28 January 2013

Concluding statement of the IMF mission: Hungary–2013 Article IV consultation and third post-programme monitoring

The mission concluded that new policy course is needed to deliver the required medium-term fiscal adjustment in a sustainable way to support growth and confidence, repair the financial sector, and promote structural reforms to boost the potential of the Hungarian economy.

GDP is estimated to have declined by around 1½ per cent in 2012 on the back of contracting private consumption and investment, and a large fiscal consolidation. Except for part of the export-orientated manufacturing sector, the rest of the economy is sputtering. Job creation in the private sector is anaemic and unemployment remained roughly unchanged despite the support from the government’s public works programme. Corporate and household bank lending continued to contract. On the basis of current policies, economic activity is expected to stagnate in 2013, with a modest positive contribution from net exports likely to be offset by continued weak domestic demand. The government believes that higher eurozone growth, strategic agreements with selected companies in the manufacturing sector, and faster absorption of EU funds would spur growth in the coming years. However, unless investment recovers from the current historically low level and with unit labour costs slowly increasing, competitiveness, exports and growth would suffer over time and keep the medium-term growth outlook subdued.

This weak performance is due partly to structural factors, but also to specific domestic policies. The needed deleveraging of the household and public sectors has inevitably had a negative impact on growth. And although imbalances have improved, the adjustment process is still not complete and will pose a further drag on activity. Government policies have sought to cushion the impact of the downturn on households, including through minimum wage hikes, mortgage relief schemes and utility tariff cuts. However, increased state interference in the economy and frequent and unpredictable tax policy changes, particularly on the corporate sector, undermined private sector activity. This contributed to a negative feedback loop between slow growth, weak investment, bank disintermediation and high public debt.

In 2012, the government demonstrated a strong commitment to fiscal consolidation. After eight years with sizeable structural deficits, the government’s priority was to reduce the overall deficit to around 2½-2¾ per cent of GDP in 2012-13 with a view to exit the EU’s Excessive Deficit Procedure (which Hungary entered into shortly after its accession in 2004). While fiscal consolidation was necessary, the government has relied excessively on ad hoc measures (VAT hikes, sectoral taxes including a new banking transactions tax (BTT), and across the board spending cuts) to cover emerging fiscal gaps, caused by slower-than-planned growth, underlying spending pressures and costly policy initiatives, like the introduction of a new PIT system at a time it was not affordable. The high frequency of new and often discriminatory measures together with the erosion of domestic fiscal institutions has dented public confidence in policy-making.

Based on current policies, the general government deficit is expected to increase in 2013-15. Assuming that the Country Protection Fund reserves are saved, the deficit is likely to reach 3¼ per cent of GDP in 2013. The bulk of the overrun is caused by possible revenue shortfalls, including from tax administration and the BTT, delays in launching the electronic toll system, and higher spending on education and copayments to EU funds. The deficit is projected to remain above 3 per cent of GDP in 2014-15. As a result, public debt would continue to hover around 78 per cent of GDP—some 10 percentage points higher than its pre-crisis level, despite the notable consolidation effort in 2012 and the one-off effect from the transfer of assets from the private pension funds in 2011.

A different fiscal policy mix can deliver the needed adjustment in a more growth-friendly and sustainable way. The original Szell-Kalman plan rightly put the emphasis on spending consolidation through structural reforms. However, three years after its conception, public expenditure remains high (even adjusting for the planned acceleration in the absorption of EU funds)—and among the highest in the region—increasingly financed through distortive taxes.

Streamlining spending while protecting the most vulnerable would open room for the needed rationalisation of the tax system which, in turn, would support investment, labour participation and growth. Possible actions include:

(i) streamlining the cost of government bureaucracy, including by implementing recently announced measures aimed at reducing central government employment, and containing spending at the local government level where savings can be found after the centralisation of health and education spending;

(ii) restructuring loss making transport SOEs to reduce state transfers;

(iii) better targeting social benefits to vulnerable groups;

(iv) gradually eliminating sectoral taxes while streamlining the corporate tax regime;

(v) reducing disincentives to labour participation embedded in the personal income tax to complement measures in the job protection plan boosting labor demand;

(vi) reducing tax expenditures; and

(vii) in addition to measures already taken, adopting a more comprehensive approach to tackle VAT fraud, particularly in the basic food sector. The goal should be to reduce public spending while phasing out distortive taxes, and bring the deficit to well below 2 per cent by 2015, which is important to set public debt firmly on a downward path.

The banking system is facing great challenges as it seeks to redefine its role in an uncertain environment. Banks are generally liquid and most appear well capitalised but they continue to experience losses resulting from high non-performing loans (NPLs) and related provisioning, a heavy tax burden and the mortgage pre-payment scheme. The share of corporate and household NPLs increased significantly in 2012 to 21 and 15 per cent respectively, and is expected to rise further in 2013. Restructured loans continue to grow and now make up a significant part of banks’ portfolios. Portfolio cleaning remains sluggish reflecting a frozen real estate market and banks’ unwillingness to realise losses, as well as legal and regulatory obstacles to debt collection. Banks’ loan portfolio is contracting, unlike in most regional countries, against a depressed economic environment and a sharp reduction in external funding. Unless bank lending recovers, the economy will struggle to grow.

A turnaround of bank lending requires improving the banking system’s operational environment. Key steps would include increasing the predictability of government policies, scaling down the tax burden, including the retroactive levies, and facilitating conditions to help banks clean up their asset portfolio, including by removing tax, legal and regulatory obstacles. These would be a more effective - and less costly and distortive - way to restore credit growth, as opposed to government initiatives to stimulate credit through tax incentives for specific bank lending and direct lending by state-controlled banks. The government’s intention to reach a new agreement with banks is encouraging, but tangible steps would be needed to address the underlying problems that undermine lending activity.

Prudential norms could contribute to reducing still-large FX swap exposures. The stock of FX swaps of the banking sector has declined by nearly one third since end-2011, in tandem with the reduction of FX-denominated assets. However, it still poses liquidity and rollover risks, and banks should be encouraged to turn to more stable sources of external funding.

The crisis management and resolution frameworks need to be upgraded in key areas. A clear framework, outlining the powers and responsibilities of the resolution authority, the triggers, and the financing arrangements, would improve the timeliness and cost-effectiveness of remedial action, if and when needed. The authorities are working in this direction and legislation is being drafted.

Full press release

See also Commission's mission to Hungary encourages continued progress in fiscal consolidation while paying more attention to raising growth potential, 28.1.13

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