Hungary: Staff Report for the 2015 Article IV Consultation

This 2015 Article IV Consultation highlights that the Hungarian economy is growing at a strong pace helped by accommodative macroeconomic policies and improved market sentiment. Driven by strong domestic demand, output grew by 3.6 percent in 2014. Unemployment declined sharply reflecting the expansion of public works programs and job creation in the private sector. Headline and core inflation decelerated sharply, and inflation expectations fell below the National Bank of Hungary’s inflation target. Going forward, output growth is projected to decelerate to 2.75 percent in 2015, on account of a smaller domestic-demand impetus owing to less-supportive fiscal stance and lower investment growth.


This 2015 Article IV Consultation highlights that the Hungarian economy is growing at a strong pace helped by accommodative macroeconomic policies and improved market sentiment. Driven by strong domestic demand, output grew by 3.6 percent in 2014. Unemployment declined sharply reflecting the expansion of public works programs and job creation in the private sector. Headline and core inflation decelerated sharply, and inflation expectations fell below the National Bank of Hungary’s inflation target. Going forward, output growth is projected to decelerate to 2.75 percent in 2015, on account of a smaller domestic-demand impetus owing to less-supportive fiscal stance and lower investment growth.


1. Economic recovery has gained momentum and vulnerabilities have declined, but underlying weaknesses continue to weigh on Hungary’s growth potential. Expansionary macroeconomic policies contributed to strong output growth in 2014 and real GDP is about to reach its pre-crisis level. Vulnerabilities have declined, but debt levels remain elevated and the associated high financing needs pose significant risks, particularly given the heavy reliance on non-resident funding, and the large concentration of the investor base. Thus, a shift in market sentiment could destabilize the economy, particularly in light of its exposure to exchange rate risk. Weak underlying fundamentals, along with policy unpredictability and a frail business environment cloud Hungary’s medium-term growth prospects. A comprehensive strategy in needed to nurture a continued recovery and stronger medium-term growth prospects, while reducing vulnerabilities.


Real GDP: Hungary and Peers


Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Sources: Haver and IMF staff calculations.

2. The role of state in the economy has been increasing. The government acquired energy companies and foreign bank subsidiaries, increased the scope of sectoral taxes, and boosted disposable incomes by expanding public works, cutting administered utility prices, and introducing the Settlement Act, which required banks to compensate borrowers for deemed unfair lending practices (Appendix I). In contrast, the government welcomes FDI in manufacturing, where it sees significant benefits to the Hungarian economy. Recently, it committed to improve the operating environment of banks.

Background and Recent Developments

3. The economy is growing at a strong pace, helped by accommodative policies and improved market sentiment. Driven by strong domestic demand, output expanded by 3½ percent in 2014. This reflects expansionary macroeconomic policies, higher investment on the back of increased utilization of EU funds, and a boost to consumption from utility price cuts. The contribution of net exports was largely driven by the rapid growth of imports. Nevertheless, improving terms of trade and strong export volume growth helped maintain a strong current account surplus.


Real GDP Growth and Contribution to Growth


Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Sources: Haver and IMF staff’s calculations.

4. Inflation continued its precipitous fall. In the face of a negative output gap, administered price cuts, and a drop in import prices, headline and core inflation decelerated sharply, to -1 and 1 percent, respectively, in February. Inflation expectations continued to drop to 2.2 percent, below the National Bank of Hungary’s (MNB) 3 percent inflation target.

5. Unemployment declined sharply, but appreciable slack remains. The unemployment rate stood at 7.2 percent in 2014:Q4, reflecting the expansion of public works programs and job creation in the private sector. Nominal wage growth in the private sector moderated to about 3½ percent in 2014:Q4. Moreover, the labor participation rate increased by 2 percentage points, but, at 67 percent, it remains significantly below the EU average.


Unemployment Rate and the Sectoral Contribution to Employment Growth


Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Sources: Haver Analytics and IMF staff’s calculations.

6. The 2014 fiscal deficit came in below target and the public debt ratio is estimated to have declined moderately. Preliminary estimates suggest that the deficit reached 2.6 percent of GDP against the 2.9 percent target, as revenues were propelled by accelerating economic activity and tax administration improvements. However, this performance masks a strong pro-cyclical increase in spending, especially on wages, and goods and services, and the fiscal impulse is estimated at 1⅓ percent of GDP. The public debt-to-GDP ratio declined moderately to just below 77 percent.

7. Monetary conditions remain accommodative. In the absence of inflationary pressures, and in the face of a negative output gap and improved risk premia, MNB kept its policy rate at a record low 2.1 percent since July 2014 and signaled its intent to maintain an accommodative monetary stance for an extended period. Meanwhile, forward rate agreements are pricing a 30 bps policy rate cut in the next 12 months. In October 2014, MNB also decided to double the allocation for the second phase of the Funding for Growth Scheme (FGS) to the equivalent of 3¼ percent of GDP and extended the program to end-2015.

8. Pressure on banks continues and state intervention in the banking sector is increasing. Private sector credit keeps contracting and the loan-to-deposit ratio has dropped to 95 percent. A heavy tax burden, significant loan-loss provisioning, and the Settlement Act have kept the banking sector in the red. Moreover, the Fair Banking Act—although increasing the transparency of pricing—will weigh on future bank profitability. Against a non-performing loan (NPL) ratio of 16 percent and sluggish portfolio cleaning, MNB set up an Asset Management Company (MARK) that will buy up to the equivalent of 1.3 percent of GDP in distressed commercial real estate loans from banks. At the same time, the state is gradually increasing its role in the banking system. Following the acquisition of MKB in 2014, it is about to finalize the purchase of Budapest Bank, and has announced the acquisition of a 15 percent stake in Erste’s subsidiary.


Credit Growth and Loan-to-Deposit Ratio

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Sources: MNB.

9. Despite a reduction in vulnerabilities, external stability concerns remain. Large and persistent current account surpluses, reflecting in part elevated savings to accelerate deleveraging, together with sharp cross-border deleveraging have contributed to a significant decline in external debt to 116 percent of GDP in 2014. However, gross external financing needs of 21 percent of GDP in 2015, about 30 percent of GDP open FX position on private balance sheets, an international investment position of -76 percent of GDP, and heavy reliance on non-resident funding of public debt, raise external stability concerns. Going forward, the decision in November 2014 to convert the FX mortgage stock (25 percent of household loans, almost all denominated in Swiss francs) to local currency loans will result in a reduction in bank foreign liabilities and lower (but still adequate) official reserves (Appendix I).

10. The real exchange rate is broadly in line with fundamentals, but non-price indicators suggest that Hungary faces competitiveness challenges. While the EBA methodology yields mixed results with a negative current account norm, the need to improve Hungary’s external balance sheet over time suggests the need for a stronger current account (Box 2). Other price indicators such as unit labor costs do not point to competitiveness problems. However, Hungary’s export market share has stagnated compared to its peers; the share of products in the top-quality quartile is low; while skill mismatches and a deteriorating foreign investment environment also weigh on export performance. Finally, Hungary’s ranking in the global competitiveness index has slipped, with the institutional framework, transparency of government policy making, and the business and regulatory environment reducing the country’s attractiveness for FDI.


Share in EU’s Exports


Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Source: IMF Direction of Trade Statistics.

Outlook and Risks

11. Staff expects growth to decelerate to 2¾ percent in 2015, on account of a smaller domestic-demand impetus due to less supportive fiscal stance and lower investment growth—given the projected decline in EU funds. Private consumption is expected to continue to grow, reflecting lower household indebtedness, accommodative monetary conditions, and higher employment. Over the medium term, output growth is set to stabilize at around 2 percent. Domestic demand is expected to recover only modestly, due to the ongoing deleveraging and tight credit conditions as time will be necessary for banks to strengthen their balance sheets. Improved terms-of-trade, thanks notably to lower oil prices, are forecast to lead to a higher current account surplus in the short run—which, coupled with continued cross-border bank deleveraging would further improve the IIP. Over the medium term, the current account surplus is expected to gradually decline, owing to a slowdown in deleveraging and aging population dynamics. Headline inflation is projected to remain very low in the coming months on account of a still negative, albeit closing, output gap and lower import prices. Provided monetary policy anchors inflation expectations, inflation will gradually return to target.

12. While there are upside risks to the baseline, the balance of risks—highlighted in the Risk Assessment Matrix—is somewhat tilted to the downside. An abrupt change in risk perception, e.g., from re-emergence of sovereign stress in Europe, further escalation of geopolitical tensions in the region, or financial stress in emerging markets, could lead to capital outflows with adverse effects on government financing and private balance sheets. A protracted period of weak external demand, notably from the euro area, would also weigh on exports. On the domestic front, continued state interference in the economy could have adverse confidence effects, further eroding competitiveness, and foster sharper cross-border deleveraging. On the upside, the Settlement Act and sustained lower oil prices could provide a higher-than-expected boost to purchasing power and investment, while the government’s commitment to improve the operating environment of banks could support a fast repair of financial intermediation and higher credit growth.

13. The authorities broadly agreed on the near-term outlook and the balance of risks, but were more optimistic about Hungary’s medium-term growth prospects. They shared staffs view that GDP growth would decelerate somewhat this year but were more upbeat about Hungary’s medium-term growth potential arguing that the economy’s sustained improvement in fundamentals has contributed to increased confidence—as evidenced by the historically low sovereign CDS spreads. Regarding the balance of risks, they agreed that recent banking legislation and lower import prices could boost consumption and investment more than expected, but concurred that deterioration in the external environment represented a key downside risk. Nevertheless, they argued that the risk of capital outflows is low given the increased share of institutional investors and the continued shift to domestic financing of the government, while the vulnerability of balance sheets to exchange rate risk declined significantly following the conversion of FX mortgages.

Policy Discussions

Discussions focused on the need for a comprehensive strategy to support growth and a reduction in vulnerabilities. On the macroeconomic front, staff advocated growth-friendly fiscal consolidation with monetary policy continuing to support growth. Regarding structural policies, staff argued for measures to revive financial intermediation, improve the investment climate, and support greater labor force participation.

A. Fiscal Policy

14. While welcoming the authorities’ commitment to fiscal consolidation, staff noted that their current strategy falls short of reducing public debt significantly over the medium term.

  • The 2015 budget implies a broadly neutral fiscal stance. Staff projects the 2015 deficit at 2.7 percent of GDP—vis-à-vis a budget target of 2.4 percent—in light of sizeable unidentified revenue sources and less optimistic assumptions on expenditure restraint and gains from tax administration improvements. This would imply only a moderate decline in public debt The expenditure-to-GDP ratio is expected to remain high, while large allocations to discretionary programs compromise the quality of spending and inefficiencies are significant, particularly in the health sector (Box 3). Moreover, the budget continues to rely on (and includes new) sectoral taxes.1

  • Staff projects the public debt ratio to come down only modestly over the medium term. In staffs view, the authorities’ medium-term fiscal target (1.7 percent of GDP structural deficit) is not ambitious and not backed by well-specified policies. For example, although the intention to downsize the public sector is welcome, more concrete steps are needed to rein in spending and add credence to such objectives. The authorities saw limited scope to reduce distortionary sectoral taxes beyond the announced reduction in the bank levy over 2016–19. Based on staffs baseline macro scenario and current policies, the deficit would hover at around 2½ percent of GDP and public debt, at around 72 percent, would remain a significant vulnerability (Appendix II).

15. Staff advocated a growth-friendly fiscal consolidation strategy aimed at reducing debt. To this end, staff recommended a moderate annual structural fiscal tightening by about ½ percent of potential GDP starting in 2015 consistent with a reduction in public debt to below 60 percent of GDP by 2022. The adjustment should be anchored in a medium-term budget framework that would incorporate reforms aimed at enhancing the economy’s human and physical capital, while also providing necessary fiscal space and being mindful of equity considerations. With expenditure close to 50 percent of GDP, priority should be given to a sustainable expenditure retrenchment and enhanced composition of spending, which would also create room to gradually rationalize the tax system. Staff thus recommended a menu of options for measures that could be adopted over 2015–20 (text table), including:

  • Steps to enhance the efficiency and progressivity of the tax system, including by reducing exemptions and gradually eliminating distortionary sectoral taxes that undermine the simplicity and predictability of tax policies, and reduce profitability with adverse consequences for private investment and growth. In particular, streamlining of financial taxation should contribute to the much-needed restoration of financial intermediation and a recovery in credit growth.

  • Tackling compliance issues, such as VAT fraud, through a comprehensive approach, that focuses on preventing fraud by identifying fraudulent companies at the registration stage and enhancing detection by further mobilizing the AML/CFT framework.

  • A more efficient social welfare system based on targeted, conditional transfers linked to revamped active labor market policies that focus on individualized skills-training and job-search assistance.

  • A scaling down of costly and inefficient programs, such as the public works program, along with the envisaged reduction in public sector employment to streamline responsibilities, and improved spending efficiency in education and health (see accompanying SIP).


Fiscal Stance of the General Government (In percent of GDP)

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Fiscal Impact of Potential Measure (2015–2020)

(in percent of GDP)

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Sources: IMF staff estimates, based on data provided by the authorities, and FAD and LEG TA reports.

Total adjustment exceeds recommended net adjustment due to the need to eliminate distortions in the tax system.

Reduce employment (rather than wages) through consolidation of institutions and responsibilities, attrition; and rationalization of local government employment.

Savings largely associated with the proposed public sector consolidation and limiting discretionary spending of the central government.

Assumes implementation of measures, which focus on preventing fraud by identifying fraudulent companies at the registration stage and enhancing detection by further mobilizing the AML/CFT framework.

16. The authorities reaffirmed their commitment to fiscal consolidation. While they agreed in principle with some of the fundamental weaknesses of the 2015 budget—for example, the unidentified revenue sources—they underscored their strong commitment to adhering to their national and European fiscal targets. They also saw scope to improve the efficiency of public investment and spending on health and education, and argued that the impact of recent and ongoing reforms is yet to yield results. Over the medium term, they project a substantial reduction in the fiscal deficit largely on the basis of past adjustments to the social transfer system and discretionary spending freezes, supported by a stronger macroeconomic outlook than staff’s. Should fiscal space materialize, they would reduce the corporate income tax, and cut the flat income tax to lower the still-high tax wedge.

17. Differences in views centered on the efficiency and desirability of select fiscal policy instruments. The authorities strongly defended the public works program—which they plan to expand and include all able-bodied welfare recipients—notwithstanding the recovery of private employment and the scheme’s uncertain benefits with regard to helping participants re-enter the primary job market. They also disagreed with the desirability to re-introduce some element of progressivity in the tax system (to counter rising inequality and create fiscal space), and the need to improve the targeting of the Job Protection Act.

B. Monetary Policy

18. Staff’s projections suggest that headline inflation will likely remain below target for an extended period. Inflation is projected to moderately pick up later in the year as the effect of last year’s administered price cuts wanes and the effect of oil price declines peters out. However, the still negative output gap would exert downward pressure on consumer prices, keeping inflation below target throughout 2016. Furthermore, the weakness in the external environment and the dynamics of oil prices pose downside risks to inflation, particularly if they continue to feed into inflation expectations.


Policy Rate, Headline Inflation, and Inflation Expectations

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

*Policy rate deflated by core inflation.Source: MNB, and IMF staff’s calculations.

19. Further cautious monetary easing would help pressures. Staff recognized that, with the policy rate at a record-low level and increased utilization of the FGS, monetary policy has been supportive, though, with inflation falling of late, the real policy rate has increased. In light of persistent disinflationary pressures, staff saw scope for further easing, particularly given the improved resilience of household balance sheets to exchange rate risk, and potential pressure for capital inflows from easing monetary conditions in the euro area. The recommended fiscal policy stance would provide further scope for monetary easing. Nevertheless, a sharp deterioration in risk perception and capital outflows (perhaps triggered by a sudden jump of the term premium on U.S. long-term interest rates) would require monetary tightening to preserve financial stability. Effective communication about the future trajectory of the policy rate would be critical to avoid adverse market reactions (see accompanying SIP).

20. Reserves are projected to decline but remain within the Fund’s adequacy range. At about €34½ billion, Hungary’s level of reserves is estimated at slightly below the upper limit of the Fund’s adequacy range. Going forward, reserves are projected to fall gradually by 2017 as MNB would provide FX liquidity to help banks close the on-balance sheet open FX position that emerged from the conversion of FX mortgages and the Settlement Act. The envisaged decline in reserves will be accompanied with a reduction in short-term external debt, keeping reserves comfortably within the adequacy range. Nevertheless, on account of still elevated financial risks, staff underscored the importance of maintaining adequate reserves for safeguarding financial stability.

21. The authorities stressed their intent to maintain accommodative monetary conditions for an extended period. Central bank officials acknowledged that inflation dynamics in recent months were weaker-than-expected, reflecting low imported inflation. They observed that the recent steps by the ECB and the FX mortgage conversion provided greater room for maneuver, and noted that further monetary easing would be considered if disinflationary pressures persist. In this regard, they added that the recent changes in the modalities of the FGS, in which the MNB assumes part of the credit risk are likely to increase its utilization. Finally, the authorities reiterated their commitment to maintain sufficient reserves as a buffer against shocks.

C. Financial Sector

22. The banking sector remains under pressure, though its vulnerability to exchange rate risk has declined. Banks continue to face a contraction in their balance sheets and, while aggregate capital and liquidity positions are adequate, MNB’s stress tests suggest that in an unfavorable macroeconomic scenario nearly one-fifth of the banking system could need substantial capital injections. On the other hand, the FX mortgage conversion has significantly reduced private sector’s exposure to exchange rate risk, and—while resulting in a more rapid cross-border deleveraging—is likely to improve asset quality and reduce the banking sector’s reliance on FX swaps.


Banks’ Profitability

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Source: MNB

23. Repairing financial intermediation is critical for sustained growth. With strained balance sheets, banks’ willingness to lend is projected to remain limited. Staff, therefore, called for improving the operating environment for banks, including through removing impediments for portfolio cleanup and reducing the tax burden. In this regard, staff welcomes the government’s recent commitment to gradually reduce the bank levy and to refrain from steps that could harm bank profitability. While the FGS has improved SME access to finance, there is still scope to modify the scheme to better support monetary transmission and enhance its impact on growth, possibly by linking the lending rate to the policy rate in a manner that adequately compensates banks for lending to riskier SMEs. Staff repeated its call to keep the FGS limited, targeted, and time bound.

24. Absent efforts to accelerate the cleanup of bank portfolios, NPLs are projected to remain elevated for a protracted period, undermining lending activity. Staff underscored the need for removing legal, tax, and regulatory impediments to help banks accelerate the cleanup of their portfolio and refocus on core business. In this regard, staff called for streamlining the liquidation process, including by increased out-of-court-framework use, provision of tax incentives for write offs, and introduction of a personal insolvency law. While the establishment of the MARK would help banks clean their portfolio in the absence of private sector demand for distressed commercial real estate loans, it is important to keep MARK’s operations fully independent and transparent to avoid a potential conflict with MNB’s price and stability objectives. In line with the recommendations of the recent MCM technical assistance mission, the MARK should be given an exclusive objective of maximizing the value of purchased assets while ensuring that the transfer of assets be done on a voluntary basis, based on a clear and consistent set of valuation criteria. This would help limit MNB’s exposure and a potential build up of contingent liabilities.


NPLs Ratio, Percent

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Source: MNB.

25. The authorities’ recent measures are likely to improve private sector balance sheets and could help re-invigorate credit growth, but staff cautioned against an increasing role of the state in the banking system. The FX mortgage conversion and MARK initiative will reduce private sector vulnerabilities and help banks repair their balance sheets faster, thus supporting investment and growth. However, announcements in favor of banking system consolidation, together with state purchases of banks, have increased uncertainty regarding the future landscape of the banking system, notwithstanding the government’s stated intention to divest bank stakes within three years. Staff stressed that lending activity should be based on adequate risk-management practices, and recommended to limit the state’s role in the banking system, also arguing that, with limited fiscal space, there is no room to build up further contingent liabilities.

26. A strong regulatory and supervisory framework is essential for safeguarding financial stability. The integration of the Hungarian Financial Supervisory Authority into the MNB in 2013 equipped it with micro-prudential instruments and re-enforced its macro-prudential tool kit. Staff welcomed the authorities’ commitment to strengthen the regulatory and supervisory framework, including through the recent adoption of a new macro-prudential regulation (that introduces more stringent LTV and PTI ratios, especially for FX loans) to prevent excessive household indebtedness.

27. The authorities were optimistic that recent policy measures will help stimulate credit. They argued that the Settlement and Fair Banking Acts will help boost households’ demand for credit, while the extension of the FGS will continue to support lending to SMEs. They acknowledged that the high level of NPLs continues to weigh on banks’ balance sheets and constrains new lending, but noted that they are working closely with the EBRD to identify ways to expedite NPL resolution. They also argued that the MARK is likely to induce more dynamic portfolio cleaning. The authorities stressed that the consolidation in the banking sector is warranted to foster competition and improve efficiency through economies of scale. They view the government’s increased role in the banking system as a necessary, but transitory, vehicle, to facilitate the consolidation and restructuring of bank balance sheets.

D. Structural Policies

28. Raising Hungary’s growth potential remains a key challenge. Potential growth is currently estimated at about 1 percent and, as investment increases, is projected to increase to around 2 percent over the medium term. These rates are below those of Hungary’s regional peers, suggesting a slow convergence towards higher income levels. This reflects a difficult business climate, the state’s increased role in the economy, demographic headwinds, low productivity, and weaknesses in the labor market, notably low labor participation among women and older workers (Box 4). Weak SME performance, partly reflecting low internationalization, weighs on growth (Box 5).


Female Labor Force Participation, 2013

(Percent of Female Population Ages +15)

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Sources: WBWDI.

29. Staff called for an ambitious structural reform agenda to remove impediments to growth. Such an agenda should focus on:

  • Improving the business climate. This would entail increasing policy predictability and transparency, strengthening anti-corruption efforts, reducing the regulatory burden, gradually eliminating distortionary sectoral taxes, and enhancing the ease of paying taxes. Staff cautioned against the government’s interventionist strategy, arguing that it could weigh on private investment and growth.

  • Enhancing competitiveness. Given the importance of non-price factors in addressing Hungary’s competitiveness challenges, staff underscored the need to move-up the value chain, increase export diversification, and improve productivity in the labor and services markets. Focus should be on strengthening R&D, alleviating SME-internationalization impediments (see accompanying SIP), and restructuring loss-making transport SOEs.

  • Addressing structural weaknesses in the labor market. Measures should aim at strengthening incentives for women to enter the labor market, including by reforming parental benefits, reshuffling spending on family benefits to also provide affordable child care, phasing out the early retirement scheme for women, and reducing the gender wage gap (see accompanying SIP). Equally important would be to upgrade labor skills and reduce skill mismatches to enhance productivity, including by strengthening the training component of active labor market programs.

30. The authorities were optimistic that recent policy measures would help improve Hungary’s growth prospects. They assessed medium-term potential growth at 2½ percent, owing to higher investment—due to increased EU fund utilization, and more favorable financing conditions for SMEs—and increased labor participation on the back of on-going labor market reforms. Moreover, they saw scope for moving up the value chain by focusing on innovation and for better integrating SMEs into the supply chain. On-going efforts to diversify export destinations and the increase in the production capacity in the automobile industry would help boost Hungary’s export performance. Nevertheless, they agreed on the need to improve the level and predictability of taxation, insolvency procedures, and access to finance. Finally, they argued that their strategy in the energy sector, that includes the creation of a state-owned utility company and acquisition of energy companies, is aimed at securing and diversifying energy supply, which is critical for enhancing Hungary’s competitiveness.

Staff Appraisal

31. The Hungarian economy is growing at a strong pace and there has been a welcome reduction in vulnerabilities. The strong economic upturn is driven by a pickup in domestic demand on the back of expansionary macroeconomic policies. Meanwhile, vulnerabilities continued to decline thanks to large and persistent current account surpluses, recent policy measures, and improved market sentiment.

32. However, vulnerabilities are still elevated and medium-term growth prospects appear subdued. External and public debt levels remain high and the associated financing needs together with heavy reliance on nonresident financing, large concentration of the investor base, and the economy’s large open FX position continue to pose risks. Hungary’s subdued medium-term growth prospects further exacerbate these vulnerabilities. At the same time, the state’s increased role in the economy along with sectoral taxes weaken the business environment, while state acquisitions in the banking and energy sectors contribute to the buildup of contingent liabilities.

33. A comprehensive strategy is needed to further reduce vulnerabilities and boost growth. Emphasis should be given to growth-friendly fiscal consolidation, revival of financial intermediation, and reforms aimed at addressing structural impediments to growth, strengthening institutions, and increasing policy predictability. Implementation of such a strategy, along with reduced state interference in the economy, would help support strong, private sector-led growth and foster a further reduction in risk premia.

34. A key priority is to put the public debt ratio firmly on a downward path while supporting growth. The authorities’ commitment to fiscal discipline is welcome, but, going forward, more ambitious efforts are needed to make a significant dent in the high public debt ratio. Such efforts should be backed by a clear and credible strategy encompassing growth-friendly fiscal reforms, including enhancing the efficiency of the tax system and public spending, tackling VAT fraud, improving the targeting of social benefits, and scaling down inefficient programs. These reforms can help enhance the economy’s human and physical capital.

35. Further cautious monetary policy easing would help guard against disinflationary pressures. Monetary conditions have appropriately supported the recovery of domestic demand. However, persistent disinflationary pressures and further moderation in inflation expectations call for a further cautious easing of monetary policy. The reduced exposure of household balance sheets to exchange rate risk and weak euro area conditions support a move in this direction. However, the central bank should stand ready to tighten if external conditions deteriorate sharply. Maintaining an adequate level of international reserves is necessary to mitigate excessive exchange rate volatility and support financial stability.

36. There is a need to repair financial intermediation. Improving the operating environment for banks, including through removing impediments for portfolio cleanup, reducing the tax burden, and enhancing policy predictability would support lending activity. Recent government pronouncements in this regard are welcome and need to be followed by concrete policy actions. Moreover, removing regulatory, legal, and tax impediments to NPL resolution, mitigating potential institutional and financial operational risks associated with the Asset Management Company, alongside a prompt introduction of a personal insolvency framework, are essential. At the same time, lending activity should be based on adequate risk-management practices, and the role of the state in the banking sector be contained. While lending under the FGS has helped improve credit conditions for SMEs, further refinement of the scheme’s modalities would help enhance its impact on growth, while avoiding risk to the central bank. The scheme should remain targeted, time-bound and limited to SMEs.

37. An ambitious reform agenda is key to lifting Hungary’s growth potential. Sustained progress on wide-ranging structural reforms aimed at improving the business climate, enhancing competitiveness, and reforming the labor market is essential for higher investment and strong, private sector-led growth. Priority should be given to promoting entrepreneurship and innovation, reducing the regulatory and tax burden, alleviating impediments to SME internationalization, and boosting productivity in the services sectors. Reforms of the labor market should aim at increasing labor participation, particularly among women and older workers, while greater emphasis should be placed on mitigating skill mismatches.

38. It is recommended to hold the next Article IV consultation on the standard 12-month cycle.

Hungary: Risk Assessment Matrix (RAM)1/

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The RAM shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks at the time of discussions with the authorities.

Response to Past Fund Policy Advice

The authorities have actively engaged in a policy dialogue with the Fund, but some policies deviated from previous IMF advice.

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External Sustainability and Competitiveness

Staff’s assessment is that the real exchange rate is broadly in line with medium-term fundamentals. EBA estimates have low explanatory power and yield mixed results for Hungary. Specifically, the Real Effective Exchange Rate (REER) approach reveals an overvaluation of the exchange rate by 15 percent, and the External Sustainability approach finds the REER undervalued by 12 percent. Moreover, the Current Account Balance approach suggests that Hungary’s REER appears to be undervalued. However, in staff’s view, although this approach is based on various fundamentals, it does not adequately capture the need for savings to remain elevated to help reduce Hungary’s still-large external liabilities. Thus, the current-account norm would need to be adjusted upward consistent with the need to strengthen Hungary’s balance sheet. Other price indicators, such as unit labor costs, do not point to price pressure on exchange rates.

Non-price factors have undermined Hungary’s competitiveness. Since 2008, Hungary’s export market share has stagnated compared to peers, reflecting sharp moderation in export growth from the pre-crisis rates. Moreover, indicators of Hungary’s attractiveness to investment suggest that competitiveness has recently eroded: its ranking in the Global Competitiveness Report slipped by 12 places in the past 3 years with the institutional framework providing a drag on overall competitiveness.


Hungary’s share in world’s exports (2007=100)

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Sources: WEO and ComTrade.

Low levels of foreign direct investment may detract from Hungary’s medium-term growth prospects. The foreign investment environment played an important role in promoting exports to the EU single market especially during 2003–06, but its contribution has gradually declined. Medium-term FDI inflows are projected to remain significantly below their historical average at the same time when Hungary’s incremental capital-output ratio is relatively favorable. This may partly reflect a leveling off of the substantial FDI Hungary received in the 1990’s as it became integrated with the regional supply chain. However, staff analysis suggests that further gains from the EU single market would depend on the authorities’ ability to reverse the deteriorating trend in the foreign investment environment and address structural bottlenecks.1

Figure 1.
Figure 1.

Hungary: Relative Contributions of Structural Factors for Exports to the EU Single Market

(differance from the NMS-10 average)

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Going forward, improvement in export quality, and diversification in products and markets would boost exports. While integration into the supply chain has helped improve Hungary’s export quality, the share of products in the top quartile of quality is relatively low. To strengthen its position as top quality product exporter, Hungary should focus on increasing innovation, enhancing vocational training and post-graduate education, scientific research, effective cooperation between science and industry and R&D. Some degree of diversification in products and markets would also help.

1/ 2011-13 average for Brazil.Sources: Eurostat; European Commission; Direction of Trade; World Economic Outlook; Hungarian Statistical Office; MNB, the Global Competitiveness Report; World Bank; and IMF staff estimates.
1 See forthcoming paper for the NMS Policy Forum: “Making the Most of the EU Single Market.”

Efficiency of Public Spending on Health and Education

Hungary’s public spending on health and education is not high by international standards and related outcomes lag behind (Figure 1). Public spending on health and education amounted to 5 percent (2012) and 4½ percent of GDP (2011), respectively, below the OECD average. At the same time, Hungary underperforms in terms of outcomes: life expectancy and infant mortality, while showing significant improvement recently, remain below the OECD average, and educational outcomes—as measured by Program for International Student Assessment (PISA) performance—are low compared to the OECD average, and have deteriorated recently.1


Efficiency of Public Health Expenditure

(Average 2007–12)

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

In the health sector, there is scope for efficiency gains of up to 2¾ percentage points of GDP over the medium-term. Data envelopment analysis suggests that efficiency has improved over time, but, at 0.45 (compared to 1 for an ‘efficient/frontier’ country), it is below the average OECD efficiency score (of 0.57), including that of countries with similar level of per capita public spending on health (with scores estimated to average 0.68). This implies potential gains of up to 2¾ percentage points of GDP, if Hungary were operating with the efficiency of frontier OECD countries. If it was as efficient as the average OECD country or as the average OECD country with similar per capita public spending on health, potential gains would range between 2/3–1¼ percentage points of GDP, while still achieving the same health outcome. Potential savings from such efficiency gains could be channeled to improving outcomes.

In the education sector, there is scope for further efficiency gains, but focus should be on improving outcomes and access to education. Efficiency of public spending on education has improved over the past decade, and at 0.90, Hungary’s efficiency score is above the OECD average of 0.61, and that of countries with similar level of per student spending on primary and secondary education (0.79). This implies that if Hungary was operating with the efficiency of frontier OECD countries, potential gains could amount up to ⅓ percentage point of GDP over the medium-term, while still achieving the same education outcomes. Once efficiency gaps are closed, consideration could be given to increasing spending with a view to further enhancing outcomes, while strengthening access to quality mainstream education, particularly for disadvantaged groups.


Efficiency Scores of Public Expenditure on Primary and Secondary Education, Average 2007–2011 1/

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Source: IMF Staff Estimates1/ Spending data is up to 2011, while the PISA scores refer to 2012.
Sources: OECD Healthand Education Database; PISA2012.1/ Public expenditure includes public subsidies to households for living costs (scholarships and grants to students/households and students loans), which are not spent on educational institutions.2/ Or latest year available.
1 Other educational outcomes, however, suggest strong performance: first-time graduation rate at upper secondary school was 94 percent in 2012, surpassing the OECD average of 84 percent.

Gender Gaps in the Labor Market

Female labor market participation (FLMP) in Hungary is very low. It is below EU and OECD averages, and also lags rates in peer countries in the region. In particular, employment of mothers with children under 2 (at 10 percent in 2008) is the lowest in the OECD.

Increasing FLMP is an economic imperative for shoring up long-term growth. In many advanced and emerging economies, population ageing and low fertility rates are compressing the size of active labor forces. This issue is also acute in Hungary. Taking into account current trends, Hungary’s labor force will shrink by around 10 percent by 2030. Increasing low FLMP will be necessary to help offset these adverse trends and boost long-term growth. The OECD estimates that full convergence in participation rates by 2030 can increase annual per capita growth rates in Hungary by 0.6 percent, on average.

A number of factors affect FLMP in Hungary. Parental leave policies and cultural pressures are tilted towards mothers of young children staying at home. This is reinforced by a shortage of affordable child care options. Older women are forced to care for elderly relatives in light of limited availability of long-term care; and—in contrast to efforts to roll back early retirement schemes and encourage participation—a new early retirement program for women was established in 2011. On the labor market, the wage gap between men and women has been growing; and tax policies result in higher marginal tax rates for second earners.


Maternal employment rates by age of youngest child

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

The impact of recent activation policies has been uneven. The overall female labor force participation rate (FLFPR) increased by 2.8 pp during 2008–13, to 50.6 percent in 2013. A decomposition of this increase by education groups and controlling for “passive” demographic effects (i.e., changes in the absolute size of these groups) reveals that activation policies primarily induced a significant increase in participation amongst women with primary education or less. In other words, while the share (and total number) of women with primary education in the female labor force decreased substantially, their participation rate also went up significantly. This was possibly induced by measures such as tightened access to benefits and participation requirements in public works programs. At the other end of the spectrum, a much larger share of working-age women now hold tertiary degrees. While this shift in itself is pushing up the aggregate FLFPR, controlling for its impact shows that women with tertiary education actually decreased their participation. This calls into question the efficacy of activation policies aimed at higher income groups, including tax incentives and attempts at making parental leave policies more flexible.


Decomposition of the change in FLMPR between 2008 and 2013 by education level, controlling for demographics

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Internationalization of Small and Medium Sized Enterprises (SMEs)

SMEs remain an important driver for Hungary’s economic activity and employment creation. However, since the outset of the crisis, their performance has been particularly weak and below that of the EU average, reflecting a host of factors, including limited access to credit for riskier SMEs, sharp deleveraging, and a deteriorating business environment. The low level of Hungarian SME internationalization, which is below the EU average, together with the collapse of domestic demand in 2009 and the weak recovery thereafter also played an important role.


Employment of SMEs

(2008=100, estimates from 2012 onwards)

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

SME internationalization in Hungary is generally low. The EC’s 2014 Small Business Factsheet, shows that apart from the cost required to export/import, Hungary scores well below the EU’s average in all internationalization criteria. The share of SMEs exporting and importing outside the EU is significantly below the EU average, and the bureaucracy—the time and number of documents required to export/import—is poorer than the EU average.


Hungary and the EU: SMEs Trade

(Percent of SMEs, average 2010–11)

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Source: EU’s Small Business Act (SBA), 2013–14.

Staff analysis corroborates the benefits of internationalization. It finds positive correlation between an increase in SMEs’ export-to-operating revenue ratio and growth of revenue and employment, suggesting that greater internationalization may generate positive spillovers through technology and knowledge transfer, and ultimately productivity and competitiveness gains. The analysis also suggests that larger firms with high share of fixed tangible assets are more likely to increase internationalization, and higher labor productivity, more favorable liquidity position, and higher leverage are associated with higher internationalization, though the positive effect of the leverage ratio disappears when its level is “excessive”.

Policies could help alleviate barriers to internationalization. There is a need to develop stronger infrastructure to improve SMEs’ exporting capacity, including by simplifying pertinent procedures, and help SMEs obtain greater information about foreign markets. Additionally, promoting innovation and reducing skill mismatches could enhance factor productivity, and facilitate faster penetration to foreign markets. Such policies can be complemented by efforts to foster higher degree of cooperation between SMEs and large multi-national companies so as to facilitate positive spillovers, through knowledge and technology transfer.

Greater SME access to finance is equally important. It is critical to repair financial intermediation by creating a better operating environment for banks through a reduction in their tax burden and accelerated portfolio cleanup. Finally, there is a need to develop an infrastructure for non-bank financing, including by increasing the availability of venture capital.

Figure 1.
Figure 1.

Hungary and Peers

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Source: Hungarian Statistical Office, MNB, EUROSTAT, IMF World Economic Outlook database, Haver Analytics; and IMF staff calculations and estimates.
Figure 2.
Figure 2.

Real Sector

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Source: Eurostat, Hungarian Statistical Office; NBH and IMF staff estimates.
Figure 3.
Figure 3.

Banking Sector

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

1/ 2014q3 data for all countries except Czech Republic and Lithuania - 2014q2. 2014 data for Russia is unavailable.Sources: MNB, FSI, WEO and IMF staff estimates.
Figure 4.
Figure 4.

Fiscal Sector

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

1/ Excludes 9.6 percent of GDP in pension assets transfer to government in 2011.Sources: Hungarian Authorities, IMF World Economic Outlook, Bloomberg and IMF staff estimates and projections.
Figure 5.
Figure 5.

Inflation and Monetary Policy

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

1/ Policy rate deflated by core inflation. Latest observation is January 2015 for all except Poland and Romania where December 2014 is used. 5-year average is calculated in a similar way.Sources: MNB, Bloomberg, WEO and IMF staff estimates.
Figure 6.
Figure 6.

External Vulnerabilities

Citation: IMF Staff Country Reports 2015, 092; 10.5089/9781475546293.002.A001

Sources: MNB, Haver Analytics, and IMF staff estimates.
Table 1.

Selected Economic Indicators, 2010–17

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Sources: Hungarian authorities; IMF, International Financial Statistics; 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.

2015 reflects the effects of the Settlement Act on credit stock.

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

Table 2.

Medium-Term Scenario, 2010–20

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Sources: Hungarian authorities; and staff estimates.

2015 reflects the effects of the Settlement Act on credit stock.

Excludes change in inventories.

Positive values indicate net incurrence of assets greater than net incurrence of liabilities.

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

Table 3.

Consolidated General Government, 2010–17 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Hungarian authorities; and staff estimates.

Based on the ESA 2010 methodology.

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

Includes the levy on financial institutions.

Includes social security contributions.

Assumes that the extraordinary reserves, included under this spending category, will not be spent in order 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.

Central Government Financing, 2010–17

(In percent of GDP)

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Sources: Hungarian authorities, and staff estimates and projections.
Table 5a.

General Government Operations (GFSM presentation), 2010–17 1/

In percent of GDP

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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.