This paper discusses backgrounds and recent developments in the economy of Hungary. The Hungarian economy has been growing at a robust pace over the past few years helped by supportive macroeconomic policies, a favorable external environment, and high utilization of European Union (EU) funds. Unemployment declined sharply, amid a continuous rise in labor participation. Inflationary pressures have remained subdued. Better-than-budgeted fiscal performance last year helped reduce the public debt ratio. But 2016 is not going to be very encouraging for Hungarian economy. Growth prospects remain subdued reflecting an adverse business climate. The balance of risks is tilted to the downside.
Since the last Article IV consultation, the Hungarian economy has continued to grow on a balanced path. The economic rebalancing has been backed by prudent and supportive policies that have led to a strengthening external balance, stable fiscal balance, and gradually declining public debt, and consequently, to substantially declining vulnerabilities.
Economic developments and outlook
The economy has been growing at a robust pace, at a rate close to 3 percent in 2015. Growth has been driven both by domestic demand and net exports. The current account has continued to widen as exports accelerated further, partly on the back of the favorable external environment and new production lines, while the terms of trade also improved, mainly due to lower commodity prices. Unemployment continued to decline below pre-crisis levels on the account of the accelerating private sector job creation and continuing public works, and despite the increasing labor force participation. Headline inflation remained suppressed by the falling oil prices and the still-negative output gap.
Going forward, the growth momentum is expected to continue, temporarily restrained somewhat by the weaker inflow of EU funds. Household consumption and domestic demand will continue to accelerate on the back of favorable income developments, repaired household balance sheets, and increased consumer confidence, as well as the pickup in housing investment and lending. On the corporate side, the Growth-Supporting Program will stimulate lending and investment. Nevertheless, despite the solid employment growth, nominal wages are expected to increase only gradually as inflation expectations remain contained.
A number of government measures are further supporting growth from 2016 onward. The extended Family Housing Support Program (CSOK) and the VAT reduction on dwellings will add to the investment activity of the private sector. The Irinyi Plan, the new industrial strategy in line with the reindustrialization policy of the European Union, focuses on promoting innovation and key enabling technologies, also supporting more productive sectors with higher value added. The tax reductions and allowances generate additional income for households and corporations. The substantial cut in the banking tax also promotes the pick-up of credit supply and supports financial stability.
The authorities assess the risks around the outlook as more balanced than in staff’s view. External vulnerabilities are considerably lessening as the share of FX-denominated bonds have significantly dropped and the nonresident holdings of public debt has been on a firmly declining trend, also aided by the self-financing program; 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 large scale and timely conversion of the Swiss franc-dominated household FX loans.
Fiscal Policy and Debt
The public debt-to-GDP ratio has been on a declining trend since 2011, moderating to 75.3 percent by the end of 2015, notwithstanding the one-off items related to asset purchases and the need to pre-finance some EU-related projects. The composition of the debt has been shifting to a more healthy structure, with a firmly declining share of FX-denominated securities, owing to the debt financing strategy to refinance maturing FX debt with domestic currency-denominated debt (except a small issuance in renminbi in April 2016). In addition, the central bank’s self-financing program shifted the incentive of holding government securities from non-resident investors to the domestic banks, thus aiding the decline of non-resident holdings of public debt. Domestic households increased further their bond holdings as well.
The authorities are committed to conducting prudent fiscal policies compatible with sustainable debt reduction, and to adhering to national and European fiscal rules. Fiscal discipline and rigorous budget execution, coupled with revenue over-performance, ensured that the 2012, 2013, 2014, and also the 2015 deficits over-performed relative to the initial targets. The 2015 deficit stood at 1.9 percent on the background of the good macro performance, and improvements in tax administration and tax compliance. The installation of online cash registers and the electronic trade and transport control system proved to be especially helpful in increasing VAT collection, fostering the whitening of the economy and tackling fraud.
The 2016 budget targets a 2.0 percent deficit. It incorporates a series of measures that strike the right balance between the efforts to reduce debt further and support growth: a 1-percentage point reduction in the personal income tax rate, higher tax allowance for families with two children, halving the bank levy, and a support scheme for new housing investments. The budget plans for 2017 will continue to follow a strategy with adhering to a declining public debt, while rationalizing and prioritizing public expenditure to leave space for high-return spending on investment in infrastructure and in human capital.
Monetary policy has been accommodative. After pausing the easing cycle in July 2015, the central bank (MNB) again cut the policy rate by 15 basis points to 1.20 percent in its March meeting, and narrowed the interest rate corridor in an asymmetric way, and unprecedentedly reduced the overnight deposit rate into negative territories. Amid the historically low level of inflation expectations, the MNB stands ready to use every instrument at its disposal to contain second-round inflationary effects, and to continue with interest rate cuts if necessary.
After announcing the Self-Financing Program in 2014, the MNB gradually transformed its monetary policy framework over the course of the past two years, with a view to channeling the liquidity of domestic banks to the sovereign bond and private sector securities markets. This included introducing the three-month deposit rate as the new monetary policy tool, phasing out the two-week central bank bill and converting it into two-week deposit, an asymmetric interest rate corridor, changing the system of reserve requirements, and the offering of 3-, 5-, and 10-year interest rate swaps.
The Self-Financing Program has been successful in contributing to the reduction of the external vulnerabilities of the economy. The FX-denominated share of government debt declined from its peak of about 50 percent, to around 30 percent. The share of domestic banks holding government securities now outweighs the share of non-resident holdings. The sovereign yields at the longer end of the yield curve declined to levels identical to those of peer countries with substantially higher sovereign ratings. The program has been unique in its achievement of reducing external vulnerabilities, while at the same time easing the monetary conditions.
The current level of international reserves is adequate by a variety of metrics, and is staying within a comfortable range even after gradually supplying the banking sector with the necessary foreign exchange for the conversion of FX-based mortgage loans. There is no compelling evidence showing that the exchange rate is misaligned.
The capital positions of the banks are strong and liquidity is ample in the system. The profitability of banks has returned to normal levels. Last year, the government signed a memorandum of understanding with the EBRD, committing to a set of measures intended to increase the profitability and lending capacity of the banking sector. These steps are already tangible or evolving: the levy on credit institution was significantly reduced and is envisaged to be reduced further next year, the contract regarding the sale of the MKB Bank has been signed, and there is intention to privatize the majority equity stakes of Budapest Bank.
A series of measures are further enhancing the resolution framework of non-performing loans. In the household segment, the new Personal Insolvency Law is expected to bear fruit in the coming period. Further allocations to the asset management agency for impaired mortgages, and the recent lifting of the moratorium on foreclosures and evictions are currently strengthening the resolution framework of housing loans. Concerning the corporate segment, the MNB, also building on the Fund’s technical assistance recommendations, established an asset management company (MARK) with the aim of serving as a voluntary and market-based option for the banks for removing distressed commercial real estate assets from their balance sheets. MARK has just started the voluntary registration period after concluding the negotiations with the European Commission on the implementation of the asset acquisition methodology, ensuring that any transaction would be voluntary and based on market prices without any state aid. The MNB’s objective is that in the medium-term MARK would operate entirely by market sources.
To enable the banking system to be more supportive of economic growth, in 2013, the MNB launched the Funding for Growth Scheme, aiming to provide liquidity to credit institutions at a preferential rate to alleviate disruptions in lending and to reverse the vicious credit squeeze/low growth cycle. Limited in size and time, the program is being phased out this year. It has been substituted by the Growth-Supporting Program launched in 2015, which intends to facilitate banks’ return to market-based lending and assists bank lending to the small- and medium-sized enterprises (SMEs) with a series of tools.
The authorities are continuing with the structural transformations and supply-side measures, intended to address structural bottlenecks and raise Hungary’s potential growth. Focusing on promoting private sector activity and improving the business environment, a series of regulatory and administrative changes have been implemented, as follows.
The reorganization of the tax authority towards a more customer-friendly system is under way. The act on the rules of taxation will be recodified in order to make the operations of the tax authority more transparent and decrease the administrative burden of taxpayers, on overall fundamentally changing the relationship between the taxpayers and the tax authority.
Building on the success of previous measures to whiten the economy and promote VAT tax compliance (e.g. online cash registers, Electronic Public Road Trade Control System), additional measures will follow. The mandatory system of online cash registers will be extended to some segments of the service sector. In 2017, an online electronic invoicing system will be introduced to provide real-time data on the invoicing. The government will encourage the use of debit cards by supporting the extension of the number of POS terminals installed with retailers.
More investment funding will be directed for the development of the local economy, especially industrial parks for SMEs, within the framework of the Modern Cities Program.
The public administration reform is under way. It seeks to streamline the government administration agencies and create more efficient structures. The forthcoming review of the civil servants’ compensation system will enhance the merit-based nature of the system while containing the wage bill.
The labor market policies are focused on boosting both labor supply and labor demand. The Job Protection Act reduced the tax wedge in a targeted manner for disadvantaged groups with the lowest productivity but with the highest responsiveness to incentives to join the labor market, 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. The increasing labor force also reflects the transition towards a work-based social security system in which the long-term unemployed have access to public works, facilitating their return to the primary labor market.
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 promoting growth, sustainable debt reduction, increasing labor participation, improving competitiveness, and reducing financial vulnerabilities.