Hungary: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund
Publication Date:
24 May 2004
eISBN:
9781451817881
Language:
English
Keywords:
ISCR; CR; deficit; GDP; government; deficit target; current account deficit; headline inflation; foreign currency; fiscal policy
Download PDF (493.5 KB)

This 2004 Article IV Consultation states that Hungary’s entry into the European Union comes on the heels of impressive accomplishments. Its successes were based on the long-lasting effects of significant structural reforms and privatization during the 1990s, which also facilitated Hungary’s outward orientation, foreign direct investment inflows, strong export performance, flexible labor and product markets, and sound banking system. The success was also rooted in undertaking macroeconomic adjustment measures when needed, and in maintaining an adequate level of international competitiveness.

Abstract

This 2004 Article IV Consultation states that Hungary’s entry into the European Union comes on the heels of impressive accomplishments. Its successes were based on the long-lasting effects of significant structural reforms and privatization during the 1990s, which also facilitated Hungary’s outward orientation, foreign direct investment inflows, strong export performance, flexible labor and product markets, and sound banking system. The success was also rooted in undertaking macroeconomic adjustment measures when needed, and in maintaining an adequate level of international competitiveness.

I. Background

1. Hungary’s entry into the EU comes on the heels of impressive accomplishments (Figure 1). Its successes were based on the long-lasting effects of significant structural reforms and privatization during the 1990s, which also facilitated Hungary’s outward orientation, FDI inflows, strong export performance, flexible labor and product markets, and sound banking system. This success was also rooted in undertaking macroeconomic adjustment measures when needed, and in maintaining an adequate level of international competitiveness.

Figure 1.
Figure 1.

Hungary: Transition and Export Performance, 1993-2003

Citation: IMF Staff Country Reports 2004, 145; 10.5089/9781451817881.002.A001

Sources: IMF, World Economic Outlook; Direction of Trade Statistics; EBRD Transition Report, 2003; and IMF staff calculations.1/ The CECs include the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia.2/ Data for 2003 are based on the first three quarters of the year.

2. More recently, while growth held up well despite the global slowdown, developments point to the emergence of significant macroeconomic imbalances.

• As a result of election promises, most public sector employees received a 50 percent increase in wages in the fall of 2002. Together with increases in the minimum wage of over 90 percent during 2001–02, these increases spilled over into the private sector. This resulted in year-average real wages on an economy-wide basis surging by some 13 percent in 2002. Real wage growth slowed in 2003, but remained high at about 7½ percent. Such rapid wage growth had adverse consequences for fiscal policy, inflation, and the current account. (Table 1 and Figure 2, panel C).

Table 1.

Hungary: Main Economic Indicators, 1999–2004

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Sources: Hungarian authorities; International Financial Statistics, IMF; Bloomberg; and IMF staff estimates.

These projections assume the government achieves its fiscal deficit target for 2004.

Consistent with the balance of payment data (not necessarily with the national accounts data).

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

For more on monetary developments see Table 8.

Average of January-February for 2004.

Including inter-company loans, and nonresident holdings of forint-denominated assets; figure for 2003 refers to the third quarter.

Figure 2.
Figure 2.

Hungary: Recent Economic Indicators, 2000–04

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

Citation: IMF Staff Country Reports 2004, 145; 10.5089/9781451817881.002.A001

Sources: Hungarian authorities; and IMF staff calculations.
Figure 2.
Figure 2.

Hungary: Recent Economic Indicators (Concluded), 2000–04

Citation: IMF Staff Country Reports 2004, 145; 10.5089/9781451817881.002.A001

Sources: Direction of Trade Statistics; Hungarian authorities; and IMF staff calculations.

• The jump in government wages and its impact on pensions made it difficult to contain the deficit of the general government (Figure 2, panel D). Combined with spending overruns in health, housing subsidies (see Appendix IV on these subsidies), and interest expenditures (described below), the deficit in 2003, according to preliminary data, was 6 percent of GDP (ESA-95 basis), compared with an original target of 4½ percent (Table 2).

Table 2.

Hungary: Consolidated General Government, 2000-04

(ESA-95 Basis)

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Sources: Hungarian authorites.

Staff estimates.

Based on staff estimates assuming no additional measures are taken other than those discussed in paragraph 13.

• Real GDP growth stayed significantly positive in 2003 (at 2.9 percent). However, consumption–fueled by wage increases, and a sharp drop in household savings and rapid credit growth, both partly stemming from an expanded housing subsidy scheme—was a leading factor (Figure 2, panels A and B).

• Core inflation has recently picked up, and, in the face of rapid consumption demand, wage and price growth in the services sector has been stubbornly high, (Figure 2, panel E). Year-on-year headline inflation reached 5.7 percent in December 2003, compared with the MNB target of 3½ ± 1 percent.

• Rapid consumption growth spilled over into imports (limiting the external sector’s contribution to growth) and the external current account deficit widened to 5.5 percent of GDP in 2003 (Table 3a and Figure 2, panels F and G).1 This widening also reflected the lagged effects of the decline in competitiveness in 2001–02 (Figure 2, panel J) and sluggish exports in the first half of the year, also because of weak external demand. At the same time, net FDI turned negative. The large current account deficit was therefore financed mainly by debt-creating inflows that can be especially volatile in the face of lost policy credibility (Figure 2, panel I).

Table 3a.

Hungary: Balance of Payments, 1999-2007 1/

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Sources: Magyar Nemzeti Bank; and IMF 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.

Including intercompany loans.

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

Table 3b.

Hungary: Balance of Payments, 1999-2007 1/

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Sources: Magyar Nemzeti Bank; and IMF staff estimates.

Incorporates the new methodology, introduced at end-March 2004, for calculating FDI-related income – mainly by including reinvested earnings but also revising estimates of repatriated earnings.

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.

3. Over the course of the past year or so, the imbalances together with policy inconsistencies have weakened policy credibility contributing to volatility in financial markets. Several factors were at play: in the second half of 2003, the pursuit and announcement of a Ft 250–260 per euro target (within Hungary’s ERM2-like exchange rate regime) when policies were inconsistent; conflicting statements by policymakers about the appropriate exchange rate level; and targets and estimates that went unfulfilled (including revisions to the 2003 fiscal deficit target and the mid-December estimate of the 2003 fiscal outcome). As markets became increasingly concerned about external and fiscal developments (and policy credibility generally), Hungary experienced significant bouts of volatility, with the forint weakening to almost Ft 275 per euro in early December (Text Figure and Figure 3). Interest rates were increased to support the currency. The main short-term policy interest rate was increased by 300 basis points in November 2003 to 12½ percent, bringing the total increase to 600 basis points since June.

Figure 3.
Figure 3.

Hungary: Financial Indicators, 2003-04

Citation: IMF Staff Country Reports 2004, 145; 10.5089/9781451817881.002.A001

Sources: Bloomberg; Hungarian authorities; and IMF staff calculations.1/ On the basis of a domestic currency denominated five-year bond. While difficult to disentangle, this differential reflects exchange rate, liquidity, and default risk.
uA01fig01

Volatility Of The Forint Against The Euro 1/

Citation: IMF Staff Country Reports 2004, 145; 10.5089/9781451817881.002.A001

Sources: Bloomberg; and IMF staff calculations.1/ The ratio of the difference between the weekly high and low over the weekly average (expressed in percent).

4. Recent data have, however, included some bright spots that give rise to optimism on the prospects for economic growth (Figure 2, panels F and J–L). The significant deterioration in external competitiveness in 2001–02 was reversed during 2003. This reflected the forint depreciating by about 11 percent against the euro, and wage moderation, alongside steady improvements in productivity, in manufacturing. Industrial production and export growth began accelerating in the second half of 2003. Meanwhile, investment growth was also rising; and although imports were booming, the share of investment goods also increased. In all, the fourth quarter saw year-on-year real GDP growth continuing to gather pace, reaching 3.6 percent.

5. The authorities announced a revised target for the general government deficit in 2004 of 4.6 percent of GDP, compared with an outturn of 6 percent in 2003. While the new target is larger than the original proposal of 3.8 percent, it reflected the slippages in 2003. With a view to enhancing transparency and credibility, the government decided on a more realistic target, rather than risking another miss by a wide margin. Consistent with this revision, expenditures are slated to drop by 1.2 percentage point of GDP compared with 2003; revenues are expected to rise by 0.1 percentage point of GDP, with increases in VAT and social security taxes (of 1 percentage point of GDP) almost offset by declines in other revenues (mostly non-tax receipts).

II. Report on the Discussions

6. Dealing with macroeconomic imbalances and re-establishing policy credibility were the most pressing issues, along with minimizing vulnerabilities on the road to euro adoption. There was general agreement that large fiscal and current account deficits, if left unattended, would impair economic prospects. Moreover, the loss of policy credibility, if not reversed, would make the financing of these twin deficits all the more precarious. Thus, without action, Hungary would be vulnerable to significant exchange rate and interest rate risks in the period immediately ahead. Over the medium term, with the market focused on the timing of euro adoption, shifts in market expectations about progress with nominal convergence will be an ever-present potential source of financial market pressure. Nevertheless, in part because Hungary stacks up well on optimal currency area criteria, the advantages of euro adoption are clear, and a credible target date would surely help to anchor expectations and minimize the output costs of bringing inflation down.2 Thus, developing and expounding a consistent policy strategy with euro adoption in mind and communicating it effectively were key aspects of the discussion.

A. Economic Outlook and Objectives

7. There was broad agreement that the outlook for this year is characterized by a pick up in growth, a temporary acceleration of inflation, and a narrowing of the current account deficit.

• With the envisaged strengthening of foreign demand and the depreciation of the forint in 2003, the external sector and business investment can be expected to make increasing contributions to real GDP growth. Meanwhile, private consumption seems set to slow in response to a slower pace of real wage gain and higher taxes. The National Interest Reconciliation Council (NIRC)—representing government, employers, and employees—recommended an increase in gross nominal wages for the private sector of 7–8 percent; after the mission, the government in late-February agreed with trade unions on an average nominal increase in the wage rate for the public sector of 6 percent. These broad considerations underlie most forecasts, with staff and official GDP growth projections ranging from 3.1 to 3.5 percent (the finance ministry based the budget on 3.5 percent growth).

• The main one-off effects on inflation are adjustments to VAT rates and excise tax hikes. According to MNB estimates, which seem reasonable to staff, the direct effect of these factors will boost the price level by 1.9 percent; the lagged effects of the recent depreciation also raise prices. Assuming no indirect effects and private sector wage growth somewhat above the NIRC recommendation (wage increases have tended to be higher), the MNB projects headline inflation of 6.9 percent at end-2004, compared with its target of 3½ ±1 percent. Largely because of lower assumptions on fuel prices, staff’s projection is 6½ percent. The finance ministry’s projection relies on lower pass-through of VAT and excise adjustments to consumer prices, with recent statements by ministry representatives suggesting inflation might be below 6½ percent.

• A projected narrowing of the current account deficit reflects a slowdown in domestic demand (with slower consumption growth). The narrowing also stems from robust export growth on the back of recovery abroad and the gains in external competitiveness in 2003. Staff projects a deficit of 5¼ percent of GDP, compared with 5.5 percent in 2003 and a sustainable level of roughly 4 percent.3 The MNB projects a deficit of 5.2 percent.

• Various risks were apparent to both the authorities and staff. Among them, a weaker-than-expected recovery abroad would lower growth and widen the current account deficit. It was generally acknowledged that the current account deficit would be larger if consumption growth did not moderate as anticipated. However, staff projections assumed conservative increases in export market share so higher exports and a smaller current account deficit are also possible. The importance of communication was also stressed: avoiding inconsistent policy statements would help to minimize the risks that could arise to investment and growth if policy uncertainty were heightened. Finally, on inflation, the up-tick in 2004 could adversely affect expectations and make it more difficult to keep inflationary pressures at bay; exchange rate weakening is another risk. On the other hand, the pass-through from VAT and excise adjustments could be lower than expected.

8. With respect to the medium term, the authorities were in the process of revising their macroeconomic framework. They noted the difficulties in keeping to the original 2005–06 fiscal targets envisaged in their last Pre-Accession Economic Program (PEP) (2.8 and 2.5 percent of GDP, respectively) in light of the fiscal slippages in 2003. They were also concerned about announcing targets that would be difficult to stick to, in circumstances in which further slippages could hurt credibility. But irrespective of any possible delay in the target date for adopting the euro,4 the authorities saw the importance of fiscal consolidation and containing the current account deficit in its own right, and the need to adjust policy further if the current account deficit did not continue to narrow. The authorities stressed, additionally, their goal of seeing investment once again grow more rapidly than consumption, noting that this, and disinflation over the medium term, would require wage moderation.

9. The authorities were considering various factors related to the timing of ERM2 entry. The government saw advantages to entry soon after joining the EU, as ERM2 could act as a disciplining factor and reinforce credibility. At the same time, the authorities saw the advantages of waiting until both the details of their macroeconomic framework were fleshed out and a narrowing of the twin deficits was more firmly in train. They also recognized the complications in determining the “right” central parity given the fragility of the current conjuncture. Thus, timing was under active review, with a sense that sooner would be better than later. For its part, staff stressed that re-establishing policy credibility and having in place policies that provide greater assurances that the necessary fiscal adjustment and disinflation would materialize were essential for establishing a timeframe for entering ERM2 and euro adoption.

10. Staff’s medium-term scenario, based on continued fiscal consolidation, shows Hungary’s current account moving to a sustainable path. The baseline (Table 4) assumes the authorities meet their target for the general government deficit in 2004 and adjustment in later years is in line with the last PEP (though the level of the deficits would be larger). Thus, the (3 percent of GDP) Maastricht fiscal deficit criterion is met in 2007. With the increase in private saving expected to be insufficient to finance rising investment (also assuming household saving rises only moderately), the current account deficit contracts to about 3.5 percent of GDP by 2007; government and external debt also decline in relation to GDP. Interest rates gradually fall from their currently high levels. The alternative scenario—which assumes fiscal slippage in 20045 and less adjustment than the baseline in later years—illustrates the risks in terms of a higher current account deficit and debt, higher interest rates and interest payments, and, over the medium term, lower growth. More generally, if various downside risks or other shocks were to materialize in line with the stress tests shown in Tables 5 and 6, external and public debt dynamics could become problematic in the absence of a policy response. All this strengthens the case for fiscal adjustment against the background of a large current account deficit.

Table 4.

Hungary: Staff’s Illustrative Medium-Term Scenario

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Source: IMF staff estimates.

These projections assume the government achieves its fiscal deficit target for 2004 and the pace of fiscal adjustment in 2005-06 is the same as in the 2003 Pre-Accession Economic Program (PEP).

Pending further data revision and reconciliation, there is a statistical discrepancy between the private sector savings-investment balance, the general government balance, and the external current account balance of about one-half percent of GDP in 2002 and 2003.

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.

Measuring the output gap is epecially difficult for a transition economy. For 2000 through 2003, the estimates are from the 2003 PEP (except that an adjustment is made for 2003 for the difference between the estimated outcome for actual GDP and the projection contained in the PEP). For 2004-07, potential GDP is assumed to grow by 4 percent.

Table 4 (Continued).

Hungary: Staff’s Alternative Scenario, 2003–07

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ESA-95.

Growth is assumed to differ from the baseline as a result of (i) a different fiscal impulse (measured by the change in the primary fiscal balance, with a multiplier of one-third); and (ii) different government debt (with a 1 percentage

Table 5.

Hungary: Public Sector Debt Sustainability Framework, 1998-2008

(In percent of GDP, unless otherwise indicated)

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Sources: Hungarian authorities; and IMF staff estimates.

Consolidated general government debt, gross debt, ESA-95 basis.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+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 in local currency value of U.S. dollar).

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

The exchange rate contribution is derived from the numerator in footnote 2/ as αε (1+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.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

This scenario is discussed in the text.

The macroeconomic variables in the baseline scenario are broadly in line with market consensus. Thus, this scenario is similar to the baseline.

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

Assumes that key variables (real GDP growth, real interest rate, and primary balance) remain at the level in percent of GDP/growth rate of the last projection year.

Table 6.

Hungary: External Sustainability Framework, 1996-2008

(In percent of GDP, unless otherwise indicated)

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Sources: Magyar Nemzeti Bank; International Financial Statistics, IMF ; and IMF staff estimates.

Derived as [r - g - ρ)(1+g) + εα(1+r)]/(1+g+ρ +gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ= change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in 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(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε <0) and rising inflation (based on 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.