Hungary
Request for Stand-By Arrangement-Staff Report; Staff Supplement; and Press Release on the Executive Board Discussion
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International Monetary Fund
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Publication Date:
17 Nov 2008
eISBN:
9781451818116
Language:
English
Keywords:
ISCR; CR; request; Hungary; financial support; IMF arrangement; The Fund; short-term debt; banking sector; current account; stabilization fund; central bank; Commercial banks; government bond; balance of payments
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This staff report for the Request for Stand-By Arrangement of Hungary examines financing conditions and economic challenges. Hungary was among the first emerging market countries to suffer from the fallout of the current global financial crisis. Compared with other emerging markets, Hungary’s higher stock vulnerabilities imply that a large amount of debt needs to be serviced and rolled over. Added risks include the large share of foreign currency lending by both domestic banks and subsidiaries of foreign parents.

Abstract

This staff report for the Request for Stand-By Arrangement of Hungary examines financing conditions and economic challenges. Hungary was among the first emerging market countries to suffer from the fallout of the current global financial crisis. Compared with other emerging markets, Hungary’s higher stock vulnerabilities imply that a large amount of debt needs to be serviced and rolled over. Added risks include the large share of foreign currency lending by both domestic banks and subsidiaries of foreign parents.

I. Background and Recent Economic Challenges

1. Hungary was among the first emerging market countries to suffer from the fallout of the current global financial crisis. As financial difficulties in advanced economies led to a decline in global liquidity and an increase in risk aversion, investors increasingly started differentiating among emerging markets. Hungary’s high debt levels and significant balance sheet mismatches negatively affected investor appetite for Hungarian assets. While there was an earlier short episode of financial stress in March 2008, Hungary’s financing conditions deteriorated sharply in mid-October 2008.

2. Balance sheet vulnerabilities built up over a long period, reflecting both excessive borrowing by the Hungarian public and private sectors, and the high risk appetite of foreign investors (Figure 1):

  • Large fiscal deficits led to rising government debt. The general government deficit averaged more than 8 percent of GDP between 2002 and 2006, and tended to rise sharply in the run-up to parliamentary elections. As a result, general government debt amounted to 66 percent of GDP as of end-2007. In addition, the size of government is relatively large compared to other countries at similar comparable income levels.

  • Banks, including foreign-owned banks, played an important role in Hungary’s increasing financial integration with the rest of Europe. The main domestic bank accounts for 21 percent of banking system assets and the major foreign-owned banks account for another 52 percent. Starting from a low base, bank credit as a share of GDP has risen steadily, though is still low compared to advanced economies in Europe. With easy access to foreign currency-denominated funding, foreign-owned banks offered foreign currency-denominated loans, and this was copied by domestic banks. Households and many corporates found the lower interest rates on foreign currency-denominated borrowing to be attractive, even though they have no natural hedge against foreign exchange risk. Banks hedge their exposures, so their foreign exchange positions are broadly balanced, but the domestic nonfinancial sector is carrying a high degree of exchange rate risk, which could translate into credit risk for banks. Over half of bank lending to the nonfinancial sector is denominated in foreign currency (mostly euro and Swiss francs).

  • Sizeable financial inflows led over time to a high level of public and private external debt. Hungary started the 1990s with higher external debt than neighboring countries in central and eastern Europe, reflecting a history of greater openness to the global economy. Along with the transition to a market economy and the process of accession to the European Union came substantial financial inflows that boosted productivity but also added to external liabilities. Financial inflows initially consisted mostly of foreign direct investment but—as financial and real integration with the rest of Europe deepened—shifted increasingly to debt-creating flows. External debt amounted to about 97 percent of GDP at end-2007.

Figure 1.
Figure 1.

Hungary: Vulnerabilities, 1995–2007

Citation: IMF Staff Country Reports 2008, 361; 10.5089/9781451818116.002.A001

Sources: Hungarian Ministry of Finance; Magyar Nemzeti Bank; and IMF staff calculations.1/ Consolidated loans of MFIs to non-government residents.

3. To reduce vulnerabilities, macroeconomic and financial policies had been strengthened since 2006. Substantial fiscal consolidation began in mid-2006 and tax administration had improved significantly. With the fiscal deficit falling from 9¼ percent of GDP in 2006 to 5 percent of GDP in 2007, the general government debt-to-GDP ratio stabilized. Regarding monetary policy, the design and implementation of the inflation targeting framework have been in line with international best practice, and the exchange rate band was eliminated in early 2008. CPI inflation, after surging in early 2007 due to the increases in VAT rates and excise taxes associated with the fiscal consolidation, has been falling steadily (notwithstanding the rapid increases in global food and energy prices in 2008) to 5¾ percent in September 2008. In the financial sector, the authorities published guidelines on banks’ risk management and consumer protection related to foreign currency loans.

4. Reflecting the impact of fiscal consolidation on domestic demand, economic growth slowed and the current account deficit narrowed in 2007 (Figure 2). Weaker domestic demand led to some easing of pressures on resource constraints. However, credit growth remained robust, reflecting investment in export-oriented industries and some smoothing of consumption. As a result, households’ debt service burden kept rising and, with most new borrowing in foreign currency, household and corporate sector net foreign currency liabilities increased. Export growth remained solid, reflecting in part exporters’ ability to expand into fast-growing markets in emerging market countries. The substantial improvement in the trade surplus was partly offset by a deterioration in net income, due largely to higher earnings of export-oriented foreign-owned companies. The composition of external financing remained largely debt-creating, though this reflected in part one-off transactions related to the change in ownership of Budapest airport and share buy-backs by the state-owned oil company.

Figure 2.
Figure 2.

Hungary: Recent Macroeconomic Developments, 2003–08

Citation: IMF Staff Country Reports 2008, 361; 10.5089/9781451818116.002.A001

Sources: Magyar Nemzeti Bank; European Commission; and Hungarian Statistical Office.

5. Even though policies had been strengthened in recent years, the combination of Hungary’s high debt levels, its role as the home country of a regionally active bank, and global deleveraging gave rise to liquidity pressures (Figure 3). Financial markets in Hungary have come under significant stress in recent weeks, reflecting the decline in foreign investors’ appetite for domestic currency-denominated assets and the rise in perceptions of counterparty risk. Banks are having difficulties rolling over maturing foreign currency swaps. Auctions of government securities have been less than fully successful and liquidity in the secondary government securities market has tightened. At the same time, government bond yields and sovereign CDS spreads have risen sharply, the stock market has fallen, and the currency has depreciated. Several banks have announced that they will slow the growth of lending, particularly foreign currency-denominated lending.

Figure 3.
Figure 3.

Hungary: Recent Financial Market Developments, 2005–08

Citation: IMF Staff Country Reports 2008, 361; 10.5089/9781451818116.002.A001

Sources: Bloomberg; Haver DLX; and Eurostat.

6. The key economic challenges include the full recognition of all underlying risks and a stronger policy response. Compared to other emerging markets, Hungary’s higher “stock vulnerabilities” imply that a large amount of debt needs to be serviced and rolled over. Added risks include the large share of foreign currency lending by both domestic banks and subsidiaries of foreign parents. These exposures were hedged, but the use of foreign exchange swaps for this purpose exposed systemically important banks to significant rollover risk in the foreign exchange swap market. Past policy action has been insufficient to reduce these risks. In particular, fiscal and current account deficits of recent years did not come down sufficiently.

II. The SBA-Supported Program

A. Overall Program Objectives

7. The SBA-supported program is designed to strengthen Hungary’s economy and thereby a foster a return of less stressed financial market conditions. A strong emphasis on credibility reflects the nature of the crisis, and Hungary’s relatively high dependence on foreign financing. Program goals also reflect the authorities’ and the staff’s agreement on longer-term policy priorities for Hungary. They include the need to reduce the size of the comparatively large public sector in the country, and to lower the structural risks stemming from balance sheet mismatches in Hungary’s financial sector. This program is consistent with Hungary’s commitments to the European Union (Box 1).

8. The program will also reduce regional vulnerabilities and spill-over effects that could result from prolonged financial instability in Hungary. A Hungarian financial group is active in several emerging market countries in Central and South Eastern Europe. Ensuring that this group remains strong and well capitalized will enhance credibility of its subsidiaries, and reduce the risk of instability in its host countries. In addition, banks from different euro-zone countries are active and prominent in Hungary. If unaddressed, any crisis in Hungary could have significant negative spill-over effects back to the home markets of these banks.

9. The program is based on strong, highly visible policy measures, coupled with sizeable financial support. Together, these two pillars are expected to stabilize expectations in key markets, thus support rollover rates, and lay the foundation for a return of investor confidence.

  • Strong policy program: The main pressure points in Hungary are the public finances and the banking sector. Given Hungary’s large public debt, substantial fiscal adjustment is needed to provide confidence that the government’s financing needs can be met in the short and medium run. At the same time, upfront bank capital enhancement is needed to ensure that banks are sufficiently strong to weather the imminent economic downturn, both in Hungary and in the region.

  • Large external financing assistance is essential to minimize the risk of a run on Hungary’s debt and currency markets, given the large external debt stock. With the holders of Hungarian debt being a broad and diversified group, official intervention in the form of a very substantial external financial buffer will help to shore up private investor confidence. At the same time, large private sector creditors—notably the foreign parent banks of the major banks in Hungary—have been encouraged to maintain their exposures to Hungary and have responded favorably.

Hungary: Cooperation with the European Union

Article 119 of the Treaty Establishing the European Community requires that a non-euro area member country consult with the European Commission and the European Union’s economic and financial committee (EFC) on its balance of payments needs before seeking assistance from other sources. Prior to the recent events in Hungary, no operating procedures had been developed for such interaction between the EU and the IMF. The process as developed in the case of Hungary could, however, become a reference on how to proceed should further cases of a similar nature arise—i.e., EU member states that are not participating in the ERM II mechanism. Key principles would include:

1. Early consultation and ongoing information exchange during program negotiations: Fund and Commission staff consulted each other as soon as Hungary reported difficult financial market conditions and the potential need for balance of payments support. In view of the severity and urgency of Hungary’s situation, the EU agreed that consultation with the EU and IMF could be in parallel, and ensured a highly accelerated implementation of normal consultation procedures (e.g. through conference calls). An EU mission overlapped with the IMF mission in Budapest for the first few days. During the remainder of the mission both teams cooperated, and coordinated efforts to proceed at the same pace. When discussions had well advanced but before final agreement had been reached both IMF and the Presidency of the Ecofin Council and the Commission made coordinated announcements to the press on their readinness to provide support to Hungary.

2. Contribution of both institutions to financing needs. The final program package (€20 billion) contains sizeable contributions from the IMF (€12.5 billion) and the EU (€6.5 billion), as well as a contribution from the World Bank (€1 billion).

3. Joint announcement to underline broad support. Staff level agreement on the programming package and the EU agreement to participate in the support package were announced in coordinated press releases by the IMF and the EU before financial markets opened on October 29. Both institutions attended a press conference later that day organized by the authorities. The IMF and EU support will be front loaded to address the urgent balance of payments needs early under the program.

4. Consistency of program design and conditionality. Both institutions will rely on policy conditionality to support program implementation. As agreed during the initial discussions among the institutions on procedures, it is expected that the EU conditionality to be included in the EU Council decision and Memorandum of Understanding will be consistent with IMF conditionality. In addition, EC surveillance mechanisms will incorporate policy commitments made by the authorities.

5. Consultation during the program monitoring process. With staff level links firmly established, there will be regular consultation during the program period. In cases where deviations from the program trigger consultation under the IMF program, the authorities will in parallel inform the EU and both institutions will coordinate closely during the related discussions.

B. Macroeconomic Framework

10. The Hungarian economy’s response to the global deleveraging is expected to be similar to the pattern of previous capital account crises, though less severe. There are four mitigating factors. First, unlike Asia in 1997-98, Hungary is starting from a period of low growth rather than overheating; second, EU structural funds are expected to provide a stable source of financing and to limit the fall in investment; third, the program includes assurances from foreign parent banks that they will maintain their exposures;1 and finally, early policy action and external support will be in place at the outset, helping to head off negative feedback loops.

11. Given the global and domestic downturn, the adjustment in 2009 will be significant (Table 1):

  • Output is expected to contract by about 1 percent in 2009. Already weak private consumption and investment will be negatively affected by both a sharp reduction in new bank lending and the depreciation of the exchange rate, which increases debt servicing on foreign currency denominated loans. With no fiscal space and tight financing conditions, fiscal policy will not be able to provide stimulus.

  • Inflation, which peaked at 9 percent (year-on-year) in early 2007, currently stands at 5¾ percent. It is expected to continue its downward trend and reach 4 percent at end-2009. The opening of a large negative output gap and the decline of global food and energy prices is expected to outweigh the effect of the depreciation of the exchange rate.

  • The current account has already been gradually narrowing in past years (Table 2). It is projected to drop by more than 4 percentage points of GDP between 2008 and 2009, mainly due to the depreciation of the real exchange rate—well within the range observed among recent capital account crisis countries—and lower growth. The process will be driven primarily by a sharp contraction of imports (which are partly upheld by imports related to investments related to EU-funds).

  • The balance in the capital and financial account is expected to fall from a surplus of €8.2 billion in 2007 to €6.4 billion in 2008 (with a large deterioration in the last quarter) and to a deficit of €7.5 billion in 2009 (with some improvement late in the year, when markets will have regained confidence). The capital account will improve somewhat as the absorption of already committed EU funds increases. However, net portfolio flows (which include financial derivatives, notably swaps), external borrowing by the government and lending to corporates are expected to slow sharply. Foreign-owned banks, which account for some 60 percent of banks’ short-term external debt, are cautiously assumed to roll over 80 percent of their funding from parent banks. Rollover rates for other forms of debt are assumed to be 70 percent.2

Table 1.

Hungary: Main Economic Indicators, 2005-09

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

Includes change in inventories.

Consists of the central budget, social security funds, extrabudgetary funds, and local governments, as well as motorway investments previously expected to be recorded off-budget in 2006-07.

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

Table 2.

Hungary: Balance of Payments, 2007-11

(In millions of euros)

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Sources: Hungarian authorities and IMF staff projections.

12. In a difficult global environment and with low domestic demand, the economy is projected to recover only gradually. Growth is expected to reach its estimated potential of 3 percent after 2011 (Table 3). This U-shaped adjustment pattern (rather than the V-shaped. pattern observed in previous capital account crises) reflects the simultaneous GDP slowdown in Hungary’s main trading partners and the global deleveraging process, which leaves less foreign capital available to quickly return to Hungary than was the case after the Asian crisis. After contracting sharply in 2009, the current account adjusts slowly over the medium term due to sluggish response of investment, combined with a slow improvement in national savings.

Table 3.

Hungary: Staff’s Illustrative Medium-Term Scenario, 2005–11

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Sources: Hungarian authorities; and IMF staff projections.

Includes change in inventories.

Includes intercompany loans.

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

C. Fiscal Policy Stance and Fiscal Framework

13. In recent years, fiscal consolidation has been the cornerstone of the government’s efforts to reduce macroeconomic vulnerabilities (Table 4). This fiscal strategy was adopted in mid-2006 following several years of expansionary policies and high fiscal deficits. While consolidation brought the headline deficit figures down from 9¼ percent of GDP in 2006 to an expected 3.4 percent in 2008, past fiscal excesses have left Hungary vulnerable to a government funding crisis, given the large size and the maturity structure of government debt. Looking forward, the growing interest burden on outstanding debt will thus also limit the room for maneuver for further fiscal adjustment. Fiscal consolidation is also constrained by the composition of expenditures, including a comparatively high government wage bill, and a high share of pensions and social transfers.

Table 4.

Hungary: Consolidated General Government, 2006-11 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Hungarian authorities; and IMF staff estimates.

Data are classified following the ESA'95 methodology, as reported to the European Commission.

Including social security contributions.

For 2009, the aggregate overall balance of local governments (cash basis) is expected to be around HUF 135 billion (slightly less than 0.5 percent of GDP). Over the last 10 years, local government finances have exhibited relatively small deficits or surpluses.

14. Given still high vulnerabilities, the authorities believe that further fiscal consolidation is needed for a credible medium-term policy stance (Box 2). Foreign participants play an important role in the Hungarian treasury bill and government bond markets.3 Funding difficulties experienced in March 2008 and more pronounced at the outset of the current crisis in October 2008, indicate that continued rollover of the large outstanding stock will require more ambitious fiscal targets to reassure markets about the solvency of the public sector. The authorities are concerned that a more accommodative stance—while politically less difficult—would put the success of the overall program at risk.

15. The authorities’ initial reaction to the crisis reflected their view that fiscal policy was insufficiently tight. Fiscal policy for 2008 was tightened after the first signs of trouble in the treasury bill market. After policy adjustment, primary government expenditures as a share of GDP are expected in 2008 to remain below the level envisaged in the budget. This will be achieved mainly by the government’s recent decision not to use reserves that were built into the budget. As a result, the general government deficit is projected to fall from 4.9 percent in 2007 to 3.4 percent of GDP in 2008.

16. In response to the further deterioration of market confidence, the program envisages a substantial revision of initial fiscal plans for 2009. The authorities’ proposals include a further tightening of the budget in an amendment to be submitted to parliament in early November (LOI ¶9). They reflect both the need to offset the revenue loss stemming from the deterioration in the economic outlook and the government’s aim to reduce the borrowing requirements (Table 4). The program envisages a general government deficit of 2.5 percent of GDP in 2009, which would imply a large structural fiscal adjustment of 2½ percent of GDP (2 percentage points of GDP more than envisaged in the 2008 Article IV staff report). The program also envisages higher interest payments, reflecting mainly higher interest rates, and incorporates the financing needs in the fourth quarter of 2008 and the first quarter of 2009 connected with the bank-support package (Table 5). If there is a further deterioration in the macroeconomic outlook, staff will consult with the authorities on policy adjustments.

Table 5.

Hungary. Borrowing Requirement of the Central Government System, 2008-09

(In billion of forints)

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Sources: Hungarian authorities; and IMF staff estimates.

Overall budget balance of the central government system (cash basis) and costs of banking sector rescue package.

No issuance in foreign currency, no net domestic currency issuance, rollover of maturing debt of 75 percent (08Q4 and 09Q1), 85 percent in 08Q2, 95 percent in 09Q3 and 105 percent in 09Q4.

Includes identified multilateral assistance from the EU and the World Bank.

17. To achieve these fiscal objectives, the authorities put emphasis on expenditure measures, consistent with their commitment to reduce the country’s large public sector (LOI ¶10). The program aims at a reduction of primary government expenditure by 2 percentage points of GDP, compared to 2008. All expenditures categories are affected, except interest payments. Measures included in the LOI are: (i) a nominal wage freeze and the elimination of the 13th monthly salary for all public sector employees (1 percent of GDP); (ii) the elimination of the 13th monthly pension for all early retirees and a cap of the 13thmonthly pension to HUF 80,000 for other pensioners (0.2 percent of GDP); (iii) postponement or elimination of indexation of selected social benefits (0.2 percent of GDP); and (iv) across-the-board cuts in other spending allocations to ministries (0.5 percent of GDP). Within the capital expenditure envelope, priority will be given to investment projects cofinanced by EU structural funds (0.1 percent of GDP). On the revenue side, the authorities have already announced that tax cuts previously envisaged for 2009 will be postponed until sufficient fiscal space has been created through expenditure restraint. Under the program, the authorities will also not make any changes in the tax code that could lead to a net revenue loss.

18. To put fiscal sustainability on a permanent footing, the government has submitted a draft fiscal responsibility law to parliament (LOI ¶11). The law has been a contentious political issue. The authorities appear to have now assembled a parliamentary majority that would support a law with the following core elements: (i) fiscal rules on public debt (which cannot increase in real terms) and the primary balance (which cannot be negative); (ii) a strengthening of the medium-term expenditure framework (rolling three-year expenditure ceilings); and (iii) the creation of a non-partisan fiscal council to provide independent and expert scrutiny. The lack of a two-thirds majority in parliament forced the authorities to abandon initial plans to introduce stricter fiscal rules for local governments, and to enshrine an enforcement procedure in the constitution. The cost of violating the fiscal framework is therefore reputational: there is ample evidence that national fiscal rules contributed to permanent improvements in primary balances in the European Union (see IMF Country Report No. 08/314, Chapter I).

Fiscal Adjustment in IMF-Supported Programs in Capital Account Crises1/

In past capital account crises, fiscal policy aimed at striking the right balance between the needs to support macroeconomic stability and to deal with underlying vulnerabilities. This can be seen from the wide range of planned fiscal adjustments under IMF-supported programs during the crises. Specifically, planned improvements in headline fiscal balances ranged from 1 percent of GDP (Mexico, Argentina, Korea) to 5 percent of GDP in Turkey. Against this background, Hungary’s program (1 percent of GDP) is at the low end of the range of planned overall balance adjustments.

That said, defining fiscal objectives consistent with medium-term debt sustainability was always an overarching concern. Targeted primary balances were accordingly set above the medium-term debt-stabilizing primary balances calculated on the basis of historical averages for nominal growth and interest rates—the only exception being Brazil (1999). In some cases, the urgent need to rapidly reduce public debt led to sizable margins over the debt-stabilizing balance—up to 5.7 percentage points of GDP in Turkey. Hungary’s program is no exception: the required primary balance under the program is 3 percentage points of GDP higher than the medium-term debt-stabilizing primary balance; but it is below the short-term debt-stabilizing balance by 1.3 percentage point of GDP.

The impact of fiscal adjustment on market confidence was also an important concern in IMF-supported programs, particularly in countries exposed to a funding crisis because unfavorable debt dynamics (high real interest rates, low growth, large stock of outstanding liabilities) or short maturity structure. The extent to which fiscal adjustment actually helped bolster confidence is difficult to assess (many other contemporaneous factors were at play) and varied across countries. However, the evidence suggests that fiscal adjustment has been instrumental in reversing capital flows in countries with well-identified public sector vulnerabilities or fiscal credibility issues (Brazil, Turkey, and to a lesser extent, Argentina and Mexico). In contrast, fiscal adjustment in Asia—where fiscal vulnerability was low—did not seem to have any short-term impact on capital flows.

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility.2/ Non-Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.

1/Ghosh, A. and others, 2002, IMF-Supported Programs in Capital Account Crises, IMF Occasional Paper No. 210 2/World Economic Outlook October 2008.

D. Financial Sector and Financial Markets

19. Hungarian domestic banks have entered this period of market stress with strong solvency positions. While solvency is still robust, liquidity pressures have emerged, in part driven by developments in the largest Hungarian bank’s foreign subsidiaries. As a result, liquidity pressures were strongest for domestic banks, which also lack the support and added credibility of a strong parent. To mitigate heightened risk perceptions, the government announced a blanket guarantee of all banks’ deposits on October 8. To further buttress credibility and ensure soundness of all banks operating in Hungary, the program includes a strong bank-support package. As an additional aim, the measures will also ensure that the main domestic bank can continue to be a responsible parent of its foreign bank subsidiaries in the region. The package was designed by the authorities in consultation with the mission and is in line with other recent initiatives in Europe (Box 3). Submission of the necessary legislation by November 10, 2008 will be a structural performance criterion (LOI ¶15).

20. The banking sector package contains provisions for added capital and funds a guarantee fund for interbank lending (LOI ¶15). Total funding of HUF 600 billion (2.2 percent of GDP) will be divided evenly between the Capital Base Enhancement Fund and the Refinancing Guarantee Fund. These Funds will be available to all private Hungarian banks of systemic importance with own funds above HUF 200 billion (0.73 percent of GDP). This in practice covers the three largest banks. The other 33 banks in the system, most of which are small and thus pose low systemic risk, are protected through the blanket guarantee of deposits by the government and the widened access to central bank refinancing through recently introduced liquidity facilities. Any amount not utilized in the Capital Base Enhancement Fund by end-January 2009 will be transferred to the Refinancing Guarantee Fund.

21. The Capital Base Enhancement Fund has been sized to bring the eligible banks’ capital adequacy ratio (CAR) up to 14 percent. The two largest banks had CARs of just below 10 percent as of end-June 2008 and will be eligible for capital increases of around HUF 200 billion and HUF 100 billion, respectively.4 Given the current exceptional level of uncertainty, capitalizing banks to this high degree is aimed at allowing them to withstand even a severe deterioration in the quality of their loan portfolio. Basic stress testing by staff indicates that, starting from a CAR of 14 percent, the largest domestic bank would be able to preserve a CAR of above 8 percent in the event of combined losses of 5 percent on HUF loans, 10 percent on foreign currency loans, and 10 percent on foreign subsidiaries’ assets. The Capital Fund will acquire preference shares that will pay a dividend based on the cost for the government plus a margin of 2 percentage points, which will increase by one percentage point annually from 2011. Safeguard measures will complete the capital increases. Banks will have the option to repurchase these preference shares whenever compatible with maintaining a strong capital position.

Europe: Cross-Country Comparisons of Financial Stability Measures

Hungary’s financial stability measures to strengthen confidence in its banking sector are broadly in line with those in the major EU countries. The support package for the banking system—an integral part of the Program—comprises capital injections and bank guarantees by the government. The former is similar to that of the United Kingdom’s in that additional capitalization is not aimed at distressed or troubled banks only. The bank guarantee scheme is different as it requires banks’ qualification for capital injection as a pre-condition for the guarantee.

Other recent stability measures include enhancements to the deposit insurance and central bank lending schemes. The recent augmentation of deposit insurance coverage is consistent with EU agreements; in addition, the government has pledged a blanket guarantee for all deposits. In the event that systemic liquidity measures are required, the MNB noted that it has various tools that could be employed; however, it has not publicized them for moral hazard reasons. Foreign exchange liquidity is the key focus, and a foreign exchange swap facility has been established.

Box Table. Europe: Government Programs to Support Financial Stability in Selected Countries

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22. The Guarantee Fund is meant to bring comfort to the providers of wholesale funding and secure the refinancing of the eligible banks. Its endowment of HUF 300 billion (1.1 percent of GDP) will be invested in euro denominated government bonds of Euro area countries and managed by the MNB. Open for new transactions until end-2009, it will guarantee the rollover of loans and wholesale debt securities with an initial maturity of more than 3 months and up to 5 years, against a fee and with appropriate safeguards.

23. Important further initiatives are underway to improve the resilience of the banking sector. The government is seeking an agreement with commercial banks to mitigate the balance sheet risks of households from their exposure to foreign currency loans, and to put in place a private debt resolution strategy in the event that asset quality deteriorates significantly (LOI ¶13). The authorities are also stepping up efforts to strengthen the HFSA’s and MNB’s capacity to assess and address solvency and liquidity concerns in banks in a timely manner, and to ensure that the economy’s access to banking functions is preserved at all times. A mechanism to grant the HFSA the necessary remedial powers for accelerated resolution of any failed bank will be submitted to parliament by end-December 2008 (structural benchmark) (LOI ¶15). These reforms will also facilitate quicker payout to insured depositors in case of need. Financial sector regulation and supervision will be further strengthened through the introduction of a positive credit registry for households; introduction of maximum loan-to-value ratio requirements for new mortgage loans, and close monitoring of foreign exchange exposures, among other measures.

24. Foreign-owned banks are expected to remain strong players in Hungary. Unlike in most capital account crises, foreign banks’ exposure is to a significant extent to their subsidiaries. These subsidiaries represent a sizeable and strategic investment of the parent banks in “brick and mortar” and in the human capital of their employees. These subsidiaries have also been a major source of growth and profits for the parents. Given their long-term interest in Hungary as a market place, parent banks of all foreign subsidiaries have issued statements of support to Hungary, in which they affirm their willingness to support their clients forint and foreign exchange needs. Yet in line with a more difficult economic environment in Hungary and some foreign parents’ own funding issues, some decline in lending in Hungary may be expected. As part of the program, stocks and flows of net foreign assets, as well as foreign exchange swap positions, will be monitored on a daily basis.

E. Monetary and Exchange Rate Policy

25. Monetary policy will aim at gradually bringing inflation back to the official target by early 2010. The exchange rate band was removed in early 2008, allowing the MNB to exclusively focus on its inflation target of 3 percent. Under the program, progress towards this goal will be monitored using a standard consultation clause. Monetary policy was tightened in the first half of 2008 in response to a rise in underlying inflationary pressures and again on October 22, when the MNB hiked the policy rate by 300 basis points to fend off a potentially destabilizing swing of the exchange rate. Looking forward, the MNB will continue to set the policy interest rate so as to bring inflation back to target at the two-year horizon (quantitative performance criterion, LOI 18). The MNB’s efforts to reduce inflation should be supported by an agreement between the government and social partners to restrain nominal wage growth. With the risk that global deleveraging may continue to put downward pressure on the exchange rate (which could have inflationary consequences), monetary policy will need to remain vigilant and premature easing will be avoided. Consistent with its inflation-targeting mandate, the MNB generally refrains from intervening on the foreign exchange market, except to stabilize disorderly market conditions.

26. The MNB will ensure that the facilities created to manage domestic currency liquidity are managed well within the inflation targeting framework. The MNB’s liquidity-enhancing measures are solely intended to improve liquidity in various market segments, not to influence prices (including bond yields), which should remain fully market-determined. It should stand ready to further expand its toolkit as needed, including by modifying the Central Bank Act to simplify and expand the use of the collateral put up by financial institutions to obtain access to its facilities.

III. Program Modalities

A. Access

27. Hungary has very large balance of payments financing needs through end-2009 (Table 6). The gross financing requirement is the sum of the current account deficit, obligations maturing during the program and the needed increase in gross reserves to cover about 80 percent of short-term debt at remaining maturity. Although the current account deficit is projected to decline to 2 percent of GDP in 2009, gross external financing requirements are still projected at about €39 billion through end-2009. Much of this financing is expected to be covered through foreign direct investment, net positive capital transfers with the European Union, portfolio flows, and bank and corporate foreign financing, leaving a €20 billion financing gap. Commitments by the European Union (€6.5 billion) and the World Bank (€1 billion) will lower the financing gap. Absent such financing, gross reserves would deteriorate substantially. Staff projects that gross reserves would fall to about €7.8 billion at end-2009, which would cover only 30 percent of short-term debt by remaining maturity, well below a desirable minimum.5

Table 6.

Hungary: Program Financing, 2008-09

(In millions of euros)

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Sources: Hungarian authorities; and IMF staff projections.

Financing difficulties are expected to persist through 2009, with no FX issuance. Non-residents share of forint-denominated securities is projected to fall from 38 to 30 percent.

Banks with foreign parent banks are expected to roll over 80 percent of short-term debt, and others 70 percent. As a result, short-term financing for banks will be negative in 2009 (following years of large build-up of debt).

80 percent of FX swaps are expected to be rolled over, recovering to 90 percent in second half of 2009.

A €500 million Fund disbursement is projected for the first quarter of 2010, bringing total prospective Fund credit to €12.5 billion.

Hungary: Exceptional Access Criteria

Staff’s assessment is that Hungary meets all four criteria for exceptional access. The total access under the SBA would equal SDR 10.5 billion (€ 12.5 billion, 1015 percent of quota), and both the cumulative and annual access limits under the program would exceed the normal access limits, requiring an evaluation of the case for exceptional access based on the four substantive criteria under the exceptional access framework:

  • Criterion 1—Exceptional balance of payments pressure in the capital account resulting in a need for Fund financing that cannot be met within normal limits. The combination of global deleveraging and Hungary’s high vulnerabilities has increased capital outflows, as illustrated by the recent depreciation of the forint. The sharp increase in sovereign spreads and a number of less than fully successful government securities auctions indicate restricted market access.

  • Criterion 2—Sustainable debt position. As the imminent economic slowdown will significantly reduce the growth of government revenue and higher interest rates will increase debt service payments, public debt sustainability hinges on further fiscal consolidation to keep the projected government debt-to-GDP ratio (66 percent of GDP at end-2007) firmly on a downward path, as illustrated in the baseline scenario (Table 8, Figure 5). However, staff’s analysis, which includes stress tests and alternative scenarios, shows that Hungary’s public debt outlook is vulnerable to shocks and underlines the fact that Hungary’s debt outlook is critically dependent on a policy change. Under the baseline scenario, external debt as a share of GDP is projected to increase initially, from 97 percent of GDP at end-2007 to 116 percent of GDP at end-2009), given a projected substantial real depreciation in 2008–09 (Table 9, Figure 6). External debt would then come down as the exchange rate appreciates somewhat and less available external financing reduces the nominal amount of the debt. Stress test shows that the external debt outlook worsens significantly if the depreciation turns out to be larger than projected in the baseline scenario. By maintaining investor confidence, a strong economic program would help prevent a sharper and more long-lasting exchange rate depreciation, which would otherwise hurt external debt sustainability.

  • Criterion 3—Good prospects of regaining access to private capital markets. Given the increased fragility of global investor confidence, Hungary’s access to private capital markets has deteriorated. How quickly access improves depends on both developments in global markets and the strength of policy measures to ensure that macroeconomic and financial policies remain anchored. Hungary has a strong track record in servicing its external debt even in periods of acute balance of payments stress. In staff’s view, Hungary’s access to private financial markets will very likely be restored.

  • Criterion 4—The policy program provides a reasonably strong prospect of success, including not only Hungary’s adjustment plans but also its institutional and political capacity to deliver that adjustment. Hungary’s track record of sound macroeconomic policy implementation over the past two years and robust institutions would underpin the proposed program. With political agreement reached on the economic program, staff believes the program has good prospects for implementation.

Table 7.

Hungary: Schedule of Reviews and Purchases

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Source: IMF staff estimates.
Table 8.

Hungary. Indicators of Fund Credit, 2008-15

(In millions of SDR)

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Source: IMF Staff estimates.

End of period.

Repayment schedule based on repurchase obligations.

Table 9.

Hungary: Proposed Access, 2008-2010

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Source: Executive Board documents, MONA database, and Fund staff estimates.

High access cases include all available data at approval and on augmentation for the 25 requests to the Board since 1994 which involved the use of the exceptional circumstances clause or SRF resources. Exceptional access augmentations are counted as separate observations. For the purpose of measuring access as a ratio of different metrics, access includes augmentations and previously approved and drawn amounts.

The data used to calculate ratios is the actual value for the year prior to approval for public and short-term debt, and the projection at the time of program approval for the year in which the program was approved for all other variables.

Figure 4.
Figure 4.

Hungary: Recent Pressures on Financial Markets

Citation: IMF Staff Country Reports 2008, 361; 10.5089/9781451818116.002.A001

Sources: Hungarian Debt Management Agency (AKK), and IMF staff calculations.
Figure 5.
Figure 5.

Hungary: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 361; 10.5089/9781451818116.002.A001

Sources: International Monetary Fund, country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Figure 6.
Figure 6.

Hungary: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 361; 10.5089/9781451818116.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2009.

28. To help contain the reserve decline, exceptional access in the amount of €12.5 billion (SDR 10.5 billion, 1015 percent of quota) will be needed6 Of this, it is proposed that up to €5 billion be disbursed up front (Table 7). Staff assesses that Hungary meets the four criteria for exceptional access (see Box 4). Staff considers that SBA terms are appropriate given the uncertainty surrounding the speed with which investors will return, which itself depends the speed of re-establishment of normal conditions in global financial markets, and the associated risk that the balance of payments difficulties may require a longer time to resolve than the SRF maturity. 7

B. Capacity to Repay the Fund and Risks to the Program

29. Hungary’s capacity to repay the Fund is expected to be strong, although continued high public sector and external debt are important risks. By the end of the arrangement, Fund exposure is projected to be about 10 percent of GDP and 53.5 percent of gross reserves (Tables 8–9). Public sector and external debt are expected to remain elevated over the program period, with public sector projected at 66 percent of GDP and external debt at 105 percent of GDP at end-2010 (Tables 10–11, Figures 5–6). However, Hungary’s excellent record of timely servicing its obligations and the likely improvement in global financing conditions in coming years provide assurances that Hungary will be in a position to discharge its obligations to the Fund in a timely manner.

Table 10.

Hungary: Public Sector Debt Sustainability Framework, 2003-13

(In percent of GDP, unless otherwise indicated)

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General government gross debt.

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).

For projections, this line includes exchange rate changes.

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

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

The scenario assumes structural balances of-2.5 percent of GDP in 2009, -1.5 in 2010, and -0.5 over 2011-13.

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

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.