account deficit on a downward trend in later years. While the authorities felt that a current account deficit of the size projected in 2003 should be easily financed, many of them agreed with staff that the risk of a (possibly disorderly) correction should not be ruled out were sizable twin deficits to prevail.

  • Risks. With the balance of risks on growth on the downside—primarily reflecting the possibility of a weaker-than-expected recovery abroad, and therefore weaker export growth, confidence, and private investment—real growth may be below the forecasts of the MNB and staff, and thus well below what was used for the budget. These risks would also widen the current account, as would a continued increase in world oil prices. While slower growth would moderate inflationary pressures, as would lower oil prices, these risks are balanced on the upside by risks from wage behavior and the possibility of higher priced oil.

10. The authorities’ most recent Pre-Accession Program (PEP) lays out medium-term objectives and is broadly consistent with the staff’s medium-term scenario. That scenario (Table 4), which is based on achieving the targets for the deficit of the general government as set out in the PEP, illustrates containing the current account deficit in the face of rising private investment and some continued decline in private saving. The authorities emphasized, and staff agreed, that the fiscal targets specified in the PEP—which envisages deficits of the general government falling below 3 percent of GDP in 2005 (on an ESA-95 basis)—were necessary in their own right to support both domestic and external objectives, and to ensure a healthy degree of macroeconomic policy consistency. The targets are also consistent with early adoption of the euro. While external and public debt dynamics can be expected to remain broadly manageable under most stress tests, these dynamics would clearly be less favorable if downside external risks were to materialize, or fiscal policy to loosen significantly, a concern especially in light of relatively high debt ratios (Tables Table 5 and Table 6).

Table 4.

Hungary: Staff Illustrative Medium-term Scenario 1/

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Source: IMF staff estimates.

Incorporates staffs policy recommendations.

The current account is not consistent with the concept of ihe use of foreign saving on a national accounts basis, which results in a statistical discrepancy in the data on the overall saving-investment balance. The reasons include the exclusion of reinvested earnings from the official statistics (an item which may vary over time, but for which official data are unavailable).

The 2002 general government balance includes various one-off financial operations (amounting to 3.1 percent of GDP) that are not part of the saving-investment balance on a national accounts basis.

ESA-95 basis.

Table 5.

Hungary: External Sustainability Framework, 1997–2007

(In percent of GDP, unless otherwise indicated)

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Sources Natiomal Bank of Hungary, IFS, and staff estimates

Derived as [r - g -ρ(1 + g)+ εα(l+r)]/(l+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ - change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e- nominal appreciation (increase m dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt

The contribution from price and exchange rate changes is defined as [-ρ(l + g) + εα(l+r)]/(l +g+ρ+gρ) times previous period debt stock, ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based oil GDP deflator).

Defined as non-interest current account deficit, plus interest and amortization on medium-and long-term debt, plus short-term debt at end of previous period

Includes preliminary data as well as projections.

Table 6.

Hungary Public Sector Debt Sustainability Framework, 1997–2007

(In percent of GDP, unless otherwise indicated)

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Source: Hungarian authorities, and staff estimates.

Consolidated general government, gross debt ESA-95 basis.

Derived as [(r- π(1+g) - g +αε(l+r]/(l +g+π+gπ)) times previous period debt ratio, with r- interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase ui local currency value of U.S. dollar)

The real interest rate contribution is derived from the denominator in footnote 2/ as r- π (1+g) and the real growth contribution as -g.

The exchange iate contribution is derived from the numeraloi in footnote 2/ as αε(l+r).

Defined as public sector deficit, plus amortization of medium and long-term public, sector debt, plus short-term debt at end of previous period

Derived as nominal interest expenditure divided by previous period debt stock.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic. inflation (based on GDP deflator).

11. Euro adoption can provide an important anchor for the macroeconomic framework over the medium term. Moreover, a number of considerations related to the criteria for optimal currency areas support Hungary’s readiness for adopting the euro: degree of openness, trade (and financial market) integration, synchronization of business cycles; and nominal price and wage flexibility.11 Reflecting these considerations and the findings of a recent study,12 the MNB has argued for adoption of the euro as early as possible—which most recently has been taken to mean 2008 in light of the setbacks to fiscal adjustment and disinflation. The Finance Minister has expressed the view that Hungary should seek to adopt the euro as early as 2007 but no later than 2009. For its part, staff sees considerable merit in early adoption of the euro, provided fiscal discipline and wage restraint (discussed below) are vigorously pursued. Staff emphasized, and the authorities agreed, that in formulating and communicating the macroeconomic policies required to meet the Maastricht criteria in a sustainable way, care must be taken to avoid the potentially disruptive effects of abrupt shifts in market expectations on the progress toward adopting the euro. In this context, staff welcomed the establishment of a working group of the MNB and the Ministry of Finance, which is an important step in promoting collaboration and progressing with needed preparatory work, and in building consensus on a euro strategy.

B. Fiscal Policy

12. The need for fiscal adjustment was not at issue. There was consensus that significant fiscal tightening would lessen the necessary degree of monetary restraint to meet the end-2004 and later inflation targets, and thereby help to avoid too strong an appreciation of the exchange rate. All agreed that fiscal adjustment would also contribute to raising national saving to support investment while avoiding crowding out private sector investment; safeguarding public debt and external viability, and generally maintaining macroeconomic stability important for sustaining growth. The authorities stressed, additionally, their goal of reverting back to investment growing more rapidly than consumption, a goal that requires wage moderation.

13. While quite large on face value, the targeted fiscal adjustment in 2003 is feasible—though not without implementation risks. The authorities aim, on an ESA-95 basis, to reduce the fiscal deficit from 9.5 percent of GDP in 2002 to 4.5 percent this year. The adjustment would be somewhat larger on a GFS basis. Since the targets for 2003 (and later years) are ESA-based but more detail is available using GFS, Table 3 reports the fiscal accounts both ways.

  • On revenues, the budget foresees a decline of 1.2 percentage points of GDP, with a reduction in personal income taxes (reflecting the tax exemption for the minimum wage and revised tax brackets) and social security contributions (reflecting a decline in the lump sum payment for health) contributing 0.8 percentage point and the rest associated with changes in non-tax revenue. Staff felt that these revenue estimates were, on the whole, achievable. Staff saw downside risks from optimistic projections for the base for the personal income tax and social security contributions, and from the possibility of lower real growth than assumed in the budget. However, the effects of the latter would be mitigated to the extent that lower growth reflects lower exports and investment, since the direct impact on budgetary revenue would be relatively small. Meanwhile, the upside to wage growth and inflation, while undesirable for other reasons, would tend to have a significant positive impact on revenues.

  • In light of the budgeted decline in revenue, total expenditures need to fall by 6½ percentage points of GDP (and somewhat less on an ESA-95 basis). The fading out of one-time outlays contributes some 3¾ percentage points to this adjustment.13 Interest expenditure drops by almost a half percentage point of GDP. Capital expenditure (which in the GFS table includes only part of central and local government capital expenditure) accounts for another one percentage point. The authorities explained that the remaining adjustment mainly reflects further restraint on investment, including road construction.14 The residual categories of current primary spending will also need to be contained at a lower level (as a percent of GDP) than in 2002, consistent with budget appropriations. Unwavering policy implementation will be required on this score.

  • The representatives of the Ministry of Finance saw particular upside spending pressures in the areas of open-ended housing grants and other subsidies. They also explained that, based on budget execution during the first half of the year, a decision would be made in July on any needed corrective measures to realize the fiscal deficit target.

  • The resulting fiscal withdrawal from meeting the deficit targets would be coming on the heels of the huge fiscal stimulus in 2001 and 2002, some of which came in the last months of 2002. As a consequence, the effects would be felt in 2003 and partially offset the fiscal withdrawal. Moreover, fiscal withdrawal is limited further because some one-off measures had little demand impact (e.g., debt consolidation operations) and the impact of others was limited by their temporary nature. Finally, the fiscal stance is not expected to unduly crunch the economy because the fiscal multiplier can be expected to be small in a small, highly open economy like Hungary.

14. 2004 is a pivotal year in which the authorities will be confronted with a number of challenges in achieving the deficit target of 3 percent of GDP. With the adjustment in 2003 relying mostly on one-off factors and lower investment spending, the case for preparing early for more durable fiscal adjustment in 2004—focusing on current expenditure—was well recognized. The discussions revealed a number of considerations in 2004 that strengthen the case for strong restraint on current spending. First, spending pressures arise from public investment needs—so there is unlikely to be much in the way of saving in this area, although some measures could enhance expenditure efficiency (e.g., international public tenders for large infrastructure projects). Second, EU membership entails a considerable reduction in import duty revenues and significant EU-related spending. Third, measures to reduce the high tax wedge on labor have already been approved with the 2003 budget.

15. Working with the authorities, and drawing on technical assistance from the Fiscal Affairs Department, a menu of options was identified. As shown in the table below, these options exceeded the overall requirements for meeting the fiscal target in 2004 (and later years).15 In addition, it will be important to limit transfers to and guarantees for state-owned enterprises, including to ensure that new “one-off” spending items do not occur. The authorities agreed that there is a need for expenditure policies and reforms in a number of areas, and they will be working to identify priority areas. The experience of other European economies in undertaking significant fiscal adjustment is relevant to the task at hand. Staff stressed that the evidence suggests that fiscal consolidation is durable and more friendly to growth when it relies more heavily on restraining spending than increasing revenue, and tackles key issues related to the government wage bill, transfers, and subsidies.16

Menu of Expenditure Reform Options and Estimates of their Potential Budgetary Savings

(In Percent of GDP)

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16. The authorities raised some key proposals for strengthening fiscal management. The Ministry of Finance was planning to introduce three-year rolling expenditure ceilings to serve as a basis for medium-term budget planning. These would be established for major budgetary chapters, with leeway for ministries to allocate spending within these chapters. In line with rules governing the disbursement of EU cohesion and structural funds, the framework would include explicitly the government’s medium-term goals and commitments in areas related to the absorption of EU funds. Though the details had not yet been fleshed out, the authorities also proposed to move toward performance-based budgeting (e.g., through the specification and quantification of the expected results of spending programs) in the context of improved transparency in the fiscal area. This would facilitate greater public surveillance of fiscal activities and could thereby promote a more efficient delivery of public services.

17. Staff reacted positively to the authorities’ proposals, when viewed as part of a coherent overall fiscal and macroeconomic framework. A key defining feature of medium-term frameworks, in contrast to simple medium-term projections, is their formal status within the annual budget process. Thus, staff strongly agreed that an essential feature should be submitting these ceilings to parliament for approval at the time of the budget, and emphasized the importance of including a statement of policy objectives to help garner broader support.17 In addition, in circumstances in which fiscal adjustment is vital, staff encouraged the use of realistic but conservative assumptions, with a view to erring on the side of fiscal overperformance. Staff strongly welcomed the actions taken to improve fiscal transparency.18

C. Wage Policy

18. The authorities explained the desired outcome of the wage guidelines for the private sector in 2003. In particular, the National Interest Coordination Council (a tripartite group consisting of the government, employers, and unions that makes wage recommendations) had recommended an increase in net real wages of 4.5 percent in 2003 for the private sector. The government saw this as compatible with an increase in nominal gross wages of 5-6 percent, on average, taking into account the reductions in the personal income tax and social security contributions.19 It was also hoped by the authorities that diminishing profit margins on the heels of the large appreciation of the forint in 2001-02 would keep wage pressures in check. However, translating the Council’s recommendation into a gross nominal wage increase requires a detailed calculation for each employee that would depend, in part, on income levels. Inflationary expectations could also differ considerably across economic agents, diminishing the clarity of the recommendation. The most recent projections by the MNB, at 8 percent, are higher than the 5-6 percent targeted by the government. Discussions with labor unions added credence to the higher figure.

19. Recognizing that wage moderation is key to supporting disinflation and external competitiveness, the discussion turned to ways to achieve this. In the first instance, staff agreed that the government needed to signal the importance it attaches to wage moderation through its wage policy for public sector employees. Thus, on the heels of the wage increases already granted, staff strongly supported the wage freeze this year for the vast majority of public sector employees, and urged the government to consider keeping wage increases in 2004 below the inflation target. Staff also saw merit in closer cooperation among the social partners—working through, say, the National Interest Coordination Council—to reach a broader consensus on wage moderation. In this regard, the experience of some current members of the euro area was of relevance: in several countries (e.g., Greece, Ireland, and Portugal), wage agreements were instrumental in bringing down inflation to meet the Maastricht criteria. Moreover, staff agreed with the MNB that recommendations should be made in (gross) nominal rather than real terms. This would make it easier for the various players to translate recommendations into actual wage increases. It would also discourage backward-looking indexation, which adds inertia to inflation and makes it more difficult to disinflate.

D. Monetary Policy and the Exchange Rate

20. Monetary policy has operated in a constrained and difficult environment. In the aftermath of the attack on the strong edge of the exchange rate band, the MNB rightly wanted to reverse the increase in base money and negative short-term real interest rates at the earliest opportunity in order to limit the potential for dissaving and a rekindling of inflationary pressures. It also wanted appropriately to sell foreign exchange to mop up liquidity and help to unwind long forint positions from the attack, and return to normal operating procedures (and transmission from official to market interest rates). As indicated in Box 1, the MNB has taken some necessary actions—and current conditions would not seem to particularly warrant a change in official interest rates now. But the central bank will have to be vigilant, yet pragmatic, to avoid undesirable consequences because of the remaining liquidity from the speculative attack, including by undertaking further sales of foreign exchange and sterilization operations. However, the scope to affect the inflation outturn for 2003 is limited, both in light of the lags involved in monetary transmission and because of the limited room for maneuver after the attack, with the inflation target essentially subordinated to exchange rate considerations for now. Thus, in a process that is already underway, the authorities have begun to shift their focus to the end-2004 target and the supporting policies to achieve it.

21. The inflation target for end-2004 can be achieved—but monetary policy cannot do it alone and keep the exchange rate close to current levels. The president of the MNB has emphasized that he would prefer to avoid a strengthening of the forint from current levels. The Finance Ministry shares this view in light of its concerns about the competitiveness of the external sector. Staffs analysis raises warning flags about overvaluation.20 With the MNB’s latitude to tighten monetary conditions constrained in this way, support from fiscal policy and wages is all the more essential. Indeed, the MNB projection of end-2004 inflation of 4 percent hinges on a significant deceleration of private sector wage growth to 5½ percent in 2004 and on achieving the fiscal deficit target for that year. In view of the limited room for maneuver for monetary policy, the authorities agreed that deviations from the fiscal adjustment announced in the PEP, and from a tight incomes policy in the public sector could hurt the credibility of the disinflation path.

22. Challenges will surely arise in the run-up to ERM-2 and adopting the euro. In current circumstances, with concerns about external competitiveness, staff concurred with the authorities that the best outcome would be if the current exchange rate band could be maintained through the run-up to ERM-2. While this, for the time being, would compromise inflation objectives (absent unexpected favorable shocks to prices), monetary policy could be afforded more room for maneuver once officially in ERM-2, perhaps in the second half of 2004. In view of lags, this would help to progress on the Maastricht inflation criterion looking ahead to 2005. At the same time, with the European recovery (and fiscal adjustment) hopefully more firmly in train, external objectives would be less pressing. Adoption of the euro in, say, 2008 would require meeting the Maastricht inflation criterion towards the end of 2006.21 While challenging, this should be feasible, provided monetary policy, aided by fiscal consolidation and wage moderation, can be better geared to inflation objectives. While B alas sa-Samuel son effects may still be present, they may amount to roughly 1 percent according to some at the MNB, which could be handled, in part or in whole, by exchange rate appreciation within ERM-2, or within the margin allowed by the Maastricht inflation criterion. That being said, a smooth passage is by no means assured—and over time more room for currency appreciation may be needed. In any event, as EU accession and the chance to officially enter ERM-2 approaches, renewed speculation may occur, on a revalued central parity. It was agreed that formulating (internally) a clear strategy for euro adoption, and communicating credible macroeconomic policies to achieve it (without being specific too early on the timing and details of entering ERM-2) can only help. Indeed, euro adoption will only be a success if low inflation is achieved as a result of a credible monetary policy and successful and durable fiscal consolidation.

E. The Financial Sector

23. The Hungarian financial system remains fundamentally sound. In 2002, banks remained adequately capitalized and liquid; profitability was solid; and, while the quality of their loan portfolio deteriorated modestly, it still remained high. Moreover, as shown in Table 7, the level of international reserves is comfortable, especially as measured by the ratios to short-term debt and broad money. Potential areas of vulnerability—flagged in last year’s follow-up to the Financial System Stability Assessment—are still relevant.22 These include the concentration of bank credit to a handful of large borrowers and some lingering reluctance by the corporate sector to hedge against foreign exchange risks (although hedging activity is reportedly on the increase). These also include the fast growth of consumer lending (though from a low base), including mortgage lending (fueled by open-ended and unsustainable government interest subsidies). In addition, despite rising vacancy rates and falling rental fees on commercial properties, business property loans continued to grow rapidly (but also from a low base). The authorities are keenly aware of all this and monitor the relevant information closely—including through the MNB’s semi-annual Report on Financial Stability and the Hungarian Financial Supervisory Authorities’ (HFSA) on-site inspections.

Table 7.

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

(Year end, in percent of GDP, unless otherwise indicated)

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

Backward-looking using actual CPI.

Comprised of loans classified as substandard, doubtful, and bad.

Excludes the Hungarian Development Bank and the Eximbank.

These data reflect the methodological changes to the BOP statistics (described in the statistical issues appendix and the data ROSC update) that were introduced in late February 2003.

Net foreign assets plus foreign exchange credit to the government and banks less foreign exchange deposits of banks.

Data for 2003 are expressed in terms of imports in 2002.

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

Including intercompany loans.

Excluding intercompany loans.

Medium-term credit amortization and gross interest expenditures, denominated in foreign currencies, excluding intercompany loans.

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

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

24. The authorities noted a number of steps to strengthen the framework for financial supervision. First, while consolidated supervision by the HFSA awaits full legal fortification, the HFSA is already performing its supervision on a consolidated basis. The HFSA indicated that they expect full legal backing to pass the parliament during the first half of this year. Second, the new Insurance Act—also expected to be adopted by parliament in the first half of 2003—will harmonize legislation with that of the EU in this area. Third, an amendment to the anti-money laundering law was pending (during the consultation discussions and was passed in late February), with a view to increasing efficiency in the fight against money laundering. In particular, the new legislation modified the definition of terrorist action and supports improvements in the operation and surveillance authority of the Financial Intelligence Unit. Implementation of the existing legislation on anti-money laundering has been strengthened (e.g., in the area of foreign exchange bureaus).

F. Structural Reforms

25. Staff supported recent structural initiatives by the authorities. Building on the impressive privatization successes in the 1990s, in which most of the economy was privatized, the government has earmarked state-owned companies with an estimated market value equivalent to about 1½ percent of GDP for further privatization this year, including a large bank. This is welcome and would help to increase FDI. In addition, progress has been made in opening the electricity market and eliminating subsidies as a result of raising regulated prices by about 10 percent in February. The latter, according to Energy Office estimates, will close the gap between costs and revenues at the state-owned grid-operator and public wholesaler. With respect to natural gas, prices for industrial users are about at world market levels. For households and other small users, the price rises scheduled for 2003 will move prices closer to, but not at, world market levels. Through a system of “block” prices, whereby the price charged increases with usage, the authorities intend that the basic needs of households will be met at lower prices while lessening distortions.

26. Staff noted Hungary’s progress in implementing current WTO agreements and in adjusting to the requirements of EU accession. Following commitments made during the Uruguay round, the “tariffi cation” of non-tariff import limits on agricultural products has advanced further and industrial tariffs were lowered significantly. Further tariff reductions are in store due to EU accession. While implying higher import levies in some cases, putting the EU customs regime into operation will reduce the average tariff for industrial goods from about 7 percent to about 4 percent, and on agricultural products from about 22½ percent to about 20 percent.

G. Transparency and International Standards

27. In addition to the progress made in the fiscal area, Hungary has made further progress in the area of economic statistics. The authorities have addressed a number of data quality issues in the national accounts, monetary statistics, and balance of payments statistics. The authorities have also confirmed their aim to move the latter to a full accrual basis, including by showing reinvested earnings in the current account, starting with the release in early 2004 of the annual data for the preceding year.23 However, analysis of fiscal issues would be helped by more timely and consistent data, including on public expenditures classified on an economic and functional basis.

III. Staff Appraisal

28. With its track record of far-reaching institutional and structural reforms, and its successes in macroeconomic management, Hungary is on the verge of EU entry. Provided that fiscal consolidation and wage restraint are vigorously pursued, aiming for early adoption of the euro has considerable merits. Hungary is already highly integrated with the EU, and stacks up favorably against optimal currency area considerations. Moreover, the goal of early adoption would be an important disciplining force for delivering needed macroeconomic policies that would be helpful irrespective of the Maastricht criteria. Against this background, staff welcomes the establishment of a working group to build consensus on a euro strategy and looks forward to its recommendations by the second half of this year.

29. Some recent developments carry risks if left unattended. Wage growth has been extremely rapid and has significantly eaten into external competitiveness. At the same time, absent offsetting action, the external current account is headed into unwelcome territory and could become especially troublesome without action to reduce the fiscal deficit, which at over 9 percent of GDP in 2002 was excessively large. While it is tempting to assume that the current account deficit will continuously be financed on favorable terms, not least in light of the market’s exuberance over EU accession, market expectations can change unexpectedly. Were sizable twin deficits to prevail, the risk of a (possibly disorderly) correction should not be overly discounted.

30. In the face of fiscal expansion and rapid wage increases monetary policy had to navigate very difficult straights. With upside risks to inflation predominating, the speculative attack against the band in January, in the face of a widening current account and concerns over competitiveness, brought to the fore the conflict between inflation and external objectives. While it would have been preferable if the turmoil could have been avoided, the response by the MNB at the time of the attack was appropriate. Nevertheless, the basic problem remains: monetary policy by itself cannot aim simultaneously to lower inflation and support external competitiveness and adjustment.

31. Against this background, staff strongly supports the authorities’ fiscal deficit targets, which call for sizable and early consolidation. The 2003-04 period offers the best opportunity to press ahead with the bulk of fiscal adjustment, ahead of the next election cycle. Achieving the deficit target as from its first budget would support the credibility of the new government and would be an important first step toward medium-term fiscal adjustment. In addition, major fiscal adjustment, now and in the medium term, is necessary to ensure continued disinflation and adoption of the euro, to minimize the chance of a disorderly external correction, and to set the stage for sustained economic growth. However, absent new measures, there are risks that the fiscal deficit target for 2003 will not be achieved. In light of the importance of upfront fiscal adjustment, corrective actions should be taken if slippages were to appear likely. Moreover, with a view to securing durable fiscal adjustment of a growth-friendly nature, it is important to prepare early for 2004—focusing on restraining current expenditure and structural reforms to achieve this in various areas, including public employment, health care, pensions, social benefits, and various subsidies. In support of fiscal consolidation in 2004 and later years, staff is positive about the proposal to introduce medium-term expenditure ceilings. These should hit at the core areas where restraint is needed, and be submitted to parliament for approval at the time of the budget, along with a supporting policy statement.

32. Wage moderation is another key component to securing further disinflation and supporting external competitiveness. Efforts on this front must begin in the public sector, with the government signaling the importance it attaches to this goal through its wage policy for public sector employees. In this regard, on the heels of the significant wage increases already granted, staff strongly supports the wage freeze for this year for the vast majority of public sector employees, and urges the government to keep wage increases in 2004 below the inflation target. Drawing on the experience of current members of the euro area, closer cooperation between the social partners to achieve wage agreements to bring inflation down to the Maastricht criteria should be seriously explored. Staff would also recommend that wage guidelines be set in (gross) nominal rather than real terms.

33. With support from fiscal policy and wage moderation, monetary policy can achieve key objectives. In the near term, the scope to affect the inflation outturn for 2003 is limited because the inflation target is essentially subordinated to exchange rate considerations. However, barring unforeseen and sizable adverse shocks to prices, the end-2004 inflation target is within reach, and the authorities have rightly shifted their focus to that target and supporting policies to achieve it. Deviating from a tight incomes policy and the envisaged fiscal deficit path, would clearly make it difficult to achieve inflation objectives without compromising external competitiveness. In the aftermath of the speculative attack, the MNB took appropriate actions to restore normal operating procedures. The central bank reversed the increase in base money and negative short-term real interest rates in order to limit the potential for dissaving and a rekindling of inflationary pressures, and current conditions would not seem to particularly warrant a change in official interest rates now.

34. The financial system in Hungary continues to be fundamentally sound. Risks to financial sector stability are well contained, with progress continuing in the regulatory and supervisory frameworks (including anti-money laundering). The potentially vulnerable areas in an otherwise healthy financial sector include the rapid growth in consumer, business property, and mortgage lending, the later being fueled by open-ended and unsustainable government interest subsidies, and lingering concerns over whether the business sector is adequately hedged against foreign exchange risks. Importantly, the authorities are aware of these risks and monitor them carefully, including through the work on the MNB’s Financial Stability Report, and the activities of the HFSA.

35. Recent structural reform initiatives are encouraging. Staff welcomes plans to complete privatization. The increase in the regulated price of electricity and the elimination of subsidies that is intended to go along with this increase are also important steps forward. Finally, while natural gas prices for households and small users still have a way to go before reaching world market levels, recent actions are on the right track.

36. Hungary’s continued participation in updating the ROSC modules as part of this year’s Article IV consultation is testament to its commitment to transparency and standards. Progress in fiscal transparency, including in compiling the fiscal accounts on an ESA95 basis, is most welcome and facilitates better monitoring and surveillance of the activities of the general government. The provision of more timely data on public spending by economic and functional classifications would facilitate further more efficient fiscal management. Improvements are notable in other areas too, including in compiling national accounts and balance of payments statistics, with a view to bringing these data more in line with international best practices. Looking ahead, staff looks forward to the inclusion of reinvested earnings in the balance of payments statistics by early 2004.

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

Table 8.

Hungary: Monetary Survey, 2001–2002

(In Billions of Forint, at Current Exchange Rates, End-of-Period)

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Source: National Bank of Hungary’s Monetary Survey.