Hungary: Staff Report for the 2005 Article IV Consultation
Author: International Monetary Fund
Publication Date:
29 Jun 2005
eISBN:
9781451818017
Language:
English
Keywords:
ISCR; CR; deficit; GDP; Standard and Poor's; staff projection; revenue shortfall; foreign currency; budget deficit; U.S. dollar; GDP deflator; monetary policy; Current account deficits
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This 2005 Article IV Consultation highlights that Hungary’s economy achieved valuable gains in 2004 with GDP growth recovering to 4 percent. The growth was supported by strong investment and robust export growth. Consumption slowed in response to rising unemployment, a moderation in wage growth and a tightening of the housing subsidy scheme. Despite these favorable developments, risks associated with the twin deficits remained. Although some fiscal consolidation has taken place, the twice upward-revised fiscal deficit target was not met.

Abstract

This 2005 Article IV Consultation highlights that Hungary’s economy achieved valuable gains in 2004 with GDP growth recovering to 4 percent. The growth was supported by strong investment and robust export growth. Consumption slowed in response to rising unemployment, a moderation in wage growth and a tightening of the housing subsidy scheme. Despite these favorable developments, risks associated with the twin deficits remained. Although some fiscal consolidation has taken place, the twice upward-revised fiscal deficit target was not met.

I. Introduction

1. Against the background of weakening growth and declining policy credibility in previous years, Hungary made valuable gains in 2004. A star performer in the late 1990s, Hungary lost ground starting in mid-2001: growth slowed and large budget and current account deficits emerged. Between January 2001 and September 2003, minimum and public sector wages were raised. In combination with housing subsidies and higher pensions, the larger wage bill put upward pressure on the budget deficit. Public sector wages pulled up private wages, which, together with rapid credit growth, induced a surge in consumption. An appreciating real exchange rate and the spillover of consumption into import growth contributed to worsening trade and current account balances. In 2004, real wages stayed relatively flat, growth recovered, its composition improved, inflation was lower, and the current account balance stabilized. Efforts to contain the fiscal deficit and procedures to control government expenditures were steps in the right direction. Although burdened by the memories of large policy swings, monetary policy achieved greater predictability.

2. Regaining sustainable control over fiscal policy remains the key challenge. The legacy of repeatedly missed budget deficit targets and the decline in fiscal transparency—including in 2004—continue to generate policy uncertainty, presenting a serious risk to further structural transformation and growth. Sustainable fiscal reforms are needed to achieve euro adoption by the authorities’ targeted date of 2010, and also to crowd in private investment and reduce the current account deficit (Box 1). The government has committed to further fiscal consolidation before the April 2006 elections. However, election years have not been propitious for fiscal reform and consolidation (Text Figure 1). The relatively benign current international environment and Hungary’s catch-up potential argue for taking decisive steps—delays will only make the task harder.

Text Figure 1.
Text Figure 1.

Hungary: Fiscal Deficits and Election Years

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

II. Recent Economic Developments

3. Brisk growth in the first half of 2004 was helped by a bounce in the euro area economy. Following growth of 3–3.5 percent in 2002–03, GDP rose in 2004 by 4 percent (Figure 1 and Table 1). Growth was especially buoyant in the first half of the year, based on strong export and investment performance, but slowed in the second half. These developments were influenced by Hungary’s close ties to the euro area. A weaker labor market moderated consumption growth. The unemployment rate increased from 5.5 percent in the last quarter of 2003 to 6.3 percent in October-December 2004; labor force participation remained low, at 60.5 percent in 2004, compared with 68 percent in the euro area. A slowing of public sector wage growth dampened private wages.

Figure 1.
Figure 1.

Selected Economic Indicators

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Sources: Hungarian authorities, Eurostat, IFO.
Table 1.

Hungary: Main Economic Indicators, 2000–06

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

In 2004, adjusting for the 13th-month bonus paid out in January 2005 results in public sector wage growth of 5.7 percent.

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

Includes change in inventories.

Consists of the central budget, social security funds, extrabudgetary funds, and local governments. Includes the costs of pension reform

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

Response to Fund Advice

The authorities have generally concurred with the thrust of Fund advice, including the need for fiscal consolidation and structural reforms. However, domestic political considerations have limited the implementation of the Fund’s recommendations.

Fiscal policy. Public wages were restrained in 2004. But only modest steps were taken to implement measures on government employment, pensions, social benefits, subsidies, education, and health care, as recommended by the Fund’s previous technical assistance. Staff’s suggestion to establish a three-year rolling fiscal framework has also not been adopted.

Interest rate policy. After the sizable interest rate hikes in 2003 to defend a depreciating forint, the policy rate was gradually lowered in 2004 following the faster-than-expected decline in inflation, broadly in line with the Fund’s recommendations. The authorities continue, however, to indicate to markets the appropriate range of the exchange rate, despite being in an inflation-targeting framework.

Financial sector. The recent Financial Sector Assessment Program (FSAP) update concluded that the regulatory and supervisory framework had significantly improved over the last four years, as recommended in the 2000 FSAP.

4. An encouraging fall in the rate of inflation started in June 2004 (Text Figure 2). The 2004 average inflation rate—just under 7 percent—reflected one-off effects of value-added tax (VAT) and excise tax rate hikes in early 2004 and higher oil prices; excluding the direct effect of the tax rate increase, average inflation was 4.8 percent. Inflation fell through much of the year—indicating that the tax adjustments did not have persistent effects—and on a month-on-month basis was down to an annualized rate of 3.5 percent by year’s end. The prices of traded goods are now rising at about the same rate as those of imported goods (Text Figure 3). From a regional perspective, Hungary’s inflation remains relatively high, reflecting the slower decline in the inflation of nontraded goods and services prices.

Text Figure 2.
Text Figure 2.

Regional CPI Inflation

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Text Figure 3.
Text Figure 3.

Hungary: Prices of Traded, Nontraded, and Imported Goods

(q/q(-1) annualized percent change)

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

5. Still preliminary data suggest that the general government deficit fell in accrual (European System of Accounts (ESA) 1995) terms in 2004. When the contributions to the second pillar of the pension scheme are added to government revenues, the general government deficit fell from 6.2 percent in 2003 to 4.4 percent of GDP in 2004 (Table 2). Excluding these notional revenues, the budget deficit declined from 7.2 percent to 5.4 percent of GDP. The deficit targets were revised upward twice during the year, in large part due to overspending and lower-than-projected VAT revenues. Moreover, the trends in VAT refunds remain unclear, and their accounting conventions have not been finalized; the deficits for 2003 and 2004 may, therefore, be revised further.

Table 2.

Hungary: Consolidated General Government, 2000-05

(ESA-95 Basis)

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Sources: Hungarian authorities, and staff estimates.

Staff estimates, assuming that part of the reserves (0.6 percent of GDP) will not be spent.

Including social security contributions.

6. The extent of the underlying fiscal consolidation, however, was less than suggested by the decline in the fiscal deficit. As one indication of this, the cash deficit (Government Finance Statistics (GFS) 1986 definition) actually rose (Text Table 1). Consolidation was helped by restraint in the wage bill and capital expenditures. The wage bill was reduced by 1 percent of GDP. But half of that reduction resulted from a change in the convention to account for bonus (or “thirteenth-month” salary) payments to public employees. Under the new convention, payments made in January 2005 were shifted to the 2005 budget rather than accruing to 2004; the January 2004 payments were treated as 2003 expenditures on an accrual basis. Also contributing to the larger cash deficit was another one-off effect: about one month of VAT receipts due in 2004 but delayed following procedural changes related to EU accession will be recorded in 2004 on an accrual basis.

Text Table 1.

Hungary: Cash-Based and Accrual Fiscal Deficit

(In percent of GDP)

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Sources: Hungarian authorities and staff estimates.

The figure for 2004 includes top-up payments to farmers.

The figures for 2003 and 2004 have been adjusted following the new methodology for recording VAT refunds.

7. The current account deficit stabilized at about 9 percent of GDP in 2004. The size of the deficit reflects the relatively low savings rate (15 percent of GDP)—the result of the public deficit and declining private savings rates—and a stable investment rate (24 percent of GDP) (Text Figure 4). Foreign direct investment (FDI), which averaged 8 percent of GDP in the late 1990s (more than 100 percent of the current account deficit), fell in 2003 to 2.6 percent of GDP before recovering to 4.2 percent in 2004 (Text Figure 5 and Table 3). Despite higher FDI in 2004, the large current account deficit required significant debt-creating financing.

Text Figure 4.
Text Figure 4.

Hungary: Savings and Investment

(Four-quarter rolling basis, in percent of GDP)

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Text Figure 5.
Text Figure 5.

Hungary: Current Account Deficit and Foreign Direct Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Table 3.

Hungary: Balance of Payments, 2000-2008

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Sources: Magyar Nemzeti Bank; and IMF staff estimates.

Including intercompany loans.

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

8. Financial markets remain generally optimistic about Hungarian prospects. In 2004, the forint strengthened by 7 percent against the euro (Figure 2) despite a sharp decline in policy interest rates. Even following the currency’s recent weakening, the exchange rate has been close to the strong edge of its band (a 15 percent range around a central parity of 282.36 forint per euro) (Text Figure 6). Risk premiums on both domestic and foreign currency bonds have fallen with improved sentiment toward the region. Financial markets may, however, be differentiating Hungary from its neighbors. Fitch downgraded Hungary’s local currency rating in January 2005 in response to concerns about the twin deficits. The magnitudes of exchange rate appreciation and spread compression have been smaller than those of other countries in the region, and forward spreads on local currency bonds have not narrowed, reflecting greater uncertainty regarding the timing of euro adoption (Figure 2).

Figure 2.
Figure 2.

Selected Financial Indicators, 2003-05

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Sources: Bloomberg, Deutsche Bank.1/ Maturing in five years, compared to bunds.2/ Foreign currency bond spreads to Germany maturing in 2010, Czech Republic matures in 2014.
Text Figure 6.
Text Figure 6.

Hungary: Forint per Euro Spot Rate

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

III. Report on the Policy Discussions

9. The authorities have anchored their policy program to the goal of adopting the euro by 2010, but this goal has not yet been supported by an active agenda of broad structural reforms. Meeting the fiscal deficit and public debt Maastricht targets will require substantial effort, despite the revisions to the Stability and Growth Pact (Box 2). Staff urged that the Maastricht criteria be achieved with a more forceful agenda of sustainable reforms. This would not only ensure successful euro adoption but also vibrant economic performance thereafter. If euro adoption is achieved largely by ad hoc measures, the scope for future policy maneuver will be reduced, and long-term growth will likely be anemic. In this context, the discussions centered on the economic outlook, the state of public finances, the strengthening of monetary policy, financial sector stability, and structural policies for increasing employment and productivity.

Revisions to the Stability and Growth Pact: Implications for Hungary

In its report of March 21, 2005, the ECOFIN Council presented proposals for “strengthening and clarifying the implementation of the Stability and Growth Pact (SGP).” When assessing whether the excessive deficit procedure (EDP) applies and whether a country complies with the Maastricht criteria, “other relevant factors” (e.g., the adjustment costs of mandatory, fully funded pension pillars) will be taken into account on a case-by-case basis. However, the overarching principles will remain: compliance with the deficit criterion requires that the deficit be close to the reference value (3 percent of GDP) and that the excess be temporary. In practice, the allowance seems unlikely to be greater than 0.5 percent of GDP. Against this background, the table below reports Hungary’s current position relative to the pre-revision Maastricht ceilings.

Table 1.

Hungary: The Maastricht Criteria

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Sources: IMF, World Economic Outlook; Hungarian authorities; and European Commission.

Criterion is 1.5 percentage points above three best performers. The figures for 2004 are actual.

Criterion is 200 basis points above the three best performers in terms of inflation. The figures for 2004 are actual.

A. Short-Term Outlook

10. The slowdown of the economy in the second half of 2004 appears to have persisted in early 2005. Industrial production (Figure 1) and indices of business sentiment are down (Text Figure 7), mirroring the weakening euro area economy. The unemployment rate has continued to rise, reaching 7.1 percent in the first quarter of 2005. Staff expects real GDP to grow at 3.4 percent in 2005 (Table 4), somewhat lower than the authorities’ projection of 3.5–3.8 percent and the consensus forecast of 3.6 percent. Staff projects that the current account deficit will decline to 8.6 percent of GDP, as the trade balance stabilizes in GDP terms and net current transfers through EU funds increase.

Text Figure 7.
Text Figure 7.

Hungary: Industrial and Retail Business Confidence

(Balance, 3-month moving average)

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Table 4.

Hungary: Staff’s Illustrative Medium-Term Scenario

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Sources: IMF staff estimates, Hungarian authorities.

Includes change in inventories.

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

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.

The exclusion of the costs of the pension reform is as indicated under the revised Growth and Stability Pact.

11. The decline in inflation can be expected to continue. Average inflation in 2005 is projected at 4 percent. The authorities assessed that the recent disinflation had been helped by intensified import competition following EU accession and by an appreciating exchange rate. They noted that the indirect tax hikes in early 2004 had not produced second-round effects on inflation. This observation is consistent with staff findings of low inflation persistence associated with forward-looking behavior of price setters and consumers (documented in an accompanying selected issues paper). Upside risks to inflation arise from movements in oil, other commodity, and unprocessed food prices; a reacceleration of wage growth; and a hike in the tobacco excise duty in 2006 (which is expected to affect the core consumer price index (CPI)).

12. The authorities acknowledged significant risks exist to meeting the 2005 budget deficit target of 3.6 percent of GDP (or 4.7 percent of GDP excluding the second-pillar pension contributions). The 2005 budget assumed GDP growth and inflation at 4 and 4½ percent, respectively, higher than the currently projected outcomes. Staff estimates that the slower growth and lower inflation could cause a revenue shortfall of about 0.6 percent of GDP. While recognizing this possibility, the authorities remain more concerned that shortfalls in projected VAT revenues could continue on account of administrative problems. In addition, the risks of overspending are serious. The traditional risk of municipal overspending is aggravated by the political cycle. Of concern also are possible overruns in open-ended spending obligations (including transfers to institutions under ministries’ purview) and pharmaceutical and housing subsidies. Past commitments (such as the thirteenth-month pension) have added to budgetary pressures and rigidities, further reducing budgetary flexibility and the ability to deal with unexpected revenue shortfalls or urgent expenditure requirements.

13. The evident risks to the deficit target will require careful use of budgeted reserves and expenditure controls. Between January and April, the cash deficit reached about 70 percent of the annual target. While some part of this deficit (that relating to delayed VAT refunds) would be recorded in 2004 on an accrual basis and the early part of the year is usually associated with large expenditures, the task for the rest of the year is a difficult one. Thus, staff emphasized that meeting the budget deficit target would require the careful release of reserves (overall 1.3 percent of GDP), based on timely identification of priority spending. There is also a need to strictly enforce the measures to limit overspending and the carryover of unused funds introduced in the 2005 budget law. If these restraints prove infeasible, staff project a deficit overshoot of 0.6 percent of GDP, which will raise the risks of a larger current account deficit, increased debt and slower growth in the medium-term.

B. Medium-Term Trends

14. Seen from a regional perspective, Hungary’s growth advantage has faded. In the late 1990s, Hungary’s reputation as a star performer was based on its rapid and consistent growth record (Figure 3). As its growth rate slowed (from an average of 4.7 percent between 1997 and 2000 to 3.6 percent a year between 2001 and 2004), so did its position relative to the other new EU member states. The short elapsed period precludes a firm assessment, but moderation in total factor productivity (TFP) growth (Figure 3) appears to have accounted for Hungary’s slower recent growth.

Figure 3.
Figure 3.

Growth Trends, 1997-2004

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Sources: IMF staff estimates, country authorities.

15. The authorities were concerned that medium-term growth may be constrained by the apparent trend decline in potential growth. In line with the authorities’ view, staff estimates show that potential growth (based on a production function approach) declined from just under 5 percent a year in the late 1990s to about 3½ percent in 2004 (Figure 3), possibly reflecting the winding down of the privatization process. Cross-country benchmarks suggest that Hungary’s potential growth rate could be considerably higher than the current 3½ percent. A staff analysis of the European growth experience—taking into account the catch-up potential due to lower initial per capita income and access to foreign capital—shows Hungary’s long-run growth potential to be in the 3.8–5.8 percent range (Box 3). If potential growth remains unchanged at the lower end of this range, growth beyond 2005 will stay in the range of 3½ to 4 percent a year, with movements reflecting euro area growth. As the authorities recognized, raising potential growth will require structural reforms to achieve higher productivity growth and greater labor force participation.

16. In the medium-term, the projected decline in the current account is crucially dependent on fiscal consolidation. With the effective real interest rate on external debt expected to be lower than the growth rate, at the current exchange rate the external debt-to-GDP ratio is projected to decline from 63 percent in 2004 to 56 percent in 2010. Increased EU resources will also reduce reliance on external borrowing. A setback to fiscal tightening and a variety of shocks, including to growth and FDI, could reverse the projected decline in the external debt ratio (Figure 4 and Table 5).

Figure 4.
Figure 4.

Hungary: Debt Dynamics, 1999-2010

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Sources: Hungarian authorities, IMF staff estimates.
Table 5.

Hungary: External Sustainability Framework, 1999-2010

(In percent of GDP, unless otherwise indicated)

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Sources: Magyar Nemzeti Bank; International Financial Statistics, IM; 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)]/(l+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.

17. The authorities do not regard the exchange rate as the main mechanism for maintaining competitive exports and reducing the current account deficit. CPI - and unit labor cost (ULC)-based real exchange rates have appreciated in recent years (Figure 5). Since significant uncertainties surround the estimates of the equilibrium exchange rate, several considerations were discussed. The authorities judged that Hungary’s high-tech export structure had, in part, insulated its exports from the real wage increases. However, staff cautioned that the technological upgrading of the economy may have slowed and Hungary faced increasing competition from other industrializing countries (Figure 5). Moreover, at least in the short run, an appreciation of the real exchange rate appears weakly associated with slower domestic production of traded goods (Figure 6). While the relative productivity of Hungary’s tradable and nontradable sectors has recently moved in line with that of its trading partners, the accumulation of net external liabilities raises questions about real exchange rate misalignments. Given the uncertainties, however, staff agreed with the authorities that the focus should be on measures to raise productivity growth and the savings rate, which are crucial for long-term external sustainability.

Figure 5.
Figure 5.

Selected Competitiveness Indicators

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Sources: UN Comtrade database; Taxonomy of export categories is based on Landesmann and Stehrer (2003).1/ Figures for 2004 are through November.
Figure 6.
Figure 6.

Hungary: Selected External Indicators

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Sources: Hungarian authorities, IMF staff estimates.

Growth and the Current Account

Hungary’s GDP growth rate averaged about 3½ percent a year between 2002 and 2004, while its current account deficit was around 9 percent of GDP. A country with the potential to catch up to the technology and income levels of advanced economies can be expected to grow relatively rapidly, while also spending more than its current income—that is, borrowing capital from the rest of the world and, hence, running current account deficits. How much of Hungary’s growth and current account deficit can be explained by this catch-up—or income convergence—process?

A cross-country analysis of European economies suggests that, in general, larger current account deficits (capital inflows) are associated with faster income convergence. However, the model’s benchmark for Hungary suggests that its current account deficit has been larger than would be expected based on the income convergence process. Hungary’s current account deficit of 9 percent of GDP was about 2½ percent of GDP larger than the central prediction of the model, though just within the statistical confidence band (Figure 1). Growth of 4 percent in 2004 was about 1 percentage point less than the central prediction (Figure 2).

Figure 1.
Figure 1.

Hungary: Current Account Predicted by Model

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

Figure 2.
Figure 2.

Hungary: Growth Predicted by Model

(In percent)

Citation: IMF Staff Country Reports 2005, 213; 10.5089/9781451818017.002.A001

C. Public Finances

18. The authorities reiterated their commitment to the targets set out in the government’s Convergence Program (CP). A fiscal consolidation relative to GDP of 0.6 percentage point per year is targeted over the next three years. In achieving consolidation, the authorities recognized that the recent divergence in accrual and cash deficit trends cannot be allowed to persist, and staff urged that changes in accounting conventions be minimized. Staff emphasized that lowering the deficit below the Maastricht limit was important, not only for euro adoption, but also because fiscal tightening, if achieved with high-quality sustainable measures, would improve macroeconomic stability, address debt sustainability issues, and contribute to higher growth. The public debt-to-GDP ratio is at 60 percent, and stress tests show that a slowdown in real growth could raise the debt ratio well above the Maastricht ceiling by 2010 (Figure 4 and Table 6). Staff, therefore, pointed out that as long as debt remained at this level the authorities would need to be prepared to respond quickly with more ambitious fiscal consolidation should debt dynamics turn adverse. Further consolidation was also desirable to make room for automatic stabilizers.

Table 6.

Hungary: Public Sector Debt Sustainability Framework, 1999-2010

(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 - π (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).