Since the last Article IV consultation Hungary has achieved a remarkable reduction in vulnerabilities despite the volatile external environment. Economic activity picked up in the past one and a half year, driven both by internal demand and net exports. The external balance has been strengthening, backed by the current account surplus and continuous reduction in external debt. Disciplined fiscal policy preserved a stable fiscal balance and moderately declining public debt.

Abstract

Since the last Article IV consultation Hungary has achieved a remarkable reduction in vulnerabilities despite the volatile external environment. Economic activity picked up in the past one and a half year, driven both by internal demand and net exports. The external balance has been strengthening, backed by the current account surplus and continuous reduction in external debt. Disciplined fiscal policy preserved a stable fiscal balance and moderately declining public debt.

Since the last Article IV consultation Hungary has achieved a remarkable reduction in vulnerabilities despite the volatile external environment. Economic activity picked up in the past one and a half year, driven both by internal demand and net exports. The external balance has been strengthening, backed by the current account surplus and continuous reduction in external debt. Disciplined fiscal policy preserved a stable fiscal balance and moderately declining public debt.

That being said, the authorities are aware of the surrounding risks and remaining vulnerabilities, stemming primarily from the volatile external environment and the still elevated financing needs. They remain committed to prudent macroeconomic policies, focusing their strategy on sustainable debt reduction, increasing labor participation, improving competitiveness, and reducing financial vulnerabilities. The authorities thank staff for the thorough and constructive discussions during the Article IV mission and for their valuable advice on macroeconomic policies.

Economic developments and outlook

The economy strengthened in 2013, with output growth reaching 3.5 percent in the first quarter of 2014. The composition of growth shifted towards a more balanced structure, where the pick-up in external demand has been complemented by the recovery of internal demand, backed by reviving public and private investment and consumption. The accelerating growth is coupled with a rising current account surplus. Headline inflation decelerated sharply driven by the still-existing spare capacities in the economy and one-off price cuts in regulated utility prices.

Going forward, growth momentum is expected to persist over the forecast horizon. Against the background of the latest incoming data the authorities are more optimistic than staff about the growth prospects, expecting GDP growth rates exceeding 2.5 percent both for the current and for next year. Rising exports will remain an important driver of growth, supported by increasing FDI in the manufacturing sector and the new production capacities brought into the automobile industry, in addition to the strengthening of external demand. Investment is likely to pick up further, as the easing of credit constraints and the increased use of EU funding add to the improved outlook for activity. Nevertheless, consumption recovers only gradually despite the improved disposable income, as deleveraging continues to act as a drag on households. Inflation is expected to rise back into the price stability range of 3 percent as the output gap narrows and the one-off effects phase out. Labor market conditions remain loose, with moderate wage conditions coupled with gradually improving private sector employment.

Fiscal Policy and Consolidation

The authorities are fully committed to conduct prudent fiscal policies compatible with sustainable debt reduction, and building buffers which allow for countercyclical policy. The key building blocks of fiscal policymaking 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).

Fiscal discipline and prudence helped the government to keep the deficit comfortably within EU limits and exit the Excessive Deficit Procedure. Rigorous budget execution and corrective actions, where needed, ensured that both the 2012 and 2013 deficits overperformed the initial target. Going forward, fiscal policy seeks to support economic recovery while complying with the requirements of the fiscal framework, which in turn is based on keeping the deficit below 3 percent, complying with the medium-term fiscal plan regarding the structural balance, and preserving the declining debt ratio.

In this vein, the 2014 budget allows for a countercyclical structural impulse of about 1 percentage point, while a broadly neutral fiscal stance is envisaged for the subsequent years. Budgeted contingency reserves for 2014 provide sufficient buffers to address unforeseen risks and meet the 2.9 percent deficit target at a comfortable margin. Corrective actions and potential savings have already been identified in order to offset the underperforming revenues due to lower than expected inflation.

The authorities appreciate staff’s constructive policy recommendation on the medium-term fiscal adjustment strategy. Many of them, where feasible, are already under implementation, or given due consideration for the 2015-17 fiscal plan. Several measures have been implemented to address tax compliance and VAT fraud: reverse charge VAT mechanism in the agricultural sector, connection of cash registers to the tax authority and limitation of cash payments between firms, the effect of these showing already early results in the 2014 VAT revenues. Streamlining the range of VAT preferential rates, while consistent with the government’s general policy, should be evaluated against equity, inequality, social, and tax efficiency considerations. Spending on non-EU related goods and services will remain under strict nominal control and decline as a share of GDP, while public nominal wages remain frozen except in the education and healthcare sectors. Social transfers will also decline substantially as a share of GDP, as pensions are indexed to inflation, while other benefits remain frozen. Sector specific taxes, except the bank levy, were replaced by consumption and turnover type taxes (financial transaction levy, telecommunication tax) based on a “broad base - low rate” approach. The centralization of the local government’s finances gives the government stricter control over spending and contracting new local debt. The reorganization of public transportation companies is ongoing.

Monetary Policy and Financial System

The Magyar Nemzeti Bank (MNB) launched an easing cycle in August 2012 in association with the improving market sentiment vis-à-vis Hungary and the strong global risk appetite. The subdued inflationary pressures, the still negative output gap, and the supportive risk perception associated with the economy allowed the continuous lowering of the policy rate to 2.5 percent. Going forward, a cautious approach to policy is needed due to uncertainty in the global financial environment. However, a tightening bias would be warranted only if risk perception shifts and global volatility increases.

The current level of international reserves is adequate by a variety of metrics, and there is no compelling evidence showing that the exchange rate is misaligned.

The monetary toolkit has been complemented by new elements. The MNB announced the Funding for Growth Scheme in April 2013, aiming at providing liquidity to credit institutions to alleviate disruptions in lending to SMEs, reinforce financial stability, reduce the external vulnerability of the Hungarian economy, and ultimately revert the vicious credit squeeze - low growth cycle. The first phase of the program (June-September 2013), with a disbursed amount of about 2.5 percent of GDP, strengthened competition in the SME credit market and substantially alleviated the interest burden of firms. The second phase, running until the end of 2014, puts greater emphasis on the stimulation of economic growth by focusing on the supply of new loans to finance new investments. Although the utilization of the second phase evolves gradually owing to the time lag needed for the implementation of new projects, 60 percent of the 126 bn HUF (about 0.4 percent of GDP) of the already contracted loans as of April were new investment loans.

From August 2014 on, the MNB’s main policy instrument will change: the two-week MNB bill will be replaced by a two-week deposit facility, which only counterparties will be allowed to hold with the Bank, and will be excluded from the range of eligible collateral for the Bank’s lending operations. This will provide an incentive to the banking sector to contribute to the reduction of the country’s external vulnerability by shifting the Hungarian economy’s debt structure towards dominantly domestic financing sources. Other changes, like the introduction of interest rate swap, long-term repo operation and asset swap can encourage banks to buy long-term HUF government bonds and improve the maturity profile of the public debt financing.

The integration of the financial supervisory authority into the central bank has been an important improvement in the financial stability framework. The established Financial Stability Board ensures the coordination between micro-prudential regulatory supervision of the individual risks of institutions and macro-prudential regulatory oversight. The revision of the Act on Credit Institutions–transposing the EU rules based on Basel III (CRD IV directive) at the end of 2013 – has also strengthened the supervisory toolbox and financial stability.

Debt and Financing Vulnerabilities

The public debt-to-GDP ratio has been on a declining path since 2010, dropping 3 percentage points by the end of 2013. The share of FX-denominated debt declined by more than 10 percentage points during the past three years, thanks to the financing strategy of covering the new financing needs by issuing domestic currency denominated papers, while FX denominated bonds were issued only to cover rollover needs. The nonresident holdings share, though still elevated, has turned to a declining trend during the past year, and there is also evidence that the composition of the foreign investor base shifted towards more stable, real money players. The retail bond program, started in 2012, has been highly successful and as a result, domestic households are currently holding 10 percent of total government securities stock. Additionally, domestic institutional investors increased their demand for government securities, and, following some changes in monetary policy instruments, demand from banks is expected to rise even more in the near future.

These developments, coupled with other improving external indicators, determined that Hungary experienced lower volatility than other emerging markets during the market turmoil over the past year.

Structural Reforms

Structural transformations and supply-side measures, intended to address structural bottlenecks and raise Hungary’s medium-term growth prospects, are underway. Diversification of export destinations, and gaining new markets are supported by the provision of effective financing and insurance facilities for exporters by the operation of Eximbank. Efforts are stepped up to develop a non-profit energy sector and reduce high energy costs for investors to international levels.

Labor market conditions have been substantially reformed to boost both labor supply and labor demand. On the demand side, changes to the Labor Code facilitated the shift towards more flexible employment types. The Job Protection Act in 2013 reduced the tax wedge (typically though allowances in social contribution tax) for disadvantaged groups with perhaps the lowest productivity, but with the highest responsiveness to incentives to join the workforce, such as low-income, low-skilled, young, old, long-term unemployed, returning mothers, career starters. The Act covered more than half of low-wage earners. More recently, the extension of the family tax allowance decreased further the tax wedge for families in the lower income brackets. Nevertheless, measures based on reported income are not preferred by the authorities due to the severe underreporting of income. However, differentiating the minimum wage based on geographic regions or employee groups may be feasible. On the supply side, the transformation of the unemployment and disability benefits and the early retirement system, encouraged the return to the job market of the groups concerned. Mobility benefits should alleviate geographical mismatches. Overall, the labor market reforms, aiming at a workfare state and work-based social-security system, are already reflected by the continuously rising labor force participation, private employment and public work scheme employment, and declining unemployment.