Economy 18 January 2023, 9:24am

High inflation actually helps the Hungarian government in a certain way

Portfolio

Mostly, we hear about the downside of inflation in Hungary reaching heights untouched for decades: life is getting more expensive, the central bank has to keep interest rates high, workers have to be compensated by massive wage increases, which risks a price-wage spiral. At the same time, high inflation also has major benefits for the state, as it raises budget revenues and reduces the debt-to-GDP ratio. The latter, the debt 'deflation', is what we are addressing here, and we estimate that the debt ratio could fall to near the 2019 low this year, even though the economy is expected to grow very modestly.

Inflation has exploded

In December 2022, prices in Hungary rose by 24.5% in annual terms, the highest rate of inflation in almost 27 years, since March 1996. And analysts say that prices have not yet peaked here, with further increases possible in January, so there is a good chance of a peak above 25%.

Average annual inflation was 14.5% in 2022, the highest since 1997. It is not expected to have peaked yet either, with analysts forecasting annual price rises of up to 18-19% this year.

Inflation may even be useful for the state

While high inflation is often a frustration in everyday life, it can be more of an advantage than a disadvantage for the state. Indeed, higher consumer prices automatically mean higher tax revenues (especially VAT revenues) in nominal terms. It is true that some public spending will also rise in parallel, for example more money will have to be spent on pensions and other social benefits, the rate of increase of which is linked to inflation.

However, there is another important positive effect of the price increase: the debt is flattening. As inflation rises, on the one hand, the nominal amount of debt is worth less and, on the other hand, GDP rises significantly in nominal terms, so that the debt-to-GDP ratio can fall significantly.

In fact, when we look at the ratio of public debt to GDP, we are effectively performing a division, where the numerator is the nominal amount of debt and the denominator is the amount of GDP. And if the latter rises significantly due to inflation, then even with rising nominal debt, the result could be a much lower rate.

The "magic ingredient" of the debt formula: the GDP deflator

But let's look specifically at the example of 2023! We do not yet know the final GDP figures for last year, but we do know from the Finance Minister's report that public debt may have fallen to 73.5% of GDP, down from 76.8% the previous year. All this with a budget deficit of 6.1% of GDP.

03 - Hungary's gross general government debt

According to Portfolio's estimates, total public debt at the end of the year was HUF 48 500 billion, and this year it will almost certainly exceed the psychological HUF 50 000 billion mark. Based on the above ratio of 73.5% and the estimated amount of debt, it can be calculated that GDP could be roughly HUF 66 000 billion in 2022.

Of course, one could say that with real GDP growth of almost 5% it was not really a challenge to reduce the debt ratio, but this year could be much more challenging, as the economy could well see a token expansion, but it cannot be ruled out that it will stagnate or even shrink minimally. But this is where the 'magic ingredient' of the debt formula comes in:

the GDP deflator.

Simply put, the GDP deflator is the inflation rate of the economy as a whole, and nominal (current price) growth has to be adjusted to get real GDP growth. In other words, even if the economy is stagnating, if the deflator is 10%, the nominal amount of GDP will increase by 10%.

Predicting the deflator is very difficult, hardly anybody has a forecast for it, one can only guess at best. There are periods when it is slightly higher than inflation, i.e. consumer price inflation, and other periods when it is lower. But basically it moves in tandem with consumer prices without significant deviation. The main difference between the two indicators is that while the CPI basically measures the change in the prices of goods and services for domestic consumption, the GDP deflator measures the price changes of total domestic production. Thus, the latter includes price changes for investment and export products, while the former does not, but the CPI includes import products, while the GDP deflator does not.

04 - Average annual inflation and GDP-deflator in Hungary

Debt ratios could plummet this year

In other words, when we look at the prospects in terms of debt, it matters very little (from a strictly arithmetic point of view) how much the economy can grow in real terms, it matters much more how much nominal growth there can be, which includes the GDP deflator. The other important change is the nominal amount of debt, which depends primarily on the budget deficit, provided that the country does not increase its debt beyond that. So, in short, the outlook for 2023 in terms of the debt model:

We estimate nominal economic growth to be in a range between 15 and 19%, broadly based on stagnating real growth and high inflation. Thus, GDP could be between HUF 76,000 billion and HUF 78,500 billion by the end of the year, up from HUF 66,000 billion last year.
The budget cash deficit could reach HUF 3,400 billion based on the budget as amended at the end of last year. This means that the debt will rise to HUF 51 900 billion this year from HUF 48 500 billion in 2022 in the base case. Of course, we also have to take into account the possibility that higher GDP will lead to more spending by the government, which is why we have forecast cash deficits of EUR 4,000 billion and EUR 4,600 billion.

The graph clearly shows that in all cases the debt ratio would fall significantly from 73.5% in 2022:

If the government keeps to the deficit target, it could be 66.1-68.4%, depending on nominal growth. This could bring the debt-to-GDP ratio close to the low of 65.5% in 2019.
A deficit overrun of HUF 600 billion would result in a debt ratio of 66.9-69.2%.
If the government were to exceed the deficit target by HUF 1,200 billion, the debt ratio would be between 67.6% and 70%.

In the latter two cases, of course, the budget deficit of 3.9% could be a problem, as the economy is unlikely to grow nominally enough to compensate for such a large increase in the budget gap. In other words, the government would probably only use this instrument as a last resort, for example if energy prices were to rise significantly again. We saw the same last year, when the deficit of 4.9% was supposed to be maintained, but with the one-off effect of gas purchases, it rose to 6.1%.

So, overall, it is very difficult to imagine a scenario in which the Hungarian debt ratio does not fall substantially in 2023, and will almost certainly be below 70% by the end of the year. This will be mainly due to high inflation, as the economy will hardly grow in real terms this year.

Cover photo: Getty Images