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.
Since the last Article IV consultation, Hungary has continued to improve its macroeconomic fundamentals. Economic activity remained strong while vulnerabilities declined, backed by prudent and supportive policies. The external balance continued to strengthen, while disciplined fiscal policy preserved a stable fiscal balance and a gradually declining public debt. On March 20, Standard & Poor’s raised Hungary’s credit rating by one notch, citing the reduced vulnerability to external shocks and a pickup in economic growth. The authorities expect a further upgrade in the near future on the basis of Hungary’s strengthening macroeconomic fundamentals.
Economic developments and outlook
The economy has continued to grow at a strong pace, reaching an annual rate of 3.6 percent in 2014 on the back of improving domestic demand. Unemployment continued to decline, reaching its pre-crisis level, on the account of accelerating private sector job creation and persisting public work programs. Notwithstanding the accelerating growth, the current account has remained in a substantial surplus. Headline inflation decelerated sharply, reflecting the still negative output gap, the decline in import prices, and one-off effects from regulated utility price cuts.
The growth momentum is expected to persist over the forecast horizon. Against the background of the latest incoming data and supportive policies, the authorities are more optimistic than staff about the growth prospects, expecting GDP to grow at a rate close to 3 percent in 2015, while in the medium- and long-run, GDP is expected to remain dynamic, driven mainly by the underlying factors which also boost potential GDP growth. The extended and prolonged Funding for Growth Scheme (FGS) is likely to promote corporate, in particular SME, investment, while the cyclicality of the EU funding receipts is likely to work in the opposite manner in 2016, acting as a temporary drag on growth. Households’ investment activity is expected to rise gradually as consumer confidence, labor conditions, and real income recover. The improving household balance sheets resulting from the settlement and conversion of FX mortgages, and the consequent removal of uncertainties, would further support the revival of private consumption.
The authorities assess the risks around the outlook as more balanced than in staff’s view. External vulnerabilities, though still important, are gradually lessening as the share of the nonresident holdings of public debt turned to a firmly declining trend during the past years; the composition of the foreign investor base shifted towards more stable, real money players; and the foreign liabilities of the banks have been reduced substantially by the conversion of the Swiss franc-dominated FX loans.
Fiscal Policy and Debt
The public debt-to-GDP ratio has been on a declining path since 2011, moderating to 76.9 percent by the end of 2014, notwithstanding a weaker exchange rate. The financing strategy allowed for the composition of the debt to shift to a more healthy structure, with a firmly declining share of FX-denominated securities. In addition, the central bank’s self-financing scheme shifted the incentive of holding government securities from the foreign banks to the domestic banks, thus aiding the decline of nonresident holdings of public debt. Domestic households continued to increase their bond holdings as well.
The authorities are fully committed to conducting prudent fiscal policies compatible with sustainable debt reduction, and building buffers which allow for countercyclical policies. Fiscal discipline and prudence helped the government to keep the deficit comfortably within EU limits, and rigorous budget execution and corrective actions, where needed, ensured that the 2012, 2013, and also the 2014 deficits over-performed relative to the initial target. The 2014 deficit is estimated at 2.6 percent on the background of an accelerating economy and significant improvements in tax administration, especially in increasing VAT collection and tackling fraud. The installation of online cash registers was especially helpful in this regard, and the recent implementation of the Electronic Trade and Transport Control System is expected to yield similar positive results.
The 2015 budget targets a 2.4 percent deficit, planning a broadly neutral fiscal stance for the current and the subsequent years. This would allow a convergence to the medium-term structural deficit target of 1.7 percent and a steadily declining public debt trajectory.
The government plans a number of changes to the fiscal framework. The intended early adoption of the 2016 budget would enhance predictability, while harmonizing the budgeting process with the European Semester. A new Tax Code is under preparation, with the intention to develop a more customer-friendly system and ease the taxpayers’ administrative burden.
The authorities appreciate staff’s constructive policy recommendations on the medium-term fiscal adjustment strategy. Some of them, where feasible, are already under implementation, or given due consideration for the fiscal plan of the coming years. For example, some measures to address VAT compliance and fraud are already yielding promising results (online cash registers) or are in the early implementation phase (road control system). Spending on non-EU related goods and services will remain under close monitoring. The government has committed to substantially lower the bank levy starting from 2016. Nevertheless, the authorities wish to keep the public work programs in operation as an important element for integrating inactive groups into the active labor force.
The central bank (MNB) cut the policy rate by 15 basis points to 1.95 percent in its March meeting, re-launching its easing cycle after an eight-month stall, and is committed to maintaining accommodative monetary conditions for an extended period. This reflects the authorities’ assessment – in agreement with Fund staff – that inflationary pressures continue to stay moderate in the medium term, supported by both domestic and international factors. Headline inflation stayed in the negative territory in the past months, while households’ inflation expectations adjusted and declined continuously during the last year. Going forward, this may help align the price- and wage-setting decisions of economic agents with the inflation target over the medium term, despite the pickup in domestic demand. The launch of the ECB’s asset purchase program and the ongoing monetary easing in the region also point to easier monetary conditions.
The current level of international reserves is adequate by a variety of metrics, and is expected to stay within a comfortable range even after supplying the banking sector with the necessary foreign exchange for the conversion of mortgage loans. There is no compelling evidence showing that the exchange rate is misaligned.
The aggregate capital and liquidity positions of the banking system are adequate, though most banks’ balance sheets have continued to shrink and their profitability has remained curtailed. Nonperforming loans, although stabilized, remained high both in the corporate and in the household segments. To repair the financial intermediation and enable the banking system to be more supportive of economic growth, the authorities have taken a series of measures, as follows:
The MNB launched the Funding for Growth Scheme (FGS) in 2013, aiming at providing liquidity to credit institutions at a preferential rate to alleviate disruptions in lending to SMEs and to reverse the vicious credit squeeze/low growth cycle. The first and second phase of the program provided financing to more than twenty-thousand SMEs, amounting to about HUF 1325 billion (over 4 percent of GDP), predominantly new investment loans. Notwithstanding the FGS’ beneficial effects, lending outside of the FGS has yet to recover, as excessive risk aversion by banks and tight credit conditions have remained present in the riskier but viable SME segment. As a response, the MNB just launched in March the FGS+ scheme, targeting SMEs with medium risk spreads that exceed the FGS’ 2.5 percent cap. Under the FGS+, the MNB will assume 50 percent of the credit risk from credit institutions, but limited to only up to a five-year period, and capped at a maximum of 2.5 percent of the outstanding FGS+ loan stock of the individual credit institution.
To clean the nonperforming commercial real estate loan portfolio, the MNB established an asset management company (MARK) with the aim of serving as a voluntary option for the banks for removing distressed assets from their balance sheets, hence catalyzing the market. Following consultations with the European Commission and the ECB, and building on the Fund’s TA recommendations, the MNB has improved the market-based characteristics of the vehicle and shifted to market pricing, and is examining the implementation of further safeguards to ensure the financial independence of the central bank. The MNB pursues its macroprudential mandate with MARK, namely, to achieve a well-functioning banking sector which sufficiently supports economic growth. MARK is expected to begin operations in the second half of 2015. The MNB highly appreciates the prompt technical assistance provided by the Fund in the set-up of the MARK.
A number of decisive steps have been taken to address the longstanding issue of foreign exchange- (mostly Swiss franc) denominated mortgages. First, the Settlement Act ensured the settlement of the non-justified interest rate, fee increases, and exchange rate spreads, setting the stage for the transition to a “fair banking system”. The Conversion Act stipulated the conversion of the FX-denominated mortgage stock at the market exchange rate. Lastly, the Fair Banking Act will ensure the transparency in pricing going forward, fostering competition. The immediate effect of these measures will reduce the profitability of the banking sector for this year; however, in the longer term, the return to fair interest margins will increase households’ repayment ability, ease their balance sheet pressures, and increase predictability. Not least, these measures will reduce banks’ exposure to foreign funding. The MNB is playing an active role in this process, both in terms of macroprudential regulation and consumer protection, and in supplying the foreign exchange for the conversion.
In order to increase the profitability and lending capacity of the banking sector, the government signed a memorandum of understanding with the EBRD, opening a new chapter with the banking sector, committing to: (i) create a framework that ensures the long-term sustainability of a stable and predictable economic policy; (ii) decrease the bank tax to the EU standards by 2019, starting in 2016; (iii) refrain from any measure that may have a negative impact on the profitability of the banking sector; and (iv) transfer all direct and indirect majority equity stakes it currently holds in local banks to the private sector within the next three years.
The authorities are continuing with the structural transformations and supply-side measures, intended to address structural bottlenecks and raise Hungary’s medium-term growth prospects. A series of regulatory and administrative changes have been implemented with an impact on the business environment, such as: a new Labor Code facilitating the shift towards more flexible employment types; a new Civil Code with reforms in the field of corporate law and contract law; the implementation of the Cutting Red Tape program, aiming to reduce entrepreneurial administrative burdens, reduce the timeframe for administrative procedures, and simplify the tax system by abolishing several minor taxes; and the one-stop-shop government windows for administrative matters. A new Tax Code is under preparation, intended to develop a more customer-friendly system with less administrative burden.
Labor market reforms are aimed at creating a workfare state, a work-based social security system where the long-term unemployed have access to public work, facilitating their return to the primary labor market. The Job Protection Act reduced the tax wedge for disadvantaged groups with the lowest productivity but with the highest responsiveness to incentives to join the workforce, such as the low-skilled, young, old, long-term unemployed, returning mothers, and career starters. Its results are already reflected in the continuously rising labor force participation alongside the declining unemployment. Several measures aimed to transform primary and higher education, as well as vocational training, serve the enhancement of human capital.
Efforts have been stepped up to diversify export destinations. The energy strategy is focused on developing a non-profit energy sector to reduce high energy costs for investors to international levels, which is key to enhancing the economy’s competitiveness.
The authorities thank staff for the thorough and constructive discussions during the Article IV mission, and for their valuable advice on macroeconomic policies. They remain committed to prudent policies, focusing their strategy on sustainable debt reduction, increasing labor participation, improving competitiveness, and reducing financial vulnerabilities.