Hungary
Staff Report for the 2010 Article IV Consultation and Proposal for Post-Program Monitoring
Author:
International Monetary Fund
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Publication Date:
03 Feb 2011
eISBN:
9781455216642
Language:
English
Keywords:
ISCR; CR; proposal; IMF staff assessment; funding; debt sustainability concern; debt; inflation expectation; headline inflation; potential GDP; central bank; output gap; foreign exchange; Pension spending; Fiscal stance; Global
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Hungary was severely affected by the crisis. The financial sector has remained resilient throughout the crisis. The Central Bank (MNB) paused in mid-2010 and has tightened interest rates by 50 basis points since November in response to a sharp rise in risk premia and higher headline inflation prints. The importance of addressing financial sector vulnerabilities is discussed. Executive Directors welcomed efforts to support distressed mortgage holders, as long as moral hazard and fiscal costs are contained. A medium-term framework was implemented.

Abstract

Hungary was severely affected by the crisis. The financial sector has remained resilient throughout the crisis. The Central Bank (MNB) paused in mid-2010 and has tightened interest rates by 50 basis points since November in response to a sharp rise in risk premia and higher headline inflation prints. The importance of addressing financial sector vulnerabilities is discussed. Executive Directors welcomed efforts to support distressed mortgage holders, as long as moral hazard and fiscal costs are contained. A medium-term framework was implemented.

I. Context

1. Hungary is emerging from a severe economic crisis. The economy was immediately and profoundly affected by the global financial strains erupting in late 2008, reflecting high pre-crisis vulnerabilities1 and close integration into global financial and goods markets.2 Further, Hungary’s growth performance was already sub-par before the crisis, given weak structural foundations. The combination of improved policies in the context of the IMF/EU-supported program (Box 1), availability of large and upfront official financing, and an easing of global financial conditions brought a stabilization from mid-2009. However, while Hungary escaped a financial meltdown, a sharp recession was not avoided: real GDP contracted by almost 7 percent in 2009 as exports fell sharply in the context of a global retrenchment in trade and domestic demand declined amid financial strains and limited policy space. Controlling for Hungary’s trade openness and pre-existing vulnerabilities, however, the GDP decline was roughly in line with other countries in the region (Section II).

A01ufig01

Portfolio Investment Held by Non-Residents

(in percent of GDP, 2009)

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

2. The government formed in mid-2010 has taken a decidedly new direction in economic policies. The elections in April 2010 saw the opposition party Fidesz win a two-thirds parliamentary majority, succeeding the technocratic government of Prime Minister Gordon Bajnai.3 The new government led by Prime Minister Viktor Orban let the IMF/EU-supported program lapse and has stated that it is not seeking a successor arrangement.

3. The new government’s focus is to jump-start the economy. With virtually all state institutions under its control and a sufficient parliamentary majority to change the constitution, the authorities see an historic opportunity for forceful policy actions, supported by an enhanced role of the state in the economy. Key pillars of this strategy are tax relief for households, enhanced family benefits (to increase low fertility rates), and targeted support to SMEs in sectors considered strategic (the so-called “New Széchenyi Plan”). In order to reconcile these policies with the limited fiscal space under the EU’s Stability and Growth Pact, the government is primarily resorting to temporary revenues measures targeted at sectors that had made large profits in recent years, as well as the de facto re-nationalization of the second pillar private pension system. Austerity measures that directly impact households’ disposable incomes are considered politically unacceptable. The efficiency of policy implementation is to be improved by reducing the role for institutions like the Constitutional Court or the Fiscal Council (Section III).

4. Two years after the crisis outbreak, Hungary’s underlying stock vulnerabilities remain significant (Figure 1 ). On the one hand, liquidity buffers in the financial sector and the external current account have improved, while the government’s cash position is strengthening, especially as it assumes a significant amount of private pension assets. On the other hand, high public and external debt (about 80 and 140 percent of GDP, respectively), low reserve coverage, large-scale currency mismatches, and the economy’s growing reliance on external funding (Section IV) have allowed vulnerabilities to persist, placing a premium on sustainable macroeconomic policies that anchor investor expectations.

Figure 1.
Figure 1.

Vulnerability Indicators in Hungary Compared to Other Emerging Markets, 2009

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

Sources: IMF Staff Estimates.

II. Macroeconomic Outlook and Risks

5. The recovery that began at end-2009 is expected to gain strength (Figure 2). Exports have increased for six consecutive quarters and employment has been rising since February 2010. More recently, signs of a pick-up in private consumption have also emerged. Going forward, tax cuts announced for 2011 are estimated to increase disposable income by about 5 percent, while solid demand in trading partner countries is projected to support export growth. As a result, staff expects real GDP growth to increase from around 1 percent in 2010 to about 2¾ percent in 2011. The current account, temporarily in surplus in 2010, will swing into deficit starting in 2012, as domestic demand and import growth strengthen. Average inflation is expected to be around 4 percent in 2011, reflecting higher commodity prices and a pass-through from tax increases.

Figure 2.
Figure 2.

Hungary: Recent Economic Developments, 2007-10

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

Sources: Hungarian Statistical Office; and IMF staff estimates.
A01ufig02

Real GDP Growth

(Annual percent change)

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

Sources: IMF staff calculations; Ministry for National Economy; and Hungarian Statistical Office.

6. Staff expects medium-term growth rates to remain below pre-crisis averages. Exports will continue to be an engine for growth, helped by some boost to export capacity from large FDI projects and the impact of the recent tax wedge reduction. More generally, competitiveness appears adequate, with CGER estimates suggesting the real exchange rate broadly in equilibrium—although qualitative indicators point to further scope for improvement through structural reforms (Box 2). The boost to disposable income from income tax cuts should persist through 2013, but the impact on consumption may be limited if the uncertain policy environment and high unemployment trigger further increases in precautionary savings. Overall, staff projects potential growth of 2—2½ percent over the medium term as recent policy initiatives may boost labor supply but discourage investment. Actual growth is projected to be roughly one percentage point higher than potential in 2012-15, gradually narrowing the large output gap. The authorities’ medium-term projections are considerably more optimistic, with actual output growth reaching 5½ percent in 2015, reflecting more favorable assumptions about labor participation (due to the income tax reform) and especially investment rates (Box 3).

7. The uncertainty around staff’s central scenario is considerable.

  • On the downside, the global recovery may slow (thus affecting exports) and risk appetite may deteriorate. Given Hungary’s high external and public debt, a change in investor sentiment would compound financing risks. Domestic demand would suffer if the Swiss franc (CHF), whose value directly impacts households’ debt servicing costs, strengthens further. High policy uncertainty could lead to a more cautious behavior by households and investors than currently built into the baseline.

  • On the upside, accommodative macro policies in advanced economies could spur global growth and induce stronger capital flows to emerging markets, which could compress Hungary’s borrowing spreads. In the long term, the effects of the recent policy package on employment and investment, if supplemented by structural reforms and improvements in the business climate, could turn out stronger than assumed in staff’s baseline. This, in addition to the expected short-term improvement in headline fiscal indicators, could reduce risk premia.

8. A high degree of openness implies spillover risks both from and to Hungary. Statements by Fidesz officials in June 2010, suggesting an imminent risk of government insolvency, upset regional markets and temporarily impacted the euro. Negative outward spillovers may also occur, should markets become concerned that policies perceived as hostile to business (such as ad hoc taxes, reversals of pension reform) set precedents elsewhere. Meanwhile, clear evidence of contagion from market pressures in European peripherals is thus far limited. Hungary’s risk premia have recently increased markedly, especially relative to regional peers (Figure 3), but this deterioration occurred amid sharp changes in the domestic policy environment. Over the last months, the three main rating agencies have downgraded Hungary to the lowest investment grade, with a negative outlook.

Figure 3.
Figure 3.

Hungary: Financial Market Developments, 2008-10

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

Sources: Hungarian national authorities; Bloomberg; and Hungarian Debt Management Agency.
A01ufig03

CDS Spreads

(Basis points)

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

Sources: Bloomberg; and IMF staff estimates.

III. Policy Discussions

9. Discussions centered on the viability of the authorities’ economic strategy, with staff advocating a more cautious approach that safeguards institutional integrity, fiscal sustainability, and financial stability. While welcoming the focus on growth, staff pointed out that the government’s strategy is risky as it relies on fiscally costly tax cuts triggering a strong response in economic activity which may not materialize. This risk is further compounded by recent steps undermining economic governance. Such an approach was particularly perilous given Hungary’s significant vulnerabilities, which make anchoring long-term market expectations a key precondition for stability. Staff suggested phasing in economic stimulus measures gradually, in line with progress in fiscal consolidation. To the extent that such policies succeed in enhancing confidence in the sustainability of Hungary’s policy framework, they would set in motion a virtuous cycle of lower risk spreads, reduced financing costs for the public and private sectors, and ultimately higher growth. Lower risks spreads would also reduce constraints on monetary policy.

A. Fiscal Policy

10. Upon taking office, the government’s first task was to contain slippages in the 2010 budget. In mid-2010 it became clear that the budget’s deficit target of 3.8 percent of GDP was unattainable due to spending overruns around the elections and revenue shortfalls. The authorities promptly adopted an emergency package that included a large special levy on financial institutions, as well as some spending cuts, but also reductions in the corporate income tax and the elimination of a number of small taxes. A second package, introduced in October to compensate for additional spending (mainly on state-owned enterprises and outlays related to floods), contained further levies on primarily foreign-owned retail chains, telecommunication and energy companies, as well as a 14-months diversion of second pillar private pension contributions to the budget. Taken together, the net deficit-reducing effect of these two rounds of measures amounted to 2 percent of GDP. Nevertheless, new revenue slippages emerged in December, putting into question the attainability of the deficit target (defined in ESA95 terms).

11. The 2011 budget is centered on the introduction of a flat-rate personal income tax, reflecting the government’s desire to quickly spur growth. This reform, which will be implemented over three years, envisages the unification and phased reduction of the marginal tax rate to 16 percent, as well as the introduction of more generous child allowances. The immediate revenue loss is estimated at 1¾ percent of GDP (and a further 1½ percent in 2012—13). The authorities explained that these tax cuts aim at improving competitiveness and spurring labor supply and investment, which—together with greater tax compliance—would eventually compensate for short-term revenue losses. Staff, while supportive of reducing the tax wedge, cautioned against overestimating Laffer-curve effects (Box 3) and argued for a more modest tax cut as envisaged in the 2009 tax reform.

12. To compensate for these tax cuts, while still meeting the deficit target of 2.9 percent of GDP agreed with the EU, the budget relies primarily on temporary measures. Key elements are a continuation of the temporary sectoral levies, the diversion of second pillar pension contributions (about 1.2 and 1.3 percent of GDP, respectively), and using assets transfers from the second pillar to fund spending (about 2 percent of GDP).4Incentives are such that virtually all contributors are expected return to the PAYG system in early 2011,5 implying total one-off revenues of about 11 percent of GDP in 2011. The use of pension assets not needed to cover current expenditures will be ultimately determined by a new supervisory body, but at least half is expected to be used to reduce gross debt. Structural measures in the 2011 budget amount to about one percent of GDP, including some staff cuts (0.5 percent of total government employment), reduced bonuses and in-kind benefits, streamlined public works programs, and lower capital spending by local governments.

13. While these measures are sufficient to meet the headline fiscal target, staff raised serious concerns about the structural fiscal position. In staffs view, revenues in the 2011 budget are optimistic in light of the 2010 revenue performance (especially on VAT and CIT), which may signal a deterioration of the tax base. Excluding the pension asset transfer, the deficit would be close to 5 percent of GDP, i.e. higher than in 2010. The heavy reliance on temporary measures implies a substantial loosening of the underlying fiscal stance in 2010. In 2011, the further structural weakening due to tax cuts is only partly offset by the above-mentioned expenditure cuts and the now permanent redirection of pension contributions (text table). Staff also argued that the envisaged measures will partly be passed on to consumers, introduce distortions by discriminating between sectors, and—through higher risk premia—send negative signals about foreign investment, which is critical for Hungary.

Hungary: Main Fiscal Indicators

(In percent of GDP, unless otherwise indicated)

article image
Sources: Hungarian authorities; and IMF staff estimates.
A01ufig04

General Government Expenditures, 2009

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

Sources: IMF Staff Calculations; respective Finance Ministries

14. To reverse the deterioration of the underlying fiscal stance, staff argued to focus on further rationalization of current primary spending and other structural reforms. At about 50 percent of GDP, public expenditure is much larger than in comparable countries in the region. Staff, drawing on technical assistance advice, identified expenditure-reducing measures of about 4 percent of GDP, which would eliminate the 2011 structural deficit and set debt on a downward trajectory. These include rationalizing the public wage bill and social benefits as well as restructuring public transportation companies.6 A property tax could be an additional source of revenue. Finally, staff urged progress in public finance management to avoid recurrence of spending slippages, as well as continued implementation of the tax administration’s compliance strategy, and the merger of the customs and tax administrations. Greater budget transparency could be achieved by publishing contingent liabilities; the latter was particularly important in view of the greater prominence given to state guarantees in the New Szechenyi plan and the recently expanded role of the state development bank MFB.

Options for fiscal consolidation

(Fiscal savings in percent of GDP)

article image
Source: IMF staff estimates, based on Hungarian authorities data.

Decreasing the generosity of benefits, introducing means-testing to universal transfers (such as child allowances), eliminating untargeted price subsidies, consolidating the design and administration of social benefits at the central and local levels.

Reduce generosity and coverage of public works programs should. Narrow the scope of active labor market policies on groups most disadvantaged in the labor market.

Reduce employment (rather than wages, which appear low relative to the private sector) through atrition; consolidate local governments to achieve better economies of scale.

Refers to the operational annual losses of MAV, BKV and MALEV.

15. The authorities agreed with some measures proposed by staff, but were reluctant to commit to concrete steps at this stage. They noted that a medium-term reform plan, to be announced in February, may yield up to 2½ percent of GDP in savings. In addition to administrative reforms (in local governments) and recent changes to public finance management (introduction of budget inspectors), the authorities envisage inter alia steps to restructure state-owned enterprises and a permanent (but smaller) bank levy. They agreed, however, that implementing structural reforms will take time and that budgetary implications are uncertain. In general, they expressed a preference for measures on the revenue side that spare households.

16. Staff also raised a number of concerns about the envisaged pension reform. First, despite the initial debt reduction, the reform puts into question fiscal sustainability, particularly if—as in the 2011 budget—assets moved to the PAYG system are used for current spending. Second, it reduces transparency and increases fiscal risks (Box 4). Third, by heavily biasing the terms in favor of switching to the PAYG system, it raises concerns about business environment and property rights. Fourth, the implied erosion of liquidity in domestic bond and equity markets could negatively impact the depth of the capital market, one of Hungary’s strengths in the region. The authorities, while acknowledging some of these drawbacks, were optimistic regarding the viability of the now expanded PAYG system, pointing to measures such as the tax reforms aimed at increasing employment and fertility rates. Further, the authorities argued that pensions were in safer hands with the state than with private pension funds, which had performed poorly. Staff countered that low returns could be better addressed by improved regulation.

17. Views on the medium-term fiscal outlook differed significantly. The authorities said that they were aiming at the medium-term objectives spelled out in Hungary’s last Convergence Programme, which envisage a headline fiscal deficit of below 2 percent of GDP in 2014 and public debt rapidly declining towards 60 percent. Staff pointed out that with the phasing out of temporary measures coinciding with further tax cuts in 2012–13,7 fiscal sustainability was not ensured under present policies, as deficit and debt levels will bounce back sharply after 2013, especially assuming staff’s more cautious macroeconomic framework. Staff’s public debt sustainability analysis shows that the debt level is particularly sensitive to growth and real exchange rate shocks (Appendix).

A01ufig05

Gross Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 035; 10.5089/9781455216642.002.A001

Sources: IMF staff calculations and Hungarian authorities

18. Staff urged the authorities to frontload durable expenditure measures and to postpone personal and corporate tax cuts planned for 2012–13 until fiscal space emerges. Such an approach was less risky than the authorities’ strategy, especially given the large required cumulative adjustment (5–5½ percent of GDP in 2013—14 to achieve the authorities own targets) and elections scheduled in 2014. In response, the authorities pointed to a relatively benign fiscal outlook under their more optimistic GDP growth assumptions and possible gains from the consolidation measures to be announced in February. If necessary, sectoral levies could be kept in place until the recovery fully took hold.

B. Financial Sector Policies

19. Hungary’s banking system has displayed resilience throughout the downturn. The sector entered the financial crisis with a solid aggregate capital position (10.2 capital adequacy ratio in Q3 2008) but relatively thin liquidity buffers (Table 10), which left some banks exposed to funding pressures in late 2008. Subsequently, liquidity positions have improved significantly. Furthermore, retained profits and capital injections by some parent banks increased the aggregate capital cushion to more than 13 percent by end- September 2010. Nonetheless, lending to the private sector contracted by almost 5 percent in 2009 and continued to stagnate in the first nine months of 2010, with mortgage lending falling particularly sharply. Pre-tax profitability has recently dropped amid an increase in non-performing loans to 9.3 percent at end-September 2010, with problem loans concentrated in unsecured consumer lending and commercial real estate. Moreover, capital and profitability are unevenly distributed across banks, with a particularly strong position at the main bank without a foreign parent.

Table 1.

Hungary: Main Economic Indicators, 2006-11

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

Contribution to growth. Calculated using 2000 prices. It includes change in inventories.

Includes change in inventories.

Consists of the central budget, social security funds, extrabudgetary funds, and local governments. It includes the IMF staff assessment of the impact of all government announced measures (October 2010), including the full amount of the bank levy in 2011.

Excluding Special Purpose Entities. Including inter-company loans, and nonresident holdings of forint-denominated assets.

Table 2.

Hungary: Central Bank Survey 2006-11

(Local Currency Billions)

article image
Sources: Magyar Nemzeti Bank and IMF staff calculations.
Table 3.

Hungary: Monetary Survey 2006-11

(Local Currency Billions)

article image
Sources: Magyar Nemzeti Bank and IMF staff calculation.

Adjusted for changes in exchange rate

Only credit to households and firms

Table 4.

Hungary: Balance of Payments, 2005-15

(in millions of euros)

article image
Sources: Hungarian authorities and staff projections.
Table 5.

Hungary: External Financing Needs 2009-15

(in millions of euros)

article image
Sources: Hungarian authorities and staff projections.

Excludes EU and IMF loans

Table 6.

Hungary: Indicators of External Vulnerability, 2005-10

article image
Sources: Hungarian authorities; and staff estimates.

Data for Financial Indicators are as of end-Sep. (M3, Lending), end-Nov. (yields), or end-Sep. (share of foreign currency loans and NPLs), and data for Financial Market Indicators are as of Dec. 28th 2010. Projections for External Indicators are for end-2010.

Loans to households and non-financial corporations only, exchange rate adjusted

Non-performing loans are defined as corporate, household, interbank, foreign and other loans that are past due for more than 90 days.

Special Purpose Entities are defined as resident corporations of non-resident owners, which perform a passive, financial intermediary function between their non-resident partners. SPEs have a marginal impact on the domestic economy, and their transactions have negligible net impact on the balance of payments (an enterprise that has a non-negligible net impact on the balance of payments is removed from the list of SPEs). Foreign assets and liabilities of SPEs are largely matched, and loans are considered as FDI in accordance with international statistical standards. Data for SPEs are not available prior to 2006.

Includes an estimate of intercompany loans falling due in the short-term.

Table 7.

Hungary: Staffs Illustrative Medium-Term Scenario, 2007-15

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Sources: Hungarian authorities; and staff estimates.

Includes change in inventories.

Excluding Special Purpose Entities. Including inter-company loans, and nonresident holdings of forint-denominated assets.

Includes interest revenue.