What is Hungary facing in the next two years?

Hungarian economy will buckle this year

After the release of the preliminary GDP data for the third quarter, it is virtually certain that the Hungarian economy will contract this year. According to Morgan Stanley, GDP will shrink by 0.5% on the back of domestic demand weakness and muted external demand growth.

Yet, MS analysts expect domestic demand growth to start recovering in 4Q23 already and to continue doing so over their forecast horizon on the back of improving real disposable income dynamics.

"Nonetheless, investment growth is likely to remain muted due to the significantly cooler housing market and EU funding uncertainty holding back public investment," the economists said. On the positive side, they noted that subdued investment activity is likely to keep imports growth suppressed, helping the net exports contribution to remain positive in 2024.

Still, they expect investment growth to recover more strongly in 2025 as Hungary unlocks access to the portion of cohesion funds that depend on the judicial reform by the end of this year and exits the rule of law procedure by the end of next year.

With that, they believe both external and domestic demand growth will pick up in the second half of 2024 and for the whole of 2025. As a result,

Morgan stanley revised up their 2024 GDP growth to 2.2% yr/yr from 1.9% yr/yr previously and see the recovery gaining pace to 2.8% yr/yr in 2025.

Inflation could still mess things up

Inflation has already dropped significantly to 9.9% yr/yr October and MS economists believe it is likely to keep decelerating meaningfully in the coming months. Yet, they think that as the favourable base effects dissipate, the disinflation process will lose steam in 1Q24 and will proceed at a much slower pace. In fact, they expect headline inflation to stabilise at around 5% yr/yr for most of 2024 on the back of sticky core inflation, which they see remaining elevated in high single digits until 3Q24.

While the very open Hungarian economy is likely to keep benefitting from the global disinflationary trends in core goods, the robust wage growth should support domestic labour-intensive services prices over the entire forecast horizon,

the analysts said. Thus, they see inflation decelerating into the central bank's tolerance band sustainably only in mid-2025 and expect it to average 4.8% yr/yr in 2024 and 3.9% yr/yr in 2025.

Analysts at Morgan Stanley continue to expect Hungary's current account to improve to around -0.4% of GDP in 2023 from the large 8.3% deficit in 2022. Furthermore, they see it moving into a 1.7% of GDP surplus in 2024.

The improvement should remain mostly driven by the terms-of-trade improvement until early 2024, yet once these effects get exhausted, we see the improving net exports in real terms continuing to support the trade balance.

Further ahead, as domestic demand strengthens in 2025, with investment growth picking up on the back of easier monetary conditions and accelerated EU funds absorption, they see the current account surplus deteriorating to 0.9% of GDP.

The government has recently revised the 2023 deficit target to 5.3% of GDP from 3.9% previously, following the underperformance of VAT receipts, which represent about one-third of total fiscal revenues and have suffered from the lower household consumption. Still, at Morgan Stanley they expect household consumption to return to growth in 2024 and thus to help fiscal revenues improve materially.

On the other hand, despite the government's efforts to limit public investment spending, social spending continues to grow at relatively fast pace and we expect it to do so in the coming years.

As a result, the analysts see government deficit coming out at 3.2% of GDP in 2024, above the current government target of 2.9% of GDP. "Further ahead, the improving growth of the tax base is likely to lead to further improvement in the fiscal deficit to 2.6% of GDP in 2025."

Nonetheless, in both 2024 and 2025 the analysts expect the primary budget deficit to stay positive at around 1% of GDP, which should lead to a continued decline in the government debt level as a percentage of GDP.

The European Commission has just released its autumn forecast, projecting that Hungary will miss its deficit targets not only this year, but in 2024 and 2025 as well.

MNB could be boldened

The MS economists expect the MNB to maintain a cautious approach to monetary policy setting by aiming to sustain a positive real ex post policy rate, which first occurred after long years in September, in order to protect HUF from global risk-off moves and suppress inflation to the 3% yr/yr target.

That said, with the rapid fall of inflation in the coming months the analysts expect to central bank to deliver a steep easing cycle of 75bp rate cuts on average per meeting until mid-2024. The significantly improved current account deficit and its path to a surplus in 2024 should remain supportive of bold monetary policy actions, they added.

The recent currency appreciation is even pointing to a rising probability of the MNB reaching out to larger 100bp cuts in the coming months

as the central bank has been highlighting that it will be deciding on a case-by-case basis at each of its monthly meetings."

They noted that in the second quarter of 2024, the temporary rise of inflation to around 5.6% yr/yr should create upside risks to their rates call.

All in all, Morgan Stanley maintains its call for the policy rate to reach 10.75% in December this year and to go down further to 6.25% by mid-2024. Further ahead, the analysts see the MNB easing its base rate down to 4.00% in 2025 as inflation continues to drift lower towards the 3% target.

In Morgan Stanley's bear scenario, weaker global growth and easier monetary policy conditions impact negatively the already subdued GDP growth outlook for the very open Hungarian economy. In this scenario FX volatility is likely to rise temporarily, but the analysts expect the MNB to consider a deeper cutting cycle once HUF depreciation risks dissipate.

In this scenario, they think that the central bank can lower its base rate to 5.75% in 2024 and 3.00% in 2025.

In the global bull scenario, stronger external demand but tighter monetary conditions abroad will most likely prevent the MNB from easing monetary policy as quickly as expected in the base case.

"Narrowing interest rate differentials against major central banks will likely increase HUF depreciation risks" and thus Morgan Stanley expects the MNB to take a pause initially, and - once these risks subside - to resume its easing cycle more cautiously than in the base case by lowering its base rate to 9.25% in 2024 and 8.00% in 2025.

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