Council opinion of 10 March 2009 on the updated convergence programme of Hungary, 2008-2011
Date: 2009-03-10
Institutions: Council of the European Union
Subjects: Hungary, budget estimate, economic convergence, economic forecasting, public finance, stability programme

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COUNCIL OPINION

of 10 March 2009

on the updated convergence programme of Hungary, 2008-2011

(2009/C 66/02)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particular
Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

(3)

On 10 March 2009, the Council examined the updated convergence programme of Hungary, which
covers the period 2008 to 2011.

After a moderate pickup in the first half of 2008, GDP declined slightly in the third quarter and more
strongly in the fourth quarter. Despite the improvement in Hungary's twin deficits in recent years, the
country has remained vulnerable due to high levels of government and external debt. Consequently,
the financial crisis hit Hungary particularly hard and led to a sharp exchange rate depreciation and
dysfunction in many segments of the financial markets. Therefore, restoring investor confidence and
improving the functioning of financial markets are the most imminent challenges for economic
policy. To this end, the central bank introduced new instruments and a new economic programme
was adopted containing further fiscal adjustments, tighter deficit targets as well as a bank rescue
package and enhanced financial sector regulation. In support of these steps, Hungary has been
granted a large (EUR 20 billion) international financial assistance (2), subject to progress in fiscal
consolidation, fiscal governance reform, financial sector regulation and supervision and structural
reforms (3), from the EU, the IMF and the World Bank. The economic programme associated with the
loan is incorporated in both the 2009 budget and the convergence programme update. The National
Bank of Hungary tightened monetary policy via a hike in the base rate in October 2008 from 8,50 %
to 11,50 % before lowering rates in the last two months of 2008 (in three steps to 10 % in
December 2008). The Hungarian forint depreciated by 2,6 % in nominal effective terms during 2008.

The programme contains two different scenarios for the macro-economic and budgetary projections:
a ‘baseline’ scenario and an ‘alternative’ scenario. The ‘baseline’ scenario is considered the reference
scenario for assessing the budgetary projections because only this scenario contains detailed calcula-
tions concerning the breakdown of the budgetary and macro-economic aggregates. It envisages that
after subdued growth of around 1 % in the previous two years real GDP growth will drop by 0,9 %
in 2009 before accelerating again to 1,6 % and 2,5 % in 2010 and 2011, respectively. Assessed
against currently available information (4), the baseline scenario appears to be based on markedly
favourable growth assumptions over the entire programme horizon, partly because the worsening of
the growth prospects in trading partner countries is likely to be more pronounced than assumed by
the programme scenario. Assuming a worse external trade performance and a somewhat larger
decline in investment, the Commission services' January 2009 interim forecast projected GDP to drop
by 1,6 % in 2009 and then to accelerate to 1 % in 2010. However, in view of recent information

(1) OJ L 209, 2.8.1997, p. 1. The documents referred to in this text can be found at the following website:

http://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) See Council Decision 2009/102/EC providing Community medium-term financial assistance for Hungary (OJ L 37,

6.2.2009, p. 5).

(3) For details on the EU medium-term financial assistance for Hungary, see the following thematic webpage:

http://ec.europa.eu/economy_finance/thematic_articles/article13488_en.htm

(4) The assessment notably takes into account the Commission services' January 2009 forecast, but also other information

that has become available since then.

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including the sharp fall in industrial production in December and the strong deceleration in credits to
corporations and households in late 2008, the outcome is likely to be much worse (around – 3,25 %
in 2009). The programme's inflation projection of 4,5 % for 2009 also appears to be on the high
side. Moreover, the strong export performance and the related improvement in the net financing
capacity of the private sector over the programme horizon seem somewhat favourable.

(4)

(5)

(6)

(7)

For 2008, the general government deficit is estimated at 3,3 % of GDP in the Commission services'
January 2009 interim forecast, against a target of 4 % of GDP set in the previous update of the
convergence programme. The overachievement of this target against the background of weak growth
is chiefly due to a favourable base effect on both the revenue and expenditure side from 2007 (when
the deficit reached 5 % of GDP).

The update sets the 2009 budget deficit target at 2,6 % of GDP which compares with 3,2 % of GDP
contained in the previous update and a projection of 2,8 % of GDP in the Commission services'
interim forecast. The target was tightened as part of the government response to the financial crisis
and against the background of a significantly deteriorated macro-economic scenario. Given the
context of the financial crisis and the high deficit and public debt, the government did not adopt any
in view of the sharper-than-expected economic
fiscal stimulus measures. More recently however,
downturn that is estimated to result in a revenue shortfall of around 1 % of GDP, the Government
adopted on 15 February an additional corrective package of 0,7 % of GDP and revised its 2009
deficit target to 2,7-2,9 % of GDP in the context of the first review of its new economic programme.
The structural balance (i.e.
the cyclically-adjusted balance net of one-off and other temporary
measures), according to the information provided in the update and as recalculated by Commission
services, is planned to improve by around 1,75 percentage points of GDP, pointing to a strongly
restrictive fiscal policy stance.

The main objective of the medium-term budgetary strategy in the update is to reduce the nominal
deficit from 3,4 % of GDP in 2008 to 2,6 % of GDP in 2009, which is expected to be followed by a
slight decline to 2,5 % in 2010 and further to 2,2 % of GDP in 2011. Since interest expenditure is
anticipated to rise by half a percentage point of GDP in 2009, the primary balance shows a larger
improvement in that year (exceeding 1 percentage point), followed by a 0,3 % of GDP improvement
until 2011 to reach a surplus of 2,2 % of GDP. The country's medium-term objective (MTO) for the
budgetary position (a deficit of 0,5 % of GDP in structural terms, i.e. cyclically-adjusted balance net of
one-off and other temporary measures) is not expected to be achieved within the programme period.
The overall budgetary consolidation of 1,2 percentage point of GDP is planned to be evenly distrib-
uted between the revenue and expenditure side. After 2009, the programme does not spell out the
detailed measures underlying the planned deficit reduction. The update estimates that the debt-to-
GDP ratio has increased steeply in 2008 to slightly over 71 %, chiefly linked to the utilisation of the
first instalment of the financial assistance from the EU and the IMF mostly for reserve build-up.
In 2009, the debt ratio is projected to increase further to 72,5 %, but in the outer years it is foreseen
to start declining at an increasing pace (to 69 %), supported also by the gradual pick-up in growth.

to downside risks, especially in the outer years of

The budgetary outcomes are subject
the
programme. The risks to the deficit path stemming from the macro-economic outlook are consider-
able throughout the entire programme period. A deeper and more protracted recession will imply
significant across-the-board revenue shortfalls and moderate increases in expenditures. However, on
the expenditure side, there have recently been a number of positive elements. Budgetary control has
considerably improved since 2006 and the enacted reform steps appear to have structurally restrained
the past pattern of budgetary slippages in some important areas (e.g. price subsidies).

In addition, the government adopted further expenditure cuts of 0,7 % of GDP for 2009 in response
to the recent sharp deterioration of the economic outlook. Nevertheless, the risk of expenditure over-
runs cannot be ruled out, especially after 2009. In particular, the planned expenditure moderation
might not be backed by follow-up steps in the reforms of the public administration, health and
education systems and the further necessary budgetary measures do not seem to be fully specified
and implemented. On the other hand, the implementation of the planned reform steps in the
pension, social benefit and household subsidy systems should contribute to expenditure moderation

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in the medium term. Even though the fiscal governance framework was considerably strengthened,
the risk of a budgetary loosening compared to plans as evidenced by past experience cannot be fully
discarded, also in view of the fact that the new budgetary framework is still untested. Risks to the
budgetary targets equally apply to the debt ratio; therefore its evolution envisaged from 2009 might
also be less favourable than projected in the programme.

(8)

(9)

(10)

(11)

A number of pension reform steps have recently been implemented, which are expected to moderate
somewhat the increase in future pension expenditure, but more needs to be done to this end. The
budgetary position in 2008 as estimated in the programme improved from the estimated starting
position of the previous programme, however, the budgetary impact of population ageing remains
high. The current level of gross debt is still above the Treaty reference value. Ensuring higher primary
surpluses over the medium term, as already foreseen in the programme, as well as further pension
reform steps as recently announced by the Government would contribute to reducing the medium
risks to the sustainability of public finances.

Until 2006 when the deficit peaked at 9,3 % of GDP, the Hungarian budgetary framework was very
vulnerable to fiscal slippages and was exposed recurrently to the electoral cycle. Following some
gradual improvement in transparency and budgetary planning starting from 2006, a reform law of
fiscal governance was adopted in November 2008 containing multi-annual numerical rules and the
establishment of a Fiscal Council. The new body will carry out independent macro-economic and
budgetary forecasts as well as fiscal
impact assessments, and assess the budgetary situation and
implemented with determination, the new set-up should be conducive to
budget proposals.
improving the transparency and sustainability of public finances. However, some important issues
remain unresolved, such as the specification of effective enforcement mechanisms and the coverage of
the subnational sector.

If

In response to the financial crisis, the Hungarian authorities did not only tighten in October 2008
budgetary targets to reduce external financing needs of the economy as part of the new economic
programme but also adopted a number of measures to ensure the stability of the financial sector. The
coverage of the deposit guarantee scheme has been increased from HUF 6 million to HUF 13 million.
The authorities also adopted a banking sector support scheme, which foresees the provision of inter-
bank guarantees as well as a recapitalisation fund. Additionally, the central bank has taken a number
of measures aimed at enhancing market liquidity, also supported by the repo agreement concluded
with the European Central Bank. Further measures to strengthen financial market regulation and
supervision are expected in line with the economic programme linked to the international financial
assistance.

In response to the economic crisis, the Hungarian authorities endorsed a budget-neutral package of
measures to stimulate the economy, including structural reform steps. In the light of the need for
imbalances, and in line with the EERP agreed in
correcting its significant external and internal
December by the European Council, the Hungarian authorities did not implement any fiscal stimulus
measures. With a view to sustaining aggregate demand and employment over 2009 and 2010, the
adopted measures include, notably, the acceleration of the absorption of EU structural funds and their
reshuffling, as well as improving the access of small and medium-sized enterprises to financing. Struc-
tural reforms are an important element of the EERP, and are especially a relevant avenue for policy
action in Hungary in light of the limited scope for fiscal stimulus and the need to improve external
competitiveness. Less emphasis has been put on strengthening competitiveness. Moreover, Parliament
adopted in December the ‘Pathway to work’ programme, which aims at creating incentives and
improving employability of the low-skilled and long-term unemployed also through a partial reorien-
tation of passive means in the Labour Market Fund towards active labour market policies. The
programme includes a sharp increase in public works schemes, as well as training programmes, and
adds incentives for better cooperation between the targeted population and the Public Employment
Service. In addition, the Government continued to reform in gradual steps the health-care and educa-
tion systems and the public administration. These measures are related to the medium-term reform
agenda and the country-specific recommendations proposed by the Commission on 28 January 2009
under the Lisbon Strategy for Growth and Jobs. On 16 February, the Government announced further
structural reforms in the area of pension, social benefits, and local governments.

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(12) Given the macro-financial risk, fiscal policy has to be restrictive. Following two years of restrictive
policy, the stance of fiscal policy would be once again restrictive in 2009 against the background of a
deep recession; in the outer years of the programme it would turn to broadly neutral. The update
confirms the medium-term adjustment path laid down in the new economic policy programme of
the authorities;
is consistent with the commitments made in the context of EU
medium-term financial assistance.

thereby it

However, the Commission services' interim forecast projecting a larger 2009 deficit at 2,8 % of GDP
together with the risks to the macro-economic projections indicates that further consolidation
measures might be necessary. Indeed, the government adopted a new corrective package of 0,7 % of
GDP, while revising its 2009 deficit target slightly upwards. The newly adopted fiscal governance
reform should contribute to improving the long-term sustainability of public finances through the
programmed reduction in the debt ratio. In view of the risk assessment, the budgetary stance in the
programme seems broadly consistent with the adjustment path for the correction of the excessive
deficit recommended by the Council, provided that all budgetary measures announced in the
programme and more recently are fully implemented as well as possible within-the-year deviations
are effectively corrected. In the years following the correction of the excessive deficit, the deficit reduc-
tion envisaged in the programme is limited and not backed up sufficiently with measures. Finally,
taking into account the risks to the debt projections mentioned above, the debt ratio is not suffi-
ciently diminishing towards the reference value over the programme period.

(13) As regards the data requirements specified in the code of conduct for stability and convergence

programmes, the programme has some gaps in the required and optional data (1).

The overall conclusion is that, in spite of distinct improvements in its high imbalances, including the reduc-
tion in the budget deficit from 9,3 % of GDP in 2006 to below 3,5 of GDP in 2008, Hungary has been
particularly exposed to the financial crisis and thus had to limit the financing need of the government rather
than stimulate the economy during the economic downturn. In this context, it adopted a policy of further
fiscal adjustments and tighter deficit targets to restore investor confidence. This strategy has been backed by
international financial assistance from the EU, the IMF and the World Bank. The programme foresees a
continuation of the front-loaded consolidation strategy, with another important adjustment in 2009 to 2,6 %
of GDP, and followed by a more moderate adjustment path towards a budget deficit of 2,2 % of GDP
by 2011. However, this deficit reduction path is subject to risks, especially since the macro-economic
assumptions underlying the programme have in the meantime become markedly favourable. This risk would
be substantially reduced by the corrective measures adopted and structural steps recently announced by the
Government together with the revision of the 2009 deficit target slightly upwards to 2,7-2,9 % of GDP.
Moreover, the adoption of the law on fiscal responsibility is an important step towards establishing prudent
fiscal policy and, if implemented with determination, should contribute to the durability of the fiscal consoli-
dation. Nevertheless, the sustainability of public finances also hinges on the continuation of structural
reforms, to the extent that they increase long-term growth, help meet budgetary targets, and reduce the
country's vulnerabilities.

In view of the above assessment, the commitments made in the framework of international financial assis-
tance, and also in the light of the recommendation under Article 104(7) of 10 October 2006 and also given
the need to ensure sustainable convergence, Hungary is invited to:

(i) in view of the risks, maintain adequate buffers, take the necessary measures to bring the budget deficit
below the 3 % of GDP threshold in 2009, and ensure that adequate progress in budgetary consolidation
towards the MTO is made thereafter, thereby setting the debt-to-GDP ratio on a declining path towards
the 60 % of GDP threshold;

(ii) ensure full implementation of the fiscal responsibility law, continue expenditure moderation through
further reforming of public administration, healthcare, and education systems, as announced, and
strengthen financial market regulation and supervision;

(1) In particular, the breakdown of stock-flow adjustment and some data on the long-term sustainability of public finances are

not provided.

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(iii) in view of the level of debt and the increase in age-related expenditure, further improve the long-term
sustainability of public finances; continue to reform the pension system after the steps already taken
in 2006-2008.

Comparison of key macro-economic and budgetary projections

Real GDP
(% change)

HICP inflation
(%)

Output gap (1)
(% of potential GDP)

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

General government
revenue
(% of GDP)

General government
expenditure
(% of GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

CP Dec 2008

COM Jan 2009

CP Nov 2007

CP Dec 2008

COM Jan 2009

CP Nov 2007

CP Dec 2008

COM Jan 2009 (2)

2007

2008

2009

2010

2011

1,1

1,1

1,7

7,9

7,9

7,9

1,9

2,7

1,3

0,9

2,8

6,2

6,1

4,8

1,1

2,3

– 0,9

– 1,6

4,0

4,5

2,8

3,0

1,6

1,0

4,1

3,2

2,2

2,9

2,5

n.a.

4,2

3,0

n.a.

2,8

– 1,7

– 1,9

– 1,1

– 0,1

0,4

n.a.

CP Nov 2007

– 0,9

– 1,8

– 1,5

– 0,9

– 0,5

CP Dec 2008

– 5,3

– 5,1

– 3,7

– 2,5

– 1,6

COM Jan 2009

– 5,3

– 6,0

– 4,0

– 3,5

n.a.

CP Nov 2007

– 4,1

– 2,3

– 1,7

– 1,3

– 0,8

CP Dec 2008

44,9

45,2

45,8

46,0

45,8

COM Jan 2009

44,9

45,5

46,1

46,4

n.a.

CP Nov 2007

44,1

44,2

43,3

42,4

42,0

CP Dec 2008

49,8

48,6

48,4

48,5

48,0

COM Jan 2009

49,8

48,8

48,9

49,5

n.a.

CP Nov 2007

50,3

48,2

46,5

45,1

44,2

CP Dec 2008

– 5,0

– 3,4

– 2,6

– 2,5

– 2,2

COM Jan 2009

– 5,0

– 3,3

– 2,8

– 3,0

n.a.

CP Nov 2007

– 6,2

– 4,0

– 3,2

– 2,7

– 2,2

CP Dec 2008

COM Jan 2009

CP Nov 2007

– 0,9

– 0,9

– 2,2

0,6

0,8

0,1

1,9

1,6

0,6

2,0

1,5

0,8

2,2

n.a.

1,1

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Cyclically-adjusted
balance (1)
(% of GDP)

Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

CP Dec 2008

COM Jan 2009

CP Nov 2007

CP Dec 2008

COM Jan 2009

CP Nov 2007

CP Dec 2008

COM Jan 2009

CP Nov 2007

2007

2008

2009

2010

2011

– 5,8

– 6,2

– 6,0

– 4,9

– 5,3

– 4,9

65,8

65,8

65,4

– 3,9

– 4,3

– 3,5

– 3,5

– 4,0

– 3,7

71,1

71,9

65,8

– 1,8

– 2,8

– 2,8

– 1,8

– 2,8

– 2,9

72,5

73,8

64,4

– 1,6

– 3,2

– 2,5

– 1,6

– 3,2

– 2,5

72,2

74,0

63,3

– 1,7

n.a.

– 2,1

– 1,7

n.a.

– 2,1

69,0

n.a.

61,8

Notes:
(1) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the

information in the programmes.

(2) Based on estimated potential growth of 1,7 %, 1,3 %, 0,9 % and 0,5 % respectively in the period 2007-2010.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. Cyclically-adjusted balances according to the programmes
as recalculated by the Commission services on the basis of the information in the programmes. One-off and other temporary measures
are 0,9 % of GDP in 2007 and 0,4 % in 2008; all deficit-increasing, according to the most recent programme and 0,9 % of GDP
in 2007 and 0,3 % of GDP in 2008; all deficit-increasing, according to the Commission services' January 2009 interim forecast.

Source:
Convergence programme (CP); Commission services' January 2009 interim forecasts (COM); Commission services' calculations.