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.
The authorities thank staff for the thorough and constructive discussions during the Article IV mission and for their valuable advice on macroeconomic policies. The authorities remain committed to prudent macroeconomic policies, focusing their strategy on sustainable debt reduction, increasing labor participation, improving competitiveness, and reducing financial vulnerabilities.
Economic developments and outlook
2012 was a challenging year for Hungary. Real GDP declined by 1.7 percent in the face of a worsening external environment, weak domestic demand reflecting the ongoing deleveraging process and significant fiscal consolidation effort, as well as a sharp fall in agricultural production caused by severe weather conditions.
The authorities expect that growth will resume in the course of 2013, backed by net exports and stabilizing domestic demand. The manufacturing sector is gaining momentum, supporting export growth and continuing attracting investments. While overall investment contracted in 2012 amid tight credit conditions, investment in manufacturing increased by 4.9 percent and is likely to remain at high levels in 2013, increasing productivity and potential output. Several significant FDI projects will be implemented in the course of 2013, which, through the vertical supply chains, will add momentum to the domestic SME sector. The strategic partnership agreements which the government has signed with a wide number of large manufacturing and other companies will further contribute to job creation and investment in R&D. Public investment will be supported by the continuous absorption of EU funds.
Private consumption growth is expected to gradually resume by 2014. The still-ongoing deleveraging in the household sector will be offset by the gradual recovery of real disposable income, supported by rising real wages, increasing labor participation, and a decelerating inflation. Inflation is expected to slow to around 3 percent, due to weak domestic demand and contained regulated energy prices.
Fiscal Policy and Consolidation
The authorities are fully committed to pursuing prudent fiscal policies compatible with sustainable debt reduction. The key building blocks of fiscal policy have been expenditure reductions through structural measures, fair tax burden sharing among various economic players in accordance with their capacity, and employment-friendly taxation which shifts the burden from labor to consumption and turnover taxes (growth-oriented reform). The fiscal consolidation strategy aims to permanently keep the fiscal deficit comfortably below 3 percent of GDP, which allows an exit from the EU’s Excessive Deficit Procedure.
In 2012, the government achieved a structural consolidation of around 2.5 percentage points of GDP, based on measures announced in the multi-annual Széll Kálmán Plan I and II, the implementation of which is continuing, implying further spending cuts in the 2013 budget. A number of further corrective actions throughout the year ensured that the 2012 fiscal deficit stood at around 2.5 percent, in spite of the worse-than-expected macroeconomic environment.
Going forward, the Hungarian government is committed to fully implement the measures underpinning the 2013 budget which will ensure the safe attainment of the deficit target. With respect to the items on which Fund staff identified a risk of slippages, the authorities assure that the necessary measures will be implemented timely (e.g. launching the electronic toll system and the connection of cash registers to the tax authority). Furthermore, the substantially increased contingency reserves (1 1/3 percent of GDP) provide sufficient buffers to address unforeseen risks, including any that surround the macroeconomic outlook. The centralization of the local government’s finances gives the government stricter control over spending, and contracting new local debt. The legally binding framework on debt reduction along with the government’s solid track record in terms of strictly fulfilling the planned deficit targets since 2010, are further factors to be considered in this context.
The power of the Fiscal Council has been strengthened by a number of measures: (i) It has been entrusted with a veto right in the adoption of the annual budget. (ii) It evaluates the budget execution twice a year on its consistency with the debt reduction goal. (iii) It has the right to evaluate any bill that has budgetary implications, or express its opinion on any other issue that has implications on budget planning, its execution, or the use of public money. In fulfilling its tasks, the Fiscal Council can rely on the expertise of the staff of the State Audit Office and the Magyar Nemzeti Bank, whose presidents are also members of the Fiscal Council. Moreover, the Council has been endowed with a small professional staff team and its own appropriation.
Taxation. Tax policy aims at creating incentives for labor participation and SME development, at the same time securing the revenues needed to pursue the structural transformations while containing the fiscal deficit. The tax burden was gradually shifted away from labor income, leaving the overall burden on capital income unchanged at an already low level. Revenues were replaced by VAT hikes, excise duties, new consumption and turnover taxes based on a “broad base – low rate” approach (financial transaction levy, telecommunication tax), taxes on negative externalities (tax on unhealthy food products, product fees, car accident tax), several tax base broadening measures (improving tax compliance, deleting tax reliefs, tax hikes on fringe benefits, stricter loss carry-forward rules) and the introduction/increase of taxes on businesses with excess market power (bank levy, tax on energy companies). Hence, funding has been secured for the launch of the Job Protection Action Plan, intended to reduce the tax burden on the most vulnerable groups of the labor market, targeting those with the highest responsiveness to incentives to join the workforce: unskilled, young and elderly workers, and those returning to the labor market after a long period of inactivity. The lump sum tax for small entrepreneurs may significantly improve compliance among the self-employed, while the small business tax provides a simple and transparent framework to promote both employment and investment among small enterprises.
Debt and Financing
The public debt-to-GDP ratio has been continuously declining since 2010. The government was also able to reduce the share of FX-denominated debt, as it completed the 2012 FX redemptions by issuing domestic currency denominated papers while maintaining the level of official reserves through the continuous inflow of EU funds. As for 2013, the government has already secured the bulk of the 2013 FX financing need by a USD 3.25 bn bond issuance in international markets in mid-February, and a EUR 1.5 bn retail euro-denominated bond sale in the domestic market during November - January.
Monetary Policy and Reserves
The Magyar Nemzeti Bank launched a rate-cutting cycle in August 2012, lowering the policy rate by a cumulative 175 basis points in seven successive steps to 5.25 percent. The monetary easing has occurred in association with the improving market sentiment vis-à-vis Hungary and the strong global risk appetite. The central bank may consider a further reduction in the policy rate if the medium-term outlook for inflation remains consistent with the 3 percent target, and the improvement in financial market sentiment is sustained.
The central bank has been continuously accumulating international reserves over the past few years. The current level of reserves is adequate by a variety of metrics. The authorities share staff’s assessment that there is no compelling evidence showing that the exchange rate is misaligned.
The resilience of the Hungarian financial system in terms of capital and liquidity is adequate, and has improved markedly over the last year. Capital adequacy exceeds 15 percent supported by ongoing deleveraging and capital injections by parent banks. Liquidity risks have abated due to the appreciation of the forint, the drop in CDS spreads, a decrease in the net FX swap exposure, and the longer maturities of swaps.
The excessive FX lending practices pursued before the onset of the global financial and economic crisis led to a relatively high and still increasing share of NPLs. Nevertheless, in the view of the supervision authority, the provisioning of NPLs is adequate, exceeding 100 percent if collaterals are taken into account. While the deleveraging is still ongoing, the government has supported the so-called managed deleveraging through various measures (e.g. fixed exchange rate repayment schemes, interest subsidy on FX loans converted into HUF, etc.). The functioning of the National Asset Management Agency is conducive to the portfolio cleaning process, which, amid weak real estate market conditions, offers targeted support to low income families by purchasing their homes.
The Financial Stability Board has started elaborating on the legislative proposal regarding crisis management and the resolution framework, with the aim of submitting it to Parliament during the Spring 2013 session.
To facilitate the restoration of lending, an agreement with the Hungarian Banking Association has been concluded, with special focus on providing credit to the SME sector. A surge of lending to exporting SMEs can be expected also from the expanding role of the Eximbank, which has recently attracted substantial resources through international bond issuance and refinancing operations.
The implementation of growth-enhancing structural reforms, including the measures of the Széll Kálmán Plan I-II is underway. The reform of the local government sub-system (including administrative tasks, public education, health care, and social services) is at an advanced stage and will continue in 2013 as well, and the reform of the higher education system is progressing. The reorganization of the MÁV group is ongoing, aiming to create an independent track operator and an integrated passenger transport company, in parallel with the divestment of assets not required for railway operations.
Labor market reforms, aiming at a workfare state, and work-based social-security system, are already reflected by the rising labor force participation and employment (both growing by 1.7 percent in 2012, leaving the unemployment rate broadly unchanged). These figures comprise employment growth in small enterprises and the extension of the public work scheme. The government views the public work programs as a temporary measure until the business sector becomes capable of absorbing those involved now in public work. Nevertheless, regular public employment continues to decline, a trend supported by some of the public administration’s recent streamlining measures (e.g. compulsory retirement at the retirement age, abandoning the practice to receive salary and pension simultaneously).