COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Hungary 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: Euro Group (euro area), Hungary, competitiveness, economic growth, financial services, indebtedness, macroeconomics, public debt, stability pact, trade balance













EUR-Lex - 52014SC0085 - EN











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52014SC0085

COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Hungary 2014 /* SWD/2014/085 final */









Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances
Hungary continues to experience macroeconomic imbalances,
which require monitoring and decisive policy action. In particular, the
ongoing adjustment of the highly negative net international position, the high
level of public and private debt in the context of a fragile financial sector
and deteriorating export performance continue to deserve very close attention so
as to reduce the important risks of adverse effects on the functioning of the
economy. 
More specifically,
despite a lacklustre export performance, the NIIP has been improving,
reflecting primarily private sector deleveraging. Although there have recently
been some encouraging signs in manufacturing, it will not be enough to bring
out by itself a marked turnaround in export performance. While the debt level
has declined, the imbalance and risks related to private debt remain, as
deleveraging has been hindered by a high share of distressed borrowers, a
depressed housing market, a fragile financial sector, a substantial share of
loans in foreign currency as well as prevailing business uncertainty. Restoring
normal lending to the economy in a sustainable manner would require improving
the operating environment for banks. A high government debt is another
important source of concern. Despite substantial improvements in the structural
fiscal balance, a weakened exchange rate, a poor growth potential and elevated
financing costs have kept the debt from declining. Hungary is not expected to
meet its medium-term objective and its structural balance is projected to
deteriorate in 2014. 
Excerpt of country-specific findings on Hungary, COM(2014) 150 final,
5.3.2014
Executive Summary and Conclusions 7
1.       Introduction  9
2.       Macroeconomic
Developments 11
3.       Imbalances
and Risks 17
3.1.     Despite a
weak export performance the NIIP is expected to continue improving  17
3.1.1.  Why has the
Hungarian export performance deteriorated in the last decade?  18
3.1.2.  External
sustainability  25
3.2.     Although
private sector deleveraging has slowed down recently, several fragilities
remain  27
3.2.1.  Household
indebtedness 28
3.2.2.  Non-financial
corporate sector 34
3.2.3.  Financial
sector 38
3.3.     The high
and stagnating level of government debt remains a key source of concern  42
4.       Specific
Topics 43
4.1.     The
business environment: an analysis based on international competitiveness
indicators 43
4.1.1.  What are
Hungary's main strengths?  46
4.1.2.  What is behind
the observed downward trend?  48
5.       Policy
Challenges 57
References 60
LIST OF Tables
2.1.     Key
economic, financial and social indicators - Hungary  16
3.1.     Extra taxes
and regulatory burdens on the financial sector since 2010  40
LIST OF Graphs
2.1.     External
and domestic demand contributions to economic growth  11
2.2.     GDP based
and LFS employment 11
2.3.     Participation
rate in the region  12
2.4.     Employment
rates in the region  12
2.5.     Potential
output growth  13
2.6.     Sectoral
decomposition of debt (non-consolidated data) 13
2.7.     Net lending
by sectors 14
2.8.     The severe
material deprivation rate in the region  15
2.9.     The share of
people living in low work intensity households 15
3.1.     Current
Account 17
3.2.     Export
market share  18
3.3.     Export
performance in volumes 18
3.4.     Export
Deflators 19
3.5.     Product
structure of exports 19
3.6.     Share of
extra EU countries in exports (%) 19
3.7.     A
decomposition of export growth in the precrisis period (2000-2007, average) 20
3.8.     A
decomposition of export growth in the post-crisis period (2007-2010, average) 20
3.9.     Export
value growth (2007-2012) 20
3.10.   Export
quantity growth (2007-2012) 20
3.11.   Export good
unit value levels in machinery and transport equipment sector (eur/100kg) 21
3.12.   Export good
unit value levels in other sectors (eur/100kg) 21
3.13.   Real
effective unit labour costs 21
3.14.   Comparative
goods level prices, euro area =1  22
3.15.   Manufacturing
productivity levels vis-a-vis EU15 countries 22
3.16.   Growth of
productivity in manufacturing subsectors (average of 2000-2011) 22
3.17.   FDI net
positions in manufacturing  23
3.18.   FDI stock,
manufacturing output and export performance (2000-2011) 23
3.19.   The
contribution of different sectors to manufacturing production  23
3.20.   Direct and
indirect value added content of exports among OECD countries in 2009  24
3.21.   The R&D
intensity of manufacturing in OECD countries (2005-2009) 24
3.22.   The NIIP  25
3.23.   Valuation
effects in NIIP  26
3.24.   The
decomposition of the net lending position  26
3.25.   Short term
external debt 26
3.26.   External
sustainability projections 27
3.27.   Household
debt 28
3.28.   Net savings
position of households 28
3.29.   Number of
houses built and real house prices 29
3.30.   Dwelling
assets in 2011  29
3.31.   Housing
affordibility*  30
3.32.   Available
housing subsidies on a median flat 33
3.33.   Credit demand
of households based on the SLO survey  33
3.34.   New loan
transactions of the households 33
3.35.   Household
repayment burden  34
3.36.   Debt of the
nonfinancial corporate sector 34
3.37.   Domestic
banks' loans to the non-financial corporate sector 35
3.38.   New corporate
loans 35
3.39.   Investment
rates in V4 countries 38
3.40.   Foreign
banks' exposure in the CEE region  38
3.41.   The
composition of private sector loans based on different banking groups 39
3.42.   NPL and loan
loss coverage on total banking sector assets (June 2013) 39
3.43.   Cost of CHF
foreign funding of mortgage loans and the average interest rate spread   40
3.44.   Government
debt and GDP/capita in EU in 2012  42
3.45.   Government
debt sensitivity analysis 42
4.1.     The
Hungarian business environment according to main international rankings 43
4.2.     Global
Competitiveness Index (WEF, 2001-2013) 44
4.3.     World
Competitiveness of Economies 44
4.4.     Attractiveness
of V4 countries as investment locations, 2006-2013  44
4.5.     World Bank
Doing Business - change in rankings 2006-2013  44
4.7.     Net FDI
stocks as % of GDP  45
4.6.     Global
Competitiveness Reports (2006-2013) 12 Pillars of Competitiveness 46
4.8.     Starting a
Business (DBR) 46
4.9a.  Complexity of
regulatory procedures 47
4.9b.  Administrative
burdens for corporations 47
4.10.   Labour
Flexibility  48
4.11.   Financial
Market Efficiency  48
4.12a.                                                                                                                      Venture Capital Availability  49
4.12b.                                                                                                                               Ease of access to loans 49
4.13.   Hungarian
Institutions and the Policy Framework  49
4.14.   Legal
barriers to entry  50
4.15.   Barriers in
the Service Sector 50
4.16.   Price
Controls 51
4.17.   Total tax
rate  51
4.18.   Paying Taxes
in the Visegrad Countries 51
4.19.   State of
cluster development 52
4.20.   Value chain
breadth  53
LIST OF Boxes
3.1.     Details of
the external sustainability calculations 25
3.2.     The FX debt
problem and government intervention  31
3.3.     Which
sectors are responsible for the decline in the investment rate?  37
4.1.     Recent
policy steps affecting the business environment 54
LIST OF Maps
No table of contents
entries found.
In April 2013, the Commission concluded
that Hungary was experiencing macroeconomic imbalances and indicated the
necessity of adopting decisive policy actions. The very negative net
international investment position (NIIP), in particular, raised concerns. In the
Alert Mechanism Report (AMR) published on 13 November 2013, the Commission
found it useful, also taking into account the identification of imbalances in
April, to examine further the risks involved in the persistence of imbalances.
To this end this In-Depth Review (IDR) provides an economic analysis 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:
·       Although a continuous improvement is projected, the NIIP remains a
major source of concern, due to its still highly negative level and high
short-term external rollover needs. The NIIP has
been improving steadily since 2009 due to a favourable external financing
position reflecting a current and capital account surplus. This is primarily
the result of suppressed domestic demand and an increasing inflow of EU funds,
while the growth of export market shares (with a 16% cumulative fall in the
2008-2013 period) has been well below that of regional peers. Recent large FDI
investments in the automobile industry might improve somewhat Hungary's
lacklustre export performance, but these new capacities will not suffice to
turn it around in a sustainable manner.
·       Despite a recent slowdown in deleveraging, indebtedness of
households and non-financial corporations also remains a key vulnerability. The improvement of the NIIP partly reflects private sector
deleveraging, which has been ongoing for the fifth year in a row, reflecting
several factors related to both the demand and supply of credit. On the demand
side deleveraging is the result of the high level of household and to some
extent corporate debt accumulated before the financial crisis. On the supply
side, a decreasing risk tolerance, a high level of external financing as well
as the deterioration in the operating environment of banks can be mentioned.
The repair of balance sheets is hindered by a high share of distressed
borrowers, a depressed housing market, a fragile financial sector as well as
prevailing business uncertainty. 
·       The situation in the financial sector continues to raise concerns. Although the sector seems to be adequately capitalised and its
liquidity position is relatively strong, the combination of a high level of tax
and regulatory burdens as well as a high share of problematic loans does not
provide the right incentives for banks to increase their lending activity.
While the central bank's subsidized lending scheme (Funding for Growth Scheme)
gave some temporary relief in access to credit for SMEs, financial
intermediation conditions have not improved in a sustainable manner.
·       Government debt has remained steadily at a high level, which is
forecast to be corrected only at a very slow pace.
Despite one-off capital transfers that decreased public debt by around 7% of
GDP, and a substantial improvement in the structural balance, government debt
has been broadly stable around 80% of GDP since 2009. The short-term rollover
needs and the interest rate burden on debt are still at elevated levels
(respectively 22% and 4% of GDP in 2014), contributing to vulnerabilities.
While in the baseline scenario the debt to GDP ratio is forecast to decline
slowly, in case of a more negative external environment or a negative shock to
domestic confidence, it will start increasing again.
·       Overall, a faster decline of Hungary's imbalances is hindered by a
relatively low growth potential. As in countries
with high debt levels, financing costs and the growth outlook can be strongly
correlated, an improved potential growth would help to decrease imbalances also
through indirect channels. The low growth potential of recent years has been
partly the consequence of debt overhang and deleveraging, but economic growth
has also been hindered by the deterioration in the business environment, due to
the introduction of excessive taxes in some sectors and increasing entry costs
in certain service sector segments.
The IDR also discusses the policy
challenges stemming from these imbalances and what could be possible policy
avenues for the way forward. A number of elements can be considered:
·       Improving the export performance would require more FDI inflows as
well as a broadening of the value chain in the export sector. The latter seems to be particularly challenging for catching-up
economies, where there is a substantial gap in terms of productivity between
foreign and domestic companies. This is also related to the problem of
relatively low value added content of exports and a low level of domestically
driven innovation. This would probably require increasing support to research
and development as well as better cooperation of businesses and universities.
In addition, improving financing conditions for SMEs would be also beneficial. 
·       The negative feedback loop between households, banks and the housing
market could possibly be tackled by a final debt relief scheme targeted to
insolvent borrowers, while mitigating risks of moral hazard and limiting the
additional tax burden on the financial sector. The
targeted nature of the scheme together with a clear commitment to end the
practice of adopting new measures would keep moral hazard risks contained. In
order not to endanger financial stability the scheme would need to be
accompanied by a reduction of the current tax burden on the financial sector.
At the same time, given a high non-performing loan (NPL) ratio also in the
non-subsidized HUF loan segment, a possible programme would also have to target
this share of indebted households, not only FX debtors. The programme would
help to improve the banking sector's portfolio and decreasing excess housing
supply, which ultimately could contribute to better lending conditions both in
terms of loan demand and supply. 
·       Improving capital accumulation possibilities as well as incentives
to portfolio cleaning are essential to ease supply-side conditions in bank
lending. The central bank's Funding for Growth
Scheme (FGS) is currently the main policy tool used to revive corporate
lending. Although subsidized schemes can be useful to tackle negative
externalities (e.g. the prohibitively high risk aversion of banks towards the
SME sector) they cannot be a substitute for a normal operating environment for
the banking sector. A large share of subsidized lending could also entail
potentially high fiscal costs and distort price signals. In order to improve
banks' operating environment, the current level of the banking sector's
taxation could be reconsidered, while legal obstacles and impediments to
portfolio cleaning could be investigated and properly tackled.
·       In addition to a better operating environment for the financial
sector, a more predictable and competitiveness-oriented policy and regulatory
framework would be warranted. An improvement in the
business environment can also be facilitated by compulsory stakeholder
consultation before any major policy initiative. Also, the role of the
competition authority in the assessment of legislative changes could be
enhanced. The corporate tax system could be simplified and entry costs in
service sector segments could be decreased. Finally, labour market reforms and
a more sustainable energy price system could also boost competitiveness. 
·       Continued fiscal consolidation efforts combined with a more
growth-friendly structure of the adjustment would also be warranted. This would require relying less on revenue measures (most notably
by lowering the excessive taxation of selected sectors) and more on expenditure
restraints. This restructuring of fiscal policy could possibly lead not only to
higher potential growth but also lower financing costs.
On 13 November 2013, the European
Commission presented 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. 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” (IDR) 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 in the
sense of the legislation and what type of follow-up in terms it will recommend
to the Council.
This is the third IDR for Hungary. The
previous IDR was published on 10 April 2013 on the basis of which the
Commission concluded that Hungary was experiencing macroeconomic imbalances and
indicated the necessity of adopting decisive policy actions. In particular, the very negative NIIP raised concerns. Overall, the
Commission finds it useful, also taking into account the identification of
imbalances in April, to examine further the risks involved in the persistence
of imbalances. To this end this IDR provides an economic analysis of the
Hungarian economy in line with the scope of the surveillance under the
Macroeconomic Imbalance Procedure (MIP).
Against this background, Section 2 reviews
the general macroeconomic developments,  Section 3 looks more in detail into
the main imbalances and risks and Section 4 analyses recent developments in
Hungary's business environment based on international competitiveness surveys.
Finally, Section 5 discusses policy challenges.
The macroeconomic outlook improves partly on
account of indirect fiscal stimulus measures 
Following a double dip recession in
2012, GDP growth has returned to positive territory since the first quarter of
2013. Real GDP growth stood at 1.1% in 2013, and
based on the Commission services' winter 2014 forecast is projected to
accelerate to around 2% in 2014-15. An increase in exports is expected to be
driven by a gradual recovery in external demand, while export performance could
also improve somewhat due to an increase in newly installed capacities in the
automobile industry. An improvement in domestic demand is foreseen on account
of improving investment and consumption, which  is partly driven by indirect
government stimulus to the economy, including (i) an acceleration in the
absorption of EU funds, (ii) cuts in household utility prices, and (iii) the
central bank's subsidized lending scheme (Funding for Growth Scheme
(FGS) ([1])).
After staying around 4-5% even during
the crisis years (2009-2012), annual consumer price inflation declined to a
historically low level in 2013. Inflation fell
below 1% in the last months of 2013, partly due to three waves of cuts in
regulated energy and other utility prices introduced as of January, August and
November. ([2]) Underlying
inflation has been declining too, due to the negative output gap, a drop in
imported inflation and decreasing inflation expectations. After staying in the
range of 1-2% in 2013 and 2014, inflation is expected to return to close to the
central bank's 3% target over the medium term.
Even though at first sight, the
Hungarian labour market seems to have been relatively resilient to the
financial crisis, employment statistics provide a contradictory picture.  Although GDP fell close to 4% between 2007 and 2013, employment
based on the Labour Force Survey (LFS) increased around ½% in the same period.
The latter increased by close to 5% between Q3 2009 - Q3 2013 (i.e. since the
lowest point in the crisis) and the improving trend has been uninterrupted. By
contrast, GDP-based employment increased by around 2½% in the same period, and
more importantly it has been broadly stagnant in the last three years.
Therefore, while a turnaround in the labour market from 2009 to H2 2010 seems
to be evidenced by both statistics, uncertainties regarding the exact state of
the labour market have increased recently. Substantial employment gains have
occurred in the public sector, due to the extensions of the Public Work Scheme
(PWS), which contributed a 1¼ pps increase in the LFS employment in the Q3
2010- Q3 2013 period. However, excluding the effect of this scheme, GDP-based
employment declined slightly (by ½ pps). Therefore the improvement in private
sector employment based on the LFS statistics in the last three years could
reflect the net increase in frontier workers, but also the whitening of the
economy.([3])These latter
two factors explain 3½ pps. out of the total improvement of 4¼ pps. in the LFS
statistics between Q3 2010 and Q3 2013.
The relatively low level of newly
created private sector jobs reflects the constraint from the labour demand
side, linked to the low level of investment and productivity. The slightly declining GDP-based employment without the effect of PWS
is a sign for  the weakness of labour demand in the private sector, as labour
participation has been increasing continuously even after controlling for the
effect of public works. This latter phenomenon is related to the successive
tightening of social transfers (including increases in the retirement age,
tightening eligibility conditions for early retirement and unemployment
benefits), but the Job Protection Act could also have incentivised
participation and employment for certain groups.([4])
By Q3 2013, the employment rate in
Hungary has almost reached the level of most regional peers. The seasonally adjusted employment rate reached 58.5% of the active
age population, which is only slightly lower than the corresponding level of
the Slovak Republic or Poland. The Czech Republic has by far the highest
employment rate in the region, close to 68%. Despite similarities in the
employment rate of three Visegrád countries, unemployment rates vary much more
reflecting differences in participation.
The medium-term growth outlook remains weak
Potential output growth remains quite
low at 0-1%, close to the EU average but well below the level of regional
peers. Hungary's potential growth was already quite
modest compared to Visegrád countries before the financial crisis and it
practically came to a halt in recent years. TFP and capital accumulation are
the main factors behind the weak growth potential. By contrast, there have been
some improvements compared to pre-crisis trends as regards the labour market,
linked to several structural reforms, mentioned above. 
Both credit demand and supply factors
have hindered capital accumulation, as discussed in the 2013 IDR. In addition to the unavoidable deleveraging among households and in
the corporate sector, deterioration in the business environment could have
hindered investment decisions. ([5])
The lack of TFP growth could be linked
to problems with financial disintermediation but also to a low level of
innovation in general. In the process of continuous
deleveraging, innovative firms have less access to capital, hence tight
financing constraints could have hindered productivity. At the same time a weak
innovation capacity has been a feature of the Hungarian economy even before the
crisis. The country has been lagging behind in terms of new FDI inflows in the
last decade compared to regional peers, while domestic innovation capacity has
also stood well below the level of EU15 countries, although this latter
phenomenon is also true for other Visegrád countries (see section 3.1.1.). 
A clear end of deleveraging is not yet
foreseen 
Deleveraging
has been ongoing since the start of the financial crisis in all private sectors
of the economy. The decline in debt levels has been
hindered by the high share of FX debt due to a weakened exchange rate compared
to pre-crisis levels. Deleveraging has been driven by both credit demand and
supply factors. From the demand side, debt overhang was observable in the
household and to some extent the corporate sectors. From the credit supply side
banking sector's decreasing risk tolerance and a deterioration in its operating
environment has contributed to a tightening of credit supply.
 As
recently net lending flows turned positive in the non-financial corporate
sector only due to the effect of one-off factors, it might be premature to
refer to a turning point in debt reduction. Supply conditions have been
eased by the central bank's FGS, and investment has also been fuelled by an
increasing inflow of EU funds. However, without the FGS, net lending flows are
still in the negative territory. ([6]) Given a still high total debt level compared to regional peers (as
opposed to a much more moderate level of loans from domestic banks ([7])) and prevailing business uncertainties, recent developments cannot
be considered as reflecting a turning point in debt reduction.
While demand for credit is expected to
increase in the household sector, the still high monthly repayment burden of
debtors, and the high share of distressed borrowers hinder a recovery. Household debt level declined by 10 pps. since the 2010 peak and
reached the level of other Visegrád countries. At the same time, the monthly
repayment burden of households remains unchanged (due to a weakened HUF/CHF
exchange rate and a lower disposable income compared to pre-crisis levels) and
the share of distressed borrowers has increased. 
A return to normal lending is also
constrained by banks' weak incentives to lending activity. Although the FGS scheme could temporarily ease financing conditions
in the corporate sector and the decreased interest rate level (passed through
from a lowered base rate) helps to stimulate credit demand in general, a return
of normal lending to the economy is hindered by a difficult operating
environment for the financial sector, most notably a high level of burdens
combined with an elevated ratio of non-performing loans (NPLs).
Government debt has stagnated since
2009, but is forecast to decline very slowly to slightly below 70% of GDP by
2023.  Despite one-off capital transfers, which contributed
to reduce debt by close to 7% of GDP, and significant improvements in the
structural balance, government debt has remained stable at around 80% of GDP in
the last few years. This reflects the effect of a weakened exchange rate, a low
growth performance and high financing costs. In the baseline scenario
government debt is projected to decrease slowly. However, this path is very
sensitive to the growth outlook, the potential financing costs and the level of
the exchange rate. Under unfavourable scenarios, debt can start increasing
again. ([8])
Private
sector deleveraging has been mirrored in a surplus of the external balance,
despite a weak export performance. Export market
shares fell by a cumulative 16% between 2008 and 2013, one of the highest falls
in CEE comparison. Despite this negative tendency, the net lending/borrowing
position of the whole economy was in surplus, driven mainly by the adjustment
of the private sector, i.e. a substantial decline in the investment
rate. ([9]) However,
this is primarily considered rather cyclical, especially in the case of
corporations. At the same time the widened output gap masks a substantial
improvement in the structural balance of the general government by over 6 pps.
if the 2013 figure is compared to pre-crisis years.
NIIP is
expected to continue improving in the medium term, despite a weak export
performance. The improvement in the NIIP is
foreseen to prevail in the medium term, primarily reflecting an increased
fiscal discipline compared to pre-crisis trends. Sticking to the MTO could help
Hungary to avoid the twin deficit problem, which was typical in the pre-crisis
decade. ([10])
The crisis has had long lasting social
consequences
All indicators on poverty have been
deteriorating since the start of the crisis, and most of them stand at a higher
level than that of other Visegrád countries. In
particular youth unemployment, the severe material deprivation rate has
increased substantially since the start of the financial crisis (both by around
8 pps.). At the same time the severe material deprivation rate and the share of
low work intensity households stand above the level of regional peers and the
difference even increased in the last years.
The weaker social position of Hungary
compared to regional peers probably reflects the deeper negative economic
effects of the financial crisis since 2008. Hungary
has undergone a severe external adjustment after the start of the financial
crisis, contributing to a deep recession and increasing unemployment. The high
share of FX loans, combined with an over 40% weakening of the HUF/CHF exchange
rate and declining employment increased the share of insolvent debtors and
could have contributed to the deterioration of poverty indicators. Given the
high level of government debt, and a budget deficit above the Treaty threshold
before the crisis, the government was hindered to pursue countercyclical fiscal
policy contrary to most EU countries. It is also possible that the particular
policy responses chosen (e.g. cutting the length of unemployment and tightening
the availability of other social benefits, while also decreasing both in size;
steps towards a more regressive taxation system) could have had a negative
effect on poverty indicators.
The Hungarian economy has been suffering
from a number of imbalances: a highly negative NIIP and an elevated level of
external debt, which stems from a high level of public and private sector
indebtedness, accumulated before the financial crisis. The decline in the NIIP has been accompanied by a gradual
deterioration of the export performance, which has become particularly
pronounced in the last years. The reassessment of risks in the financial crisis
led to the deleveraging of previous excessive debt levels, which depressed
further an already declining housing market.
3.1.      Despite
a weak export performance the NIIP is expected to continue improving
After persistent current account
deficits contributing to a rapidly deteriorating NIIP position, the crisis
brought about a sharp improvement in the external balance mostly on account of
increased net savings of households and corporations. The collapse of domestic demand turned the current account into a
surplus, despite a lacklustre export performance. The improvement of the
external balance (by around 7 pps. between 2008 and 2009) primarily reflected
the adjustment of the private sector, although the structural budget balance
has also improved (by around 2 pps.). The adjustment was smoothed by a Balance
of Payments assistance programme of the EU and IMF([11]).
Although the export performance has
weakened, Hungary has recorded a net lending surplus that has contributed to a
declining NIIP and external debt since 2009. While
it has been the most dynamic compared to the other three Visegrád (V3)
countries in the early 2000s, export growth has slowed down gradually later,
culminating in a sharp fall in export market shares since the financial crisis.
While the fall of country exports compared to world exports is a general
European phenomenon, contrary to other V3 countries, Hungary has been in the
group of the worst performing Member States in the region, with and 16% fall in
export market shares in the 2008-2013 period. With an openness ratio ([12]) of close to 160% of GDP (among the highest in the world) a
slowdown in export performance could seem partly inevitable at some point.
However, the fact that the other V3 countries have a similar openness ratio
suggests that a better export performance is still possible. As the highly
negative NIIP and the high level of external debt are among the main sources of
Hungary's vulnerabilities, it seems warranted to ask whether the improvement is
expected to continue in the coming years, especially in view of a deteriorating
export performance.
The analysis presented below suggests
that the NIIP will likely improve in the medium term. This improvement is driven by a more contained domestic demand
compared to pre-crisis levels due to improved fiscal discipline and a
substantial inflow of EU funds. 
The current highly negative level of the
NIIP, combined with high external rollover needs in the absence of an obvious
improvement in the export performance, keep the economy vulnerable, and should
still be considered as an imbalance. The extent of
vulnerability also depends on whether the future path of the NIIP will be
financed mainly from FDI or debt sources. If the country is able to at least
maintain the current net stock of FDI (as a percentage of GDP) in the next ten
years, the NIIP would be almost fully financed from FDI flows in the baseline
scenario. Under less favourable macroeconomic scenarios, debt type financing
will very likely prevail, therefore keeping vulnerabilities at a higher level
for a prolonged period. 
3.1.1.   Why
has the Hungarian export performance deteriorated in the last decade?
A detailed analysis of the Hungarian
export performance suggests that the deterioration is primarily related to
tightening supply constraints. This is partly
linked to the inability to attract new FDI inflows but also to the weak
spillover linkages between multinationals and domestic companies. Although recently
there have been some large investment projects in the automobile industry, a
marked improvement in the export sector is not expected. This latter would
require reliance on a broader set of export segments and also improved
performance in terms of the value chain breadth.
Some detailed stylised facts
The underperformance of Hungarian
exports is primarily related to goods, while services exports broadly grew in
line with the regional average. At the same time it
is also important to stress that Hungary only slightly underperformed vis-à-vis
other V3 countries in terms of volumes. Therefore export price developments are
the main reason behind the differences in export performance. While the
Hungarian export deflators have broadly stagnated since 2000 the other V3
countries were able to increase their deflators by around 30 to 70%. 
 
The four Visegrád (V4) countries have a
broadly similar product structure, but Hungary experienced some unfavourable
one-off shocks during the crisis, which affected the export performance
significantly. All V4 countries are primarily
involved in producing machinery and transport equipment products for exports,
with Poland having a somewhat less concentrated structure compared to the other
V3 countries. Nevertheless, Hungary has experienced significant plant closures
in the export sector in the last few years due to global decisions of
multinational firms mostly in the electronic equipment subsector ([13]). However, it is not clear if these decisions are already related
to Hungary's loss of competitiveness, as no comparable data is available for
other countries in the region. Also, as in terms of export performance the
country has lagged behind continuously since the early 2000s vis-à-vis regional
peers, these one-off shocks cannot be the sole explaining factor behind the
deterioration.
In terms of the country structure of exports,
V4 countries can be split into two subgroups. EU
countries are accounting for around 75% of exports for Hungary and Poland,
while this share is higher at 85% for Slovakia and the Czech Republic.
Nevertheless all countries have reoriented to some extent their trade towards
non-EU countries in recent years.
The shift share analysis suggests that
differences in export developments are not attributable to the initial product
or geographical distribution, but to market share gains in individual product
or country markets. In this respect Hungary has
been the least successful among the Visegrád countries before, as well as after
the financial crisis (see graph 3.7 and 3.8).
The deterioration of Hungary's
competitiveness in the export sector is primarily related to the machinery and
transport equipment subsector. It is important to
stress, that – as is the case with total goods and services exports −
this tendency is not visible in terms of volumes, but reflects differences in
export unit values. In terms of volumes, other sectors than machinery explain
the lower performance of Hungary although the general difference compared to
regional peers is smaller (except compared to the Czech Republic)([14]).
Hungary's underperformance in terms of
prices is a consequence of an initially very high level of unit values,
which the country was unable to increase further in the last decade. The unit values of other V3 countries increased, probably
reflecting the effect of product upgrading. The differences in the level of
total export unit values is a consequence of the different pattern of the
machinery and transport equipment sector, while the price trends of other
sectors seems broadly similar.
Overall, Hungary's weak export
performance compared to regional peers is primarily attributable to a weaker
price/value performance of the machinery and transport equipment sector. Hungary has also been slightly lagging behind in terms of volumes,
although this occurred in other export sectors than machinery. Nevertheless,
the country continues to have the highest level of export unit values, which
could reflect a still competitive product quality in regional comparison.
Drivers behind the weak export
competitiveness
Price
competitiveness
While there was no substantial
difference in the pre-crisis years, the Hungarian price and cost
competitiveness improved substantially after the financial crisis if compared
to the Czech Republic and Slovakia. In terms of
unit labour costs based real exchange rate, all countries but Poland had a
similar real appreciating trend until 2007, while both Hungary and Poland
gained competitiveness due to the depreciation of the nominal exchange rate in
2009. A comparison of goods price levels also point to Hungary and Poland
having the lowest prices among the V4 countries after the start of the
financial crisis.
Product
quality
The worse performance of Hungarian
export deflators compared to other V3 countries might point to differences in
product upgrading. Benkovskis and Worter (2012)
estimate the effect of product quality for different EU countries including the
V4 countries. After estimating quality, they produce quality-adjusted price
competitiveness measures. Their results show that while other V3 countries'
export deflators increased substantially in the last decade, after adjusting
for quality they showed a steep declining trend. At the same time, while
Hungarian export prices remained stable, this is also true for quality-adjusted
prices. This suggests that Hungary has become less competitive due to its
inability to improve the quality of its products. 
Productivity,
FDI and the value added content of exports
Hungary's manufacturing productivity
growth has also been lagging behind compared to regional peers, i.e. the export
performance could have been hindered by supply side constraints. The slower productivity growth of Hungary is broadly valid across
all subsectors, therefore it cannot be considered as the result of some
idiosyncratic shock. Somewhat similarly to the case of exports, the relative
productivity improvements of other V3 countries reflect a catching-up process.
While Hungary had one of the highest levels of manufacturing productivity among
V4 countries in the first half of the decade, currently it has the third lowest
figure, well below the level of the Czech Republic and Slovakia.
V4 countries lag well behind the EU
average in terms of innovation capacity, and FDI inflows are one of the most
important sources of productivity and product quality improvements. Earlier research (Oblath, 2009) concluded that Hungary's export structure
contained a large share of high quality products in the early 2000s in
manufacturing, similarly to the most developed EU countries. This conclusion is
reinforced by the initial high level of export prices. The advanced level of
product quality was accompanied by a very high level of FDI in Hungarian
manufacturing compared to other V3 countries. 
While the other V3 countries increased
the stock of FDI in manufacturing, Hungary's stock even declined until 2011, as
practically no new production capacities were installed. ([15]) Indeed it seems that productivity and
export performance are strongly related to FDI, a relationship which has been
confirmed by several empirical studies.([16])
While there was an upswing of FDI in
manufacturing in 2011-2012, it is not obvious whether this represents a marked
turnaround compared to past tendencies. These
increased flows are mostly related to the automobile sub sector, where business
plans suggest that the number of produced cars can almost double between
2012-2014.([17]) The MNB
estimated that new investments in the automobile industry could contribute to
increasing exports in cumulative terms by around 6.5%, although the exact time
profile of production pick-up is uncertain. Indeed, data for 2013 already show
an improvement in the export market share compared to 2012, and a quick pick up
in the industrial production of the automobile sector. However it is
questionable whether the automobile sector is enough in itself to turn around
the past deterioration in export competitiveness, especially due to the fact
that the negative trend in the electronic equipment subsector has remained
uninterrupted. Also it is not obvious whether these new investments represent a
turnaround in FDI trends compared to past tendencies as the general business
environment in Hungary has remained problematic. 
As Hungary is already highly integrated
into the world economy, further trade gains would also require increasing the
importance of domestic value chains. However, both
the domestic value added content of exports and particularly the domestic
innovation activity seems to be low compared to more developed EU countries
(although this latter is also true for all V4 countries). While three Visegrád
countries (Czech Republic, Slovakia, and Hungary) have a broadly similar value
added content of exports of around 60%, this figure is somewhat higher for
Poland (around 70%). This 60% level is relatively low compared to an average of
72.5% for the 58 countries (mostly OECD members) in the OECD-WTO database. Although
the direct value added content is somewhat higher than at other V3 countries,
the indirect value added (spillover) effects of exports Hungary at 18% is one
of the lowest among the countries surveyed, which is also lower than the value
of regional peers. As around 75% of exports are produced by foreign-owned
companies and close to 50% by big foreign-owned corporates, the low spillover
possibly indicates difficulties in connecting the SME sector to the
multinational export sector. The relatively low value added content of exports
is also reflected in international competitiveness indicators, which point
toward a substantial deterioration in the value chain breadth and cluster
developments in the last 7-8 years.([18]) 
Export performance could benefit from
further FDI inflows, but also higher spillovers from multinationals to domestic
companies as well as a higher share of domestically-driven innovation. An improvement in the business environment would help attracting
more FDI. While the Hungarian government considers manufacturing as a priority
sector in terms of foreign capital, the risk of spillovers of a deteriorating
investor sentiment from services to manufacturing cannot be excluded. Positive
spillovers to domestic companies could be boosted by increasing the
availability of SME export financing.([19]) but also possibly an improved vocational education system. ([20]) Domestic innovation could be enhanced by improving the research
infrastructure as well as enhancing the cooperation among businesses and
universities. 
3.1.2.   External
sustainability
External imbalances have been declining
steadily as the NIIP improved from the lowest level in the EU in 2009 (-117%)
to -99% of GDP by 2013. Roughly half of the NIIP
consists of debt securities and another half could be considered as FDI or
portfolio investment. The improvement in the NIIP primarily reflects a
declining external debt of the banking sector. 
Despite a sizeable correction of the previous
current account deficits already in 2009, the NIIP has started to decline only
since 2010 due to revaluation effects. The
deterioration in the NIIP from 2008 to 2009 occurred on account of the combined
negative effect of a sharp recession and an exchange rate depreciation. Since
2009, a continuous decline in external imbalances has been recorded, mostly on
account of a trade surplus of around 5-7% of GDP and persistent inflows of EU
funds, which ceteris paribus have improved the external balance in the
magnitude of around 2-4% of GDP.([21])
Although the short term external debt
has also declined by around EUR 10 bn (10% of GDP) from its 2011 peak, it is
still high at around EUR 25 bn (25% of GDP). While
currently a combined current and capital account in the range of 6% of GDP
eases refinancing tensions, Hungary still needs to attract foreign investors in
order to rollover maturing debt.
Sustainability calculations for the next
decade suggest that the improvement of the NIIP will most likely continue as
the economy recovers. As the actual external
balance of the economy is well above the NIIP stabilising net lending position
(6.1% as opposed to -3,5% of GDP), the starting situation of the economy
suggests continuing  NIIP improvement. Given an underlying current account([22]) which is only slightly negative (at around -1% of GDP) and a
capital account in surplus due to the expected  inflow of EU funds, the NIIP
could be projected to improve even in the medium term. Indeed, based on
different macroeconomic scenarios, this picture seems to be robust, although
the exact pace of improvement is sensitive to macroeconomic assumptions (see
Box 3.1). In the baseline scenario the NIIP could increase above -50% of GDP by
2023. In an unfavourable scenario, it could be around -70% of GDP by 2023,
which is still relatively high in international comparison. However, without
the help of a persistent surplus in the capital account the NIIP position under
more negative circumstances would remain broadly unchanged (at around -95% by
2023).
Compared to pre-crisis trends, the
improving NIIP position is primarily driven by a stronger fiscal discipline. To understand NIIP trends it is also crucial to see whether the
behaviour of different sectors has changed persistently. As before the crisis
Hungary had a persistent twin deficit, assuming that its structural balance
will now stick to the country's MTO of a 1.7% of GDP government deficit, such a
scenario would improve ceteris paribus the external position by around 6
pps. ([23])
3.2.      Although
private sector deleveraging has slowed down recently, several fragilities
remain
The high level of private sector
indebtedness is considered as a major imbalance of the Hungarian economy. Before the financial crisis, private sector debt increased well
above the level of regional peers, and the debt structure became particularly
fragile due to a high share of FX loans. The financial crisis has triggered a
5-year spell of deleveraging in the country, starting in 2009, with dire
consequences for economic growth and the housing market. 
While debt levels have declined
substantially, private sector indebtedness in the context of a fragile
financial sector should be considered as an important source of imbalance. Deleveraging has halted in the non- financial corporate sector,
where investment has been recovering, albeit on account of some stimulus
measures (the increasing absorption of EU funds and the central bank's
subsidized lending scheme (Funding for Growth (FGS)). However, as the general
business environment remained problematic and also total corporate debt stands
well above the level of other V3 countries, it is too early to conclude that
the sector has already reached a sustainable position. A turning point is even
more uncertain in the household sector, where despite increasing real
disposable income since 2013 and some slightly improving signs in credit demand
the high share of distressed borrowers and a depressed housing market hamper
achieving the endpoint of debt reduction. With a loan-to-deposit ratio of
around 110%, there are also signs of a slowdown in the banking sector's
deleveraging process, which in principle could support the easing of credit
conditions. However, at the current juncture a problematic and uncertain
operating environment does not give the right incentives for banks to expand
credit flows.
3.2.1.   Household
indebtedness
Household indebtedness quadrupled during
the decade before the financial crisis and exceeded by far the level of
regional peers by 2008. Despite a weakening
economic performance, this process has been driven by optimistic expectations
about income convergence to EU15 levels and the prospects of EMU membership,
but also by ample liquidity and high risk tolerance of the banking sector.
Mortgage indebtedness was first driven by a general housing subsidy scheme in
the early 2000s, which ended in late 2003. After the restriction of subsidized
HUF lending, the widespread expansion of FX loans has been driven by the high
interest rate differential of HUF loans compared to CHF ones in a generally
risk prone environment.
The crisis brought a sharp adjustment
among households, banks and on the housing market through a combination of
demand and supply factors. On the demand side,
increasing economic uncertainty and increasing unemployment decreased the
demand for credit. At the same time, decreasing external funding and risk
tolerance of banks tightened credit supply conditions. Excess housing supply
was also increased by the negative feedback loops between the housing market
and the financial sector. On the one hand the fall in real estate prices (even
combined with a fall in the HUF/CHF rate) contributed to huge increases in the
loan-to-value ratios among household mortgages. This made it more difficult for
households to repay the debt burden, increasing the share of those households
who are non-performing. In addition, a depressed housing market made it
difficult for banks to sell the collateral in the case of these non-performing
loans. This hampers a cleaning-up of banks' balance sheets and restoring normal
lending to the economy.
The household sector has cut back its
expenditure mostly related to housing investment since 2009 which has
contributed to a continuous surplus of net savings.
However due to revaluation effects (on account of a 40% weakening of HUF/CHF
exchange rate, which repriced existing FX debt amounting to over 2/3 of total
household debt in Q4 2008), household debt only started to decline in
2011. ([24])
Consequently, the deleveraging process
had sharp consequences on the housing market. Overall, Hungary's housing prices
have fallen by close to a cumulative 35% since the latest peak in 2004, while
the number of houses built has dropped by around 75%. ([25])The decline
in housing prices  was not preceded by a real estate boom before the crisis, in
fact real house prices have been declining slowly since 2004. As a declining
housing market has wide-ranging spillovers to the economy (from the negative
effects on housing investment rate to the banking sector's cautious behaviour
towards lending), it is important to understand to what extent the fall should
be seen as a cyclical or rather a more structural phenomenon.
A number of factors suggest a structural
oversupply in the housing market, which would possibly require several years to
be reduced in case of no policy change. First, as a
result of increasing NPLs, the financial sector has accumulated a
non-negligible amount of housing stock. According to the central bank's
estimates, financial institutions own around 150000 dwellings in their
portfolios, a number which is approximately 15 times the current annual amount
of houses built in the country (at 10000), but even stand around 3¾ times of
the pre-crisis investment level (40000 houses per annum). As the sector waits
for a better market environment to clean up portfolios, once a recovery has
started, this supply would also appear in the market. Second, the utilisation
rate of the available housing stock is still at a historically low level (below
90%). Third, housing wealth is still relatively high in international
comparison (measured as a share of GDP), even higher than in some developed
countries.([26])
Finally the weak potential growth
performance of Hungary ([27]) means that
household disposable income is not expected to generate dynamic housing demand
in the future. However, given the relatively high stock of housing, quality
upgrading could be the main factor driving housing investments in the future.([28])
 (Continued on the next page) 
 Box (continued) 
A sharply
reduced debt level and improved housing affordability might suggest a turning point
in household deleveraging. On a positive note
several factors indicate the possibility of an endpoint to household debt
reduction. First, the level of household debt has declined (by 10% of GDP
between 2010 and 2013) to those recorded in the other V3 countries and the
share of FX debt has also fallen (from 70% in 2009 to 53% in 2013), lowering
financial fragilities. Second, housing affordability indicators point to an
improving entry point for housing investment. House price-to-income ratios have
declined by 40% compared to the 2004 peak, and the amount of housing subsidies
has more than doubled for a median flat in the last two years. Third, the lower
interest rate environment also supports household borrowing. Finally, banks are
also slightly easing credit conditions, although from a very tight level in a
historical perspective, and report an increasing credit demand in the Loan
Officer's Survey for the second consecutive quarter.
  
However the high monthly repayment
burden, a high share of distressed borrowers as well as a weak housing market
still hinder a possible recovery. Notwithstanding a
declining debt level, the monthly repayment burden of households has remained
unchanged since 2008 due to the weakening of the HUF/CHF exchange rate and
deteriorating disposable income. In addition, despite a series of measures, the
problem of distressed borrowers has not been resolved yet, as reflected in a
household NPL ratio in the banking sector's balance sheet close to 20%. ([29]) Finally, it should also be  noted that, as the primary type of
household lending is mortgage backed, a recovery in household lending would
first appear as a recovery in the mortgage market. However, as discussed above,
the housing sector still shows signs of oversupply. Therefore overall it is not
surprising that gross lending flows still stood below 20% of their pre-crisis
levels in Q2 2013.
3.2.2.   Non-financial
corporate sector
Compared
to households, it is more difficult to gauge whether the non-financial
corporate sector was suffering from a debt overhang at the start of the financial
crisis. The comparison of corporate indebtedness is
hindered by several methodological caveats including companies' tax
optimisation activities. ([30]) Pre-crisis corporate sector indebtedness among SMEs has been
driven by similar factors as among households (e.g. optimistic expectations on
convergence, low real interest rate on CHF loans assuming exchange rate
stability), while the determining factors for larger companies usually
differed. Given the better financing opportunities of the latter, their level
of indebtedness is more linked to the potential profitability of individual
projects. The funding of this latter group is to large extent linked to foreign
bank or intercompany loans. ([31])
While corporate sector debt data still
indicates a significant difference, outstanding loans from domestic banks show
that the indebtedness of the Hungarian corporate sector is already close to the
level of regional peers. Although domestic loan
data would not suggest debt overhang for the non-financial corporate sector
even at the start of the financial crisis, total debt data still indicates an
over-indebtedness of the sector. The fact that the two data sources present a
very different picture of the non-financial corporate sector in international
comparison increases the uncertainties as to what extent past deleveraging has
been warranted from the credit demand side and whether further debt reduction
efforts are necessary.
 Despite this caveat, several studies
indicate that the fall in domestic lending since the start of the financial
crisis should be seen as somewhat excessive and not fully warranted by the high
level of loans in the sector. First MNB (2010) estimated that contrary to
the household sector, corporate level indebtedness did not exceed the estimated
equilibrium level by 2008. Second, Hosszú et. al. (2013) suggests that in the
last years between half and two-thirds of the decline in corporate lending has
been attributable to tight credit supply factors. Finally, based on the
analysis of Cuerpo et al (2013) it can be concluded that loan supply pressures
were one of the highest in Hungary among EU countries, while loan demand
pressures stood at the average in 2012.([32]) 
Deleveraging
has stopped in Q3 2013 in the corporate sector on account of the central bank's
FGS scheme. ([33]) Both credit demand and supply factors have been improving, but the
increase in lending is attributable to the first allocation of funds under the
central bank's FGS. Without this latter, net lending flows would have remained
negative. ([34]) The scheme,
which is targeted towards SMEs contributed to a net increase in lending flows
of around 0.8% of GDP in Q3 2013 or around 3½% of the outstanding corporate
lending stock granted by domestic banks. Corporate sector demand for long-term
loans is also gaining momentum, and in parallel investment has picked up
recently, both factors pointing to a turning point in deleveraging.
However, it is yet too early to conclude
that recent improvements can be sustained, as they also reflect the effect of
one-off factors. As regards the supply side,
although the central bank can temporarily ease supply side conditions with the
FGS, persistently better conditions would require an improvement in the operating
environment of banks. On the demand side, improved demand for investment would
also require better growth prospects and decreased business uncertainty. While
the fall in investment has also stopped in the latest quarters, it seems that
the figures could have been substantially influenced by the increased inflow of
EU funds, and to a smaller extent, the first allocation of the FGS scheme (see
Box 3.3). Despite all these caveats, recent data presents Hungary in a slightly
better relative position in regional comparison than before, although the
relative improvement is also linked to the declining investment rate of other
countries in the region.
3.2.3.   Financial
sector 
The aggregated balance sheet of the
Hungarian commercial banking sector had been shrinking since mid-2010, but the
process halted by the end of 2013. This reflects on
the one hand the allocation of the FGS, but possibly also the effect of more
structural factors: with a loan to deposit ratio around 110% (down from 160% in
early 2009) banks could naturally slow down their deleveraging. The halt in the
process has been also reflected in a slowdown in the withdrawal of foreign
banks' external funding from the country.
However, the aggregate picture masks
huge differences in the characteristics of individual banks. In this regard, MNB (2013b) identified 5 groups of banks. These are
(i) foreign owned large banks, (ii) mainly domestic-owned large and
medium-sized banks active in foreign currency lending to households, (iii)
smaller banks with less activity in foreign currency lending and moderate
overall lending activity prior to the crisis, (iv) larger cooperative credit
institutions that have access to interbank funds and also participate in
foreign currency lending, (v) other cooperative credit institutions. Despite a
decline around 3% since the pre-crisis peak, foreign-owned big banks still have
a dominant market share in private sector lending (at 62% in Q1 2013). However
they perform worse in terms of profitability in the last years than others and
still possess the highest loan- to-deposit ratios (around 140% in Q1 2013).
Therefore deleveraging will probably continue for this group. While other
actors have partially compensated for the market share loss, given the
dominance of foreign owned banks, so far this restructuring has been
accompanied with a significant fall in total lending volumes. Although the
activity of the savings banks sector ([35]) and possibly that of some domestic banks can increase, it is not
clear whether it can be enough to offset the shrinking asset side of the
foreign-owned commercial banking sector, especially after the expiry of the
effects of FGS.
Despite some improvements in net lending
flows the general operating environment of the banking sector has remained
particularly problematic due to a combination of high taxes and regulatory
burdens and a high share of problematic portfolios.
Portfolio quality declined in both the corporate and household segments since
the start of the financial crisis. The banking sector's balance sheet is
heavily burdened with non-performing credit representing one of the main risks
for financial stability in Hungary. One in five corporate loans are classified
as delinquent (based on MNB data) and although it has reached a plateau, it is
not expected to decrease visibly until 2015. In case of households, the
non-performing credit was close to 18% in Q3 2013. However, shorter maturity
delinquencies (below 90 days) also stand at 15% of the portfolio. Therefore,
overall more than one third of the banking sector's household portfolio
presents some problems. Nevertheless, the coverage ratio of NPLs is relatively
high in international comparison at close to 60% of the total portfolio,
although it is much lower for restructured loans at 20%. 
Any major improvement in terms of
portfolio quality would require much faster portfolio cleaning. This is hindered on the one hand by the more generous provisioning
rules for restructured loans and on the other hand by the inefficiencies in the
resolution procedures. In addition, policy uncertainty and a weak operating
environment - contributing to increased uncertainty on potential losses - are
also obstacles.
Starting from an already excessive
level, extra taxes and regulatory burdens ([36]) on the sector have increased further.
These have been imposed on the sector through successive steps in the last
years. The magnitude of them stands in the range of 1¼-1½% of GDP on a sector
which has a value added of less than 4% of GDP. ([37]) Against the background of high levels of tax burdens and
non-performing assets the banking sector has been loss-making since Q4 2011.
The return on equity (ROE) stood at -2% in Q2 2013, slightly higher than in
previous years. As mentioned previously, the average figures mask a severe
dispersion between individual banks with the biggest bank generating
substantial profits (to a large extent from activities outside Hungary) while
mostly foreign-owned banks produce either a small profit or larger losses. The
low level of profitability among the latter group is probably not sustainable
and there is a risk that some actors may decide to leave the market in the next
few years. 
The government justified the
introduction of extra taxes and regulatory burdens as an endeavour to address
the problem of insufficient competition due to market power in the sector. Indeed, there seem to be competitiveness problems particularly in
the retail segment ([38]) as banks
were able to increase their interest margin well above the change in funding
costs. However, it is doubtful whether the policy steps taken so far solves the
issue of monopoly pricing, while decreasing banks' market power without
restoring a normal taxation environment for them could endanger financial
stability.
Extra taxes and regulatory burdens on
banks triggered a negative feedback loop for the economy. Banks have been trying to pass through their increasing tax burdens
to their customers by increasing the high level of interest rate margins on
existing FX loans and raising fees for financial intermediation. These steps
have triggered new government measures, i.e. most recently the introduction of
two free cash withdrawals per month. 
With high burdens on the sector, banks
welcomed the introduction of the FGS, which contains an implicit capital
transfer. The attempt of the central bank to ease
financing constraints in the SME segment should be acknowledged and the
programme also helped to decrease the share of FX loans in the SME segment
(from 52% to 44%).
However, it cannot be considered a
substitute for a better operating environment for banks, which would be
essential to revive lending in a sustainable manner, and can also entail
non-negligible risks if applied on an extended scale. ([39]) The FGS has a potential total size of HUF
2750 bn, which is close to 10% of GDP. Subsidized lending of this size can
entail significant risks. The potential costs are related to the zero cost
refinancing of the central bank (which triggers ceteris paribus losses at the
MNB) and there are risks of possibly unsustainable competition due to a fixed
interest rate margin at 2.5%. As regards the latter, it is questionable whether
this margin is high enough in an emerging country like Hungary (with a
financing cost of the sovereign at 6%) to potentially cover around two-thirds
of the 2012 SME loan stock. The application of this very low margin on a large
scale can trigger potential fiscal costs (if it potentially leads to imprudent
lending partly covered by state guarantees) or can have spillover effects to
lending rates of the non-SME segment.([40])
Based on the MNB's calculation the
banking sector would manage to remain liquid and solvent under a stress
scenario due to an initial high level of liquidity and capital and an adequate
level of loan loss coverage, but also due to foreign banks' commitment to their
subsidiaries. Regular stress tests led by the
central bank require a global capital adequacy ratio of 8% under the stress
scenario. The latest stress tests indicate capital needs at two banks in the range
of HUF 116 bn (0.4% of GDP) under the stress scenario. Given that foreign
owners recapitalised their subsidiaries several times (altogether by around 3½%
of GDP since the start of the crisis) this risk seems to be manageable. In
terms of liquidity, the sector remains above the regulatory requirement of 10%
30-day liquidity to total assets even in the stress scenario. However, as there
is a major shortfall of FX liquidity, the smooth functioning of swap markets
(supported by the MNB), especially in the stressed case, remains paramount to
the proper functioning of the banking sector.  
There have been important regulatory
changes in the supervisory environment. The
Hungarian Financial Supervisory Authority (HFSA) was integrated into the
central bank structure on 1 October, which can lead to positive synergies. This
is especially so as the MNB has been equipped with the right to use
macroprudential tools and has become the dedicated authority responsible for
macroprudential oversight. As one of the major reasons behind the widespread
increase in FX lending was the inefficient macroprudential set-up this seems to
be a step in the right direction.([41]) ([42])
3.3.      The
high and stagnating level of government debt remains a key source of concern
While standing below the EU average,
Hungary's government debt is still well above the level of regional peers and
hence remains an important imbalance. The debt
level is high compared to the country's economic development and taxing
capacity. This problem is also reflected in the fact that the interest
expenditure on government debt is the upper edge of EU countries (at 4% of GDP
as opposed to the EU average of 3% of GDP). Also, the short-term rollover need
at 20% of GDP should be considered as relatively high. As close to two-thirds
of the debt stock is held by foreign investors, this remains an important
source of fragility.
Debt is projected to only decrease very
slowly to below 70% of GDP by 2023 in the baseline scenario, however this path
is very sensitive to assumptions on the interest rate, growth and exchange
rate. ([43]) Under unfavourable scenarios, the debt can start to increase again.
A more robust debt reduction strategy would require a higher growth potential,
which would have favourable spillover effects also on financing costs. 
4.1.      The
business environment: an analysis based on international competitiveness
indicators
As highlighted in 2013 IDR and in
section 2, Hungary suffers from a low GDP growth potential, mostly linked to a
very low TFP contribution and reduced availability of capital. Recent developments and shortcomings in the Hungarian business
environment shed some light on how this is happening, as evidenced in
international business environment indicators. ([44]) 
International competitiveness indicators
point to a deterioration in the Hungarian business environment during the last
decade. Although international indicators diverge
in terms of the exact time when Hungary relative position has started
worsening, all of them identify the peak in Hungarian competitiveness before or
at the outset of the international financial crisis and point to deterioration
since then. In the period under examination, ([45]) this is particularly clear for the Global Competitiveness Index
(GCI) and World Competitiveness Scoreboard that have recorded their worst
ranking for Hungary in their latest publications, while according to the World
Bank Doing Business Report (DBR) the bottom was reached in 2006. ([46])
Hungary has lost its frontrunner
position among Visegrád (V4) countries in terms of international
competitiveness. Moreover, while Hungary was the
best among the V4 until 2004 according to the Global Competitiveness Report
(GCR) and the World Competitiveness Yearbook (WCY), both studies classified it
as the least competitive economy in 2009. However, since then the situation has
improved again and Hungary has gained some ground on the Czech and Slovak
Republics. ([47])
The deterioration in Hungary's relative
position is particularly pronounced according to the surveys of the
German-Hungarian Chamber of Industry and Commerce (DUIHK).  The country has become the least attractive among the V4 countries,
given that the other three Visegrád countries (V3) have broadly kept or
improved their positions over recent years. As a result, in 2013 Hungary is
only the 10th country in terms of preferred investment location
among the listed 20 CEE countries, while the other V3 countries occupy the
first places. This helps explain why Hungary has now the lowest investment rate
among V4 countries (see Graph 3.39). 
 
According to the DBR, the area which has
weakened the most in comparative terms is Getting Credit, while Hungary
remains the worst performer in regional terms in Investors' Protection
and Paying Taxes. Whilst Hungary used to
rank second in Getting Credit in 2006 after the Slovak Republic, it is
now the fourth one among V4 countries. In the meantime, there was a further
deterioration in the Hungarian rankings for Investors' Protection and Paying
Taxes, ([48]) so it
remained the least performing among Visegrád countries for these indicators.  
According to the GCR, the deterioration
of Hungary's relative position has happened because since 2006 most
competitiveness sub-indicators have deteriorated.
In fact, 10 out of the so called 12 "pillars of competitiveness" have
worsened whilst only the Infrastructure and the Technological
Readiness ones have improved. Although a similar trend was recorded also
for the other V3 countries, the Hungarian deterioration has been quicker, in
particular in the areas of Financial Market, which is now considered as
the least efficient and trustworthy in the region, Institutional Environment,
and Business Sophistication.
A deteriorating competitiveness could
also explain the fact that since the early 2000s, Hungary has been unable to
attract substantial additional FDI flows as opposed to the other V3
countries. ([49]) 
4.1.1.   What
are Hungary's main strengths? 
According to the DBR overall ranking,
before the crisis the Hungarian economy had a good starting position, also
thanks to a number of reforms in business regulation that had made Hungary an
attractive investment target. These reform steps
were successful in making easier: i) Registering Properties, ii) Dealing
with Construction Permits, and iii) Starting a Business. ([50]) Despite the deterioration observed since the crisis, Hungary still
has a number of strengths. For example, reforms introduced in Starting a
Business still make it the quickest among V4 and the second cheapest to
start a business in, while Hungary is still the 15th easiest country
worldwide to Enforce Contracts in.
More recently, the implementation of the
Magyary and Simple State programmes ([51]) has reduced the complexity of regulatory processes. The effects of the programmes are already reflected in the 2013
OECD Product Market Regulation (PMR) overall indicator, which has improved
compared to 2008. ([52]) However,
the same study shows that despite the improvements brought about by these
reform efforts in terms of simplification of regulatory procedures and of
reduction of the administrative burden for corporations, the latter remains
heavy in regional comparison.
Hungarian infrastructures are assessed
as the second best in the region and broadband penetration is well above the
regional average. Namely, the quality of Hungarian
roads is now considered the best one in the region (according to both the GCR
and the DUHIK respondents), ([53]) while   the
number of fixed broadband internet subscriptions per capita has grown more than
threefold in the last six years. This explains why the Technological
Readiness indicator in GCR has increased well above the regional average.
In addition, the new labour code
introduced in 2011 is starting to deliver in terms of increased flexibility. Namely, hiring and firing practices have been made easier and now
Hungary is ranked as the most flexible labour market in the region according to
GCR, while it was the least one as early as 2010. In spite of this, the
perception of Labour Flexibility in GCR has started decreasing again
since the 2011 report, mainly on account of reduced cooperation between workers
and their employers and of a reported diminished flexibility in wage
determination.
4.1.2.   What
is behind the observed downward trend?
Financial intermediation  
The DBR and GCR indicators complement
each other in explaining why the Hungarian financial market is perceived as not
functioning well and the reasons behind a prolonged credit shortage in the
economy. The Hungarian ranking in Getting Credit
under the DBR is modest mainly due to the absence of a public registry covering
borrowers and despite the introduction in 2012 of the first credit bureau law
mandating the creation of a database with positive credit information on
individuals. This is confirmed by the Commission's report on European SMEs,
which shows that in the area of access to finance, there has been deterioration
since 2008 and that the Hungarian financial market still performs worse than
the EU average one. ([54]) Also, The
GCR pillar of Financial Market Development has steadily deteriorated
since 2006 due to a limited Availability of Venture Capital, Financing
through Equity Markets, and Financial Services and Loans. 
In addition to the unavoidable
deleveraging of households and corporates, the observed financial
disintermediation could be partially explained by a problematic operating
environment for the financial sector (see section
3.2.3). In fact, the severe deterioration in the Hungarian financial market has
continued, and sometimes even accelerated, in the last three years. Venture
Capital Availability was severely affected by the international financial
crisis and Hungary, which used to be the best regional performer in the GCR, is
now the least successful. ([55]) Problems in financial intermediation are also confirmed by
reported difficulties to Access Loans for companies, which the National
Bank of Hungary is now trying to curb through the Funding for Growth Scheme,
whose impact on business confidence indicators will only be observable as from
next year's GCR.
Investors protection and Institutions
Policy unpredictability and high taxes
are also reflected in a low degree of investors' protection. On the one hand, the GCR makes evident the very negative effect of
the Hungarian tax system: only 13 tax systems among the countries covered
provide fewer incentives to invest. Besides, "policy instability" was
the second most cited obstacle to doing business in their latest report. ([56]) On the other hand, DBR confirms that Hungary has still one of the
weakest frameworks to Protect Investors, ([57]) as no single reform has been introduced in this area in the period
under examination, and given that company management is not obliged to disclose
transactions affected by conflicts of interest to minority stakeholders yet.
An analysis of the causes behind the
marked deterioration in the Institutional set up indicator in the
GCR ([58]) shows
that the loss in competitiveness has taken place mainly until 2009-2010 and that it was to a large extent driven by the deterioration in
the policy-environment-related indicators (see Graph 4.13). As a consequence, in the GCR Hungary
currently ranks in the lowest quartile among EU Member States in terms of: Burden
of Government Regulation (25th in the EU), Efficiency of
Legal Framework In Challenging Regulations (27th) and Transparency
of Policy Making (27th). The latter has particularly weakened in
the last two years, showing that the lack of consultations of stakeholders on
new policy measures by the government may have had already an effect on the
perception of business executives.  
This is confirmed by respondents to the
DUIHK survey ([59]), who
mention Legal Stability as well as the Predictability of Economic
Policy as primary weaknesses in the economic framework. These weaknesses and their recent aggravation are probably linked also
to a series of policy measures that have been introduced in the last years
(increasing number of extra taxes on some sectors and increasing entry costs
and barriers in certain service sector segments, see Box 4.1). 
Further analysis of GCR Institutions
indicators confirms an unfavourable picture of government transparency as well. Many respondents highlighted the Lack of Trust in Politicians
(Hungary ranks 129th out of 148 countries) and in the government,
hinting that there is Favouritism in Decision of Government's Officials
(116th), Wastefulness of Government Spending (110th)
and Diversion of Public Funds (110th). It should be
highlighted that most of the deterioration in this respect took place until
2009, while since then the indicators have remained broadly stable.
Barriers to competition 
Restrictions to entry in certain service
sectors have reduced the number of suppliers, excluded new entrants and reduced
competition. As shown by PMR indicators, Barriers
in the Service Sector have substantially increased in the last ten years,
contrary to what has happened in the other V3 countries, and Legal Barriers
to Entry have become by far the highest in the region. In this respect,
recent government policies played a decisive role for the current state of play,
as the introduction of: the Plaza Stop Law, regulations in the district
heating, waste management, meal vouchers, tobacco retail and pharmaceutical
retail sectors (see Box 4.1) have reduced the number of economic actors present
in the market. 
 
Price Controls also represent a drag on competition.
As reflected in the PMR indicators, substantial efforts in the reduction of
regulated prices are visible only until 2008. Then the trend has reversed in
Hungary and, to a smaller extent, in the Czech Republic. This could be linked
to the existence of regulated energy (electricity and gas) prices for universal
services and to the utility price cuts that have been decided by the government
since 2013 (see Box 4.1). 
As a first consequence, in recent years
investment in those sectors has substantially decreased (see Box 3.3). If this tendency is continued over time it could weaken network
infrastructures, with negative spill-over effects on all other sectors. In
fact, these policies do not only distort resource allocation across sectors,
but also increase running costs for all companies, given that network
industries are instrumental in the production chain of all companies.
Taxation
In spite of the substantial reform
efforts made on taxation, the overall country assessment has slightly
deteriorated and remained the worst performing among other V3 countries (see
Graph 4.18). Recent
reforms included a reduction in the corporate income tax rate and the
introduction of simplified forms of tax payments for small and micro
enterprises which, between 2006 and 2013, have substantially reduced the total
tax rate for companies and hours needed to pay taxes, as reported by
DBR. ([60])  
Reverse developments have curbed the
potential of those earlier reforms; hence Hungary is still the 3rd
most difficult country to Pay Taxes in the EU according to DBR. ([61]) In
particular, the government has adopted a number of sector-specific taxes (e.g.
in the telecom, financial and energy sectors) and increased the health
insurance contribution. The DUIHK acknowledges the complexity of the domestic
taxation system as one of the main constraints to doing business as well ([62]).
Moreover, Hungary is well above the OECD
and regional averages in terms of Total Company Tax Rate as computed in
DBR. ([63]) This happens despite a very low profit tax and mainly on account of
high rates for labour taxes and social security contributions. 
Business sophistication and innovation
Finally, Business Sophistication
has also deteriorated markedly. The latter is
clearly the area where the situation has deteriorated the most in absolute
terms, as Hungary has fallen 60 places back in the relevant ranking between the
GCR 2006-2007 and the latest release. This occurred mainly on account of a
severe deterioration in terms of integration of local companies into the
international value added chain and cluster development. The Hungarian value
chain breadth ([64]) was deemed
to be good by most respondents (GCR ranking was 27th worldwide in
2007 and 32nd in 2008) and actually Hungary was the second best
among V4 countries in this respect. Since then, the country has experienced a
severe deterioration in both indicators ([65]) which has not taken place in the other V3 countries, showing that
such a development cannot be attributed to the international crisis alone. As
regards cluster development, until 2008 Hungary was the 6th
best performing countries worldwide, while recently it fell back to 111th
in the GCR. ([66])
This means that spill-over effects from
large manufacturing companies operating in Hungary are limited (see also
section 3.1.2) and that the situation is not improving over time. Despite the initiation of tailor-made activities, such as the
supplier programme coordinated by the Hungarian Investment and Trade Agency,
Hungarian companies cannot properly integrate within the international value
chain yet. This has severe consequences, as close integration with large
multinationals is particularly important, as most Research and Development (R&D)
worldwide happens at the frontier. In fact, domestically driven innovation is
very limited in Hungary, as the number of companies doing R&D is about half
the EU average while those producing patents is about a third of it. ([67]) 
 (Continued on the next page) 
 Box (continued) 
The analysis found several specific
aspects contributing to macroeconomic imbalances in Hungary: a highly negative
NIIP and a high level of private and public debt in the context of a fragile
financial sector and weakening export performance.
The incidence of several of these factors has diminished in the last years but
important vulnerabilities remain. Decreasing them would require decisive policy
action.
The NIIP has been improving, and
sustainability calculations suggest that this tendency will prevail;
nevertheless it will remain a key source of concern due to the current still
highly negative level and high level of short term rollover needs. The degree of fragility also depends on to what extent the
external position will be financed from FDI or debt flows. Due to the high
short-term external rollover needs the country still has to rely to a large
extent on foreign investors' confidence. Therefore a business-friendly
environment would be needed. 
While there are some signs that
deleveraging is about to be completed in the private sector, important
fragilities persist. These are primarily linked to
the high share of insolvent debtors and the high monthly repayment burden among
households, as well as a depressed housing market and the high level of business
uncertainty. A turning point in deleveraging is also not yet justified from the
credit supply point of view. While lending conditions were eased slightly in
the last quarters, on account of the central bank's Funding for Growth Scheme
(FGS), non-subsidized net lending flows have remained negative for the fifth
consecutive year. The high ratio of non-performing loans (NPLs) and the high
tax and regulatory burdens on the banking sector do not provide banks with the
right incentives to increase their lending activities.
A high level of government debt remains
a key source of fragility, as it is forecast to decline only at a very slow
pace. Despite one-off capital transfers, which
contributed to reducing debt by around 7% of GDP, and a substantial improvement
in the structural balance, government debt has been broadly stable since 2009,
around 80% of GDP, reflecting a weakened exchange rate, low economic growth and
high financing costs. Also, the high short-term rollover needs, the interest
rate burden, as well as a high share of foreign investors in the government
bond market are important sources of vulnerabilities.
Behind the imbalances mentioned above,
there is the general problem of the low growth potential of Hungary. As in countries with high debt levels, the financing costs and the
growth outlook tend to be strongly negatively correlated, an improved potential
growth outlook would help decrease imbalances also through indirect channels.
The low growth potential of recent years has been partly the consequence of
debt overhang and deleveraging, but economic growth has also been hindered by
the deterioration in the business environment, due to excessive taxation of
selected sectors and increasing entry costs in certain service sector segments.

These fragilities were broadly
identified and discussed in the first and second editions of the IDR and
relevant policy responses were reflected and integrated in the country-specific
recommendations addressed to Hungary in July 2013.
The assessment of progress in the implementation of these recommendations will
take place in the context of the assessment of the National Reform Programme
and Stability Programme under the European Semester. Against this background,
this section also discusses different policy avenues that could be envisaged to
address the above-mentioned challenges.
Export competitiveness
The export performance could be enhanced
by further FDI inflows into export-oriented industries, which would require a
more predictable policy environment. Although
Hungary is already highly integrated into the world economy in terms of the FDI
stock, this reflects a rapid pace of integration until the early 2000s, while
the FDI stock to GDP in manufacturing has broadly stagnated in the last decade.
The lack of new FDI investments in manufacturing has contributed to the fact
that the country was unable to upgrade its product quality and to increase
productivity on a sufficient scale. At the same time, the recent increase in
FDI in the automobile sector does not seem sufficient in itself to boost
competitiveness substantially as the improvement in the export sector is not
broad-based enough.
Broadening the value chain is also
essential to promote exports. This seems to be
particularly challenging for catching-up economies, where there is a
substantial gap in terms of productivity between foreign and domestic
companies. The problem is also reflected in the relatively low value added
content of exports. Increasing the value added content would require a higher
level of economic spillovers from multinationals to domestic companies, but
also more genuine innovation in the country. This could require increased
support to research and development, enhanced cooperation between business and
universities, as well as better financing conditions for SMEs. 
Private sector indebtedness
The negative feedback loop between
households, banks and the housing market could possibly be tackled by a
comprehensive package, based on a final debt relief programme targeted to
insolvent borrowers, while mitigating the risk of moral hazard and limiting the
additional tax burden on banks. The targeted nature
of the programme would ensure that only unavoidable costs are borne by the
financial sector and the government.  This can be accompanied by a clear
commitment to refrain from adopting further measures in order to minimize the
risk of moral hazard. At the same time, given the high NPL ratio also in the
non-subsidized HUF loans segment, a possible programme would also have to
target this share of indebted households, and not only FX debtors. The
programme would help to improve the banking sector's portfolio, which
ultimately would contribute to improving lending conditions. However, costs
from a new scheme cannot be imposed on banks without a corresponding reduction
in their tax burden.
Additional targeted measures to
stabilise the housing market might also be considered. Supporting energy efficient building and renovation of the
amortised housing stock could also contribute to a revival of the housing market.
However, instead of general subsidies for lending, the programmes could be
targeted to those who are financially constrained.
Improving capital accumulation
possibilities as well as incentives to portfolio cleaning are essential to ease
credit supply side conditions. Recent measures
targeted towards the SME sector, most notably the FGS, aim to revive corporate
lending. Although subsidized schemes can be useful to tackle negative
externalities (e.g. the prohibitively high risk aversion of banks towards the
SME sector) they cannot be a substitute for a normal operating environment for
the banking sector. A large share of subsidized lending could also lead to
potentially high fiscal costs and distort price signals. In order to improve
banks' operating environment, the current tax level on the sector could be
lowered, while legal obstacles and impediments to portfolio cleaning could be
investigated and properly tackled.
Public sector indebtedness
A marked decline in government debt
could result from a more growth-friendly fiscal consolidation strategy. Although the structural balance improved substantially compared to
pre-crisis levels, the composition of the adjustment was repeatedly skewed
towards the revenue side. Despite recent cuts in labour taxes, the fiscal
consolidation episodes between mid-2006 and 2008 and from 2010 have been
characterised by a reliance on tax increases, in the latter case consisting of
to a large extent an increase in various corporate surcharges with detrimental
effects on growth. Overall, Hungary's general government expenditure (hovering
around 50% of GDP) in relative terms is considerably higher than in the other
Visegrád countries, which implies that the public sector must claim a large
share of resources to maintain a sound fiscal stance, in compliance with EU
rules. In addition, also in view of the relatively sizeable assets of the
Hungarian government, some parts of this portfolio could be considered to be
sold in order to support sovereign funding needs and accelerate debt reduction.
Potential growth
Improving the growth potential of
Hungary would require improving the operating environment for the financial
sector and a more stable regulatory framework in general.  A more predictable policy environment could be facilitated by
compulsory stakeholder consultation before any major policy initiative, as well
as an enhanced role of the competition authority in the assessment of
legislative changes. The corporate tax system could be simplified and entry
costs in service sector segments could be decreased. Finally, labour market
reforms and a more sustainable energy price system could also boost
competitiveness. 
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([1])  On the FGS scheme, see more details in
section 3.2.2.
([2])  These measures had an overall effect on
the inflation rate of over -1 pp for 2013 and entail - as a full -year effect -
an additional reduction in the inflation rate of around 1 pp for 2014.
([3])  In addition to some methodological
differences, the statistical discrepancy between the LFS and GDP consistent
employment figures primarily arise from two sources. On the one hand the LFS
statistics counts the number of Hungarian nationals employed (who have a
Hungarian residence), while the latter estimates the number of persons used for
the production of the Hungarian GDP, i.e. residents and non-residents working
in Hungary. Also, in the case of GDP-based employment, the CSO estimates the
number of home and grey economy workers.
([4])  The Job Protection Act was introduced
as of January 2013, and provides reduced social security contributions for
targeted groups (e.g. low skilled, young and elderly employees, long term
unemployed and women returning from maternity leave.)  
([5])  A more detailed assessment of recent
trends in the business environment can be found in section 4.
([6])  It should be stressed that a ceteris
paribus calculation of deducting the amount of new loans allocated in the first
phase of the FGS underestimates the potential magnitude of net lending without
the programme, as some of the loans disbursed in the scheme would have been
granted anyway. However at least it helps to present that FGS had a huge effect
on lending statistics in Q3.
([7])  See section 3.2.2 for more details.
([8])  See section 3.3 for more details. 
([9])  The investment rate has declined from a
pre-crisis level around 22% to 17½% of GDP by 2012.
([10]) See details on the external
sustainability analysis in section 3.1.3.
([11]) See details at 
http://ec.europa.eu/economy_finance/assistance_eu_ms/hungary/index_en.
([12]) The openness ratio is defined as the
sum of exports plus imports over GDP.
([13]) Among others these included the closure
of the following plants or companies: Elcoteq, Flextronics, Nokia and Sony. The
central bank estimates that these shocks could have resulted in a 5% fall in
exports in the last few years. 
([14]) It should be noted that export unit
values are not price levels per se, therefore the problem of different product
composition can hinder international comparison of unit values much more than the
comparison of export deflators.
([15]) We discuss net FDI inflows so as to
avoid that cross border financing distorts the picture. Nevertheless, in case
of the manufacturing sector the use of inward FDI stock data would have given a
broadly similar picture.
([16]) See for example Pain-Wakelin (1998),
Damjan et. al. (2013) or Rahmaddi and Ichiasi (2012).
([17]) E.g. see Napi (2013) "Robbanás
várható a magyar autógyártásban hamarosan" 25, November 2013.
([18]) See section 4 for more detail.
([19]) The Hungarian EXIM bank's facilities
has been recently extended and upgraded to support export and export supplier
financing.
([20]) A recent survey of the German-Hungarian
trade and industrial chamber indicates that only every sixth company leader is
satisfied with the vocational training system, while over 40% have serious
reservations.
([21]) Assuming EU funds do not generate
additional investments at the macro level, it can be considered as a source of
financing. This seems to be the correct assumption, as despite increasing EU
funds by around EUR 3 bn, the investment rate declined by over 4 pps. between 2007-2012.
At the same time, recently, the effect of EU funds on investment activity could
have increased. (see box 3.3 ).
([22]) The current account adjusted for
cyclical and possibly for past real exchange rate effects. Given the volatility
of the exchange rate and the uncertainty in the elasticities, in the
calculations we use the underlying current account which is only corrected for
cyclical effects.
([23]) Comparing the pre-crisis average structural
government deficit of around 8% of GDP with Hungary's MTO of a deficit of 1.7%
of GDP.
([24]) The decline in household FX debt since
2011 has also reflected 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. This was one in a
series of economic policy measures targeted toward FX borrowers. While it
helped to decrease FX debt by around 24%, it triggered substantial losses for
the banking sector and contributed to an increase in the NPL ratio (see Box
3.2). 
([25]) The decline in housing prices has
marked regional disparities. Larger price declines since 2008 have been
observed in those regions where the starting price levels were initially lower,
also the proportion of forced sales were most relevant in these areas. The
worse performing regions in terms of prices were also those which experienced
the biggest increase in unemployment rates. Therefore the housing regional
market situation has mirrored regional disparities of economic performance.
([26]) As housing is primarily a non-tradable
good among other factors (like demography and institutional determinants) its
consumption should be driven by economic developments. Given Hungary's high
level of housing stock compared to its development level, it is possible that
the country will continue to suffer from an excess supply in the medium term.
The high level of housing stock probably also comes from the special
circumstances of Hungary before the transition where in a relatively liberal
economy with suppressed financial intermediation, the only way to accumulate
household wealth was housing. See e.g. Zsoldos (1997).
([27]) See section 2 for more details.
([28]) I.e. assuming an initial housing stock
of 250% of GDP and a 100 year life span, the amount of  investment which
recovers amortisation could add around 2.5% to residential investment which
stood at only 2% of GDP in 2012.
([29]) This partially reflects the weak
economic situation in the country, but also the fact that several measures were
not particularly targeted towards problematic borrowers and created moral
hazard which damaged  the payment culture by creating expectations for further
favourable debt relief schemes (see Box (3.2))
([30]) This includes the existence of Special
Purpose Entities (as discussed in last year's IDR), but also the fact that "normal
multinationals" can restructure their activity in a way so as to report
their profit in the lowest tax environment.
([31]) Financial accounts data suggests that
roughly 60% of corporate loans are foreign loans.
([32]) See Kovács (2013).
([33]) In April 2013, the MNB Monetary Council
approved the FGS which is built around 3 pillars: The 1st pillar is based on
granting new loans to SMEs - The MNB offers commercial banks funds at 0%
interest rate, which banks can lend to SMEs at max. 2.5%. The preferential rate
loans could be used only to finance investments, working capital, contribute to
EU financial support and to redeem loans. The 2nd Pillar is based on the
conversion of existing foreign currency (FX) loans of SMEs into forint loans,
based also on zero cost funding to banks and capped interest rates at 2.5%.
Simultaneously, MNB planned to decrease international reserves by the same
amount and to make them available to banks to repay short-term foreign
liabilities. As a result, the net FX exposure of Hungary would remain
unaffected. The 3rd Pillar has been planned decrease of the outstanding amount
of two-week MNB bills by 20% (HUF 900 bn) to reduce Hungary’s gross external
debt. In the first phase of the FGS, HUF 701 bn were utilised (from HUF 750
bn), out of which 290 bn (1% of GDP) was recorded as new credit and the rest
was used to refinance debt (of which HUF 229 bn was FX). Due to the first
allocation of the scheme, the share of FX debt among SME-s has declined from 52
to 44% of their loan stock, After the first phase, the FGS was expanded in
September to a max. potential size of HUF 2.75tn (~close to 10% of GDP or 2/3
of the 2012 SME loan stock) running till end-2014, out of which HUF500bn became
immediately available. As regards the third pillar there was a relatively
moderate demand (by end-2013, it exceeded HUF 150 bn or some EUR 0.5 bn)
compared to the planned amount. 
([34]) It should be stressed that a ceteris
paribus calculation deducting the amount of new loans allocated in the first
phase of the FGS underestimates the potential magnitude of net lending without
the programme, as some of the loans disbursed in the scheme would have been
granted anyway. However at least it helps to show that the FGS had a huge
effect on lending statistics in Q3 2013.
([35]) In July 2013, a new law was adopted for
the cooperative sector. In the new system a unified institutional fund (where
the government injected HUF 136 bn (around 0.35% of GDP) from the budget in
December 2013) together with the already existing Takarékbank (central bank of
the savings bank sector) are the key participants in the sector. Takarékbank
does unified liquidity management, and supplies the financial infrastructure of
the sector, while the new Institutional Fund will be a supervisory authority
and the lender of last resort. Additionally the law allowed the State to gain
majority ownership in Takarékbank via the Hungarian Post and the development
bank (MFB). This measure has been controversial and criticised by many local
stakeholders and several lawsuits are currently in the court process. 
Equipped with an adequate level of
capital the sector has a sizeable lending potential. While it collects over 10%
of deposits of the banking sector it only has 6% of the assets with a
loan-to-deposit ratio of around 50%. In terms of future plans it is expected by
the management that the sector can double or triple its size. However this
strategy is expected to be completed by the end of the decade and not in the
very short term, as currently the sector focuses on restructuring and would
like to achieve a sustainable expansion.  
In January 2014, after just a few
months of gaining a majority stake in Takarékbank, the government launched an open, international tender to sell
its majority stake in Takarékbank, foreseen to be concluded by end-March 2014. 
([36]) By extra taxes and regulatory burdens
we refer to sectoral taxes and other regulatory burdens that are specific for
the financial sector.(see table 3.1.)
([37]) Based on Havrylchik (2012), bank taxes
as a percentage of assets stood the highest level among OECD countries after
taking into account the bank levy. 
([38]) See also Havrylchyk (2012).
([39]) Estimates whether the programme can be
successful on a larger scale varied markedly among experts The median
expectation is that around HUF 800-900 bn could be allocated in the second
stage from the total envelope of HUF 2000 bn.
([40]) As banks receive an implicit capital
transfer under FGS (due to the zero cost financing), while lending rates are
artificially low for SME-s it cannot be excluded that banks try to lower rates
below prudent levels in the non-SME segment so as to avoid losing their
clients. 
([41]) See e.g MNB (2013a).
([42]) While generally being supportive of a
unified macro- and microprudential authority, the ECB expressed some concerns
about the way the new integrated supervisory framework was implemented. The
critical opinion was driven by the insufficient time allowed to the ECB to
examine the draft legislative provisions and by the lack of time for the
transfer of supervisory tasks for the HFSA. The ECB also raised its concerns
about the central bank's independence after its merger with the HFSA.
([43]) The baseline scenario takes as point of
departure the Commission's Autumn 2013 forecast. The long-term budgetary
projections released with the 2012 Ageing Report have been incorporated in the
simulations, including the long-term fiscal impact of the pension reforms. Available
figures on debt maturity structure (Bloomberg) and share of short and long-term
debt (Eurostat) have been used.
([44]) Several International Organisations and
think tanks have long been assessing the degree of competitiveness of world's
economies. The most cited ones being probably the World Bank's Doing Business
Report (DBR) and the World Economic Forum's Global Competitiveness Report
(GCR). One practical difference among the two researches is that the DBR does
not provide a cumulative score of a certain country's competitiveness, nor it
does that for the 10 sub-set of indicators contributing to the overall score,
but only provides the ranking which is heavily affected by the overall number
of assessed counties (i.e. DBR covered only 155 countries in 2006, it has 189
this year). This is why the use of rankings has been kept to the minimum and
wherever possible absolute scores and updated consolidated data published by
the International Organisations have been used instead.  On top of these two
researches, the IMD World Competitiveness Yearbook (WCY) is also considered
among reliable sources of country competitiveness analysis. Given that it would
be questionable to single out one research method as the best one, a
comparative analysis of all studies is warranted in this IDR. In addition,
results from the survey of the German-Hungarian Chamber of Industry and
Commerce are also presented, as German companies are the biggest foreign
investors in Hungary. Finally, OECD product market regulation (PMR) indicators
for 2013 have been used in this paper. (See OECD (2013). The reported PMR
indicators for Poland are based on preliminary estimates as some of the
underlying data has not been validated with national authorities. Subsequent
data validation may lead to revisions to the indicators for the country. 
([45]) This paper is based on GCR from
2001-2002 to 2013-2014; Doing Business Reports from DBR2006 to DBR 2014; and
WCY from 2003 to 2012.
([46]) Then Hungary was ranked 66th
in the world, while it reached its best performance in DBR 2009, when it ranked
41st.  
([47]) Since the GCR 2009-2010, the Global
Competitiveness Index for both the Czech and the Slovak Republics have
decreased by about 5%, while the Hungarian one has slightly improved. The same
trend has been observable in the WCY: the Czech and the Slovak Republics have
lost in terms of competitiveness from the 2009 edition, while Hungary has improved.

([48]) From 118th in 2006 to 128th
and from 118th to 124th respectively.
([49]) We use net FDI stock data in the
analysis so as to avoid that cross border capital flows distort the underlying
picture. Nevertheless this method also has its own weakness as "true"
FDI outflows could also speed up after a certain level of integration into the
world economy. See also section 3.1.1.2.
([50]) Specifically: the time to register a
property decreased from 78 to 17 days and the relevant ranking in DBR improved
from 103rd in 2007 to 57th in 2009; the cost to obtain a
building permit went down to just 10.3% of annual income per capita, making
Hungary the 6th cheapest in the world in relative terms at that
time; and the capital to start a business was cut by about 80% making Hungary
the 27th easiest country to start a business in, up from the 87th
position it occupied in 2007. The paid-in minimum capital requirement (i.e. the
amount that an entrepreneur needs to deposit before registration and/or up to 3
months following incorporation) is recorded by the DBR as a percentage of the
economy’s income per capita. In Hungary, the paid-in minimum capital was
reduced to just 10.8% in 2009, down from 65.1% of income per capita one year
before.
([51]) See Box 4.1.
([52]) The overall Product Market Regulation indicator
for Hungary has improved from 1.40 to 1.31. A progress of a similar magnitude
was achieved in the Czech Republic (from 1.50 to 1.39), while in the Slovak
Republic the improvement was even better (from 1.57 to 1.31). 
([53]) See: World Economic Forum (2013) and German-Hungarian
Chamber of Industry and Commerce (2013)
([54]) European Commission (2013c). 
([55]) However, there are some contradictions
according to different sources of statistics. Based on European Commission
(2013c), access to venture capital improved substantially in 2011 over the
previous year, having swung from being considerably below the EU average to
slightly above. This was mainly on account of specific allocations for venture
capital made available under the EU financed JEREMIE programme as from December
2010.  
([56]) 15.9% of respondents have indicated it,
preceded only by "access to finance", which was cited by 16.3% of
surveyed business executives.
([57]) Hungary is now ranked 128th out
of 189 countries in the DBR.
([58]) It moved from the 45th position
worldwide in 2006 to the 84th in 2013.
([59]) German-Hungarian Chamber of Industry
and Commerce (2013)
([60]) The total tax rate was cut by 7
percentage points, while hours needed to pay taxes were reduced by nearly 20%.   
See http://www.doingbusiness.org/data.
([61]) Italy and Romania being worse. Under
the category Paying Taxes Doing Business brings together: the amount of taxes
and mandatory contributions that a medium-size company must pay in a given year
and the administrative burden of paying taxes and contributions (i.e. number of
payments required and time needed).
([62]) German-Hungarian Chamber of Industry
and Commerce (2013)
([63]) The Total Tax Rate in Doing Business
reports measures the amount of taxes and mandatory contributions borne by the
business in the second year of operation, expressed as a share of commercial
profit. It includes the profit or corporate income tax, social contributions
and labour taxes paid by the employer, property taxes, property transfer taxes,
dividend tax, capital gains tax, financial transactions tax, waste collection
taxes, vehicle and road taxes, and any other small taxes or fees. DBR 2014
reports the total tax rate for calendar year 2012.
([64]) Assessed by the question: "In your
country, do companies have a narrow or broad presence in the value chain?"
([65]) Loosing 105 and 74 ranking positions
from their respective peaks.
([66]) Assessed by replies to the following
question: "In your country, how widespread are well-developed and deep
clusters (geographic concentrations of firms, suppliers, producers of related
products and services, and specialized institutions in a particular
field)?"
([67]) European Commission (2013d).