Executive summary 1

1. Scene setter: economic situation and outlook 4

2. Imbalances, Risks and Adjustment 13

2.1. External sustainability 14

2.2. Government debt sustainability 21

2.3. Financial sector risks and deleveraging 29

2.4. Labour market with a focus on public works 40

3. Other structural issues 49

3.1. Fiscal policy 50

3.2. Labour market and social cohesion 53

3.3. Education and skills 57

3.4. Business environment 60

3.5. Network industries and environment 64

A. Overview Table 67

B. Standard Tables 74

LIST OF Tables

1.1. Key economic, financial and social indicators 9

1.2. The MIP scoreboard 10

2.2.1. The examined fiscal policy-risk scenarios 21

2.3.1. Budget contribution to mortgage relief schemes (2011-2015, HUF bn) 28

2.3.2. Policy measures increasing the burden on the banking sector 30

B.1. Macroeconomic indicators 68

B.2. Financial market indicators 69

B.3. Taxation indicators 69

B.4. Labour market and social indicators 70

B.5. Labour market and social indicators (continued) 71

B.6. Product market performance and policy indicators 72

B.7. Green growth 73

LIST OF Graphs

1.1. GDP in 2010 constant prices 3

1.2. External and domestic demand contributions to economic growth 3

1.3. Headline inflation and core inflation 4

1.4. Net Lending/Borrowing by Sector 5

1.5. Potential output growth 6

2.1.1. Components of Net International Investment Position 12

2.1.2. Components of the external position (current and capital accounts) 13

2.1.3. Evolution of Hungary's export market share (year-on-year) 14

2.1.4. Net foreign direct investment in the region (% of GDP) 16

2.1.5. Foreign direct investment flows in Hungary (% of GDP) 16

2.1.6. Greenfield foreign direct investment inflows into Hungary (2003-2014) 17

2.2.1. Gross government debt ratio: historic data and short-term projection 19

2.2.2. Composition of the annual change in gross government debt 19

2.2.3. Gross government debt ratio: the baseline scenario 20

2.2.4. Gross government debt ratio: state acquisition and wage compensation scenarios 21

2.2.5. Gross government debt ratio: the Paks II and the combined policy scenarios 22

2.2.6. Gross government debt ratio: sensitivity to macroeconomic variables 22

2.2.7. The share of FX denominated government debt and the effect of previous exchange rate changes on the gross debt ratio 23

2.2.8. Stochastic debt projections, 2015-19 23

2.2.9. Fiscal policy-risks scenarios compared with the debt-reduction benchmark set by the one-twentieth rule 24

2.3.1. Decomposition of private sector debt 25

2.3.2. Decomposition of credit flows 25

2.3.3. Change in corporate loans in international comparison (annual transaction-based growth rates) 26

2.3.4. Change in household loans in international comparison (annual transaction-based growth rates) 27

2.3.5. External funding transactions in the local banking sector (cumulative changes) 29

2.3.6. The Financial Conditions Index (FCI) and economic growth 33

2.3.7. Deleveraging pressures on the supply and demand side 34

2.4.1. Participation, employment and unemployment 35

2.4.2. Activity rate 35

2.4.3. Unemployment rate 36

2.4.4. Change in employment by source of employment, sectoral breakdown 38

2.4.5. Change in employment by source of employment 38

2.4.6. New vacancies and registered unemployed 38

2.4.7. Employment level with and without the public works 39

2.4.8. Probability of successful exit from the Public Work Scheme, by education 40

2.4.9. Probability of successful exit from the Public Work Scheme, by age cohort 40

2.4.10. Probability of successful exit by time spent in the Public Work Scheme (months) 40

3.2.1. The severe material deprivation rate in the region 49

3.3.1. Impact of socio-economic status on mathematics performance (2012) 51

3.3.2. Drop-out rate from tertiary education (2011) 53

3.4.1. Public R&D intensity (1), 2005-2013 57

LIST OF Boxes

1.1. Trade linkages and energy tie of Hungary to Russia 7

1.2. Economic surveillance process 8

1.2. Economic surveillance process 8

2.4.1. Recent tax and benefit measures affecting the low-skilled 37

2.4.2. Participation and budget allocation of the public work scheme 41

LIST OF Maps

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Following a meagre growth performance in the aftermath of the crisis, Hungary’s GDP is expected to have increased over 3% in 2014, supported by stimulus factors of temporary nature. The surge in growth was driven by temporary measures and factors, such as the increased absorption of EU funds, subsidised loan schemes as well as the regulated utility price cuts. Accordingly, the Commission forecasts a deceleration in growth from 3.3% in 2014 to around 2.5% in 2015 and around 2% in 2016 as the temporary effects peter out. The current negative headline inflation will likely pick up towards 3% by the end of 2016. The trend of employment gains is projected to continue to be led by the private sector. The government deficit is expected to remain broadly around 2.5% of GDP between 2014 and 2016, which may not be sufficient to achieve a robust debt reduction.

This Country Report assesses Hungary's economy against the background of the Commission's Annual Growth Survey which recommends three main pillars for the EU's economic and social policy in 2015: investment, structural reforms, and fiscal responsibility. In line with the Investment Plan for Europe, it also explores ways to maximise the impact of public resources and unlock private investment. Finally, it assesses Hungary in the light of the findings of the 2015 Alert Mechanism Report, in which the Commission found it useful to further examine the persistence of imbalances or their unwinding. The main findings of the In-Depth Review contained in this Country Report are:

· Despite the rapid improvements in recent years, external indebtedness continues to be at unsafe levels. Rebalancing of the economy has been on-going since the crisis, driven by sustained current and capital account surpluses, which reflect both private sector deleveraging and the increasing positive contribution from EU funds. In parallel, there has been some structural deterioration on the financing side, as net foreign direct investments, in particular greenfield inflows, have slowed down.

· The high level of government debt remains an important source of vulnerability for the Hungarian economy. Medium-term sustainability simulations show public debt, in a baseline scenario, falling further in the coming decade. However, the projected improvements are subject to important fiscal policy-related risks and a considerable vulnerability to economic shocks is still present.

· Financial deleveraging has continued in a difficult context characterised by a high regulatory burden on the financial sector and a high level of non-performing loans. The fall seen in the loan-to-deposit ratio has to a large extent been necessary in order to repair balance sheets. Nevertheless, the pace and the channels through which the deleveraging pressures materialised were heavily influenced by financial sector policies, in particular the imposition of a high tax burden. Subsidised lending schemes and the recent pick-up in growth have started to reduce the speed of deleveraging, which is, however, expected to continue in the coming years.

· The Public Works Scheme appears to be an inefficient active labour market policy measure and distorts the proper functioning of the labour market. It nominally reduces unemployment, but there is a risk, also from a budgetary point of view, that public works of such a magnitude could entail significant ‘lock-in’ effects and become a permanent replacement for the system of welfare benefits for the low-skilled. The scheme is not adequately coordinated with other public employment services, and does not sufficiently support the reintegration of participants into the open labour market.

The Country Report also analyses other macroeconomic issues and the main findings are:

· Investments peaked in 2014 and are forecast to decelerate until 2016. Investments started to grow in 2013 for the first time since 2008. In 2014, they showed more than 10% real growth, mainly on the back of EU co-financed public investments. As EU fund absorption is expected to be lower in 2016, this will bring investment growth to around zero.

· The efficiency of the Hungarian tax system is affected by a number of flaws both in terms of design and governance. Recent changes have reignited the earlier trend of raising the weight of sector-specific corporate taxes. The tax burden on some groups of low income earners has remained among the highest in the EU. At the same time, there has been some progress in fighting tax evasion.

· The unstable regulatory framework, the lack of transparency in decision-making procedures and inadequate consultation of interested parties are, together, weighing heavily on the business environment. Frequent and unpredictable regulatory changes, often resulting in new entry barriers in certain sectors, are worsening the investors’ perception. This is exacerbated by the fact that the quality of legislative processes suffers from, inter alia, the lack of proper ex ante impact assessments and short transition periods for stakeholders.

· Overall, Hungary has made limited progress in addressing the 2014 country-specific recommendations. In particular, despite the sharp increase in the share of subsidised loans, normal lending in the economy has not yet returned, partly linked to the further increase in the overall regulatory burden on the financial sector. There has been some progress in the area of tax compliance and in the continued reorganisation of state-owned public transport companies. Some progress has also been made in strengthening the targeted active labour market policies: both the preparation of the profiling system in the Public Employment Service and set-up of the youth mentoring network are on schedule. However, some country-specific recommendations have remained broadly unaddressed. Specifically, the policy advice on the re-arrangement of the tax structure has not been followed. The period of eligibility for unemployment benefits has not been increased and worsening poverty indicators continue to call for integrated policy measures. Entry costs and regulatory restrictions have further increased in several market segments, particularly in the service sector. A systemic approach to promote inclusive mainstream education is yet to be developed.

The Country Report reveals the policy challenges stemming from the analysis of macro-economic imbalances, namely:

· Hungary is still facing considerable external debt rollover needs, thus maintaining the confidence of foreign investors is of utmost importance. A number of anti-competitive measures over the recent years in the non-tradable sectors are weighing on the attractiveness of the country as business location.

· Normal lending flows to the economy have yet to be restored. Subsidised lending schemes cannot substitute a sound operating environment for banks. There is a lack of sufficient capital accumulation possibilities in financial intermediation and the adopted relief schemes were not targeted. State interventions in the banking sector via increased direct ownership, even for a temporary period, may entail significant fiscal risks.

· The increasing dominance of the Public Work Schemes poses a significant challenge for improving the efficiency of active labour market policies. This is all the more so in light of its limited positive effect on the employment chances of participants and its quadrupling budgetary cost over the last four years.

Other policy challenges are: The legislated medium-term budgetary framework is not yet implemented. Despite recent progress, there is still a significant scope to improve administrative efficiency in tax collection and to reduce tax evasion. Gaps remain in the efficiency and coverage of social assistance. The rigorous enforcement of the legislated conditions for law-making is still missing. There are shortages of skilled professionals in science and engineering and of the SME’s innovative capacities. Transitions between the stages of education are still weak and systemic measures to promote inclusive mainstream education, early school leaving prevention and wider access and completion of tertiary education have not been put in place. The adopted price cuts for household consumers in the energy sector have not been reviewed.

Macroeconomic developments

Hungary's economic growth has generally been weak since the start of the crisis, and growth accelerated significantly only since 2014. After the crisis, Hungary experienced a moderate recovery in 2010 and 2011 (0.8% and 1.8% respectively), before the country fell back into recession again in 2012 with a negative 1.5% GDP growth. In 2013, economic activity revived again with a moderate 1.5%. After five years of continuous decline, 2013 was the first year when gross fixed capital formation turned positive.

GDP has only reached the level of the pre-crisis period but lags behind regional peers. The Hungarian GDP is still below its 2008 level by about 1%, while Poland's and Slovakia's GDP far exceed the pre-crisis levels.

Graph 1.1: GDP in 2010 constant prices

Source: European Commission Note: * Data is based upon European Commission winter 2015 forecast

GDP picked up in 2014, and based on the Commission’s winter 2015 forecast it is projected to have accelerated to 3.3%. This is attributed to growing domestic demand with a significant contribution of gross fixed capital formation. The surge in growth (3.8% in the first half of 2014), however, was supported by temporary measures and factors, such as the stepped-up absorption of EU funds and the central bank’s Funding for Growth Scheme of subsidised loans to small- and medium-sized enterprises.

Economic activity has started to slow down slightly in the second half of 2014 and is expected to further decelerate until 2016. According to the Commission's 2015 winter forecast, economic growth is projected to stand at 2.4 % and 1.9 % in 2015 and 2016, respectively, reflecting the fading of the above mentioned time-bound stimulus measures. The flash estimate for 2014 annual growth is 3.5%, which increases somewhat the positive risks to the Commission’s projections.

Graph 1.2: External and domestic demand contributions to economic growth

Source: European Commission

Domestic demand is expected to remain the main driver of economic growth in the coming years, but with a shift from investment to private consumption. Due to measures easing the burden of mortgage loans on households (see below), real disposable income will be affected positively in 2015, and this would stimulate consumption (Graph 1.2). With the start of the new Multiannual Financial Framework period for EU structural and investment funds, the absorption of EU funds is expected not to be at full speed in 2016. The associated drop will have a visible impact on investment activity, particularly in the public sector, and as a result investment growth is projected to be negative in 2016. Export growth, which is set to decrease in 2015 due to lower demand from major trade partners, is expected to pick up again in 2016, while imports will remain stable fuelled by private consumption. Thus net exports will contribute moderately to growth in 2015, but more significantly in 2016.

Household final consumption expenditure could be boosted by expanding real disposable income. First, this is due to the adopted settlement scheme for household loans, which requires banks to compensate borrowers for unfairly applied terms (for details, see section 2.3). This elevates the consumption path by almost 1 pp. in 2015. Second, also linked to the reduced uncertainty concerning mortgage loans, the precautionary savings attitude of households is expected to start to gradually decrease. Finally, there is the effect of low inflation which increases the purchasing power of wages and pensions.

Inflation was on average around 5% until 2011, but has started to decrease rapidly since 2012. The fall in inflation was driven by regulated and utility price cuts. Inflation decelerated to -0.2% in 2014, which was also influenced by falling oil prices as well as by imported disinflation. Inflation expectations have adjusted downwards, but core inflation in 2014 remained in positive territory. With the weaker exchange rate passing through to prices, inflation is expected to increase gradually to reach the 3% target of the central bank by the end of 2016.

Graph 1.3: Headline inflation and core inflation

Source: MNB

LABOUR MARKET SITUATION

The number of employed rose to an all-time high and unemployment rate dropped to an all-time low in 2014. While employment has also recovered in the private sector with the economic uptake, this happened to a large extent on account of the expansion of the Public Work Scheme since 2011. Without the public works, the unemployment rate would be higher by at least 1.5 pps. Furthermore, it is foreseen in the medium-term budgetary plans that the size of the scheme will be further extended. It needs therefore a closer look to assess whether recent labour market developments, heavily influenced by the Public Work Scheme, can lead to a lasting improvement in Hungary's employment in the open labour market (see section 2.4).

Although both the employment rate and the activity rate are increasing, they are still low in international comparison. Activity is increasing rapidly, but still below the level of regional peers and by some 5 pps. below the EU average. At the same time, unemployment declined to the second lowest level among the Visegrád countries.

Despite the improvements in the labour market, all poverty indicators have shown a substantial and continuous deterioration since the start of the crisis. Specifically, the number of young people not in employment, education or training has been constantly increasing since 2010 and the number of people at risk of poverty or social exclusion has been increasing since 2009.

Budgetary developments and outlook

Following the exit from the Excessive Deficit Procedure in 2013, Hungary's general government deficit has been kept under control. In 2014, the headline deficit is projected in the Commission's 2015 winter forecast to reach 2.6% of GDP, compared to 2.4% of GDP in the previous year. The estimated deterioration in the structural balance is more significant (1.3 pps.) revealing the easing of the fiscal stance in the election year. The government deficit is projected to increase slightly further this year before decreasing to 2.5% of GDP in 2016. The structural balance is also forecast to improve moderately, but will remain well above the country's medium-term objective (i.e. -1.7% of GDP).

Government debt is expected to decrease only very moderately in the short term. The debt-to-GDP ratio is forecast to having increased by about 0.4 pp. in 2014 to 77.7% mainly on account of the weakening of the exchange rate. The debt reduction is expected to be rather contained in 2015 and relatively faster in 2016.

The high level of public debt is a source of fragility for the Hungarian economy. With the current level of the gross government debt-to-GDP ratio, the country occupies an outlier position within the group of low and middle income economies. This results in elevated risk premia containing investment and economic activity. Although the government debt has been declining since the beginning of the decade, it is not yet on a firmly decreasing path. It is therefore relevant to explore the medium-term prospects for debt reduction (see section 2.2).

Financial sector

Private sector indebtedness continued decreasing on the back of a persistent active deleveraging in the economy, which pace has slowed down recently. The balance sheet repair in the private sector has predominantly been driven by the continued contraction in private sector credit flows. Net lending flows to the private sector have improved recently, as the subsidized lending programmes provided some temporary relief in access to credit for firms, in particular for SMEs. However, the conditions of financial intermediation have not improved in a sustainable manner to restore normal lending.

The situation in the financial sector continues to raise concerns. Although the sector seems to be adequately capitalised (the aggregate capital adequacy was hovering around twice of the regulatory minimum of 9% in recent quarters) and its liquidity position is relatively strong, the combination of a high level of tax and regulatory burdens as well as a high share of problematic loans does not provide the right incentives for banks to increase their lending activity. The persistence of banks' negative profits represents a risk to financial stability, which was exacerbated by costs of the ongoing settlements with foreign-exchange borrowers and the new tightening regulatory steps. An analysis is therefore warranted on the main drivers of the deleveraging process and the related risks (see section 2.3).

External Balances

The external balance of the country is stable. The current account turned positive in 2010 and currently stands just above 4% of GDP. In the Commission’s 2015 winter forecast, it is expected to increase further, as the surplus in goods and services trade balance rises. The capital account surplus is projected to increase slightly in 2015 and to decline in 2016, reflecting the dynamics of EU funds absorption. Similarly, the net lending position will improve until 2015, but with reducing EU fund inflows, it is projected to decrease below 8% of GDP in 2016.

Graph 1.4: Net Lending/Borrowing by Sector

Source: European Commission

Private sector deleveraging has been mirrored in a surplus of the external balance, despite a weak export performance. Export market shares fell by a cumulative 19% between 2009 and 2013, the worst export performance in a regional comparison. Despite this negative development, the net lending/borrowing position of the whole economy was in surplus, driven mainly by the adjustment of the private sector resulting in a substantial decline in the investment rate.

(see section 2.1).

Medium-term economic outlook

Although somewhat improving, the growth potential of the country remains moderate. The weak growth potential mainly reflects a weak total factor productivity which in turn is linked to problems with financial intermediation as well as to the low level of innovation in the economy in general. Capital accumulation is also below the pre-crisis level. This is due to deleveraging (see section 2.3), but partly also stems from the perceived deterioration in the business environment. On the other hand, there have been some improvements in the contribution of labour to potential growth, which is linked to structural reforms (see section 2.4 for details). Looking ahead, the growth potential of the country is estimated at 1.8% on average between 2014 and 2016 according to the Commission's winter forecast, but it is projected to decline to 1.5% in the medium term. In an international comparison, Hungary is lagging behind regional peers in terms of potential growth. Hungary's potential growth is significantly below that of Poland (3.1%) and Slovakia (2.5%), while it is somewhat higher than in the case of the Czech Republic (1.2%).

There is a lack of appropriate economic policies to address Hungary's relatively low grow potential. Normal lending in the economy is not yet restored due to a high regulatory and tax burden on the financial sector and the continued need for portfolio cleaning. In addition, the Hungarian tax system faces several challenges both in terms of design and governance. The increased reliance on sector-specific taxes in recent years may have exacerbated the productivity problems. The introduction of additional restrictions to entry in certain service sectors also hamper an efficient allocation of economic resources and increase uncertainty for investors. The unstable regulatory framework coupled with a lack of transparency in decision-making procedures and inadequate stakeholder consultations are negatively affecting the business environment. Moreover, the education system appears to have a low ability to tackle the substantial disparity in the employment opportunities of high and low-skilled workers through increasing the education attainment.

Graph 1.5: Potential output growth

Source: European Commission

Box 1.1 summarises trade and energy linkages between Hungary and Russia. Regarding foreign direct investment, Hungary's exposure is not large, but one bank is substantially affected by the Russian crisis. The direct trade effect of the Russian crisis is also not significant, but together with indirect trade effects there is a small negative effect on GDP. The energy (oil and gas) exposure on the other hand is relatively large.

Box 1.1: Trade linkages and energy tie of Hungary to Russia FDI from Russia to Hungary is negligible, while Hungarian FDI outflows to Russia are also not significant, namely around 0.6% of GDP. Nevertheless, most of this FDI is related to one company, Hungary's largest commercial bank, OTP. OTP's exposure to Russia is around 3% of GDP. The bank has a very high capital adequacy ratio at 20% as well as high loan loss coverage in the Russian markets (around 100% in Russia). While the intensification of the Russian crisis could have a significant effect on its capital position, the bank’s excess capital is above the regulatory requirement (at around 2.8% of GDP) and is close to its total exposure to Russia. This being said, OTP does not have a large parent bank behind it and its total size of assets stand around one third of Hungarian GDP. Therefore, its exposure could be an important vulnerability. As regards trade channels, the share of exports to Russia is around 4½ % of total exports (2.9% in goods and 1.3% in services, 2013 data) while the share of imports from Russia in total imports is around 9½% (9% in goods and 1.3% in services, 2013 data,). As regards the product structure of imports, Hungary is most exposed to Russia in terms of energy supply. The share of Russian gas in the country's natural total consumption is 64.5%, the share of Russian oil in total oil gross inland consumption is 91.3% (indirectly through Ukraine) and the share of Russian coal in total coal gross inland consumption is 3.1%. Current storage levels could mitigate the effects of such disruptions albeit just temporarily as they would cover supply needs for more than two months in case of natural gas, and for around 100 days in case of crude oil. Other sources of supply are deemed to be extremely difficult to find in the short to medium term, especially with regard to gas. In fact, the pipelines connecting Hungary to Western Europe (through the Austrian exchange and the new Slovak one, which is not yet operational) could not ensure a sufficient level of provision given the current demand. Moreover, the Southstream project was officially abandoned in December 2014. Alternative solutions are currently being investigated. Although in the first half of 2014 exports to Russia and Ukraine declined by 20% and 10% year-on-year, respectively, GDP was a strong (3.8% year-o-year during this period and export volumes also performed well with a 7.2% growth. Overall, the Russian slowdown has not affected visibly the Hungarian economy yet. While the confidence channel effect is more prominent (the decline in stock prices affects both investment – user cost channel – and consumption – wealth effect) and has a negative GDP growth effect of less than 0.1 pp in 2014 and 0.3 pp in 2015. Hungary’s trade comes mostly from countries that have relatively strong trade linkages with Russia (Germany, Austria and Central and Eastern European Countries). Finally, the indirect effects (the effects of the Russian crisis on Hungary's major trade partners) are forecast to have a further negative growth effect of 0.1 pp for both 2014 and 2015. Overall, according to most recent calculations of the Commission services', the negative impact of the Russian crisis on Hungary's GDP growth is estimated at 0.2 pp. in 2014 and is expected to be around 0.4 pp. in 2015. The devaluation of the RUB against the HUF (and against the EUR) reduces export revenues for the concerned Hungarian firms, which affects profits, investments and thus GDP. Several Hungarian companies have a large exposure to Russia. In terms of exports, the pharmaceutical industry has a very significant share of revenues (around 30%) from Russia (revenues totalling around 0.4% of GDP).

Box 1.2: Economic surveillance process The Commission’s Annual Growth Survey, adopted in November 2014, started the 2015 European Semester, proposing that the EU pursue an integrated approach to economic policy built around three main pillars: boosting investment, accelerating structural reforms and pursuing responsible growth-friendly fiscal consolidation. The Annual Growth Survey also presented the process of streamlining the European Semester to increase the effectiveness of economic policy coordination at the EU level through greater accountability and by encouraging greater ownership by all actors. In line with streamlining efforts this Country Report includes an In-Depth Review — as per Article 5 of Regulation no. 1176/2011 — to determine whether macroeconomic imbalances still exist, as announced in the Commission’s Alert Mechanism Report published on November 2014. Based on the 2014 In-Depth Review for Hungary published in March 2014, the Commission concluded that Hungary was experiencing macroeconomic imbalances, which require monitoring and decisive policy action, in particular, the ongoing adjustment of the highly negative net international position, the high level of public and private debt in the context of a fragile financial sector and deteriorating export performance continue to deserve very close attention. This Country Report includes an assessment of progress towards the implementation of the 2014 Country-Specific Recommendations adopted by the Council in July 2014. The Country-Specific Recommendations for Hungary concerned public finances and taxation, financial sector, labour market, education, business environment and network industries.

Table 1.1: Key economic, financial and social indicators

(1) Domestic banking groups and stand-alone banks. (2) Domestic banking groups and stand-alone banks, foreign-controlled (EU and non-EU) subsidiaries and branches. (3) Real effective exchange rate (*) Indicates BPM5 and/or ESA95 Source: European Commission, 2015 winter forecast; ECB

Table 1.2: The MIP scoreboard

Flags: na: not available. Note: Figures highlighted are the ones falling outside the threshold established by EC Alert Mechanism Report. For REER and ULC, the second threshold concerns non-Euro Area Member States. (1) Figures in italic are according to the old standards (ESA95/BPM5). (2) Export market shares data: the total world export is based on the 5th edition of the Balance of Payments Manual (BPM5). (3) Unemployment rate: i=Eurostat backcalculation to include Population Census 2011 results. Source: European Commission

Although the current and capital accounts have repeatedly recorded historically high surpluses, the stock of net external liabilities at above -80% of GDP continues to be in risky territory. The rapid decrease in the Net International Investment Position since 2009 has led to a notable correction in the severity of the related risks. The robust net lending position of around +8% of GDP in both 2013 and 2014 was supported by all external balance components, including the recently improving export performance. The drivers of this development and its durability are analysed in more detail in this section. Finally, a short discussion is warranted on the recent slowdown in foreign direct investment inflows, as the composition of debt-creating and non-debt creating elements on the financing side has important economic implications.

Adjustment in external indebtedness

Since peaking at -116% of GDP in 2009, the overall improvement in the Net International Investment Position has been above 30 percentage points, reflecting the increasing current and capital account surpluses. The degree of the adjustment in the external balances reflects a level of rebalancing similar to that seen in the vulnerable euro area countries. At the same time, Hungary’s regional peers (Visegrád countries) typically recorded improvements of much smaller magnitude (a couple of percentage points) over the last five years, their net lending positions are still being in deficit or showing a small surplus. Nevertheless, the significant reduction in external imbalances had up until 2012 been mainly driven by the compression of imports. The country’s export performance clearly underperformed that of its regional peers, as demonstrated by the large accumulated losses in export market shares (see the detailed comparative analysis in the 2014 In-Depth Review). From a sectoral point of view, some two-thirds of the total change is attributable to the financial sector, and the remaining one-third to the private sector, with both the household and corporate sectors increasing their savings rates (while the net position of the central bank and the general government remained broadly unchanged).

The rapid improvement in the Net International Investment Position has continued in 2013 by some 10 pps to -84% of GDP on account of declining external debt. Net external debt has declined from close to 70% of GDP in 2012 to around 58% by end-2013. The recent improvements came in spite of some negative effects from valuation changes in both 2012 and 2013, when the exchange rate remained relatively stable. This may turn out to be an even more important factor as the recent waves of forint depreciation may suggest a risk of prolonged weakness with the national currency. The stabilisation of this robust net lending position seen in recent quarters occurred despite a substantial pick-up in investment (which grew at 16.8% year-on-year in the first half of 2014). This suggests that the external balance surplus is also a result of improving export performance.

Graph 2.1.1: Components of Net International Investment Position

(1) Reserve assets excluded, * indicates estimated figure using quarterly data Source: European Commission

Based on current information, the Net International Investment Position is anticipated to improve further markedly in the coming period. By mid-2014, it declined further to around 82% of GDP. Regarding 2015 and 2016, the surplus projections for both the current and capital accounts contained in the Commission’s 2015 winter forecast, ceteris paribus, would imply a further steep reduction in the Net International Investment Position to below 70% of GDP by the end of 2016. ([1]) Looking further ahead, the illustrative medium-term scenarios modelled by the Commission show that Hungary would need to achieve a current account surplus of only 1.5% of GDP on average over the next 10 years in order to halve its negative Net International Investment Position by 2024 (to around -42% of GDP). Based on the government plans regarding the potential EU structural fund inflows in the present and forthcoming multiannual financial frameworks, the capital account could plausibly be projected to show a surplus in the magnitude of at least 2% of GDP in the coming decade. Taking into account this additional positive factor, the current account could be in a slight deficit of around 0.5% of GDP, yet the Net International Investment Position ratio could still be halved.

All components of the current account have generally been constantly improving since 2008, leading to a historically high surplus of slightly over 4% of GDP in 2013. Both the goods and services sub-balances have recorded significant surpluses, the former despite the fact that Hungary repeatedly had one of the highest trade deficits of energy products in the EU (consistently more negative than –6% of GDP over recent years). In addition, the structurally high primary income deficit (reflecting the accumulated large foreign direct investment stock) has been progressively curbed throughout the recent period. While the balance of factor incomes registered massive deficits of more than 6% of GDP prior to the crisis, more recently, it has been on a downward path falling to below -3% of GDP. This is chiefly due to the remittances of the rapidly increasing number of Hungarian frontier workers. ([2]) In addition, the recent decreases in debt service payments (reflecting the fall in both interest rates and external indebtedness) also lowered the deficit.

Graph 2.1.2: Components of the external position (current and capital accounts)

* indicates estimated figure using quarterly data. Source: European Commission

Financial flows from the EU made an increasing contribution to the current account surpluses as well as to improvements in the net external financing capacity. Current EU transfers (primarily direct agricultural payments) improved the current account by close to 2% of GDP in recent years, while EU structural fund flows financing predominantly investment activities (registered in the capital account) followed a constant increase after the EU entry in 2004 to the magnitude of 2% of GDP in 2010 and rising further to over 3.5% of GDP in 2013. The recently observed levels of EU inflows are expected to be at least maintained in 2015, with some scheduled declines in subsequent years. Overall, financial relations with the EU progressively contributed to the increase in the country’s net lending.

Despite the recent large adjustments, the negative Net International Investment Position and the associated relatively high rollover needs continue to represent a source of vulnerability for the economy. Looking forward, sustainability calculations suggest there will be further significant improvements, even if the size of EU fund inflows will be moderating. Nevertheless, the country is still facing considerable external rollover needs (close to a yearly 25% of GDP), which underlines the importance of maintaining the confidence of foreign investors.

Drivers of trade performance

Following the uninterrupted fall in export market shares between 2009 and 2012, the deterioration was broadly halted in 2013. The five-year loss in export market shares experienced by Hungary (-19.2% in 2013) was much more substantial than that of its regional peers (Czech Republic: -7.7%, Poland: -0.4%; Slovakia: -2.2%), while other new Member States (Baltic countries, Bulgaria, and Romania) have all recorded positive figures, often large increases). The moderate turnaround (year-on-year growth of 4.1% in 2013) in the export market share has chiefly been driven by increased production capacity in the automobile industry, which, according to the companies’ reports, could have added to exports 2 to 4 percentage points in recent years. Based on the Commission’s 2015 winter forecast, the export market share is expected to continue improving over the period to 2016.

The loss of export market shares occurred despite slightly improving cost competitiveness since the crisis. Growth in nominal unit labour costs remained under control. Despite a 19% hike in the minimum wage in January 2012 with some spill-over effects on the whole wage structure, the year-on-year unit labour costs growth was limited to 3.5%). The adjustment in the real effective exchange rate had originally been driven by the nominal depreciation of the forint and was subsequently supported by successive moderate declines in real compensation per employee. Indeed, based on updated estimates using the Commission's fundamental exchange rate equilibrium method ([3]), the real effective exchange rate for 2012 appeared to be somewhat undervalued (by roughly 3.7-5.6%). In this context, it is worth highlighting that the expected positive effects of the real effective exchange rate depreciation are likely to have been attenuated by a number of factors. First, given the high volume of foreign currency debt in the corporate sector ([4]), improvements in price competitiveness could well have been offset by a deterioration in firms’ balance sheet position. Second, the import share of Hungarian exports is traditionally one of the highest in the EU (hovering around 45% over the last 15 years ([5])), implying that the impact of the exchange rate on exports is proportionally limited.

Graph 2.1.3: Evolution of Hungary's export market share (year-on-year)

Source: European Commission

The large cumulative losses in export market shares could therefore be attributed to deteriorating non-cost competitiveness factors. The traditional resilience of the Hungarian export sector has to a large extent been predicated on the very significant share of high-technology goods. Its share in total exports was hovering over 20% over the decade 2000-10, but has started to gradually decline since 2009 and reached around 16% in 2013. This is still the highest ratio among new Member States, but nevertheless represents some quality shift in the export structure. Furthermore, Vandenbussche (2014) ([6]) found in an empirical study that Hungary displays a ‘bimodal’ quality distribution in the structure of its export products. This specialisation pattern is characterised by two peaks in the distribution: one in low, and one in the high quality products, with relatively few goods in the middle field. Low quality products are increasingly facing tough price competition from emerging markets, in particular from China. The study referred to above also found that quality upgrades between 2007 and 2011 showed an overall slow dynamics in the Visegrád countries (including Hungary, unlike in the Baltic states for example), which left a considerable part of their exports exposed to cost competition.

Looking ahead, the durability of the record high trade surpluses in the medium term may not be guaranteed. Starting from a level slightly above zero prior to the crisis, the trade surplus had surged to close to 8% of GDP by 2013. Concerning the overall values, service exports are much lower (some one-fifth) than the country’s exports of goods, but the two factors’ respective contributions to the increased surplus were broadly even in recent years. The question that naturally arises is to what extent the adjustment could be considered permanent, or at what level the trade balance will be when the temporary factors (such as the subdued domestic demand) peter out. In this context, it is worth recalling that according to the calculations by Halpern-Oblath (2014) ([7]), based on Hungary’s trade openness, its relative economic development (as measured by its GDP per capita in purchasing power parity terms) and the valuation of the local currency, the high surplus level in 2013 cannot be explained by the country’s fundamentals. At the same time, some recent factors may delay the expected moderation of the trade surplus. First, Hungary is set to enjoy a sizeable terms-of-trade improvement due to the substantial fall in the oil price. Second, some of the recent large-scale investments in the automotive industry are still in the maturation phase, and industrial production and exports will therefore further boosted in 2015 and potentially even in 2016.

Recent investment trends may suggest some deterioration in the services trade balance in the coming period. The investment-to-GDP ratio has stayed below 20% in the 2011-2013 period, compared to its level of 23%-24% seen prior to the crisis. This being said, the 2014 surge in investment as projected in the Commission’s forecast should correct some of this erosion. In parallel to this overall decline, there was a significant change in the composition of investment activity over the last five years: the relative share of manufacturing and public investments increased, largely at the expense of real estate activities, but the share of market services also declined (e.g. wholesale and retail trade, transportation and storage, accommodation, information and communication). Given the significant role played by these internationally ‘tradable services’ in recent trade surpluses, the continuation of these trends may impact the country’s external lending position both directly (through reduced trade in services) and indirectly (through a smaller net balance of tourism).

Despite Hungary’s recent high trade surpluses, and the improved cost competitiveness, the turnaround in its export performance is not yet ensured. Further integration of domestic companies into global supply chains would be conducive to increasing the domestic value-added as well as potentially making more resilient the product structure of exports. In previous years, repeated interventions by the government in the functioning of certain service sectors, typically by increasing restrictions to entry, and the unpredictability of these actions have led to greater uncertainty for investors.

Foreign direct investments

The continued sluggishness of foreign direct investments in Hungary is a source of concern. Attracting foreign direct investment has traditionally been treated as an important means of structural upgrading, technology transfer and productivity growth in the new Member States. For the Central and Eastern European region, annual net foreign direct investment flows are considerably smaller than prior to the crisis, reflecting a wider European trend. Nonetheless, the decrease appears to be slightly more pronounced in Hungary than for other new Member States, in particular over recent quarters (see Graph 2.1.4, which shows statistics including special purpose entities as these are the internationally comparable data).

Graph 2.1.4: Net foreign direct investment in the region (% of GDP)

Source: European Commission Calculation

Annual net foreign direct investment flows ([8]) have been on generally decreasing trend since Hungary’s accession to the EU ten years ago. Numerous one-off factors have featured over recent years, which could substantially distort the assessment of foreign direct investment. Specifically, it may be worth filtering out two factors to better capture the ‘genuine’ foreign direct investment transactions by non-resident corporations: (i) the continuous wave of capital injections by parent banks to offset the capital shortfall resulting from losses in their Hungarian subsidiaries (see also the discussion in section 2.3); (ii) large-scale corporate acquisitions by the state (2011: MOL, 2013: E.On). MNB ([9]) estimated the underlying trend (adjusted for the above-mentioned significant one-off impacts) in net foreign direct investment flows at an annual average of around EUR 0.5-1 billion between 2010 and 2013. An important explanatory factor for the low average is the decrease in reinvested earnings: in a subsequent central bank report ([10]), the average ratio for reinvested profits was reported to be ca. 40% prior to the crisis, while the corresponding average for the 2009-13 period is less than 20%. On a positive note, while in 2009-10, dividend payments even exceeded total profits of foreign-owned firms (as presumably many parent companies used the retained earnings of subsidiaries to tackle their liquidity needs), the situation has been improving since 2011.

Graph 2.1.5: Foreign direct investment flows in Hungary (% of GDP)

(1) The data series are excluding SPEs Source: MNB

Statistics focusing on greenfield foreign direct investment investments also suggest a deteriorating attractiveness. Total foreign direct investment inflows as reported in the balance-of-payment statistics may overestimate the related boosting effects as flows corresponding to the acquisition of existing facilities are also included. It is therefore useful to analyse a dataset showing only greenfield investments, i.e. only those projects where a company establishes or expands its manufacturing base, service function, or extraction operation. This is important as greenfield projects, by definition, increase the host country’s production capacity, thereby exerting a positive impact on economic growth, whereas this is not necessarily the case for mergers and acquisitions. Greenfield foreign direct investments show a clear deceleration in the aftermath of the crisis (see Graph 2.1.6), which is reflected in their decreasing role in private sector employment creation: while between 2004 and 2007, they accounted for at least 40 000 new jobs each year, this decreased to around 10 000 recently.

Graph 2.1.6: Greenfield foreign direct investment inflows into Hungary (2003-2014)

(1) Data for 2014 covers the January - August period. Source: Financial Times FDImarkets database

The underlying foreign direct investment flows have recently even recorded negative figures. The last available reading for the net foreign direct investment figure between Q4-2013 – Q3-2014 is EUR 0.5 billion, but if parent bank recapitalisations are deducted, the resulting figure is some EUR -1 billion. Furthermore, the observed outflow from non-financial corporations is not concentrated, but spread across a wide range of industries, including machinery, trade and communications. The recently concluded series of strategic partnership agreements ([11]) do not appear to have been able to reverse the negative trend.

The slowdown observed in net foreign direct investment flows, including greenfield investments, in particular over recent quarters, may be linked to a number of measures with potential detrimental impacts on the business environment. Specifically, the introduction of new barriers in previously open markets and the increased reliance on sector-specific taxation might have detracted from the overall attractiveness of the Hungarian economy. Moreover, the regulatory framework suffers from the lack of both systematic stakeholder consultations and evidence-based impact assessments (see the discussion on business environment in section 3.4). Accordingly, among the Visegrád countries, OECD Product Market Regulation indicators show Hungary as having the highest legal barriers to entry. In addition, recent international competitiveness surveys (e.g. World Economic Forum) rank the country as having the least transparent policy-making in its Visegrád peer group.

At somewhat below 80% of GDP, Hungary's general government debt is an important remaining vulnerability of the economy. Hungary's public debt is below the EU average, but is significantly higher than that of its regional peers ([12]) and exceeds the level which would be in line with the country's economic development ([13]). Although decreasing, Hungary's short-term sovereign financing needs are still among the highest within the group of emerging and middle income economies. The strong dependency on external sources is a further factor contributing to the high exposure of the economy to risks related to government debt. After reviewing the origins of high public indebtedness, this section examines the prospects for reducing government debt. The surplus of the primary government balance (maintained since 2012) ensures a precondition for debt-reduction and the required further improvement could be facilitated by expected savings is age-related costs. The country's low growth potential, however, could hamper the decline of government debt and remains a source of fragility. Moreover, foreseeable budgetary risks may prevent the improvement of the primary balance. The impacts of these driving forces and risk factors are assessed on the basis medium-term debt projections.

Historic developments and short-term outlook for government debt

The current high level of Hungary's government debt is the result of lax fiscal policies in the last decade exacerbated by the impact of the subsequent financial and economic crisis. Hungary saw a rapid increase in its government debt ratio during the last decade. From a level of 51.9% in 2001, it rose by almost 30 pps., to reach around 81% over ten years (see Graph 2.2.1). In the pre-crisis years, this was driven by accumulating primary deficits (which reached an annual average of 3½% of GDP between 2002 and 2007; see Graph 2.2.2). At the same time, both the "snowball" effect ([14]) and stock-flow adjustments overall were able to contain the dynamics of rising public indebtedness thanks to a relatively high growth and the still significant receipts from privatisation. The outbreak of the financial crisis brought a turnaround in this situation. The primary deficit was practically eliminated as a result of fiscal consolidation efforts, including measures implemented under the EU-IMF financial assistance programme for Hungary. But the fall in output generated a large debt-increasing effect. Moreover, stock-flow adjustments made a contribution of a similar magnitude to the rising debt levels. This occurred mainly because of a sharp increase in state cash deposits ([15]), but also as a consequence of the depreciation of the forint.

Graph 2.2.1: Gross government debt ratio: historic data and short-term projection

(1) Figures for 2014-2016 refer to the European Commission 2015 Winter Forecast. Source: European Commission

Graph 2.2.2: Composition of the annual change in gross government debt

Source: European Commission Calculation

The government debt ratio has been falling since the start of the current decade and is expected to continue decreasing moderately in the short term, but it is not on a firm decreasing path yet. Between 2011 and 2013, the debt ratio was reduced by 3.6 pps., but this mainly was the result of a one-off effect generated by stock-flow adjustments. The debt-decreasing impact of the significantly improving primary balance was more than offset by the joint effect of low growth and relatively high financing costs. The debt reduction was therefore achieved thanks to the sizeable capital transfer (amounting altogether to 10% of GDP) that resulted from the state's takeover of mandatory second-pillar private pension assets during the same period. ([16])

With the fading effect of the pension asset transfer, the European Commission 2015 winter forecast projects a slowing down in the speed of debt reduction. Over the short-term horizon of 2014-16, the debt ratio is expected to decrease by only 1.2% of GDP. The reduction of the debt level is expected to be contained by adverse stock-flow adjustment effects, which may even result in a slight increase of the debt ratio in 2014 ([17]). At the same time, the primary balance, although deteriorating slightly, would already set the pace for debt reduction. This is because the snowball effect (i.e. the effect of interest rates on government debt and GDP growth), would not counteract its impact noticeably in the short term thanks to economic recovery. However, the macroeconomic drivers of debt dynamics are expected to change adversely for Hungary in future years as the economy reverts to its relatively low growth potential and sovereign yields start to rise again from their current historically low levels. This implies that the primary balance would need to be improved in the medium term to ensure that the government debt continues to decrease sufficiently, unless the growth potential of the country can be increased. This issue is explored on the basis of a medium-term debt projection analysis.

Medium-term debt projections

The medium-term debt projection for Hungary was performed with the help of the European Commission’s debt sustainability analysis framework. Crucially, the Commission’s baseline scenario discussed below is based on assumptions of long-run convergence of the main macroeconomic variables ([18]). The projection relies also on the assumption of constant fiscal policy (i.e. the underlying structural primary balance is set at the value of the last year for which a short-term forecast is available – 1.3% of GDP in 2016), and incorporates the effect on the fiscal balance of the changes projected in ageing costs (i.e. demography-sensitive public expenditures, like pensions, healthcare and long-term care) based on the Commission's most recent report on ageing.

Graph 2.2.3: Gross government debt ratio: the baseline scenario

Source: European Commission Calculation

The Commission’s baseline scenario projects a debt trajectory for Hungary that declines steadily in the medium term, primarily as a result of the projected decrease of ageing costs (see Graph 2.2.3). Along the baseline, the debt-to-GDP ratio is expected to decrease – at an accelerating rate during the next decade – from about 76% in 2016 to below 62% by 2025 (i.e. an overall decrease of 15 pps. equivalent to an average annual rate of 1.6 pps.). This improvement is largely driven by savings in age-related costs, which account for about two-thirds of the total estimated reduction ([19]). If, however, the primary balance was not to improve beyond the level forecast for 2016 (i.e. in the absence of the projected savings in age-related costs), Hungary’s debt ratio would likely decrease rather very slowly, remaining above 70% by the end of the examined 10-year period, under the given macroeconomic assumptions. On the other hand, the projected savings in ageing costs cannot secure a steadily declining path with the debt-to-GDP ratio essentially remaining stagnant, if the structural primary balance was to revert to its historical average (-0.5% of GDP vs. 1.3% for the baseline) as it is assumed under the historical structural primary balance scenario. This highlights the importance to sustain fiscal consolidation efforts.

The projected fall in ageing costs, which would facilitate the reduction of debt, reflects to a large extent the effect of parametric pension reforms. Most of the projected savings in demography-sensitive public expenditure incorporated in the baseline scenario (around 90%) will arise from the reduced level of spending on public pensions. The costs of financing public pensions will fall in Hungary despite a steadily ageing population ([20]). This demonstrates the effect of successive parametric reform measures, adopted in part under the EU-IMF financial assistance programme, with the aim of reducing pension expenditure from a relatively high level in an international comparison. These measures limit both the level of benefits and the number of recipients over the projection period. ([21]) However, studies on the Hungarian pension system raise concerns regarding the future adequacy of retirement benefits as the number of elderly people without a sufficient contribution record to earn at least a modest pension is expected to increase considerably.([22]) To tackle old-age poverty effectively, additional spending might thus be needed potentially leading to lower-than-projected savings in ageing-costs.

Table 2.2.1: The examined fiscal policy-risk scenarios

Source: European Commission Calculation

Hungary's debt reduction path is surrounded by considerable budgetary risks. In order to better evaluate these risks, the debt sustainability analysis framework was extended, by adding alternative scenarios that included assumptions on potential adverse fiscal policy developments. The following plausible policy-risk scenarios were examined (for the corresponding assumptions see Table 2.2.1): (i) the state acquisition scenario reflects the government’s revealed preference for extending state ownership (in particular in the energy, banking and public utility sectors); (ii) the wage compensation scenario reflects the accumulating wage pressures in the government sector (with the majority of public employees' salaries having been nominally frozen since 2008) and the wage compensation schemes that are already implemented or are planned to be introduced in certain sub-sectors. It is therefore assumed that the public wage bill would gradually revert back to its historical average; (iii) the Paks II nuclear power plant construction scenario models the impact of a large scale investment project on government debt. The estimated total costs of the project is EUR 12.5 billion, and it is planned to be implemented under an inter-governmental contract already signed with Russia ([23]); and (iv) the combined policy-risk scenario incorporates simultaneously all the above mentioned effects on the government debt trajectory.

Graph 2.2.4: Gross government debt ratio: state acquisition and wage compensation scenarios

Source: European Commission Calculation

Graph 2.2.5: Gross government debt ratio: the Paks II and the combined policy scenarios

Source: European Commission Calculation

The budgetary risk scenarios examined would counteract to a considerable extent the effect of favourable age-related cost-savings on government debt. The state acquisition scenario would absorb about a fifth of the total debt-reduction projected in the baseline with a contained decrease of government debt during the second half of this decade, while the salary increases in the wage compensation scenario would negate a quarter of the reduction (see Graph 2.2.4). The impact of the planned nuclear power plant construction on public debt (as simulated under the Paks II scenario) is more substantial, equivalent to more than a half of the debt reduction achieved in the baseline (see Graph 2.2.5). The debt trajectory would flatten out and even slightly increase when the construction begins, before the effect of the declining ageing costs and the moderately improving economic growth eventually prevail, and the government debt ratio would remain close to 70% in the completion year (i.e. 8 pps. above the projected end-point of the baseline scenario). Allowing the combined impacts of the examined adverse fiscal policy developments, the government debt would start to increase again resulting in a full crowding-out effect vis-à-vis the baseline scenario. In sum, budgetary risks could significantly alter the favourable outlook for debt reduction indicated by the baseline projection ([24]).

Graph 2.2.6: Gross government debt ratio: sensitivity to macroeconomic variables

Source: European Commission Calculation

Graph 2.2.7: The share of FX denominated government debt and the effect of previous exchange rate changes on the gross debt ratio

(1) The series showing the proportion of foreign currency debt uses annual averages. (2) The revaluation effect shows the component of stock-flow adjustment that affects the debt ratio, as a result of exchange rate changes. Source: MNB, Central Statistical Office of Hungary

The debt trajectory projected for Hungary displays a relatively high sensitivity to macroeconomic shocks. This is particularly the case for potential exchange rate movements due to a high proportion of foreign currency-denominated government liabilities (currently at around 40%; see Graphs 2.2.6 and 2.2.7). Since the beginning of the crisis, exchange rate developments have overall generated a debt-increasing impact equivalent to almost 8% of GDP. Assuming a shock – unfolding during 2015 and 2016 – identical to the maximum historical change seen in the exchange rate in recent years (i.e. the depreciation episode in 2011), the debt ratio would immediately rise above 80%, and within ten years, would reach a level that deviates from the baseline by around 5 pps. Given this, the Hungarian government's plan to reduce the proportion of its debt held in foreign currency – potentially close to the pre-crisis level of about 30% – via the central bank's self-financing programme would limit the risk exposure of government debt. ([25]) Turning to sensitivity tests for the other macroeconomic drivers, a permanent +1 pp. increase in interest rates (on newly issued and rolled over debt) is estimated to raise government debt over the projection horizon by about 4% of GDP. On the other hand, an increase of the real growth rate (or inflation) of +0.5 pp. would have a cumulative debt-reduction effect of a similar magnitude (or a symmetric debt-increasing effect for an equivalent shock with a negative sign). The likelihood of unfavourable scenarios in which a combination of adverse macroeconomic shocks would affect the debt trajectory can be investigated using stochastic debt simulations.

Graph 2.2.8: Stochastic debt projections, 2015-19

Source: European Commission Calculation

Simulations reveal that the government debt reduction path is not robust enough to show resilience against adverse shocks. In the medium-term baseline scenario, government debt is expected to decline gradually to 73% of GDP by 2019. Stochastic debt simulations based on historical macroeconomic shocks to the interest rate, the exchange rate, GDP and inflation indicate, however, that there is about a 40% probability that debt will exceed 77% of GDP by 2019 (see Graph 2.2.8). This implies that there is a 40% chance of the debt trajectory remaining flat or reverting to an increasing path.

Graph 2.2.9: Fiscal policy-risks scenarios compared with the debt-reduction benchmark set by the one-twentieth rule

(1) The figures show the difference between the level of debt dictated by the backward looking debt-reduction benchmark and the projected debt ratio. A negative value indicates an insufficient debt-reduction on this account. Source: European Commission Calculation

Hungary's public debt sustainability analysis highlights the need to sustain fiscal consolidation and to pursue growth-friendly economic policies. The above discussion allows to draw a number of conclusions on the prospects for the reduction the country's high indebtedness. First, the Commission's baseline scenario projects a steadily declining public debt ratio primarily due to the impact of successive pension reforms. On this basis, a considerable progress towards the threshold value could be expected. Second, the generally favourable medium-term outlook indicated by the baseline scenario is nevertheless subject to significant negative risks. Adverse fiscal policy developments reflecting plausible assumptions could prevent the achievement of a sufficiently declining path. Moreover, Hungary's debt trajectory remains highly fragile against adverse macroeconomic shocks. Third, the analysis also underlines the importance of maintaining the commitment to fiscal consolidation. With a government deficit stuck at its current level, Hungary's public debt would not be placed on a firmly decreasing path. Thus to the extent that the projected savings in age-related costs would be absorbed by budgetary policies, the need for further consolidation efforts would reoccur: this is also revealed by the assessment of the policy-risk scenarios against the criterion of the one-twentieth rule (i.e. the debt reduction benchmark laid down in the Stability and Growth Pact; see Graph 2.2.9). Finally, an improvement in the country's currently low growth potential would ensure a more robust debt-reduction path. The debt trajectory would also benefit then from the positive feedback effect of decreasing financial costs.

Private sector deleveraging has continued in a difficult context characterised by a high regulatory burden on the sector and a high level of non-performing loans. The fall in the loan-to-deposit ratio has to a large extent been necessary to correct accumulated imbalances and repair balance sheets, most notably in the household sector. Nevertheless, the pace and the channels through which the deleveraging pressures materialised were heavily influenced by financial sector policies, although subsidised lending schemes and a pick-up in growth from mid-2013 reduced the speed of deleveraging. This section analyses the main drivers of the deleveraging process and the related risks for the financial sector, also in the context of ongoing policy measures (most notably settlements with borrowers and de facto mandatory conversion of foreign exchange denominated mortgage loans). These issues are all the more important as the comparatively weak growth potential of the country may be linked to financial deleveraging through a number of channels.

Private sector debt and lending flows

Private sector indebtedness continued decreasing rapidly on the back of a persistent fall in credit in the economy. Private sector debt (in consolidated terms) stood at 95% of GDP in 2013 ([26]), which marks an improvement of some 20 pps. over the last two years. The recent adjustments were predominantly driven by the continued contraction in private sector credit flows, both in the household and the corporate sector. This ‘active deleveraging’ was in an accelerating phase until 2012, but thereafter slowed down markedly to -1% in 2013. Credit dynamics were shaped by a combination of a high level of non-performing loans, a high regulatory burden on the financial sector and continuous decline in house prices.

Graph 2.3.1: Decomposition of private sector debt

Source: European Commission

Graph 2.3.2: Decomposition of credit flows

Source: European Commission

Despite some temporary rebounds in corporate net lending flows thanks to the Funding for Growth Scheme, market-based lending is still not improving. The crisis hit the SMEs more severely than larger corporates, which were able to access financing more easily through the use of trade finance and intercompany loans, but were prevented from taking on further debt due to elevated uncertainty. Net corporate lending flows moved to slightly positive territory in some recent quarters, mainly on account of the Funding for Growth Scheme), which grants banks zero cost financing that they can then lend on to SMEs at a capped interest rate margin of 2.5%. Non-subsidised lending failed to rebound ([27]), despite the fact that successive base rate cuts brought about a 5 pps decline in the interest rate of new loans issued in forints.

Graph 2.3.3: Change in corporate loans in international comparison (annual transaction-based growth rates)

(1) Club Med contains Greece, Italy, Portugal and Spain, Baltic states contains Estonia, Latvia and Lithuania Source: MNB

The Funding for Growth Scheme has brought some relief for corporate credits. In the first phase of the scheme, a total of HUF 701 bn were utilised in 2013, out of which ca. 40% (HUF 290 bn, or 1 % of GDP) was recorded as new credit; the rest was used to refinance debt. Subsequently, the Funding for Growth Scheme was expanded to a maximum additional size of HUF 2000 bn (i.e. around 9% of GDP together with the first phase), running until end-2015 (the Monetary Council extended the original deadline of end-2014 by one year in September 2014). Half of the total allotment (HUF 1000 bn) was opened up in the standard part of the second phase to date, where only 10 % of loans could be used for refinancing. There were successive adjustments throughout 2014 in the modalities of the scheme to broaden its coverage as well as to increase the lending limits. The total value of contracts submitted to the central bank during the second phase reached around HUF 600 bn (2% of GDP) by the end of January 2015. Some 80% of these loans have already been disbursed and slightly over 60% serve investment purposes. On 18 February, the central bank announced the launch of a new sub-scheme with a HUF 500 bn envelope (the so-called ‘Funding for Growth Scheme+’), which aims to reach more risky SMEs through a partial takeover of the credit risk by the central bank. ([28])

The Funding for Growth Scheme and other subsidised schemes may entail non-negligible fiscal costs over the medium term. The Funding for Growth Scheme’s extension till the end of 2015, combined with increased allotments, also to target non-prime customers, are expected to further support lending to SMEs. The share of subsidised loans within the total SME credit portfolio has increased substantially over the last years: from around 10% in 2012 to close to 40% by Q3 2014. This was chiefly due to the roll-out of the Funding for Growth Scheme, but the step-up in Eximbank (Hungarian Export Credit Insurance Plc) activities, in particular its ‘Export promoting credit programme’, through which new loans worth over 1% of GDP were issued in 2014, contributed importantly to this surge. ([29]) From a financial stability perspective, it is preferable for the lending rate to be tightly linked to the policy rate in order to curb excessive risk-taking by banks and to reduce misallocation of capital. While targeted support schemes are being promoted in many countries across the EU, mostly to address market failures, it is important to keep the current schemes time-bound and well-targeted, and to recognise their embedded fiscal cost.

Household lending seems to have passed its lowest level. By 2013, households’ debt-to-GDP ratio had fallen substantially to reach a level similar to that of its regional peers. In addition, after successive rate cuts by the central bank, lending rates on newly disbursed HUF loans declined by 4 pps. Based on the calculations of the MNB, after five years of deleveraging, the debt-to-income ratio is now on a healthier footing. Specifically, the monthly payment-to-income ratio for households declined by close to 1/3 (from 13% to below 10%). This being said, there are some signs of a structural change in the behaviour of many segments of the households towards the banking system and financial intermediation (e.g. the surprisingly low take-up of the exchange rate cap scheme, which provided financial benefits for participating foreign exchange mortgage borrowers). Hence, the demand for credit may remain subdued even with a stronger wealth and income position. Moreover, as late as autumn 2013, more than half of households with a loan still considered their debt as being excessive and expected some repayment difficulties going forward, the highest ratio among the surveyed countries in Central, Eastern and South-eastern Europe. Similarly, only about 2% of respondents planned to take out new loans within the next 12 months, the lowest share in the region (and less than a third of the corresponding Hungarian figure from 2008). ([30])

There are a number of factors expected to offer a gradually increasing support to credit demand in the household sector. First, households’ real incomes are on an increasing path for the third year in a row. Second, the ongoing loan settlements (see details below) could further increase consumer demand by reducing household debt by around 10%. However, the recent tentative signs of a revival in lending to households may not be sufficient to bring net lending flows out from negative territory.

Graph 2.3.4: Change in household loans in international comparison (annual transaction-based growth rates)

(1) Club Med contains Greece, Italy, Portugal and Spain, Baltic states contains Estonia, Latvia and Lithuania Source: MNB

2014 seems to be a turning point for the housing market. For the first time since the start of the crisis, a positive year-on-year trend was registered for the number of new dwellings put to use (an increase of 27% from 2013). Moreover, the number of market transactions is also increasing: in 2014, more than 100 000 dwellings were expected to be traded, up from some 89 000 a year before. However, these positive developments are measured from a very low starting point, as construction and transaction activities in the housing market in 2013 have been the lowest, or very close to the lowest since EU accession. In particular, the number of dwellings built by businesses shrank markedly: around 3 000 in 2013, compared to an average above 17 000 during the period 2007-09.

Portfolio quality remains a major challenge, despite some recent improvements. Corporate and retail loans have a similar weighting in banks' aggregated balance sheet accounting for about 45% and 47% of banks’ total loan portfolio, respectively. At the end of June 2014, 22.3% of banks’ loan portfolio was past due (compared to 23.9% at the end of June 2013). The non-performing loan indicator (90 days or more past due) stood at 18.8% for the household sector, but had dropped to 16.8% for the corporate sector from around 19% a year earlier. The coverage ratio of non-performing loans remains relatively high (close to 60%) in international comparison. Nevertheless, the high proportion of restructured loans (17% of the total portfolio in Q2 2014) could cause problems, especially in light of the fact that the coverage ratio for restructured loans is relatively low. This raises questions as to the real quality of the loan portfolio, especially given that some 44% of restructured loans become problematic again. Efficient portfolio cleaning is hindered by the lack of a market for purchasing receivables, particularly in the case of project loans, the virtual lack of foreclosures and the inefficiency of in-court and out-of-court resolution proceedings. This is illustrated by the relatively high average time taken to settle disputes (compared with other countries), and the low expected recovery rate. Banks have, on average, a relatively high exposure to the commercial real estate and construction sectors, and to trade and manufacturing, which together account for close to 70% of all corporate loans. The commercial real estate part of the loan book accounts for nearly half of all distressed corporate loans. In November 2014, an Asset Management Company was established directly under the central bank, but its operational modalities are still not final and purchases have not yet begun. This unique set-up raises legal concerns and presents a potential risk for the budget and the central bank's credibility. The European Central Bank and the Commission are in discussion with the Hungarian central bank in order to avoid the potential breach of relevant Treaty provisions.

Table 2.3.1: Budget contribution to mortgage relief schemes (2011-2015, HUF bn)

(1) For the sake of simplicity, budgetary costs are aggregated at current values. Source: MNB, Ministry for National Economy, European Commission Calculations

Foreign exchange indebtedness of households is still the major reason behind the high share of non-performing credit. This reflects the weak economic situation of the country since the start of the financial crisis, as well as the fact that most of the foreign exchange relief schemes adopted so far have not been targeted at distressed borrowers. This latter issue is illustrated by the fact that performing borrowers have to date received around twice as much support from the budget than have defaulted households (see the details in Table 2.3.1). The practice of repeatedly introducing new relief schemes has deteriorated the payment culture ([31]) among Hungarian borrowers. The only programme targeted at distressed borrowers is that of the National Asset Management Agency, which has agreed to purchase close to 25 000 dwellings owned by distressed borrowers by the end of 2014. However, the scheme’s target falls short of the number of flats owned by problematic borrowers, which is estimated to be around 150 000. The ongoing settlement scheme will reduce the total debt of borrowers by approximately 16% on average, with marked heterogeneity among loan holders. This alone will probably not resolve the problem of non-performing loans.

Normal lending flows to the economy have not yet been restored. While the numerous support schemes introduced have certainly alleviated the credit supply constraints that many Hungarian SMEs experienced, they cannot provide a permanent substitute for a sound operating environment for banks. Moreover, the significant further plans for subsidised lending may end up crowding out market lending if the schemes are not properly targeted and imply non-negligible risks in terms of future fiscal costs. Despite the tentative signs of revival in the housing market in terms of both volumes and prices, net lending flows to households may remain negative in the foreseeable future. It was recommended to Hungary to tackle the issue of restructured loans provisioning and improvement in insolvency proceedings along with the ability of lenders to foreclose collateral. On all these issues Hungary has yet to make progress.

Situation in the banking sector

The Hungarian banking sector has been struggling to regain adequate profitability since the onset of the crisis. In recent years, banks' results were persistently negative, affected by a number of government schemes aimed at supporting foreign currency borrowers (see Table 2.3.2 for details) as well as the high and worsening levels of non-performing loans. In addition, a substantial tax burden (the highest in the EU, mainly in the form of a levy on financial institutions based on their 2009 balance sheet in place since 2010 and the financial transactions duty introduced in 2013) has also taken its toll on profits. The weak level of economic activity, at least until mid-2013, the volatile operating environment and the generally low profitability compared to neighbouring countries have encouraged foreign parent banks to deleverage in Hungary in a sustained way (almost 6% per year on average). The loan-to-deposits ratio is now approaching 100%, down from a peak of 155% in December 2008. In parallel, however, the same parent banks have provided abundant capital (well over EUR 4 billion in cumulative terms since 2009, see graph 2.3.5) to keep their local Hungarian subsidiaries in line with local and international capital and liquidity rules.

Despite persisting profitability problems, banks are well capitalised and their liquidity position is strong. Throughout the recent years, banks have maintained a considerable capital buffer, due mostly to repeated capital increases by foreign parent banks. Accordingly, the capital adequacy ratio reached a record high of 19.5% in Q1 2014, an indication of the sector’s strong shock-absorption capacity. All banks registered values above the regulatory minimum of 9%. The build-up of this substantial excess capital was primarily linked to the expected further losses stemming from additional relief schemes for mortgage borrowers. In addition, Pillar II supervisory requirements related to individual risks also called for a high capitalisation level of banks. Banks' short-term liquidity (mainly available in forints) is also adequate at more than twice the regulatory requirement. Under stressed conditions the liquidity surplus of Hungarian banks also exceeds the regulatory minimum, while capital needs are very limited. Nevertheless, the persistence of banks' negative profits represents a medium- to long-term risk to financial stability.

Graph 2.3.5: External funding transactions in the local banking sector (cumulative changes)

Source: MNB

The recent series of measures put considerable additional strains on banks. Recent laws adopted to implement the Supreme Court’s uniformity decision on bid-ask spreads and the unilateral interest rate increases for all retail loans in the past ten years could overall lead to potential gross losses for the entire financial system of around HUF 950 bn (or over 3% of GDP). The effect on the banking sector’s profit is somewhat smaller: first, only around 83% of the gross impact will be felt by banks as the adverse impact is moderated by provisions already set aside. This still leaves banks facing a net loss of around HUF 600 bn (or 2% of GDP), which will wipe out, ceteris paribus, close to three quarters of the sector's excess capital. In addition, the legislated interest rate moratorium has further complicated the profitability situation. On a positive note, the Memorandum of Understanding concluded with the European Bank for Reconstruction and Development on 9 February 2015, includes a commitment by the government to more than halve the bank levy by 2017, and then further align it with the European average by 2019.

Table 2.3.2: Policy measures increasing the burden on the banking sector

(1) The rate on the amount of total deposits was increased from 0.06% to 0.1% in 2014 and further to 0.14% in 2015. Source: MNB, Ministry for National Economy, European Commission Calculations

The new rules on consumer interest rates, and in particular the law on ‘fair banking’ clearly improve the transparency and predictability of lending transactions, but at the price of further strains on profitability. The comprehensive overhaul of consumer credit regulation came into effect in February 2015. It prescribes the use of fixed or reference-based interest rates for both existing and new household loan contracts. Specifically, in the case of credit agreements of a less than three years duration, the interest rate or the spread is fixed without any possibility of change. If the repayment period is longer than three years, the interest rate may be modified once every three years, and for a maximum of five times over the entire life of the loan. Moreover, the adjustments in interest rates are allowed strictly on the basis of objective criteria, which are supervised by the central bank (the determining factors cannot be influenced by the concerned commercial bank, for instance the liquidity premium on the interbank market). While the conversion of foreign exchange mortgages was profit-neutral as it was carried out at market exchange rates, the legislated re-setting of the interest rates of the new forint loans have also tightened banks’ margins. The combined permanent negative impact on interest revenues of the fair banking regulation and the new rules for converted mortgages could be around HUF 100 bn per year. ([32]) Overall, Hungarian banks are expected to remain persistently the worst performers in terms of profitability in the Central and Eastern European region, which has serious implications for the sector’s ability to attract foreign capital and funding.

The State has consistently pursued a strategy of extending its direct ownership in the Hungarian banking sector. Following the acquisition of minority stakes in two small lenders (Széchenyi Bank and Gránit Bank) in 2013, it completed the purchase of MKB (the country’s fifth largest commercial bank in terms of balance sheet) in September 2014 (the price was around 0.05% of GDP, but the seller Bayerische Landesbank agreed to undertake a capital injection of 0.25% of GDP). In February 2015, it acquired Budapest Bank (the eighth largest commercial bank) from GE Capital for a maximum price of 0.6% of GDP. While MKB has been exposed to significant losses originating mainly from its commercial real estate loan portfolio, Budapest Bank, with its strong SME business focus, has managed to remain profitable in recent years. In parallel, the government has started to establish a new complex financial centre. It is foreseen to consist of the following elements: (i) the Hungarian Post with its 2700 units nationwide - in September 2014, the Post acquired a minority stake at FHB Commercial bank; (ii) the restructured system of savings associations (altogether 1600 branches); and (iii) the Hungarian Development Bank Group.

Although the government's strategy is to sell its stake in the newly nationalised institutions, the increasingly large ownership has the potential to expose public finances to a contingent liability. This risk – well-evidenced in many countries during the recent financial crisis – was underlined by the bankruptcy of Széchenyi Bank in early December 2014, whose credit stock has reportedly almost tripled over the last 18 months (i.e. following the state purchase of a minority stake), but whose operation involved serious irregularities. The State has probably lost all of its capital injection of HUF 3 bn in about 1.5 years, which has already put some strain on public finances. ([33]) MKB, which the State officially acquired in September 2014, was placed under resolution just three months later, on 18 December 2014. In the context of the recent agreement with the European Bank for Reconstruction and Development, the government expressed its intention to transfer its entire majority stakes in local banks to the private sector within the next three years.

Policy measures to help improve the capital accumulation possibilities for banks, and thereby restore normal lending flows show a large implementation gap vis-á-vis the size of the challenge. The tax burden on banks remained at the former elevated levels (close to 1¼% of GDP per year since 2013). There were only two small adjustments: (i) the September 2014 law on settlements offered a small compensation for banks: some 0.05% of GDP could be recouped from their corporate taxes starting from 2015; (ii) on card payments, the normal tax rate was replaced by a flat annual financial transaction duty, thereby contributing to the increased use electronic payment means. With the notable exception of the conversion scheme for foreign exchange mortgages, the advocated systematic consultation with stakeholders on new policy initiatives has at best been occasional. The government transposed the EU directive on bank resolution, hence responding to this part of last year’s recommendation.

Interlinks with the growth potential

The Hungarian banking system has proved to be extremely pro-cyclical in recent years. The accumulated highest foreign exchange share in private sector credit stock in the entire Central and Eastern European region (65% in 2008) had an adverse legacy even in the case of performing loans: Endrész-Harasztosi (2014) ([34]) found that firms with foreign exchange loan had an investment rate 4-5 pps lower during the crisis than would have been the case in the absence of such debt. Regarding the drivers of deleveraging, central bank experts estimate that the demand and supply side of the credit market have had an overall broadly equal contribution to the deleveraging in the corporate sector over the 2009-13 period, while the dominant factor was identified to be the lack of demand in the household sector (Bodnár et al., 2014([35])) .

Box 2.3.1: Capital gap in Hungary and its link to financial variables The capital gap is estimated by decomposing capital in a trend and cyclical component so that trend capital is consistent with supply side conditions. The standard optimality condition for capital is used which equates the marginal product of capital with capital cost. The trend capital stock can therefore be written as a positive function of equilibrium employment growth, a positive function of trend TFP growth and a negative function of the growth rate of trend capital cost. The respective elasticities can be derived from the parameters of the production function which is used for potential output estimation in the Commission. A non-zero capital gap can happen if too much capital was accumulated because of for example a housing bubble or a stock price bubble. Shocks can occur to the economy which especially affect capital, e.g. financial shocks, such as credit loosening or tightening by banks, shocks to term spreads, loans and bank loan deposit ratios, or shocks to house prices or other assets, leading to an adjustment in capital. These (financial) shocks can be of great importance, as it has been shown in recent business cycle studies that they account for about 33% of forecast error variance of GDP. (1) In the case of Hungary, capital has been above trend capital since 2008 (see Graph 1). However, according to the Commission’s 2015 Winter forecast, in 2014 the gap is expected to be zero and decreasing afterwards. To research this, Commission experts related the capital gap to several financial variables, and the results are presented in this Box. (2) Using factor analysis, it was possible to limit the financial variables to credit to households as a share of GDP, growth in total loans and short term interest rates. A linear regression of the capital gap on these selected financial variables and a lagged capital gap term (Table 1) shows that a higher reliance on credit (proxied by a larger credit-to-GDP ratio) leads to a larger positive capital gap. Also an increase in the growth of loans is positively related to the capital gap. Just before the peak in the capital gap in 2009, the growth in loans started to decrease and became negative in 2009. Credit to households seems to be more of a lagged indicator only starting to decrease in 2010. It was also found that the loan-to-deposit ratio follows a similar path as the capital gap, suggesting that this ratio might be a good financial indicator for the capital cycle in Hungary, although the available time series are too short. Since the capital gap is often related to the output gap, this relationship is used to check the robustness of the results. Cancelling out the impact of the output gap on the capital gap leads to very similar estimations of the coefficients of the financial variables as well as their significance. The decrease in the capital gap after 2009 as such seems to be clearly related to the deleveraging process in the Hungarian financial sector; and it could possibly be interpreted as a natural correction of the previously accumulated imbalances. The negative forecast capital gap for the coming years might be related to the continuing deleveraging, which puts pressure on the credit market. _________________________________ (1) See for example Hubrich, K., D'Agostino, A., Cervená, M., Ciccarelli, M., Guarda, P., Haavio, M., et al. (2013), Financial shocks and the macroeconomy: heterogeneity and non-linearities, Frankfurt: ECB. (2) Pioneering work has been done by the Bank for International Settlements, see the following publications: Borio, C., Disyatat, P. & Juselius, M. (2013), Rethinking potential output: Embedding information about the financial cycle. and Borio, C., Disyatat, P. & Juselius, M. (2014), A parsimonious approach to incorporating economic information in measures of potential output. Working Papers No. 442.

Both analytical models and market surveys suggest that deleveraging is likely to continue in the coming years. A large part of the deleveraging observed over the last five years could certainly be interpreted as a natural correction of the accumulated indebtedness, most notably in the household sector. However, its pace and the channels through which these pressures have been materialising were heavily influenced by financial sector policies (see also Box 2.3.1 for a discussion on the interlinks between financial variables and potential growth trajectories). A very similar pattern can be identified from the Hungarian central bank's financial condition index (Graph 2.3.6), which shows that the financial sector has contributed negatively to economic growth as supply-side constraints have remained tight in a historical perspective, and recent quarters have not been an exception. Looking ahead, updated Commission estimates based on Cuerpo et al. (2013) ([36]) identify remaining deleveraging needs for Hungary, but at a relatively moderate level (more than 10% of GDP for households and less than 10% of GDP for corporates) compared to that needed in vulnerable countries in the periphery. This analysis reveals that in 2013 Hungary showed one of the most significant overall loan supply pressures in the EU, partly linked to the poor capital accumulation developments of the banking sector.

Restoring financial intermediation in a sustainable manner does not appear to be feasible under the current operating environment for the banking sector. After many years of deleveraging, the proper incentives to lend are still missing for banks. Nonetheless, there are tentative signs that the period of rapid deleveraging with its detrimental impacts on economic activity might soon be over for Hungary. While investment had been declining continuously until 2013, there has been a visible upturn since then, first fuelled by government investment (linked to a substantial inflow of EU funds), but more recently also by the pick-up in the corporate segment. Nevertheless, the turnaround is based on fragile foundations as without the subsidised schemes, corporate lending would undoubtedly have remained in the negative territory. Implementing rigorously the measures laid down in the recent Memorandum of Understanding with the European Bank for Reconstruction and Development will be conducive to returning to a sound and predictable financial policy framework.

Graph 2.3.6: The Financial Conditions Index (FCI) and economic growth

Source: MNB

Graph 2.3.7: Deleveraging pressures on the supply and demand side

Source: European Commission

Recent indicators show significant improvements in the Hungarian labour market. This is partly due to the strong economic growth seen in 2014, but is also the result of the increased reliance on subsidised job creation in the public sector, namely the Public Works Scheme. This section examines the current state of the labour market and how this has been influenced by public works. It also evaluates the plans laid down in the 2015 budget to further increase both the number of public works programmes and the resources allocated to the scheme. The section concludes that, without public works, unemployment would be higher. Empirical evidence suggests that public works have only a limited effect in terms of facilitating entry or re-entry into the open labour market. Instead of finding a job, individuals tend to return to public works.

The labour market, recent improvements

The three-year average (2011-13) unemployment rate remains above 10 % in Hungary, as it has been for the last three years, but will fell below next year. The average will fall below 10 % next year, the yearly unemployment rate in 2014 being around 7½%. This is partly due to an increase in employment, resulting from the economic growth seen since mid-2013.

Graph 2.4.1: Participation, employment and unemployment

Source: Central Statistical Office (KSH)

Although the activity rate has been increasing since 2009, it remains low by international standards. Nonetheless, Hungary’s activity rate is increasing faster than that of its regional peers (see Graph 2.4.2). The activity rate stood at 67.8 % in Hungary in the third quarter of 2014, while the EU average was 72.6 %. As in Hungary the number of unemployed is decreasing and employment increases faster than activity (Graph 2.4.1), people are accordingly exiting inactivity and becoming employed.

Graph 2.4.2: Activity rate

Source: European Commission

Having peaked in 2010, the unemployment rate has since been decreasing. The pace becoming more and more rapid since 2012 due to the expansion of the public works. The unemployment rate reached a high of 11.2 % in 2010, before starting to slowly decelerate. Hungary had had the second highest unemployment rate in its region before 2012, but by the end of 2014, its rate was the second lowest (see Graph 2.4.3).

Graph 2.4.3: Unemployment rate

Source: European Commission

The after-effects of the economic recession were a factor in Hungary’s low activity levels, but structural problems have been identified as the underlying cause. According to Fazekas and Scharle (2012) ([37]), Hungary’s low employment level can be traced back to unfavourable demographic trends and the crisis experienced at the time of the regime change. The drop-out of workers from the labour force was partly attributable to a depreciation of human capital and the ensuing mismatches in the labour market. The rate of non-employed people taking up employment remained low due to easy access to early retirement or disability benefits. A f