Hungary country assessment

• Implementation of the fiscal consolidation plan is critical to maintain investor confidence. The government’s various announced measures envisage considerable savings, of over 4 per cent of gross domestic product (GDP), which are necessary for medium-term fiscal sustainability despite the current budget surplus, and improved debt ratios resulting from the government’s acquisition of mandatory pension funds.
  
• Hungary needs to preserve an open and even-handed approach to foreign investment. Early and credible measures are needed to bring to an end the “crisis taxes” imposed on four sectors, and to reassure banks that loan contracts will not be subject to regulatory interference which would erode bank equity.
  
• Independence of the central bank and the fiscal council are essential for sound economic governance. These institutions should be strengthened in the interests of credible and sustainable macroeconomic and fiscal policy-making.

Hungary’s recovery remained weak by regional standards. The economy grew by 1.1 per cent in 2010, with domestic demand continuing to stagnate well below pre-crisis levels. Recent indicators point to the strength of industrial production and exports, both of which continued to benefit from the recovery in the core eurozone economies in early 2011. Weakness in domestic demand is persisting, as it is held back by high unemployment levels (over 12 per cent in mid-2011), and the continued contraction in credit to both households and the corporate sector. This may explain why the economy saw a 0 per cent quarterly GDP growth in the second quarter of 2011 when export demand slowed down.
 

A new fiscal reform programme is addressing some long-standing vulnerabilities. The substantial financial sector levy, first imposed in the summer of 2010 was extended for another two years and supplemented by taxes on a number of other sectors (telecommunications, energy and retail services). These “crisis taxes” have been criticised by investors as discriminatory in targeting industries with significant sunk costs, and the levy on the telecommunications sector was found by the European Commission to be contravening Community law. The government also reduced the tax burden on small and medium-sized enterprises (SMEs) and introduced a flat-rate personal income tax. The target for the 2010 deficit under the European Union/International Monetary Fund (EU/IMF) programme was narrowly missed, with the deficit reaching 4.2 per cent of GDP.
 

In 2011 the budget targeted a surplus of about 2 per cent GDP.

This may be achieved as the shift of private pension assets into the state system is recorded as one-off revenue (amounting to about 9.5 per cent of GDP). While the surplus will therefore be temporary, the government’s most recent convergence programme update aims to reduce the budget deficit to below 2 per cent of GDP by 2015, largely through expenditure reductions in areas such as social and health care benefits. To this end, the Szell Kalman Plan was announced in the spring although it will, for the most part, take effect in 2012 and 2013 and important implementation details will need to be finalised. In view of the deterioration in the economic outlook, in September the government  announced a large additional consolidation package of 2.5 per cent of GDP in order to achieve the 2012 deficit target that meets the Maastricht threshold. On the external side, the country is now running a current account surplus, which has reduced pressures on the currency. International bond investors have also been encouraged by the government’s fiscal strategy, as underlined by several successful international bond issues in the first half of 2011. However, gross foreign direct investment (FDI) inflows slowed to about 1 per cent of GDP last year.
 

Hungary remains vulnerable to external shocks, such as loss of capital market access due to investor risk aversion, or from exchange rate depreciation, in particular in relation to the Swiss franc. If the country can address macroeconomic vulnerabilities, in particular through implementation of its fiscal reform programme, trend growth of between 2 and 3 per cent could be achieved.

Hungary is still attractive for certain export-oriented investors. However, surveys show that there remain a number of important impediments to investment, and overall FDI flows have subsided. The World Bank’s Doing Business 2011 survey ranks Hungary at 46th out of 183 countries, a slight improvement compared with a year earlier, with notable progress in tax administration and in registering property. Investor protection remains a considerable problem, according to this survey.
 

Ambitious government attempts to address the legacy of foreign exchange-based lending may undermine broader investor confidence. The stock of household foreign exchange borrowing has become more burdensome as the widely-used Swiss franc continued to appreciate amidst a broader flight to safety. Previous restrictions on foreign currency lending were at first considerably tightened (through a ban on registering collateral), but then had to be partially lifted, due to concerns over compliance with EU legislation. In May 2011 the government announced an agreement with the banking association to shield mortgage borrowers from exchange rate fluctuations, while at the same time lifting a long-running ban on foreclosures of delinquent mortgage loans. Given the very low take-up of this scheme, a further initiative was announced in September 2011 which would allow borrowers to pre-pay FX mortgages at a heavily discounted rate. This initiative has raised concerns over 
the sanctity of private contracts and compliance with EU law, and unsettled investors in a broader range of sectors. It risks undermining bank capital positions, raising funding costs and setting back a recovery in credit growth.
 

Reversals in pension reform put at risk plans to develop a local bond market. In autumn 2010 the government decided to offer strong incentives for shifting assets held in private pension funds back into the state system, which nearly all beneficiaries did. This measure was in part motivated by a better appreciation of the fiscal costs associated with the transition to a partially funded pension system while continuing to finance a state-run pay-as-you-go system, and by the fact that European fiscal accounting rules offer very limited recognition of such costs. Through this near-complete abolition of the second pillar pension system the government again assumes future liabilities for retirement payments and has put in doubt private property rights over financial assets. The government’s acquisition of significant equity stakes in important Hungarian companies is problematic for corporate governance. The measure is also likely to set back the growth of local institutional investors that could underpin the development of local capital markets. Reforms to allow a broader set of financial institutions to issue forint-denominated mortgage-backed securities also remain on hold.
 

Full unbundling of the power sector and curtailing the dominant position of the state-owned supplier, MVM, are pending. Competition in transmission services is still restricted. In July 2011 the Hungarian power exchange initiated trade in futures contracts up to one year ahead, and a gas exchange market will be in operation from 2013. In May 2011 the government sought to clarify the ownership of the refinery company MOL and announced the acquisition of a minority stake, purchased from the Russian company Surgutneftegas for about €1.9 billion (about 2 per cent of GDP). However, the government’s intentions regarding this ownership, with what amounts to a controlling minority stake, remains uncertain.
 

The railway company and several municipal transport companies remain heavily loss-making. The financial performance of MAV, the state-run company operating the rail network, remains poor. The government is considering consolidating, within the general government budget, the €1.2 billion debt the company owes relating to operating expenses and equipment purchases, although this debt assumption appears to be delayed compared to the original plans. The government is also seeking efficiencies through a substantial investment programme including the utilisation of EU grant funds and possibly Chinese investment.
 

The government has introduced governance changes to important state institutions. It has curtailed the rights of the Constitutional Court to review tax legislation and other fiscal measures, and it has changed the appointment procedures of members of the central bank’s monetary policy committee. A new Fiscal Council established under the revised Constitution has a narrower mandate in assessing the medium-term fiscal outlook, even though a new debt limit has been set, and the Council will have a veto right over the budget.