IMF publishes highly critical Staff Report on Hungary

Summary

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 2.5% of gross domestic product, “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% 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."

Outlook and Risks

The outlook is unusually uncertain and risks are on the downside.

In the baseline scenario, staff expects a further slowdown in Europe, which causes the Hungarian economy to stagnate in 2012 and recover only gradually thereafter.

By contrast, in the adverse scenario, a worsening of the Eurozone crisis triggers a recession and the emergence of an external financing gap.

“Unlike in the previous crisis, parent banks may be less likely to significantly increase their funding to subsidiaries given the policy environment in Hungary and pressures in the eurozone. Given low fiscal and external buffers, such a scenario could well weaken Hungary’s capacity to meet its external obligations in 2012-13," the IMF staff said.

“Assuming automatic fiscal stabilizers are allowed to operate fully, a sharp surge in bond yields, and only a slow recovery in economic growth, public debt would continually rise over the forecast horizon."

Staff noted that the authorities broadly agreed with staff’s assessment but saw a low likelihood of the adverse scenario materializing in its entirety.

The Hungarian authorities:

• concurred that growth faced downward risks in the event of a sustained eurozone crisis;
• were particularly concerned about the spike in sovereign borrowing needs stemming largely from the pending repayments to the IMF; but
• were more upbeat about the economy’s resilience.

FX reserves do not give enough manoeuvring room

On financing, the authorities highlighted the fact that reserves were twice the level seen before the last crisis and pointed to large non-resident holdings of domestic debt as a sign of confidence in current policies.

Staff countered that “reserves are not large compared to short-term liabilities and that and that non-resident investment could quickly reverse, as seen in 2008."

Staff noted that short-term external debt of 45% of GDP (on a residual maturity basis) in a context of rising global risk aversion suggests a large potential demand on FX buffers.

“Furthermore, recent events-- notably the government’s purchase of EUR 2 billion of shares in the energy company MOL and the MNB’s provision of FX liquidity after the recent early mortgage repayment scheme--are proof of the unexpected need for reserves. With respect to the latter, staff supported the MNB’s decision to provide such liquidity as it mitigates excessive pressure on the exchange rate and the particular agreement with banks included a requirement on their part to reduce short-term external liabilities."

Policy challenges

“The core policy challenge for Hungary going forward is addressing large debt burdens without choking already weak growth," staff said.

The 2012 budget targets a general government deficit of 2.5% of GDP and implies around 3% of GDP in structural fiscal adjustment, it added.

The already announced tightening (which relies heavily on the Széll Kálmán Plan and the hike to the VAT and excise tax rates) is “adequate to generate small primary surpluses going forward."

“Staff agreed that, while ambitious and pro-cyclical, material adjustment was justified given that public debt (at close to 80% of GDP) remains high and policy credibility in the financial markets is low."

Furthermore, there is a real risk that EU commitments concerning Cohesion Fund could be suspended from 2013 if Hungary remains in violation of the excessive deficit procedure which inter alia requires a deficit below 3%.

Reaching fiscal target will in any event be difficult

In contrast to the authorities forecast, staff projects the 2012 budget deficit to reach a looser 3.5% of GDP, GDP, primarily reflecting more conservative estimates of key macroeconomic parameters (e.g., growth, interest rates, and the exchange rate) and more cautious savings assumptions in regards to transport sector reforms." (See table above.)

Staff noted, however, that implementation risks loom large, particularly given the weak economic environment.

Staff encouraged the authorities to upfront identify possible corrective measures in the event that downside risks materialize.

“Both the authorities’ and staff’s forecast include 0.75% of GDP in fiscal “reserves" which are unallocated expenditures: unless they receive special authorization in 3Q2012 the reserves cannot be spent and thus would reduce the deficit accordingly. This cushion may not be adequate, however, to avoid slippage in the event that the macroeconomic environment or budget execution deteriorate materially. In such a case, the implied outturn could jeopardize Hungary’s medium term debt sustainability. Staff suggested that further contingency measures be identified upfront."

In doing so, the authorities should aim at increasing the durability of adjustment by focusing on greater efficiencies in expenditures, e.g. (i) restructuring state-owned transport companies; (ii), rationalizing public employment on the local level, and (iii) means testing social assistance (iv)rather than increasing taxes further.

Addressing these issues now could in any event be important from a medium term perspective: “as special sector taxes on retail, telecommunications, and energy sectors are expected to be eliminated in 2013 (contributing to a permanent loss of revenue from that year), growth may not pick up sufficiently to provide the hoped-for support to further deficit reduction."

The IMF staff also recommends

• eliminating special sector levies;
• revisiting elements of the flat tax; and
• rationalizing related wage and compensation reforms.

These steps would minimize adverse effects on medium-term growth prospects and the poor, it said.

Improvement needed in fiscal governance

“Given already weak growth, seeking other methods of building policy credibility could usefully supplement the necessary fiscal tightening."

In this context, staff suggested a strengthening in proposed fiscal rules:

• guidelines restricting the growth in general government debt should be related to the output gap in order to avoid excessive pro-cyclical tightening;
• with respect to local governments, more explicit rules-based borrowing constraints that guide ex-ante budgeting for individual municipalities and include formal triggers for non-compliance would be more effective than current proposals;
• the effectiveness and independence of the reformed Fiscal Council should be enhanced. (At a minimum, it should be tasked with independent impact analysis of all fiscal initiatives, including those with impact outside the current budget cycle.)

Dealing with foreign exchange (FX) Mortgages: Less Government Intervention

The authorities are focused on reducing the burden of CHF debt on households. They did not contest staff’s assertion that the most recent measures to address the burden have been, on the whole, unproductive. At the same time, staff conceded that a voluntary, limited and well designed restructuring of Swiss franc debt may help the recovery.

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