Hungary After Shock Therapy: What Will The Future Bring?

As the solution to these issues, some analysts and politicians recommend increasing the budget gap, while others would commit to a stringent fiscal policy. The present article attempts to look into this policy debate, with the rather disappointing conclusion that economic realities leave very limited elbowroom for Hungary’s economic policy.

Having just survived the most turbulent phase of the crisis, Hungary is now facing the same challenge as before: staying on a sustainable government debt path. Back in early 2009, before the crisis hit delivered its second major blow in March, Portfolio.hu had reviewed the situation, concluding that this would not be an easy task to accomplish. The shock therapy and a new IMF loan suggested at that time as future possibilities have now been partly realized. Budget adjustments resulting in savings on a scale of HUF 1,000 billion per year, together with the extension of the Stand-By Arrangement with the IMF have gone a long way to improve Hungary’s economic outlook, however the current situation is still not perfectly reassuring.

That wretched government debt, again...

In the present state of affairs, Hungary’s long-term government debt path remains highly suspicious. Notwithstanding fiscal adjustments and the cessation of global turbulence, some aspects of the country’s economic fundamentals have not improved at all. While the country has made a leap forward as far as fiscal restraint is concerned, one can safely assume it will take a while before the interest rate environment returns to the pre-crisis levels, and Hungary’s potential economic growth forecasts are getting increasingly gloomier.

Without going into the details of the projected government debt dynamic, let us assess a few key parameters - just to be clear about the facts. Potential GDP growth is currently estimated at about 2%; in this environment the primary balance may have 0-2% surplus while the real interest rate could be anywhere between 2% and 4% depending on the rate at which the economy is recovering. By and large, the central bank analysts probably followed the same logic; while we know the model parameters they used, their projected debt paths are very similar to Portfolio.hu’s earlier calculations.

NBH Research Director Ágnes Csermely presented her team’s forecasts in a recent economics conference. The following chart summarizes her findings:



Summary: At present, the sustainability of Hungary’s debt path chiefly depends on the interest rate environment. The latter is mostly influenced by external factors, and one can safely assume that the former "golden era" of practically microscopic risk premia will not return for quite a while. Of course, this is not to suggest that yields cannot go any lower - of course a decrease in yields is possible, however certainly not on a scale that would allow Hungary to achieve a highly spectacular reduction to the debt ratio. Given this limitation, there remain two other parameters economic policymakers can influence in order to contain spiralling government debt: economic growth and the budget gap.

Fragile balance or growth: Do we really have a choice?

This argumentation takes us to the major dilemma policymakers are facing: What is the best approach Hungary should take in order to achieve a firm decline in government debt - keeping a tight check on the budget deficit, and/or stimulating economic growth potential? What is the connection between the two methods?

Although the general public in Hungary may not yet be aware, the budget is currently so well balanced that the government deficit may be lower than 3% of GDP, assuming Hungary's economic growth runs to its full potential. In actual fact, the present level of stability is on a par with the benchmark year 2000. On the other hand, one should not overlook the almost traditional pitfalls of budget planning. What we have here is a budget built on the (not extremely stable) foundations of the 2009 budget, an election year it needs to be implemented, with most of its buffers seen disappearing into thin air early on in 2010. This has loose fiscal discipline written all over it. (And we have not even counted one-off expenses you would normally expect from a new government, such as writing off the losses of state-owned companies.)

The growth prospects of the national economy are much less promising. In the current structure, characterized by an inflexible labour market and weakened appeal to foreign investors amid the global recession, Hungary is unlikely to exceed a sustainable annual average growth rate of 2-2.5% in the long run. Potential growth rate estimates always come with a high uncertainty factor, but this figure is our best estimation based on facts that are currently available. In sum, Hungary needs to improve its long-term growth prospects in order to "outgrow" its massive government debt. In our view, the recovery phase of the recession cycle, when GDP is expected to growth at a faster rate, may offer a window of opportunity for the government to take action with measures aiming at macroeconomic stability, tax reform (including tax cuts), infrastructure development and credibility.

What should Hungary do then?

In the following you find a draft version of routes that Hungary formally has a chance of taking.

I. Equilibrium Scenario

In theory, Hungary may achieve a stable debt reduction rate if it tidies up the budget to a full balance. In this case, the primary budget balance will show such a surplus that will offset the negative implications of even a high real interest rate and a further worsening potential growth. This will create macroeconomic stability. And macro stability will boost confidence in the country.

There are several risks to this scenario, however, Firstly, it would be hard to see through, as it would require additional and very tough austerity measures. And it would put even stronger restraints on short-term growth. Under such fiscal adjustment, the government should lean heavily on the revenue side, which would eat into potential growth again. Altogether, Hungary’s chances of convergence would become even more distant and the funds indispensable for the required restructuring would dry up, too.

II. Growth scenario

Let’s see what’s on the other side of the wall. Why not trying to foster economic growth as soon as we can, now that we see absolutely no chance for a lasting success? Whoa, not so fast! The fastest way to a speedy growth boost leads via revving up domestic demand (consumption), but these measures are ineffective in the long run. The contradiction may be resolved the best if we think 'massive tax cuts’. This way we would surrender the need for short-term fiscal stability (possibly under an IMF shield) and try to make the economy more dynamic by reducing labour taxes and other modernisation schemes.

Needless to say, this scenario is not without risks, either. First of all, the deterioration of macroeconomic stability in the current global environment would have unpredictable consequences. Secondly, after experiencing some bursts of success, economic policy may easily become "lazy" and Scenario IV would take the centre stage. And let’s not forget that on this macro path euro adoption is not on the corner. Assuming that entering ERM-2, the anteroom for euro zone accession, will hardly be allowed with a growing and/or bulging deficit and a debt path winding higher and higher for years, Hungary will not be able to adopt the euro even by the end of the next governmental cycle.

III. Flexible Scenario

After due consideration of the aforementioned, we believe the best solution would be if the government pursued a tight fiscal policy that would allow a gradual reduction of the budget deficit and even help improving the growth outlook.

Under this scenario, Hungary’s budget gap would remain below 3% of GDP persistently and the growth potential would rise gradually. The problem is that the two needs are in conflict on several points (e.g. the need to lower labour taxes and the high initial costs of structural reforms).

Nevertheless, this may still be the optimal solution, since regaining the credibility of economic policy may have a benign impact on rates, as well. The headache in this scenario is that the measures aimed at fostering growth in the long run could turn out to be too feeble and the pace of growth would start picking up more slowly. In this case the cabinet really needs to explore any and all opportunities that would not hurt the balance.

IV. Inertia Scenario

In view of the need for GDP growth, no fiscal stabilization takes place, but the government does not make any efforts to improve competitiveness, either. As the recession cycle is drawing to an end and the economy enters a growth phase, policymakers look on with satisfaction but fail to make efficient use of excess resources. In these circumstances, chances of a decreasing government debt path are very low, unless the external environment is extremely favourable. However we believe the latter is unlikely as markets begin to price in Hungary's slipping chances for euro adoption in the near future.

As you can see, Hungary’s elbow room in economic policy remains really small and is surrounded by risks that are both economic and political in nature. There is no big conclusion we want to make. However - and we hope it is not an overly bold aspiration - it would be nice to know that when Hungary’s policymakers decide on what economic path to take they considered similar aspects to these."

Source: Portfolio Online Financial Journal