COMMISSION STAFF WORKING DOCUMENT In-depth review for HUNGARY in accordance with Article 5 of Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL AND TO THE EUROGROUP Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances
Date: 2013-04-10
Institutions: European Commission
Subjects: Hungary, competitiveness, economic growth, economic recession, economic reform, indebtedness, macroeconomics, political crisis, private investment, public debt

EUROPEAN 
COMMISSION 

Brussels, 10.4.2013  
SWD(2013) 119 final 

COMMISSION STAFF WORKING DOCUMENT 

In-depth review for HUNGARY 

in accordance with Article 5 of Regulation (EU) No 1176/2011 on the prevention and 
correction of macroeconomic imbalances 

Accompanying the document 

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN 
PARLIAMENT AND THE COUNCIL AND TO THE EUROGROUP 

Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and 
correction of macroeconomic imbalances 

{COM(2013) 199 final} 
{SWD(2013) 113 final} 
{SWD(2013) 114 final} 
{SWD(2013) 115 final} 
{SWD(2013) 116 final} 
{SWD(2013) 117 final} 
{SWD(2013) 118 final} 
{SWD(2013) 120 final} 
{SWD(2013) 121 final} 
{SWD(2013) 122 final} 
{SWD(2013) 123 final} 
{SWD(2013) 124 final} 
{SWD(2013) 125 final}

EN 

   EN 

 
 
 
 
 
  
 
 
 
 
 
Contents 

Executive summary and conclusions ..........................................................................................3 

1. 

2. 

2.1. 

2.2. 

2.3. 

2.4. 

2.5. 

2.6. 

3. 

3.1. 

3.2. 

3.3  

4. 

Introduction...................................................................................................................5 

Macroeconomic situation and potential imbalances.....................................................5 

Macroeconomic scene setter.........................................................................................5 

Sustainability of external positions...............................................................................7 

Competitiveness and trade performance.....................................................................11 

Private sector indebtedness.........................................................................................14 

Public sector indebtedness ..........................................................................................17 

Labour market developments .....................................................................................18 

In-depth analysis of selected topics: The underlying reasons of Hungary's low 
growth potential ..........................................................................................................21 

An analysis of potential growth: past tendencies and prospects.................................22 

 Recent changes in the corporate tax system and their potential behavioural effects.27 

Credit market conditions' impact on deleveraging .....................................................30 

Policy challenges ........................................................................................................33 

REFERENCES .........................................................................................................................36 

2 

 
 
 
 
EXECUTIVE SUMMARY AND CONCLUSIONS  

In May 2012, the Commission concluded that Hungary was experiencing serious imbalances, 
in particular as regards developments related to the net international investment position and 
implications of high government debt. In the Alert Mechanism Report (AMR) published on 
28 November 2012, the Commission found useful, also taking into account the identification 
of  a  serious  imbalance  in  May,  to  examine  further  the  risks  involved  and  progress  in  the 
unwinding  of  imbalances  in  an  in-depth  analysis.  To  this  end  this  In-Depth  Review  (IDR) 
takes a broad view of the Hungarian economy in line with the scope of the surveillance under 
the  Macroeconomic  Imbalance  Procedure  (MIP).  The  main  observations  and  findings  from 
this analysis are: 

•  Hungary  has  been  experiencing 

imbalances, 

in  particular  as  regards 
developments  related  to  the  net  international  investment  position  (NIIP)  and 
public debt as mentioned in last year's IDR. External imbalances have decreased 
as the current account is in surplus for the third year in a row and the NIIP has 
been  improving  steadily  (from  -117%  in  2009  to  above  -103%  in  2012),  but  it 
remains significantly more negative than the threshold. This is expected to be the 
case also in the years to come. The current account turnaround that started in 2009 
was mainly the result of a fall in domestic demand amidst a sharp recession; export 
competitiveness has rather deteriorated somewhat. After a marked decline during the 
2009 recession, the deficit in the factor income has started to widen again, though it 
remains below pre-crisis levels. Both elements suggest that the external correction is 
partly cyclical.  

•  Most  of  the  recent  external  adjustment  reflects  the  deleveraging  of  the  private 
sector. Private sector deleveraging is necessary to correct imbalances most notably in 
the household sector. While this has been happening, the rapid fall in corporate credit, 
against the background of policy uncertainty and sectoral surtaxes most notably on the 
financial  sector,  has  contributed  to  historically  low  investment  and  productivity 
growth rates and therefore eroded the country's growth potential, which is very low.  

•  Public debt, which was reduced from 82% to below 79% in the 2010-2012 period 
thanks  to  one-off  capital  transfers  from  the  abolition  of  the  mandatory  private 
pension  scheme  as  well  as  some  consolidation  measures,  is  still  very  high 
compared  to  the  country's  GDP  per  capita  level  and  regional  peers.  Given  the 
combination of a weak growth potential, high debt level and financing costs, a very 
high share of foreign ownership of public debt securities and the relatively high gross 
financing needs, public sector deleveraging is a vulnerable process. 

•  At  first  sight,  the  relatively  high  level  of  the  unemployment  rate  (persistently 
above  10%  since  the  start  of  the  crisis)  seems  less  of  a  concern  as  it  mainly 
reflects an increased participation rate, while employment returned to pre-crisis 

3 

 
 
levels. While private sector employment has also improved in the SME sector, recent 
increases in employment are strongly linked to public work schemes, and there are no 
visible signs of movements from public work to the open labour market. Part of the 
problem  can  be  the  insufficient  training  elements  in  the  scheme.  While  its  social 
policy  advantages  should  be  acknowledged,  the  public  work  scheme  is  unlikely  to 
contribute in a sustainable manner to GDP growth. The sustainability of the increase 
in  private  sector  employment  is  questionable  due  to  a  low  level  of  investment  and 
productivity.  

The  IDR  also  discusses  the  policy  challenges  stemming  from  these  developments  and 
possible policy responses. A number of elements can be considered: 

In  this  context,  the  in-depth  review  concludes  that  though  the  adjustment  process  is 
ongoing and there have been improvements most notably in the external imbalances, a 
number of policies that cannot be considered market friendly have contributed to losses 
in the country's growth potential. The combination of high level of debt stocks and low 
growth keeps the country vulnerable and exposed to sudden adverse changes in market 
sentiment. Therefore, in addition to flashing indicators of the scoreboard such as the highly 
negative size of the net international investment position, public and private sector debt and 
high  unemployment  rate,  the  business  friendliness  of  the  economic  environment  deserves 
very close attention so as to reduce the important risks of adverse effects on the functioning 
of the economy. 

While continuing on the path of fiscal consolidation to create the basis for sustainable 
growth,  the  policy  response  could  usefully  include  a  revision  of  the  tax  system  by 
lowering  surtaxes  on  certain  sectors  (most  notably  on  the  financial  sector),  and  more 
generally  creating  a  more  business  friendly  environment.  These  steps  should  also  make 
the country less vulnerable to changes in market sentiment and restore its attractiveness for 
foreign  direct  investment  and  bank  funding  which  would  result  in  improved  lending, 
investment and economic growth. In addition, structural reforms in both labour and product 
markets are worth pursuing in order to lift the country's potential growth. These may include 
steps toward more efficient active labour market policies, including a thorough review of the 
Public Works Scheme with respect to training elements and by reinforcing the capacity of the 
Public  Employment  Service.  In  addition,  a  strengthened  functioning  of  competition 
enforcement,  public  procurement  rules  could  be  suggested.  The  on-going  efforts  to 
implement  measures  that  lower  the  administrative  burden  is  commendable  and  could  be 
continued  and  plans  envisaged  in  the  National  Reform  Programme  fully  implemented. 
Improving  educational  outcomes  can  also  positively  affect  growth.  Finally  a  reform  of  the 
transport and energy systems toward more sustainable levels is necessary from both the point 
of view of fiscal sustainability and economic efficiency. 

4 

 
 
1. 

INTRODUCTION 

On  28  November  2012,  the  European  Commission  published  its  second  Alert 
Mechanism  Report  (AMR), prepared in accordance with Article 3 of Regulation (EU) 
No.  1176/2011  on  the  prevention  and  correction  of  macroeconomic  imbalances.1  The 
AMR  serves  as  an  initial  screening  device,  helping  to  identify  Member  States  that  warrant 
further in-depth analysis to determine whether imbalances exist or risk emerging. According 
to Article 5 of Regulation No. 1176/2011, these country-specific “in-depth reviews” should 
examine the nature, origin and severity of macroeconomic developments in the Member State 
concerned, which constitute, or could lead to, imbalances. On the basis of this analysis, the 
Commission  will  establish  whether  it  considers  that  an  imbalance  exists  and  what  type  of 
policy follow-up it will recommend to the Council. 

This is the second IDR for Hungary. The previous IDR was published on 30 May 2012 on the 
basis  of  which  the  Commission  concluded  that  Hungary  was  experiencing  serious 
imbalances, in particular as regards developments related to the net international investment 
position and implications of the high government debt.  

The updated AMR scoreboard showed that Hungary exceeded the indicative threshold 
in the case of four out of ten indicators in 2011. In addition to the public debt ratio and the 
net international investment position (NIIP) standing at 81% of GDP and -105.9% of GDP, 
respectively,  the  private  sector  debt  and  the  unemployment  rate  were  also  registered  above 
the thresholds (with values of 167% and 10.7%, respectively). In line with the conclusion of 
the AMR, Hungary is subject to an in-depth review. To this end this IDR takes a broad view 
of  the  Hungarian  economy  in  line  with  the  scope  of  the  surveillance  under  the 
Macroeconomic Imbalance Procedure (MIP). 

Against  this  background,  Section  2  of  this  review  looks  more  in  detail  into  these 
developments covering both the external and internal dimensions, followed by specific focus 
sections  on  the  country's  growth  potential  in  Section  3.  Section  4  presents  possible  policy 
considerations. 

2. 

MACROECONOMIC SITUATION AND POTENTIAL IMBALANCES 

2.1.  Macroeconomic scene setter 

Since Hungary had a high external financial exposure and a weak growth potential in 
the  pre-crisis  years,  it  was  among  the  first  economies  to  experience  a  sudden  stop  in 
2008. On the account of a sharp collapse in external and domestic demand, economic activity 

1 See European Commission (2013) 

5 

 
 
 
                                                            
declined  by  around  6¾%  in  2009.  Following  a  macroeconomic  adjustment  programme 
agreed with the EU and IMF in the context of a EUR 20 bn financial assistance envelope, the 
situation stabilized and growth resumed in the second half of 2009. In 2010 and 2011, GDP 
grew at a modest rate of 1.3% and 1.6%, respectively. Growth was driven exclusively by the 
external  balance,  with  the  export  sector  performing  well  while  domestic  demand  remained 
firmly in negative territory.  

The  economic  recovery  was  moderate  and  short  lived  with  Hungary  experiencing 
recession  again  in  2012  by  -1.7%  of  GDP  according  to  the  Commission  services'  2013 
Winter  forecast.  The  negative  GDP  growth  rate  was  mainly  caused  by  a  large  drop  in 
domestic  demand,  with  all  components  (private  and  government  consumption,  investment 
and inventories) contributing negatively. On the production side, GDP was dragged down by 
a historically weak agricultural output due to a drought. 

Graph 1: External and domestic demand contributions to economic growth 

)

%

(
e
t
a
r
h
t

w
o
r
g

l

a
u
n
n
A

10

8

6

4

2

0

-2

-4

-6

-8

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Investment

Net exports

Consumption

GDP growth (2005 prices)

Source: AMECO 

A small decline in GDP (0.1%) is projected for 2013 by the Commission services, with a 
return to growth in 2014 by 1.3%. While domestic demand is still expected to fall slightly 
this year, growth in 2014 is expected to be more broadly based. An improvement in export 
markets and a strengthened capacity of newly installed car production facilities contribute to 
a  pick-up  in  exports,  while  domestic  demand  (including inventories)  is  expected  to  recover 
slowly  to  around  0.7%  in  2014.  Looser  lending  conditions  are  expected  to  help  investment 
somewhat at the end of the forecast horizon, while moderating inflation is likely to support 
consumption growth. 

Hungary's  recovery  has  been  the  weakest  among  Visegrád  countries  since  the  2009 
recession.  This  can  be  linked  to  the  country's  particularly  weak  growth  potential 
showing a persistent stagnation since the start of the crisis. Among the factors of potential 
6 

 
 
 
 
 
 
 
growth the contributions from productivity and capital accumulation seem to be particularly 
low. Productivity growth has been in the negative territory in recent years, while investment 
stands at historically low levels, just compensating for net amortisation. 2 

2.2. 

 Sustainability of external positions 

After the NIIP of Hungary had risen persistently to exceptionally high levels (-117% of 
GDP) by 2009, it declined steadily (to around -106% of GDP in 2011) and is expected to 
come close to -103% by the end of 2012 (compared to a threshold of -35%). Net external 
debt was around 52% of GDP in 2011, and is expected to remain close to half of the NIIP 
also  in  2012.3  The  accumulation  of  the  strongly  negative  NIIP  until  2009  was  primarily 
explained  by  the  substantial  current  account  deficits  in  many  years  prior  to  the  crisis 
(averaging  7.5%  of  GDP  in  the  2000-2008  period),  when  the  gradual  improvements  in  the 
trade and transfer balances were not sufficient to counterbalance the structurally high factor 
income  deficit  (as  explained  in  last  year's  IDR  study).4  Besides,  the  dividend-type  income 
linked  to  the  relatively  large  FDI  stock  (the  latter  amounting  to  67%  of  GDP  in  2011)  the 
increasing interest expenditure related to both public and private foreign debt also contributed 
to the steadily growing factor income deficit, which peaked at close to 7.5% of GDP in 2007. 
Nevertheless, the high share of FDI in the NIIP position might alleviate somewhat the short- 
to medium-term sustainability concerns. 

2 More details on potential growth can be found in section 3.1. 

3 It is worth distinguishing between liabilities that require the repayment of the principal by the home country in 
the  foreseeable  future  and  non-debt-generating  (FDI)  type  of  external  liabilities.  Due  to  its  shorter  term 
repayment  profile  and  counter-cyclical  interest  payments,  the  increase  in  debt-generating  financing  brings 
higher  vulnerabilities.  Furthermore,  FDI  type  financing  is  also  associated  with  an  increase  in  technology 
transfers. However, it is also important to stress that the rate of return on FDI is on average higher than the rate 
of  interest  on  external  debt,  contributing  ceteris  paribus  to  a  more  negative  income  balance  in  the  current 
account. 
4 European Commission (2012): Macroeconomic Imbalances – Hungary. European Economy, Occasional 
Papers. No. 106., Directorate General for Economic and Financial Affairs, Brussels 

7 

 
 
 
                                                            
Graph 2: Components of NIIP (BOP definition, % of GDP) 

Source: Eurostat, *2012 is based on latest available quarterly data 

In  the  context  of  a  sharp  drop  in  real  GDP  in  2009  and  the  following  lacklustre 
recovery, the current account balance turned positive. The current account surplus stood 
around 1% of GDP in the 2010-2012 period. The turnaround from high deficits to a moderate 
surplus was partly driven by the rapidly contracting domestic demand, compressing imports, 
while export competitiveness rather deteriorated somewhat (for details see the next section). 
The recent current account surpluses are partly linked to the historically low investment rate 
in  the  corporate  sector,  but  also  factors  like  the  increased  precautionary  savings  of 
households,  both  of  which  are  also  to  some  extent  structural  phenomenon.  Increased 
precautionary  savings  of  households  is  linked  to  the  increasing  income  uncertainty,  most 
notably stemming from the high share of FX loans in lending to households and the possible 
impact of exchange rate fluctuations. Despite a declining share of FX debt by 23% after the 
early repayment scheme,5 its share in outstanding household loans is still well above 50%. A 
10% permanent depreciation of the HUF ceteris paribus increases household debt by close to 
2 pp of GDP and the monthly debt service burden by close to 1 pp of disposable income.  

The  current  account  surplus  is  estimated  in  the  Commission  services'  2013  Winter 
forecast to have increased in 2012 to 2.3% of GDP. Moreover, it is projected to reach 
3.3% and  3.6% of GDP  in  2013 and 2014, respectively. This is partly due a recovery in 

5 See more details on the scheme in section 3.3. 

8 

 
 
 
                                                            
external demand, but also to the fact that exports should be further boosted by car industry 
investments.  Finally  it  also  shows  that  the  weakness  of  domestic  demand  is  expected  to 
persist. Overall, the trade balance in goods and services is expected to reach 9% of GDP by 
2013. This improvement will be to some extent counterbalanced by the projected increase in 
the factor income deficit as dividend-type income should move towards its pre-crisis level as 
the economy slowly recovers (increasing from the low point of 5.4% of GDP in 2009 to 6% 
of GDP in 2014). Given that EU structural fund inflows should further increase the surplus in 
the capital account (from 2.4% of GDP in 2011 to around 4% of GDP in 2014) net external 
lending could reach some 7.3% of GDP in 2014, compared to the level of 7.1% of GDP in 
2013.  

Graph 3: Components of the current account balance (BOP definition, % of GDP) 

Source: Eurostat, 2012 is based on latest available quarterly data 

Despite  the  expectation  that  the  negative  NIIP  will  continue  to  decline  swiftly,  it  is 
expected  to  remain  at  exceptional  high  levels  in  the  next  few  years.  Assuming  no  other 
changes, the current and capital account projections of the Commission services' 2013 Winter 
forecast for the 2012-2014 period would imply a level of -88% of GDP by the end of 2014 
from  an  expected  level  of  around  -102.5%  of  GDP  in  2012.  Nevertheless  the  high  gross 
external borrowing requirement of the whole economy albeit decreasing, will remain a factor 
of  fragility  in  the  foreseeable  future.  Focusing  on  short-term  external  debt,  EUR  30  bn  per 
year will need to be rolled over by economic sectors in the coming years,6 a magnitude that 
implies potentially important vulnerabilities in case of turbulent market conditions.  

6 Koroknai, P.– Lénárt-Odorán, R. (2012)  

9 

 
 
 
 
                                                            
Graph 4: Sectoral decomposition of net external debt (% of GDP) 

Source: MNB 

Looking even further, the level of NIIP is currently anticipated to continue improving 
due  to  sustained  trade  surpluses,  capital  inflows  from  EU  funds  and  somewhat 
improving  growth  dynamics.  However,  given  the  very  negative  starting  position 
reaching  the  MIP  indicative  threshold  of  -35%  of  NIIP  would  require  a  decade.  The 
Commission  services'  calculations  on  the  basis  of  a  number  of  simplified  but  plausible 
assumptions7 for GDP growth and inflation show that Hungary would need to achieve a net 
lending surplus of around 4% of GDP on average over the 2012-2022 period in order bring its 
NIIP to below the MIP indicative threshold (-35% of GDP). Assuming that the net EU fund 
inflow  to  the  country  will  slightly  decline  from  levels  foreseen  in  2013-2014,  the  capital 
account could plausibly be projected to be in a surplus of around 2% of GDP in the coming 
decade (from a level of 3-4% of GDP foreseen for 2013-2014). Also taking into account this 
positive  contribution,  the  necessary  current  account  surplus  to  be  sustained  in  the  coming 
decade to bring the NIIP ratio to the much safer territory mentioned above is around 2% of 
GDP i.e. comparable to current levels.  

Risk  scenarios  regarding  the  evolution  of  the  NIIP  present  a  more  nuanced  picture. 
Once the recovery in the economy is associated with a weaker competitiveness and a smaller 
trade  balance  (by  2  pp  of  GDP)  compared  to  the  economic  assumptions  contained  in  the 
above scenario (i.e. reaching the -35% NIIP threshold by 2022), this would, ceteris paribus, 
still point to a massive improvement in the negative NIIP by roughly halving it from its 2011 
level to somewhat below -60% of GDP by 2022. In turn, a sustained lower economic growth 
by  1  pp  would  result  in  a  more  negative  NIIP  in  2022  by  some  10  pp  compared  to  the 
baseline  scenario.  Finally,  if  interest  rates  would  remain  at  an  elevated  level  by  200  bps 

7 See 2012 Fiscal sustainability report 

10 

 
 
 
                                                            
compared to the baseline (a stronger hike was observable at the beginning of 2012), the NIIP 
would turn out to be in the neighbourhood of -55% of GDP at the end of the reference period. 

2.3. 

Competitiveness and trade performance 

The continuous rapid increase in the surplus of the trade balance in goods and services 
(from  0.3%  of  GDP  in  2008  to  an  expected  9.6%  of  GDP  in  2014)  also  reflects 
weaknesses  in  the  economy.  An  unsustainably  low  corporate  investment  rate  and  weak 
consumption  keep  domestic  demand  contained,  while,  as  was  argued  above,  export 
competitiveness did not change substantially, or even deteriorated as a result of counteracting 
forces.  

Graph 5a: Decomposition of developments in ULCs   

Graph 5b: Decomposition of REER* 

Source: AMECO 

Note: *The REER is calculated as a deflated weighted average of the bilateral exchange rates with a group of 
36 industrial countries (IC36). 

Price  competitiveness  improved  compared  to  pre-crisis  levels  mainly  due  to  a 
substantial  weakening  of  the  exchange  rate.  However,  despite  the  government's 
compensation  scheme,8  the  substantial  minimum  wage  hike  in  2012  (19%)  could  have 
eroded these competitiveness gains somewhat due to spillover effects of minimum wage 
increases.  Although  the  scoreboard  indicator  on  nominal  unit  labour  costs  (ULC)  is  not 
above  the  benchmark  for  2011  (+3.7),  it  was  quite  high  for  most  of  the  last  decade,  in 

8 In order to compensate employers for the labour cost increase resulting from the minimum wage increase and 
to ensure that the nominal net wages are maintained while the employment tax credit scheme is eliminated, the 
government introduced substantial wage subsidies to firms, most likely temporary and certainly decreasing over 
time.  

11 

 
 
 
 
 
                                                            
particular for the traditionally non-tradable market services sectors (see also last year's IDR in 
this  respect).  The  increases  in  nominal  ULC  had  aggravated  the  deterioration  of  the  cost 
competitiveness  position  of  Hungary,  as  reflected  in  the  increase  of  the  real  effective 
exchange rate (REER), which was also more pronounced at the beginning of the last decade. 
The  crisis  brought  about  a  sharp  depreciation  in  the  ULC-based  REER  due  to  the  nominal 
depreciation  of  the  forint  (mostly  in  2009)  as  well  as  the  successive  declines  in  real 
compensation per employee and the decline in private sector employment in 2009 and 2010. 
Since then, cost competitiveness as measured by REERs broadly stagnated and has remained 
broadly unchanged also in 2012. Based on updated estimates using DG ECFIN's fundamental 
exchange  rate  equilibrium  method,9  the  Hungarian  REER  in  2012  appears  to  be  somewhat 
undervalued (by some 5%).  

the 

improvement 

in  price  competitiveness,  Hungary's  recent  export 
Despite 
performance  is  weakening  partly  due  to  cyclical  but  also  to  structural  non-price 
competitiveness factors. This is demonstrated by the fact that Hungary's export market share 
turned into negative territory since 2009 after a period of virtually uninterrupted growth in the 
1995-2008  period.  In  view  of  the  high  elasticity  of  Hungarian  exports  to  world  demand  a 
falling market share could have been seen as cyclical in the early crisis years, but the negative 
tendency in the last years seems to be in part structural.  

Graph 6: Export market share growth (% y-o-y) 

Source: Eurostat 

9 For the methodological approach see Salto and. Turrini (2010). 

12 

 
 
 
 
 
                                                            
The marked decline of inward direct investment over the recent years contributed to a 
stagnating  total  stock  of  net  foreign  direct  investment.  This  also  reflected  relocation 
decisions  of  a  number  of  multinational  manufacturing  companies,  triggering  the  loss  of 
productive capacities most notably in the electronic equipment sector. As was set out in detail 
in  last  year's  IDR,  this  decline  in  FDI  inflows  is  partly  mirrored  in  the  fall  in  the  ratio  of 
reinvested profits. However, there have also been counteracting tendencies; in particular, very 
substantial FDI investments (around 2% of GDP) into the automobile industry to some extent 
already increased or will increase in the coming years productive capacities in the automobile 
sector  (by  some  50%).  Furthermore,  the  government  has  been  signing  strategic  agreements 
with large multinationals, mostly in the manufacturing sector.10 It is yet to be seen whether 
these  latter  trends  will  turn  around  the  above  described  negative  tendency  in  export 
performance.  

While  the  Hungarian  export  performance  has  been  much  better  than  the  European 
average it has been lagging behind compared to that of regional peers. In particular, the 
increase in Hungary's export market share has been weaker in the goods category, while the 
service  sector  was  among  the  best  performers  in  Europe.  Nevertheless,  even  the  service 
sector could only experience moderate increases in the export performance since the start of 
the financial crisis. 

Graph 7: World market share in goods (annual growth): before and during the crisis 

Source: Commission services' calculations based on UN COMTRADE data 

10 As of mid-February 2013, 15 strategic agreements were concluded (covering in total over 50 000 employees, 
or  close  to  3%  of  the  headcount  of  the  private  corporations  with  more  than  4  employees),  and  according  to 
media information, the number of such agreements can even reach 40 over time. There is no uniform content of 
these  deals,  but  mostly  in  exchange  for  the  promise  to  expand  investment  and  employment  the  government 
commits to cooperate closely with these companies. 

13 

 
 
 
                                                            
Graph 8: World market share in services (annual growth): before and during the crisis 

1
1
0
2
-
7
0
0
2
e
t
a
r
h
t
w
o
r
G

3

2

1

0

-1

-2

-3

-4

-5

-6

-7

-8

MT

PL

HU

CZ

SE SI
EE

LT

AT

ES

DE

PT

DK

BG

LV

FI

LU

BE

NL

FR

IE

RO

IT

UK

EL

CY

-6

-4

-2

0

2

SK

4

6

8

10

12

14

Growth rate 2000-2007

Source: Commission services' calculations based on UN COMTRADE data 

2.4. 

Private sector indebtedness 

While  private  sector  debt  (167%  of  GDP)  entered  into  the  flashing  territory  again  in 
2011,  this  reflects  the  revaluation  effect  of  a  substantially  weakened  exchange  rate. 
However,  some  statistical  accounting  differences  in  the  non-financial  sector  debt  data 
make a precise international comparison more difficult.11 Private sector debt had almost 
tripled  from  2000  to  2009  (when  it  peaked  at  170%  of  GDP  and  thereby  stood  out  among 
catching-up economies as discussed in last year's IDR). It then declined markedly in 2010 in 
the context of strong deleveraging (net private sector credit flow recorded a sharply negative -
18.7% in that  year). As regards 2011 and  2012, when looking at  transaction based data for 
these  years,  the  deleveraging  continued  as  credits  declined  rapidly  for  both  the  household 
(7%  and  14%,  respectively)  and  corporate  sectors  (around  5%  for  both  years).  However, 
given the large share of FX denominated loans, especially in household mortgages (still close 

11 The non-financial private sector debt of Hungary is distorted by the different accounting practice of special 
purpose  entities  (SPEs)  in  the  Hungarian  statistics  compared  to  other  Member  States.  According  to  current 
practice,  SPEs  are  classified  as  non-financial  corporations  in  the  Hungarian  statistics.  This  practice  deviates 
from that of other Member States in which SPEs and other SPE-type units engaged in financial intermediation 
are usually classified as being part of the financial corporations sector. For this reason, the non-financial private 
sector debt of Hungary in the EIP Scoreboard indicator is not comparable to the figures of many other Member 
States  concerned.  Debts  of  SPEs  amounted  to  17-34%  of  GDP  in  the  last  years,  substantially  increasing  the 
indicator  for  Hungary.  As  these  corporates  are  set-up  for  tax  optimization  purposes  and  do  not  have  real 
economic  relationship  with  residents,  they  should  be  distinguished  from  other  companies.  This  comparability 
issue is being addressed by a Task Force at European level. 

14 

 
 
 
 
 
 
                                                            
to 55%), in 2011, this effect could have been more than offset by the 12% depreciation of the 
forint compared to its end-2010 level.  

Graph 9: Decomposition of debt (% of GDP) 

Source: Eurostat 

While  a  meaningful  degree  of  deleveraging  has  been  inevitable  especially  in  the 
household  sector,12  it  is  rather  the  monthly  repayment  burden  than  the  level  of  debt, 
which  seems  to  be  particularly  high.  The  monthly  debt  service  is  particularly  elevated 
(especially  compared  to  regional  peers)  due  to  the  high  interest  rate  burden.13  The  high 
interest rate burden is primarily linked to the high sovereign cost of the country, but interest 
rate margins in the household sector also stand out in international comparison. The latter can 
partially be explained by the quality of the bank's loan portfolio, but some competitiveness 
problems in the financial sector could also be highlighted. The latter is also reflected in the 
fact that despite recent decline in funding costs, the interest rate burden of households did not 
decline.  

12 Deleveraging pressures are discussed in more detail in section 3.3. 
13 See MNB's "Analysis of the convergence process, 2010. 

15 

 
 
 
 
 
                                                            
Graph 10: Interest burden and loan exposure of households 

Source: Fáykiss-Szigel (2012) 

The  decline  in  household  debt  reflects  to  some  extent  the  controversial  scheme  put  in 
place by the authorities allowing for an early repayment of households' FX mortgages 
at  a  fixed  exchange  rate  well  below  the  relevant  market  rate.14  While  this  helped 
decreasing FX exposure of households, it triggered a net loss of close to 1% of GDP for the 
financial sector (taking into account some burden-sharing between the banking sector and the 
government  laid  down  in  the  mid-December  2011  agreement)  and  since  the  scheme  helped 
primarily the most solvent debtors, the share of the problematic ones has increased in banks' 
portfolios. This is also reflected in the high household NPL rate  of  16% in the first half of 
2012. Based on final transaction based data, given that less than one-third of the repayments 
were financed from HUF loans, household debt was reduced by around 3.6% of GDP in Q4 
2011-Q1 2012 (filtering out the exchange rate effect).  

Regarding  corporate  debt,  the  rapid  decline  not  only  reflects  weaker  and  more 
uncertain growth prospects, but also extremely tight lending conditions of the banking 
sector,  partly  a  result  of  policy  uncertainty  and  permanent  extra  burdens  on  the 
financial sector (currently around 1½% of GDP). The consequences of these policies on 
the  country's  growth  potential  and  investment  dynamics  are  analysed  in  detail  in  the  next 
section of the study.  

14 See more details on this topic in the first IDR on Hungary published in May 2012. 

16 

 
 
 
 
 
 
                                                            
2.5. 

Public sector indebtedness 

The deleveraging in the private sector takes place in a context of efforts to reduce the 
high public debt level. In 2011, gross public debt declined only slightly by less than half a 
percentage point to 81.4% of GDP. This small improvement is even linked to the huge one-
off revenues from the abolition of the mandatory private pension scheme (9½% of GDP), a 
large part of which has already been used for debt reduction. However, this was almost fully 
offset  by  the  significant  depreciation  of  the  forint  by  over  10%  compared  to  its  end-2010 
level, which gave rise to an unfavourable valuation effect of government debt denominated in 
foreign currency. In 2012, after significant fiscal efforts (the structural balance improved by 
over 2½% of GDP) and some helpful revaluation effects as well as further debt repayments 
from  the  transferred  pension  assets  ,  the  debt-to-GDP  ratio  is  estimated  in  the  Commission 
services' 2013 Winter forecast to have declined by some 3 pps to 78.6%, and it is forecast to 
gradually decrease further to below 78% by 2014.  

While in the baseline scenario debt is expected to broadly stabilize at the current level, 
debt sustainability calculations show that it can turn to an increasing path if financing 
conditions  deteriorate.  In  the  baseline  scenario  of  the  Commission  services'  medium-term 
projections15  the  debt-to-GDP  ratio  is  expected  to  decline  very  slowly  to  around  74%  until 
2020.  However,  a  detailed  sensitivity  analysis  on  alternative  interest  rate  and  growth 
assumptions  compared  to  the  baseline  scenario  reveals  the  vulnerability  of  the  Hungarian 
situation. For instance if long-term interest rates would permanently stay at around 8.5% (a 
level  comparable  to  the  severe  financial  market  stress  in  Q1  2012),  debt  would  start  to 
increase  rapidly  already  from  2014  onwards,  to  reach  85%  of  GDP  in  2020.  A  somewhat 
similar  debt-increasing  path  could  be  the  outcome  of  a  one  percentage  point  permanent 
deterioration  in  the  structural  balance.  Therefore,  although  the  assumed  primary  surpluses 
over  the  projection  horizon  help  the  decrease  of  public  debt,  the  outlook  is  sensitive  to 
alternative  interest  rate  and  growth  scenarios,  due  to  the  combination  of  weak  growth 
potential  and  relatively  high  financing  costs  and  high  starting  debt  level.  In  addition,  as 
around  40%  of  the  central  government  debt  is  denominated  in  foreign  currency,  a  10% 
permanent depreciation of the HUF ceteris paribus increases debt by 3 pp of GDP. Adverse 
market  conditions  might  cause  a  combined  negative  shock  to  debt  sustainability,  e.g. 
increasing  yields  and  a  weaker  exchange  rate  in  parallel.  Under  these  circumstances  even 
worse  outturns  are  imaginable  compared  to  those  presented  on  graph  11  as  negative 
scenarios, with possible spillovers to private sector debt refinancing. 

15  Using  the  projections  for  growth,  real  interest  rates  and  the  structural  balance  for  2013  and  2014  of  the 
Commission  services'  Winter  2013  forecast,  while  keeping  the  structural  balance  constant  and  using  the 
assumptions of the 2012 Ageing report with a real interest rate around 3-3.5%, and growth rates of around 1% 
thereafter. 

17 

 
 
 
                                                            
Graph 11: Public debt scenarios 

baseline scenario

250 BP stress for 2 year with growth effects

`-1 pp shock to the structural balance from
2013
2012q1 yields with growth effects

1
0
0
2

2
0
0
2

3
0
0
2

4
0
0
2

5
0
0
2

6
0
0
2

7
0
0
2

8
0
0
2

9
0
0
2

0
1
0
2

1
1
0
2

2
1
0
2

3
1
0
2

4
1
0
2

5
1
0
2

6
1
0
2

7
1
0
2

8
1
0
2

9
1
0
2

0
2
0
2

% of GDP

90
85
80
75
70
65
60
55
50
45
40

Source: Commission services 

Unfavourable  alternative  scenarios  are  not  highly  unlikely  given  the  possibility  of 
negative market reactions if foreign investors' risk appetite decreases in general and for 
Hungary  in  particular,  as  the  high  share  of  FX  and  foreign  ownership  in  public  debt 
and also the high gross annual public refinancing needs (close to 20% of GDP for 2013) 
are  important  sources  of  concerns.  In  the  context  of  favourable  global  market  conditions 
for  most  of  2012,  maturing  FX  public  debt  (notably  over  EUR  3.5  bn  of  IMF  repayments) 
was renewed from stepped up issuance of HUF-denominated bills and bonds (including also 
the  doubling  of  retail  securities  over  the  course  of  2012)  and  existing  liquid  reserves.  This 
coupled with the marked appreciation of the forint compared to the early 2012 levels (close to 
10%) reduced the FX share of public debt from around 50% to just below 40% at the end of 
the year. However, non-residents play an increasingly significant role in the domestic bond 
market: throughout 2012 their holdings set successive all-time records and by end-year they 
owned  slightly  over  HUF  5000  bn  of  papers,  or  close  to  44%  in  terms  of  market  share.  In 
sum,  some  two-thirds  of  the  public  debt  is  owned  by  non-residents.  This  means  that  the 
country is highly exposed to sudden changes in market sentiment, as it happened in October 
2008 when the first EU and IMF support programme was requested and provided.16  

2.6. 

Labour market developments 

Although  the  indicator  on  unemployment  (3-year  average)  has  exceeded  the  MIP 
indicator  threshold  in  2011  (10.7%  against  10%),  there  have  been  moderate 
improvements in the area of the labour markets. In particular, most recent figures indicate 
that the employment rate reached its pre-crisis level (at 51%, see graph below). This occurred 

16 On the first  BoP assistance programme see the following link: 
http://ec.europa.eu/economy_finance/assistance_eu_ms/hungary/index_en.htm 

18 

 
 
 
 
                                                            
in parallel with a steadily increasing activity rate (some 2 pps to 57% from pre-crisis levels). 
Over  the  last  two  years,  the  government  introduced  numerous  reforms  to  stimulate  labour 
market supply, including notably a massive tightening in social benefits and the elimination 
of early retirement schemes from 1 January 2012. The drastic cut in unemployment benefits 
has been rather controversial, notably from an efficiency point of view.17 Therefore, in spite 
of  its  recent  decline,  unemployment  remained  relatively  high  basically  due  to  increasing 
participation rather than to a loss in employment. In the Commission services' 2013 Winter 
Forecast, the unemployment rate is projected to remain in double digits (i.e. implying that the 
3-year  average  would  remain  somewhat  above  the  indicative  threshold)  over  the  entire 
forecast horizon.  

Graph 12: Key labour market statistics in Hungary (age group 15-74) 

Source: Eurostat 

While it is important to recognise Hungary's achievements in increasing the supply side 
of the labour market as part of its structural reform programme, a few caveats remain. 
First, close to half of the recent increase is linked to the stepping up of Public Work Schemes 
(PWS) and so far there is no tangible sign of transition from public employment to the private 
sector.18 Based on empirical studies, there is a clear risk that participants will remain in the 
circle of  public work-benefit-public  work  for  a  long  period,  especially in those parts of the 
country  where  the  open  labour  market  is  unable  to  offer  real  possibilities.  Second,  it  is 
questionable whether there can be a sustainable increase in private sector employment as long 
as the growth potential is weak and there is a lack of investment. Third, as the public work 

17  Shortening  the  unemployment  benefits  to  three  months  might  result  in  increasing  skill  mismatches  as  this 
period is unusually short on average to find a new job for skilled labour. See MNB (2011) on this subject.  

18  See  for  example  Fazekas-Kézdi  (2012).  Improving  the  training  element  of  the  PWSs  would  be  especially 
warranted as proposed in CSR 4. 

19 

 
 
 
 
 
                                                            
wage is lower than the minimum wage, in some low wage non-government dominated sectors 
that are also covered by public work programmes (like agriculture, construction), there is an 
increasing risk that the latter can crowd out private sector companies. Overall, it is yet to be 
seen whether the recently adopted Job Protection Act, which contains sizeable cuts in social 
security  contributions  for  certain  target  groups  (and  can  be  considered  a  step  towards 
improving labour tax incentives) can counterbalance the negative labour supply effects of the 
full  abolishment  of  the  employment  tax  credit,  which  increased  taxation  of  low-income 
earners substantially as of 2012.  

20 

 
 
3. 

IN-DEPTH  ANALYSIS  OF  SELECTED  TOPICS:  THE  UNDERLYING  REASONS  OF 
HUNGARY'S LOW GROWTH POTENTIAL 

After a weak recovery from the sharp recession in 2009, Hungary was the first among 
central and eastern European (CEE) countries to enter into a recession again this year. 
Although  on  the  one  hand,  macroeconomic  imbalances  are  declining  as  persistent 
current  and  capital  account  surpluses  decrease  the  NIIP  ratio,  high  debt  levels 
combined  with  high  financing  costs  and  a  weak  growth  outlook  keep  the  country 
vulnerable. This section investigates the underlying reasons of the weak growth potential of 
the country. In the first section existing results on potential output calculations are reviewed, 
including the role of different inputs. The second section discusses the possible behavioural 
effect  of  recent  tax  developments,  most  notably  in  light  of  sectoral  taxes  introduced  in  the 
country. Finally, the impact of financial sector deleveraging is discussed. 

Graph 13: GDP in Hungary and Visegrád countries

19 

Source: Eurostat 

19 Visegrád countries are the Czech Republic, Hungary, Poland and Slovakia.  

21 

 
 
 
 
 
 
 
                                                            
Graph 14: Public debt and potential GDP growth 

5
1
0
2
-
1
1
0
2
h
t
w
o
r
g

l
a
i
t
n
e
t
o
p

%

,
e
g
a
r
e
v
a

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0

-3.0

HU

0

20

40

60

80

100

120

140

160

180

public debt, % of GDP in 2011

Source: Eurostat and Commission services 

3.1. 

An analysis of potential growth: past tendencies and prospects 

Hungary's potential growth seems to lag behind regional competitors. While in the case 
of the country a gradual slowdown was observable in the second part of the last decade, 
potential growth for the Czech Republic, Poland and Slovakia remained stable or even 
increased.20 The crisis has contributed to a sizeable slowdown in all countries, but given its 
unfavourable starting position, potential growth came practically to a halt in Hungary.  

20 A detailed description of the calculation of the Commission's potential growth methodology can be found in 
D'Auria et. al. (2010). 

22 

 
 
 
 
 
 
 
 
 
                                                            
Graph 15: Potential output based on the Commission's methodology in Hungary and Visegrád countries 

HU

PL

7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

labour

capital

TFP

POT GDP

labour

capital

TFP

POT GDP

CZ

SK

7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0

7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0

labour

capital

TFP

POT GDP

labour

capital

TFP

POT GDP

Source: Commission services 

It should be also noted that the current assessment of a relatively low potential growth rate in 
Hungary is broadly shared among other institutions (IMF, OECD). 

Graph 16: Potential growth outlook of Hungary according to different institutions 

COM

IMF

MNB

OECD

%

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

08

09

10

11

12

13

14

Source: Commission's services Winter Forecast, OECD iLibrary, December 2012, IMF WEO 2012, MNB, 
Quarterly Report on Inflation, September 2012 

23 

 
 
 
 
 
Looking  at  the  factors  behind  potential  growth  reveals  that  it  is  TFP  and  capital 
accumulation  where  the  country  clearly  lags  behind  compared  to  regional  peers.  By 
contrast,  there  have  been  some  improvements  compared  to  pre-crisis  trends  as  regards  the 
labour  market.  According  to  the  current  assessment  contained  in  the  Commission  services' 
Winter  2013  forecast,  capital  and  labour  are  making  a  moderately  positive  contribution  to 
growth while  TFP is  making a negative one.  21 In a financial crisis, opposing factors are at 
work on TFP.22 On the one hand, problems with financial intermediation can decrease TFP, 
while increased competitive pressure and the closure of inefficient plants can increase it. As 
discussed  in  chapter  2  and  also  in  more  detail  in  chapter  3.3,  since  the  start  of  the  crisis 
lending  to  both  the  corporate  and  household  sectors  has  been  declining.  The  scale  of  the 
decline in the corporate sector is exceptionally high when compared internationally.  

Graph 17: Corporate sector lending in Visegrád countries 

120%

115%

110%

105%

100%

95%

90%

85%

80%

75%

0
0
1
=

8
0
0
2

r
e
b
o
t
c
O

8
0
t
c
O

9
0
n
a
J

9
0
r
p
A

9
0

l

u
J

9
0
t
c
O

0
1
n
a
J

0
1
r
p
A

0
1

l

u
J

0
1
t
c
O

1
1
n
a
J

1
1
r
p
A

1
1

l

u
J

1
1
t
c
O

2
1
-
n
a
J

2
1
r
p
A

2
1

l

u
J

Poland

Slovakia

Czech Republic

Hungary

Source: MNB (2012) 

A  possible  reason  behind  the  very  low  and  recently  even  negative  TFP  is  the  problem 
with  financial  intermediation.  In  countries  with  extremely  high  loan  supply  pressures, 
productive companies can fall out of business easily.23 This seems all  the  more  likely as 
TFP growth before the crisis was solid and comparable to other Visegrád countries. As there 

21  TFP  reflects  the  efficiency  in  the  use  of  inputs,  which  are  combined  during  the  production  process.  This 
efficiency depends on a couple of factors including management capabilities, educational experience, skill level 
of the staff, the competition environment and also financial conditions. 
22 See for example D'Auria et. al. (2010). 
23 Negative TFP growth rates are observable also in Greece and Cyprus, countries with loan supply pressures 
similar to Hungary. See also section 3.3. on this subject. 

24 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                                            
has  been  some  back-ward  steps  in  terms  of  service  sector  competitiveness,24  this  can  also 
justify the decrease in productivity. 

The declining contribution of capital is a reflection of a historically low investment rate 
in  the  economy.  This  latter  was  above  20%  in  the  decade  prior  to  the  financial  crisis, 
comparable  to  other  countries  in  the  region.  Since  then,  it  has  decreased  to  around  17%  of 
GDP  while  remaining  at  their  pre-crisis  level  in  Visegrád  countries.  It  is  not  clear  to  what 
extent this decline reflects demand or supply factors. On the one hand, from the demand side, 
increased economic uncertainty during the crisis, with an increasing share of sectoral surtaxes 
on  the  corporate  sector  could  have  contributed  to  lower  investment  incentives  for  firms.  In 
addition, a natural deleveraging process has taken place most notably in the household sector. 
On  the  other  hand,  financial  sector  deleveraging,  which  has  also  been  triggered  by  extra 
burdens on the sector, caused tight credit supply that has been also detrimental to investment 
(see also 3.3. on this subject). 

Graph 18: Investment rate (investment/GDP) in Hungary and Visegrád countries 

% of GDP
30

27

24

21

18

15

00

01

02

03

04

05

06

07

08

09

10

11

12

13

14

HU

CZ

PL

SK

Source:Eurostat 

24 In addition to increasing burdens of the financial sector, corporate tax burden on several other service sector 
segments have been increased (e.g. telecom, energy, retail). See also chapter 3.2 on this subject. Furthermore, 
recent steps to increase entry costs in certain service sector segments (e.g. plaza stop, ownership and corporate 
governance  restrictions  in  the  pharmaceutical  sectors)  are  also  not  helpful  from  the  point  of  view  of  medium 
term productivity growth. 

25 

 
 
 
 
                                                            
Finally, the contribution of employment to potential growth has improved recently, and 
it is comparable to other countries in the region. This tendency is largely linked to policy 
measures designed to increase the participation rate (that lowered the replacement ratio and 
tightened eligibility conditions for pensions as well  as  other social  transfers). However, the 
persistent rise in the participation rate has not been accompanied by a proportional increase in 
employment.  Therefore  unemployment  rose  persistently  above  10%.  After  a  marked  fall  of 
above  5%  (from  Q3  2008  to  Q1  2010),  employment  gradually  returned  to  pre-crisis  levels 
this year. However close to half of the employment increase can be linked to the Public Work 
Schemes, while the sustainability of an increase in private sector employment is questionable 
given the low level of investment and the lack of productivity growth.  

Graph 19: Growth of trend employment rate in Hungary and Visegrád countries 

CZ

HU

PL

SK

%
3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

00

01

02

03

04

05

06

07

08

09

10

11

12

13

14

Source:Commission services 

26 

 
 
 
 
 Recent  changes  in  the  corporate  tax  system  and  their  potential  behavioural 

3.2. 
effects 

In  2010  the  incoming  government  set  itself  the  goal  to  reduce  the  overall  corporate 
income tax rate by introducing a fully flat rate of 10% by 2013.  25 While this ambition 
has  been  reviewed  in  the  Széll  Kálmán  reform  programme,  which  postponed  the 
elimination of the higher corporate income tax rate, special tax regimes for corporations 
have  been  created  for  small  and  medium-sized  companies  both  in  the  form  of  an 
effective preferential corporate income tax rate (already in 2010) and through targeted 
tax schemes (from 2013). In parallel, surtaxes26  on corporations in specific sectors have 
been  applied  and  extended  to  raise  revenues  to  counterbalance  costs  of  preferential 
corporate  tax  regimes  for  SMEs  and  cuts  in  labour  taxes,  several  rising  expenditure 
items, the phasing out of temporary tax elements in order to keep fiscal consolidation on 
track. Importantly, only selected sectors face a higher tax burden, while small and medium-
sized companies are eligible for preferential corporate income tax rates as well as targeted tax 
schemes. 27 

Revenues from sectoral taxes have gradually increased from ½% to 2½% of GDP from 
2009  to  2013  (see  graph  20).  This  comes  in  addition  to  the  revenues  of  around  1%  of 
GDP  from  the  standard  corporate  income  taxes  and  1½%  of  GDP  from  the  local 
business tax. Although some sectoral surtaxes were introduced already before 2010 (such as 
those  on  credit  institutions,  pharmaceutical  companies  and  energy  service  providers),  their 
magnitude  was  minor  compared  to  the  overall  size  of  the  budget  and  was  also  limited 
compared  to  the  profits  in  the  sectors  concerned.  In  2010,  as  part  of  budgetary  corrective 
measures, further significant (above 1% of GDP) but temporary surtaxes were introduced in 
the  financial,  energy,  telecom  and  retail  sectors.  In  2011,  the  tax  burden  on  the 
pharmaceutical  companies  was  close  to  doubled.  In  2012,  the  government  announced  the 
replacement  of  temporary  surtaxes  by  permanent  taxes.  In  particular,  a  new  permanent  tax 
based on minutes of phone calls and the number of short messages sent was introduced in the 
telecom  sector  already  in  mid-2012,  while  other  permanent  sectoral  taxes  in  the  utilities 

25 In this section we use the term of "Taxes on Corporations" to refer to all taxes that targets the corporate sector, 
including corporate income taxes, taxes on stocks of capital owned by the corporate sector and other surtaxes on 
corporations.  

26 Surtaxes are levied in specifically on activities in given sectors in addition to the general corporate income 
taxes. 
27 The design of some of the sectoral taxes may also discriminate against foreign-owned operators. The sectoral 
taxes  on  retail  and  on  telecommunications  sectors  have  been  subject  to  infringement  procedures  as  the 
progressivity  of  the  taxes  –  uniquely  tailored  and  applicable  to  the  respective  sectors  –  were  found  to  be 
disproportionally falling on foreign-owned operators. 

27 

 
 
 
                                                            
sector  were  launched  in  2013.28  In  addition,  the  progressive  surtax  on  the  financial  sector 
whose  base  is  the  2009  balance  sheet  was  announced  to  be  maintained  as  a  permanent  tax 
contrary  to  an  earlier  agreement  with  the  banking  sector  (to  be  halved  in  2013  and  further 
lowered  from  2014).  Furthermore,  a  consumption-type  insurance  tax  was  introduced  as  of 
2013.  Finally,  a  new  financial  transaction  duty  was  introduced  from  2013,  and  after  the 
exclusion of central bank transactions from the tax base29 its rate was increased from 0.1% to 
0.2% (and to 0.3% in case of cash withdrawal).30  

Graph 20: Hungary: Taxes on corporations as a % of GDP 

6

5

4

3

2

1

0

P
D
G
%

4
0
0
2

5
0
0
2

6
0
0
2

7
0
0
2

8
0
0
2

9
0
0
2

0
1
0
2

1
1
0
2

2
1
0
2

3
1
0
2

surtaxes

standard corporate income tax

local business tax

Source: Commission services' calculations 

It should be stressed that (sur)taxes on corporations may have negative incentive effects, 
especially when inputs to production are not exempted. In particular, they may impact 
on economic growth via several channels, notably through their potential distortionary 
impact on investment and productivity.31 In the current Hungarian case investment may be 
reduced not only due to diminishing after-tax return but also in light of the fast deleveraging 
process in the financial sector, which could also reflect the impact of the very high surtaxes 
on financial institutions (see details in 3.3.). Besides, frequent changes of taxes may also have 

28 The 8% surtax introduced in 2009 on the (adjusted) pre-tax profit of energy suppliers was extended to other 
utilities  in  2013  and  the  rate  was  increased  to  31  %,  i.e.  the  de  facto  corporate  income  tax  rate  of  subjected 
companies increased to 50 %. Additionally, pipelines and other utility networks bear an extra tax as of 2013. 

29 The first version of the act on the financial transaction duty (adopted on 9 July 2012) seemed to breach the 
independence  of  the  central  bank  and  the  prohibition  of  monetary  financing.  After  several  rounds  of 
modifications, the final law (adopted on 19 November 2012) exempted central bank transactions from the duty.   
30 It is worth mentioning that in the case of the local business tax the full deductibility of intermediate goods and 
services  from  the  turnover  has  been  eliminated  for  bigger  firms,  which  is  expected  to  affect  mostly  those 
companies that have high intermediate costs while their profit margins are limited, namely the retail and energy 
companies.   
31 See Johanson et. al. (2008) and Mirrlees et. al (2011). 

28 

 
 
 
 
 
 
                                                            
a  negative  impact  on  investment  by  creating  an  uncertain  business  environment.  Recent 
changes  in  the  design  and  rates  of  the  Hungarian  corporate  taxation,  a  growing  number  of 
sectors  subject  to  surtaxes  and  the  replacement of  temporary  sectoral  taxes  with  permanent 
ones even against earlier agreements could have such an effect (see graph 21).  

Graph 21: Size of the new surtaxes on corporations in 2013 as a % of GDP 

2.5

2

1.5

1

0.5

0

P
D
G

f
o
%

CP '12

Draft '13
budget

July '12

1st Oct
Package

2nd Oct
Package

Adopted '12
budget

Extra levy on financial institutions

Financial transaction duty

Extra income tax of energy providers

Telecom tax

Extra tax on utility providers

Source: Commission services' calculations 

From the point of view of a catching-up country, it is also important that high taxes on 
corporations may also discourage inbound foreign direct investment. In addition, to the 
extent  that  taxes  on  corporations  reduce  FDI  and  the  presence  of  foreign  multinational 
enterprises they can hinder technology transfers and knowledge spill-overs to domestic firms.  

The  introduction  of  specific  sectoral  taxes  also  tends  to  artificially  reallocate  capital 
inputs  between  sectors,  creating  economic  inefficiencies.  This  is  particularly  true  when 
those  specific  surcharges  cannot  be  justified  by  the  exemption  to  other  taxes32  or  by  the 
existence  of  sector-specific  rents.  However,  in  these  latter  cases  sectoral  taxes  should  be 
designed in a way that they respectively mimic the exempted base or capture the rent and also 
do not have a detrimental effect on investment incentives due to an excessive size. 

The  investment  ratio  has  declined  to  its  historical  low  level  (17%)  and  investment  is 
most subdued in sectors particularly hit by surtaxes. Moreover, the reinvested earnings of 
foreign companies fell to their historically lowest level. A possible sign of the worsening of 
the  business  environment 
in  selected 
competitiveness surveys, like the Global Competitiveness Report, where the country has lost 
12 places compared to the previous year.  

the  deterioration  of  Hungary's  position 

is 

32 The exemption of the financial sector to VAT could call for compensatory taxes. 

29 

 
 
 
 
 
 
 
 
                                                            
3.3   Credit market conditions' impact on deleveraging  

As discussed in section 2, private sector debt rose somewhat above the threshold level of 
155%  of  GDP  in  2011,  although  already  declined  slightly  below  to  around  152%  in 
2012,  based  on  quarterly  data.  While  the  current  level  (  level  is  not  especially  high 
compared  to  the  European  average,  private  sector  debt  is  well  above  that  of  regional 
peers and also taking into account Hungary's development level. Further fragility comes 
from  the  high  repayment  burden,  due  to  the  relatively  high  interest  rates  compared  to 
developed  countries.33  Therefore  the  need  for  private  sector  deleveraging  has  been  evident 
since the start of the crisis.  

There is also a deleveraging pressure from the credit supply point of view. The need for 
banks to roll over high levels of external funding and their decreasing risk tolerance have also 
contributed  to  a  tendency  to  decrease  loan-to-value  ratios,  partly  through  the  tightening  of 
lending conditions.  

The  deleveraging  pressure  has  been  also  incentivised  by  government  policies  in  the 
recent past, which contributed to a fast decline in external debt and a continuous fall in 
both  corporate  and  household  credit.  On  the  credit  demand  side,  the  early  repayment 
scheme of the government, introduced in late 2011 and which allowed households to repay 
their  FX  debt  at  a  predetermined  exchange  rate  level  much  stronger  than  the  market  rate 
should  be  mentioned.  On  the  one  hand  this  measure  contributed  to  a  fall  by  23%  in 
outstanding household FX loans and decreasing the FX exposure. However, the scheme also 
had a negative effect on banking sector profitability of around 0.9% of GDP, contributing to 
sizeable  losses  in  2011  (a  return  on  equity  of  -3.9%).34  The  low  level  of  profitability  may 
have contributed to the decline in funds allocated to the country, and consequently may have 
had a negative effect on credit supply. Credit supply pressures have been further exaggerated 
by  the  extra  tax  burden  on  the  financial  sector,  which  gradually  increased  from  0.03%  to 
1½% of GDP from 2009 to 2013 (as indicated in the previous sub-section). 

In addition to lower risk tolerance after the financial crisis, high sovereign spreads and 
increasing  non-performing  loan  (NPL)  rates  have  also  increased  banks'  risk  aversion. 
As foreign funding of the banking sector is closely linked to the sovereign's funding cost, 
sovereign risks and the banking sector's credit supply behaviour are strongly connected 
through  this  channel.  In  a  recent  paper35  loan  supply  pressures  among  Hungarian  banks 
were identified as one of the strongest in Europe. These pressures have a clear linkage with 
the pace of adjustment in the banking sector. The presence of international banks in Hungary 
has been declining steadily, while these banks broadly kept their position in other Visegrád 
countries. 

33 See MNB (2010) on this issue. 

34 See HFSA  (2012). 
35 See ECFIN (2012). 

30 

 
 
                                                            
Graph 22: 10 year government bond yields in Visegrád countries (monthly average) 

Source: Eurostat 

Graph 23: Loan supply pressures and the liabilities of the banking sector* 

Source: Commission services 
*Loan  supply  pressure  is  a  composite  indicator  of  banks'  financial  conditions  bounded 
between  0  and  10..  This  contains  the  NPL  rate,  banks  profitability,  capital  adequacy, 
sovereign CDS and results from lending surveys. See more detail in ECFIN (2012) 

31 

 
 
  
 
 
 
 
Graph 24: Foreign banks' exposure in Visegrád Countries 

Hungary

Poland

Czech Republic

Slovakia

% of GDP
120

110

100

90

80

70

60

50

40

30

6
0
-
c
e
D

7
0
-
r
a
M

7
0
-
n
u
J

7
0
-
p
e
S

7
0
-
c
e
D

8
0
-
r
a
M

8
0
-
n
u
J

8
0
-
p
e
S

8
0
-
c
e
D

9
0
-
r
a
M

9
0
-
n
u
J

9
0
-
p
e
S

9
0
-
c
e
D

0
1
-
r
a
M

0
1
-
n
u
J

0
1
-
p
e
S

0
1
-
c
e
D

1
1
-
r
a
M

1
1
-
n
u
J

1
1
-
p
e
S

1
1
-
c
e
D

2
1
-
r
a
M

2
1
-
n
u
J

2
1
-
p
e
S

*Source: BIS 

While the Hungarian banking sector seems to be well capitalised (with capital adequacy 
ratios around 15%), bank lending surveys for the corporate sector in Hungary show a 
persistent tightening of lending conditions, mentioning a decreasing willingness to lend 
as  the  primary  reason.  This  means  that  currently  the  financial  sector  has  a  very  negative 
contribution to economic growth in Hungary. Though deleveraging can be considered as an 
equilibrium  phenomenon  due  to  the  high  level  of  private  sector  debt,  high  share  of 
nonperforming assets in their portfolio, government measures contributed to supply pressures 
that  are  among  the  highest  in  Europe.  Based  on  most  recent  calculations  of  the  Hungarian 
central  bank  the  contribution  of  the  financial  sector  to  economic  growth  (the  new  financial 
condition  index)  has  been  highly  negative  since  the  start  of  the  crisis  and  has  been  even 
increasing recently, to around -2% annually.36 

Overall  it  seems  that  household  deleveraging  is  primarily  demand  driven,  while 
corporate sector deleveraging is rather supply driven.37 An updated estimate of Kiss et. al. 
(2006) on a large panel of countries indicates38 that household debt to GDP reached or even 
exceeded its equilibrium level by 2008, but this was not the case in the corporate sector. The 
possibility of decreasing demand in corporate credit is also less likely from the point of view 
of  loan  duration.  Since  the  crisis  due  to  increased  economic  uncertainty,  long-term  loans 
decreased  more  than  short-term  ones  in  most  countries.  As  long-term  loans  are  more 
dominant in the household sector, decreasing credit demand should be more obvious in this 

36 See MNB (2012). 

37 See also MNB (2012) "Report on Financial Stability", November. 
38 See MNB (2010). 

32 

 
 
 
 
                                                            
case.39  In  either  case,  the  exact  size  of  pressure  is  uncertain,  as  the  debt  level  is  subject  to 
uncertainty since the part that is denominated in FX (around 55% in both the household and 
corporate  sector)  is  subject  to  exchange  rate  fluctuations  and  therefore  also  to  market 
sentiment.  

4. 

POLICY CHALLENGES 

The analysis in sections 2 and 3 indicates that macroeconomic developments in the areas 
of  net  international  investment  position  (NIIP),  public  and  private  debt  are  the  main 
challenges  for  Hungary,  together  with  the  need  to  improve  the  business  environment 
and  competitiveness  in  order  to  increase  the  country's  growth  potential  and 
employment opportunities. It should be recalled that these challenges were identified under 
the  MIP  in  the  first  IDR  and  relevant  policy  responses  were  reflected  and  integrated  in  the 
country-specific  recommendations  issued  for  Hungary  in  July  2012.  The  assessment  of 
progress in the implementation of those recommendations will take place in the context of the 
assessment of the Hungarian National Reform Programme and Stability programme under the 
European  Semester.  Against  this  background,  this  section  discusses  different  avenues  that 
could be envisaged to address the challenges identified in this IDR 

Last  year's  IDR  already  showed  that  Hungary  was  experiencing  macroeconomic 
imbalances, most notably in the form of a highly negative NIIP and a high public debt. 
This updated assessment has come to the conclusion that since last year, an adjustment 
of  these  macroeconomic  imbalances  is  on-going.  However,  there  some  caveats  in  the 
process. First of all, the current account surplus and steadily declining NIIP primarily reflects 
private sector adjustment, although there has been a structural adjustment in the public sector 
of  close  to  3%  between  2008  and  2012.  While  private  sector  deleveraging  is  necessary  to 
correct  imbalances  most  notably  in  the  household  sector,  the  rapid  fall  in  corporate  credit, 
against  the  background  of  policy  uncertainty  and  extra  burdens  on  the  financial  sector,  has 
contributed to historically low investment rates. This, in turn, has eroded the country's growth 
potential.  At  the  same  time  the  reduction  of  public  sector  debt  in  2011,  which  is  also  high 
compared  to  regional  peers,  decreased  only  slightly  mainly  on  account  of  one-off  capital 
transfers. In 2012, after significant fiscal efforts (2½% of GDP in structural terms), a further 
sale  of  pension  assets  and  some  helpful  revaluation  effects,  public  debt  declined  further. 
However the current account surplus still reflects high private sector savings and the lack of 
investment, rather than a substantially increased net savings in the public sector. 

39On  the  contrary,  recent  analysis  of  the  Commission  services  has  concluded  that  there  were  demand  side 
deleveraging pressures in the corporate sector, but not in the household sector. Part of the difference can come 
from the fact that the latter analysis includes special purpose entities in the corporate sector which distorts the 
Hungarian  figures  upwards.  On  the  other  hand,  the  high  monthly  repayment  burden  in  the  household  is  not 
included in the analysis. See ECFIN (2012) 

33 

 
 
                                                            
Overall, Hungary is facing the following policy challenges. 

The most important policy challenge is to create a more business friendly environment. 
The  reliability  and  stability  of  the  institutional  framework  is  very  important  in  this  respect. 
During the last year several steps (including the adoption of the amended central bank law, an 
increase in the analytical remit of the Fiscal Council) were taken, which should be welcomed. 
However, the predictability of economic policies, including tax changes is also an important 
element of business conditions. Recent tax policy changes have not improved the operational 
environment, most notably for large firms in the service sector. Ensuring a stable regulatory 
and  business-friendly  environment  for  financial  and  non-financial  enterprises,  including 
foreign direct investors, was also recommended by the Council under the European Semester 
in 2012. Economic convergence to EU-15 member states would require lifting the investment 
rate and raising productivity. Given Hungary's lower GDP per capita and its distance from the 
technological  frontier,  a  successful  catch-up  strategy  cannot  be  expected  without  the 
continuing  reliance  on  foreign  capital  and  funding.  This  would  necessitate  increased  policy 
predictability and a revision of the corporate tax system, where the high reliance of corporate 
surtaxes  on  some  certain  sectors  most  notably  on  the  financial  sector  should  be  decreased. 
However  this  should  be  done  without  endangering  the  achievement  of  the  fiscal  targets. 
Therefore  a  broad  revision  of  the  budget  both on  the  revenue  and  expenditure  side  may  be 
necessary. 

A  related  challenge  is  to  restore  normal  lending  in  the  economy,  most  notably  for  the 
corporate  sector.  Persistent  productivity  increases  and  a  higher  investment  rate  cannot  be 
expected without efficient financial intermediation. In addition to decreasing the tax burden 
on  the  financial  sector,  this  would  require  an  agreement  between  the  government  and 
commercial banks that would give the right incentives for both parties keeping the financial 
sector profitable but also taking into consideration pressing fiscal consolidation needs. This 
could among others include some further tax incentives to increase lending in the economy. 

Fiscal consolidation should be continued in line with the Council recommendations both 
under  the  European  Semester  and  the  Excessive  Deficit  Procedure.  This  will  also 
facilitate the sustainable improvement of the negative NIIP, without putting all the burden of 
adjustment  on  the  private  sector.  While  public  debt  is  still  outstanding  compared  to  the 
country's  development  level  and  regional  peers,  the  efforts  of  the  government  to  keep  the 
budget  deficit  permanently  below  3%  of  GDP  should  be  acknowledged.  Given  the 
combination  of  a  weak  growth  potential,  high  debt  levels  and  financing  costs,  a  very  high 
share  of  foreign  ownership  of  public  debt  securities  and  the  relatively  high  gross  financing 
needs, public sector deleveraging is a very vulnerable process. Therefore fiscal consolidation 
measures should be carefully selected in order not to hamper economic growth in the medium 
term.  In  this  context,  a  loan  agreement  with  international  organisations  (even  if  treated  as 
precautionary  in  line  with  official  plans)  would  also  contribute  to  stabilizing  the  situation. 
However, the latter would require a change toward more growth friendly policies. In addition, 
steps could include the full implementation of the Széll Kálmán Plan as recommended by the 

34 

 
 
Council in March 2012 and the additional expenditure side measures announced in the April 
2012 convergence programme.  

The  sustained  reduction  in  stock  vulnerabilities  would  necessitate  raising  the  growth 
potential and the employment rate through further structural reforms. In addition to the 
ones mentioned above, further measures might need to be considered along the 2012 Council 
recommendations  under  the  European  Semester.  While  the  government's  efforts  to  increase 
the  participation  rate  and  also  SME  employment  should  be  welcomed,  a  more  careful 
approach might be needed in order to be able to increase the employment rate in a sustainable 
manner.  Steps  toward  a  more  business  friendly environment would help to improve private 
sector labour demand. In addition, as recent improvements in employment are strongly linked 
to public employment without visible signs of movements from the Public Work Scheme to 
the  open  labour  market,  more  efficient  active  labour  market  policies  are  essential.  These 
might  include  a  thorough  review  of  the  Public  Works  Scheme  with  respect  to  training 
elements and by reinforcing the capacity of the Public Employment Service. 

Furthermore,  fostering  competition  in  product  markets  could  stimulate  growth  by 
creating incentives for firms to use their resources more efficiently, responding also to 
the 2012 Council recommendations. These may include steps to strengthen the functioning 
of  competition  enforcement  institutions  and  the  public  procurement  rules,  but  also 
reconsidering increasing entry costs in certain service sector segments. The on-going efforts 
to  implement  measures  that  lower  the  administrative  burden  is  commendable  and  could  be 
continued  and  plans  envisaged  in  the  National  Reform  Programme  fully  implemented. 
Improving  educational  outcomes  can  also  positively  affect  growth.  Finally  a  reform  of  the 
transport and energy systems toward more sustainable levels is necessary from both the point 
of view of fiscal sustainability and economic efficiency. 

35 

 
 
REFERENCES 

D'Auria, F. – Denis, C. –Havik, K. –Mc Morrow K. – Planas C. –Raciborsky R.- Werner R.. 
(2010):  "The  production  function  methodology  for  calculating  potential  growth  rates  and 
output  gaps"  European  Economy,  Economic  Papers  No.  420,  European  Commission, 
Brussels 

ECFIN (2012): "Indebtedness, deleveraging and macroeconomic adjustment". Note for LIME 
working group, manuscript, European Commission, Brussels 

European  Commission  (2012):  "Macroeconomic  Imbalances  –  Hungary."  European 
Economy,  Occasional  Papers.  No.  106.,  Directorate  General  for  Economic  and  Financial 
Affairs, Brussels 

European  Commission  (2012):  "Fiscal  Sustainability  Report:  2012"  European  Economy 
8/2012 

European Commission  (2013) "Alert Mechanism Report" Brussels, 18.11.2012 

Fáykiss,  P  –Szigel,  G.  (2012)  "The  effect  of  indebtedness  on  the  financial  and  income 
position of  Hungarian Households" MNB Bulletin, February 

Fazekas,  K.  -  Kézdi,  G.  (2012):  "The  Hungarian  labour  market"  MTA  Research  Centre  for 
Regional and Economic Studies. 

Hungarian  Financial  Supervisory  Authority  (2012)  "Briefing  on  the  early  repayment",  12 
March 2012. (available in Hungarian) 

Åsa  Johansson,  Christopher  Heady,  Jens  Arnold,  Bert  Brys  and  Laura  Vartia  (2008):  "Tax 
and economic growth", OECD Economics Department Working Paper No. 620. 

Kiss,  G.  -  Nagy,  M.  -Vonnák,  B.    (2006)  "Credit  Growth  in  Central  and  Eastern  Europe: 
Convergence or Boom?" MNB Working Papers 2006/10. 

Koroknai,  Péter  –  Lénárt-Odorán,  Rita  (2012):  Developments  in  external  borrowing  by 
individual sectors. MNB Bulletin, October 2012. pp. 46-56. 

Mirrlees, J- Adam, S- Besley, T- Blundell,R -Bond, S- Chote, R - Gammie, M-Johnson, P- 
Myles,  G  and  Poterba,  J    (2011)"Tax  by  Design:  the  Mirrlees  Review"Oxford  University 
Press: September 2011. 

MNB (2010) "Analysis of the Convergence Process"  

MNB (2011) "Analysis of the Convergence Process"  

MNB (2012) "Report on financial stability" November 

Salto,  Matteo  –  Alessandro  Turrini  (2010):  "Comparing  alternative  methodologies  for  real 
exchange rate assessment" DG Economic and Financial Affairs, Economic Papers No. 427. 
European Commission, Brussels 

36