The authorities thank staff for the thorough discussions during the Article IV consultation and for their valuable advice. They agree with the general thrust of the report although differences of opinion remain on some of staff’s findings. In spite of the challenging external environment, the authorities are committed to implement prudent macroeconomic policies and comprehensive structural reforms, including structural fiscal consolidation measures.

Economic Outlook

Economic growth has resumed after the 2008–09 crisis, although the recovery remains fragile with growth rates below the pre-crisis levels. The recovery was mainly driven by a rebound in external demand and exports. Internal demand (both consumption and investments) remains weak.

Renewed risks from the debt crisis in Europe have heightened financial uncertainties, affecting business and household confidence in major foreign trading partners. The slowdown in exports negatively affects the Hungarian manufacturing sector, the most buoyant sector during the recovery, in turn negatively impacting labor demand, households’ disposable income and corporate profits.

Increasing risk premia and tighter credit conditions constrain investment and household consumption. Even though previously announced major manufacturing investments are carried out as planned, household investments fall short of previous projections. The appreciation of the Swiss Franc increased the debt service of households, which is a serious drag on their disposable income. Moreover, the increased and prolonged uncertainty and unfavorable unemployment developments structurally reduce households’ propensity to consume, despite the additional overall net income gained with the introduction of the flat tax system.

Besides the weak external environment, constrained credit conditions, the weakening of the exchange rate, the protracted balance sheet adjustment of the private sector and the tightened fiscal policy, all suggest weaker than expected economic growth. Consequently, the government has revised its growth projection, and now projects a nearly stagnating economy for 2012 with a 0.5 percent growth which will only gradually recover in the next few years. For 2012, inflation is expected to remain above target due to the one-off effect of indirect tax increases. Inflation is expected to return to around 3 percent in the course of 2013.

Fiscal Policy and Structural Reforms

The government is fully committed to keep the budget deficit below the EU requirement of 3 percent in 2012 and beyond. For this year, the general government deficit target is 2.5 percent of GDP, one of the lowest in the EU. Reaching this target implies a major adjustment in the structural fiscal position of more than 3 percent of GDP. This fiscal adjustment is based on a broad set of measures, in particular: (i) the growth supporting measures of the structural reform program announced in March 2011 (Szell Kalman Plan); (ii) expenditure cuts, in particular cuts in public wage costs, a freeze of social transfers and other budgetary chapters) and (iii) hikes in VAT rate and excise taxes. The government has recently taken additional measures due to the weaker growth outlook.

While the authorities prepared the 2012 budget based on a conservative macroeconomic forecast, they are aware of the risks surrounding the macroeconomic outlook. To ensure that the 2.5 percent deficit target is achieved even under deteriorating macroeconomic conditions, high fiscal reserves, now amounting to more than 1 percent of GDP are included in the budget. Indeed, recent measures have further increased these reserves from the 0.75 percent of GDP level mentioned in the Staff Report. The government is committed to make every effort to save these reserves. The budget bill explicitly stipulates that reserves can only be used in the fourth quarter of 2012 and only to the extent this would not jeopardize reaching the 2.5 percent deficit target. Under these conditions staff’s deficit projection of 3.5 percent seems exaggerated, since staff implicitly assumes unrealistically that the full amount of reserves will be spent.

Debt Sustainability and Fiscal Rules

The new constitution, effective January 1, 2012, requires a permanent reduction of the public debt which is currently close to 80 percent of GDP, to no more than 50 percent of GDP. Until this target is reached, budget bills must ensure a declining debt-to-GDP ratio, barring special circumstances such as a severe recession.

The pace of the debt reduction is determined by a countercyclical, simple fiscal rule included in the recently adopted Stability Act. Under this rule, the allowed debt growth rate is related to the expected inflation and output growth. Staff observes that the new rule may be suboptimal under some specific circumstances. However, there is a trade-off between a simple, easily understandable rule and a rule that fits every circumstance. The government believes that a parsimonious rule, coupled with the 50 percent debt ceiling serves as an effective communication tool with market participants, to demonstrate the commitment of the government to keep the public debt on a sustainably declining path. Experience shows that the previously more complicated fiscal rule was not well understood by the markets, and therefore less suitable to build confidence. The government is carefully considering the staff’s suggestion to relate the allowed debt growth to the output gap instead of the output growth. This proposal may be justified from a theoretical perspective. However, its practical implementation faces well-known difficulties, in particular a credible estimation of the output gap that could lead to policy mistakes.

Monetary Policy and the Central Bank

The authorities concur with staff’s assessment that the current tight monetary policy stance is appropriate. While the weak internal demand points to little inflationary pressures, the significant currency mismatch (large stock of FX denominated loans) and the increasing risk premia leave little room to run a countercyclical monetary policy.

As part of the new constitutional system, a new Central Bank Act has been passed on December 30, 2011. All comments by the European Central Bank on the draft law have been taken into serious consideration and most ECB recommendations have been accepted. The new constitution creates the possibility for merging the financial supervisor and the central bank. However, no such reorganization will be implemented during the tenure period of the current central bank governor. The government confirms that it has respected the central bank independence, and will continue to do so.

Under the new law, the central bank is responsible for the analysis, prevention and mitigation of macroprudential risks, in particular those stemming from the financial system. The Central Bank Act enables the central bank Governor, in accordance with the decision of the Monetary Council, to issue binding decrees to reduce systemic risk or prevent their build up in areas not regulated by law or Government Decrees. Such decrees may for instance aim at curbing excessive credit growth, and introduce liquidity requirements to avoid the build-up of systemic liquidity risks. Such measures may also regulate the timing, structure and operation of the anti-cyclical capital buffers and establish additional requirements to reduce the risk of failure of systemically important financial institutions.

Financial Sector and FX Mortgage Repayment

Since two-thirds of housing loans are denominated in foreign currency, especially Swiss Francs, the sharp appreciation of the CHF triggered the adoption of measures to support households indebted in foreign currency. The measures adopted last summer were generally well received. They consisted of granting additional credit to finance the increased debt service due to the appreciation of the foreign currency. However, the measures adopted in September, allowing full repayment of foreign currency mortgage loans at a preferential exchange rate, created controversy. They may result in a significant loss for the banking sector and create pressures in the exchange market. Moreover, the staff argues that the measures were not sufficiently targeted to borrowers for whom the appreciation of the Swiss Franc created the most serious difficulties. Therefore, last December, the government has reached agreement with the Banking Association on a scheme that ensures a more balanced burden sharing among households, the banking sector and the government, as detailed in Box 4 of the Staff Report. The government agreed to not submit or support any further regulation concerning FX lending unless it is supported by the Banking Association. Furthermore, this recent agreement should have a positive impact on growth as it also includes a lowering of the bank levies according to the amount of new loans that banks extend to small and medium size enterprises.

Final remarks

Hungary is in the process of implementing long-lasting structural reforms. The aim of the government is to enhance credibility in the financial markets, preserve macroeconomic stability and increase the economic growth potential. These ambitious objectives could be more successfully reached under a program supported by the European Union and the Fund. Therefore, the authorities have requested from the EU and the Fund a precautionary financial support arrangement. The authorities are committed to engage in these negotiations in a constructive manner, ensuring a successful outcome.