Hungary

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Country assessments

Highlights

• Further budget consolidation has begun to address Hungary’s long-standing fiscal vulnerabilities. This consolidation has allowed an exit from the European Union’s (EU’s) Excessive Deficit Procedure, albeit at the cost of depressing domestic demand and investor sentiment. Cross-border deleveraging of banks’ external liabilities has proceeded at the fastest pace of all EBRD countries of operations.
• Rapidly falling inflation has allowed a significant easing in monetary policy and experimentation with unconventional monetary policy tools. In addition to cutting its policy rate, the Hungarian National Bank (Hungary’s central bank) has extended preferential financing for on-lending by commercial banks to small and medium-sized enterprises (SMEs), although demand for corporate credit remains depressed.
• Increases in sector-specific taxes and administrative intervention in the retail energy sector have further undermined investor sentiment. Contrary to original intentions, taxes on several sectors are now permanent in their modified form. Hungary has one of the lowest rates of total capital formation in the EU, and the total capital formation has returned to 1999 levels, which will undermine potential growth for some time. 

Key priorities for 2014

• Predictable and business-friendly investment conditions, and an even-handed tax regime that is applied across all investors and sectors, are needed. The government’s “strategic partnership agreements” with a number of multinational companies could help to boost export-oriented investment.
  
• The independence of the energy sector regulator should be safeguarded. This would assure investors of impartial control of utility tariffs, which should not be subject to ad-hoc government intervention.
  
• Further measures to reduce foreign currency exposures of households should be based on equitable burden-sharing between banks, mortgage borrowers and the government itself. Three separate bank taxes imposed since 2010, and rising non-performing loans in the corporate sector, have substantially diminished bank profitability, and hence the general appetite for lending.

Macroeconomic performance

Growth has marginally revived in the first half of 2013, after a contraction in 2012. In 2012 weaknesses in export markets contributed to the ongoing contraction in domestic demand, resulting in an overall decline in GDP of 1.7 per cent. GDP growth in the first half of 2013 was almost entirely due to an increase in inventories, and to some extent in exports, while consumption by both households and the government sector declined, and gross fixed capital formation fell further, to 1999 levels.

Given weak domestic demand, the current account continues to show a surplus, of 1.0 per cent of GDP in 2012, and therefore supports the forint. As a component of demand, exports showed some revival in early 2013. Nevertheless, growth in export volumes fell slightly in 2012 compared to the previous year, in marked contrast to other central Europe and Baltic states, possibly indicating a loss in competitiveness. Industrial production, including of manufactured goods, similarly saw a marginal decline, although some notable and long-planned capacity came on-stream within foreign-owned car plants over the course of the year. With an export share of 95 per cent of GDP, Hungary remains one of the most open economies in the transition region, and has established itself as an integral link in “global value chains” of internationally integrated production processes, in particular given the use of Hungarian intermediate goods in the exports of other countries.

The government persisted with its fiscal consolidation efforts. In 2012 the budget deficit was 2.0 per cent of GDP, from a surplus of 4.3 per cent in the previous year. This allowed Hungary to finally exit the Excessive Deficit Procedure of the EU, to which it had been subject since accession in 2004. Public debt remains a key vulnerability, with the ratio of public debt to GDP still at around 80 per cent of GDP in mid-2013. Under new fiscal rules the 2014 budget should not raise this ratio. Nevertheless, Hungary’s distortive tax policies continue to inhibit growth and investment. Amendments to the 2013 budget raised two sector taxes, and significantly increased the financial transactions tax, and the deficit has increased further this year.

Strong investor interest in higher yielding global emerging market bonds benefited government refinancing in domestic and international bond markets, notwithstanding a sovereign risk assessment in the “speculative” range. Of emerging market economies, Hungary therefore has the highest non-resident participation in its domestic bond market. Government fiscal reserves remain high, and in July 2013 the government announced an early repayment of outstanding liabilities to the International Monetary Fund, which were incurred under the 2008 financial programme.

Substantial monetary easing has been complemented by preferential lending schemes by the central bank. Inflation has fallen gradually, to 1.6 per cent in annual terms in September 2013. This has allowed the central bank to reduce the key policy rate in 15 successive steps, to 3.4 per cent by October 2013. Moreover, the central bank is seeking to counteract the ongoing contraction in credit through the preferential “Funding for Growth” scheme. Measures that were announced earlier in the year were extended in September. These will make a total of up to Ft 2.75 trillion (over 9 per cent of GDP) in funding at preferential rates available to commercial banks, primarily for on-lending to SMEs, with a maximum 2 per cent margin (additional costs arise where government guarantees are sought). Unconventional policy measures are unlikely to be effective without an improvement in business sentiment in the banking sector.

Major structural reform developments

A highly uncertain corporate tax regime that targets individual sectors continues to depress the overall investment rate. Overall gross fixed capital formation, which is a key driver of the potential growth rate, fell further, to 17.8 per cent of GDP in mid-2013 – the lowest investment rate among new EU member states. Sector-based taxes on the financial, energy and telecommunication sectors were intended as a crisis measure. However these taxes were made permanent in modified form in 2011, and a further tax on utilities was introduced in early 2013. Sector-specific taxes account for a substantial share of the tax burden on the corporate sector, and uncertainty over taxation levels and administration have discouraged investment. According to the World Bank 2014 Doing Business report, the quality of Hungary’s business environment has deteriorated further following previous years’ declines. Overall, the measures of the quality of the business environment indicated a deterioration, to fifty-fourth of 189 countries, which was in large measure due to investor perceptions about the tax burden, as well as poor investor protection.

The energy regulator reduced all household electricity and heating tariffs by 10 per cent in January 2013. This further undermined the financial position of utility providers, which have been loss-making for some time. While this decision was successfully challenged by the industry, more recent legislation may mean that government influence over the regulator may prevail, as the regulator’s decisions can no longer be contested in court. The dispute over energy pricing has contributed to a further divestment from the sector by several companies. As part of a government initiative to bring gas storage and transport under state control, in March 2013 the state-owned Hungarian Electricity Works (MVM) concluded an agreement for the acquisition of assets from E.ON, which operated the largest trading network in the country.

The government is seeking to further entrench the country’s position as an attractive platform for foreign direct investment (FDI) by export-oriented multinational companies, in particular in the manufacturing sector. Since 2010, 30 multinational firms have signed “strategic partnership agreements” with the government, typically committing to continued expansion and job creation in return for a favourable and predictable investment environment. There have been a number of expansions of existing facilities, including in the car components, machinery, and electronics sectors. Several companies have announced the relocation of research and development, and other skills-intensive functions, into Hungary. Total inward investment in 2012 was 10.9 per cent of GDP, with net FDI at 2.1 per cent. Income accruing to FDI enterprises remains relatively steady, at around 6 per cent of GDP, which is only slightly down from the years that preceded the 2008-09 financial crisis. However, the proportion of reinvested earnings has fallen substantially, to about 16 per cent in 2012.

Hungary introduced a financial transactions tax in 2013. To date, it is the only country in central Europe that has introduced such a tax. In a budget amendment in spring 2013, the initially announced financial transactions tax rate of 0.1 per cent was raised to 0.2 per cent for most types of transactions, and to 0.3 per cent for cash transactions. Moreover, the consolidation of around €2.1 billion (Ft 624 billion) in municipal debt under the central government resulted in a one-off additional charge on banks’ liabilities under the financial transactions tax. These substantial tax pressures on banks, coupled with the growing provisioning burden for non-performing loans in the corporate sector, contributed to losses of €132 million (Ft 39.3 billion) in the banking sector in 2012, further diminishing banks’ appetite for lending.

The banking sector remains well capitalised, although loan delinquencies continue to rise. In the context of depressed credit demand, and adverse tax and regulatory measures, the industry continues to adopt a strategy of cost-cutting and deleveraging. The pace of deleveraging in Hungary has been the most rapid in the transition region in 2012, with outflows of bank liabilities of about 10 per cent of GDP. Clearing up the legacy of foreign currency loans remains a central prerogative of the government. The 2011 scheme that allowed households to repay foreign currency mortgage debt at preferential currency rates reduced household foreign exchange debt by about 23 per cent, and implied costs to banks of almost 1 per cent of GDP. A further conversion of foreign exchange mortgages into forint loans could therefore have drastic ramifications for capital positions within a banking sector that is still loss-making, and may further undermine the recovery in corporate credit that the government seeks to encourage.

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