Economy 8 March 2022, 12:40pm

Hungary's budget could also be hit by Russia-Ukraine war and sanctions

Portfolio

In the wake of the Russian-Ukrainian war and the series of sanctions imposed by Western countries on Russia, the outlook for the Hungarian economy has changed dramatically in just a few days. Analysts and market players alike started to draw up pessimistic scenarios for 2022: lower GDP growth than previously projected, persistently higher inflation, higher interest rates, weaker forint exchange rate, soaring energy prices. All in all, it is a mix that could easily lead to an overshoot of the the ambitious budget deficit target of 4.9% of GDP. The question is how long the "strategic calm" of fiscal policy can last in the face of deteriorating trends, as this year's budget is not padded with large reserves and the room for manoeuvre is steadily shrinking. Especially in the light of the latest fiscal position paper published on Tuesday morning.

Reality bites

The Russian invasion of Ukraine is in its second week, and so far there is no sign of it ending very soon. The protracted war is extremely tragic in terms of human casualties, civilian deaths and the rising tide of refugees.

Another consequence of a prolonged conflict is that it will take a toll on economies and that economic, financial and business sanctions against Russia by Western countries could be stepped up. The negative consequences of the war and sanctions directly affect the Hungarian economy through several channels: trade, financial (interest rates, lending, investment), country risk (forint exchange rate, yields), supply chain, energy, confidence, loss of wealth, and the prospects for economic growth are all worsening.

An already stretched budget...

In the light of the gloomy economic outlook (especially in the event of a protracted war), it is not at all unimportant what reserves the Hungarian state has and to what extent these are sufficient to counter negative risks. To assess this, it is first worth taking stock of the state of the 2022 budget at the end of February:

In 2021, the Hungarian economy bounced back quickly from the downturn caused by the coronavirus crisis, allowing the budget to start this year with a higher revenue base than previously planned.
But much of this increased room for manoeuvre has already been used by the budget in the run-up to the elections (3 April). Building on last year's strong base, the government has already embarked on a spectacular fiscal spending spree at the end of 2021, followed by an unprecedented fiscal profligacy in the first two months of 2022 (personal income tax refund, 13th-month pension, wage hikes), which led to a sizeable shortfall at the start of the year, and will set the tone for the full year's fiscal performance.
The government has planned the 2022 budget with a general reserve of HUF 150 billion (part of which has already been spent by the government in two months), and there is still a buffer of HUF 150 billion left in the Investment Fund. These two items together do not seem to be a significant amount in the light of the current risks.
The government has stretched this year's budget so far itself: at the end of December, it committed to a deficit target of 4.9% of GDP instead of the original 5.9%, and it also revealed that it will make an adjustment of HUF 755 billion to achieve this, although it turns out that much of this is still a promise. Interestingly, on the day after Russia attacked Ukraine, Finance Minister Mihály Varga stressed that "it was the right decision to increase Hungary's financial reserves at the end of last year and to significantly improve this year's budget deficit target".
And the Hungarian government is still waiting for the recovery funds from the EU.

... is getting even more stressed by sanctions

The world around the Hungarian economy has changed substantially in just a few days. Among these, we highlight those factors that could be crucial for the sustainability of the budget deficit:

The government has so far projected GDP growth of 5.9% in 2022. According to official communications, the economic outlook has not changed so far (it remains realistic in the government's assessment, although it admits that the war is worsening the picture), but inflation could be higher (the government expected an annual average of 4.8% for 2022 at the end of last year). But analysts are already steadily lowering their GDP forecasts for this year by 1-2 percentage points. This in turn could have a significant impact on the fundamentals of the budget, in particular by causing revenue shortfalls (payments by business organisations, PIT contributions, contribution income, consumption-type tax receipts).
While higher-than-planned inflation will automatically increase some spending in this year's budget, it will also boost consumption tax revenues. On the other hand, the high GDP deflator helps to achieve the lower deficit-to-GDP target.
Higher inflation and rising central bank interest rates will lead to a steady rise in yields, so government interest expenditure could also be higher than planned.
The exchange rate of the forint affects the fiscal balance through several channels, but perhaps it will be most important for the central bank profit. As György Matolcsy, the Governor of the central bank (MNB), already indicated in January, the bank will suffer a loss of hundreds of billions of forints, for which the state will have to find a source of revenue if it wants to compensate.
In the light of soaring gas prices, it is becoming increasingly expensive for the state to keep households' overheads artificially low. Portfolio estimates that the cost to the state of buying gas is more than five times the price at which it can pass it on to those entitled to provide universal services in scope of its reduced overheads scheme. Meanwhile, the buffer state-owned Hungarian Electricity Works (MVM) had previously accumulated has already melted away due to the high gas prices of recent months. Previously, we had calculated a potential loss of HUF 850-900 billion for the group at a significantly lower market gas price and a stronger forint exchange rate. This alone could put a severe dent in this year's budget, since, as we have shown, reserves do not amount to that much. Interestingly, the government has also had to implement a major recapitalisation of state-owned companies of close to HUF 140 billion in recent days. We do not know what this recapitalisation is related to.
Although to a lesser extent for now, the state is already bearing the burden of the fuel price freeze through a reduction in excise duty, a waiver of the stockpiling fee (which will mean a revenue release of HUF 8-9 billion for now) and state support for smaller pumps (which we estimate will also mean some tens of billions of forints in extra expenditure). It is true that, due to transit traffic and the upsurge in cross-border consumption, the state can also realise higher tax revenues on higher consumption. Therefore, the net loss is not expected to seriously affect this year's deficit target.

What are the cabinet's options?

Last week, the Prime Minister's chief of staff, Gergely Gulyás, said that the government was confident that the 4.9% of GDP deficit target would be met, but that this could change fundamentally if the war drags on until the end of the year. This implied that the government also expects such pessimistic scenarios, in which case a large-scale revision of the 2022 budget cannot be excluded. However, this would be a political call, and therefore no concrete proposals are expected to be made before the 3 April elections.

Our source with insight into the government's economic decisions also said that the budget deficit will not change for the time being because the government is committed to deficit reduction (although EU rules could allow for a looser mode this year).

Earlier this month, the European Commission said EU countries should move to a neutral fiscal stance next year from a supportive stance in 2022, with high debt countries focusing on tighter fiscal policy and low debt ones on more investment.

Based on the 2022 Winter Economic Forecast, the Commission is of the view that transitioning from an aggregate supportive fiscal stance in 2020-2022 to a broadly neutral aggregate fiscal stance appears appropriate in 2023, while standing ready to react to the evolving economic situation,

the Commission said.

"The Commission is of the view that starting a gradual fiscal adjustment to reduce high public debt as of 2023 is advisable, while too abrupt a consolidation could negatively impact growth and, thereby, debt sustainability," it added.

In the Hungarian government it is argued that the assessment of the economic damage should only start once the war is over. However, if the war drags on, the cabinet will have to step in much earlier and intervene to prevent the budget deficit from spiralling out of control.

Indeed, in the current tight financial market situation and in light of the suffering of the Central and Eastern European region, the government cannot risk reaching the low deficit target and announcing higher financing needs (compared to last year, the government has reduced the general government cash balance by HUF 1.8 trillion! This would immediately attract the attention of investors and credit rating agencies - which have been very active and responsive lately - and the smallest price to paz would be that the Hungarian state would be able to raise funds at an even higher cost.

Cover photo: Hungarian soliders near a help centre set up for refugees of Russia's war on Ukraine at Barabás on 3 March, 2022. Source: MTI/Zsolt Czeglédi