Hungary
Second Review Under the Stand-By Arrangement, Request for Waiver of Nonobservance of Performance Criterion, and Request for Modification of Performance Criteria: Staff Report; and Press Release on the Executive Board Discussion
Author:
International Monetary Fund
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Publication Date:
30 Jun 2009
eISBN:
9781451818147
Language:
English
Keywords:
ISCR; CR; SDR; reform; VIII.; government financial support; disbursement of SDR; short-term debt; FX funding needs; FX swap market; economic activity; CPI inflation
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This paper discusses key findings of the Second Review under the Stand-By Arrangement for Hungary. All end-March 2009 quantitative performance criteria and the continuous performance criterion on nonaccumulation of external arrears were met, as well as the end-March indicative target on central government debt. The end-March structural performance criteria related to pension reform and government lending to banks were met. The structural performance criterion on amendments to the Financial Stability Act was not fully met but, on the basis of the corrective action taken, IMF staff supports the authorities’ request for a waiver.

Abstract

This paper discusses key findings of the Second Review under the Stand-By Arrangement for Hungary. All end-March 2009 quantitative performance criteria and the continuous performance criterion on nonaccumulation of external arrears were met, as well as the end-March indicative target on central government debt. The end-March structural performance criteria related to pension reform and government lending to banks were met. The structural performance criterion on amendments to the Financial Stability Act was not fully met but, on the basis of the corrective action taken, IMF staff supports the authorities’ request for a waiver.

I. Introduction and Summary

1. Macroeconomic and financial policies are on track. The end-March 2009 quantitative performance criteria and indicative target, as well as the structural performance criteria related to pension reform and government lending to banks, were all met. The structural performance criterion on amendments to the Financial Stability Act was not fully met, but corrective action has been taken.

2. However, Hungary’s economic outlook has worsened due to a further deterioration of the global environment. With exports amounting to 80 percent of GDP and the close integration of financial markets, the fall in external demand and tight external financing conditions are leading to a sharper-than-envisaged economic contraction. As a result, tax revenue will be lower and credit quality will be worse.

3. Against this background, the policy settings under the program have been revised to strengthen fiscal sustainability and preserve financial stability:

  • More ambitious structural spending and tax reforms are under way to strengthen fiscal sustainability, allowing the partial accommodation of automatic stabilizers and an increase in the fiscal deficit target in 2009.

  • The revised program puts additional emphasis on measures to help preserve financial stability, including careful monitoring of support for banks, strengthening bank supervision, and improving the remedial action and bank resolution frameworks.

  • Monetary and exchange rate policy will continue to target inflation over the medium term while being prepared to act as needed to mitigate risks to financial stability.

4. The fragility of the political situation presents implementation risks. In April, following the prime minister’s replacement through a constructive motion of no confidence, a new government was formed. Parliamentary elections are scheduled for April 2010, but early elections are possible. To help foster broad-based ownership of the program, Fund staff have undertaken extensive outreach to the media and the political opposition.

5. Fund staff have continued to cooperate closely with the staff of the European Commission (EC). Fund and EC staff consult each other regularly regarding economic and policy developments, and field parallel missions to Hungary. The second tranche of the EU’s balance of payments support (€2 billion) was disbursed in March 2009. The third disbursement (€1.5 billion) is expected in June. Fund staff have also cooperated closely with World Bank staff.

II. Recent Developments

6. The economic downturn is sharper than envisaged at the first review, mostly due to larger-than-expected deteriorations in partner countries (Table 1 and Figure 1):

Table 1.

Hungary: Main Economic Indicators, 2005–10

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

Contribution to growth. Calculated using 2000 prices.

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.

Excluding Special Purpose Enterprises. Including inter-company loans and non-residents holdings of forint-denominated assets.

Figure 1.
Figure 1.

Hungary: Recent Economic Developments

Citation: IMF Staff Country Reports 2009, 197; 10.5089/9781451818147.002.A001

Sources: Hungarian Statistical Office; and IMF staff calculations.

  • Economic activity is contracting sharply. Real GDP fell by 6.7 percent year-on-year in 2009Q1. The unemployment rate rose to 9.9 percent in the three months to April, compared to 7.7 percent a year ago. The fall in retail sales is still accelerating, though the sharp decline in industrial production appears to be moderating.

  • Core CPI inflation has stabilized at about 3 percent, reflecting the offsetting effects of the large output gap and exchange rate depreciation. Headline CPI inflation increased to 3.8 percent in May on higher food prices. Private sector wage growth excluding bonuses was 6.5 percent y-o-y in March.

  • The current account deficit is narrowing. Imports are contracting more quickly than exports. The income balance is improving due to lower profit repatriation by non-residents. Large EU transfers are contributing to a surplus on current transfers. As a result, the current account deficit is expected to narrow from 9.6 percent of GDP in 2008Q4 to 3.6 percent of GDP in 2009Q1.

7. Financial markets remain under stress, but strains have eased since March in line with global developments (Figure 2):

Figure 2.
Figure 2.

Hungary: Financial Market Developments, 2008-09

Citation: IMF Staff Country Reports 2009, 197; 10.5089/9781451818147.002.A001

Sources: National authorities; Bloomberg; and AKK.

  • The forint reached an all-time low of 317 against the Euro in March. In response, the central bank announced publicly that it stood ready to use the full range of monetary policy instruments at its disposal to prevent a disorderly depreciation. At the same time, the international community’s readiness to provide external financing—as reflected in the G20 meeting—helped to stabilize the foreign exchange market. Since then, the forint has strengthened to about 280-290 against the Euro.

  • Conditions in the government bond market have also improved. The yield on the benchmark 5-year bond fell from about 13½ percent in March to about 10 percent in May, and the CDS spread from more than 600 bps in March to about 300 bps in May. The debt management agency re-started auctions of modest amounts of government bonds in April. These auctions have been broadly successful, though demand for bonds is being supported by large bond buy-backs.

  • Banks’ FX liquidity positions have strengthened. Foreign parent banks have maintained exposures to their Hungarian subsidiaries. Three banks without foreign parents, among them Hungary’s largest bank, have received FX loans from the government. The central bank’s new 3- and 6-month FX swap facilities have helped to stabilize conditions in the FX swap market, which banks use to cover their FX funding needs. The effective Euro interest rate over euribor paid by Hungarian banks in overnight swap transactions fell from about 300 bps in March to about zero in May.

  • External financing was stronger than expected in 2009Q1. For banks, parent bank funding was stable and other net external flows were less negative than envisaged. Nonresidents’ holdings of forint-denominated government securities fell in 2009Q1, though the pace of the sell-off eased. For corporations, external debt rollover was lower than projected. Overall, international reserves were well above the program floor at end-March, leading to an increase in reserve coverage to 89 percent of short-term debt.

III. Policy Discussions

A. Macroeconomic Framework

8. The revised macroeconomic framework for 2009 largely reflects the impact of weaker projected growth in Hungary’s main export markets (LOI ¶6-8).

  • Real GDP is now projected to fall by 6.7 percent, compared to 3.3 percent at the first review, largely due to the impact on Hungary’s exports of the sharper contraction in the Euro area. Exports are now projected to fall by 15 percent, compared to 3 percent at the first review, implying much worse prospects for income and employment. Thus, weaker consumption and investment reflect primarily the downward revision to exports, as well as stricter lending criteria. The risks to the forecast remain large: prospects for recovery in Hungary’s main trading partners are highly uncertain, global investor appetite for Hungarian assets remains volatile, and the severity of the credit crunch in Hungary is unclear.

  • Credit to the economy is expected to contract in real terms in 2009 (Table 2), reflecting weak demand, efforts by banks to reduce risk-weighted assets, and ongoing constraints on external bank funding. Broad money is projected to grow slightly more than at the time of the first review, as a less sharp drawdown of corporate deposits (in line with stronger-than-expected external financing conditions in 2009Q1), a weaker exchange rate, and higher inflation, more than offset the weaker outlook for real GDP growth.

  • The current account deficit is expected to narrow to 4.1 percent of GDP in 2009 (Table 3). The size of the adjustment relative to 2008—roughly 4 percentage points of GDP—is slightly higher than at the first review. Projections for both imports and exports have been revised down since the first review.

  • CPI inflation is projected to be higher than at the first review. While the output gap has widened, the larger-than-envisaged increases in VAT and excise duties have led to an increase in projected inflation. Average inflation in 2009 is projected to be 4.5 percent, compared to 3.8 percent at the first review.

  • The existing official support package continues to provide adequate resources to meet Hungary’s external financing needs in 2009. Parent banks’ recent confirmation of their commitments to maintain their exposures to Hungary, together with the authorities’ measures to provide FX liquidity to banks, mitigate the risks to banks’ external financing (Table 4). Nevertheless, given the continued fragility of global financial markets, the authorities and staff agreed to maintain cautious assumptions going forward, broadly in line with the original program projections.

  • Official external financing provides the capacity for the authorities to mitigate downward pressure on the exchange rate. Available instrument include FX swaps, FX lending to banks, and intervention in the event of disorderly market conditions. In the program projections, the central bank’s net foreign assets (NFA) are projected to decline gradually. Government deposits at the central bank are projected to fall, as the government uses resources from the official support package to finance the fiscal deficit, to redeem government bonds, and for bond buy-back operations.

Table 2.

Hungary: Monetary Accounts, 2005–10

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Sources: Magyar Nemzeti Bank and IMF staff calculation.

Includes anticipated disbursement of the first IMF tranche under the SBA to the government, as well as disbursements of EU and WB funds.

Includes built-up of government deposits commensurate with the disbursement of the first IMF tranche, EU and WB funds; as well as the use of deposits to finance the government’s net borrowing requirements.

Controls for fluctuations in the exchange rate.

The first two IMF tranches were disbursed to the government, who deposited the funds with the MNB and converted them into forint. As a result, IMF disbursements were recorded as a foreign asset but domestic liability of the MNB. The future tranches are also assumed to be disbursed to the government.

Table 3.

Hungary: Balance of Payments, 2007-11 1/

(in millions of euros)

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Sources: Hungarian authorities and staff projections.

Excluding Special Purpose Enterprises.

Including direct FX lending to banks.

Table 4.

Hungary: Indicators of External Vulnerability, 2005-08

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Source: Hungarian authorities; and staff estimates.

Non-performing loans are defined as loans past due more than 90 days.

9. The economy is expected to stabilize in 2010, but there are risks to the outlook for external financing (Table 5). Real GDP is expected to contract by 0.9 percent in 2010, with a gradual recovery setting in only in the second half of the year. Exports should benefit from the global recovery, exchange rate depreciation, and the reduced tax wedge on labor. The moderation of global financial market stress, combined with the measures under the program to strengthen fiscal sustainability and preserve financial stability, are expected to improve financing conditions and thus support private investment. Private consumption will continue to be weighed down by losses in employment and reductions in social transfers. Regarding external financing, global financial turbulence has lasted longer than expected in November 2008, giving rise to considerable uncertainty about the resumption of private external financing flows. The financing outlook for 2010 will be revisited later this year.

Table 5.

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

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Sources: Hungarian authorities; and staff estimates.

Includes change in inventories.

Includes intercompany loans.

10. The program aims to ensure that government and external debt are firmly on sustainable paths (Appendix Tables 1 and 2, and Appendix Figures 1 and 2). The government debt-to-GDP ratio is expected to peak at 80 percent at end-2010, a higher level than projected at the first review, due to higher fiscal deficits in 2009-10 (see below), lower nominal GDP, and a weaker exchange rate. Looking further ahead, the projections assume a constant structural overall surplus of about 1 percent of GDP after 2012, implying a substantial rise in the primary surplus (to about 4 percent of GDP by 2014), which is essential to reduce the public debt-to-GDP ratio under a broad range of adverse shocks. The external debt-to-GDP ratio is expected to peak at 139 percent at end-2009, a higher stock than projected at the first review, due to a weaker exchange rate and lower nominal GDP. Due to the expected improvement in the trade balance, a pick-up in growth, and a return of non-debt creating capital inflows, external debt would gradually decline starting in 2011. The debt outlook would worsen significantly if the exchange rate was to depreciate further.

Appendix Table 1.

Hungary: Public Sector Debt Sustainability Framework, 2004-14

(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.

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.

Appendix Table 2.

Hungary: External Debt Sustainability Framework, 2004-14

(In percent of GDP, unless otherwise indicated) 1/

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Excluding Special Purpose Enterprises

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 euro terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = 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).

For projection, line includes the impact of price and exchange rate changes.

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

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.