Hungary: Staff Report for the 2017 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
12 May 2017
eISBN:
9781484300459
Language:
English
Keywords:
ISCR; CR; draft budget; deficit; staff appraisal; headline inflation; potential GDP; MNB target; MNB swap contracts; tolerance band
Download PDF (1.2 MB)

Hungary has succeeded in achieving several years of high economic growth as well as reduction of debt and other vulnerabilities. However, external and public debt remain high. Growth decelerated in 2016 partly due to slower absorption of EU funds and related investment. The output gap is closing, unemployment has declined to about 41/2 percent--partly reflecting a still appreciable public employment scheme, and reflation is gaining traction.

Abstract

Hungary has succeeded in achieving several years of high economic growth as well as reduction of debt and other vulnerabilities. However, external and public debt remain high. Growth decelerated in 2016 partly due to slower absorption of EU funds and related investment. The output gap is closing, unemployment has declined to about 41/2 percent--partly reflecting a still appreciable public employment scheme, and reflation is gaining traction.

Context

1. Hungary has succeeded in achieving several consecutive years of high economic growth and debt reduction, but vulnerabilities remain. Growth has been buoyant since 2013, supported by high utilization of EU funds, a favorable external environment (low interest rates and commodity prices and strong export growth), as well as accommodative monetary and fiscal policies. However, external and public debt levels and financing needs remain sizeable despite their steady decline in recent years. At the same time, perceptions of Hungary’s business environment have worsened somewhat and parliamentary elections scheduled by Spring 2018 could increase pressure for more public spending and interventions in the economy.

2. The authorities have taken steps to address some policy challenges. Progress has been made in improving tax collection, including by shifting segments of the grey economy to the formal sector. Reliance on foreign financing continues to be reduced. Government and Magyar Nemzeti Bank (MNB) policies have succeeded in stimulating growth, virtually closing the output gap, and reducing unemployment to a historically low level. But they have also meant that structural fiscal adjustment has stalled. Evolving external and domestic risks bring new challenges that require a rebalancing of the macroeconomic policy mix, while placing more emphasis on structural reforms to enhance potential growth and further reduce vulnerabilities.

Background and Recent Developments

3. Despite robust private sector consumption, economic activity decelerated in 2016 mainly due to a sharp reduction in public investment. This reduction was driven by a low absorption of EU funds due to the shift to a new program period. In addition, export growth decelerated somewhat as major automotive manufacturers reduced output as they upgraded their production lines. As a result, real GDP growth slowed to an estimated 2 percent. Although this growth rate was above the EU average, it was somewhat lower than growth in regional peers. The strong private sector consumption growth was supported by rapid employment growth and a falling unemployment rate, high wage growth, and tax reductions.

A01ufig1

Real GDP: Hungary and Peers

(2008Q1=100)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Haver Analytics; and IMF staff calculations.
A01ufig2

Contributions to Real Growth

(Percentage points, Y/Y percent change)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Haver Analytics; and IMF staff calculations.

4. Inflation started to pick up towards the end of 2016, while unemployment continued its steady decline. In March, core and headline inflation reached 1.9 and 2.7 percent y-o-y, respectively (MNB target is 3 +/-1 percent). At the same time, the unemployment rate has stayed below 4½ percent since November 2016. Even when excluding the Public Works Schemes (PWS), employment now exceeds its level prior to the global financial crisis, with severe shortages reported for both skilled and unskilled labor. Average earnings increased by about 10 percent at end-January 2017 (y-o-y). Asset prices also increased strongly. Real estate prices grew by 15 percent country-wide and by 22.8 percent in the Budapest area (y-o-y in September 2016). The Budapest stock market index (BUX) 1 increased by 19.6 percent y-o-y at end-March 2017. All this points to upside risks to inflation.

A01ufig3

Inflation and Policy Rate

(Percent change, year on year)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Hungarian National Bank (MNB); Hungarian Central Statistical Office (HCSO); and IMF staff calculations.
A01ufig4

Unemployment Rate and the Sectoral Contribution to Employment Growth

(Percent change (yoy))

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Haver Analytics; and IMF staff calculations.

5. The government outperformed its 2016 fiscal target. The slowdown in EU funds disbursement coincided with improved collection of social security contributions and corporate income tax. Furthermore, interest and EU funds-related outlays declined. However, other expenditures increased, including the wage bill. Consequently, based on preliminary data, staff estimates that the general government deficit widened to about 1.7 percent of GDP, up from 1.6 percent a year earlier. However, the primary structural surplus is estimated to have declined from 2.2 to 1.4 percent of GDP.

6. The MNB continued to ease the monetary policy stance in 2016. The base rate was lowered in three steps from 1.35 percent in March 2016 to 0.90 percent in May and the interest rate corridor was narrowed. Furthermore, the 3-month money market (BUBOR) rate declined by about 80 basis points since July 2016. During the same month, the MNB stopped offering interest rate swaps (IRS) as part of the self-financing program, which aims at encouraging banks to place their excess liquidity in government securities. Effective Q4 2016, the MNB capped the amount of its key instrument for the base rate, hence pushing excess liquidity into both government securities and the money market. The cap was cut further in Q1 and Q2 2017. Coincidingly with the introduction of the cap, the MNB began offering liquidity swaps. Moreover, in December the reserve requirement ratio was halved to 1 percent. In addition, the MNB continued to gradually adjust its unconventional monetary policy instruments. The Market-Based Lending Scheme (MLS) introduced in early 2016, continued to support similar lending, with 15 of the 17 participating banks exceeding their commitments to lend to SMEs as of February 2017.2

A01ufig5

Money Market Interest Rates

(Percent)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Hungarian National Bank (MNB); Hungarian Central Statistical Office (HCSO); and IMF staff calculations.1/ In August 2014, the base rate was changed from 2-week MNB bills to 2-week MNB deposits (non-tradable). Since September 2015, the base rate refers to the 3-month MNB deposit rate.

7. Since 2013, the MNB has taken numerous initiatives to mobilize excess liquidity in the banking system. The reduction in interest rates and vulnerabilities, while maintaining price and financial sector stability, has been possible in part due to low inflation and in part due to a substantial structural liquidity surplus. Traditional measures have included lowering the policy rate. Additional initiatives have included making the underlying instrument for the key policy rate less liquid, extending its maturity, reducing the frequency of its auctions, and capping the tendered amounts, as well as changing the interest rate corridor. These gradual steps have pushed excess liquidity into government securities and the money market, and also encouraged lending to the private sector.3 In addition:

  • The money market rates have been reduced and given more prominence, which has strengthened the domestic interest channel. The bulk of the FX denominated household loans were converted to variable HUF rates during 2015 and are now linked to domestic money market rates.

  • The self-financing program, which aims at pushing excess bank liquidity to government securities, has facilitated a reduction of FX denominated as well as externally held public debt, hence lessening vulnerabilities and lowering the financing costs of the government.

  • In 2013, the MNB introduced the Funding for Growth Scheme (FGS), providing inexpensive liquidity to banks to on-lend to micro, small, and medium-sized enterprises (SMEs). There were several modifications and the FGS expired in March 2017. In early 2016, the MNB introduced the Market-Based Lending Scheme (MLS), which offers incentives to banks that commit to increase their lending to SMEs.

8. Nonetheless, the economic recovery has remained credit-less since the global financial crisis. The stock of gross loans to households declined by 2.5 percent during 2016. Furthermore, the stock of gross loans to NFCs declined by 0.2 percent during 2016. Lending to SMEs, on the other hand, performed much better, partly due to the various supportive initiatives (e.g., FGS and MLS).4 Bank deposits increased persistently. Thus, banks continued to increase their placements in government securities and continued to deleverage.5 However, new bank lending (transaction basis) has been picking up, which suggests that deleveraging may be slowly coming to an end.

A01ufig6

Bank Loans to Non-Financial Companies and Households 1/

(Percent of GDP 2/)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Hungarian National Bank (MNB); and IMF staff calculations.1/ Stock of loans (not transaction basis) of credit institutions supervised by the MNB.2/ Rolling annual GDP based on previous four quarters.

9. On average, banks remained liquid and well capitalized, and achieved high profits in 2016. The average capital ratio was 16.4 percent at end-2016. A large part of the substantial increase in profits was due to revoked provisions as well as the sale of shares in VISA Europe. The non-performing loan (NPL) ratio declined from 11.7 percent at end-2015 to 7.4 percent at end-2016.6 The role of the MNB-owned asset management company for commercial real estate (MARK) changed during 2016. In February 2016, an agreement was reached with the European Commission on the pricing methodology in order to avoid state-aid issues. Purchases would be externally financed, hence avoiding ECB concerns regarding MNB monetary financing.7 In June 2016, the sound parts of the state-owned MKB bank were privatized. In 2016, the state and the EBRD each purchased 15 percent of Erste Hungary in line with a 2015 Memorandum of Understanding aimed at strengthening the financial sector and economic growth.

A01ufig7

Non-Performing Loans and Credit Growth, 2010-2016 Q4

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Hungarian Central Statistical Office; Hungarian National Bank (MNB); IMF’s Financial Soundness Indicators Database: IMF Staff Reports; and IMF staff calculations.

10. Hungary’s net IIP continued to improve, but external debt and financing needs remain high. By end-2016, the net liability position nearly halved to -65 percent of GDP from -119 percent of GDP in 2009. During the same period, gross external debt declined to around 96 percent of GDP from close to 150 percent of GDP, reflecting large and persistent current account surpluses as well as cross-border deleveraging. Gross external financing needs also declined to about 18 percent of GDP. However, reliance on non-resident funding of public debt remains sizable, with external public debt standing at about 40 percent of GDP. External risks have increased somewhat (see the RAM), while international reserves declined by end-2016 to €24.4 billion, down from €30.3 billion a year earlier. This decline largely reflected the maturing swap contracts with commercial banks related to the 2014-15 conversion of FX-denominated household loans to HUF and the repayment of part of FX-denominated external public debt in the context of the self-financing program. Nevertheless, a comfortable cushion was maintained with respect to the reserves-to-short-term debt ratio (132.7 percent) and reserves remained broadly adequate relative to the Fund’s metric. Reserves are projected to increase under the baseline scenario with the phasing out of the impact of the FX-loans conversion program and expectations for sizable EU funds inflows. Additionally, a three-year bilateral currency swap agreement between the MNB and the People’s Bank of China of RMB 10 billion (about €1.4 billion) was renewed in September 2016. Market sentiment towards Hungary continued to improve, and the three main rating agencies upgraded the country to investment grade in 2016.

11. Hungary’s external position is broadly in line with fundamentals, but non-price indicators suggest that Hungary continues to face broader competitiveness challenges. The exchange rate remained market determined and fluctuated against the euro within a 5 percent range. The EBA methodology yields mixed results. Staff considers the current account regression to be most informative, but believes that its estimated current account norm—a small deficit—is too low given Hungary’s still-elevated vulnerabilities and constrained policy space. As noted above, while external liabilities have declined and their profile has improved (see Box 2), they remain sizable. To tackle Hungary’s vulnerability to external shocks, there is a need to maintain current account surpluses over the medium term. Taking into account these factors, the real exchange rate appears broadly in line with fundamentals, consistent with the assessment of the 2016 Article IV consultation. However, while price indicators do not point to competitiveness problems, Hungary’s export market share has not kept pace with its peers. Despite recent improvements, prospects for FDI in Hungary – which is projected to remain below its pre-crisis average – could weigh on future export performance. Moreover, the external risk of retreat from cross-border integration and potential implications for trade are salient given that Hungary is a small open economy and participant in the German-Central European supply chain.

Outlook and Risks

12. Growth is projected to pick up to about 2.9 percent in 2017, largely on the back of a rebound in investment. The recovery in EU funds absorption and related investment, together with planned projects in the automotive industry, will be the main drivers of growth in the short term. Private consumption will remain strong as wage increases continue to boost disposable income. The relaxation of the fiscal stance (see below) together with the accommodative monetary policy, will also support demand. Labor market conditions are projected to remain tight, with wage growth pressures further building up. All these factors would contribute to a narrowing of the external current account surplus and a rise in inflation, which is forecast to approach the upper boundary of MNB’s tolerance band by early 2018.

13. The medium-term outlook for growth and inflation remains favorable and is subject to both downside and upside risks. On the downside, a normalization of monetary policy in the U.S. and euro area and tighter global financing conditions could lead to an increase in capital outflows and financing cost. By the same token, a tightening of the monetary stance in Hungary could lead to large capital inflows, especially in view of the recent upgrades by rating agencies. This could harm competitiveness and growth. A significant slowdown in the still-fragile euro area recovery and/or increased trade barriers would dampen exports. Domestically, a further increase of the state’s role in the economy and frequent policy changes could have adverse effects on business confidence. In addition, rising demand and the expansion of the housing scheme could inflate asset-prices. 8 A rise in political pressure to increase spending would also contribute to higher inflation. On the upside, U.S. and euro area growth could be higher than anticipated, and this could boost growth and enhance confidence in Hungary, reducing financing costs.

14. The authorities’ growth projections are higher than staff’s. They envisage growth in the 3.5–4.1 percent range in the short term as they expect stronger consumption in view of the positive income trends. They also anticipate higher investment related to EU funds absorption as well as in response to the cut in the corporate income tax. Regarding risks to the outlook, the authorities broadly agreed with staff but pointed to additional upside risks, including an even higher absorption of EU funds that would lead to even higher public investment and growth. They also pointed to their favorable track record in meeting or over-performing their fiscal targets during the previous election.

15. The authorities broadly agreed with staff’s assessment of the external position. They however stressed the temporary nature of the 2016 decline in reserves, and deemed their level as adequate (Box 2). They also highlighted the ongoing reduction in external liabilities and the sizable share of inter-company lending in external debt as factors enhancing Hungary’s external sustainability (Annex II). Nonetheless, they reiterated their determination to continue to strengthen Hungary’s external position. In this regard, they have established a committee chaired by the Minister for National Economy to recommend measures to boost competitiveness.

Policy Agenda

A. Fiscal Policy

16. An expansionary fiscal stance is projected for 2017–18. The 2017 budget targets a general government deficit of 2.4 percent of GDP. However, new measures were announced in December 2016, after the budget was adopted, with a view to boosting economic growth. Specifically, social contributions by employers will be reduced from 27 to 20 percent and the corporate income tax (CIT) rate from 19 percent (and 10 percent for SMEs) to a 9 percent flat rate, making it the lowest in the EU. With these measures, as well as previously planned reductions in the VAT rate for selected items, higher spending on compensation of employees, and ambitious public investment programs, staff projects the overall deficit to reach about 2.6 percent of GDP in 2017 and 2.5 percent in 2018. As a result, the overall and primary structural balances would worsen significantly. The debt-to-GDP ratio would barely decline over the medium term and would remain elevated at about 70 percent (DSA).

17. A faster decline in public debt and deficit is needed and the present economic conditions provide an opportunity for achieving this. In staff’s view, it would be preferable to take advantage of Hungary’s favorable economic setting and reduce the structural deficit by about 0.4 percentage points annually on average over the medium term. This would be consistent with meeting the authorities’ medium term target of a 1.5 percent structural deficit by 2019 and lead to a reduction in public debt to about 60 percent of GDP by 2022, which would help reduce vulnerabilities and financing costs, guard against contingent liabilities9 (see DSA), and go a long way towards achieving the authorities’ strategic objective of debt at 50 percent of GDP. Given the virtual closure of the output gap, the short-term negative impact on growth would be limited, as monetary policy can then remove accommodation more slowly, with beneficial effects for investment and competitiveness (Box 2). If such a different macroeconomic policy mix was also flanked with structural reforms, the economy would benefit from both a faster reduction in external vulnerabilities and higher potential growth.

A01ufig8

Fiscal Stance of the General Government

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

18. It would be important to ensure that such fiscal adjustment be growth friendly. Such adjustment should, therefore, involve a reorientation of public expenditure toward physical and human capital development. Consolidation should focus on rationalizing less productive current expenditures, while enhancing revenue mobilization by reducing exemptions and further improving tax administration.

  • Revenue: The tax base can be broadened by reducing exemptions and preferential regimes, including eliminating excise exemptions for fuel. This would help offset much of the revenue loss from a phasing out of remaining sectoral taxes. In addition, the authorities could consider an eventual introduction of a modern real estate tax over the medium term after careful preparation.

  • Expenditure: It would be desirable to gradually reduce the wage bill, generalized subsidies, and spending on goods and services. The wage bill is high by international standards and has been on the rise, as wage increases have not been accompanied by the long-awaited public administration reform. The implementation of such reform is necessary. It would also have a limited social cost as any civil service retrenchment would likely be absorbed by the private sector and would in fact help address some of the labor shortages. This reform can be underpinned by a targeted/rolling expenditure review that would identify government priorities. Spending on goods and services is also high compared to peers. Generalized subsidies of fuels and transportation are regressive and should be better-targeted or eliminated, while protecting the vulnerable groups through more efficient mechanisms building on, and enhancing, the current system of providing subsidized transportation ticket to student and pensioners.

Fiscal impact of potential measures, 2017–2022 average per year

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19. The authorities are of the view that they will meet their budget target and noted their past over-performance in this area. They envisage that the recent reduction in taxes and social security contributions would lead to higher incomes and economic growth and thus to more tax revenue. Given the limited fiscal space, they do not plan to reduce sectoral taxes other than the bank levy. They believe that the lower VAT rates for some products are instrumental in improving tax compliance as well as supporting the poor, who disproportionately consume such products. In case of a revenue shortfall due to the tax reduction package that was announced in December, they will use the fiscal reserves to secure their deficit target. Staff pointed out that it would be better to keep budgetary reserves to their intended objective of meeting unforeseen developments and that it is preferable to develop a contingency plan that would include elements from staff’s recommended measures.

20. The authorities emphasized their commitment to adhering to the national and European fiscal rules over the short and medium terms. They highlighted Hungary’s significant progress, compared to other EU countries, in reducing public debt. They reaffirmed their commitment to achieve further gradual reduction in debt in line with EU rules, while still providing some fiscal stimulus to support growth. With regard to considering a modern real estate tax system over the medium term, the authorities were concerned about the social impact and did not see a need for such a system as local governments already collect property taxes. Staff is of the view that a modern real estate tax system would have a large potential and that it can easily include built-in preferential treatment for the primary residence. The pre-requisite reforms such as enhancing land registration and the cadaster would also have the added benefits of strengthening property rights and thus access to finance and functioning of the real estate market, which would in turn help improve labor mobility across regions and therefore support economic growth.

B. Monetary Policy

21. The monetary policy stance will need to be kept under review in light of underlying inflationary pressures and the projected loosening of the structural fiscal balance. The MNB has appropriately eased monetary policy during 2016, as inflation was subdued during most of the year and growth was less than initially projected. Going forward, inflation pressures are building up and headline inflation is getting close to the target (2.7 percent in March). It is expected to overshoot slightly but stay within the upper band in early 2018. In 2017, bank lending is expected to pick up, spurred by activities related to EU structural and investment funds as well as higher incomes and increasing real estate prices. Timely action is thus essential to influence inflation expectations and maintain credibility. The speed of withdrawal of the monetary stimulus would, among other factors, need to be dependent on the fiscal stance: a smaller-than-projected fiscal deficit would facilitate a more gradual normalization of the monetary conditions.

22. The MNB has continued to skillfully adapt its unconventional monetary policy instruments, but the time seems ripe to phase them out. The introduction of liquidity swaps has facilitated banks’ day-to-day liquidity management. The decision to let the FGS expire by end-March 2017, is also welcome. SMEs will continue to be supported by the existing Market-Based Lending Scheme of the MNB and various EU-funded schemes. In the case of a severe balance sheet recession, as the one Hungary experienced after the global financial crisis, in addition to credit policies, policies to spur demand and boost confidence were also needed to mitigate the unavoidable deleveraging. However, as explained earlier, deleveraging now seems to be gradually coming to an end, and new lending is beginning to pick up. The usual monetary policy transmission mechanisms are thus likely to be restored and therefore unconventional monetary and credit policies should be gradually phased out.

23. The MNB concurs with staff that monetary policy will ultimately have to be tightened, but continues to be focused also on supporting growth. The authorities estimate the output gap to be still slightly negative. Moreover, they believe that, since potential output is to some extent endogenous, labor shortages and wage pressures will help stimulate investment in advanced technology and facilitate labor-capital substitution which would boost productivity. Furthermore, they are of the view that inflation expectations remain poised and that the wage share in the cost of production is still generally low in Hungary and can be easily absorbed by the more profitable companies. Against this background, the MNB does not see an imminent risk to not remain within its inflation tolerance band.

C. Financial Sector

24. On average, Hungarian banks are liquid, well capitalized, and profitable. Improved bank profitability in 2016 has reportedly contributed to banks’ increased willingness to lend. Staff welcomes the MNB’s intention to continue to enhance supervisory practices and guidelines on evaluation of collateral. The macroprudential rules that were introduced and strengthened in recent years have also been useful pre-emptive measures to improve lending practices.10 The MNB has developed new housing price indices and pricing models to better monitor the booming housing market in Budapest and some parts of Western Hungary, which is a commendable initiative. The decision to rely on external funding for the potential purchases of non-performing loans by MARK is also helpful. In addition, the authorities’ intent to sell MARK is in line with past staff advice. In recent years, the MNB has established several foundations to support the country’s economic and education objectives. These foundations have stopped buying government securities in the primary market and instead purchase such securities in the secondary market, in line with ECB recommendations.

25. While balance sheets have strengthened with progress in reducing NPLs and FX mismatches, it is important to remain prudent to guard against other risks including those that could arise from increased real estate prices. Staff therefore welcomes the strengthening of the macroprudential framework, which is timely as the re-leverage cycle starts to take off. In particular, debt cap rules, which the authorities noted could have helped contain the credit-fueled boom-bust cycle during the global financial crisis, were introduced. The MNB and staff agreed that macroprudential measures should focus on addressing systemic risks. Other concerns such as supply bottlenecks should be addressed directly through structural reforms. The authorities believe that the operational costs of many Hungarian banks are relatively high. Consolidation among the many cooperative credit institutions is expected to continue in 2017. The authorities agreed with staff that consolidation of the banking industry should be market determined.

D. Structural Policies

26. Advancing structural reforms is essential to boosting productivity, thereby supporting growth and broadening its base. Ensuring effective utilization of EU funds is key in this regard. Furthermore, an expedited implementation of reforms is needed, specifically:

  • Labor market policies. Labor shortages have become one of the key binding constraints on growth. Therefore, it would be important to build on past efforts to continue to upgrade vocational training in order to match the skills demand in the labor market. It would also be important to modify the public works schemes to improve the skills and productivity of its participants and encourage them to gradually move to the primary labor market. The authorities share this view and have already announced their intention to reduce the number of the schemes’ participants. Furthermore, boosting activity rates, particularly for women including through affordable childcare, would also help increase employment and output. In this regard, the authorities pointed out that they intend to increase the number of childcare facilities.

  • Competitiveness. Hungary has lost ranking in competitiveness indicators. The main reported challenges are related to getting electricity, paying taxes, and starting a business. A committee, led by the Minister for National Economy, is already putting together a plan to address these challenges. Perceived corruption and frequent changes in rules and regulations have also been reported as impediments to doing business. It would, therefore, be important to address these issues through enhancing transparency and policy predictability. The authorities noted that the high frequency of introducing new rules and regulations was necessary in the past to meet EU regulatory standards and to deal with the 2008 economic crisis. They explained that compared to the crisis years, the number of laws and regulations that are introduced annually has significantly decreased.

Staff Appraisal

27. Over the past several years, Hungary has succeeded in boosting growth and employment and in reducing vulnerabilities, although these are still relatively high. The pickup in growth was supported by high utilization of EU funds, a favorable external environment, as well as accommodative monetary and fiscal policies. However, despite robust private sector consumption, GDP growth temporarily slowed in 2016 to an estimated 2 percent, mainly as a result of a decline in investment. This was mostly due to subdued absorption of EU funds. Hungary’s economic risks are mitigated by the improvement in the current account and international investment position over the past years and by the enhanced market sentiment. Nonetheless, a further reduction in vulnerabilities is necessary, as external and public debt levels and financing needs remain sizeable and global risks appreciable. Hungary’s external position is broadly in line with macroeconomic fundamentals though non-price indicators point to some competitiveness concerns.

28. Fiscal policy should focus on advancing growth-friendly consolidation for faster public debt and deficit reduction. Staff is of the view that such consolidation should focus on enhancing the quality of expenditure and composition of revenue, while steadily improving the structural fiscal balance. Reforms should aim to gradually reduce the elevated wage bill as part of a comprehensive administrative reform. In addition, reducing and better targeting generalized subsidies would help decrease their cost while protecting the poor. These reforms, along with measures to enhance revenue mobilization, such as reducing sectoral taxes and streamlining multiple VAT rates and exemptions for fuel and tobacco excises, would help rebuild room for fiscal policy maneuver. Such a growth-friendly consolidation would also help achieve a much-needed faster decline in the deficit and public debt. With such a strategy, monetary policy could stay accommodative for a longer time. These elements and other measures to enhance productivity and competitiveness would help realize the authorities’ dual objective of achieving sustainable growth and boosting the economy’s medium term potential.

29. Current monetary policy settings can be maintained, but some removal of accommodation may well be needed before the end of 2017 in light of risks from inflationary pressures, including that fiscal policy provides more stimulus than warranted. The monetary stance can remain accommodative in the near term, but with underlying inflationary pressures building up, additional stimulus is unwarranted and some removal of accommodation may well be needed, in particular if fiscal policy is not tightened as recommended. The MNB has appropriately eased monetary policy during 2016, as inflation was subdued during most of the year and growth was less than initially projected. Going forward, inflation pressures are building up and low commodity prices can no longer be counted on to mitigate these pressures. It is therefore important to be ready to take timely actions to keep inflation expectations anchored and maintain credibility. With banks and the economy doing much better and new lending resuming, the usual monetary policy transmission mechanisms are likely to be restored and therefore unconventional monetary and credit policies should be gradually phased out.

30. Advancing structural reforms would boost productivity, thereby supporting growth and broadening its base to the benefits of more sectors and segments of the population. Ensuring effective utilization of EU funds is key in this regard. In the labor market, it would be important to address skills-mismatches, strengthen training to improve skills and productivity especially of participants in the public works schemes, and boost female labor force participation. Finally, it would be essential to enhance the business environment by addressing perceived corruption through improved transparency, enhancing policy predictability, continuing to improve the ease of paying taxes, and streamlining regulations.

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

The Macroeconomic Policy Mix—Implications for Growth—An Illustrative Framework 1/

The Flexible System of Global Models (FSGM) provides a useful analytical tool to assess the impact on growth associated with the implementation of fiscal, monetary, and structural policies.2

In comparison with the baseline scenario, staff recommends fiscal measures amounting to an average annual consolidation of about 0.4 percent of GDP over the medium term. The fiscal tightening would temporarily have a moderate negative impact on growth. However, such a consolidation would allow monetary policy to be more accommodative compared to the baseline scenario, which would have a partially offsetting positive impact on growth. The combined aggregate effect on growth (blue lines in Figure 1) would therefore be very small. Also, there would be substantial positive benefits in terms of reduced fiscal deficit and public debt, as well as a stronger trade balance which will lead to higher output beyond the horizon shown.

Figure 1.
Figure 1.

Hungary: Medium term impact of the Macroeconomic Policy Mix, 2017-22

Fiscal package and endogenous monetary policy 1/

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

1/ In percentage difference with the baseline scenario.

Furthermore, this simulation is conservative and does not account for the fact that part of the recommended fiscal adjustment is imbedded in measures to improve the tax system and public administration. This would help enhance efficiency, better the business environment, and ease shortages in the labor market.

In a second simulation (red lines in Figure 1), structural reforms supplement the fiscal and monetary package. These reforms aim at improving the public works schemes, reforming public administration, and reducing red tape, with a view to strengthening the business environment. They would raise potential output and support growth both in the short and long terms. In particular, the short-term impact of these reforms is difficult to quantify given the uncertainty surrounding the speed by which the private sector would respond.3 The models can nonetheless give a useful gage on the likely range of the growth dividend. They indicate that structural measures could improve the average annual growth rate by about ½ percentage point compared to the baseline. At the same time, the combination of lower deficit and higher growth would reduce the public debt-to-GDP ratio by about 12 percentage points over the medium term.

1/ Prepared by Zoltan Jakab (RES) and Michelle Hassine (EUR).2/ The FSGM is a system of models developed by staff in the IMF Research Department. More details on this methodology can be found in “The Flexible System of Global Models—FSGM,” IMF Working Paper 15/64, available at http://www.imf.org/~/media/Websites/IMF/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp1564.ashx.3/ Improving the public work scheme alone could have substantial benefits. Participants in the scheme constitute about 5 percent of the labor force. Reforms aimed at shifting even only 10 percent of these participants annually to the primary labor market, which is suffering from severe shortages at all skills levels, could have a substantial impact on productivity and growth.

External Sustainability and Competitiveness 1/

Current account: The level and trend of Hungary’s current account and trade balances do not raise major competitiveness concerns. The current account surplus continued to increase in 2016 to an estimated 4.9 percent of GDP, from 3.4 percent in 2015 and 2.1 percent in 2014, reflecting buoyant exports. The deficit on the primary income account, which includes repatriation of earnings by foreign companies, is estimated to have narrowed slightly in 2016. The current account surplus is expected to moderate over the medium term as import growth picks up due to increased consumption and investment.

A01ufig9

Hungary: Current Account Balance

(percentage of GDP, 2009-2016)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Magyar Nemzeti Bank (MNB); and IMF staff calculations.

Foreign assets and liabilities: The net International Investment position (IIP) is estimated to have been - 65 percent of GDP in 2016 and is projected to improve to -27 percent by 2022. Gross foreign liabilities fell by 55 percentage points of GDP since 2009, while gross foreign assets remained relatively steady. This reduction in external exposures reflects the post-crisis deleveraging of the banking sector, as well as the FX mortgage conversion and self-financing schemes. Slightly more than half of gross foreign liabilities is related to direct investment (a 9 percentage points increase from 2009), while around one-quarter reflects portfolio investment. The maturity profile of external liabilities has improved, with the share of short-term liabilities having declined three percentage points since 2009, to 7 percent. In 2016, external debt declined to 96 percent of GDP (and it is expected to trend lower in the coming years), while gross financing needs fell to around 18 percent of GDP.

Reserve adequacy: Reserves, at €24.4 billion as of March 2017, remain broadly adequate according to the Fund’s metric and maintain a comfortable cushion relative to the benchmark of 100 percent of short-term debt. Last year’s €6 billion decline in reserves largely reflected the reduction in the government’s net external borrowing, and banks’ redemption of MNB swap contracts related to the household FX loan conversion scheme. Both of these programs are reducing external exposures, although they put some downward pressure on reserves at a time when external risks are elevated. With the FX conversion scheme concluding this year, reserves are expected to increase and remain in the recommended ranges.

A01ufig10

Hungary: Reserves Against Risk-weighted Metric

(Reserves as a percentage of metric, 2011-2022)

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Magyar Nemzeti Bank (MNB); and IMF staff calculations.

Hungary’s external position appears to be broadly in line with medium-term fundamentals. EBA yields mixed results for Hungary. The two Real Effective Exchange Rate (REER) approaches suggest an overvaluation of the exchange rate of 8 to 29 percent, but these approaches leave a large residual (up to 31 percent) that is not explained by the policy variables. Also, those findings appear inconsistent with Hungary’s buoyant trade and current account balances. The External Sustainability (ES) approach suggests that the exchange rate may be undervalued by 11.5 percent. However, this is based on stabilizing Hungary’s net borrower position (NFA/GDP) at its recent level, which would be consistent with a medium-term current account deficit of 2.5 percent of GDP.

External Balance Assessment Results

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Source: 2016 External Balance Assessment (March 2017)

Staff believes that the CA approach is the most informative for Hungary, although its CA norm may be too low given Hungary’s still-elevated vulnerabilities, and constrained policy space amid heightened external risks. While Hungary’s trade balance remains robust, its current account balance fluctuates due to sizable negative net primary income and the EU funds cycle (also affecting the capital account). Additionally, the CA regression has had difficulty fully explaining current account swings in some countries that have gone through boom/bust episodes in credit and asset markets. This may be the case for Hungary where the model has predicted a smaller current account balance since the crisis when it moved from deficit into surplus. These country-specific factors lead staff to conclude Hungary’s external position is broadly in line with medium-term fundamentals, consistent with the assessment in the 2016 Article IV.

Non-price indicators continue to suggest that Hungary faces broader competitiveness challenges. Unit labor costs are still attractive relative to peers, although this largely reflects the post-crisis compression in compensation, which has started to unwind. Additionally, perceptions of Hungary’s investment climate (reflected in indicators like the World Bank’s Doing Business report and the World Economic Forum’s Global Competitive Index) are not as favorable as those for some of its neighbors. Unpredictability of policymaking has been cited as one challenge, although the authorities emphasize that this perception is largely a legacy of the crisis-fighting period. Labor shortages, particularly skilled labor, are another key challenge.

Greater export diversification and steady and sustained FDI would be supportive of medium-term growth and efforts to reduce external vulnerabilities. While exports continue to increase relative to GDP, their share within the EU has not grown as rapidly as that of regional competitors. FDI played an important role in promoting exports, but its contribution has gradually declined. Medium-term FDI inflows are projected to remain below their historical average despite Hungary’s relatively favorable incremental capital-output ratio. Efforts to expand labor participation and the pool of skilled workers, including through better vocational training and affordable childcare, will be important to bolster competitiveness and further enhance Hungary’s appeal to foreign investors.

A01ufig11
1) Increase indicates appreciation.2) Trade openness defined as total exports and imports as a share of GDP.Sources: Eurostat; European Commission; Direction of Trade; World Economic Outlook; Hungarian Statistical Office; MNB; UNCTAD; WEF Global Competitiveness Report (2016/17); World Bank; Doing Business Report (2017); and IMF staff calculations.
1/ Prepared by Dora Douglass Kochman (SPR).
Figure 1.
Figure 1.

Hungary: Real Sector

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Eurostat; Haver Analytics; Hungarian Statistical Office; OECD; and IMF staff calculations.
Figure 2.
Figure 2.

Hungary: Inflation Developments and Projections, 2007–18

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Magyar Nemzeti Bank (MNB); Hungarian Central Statistical Office (HCSO); Consensusforecast; Haver; and IMF staff calculations.1/ Dotted lines reflect WEO forecasts, and fu II line MNB’s most recent forecast2/ Peers include Czech Republic, Slovakia, Poland and Romania. Shaded area represents area between max and min of peers.3/ Analysts’ expectations according to MNB calculations based on information compiled by the EC.4/ Prices that a re slow to change.5/ Excludesprocessed food prices.
Figure 3.
Figure 3.

Hungary: Monetary and Exchange Rate Developments, 2007–17

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Magyar Nemzeti Bank (MNB); Hungarian Central Statistical Office (HCSO); Bloomberg; and IMF staff calculations.1/ Monetary stance compared to the period average. For instance, the percentage deviation of the reel effective exchange rate (REER, deflated by CPI) compared to period average. Weight on real interest rate (BUBOR rate deflated by core inflation) is 0.75.2/ As reported by the MNB. An increase means a depreciation.3/ In August 2014, the base rate was changed from 2-week MNB bills to 2-week MNB deposits (non-tradable). Since September 23, 2015, the base rate refers to the 3-month MNB deposit rate.4/ Real-interest rate refers to the 3-month T-bill rate deflated by the previous 12-month change in the CPI.5/ Volatility measured as standard deviation in percent of average spot HUF/EUR over recent 22 observations.6/ Average daily turnover in the spot, forward and swap HUF/EUR markets. Excludes options and transactions on exchanges.7/ Since September 23, 2015, the amount of 2-week MNB deposits have been gradually reduced. Instead, 3-month MNB deposits were introduced and used to set the policy rate. The auctioned amounts were capped effective Q4 2016.8/ Nominal GDP is the cumulative GDP over recent four quarters.
Figure 4.
Figure 4.

Hungary: Banking Sector Indicators

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Magyar Nemzeti Bank (MNB); IMF Financial Soundness Indicators Database; IMF, World Economic Outlook; and IMF staff calculations.1/ Latest available data used for countries where 2016Q2 is not yet available.2/ Used latest quarter available for each year. 2016 data not available for Russia.
Figure 5.
Figure 5.

Hungary: Role of the State in the Economy, 2006–16

Citation: IMF Staff Country Reports 2017, 123; 10.5089/9781484300459.002.A001

Sources: Eurostat; national authorities; and IMF staff calculations.
Table 1.

Hungary: Selected Economic Indicators, 2012–18

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Sources: Hungarian authorities; IMF, International Financial Statistics; Bloomberg; and Fund staff estimates.

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.

Hungary: Medium-Term Scenario, 2012–22

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Sources: Hungarian authorities; and Fund staff estimates.

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 3a.

Hungary: Consolidated General Government, 2012–22

(In Billions of Forints)

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Sources: Hungarian authorities and Fund staff estimates.

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

Includes the levy on financial institutions.

Includes social security contributions.

Table 3b.

Hungary: Consolidated General Government, 2012–22

(In percent of GDP, unless otherwise indicated)

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Sources: Hungarian authorities and Fund staff estimates.

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

Includes the levy on financial institutions.

Includes social security contributions.

Table 4.

Hungary: Balance Sheet of the Central Bank, 2012–18

(In Billions of Forints, unless otherwise indicated)

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Sources: Hungarian National Bank (MNB) and Fund staff estimates.
Table 5.

Hungary: Monetary Survey, 2012–18

(In Billions of Forints, unless otherwise indicated)

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Sources: Hungarian National Bank (MNB) and Fund staff estimates.

Only credit to households and firms.

Based on transaction data, i.e., adjusted for exchange rate changes.

Table 6.

Hungary: Balance of Payments, 2012–22

(In Millions of Euros, unless otherwise indicated)

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Sources: Hungarian authorities and Fund staff estimates.

Includes financial derivatives.

Excludes Special Purpose Entities.

Excludes Special Purpose Entities and direct investment (inter-company) debt liabilities.