The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of Hungary 2005 published on 19 July 2005.
In 2003-04 there were strong tensions in the macroeconomic policy mix that adversely affected market confidence. Uncertainties about the future course of exchange rate policy provoked attacks on the forint in both directions, establishing an unhealthy environment of volatility to which the Central Bank had to respond with strong policy rate moves. Booming domestic demand and persistently missed fiscal targets generated doubts about a rapid fall of inflation, which had surged after a series of administrative measures aimed at increasing budget revenues. High interest rates were maintained well into 2004, even as the forint appreciated to near the strong end of the target band. These developments provoked another round of public disagreement on the conduct of policy between the Central Bank and the government. However, a series of reductions in the base rate since the second half of 2004 has reduced tensions considerably, and further rate cuts are expected. Indeed, monetary policy was tight in 2004 and, because of lags in policy impacts, inflation at the end of 2005 is likely to be within the target band but well below the centre of it. Despite the easing of tensions, financial markets still regard progress in inflation and deficit reduction as fragile, adding nervousness to the foreign exchange market that is compounded by the large current account deficit.
Some refinements to targeting rules and institutional arrangements in monetary policy would help euro entry
Going forward, the inflation outlook now seems well on track to fulfil the Maastricht criteria in time for euro entry in 2010. Inflation in the year to March 2005 was 3.5%, not far off the level likely to be needed to meet the inflation criterion. Some fine-tuning of the Central Bank’s inflation targeting regime in the run up to euro entry would help avoid missing policy goals:
The current approach to setting inflation targets involves the setting of new end-of-year inflation targets once a year, implying that in monetary policy the time lag to target varies during the year. This could be remedied if the target was set in terms of a fixed number of quarters ahead or if a rather longer-term target were set.
The authorities should ensure that the schedule of Monetary Council members’ terms of office avoids the replacement of several council members at the same time to reduce the risk of actual, or perceived, swings in the outlook. Though it is too late to avoid this for the additional four members that recently increased the council from nine to thirteen members earlier this year, future changes in Monetary Council membership should aim to avoid such situations arising.
Fiscal consolidation has been a lot less robust than it appears
Ensuring fiscal sustainability must be a key priority. At the first glance, the budget deficit also looks well on track to meeting the 3% Maastricht limit required for euro entry. In 2004, the deficit was 4.5% of GDP, down from 6.2% in 2003 and 8.5% in 2002. But, progress in sustainable fiscal consolidation has been less impressive than these deficit figures imply. The deficit reductions partly reflect one-off accounting items and changes in accounting practices. Stripping away these influences reveals that the adjusted deficit is just 1.1 percentage points lower since the government came into office in 2002, which is about half the deficit reduction initially planned by the government over this period. Meeting the fiscal targets necessary to enter the euro area will thus require major efforts in the years to come.
Inflation, interest rates and government deficit outcomes
1. Index of consumer prices excluding energy, food, alcohol and tobacco.
Source: Ministry of Finance and OECD Economic Outlook, No. 77 Database.
This year’s budget relies heavily on one-off operations. The 2005 budget outlines plans for a 0.9 percentage-point deficit reduction to 3.6%. Most importantly, the deficit is being helped by a new public-private partnership deal for motorway construction that is taking an amount equivalent to 1.4 percentage points of GDP off budget, suggesting that the 2005 budget, together with the increase in private infrastructure spending, is in fact expansionary. Any slippage from this target should be avoided. Achieving targets beyond 2005 will have to take into account that from 2007 onwards adjustments relating to compulsory private pensions can no longer be included in the headline Maastricht deficit, though the net cost of the pension reform shall be also partially taken into account for the decision of the Council of the EU on the abrogation of the excessive deficit, if the deficit has declined substantially and continuously and has reached a level that comes close to the reference value.
Failure to reach targets and blurring of deficit outcomes is damaging credibility. To remedy this, a transformation in the attitude to fiscal policy is needed. In particular, the authorities should:
Use realistic estimates for the current year’s deficit outcome in making budgets for the upcoming year, make prudent assumptions on real GDP growth and deflators, and improve projections of revenue and spending items. To make sure that these measures are effective, strict rules on the use of positive revenue and expenditure surprises should be applied.
Communicate more transparently on the contents of the budget, particularly on the key factors behind shifts in revenue and expenditure, and communicate more openly on positive and negative developments over the course of the budget year. This would also allow the Central Bank to reduce the level of comment and detail on its fiscal projections in quarterly inflation reports.
Further steps to tighten spending discipline have been taken recently, but more must be done to ensure fiscal sustainability
In terms of concrete measures to improve spending discipline, welcome new rules have been introduced including expenditure freezes, tighter conditions on unspent appropriations and stronger ceilings on decentralised agencies. These steps should be backed up by stronger medium-term fiscal commitment. In particular, there should be a more strongly binding commitment to the fiscal objectives laid out in the Convergence Programmes. In addition, within the budget process itself, a medium-term framework should be introduced and long-term fiscal projections regularly updated.
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