Country Report Hungary
Hungary’s economy fell back into recession last year, as weakening exports could no longer compensate for strongly declining domestic demand amid sizeable fiscal austerity measures to keep Hungary’s budget deficit below 3% of GDP. Even though Hungary’s Fidesz-led government achieved this target last year, this came at the cost of rather unpredictable ad-hoc tax increases that have unnerved investors. Meanwhile, the checks and balances of Hungary’s democracy remain under pressure, while Fidesz’s popularity ahead of the 2014 parliamentary elections cooled markedly. Since Hungary’s government managed to issue USD bonds to finance a large part of its 2013 external debt repayments, it is unlikely to pursue another IMF credit line any more. However, access to multilateral assistance remains advisable, as re-emerging global risk aversion could hinder the heavily-indebted country from accessing international capital markets again.
Economic structure and growth
Hungary is a small, very open economy with a nominal GDP of USD 124bn (2012). Given a population of 10m, nominal GDP per capita amounted to USD 12,430, or USD 19,705 in PPP terms, last year. Benefitting from its highly-educated workforce and a relatively favorable investment climate, Hungary has been a major recipient of foreign direct investment prior to the onset of the global economic crisis, which has helped modernize its existing large manufacturing base. Industrial production, mainly machinery and chemical production, car manufacturing , as well as food processing, generates almost 30% of national output, while services, including transportation and tourism, account for about 70% of GDP. Reflecting the strong integration of Hungary’s manufacturing and transportation sectors into European supply chains, exports and imports of goods and services both account for about 100% of GDP. This renders local economic developments heavily dependent on euro area demand for intermediary and finished products. Hungary’s dependency on the euro area is further increased by strong financial linkages, as the country’s banking sector is dominated by subsidiaries of euro area banks which depend on funding from their parent banks.
While Hungary’s close trade and financial links with the euro area turned it into one of the best-performing countries in the Central-Europa prior to the onset of the global economic crisis, the situation has changed dramatically since 2009 when major weaknesses of the local economy became apparent. While Hungary’s particular exposure to external developments explains part of its current problems, recurrent domestic policy mistakes further aggravated the country’s difficulties. On the eve of the global economic crisis in 2008/9, Hungary’s economy ran a sizeable twin deficit on both the current and the fiscal account, which rendered the country and its government heavily dependent on external financing. Moreover, a pre-crisis credit boom had left the Hungarian private sector, particularly households, overleveraged, while recurrent large fiscal deficits had led to the build-up of a sizeable public debt position. Even worse, anticipating quick accession to the euro area, both the private and the public sector had borrowed heavily in foreign currencies, which exposed their respective debt loads to fluctuations in the value of the Hungarian forint.
Once the global economic crisis hit, world trade collapsed and global risk aversion spiked as a result, this bet on the future proved fatal. Driven by the depreciation of the Hungarian forint against the euro, the Japanese yen and the Swiss franc, repayment costs for the heavily-indebted Hungarian economy rose quickly, while mounting unemployment further ate into tax revenues and households’ repayment capacity. Faced with the threat of a sovereign default, Hungary’s government was forced to implement strict fiscal consolidation measures and apply for IMF support in 2008, which prevented it from providing stimulus when private consumption tumbled due to the emergence of a mortgage crisis. Hungary’s private and public consumption has been in contraction mode since then and continues to depress economic growth, leaving external demand and investments as the sole growth drivers.
Unsurprisingly, the mortgage crisis did not leave the financial sector unscathed and continues to undermine its current position, as does increasing ‘crisis taxation’ in spite of the sector’s difficulties. Non-performing loans in the household sector have increased from 4% of total loans in early 2009 to about 16% in the second and third quarter of last year. Moreover, particularly the loan quality of foreign-currency denominated mortgages deteriorated sharply amid recurrent forint weakness, which illustrates that a mortgage payment relief program adopted to the detriment of banks in 2011 could not turn the tide. At a time when the forint was depreciating strongly against major currencies, the program allowed borrowers to repay their mortgage against the more favorable 2008 exchange rate. Yet, owing to the requirement to repay the entire mortgage at once, only the strongest borrowers could participate in the program, leaving banks not only with an exchange-rate related loss, but also relatively more weak borrowers. Notwithstanding the program’s negative impact on banks’ already deteriorated financial position, the current government imposed several ‘crisis taxes’ on the sector that further undermined its profitability. Besides leaving a bank tax in place throughout 2013 instead of halving it as promised earlier, the current administration also introduced a new transactions tax last year. The measures are expected to drive additional deleveraging by foreign banks and thereby solidify Hungary’s current severe credit crunch. While the sector is expected to have operated at a loss once more last year, shrinking loan books contributed to relatively solid capitalization with a sector-wide capital adequacy ratio of 14.8% in June 2012.
As domestic demand has been a drag on growth in since 2008/9, Hungary’s competitive industrial sector formed the backbone of a weak economic recovery in both 2010 and 2011. Benefitting from its integration into European supply chains as a consequence of sizeable pre-crisis relocations of production, particularly in the car industry, the sector’s output moved in close tandem with the recovery in central European industrial production in recent years. Moreover, given the current government’s preference for exporting manufacturing companies over the services sector, it benefitted from the absence of ‘crisis taxes’. Going forward, however, we caution that this driver of Hungary’s economy could weaken at least in the first half of 2013. Besides flagging industrial production growth across the region, Hungary’s ongoing credit crunch and policy uncertainty due to the current government’s erratic unorthodox economic policies might undermine necessary investments in the sector.
Reflecting domestic weaknesses and considerable dependency on economic developments in the euro area, Hungary’s recent economic performance has been rather disappointing. After having emerged from a very deep recession in 2009, when GDP declined by 6.8%, Hungary’s economy re-entered recession last year, as strongly declining investments and private consumption dragged growth down to -1.4%. Given that investments and private consumption are likely to continue to fall, Hungary is expected remain in recession in 2013. While growth is expected to likely come in at -0.4%, we caution that the downside risks are considerable. External demand, the only remaining positive growth driver, could turn out to be weaker than expected, particularly in the first half of 2013. Moreover, a renewed escalation of the euro area sovereign debt crisis could lead to an additional weakening of external demand. At the same time, domestic demand could be hurt by strongly increasing debt service costs due to rising yields on Hungarian external debt in combination with a further weakening of the forint.
Political and social situation
Following its landslide victory at the April 2010 parliamentary elections, Hungary’s politics are dominated by the right-wing Fidesz-party under the leadership of Victor Orbán. The party currently holds a two-third majority in parliament, which enables it to pass even constitutional changes without the need for opposition support.
Having won the elections on the back of rising public disenchantment with the leadership of the now opposition socialist MSzP and its austerity policies, Fidesz has embarked on a drastic change of Hungarian politics during the first two years of its four-year term. This change has not only affected the country’s economic policies and relations with the IMF, but also threatens to undermine Hungary’s democratic structures. Driven by an apparent intention to remove former socialist officials from public services and media in order to strengthen more ‘conservative’ forces within Hungary’s administration and society, Fidesz has passed various laws to strengthen the party’s grip on public institutions. Some new laws thereby ensure party influence even if Fidesz were to lose power and end up in opposition. So far, these efforts have resulted in the creation of a fiscal committee dominated by Fidesz-members that can force the dissolution of parliament in case annual budgets cannot be based before the end of March of each year, as well as the appointment of party loyalists to high-ranking positions within the country’s constitutional court and central bank. These new appointments have drastically reduced the independence of these institutions. Recent attempts to introduce mandatory voter registration, which could have favored the Fidesz-party in the upcoming 2014 parliamentary elections, were rebuffed by the constitutional court, however, which illustrates that Fidesz-control so far remains incomplete. Still, it remains to be seen whether the constitutional court’s relatively critical stance can be upheld. In response to its recent rejection of several bills, a revision of Hungary’s new 2012 constitution has been sent to parliament in mid-February. Most importantly, these constitutional amendments would bar the constitutional court from ruling on the actual content of laws and strip it of its right to refer to previous judgments that predate the 2012 constitution. Moreover, recently rejected bills, including controversial plans to force recipients of public student grants to stay in Hungary after the completion of their studies could be included in the constitution, irrespective of their non-constitutional nature. If adopted, which given Fidesz’s 2/3-parliamentary majority is likely, the new amendments could seriously undermine the checks and balances of Hungary’s democracy.
Fidesz’s economic and social policies are oftentimes characterized by a combination of rather ‘unorthodox’ ad-hoc measures reflecting a preference for state dirigisme and a certain degree of Hungarian nationalism. In terms of economic policies, this has resulted in the imposition of various ‘crisis taxes’, preferably imposed on sectors with large foreign participation, that threaten to undermine Hungary’s business climate. Owing to the incompatibility of various policies with EU law, the European Commission is currently taking actions following Hungary’s failure to modify laws regarding central bank independence, the national data protection authority, a crisis tax on the telecommunications sector and the forced early retirement for judges older than 62 years. External criticism is mostly rebuffed with recurrent references to periods of Hungarian resistance against external suppression, ranging from the Habsburg Empire to the Soviet Union. These allusions tend to overshadow debates over EU and IMF support, while revisionist tendencies regarding the 1920 Trianon Treaty repeatedly burden relations with neighboring countries.
While Fidesz’s policy mix resonated well with Hungarian voters in 2010 amid widespread bitterness over the conditions imposed under an IMF standby-agreement, support for the party has weakened considerably since then. In particular, Hungary’s poor economic performance after two years of ‘unorthodox’ fiscal austerity measures and high unemployment in spite of recently enacted enforced labor programs threaten to undermine Mr Orbán’s chances at re-election next year. In general, there seems to be a rising feeling of disillusionment with Hungary’s entire political elite. In recent polls held since November 2012, support for Fidesz stagnates at about 20%, slightly better than the opposition MSzP at 16%, while support for the extreme-right Jobbik (currently the second-largest party in parliament) fell to 6%. The newly-formed opposition electoral alliance ‘Together 2014’ under the leadership of former prime-minister Gordon Bajnai would not even manage to enter parliament with its current support by 4% of the electorate.
Even though Hungary’s external relations, particularly with the EU and the IMF are somewhat strained, they remain workable. This should bode well for the conclusion, if needed, of an EU-IMF standby-agreement if the need were to arise. Yet, we expect strict conditions to be set, which could become difficult for Mr Orbán to sell to his electorate. Notwithstanding, recently taken policy steps to meet EU fiscal demands underline the Hungarian government’s willingness to cooperate if needed.
Since taking office in 2010, the current government’s economic policies have been dominated by the ongoing need for fiscal consolidation in order to rein in considerable budget deficits that undermined the sustainability of Hungary very high public debt burden. While being staunchly committed to meeting the EU’s deficit threshold of 3% of GDP in order to exit the European Commission’s Excessive Deficit Procedure (EDP), Mr Orbán’s cabinet so far failed to present a comprehensive fiscal consolidation plan. While pushing for lower public expenditures, the government repeatedly resorted to ‘unorthodox’ policy measures, ranging from the nationalization of private pension savings to the above-described mortgage payment relief program and the imposition of various so-called ‘crisis taxes’ that have oftentimes been imposed on sectors with sizeable foreign ownership. Avoiding tax increases for Hungarian households appears to be one of the main drivers of the current policy mix. Even though the associated increase in revenues has so far helped the Fidesz-government to bring down its budget deficits and stabilize public debt, the various tax increases have been rather unpredictable and distortionary. Moreover, they undermined investor confidence at home and abroad, which seems to depress investments and thereby undermines (potential) economic growth that is necessary for sustainable, non-self-defeating, fiscal consolidation.
Following the adoption of additional fiscal consolidation measures worth 2.5% of GDP in the 2013 budget, the Hungarian government expects to reduce this year’s budget deficit to 2.7% of GDP, down from 2.9% in 2012. Similar to previous years, raising tax revenues plays an important role, given planned increases of the financial transactions tax, the delay of the previously planned halving of the bank tax or the introduction of new taxes for telecommunications and utilities companies. Given the distortionary impact of these tax increases on investments and growth, we caution that the deficit could once more exceed the 3%-threshold.
Given earlier breaches of EU deficit rules, Hungary has been subject to the EU’s Excessive Deficit Procedure since 2004 and will remain so, even as the European Commission recognized Hungary’s efforts in meeting the required 3% deficit threshold in both 2012 and 2013. As long as the EDP is not lifted, Hungary runs the risk of losing important EU cohesion funds (about 2-3% of GDP). The European Commission’s decision is officially based on the assessment that the 2014 deficit might exceed the threshold once more due to weak economic growth and rising pre-election spending, but in our view also reflects serious concerns about the sustainability of the chosen consolidation approach. Notwithstanding these concerns, Hungary’s public debt level is expected to stabilize at about 80% of GDP in the coming years, provided the forint does not depreciate strongly and thereby increases the value of the large portion of foreign-currency denominated debt.
Owing to its success in reducing its budget deficit below 3% of GDP last year, as well as continued external market access, the Hungarian government’s efforts to conclude a USD 21bn EU-IMF credit line have weakened markedly in recent months. While official negotiations have been ongoing, progress has been lackluster given marked differences in opinion about Hungary’s ‘unorthodox’ policies and possible conditions that would come with such a credit line. Following Hungary’s successful sale of USD 3.25bn in US-denominated bonds with maturities of 5 and 10 years in February 2013 amid plans to issue a total amount of about USD 5.3bn of foreign-currency denominated bonds this year to repay maturing debt, an EU-IMF credit line has become increasingly unlikely. Notwithstanding, we note that the successful bond issue was mainly due to ample liquidity on international financial markets and the current improved market sentiment regarding the euro area sovereign debt crisis. We consequently caution that a renewed deterioration of market sentiment or even weaker Hungarian growth could preclude market access.
In recent months, Hungary’s central bank has received considerable attention by international observers amid attempts by the government to legally limit its independence. While EU objections eventually resulted in the failure of these plans, we note that the independence of the central bank has already been severely compromised by the appointment of four additional Fidesz-loyalist members to the once three-member strong Monetary Policy Council. Since monetary policy is decided by simple majority, these appointments have de-facto dethroned the current head of the central bank, Andras Simor, and his two colleagues. All three had been appointed by the previous government. Since their terms will end in March 2013, prime-minister Orbán will present new candidates in late February. Current economics minister György Matolcsy, a major supporter of Hungary’s ‘unorthodox’ policies, could become one of the candidates. Even though his nomination might spook markets, we note that the current Fidesz-majority in the MPC has already led to a marked shift in monetary policy away from targeting inflation to promoting domestic demand. In spite of headline inflation staying far above the 3%-target, the MPC repeatedly cut its benchmark rate from 7% in September 2012 to 5.5% last January, as core inflation appears to hover around 2%. It remains to be seen, however, whether these cuts will actually boost domestic demand, as Hungary’s large foreign-currency denominated debt load limits the effectiveness of monetary policy. Instead of boosting domestic demand, the recent rate cuts will likely be counteracted by a depreciation of the forint and the consequent increase in debt service costs for the private and public sector.
Balance of payments and external situation
Hungary’s once large current account deficit improved markedly in recent years, as a strong decline in domestic demand combined with relatively stable export growth helped turn this deficit into small surpluses in both 2010 and 2011. While Hungary’s trade balance improved from a deficit of about 1% of GDP in 2008 to a surplus of 3.5% of GDP last year, export-related transportation services contributed to the improvement of the services balance surplus from 1.5% of GDP to 3.8% of GDP during the same period. While ongoing weakness of domestic demand led to a stabilization of the surpluses on the trade and services balances, rising debt servicing costs due to recurrent forint depreciations increased Hungary’s structural income balance deficit last year and thereby dragged the current account back into a limited deficit of 0.3% of GDP. The current account deficit is expected to increase to a still limited 2% of GDP in the coming years. Hungary’s foreign exchange reserves declined by about USD 5bn to USD 43.6bn last year, which mainly reflects the repayment of external debt, markedly weaker portfolio inflows and the central bank’s foreign exchange market interventions to stabilize the forint. Given next year’s expected FX-reserves debt service cover of 64% and a limited 4 months of import cover, Hungary’s liquidity position is relatively weak, particularly given the risk of further forint depreciation.
In spite of recent years’ ongoing deleveraging, Hungary’s private and public sector remain heavily indebted to foreign lenders, as foreign debt amounted to about USD 170bn (138% of GDP) last year. Public and private medium-to-long-term debt constitutes about 82% of Hungary’s external debt load, while IMF debt and short-term debt amount to around 12% and 6%, respectively. A considerable part of the private external debt reflects relatively stable intercompany lending. Notwithstanding, the very large external debt exposure, particularly of the sovereign, exposes the Hungarian economy to shifts in investor sentiment, as most of this debt has to be refinanced by external bond issuances. While the current ample liquidity on international capital markets and improved sentiment regarding European sovereign debt should help Hungary refinance its large external debt load, we caution that a sudden change in confidence could trigger considerable refinancing problems. Consequently, the swift conclusion of an EU-IMF precautionary credit line would certainly boost confidence in Hungary’s ability to manage its external debt burden this year.