Hungary’s government will need strict expenditure control and cautious use of contingency reserves in 2010, and further measures to be implemented in 2011 if it wants to put government debt firmly on a declining path over the medium term and lower the budget deficit to below 3.0% of GDP, the International Monetary Fund (IMF) said on Wednesday after completing the fourth review of Hungary’s economic performance under a USD 25.1 bn loan programme (Stand-By Arrangement, SBA).
While the 64-page document is “only" a summary of the mid-November IMF mission discussions with local authorities, it does contain new information. The parties discussed possible policy responses in the event of a resurgence of large capital inflows, and what should be done if the forint comes under strong and sustained upward pressure.
EUR/HUF made several attempts in the autumn to break south of 265 and a number of foreign investment banks came out with positive exchange rate and interest rate projections for the enxt six months. In light of this, it is no wonder the IMF staff put the issue of a potential marked HUF strengthening on the table and discussed possible responses. What is surprising is that they have made the findings public.
“If the exchange rate comes under strong and sustained upward pressure, the authorities and staff agreed on the importance of an appropriate policy mix within the inflation targeting framework, including, if needed, interest rate cuts and a consistent communication policy. FX intervention could be used in the event of excessive exchange rate volatility," the IMF said.
The IMF approved a USD 1.15 billion loan tranche last week but Hungary had already indicated it would not draw down the funds. Access to the remainder of the loan was earlier extended to 5 October 2010 to cover the transition to a new government next year.
In a statement, the IMF Staff Representative on Hungary summed up in three points the lender’s key remarks.
It said that i) recent data releases have been consistent with the economic outlook in the staff report, ii) fiscal performance remains broadly in line with the programme and iii) financial sector policy developments are also on track.
The key messages of today’s statement are not different from the documents issued on 20 October, as the IMF continues to acknowledge that Hungary is on track to meet the key macro and fiscal goals. However, it stressed that strict expenditure control is needed to meet the 2010 deficit target and further measures should be put in place in 2011 to cut the gap to below 3.0% of GDP.
Key risks
“While the adopted budget provides for substantial reserves, meeting the fiscal objectives for 2010 will require strict expenditure control," the IMF said, adding that “considerable macroeconomic and execution risks surround the budget projections for 2010."
Two types of risks are so significant that they are reflected in staff’s baseline scenario: (i) lower-than-projected revenue due to the stock building of excise stamps in 2009 and the continuation of weakness in the gambling tax and corporate tax; (ii) higher-than-projected subsidies to the public transport system, as the impact of the envisaged reforms is uncertain and may be insufficient to improve the sector’s profitability.
“Taking these factors into account, the remaining budgetary reserves would amount to about 0.5% of GDP," vs. overall budgetary reserves to 0.8% of GDP.
“While this level appears broadly adequate to cover other risks, the authorities and staff agreed that strict expenditure control will be essential to meet the 2010 fiscal objectives. In this regard, the authorities pointed to two factors underpinning spending discipline: (i) the appointment of treasurers in the line ministries; and (ii) clarity on appropriations from the beginning of the year (in contrast to 2009, when line ministries had to implement cuts during the course of the year)."
Public transport a problem
Hungarian authorities said they would intensify their efforts aimed at restructuring the public transport system. The government will prepare a business plan for the state-owned railway company (MÁV) consistent with the planned savings in the 2010 budget by 7 December 2009 (prior action) and announce decisions on fares and subsidies for the entire public transport system by 15 December 2009, the IMF reminded.
Overall, the pledged measures are expected to generate savings of at least HUF 30 billion, the authorities said.
“While the envisaged reforms are expected to generate some savings in the short-term, the authorities need to tackle more forcefully the structural inefficiencies affecting the sector’s profitability. Absent such structural reforms, the situation of the sector will continue to represent a significant drain on government finances, complicating fiscal consolidation efforts."
Other key findings
Important progress has been made in strengthening policies that underpin fiscal sustainability and financial stability since the SBA was approved in November 2008.
Government spending has been reduced in a durable way, while allowing the fiscal deficit to increase in 2009 to avoid exacerbating the economic contraction. In the financial sector, bank supervision and the remedial action framework have been enhanced. By better anchoring market expectations and creating room for a cautious reduction in the policy interest rate, these measures have allowed Hungary to take full advantage of the ongoing stabilization in global financial conditions.
Macroeconomic and financial policies are on track.
All end-September 2009 quantitative performance criteria, the continuous performance criterion on non-accumulation of external arrears, the indicative target on central government debt, as well as the continuous structural benchmark related to government lending to banks, were all met.
Inflation in September breached the lower inner band of the inflation consultation mechanism and the central bank had a discussion with Fund staff. The structural benchmark on submission of legislation to parliament on strengthening the institutional framework for bank supervision was met with only a minor delay.
Hungary’s economic outlook has improved modestly since the last review, reflecting in part the nascent recovery in the euro area.
Real GDP is contracting sharply this year and is expected to fall a little further in 2010. The current account deficit is narrowing quickly this year. Inflation is expected to rise temporarily through early 2010 due to the increases in the VAT rate and excise duties, and then fall to below the central bank’s inflation target by mid-2010. Against this background, the key objectives of the program remain to improve fiscal sustainability and preserve financial stability.
The government should be prepared to take additional measures, if necessary, to underline its commitment to fiscal sustainability.
The 2010 budget credibly reflects structural spending cuts decided in June, but strict expenditure control and a cautious use of contingency buffers will be essential to manage risks. Concrete measures backing planned savings in local governments and in public transportation have been identified and incorporated into the budget. However, risks remain and, if combined, could rapidly exhaust planned buffers. In particular, the implementation of adjustment measures in non-central institutions (local governments and public transportation) is subject to large uncertainty. To mitigate the resulting risk to program targets, recent initiatives to strengthen expenditure controls should be continued, and reserves should only be used when offsets cannot be found within existing appropriations. At the same time, the authorities need to strengthen their efforts to restructure the public transport system.
It is essential that the authorities continue to implement measures to preserve financial stability.
In the banking system, funding levels have remained stable and capital levels are well above regulatory requirements, but pressures on capital will rise due to the impact of the economic downturn on credit quality. The authorities should continue to carefully monitor the financial soundness of credit institutions that have received FX loans from the government, so as to safeguard financial stability and minimize risks to public finances. The HFSA has stepped up its on-site inspections, and should conduct follow-up inspections on capital adequacy and credit quality. At the same time, it is important to introduce regulation to reduce risks related to lending to households in foreign currency, to implement the proposed reform of the institutional arrangements for bank supervision, and to develop a concrete proposal for strengthening the bank resolution framework. These actions would imply material but not yet sufficient progress in financial sector reforms. The need for the HFSA to have the authority to issue regulations, as well as parliamentary adoption of the proposal to strengthen the bank resolution framework, will have to be taken up with the new government after the elections.
Monetary and exchange rate policy will continue to target inflation over the medium term, while taking into account risks to financial stability.
The combination of improved global financial conditions and increased confidence in fiscal sustainability created room for interest rate cuts in recent months. Going forward, continued fiscal consolidation and stable external financing conditions would allow for further cautious interest rate cuts.
Implementation of policies consistent with the program remains essential to strengthen macroeconomic stability and provide the basis for strong, sustainable growth over the medium term.
Staff support the authorities’ requests for completion of the fourth review and the modification of the central government primary cash balance and NIR performance criteria.
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