Public Information Notice No. 12/4

Public Information Notice: IMF Executive Board Concludes Article IV Consultation and Second Post-Program Monitoring Discussions with Hungary

January 25, 2012

On January 18, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation and the Second Post-Program Monitoring discussions with Hungary.¹

Background

Economic growth in Hungary is slowing and market perception of recent policy measures has been negative. After a modest rebound from the 2008–09 crisis, the economic growth is estimated at about 1¼ percent in 2011; exports, helped by strong links with the resilient German export sector, were the sole engine of growth as domestic demand contracted for a second consecutive year.

Growth prospects for the current year are negatively affected by spillovers from the eurozone crisis and domestic policy missteps. The eurozone crisis is weighing on Hungary’s external demand, with exports to Europe decelerating since June. Domestically, private consumption is constrained by tightening credit, rising foreign currency debt service, weak wage growth, high unemployment, and a sharp decline in consumer confidence. Meanwhile, fixed investment, which is particularly important for medium-term growth, is declining sharply with little sign of stabilizing amid a volatile policy environment and ample excess supply.

Over the past year, the authorities have enacted a number of significant structural reforms and policy changes. The “Szell Kalman plan” announced in 2011 aimed at improving the medium term growth potential through structural reforms on the expenditure side. A range of other policy measures were more controversial, including with financial markets, in particular steps to support foreign currency mortgage holders, changes to the tax regime and labor market policies, special levies on largely foreign-owned sectors (retail, telecommunication, energy and banking) and the de facto nationalization of the second pillar of the pension system.

Fiscal and monetary policy are facing constraints, given financial market pressures and inflationary pressures. In 2010–11, fiscal policy was expansionary, as permanent tax cuts caused a widening in the structural deficit by around 3 percent of GDP. The recently adopted 2012 budget tightens fiscal policy substantially, primarily by incorporating elements of the Szell Kalman plan and raising VAT and excise taxes. In addition, despite a still large output gap, the Central Bank recently increased the policy rate to 7 percent given ongoing risks to both inflation and the financial sector from a rising risk premium and a weakening exchange rate.

The slower growth, Europe-wide deleveraging and recent government actions are weighing on the financial sector. Non-performing loans to firms and households have risen to 14 percent. The resulting need to increase provisioning–compounded by the large bank tax and the government’s recent early repayment scheme for foreign currency mortgages–has sharply reduced bank profits. System-wide capital adequacy remains well above the regulatory minimum but the sharp losses have necessitated equity increases among select foreign banks. Meanwhile, liquidity appears adequate but funding is increasingly short term and expensive.

Looking forward, growth is expected to resume gradually from 2013, largely dependent on euro area growth prospects, but remain below potential for some time. The outlook is subject to significant downside risks, including possibly the emergence of an external funding gap.

Executive Board Assessment

Executive Directors noted that the rebound from the crisis has been modest and vulnerabilities remain high. Furthermore, concerns about domestic policies and rising global risk aversion are weighing on sentiments in financial markets. Directors therefore underscored the need for a well-crafted policy mix that restores confidence in economic governance, anchors the ongoing adjustment, and strengthens economic institutions.

Directors concurred that, despite the weaker growth outlook, fiscal tightening is necessary given Hungary’s high public debt and uncertain financing prospects. The authorities’ 2012 deficit target of 2½ percent of GDP, while ambitious, is broadly appropriate. However, given downside risks, Directors suggested identifying contingency measures, focusing on durable and fiscally-sustainable measures that help lay the groundwork for a credible medium-term fiscal stance. Directors also called for a coherent tax and expenditure policy mix that would limit the impact of fiscal consolidation on growth and protect the most vulnerable sections of the population.

Directors commended the authorities’ commitment to fiscal sustainability in the recently-passed constitutional mandate, which requires reducing public debt to below 50 percent of GDP. They emphasized that lasting improvement in fiscal performance will require a strengthening of fiscal institutions and governance. In this connection, they underscored that the recently-reformed Fiscal Council should be significantly strengthened, so it can provide an independent and timely assessment of fiscal developments.

Regarding the financial sector, Directors noted that in an environment of deteriorating portfolio quality, negative profits, and increasing pressure on funding, it is important to ensure that banks maintain adequate buffers. Recent efforts by supervisors to proactively address potential pressures on banks’ provisioning, capital, and liquidity were therefore appropriate. In particular, Directors welcomed the forthcoming regulations on minimum liquidity ratios and planned reduction in the bank tax, and encouraged the finalization of a bank resolution framework. Directors also noted that the limited restructuring of Swiss franc debt contained in the recent agreement with the banking sector could help the economic recovery, while suggesting that the scheme could be better targeted.

Directors agreed that the tightening bias of monetary policy is appropriate at this time to help contain inflation and better anchor inflation expectations. Monetary tightening, by limiting exchange rate depreciation, will also support financial sector stability given the large exposure of banks to foreign-currency household debt. Directors expressed concern that recent legislation, which changes the governance structure of the central bank, calls into question the authorities’ commitment to central bank independence.

Directors stressed the importance of tackling the structural bottlenecks that impede investment. Particular attention must be paid to reforms that improve the business environment, competitiveness, and labor supply. Directors welcomed recent initiatives to increase labor force participation rates, while noting that some other labor market reforms need to be better aligned with this objective.

Directors agreed that a Fund-supported program in concert with other international lenders, which would require a strengthened policy framework and strong ownership by the authorities, could relieve some of the constraints facing the Hungarian economy.