Public Information Notice No. 02/58

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Hungary

June 5, 2002

On May 22, 2002 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.¹

Background

Hungary achieved remarkable economic success in the four years to 2000. The country maintained strong output growth, increased employment, raised the investment-to-GDP ratio, reduced inflation significantly, narrowed the fiscal deficit, and lowered the current account deficit to a sustainable level.

Although economic growth slowed in 2001, the economy showed considerable resilience to the weaker external environment. GDP growth was a still respectable 3.8 percent, down from 5.2 percent in 2000 but higher than most other countries in the region. While export growth decelerated as the year progressed, it nevertheless outpaced growth in Hungary's export markets. Domestic demand was partly supported by buoyant private consumption on the back of strong real wage gains. Meanwhile, the unemployment rate edged down to 5.6 percent by the start of 2002.

Fiscal policy turned expansionary in 2001, also contributing to domestic demand and economic growth in that year. The fiscal stimulus was sizable, estimated at about 2 percent of GDP. This contributed to public investment and growth at a time when private investment was being scaled back. But the higher level of public spending—notably on wages and pensions—has increased the challenge of attaining the government's desired medium-term fiscal adjustment.

The authorities successfully introduced a new monetary policy framework—widening the exchange rate band in May 2001 to ±15 percent against the euro and adopting inflation targeting in June 2001. Notwithstanding a string of interest rate cuts since the band widening, this led to a tightening of monetary conditions.² With inflation expectations falling faster than nominal interest rates, real short-term interest rates have increased modestly, and the forint has strengthened against the euro by some 10 percentage points since the band widening.

Inflation has come down markedly. After peaking at 10.8 percent in May 2001, year-on-year consumer price inflation declined steadily to 5.9 percent in March 2002. This reflected moderating growth in tradable goods inflation owing largely to the appreciation of the forint; a drop in services sector inflation to single digits, attributed to greater competition; and a decline in food and fuel prices. Core inflation, which excludes certain fuel and food prices and administrative prices, declined by 4.2 percentage points over the same period.

Amid tight labor market conditions, wage growth has picked up. Year-average economy-wide nominal wage growth reached 18 percent in 2001, compared with headline inflation of 9.2 percent. This rapid pace of growth reflected in part a 57 percent increase in the minimum wage, introduced in January 2001—although with some low wage workers actually receiving higher but unrecorded pay, the minimum wage hike had the effect of raising measured wages much more rapidly than actual wages paid in the private sector. The minimum wage was raised again by 25 percent in January 2002.

The external current account deficit narrowed in 2001, and external financing was unaffected by emerging market tensions over the past year. The deficit was 2.1 percent of GDP, down from 2.9 percent of GDP in 2000. Import growth moderated owing to the sharp drop in private investment growth and lower oil prices; exports, though slowing during the year, were buoyant on a year-average basis; and tourism receipts were strong. The capital account was fully liberalized in mid-2001. Access to international financial markets has remained on favorable terms, even amid emerging market turmoil.

Executive Board Assessment

Executive Directors commended the authorities for Hungary's remarkable economic progress in recent years and its success in weathering the recent global economic slowdown. They attributed this result to generally sound macroeconomic management, far-reaching institutional and structural reforms, including the lasting effects of the bold reform measures of the early and mid-1990s, and Hungary's integration with the EU. However, in spite of Hungary's generally favorable economic outlook, Directors noted that there remain important areas where some weaknesses need to be addressed, most notably in the fiscal domain.

In light of Hungary's already high degree of integration with the EU, most Directors viewed the objective of early EU accession and timely adoption of the euro as appropriate and helpful for anchoring policy. But they stressed that achieving this objective would pose significant policy challenges, made all the more difficult by the expansionary fiscal stance last year and the continued significant fiscal stimulus that would occur this year without offsetting measures. Moreover, against the background of rapid growth in public sector wages, minimum wage hikes, and still tight labor market conditions, macroeconomic policy restraint would be essential to support the achievement of inflation objectives.

On the monetary front, Directors welcomed the firm downward track of inflation over the past year, attributed in large part to the well-managed introduction of the new monetary policy framework. Widening the exchange rate band allowed the National Bank of Hungary to appropriately tighten monetary conditions, and the successful resumption of disinflation helped to foster the credibility of the new inflation targeting regime.

Nevertheless, Directors considered that there exists an upside risk to inflation, and that securing the targeted degree of disinflation would require a determined effort. They recommended that monetary policy be kept tight to prevent a rekindling of inflationary pressures, particularly with economic activity expected to pick up. However, Directors noted that the appreciating currency and rising labor costs raised concerns about external competitiveness, and cautioned the authorities against excessive reliance on monetary policy. They stressed the importance of support from fiscal policy, emphasizing that a fiscal correction would moderate the necessary degree of monetary tightness and help avoid too strong an appreciation of the forint.

For this and other reasons, Directors emphasized the need to reverse the considerable fiscal expansion underway at the earliest opportunity. While acknowledging that in 2001 the fiscal expansion helped moderate the economic slowdown, they thought that a broadly neutral fiscal stance in 2002 would be appropriate. This would avoid adding stimulus as economic growth gathers pace, preclude the crowding out of private investment, and facilitate meeting medium-term fiscal consolidation objectives. As an additional benefit, it was observed that a strong, early, and visible commitment to rein in the fiscal deficit would add to the credibility of the targeted disinflation path—thereby anchoring inflation expectations more firmly, moderating wage growth, and, ultimately, minimizing the real costs of disinflation.

In the view of the Directors, spending restraint will be key for meeting fiscal deficit targets. They considered that adopting medium-term expenditure ceilings—within a well-developed medium-term fiscal framework—would help secure the desired fiscal adjustment path. A few Directors advocated making these expenditure ceilings public to enhance credibility, including by garnering political commitment. Directors strongly supported the ongoing preparation of a public expenditure review, and encouraged the authorities to complete the review as soon as possible, with the aim of presenting options for greater spending restraint.

To help support fiscal consolidation, as well as increase policy flexibility and improve the economy's resilience, Directors urged the government to press ahead with remaining structural reforms. In light of Hungary's rapidly aging population, they viewed pension and health care reforms as core. Further reforms to ensure the pension system's viability should aim, in part, to increase the effective supply of labor. Health care reform should focus on strengthening expenditure control while delivering quality services. Directors also underscored the need to rationalize public sector employment, in order to reconcile the difficult task of retaining high quality staff while keeping the overall wage bill in check. In addition, they encouraged the government to move forward with liberalizing the energy market and to refrain from ad hoc caps on regulated prices.

Directors welcomed the findings of the update of the Financial System Stability Assessment, which confirmed that the financial system remains fundamentally sound. They commended the government for the further strengthening of the legal framework over the past year, including new legislation aimed at combating money laundering and terrorist financing. They stressed, nevertheless, the importance of ensuring robust implementation over the period ahead. In the current environment of more volatile exchange rates and an open capital account, a few Directors also encouraged the authorities to monitor closely the foreign exchange exposure of banks' clients.

Directors welcomed the authorities' intention to publish the staff report and associated documents, and observed that Hungary's participation in updating Report on the Observance of Standards and Codes modules represents a welcome commitment to transparency and standards. While commending ongoing efforts in several areas, including the recent agreement to place balance of payments statistics on an internationally comparable basis by early 2003, they observed that there was room for improvement with regard to fiscal transparency. In this regard, Directors urged the authorities to integrate all the fiscal activities of institutions currently outside the scope of the government budget into the regular budgetary process.