HUNGARY: THE REVIVAL OF THE PANNON PUMA

Hungary was a front runner in transition until the early 2000s thanks to the fact that the country had one of the highest per capita foreign investment levels in the region, a stable fiscal situation, and a rapid growth rate. This, however, quickly evaporated and the 2008 global financial crisis hit the country severely. This was due to a vulnerability which stemmed from weaker growth potential and a high level of external indebtedness. Hungary’s earlier growth model was based on exports to the European Union, which account for three quarter of total exports, and are based on a wide variety of products, from food to high-tech electronics and car parts. Rapid wage increase in the public sector together with tax increases undermined this model, however, and domestic consumption took over as the main driver of the economy.


FISCAL CONSOLIDATION WAS NOT COMPLETE BEFORE THE CRISIS


In the first phase between 2002 and 2006, the first Left-Liberal coalition of the Millenium, the fiscally indulged wage increases did not only fuel consumption, but later fiscal consolidation programs relied on tax increases, which hurt labour competitiveness. At the same time, fiscal efforts remained ineffective at curbing fiscal overspending, and the overall budget deficit remained high – around 6-7% of GDP – through the whole period, which was mostly financed by foreign portfolio investment, either through local or foreign currency denominated bonds. This had basically several negative consequences. First, potential growth rate that stood at about 4% of GDP at the beginning of the
aforementioned period started to decline, while public and external debt ratios began to rise. The latter was not seen as that risky at the beginning, because existing stock levels were low, the public debt-to-GDP ratio was 52%, while the net external debt was close to zero. The government at that time also kept on emphasizing the goal of rapid entry into the Euro zone and projected a target year of 2010, which was quickly abandoned after the 2006 elections. In this period, between 2002 and 2006, monetary policy attempted to lower inflation, but lack of fiscal credibility and a continuous overshooting of fiscal deficit targets led to several ‘forint crises’, in the form of the rapid depreciation of the currency, followed by a sharp increase of the base rate.

The year 2006 saw another Parliamentary election, which true to tradition brought a large increase of the budget deficit. This, as usual, happened not just because of overspending, but also due to debt takeovers from state-owned companies, which transformed off-balance-sheet debt into on-sheet items. This was not much different in 2006, while the underlying deficit also widened mainly due to the reduction of the valueadded tax. The second period of fiscal consolidations took place between 2006 and 2008, under the second Left-Liberal government of the period. The government program decided finally on significantly lowering the deficit, but at the expense of direct and indirect tax increases. This further lowered Hungary’s growth potential and together with a tighter fiscal stance, brought the economy basically to a halt. Very low growth meant that debt dynamics became unfavorable and the public debt ratio reached 70% of GDP. Relatively high inflation coupled with a relatively stable exchange rate encouraged households to borrow increasingly in foreign currencies, especially after their real wages started to decrease as a result of the fiscal tightening measures. Smoothing out consumption via borrowing at a time of real wage decline is a common behavior of
households in developed economies, but became observable for the first time in Hungary. Although it helped domestic demand to contract less amid the fiscal consolidation, it also kept the current account deficit high and therefore contributed to maintaining the country’s unsustainable external debt path. It also exposed households to foreign exchange rate risk, as the outstanding debt amount in forints depended mainly on the forint to Swiss franc exchange rate. Hungary thus went into the crisis with a very weak fundamental background, since not just actual trends like household credit financed consumption were unsustainable, but accumulated debt levels also carried significant risks, like the exchange rate risk for households, or the rollover risk for banks. These risks were cited many times by international institutions like the IMF well before 2008.

CRISIS MANAGEMENT RESTORED EXTERNAL DEBT SUSTAINABILITY

The third phase of fiscal consolidation came after the Free Democrats left the coalition, and a new Socialist government – a minority administration – was inaugurated by the Parliament in the spring of 2009. As part of a large, i20bn funding program, the IMFEU-World Bank program set ambitious fiscal targets in order to establish sustainable public debt and external debt paths. Large scale expenditure cuts, like cancelling bonus payments for pensioners and public servants, together with the restructuring of the personal income tax system aimed at lowering the burden of high taxes on the economy. These measures were successful in lowering the deficit to 4% of GDP and achieving a cyclically-adjusted primary surplus of over 2% of GDP, but left several key shortages of the economy unchanged. Most of Hungary’s neighbours and regional peers had adopted a flat-tax personal income tax system years before, and enjoyed higher employment levels. Several state-owned companies were still accumulating debt outside of the state debt, and municipalities were running deficits after the government cut back on central funding.

The collapse of consumption basically erased all inflationary pressures from the economy, and although the increase of the value-added tax rate from 20% to 25% in July 2009 pushed up headline inflation to above 5%, underlying inflation remained low and taxadjusted core inflation dropped to below 2% on an annual basis. This meant that Hungary came close to achieving price stability, which is a highly important step as the country had lagged behind its peers for many years on the inflation front. Shrinking domestic demand also reduced the country’s imports, and in spite of a sharp export decline, the foreign trade balance was subsequently able to improve. The overall current account gap turned into a surplus and the country’s external debt levels started to decline both in gross and in net terms. This meant that the IMF program’s goal of setting a sustainable external debt path was met after one year. This was, however, not the only challenge for the government, and sustainable fiscal policy required further steps.

FISCAL CHALLENGES INHERITED BY THE NEW GOVERNMENT OF 2010

The new centre-right government which came to power after the Parliamentary elections in April 2010 set tax reductions as its first priority. Lowering the tax burden on the economy became inevitable because the country’s growth potential had fallen to just 2-2.5%, and the high level of public debt – more than 78% of GDP at the end of 2010 – carried the risk of a debt spillover. This became a major risk, especially after the Greek and the Euro zone crises of the spring, as investors demanded higher risk premiums from indebted countries around the world. Hungary’s risk premium, which insures against a default – credit default spread – rose from 1.7% to over 3.0% between April and June. The new government had to face two major challenges, which seemed to be partially counteracting each other over the short-term. One was to raise growth potential, the second was to establish a sustainable fiscal path. After the elections, the new government’s plans to lower the tax burden at the expense of higher deficits rapidly proved unacceptable for both the markets and the European Commission. The government was in a difficult position. It wanted to keep its election promise of no more austerity measures for the common people, while it also had to respect fiscal consolidation efforts in Europe. By April, the budget deficit reached 80% of the full-year target, and exceeded 100% by June, so budget tensions intensified clearly. Hungary has little fiscal credibility in the EU. Since it joined in 2004, it met only the 2007 fiscal target. In all other years the targets were exceeded. If another fiscal slippage occurs, Hungary would probably risk the suspension of cohesion funds. Due to the high level of debt, the sustainability of public debt also depends on the growth outlook, which became gloomier after the world economy started to show signs of deceleration during the summer. The ‘L’ shaped global recovery and high risk premiums of indebted countries made it highly unlikely that Hungary would be able to grow faster without significant fiscal restructuring.

EARLIER FISCAL CONSOLIDATIONS RELIED ON TAXES AND INFLATION

Hungary has a long history of fiscal consolidations since the ‘70s. The country has been basically trapped in so-called “stop-go cycles” for the last 40-years, as twin deficits were financed from external credit, and thus fiscal austerity kicked in when liquidity conditions tightened on the international financial markets. Several times during the last four decades, governments usually increased direct and indirect taxes and inflated away expenditures in order to lower the budget deficit . These measures, however, kept inflation moderately high and inflation expectations elevated for decades. High yield levels pushed up the cost of public debt, while uncertainty over the future lowered the savings appetite of households. This led to a significant crowding out effect between public sector borrowing and private investment, and contributed to the persistent twin deficit problem and “stop-go cycles”. The government often tried to borrow from abroad to avoid this, which then incurred foreign exchange risk into public debt and worsened the country’s credit risk rating. Beside fiscal overspending, lack of sufficient household savings was also a factor behind the persistent external indebtedness. For example, Hungary achieved a significant improvement of the balance of payments after 2008, while most of the adjustment came from companies’ lower financing needs due to excess capacity. This carried the risk that the current account gap would widen again with the recovery process at some later point.

THE VICIOUS CIRCLE: HIGH TAXES, LOW EMPLOYMENT AND TAX EVASION

As tax increases were part of the fiscal consolidation packages in all previous cases, the general government’s redistribution ratio remained high at around 45% of GDP, while the consolidated expenditures-to-GDP ratio did not decrease from the 50% of GDP level. The 2002 government program decided to make the minimum wage tax exempt in order to help the employment of lower skilled workers, but the wage burden remained high for the average wage level. Tax wedge on the average income was the second highest in Hungary, in 2008, after Belgium out of the EU’s 27 countries. At the same time, employment level remained the second lowest after Malta. Widespread tax evasion meant that most of the taxes were paid by a smaller group of employees, so there were strong
incentives to avoid tax payments, and tax evasion became even more widespread. This vicious circle undermined fiscal consolidation efforts and is probably the main reason behind Hungary’s unsustainable public finances. Most importantly, Hungary has so far never achieved sustainably low budget deficits.
Periods of low deficits usually did not last longer than 2 years, and the next election saw a rapid increase of the deficit back to unsustainable levels. The transparency of public finances remained opaque, and this made the role of fiscal oversight bodies harder, and also complicated the task of governments when they tried to control spending.

REVERSING THE VICIOUS CIRCLE

After the European Commission made it clear that Hungary has to stick to the pledged 3.8% of GDP deficit target in 2010, and to the 3% of GDP target in 2011, the new government announced the so-called “29 points” program. Its main elements were the introduction of a preferential corporate income tax rate of 10%, up to a revenue of Ft 500m ($2.5m), a 0.6% of GDP spending cut in government bureaucracy, and a special levy on financial service providers worth also 0.8% of GDP.
The second government plan added a flat personal income tax rate of 16% from 2011, and an extension of the 10% corporate income tax rate for all companies from 2012. The revenue fallout will be compensated by special taxes worth 0.6% of GDP on the energy, telecommunication and retail sectors. Mandatory private pension contributions will be redirected into the state budget from private pension funds worth about 1.3% of GDP. The government will also try to renegotiate PPP contracts in order to save money. These measures seem to be enough to lower the deficit from 3.8% to below 3.0% of GDP in 2011, which would put Hungary in the top third of the EU27 in the general government deficit ranking.
The goals of the program are quite clear. Lower taxes on labour are aimed at improving employment and whitening the economy, lower deficit makes the fiscal path sustainable even if the nominal growth rate remains low at around 5%, while the lack of direct inflation acceleration measures could keep inflation expectations low.

RISKS OF THE PROGRAM

As we mentioned before, Hungary has a long history of unsustainable fiscal consolidations due to the negative effects of previous programs. In our view, reversing the vicious circle of high taxes, low employment, tax evasion and persistently high inflation is the key for a sustainable fiscal consolidation program. But there are several arguments beside this, as well.
First and foremost, using private pension fund contributions as budgetary revenues in financing tax cuts means that long-term savings will be paid out today. On its own, this can be seen as a lowering of the households’ saving ratio, which are needed to keep the balance of payments healthy.
Against this, one could argue that the combined public and household savings ratio may not worsen at all because of the deficit reduction by 0.8%, depending on the marginal saving rate of the tax cut on labour. Then there is the question of whether Hungary can afford the debt accumulated by the transition to private pension funding. Hungary was among the first countries to run into the wall of foreign financing during the crisis, and thus the public debt level could be an effective limit on growth, through higher financing cost for the economy. Faster debt reduction may help in this respect, or if we assume an unchanged deficit level with other measures, better sustainability of the deficit reduction
could help here. Lastly, the pro growth effect of lower taxes on labour could outweigh the negative effect from lower accumulated savings on private pension accounts over time.
Employment and growth will thus be essential for the program. Secondly, special taxes can have negative effects on investments. Although the government seems to have targeted sectors which were highly profitable before the crisis and do not face much competition from abroad, investors’ sentiment could be negatively affected by an effective tax burden of over 50% in some cases. This effect could be
mitigated if these taxes are seen as only temporary, and if faster growth compensates for the lower profit ratio. The current outlook of about 3% growth p.a. in the next 3 years is expected to generate enough tax revenues for the budget to compensate for the phasing out of special taxes in 2013 if overall budgetary spending rises only marginally in real terms.
Thirdly, the program implies that government expenditures could shrink in GDP terms as a result of a faster growth rate. Hungary has considerably higher fiscal spending than its peers and even taking into account the higher level of public debt, this leaves around 5% of GDP spending unwarranted by regional standards. This means that growth will not just be important for phasing out special taxes by 2013, but also to lower expenditures to the regional level, much needed to sustain the lower tax level.
A tax system consisting of 10% corporate, 16% personal and 25% value-added tax rates appears one of the most competitive in the region, but there is still considerable dependence on export markets due to the high level of external indebtedness.
It is also an experience that spending overhauls are usually most successful in frontloaded programs as the political will could fade over time.
Lastly, lowering taxes is just one element of labour demand, and thus simplifying bureaucracy and establishing a generally attractive environment for work could require other steps as well. Namely, enforcing tax awareness and changing the common practice of tax evasion could be at least as important in order to generate revenues for the budget.

PROMISING SIGNS OF EXPORT LEAD GROWTH AND MONETARY
POLICY CHALLENGES

Several world-renowned car manufacturers have in recent months announced the establishment of new plants or the expansion of existing ones in the coming years. The increase of exports did not stop during the summer months, and export sales could reach the pre-crisis level in about 6 months if the current trend remains undisturbed. These are encouraging signs and underpin consensus expectation for a growth rate of around 3% from 2011 onwards.
Recoveries from balance of payment crises, however, also depend on the depreciated realeffective
exchange rate that helps the current account to turn into a surplus. But maintaining this healthy external balance development will be challenging, especially in the case of Hungary, where a large part of the consumption is from abroad or competes heavily with imports. Recent experience of countries with similar economic paths suggests that monetary policy should focus more on the exchange rate than usual, especially as inflation is usually returning only slowly, due to the depressed domestic demand. Thus the interest rate policy should take more account of the level of the exchange rate, and even direct interventions on the foreign exchange market were often carried out to defend the currency from unsustainable appreciation.

LAGGARDS USUALLY CATCH UP WITH OTHERS IN THE CEE REGION

If the program is well conducted and risks are also taken into account, Hungary may have a good chance to revive its reputation as the “Pannon Puma” in the coming years. The Central European transition process has already showed its major strength in several cases: countries that lagged behind peers for a considerable period started to catch up sooner or later and were successful in re-establishing a balanced nominal and real convergence track. Hungary’s real convergence process came to a halt basically after 2006 at the level of about 62% of the EU27’s income level on a purchasing power parity basis. When others witnessed similar problems in earlier years, the catch-up process saw fast growth rates both relative to their own history or to the peers at that time. Why shouldn’t Hungary follow this regional pattern?

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