Hungary: Staff Report for the 2013 Article IV Consultation and Third Post Program Monitoring Discussions
Author: International Monetary Fund
Publication Date:
29 Mar 2013
eISBN:
9781484398388
Language:
English
Keywords:
ISCR; CR; FX financing need; economy; largely not observed; central bank; current account; foreign currency; private sector; monetary policy
Download PDF (1.1 MB)

This paper presents 2013 Article IV Consultation and Third Post Program Monitoring discussions on Hungry. While the output gap remains sizable, inflation expectations are not well anchored, and after seven consecutive policy rate cuts a pause seems prudent. Further monetary policy easing can be supported by stronger macroeconomic policies. Some efforts have been made to improve labor participation, but potential growth remains far too low for a country that should converge faster to EU-average incomes. The IMF report suggests that maintaining market confidence and reviving growth are the most pressing priorities for which decisive action to improve policies is needed.

Abstract

This paper presents 2013 Article IV Consultation and Third Post Program Monitoring discussions on Hungry. While the output gap remains sizable, inflation expectations are not well anchored, and after seven consecutive policy rate cuts a pause seems prudent. Further monetary policy easing can be supported by stronger macroeconomic policies. Some efforts have been made to improve labor participation, but potential growth remains far too low for a country that should converge faster to EU-average incomes. The IMF report suggests that maintaining market confidence and reviving growth are the most pressing priorities for which decisive action to improve policies is needed.

Context

1. Hungary has been plagued by low growth and high debt for much of the last decade. Growth performance has been one of the weakest in the region, and real GDP in 2012 was about 6 percent below the 2008 level. At the same time, public and external debt and currency mismatches in the economy have been very high (Figure 1).

Figure 1.
Figure 1.

Hungary and Peers

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: Hungarian Statistical Office, MNB, World Bank, and IMF staff estimates.
uA01fig02

Real GDP Growth

(Percent)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: WEO.

2. The recent weak growth performance has been due to structural factors as well as domestic policy missteps. More than four years since the onset of the financial crisis, the economy is undergoing a difficult period of balance sheet adjustment which inevitably exerts a negative impact on growth. And although the imbalances have improved, the adjustment process is still not complete. Government policies have sought to cushion the impact of the downturn on households, rein in fiscal deficits, and boost employment. However, increased state interference in the economy including through frequent and unpredictable policy changes (e.g., sectoral taxes, pension nationalization, mortgage pre-payment schemes, utility tariff cuts) and the weakening of institutions (e.g., diminished role of the Fiscal Council and the Constitutional Court) have hurt the investment climate, undercutting prospects for recovery (Box 1).

3. Despite considerable headwinds, financial stability was broadly maintained in 2012. With large vulnerabilities and limited space to absorb shocks, financial pressures rose sharply in late 2011–early 2012, in the wake of growth and financial spillovers from the eurozone crisis, which exacerbated existing strains on the domestic economy. However, despite these pressures, the authorities managed to navigate a challenging year and maintain macroeconomic stability. The external financial environment has improved considerably in recent months, but this has not translated into benefits for the broader economy.

Implementation of Past IMF Recommendations

During the last Article IV consultation, Directors underscored the need for a different policy mix to restore confidence in economic governance, anchor the ongoing adjustment, and strengthen economic institutions. Overall, there was no major change in policy direction in 2012, and several policies deviated from past Fund advice.

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Recent Economic Developments

4. The economic environment deteriorated markedly in 2012. Against strong headwinds from a challenging environment, strained balance sheets, and a drag from the significant fiscal adjustment, the economy slipped into a second recession in four years, with real GDP estimated to have declined by 1.7 percent (Figure 2).

Figure 2.
Figure 2.

Hungary: Real Sector

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: Hungarian Statistical Office; NBH and IMF staff estimates.

  • Consumption resumed its trend decline (about - 2½ percent in 2012) despite several initiatives to support household incomes and improve labor market conditions. In particular, the minimum wage was increased by 18 percent in 2012; the public works program was extended to cover over 100,000 workers; and various mortgage restructuring schemes were implemented (Box 2). Nonetheless, consumer confidence remained depressed and household consumption continued to decline reflecting the elevated debt service burden, erosion of real disposable income due to high inflation, and heavier tax burden on low income workers from the regressive flat personal income tax. Unemployment stayed flat at around 10.7 percent (e-o-p), near post crisis high levels, as demand for labor from the private sector remained subdued.

uA01fig03

Household Indebtdedness and Real Disposable Income

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Sources: MNB and IMF staff estimates.

  • Investment dropped to the lowest levels in 10 years (and at around 16 percent of GDP is below normal amortization levels), reflecting, inter alia, the weak business environment. This decline goes beyond the depressed construction sector, and structural problems in the corporate sector are increasingly coming to the fore. Manufacturing output declined in most sectors in 2012 and is now about 13 percent below the 2008 peak. A notable exception is the auto industry that continues to benefit from its close links to the German supply chain and past investment decisions.

  • Net exports remained the only source of growth, on the back of continued import compression and the expansion of the auto industry. Although the recent weakening in the pace of exports can be attributed to a worsened external environment, the decline in export market shares in recent years indicates that Hungary may be losing ground compared to peers (Box 3).

uA01fig04

Domestic Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: Hungarian Statistical Office and IMF staff estimates.
uA01fig05

Hungarian and German Exports Real Growth

(YOY Percentage Change)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: Eurostat.

5. Financial intermediation declined sharply. Banks have continued to scale down their operations under pressure from heavy taxation, losses from government mortgage relief schemes, and rising NPLs (Figure 3). The reduction in external funding accelerated beyond the pace seen in peer countries, and the loan-to-deposits ratio dropped sharply to 111 percent at end-2012. Most of this reflects reduced lending as the deposit base has remained broadly stable. Banks have tightened their lending standards and are less willing to expand in the corporate sector, particularly to small and medium enterprises (SMEs). Demand for new loans, especially from households, is also very weak. Non-performing loans (NPLs) continued to increase in both the retail and corporate segments (reaching 15 percent and 21 percent, respectively).1 Restructured loans are on the rise (11 percent of all loans), reflecting the implicit incentive by the absence of penalties in the form of provisions.

Figure 3.
Figure 3.

Hungary: Banking Sector Developments

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Sources: MNB, IFS, WEO and IMF staff estimates.
uA01fig06

External and Internal Deleveraging

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Sources: IFS and MNB
uA01fig07

Credit Growth

(YOY, Exchange rate Adjusted)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: MNB.

6. The fiscal deficit declined below 3 percent of GDP. After nine years under the excessive deficit procedure (EDP) and to avoid the suspension of cohesion funds, the government embarked on a sizable consolidation (Figure 4). The 2012 deficit is estimated at 2½ percent of GDP, implying a structural adjustment of 2¾ percent of GDP. This required the adoption of several fiscal packages during the year as the budget faced pressure from revenue shortfalls from a weakening economy and expenditure slippages. Overall, around two thirds of the announced measures were revenue based, including the increase in the standard VAT rate from 25 to 27 percent (the highest rate in Europe), hikes in excise taxes, and increases in health care contributions. In addition, the budget continued to rely on existing and new special taxes levied on bank, retail, telecom, and energy sectors. Some efforts were made at reducing spending on goods and services and capital transfers.

Figure 4.
Figure 4.

Hungary: Fiscal Sector

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Sources: IMF staff estimates and projections and Hungarian Authorities.1/ Excludes 9.6 percent of GDP in pension assets transfer to government in 2011.

Main Fiscal Measures in 2012

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Source: IMF staff estimates.

7. After a difficult first part of 2012, sovereign financing conditions improved considerably in recent months on the back of improved risk appetite globally. Hungary came under severe financial stress starting in late 2011 with sovereign spreads reaching 650 bps and the forint hitting 320 per euro. Conditions started to ease in the summer following actions by major central banks and the authorities’ commitment to keep the fiscal deficit under control. Flows into government domestic debt surged, particularly in the second half of the year, and, by end 2012, about 45 percent of the stock of domestic government bonds (about €17 billion) was held by non-residents. Taking advantage of the favorable environment, in February 2013, the government returned to the external markets (the first time since May 2011) with a US$3.25 billion bond placement.

uA01fig08

5-year Sovereign CDS Spreads

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: Datastream* Poland, Czech Rep., Slovak Rep., Romania, Bulgaria, Ukraine, Estonia, Latvia, Lithuania, Croatia, and Slovenia.

8. Against a decline in risk premia and a weak economic outlook, the MNB started to ease monetary policy in the second half of 2012 (Figure 5). The policy stance was kept tight during the first seven months of the year as financial conditions were unsettled and inflation remained stubbornly above 5 percent. Since August, policy rates have been cut by 175 basis points in seven successive steps. These were split vote decisions, with the monetary council’s (MPC) external members outvoting MNB’s management. The majority considered that the effects of cost-push factors (energy prices and indirect tax rate hikes) that kept inflation above the central bank’s 3 percent target were waning, and the pull from weak demand conditions was sufficient to steer inflation towards the target by mid-2014. The exchange rate closed at HUF291 per euro at end 2012, appreciating by 6½ percent during the year, but suffering bouts of volatility.

Figure 5.
Figure 5.

Hungary: Inflation and Monetary Policy

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Sources: MNB, Bloomberg, WEO and IMF staff estimates.

Outlook and Risks

9. Staff expects weak growth conditions to continue. Real GDP is projected to remain broadly flat in 2013 as the negative carry over from 2012 and persistently weak domestic demand are expected to offset a modest contribution from net exports. Consumption is likely to remain depressed despite a small increase in disposable income as households continue to repair their balance sheets. Similarly, amid a generally unfriendly environment weak, investment and bank deleveraging are expected to continue (Box 4). A mild recovery is expected in 2014 and thereafter as domestic demand bottoms out. Yet weak policies, low labor participation, and the poor investment climate are likely to keep growth subdued in the medium term.2 Current account surpluses are projected for 2013–14, which would gradually narrow as domestic demand and imports recover. Absent new tax hikes and administrative price adjustment, inflation will moderate in 2013–14.

uA01fig09

Real Potential Output Growth In Hungary and Regional Peers 1/

(Percent)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: IMF staff estimates.1/ The sample includes Bulgaria, Croatia, Czech Republic, Estonia, Lithuania, Poland, Romania, Russia, Slovak Republic, Slovenia, Turkey and Ukraine.

10. Downside risks to the baseline outlook are considerable. On the domestic side, the recession could prove more persistent prolonged by weaker than expected private consumption and business confidence. On the external side, the reemergence of pressures in the euro area could be particularly destabilizing for Hungary given its strong regional trade and financial linkages leading to sharper credit crunch and economic slowdown. In addition, a reversal of capital flows, including markedly diminished non-residents’ participation in Hungarian securities, prompted by either an intensification of the euro area crisis or domestic policies could cause severe funding pressures and an abrupt depreciation. In turn, this would further impair balance sheets given the still sizable foreign currency exposures (Box 5) and undermine external sustainability (Appendix).3 On the upside, sustained capital inflows could lead to an exchange rate appreciation and improved balance sheets, providing a boost to domestic demand.

Authorities’ views

11. The government was generally sanguine about the outlook and confident that current policies will support economic recovery. It viewed the 2012 contraction as the result of external headwinds, the poor agricultural harvest, and the drag from fiscal adjustment. It expected real GDP to grow by 0.9 percent in 2013 and 2 percent in 2014, as external conditions improve, the drag from the fiscal stance is lifted, targeted measures increase household disposable income, and the absorption of EU funds is accelerated. The MNB was less upbeat. It expressed serious concerns about the worsened growth outlook. It estimated that potential growth declined to around 0–½ percent in 2012 (in line with staff’s assessment), and expected it to rise to a modest 1 percent in 2013–14.

Policy Discussions

Discussions centered on the viability and challenges of the current economic strategy, the sustainability of the fiscal adjustment, the need to repair bank and household balance sheets, and structural reforms to support investment and job creation.

A. Ensuring Fiscal Sustainability: Quality Matters

12. The authorities are determined to exit the EDP as soon as possible. Following the sharp adjustment last year, the 2013 budget targets a slight increase in the headline deficit to 2¾ percent of GDP, implying a broadly cyclically neutral stance. The broader direction of policies in the 2013 budget remains unchanged. Tax revenue is expected to increase by more than 1 percent of GDP, mainly on the back of sectoral taxes, most of which were revised and became permanent in 2013, and a new tax on bank transactions (BTT). The latter was introduced to fund the implementation of the Job Protection Plan which reduces social security contributions for companies employing specific groups of workers.4,5 Overall, revenues in the form of sectoral taxes are expected to rise to around 2½ percent of GDP in 2013. Total spending is expected to exceed 50 percent of GDP.

Main fiscal measures for 2013

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Source:IMF staff estimates.

13. Based on current policies, the 2013 target is expected to be missed. Staff supported the slightly looser 2013 target (relative to the 2.2 percent target under the convergence plan), given the weak state of the economy, but expressed deep concern about the composition and adequacy of measures underpinning the budget. Absent new measures, the deficit is likely to reach 4½ percent of GDP with the overrun mainly caused by overestimation of revenue including from optimistic macro projections, unsubstantiated tax administration gains and the BTT, delays in launching the electronic toll system, higher spending on education, and copayments to EU funded projects. While the budget includes a buffer of about 1¼ percent of GDP in the form of contingency reserves, this is insufficient to cover the projected shortfall. Assuming these contingency reserves are not spent, the deficit would be limited to 3¼ percent of GDP in 2013. In this regard, staff called for additional measures to reach the deficit target.

uA01fig10

General Government Overall Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: Hungarian authorities and IMF staff estimates.

14. Staff recommended a stronger medium-term adjustment. On current plans, the fiscal deficit will remain above 3 percent of GDP over the medium-term, keeping public debt close to 80 percent of GDP. This would be some 10 percentage points higher than its pre-crisis level—despite the one-off effect from the transfer of assets from private pension funds in 2011. This high level of debt, and the corresponding large financing needs, would keep Hungary vulnerable to shocks and swings in market sentiment (Table 4 and Appendix I). In this regard, staff called for stronger action to bring the deficit sustainably well below 2 percent of GDP by 2015 to support decisive debt reduction.

Table 1.

Hungary: Selected Economic Indicators, 2008–14

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Sources: Hungarian authorities; IFS; Bloomberg; and IMF staff estimates.

Includes change in inventories.

Actual final consumption of households.

Excludes change in inventories.

Consists of the central government budget, social security funds, extrabudgetary funds, and local governments.

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

Table 2.

Hungary: Medium-Term Scenario, 2008–18

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Sources: Hungarian authorities; and IMF staff estimates.

Excludes change in inventories.

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

Includes interest revenue.

Table 3.

Hungary: Consolidated General Government, 2008-14 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Hungarian authorities; and Fund staff estimates.

Data are classified following the ESA’95 methodology.

Includes sectoral levies. Also, starting 2013 includes revenues from the financial transaction levy.

Includes the levy on financial institutions.

In 2011 and 2012 includes 9.6 and 0.2 percent of GDP, respectively, from the transfer of pension assets to the state system.

For 2014, all non-interest expenditure categories are projected according to the nominal GDP growth rate.

Includes social security contributions.

Different from 2011 Article IV Report assumption, Staff now assumes that the extraordinary reserves, included under this spending category, will not be spent, to reach the deficit targets.

In 2011 includes debt takeover of the transport sector company MAV (0.2 percent of GDP)and the capitalization of the National Development Bank (0.1 percent of GDP).

Table 4.

Hungary: Central Government Financing, 2010-14 1/

(In percent of GDP)

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Source: Hungarian authorities and Fund staff estimates.

Cash deficit as reported by the authorities is adjusted for the below-the-line transactions. For 2011, gross financing needs also include the purchase of MOL company shares and the recapitalization of the MFB bank.

uA01fig11

Public Debt and the Structural Fiscal Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Sources: Hungarian authorities and IMF staff estimates.

15. Importantly, staff called for a significantly different composition of fiscal policy to improve growth prospects and ensure the sustainability of the fiscal adjustment. The tax burden on several economic sectors has increased, undermining investment, employment, and growth. At the same time, public expenditure is among the highest in the region (Box 6). Staff argued for a medium-term plan to streamline spending while protecting the most vulnerable, which would open room for the needed rationalization of the tax system.6 Possible actions include: (i) reducing the cost of the central government bureaucracy and containing spending at the local government level, where savings can be found after the centralization of health and education spending; (ii) restructuring loss making transport state-owned enterprises (SOE)s to reduce state transfers; (iii) better targeting social benefits to vulnerable groups; (iv) gradually eliminating sectoral taxes while streamlining the corporate tax regime; (v) reducing disincentives to work embedded in the personal income tax; and (vi) reducing tax expenditures and adopting a more comprehensive approach to tackle VAT fraud, particularly in the basic food sector (Box 7).7

16. Staff underscored the need to move ahead with the structural fiscal reform agenda and strengthen fiscal institutions. Enhancing fiscal institutions would better support macroeconomic and fiscal performance. In this regard, staff recommended: (i) introducing a medium-term budget framework that will support the targets under the Convergence plan and EU fiscal rules; and (ii) strengthening the fiscal council by enhancing its independence, providing it with sufficient resources, and broadening its mandate to effectively assess budgetary objectives and risks.

Authorities’ views

17. The government was confident that the 2013–14 deficits will remain below 3 percent of GDP. It argued that despite some possible slippages, the contingency reserves are sufficient to meet the deficit target. The government saw no room to change the current tax system, which in its view, balances appropriately the tax burden among the various sectors of the economy. In this respect, they also saw no need for sizable reduction in spending, although they noted plans to reduce the cost of public administration. They also noted their plans to strengthen the budgetary framework by introducing the European Structural Balance rule for the general government by end-2013.

B. Monetary Policy—A Difficult Balancing Act

18. The recent monetary policy easing was supported by favorable external conditions, yet inflation is not well anchored. Headline inflation is projected to decline in 2013 on the back of a one off (10 percent) adjustment in regulated energy prices for households, but, as this impact wears off, inflation is expected to increase before the pull from the output gap brings it close to the target by end-2014. Core inflation is set to decelerate at a more gradual pace. However, upside risks are considerable, stemming from the uncertainty about the degree to which spare capacity in the economy will restrain rising production costs, including from higher taxes and nominal wage increases.

uA01fig12

Inflation

(yoy)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: IMF staff’s estimates.

19. Staff argued that a pause in the easing cycle seems prudent and further cuts should be considered only in the context of strengthened macro policies and improved market conditions. Beyond the uncertainty surrounding the inflation trajectory, staff cautioned that policy rate cuts cannot substitute for other policies to jump-start growth, particularly when the credit channel is impaired. In fact, with fickle market confidence, deep policy rate cuts could lead to currency depreciation and could risk de-stabilizing the financial system, given the sizable FX exposures in private balance sheets. Stronger policies (including fiscal), moderation of inflation expectations, and low risk premia would facilitate further policy rate cuts. In this regard, maintaining the legal and operational independence of the MNB is critical.

20. Although there is no compelling evidence that the forint is considerably misaligned, structural factors may be eroding competitiveness (Box 3). Standard methodologies find only weak evidence for overvaluation. Nonetheless, Hungary has been gradually losing export market share and lagging labor productivity has raised unit labor costs relative to peers due mostly to structural factors rather than exchange rate developments. Considering the balance sheet exposure to exchange rate movements, improving competitiveness should be based on removing the impediments that hamper investment and hold back private activity, and advancing structural reforms. This would help to maintain a strong current account and improve the large negative net international investment position over time.

21. An adequate reserve position would help provide strong buffers against shocks. Reserves are currently within the IMF adequacy range. However, given the still high short-term external debt and FX exposure of Hungary’s economy, reserves should be maintained at levels sufficient to provide foreign currency liquidity to markets under adverse external shocks. Periods of continued capital inflows can provide an opportunity to build reserves within the current exchange rate regime.

uA01fig13

Reserve Adequacy

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: IMF staff estimates.

Authorities’ view

22. Views within the MNB were divided. The MNB management favored a tighter monetary stance. They expressed concern that the higher production costs and possible over-estimation of the output gap may lead to higher inflationary pressures in the period ahead. They also doubted the effectiveness of monetary easing to spur growth in the current juncture, given the impaired credit channel and the adverse balance sheet effects of a weaker currency that may be associated with further cuts. The external MPC members were more sanguine about the inflation outlook, arguing that higher production costs will not result in inflationary pressures as the output gap remains sizable. In this regard, they were convinced that the improved external environment creates room for monetary policy easing and that policy rate cuts could contribute to credit growth. The MPC members assessed the level of reserves as adequate by a variety of indicators. The MNB did not see the forint as overvalued, but shared staff’s concerns that Hungary’s international competitiveness may have started to weaken recently.

C. Financial Sector—Restore Conditions for Financial Intermediation

23. While the banking system is generally stable, important vulnerabilities remain. Banks’ average capital adequacy ratio (CAR) as of end-2012 (15 percent) appears adequate and stress tests conducted by the Central Bank indicate an improvement in the shock-absorbing capacity of the banking sector as a whole. However, with subdued economic activity, rising non-performing and restructured loans, possibly over-stated collateral, and a heavy tax burden,8 banks’ profitability is projected to remain low. In this difficult landscape, banks are planning to further scale down their operations. Credit growth is projected to remain negative in 2013 on the back of weak household demand and banks’ limited appetite to lend. Reduction of parent banks’ cross-border exposure (including to their subsidiaries) is likely to continue, albeit at a more gradual pace, and thus contribute to the negative credit growth and weak economic activity in the period ahead. 9

24. Higher bank provisioning is needed in view of the worsening asset quality and weak collateral. Rising corporate and household NPLs point to the risk of further losses,10 particularly given the relatively low provisioning (47 percent), and the high level of restructured and ever-greened loans.11 Staff underscored that adequate provisioning, including through more frequent and realistic appraisals of collateral, would help minimize uncertainty regarding future losses and assist with the cleanup of balance sheets.12 In addition, staff stressed the need for closer monitoring of repeated loan restructurings to ensure that non-performing loans are adequately reported and provisioned for.

uA01fig14

Hungary: Non-Performing Loans in the Private Sector

(Percent of Total Loans)

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: MNB.

25. Speeding up portfolio cleaning is desirable but banks’ capacity to absorb further losses is limited. Portfolio cleaning remains sluggish. Staff concurred with the authorities that resolution of NPLs should be led by banks in a cooperative fashion, yet noted that a more proactive approach, which would provide incentives for the banks to clean up their portfolios, is warranted. In this regard, staff stressed the need to remove legal, tax and regulatory impediments to facilitate speedy liquidation of collateral while keeping an adequate balance between creditors and debtors rights.13 Establishing a personal insolvency framework would also help expedite the portfolio cleaning process. Staff noted that developing an out-of-court debt restructuring framework would reduce present delays and high collection costs while further alleviating the pressure on the judicial system. Staff welcomed the establishment of the National Asset Management Agency (NAMA), though saw room to relax the participation requirements and change its financing structure to reduce the burden on the treasury.14

26. Banks need more stable sources of external funding to reduce reliance on FX swaps. The stock of FX swaps (used to hedge on-balance sheet open FX positions) declined in 2012, in tandem with the reduction in banks’ FX assets. But at a level of €10 billion (about 10 percent of GDP) and with relatively short maturity (on average 1½ years), FX swaps represent a significant vulnerability to the financial system as they can amplify the negative effects of external shocks on the exchange rate. Staff noted the recent improvements in the macro-prudential regulatory framework, including the introduction of the FX Funding Adequacy Ratio (FFAR),15 and stressed that, as the reduction of banks’ FX assets continues, banks should be encouraged to turn to more stable sources of external financing. In this regard, staff also welcomed the authorities’ efforts to reduce the rollover and liquidity risks associated with FX swaps by negotiating with the banks to voluntarily limit their off-balance sheet net FX position to below 15 percent of total assets.

27. Hungarian banks’ regional operations should continue to be monitored to minimize the risk of potential adverse outward spillovers. The largest domestic bank has several subsidiaries in the region accounting for about 40 percent of its total assets. While these subsidiaries are mostly small, they are relatively large in Bulgaria and Montenegro (among the top three banks by bank assets).16 The HFSA is in regular contact with host country supervisors and staff does not see an imminent risk of systemic spillovers in the host countries from the activities of this bank. Continued effective supervision of banking group’s and enhanced cooperation with host country supervisory agencies will be critical to ensure the stability and soundness of host country financial systems.

28. Staff warned against an increased role of the government in providing credit to the economy, particularly given the limited fiscal space. The government’s efforts to facilitate lending to SMEs through tax incentives, refinancing, and direct lending by the state-controlled banks has had little success so far, and further efforts to expand the government’s involvement in lending to the private sector are underway. Staff argued that the most efficient way to restore credit growth is through improving the broader policy framework and its predictability, including by abolishing the bank levy, which is delinked from banks’ current size and performance. Staff, in this regard, welcomed the governments’ intent to re-engage with banks in an effort to establish a better operational environment.

Authorities’ views

29. The authorities agreed that the lack of financial intermediation undermines economic activity. They concurred that credit is likely to continue to contract in 2013 due to both demand and supply factors. They saw a role for government action, including through credit guarantees and mortgage rate subsidies, to improve SMEs’ access to credit and reduce the cost of borrowing to households. While agreeing that the high share of NPLs and restructured loans burdens banks’ balance sheets, the authorities expressed concern that forcing banks to move faster with portfolio cleaning would amplify their losses, particularly given the weak real estate market. The MNB agreed that the regulatory framework could be strengthened to ensure adequate provisioning. However, the financial supervision authority (HFSA) was more optimistic arguing that loan-loss provisioning is adequate and the recent improvement in the banks’ capital position would be sufficient to withstand possible losses. The HFSA noted its intent to issue guidelines to banks within the first half of 2013, requiring additional provisions for loans that have been restructured multiple times. They also stressed their plans to enforce stricter collateral valuation for real estate, and harmonize appraisal methods across banks. The authorities are working on a bank resolution framework, including with IMF technical assistance, aiming to submit legislation for parliamentary approval by June-2013.

D. Structural Issues—Raising Potential Growth

30. Hungary’s growth prospects have deteriorated in recent years. Unconventional policies, high and uneven tax rates, and heavy regulatory burden have eroded investors’ confidence and contributed to a sharp decline in investment, undermining growth and aggravating the ongoing balance sheet adjustment in the economy. While estimates are subject to considerable uncertainty, Hungary’s potential GDP growth over the medium-term (around 1½ percent) is significantly below its peers and well below the level needed to bring the high unemployment back to its pre-crisis levels.

uA01fig15

Burden of Government Regulations

Citation: IMF Staff Country Reports 2013, 085; 10.5089/9781484398388.002.A001

Source: Global Competitiveness report 2012–13, WEF.

31. The gains to potential growth from comprehensive efforts to raise productivity and labor participation could be substantial. In this regard, measures are needed to:

  • Improve the business climate. Hungary’s ranking (54) in the World Bank’s Doing Business Report continued to deteriorate in 2013 after falling both in 2012 and 2011 (by 5 and 8 places, respectively), primarily due to worsening perceptions about investors’ protection, institutions, and tax burden. A level playing field for all business, a stronger investor protection framework, and a more predictable policy framework, including through more balanced fiscal consolidation and a better operational environment for banks would help support investment and economic activity.

  • Raise the exceptionally low labor participation rate. The authorities have placed job creation as a key policy objective and have adopted measures to stimulate employment, including by tightening unemployment and welfare benefits, expanding the public works program, and reducing tax rates and social contributions for some segments of the labor force. Staff argued for (i) a more employment-friendly taxation for low income earners, including by introducing a basic allowance in the personal income tax to increase labor supply; (ii) upgrading the public works program by significantly scaling up training and skillenhancing services; and (iii) raising women’s participation in the labor market by reorienting public spending from cash benefits, including overly long post-maternity parental leave benefits, towards the development of high quality early childhood education and day care centers.

  • Strengthen competition. Possible measures in this area include the reduction of unnecessary regulations and entry barriers that continue to pose obstacles to entrepreneurship, and enhancing the operation, effectiveness, and role of the Competition Authority.17 In addition, increasing competition in the services sectors can raise productivity. This includes the utility sector, where reforms to allow for more competition is a more sustainable way to help drive down utility tariffs than administrative measures.

  • Enhance the efficiency of SOEs. The restructuring of loss making transport SOEs is long overdue and could help improve services and resource reallocation while phasing out a persistent drain on the budget.

Authorities’ views

32. While agreeing on the need to remove structural bottlenecks to growth, the authorities envisage a more favorable growth outlook based on ongoing initiatives. In their view, the fiscal adjustment in 2012 and the commitment to fiscal prudence constitutes a solid base to jumpstart the economy. Private investment would be supported by strategic agreements with large manufacturing companies and more targeted use of EU transfers. They pointed out that Hungary’s labor market regulations ensure a high degree of flexibility, and labor participation will continue to increase thanks to recent changes to early pension requirements and unemployment and disability benefits. Labor demand will strengthen on account of the targeted relief afforded by the Job Protection Plan. Finally, they noted that exports could be supported by expanding the role of the Eximbank and by efforts to strengthen trade links with non-EU partners such as China, Russia, and the Arab countries.

Post Program Monitoring

33. In the current favorable market environment no official financing is envisaged. Outstanding Fund credit to Hungary is projected to fall below 200 percent of quota in August 2013, and be mostly eliminated by mid-2014 (Table 11). Hungary’s capacity to repay the Fund is expected to remain adequate, assuming continued access to international capital markets and/or continued strong nonresident participation in the domestic government debt market. However, downside risks (as described in paragraph 10) remain sizable and should they materialize meeting the debt payments could become challenging.

Table 5a.

Hungary: General Government Operations (GFSM presentation), 2008-14 1/

(In percent of GDP)

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Sources: Hungarian authorities and IMF staff estimates.

Subcategories within tax revenues follow the ESA95 presentation.

The distinction between grants and other transfers is not available in the ESA95 main tables which are the source of data for this table.

Includes net acquisition of nonproduced nonfinancial assets.

Excludes fixed capital consumption.

Table 5b.

Hungary: General Government Stock Positions, 2008-14 1/

(In percent of GDP)

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Sources: Hungarian authorities and IMF staff estimates.

GFSM 2001 presentation.