Public Information Notice No. 01/47

Public Information Notice: IMF Concludes Article IV Consultation with Hungary

May 18, 2001

On May 4, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.¹

Background

Strong external demand boosted economic activity in 2000, allowing Hungary to post the strongest overall performance in the region and maintain its position at the forefront among the EU accession candidates. Real GDP grew by 5.2 percent in 2000. While exports were the engine for growth, domestic demand growth remained moderate, reflecting slow real wage growth.

Robust economic growth has been accompanied by signs of bottlenecks for skilled labor. Employment rose by 1 percent in 2000. The unemployment rate fell by ¾ percentage point to 6 percent (seasonally-adjusted) by end-2000 and was less than 3 percent in the Budapest area. Higher-than-expected inflation kept the gain in real net wages to 1.5 percent (year average) in 2000.

Inflation has come down markedly since 1995, when the crawling band exchange regime was introduced, but recent progress with disinflation has been disappointing. Average inflation for 2000--at 9.8 percent--barely budged from the 10 percent recorded for 1999 and was well above the government's target range of 5-7 percent. The reversal of the disinflation trend in mid-2000 initially reflected exogenous supply shocks-including higher world oil prices and the weaker euro. However, core inflation has also been rising, reflecting in part an increase in unprocessed food prices as a result of growth in external demand, but also the fact that domestic factors have been increasingly at play.

Over the past year, monetary and exchange rate policies have had to cope with the competing challenges of inflationary and capital inflow pressures. Early in 2000, heavy capital inflows kept the forint at the strong edge of its narrow band, forcing the central bank to cut interest rates. By mid-2000, interest rates had been cut by more than 300 basis points, while the monthly rate of crawl was cut only once, from 0.4 percent to 0.3 percent in April 2000. This loosening of the monetary stance occurred against a background of a rekindling of inflation, a tight labor market, and strong economic growth. When capital market pressures subsequently cooled and in response to an unforeseen jump in inflation in September, the National Bank of Hungary hiked its key policy rates by one percentage point. In the first two months of 2001, amid a steady uptrend in core inflation, capital inflows prompted the central bank to cut rates twice-totaling 50 basis points. With a view to tightening monetary conditions, the monthly rate of devaluation was lowered from 0.3 to 0.2 percent from April 1, 2001. On May 4, 2001, to give monetary policy more room for maneuver to better fight inflation and to take a first step toward conformity with ERM-II, the crawling band was widened from ±2.25 percent to ±15 percent. At the same time, the National Bank of Hungary proposed to accelerate the capital liberalization process through relaxing the restrictions on short-term capital flows and derivative transactions between residents and non-residents.

The general government deficit for 2000 came in at 3½ percent of GDP, in line with the government's deficit target. Through November, the outturn suggested that the deficit target would be substantially undershot, but, in December, the much higher-than-projected revenues were largely offset by higher expenditures, particularly on social security items and capital transfers to the state privatization agency and the Hungarian Development Bank.

External competitiveness remained strong, with the external current account deficit narrowing in 2000. Industrial labor productivity-up by almost 17 percent in 2000--far outpaced real wage gains, leading to a depreciation in the real effective exchange rate (based on unit labor costs) over the year. Rising export market shares and strong corporate profitability in the export sector also support the assessment of solid competitiveness. During most of the year, export growth exceeded that for imports, tourism revenues boosted the services account, and fiscal policy was tighter-than-budgeted, contributing to an improved external position. Thus, despite the worsening of the terms of trade, the external current account deficit narrowed to 3.3 percent of GDP in 2000, down from 4.4 percent a year earlier.

With credit ratings approaching advanced economy levels, Hungary maintains ready access to external financing--but external debt levels remain high. Spreads on sovereign benchmark bonds are among the lowest in the region, and, attracted by Hungary's strong economic fundamentals and convergence prospects, foreign investors' share of holdings of forint-denominated government securities reached record highs. However, in contrast to 1999, strong net FDI inflows were more than offset in 2000 by substantial portfolio equity outflows. Net external debt, as a percent of GDP, is now almost half its level in 1995, gross external debt has fallen over the same period, and the debt service burden has shrunk significantly. Nevertheless, external debt, at about 60 percent of GDP on a gross basis, remains high, although the public sector share has declined substantially, while private sector debt, mostly that of foreign-owned corporations, has increased from low levels.

Executive Board Assessment

Executive Directors commended the authorities for Hungary's impressive economic performance-one of the strongest in the region over the past year. In particular, they welcomed the remarkable export growth, strong external competitiveness, and withdrawal of fiscal stimulus that had led to the narrowing of the external current account deficit in 2000. Directors considered that Hungary should maintain its track record of careful macroeconomic management, while pressing ahead with remaining structural reforms, in order to ensure strong and sustainable medium-term growth and Hungary's position as a frontrunner for EU accession.

Directors expected the economic expansion to remain strong in 2001, though driven increasingly by domestic demand, but were concerned by some emerging trends. Inflation picked up in mid-2000 and has returned to double digits, while real wage growth has been strong this year amid increasing signs of labor shortages; and real interest rates remain near record lows. Furthermore, fiscal policy looks set to provide a substantial stimulus in 2001 and 2002, which could exacerbate inflationary pressures and problems caused by capital inflows, and cause the current account deficit to exceed the government's target.

Against this background, Directors welcomed the decision to widen the exchange rate band, as it would provide room for maneuver for monetary policy to address some of these concerns. However, Directors emphasized that monetary policy could not by itself achieve both inflation and external objectives, especially in the context of robust economic growth, and that it will be important to have an appropriate fiscal adjustment.

Directors considered that fiscal policy should make a key contribution in addressing inflation and preserving the external position. They agreed that the Széchenyi Plan has a role to play in closing the economic gap with the EU, but urged that due regard be given to macroeconomic vulnerabilities and constraints in phasing in the associated expenditures. Directors agreed that a broadly neutral fiscal stance in 2001 and 2002--which would require a substantial withdrawal of fiscal stimulus relative to that embedded in the budget and in planned off-budget spending-would be appropriate. They considered that much of the recommended tightening could be achieved by safeguarding revenue overperformance, but scaling back current and off-budget expenditures is also important.

Directors agreed that the narrow crawling exchange rate band had contributed to Hungary's past successes, but that it had outlived its usefulness. In view of the present and prospective challenges to policy, they welcomed the widening of the band, which should facilitate the central bank's efforts to reduce inflation by providing the necessary leeway to tighten monetary conditions, when needed, including through a moderate appreciation of the forint. Most agreed that a moderate appreciation, if it occurred, would not derail Hungary's strong external competitiveness. Greater exchange rate flexibility would also strengthen the financial system by discouraging speculation and unhedged borrowing. A few Directors suggested that, under a more flexible exchange rate regime, the authorities should give consideration to an inflation-targeting approach to monetary policy. Directors urged the authorities to review the remaining short-term capital controls at an early date, noting that, in the context of increased exchange rate flexibility, dismantling these controls would help foster the development of more liquid and deeper hedging markets, but that it would also require that sound regulatory and prudential controls be effectively implemented.

While considering that some increase in the minimum wage may be justified, Directors expressed concern that the size of the increase this year and next could jeopardize employment in weaker sectors and possibly add to inflationary pressures by generating higher wage demands across a broader spectrum. They urged the authorities to consider scaling back the size of the increase planned for next year or to allow exemptions for youths and depressed regions and industries, as in some EU member countries, if developments necessitate it. In addition, Directors stressed that ad hoc caps on regulated prices should be temporary and are an undesirable way of curbing inflation.

Directors considered that Hungary's medium-term economic prospects are promising, but noted that the fiscal impact of EU accession will be rather substantial. In this light, they encouraged the authorities to aim for greater fiscal consolidation than currently planned, particularly in view of uncertainties regarding private saving behavior. This, backed by structural reforms, would help ensure external sustainability and support durable growth. While recognizing the political constraints, they urged the authorities to move ahead quickly with the remaining structural reforms in those priority areas already identified by the authorities--pensions, health care, local government financing, and public administration.

Directors congratulated the authorities for participating in the Financial Sector Assessment Program. They recognized and welcomed the resilience and strength of the financial system as identified by the Financial System Stability Assessment. They considered Hungary to be at the forefront of financial sector reform among the accession countries, and welcomed the National Bank of Hungary's Report on Financial Stability. Directors noted, nevertheless, that further reforms are needed in several crucial areas, including full implementation of consolidated reporting and supervision of financial groups, and increasing the autonomy of the Hungarian Financial Supervisory Agency.

Directors commended the authorities for having taken significant additional steps with regard to transparency and standards since the last Article IV consultation. Nevertheless, as discussed in the fiscal transparency module of the Report on Observance of Standards and Codes (ROSC), and to increase transparency further, they urged the authorities to bring all fiscal activities (including off-budget spending, particularly that associated with motorway construction) into the consolidated government accounts.

Directors observed that Hungary's statistics are generally of high quality and are adequate for surveillance, as confirmed by the data dissemination module of the ROSC. They, nevertheless, encouraged the authorities to proceed with their plans to improve statistics in some key areas. In this regard, Directors recommended that the balance of payments data (including retained earnings) be compiled on a full accrual basis, and that more complete coverage be provided in the fiscal accounts to facilitate a more accurate calibration of the fiscal stance.