Mission Concluding Statement 

Hungary: Staff Concluding Statement of the 2018 Article IV Mission

June 27, 2018

Hungary has achieved several years of strong growth and substantially reduced its external debt. However, the public debt ratio has come down only to a limited extent. With economic expansion well entrenched, now is the time to do more to reduce this vulnerability and create space for policy to be able to react again when new shocks hit. Rebalancing the policy mix and advancing structural reforms would also help moderate the reduction of the external current account surplus that is being driven by strong domestic demand.

The Hungarian economy is expected to achieve another year of strong growth in 2018. Staff projects GDP to grow by around 4 percent, similar to last year. The strong economic expansion will continue to be supported by robust private consumption and EU funds-related investments. However, the output gap has closed. It will turn positive over the medium term, and growth is projected to gradually decelerate starting in 2019 as the utilization of EU funds tapers off unless substantial structural reforms are implemented to boost productivity and potential growth. Downside risks have increased with tightening global financing condition, recent developments in capital markets, and growing trade tensions. Furthermore, in the absence of structural reforms, the strong domestic demand is resulting in a rapid increase in imports and a narrowing of the external current account surplus. Asset prices and wages have been rising. Furthermore, consumer price inflation picked up to 2.8 percent in May, largely due to energy prices, close to the Magyar National Bank’s (MNB) inflation target of 3 percent.

The 2018 overall fiscal deficit is projected at about 2.4 percent of GDP, which is almost half a percentage point more than the previous year’s deficit. However, in view of the strong cyclical position and decreased interest expenses, the deterioration in the structural primary balance would be even larger. In view of this, the 2019 budget is an important step in the right direction as it aims at almost neutralizing this procyclical stance by targeting an overall deficit of 1.8 percent of GDP. This will be achieved through lower spending on goods and services, social transfers, and interest payments. These savings will more than compensate for the planned reduction in social security contributions, which aims at lowering the tax wedge. However, since the mission’s assumption for GDP growth in 2019 is smaller than that of the budget, staff projects the overall fiscal deficit at around 2 percent of GDP.

In view of the increased risks, it would be desirable to expedite the reversal in the procyclical fiscal stance and the reduction in public debt. Such a rebalancing of the policy mix would also alleviate the burden on monetary policy. Staff would, therefore, recommend a set of growth-friendly fiscal measures to achieve smaller deficits starting in the second half of 2018 and over the medium term. Phasing out the remaining sectoral taxes, broadening the tax base, and further enhancing tax administration would reduce distortions while boosting revenue collection. Furthermore, property taxes are low compared with other countries and modernizing them would help local governments raise revenue to finance spending on healthcare, education, and infrastructure, while protecting the vulnerable. On the expenditure side, reforming public administration would help reduce the wage bill while facilitating a competitive public salaries scale as well as improving the provision and quality of public services. There is also room to further decrease spending on goods and services. In addition, eliminating generalized subsidies, while protecting the poor by targeted measures, would enhance efficiency and save resources.

Once inflation sustainably approaches the upper half of the tolerance band (3±1 percent), the monetary policy stimulus would need to be gradually scaled back. During 2017 and in early 2018, the MNB further relaxed its monetary stance, mostly with the help of unconventional tools. Imported inflation has been low and large wage increases have thus far been mitigated by lowering social security contributions. However, the output gap has closed and labor shortages are intensifying. Against this backdrop, the normalization of the monetary stance should be data dependent. The risks related to premature tightening have declined now that economic expansion is well entrenched. Rising inflationary pressure and falling current account surpluses point to accelerating domestic demand, which calls for some removal of the monetary accommodation, starting with unconventional measures. We, therefore, welcome the recent MNB communication, which emphasizes the commitment to its inflation target and keeps the options open to take any action to achieve it. We also welcome the commitment to let the Market-Based Lending Scheme expire as scheduled by end-2018.

The banking sector is on average profitable, liquid, and well-capitalized. Bank lending to the private sector, including small- and medium-size enterprises, has been increasing. Non-performing loans continued to decline due to NPL sales and better debt service. Staff welcomes the MNB’s continued enhancing of supervisory practices and guidelines in line with EU requirements. MNB’s estimates do not point to a significant overvaluation of real estate prices. Furthermore, household debt in percent of GDP is relatively low compared to EU peers and is almost completely denominated in local currency. Nonetheless, the MNB has preemptively tightened macroprudential rules to reduce risks and is encouraging fixed interest rate mortgage lending. Incentives that stimulate housing demand, especially the reduced VAT on new dwellings, should also be phased out.

Improving productivity through structural reforms is key to achieving convergence and higher living standards. In this regard, we welcome the establishment of the Competitiveness Council and the implementation of some of its recommendations to improve the business environment. To further make progress in this regard, it is important to address the challenges in the areas of obtaining construction permits and electricity connection, ease of paying taxes, and perceived corruption. It is also important to level the playing field for all investors, including SMEs and FDI, by reducing red tape and simplifying the regulatory environment. In addition, as highlighted by the MNB’s Competitiveness Report, there is a need to improve education and vocational training to address skills mismatches, and to continue to reduce the number of participants in the public works schemes to release them to the primary labor market. Increasing the availability of child-care facilities would also improve labor market participation, especially among women.

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A staff team led by Khaled Sakr visited Budapest during June 14 – 26 2018. The mission met with State Secretaries of the Ministry of Finance Ms. Hornung and Mr. Banai, Deputy Governor of the National Bank Márton Nagy, other senior officials, and representatives of the private sector and think tanks. Staff is grateful to the authorities for their excellent collaboration, kind hospitality, and candid and constructive discussions.