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# 52015SC0036

**COMMISSION STAFF WORKING DOCUMENT Country Report Hungary 2015 Including an In-Depth Review on the prevention and correction of macroeconomic imbalances {COM(2015) 85 final} This document is a European Commission staff working document . It does not constitute the official position of the Commission, nor does it prejudge any such position. /\* SWD/2015/0036 final \*/**

  

Executive summary  1

1.       Scene
setter: economic situation and outlook  4

2.       Imbalances,
Risks and Adjustment 13

2.1.   External
sustainability  14

2.2.   Government
debt sustainability  21

2.3.   Financial
sector risks and deleveraging  29

2.4.   Labour market
with a focus on public works 40

3.       Other
structural issues 49

3.1.   Fiscal policy  50

3.2.   Labour market
and social cohesion  53

3.3.   Education and
skills 57

3.4.   Business
environment 60

3.5.   Network industries
and environment 64

A.      Overview
Table  67

B.       Standard
Tables 74

LIST OF Tables

1.1.     Key
economic, financial and social indicators 9

1.2.     The MIP
scoreboard   10

2.2.1.  The examined
fiscal policy-risk scenarios 21

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

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

B.1.     Macroeconomic
indicators 68

B.2.     Financial
market indicators 69

B.3.     Taxation
indicators 69

B.4.     Labour
market and social indicators 70

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

B.6.     Product
market performance and policy indicators 72

B.7.     Green
growth  73

LIST OF Graphs

1.1.     GDP in 2010
constant prices 3

1.2.     External
and domestic demand contributions to economic growth  3

1.3.     Headline
inflation and core inflation  4

1.4.     Net
Lending/Borrowing by Sector 5

1.5.     Potential
output growth  6

2.1.1.  Components of
Net International Investment Position  12

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

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

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

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

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

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

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

2.2.3.  Gross
government debt ratio: the baseline scenario  20

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

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

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

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

2.2.8.  Stochastic
debt projections, 2015-19  23

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

2.3.1.  Decomposition
of private sector debt 25

2.3.2.  Decomposition
of credit flows 25

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

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

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

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

2.3.7.  Deleveraging
pressures on the supply and demand side  34

2.4.1.  Participation,
employment and unemployment 35

2.4.2.  Activity rate  35

2.4.3.  Unemployment
rate  36

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

2.4.5.  Change in
employment by source of employment 38

2.4.6.  New vacancies
and registered unemployed   38

2.4.7.  Employment
level with and without the public works 39

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

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

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

3.2.1.  The severe
material deprivation rate in the region  49

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

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

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

LIST OF Boxes

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

1.2.     Economic
surveillance process 8

1.2.     Economic
surveillance process 8

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

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

LIST OF Maps

No table of contents
entries found.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Macroeconomic developments

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

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

Graph 1.1:     GDP in 2010 constant prices

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

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

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

Graph 1.2:     External and domestic demand contributions to economic growth

Source: European Commission

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

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

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

Graph 1.3:     Headline inflation and core inflation

Source: MNB

LABOUR MARKET SITUATION

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

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

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

Budgetary developments and outlook

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

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

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

Financial sector

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

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

External Balances

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

Graph 1.4:     Net Lending/Borrowing by Sector

Source: European Commission

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

 (see section 2.1).

Medium-term economic outlook

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

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

Graph 1.5:     Potential output growth

Source: European Commission

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

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

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

Table 1.1:       Key economic, financial and social indicators

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

Table 1.2:       The MIP scoreboard

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

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

Adjustment in external indebtedness

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

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

Graph 2.1.1:   Components of Net International Investment Position

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

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

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

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

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

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

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

Drivers of trade performance

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

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

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

Source: European Commission

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

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

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

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

Foreign direct investments

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

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

Source: European Commission Calculation

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

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

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

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

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

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

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

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

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

Historic developments and short-term outlook
for government debt

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

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

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

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

Source: European Commission Calculation

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

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

Medium-term debt projections

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

Graph 2.2.3:   Gross government debt ratio: the baseline scenario

Source: European Commission Calculation

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

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

Table 2.2.1:     The examined fiscal policy-risk scenarios

Source: European Commission Calculation

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

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

Source: European Commission Calculation

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

Source: European Commission Calculation

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

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

Source: European Commission Calculation

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

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

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

Graph 2.2.8:   Stochastic debt projections, 2015-19

Source: European Commission Calculation

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

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

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

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

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

Private sector debt and lending flows

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

Graph 2.3.1:   Decomposition of private sector debt

Source: European Commission

Graph 2.3.2:   Decomposition of credit flows

Source: European Commission

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Situation in the banking sector

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

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

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

Source: MNB

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

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

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

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

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

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

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

Interlinks with the growth potential

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

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

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

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

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

Source: MNB

Graph 2.3.7:   Deleveraging pressures on the supply and demand side

Source: European Commission

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

The labour market, recent improvements

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

Graph 2.4.1:   Participation, employment and unemployment

Source: Central Statistical Office (KSH)

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

Graph 2.4.2:   Activity rate

Source: European Commission

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

Graph 2.4.3:   Unemployment rate

Source: European Commission

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

Structural problems still affect the
labour market, first of all the tax and incentive structure. Frequent changes in the tax and incentive structure were the result
of significant fiscal policy cycles in previous years (for fiscal policy, see
below or chapter 3.1). More recently, the increasingly unstable business
environment and tax cuts for high income earners have created the need for
repeated fiscal correction with savings often affecting labour market and
social policies. The second structural problem is that the discretionary and
non-transparent nature of minimum wage setting often results in significant
jumps not matched by increasing productivity ([38]). A relatively high level of the minimum wage may have an adverse
effect on disadvantaged groups and regions as well as sectors with lower
productivity.

Recent tax and benefits reforms have had
both positive and negative effects on overall employment. While reforms to early retirement and disability benefits aimed at
increasing labour market participation are expected to have positive effects in
the long run, cuts in benefits may have had a contractionary effect in the short
run. While the tax reform has eased the tax burden on high-income earners, the
overall effect of the measures introduced on low-income and low-skilled
workers, the part of the labour force most likely to move in and out of
employment as a result of changes in incentives and the overall economic
environment, has been mixed. The Job Protection Act introduced targeted
reductions in the social contributions paid by employers for certain groups ([39]). This increased demand for labour and counterbalanced the effect
of increases to the minimum wage and the removing of the employee tax credit
(see Box 2.4.1 on recent labour market tax measures
affecting low-skilled workers). The reforms have,, however, overall not had a
clear favourable effect on employment ([40]). Box 2.4.1 reviews recent labour market tax
measures affecting low-skilled workers.

Box 2.4.1: Recent tax and benefit measures affecting the low-skilled A flat personal income tax of 16% was introduced in steps between 2011 and 2013. This significantly reduced the effective tax rate of high income earners. Low income earners were affected negatively by the elimination of the employee tax credit. At the same time the family tax credit (dependent on the number of children) was significantly extended especially for those with at least three children and a high enough taxable income to take advantage of the full tax credit. Starting from 2014, the family tax credit was further extended, by allowing it to be credited against employee social security contributions. This benefited low and middle-income families who previously could not use the full amount family tax credit. The adverse effect on low income earners has been partly counterbalanced by the introduction of targeted cuts in the employer's social security contributions in the framework of the Job Protection Act, from January 2013 (for a discussion of the tax wedge of low income earners, see section 3.1, for target groups, see above). The measure targeted groups whose activity rate has indeed been low. The measure has also counterbalanced a significant increase in the minimum wage in 2013. Benefit-related reforms that had an effect on the labour market include the reduction of the duration and generosity of the unemployment benefit, and reforms to welfare benefits, including related reforms to the public works program. The duration of the unemployment benefit was reduced to maximum of 90 days in September 2011. This is the lowest benefit period of the jobseekers’ allowance in the EU, and does not correspond to the average time needed to find a job in Hungary which is above 1 year. In parallel, the maximum amount of unemployment benefits was also reduced to the minimum wage. Before, the maximum duration of unemployment benefits was altogether 9 months, their generosity reducing after 3 months and again after 6 months. Welfare benefits, i.e., benefits for the unemployed who are not eligible for other benefits, have been also reformed. Between 2006 and 2008, the “regular social benefit” was determined as a function of total family income, and was capped at the minimum wage. Since 2009, the welfare benefit is lump-sum and is currently equal to 80% of the minimum old-age pension, currently HUF 22,800 (about EUR 70 per month; the benefit is currently named “foglalkoztatást helyettesítő támogatás”). Eligibility to the welfare benefit is conditional on 30 days of activity  per year which can be public work, earning activity on the primary labour market (including household work and simplified employment), participation in labour market programme, training advertised for a period of at least six months or voluntary activity of public interest. Recent developments in the participation an budgetary allocation for the public work scheme are described in Box 2.4.2. Other measures with a focus of directly increasing labour market participation and achieve expenditure savings included the review of disability-related benefits and the elimination of pathways to early retirement.

The Public Works Scheme was responsible
for a large proportion of employment growth in 2012 and 2013, but private
sector employment also started growing significantly from late 2013. Public administration (the sector the Public Works Scheme falls
under) provided most of the employment growth in early 2013, with the
contribution made by industry starting to increase in the last quarter of 2013
and the services sector becoming more significant in 2014. Graph 2.4.4 shows the composition of employment
growth by sector, as compared with the same quarter of the previous year. It
separates out growth in domestic employment, cross-border employment and
state-supported employment (created through the Public Works Scheme), The
figures shown confirm that, during most of 2012 and 2013, employment growth was
driven by employment abroad and in the Public Works Scheme. Domestic employment
outside the Public Works Scheme started showing a significant increase in late
2013 (see Graph 2.4.5).

Graph 2.4.4:   Change in employment by source of employment, sectoral breakdown

Source: Labour Force Survey

Graph 2.4.5:   Change in employment by source of employment

Source: Labour Force Survey

The number of new private sector
vacancies increased in 2014, but is still below pre-crisis levels. The number of unsubsidised new vacancies increased to around
50 000 in the third quarter of  2014, which is still, however,
around 70 % lower than before the crisis. The number of registered
unemployed, meanwhile, fell to a level similar to that seen in the pre-crisis
period. The economy is therefore currently characterised by a level of
unemployment roughly equal to that seen before the crisis, alongside lower
labour demand (see Graph 2.4.6). The number of government-sponsored
jobs offered in October 2014 was, however, two and a half times bigger than a
year before, 95 % of these jobs were created through public works.

Graph 2.4.6:   New vacancies and registered unemployed

Source: National Employment Service, European Commission

The Public Works Scheme that was in
operation over winter 2013-14 radically changed the employment patterns seen at
the end of the year (Graph 2.4.1).
Previously, public works had mainly been stopped during the winter due to the
seasonal nature of most of the works. The employment which these works created
therefore followed the same pattern as traditional seasonal work. In view of
this, an increase in the number of jobseekers of around 100 000 and an
increase in the unemployment rate to 11-12 % would normally have been
expected towards the end of 2013. With the introduction of the winter Public
Works Scheme, however, the decline in employment and the increase in
unemployment were avoided. The scheme’s target was to provide work for
200 000 people between November 2013 and March 2014.

Without the extensive use of public
works, yearly unemployment could have been around 11½% in 2013 instead of the
official 10.2 %. This estimate of the
hypothetical unemployment rate is based on the assumption that half of those
employed in public works were previously inactive, thus the calculation
recognises the scheme’s effect in ‘activating’ a previously inactive part of
the workforce. Without the Public Works Scheme, employment is likely to have
remained below 4 million in 2013, but would still have reached the pre-crisis
levels (see Graph 2.4.7).

Graph 2.4.7:   Employment level with and without the public works

Source: Central Statistical Office (KSH), European Commission

The Public Work Scheme: an effective measure
to tackle unemployment?

Studies examining the Hungarian public
works conclude that these programmes are inefficient and do not sufficiently
support the reintegration of participants into the open labour market. Fazekas and Scharle (2012) argue that the public works programmes
set up in Hungary between 2000 and 2010 were failures in terms of reducing
long-term unemployment. Public works do not improve participants’ employment
prospects, nor do participants gain a wage advantage. In another study, Csoba
and Nagy (2012) conclude that participants in public works programmes were no
more likely to find work than those not taking part in any programme. ([41]) Other existing active labour market policies, such as subsidy
schemes and training programmes, were found to have positive effects. Evidence
on whether public works are effective in leading participants into unsubsidised
jobs afterwards is mostly negative for other central European transition
economies as well. ([42])

A recent study of the current scheme
finds that public workers have a low and falling chance of finding a job within
six months of participation. Bakó et al. (2014) ([43]) examined for the period 2012-2013 whether participants in the
Public Work Scheme could find a job on the open labour market within 180 days
of exiting the scheme (termed 'successful exit'). Results indicate that the
probability of a successful exit increases with educational attainment and
decreases with age (see Graphs 2.4.8 and 2.4.9). The extension of the programme in
2013 coincided with a fall in the overall probability of a successful exit. ([44]) While it was 13% in 2012, it decreased to 11% in 2013.

Graph 2.4.8:   Probability of successful exit from the Public Work Scheme, by education

Source: Bakó et al., 2014

Graph 2.4.9:   Probability of successful exit from the Public Work Scheme, by age cohort

Source: Bakó et al., 2014

Longer participation in public works
decreases the chance of a successful exit. The
longer a person remains employed through the Public Works Scheme, the lower is
their chance of successful exit (see Graph 2.4.10). Nearly half of the participants
were involved in the same public works programme more than once. One possible
explanation for this is a selection effect. Some individuals have a higher
probability of finding a job, while the rest are likely to return to public
works repeatedly.

Public works might also cause a possible
crowding out effect. This happens because the wages
in the Public Work Scheme are lower than the minimal wage. For example even in
higher qualified jobs (e.g. data entry), public workers can be employed instead
of the workforce currently employed there. There is survey data providing
evidence that there are people doing the same job in the Public Work Scheme for
lower wages in comparison to what they did before with a regular work contract
for the  municipalities ([45]).

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

Source: Bakó et al., 2014

The number of people within the Public
Work Scheme and the allocated budget have been increasing extensively over time
and are planned to further double until 2018. Box 2.4.2 summarises the participation in the
Public Work Scheme with the budgetary resources spent and planned to be spent
on public works.

Box 2.4.2: Participation and budget allocation of the public work scheme Public works have been used in Hungary since 1991 but their size remained small until 2000 ([46]). As part of a workfare reform, the coordination became to municipalities' responsibility. Eligibility rules were tightened for unemployment assistance and recipients were obliged to work in the public works for at least one month a year. New schemes were introduced in 2009 (“Way to work” program) and in 2011 ("The National Public Work Program"). The programmes increased the number of participants significantly and a shifted public work related employment toward short-term contracts. In 2011, a new type of employment relationship was created, the ‘public works contract’ which removes participants in a public works program from the coverage of labour legislation in many aspects. Notably, public employment is exempt from the statutory minimum wage regulation. For 2015, the minimum wage in public works is set at about 75% of the regular minimum wage (at HUF 79 155 gross, or about EUR 255). The reform had the declared aim to involve more participants for the same funding. Current plans include significant further expansion of the scheme until 2018. The funding for public works has doubled from 2010 to 2012 and is growing ever since. The weight of the Public Work Scheme increased both in the number of people employed and the amount budgeted to the scheme (see charts above). In the autumn of 2013, the Public Work Scheme was amended by the winter Public Work Scheme element to avoid the typical end-year seasonal decline. This element aimed to include 200 000 workers per month during the period November 2013 to March 2014. Based on the experiences, the government decided to allocate 0.2% of GDP extra in the 2014 budget of the public works to achieve that the number of public workers on average stays at the 200 000 level throughout 2014. Moreover, the 2015 budget contains plans until 2018, showing that the expenditure on the public works are going to be elevated further (twice the size in 2018 than it was in 2014). A rough calculation implies that by 2018, 350 000 people would be in the scheme, 8.5% of the currently employed. The yearly average based on the first ten months of 2014 is around 183 000 people. It seems that the Public Work Scheme is to replace social welfare on the one hand and active labour market programmes on the other. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ (1)  Koltai L. (2012): "Work Instead of Social Benefit? Public Works in Hungary" Peer Review on “Activation measures in times of crisis: the role of public works”

No progress has been made in evaluating
the effectiveness of the Public Works Scheme, but limited progress has been
made in reinforcing its activation elements. Only a
quarter of the training courses offered in the 2013-2014 winter scheme led to a
qualification. Training will be provided again throughout the 2014-15 winter
period. This time 60 % of the training courses will lead to
qualifications recognised by the state, but most of these will relate to
qualifications needed by participants to perform their jobs in the public works
programmes. Legislative amendments will allow participants to attend job
interviews, and the Public Employment Service will offer them specific jobs when
available. The amendment also includes sanctions to oblige the individual to
accept any suitable job offer.

Overall, the extension of the Public
Works Scheme, and the almost exclusive reliance on this scheme as a means of
providing employment, are hard to justify, given the limited positive effect it
has on participants’ chances of finding employment subsequently. There is a risk that, rather than providing temporary income
support in times of recession, an extensive public works scheme may create a
significant ‘lock-in effect’ and may become a permanent replacement for the
system of welfare benefits for groups who are unlikely to  find regular
employment. The scheme is seen as a major component of the anti-poverty
measures, but, regardless of providing work opportunities for many, it has not
reduced poverty due to the low achievable wage level. The effectiveness and the
sustainability of the Public Works Scheme would therefore deserve close monitoring.

The Hungarian tax system is
characterised by several challenges both in terms of design and governance. The total tax burden in Hungary, at 38.6% of GDP in 2014, is the 8th
highest in the EU and the highest in the region. In terms of the least
distortive taxes to growth, the share of consumption taxes is already rather
high, while the revenue from recurrent property taxes remains low and well
below average. By contrast, reliance on sector-specific levies is inefficient
from both a fiscal and an economic perspective. Despite recent progress, there
is still a lack of administrative efficiency and concerns regarding tax evasion
remains.

The re-regulation of the fiscal
framework since 2010 is yet to be completed with improvements on credibility,
transparency and effectiveness. The budgetary
planning horizon was legislated to be extended beyond the actual budget year,
but its implementation is yet to be launched. The Fiscal Council's narrow list
of mandatory tasks and its analytical capacity are still not commensurate with
its budgetary veto right.

Tax policy

Following a period of relative stability
in tax policy, the recent tax changes have reignited the earlier trend of
raising sector-specific corporate taxes. The main
concern in the area of corporate taxation is the increasing reliance on
sector-specific taxes. The trend of introducing such taxes began around 2006
and was significantly reinforced after 2010. By 2013, sector-specific corporate
surtaxes, amounted to some 2.15% of GDP, mainly affecting the financial and
utilities sectors. Because of their selectivity, such taxes have been
identified as a cause of distortions to investment across sectors. In addition,
their introduction and subsequent modifications have been unpredictable.

In the course of 2014-2015 some new
sector specific taxes were introduced and some of the existing ones were
increased. In some cases, the impact of these taxes
is selective across operators within the sector concerned. In particular, the
highest rate of the advertisement tax, in force since August 2014, was
increased from 40% to 50% (on turnover). This change affects only one
broadcaster. A sectoral tax with a steep schedule of up to 4.5% of the turnover
was introduced on tobacco manufacturers and distributors. The ‘food chain
control fee’, originally set at a rate of 0.1% of turnover, is now applied to
daily consumer goods retailers, and has a progressive rate structure with a
maximum rate of 6% of turnover. The public health tax was extended to alcoholic
beverages with rates being determined broadly in proportion to the alcohol
content. Two categories of spirits, for which local production is significant,
were, however, exempted.

The labour tax burden for low income
earners in Hungary is among the highest in the EU, even after taking into
account the effect of recent measures such as the targeted social contribution
cuts included in the Job Protection Act. Most
notably, Hungary has the highest tax wedge in the EU for single workers at 50%
of the average wage, and the 4th highest at 100% of the average wage
(both increased since 2010). ([47]) However,
tax wedges for workers with children are substantially lower due to a family
tax credit, which is especially generous towards families with higher earnings
and at least three children (see details in box 2.4.1.). The high tax wedge of
low income earners is a particular challenge in Hungary since the employment
opportunities of the low-skilled are weak. A planned doubling of the family tax
credit is relevant for low wage earners with two children, but it is due to be
phased in between 2016 and 2019. No other change for a general reduction of tax
wedge relevant to all low earners is foreseen.

The effectiveness of VAT enforcement and
compliance measures as gauged by the VAT gap, is at 25%, which is significantly
above the EU average (16%), but lower than in some of the regional peers. ([48]) Some recent
measures are bringing about the tightening of controls. First, the
establishment of on-line links to cash registers in the retail sector has been
completed by the end of 2014 with favourable results in terms of VAT revenues.
The extension of this requirement to certain service segments (e.g.
restaurants, hairdressers) is foreseen for the course of 2015. Second, an Electronic
Road Cargo Inspection System was introduced in 2015, which primarily aims at
reducing VAT carousel fraud. Finally, the threshold for itemised VAT
declaration was lowered.

According to the World Bank Doing
Business 2015 report, compliance time with tax obligations for businesses has
stagnated in Hungary in recent years and has remained the 4th
highest in the EU. Tax compliance costs are
particularly high for small and medium-sized enterprises, amounting to a ten
times higher burden for them in proportion to turnover than in the case of
larger firms. ([49]) There is no
systematic ex ante evaluation of the compliance impact of new tax provisions.
This appears to be a particularly important issue for the introduction of the
Electronic Road Cargo Inspection System (see above), which, according to
businesses put a large compliance burden on operators. Additionally, a new rule
granting broad taxation rights to local governments as of 2015 potentially
leads to surge in the variety of local taxes, leading to increased compliance
costs in the taxation of natural persons. At the same time, the Hungarian
corporate tax system still features a multitude of tax regimes (including three
simplified tax schemes), dealing with which is costly for businesses.

There have recently been a number of tax
increases in the field of environmental taxation.
Specifically, excise duties on some fuel products were increased as of 2015.
Moreover, environmental product fees were raised on a set of products. At the
same time, the scope of that fee was extended to certain products, such as
photovoltaic panels, in a way that is questionable in view of green economy
goals. Additionally, the Hungarian tax system is still characterised by some
environmentally harmful subsidies, including the favourable tax treatment of
personal use of company cars ([50]). While the
company car tax favours the renewal of the vehicle fleet, it does not
compensate for the incentive to travel greater distances resulting in increased
emissions, congestion and social costs.

Overall, Hungary has made limited
progress to address the 2014 tax recommendation.
The role of sector-specific taxation has even increased. The progress on
reducing labour taxes on low-wage earners is limited as the planned changes
affect only workers with two children and the implementation will begin in
2016. Tax compliance costs, which are particularly high for small and medium
sized enterprises, has stagnated in recent years. Despite some recent increases
in environmental taxation, there has been limited progress in shifting the tax
burden to environmental taxes.

Fiscal framework

Hungary began the process of
fundamentally re-regulating its national fiscal governance framework in late
2010, which has led to mixed results. The revamp
has weakened some aspects of the efficiency of its operation (notably, by
replacing the forward-looking real debt rule with a pro-cyclical debt ceiling),
while strengthening others (inter alia, by establishing a commendable strong
Constitutional basis for the new set-up). Moreover, the reform originally did
not touch the existing medium-term budgetary framework, thus remaining purely
indicative. As to institutional aspects, the Fiscal Council received some
reinforcement in 2012, both in terms of optional tasks and resources. Most
notably, a small dedicated analytical team was set up within the Office of the
Parliament. However, the Council's analytical remit and capacities are still
not commensurate with its unprecedented veto competence over the annual budget
bill.

The long overdue strengthening of the
medium-term budgetary framework was legislated in December 2013, but its test
of effectiveness in genuinely lengthening the planning horizon has been
postponed until the 2016 budget. The main novelty
introduced by the new regulation is that differences between the medium-term
budgetary framework (laid down in a government resolution with three-year
expenditure and revenue plans) and the draft budget bill for any given year
must be fully justified by factors or developments falling outside the scope of
government influence, such as changes in the macroeconomic environment. The
obligation to issue such a resolution was missed in 2014 (the original deadline
was 30 April 2014). The government first argued that some delay was inevitable due
to the national election and the ensuing formation of the new (re-elected)
government (completed in early June), but this issue has subsequently not been
rectified. Consequently, the 2015 budget was prepared in the traditional way,
with a narrow focus on the actual budget year. Neither the indicative
three-year plans contained in the justification of the previous year’s budget,
nor the Convergence Programme plans played a meaningful guiding role in the
derivation of budgetary appropriations.

The Fiscal Council is not yet a body
with a strong and unbiased analytical basis, in contrast with its uniquely
strong veto power. Despite its existing broad
optional mandate to comment on any relevant public finance issues, over the
last three years, the Council has not published any own analysis or opinion
beyond what was strictly required by law. Its decisions are so far only based
on qualitative risk assessments to date, and not on publicly accessible
detailed calculations. ([51]) On a
positive note, the Council has started to increase the number of commissioned
external studies, such as short-term forecasts and analytical papers from
partner institutions. In addition, a new initiative has been launched to
commission a medium- to long-term macro-fiscal baseline papers from research
institutes. Nonetheless, these undertakings could not replace the function of a
genuine quantitative analysis of the official macro-fiscal projections. The
Fiscal Council’s standing would be enhanced by basing its opinion on the basis
of a clear numerical benchmark: its own forecast and impact assessments. ([52])

Overall, Hungary has made limited
progress in addressing the fiscal governance recommendation. The implementation of the recently legislated medium-term budgetary
framework suffered from repeated delays, and no legal action was taken to
improve the transparency of public finances and to broaden the mandatory remit
of the Fiscal Council.

While in general the Hungarian labour
market improved in 2014, significant challenges remain. Total employment increased to 62.8% by the third quarter of 2014
(the EU28 average was 65.5%) and the unemployment rate was 7.4% for the age
group 15-64. Part of the improvement in labour market data can be explained by
expansions of the Public Works Scheme and increased cross-border working, but
faster-than expected output growth in 2014 contributed to improved employment
in the private sector (see section 2.4. for details). Long-term and youth
unemployment remains high. The employment gap of women with small children and
Roma is particularly high. ([53]) Both
absolute and relative measures of poverty increased in recent years, indicating
that the ability of the social safety net to reduce poverty has diminished. The
social and education systems are persistently characterised by a low ability to
reduce the inequality of chances. Despite recent changes in the health care
system, major challenges remain for the Hungarian health system, including poor
health outcomes, low spending levels and an inefficient use of resources.

Labour market functioning

The labour taxation is not
employment-friendly for certain employee categories
(like single and/or low skilled), which constitute an important barrier;
particularly for low-wage earners (see section on taxation 3.1).

In general labour market transitions
remain very limited primarily due to institutional constraints reducing the
potential of the labour market. The unemployment
benefits scheme and the employment policies available, in particular the public
works scheme, are ineffective in supporting labour market transitions. Funds
for labour market policies are not allocated based on a systematic impact
assessment of measures. Long parental benefits and low childcare coverage also
hamper the transition of women with small children back into the labour market.

Unemployment benefits

At three months, Hungary has the
shortest duration of unemployment benefits in the EU but the average time
required by job seekers to find employment is over one year. While a short duration of unemployment benefits may enhance job
search, it may also force jobseekers to accept jobs that do not match their
qualifications, increasing turnover and reducing overall productivity in the
economy. Other jobseekers, facing the limited benefit duration and not having
adequate financial savings, may be indirectly forced to join the Public Works
Scheme.

Active
labour market policies

Despite steps to develop the profiling
system, there is still significant room for improvement in active labour market
policies. The active measures target those whose
unemployment benefit expires but without profiling the individuals. While low
skilled workforce is a major problem, paired with a generally low participation
in lifelong learning, the schemes (including trainings) are not specifically
designed to the personal needs of the individuals. The development of a
profiling system is under way according to its original timetable: the project
was previously run by the head office, and will be taken over by the ministry
responsible for employment policy. The planned profiling is to provide
standardised system for directing people into the various schemes and a variety
of individualised services to be offered for jobseekers, taking also into
account local labour market conditions. While the plan is a step in the right
direction, it is uncertain how the system will be used by other relevant
authorities responsible for the various schemes in the future. The Public Works
Scheme has been growing while other active tools receive proportionally less
resources. (see also chapter 2.4). Funds for labour market policies are not
allocated based on a systematic impact assessment of measures.

The fragmented governance of the employment
measures among various ministries may further reduce their effectiveness. Notably the fact that the Interior Ministry is responsible for the
administration of the Public Work Scheme, ([54]) carries further risk in this regard.

As from January 2015, the head office of
the Public Employment Service was abolished. Its
previous tasks in the field of employment policy will be delegated to various
authorities and local labour offices will be reorganised as well. This
fragmented institutional setup itself poses challenges on local labour offices
and producing evidence related to employment policy impact.

Youth unemployment

Parallel to general trends in Hungary,
both the employment and unemployment rate of young people continued to improve
in 2014. However the number of young people (under
25) not being in employment, education or training  has further increased (from
11.3% in 2007 to 15.4% in 2013) with the growing proportion of early school
leavers - Roma youth are overrepresented both among those not being in
employment, education or training and early school leavers. ([55])

The Hungarian Youth Guarantee is only
partially meeting the challenge of youth unemployment. This is because there is no guarantee what the quality offer will
cover and whether sufficient human capacity at the Public Employment Service
will be ensured for implementing the scheme. This can be seen in the inability
to provide quality offers within the time period of four months. Several active
measures have been launched even before the introduction of the Youth
Guarantee, which will be boosted by the new programme aiming at the involvement
of long term young jobseekers into specialised measures. A legal modification
will ensure that young people below 25 and those involved in active labour market
programmes do not have to accept public work. This modification is to guarantee
also that the definition of the "quality offer" will exclude public
work and ensure that the trainings will lead to qualification. It is crucial
that the monitoring system supports the follow up of the results and shows
clearly the impacts of the Youth Guarantee on youth related macro indicators,
particularly for disadvantaged groups such as the Roma.

Female
participation and low skilled workers

The impact of parenthood on employment
of mothers is the highest in the EU. While the
general employment rate of women increased, it is still low compared to EU
average, particularly for those with small children. This is due to long
parental benefits and a low coverage of children in childcare facilities, in
particular under the age of 3 years. Hungary has not yet reached the 33%
Barcelona Targets of childcare participation. Efforts made in the previous
years resulted in improved access to childcare which is to be continued to
further facilitate female labour market participation. Hungary's gender pay gap
has risen to 20.1% in 2012 and stands well above the 16.4% EU average.

The disparity in the employment
opportunities of high and low-skilled workers is bigger than in most EU countries. Low-skilled workers have a very low employment rate (38.2%; EU
average 51.4%, for age group 20-64) and their wage discount is considerable as
compared to other workers. In the case of 25-49 years old the difference
between employment rate of low skilled and the general population is 26 pps.,
thus it is two thirds of the overall employment rate. Education and training
offers for job-seekers have not been able to address the challenges in basic
and professional skills that are hampering labour demand for the low-skilled.

Social protection and
poverty

Indicators of poverty and social
exclusion show a deteriorating situation in Hungary since the crisis,
especially for children and the Roma. While the
proportion of individuals at risk of poverty or social exclusion has decreased
in Europe, 33.5 % of the Hungarian population falls into this category.
Between 2008 and 2013, the proportion of children at risk of poverty and social
exclusion increased from around 33 % to 43 % (compared with an EU
average of 28 % in 2013). Poverty remains especially high among Roma,
with 81% at risk of poverty, 60% lacking basic amenities, 39% living in low
work intensity households, and 67% of working Roma experiencing in-work
poverty. ([56]) The severe
material deprivation index for Hungary is significantly above the EU average.
The proportion of low work intensity households is falling, but in-work poverty
has increased.

Graph 3.2.1:   The severe material deprivation rate in the region

Source: Eurostat

The targeting of income redistribution
is very weak. The upper three income deciles
receive more in social transfers than the bottom three income deciles. Recent
administrative cuts in utility prices do not appear to have substantially improved
the affordability of housing for poor households. At the same time, the measure
has created significant savings for households that were not in need: 36 %
of the cost reduction benefited those in the highest income quintile, while
only 15 % reached the lowest quintile. The situation of the most
vulnerable groups is generally not affected by the utility price cuts.

Gaps remain in the efficiency and
coverage of social assistance. Public social
spending as a share of GDP has increased in all OECD members of the EU since
the crises with the exception of Hungary. Among OECD countries Hungary is the
only country where cash income support for those in working age significantly
decreased in this period, by 6% in real value. The Public Works Scheme has not
reduced poverty among participants (see also section 2.4). Restrictive income
protection policies, including the nominal freeze on social transfers in force
since 2008 and the cutting back of the unemployment benefit period to three
months, contributed to the worsening of the poverty situation. The restrictions
on eligibility for social benefits mean that half of all jobseekers are left
without any benefits.

Plans to introduce further cuts to the
social protection budget and to allow greater discretion in awarding benefits
at local level carry the risk that the coverage and adequacy of benefits could
further decrease. The budget for 2015 contains
approximately 10% less funding for social protection. The system of in-cash
welfare benefits is currently undergoing reform: the various types of social
benefits will be merged and local governments will be able to exercise more
discretion in awarding benefits. The ‘employment substitute benefit’ received
by the majority of beneficiaries is to be gradually phased out by 2018 and
replaced by an offer of employment under the Public Works Scheme. As of March
2015, this type of social assistance will be administered centrally, along with
some other forms of ‘income-type benefits’. One single ‘expense compensating’
benefit will replace all the other forms of social benefits currently provided
by local government. The amount of benefits awarded (capped at HUF
28 500) and the eligibility rules will be left at the discretion of local
authorities. Although poor authorities will receive compensation for the
benefits they have paid out from the central budget if needed, the
decentralisation risks further increasing regional inequalities.

Health care systems

Despite several organisational changes
implemented between 2010 and 2014, some of the major issues facing the
Hungarian health system have not yet been resolved, including poor health
outcomes and an inefficient use of resources. Both total
and public healthcare spending in Hungary remain below the EU average, with
public funding showing a declining trend. ([57]) Hungary systematically appears towards the bottom of the ranking
for headline health status indicators, such as life expectancy at birth.
Premature mortality, measured in terms of potential years of life lost is not
just among the highest, but is declining slowly in Hungary in international
comparison, particularly among males. This is largely attributed to
persistently high levels of mortality from diseases of the circulatory system.
High mortality rates among the working-age population are prevalent. The
overall efficiency of the Hungarian health system appears to be lagging
compared to the rest of the EU, even taking into account relatively low
spending levels, socio-economic factors and population life style behaviour.
This observation holds for a range of considered health outcome measures and
also when using various relevant assessment techniques. ([58])

Structural inefficiencies are being
created by a number of specific characteristics of the Hungarian health system. The level of out-of-pocket payments is disproportionately high,
added to which there is widespread use of informal payments. This translates
into health inequalities, affecting vulnerable groups in particular. Healthcare
services are characterised by an excessively hospital-centred model. Hospitals
are continuously generating arrears, which necessitate sizeable ad hoc payments
from the state budget. Hungary also has relatively few general practitioners
with a suboptimal geographic distribution. Weak payment incentives also result
in general practitioners playing an ineffective ‘gatekeeping role’ while use of
hospital services is high. A significant number of healthcare professionals
have left the country and there are significant skills shortages, which are
threatening the sustainability of the provision of healthcare services.

The reforms implemented in recent years
were mainly targeted at financing and service delivery, the aim being to
contain the costs of care and to achieve further efficiencies. It is not yet possible to evaluate the effect of these reforms in
terms of health outcomes. A new strategy for healthcare is currently being
developed, and includes plans to redistribute hospital capacity in order to
eliminate duplications and reduce hospitals’ level of debt.

Overall, Hungary has made limited
progress in addressing the labour market and social cohesion recommendation. Some progress has been made on active labour market policies as the
preparation of the profiling system of the Public Employment Service is in
progress. Some progress has been achieved in setting up the mentor network in
the first Youth Guarantee programme, but it is not sure whether sufficient human
capacity at the Public Employment Service will be ensured. No progress has been
made in revising the public works scheme and the system of unemployment
benefits. Some progress has been made in modification of social assistance cash
benefits and in implementing the Roma inclusion the monitoring system. Poverty
has been increasing, while an integrated policy approach to improve the
situation of the most vulnerable groups is still missing.

While educational attainment has been
increasing in Hungary, there are significant challenges regarding the
inclusiveness and flexibility of the system. The
country's education and training system is not capable to compensate
sufficiently for the educational and cultural disadvantages of students from
low socio-economic status. The proportion of low achievers in basic skills and
the early school leaving rate are increasing, in particular among the
disadvantaged. The prevalence of the high share of Roma majority schools and
classes remains a major issue. The transition possibilities of students to move
between different educational paths are limited. The lack of measures to widen
access and reduce drop-out rates in higher education remain a cause of concern.
There are a number of ongoing reforms in the education sector, the effects of
which on outcomes are not monitored and evaluated in a systematic way.

Graph 3.3.1:   Impact of socio-economic status on mathematics performance (2012)

Source: OECD PISA 2012 (Table II.2.4a)

In contrast to the trend seen at EU
level, the proportion of early school leavers in Hungary has increased since
2010. The rate of early school leaving reached
11.8% in 2013 and is thus moving further away from the national target of 10%.
Early school leaving is particularly high in vocational education and training
(30%), in less-developed regions ([59]) and among Roma (82%) ([60]). Both the PISA and national competence tests show that the
proportion of low-achievers in reading, maths and science is increasing, and
confirm the strong correlation seen between socioeconomic status and
performance in education. Teachers are not prepared to provide sufficient
support to low-achievers and potential drop-outs ([61]) and low-achieving schools are not required to take action to
improve their results.

In November 2014, the government adopted
a strategy for addressing the problem of early school leaving, but its
effective implementation may be hampered by the lack of cross-sectoral
coordination and a clear implementation plan. An inspectorate and pedagogical services were introduced in 2014 and
the rollout of further elements of the reform are planned for 2015 (related to
the professional development of teachers, institutional action plans for
addressing weak performance, and extending competence measurement). These
elements may provide schools with the means for supporting learners so as to
help them achieve all the main competences by the end of compulsory education.
The relevant parties were, however, not consulted during the development of the
strategy. In addition, the strategy does not go far enough in addressing the
challenges faced in vocational education and training and in less developed
regions.

The considerable share of Roma majority
schools and classes and a lack of high quality, inclusive mainstream education
accessible to all remains a major challenge. The
proportion of Roma children attending Roma majority schools or classes remains
high: 45% of Roma pupils attend schools or classes where 50% or more of their
classmates are Roma. ([62]) The
educational attainment of the Roma pupils is lower than the national average.
In 2012, 77.7% of the Roma had only completed the eight years of primary
education (i.e. primary education was their highest educational attainment)
compared with 24.6% of the national average. Less than 1% of the Roma acquired
a tertiary degree compared to the national average of 18.5% in the adult
population. ([63])

While some measures have been
implemented to support the education of Roma, a comprehensive and systemic
approach to reducing the share of Roma majority schools and classes in
education has not been put in place. Some
administrative measures to address the prevailing issue of the high share of
Roma majority classes and schools in state-maintained schools are in place.
Ongoing programmes such as ’Tanoda’ and ’Útravaló’ contribute to increasing the
competence levels of disadvantaged pupils. The school development strategy
relies on the centralisation of public education management and the development
of teachers' professional skills as a means of providing better quality
education for all and ensuring that education also reaches the disadvantaged.
In January 2015, an amendment to the school education law was adopted, allowing
the government to determine the conditions under which religious and
nationality-specific education is permitted. Stakeholders fear that the
legislation could be used to anchor or even extend separated education of Roma
in the system.

Transition between the different forms
and stages of education and to the labour market is still a challenge. Students’ educational performance influences the choice of
secondary schools ([64]). In
principle, changing educational paths is possible. In practice, however, the gap in the competence level
between pupils widens during their time in different types of upper-secondary
schools, making it difficult to change between schools at a later stage. Pupils
in vocational schools (‘szakiskola’) face obstacles to progress to higher
education. ([65])

The planned changes in the allocation of
state-funded places in secondary education may harm transition possibilities. In November 2014, the government announced its intention to improve
participation in vocational education and training and to reduce the number of
general secondary school places, where pupils study for the matura. This
may result in fewer applicants to higher education, and may make the vocational
path less attractive to high-performing students. Combined with the increasing
admission requirements for higher education, this development could further
limit the social mobility of the disadvantaged.

Monitoring of the implementation of the
vocational training reform has not been established. This gives particular cause for concern with regard to the
shortened three-year vocational school programme (‘szakiskola’) and the ‘bridge
programmes’ and their possible effects. An insufficient level of basic skills
may limit students' chances of succeeding in further learning or of changing
jobs in the long term. Despite financial incentives offered to companies and
the significant role played by the Chamber of Commerce and Industry in
supporting this reform, it is difficult to find good quality, practical
training courses in some regions and for certain professions.

The labour market demand for graduates
of higher education is high and the number of jobs requiring for high-skilled
professionals will further increase in the medium term. The employment rate among recent higher-education graduates in
Hungary was 85.6% in 2013, compared with the EU average of 80.7%. The rate of
employment for those graduating from upper-secondary education in Hungary,
meanwhile, was 64.9 %. The relative earnings of workers with university
education are high, as are the private and public returns on tertiary
education. ([66])

While tertiary attainment has increased,
recent measures fail to improve the higher education participation of the
disadvantaged.  Hungary has
exceeded its national target rate for tertiary attainment of 30.3% among 30-34
year olds (with a rate of 31.9% recorded for 2013), but the level of tertiary
attainment still remains below the EU average (36.9%). In 2014, the number of
students admitted to state funded courses decreased, even though 11% more
students applied to higher education than in 2013. The fall in the number of
state funded places is about 15% since 2011. ([67]) Participation in higher education largely depends on support from
students' families and 25% of the students live under very modest financial
conditions. ([68]) The current
funding system does not guarantee equitable access. Overall, general government expenditure on education amounted to 4.8% of GDP
in 2012, a fall of 0.9 pp. on 2011 spending levels. Hungary
has the highest drop-out rate in higher education in the EU at 47%. Systematic
monitoring and analysis of the reasons for students dropping out is not in
place.

Ongoing reforms prioritise the promotion
of outstanding achievement, while policies to tackle non-completion of
education or to widen access for disadvantaged students are not in place. The practice of giving extra points to students from disadvantaged
backgrounds when assessing their applications for higher education slightly
improved their chances of being awarded a place, but their participation rate
remains low. The new higher-education strategy increases the national target
for tertiary attainment to 34% and puts particular emphasis on improving
performance. There are, however, no plans to examine the causes of the high
drop-out rate or to make guidance, mentoring and support widely available to
students. The proposal for a performance-based financing system for higher
education favours outstanding student achievement rather than trying to
increase the proportion of students who complete their studies. A new
institution type, ’community college’ is to provide education opportunities in
disadvantaged regions. Its particular role and management structure have not
yet, however, been specified.

Graph 3.3.2:   Drop-out rate from tertiary education (2011)

Source: OECD Education at a Glance 2013 (Table A4.1, p.71)

Overall, Hungary has made only a limited
progress in addressing the education recommendation. Although a national strategy was adopted in 2014, little tangible progress has been made so far on early school
leaving prevention with the proportion of early school leavers showing an
increasing trend. More should be done in promoting inclusive mainstream
education, a systemic approach, and active measures, to reducing the share of
Roma majority schools and classes remain to be missing.
Limited progress has been made to support transition to
the labour market. No action was taken to monitor the implementation of the
vocational training reform and further measures are needed to support the
transition between different stages of education. The adoption of a national higher education strategy by the
government has been announced in December 2014, aiming at an increase of the
national tertiary attainment target to 34%. Yet policies supporting access for
and completion of higher education by the disadvantaged have received little
attention so far.

The unstable regulatory framework
remains one of the biggest challenges for Hungary in terms of improving its
business environment. Frequent and unpredictable
regulatory changes, often at short notice and without allowing the parties
concerned a sufficient transition period, new entry barriers in certain
sectors, or the introduction or increase of sector-specific taxes, all have
continued to weigh on the business environment and on competition in 2014.
Legislative processes continued to be characterised by a lack of transparency
and the notable absence of systematic consultations with the relevant parties.
Corruption affecting public decision-making and public procurement remained a
cause of concern.

Competition

The stabilisation of the regulatory
framework and fostering market competition especially in the services remains a
big challenge. The progressively increasing
restrictions to entry in certain service sectors are hampering the efficient
allocation of economic resources and increasing uncertainty for investors. The
barriers to market entry introduced in the service sector in recent years have
not been removed ([69]) and,
instead, further barriers were introduced in 2014 (see below).

Recent legislative initiatives on the
retail sector resulted in new barriers and affect certain market players
disproportionately. New restrictions include the
increase of the food chain control fee (see section on taxation), the
regulations prohibit Sunday and night opening for medium to large shops, and
forbid companies that have been operating at a loss for two consecutive years
from selling consumer goods. While the so-called ‘Plaza Stop Law’, prescribing
ex ante central authorisation for all retail establishments over 300 m2,
expired on 1 January 2015, the new law establishing a similar retail
authorisation procedure for outlets over 400 m2 does not provide
sufficiently clear criteria for authorisation to prevent arbitrary
decision-making, and no implementation decree has yet been enacted. These
various measures could potentially have a serious negative effect on retail
competitiveness. Barriers to entry in the Hungarian retail sector increased
continuously between 2008 and 2013, as evidenced by the OECD’s Product Market Regulation
Indicators for the service sector ([70]). The size of mark-ups was already among the highest in the OECD
before the crisis, and the allocative efficiency indicator is among the lowest
among EU countries.

A series of recent changes to the
Hungarian competition law are a source of concern.
Based on a provision introduced in late 2013, the government declared thirteen
mergers (in the energy, financial, textbook publishing, IT and transport
sectors) to be of strategic national interest in 2014, thereby bypassing the
scrutiny of the Hungarian Competition Office. The procedure for assessing
potential mergers is more transparent in other Member States, where the
assessment of the proposal on competition grounds, and the political decision
to authorise the merger, are clearly separated and their results communicated
openly.

Transparency of decision-making and quality
of legislative processes

The quality of Hungarian legislative
processes suffers from lack of transparency, compromised ex ante impact
assessments and the short transition periods given to those affected by the
legislation to prepare for its implementation. As a
consequence, laws frequently have to be amended within one year of their
publication. ([71]) This
deteriorates the predictability of the law-making process, and thus the
business environment.

Impact assessments are rarely publicly
available, the published impact assessment sheets are often lacking in quality. The frequent use of motions from individual members of parliament
([72]) circumvents
mandatory impact assessments and consultations ([73]). Where proposals are initiated by the government, consultations
with the relevant parties are often rushed. The median time elapsed between the
submission of a draft bill and the publication of the final law in 2014 was
16-37 days, which means that consultations and the preparation of legislation
are subject to time pressure. Moreover, the transition periods allowed under
new legislation are short.

Corruption

Corruption in public administration
remains a matter of concern. The 2014 EU
Anti-corruption Report points to concerns related to informal relations between
businesses and political actors at local level. Research points to the
existence of "close contractual relationships" between business and
political elites ([74]); unstable
legislation and shortcomings in the system of political parties' financing and
in public procurement as key drivers of the problem. A recent legislative act
lifts previously existing restrictions on access to public funding by
politically affiliated organisations and eliminates rules against conflict of
interests and transparency requirements. Restrictions on public access to
information effectively hamper transparency and further elevate corruption
risks. Corruption in public healthcare also remains an issue and no concrete
plans have been put forward to address it.

The integrity management framework and
the electronic platform for whistle-blower reports are in place, but there is
no evidence as to their effectiveness in curbing corruption. Integrity advisors have been appointed in some public institutions.
They are subordinated and report to the head of their institutions.
Furthermore, the 2013 whistle-blower law lacks measures to protect
whistle-blowers from retaliation. Coupled with a general lack of trust in the
effectiveness of prosecution of corruption, fear of retaliation sheds doubt on
the effectiveness of the system to fight corruption.

Among other fields, public procurement
is particularly vulnerable to corruption. The 2013
Eurobarometer shows a significant number of business respondents concerned
about corrupt practices in public procurement. As regards EU co-funded
projects, the Commission repeatedly observes the lack of respect of the
principles of equal treatment, transparency, non-discrimination and sound
financial management in public procurement procedures. Whereas the formal
arrangements are in place for ensuring transparent contract award procedure,
the application of public procurement rules and principles seem to fail often
in practice. Partiality appears to be frequent in case of major infrastructure
investments ([75]).
Bid-rigging is the most frequently encountered form of corruption in Hungary. ([76])

Public procurement

Significant concerns remain in Hungary
in the field of public procurement with regard to ensuring competition and
transparency. Steps have been taken to address
these issues, and future results will have to be closely monitored. The bodies
responsible for the uniform application of the procurement rules, control,
monitoring as well as legislation are now within the Prime Minister's Office.
The concrete results of this recent reorganisation remain to be seen. In
November 2014, Hungary submitted an Action Plan which includes measures
concerning the transposition of the new public procurement directives and the
steps to foster inter alia competition and transparency, including measures on
e-procurement. In 2014, a low level of competition in public procurement ([77]) and the extensive use of direct award of contracts persisted ([78]).

A more frequent use of e-procurement could
generate significant cost savings, improve the transparency of public
procurement and increase competition. The
electronic submission of tenders is not used in practice, although
theoretically available ([79]). The main
challenge for the Hungarian government is to adopt a comprehensive strategy for
the transition to mandatory e-procurement in the first half of 2015, as part of
the broader public procurement reform. The success of this process will greatly
depend on ensuring adequate human resources, sufficient administrative capacity
as well as ensuring that the system clearly fosters transparency.

Administrative burden

Although recent efforts to cut red tape
brought about positive changes in certain specific areas, overall
administrative burden remains high in Hungary.
Administrative burden of businesses was targeted by the Cutting Red Tape
programme which was completed in 2014; however, no independent evaluations were
made publicly available as regards its actual impact. Moreover, important
challenges remain in the tax compliance burden or burden associated with
frequent legislative changes and short transition periods. In a number of
important aspects,  – such as the compliance costs of taxation, time needed to
export, use of evidence-based legal instruments, strategic capacity and
irregular payments and bribes – Hungary performs below the EU average. ([80])

The overall effectiveness of public
administration remains a challenge over the short and medium term. Administrative reform measures were continuously implemented under
the Magyary programme, with a focus on centralisation and simplification of
administrative procedures. Challenges remain in the area of better depth and
coverage of regulatory impact assessments; enforcement, monitoring and
evaluation of strategies and other programmes. Further simplification and
cost-cutting of the public administration are planned pursuant to a recent
proposal that foresees the integration of specialised authorities (such as the
environmental authorities, mining authorities and national park directorates)
into the Government Offices under the supervision of Government Commissioners.
Hungary is currently developing its Public Administration and Public Services
Development Strategy 2014-2020, with a focus on organisation, human resources
management, quality of public services and electronic supports.

EU fund management

A lack of stability and transparency in
the implementation system of EU Structural Funds in Hungary contributes to
bottlenecks for the effective delivery of investments. Reorganisation of the managing authorities and implementing bodies
did not follow an articulated strategy and further changes are announced.
Investment strategies or capacity development measures to ensure the delivery
of projects are not yet in place for some key areas (e.g. health, transport,
ICT).

Research and development

Public R&D intensity in Hungary has
decreased over recent years from 0.46% of GDP in 2007 to 0.41% in 2013; this
level is not only well below EU average (0.72%), but also lower than in most of
the Central and Eastern European countries. This
development threatens to undermine the already weak supply of human resources
for science and technology ([81]), the
quality of science base and contributes to a brain drain. While the adoption of
the Smart specialisation strategy in November 2014 and of the 'Higher education
concept' in 2015 could help to bring about a more effective public funding
system, their successful implementation will also depend on a reversing of the
decreasing trend in public R&D intensity and institutional funding.

Graph 3.4.1:   Public R&D intensity (1), 2005-2013

Source: (1) Public R&D intensity: Government Intramural Expenditure on R&D (GOVERD) plus Higher Education Expenditure on R&D (HERD) as % of GDP. Source: European Commission

The innovation capacity of SMEs has not
improved, despite the implementation of several support schemes. Increase in business R&D investment has been driven by foreign direct
investment. Multinational companies' presence in Hungary is insufficiently used
and the emergence of a national research and innovation ecosystem with
innovative SMEs could be fostered. Some positive signs are linked to the
approval of National Research and Development and Innovation Strategy
(2013-2020) which sets out measures explicitly targeting innovative SMEs.

The consolidation of the Hungarian
research and innovation system is still an ongoing process. This is due to the annual reorganisation of major innovation
policy-making bodies and theresearch, development and innovation funding
structure ([82]).

Overall, Hungary has made limited
progress in addressing the business environment recommendation. No progress has been achieved to stabilise the regulatory framework
and foster market competition, especially in the services sector. The
implementation of the Cutting Red Tape programme was finalized in 2014 tackling
administrative burden for some areas, however new measures introduced in other
policy fields resulted in increased administrative burden. A reorganisation of
public procurement administration leading to changes in the structure and
personnel of the system has been done in 2014, but the concrete results remain
to be seen. In November 2014 Hungary submitted an Action Plan in the context of
fulfilling the ex-ante conditionalities for the European Structural and
Investment Funds. While this goes in the right direction, the implementation of
the Action Plan needs to be closely monitored. The uptake of e-procurement is
featured in the Hungarian Government's concept for the new Public Procurement
Act, transposing the new public procurement directives. The government
announced measures to improve the anti-corruption framework introducing
corruption risk assessments as part of the mandatory impact assessments and an
information campaign on corruption prevention for different target groups.

Energy networks and internal market

Hungary’s electricity transmission
networks are well connected to all its neighbours, with the exception of
Slovenia, through interconnectors, and the country’s interconnection capacity
(measured relative to the net domestic power generation capacity) is well above
the required 10 % level. The security of
natural gas supply is compromised by the lack of bi-directional connections
with Croatia and Romania, with gas currently only able to flow from Hungary to
these countries, but not in the other direction. Interconnectors allowing
reverse flow are scheduled to be built by 2018. The gas interconnector between
Slovakia and Hungary is expected to become operational in the first quarter of
2015, improving Hungary’s access to competitive gas sources in central and
western Europe.

During the past few years several
regulatory measures have impacted the business climate in the energy utility
sector in Hungary. Recognised rates of returns on
investments in the regulated market segments were successively reduced to
practically 0%, some cost elements (e.g.: charges levied on network
infrastructure and banking transactions) were excluded from justified costs,
and special taxes were levied on the energy sector.

Sustainability of recent price cuts

In 2013 and 2014 significant retail
electricity and gas price cuts ([83]) have been implemented by the government with impact on
profitability of utilities. As result, by the end
of 2014 electricity and gas retail prices for household consumers were down by
23.5% compared to 2012. The Universal Service Provision segment of the retail
electricity and gas utilities has never been a profitable business since data
sets are available in 2007. In 2013 the Universal Service Provision segment of
the four different regional utilities ([84]), in the retail gas market, and the similar segment of the four
different utilities in the retail electricity market produced a combined loss
of HUF 41 bn (some EUR 140 million).

The sustainability of price cuts for
household consumers depends on the operators' ability to cross-subsidise these
losses from other business segments. Under current
tariffs, only significantly lower wholesale electricity and gas prices, leading
to lower purchase costs for retailers, could improve the profitability of the
Universal Service Provision segment; however, in the long run this does not
seem to be realistic.

Reviewing the impact of the price
regulation on the energy sector is limited and the autonomy of the national
regulator on deciding on network tariffs was not reinforced. In the first quarter of 2015, Hungary is scheduled to launch a
comprehensive study on the impacts of price regulation. It is unclear how a new
state-owned utility holding ([85]) could offer
lower prices for the consumers and cover its costs at the same time, unless it
would be financially compensated for permanent losses by the state.

Renewable and energy efficiency measures

Hungary has reached the interim
2011/2012 renewable energy target towards the 2020 target. The developments in electricity and transport sectors do not meet expectations
presented in Hungary's National Renewable Energy Action Plan.

The current energy saving target of
Hungary looks outdated in the light of the latest energy consumption
developments. The primary energy consumption target
in 2020 is based on a projection of business-as-usual scenario, which would
allow a 24% increase by 2020, given that the country's primary energy
consumption was 21.7 Mtoe in 2012 (based on Eurostat data, decreasing since
2005). This increase appears as "saving" because the "business
as usual" scenario forecasts a worrying 53% increase in 8 years.

Preparing and adopting legislation
necessary to increase energy efficiency in only limited. Hungary is the only EU country which has failed to submit its
National Energy Efficiency Plan, its long-term renovation strategy, and that
has notified no measures yet to transpose the Energy Efficiency Directive.
Energy intensity remains high by EU standards, especially for households.
Combined heat and power generation is not supported in a way required by EU
legislation.

Transport sector

Progress has been made in the
reorganisation of MÁV (state railways) and Volán (interurban bus) companies,
and in the service level of public transport in Budapest. The inefficient organisation and operation of the major public
transport companies have been a significant burden on the state budget for
years, while long-term underinvestment in rolling stock and infrastructure have
put service provision and human health at risk. On 1 January 2015, the 24
interurban bus companies were replaced by seven regional ones. This measure is
expected to help optimise transport services and reduce overall costs. Both the
state railway company and the Budapest transport company have recorded positive
operational results in recent years ([86]) but their level of debt continues to put considerable strain on
the budget.

While rolling stock is being renewed,
the state of infrastructure remains largely unaddressed. The average age of rolling stock is still very high, but is
decreasing both in the case of rail and metropolitan transport. New rolling
stock has been able to be purchased in part due to the reallocation of funding
from the EU Cohesion Funds previously intended for the improvement of rail and
waterway connectivity. At the same time, there are still permanent speed limits
on 38 % of the rail network and no action has been taken to improve the
navigability of the Danube.

Steps have been
taken towards the introduction of electronic ticketing in Budapest in 2017,
which will allow the tariff system to be revised.
The new transport development strategy for Budapest examines the capital’s
transport system, identifying the current shortcomings and the areas for
potential improvement. It does not, however, provide any information as to the
financing and timing of investments. The introduction in January 2015 of tolls
for passenger cars on ring roads and some expressways came unexpected. The
government’s sole purpose in introducing the measure was to raise revenue.
Offering annual regional vignettes may appear to make the road charges more
proportionate for regular users, but in practice, increases in the number of
roads on which tolls are charged are placing a disproportionate burden on
occasional users and can divert traffic to urban areas. The introduction of
congestion charging in Budapest is currently being planned for the end of 2016,
but details of the plans are not yet known. The measure may not only raise
revenues but could also make public transport more competitive and reduce negative
externalities.

Telecommunications
and digital economy

Hungary scores somewhat below the EU
average for the availability of basic fixed broadband infrastructure, as
5.6 % of homes are not yet connected (compared with 2.8 % in the
EU). ([87]) At the same time, fast broadband access technologies (at least 30
Mbps) are already available to 74 % of homes, above the EU average of
62 %. The government has recently set the ambitious target of fast
broadband being available to all homes by 2018, two years ahead of the European
target set in the Digital Agenda for Europe. Besides public investments, the
modernisation of telecommunications infrastructure will require significant
private investments as well, which is extremely difficult to attract, given the
extraordinary sectoral tax currently levied on telecommunications operators.

Businesses in Hungary do not fully
exploit the opportunities offered by digital technologies. For example, 36 % of firms shared internal information on
sales and purchases electronically in 2014, compared with the EU average of
44 %. Only 26 % of businesses communicated with customers through
social media (compared with 36 % in the EU), and 8 % used cloud
computing services (19 % in the EU). Looking at eCommerce, 32% of
Hungarians shopped online as opposed to 50% in the EU, and only 10% of SMEs
were selling online (15% in the EU).

The instability of Hungary’s strategic
framework can create a bottleneck effect in the flow of investment into online
public services and digital public administration.
The Magyary Programme 2014-20 contains a long-term strategy for reducing the
administrative burden. The new public administration and public services strategy
is also being drafted. The links between these strategies and the ‘digital
state’ pillar of the national ICT strategy is unclear.

Environment

Hungary does not fully exploit economic instruments
to promote prevention of waste generation, to avoid incinerating and
landfilling reusable and/or recyclable waste, while making reuse and recycling
more economically attractive. Such instruments
could stimulate the circular economy, and improve the resource efficiency.

Commitments || Summary assessment ([88])

2014 country specific recommendations (CSRs)

CSR 1: Reinforce the budgetary measures for 2014 in the light of the emerging gap of 0.9% of GDP relative to the Stability and Growth Pact requirements, namely the debt reduction rule, based on the Commission 2014 spring forecast. In 2015, and thereafter, significantly strengthen the budgetary strategy to ensure reaching the medium-term objective and compliance with the debt reduction requirements in order to keep the general government debt ratio on a sustained downward path. Further enhance the binding nature of the medium-term budgetary framework through systematic ex-post monitoring of compliance with numerical fiscal rules and the use of corrective mechanisms. Improve the transparency of public finances, including through broadening the mandatory remit of the Fiscal Council, by requiring the preparation of regular macro-fiscal forecasts and budgetary impact assessments of major policy proposals. || Hungary has made limited progress in addressing CSR 1 of the Council recommendation (this overall assessment of CSR 1 excludes an assessment of compliance with the Stability and Growth Pact): · No progress was made to implement the recently legislated medium-term budgetary framework. Government representatives announced that the issuance of the first resolution containing medium-term revenue and expenditure plans for the 2016-2018 period could take place in the first months of 2015. · Limited progress in improving the transparency of public finances and broadening the mandatory remit of the Fiscal Council. While the legal task list of the Fiscal Council was not extended, it plays a slightly more prominent role through publishing commissioned studies.

CSR 2: Help restore normal lending flows to the economy, inter alia by improving the design of and reducing the burden of taxes imposed on financial institutions. Adjust the financial transaction duty in order to avoid diverting savings from the banking sector and enhance incentives for using electronic payments. Investigate and remove obstacles to portfolio cleaning inter alia by tightening provisioning rules for restructured loans, removing obstacles to collateral foreclosure as well as increasing the speed and efficiency of insolvency proceedings. In this respect, closely consult stakeholders on new policy initiatives and ensure that these are well-targeted and do not increase moral hazard for borrowers. Further enhance financial regulation and supervision. || Hungary has made limited progress in addressing CSR 2 of the Council recommendation: · Limited progress in restoring normal lending. Since mid-2013, lending has mainly relied on the subsidised lending schemes, which has managed to loosen supply constraints, but cannot substitute for a sound operating environment for banks on a permanent basis. No progress in reducing the surcharges on the financial sector. Moreover, the ongoing settlements with borrowers and other new regulatory measures (while improving consumer protection and the transparency of pricing) are estimated to result in substantial further losses for the financial sector. · Some progress in the design of the financial transaction duty as the normal tax rate was replaced by a flat annual fee for card payments from 2015. · Limited progress in incentivising portfolio cleaning. In the household sector, the National Asset Management Agency has contracted close to 25 000 (and completed the purchase of around 14 000) real estates by end-2014. For non-financial corporations, the MNB set up an Asset Management Company, primarily aimed at commercial real estates. Discussions are ongoing to ensure that the new institution is governed in compliance with EU rules. Consultation with stakeholders on new policy initiatives has been at best occasional. · Substantial progress in financial regulation, as the government has transposed the EU directive on bank resolution.

CSR 3: Ensure a stable, more balanced and streamlined tax system for companies, including by phasing out distortive sector-specific taxes. Reduce the tax wedge for low-income earners, inter alia by improving the efficiency of environmental taxes. Step up measures to improve tax compliance — in particular to reduce VAT fraud — and reduce its overall costs. || Hungary has made limited progress in addressing CSR 3 of the Council recommendation: · No progress in ensuring a more normative corporate tax regime. In contrast, a number of new sector-specific taxes were introduced with a steep progressive schedule or existing ones were increased. · Limited progress in reducing the tax wedge for low-earners. A doubling in the family tax allowance after two children is scheduled to be introduced in four linear steps way between 2016 and 2019. This measure will have only a minor effect on the tax wedge of a limited number of workers. · Some progress in the field of tax compliance. Following the successful completion of the establishment of on-line links to cash-registers for retail outlets, the authorities are planning to extend this requirement to a number of market services. The threshold for itemised VAT declaration was lowered as of 2015. A new surveillance system has been established from January 2015, which will permit the real-time monitoring of the transport of VAT-liable goods. · No progress in reducing the compliance costs of taxation. The compliance burden impact of new measures, such as the launch of road cargo inspection system and a new system for local taxes, is not monitored.

CSR4: Strengthen well-targeted active labour market policy measures, inter alia by accelerating the introduction of the client profiling system of the Public Employment Service. Put in place the planned youth mentoring network and coordinate it with education institutions and local stakeholders to increase outreach. Review the public works scheme to evaluate its effectiveness in helping people find subsequent employment and further strengthen its activation elements. Consider increasing the period of eligibility for unemployment benefits, taking into account the average time required to find new employment and link to activation measures. Improve the adequacy and coverage of social assistance while strengthening the link to activation. In order to alleviate poverty, implement streamlined and integrated policy measures to reduce poverty significantly, particularly among children and Roma. || Hungary has made limited progress in addressing CSR 4 of the Council recommendation: · Some progress has been made on active labour market policies as the preparation of the profiling system of the Public Employment Service is in progress according to the original schedule. Institutional changes in the public employment services have been launched which might jeopardize the coordination and implementation of active policy measures. · Some progress for setting up of the mentor network in the framework of first Youth Guarantee active labour-market programme, but the Youth Guarantee is only partially meeting the challenge: the quality offer will be provided only within 6 months that raise concern whether sufficient human capacity at the Public Employment Service will be ensured for implementing the scheme. · No progress has been made in revision of the public works scheme and its effectiveness has not improved. According to the 2015 budget, passive and active measures will rely more and more on public works while further improvement is needed to provide trainings and services required for open labour market participation. Limited progress in strengthening activation elements of the public works scheme as time will be allowed for attending job interview; further improvement is needed to provide trainings required by open labour market employers. · No progress has been made to increasing unemployment benefit. Activation element is strong during the unemployment benefit period as there is a co-operation obligation with the Public Employment Service. · Some progress has been made in modification of social assistance cash benefits: the new system will be more transparent however the adequacy and coverage is uncertain. It is strongly linked to activation. · Some programmes have been implemented for Roma inclusion and the monitoring system has been set up. However only limited progress has been made to general poverty reduction; poverty indicators do not improve significantly and streamlining and policy integration still missing.

CSR 5: Stabilise the regulatory framework and foster market competition, inter alia by removing barriers in the services sector. Take more ambitious steps to increase competition and transparency in public procurement, including better use of e-procurement and further reduce corruption and the overall administrative burden. || Hungary has made limited progress in addressing CSR 5 of the Council recommendation: · No progress has been achieved to stabilise the regulatory framework and foster market competition, especially in the services sector. · A reorganisation of public procurement administration leading to changes in the structure and personnel of the system has been done in 2014, results remain to be seen. Hungary submitted an Action Plan in the context of fulfilling the ex-ante conditionalities for the European Structural and Investment Funds. The Plan includes measures concerning the transposition of the new public procurement directives and the steps to foster inter alia competition and transparency, including measures on e-procurement. While this goes in the right direction, the implementation of the Action Plan needs to be closely monitored. · The uptake of e-procurement is featured in the Hungarian Government's concept for the new Public Procurement Act. The integrity management system is established, but its effectiveness in dealing with corruption allegations needs to be proven. The government announced measures to improve the anti-corruption framework including new amendments to the whistleblower law, introducing corruption risk assessments as part of the mandatory impact assessments and an information campaign on corruption prevention for different target groups. The implementation of the Cutting Red Tape programme was finalized in 2014 tackling administrative burden for some areas, however new measures introduced in other policy fields resulted in increased administrative burden.

CSR6: Implement a national strategy on early school leaving prevention with a focus on drop-outs from vocational education and training. Put in place a systematic approach to promote inclusive mainstream education for disadvantaged groups, in particular Roma. Support the transition between different stages of education and towards the labour market, and closely monitor the implementation of the vocational training reform. Implement a higher-education reform that enables greater tertiary attainment, particularly by disadvantaged students. || Hungary has made limited progress in addressing CSR 6 of the Council recommendation: · Limited progress has been made on early school leaving prevention. A national strategy was adopted in November 2014, implementation is yet to be seen. · Limited progress has been made in promoting inclusive mainstream education; a systematic approach still needs to be developed. · Limited progress has been made to support transition to the labour market. No action was taken to monitor the implementation of the vocational training reform and no measures has been taken are needed to support the transition between different stages of education. · Limited progress has been made in implementing a higher education reform that enables greater tertiary attainment of disadvantaged students. The adoption of a national higher education strategy by the government was announced in December 2014, including an increase of the national tertiary attainment target to 34%.

CSR 7: Review the impact of energy price regulation on incentives to invest and on competition in the electricity and gas markets. Take further steps to ensure the autonomy of the national regulator in establishing network tariffs and conditions. Take measures to increase energy efficiency in particular in the residential sector. Further increase the sustainability of the transport system, inter alia by reducing operating costs and reviewing the tariff system of state-owned enterprises in the transport sector. || Hungary has made limited progress in addressing CSR 7 of the Council recommendation: · In most Member States where price regulation still exists, the prices, network tariffs and methodology of their calculation are set by the regulator, but in Hungary, they continue to be practically set by the government while the regulator only gives its opinion. · Limited progress as to more regulatory autonomy and reviewing policies to regulate prices. · Energy consumption has been decreasing in 2005-2012, even though energy intensity remains high by EU standards, especially for households. The country is on track in reaching its energy efficiency target, which was set at a fairly unambitious level. Limited progresses have been made in preparing and adopting the legislation necessary to increase energy efficiency. A number of subsidy programmes were announced, however no progress has been made in terms of the economic incentives to reduce energy use. · Some progress in restructuring the state-owned enterprises (MÁV and Volán), and in reducing the debt stock of MÁV. The reorganisation of Volán bus companies was finalised in January 2015. Some progress has been made in improving environmental sustainability thanks to gradual renewal of old rolling stock.

Commitments || Summary assessment

Europe 2020 (national targets and progress)

Employment rate target: 75%

Employment rate 60.7% in 2011; 62.1% in
2012; 63.2% in 2013 and 66.7% in 2014. While the employment rate is
increasing, the pace of improvement is still not enough to achieve the Europe
2020 target and substantially reduce the difference from the EU average,
particularly taking into account open labour market participation which
continues to be a concern. Youth unemployment is still a challenge.

Early school-leaving target: 10% || Early leavers from education and training (percentage of the population aged 18-24 with at most lower secondary education and not in further education or training): 2010 - 10.5%, 2011 - 11.2%, 2012 - 11.5%, 2013 - 11.8%. The figures are particularly high among vocational school students (30%) and among Roma (seven times higher than in the non-Roma population; i.e. 82%). No achievement in this regard but the trend is worsening.

Tertiary education target: 30.3% || Tertiary educational attainment: 28.1% in 2011, 29.9% in 2012 and 31.9% 2013. Therefore, Hungary has already exceeded the national target, which is still below the EU average.

R&D target: 1.8% of GDP and 3% by 2030 || While R&D intensity grew in 2007-2013 by an annual 6.5% reaching 1.41% in 2013 public R&D intensity decrease from 0.46% in 2007 to 0.41% in 2013. However Hungary seems to be on track to reach its R&D intensity target for 2020 due to an increase in Business expenditure on R&D (data for 2014 are not available yet). According to the commitments (RDI strategy), Hungary will increase its research and development expenditures to 1.8% of the GDP by 2020 and 3% by 2030. A complementary target is that BERD would reach 1.2% by 2020.

Target on the reduction of population at risk of poverty or social exclusion in number of persons: 450 000 || 3.05 million People were at risk of poverty or social exclusion in 2011, close to 3.19 million in 2012 and 3.28 million in 2013 (against a 2008 baseline of 2.83 million). No improvement was achieved in this target.

Greenhouse gas (GHG) emissions target: +10% compared to 2005 emissions (ETS emissions not covered by this national target) || Change in non-ETS greenhouse gas emissions between 2005 and proxy 2013: -21%. Based on the latest national projections submitted to the Commission and considering existing measures, it is expected that Hungary will achieve the target: -16% in 2020 as compared to 2005 (i.e. a margin of 26 pps. below target).

2020 renewable energy target: 13%. Share of renewable energy in all modes of transport: 10 % || According to the preliminary data of EurObserver (in the lack of 2013 official Eurostat data, to be published later), the share of renewables in Hungary's final energy consumption was 10.1%. Hungary has reached the interim 2011/2012 renewable target towards the 2020 target, but the level of consumption from renewable energy decreased in 2011 and 2012. In 2011 and 2012 the share of renewable energy has increased only in heating sector while the share of renewable energy in electricity decreased in 2011 and continued to decrease in 2012. The developments in electricity and transport sector are both below Hungary's National Renewable Energy Action Plan (NREAP) expectations in these sectors. A renewable energy support scheme reform was announced in 2011 is delayed since then.

26.6 million tonnes of oil equivalent (Mtoe) primary consumption || The energy consumption target given in the 2014 National Reform Programme (NRP), when compared to the 2012 consumption, actually allows a 24% increase. This appears as "saving" because the "business as usual" scenario forecasts a worrying 53% increase in 8 years.

18.2 Mtoe final energy consumption || The Staff Working Document of the 2014 exercise highlighted the unrealistic nature of the 2020 BAU scenario on energy consumption (and of the related saving target), compared to observed trends between 2008 and 2012. In the final version of the operational program on Energy Efficiency and Environment submitted to the Commission in December 2014 HU indicated that an updated scenario and target would be adopted by 31 March 2015.

Table B.1:       Macroeconomic indicators

(1) The output gap constitutes the gap between the actual and potential gross domestic product at 2010 market prices. (2) The indicator of domestic demand includes stocks. (3)  Unemployed persons are all those who were not employed, had actively sought work and were ready to begin working immediately or within two weeks. The labour force is the total number of people employed and unemployed. The unemployment rate covers the age group 15-74. Source:  European Commission 2015 winter forecast; Commission calculations

Table B.2:       Financial market indicators

(1) Latest data November 2014. (2) Latest data Q2 2014. (3) Overdue loans declared nonperforming before 90 days. (4) All data refer to the annual data ending March of the indicated calendar year. Figures up to 2012 are based on Basel II. Data from 2009 onwards are reported by the authorities for dissemination on the IMF's FSI website. (5) Latest data September 2014. (6) Latest data June 2014.  Monetary authorities, monetary and financial institutions are not included.     \* Measured in basis points. Source:  IMF (financial soundness indicators); European Commission (long-term interest rates); World Bank (gross external debt); ECB (all other indicators).

Table B.3:       Taxation indicators

(1) Tax revenues are broken down by economic function, i.e. according to whether taxes are raised on consumption, labour or capital. See European Commission (2014), Taxation trends in the European Union, for a more detailed explanation. (2)  This category comprises taxes on energy, transport and pollution and resources included in taxes on consumption and capital. (3) VAT efficiency is measured via the VAT revenue ratio. It is defined as the ratio between the actual VAT revenue collected and the revenue that would be raised if VAT was applied at the standard rate to all final (domestic) consumption expenditures, which is an imperfect measure of the theoretical pure VAT base. A low ratio can indicate a reduction of the tax base due to large exemptions or the application of reduced rates to a wide range of goods and services (‘policy gap’) or a failure to collect all tax due to e.g. fraud (‘collection gap’). It should be noted that the relative scale of cross-border shopping (including trade in financial services) compared to domestic consumption also influences the value of the ratio, notably for smaller economies. For a more detailed discussion, see European Commission (2012), Tax Reforms in EU Member States, and OECD (2014), Consumption tax trends. Source:  European Commission

Table B.4:       Labour market and social indicators

(1) Unemployed persons are all those who were not employed, but had actively sought work and were ready to begin working immediately or within two weeks. The labour force is the total number of people employed and unemployed. Data on the unemployment rate of 2014 includes the last release by Eurostat in early February 2015. (2)  Long-term unemployed are persons who have been unemployed for at least 12 months. Source:  European Commission (EU Labour Force Survey and European National Accounts)

Table B.5:       Labour market and social indicators (continued)

(1) People at risk of poverty or social exclusion (AROPE): individuals who are at risk of poverty (AROP) and/or suffering from severe material deprivation (SMD) and/or living in households with zero or very low work intensity (LWI). (2) At-risk-of-poverty rate (AROP): proportion of people with an equivalised disposable income below 60 % of the national equivalised median income. (3 Proportion of people who experience at least four of the following forms of deprivation: not being able to afford to i) pay their rent or utility bills, ii) keep their home adequately warm, iii) face unexpected expenses, iv) eat meat, fish or a protein equivalent every second day, v) enjoy a week of holiday away from home once a year, vi) have a car, vii) have a washing machine, viii) have a colour TV, or ix) have a telephone. (4) People living in households with very low work intensity: proportion of people aged 0-59 living in households where the adults (excluding dependent children) worked less than 20 % of their total work-time potential in the previous 12 months. (5) For EE, CY, MT, SI and SK, thresholds in nominal values in euros; harmonised index of consumer prices (HICP) = 100 in 2006 (2007 survey refers to 2006 incomes) (6)2014 data refer to the average of the first three quarters.  Source: For expenditure for social protection benefits ESSPROS; for social inclusion EU-SILC.

Table B.6:       Product market performance and policy indicators

(1) Labour productivity is defined as gross value added (in constant prices) divided by the number of persons employed. (2) Patent data refer to applications to the European Patent Office (EPO). They are counted according to the year in which they were filed at the EPO. They are broken down according to the inventor’s place of residence, using fractional counting if multiple inventors or IPC classes are provided to avoid double counting. (3) The methodologies, including the assumptions, for this indicator are presented in detail here:  HYPERLINK "http://www.doingbusiness.org/methodology" . (4) Index: 0 = not regulated; 6 = most regulated. The methodologies of the OECD product market regulation indicators are presented in detail here:  HYPERLINK "http://www.oecd.org/competition/reform/indicatorsofproductmarketregulationhomepage.htm" (5) Aggregate OECD indicators of regulation in energy, transport and communications (ETCR). Source:  European Commission; World Bank — Doing Business (for enforcing contracts and time to start a business); OECD (for the product market regulation indicators)

Table B.7:       Green growth

Country-specific notes: 2013 is not included in the table due to lack of data. General explanation of the table items: All macro intensity indicators are expressed as a ratio of a physical quantity to GDP (in 2000 prices)           Energy intensity: gross inland energy consumption (in kgoe) divided by GDP (in EUR)          Carbon intensity: Greenhouse gas emissions (in kg CO2 equivalents) divided by GDP (in EUR)           Resource intensity: Domestic material consumption (in kg) divided by GDP (in EUR)           Waste intensity: waste (in kg) divided by GDP (in EUR) Energy balance of trade: the balance of energy exports and imports, expressed as % of GDP  Energy weight in HICP: the proportion of "energy" items in the consumption basket used for the construction of the HICP Difference between energy price change and inflation: energy component of HICP, and total HICP inflation (annual % change) Environmental taxes over labour or total taxes: from DG TAXUD’s database ‘Taxation trends in the European Union’ Industry energy intensity: final energy consumption of industry (in kgoe) divided by gross value added of industry (in 2005 EUR) Share of energy-intensive industries in the economy: share of gross value added of the energy-intensive industries in GDP Electricity and gas prices for medium-sized industrial users: consumption band 500–2000MWh and 10000–100000 GJ; figures excl. VAT. Recycling rate of municipal waste: ratio of recycled municipal waste to total municipal waste Public R&D for energy or for the environment: government spending on R&D (GBAORD) for these categories as % of GDP Proportion of GHG emissions covered by ETS: based on greenhouse gas emissions (excl LULUCF) as reported by Member States to the European Environment Agency Transport energy intensity: final energy consumption of transport activity (kgoe) divided by transport industry gross value added (in 2005 EUR) Transport carbon intensity: greenhouse gas emissions in transport activity divided by gross value added of the transport sector Energy import dependency: net energy imports divided by gross inland energy consumption incl. consumption of international bunker fuels Diversification of oil import sources: Herfindahl index (HHI), calculated as the sum of the squared market shares of countries of origin Diversification of the energy mix: Herfindahl index over natural gas, total petrol products, nuclear heat, renewable energies and solid fuels Renewable energy share of energy mix: %-share of gross inland energy consumption, expressed in tonne oil equivalents \* European Commission and European Environment Agency \*\* For 2007 average of S1 & S2 for DE, HR, LU, NL, FI, SE & UK. Other countries only have S2. \*\*\* For 2007 average of S1 & S2 for HR, IT, NL, FI, SE & UK. Other countries only have S2. Source:  European Commission unless indicated otherwise, European Commission Calculation

([1])  Moreover, the conversion of households’
foreign exchange mortgage loans into forints may further reduce the gross
external debt figures through banks’ balance sheet adjustment. At the same time,
as credit institutions have predominantly obtained the necessary foreign
exchange funds through the central bank’s liquidity instruments, net external
debt will not be affected by the conversion (i.e. the decline in gross external
debt entails a decrease in international reserves).

([2])  In September 2014, the Central
Statistical Office introduced important methodological changes (more
appropriate data sources for both the headcounts and the wages) for the
calculation of compensation of employees, which overall led to a very
significant revision of past data: most notably, the 2013 income balance was
improved by 1.4% of GDP. As a consequence, this sub-item’s net surplus more
than tripled within a short time-period: from 0.6% of GDP in 2010 to 2.1% of
GDP in 2013. See for further details Central Statistical Office (2014), National
accounts of Hungary, 2013 (preliminary data).

([3])  For methodological details, see Salto,
Matteo – Alessandro Turrini (2010), Comparing alternative methodologies for
real exchange rate assessment, European Economy Economic Papers No. 427.

([4])  Before the outbreak of the crisis, some
55% of all corporate domestic loans were denominated in foreign currency, out
of which up to two-thirds were unhedged, suggesting a significant degree of
currency mismatch in the economy.

([5])  The Hungarian central bank published
various estimates for the import content, and based on 2008 data, it arrived at
an even higher ratio of 56% (Bodnár, Katalin, György Molnár, Gábor Pellényi,
Lajos Szabó, Judit Várhegyi (2013), Dynamics of the trade balance and developments
in exports and imports, MNB Bulletin, Special October issue, pp. 37-45.). The
central bank study found that the local value added content was particularly
low for electronic and optical products as well as for vehicles (most notably
for the automotive industry).

([6])  Vandenbussche, Hylke (2014), Quality in
Exports, European Economy Economic Papers. No. 528.

([7])  Halpern, László – Gábor Oblath (2014),
The “bright” and gloomy side of economic stagnation, Economic Review, Vol. 61.
No. 7-8. pp. 757-800.

([8])  When analysing trends in foreign direct
investments, it is worth focusing on net transactions, as the gross capital
flows are heavily affected by the increasing weight of capital flowing through
Hungary (capital in transit).

([9])  MNB (2014a), Developments in Foreign
Direct Investment in Hungary after the crisis, In: Report on the Balance of
Payments – July, pp. 23-31.

([10]) MNB (2014b), Corporate incomes, In:
Report on the Balance of Payments – September, pp. 24-33.

([11]) The government concluded some 50 strategic
partnership agreements between mid-2012 and end-2014. According to Transparency
International Hungary (Lifting the Lid on Lobbying. Strategic Partnership
Agreements in an Uncertain Business Environment. National Report, 2014), the companies
in question represent slightly more than 8% of private sector headcount, but
they account for ca. 35% of total exports. Moreover, there is a notable
concentration in the sectors openly preferred by the government: the companies chosen
for such agreements cover approximately 90% of employment in the pharmaceutical
sector, 37% in automotive industries and 47% in electronic and electrical
industries.

([12]) Hungary's government debt ratio stood
at 77.3% of GDP in 2013, whilst the average of the debt ratios of the other
three Visegrád countries was only 52%.

([13]) By regressing the debt ratio on per
capita income, which could be seen as an indicator of a nation's wealth,
Hungary's government debt is found to be around a third higher than would be
expected at a similar income position. See also Hungarian central bank (MNB)
(2013), Projection on the evolution of government deficit and debt (in
Hungarian).

([14]) The snowball effect measures the annual
change in the debt-to-GDP ratio, which is produced by the difference between
the implicit nominal interest rate and nominal growth. The magnitude of the
effect is proportional to the previous year's debt ratio.

([15]) While there was a temporary increase in
the level of cash deposits due to the frontloaded nature of the EU-IMF financial
assistance loan, government deposits have remained considerably higher since
the crisis (i.e. around 5.5% of GDP on average compared with the pre-crisis 
levels of around 2.5%). This reflects the higher liquidity needs of government
financing when market conditions are more volatile.

([16]) Only about 70% of the transferred
assets were used directly for debt reduction, while some 15% was kept in the
permanent state portfolio with rest absorbed by the increased deficit in 2011.
Moreover, the debt-reducing impact of pension assets was further reduced by
offsetting stock-flow adjustments, including the revaluation effect of
weakening the exchange rate and the financing of company acquisitions by the
state.

([17]) In 2014, this is mainly due to
weakening of the exchange rate, but also partly to corporate takeovers by the government.
In 2015, the need to provide domestic advance payments in the closing phase of
EU co-financed projects is a major factor hindering the reduction of debt.

([18]) The convergence path of the underlying
macroeconomic variables includes the following central assumptions as agreed by
the Economic Policy Committee: i. long-term interest rates converge to 3% in
real terms, while the short-term interest rates move to a value consistent with
the historic euro-area yield curve. ii. real GDP growth is determined by the
assumed closure of the output gap in T+5 (i.e. 2019) and potential growth
estimated on the basis of the T+10 methodology. In the case of Hungary, this
implies that the annual growth rate decelerates from around 2% in 2016 to 1.5% in
2019 and then gradually increases to 2% by 2025.

([19]) New estimates of age-related costs are scheduled
to be prepared in spring 2015. The overall profile of the forthcoming
age-related cost projections for Hungary is likely to be broadly similar to
that of the 2012 Ageing Report, i.e. showing a decrease in costs over the
coming decade.

([20]) The number of people aged 65 or over is
projected to increase in Hungary by 18% between 2015 and 2025.

([21]) An important element in limiting
expenditure on pension is the reshaped indexation rule applied to benefits,
which has been linked exclusively to inflation. In addition, a number of measures
were introduced to increase the effective age of retirement. This includes the
gradual increase of the statutory retirement age to 65 years and the removal of
most of the options for early retirement. For more details, see Hungarian
Ministry of National Economy (2014), Country fiche on pensions – Hungary.

([22]) The Prime Minister's Office (2010), Report on the Pension and Old-aged
Roundtable (in Hungarian).

([23]) The projection took into account the
investment's effect on growth and additional tax receipts incorporating the
estimates of a recent cost-benefit analysis. See Romhányi, B. (2014), The Paks
II Project: Budgetary policy aspects of the investment, Climate Policy
Institute.

([24]) The budgetary risk scenarios could also
be assessed in terms of fiscal effort – assumed to be implemented on a
permanent basis in 2017 – which would be required to bring the debt ratio back
onto its baseline path by 2025. On this basis, the assumed extension of state
ownership would need an offsetting effort of 0.3% of GDP, while this would
amount to 0.4% of GDP under the public-sector wage increases. To counterbalance
the impact of the nuclear power plant project, the primary balance should be
improved by t 0.9% of GDP, and the required improvement would be 1.7% of GDP for
the combined risk scenario.

([25]) The self-financing programme announced
in April 2014 entails a set of monetary policies to channel excess liquidity of
commercial banks from the central bank's account to government securities. Thus
the debt management agency could switch to increased forint issuances, while
repaying maturing foreign currency debt by converting the receipts at the
central bank, resulting in a parallel decline of the central bank's
foreign-exchange reserves. Note, however, that this conversion process involves
a trade-off from the point of view of gross government debt. Notably, exchange-rate
losses resulting from the recent years of depreciation will be realised
irrevocably. See Hoffmann, M. and P. Kolozsi (2014), The self-financing programme resulted in a more stable sovereign
market, MNB (in Hungarian).

([26]) It should be noted that there was a
considerable downward level shift in private sector debt due to a number of
methodological changes introduced in mid-2014. The most significant change was
the reclassification of many entities (e.g. captive financial institutions,
holding companies, special purpose entities), from ‘S.11 non-financial
corporations’ to ‘S.12 financial corporations’, which alone led to a decrease
in the private sector debt ratio by 25-30 pps (!) over the period 2011-13.

([27]) Based on the calculations of central bank
(MNB), market-based lending continued its declining trend throughout 2013-2014.
See MNB (2014), Funding for Growth Scheme: The first 18 months.

([28]) Since its launch in spring 2013, the Funding
for Growth Scheme has already exceeded its famous precedent, the Bank of
England’s ‘Funding for Lending’ scheme in relative terms (well over 4 pps of
GDP of contracted amounts vs 3 pps of GDP). Based on the trends seen in the
months in late 2014 (ca. HUF 60 bn increase in the take-up per month), it is
very likely that the budget already allocated to the standard scheme will be fully
utilised until the end of 2015. Even if one assumes that only half of the new ‘Funding
for Growth Scheme +’ budget will be taken up, the total size of the programme
would still be brought to some 6.3 pps of GDP.

([29]) A study by MNB compared the total cost
of the Funding for Growth Scheme’s loans with other subsidised facilities. The
scheme was found to be clearly the cheapest preferential financial product, showing
an overall cost advantage of at least 1.5 pps. See MNB (2014), Preferential
financing schemes for Hungarian SMEs and the FGS. In: Funding for Growth
Scheme: The first 18 months. pp. 26-43.

([30]) These findings are based on the Austrian
central bank (OeNB) Euro Survey, which covers the following ten countries in Central,
Eastern and Southeastern Europe: EU Member States: Bulgaria, Croatia, the Czech
Republic, Hungary, Poland, Romania; non-EU Member States: Albania, Bosnia and
Herzegovina, the Former Yugoslav Republic of Macedonia, Serbia. See Corti,
Majken – Thomas, Scheiber (2014), How Did CESEE Households Weather the Crisis?
Evidence from the OeNB Euro Survey, Focus on European Economic Integration
Q2/14, pp. 76-87.

([31]) Based on MNB (Report on Financial
Stability, November 2013), some 25% of respondents who did not apply for the
exchange rate cap system said that they were waiting for a new and improved
scheme.

([32]) MNB (2014), Report on Financial
Stability, November

([33]) In addition, following the bankruptcy
the government voluntarily provided extra coverage for deposits in the
Széchenyi bank on top of the standard deposit guarantee (it covered 49% of
deposits above the maximum amount of EUR 100 000, corresponding to the State’s
49% share in the bank’s equity). This step more than doubled the budgetary cost
of this bank failure, and has raised some concerns both in terms of the use of state
aid, and the principle of a level-playing field.

([34]) Endrész Marianna – Péter Harasztosi
(2014), Corporate Foreign Currency Borrowing and Investment. The Case of
Hungary, MNB Working Papers, 2014/1

([35]) Bodnár Katalin – Zsolt Kovalszky –
Emese Kreiszné Hudák (2014), Recovery from crises and lending, Financial and
Economic Review, Vol. 13, No. 4.  pp. 57-85.

([36]) Credit market conditions on the supply
and demand side are assessed against aggregate macro-financial proxies as well
as against direct survey indicators. See for details Cuerpo, Carlos – Inês
Drumond – Julia Lendvai – Peter Pontuch – Rafal Raciborski (2013),
Indebtedness, Deleveraging Dynamics and Macroeconomic Adjustment, European
Economy Economic Papers, No. 477.

([37]) Fazekas and Scharle, (2012): From
pensions to public works: Hungarian employment policy from 1990 to 2010.

([38]) Until 1 January, 2011 the minimum wage
was set through tripartite negotiations through the National Council for the
Reconciliation of Interests. 2011 was a turning point in social dialogue in
Hungary: the previous Council was abolished, and replaced by a high-profile
body, the National Economic and Social Council (including NGOs, church related
organisations and other stakeholders besides social partners). Its operation is
based on law but the consultation is not binding for the government

([39]) The Job Protection Act was came into
force in January 2013, and introduced reduced social security contributions for
targeted groups (e.g. low-skilled, young and elderly employees, the long-term
unemployed and women returning from maternity leave).

([40]) Benedek, D., Kátay, G. and Kiss, A.
(2013): Microsimulation as a tool for assessing the impact of tax changes. In:
Fazekas, Benczúr and Telegdy (Eds.): The Hungarian Labour Market 2013.

([41]) Csoba, J. and Nagy, Z. E. (2012): “The
Evaluation of Training, Wage Subsidy and Public Works Programs in Hungary” In:
The Hungarian Labour Market 2012 In Focus: The evaluation of active labour
market programs; p. 96.

([42]) Puhani, P. A. 1998. ‘Advantage Through
Training?’ Centre for European Economic Research, Discussion Paper No 98–25.

([43]) Bakó Tamás, Cseres-Gergely Zsombor, Kálmán
Judit, Molnár György and Szabó Tibor (2014): "A munkaerőpiac peremén
lévők és a költségvetés", esp. pages 44-66, available at the site of
the Fiscal Council and Parliament.

([44]) This contradicts the official government
figures, according to which the successful exit rate rose from 11.6 % in
2012 to 13.0 % in 2013. The methodologies used in producing the two sets
of figures differ, which may explain the divergence in the trends shown.

([45]) Farkas Zs, Molnár Gy and Molnár Zs:
2014. "A közfoglalkoztatási csapda", Magyar Szegénységellenes Hálózat

([46]) Koltai L. (2012): "Work Instead of
Social Benefit? Public Works in Hungary" Peer Review on “Activation
measures in times of crisis: the role of public works”

([47]) Tax and benefits indicators database
(OECD - European Commission, latest data, 2013).

([48]) http://ec.europa.eu/taxation\_customs/resources/
documents/common/publications/studies/vat\_gap2012.pdf

([49]) OECD (2015), Hungary: Towards a
Strategic State Approach, OECD Public Governance Reviews, p. 93.

([50]) Harding, M. (2014), “Personal Tax Treatment
of Company Cars and Commuting Expenses: Estimating the Fiscal and Environmental
Costs”, OECD Taxation Working Papers, No. 20.

([51]) A reinforced Fiscal Council could
subsequently also be tasked with evaluating the completeness and validity of
the government's justifications of the differences between the medium-term
plans and the actual budget figures. In this regard, the regular preparation of
comprehensive macro-fiscal forecasts would help the Fiscal Council to verify
the government's explanations for possible deviations vis-à-vis the medium-term
plans, which could considerably enhance the integrity and predictability of the
entire medium-term framework.

([52]) Indeed, it was a telling sign that the
Fiscal Council announced an affirmative opinion on the 2015 draft budget plan
in October 2014, while at the same time admitted that it was not able to
determine the budgetary costs of the new tax package. See Fiscal Council (2014),
Opinion of the Fiscal Council on the draft 2015 budget proposal.

([53]) The Roma-non-Roma employment gap is 34 pps. (Roma survey – Data in Focus: Poverty and employment: the situation of Roma in 11 EU
Member States, European Union Agency for Fundamental Rights, 2014,and Employment and Social Developments in Europe 2014, European Commission.

([54]) The Ministry of National Economy (MoE) has an overall
responsibility for employment policy, the Ministry of Interior (MoI) is
responsible for the Public Work Scheme and the Ministry for Human Capacities
(MfHC) holds responsibilities for social assistance system, for the
rehabilitation of disabled people and for family issues (including regulation
of parental leave and childcare facilities). Labour offices operating in the
framework of government offices at local level has been supervised parallel by
MoE and MoI, while MfHC established its separate institution for rehabilitation
and social issues.

([55]) NEET rate among Roma 16-24 year old is at 37%, ESL-rate at 82%.
Roma survey – Data in Focus.

([56]) Roma survey – Data in Focus: Poverty and employment: the situation
of Roma in 11 EU Member States, European Union Agency for Fundamental Rights,
2014.

([57]) In 2012, total health expenditure was 7.8% of GDP in Hungary
compared with 9.6% of GDP in the EU based on WHO data in 2012. At the same
time, share public spending was about 64% of total health expenditure compared
with the EU average of 76%, WHO data from 2012.

([58]) See the report from 2015 on Comparative
efficiency of health systems, corrected for selected lifestyle factors. http://ec.europa.eu/health/systems\_performance\_assessment/docs/2015\_maceli\_report\_en.pdf

([59]) Hungarian central statistical office
education data 2012/2013.

([60]) Roma survey – Data
in Focus: Education: the situation of Roma in 11 EU Member States, European
Union Agency for Fundamental Rights, 2014.

([61]) A végzettség nélküli iskolaelhagyás
elleni középtávú stratégia. November 2014. (Mid-term Strategy Against School
Leaving Without Qualification).

([62]) Roma Education in Comparative
Perspective. Findings from the UNDP/World Bank/EC Roma Survey. 2014.

([63]) Hungarian Social Inclusion Strategy.
The situation of Roma.

([64]) The best performing students tend to go
to general secondary schools that give direct access to higher education (in
total around 79 % of the relevant age group), while those with weaker
performance in education choose the vocational school (‘szakiskola’)
(21 %). Hungarian central statistical office preliminary education data
2014/2015.

([65]) Korai iskolaelhagyas a magyarorszagi
szakkepzesben. Refernet. 2013
http://www.observatory.org.hu/wp-content/uploads/2013/09/ReferNet\_2013\_ESL\_HU.pdf

([66]) OECD Education at a Glance 2014. Chart
A7.1.

([67]) Modernisation of higher education in
Europe. Access, retention and employability 2014. Eurydice report.

([68]) Szilvia Nyüsti: Disparities in the income and use of time of full-time students. Pp.
39-52. In: The Social Dimension of Higher Education.
The results of Eurostudent V in Hungary. Budapest. 2014. Educatio Public Services Non-profit LLC.

([69]) Including for tobacco retail,
pharmacies, textbook publishing and distribution, waste management, mobile
payments, meal vouchers and retail outlets.

([70]) The biggest negative change between
2003 and 2013 was in the area of special regulation on large outlets http://www.oecd.org/eco/reform/indicatorsofproductmarketregulationhomepage.htm
.

([71]) The percentage of laws modified within
one year fell from 26.4 % in 2011 to 12.7 % in 2013, but is still
at a high level. Empirical data on the legislative processes in this section
are taken from: Corruption Research Center Budapest (2015), The Quality of Hungarian
Legislation 2013-2014.

([72]) In the first half of 2014, 19 %
of all published laws originated from drafts submitted by an individual member
of parliament. The equivalent percentage in the second half of the year was 25 %.

([73]) OECD (2015), Hungary: Towards a
Strategic State Approach, OECD Public Governance Reviews, OECD Publishing,
Paris.

([74]) Controlling Corruption in Europe: The Anti-corruption
Report — Volume 1.

([75]) Alina Mungiu-Pippidi (editor) (2013):
Controlling Corruption in Europe, The Anticorruption Report.

([76]) Bid-rigging is when a contract is
promised to one party, although for the sake of appearance other parties also
present a bid. For further information on Hungary, see PWC and Ecorys (2013):
'Identifying and reducing corruption in public procurement in the EU', Report
commissioned by OLAF.

([77]) The high administrative burden on
tenderers results in a low number of bids per public tender. Hungary ranked the
4th lowest in market competitiveness according to the ‘Cost-effectiveness
study’ with an average of 3.5 bids per tender (EU average 5.4). The high frequency of tenders obtained by some specific contractors
and bidding by consortia involving the major actors of the market are signs for
limited or distorted competition that materialise in investment costs being
often higher in Hungary than the EU average, as assessed by JASPERS (Joint
Assistance to Support Projects in European Regions) experts.

([78]) In 2014, Hungary had 10.6% of
negotiated procedures without publication for above threshold tenders, compared
to an EEA average of 6.2% / median of 4.7%. This is the 6th highest
proportion in the EU.

([79]) Since July 2013, a public procurement
database is available online and must be updated by all tenderers. However, it
is not completely transparent, as due to design weaknesses data, it is
sometimes not coherent and the database does not allow for meaningful searches
or researches. http://www.crcb.eu/?cat=6

([80]) Public administration scoreboard 2014: 
http://ec.europa.eu/enterprise/policies/industrial-competitiveness/monitoring-member-states/improving-public-administration/index\_en.htm
Hungary  ranks 24th in the EU in the overall effectiveness of public
administration

([81]) Science and Engineering graduates
(ISCED 5 and 6) per thousand population aged 25-34 was 8.6% in 2012, which is
well below the EU average of 16.3%.

([82]) The government adopted the law on
'Scientific Research, Development, and Innovation' (24 November 2014) providing
legal mandate to the structure of the new Hungarian R&I landscape. The
National Office for Research, Development and Innovation is the governmental
body responsible for research, development and technological innovation as of 1
January 2015. The new office is responsible for the National Research,
Development and Innovation Fund that integrates the Hungarian Scientific
Research Fund (OTKA) and the Research and Technological Innovation Fund (KTIA).

([83]) As of 1 January 2013 both electricity
and retail prices for household consumers under the Universal Service Provision
were cut by 10%, which was followed by a further cut of 11.1% as of 1 November
2013. In April 2014, the retail price of natural gas was reduced by 6.5%, while
in September 2014 retail electricity prices were cut by 5.7% and as of October
district heating tariffs by 3.3%.

([84]) In the gas market Tigaz, GDF Suez,
E.ON, Fogaz produced a combined loss of 27 bn HUF. In the electricity market, E.ON,
Emasz, Edasz, EDF Demasz produced a combined loss of 14 bn HUF.

([85]) According to
the latest news a state-owned utility will start operating as of March 2015,
entering in the retail gas utility sector; later it might also enter in the
retail electricity sector.

([86]) The Centre for Budapest Transport has
recorded increasing revenues from ticket sales since 2010. Fare revenues
continued to increase last year despite the reduction in monthly ticket prices
for individuals. Source: www.bkk.hu.

([87]) Source of figures quoted in this
section: Digital Agenda Scoreboard, http://ec.europa.eu/digital-agenda/en/digital-agenda-scoreboard

([88]) The following categories are used to
assess progress in implementing the 2014 country-specific recommendations:       
No progress: The Member State has neither announced nor adopted any
measures to address the CSR. This category also applies if a Member State has
commissioned a study group to evaluate possible measures.           
Limited progress: The Member State has announced some measures to
address the CSR, but these measures appear insufficient and/or their
adoption/implementation is at risk.   
Some progress: The Member State has announced or adopted measures to
address the CSR. These measures are promising, but not all of them have been
implemented yet and implementation is not certain in all cases.       
Substantial progress: The Member State has adopted measures, most of
which have been implemented. These measures go a long way in addressing the
CSR.
Fully addressed: The Member State has adopted and implemented measures
that address the CSR appropriately.

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