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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Hungary published on 11 February 2010.
How has the global crisis affected Hungary?
Hungary has been in one of the most severe recessions among OECD countries, with the projected fall in real gross domestic product (GDP) in 2009 being double the OECD average. Hungary’s economy suffered from a trade collapse just like other transition economies in the region, but the global crisis has been compounded by a collapse in investor confidence in forint-denominated assets. This triggered a steep depreciation of the exchange rate in October 2008 and led the authorities to request financial assistance from international organisations. A combined credit package of EUR 20 billion was granted in November 2008 by the International Monetary Fund (IMF), the European Union (EU) and the World Bank.
High foreign currency indebtedness (Figure 1) and weak fiscal sustainability were at the root of the loss in confidence of foreign investors. Foreign exchange lending became a common practice due to the interaction of several factors, reinforcing each other. On the credit demand side, lenders were encouraged to borrow by the persistently wide spread between interest rates in Hungary and western-European countries, a relatively stable currency, and the expectation of convergence. On the credit supply side, banks favoured foreign currency lending owing to the lack of domestic forint savings and also over-optimistic assumption on convergence. As a result, households and enterprises have become increasingly indebted in foreign currency, especially in Swiss francs. Total external debt reached about 120% of GDP at the end of 2008, compared to less than 50% in Poland and 40% in the Czech Republic. At the climax of the financial crisis (October 2008), gross international reserves fell short of covering short-term foreign currency debt at remaining maturity. At the same time, the capacity of the government to bail out private investors appeared limited owing to the high public debt and the still significant fiscal deficit.
Share of foreign currency loans in total domestic credit
Source: MNB (2009), “Financial Accounts”, Statistical Time Series, Magyar Nemzeti Bank, December.
What challenges arise for economic policies?
Unlike most other OECD countries, macroeconomic policies could not afford to support the economy and had to remain tight to avoid further depreciation of the exchange rate. For the central bank, defending the forint had at times to take precedence over inflation targeting. On the fiscal side, spending was cut significantly to reinforce confidence, including nominal cuts in public wages and pensions. The pro-cyclical stance was similar to policies followed by other emerging countries with foreign currency debt overhangs. In those countries, the positive impact of reversing capital flows proved to outweigh the negative impact of tight macroeconomic policies: the restoration of market confidence eventually led to currency appreciation and interest rate declines, which lightened the private sector debt burden, stimulating activity. In the meantime, transitory high domestic interest rates had limited pass-through to the economy since most indebtedness is in foreign currency. In Hungary also, tight macroeconomic policies, together with international support, have been successful in stabilising the currency, allowing the central bank to resume interest rate cuts in mid 2009 and the government to let automatic stabilisers work in part.
The need to restore foreign investor confidence also acted as a trigger to implement long-overdue structural reforms. Improving fiscal sustainability required going beyond short-term expenditure cuts. Hungary has made significant progress in reducing the cyclically-adjusted fiscal deficit over the past years. In particular, the government has improved the targeting of social transfers and has reduced inefficient subsidies. In May 2009, the government adopted a new pension reform that should significantly mitigate the rise in ageing costs. This reform, which increases the retirement age, will also favour labour supply, thereby supporting potential growth. Moreover, on 1 July 2009, the government implemented a far-reaching tax reform that switches the tax burden from labour to consumption: an increase in the value added tax rate by 5 percentage points (together with a rise in excise taxes and the creation of a wealth tax) allowed significant cuts in employer social contributions and the personal income tax. This reform should support potential growth and employment by reducing economic distortions.
Before the crisis, Hungary’s productivity gap vis-à-vis the OECD average was already large. Real income convergence came close to a halt in 2007 08 and is likely to have been reversed in 2009. The depth of this recession is bound to leave deep marks in productive capacity. Consequently, boosting potential growth calls for continued structural reforms encompassing labour market, education, entrepreneurship and innovation. In particular, active labour market policies should be better targeted at the unskilled. For the recent reduction in maternity leave to lead to a significant increase in female participation, it is essential that public support for childcare (e.g. part-time work, working from home, nursery services) is expanded. The still generous maternity leave provisions should be reduced further, while public support for childcare should be expanded in parallel. Regarding product market policies, barriers to firm creation should continue to be reduced. The share of research and development in GDP should increase and collaborative links between research institutions, universities and the business community should be strengthened.
A well-balanced policy mix is the key to maintaining a sustainable growth path in Hungary. Fiscal consolidation is a pre-requisite since market confidence is needed to allow the central bank to base its policy stance solely on inflation targeting. Hence, fiscal consolidation, through structural reforms, should continue, while avoiding excessive pro-cyclicality if the economy deteriorates beyond anticipation. As the economy recovers and monetary policy shifts emphasis from financial stability to inflation targeting, the central bank should continue to carefully communicate to financial markets so as to avoid financial stability concerns in case of sudden changes in market confidence, as has happened in the past. Continued in-depth analysis of the impact of the recession on potential output should help guide monetary policy within the inflation targeting framework, given the difficulty of interpreting inflation shifts in Hungary.
How to obtain this publication
The complete edition of the Economic Survey of Hungary is available from:
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.
For further information please contact the Hungary Desk at the OECD Economics Department at email@example.com.
The OECD Secretariat's report was prepared by Margit Molnar and Colin Forthun under the supervision of Pierre Beynet. Research assistance was provided by Desney Erb.