A heavy legacy of government decisions strains the Hungarian economy - EC review

Public perception is that the period before 2022 will be one of rapid GDP growth, while the following quarters will be one of recession. But if we look at the last two years from a real gross domestic income (RGDI) perspective, a much more nuanced picture emerges: from 2021 onwards, macroeconomic incomes started to decline as the exchange rate started to deteriorate due to rising energy prices. As energy input costs started to normalise, Hungary's income position started to improve, even though GDP data were already showing recession and stagnation.

The impact was particularly striking due to Hungary's high dependence on energy imports, according to the European Commission report. In their analysis, they found that while real GDP in Q2 2022 was 6.5% above its pre-pandemic level,

RGDI remained unchanged compared to Q4 2019, pointing to difficulties in adjusting to strong external shocks.

So, the huge deterioration in the terms of trade caused by the energy crisis has already started to eat into national income in the pre-election period, when it was already being fuelled by domestic demand. In the recession period, however, the terms of trade have already started to improve, and hence the RGDI has been able to increase.

Put simply, the record energy prices of two years ago fell last year, leading to a huge improvement in the country's energy balance, while imports fell as a result of high inflation and stagnating household consumption. According to the report, the two factors contributed equally to the improvement in the external balance, so it is not just the fall in gas and oil prices that improved the external balance, in fact the fall in household consumption was an equally powerful factor.

It should be noted that in 2022, the government has taken a number of measures to maintain consumption. On the one hand, it was an election year, in which millions of personal income tax credits were granted to families with children, and these reserves kept demand up for a long time (even though they had a significant inflationary impact), and price caps were introduced on fuel and basic foodstuffs.

However, according to the Commission's calculations, these measures have only temporarily cushioned the impact of the deterioration in the terms of trade.

Moreover, the review concludes that these have worsened the situation in the medium and long run, because Hungarian economic policy initially aimed at protecting household purchasing power, which slowed down the economy's adjustment to external shocks. Price caps on fuels, household energy and some food products partially protected consumers from rising import prices. In doing so, the government was led to hope that the deterioration in terms of trade would be mild and temporary. Technically, these policies, together with expansionary fiscal measures, boosted import demand and inflation, leading to higher external trade deficits in 2021-2022.

In response to these challenges, the Hungarian government under Viktor Orbán adjusted some policies at the end of 2022: the overheads reduction was limited (i.e. regulated utility tariffs were increased above average consumption) and the price cap on fuel prices was lifted in December 2022, leading to higher retail energy prices and inflation. Higher interest rates also started to curb lending, which contributed to a contraction in domestic demand and imports in 2023.

In its review, the European Commission has broken down the changes in the external trade balance into the contribution of price and volume changes. The first item is the price level effect, which shows how changes in the average price level of exports and imports affect the external trade balance. The second is the volume effect, indicating the contribution of changes in export and import volumes.

Based on these, they find that the worsening external trade balance in 2021-2022 is due to both changes in trade conditions (i.e. export volumes and prices have become less favourable) and increases in import volumes and prices linked to rising domestic demand. Moreover, the effects were partly offset by the export recovery following the Covid-19 pandemic.

"After recording in 2022 the largest deficit in nearly two decades, the current accountimproved in 2023 owing to lower energy prices and weaker import demand. [...] The improvement in the cyclically-adjusted current account balance was mostly driven by external developments – falling import prices, essentially – rather than domestic policy action", the European Commission argues.

Looking ahead, the current account balance is expected to deteriorate as the economy emerges from recession: this is because domestic demand for goods and services is rising as the economy expands, leading to higher imports and potentially larger trade deficits.

Hungary's economic fundamentals predestine for a small current account surplus, according to the Commission's analysis. This means that, on the basis of factors such as the structure of production, savings and investment rates, and demographic data, Hungary should have a slight current account surplus.

However, they believe that the prospects of economic recovery are overshadowed by the legacy of the government's prestige policies - price caps, interest rate freeze, etc. Expansionary fiscal policies and energy subsidies have increased public debt and risk premiums in recent years. Fiscal consolidation will have to start from a high deficit level of around 6.7% of GDP by end-2023, made even more difficult by the possible shortfall in consumption tax revenues due to the effects of subdued and still fragile domestic demand.

In addition, the recently announced HUF 675 billion cut in public investment, high financing costs and uncertainty about the medium-term outlook could also affect capital accumulation, productivity and potential growth, the Commission says, adding that improvements in these areas will be key to overcoming economic challenges.

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