Risks mount, Hungary could end decade-long debt reduction series

Head of State Audit Office concerned about debt

Hungary’s recovery plan may not be approved until next year by the European Commission, but the government has pledged that it would carry out planned investments and would pay for these from the central budget if needed. This, however, would carry two risks: 

• First, this will place additional burdens on a budget that is already in a difficult situation. The government has planned for a deficit of 7.5% of GDP in this year’s budget, a slight reduction from last year’s 8.1% and a substantial increase considering fast GDP growth. If the budget breaks down, so could the debt reduction plan.
• In the case of unapproved projects, it could be hard to get the invoices approved by the European Commission later on. Hungary’s government has effectively promised to begin carrying out its own plans, while the EU may not see all of these as being in line with the purpose of the recovery fund. The risk is that money spent in hopes of getting reimbursed after the fact may not in fact be accepted by the EC. This would not only re-write this year’s financing plans but would also push the entire deficit and debt trajectories higher due to a permanent loss of funding.

The above risks were highlighted last week by László Domokos, President of the State Audit Office (ÁSZ), and director Gyula Pulay in an article on Növekedés.hu. In their view, certain government investments and the generous pre-financing by the EU should be reviewed and reined in, forming reserves in the budget for managing the above risks.

The audit office officials also say that if Hungary’s recovery plan is not approved next year for some reason, the end-2022 debt reduction target could be jeopardised as well. For this reason, they propose that the roughly HUF 600 billion in extra budget revenues thanks to higher than expected growth this year should not be spent but should be used instead to repay debt faster. Our calculations evaluate the first risk and this year’s debt scenarios.

What could debt reduction depend on?

Partly in reaction to the Domokos article, we have updated our debt rate projection model. But what are the main factors this year? In short, changes in the numerator (GDP) and denominator (debt), but there are a number of other variables at play:

• In the case of GDP, we need to know the nominal gross domestic product for the numerator, not just this year’s real GDP growth, which means the GP deflator must be known.
• As for debt, the important figure is again nominal debt, which under most cases equals the previous year’s debt and the current year’s deficit. However, the government does have some leeway as it could also spend form its ready cash (KESZ account). While this carries some liquidity risks, we have seen such transactions to “adjust” the year-end debt figure in recent years.

These indicators should together yield a debt lower than the 80.4% of GD at the end of 2020.

How much should we be concerned?

We have again used two variables for the year-end debt-to-GDP ratio:

• We calculated with 6%, 7%, and 8% real GDP growth. Based on data for the second quarter, it would be a surprise if this year’s growth was outside this range. We estimated a fixed 4% deflator, for nominal growth of 10 to 12%.
• As for debt, we based the calculations on the government’s HUF 3,990 billion deficit plan. Nominal debt could grow from last year’s HUF 38,400 bn by HUF 3,700, 4,200 or 4,700 bn.

Based on the above two variables, there are nine possible scenarios:

As the graph shows, not all scenarios would lead to a reduction in debt this year.

The main downside and upside risks surrounding the end-2021 debt level are as follows:

• The cabinet has conceived a strong stimulus budget due to which the debt-to-GDP ratio would drop only symbolically to 79.9% from 80.4% (given the parameters available at the planning of the budget). This implies that negative impacts on the budget could rapidly upset the plan for a descending debt trajectory.
• Massive EU funds could be missing from this year’s budget which, in relation to the aforementioned financing commitment of the government, will lead to an increase in the shortfall (you can read more about this below).
• Economic output will certainly increase more than the 4.8% the budget is based on, and inflation is also to exceed 3.0%. This will not only raise the denominator of the debt ratio but could also lower the deficit, unless the cabinet uses its fiscal position that would automatically improve thanks to extra revenues to worse the balance by increasing expenditures further.

The main downside risks is that the approval of the recovery fund and new EU programmes get delayed and no funding for these will be transferred by Brussels for months. This is dangerous because the government pencilled in HUF 2,515 bn worth of spending and HUF 2,033 bn worth of EU funds to be received.

Out of the HUF 2,033 bn the cabinet hopes to draw from Brussels, only HUF 534 bn have been transferred so far, while payments from own resources are progressing well relative to targets. If the government fails to strike a deal with the Commission by the autumn, the ESA gap planned to reach HUF 482 billion could be HUF 1,100 to 1,200 billion on the assumption that Hungary will receive at least some EU funding. This implies that on top of a HUF 4,000 billion cash flow-based shortfall, the country could need up to HUF 800 to 900 bn worth of extra financing.

The chart above depicts that with a HUF 4.7 trillion cash-based deficit even an 8% GDP annual average GDP growth would not enable Hungary to lower its debt ratio relative to 2020.

The negative risk of hundreds of billion forints worth of EU funds being stuck may sound alarming at first, but there’s a positive risk of similar size here. The economy would hardly be able to grow less than 6% this year even if the fourth wave in the coronavirus pandemic proves to be severe. GDP growth of over 7% is even more likely and 8% cannot be excluded, either. This would generate up to HUF 800 billion larger revenues for the budget than originally planned.

The key question is what will happen to that. It may be used as the source of investment projects as a replacement of EU funds held up temporarily or persistently, i.e. the extreme negative and positive factors could neutralise each other. If, however, the windfall gain will fuel the government’s already massive appetite to spend even further, projections for the end-2021 debt ratio will be even more in the spotlight.

There is a shortcut, though

Should the opposing risks lead to an increased financing need for the budget, a secret weapon is still left for economic policy to resort to. And that is the government’s cash pool, the Single Treasury Account (KESZ), which practically holds the cabinet’s liquid reserves on an account at the National Bank of Hungary (MNB). This can be tapped at any time. It is also key that about HUF 1.5 trillion worth of pre-financing (e.g. the Eurobond issuance in the autumn) also ended up here.

According to the central bank’s end-July data, more than HUF 3.1 trillion were kept on this account.

Firstly, the government can use this to finance budgetary expenditures (e.g. to cover payments EU funds were supposed to) without inflating public debt. Secondly, it may also tap the KESZ account to finance operations that reduce debt at the end of the year, e.g. it could buy back government bonds using this resource.

The entire liquidity reserve will certainly not be exhausted, of course, but around HUF 1 to 2 trillion of it could be freed up to lower the debt or finance the budget deficit. If we take into consideration only the HUF 1.5 trillion worth of pre-financing from last year, general government debt could rise only by about HUF 3 trillion in nominal terms even at a higher budget shortfall

which could make a debt-to-GDP ratio of 77 to 79% realistically attainable by the end of the year.

Cover photo: Getty Images