Mission Concluding Statement 

Hungary: Staff Concluding Statement of the 2022 Article IV Mission

November 18, 2022

Budapest, Hungary: While the economy was recovering from the COVID-crisis, a succession of shocks and loose fiscal policy pushed inflation above 20 percent and fueled a large external deficit. Appropriately, the central bank responded by significantly tightening monetary policy since June 2021, and the government plans an ambitious fiscal adjustment for 2023. A tight and consistent policy mix is indeed important to drive inflation towards the central bank’s target, reduce the fiscal and current account deficits, and lower public debt. Energy-related and other price caps should be relaxed to foster energy-saving, lower imports, and reduce associated fiscal costs. At the same time, well-targeted support is needed to help mitigate the impact of rising costs of living on the vulnerable. Large uncertainty around the baseline outlook calls for the needed overall policy tightening to remain flexible and data dependent.

Economic imbalances have widened . As the recovery from the COVID-crisis was taking hold and the labor market was tightening, the economy was hit by supply-chain disruptions, rising energy and commodity prices amplified by Russia’s war in Ukraine, and a drought. Together with loose fiscal policy in 2021 (with a deficit of 7.1 percent of GDP) and early this year, these shocks intensified inflation, now among the highest in the European Union (EU), and turned the current account into a large deficit. The exchange rate depreciated and funding costs increased, both by more than for peer countries.

After a rapid recovery, economic growth is losing momentum and sizable risks can significantly worsen the outlook. Growth remained very strong in the first half of 2022 and is expected close to 5 percent for the year. However, a sharp deceleration is expected in 2023 as high inflation erodes households’ real income (notwithstanding a resilient labor market), domestic policy tightens, external demand weakens, funding costs rise, and uncertainty weighs on investment. Under the baseline, as international energy prices are anticipated to ease and domestic demand moderates, the current account deficit is expected to improve significantly and inflation to decelerate to single digits by the end of 2023. However, downside domestic and global risks could significantly worsen the outlook, including untimely or incomplete delivery of expected EU funds, higher-than-expected global funding costs, higher-than-expected commodity prices, and an EU-wide shut-off of Russian gas.

Consistent overall policy tightening is needed to restore economic balances amid large uncertainty. The central bank has responded to rising inflation by significantly tightening monetary policy since June 2021. The government took measures to rein the fiscal deficit in 2022 and plans an ambitious adjustment for 2023. Maintaining a consistently tight and credible fiscal and monetary policy mix is crucial to tackle inflation and reduce vulnerabilities from economic imbalances. At the same time, well-targeted support is needed to alleviate the impact of rising cost of living on the vulnerable households. In a volatile global environment in which financing conditions are tightening, prudent policies are needed to avoid the risk of disorderly market conditions.

The planned fiscal adjustment in the 2023 budget is appropriate. The government expects a deficit of 6.1 percent of GDP this year. The budget aims to reduce it to 3.5 percent of GDP in 2023. This tighter fiscal stance is needed to keep debt on a downward path amidst decreasing but still-sizeable financing needs and rising costs, and to complement monetary policy in dampening demand and inflation. Rebuilding fiscal buffers is advisable considering significant risks. Absent new shocks, the planned adjustment in 2023 appears achievable owing to higher revenues boosted by inflation and new tax measures, the unwinding of one-off expenses carried out in 2022, cuts in goods and services spending, and the postponement of investment projects. Demand shocks that would significantly weaken expected growth may prompt the pace of the necessary fiscal adjustment to be slightly more gradual. Conversely, supply shocks or tighter-than-expected financing conditions may require a sharper fiscal adjustment.

However, the composition of the adjustment could be improved to minimize its impact on growth. Temporary windfall taxes on the energy and banking sectors should end upon expiration as ex-post taxes risk discouraging investment and their extensions could erode the credibility of tax policy. The recently-increased financial transaction tax is distortive and may incentivize informality. Careful prioritization of delayed investment projects is important to preserve the most productivity-enhancing capital spending. With one of the highest goods and services spending shares in the EU, there is indeed scope to reduce operational spending, which should be achieved through efficiency gains to the extent feasible while preserving basic public services.

Price caps should be avoided as they have contributed to widening economic imbalances and are ineffective in fighting inflation. Artificially low prices due to price caps on some products may lead to shortages, divert inflation to other goods, erode suppliers’ margins, and disproportionately benefit higher income groups. The motor fuels price cap led to a surge in demand for fuels that increased imports. The price cap on selected food products has been ineffective in controlling food inflation—currently the highest in the EU—as distributors raised prices on other foods. While the longstanding household utility price cap has shielded households from surges in energy costs, it also benefits the richer more, disincentivizes energy savings, and contributes to deteriorating the trade balance. In turn, this put pressure on the exchange rate and domestic inflation. The relaxation in August of the household utility price cap for above-average consumption was one step in the right direction, but more is needed to foster energy saving as domestic prices remain among the lowest in the EU, costs are still high, and pressures on energy supply may last long.

Direct support to the vulnerable would be more effective in mitigating the impact of high inflation. Refining the new block utility tariffs for households by lowering the threshold for the subsidized rate to a basic consumption amount per household would improve the targeting of the system and improve price signals. A more effective approach would be to provide targeted transfers through existing social safety nets or lump-sum payments to vulnerable households. This would help shield them from the cost-of-living crisis while containing the fiscal cost of the measures. Furthermore, it would maintain price signals that are needed for demand to adjust and reduce pressures on the current account and exchange rate.

Tight monetary policy remains needed until inflationary pressures clearly and sustainably ease. The recently introduced overnight one-day deposit tender has become the de facto policy rate. At 18 percent, it amounted to a significant tightening in monetary policy on top of large cumulative increases in the base rate and recent liquidity measures. Considering the still-rapid pace of increases in core inflation, which is among the highest in Europe, and the risks of a wage-inflation spiral in a still-tight labor market, such tightening remains appropriate. Indeed, in weighing policy trade-offs under high uncertainty, the potential costs of under-tightening (including entrenched high inflation, a higher eventual cost of controlling it, and the risk of de-anchoring inflation expectations) outweigh those of over-tightening (lower output). Monetary policy ahead should remain data dependent and focused on driving inflation towards the target. In a period of high uncertainty, continued exchange rate flexibility serves as a shock absorber in the face of numerous external risks.

The significant monetary policy tightening to date should be allowed to work its way through the system. The MNB’s shift toward more conventional liquidity-absorbing tools is welcome as it should help strengthen monetary policy transmission. However, the caps on mortgage and SMEs interest rates should not be extended beyond their current expiration as they hamper the transmission of monetary tightening, in addition to discouraging prudent credit demand and being an untargeted way to support borrowers.

The overall banking sector buffers appear adequate but supervisory vigilance and timely provisioning remain warranted in a deteriorating environment. Credit risks are expected to rise as growth slows, costs rise—particularly for energy-intensive industries—and higher interest rates test imbalances in the real estate market. Bank profitability may come under pressure if higher net-interest margins do not fully offset costs of additional windfall and indirect taxes, and caps on variable interest rates. Furthermore, the impact of rising interest rates on nonbank financial institutions also requires close monitoring.

Strengthening the security of energy supply is critical but will take time. Hungary has taken emergency measures to avoid gas shortages this coming winter. These include filling gas storages to a high level, which now covers more than half of annual consumption, and contracting additional imports from Gazprom. Hungary’s ability to diversify away from Russian gas and oil is limited by its geography as a landlocked country, and its capacity to significantly reduce the share of gas in the total energy mix. This creates risks for the 2023-24 winter and puts a premium on measures to foster demand adjustment. Diversification away from gas will require significant investment over several years, primarily in projects that shift households from gas-powered to electricity-powered heating, reduce the share of gas in power production, and strengthen the electricity grid to handle alternative energy sources, including solar. Securing the financing for these large-scale investments is critical.

Strengthening transparency and the anticorruption framework will improve the business environment and the efficiency of public spending. In consultation with the EU, the government has launched regulatory and institutional reforms aiming to strengthen the rule of law, judicial independence, and the anti-corruption framework, areas where perception indicators have lagged EU peers in recent years. The central bank is also continuing to strengthen the anti-money laundering framework in line international FATF standards. Continued progress in these areas will help strengthen the business environment, long-term growth prospects, and efficiency in public spending.

The mission would like to thank its counterparts for their hospitality and the quality of the discussions.