Abstract
This Selected Issues paper assesses recent trends in Hungary’s potential growth and medium-term growth prospects. It analyzes to what extent the recent moderation of GDP growth reflects structural factors. The paper lays out some stylized facts about the Hungarian economy that could explain the growth slowdown observed in recent years. It provides estimates of potential growth using various methods, identifies the sources of the growth slowdown, and offers forecasts of potential growth over the medium-term under the baseline scenario. A model-based approach is also employed to estimate potential growth over the medium term under a reform scenario.
Taking Stock of Hungary’s External Vulnerabilities1
A. Introduction
1. The 2013 Country report for (IMF, 2013) underscored external vulnerabilities as a key risk factor for Hungary. The report noted the high open foreign currency positions on balance sheets, high external debt and financing needs, as well as high share of nonresident investors in government bonds (HGB) as key sources of vulnerability. The report cautioned that a reversal of capital flows, a change in investor sentiment or a broader loss of confidence in emerging markets (EMs) could lead to large funding pressures, exert pressure on the exchange rate, and cause wide spread balance sheet effects.
2. However, Hungary experienced lower volatility than other EMs during the market turmoil over the past year. While a number of EMs experienced capital outflows and pressure on their exchange rates starting in late May 2013 (following the Fed’s announcement of earlier-than-expected tapering of bond purchases), Hungary experienced relatively lower volatility. And even though the country was affected more during the volatility episode of January-February 2014, the impact was relatively short lived and not as severe as initially feared.
3. Against this backdrop, this chapter attempts to reassess Hungary’s external vulnerabilities. It draws motivation from Hungary’s relatively better performance against its peers, raising the question of how vulnerable the country is to external shocks and how its vulnerability compares to other EMs. The chapter also assesses external risks facing the economy in the near-to-medium term. Section B recounts Hungary’s performance during the bouts of market turmoil over 2013–14. Section C notes the improvements that had been instrumental in Hungary’s favorable performance, and Section D describes remaining sources of external vulnerabilities. Section E discusses how external risks could affect Hungary in light of improved fundamentals. Section F concludes.
B. Developments over 2013–14
4. As EMs equity and bond flows turned in 2013:H1, flows to Hungary remained resilient. Flows to EMs began declining in February 2013, starting with equities and reflecting improved growth outlooks in advanced markets against weakening growth prospects in EMs. In May 2013, a Fed announcement brought forward the expected timing of tapering bond purchases, and led to a change in the outlook for interest rates and induced bond outflows, thus exerting further pressure on EMs currencies. While EMs were affected differently during these bouts of volatility, Hungary’s experience was better than that of the so-called “Fragile 5” countries (Brazil, India, Indonesia, South Africa, and Turkey) and in line with other EMs’ average. Spreads rose by around 20 bps during May–June in Hungary, while for other EMs spreads rose by 40 bps on average. Capital outflows from EMs continued through August; EPFR data shows that bond outflows between May–August were about 7 percent for Hungary, in line with other EMs, while it was between 7–9 percent for the “Fragile 5”. The forint remained broadly stable against the $US during this time when other EMs currencies depreciated significantly.
EMBI spreads
(May 22, 2013=100)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg and Fund staff calculations. Shaded area represents range from 20th to 80th percentile.EMBI spreads
(May 22, 2013=100)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg and Fund staff calculations. Shaded area represents range from 20th to 80th percentile.EMBI spreads
(May 22, 2013=100)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg and Fund staff calculations. Shaded area represents range from 20th to 80th percentile.
Exchange Rate vs. Bond Yields Change
(5/22/2013 to 3/6/2014)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg and Fund staff calculations.Exchange Rate vs. Bond Yields Change
(5/22/2013 to 3/6/2014)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg and Fund staff calculations.Exchange Rate vs. Bond Yields Change
(5/22/2013 to 3/6/2014)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg and Fund staff calculations.5. The January–February 2014 episode was more severe for Hungary, though short-lived. Spreads rose sharply in late January as EMs experienced another round of volatility, triggered by a culmination of factors, notably negative news from EMs including lower-than-expected PMI data from China, in the context of expectations that the Fed will further scale back its asset purchases. This time around, Hungary was affected more than it was over the May–June 2013 episode, and even relative to other EMs. Outflows coincided with the central bank of Hungary’s (MNB) statement about monetary policy stance in late-January 2014. Pressure on the exchange rate continued through mid-February, as markets watched closely the redemption of a large bond (HUF 537 billion, €1.8 billion) that was held in large part by nonresident investors. Intraday volatility of the exchange rate also rose sharply around this time, indicating continued pressure in the FX market. Since then, markets have stabilized in Hungary, as well as across the broader EMS universe, though nonresident holdings of HGBs have gradually declined by HUF 270 billion (year-to-date, see below).
EPFR Bond Cumulative Flows
(Dec 3, 2013=100)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: EPFR and Fund staff calculations.EPFR Bond Cumulative Flows
(Dec 3, 2013=100)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: EPFR and Fund staff calculations.EPFR Bond Cumulative Flows
(Dec 3, 2013=100)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: EPFR and Fund staff calculations.
HUF/EUR
Intraday Movements
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Sources: Bloomberg.HUF/EUR
Intraday Movements
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Sources: Bloomberg.HUF/EUR
Intraday Movements
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Sources: Bloomberg.C. Factors Contributing to Hungary’s Resilience over the Recent Turmoil
6. Improvements in Hungary’s external indicators helped when markets differentiated among EMs. The countries that saw the larger current account (CA) deterioration were affected more in the summer 2013 turmoil. Hungary’s CA turned from a deficit of 7–8 percent of GDP before the global financial crisis (GFC) to a surplus of 1–3 percent in the last two years. The higher CA balance owes in part to low domestic demand keeping import demand compressed. At the same time, EU fund inflows of €4–5 billion per year have supported the external position.
Current Account vs Exchange Rate
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg, Haver and Fund staff calculations.Current Account vs Exchange Rate
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg, Haver and Fund staff calculations.Current Account vs Exchange Rate
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg, Haver and Fund staff calculations.
Current account balance
(Change from 2007 to 2012, in percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: IFRS.Current account balance
(Change from 2007 to 2012, in percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: IFRS.Current account balance
(Change from 2007 to 2012, in percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: IFRS.
External Liabilities
(in percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB and Fund staff calculations.External Liabilities
(in percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB and Fund staff calculations.External Liabilities
(in percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB and Fund staff calculations.
Gross International Reserves
(in percent of IMF Metric)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: IFRS and Fund staff calculations.Gross International Reserves
(in percent of IMF Metric)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: IFRS and Fund staff calculations.Gross International Reserves
(in percent of IMF Metric)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: IFRS and Fund staff calculations.7. Ongoing deleveraging has also helped improve balance sheet risks. Hungary’s external debt has declined by an impressive 31 percentage pointssince peaking at 150 percent of GDP in 2009. The decline in private external debt, most significantly in the banking sector, coupled with policies to convert foreign currency denominated debt with local denomination, has reduced exposure to exchange rate risks. Gross international reserves (GIR) remaining broadly stable while external debt was reduced has helped improve reserve coverage, appearing favorable against other EMs and giving comfort to markets. The early repayment of the outstanding credit to the IMF added to this improvement despite temporarily reducing GIR. The banking sector is adequately capitalized despite the heavy cross-border deleveraging, tax burden, and low profitability.
8. Similarly, there have been improvements in key domestic indicators. Improvements in fiscal balances have been instrumental. Hungary’s fiscal balance exhibited a welcome turnaround, falling below the 3 percent of GDP limit and thereby led to Hungary’s exit from the EU’s Excessive Deficit Procedure (EDP) in mid-2013. The government’s continued commitment to keep the fiscal balance above the EDP threshold is another positive factor that has kept the demand for government securities robust. Hungary’s declining inflation, albeit partly owing to administrative price cuts, may have also contributed to the country’s resilience, as those with rising inflation were affected more in the turmoil over the last summer.
Inflation
(avg. May-July 2013, percent)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg, Haver and Fund staff calculations.Inflation
(avg. May-July 2013, percent)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg, Haver and Fund staff calculations.Inflation
(avg. May-July 2013, percent)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Bloomberg, Haver and Fund staff calculations.9. Sizeable nonresident holdings of government bonds have provided some stability to bond flows. The high concentration of nonresidents in the government securities market whose holdings have been broadly stable have provided an anchor while other EMs were experiencing outflows. While exact data on nonresident investors and their holdings are not available, they hold 32 percent of outstanding HGBs, close to half of which may be due to Franklin Templeton. Templeton’s holdings are likely to have been broadly stable, with purchases increasing ahead of large redemptions so as to maintain overall holdings relatively constant. That said, recent data point to nonresident holdings switching from HGBs to MNB bills, which could be indicative of a change in strategy (see next section). Nonresident participation has typically also allowed for yields to remain lower in EMs, though in the case of Hungary the policy rate has been a strong driver of bond yields (See Pradhan et al, 2011).
Nonresident Holdings and Interest Rates
(in percent)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: EMED Emerging EMEA and staff calculations.Nonresident Holdings and Interest Rates
(in percent)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: EMED Emerging EMEA and staff calculations.Nonresident Holdings and Interest Rates
(in percent)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: EMED Emerging EMEA and staff calculations.D. Remaining Sources of Vulnerabilities
10. Notwithstanding significant deleveraging, external debt remains large. External debt stood at 119 percent of GDP at end-2013 (30 percent of which is intra-company debt), with the share of short-term debt at remaining maturity rising from around 20 percent before the GFC to around 30 percent in 2013. While the debt ratio appears sustainable in the face of standard shocks (See External DSA in Appendix 1 of the accompanying Staff Report), the level is still very high by international standards and continues to be a drag on growth. The net investment position (NIIP) also remains highly negative by international standards at above -90 percent of GDP (over -300 percent in BPM6 definition), even after taking into account intra-company loans. These unsustainable levels suggest that the deleveraging process is likely to continue in the coming years, as also reflected in staff’s baseline projections for Hungary.
11. High external liabilities also keep external financing needs elevated, which is subject to rollover risk. Despite the CA being in surplus, external financing needs remain large by international standards at around 30 percent of GDP in 2014. Moreover, the CA balance is expected to shrink in the coming years and turn to a deficit by the end of the medium term, adding to external financing needs. The decline in the CA balance is expected to tend toward its long-term norm of a 1½–2 percent of GDP deficit, which mainly reflects: (i) savings normalizing to lower levels as implied by Hungary’s aging population and as the deleveraging process comes to an end; and (ii) imports recovering in line with a closing output gap. As shown in Table 10 of the accompanying staff report, meeting such high external financing needs requires public sector rollover rates to be sustained above 100 percent over the medium term.
Net Foreign Assets, Liabilities and NIIP
(In Percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Haver Analytics.Net Foreign Assets, Liabilities and NIIP
(In Percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Haver Analytics.Net Foreign Assets, Liabilities and NIIP
(In Percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Haver Analytics.
External Financing requirement in 2014
(in % of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Fund staff estimates.External Financing requirement in 2014
(in % of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Fund staff estimates.External Financing requirement in 2014
(in % of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: Fund staff estimates.12. Heavy reliance on nonresidents can be a double-edged sword. Nonresident holdings remained broadly stable at around HUF5 trillion (40 percent of outstanding stock) over the May–July 2013 turmoil episode, but have gradually declined since then to around HUF 4.8 trillion (35 percent of outstanding) by end-March 2014. Most of the decline is contained to January-February volatility episode, during which time holdings of MNB securities increased by HUF 465 billion, almost twice the decline in nonresidents’ HGB holdings. This shift to MNB securities may reflect large nonresident investors smoothing or winding down their HGB positions gradually so as not to move the market. Large bond redemptions are coming up, including a HUF 533 billion (€1.7 billion) bond in August 2014, and meeting the high rollover needs of the public sector hinges crucially on continued demand from nonresident investors. That said, a high concentration of nonresident institutional investors which provides stability during normal times, as in the case of Templeton and Hungary, can become destabilizing under severe external shocks (IMF 2014a).
Nonresident holding of MNB securities
(in percent of total nonresident holdings of HUF securities)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB.Nonresident holding of MNB securities
(in percent of total nonresident holdings of HUF securities)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB.Nonresident holding of MNB securities
(in percent of total nonresident holdings of HUF securities)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB.13. Large net open positions continue to pose risks to balance sheets from large exchange rate movements. Open positions have been declining from the peak of nearly 60 percent of GDP in 2009 to around 20 percent in 2013. Nonetheless, about 10 percent of GDP on household and 14 percent on corporate balance sheets are significantly large unhedged positions that leave these sectors susceptible to exchange rate depreciation. Moreover, the exchange rate risk can be exacerbated by market perceptions of psychological thresholds for the HUF/EUR rate if they expect the MNB to intervene against depreciation pressures and therefore keep positions unhedged (“moral hazard” problem).
Open FX Positions by Sectors
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB.Open FX Positions by Sectors
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB.Open FX Positions by Sectors
(In percent of GDP)
Citation: IMF Staff Country Reports 2014, 156; 10.5089/9781498379861.002.A002
Source: MNB.E. External Risks and Potential Impact
14. External risks remain significant. The key risks facing EMs, including Hungary, pertain to changing global economic and financial conditions that may create more volatility in the period ahead: a decoupling of advanced economy monetary policy, as interest rates rise in the U.S. but remain low in the euro area, and slowing EMs potential growth relative to the exceptional levels seen in the 2000s. In addition, escalation of geopolitical tensions pose additional downside risks, as Hungary, like the rest of Eastern Europe is highly exposed to Ukraine and Russia through trade and financial channels, including through common institutional investors. The potential impact of such shocks on EMs is studied in the recent Regional Economic Issues (IMF 2014b), World Economic Outlook (IMF 2014c), and Cubeddu et al (2014).
15. Sharp tightening of global financial conditions could have a significant impact on portfolio flows in Hungary. Such a shock could lead to another bout of volatility as seen over the last 12 months, leading to a change in investor sentiment or repricing of emerging market risk. In such an event, whether Hungary would be relatively less affected, as in May–June 2013, or relatively more, as in January–February 2014 (or in early 2012), is hard to determine. IMF 2014b estimates that a combined shock of larger-than-expected rise in U.S. long-term bond yields of 50 basis points, a 20 basis point rise in the VIX and a rise in U.S.-German long-term bond spreads could affect Hungary, more than regional peers, through portfolio outflows of up to 8 percent of stock. The study finds that the potential impact on spreads could be up to 170 basis points, a medium impact relative to peers, whereas the impact on bond yields would be relatively low at up to 120 basis points.
16. Such a shock could also take a toll on longer-term growth, but the impact could be mitigated by other factors. The partial impact estimated from long-term panel regressions is about 0.4 percentage points decline of real GDP growth over the next 5 years (see Cubeddu et al. (2014) for details of the model). This result likely overestimates the impact on growth as tighter financial conditions would come about only if growth prospects in the U.S. are better, which would be expected to have a positive, albeit small effect on Hungary.1
F. Conclusions
17. Welcome improvements in fundamentals have reduced, but not eliminated, Hungary’s external vulnerabilities. Marked improvements on the external front, including the strong adjustment of the current account, improved reserve coverage, and reduced external debt, have at times given comfort to market participants and kept Hungary relatively little affected during bouts of volatility over the past year. Nevertheless, the large remaining vulnerabilities of the economy, the still-high external debt and resulting financing needs, sizeable open positions, and continued dependence on nonresident demand for HGBs make Hungary vulnerable to external shocks. The potential impact of such shocks could be significant. Therefore, it is crucial for Hungary to bank on the improvements that have been achieved over the last few years, and continue diligently to reduce its remaining vulnerabilities and recalibrate its macroeconomic policies to build buffers.
18. Last but not least, strengthening institutions and increasing policy predictability will be key to maintaining market confidence. EMs’ experience over the last year shows how fragile market sentiment can be, and there is no guarantee that countries that were spared at certain times will be spared again in the next bout of volatility. In the face of a changing sentiment toward EMs, strong fundamentals, adequate buffers and policy credibility are the best tools to weather potential volatility.
References
Cubeddu, L., A. Culiuc, G. Fayad, Y. Gao, K. Kochhar, A. Kyobe, C. Oner, R. Perrelli, S. Sanya, E. Tsounta, Z. Zhang, “Emerging Markets: Where are They Headed?” Staff Discussion Note, forthcoming.
IMF, 2013, Country Report No. 13/85, March.
IMF, 2014a, Global Financial Stability Report, “Chapter 2: How Do Changes in the Investor Base and Financial Deepening Affect Emerging Market Economies?” April.
IMF, 2014b, Regional Economic Issues, Central, Eastern and Southeastern Europe, April.
IMF, 2014c, World Economic Outlook, April.
Pradhan M, R. Balakrishnan, R. Baqir, G. Heenan, S. Nowak, C. Oner, S. Panth; 2011, “Policy Responses to Capital Flows in Emerging Markets” Staff Discussion Note SDN/11/10, April.
