Hungary: 2019 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Hungary
Author: International Monetary Fund. European Dept.
Publication Date:
05 Dec 2019
eISBN:
9781513521404
Language:
English
Keywords:
ISCR; CR; headline inflation; MNB; rate; holding; broad money; output gap; value chain; mortgage bond purchase scheme; Inflation; Global
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2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Hungary

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Hungary

Context

1. Building on its impressive recovery from the global financial crisis, Hungary could utilize more the current upswing to further strengthen its resilience and potential growth. In 2018, Hungary was one of the fastest growing economies in Europe (Figure 1). Public debt declined 10 percentage points to 70.2 percent of GDP over 2011–18, and external deleveraging has been even more sizable (Annex I). Unemployment fell threefold to 3.7 percent. However, notwithstanding the ongoing fiscal consolidation, the structural fiscal position still appears procyclical. Wages have been rising rapidly against labor shortages, and key structural reforms that would help increase labor participation, apart from fiscal measures, have been lagging.

Figure 1.
Figure 1.

Real PPP GDP per Capita Growth

(In percent)

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Sources: IMF; World Economic Outlook (WEO); and IMF staff calculations.

Background and Recent Developments: Going Strong

2. Booming domestic activity mitigated the effect of the external slowdown, while inflation hovered close to the upper end of the tolerance band. Growth in 2018 was considerably higher than projected, at 5.1 percent. It was largely driven by domestic demand, including record-high EU funds-related investment (Figure 2). Growth remained high in 2019, averaging 5.1 percent in the first two quarters. Both headline and core inflation, increased in 2018-H1 2019 but remained within the tolerance band (3±1 percent) (Figure 2). Headline inflation has been driven by food and energy prices, as well as increases in excises on alcohol and tobacco.

Figure 2.
Figure 2.

Real and Fiscal Sector Developments

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

3. Unemployment reached historic lows and wage pressures persist. Unemployment has been below 4 percent since late-2017. Wage growth was 10.6 percent in 2018 and remained strong in 2019 (Figure 2). The spillover from wages into inflation has been contained in part due to a relatively low wage share in production costs, high profitability, well-anchored inflation expectations, reduced social security contributions, and low imported inflation.

4. While the budget targets have been met, fiscal policy appears to have stayed procyclical. The overall deficit deteriorated somewhat in 2017 and improved only slightly in 2018 – during two years with appreciably above-potential growth. This was mainly due to the reduction in corporate income tax rates, social contributions, and increased capital spending. Thus, the primary structural (PS) balance worsened further by about two percentage points over 2017–18 (Figure 2). Nonetheless, the 2018 deficit slightly outperformed the budget target of 2.4 percent of GDP due to higher-than-expected VAT collection and lower spending on goods and services.

5. Monetary policy remained accommodating, notwithstanding a modest tightening in Spring 2019. As inflation approached the upper half of the tolerance band in March 2019, the MNB increased the overnight deposit rate from -15 to -5 bp and modestly reduced excess liquidity by limiting the rollover of its FX liquidity swaps, resulting in a slight increase in short-term money market rates (Figure 3).

Figure 3.
Figure 3.

Financial Sector and Housing Indicators

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

6. Credit continued to grow and NPLs reached new lows. Bank lending to non-financial companies and households increased by 10.6 percent, y-o-y, during 2018 and remained buoyant in 2019 (Figure 3). The NPL ratio declined to 2.5 percent at end-2018. System-wide liquidity is above prudential requirements, and profits are solid.

7. Hungary’s external position in 2018 is estimated to be moderately stronger than the medium-term fundamentals and desirable policy settings (Annex II). Although the current account receded towards a deficit, it is still somewhat stronger than the estimated current account norm. The current account gap mostly reflects the stock of the private sector credit being low. Reserves increased significantly, resulting in an improvement in adequacy indicators. HUF has been depreciating against the euro throughout 2019 but remained stable in real effective terms. Hungary’s deleveraging process has contributed to a reduction in portfolio flows and, combined with policies to reduce external vulnerabilities, led to an upgrade by rating agencies (Figure 4).

Figure 4.
Figure 4.

External Sector Developments

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Outlook and Risks: A Balancing Act

8. The outlook remains broadly favorable. Growth is projected to decelerate from its highs starting in 2019 amid relatively sluggish global activity and declining EU funds-related investment, but to remain in the 3.5–2.0 percent range in the medium term despite the negative demographics. Capacity has been constrained by labor shortages, but the pressures are somewhat less now, as businesses are preparing for a gradual deceleration in growth. Wage pressures also seem to be moderating after the recent hikes and more leveled workers’ expectations given the global developments. The substantial increase in household savings over the past years and the completion of the deleveraging process will help keep up consumer spending. On the external front, despite the coming on line of exports from recent FDI investments, the still buoyant imports and slowing growth in the EU will keep the current account in a slight deficit. Inflation is expected to hover around 3 percent, with some downside risks given the cooling off in the labor market and low imported prices, reflecting the developments in the main EU trading partners.

9. Risks to the baseline scenario for real GDP growth are somewhat to the downside owing to deteriorating global growth prospects and trade tensions (Annex III). Exports may come under pressure due to the slowdown in Germany, lower foreign demand and possible increase in trade barriers. This said, Hungary’s specialization in high-end vehicles and the recently announced high-tech investments in the car and electric batteries industry may protect its production and exports compared to neighboring automotive producers. Nonetheless, some delays in execution or scaling down cannot be ruled out (Box 1). A worsening in global macro conditions could also hamper growth more broadly but the substantial deleveraging and the authorities’ strategy of reducing external financial exposure would limit possible spillovers. Domestically, risks appear to the upside. The aforementioned demand boom could go on to generate more growth than projected, and there could be more capacity in the economy than estimated, as may be indicated by the repeated under-estimation of projected growth and potential output. There could also be an important contribution from a further increase in labor participation or inward migration by ethnic Hungarians. The authorities have implemented past staff advice to a certain degree, in particular with steady fiscal deficit reduction (albeit not in structural terms) and substantial progress in scaling back the public works scheme (PWS) (Box 2). Some of the impediments to doing business were also addressed (Annex IV).

Authorities’ Views:

10. The authorities agreed with the balance of risks. They see the slowdown in global (especially eurozone and major emerging economies) activity, Brexit, and increased trade protectionism as key downside risks, although they noted that spillovers from Germany’s manufacturing cycle have recently moderated. In their view, upside risks include stronger labor supply and household consumption. They also believed that additional impetus could come from the implementation of competitiveness reforms.

Policy Agenda

11. Strong growth should be used as a springboard for building fiscal space, while improving expenditure quality, and addressing long-standing structural challenges. The favorable position in the cycle supports further fiscal consolidation to increase buffers and improve the structure and efficiency of spending. Less procyclical fiscal policy would also facilitate a more gradual normalization of monetary policy and help ease demand pressures, including in the housing market. Any short-term reform costs can be absorbed more easily during the current favorable cyclical position. Staff stressed that this was also an opportune time to pursue reforms targeted at improving potential growth and thus welcomed the roll-out of the government’s “Program for a More Competitive Hungary.”

A. Fiscal Policy: Creating Space While Enhancing Quality

12. Although the overall fiscal deficit targets a decline to 1.8 percent of GDP in 2019, it would still constitute a procyclical impulse. Data thus far indicate that the budget deficit will likely be met. Revenue losses from the 2018–19 reduction in tax rates are being offset by higher receipts due to positive developments in the labor market, a rapid growth in private consumption, and gains in tax collection efficiency. Efforts have been made to reduce the share of gray economy which is evident from buoyant gains in VAT collection. On the expenditure side, the ongoing small cuts in public employment, mostly through attrition and a marked reduction in central government administrative staff, are not expected to produce budgetary savings as wages continue to increase. EU funds-related expenditure will peak over 2019–20. Several fiscal stimulus measures, mostly aimed at improving demographics, were introduced with the 2019 budget. The cost of the stimulus measures is expected to be fully covered by a general budgetary reserve of about 0.6–1.0 percent of GDP over 2019–21. With output growth above potential, the structural primary balance would deteriorate by about 0.3 percentage points, to reach around -0.8 percent in 2019.

Selected Stimulus Measures

Reduction of the VAT on accommodation from 18 to 5 percent

Increase in R&D spending

Subsidized loan for young married couples

Granted debt relief for mortgage loans after the birth of up to three children

Car sales subsidy for families with at least three children

Support for language studies by secondary-school students

Source: Hungarian Authorities.

13. Hungary’s public debt and financing needs (GFN) remained high as of end-2018. Despite being on a downward trend, public debt was slightly above 70 percent of GDP, GFN increased in recent years and were among the highest in the EU in 2018, at around 20 percent of GDP. In view of this situation, staff assess Hungary’s fiscal space to be at risk. However, GFN are projected to decline over the short and medium terms, including under the standard stress tests. Other baseline projections are favorable for the overall balance and debt-to-GDP ratio (Annex I). This positive outlook would help create some fiscal space, which can be used in future downturn and to address the demographic pressures.

14. The public debt strategy should therefore continue to focus on lengthening maturities, while striking a balance between further reducing foreign exposure and containing the interest expenditure. The recently introduced new retail bond (MÁP+) is helping to reduce rollover and FX risks and to attract greater household savings. However, its much higher yield than other government bonds has led to subscriptions so far surpassing expectations.1 Staff highlighted the opportunity cost of such an expensive funding and its potential crowding-out effects. In addition, this funding program does not impose an upper subscription limit for an individual or a household, which makes it potentially regressive and increases the risk of arbitrage. Staff therefore suggested to cap the size of the total current offering and to anchor the interest rate of future offerings closer to the government bond market yield curve.

15. The 2020 budget foresees a further reduction in the overall deficit to 1 percent of GDP. While staff welcomes the planned fiscal consolidation, this would imply only a modest fiscal withdrawal. The ambitious 2020 budget target is planned to be achieved through further improvements in tax collection and lower public investment. Staff projects a somewhat higher deficit (1.5 percent of GDP) due to a lower GDP growth assumption and a somewhat smaller decline in expenditure.

16. The authorities’ medium-term targets reflect steady consolidation, although the underlying measures have not been specified. Staff considers the authorities’ consolidation plan presented in the 2019 “Convergence Programme” appropriate. According to this plan, both the overall and cyclically-adjusted balances would move close to zero by 2023, thus providing room for fiscal policy maneuver, especially with the resulting downward debt path. Similar to its 2020 projection, staff’s medium-term baseline scenario implies somewhat higher deficits than the authorities’ plan due to lower growth projections and the absence of explicit consolidation measures, other than a possible reduction in public investment.

17. To achieve the authorities’ targets, staff recommended a mix of growth-friendly revenue and expenditure measures (Figure 5).

  • Revenue: (i) reduce exemptions and preferential regimes; (ii) further phase out sectoral taxes; and (iii) offset any further tax rate cuts with other revenue through broadening the tax base.

  • Expenditure: (i) reduce spending on goods and services, which is above the peers’ average; (ii) continue to reduce the public wage bill, focusing on rationalizing employment in the public sector (which is substantially higher than in peers), while ensuring adequate provision of quality public services (Figure 6); and (iii) rationalize generalized subsidies, including on energy and transport, while adequately protecting the poor through better targeting .

Figure 5.
Figure 5.

Adjustment Scenario and Measures

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Figure 6.
Figure 6.

General Government Wage Bill and Employment

(Latest available data)

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Source: IMF FAD Government Wage Bill and Employment Dataset.

18. The above measures are largely similar to those recommended in recent years but lower in magnitude given the more favorable outlook for the deficit and public debt. The proposed average annual adjustment of around 0.3 percentage points over the next five years would lead to public debt falling to 50 percent of GDP (which is lower than under last year’s adjustment scenario) and a structural primary surplus of about 2 percent of GDP by 2024 (Figure 5). Any additional savings beyond the recommended amount can be used to boost infrastructure investment in the outer years of the medium term to compensate for the projected decline in EU funds. In general, to support growth, particular emphasis needs to be placed on the quality of public spending. Rationalizing public sector employment would also release labor force to the private sector, thus helping to ease the severe shortages.

Authorities’ Views:

19. To achieve the planned fiscal consolidation, the authorities intend to continue to increase the efficiency of tax collection and reduce public investment as needed. They pointed out that substantial reserves programmed on the expenditure side provide buffers for achieving the targets. The authorities highlighted their success in cutting more than 20 percent of staff positions across the central government administrative level in 2018–19. They indicated that they would further consider possible rationalization of public employment based on identification of inefficiencies and progress in digitalization and improvements in processes. The authorities view most of the remaining sectoral taxes as turnover taxes with less distortive impact on the economy. They could be reduced in the future if efficiency gains lead to lower profits and price reductions for consumers. The authorities plan to further reduce the tax burden on labor whenever the economic situation allows. They believed that the retail bond MÁP+ is contributing to lengthening maturities, reducing external vulnerabilities, and containing consumption and imports as well as the pressure in the real estate market.

B. Monetary Policy: Staying Tuned to the Challenges

20. Over the near term, monetary policy can afford to be somewhat more patient with removing accommodation, especially in view of the weaker global outlook and downside risks. While domestic demand has surprised on the upside, prospects for global demand have worsened. Also, inflationary pressures have abated since May 2019. Strong wage growth has been mitigated by reduced social security contributions and profit margins. Despite a positive output gap, inflation is being contained by cheaper imports given the price dynamics in European trading partners. Staff projects average inflation to stay around 3.4 percent in 2019 and move back towards the midpoint of the tolerance band over the medium term. This is premised on current staff projection for growth and imported inflation, as well as the MNB maintaining the money market rates at current levels in the near term. Should data point to upward inflationary pressure building up, the MNB will need to take prompt action in view of the usual monetary policy transmission lags. Clear and timely communication would also be key under these circumstances.

21. Close monitoring of the implications of the existing and new unconventional arrangements is warranted. Two measures—the MNB’s mortgage bond purchase scheme and its sales of unconditional interest rate swaps—were phased out by end-2018, as planned. With respect to the FX liquidity swaps, the MNB has been calibrating them to achieve the intended money market rates within its interest rate corridor, becoming a net provider of liquidity to banks. In January 2019, a “Funding for Growth Scheme Fix” was introduced to encourage long-term fixed-rate lending to SMEs. In July 2019, a “Bond Funding for Growth” scheme was rolled out to develop the corporate bond market. Staff advised that their effectiveness in achieving their other objectives be continuously assessed to minimize market distortions.

Authorities Views:

22. The MBN considers that downside risks to inflation have recently increased due to the disinflationary impact from the slowdown in Europe. The MNB will continue to assess the effects on inflation from the pass-through effects from the eurozone, the monetary policy stance of major central banks, the effect of the new retail government security on savings, the impact of the counter-cyclical fiscal policy, and other domestic factors on the economy. The authorities stressed that the new unconventional tools are not intended to achieve immediate monetary policy objectives as their liquidity impact is being sterilized. The objectives are to further enhance financial stability (by reducing interest rate risk for SMEs) and develop the corporate bond market.

C. Financial Sector: Harnessing Stability

23. The banking system is overall healthy, and its resilience should continue to be buttressed. The system remains, on average, well capitalized, profitable, and liquid. The NPL ratio continues to decline due to improved repayment capacity, NPL sales, and credit growth. The MNB’s stress tests show that all banks observe the solvency test and that most banks can meet the regulatory liquidity requirement without adjustments. The MNB’s recommendations to use independent evaluators for collateral appraisals appear to have harmonized evaluation practices. The integration of the many credit cooperatives into one banking group is continuing. A final decision on the privatization of Budapest Bank is currently being worked out. It would be important that consolidation of the banking system continued to be market-based. Some amendments have been made to the insolvency legislation to increase the ability of creditors to enforce their interests and improve the rate of recovery of claims, but further improvements are needed. Staff thus welcomed the intention to review the legislative and institutional framework for bankruptcy and liquidation proceedings in 2020.

24. Efforts to scale back house purchase incentives and to address supply constraints are needed to mitigate market pressures. In 2018, housing price growth was in double digits, especially in Budapest, partly supported by high wage growth, fiscal incentives, and labor scarcity in the construction sector (Figure 3). Budapest house prices appear high compared to fundamentals. Given that a large part of purchases is paid for with private savings, including by foreign citizens, and is done for investment purposes, tightening of macroprudential measures (loan-to-value and debt service-to-income (DSTI) may not be sufficient to contain house price inflation, but can reduce the likelihood of risky mortgages. Moderating price increases would therefore be helped by reviewing the various fiscal incentives for house purchases, basing them on means-testing and targeting, reducing impediments to doing business to spur construction, improving transportation network and commuting options, and improving urban planning to increase housing supply over time. In the context of money laundering risks in the sector, staff also encouraged the authorities to continue their AML/CFT efforts, as Hungary remains on enhanced follow-up based on Moneyval’s 2016 assessment, including by continuing to monitor large purchases of luxury real estate.

25. The authorities launched several initiatives to reduce the mortgage interest rate risk.2 While most new housing loans now have longer interest fixation periods—likely facilitated by the MNB Certified Consumer-Friendly Housing Loans and the DSTI requirements—there is still a high portion of existing housing loans with variable rates. The MNB thus agreed with banks that they inform their clients about the interest rate risk and offer to convert to fixed-rates.3 Thus far, the impact of this measure has been limited. To contain potential risks from FX exposure of some of the commercial real estate companies, the MNB has announced that beginning in 2020 a small risk-weight would be also assigned to FX performing project loans when calculating the systemic risk buffer.

Authorities’ Views:

26. The authorities are monitoring housing prices, especially in Budapest, even though they are still much lower than in comparable cities in Western Europe. They also noted that assessment models do not capture the fact that many of these purchases are for investment and generate rental income. They agree that additional tightening of macro prudential measures is unlikely to have a significant impact. There is preliminary evidence that the introduction of the retail bond MÁP+ coincided with a decline in apartment sales transactions in Budapest. Some of the MNB’s proposals—included in the MNB’s Competitiveness Program, like tightening the rules for purchases of residences for investment purposes and expanding construction capacity, could help moderate the market.

D. Structural Reforms: It’s Go Time

27. Improvements in competitiveness are needed to sustain high income convergence and address demographic challenges. Rising wages against low labor productivity, decelerated export growth, and shortcomings in the business environment underline the need to invigorate the reform efforts. The government’s Program for a More Competitive Hungary and the Central Bank’s extensive agenda to improve competitiveness rightly seek to boost potential output. What is needed now is timely implementation of prioritized reform measures that focus on reducing the identified impediments to doing business. Such prioritization should focus on leveling the playing field for SMEs, improving governance and transparency, increasing labor participation, and enhancing education and vocational training.

28. Staff lauded the increased focus on enhancing productivity of SMEs. Ongoing efforts to simplify the tax system for the SMEs will be helpful. Staff, in particular, supported the authorities’ intention to reduce the large number of taxes and advised to phase out the sector-specific taxes. There is also merit in removing sectoral exemptions and applying a modern competition policy framework as widely as possible. Further, it would be important to closely monitor the implementation of R&D investments supported by grants to safeguard transparency and to maximize value and efficiency.

Main Parameters of the Authorities Growth Strategy:

The government is determined to keep GDP growth 2 percentage points above the average of advanced EU countries by:

  • Gradually reducing the tax burden as fiscal space allows (reduction of the num ber of various taxes and fees to below 40),

  • Improving education and vocational training to address skills mismatches,

  • Increasing employment by attracting ethnic Hungarians from neighboring countries and enhancing incentives to work for women and pensioners, and

  • Supporting SMEs and increasing their export orientation by implementing structural reforms.

29. Over the past few years, the authorities have been taking steps to improve the business environment, but important challenges persist. High frequency of issuing regulations, protecting minority investors, getting electricity, among others, are the areas that still need improvement (Figure 7). Perceived corruption and public procurement practices have also been reported as impediments to doing business. A digital land registry map and data service were introduced to improve construction permit procedures, and connection to utilities should now take less time. Registration for most common types of companies has become free of charge, and companies no longer need to register at a local level as tax payer data is now synchronized. These improvements should help enhance competitiveness indicators (Figure 7). The introduction of the central electronic public procurement system, in line with the EU Public Procurement Directive, is a step in the right direction. However, it would be important to address any remaining concerns, including by ensuring transparent and competitive procurement processes, in line with EC recommendations.

Figure 7.
Figure 7.

Competitiveness, Doing Business and Governance Indicators

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Sources: National authorities; IMF staff calculations from “Reassessing the Role of State-Owned Enterprises in Central, Eastern, and South Eastern Europe: European Department, June 18, 2019.

30. SOEs’ productivity lagged behind since 2012.4 The authorities intend to monitor better their efficiency and, more generally, the services provided by state agencies. Staff also advocated to improve the oversight of risks emanating from the SOEs and introduce clear rules for fiscal support to maintain competitive neutrality, good governance, and budgetary transparency (Figure 7).

31. Labor market shortages should be addressed through further increasing participation rates and scaling down the PWS. Participation rates have registered one of the fastest rises among the EU members, especially in the older age groups, and now stand slightly below the EU average of 74 percent. Further progress in offering adult education and vocational training opportunities as well as increasing the number of daycare centers will help raise the active labor force, especially among the female population. Releasing labor from PWS already decreased the number of participants from the peak of 202,000 to around 100,000 in 2019 (Box 2). Going forwards, the authorities intend to further reduce this number but keep the scheme operational, mostly giving an opportunity to those who have most difficulties in entering the primary market.

Authorities’ Views:

32. The authorities broadly concurred with staff’s recommendations and highlighted that their competitiveness agenda is comprehensive and broad-based. In order to ensure timely progress, actions have been taken to strengthen the monitoring of implementation. The identification of tasks and deadlines for all the line ministries have been established together with a set-up of a monitoring system. The first report will be published soon. The MNB will monitor progress through the “Competitiveness Mirror” (released in the fall) which will assess to what extent the 330 competitiveness recommendations have been implemented. The authorities recently introduced a new procurement system with simplified procedures and lower administrative burdens expect this to help improve doing business indicators and perceived governance rankings. With regards to simplifying the tax system, the advertising tax is suspended till 2022. The authorities are determined to support innovation, especially by SMEs, including through the recently introduced cash incentive scheme to encourage technology-oriented investments and R&D spending.

Staff Appraisal

33. Over the last decade, Hungary achieved further income convergence at an impressive speed and has become less vulnerable to shocks. Over the medium-term, the fiscal balance is expected to further improve. Public and external debts would continue to decline, and domestic credit growth is envisaged to remain buoyant. However, short-term prospects are clouded by wavering global growth, trade tensions, and Brexit. Furthermore, Hungary’s growth is likely to decelerate unless structural reform efforts are redoubled to improve productivity and boost the economy’s potential.

34. The government’s medium-term fiscal policy targets are appropriate but specific measures are needed to secure them. The government’s envisaged consolidation would gradually reverse the procyclical fiscal stance of the past few years and allow monetary policy to remain accommodative for a longer period. Introducing a mix of growth-friendly revenue and expenditure measures will help achieve the authorities’ fiscal targets. Revenue can be enhanced through reducing exemptions and preferential regimes, as well as broadening the tax base while continuing to phase out sectoral taxes. Streamlining expenditure can be achieved through moderately reducing spending on goods and service and the public wage bill, building on the progress made at the central government administrative level. Generalized transport and energy subsidies could also be rationalized and targeting improved to protect the poorer households. Any additional savings can be used to finance infrastructural investment in the medium term to compensate for the eventual decline in EU funds. It is also important to implement the government’s plan to enhance the monitoring of SOEs to improve efficiency and reduce the risk of contingent liabilities. While reducing currency risks is a prudent objective of the public debt management strategy, there is also merit in avoiding a large increase in interest costs and in achieving a further lengthening of maturities.

35. Given the recent moderation of inflation and weaker external environment, it is appropriate for the monetary stance to remain accommodative. However, attention should be given to any emerging price pressures. In addition, clear and timely communication will remain essential for effective forward guidance. Close monitoring of the unconventional arrangements is warranted to continually assess their success in achieving their objectives while reducing the risk of market distortions. To help contain real estate price pressures, there is merit in reviewing the various fiscal incentives for house purchases, basing them on means-testing targeting, and reducing impediments to doing business in the construction sector.

36. Improvements in competitiveness are needed to boost potential output. It is important to further simplify and shorten the processes required to obtain building permits and business licenses and to continue to speed up connection to utilities. Additional efforts to enhance governance, including in public procurement practices, would also be helpful. Supporting the growth and development of SMEs will also require simplifying regulations as well as changing them less frequently. The commendable effort to increase participation in the labor market, especially for women, should be complemented with the above reforms, and with improving the quality of education, vocational training, and public services. The timely downsizing of the PWS, with a view of releasing workers to the very tight primary labor market, is also encouraging and should continue.

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

Table 1.

Hungary: Selected Economic Indicators, 2014–20

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

Data as of October 1, 2019.

Q2 data for 2019.

Table 2.

Hungary: Medium-Term Scenario, 2014–24

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Sources: Hungarian authorities; and Fund staff estimates and projections.

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

Table 3.

Hungary: Consolidated General Government, 2014–24

(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: Central Bank Survey, 2014–20

(In Billions of Forints, unless otherwise indicated)

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

Data are from MNB’s monetary statistics Table 2.a.1 on bank assets.

Does not include holdings of shares and equity stakes issued by other residents, which are captured in other items net. The Pallas Athene Foundations are not part of the MNB’s balance sheet.

Table 5.

Hungary: Monetary Survey, 2014–20

(In Billions of Forints, unless otherwise indicated)

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

Only credit to households and firms.

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

Table 6.

Hungary: Balance of Payments, 2014–24

(In Millions of Euros, unless otherwise indicated)

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Sources: Hungarian authorities and Fund staff estimates.

A negative sign for financial accounts items indicates a net inflow per BPM6.

Includes financial derivatives.

Excludes Special Purpose Entities.

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

Table 7.

Hungary: Financial Soundness Indicators for the Banking Sector, 2014–19

(In percent, unless otherwise indicated, end of period)

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Sources: Magyar Nemzeti Bank (MNB); and IMF’s Financial Soundness Indicators Database.

The decline in NPLs in 2015 was partially due to the settlement of unilateral interest hikes and exchange rate margins deemed unfair by the Supreme Court. The oldest unpaid interest, fees and penalties were paid first.

Global Automotive Industry: Hungary’s Participation and Prospects1

Recent developments: The global car industry witnessed important changes in 2018. Vehicle production in 2018 fell (by 6 percent) for the first time since the Global Financial Crisis, and sales (and exports) were also weak. The downturn was synchronized across markets. There were several factors behind the downturn: China phased-out tax credits on car purchases and tighter lending conditions for auto loans were observed in large car buyers (US, UK, China). Structural changes also contributed to the developments through technological changes (demand for electric cars, car sharing) and higher environmental standards. Finally, increased tariffs on steel and aluminum, issues with emissions compliance in Germany, and expectations of the rise in car tariffs, have added to the fallout.

Hungary’s exposure. The motor vehicle industry in Hungary accounted for 4.9 percent of gross value added in 2017, and over 7 percent considering input linkages. Cars are Hungary’s top exports, followed by vehicle parts, and spark-ignition engines, all accounting for 16 percent of total exports. Germany is Hungary’s most important trading partner (27 percent share), not least due to the linkages with the German Value Chain (Figure 8). Hungary is also a net exporter of car components, and the ratio of export to import of car parts remained unchanged between 2007–17 comparing to a decline in some of its competitors (Figure 8).

Figure 8.
Figure 8.

Automotive Sector Statistics

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Risks to output. Hungary is predisposed to various of the aforementioned car industry shocks. While it is difficult to gauge, some estimates suggest that a demand shock of a 10 percent decline in the demand for (and subsequently production of) German finished vehicles would lead to the reduction in gross output and value added in Hungary at -0.25 and -0.15 percentage points, respectively (Bank of Spain, 2019; Figure 8).2 A supply shock of a 22.5 pps car tariff increase by the US on Hungarian car exports could shave off around 0.25 pps from Hungary’s growth (Morgan Stanley Research (2019) based on latest available data as of 2014). The economies that would be directly exposed experience somewhat smaller declines as part of the shock is ‘exported’ to their main trading partners through reduced demand for intermediate goods imports. Also, Hungary’s direct car exposure to the US has declined in recent years.

Mitigating factors and opportunities. Assuming lower demand elasticities for more expensive goods, demand shocks are somewhat cushioned for Hungary given that the production is concentrated on high-end (German brand) vehicles unlike in Slovakia and to some extent in Czech Republic (Figure 8). Several manufactures are also opening electric car production lines in their plants following the current demand trends. Battery production (by Samsung, GS Yuasa, SK Innovations) and exports (including for electric cars) are gaining speed due to FDI in the sector (Convergence Program, 2019; Figure 8). To further mitigate its exposure to various shocks, together with adapting to new trends in the industry, Hungary should make efforts to expand the potential of the external sector by increasing productivity, including through targeted skills training and automation, upgrading transport and digital infrastructure, and reducing impediments to doing business for domestic companies to become GVC suppliers and exporters, in general.

1/ Prepared by S. Vtyurina.2/ Given the integration of the car industry value chain, a decline in car production in each of the economies will have a knock-on effect on the industry itself (direct effect) and on other sectors and countries that provide the inputs needed for car manufacturing (indirect effect). Germany would suffer the greatest impact on their own gross output and value added and would have the biggest knock-on effects on other economies, in particular in eastern Europe.

Public Works Scheme1

The public works program is the single largest government intervention in the Hungarian labor market. It involves three subprograms: national public works, longer-term public works, and “start-work” pilots. Most of the programs’ clients are jobseekers with past work experience but no recent employment history. Additionally, many public works clients who have been inactive earlier and lost their income as a result of the unemployment benefit scheme transformation are coming from poor and vulnerable households (World Bank, 2017).

Given the booming labor market, the initial objectives of providing employment opportunities and social support have been reached and the program is being scaled down. Participation decreased from the high of 202 thousand in 2016 to 101 thousand in Q2 2019, or about 2.6 percent of the total workforce, well ahead of the government’s 2020 target. Several changes to the scheme took place after 2013 with the program’s objective shifting from reaching out to and mobilizing inactive individuals towards facilitating participants’ successful exit to the primary labor market. The replacement allowance was in place till end-2018, which allowed public employees to be employed in a private sector before exiting the PWS while compensating for any wage difference. The wages of public workers will not be raised for the third year in a row in 2019 as the government encourages people to seek opportunities elsewhere, while also limiting the fiscal costs.

The program structure and incentives could be improved. Efforts should be made to limit the time of participation in the program as an inverse relationship has been observed between the duration of participation and the likelihood of employment outside the program, except for some groups (partially disabled, very low skilled) (European Commission, 2017). Perhaps an overview of the universal unemployment benefit (UB )duration is warranted as participation in the PWS has been incentivized by the UB’s very short duration, which at 3 months is the lowest in the EU. One of the most prominent shortcomings is that the program absorbed funds from other more efficient labor market tools (as active labor market policies (ALMPs)) and provided a lower income than the minimum wage. The per capita cost of the scheme is higher, and its efficiency is lower than that of ALMPs (Fertig and Csillag, 2015). While the reemployment rate is gender-balanced, there is a higher reemployment rate for younger age cohorts (younger than 25 years), perhaps, suggesting that increasing the availability of child-care facilities would improve participation among an oder cohort of women (25–39 age group) coming out of this program, and women, in general.

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Public Works Scheme

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Source: Hungarian Authorities.
1/ Prepared by S. Vtyurina.

Annex I. Public and External Debt Sustainability Analysis

Public Debt Sustainability Analysis

1. The baseline scenario assumes no material fiscal adjustment over the projection horizon, except for the small intended reduction in public investment. It is underpinned by the following assumptions:

  • Real GDP growth is projected to moderate from 4.9 percent in 2019 to 3.5 and 3.0 percent in 2020 and 2021, respectively. The projected slowdown in growth reflects the expected slowdown in the EU funds absorption and lower growth in major trade partners. Over the medium term, growth is projected to decline close to 2 percent, which is broadly consistent with the medium-term growth potential.

  • GDP deflator is projected to grow by 3 percent over the medium term in line with the central bank’s inflation target.

  • The primary fiscal position is projected to remain broadly unchanged averaging about 0.5 percent of GDP over the projection period. The projections incorporate the already announced reductions in the social security rate for employers and tax rates, lower EU funds (starting in 2020), higher compensations of public employees, declining public investment and still favorable financing conditions.

2. The baseline projections are underpinned by realistic assumptions but risks to growth are on the upside. Previous forecasts of growth, primary balance and inflation tended to be conservative. Comparing to other countries, projection errors seem reasonable, as reflected in the interquartile range.

3. The projected decline in public debt reflects only small fiscal adjustment. The public debt-to-GDP ratio is forecast to decline from 70.2 percent in 2018 to about 56 percent by 2024. Under the baseline scenario, in cumulative terms, the primary balance will contribute only by 2.7 percentage points to the declining debt path. In contrast, the cumulative contribution of the interest rate-growth differential is projected to be about 10 percentage points, reflecting growth being above the effective interest rate on public debt. Gross financing needs are forecast to drop between 10 to 12 percent of GDP over the projection horizon on account of recently extended maturities of sovereign bonds.1

4. The projections of public debt and gross financing needs are particularly sensitive to growth, combined macro-fiscal, and contingent liabilities shocks:

  • Growth shock. Slower growth remains the principal risk to debt sustainability. Assuming a decline in growth by one standard deviation for 2019 and 2020, the debt-to-GDP ratio is forecast to reach 70 percent, i.e., 10 percentage points above the baseline in 2024. Under the same assumptions, gross financing needs would reach 16 percent of GDP, i.e., about 3 percentage points above the baseline level by the end of the projection period.

  • Macro-fiscal shock. If shocks to growth, interest rate, and primary balance occur simultaneously, the debt-to-GDP ratio would reach at 74 percent at the end of the projection horizon. In this case, financing needs would reach at 17 percent of GDP.

  • Contingent liabilities shock. A standardized shock of 10 percent of financial sector assets is used to represent a hypothetical realization of contingent liabilities. In such a scenario, the debt-to-GDP ratio would reach 74 percent at the end of the projection horizon and financing needs would reach 19.5 percent of GDP.

5. The fan charts show moderate uncertainty around the baseline. The width of the symmetric fan chart, estimated at almost 20 percent of GDP, illustrates the degree of uncertainty for equal-probability upside and downside shocks. Assuming less favorable economic conditions than under the baseline scenario―upside shocks to growth and primary balance are constrained to zero―public debt dynamics would remain broadly stable at about 70 percent of GDP.

6. Hungary’s debt profile has improved but still indicate some risks. The external financing needs are above the upper risk-assessment benchmark, but the risk is to a certain extent mitigated by the fact that a sizeable share of foreign liabilities accounts for intra-company loans. Public debt in foreign currency and public debt held by non-residents have declined considerably in recent years. To further reduce external financing requirements and the share of public debt held by nonresidents, a new five-year retail bond denominated in domestic currency with gradually increasing interest rates over time was launched in mid-2019. In line with current favorable financing conditions and large investor base, spreads are below the lower-risk assessment benchmarks. The share of short-term debt has decline recently, although from relatively high levels.

7. Risks to debt sustainability, however, can be weighed against a number of mitigating factors.

  • Investor base. Debt is now held predominantly by domestic financial institutions and households, with the non-resident component decreasing and estimated below 40 percent of total debt. This factor―coupled with ample liquidity in the system and still relatively low demand for private sector credit―has incentivized banks to purchase sovereign debt.

  • Buffers. There is a cash cushion in the form of deposits accumulated by the public sector, which is around 5 percent of GDP. This implies a lower public debt-to-GDP ratio on a net basis and some liquidity cushion that could help cover financing needs for a few months.

Figure 1.
Figure 1.

Hungary Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ EMBIG.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r – π(1+g) – g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r – π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Figure 2.
Figure 2.

Hungary Public DSA – Realism of Baseline Assumptions

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Source: IMF Staff.1/ Plotted distribution includes all countries, percentile rank refers to all countries.2/ Projections made in the spring WEO vintage of the preceding year.3/ Hungary has had a cumulative increase in private sector credit of 80 percent of GDP, 2015–2018. For Hungary, t corresponds to 2019; for the distribution, t corresponds to the first year of the crisis.4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.
Figure 3.
Figure 3.

Hungary Public DSA Risk Assessment

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Source: IMF staff.1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are: 200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.4/ EMBIG, an average over the last 3 months, 11/1/2018–1/30/2019.5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.
Figure 4.
Figure 4.

Hungary Public DSA – Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Source: IMF staff.
Figure 5.
Figure 5.

Hungary Public DSA – Stress Tests

Citation: IMF Staff Country Reports 2019, 357; 10.5089/9781513521404.002.A001

Source: IMF staff.
Table 1.

Hungary: External Debt Sustainability Framework, 2014–2024

(In percent of GDP, unless otherwise indicated)

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Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.