On May 23, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Hungary.¹

Hungary’s economy emerged from the 2012 recession and posted 1.1 percent growth last year, mainly driven by government investment and consumption, and also net exports. Private demand—although strengthening on the back of accommodative monetary conditions and improved market confidence—remained weak, and credit to the retail and corporate sectors continued to contract, albeit at a slowing pace. Output growth is projected to pick-up to 2 percent this year as investment and private consumption continue to improve, while exports expand further. Underlying inflationary pressures have eased, and inflation expectations have come down to around the National Bank of Hungary’s (MNB) inflation target. Unemployment declined despite the increase in the participation rate, mainly due to the expansion of public works programs; but labor market conditions remain weak.

Hungary has experienced a welcome reduction in its vulnerabilities thanks to a persistent current account surplus, low headline inflation, and a significant fiscal consolidation. These developments helped Hungary withstand various bouts of emerging market turmoil over the past year relatively well. However, still-high public and external financing needs, heavy reliance on nonresident funding, uncertainty regarding advanced economies’ monetary policies, and the potential reemergence of financial stress in emerging markets pose risks. The government has secured financing for most of its maturing external debt in 2014 with the recent Eurobond placements.

Hungary has demonstrated a strong commitment to keeping the fiscal deficit within the EU limit. The 2013 deficit is estimated at 2.2 percent of GDP, over-performing the 2.7 percent target, as lower tax revenues were more than offset by prudent expenditure control. Public debt declined only slightly to just above 79 percent of GDP. For 2014, the deficit target of 2.9 percent of GDP implies a structural relaxation of about one percent of GDP leaving public debt broadly unchanged at about 79 percent of GDP.

Comforted by decelerating inflation, low risk premia, and a negative output gap, the MNB reduced the policy rate to a record-low level of 2.5 percent (as of April 2014). Furthermore, the MNB introduced the Funding for Growth Scheme with the aim of easing access to finance for SMEs and improving their credit conditions through the provision of subsidized lending interest rate.

Hungary’s medium-term growth prospects remain subdued, as private consumption is still hampered by the ongoing repair of households’ balance sheets; while the weak business environment continues to weigh on private investment. Banks remain under stress, reflecting the heavy tax burden, high non-performing loans, and a weak growth outlook. Labor participation, while somewhat increasing, remains low. These challenges are further compounded by rising competitiveness pressures, as reflected in the loss of export market share, owing to the deterioration in the business climate, particularly the institutional framework and tax policy.

Executive Board Assessment²

Executive Directors welcomed Hungary’s economic recovery, supported by accommodative policies, but noted that the economy continues to face significant risks arising from an uncertain global environment, the still high public debt, large financing needs, and extensive reliance on non-resident funding.

Against this background, Directors underscored the need for a recalibration of macroeconomic policies to rebuild policy buffers and ambitious structural reforms to improve medium-term growth prospects. Priorities include strengthening institutions, increasing policy predictability, and promoting private sector participation in the economy.

Directors welcomed the authorities’ commitment to fiscal prudence and sustainable debt reduction. They encouraged the authorities to implement a durable adjustment strategy, focusing on expenditure retrenchment and elimination of distortionary taxes. Continued efforts are also needed to reduce tax exemptions and address VAT fraud. Directors noted that these steps should be complemented by growth-friendly fiscal reforms, which could entail better targeting of social benefits, restructuring the remaining loss-making SOEs, and streamlining public sector employment. Directors welcomed the authorities’ intention to introduce a multi-year budget framework and underscored the importance of an independent and adequately-resourced fiscal council.

Directors observed that, while inflationary pressures have eased and inflation expectations have come down, there remains uncertainty surrounding the external environment, which calls for caution in monetary conduct. Directors saw merit in halting the monetary easing cycle as long as there are no evident signs of inflationary pressures, noting that the current accommodative stance can continue to support economic activity. They also emphasized that adequate international reserves would help mitigate exchange rate volatility and support financial stability.

Directors called for further steps to restore financial intermediation and facilitate the resolution of non-performing loans, including by reducing taxes on banks and removing legal and regulatory impediments to a clean-up of banks’ portfolios. They saw scope for further refining the modalities of the Funding for Growth Scheme to improve the targeting and effectiveness of its lending.

Directors welcomed progress in improving the functioning of the labor market. They stressed that broad-based structural reforms are essential to boost potential growth and support Hungary’s advancement in the regional supply chain. They also recommended improving the business climate, including by reducing the regulatory burden and rationalizing taxes.