Public Information Notice No. 05/82

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Hungary

June 29, 2005

On June 15, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.¹

Background

Hungary's entry into the European Union on May 1, 2004 was a tribute to its successful transition to a market economy. The country's willingness and ability to undertake structural reforms in the middle of the 1990s laid the groundwork for the subsequent macroeconomic successes. However, Hungary lost ground starting in mid-2001: growth slowed and large budget and current account deficits emerged.

In 2004, valuable gains were achieved. Real GDP growth recovered to 4 percent, supported by strong investment and robust export growth, in turn, helped by a bounce in the euro area economy in the first half of the year. Consumption slowed in response to rising unemployment, a moderation in wage growth and a tightening of the housing subsidy scheme. Wage deceleration also helped support disinflation, with inflation declining to an annualized 3.5 percent by year-end. The current account deficit stabilized, albeit at a still high level of 9 percent of GDP. Financial markets retained an optimistic view of Hungary. Despite a sharp decline in policy interest rates, the forint appreciated modestly against the euro and risk premiums fell.

Despite these favorable developments, risks associated with the twin deficits remained. Although some fiscal consolidation has taken place (in European Standards of Accounts' 95 terms), the twice upward-revised fiscal deficit target was not met. While Foreign Direct Investment recovered in 2004 to 4.2 percent of GDP from its 2003 trough, more than half of the current account deficit still had to be financed by debt-creating flows. A new vulnerability is emerging, as households and small businesses are borrowing in foreign currencies, likely without adequate hedging. Forward spreads on local currency bonds have not narrowed, reflecting uncertainty regarding the timing of euro adoption.

Moreover, growth slowed in the second half of 2004 and in the first months of 2005, with a slowdown in industrial production and a continued increase in unemployment. Business and consumer confidence indices have also deteriorated.

Executive Board Assessment

Executive Directors commended the authorities on Hungary's robust performance in its first year as an European Union (EU) member. Administrative challenges generated by EU accession were overcome successfully, the export sector responded positively to increased competition, and macroeconomic imbalances were contained.

At the same time, Directors noted that vulnerabilities exist, including the high current account and fiscal deficits, and that Hungary's growth potential and performance have declined. They urged the authorities to maintain a track record of consistent and predictable policies in order to raise productivity and growth in the short run and prevent their erosion in the medium term. This will be necessary to secure a satisfactory rate of income convergence with other EU members. Growth- and savings-enhancing policies will also help reduce domestic and external vulnerabilities and retain the confidence of financial markets, especially in the context of the large appreciation of the real exchange rate in recent years. Directors also stressed that policies for raising employment will be vital to ensuring that the benefits of growth are widely spread.

Directors considered regaining control over fiscal policy to be the key challenge facing Hungary. They emphasized that fiscal consolidation is crucial, noting that missing the 2005 fiscal deficit target would set back debt reduction and further damage policy credibility. Beyond 2005, Directors felt that adherence to at least the fiscal targets in the Convergence Program is essential not only for euro adoption by 2010, but also because slippages would undermine macroeconomic stability, debt sustainability, and medium-term growth prospects.

For 2005, Directors noted that the anticipated risks of overspending and revenue shortfalls are now materializing. At the same time, available budgetary reserves are substantially lower than originally budgeted. Directors therefore welcomed the authorities' commitment not to use the remaining budgetary reserves, and urged the authorities to take prompt additional deficit-reducing measures. They cautioned against actions that lower the reported deficit while maintaining fiscal stimulus. They felt, instead, that expenditure-reducing reforms—particularly in the health and education sectors—and the phasing out of interest rate subsidies would not only reduce the budget deficit, but also improve the delivery of public services and help raise private savings. They underscored also the need for a wide-ranging tax reform, with a focus on lower rates and a broader base. Such a reform needs to be taken alongside structural measures to reduce spending, so as not to endanger fiscal consolidation. Directors welcomed the authorities' intention to request a fiscal Report on the Observance of Standards and Codes (ROSC) in 2006.

In order to improve fiscal performance and restore credibility to policy targets, Directors recommended the strengthening of fiscal institutions and the budgetary process. They welcomed the recently approved Public Finances Law, while cautioning that much remains to be done. In particular, they stressed the importance of creating a medium-term fiscal framework to improve fiscal discipline, while also achieving greater budgetary transparency and predictability. In this context, they urged the adoption of a three-year rolling framework, further checks and balances in the expenditure management system, and more extensive budgetary oversight by the State Audit Office.

Directors advised against frequent changes in fiscal accounting practices, and urged caution and transparent reporting on the use of private-public partnerships. They warned that if ad hoc accounting and expenditure reduction measures are relied upon to meet the Maastricht criteria, Hungary would risk entering the euro area with a large underlying deficit, which would undermine long-term growth prospects.

Directors welcomed the disinflation in late 2004 and early 2005, and viewed the reduction in interest rates as an appropriate response. With the 2005 and 2006 inflation targets projected to be on track, Directors recommended that future interest rate policy be cautious and guided by the market's inflation expectations. In this regard, most Directors also emphasized the importance of focusing monetary policy on containing domestic inflationary pressures, rather than on stabilizing the exchange rate, and of communicating this clearly to markets.

Most Directors commended the authorities' intention to strengthen the inflation-targeting framework. They supported the planned reduction in the inflation target to 3 percent a year in the medium term, to be achieved over a rolling horizon, noting that this would bring policies closer in line with international best practice.

Directors commended the continuing soundness and increased profitability of the financial sector, but were concerned that the growing share of foreign currency debt held by the private sector could become a source of vulnerability. In this context, they urged authorities to closely monitor the expansion of foreign currency-denominated borrowing—especially by households and small- and medium-sized firms that likely are not naturally hedged. In this regard, they encouraged stronger disclosure requirements, appropriately formulated additional provisioning for foreign currency loans, and the development of market-oriented risk-hedging instruments. They also urged adoption of regulatory initiatives in the pension funds and insurance sectors, and changes to safeguard the independence of the Hungarian Financial Supervisory Authority, as recommended by the recent Financial Sector Assessment Program (FSAP) update.

Regarding structural measures, Directors considered that raising Hungary's low labor participation rate, enhancing labor market flexibility, and increasing productivity are priorities. They therefore welcomed the recently-published National Action Plan for Employment, which aims at facilitating geographic and occupational mobility, reducing the impediments to part-time employment, and implementing vocational educational reforms. Moreover, they recommended that further increases in the minimum wage be limited to productivity growth. They welcomed the authorities' strategy for using EU funds to raise the productivity of small- and medium-sized firms and improve the business environment, but stressed the importance of fiscal structural reforms to ensure that EU funds are used to achieve long-lasting gains.