Forecast 2010

In the past 1.5 years, a huge improvement took place in Hungary's external and internal deficits, however, the price paid includes the substantial drop of consumption, investments and GDP. The corrective measures of economic policy received positive international recognition and improved the credibility of Hungary considerably. The modest room for manoeuvring in the new government's fiscal policy – perhaps amounting to about 1-1.5 per cent of GDP as presented in the March Forecast of GKI as well – has been further reduced by the Greek crisis…

In the past 1.5 years, a huge improvement took place in Hungary's external and internal deficits, however, the price paid includes the substantial drop of consumption, investments and GDP. The corrective measures of economic policy received positive international recognition and improved the credibility of Hungary considerably. The modest room for manoeuvring in the new government's fiscal policy – perhaps amounting to about 1-1.5 per cent of GDP as presented in the March Forecast of GKI as well – has been further reduced by the Greek crisis (then to minimum levels after neglecting the potential consequences of the Greek situation). After the serious mistakes made by the government in economic policy and communication at the beginning of June, even some smaller modification of this year's targets became impossible: the EU and financial markets expect that Hungary should insist on the 3.8 per cent general government deficit relative to GDP. Tightening has been placed on the agenda instead of loosening.

The aggregate GDP of the world economy grows by 4 per cent in 2010 after the 0.9 per cent decline in 2009. Following the 2.4 per cent contraction in 2009, GDP growth in the US is expected to total about 2.8 per cent in 2010, which is marked growth, but below the pre-crisis figure before. Recovery in the European Union is expected to be very slow and rather differentiated. After the 4.2 per cent decline in 2009 the combined GDP of the EU is likely to increase by 1 per cent. Based mostly on external demand, Germany's GDP increases by 1.2 per cent in 2010, following a 5 per cent drop in 2009. As a result of the fiscal expansion in the majority of member states the general government deficit of the EU relative to GDP is projected to reach 6.8 per cent in 2009 and 7.2 per cent in 2010 (after 2.3 per cent in 2008). The government debt to GDP ratio is likely to grow from 62 per cent to 74 per cent and 80 per cent in the same years. Both indicators will be higher than the 3 per cent and the 60 per cent benchmarks. Managing recovery from the crisis (the exit strategy) is possible only on the fiscal side in terms of reducing general government expenditures, which entail serious political and social tensions.

The US Fed's federal funds rate is between 0 and 0.25 per cent; the reference rate of the European Central Bank is 1 per cent, long-term bond yields are much higher than these levels. Neither the Fed, nor the ECB is expected to raise their official rates in 2010. The Greek crisis reinforced the "lender of last resort" role of the US, so the yield of US government bonds declined and the dollar strengthened. The crisis of the Eurozone will lead neither to the disintegration of the Economic and Monetary Union, nor to the exit of certain member states. Following the US$1.47 exchange rate in 2008, and the US$1.39 in 2009, the annual average exchange rate of the euro to the US dollar is expected to average about US$1.30 in 2010. From the average annual price of 62US$ per barrel in 2009, the price of crude oil (Brent) is expected to increase to US$82 in 2010.

Until May, GKI's economic sentiment index had been rising continuously and markedly for one year, and both the consumer and the business confidence index was above the level recorded in the last "peace month" before the crisis, i.e. in September 2008. In the business sector expectations improved in all industries, however, more pronounced improvement could be seen in the case of industrial companies, which rely on external markets, than in the case of those targeting the domestic market. Opinions about the prospects of the Hungarian economy are also improving, in industry and trade those expecting improvement outnumber those anticipating deterioration. GKI's consumer confidence index grew remarkably in April and May (prior to and after the parliamentary elections).

The economic policy options for the new government are determined foremost by the general government deficit, which has to be accepted by international institutions and the financial markets. Earlier GKI forecasts underlined that the original 3.8 per cent deficit target relative to GDP could be achieved. A maximum of 5 per cent deficit was said to be feasible (only if there were one-off consolidation expenses and structural reforms). Nonetheless, following the Greek crisis, the reliability and the discipline of government budgets became unquestionable priorities in the EU. Although the current balance of the Hungarian general government is rather favourable in European comparison – in the May forecast of the European Commission, Hungary is expected to have the 6th lowest deficit in the EU – European institutions would tolerate raising the deficit target only if international circumstances deteriorate unexpectedly and to an unavoidable extent. In 2009 the crisis justified such change, in 2010, however, the business cycle is perhaps more favourable than expected earlier. Besides, the "fiscal appetite" of Hungary in 2000-2006 has not yet been forgotten by international financial markets. All these factors were neglected by the new government. In such circumstances, the official communication – referring to an economic emergency situation, and envisioning sovereign default -, which did not have sound basis and was launched more for internal political purposes, proved to be a serious political mistake. The credibility of the Hungarian government and the economy suffered serious damage, as the fall of the Hungarian currency and the international reactions, more precisely the general consternation showed. Confidence is essential for the Hungarian economy, and it can be regained only by applying straightforward and sustained discipline in economic policy. Since practically there is no more room for loosening the budgetary discipline, GKI expects an approximately 4 per cent deficit relative to GDP in 2010 (and assumes that the less than 3 per cent deficit target for 2011 in the convergence programme will be confirmed).

The 29-point Action Plan announced by the Prime Minister at the beginning of June is a first and necessary reaction to the situation: many elements are appropriate concerning the direction, but the plan is not necessarily sufficient. For the markets (foreign actors and the EU) the most important message of the announcement was that the government would not take irresponsible steps that enhance the deficit to stimulate the economy. Subsequently, the forint started to strengthen and risk premiums set to decline. For the Hungarian public the main message of the Action Plan is that the government is on board. In fact the Action Plan consists of three parts. 1.) A HUF350 billion cut in government expenditures in 2010 (behind which there can be some unspecified room for a tax reduction amounting to a few ten billion forints, c.f. the cancellation of ten "small" taxes and the extension of the base for the lowest corporate tax rate). 2.) For 2011 a substantial reduction of the personal income tax, including the introduction of a flat tax system combined with enhanced childcare tax allowances, which raises the net personal income by a similar extent as the extension of the tax base for the lowest rate up to HUF15 million income. The Bajnai government passed a similar law for 2011, however, this time the tax allowance will be abolished, which raises the tax burdens of low income strata. 3.) Many small, sometimes useful, occasionally populist, and in some cases hardly executable ideas. The Action Plan reveals a substantial change compared to the communication pursued in the past years and in the election campaign, because the government introduces austerity measures and cuts in public spending, there is no broad tax reform, and the tax modifications announced favour high and medium income families and put burden on low income strata. Based on the available information, the minimum 0.5-1 per cent overspending relative to GDP) remains in the 2011 budget, which is a problem.

Without more concrete measures, it is still hard to evaluate the Action Plan properly. Taxing the financial institutions for three years and receiving an additional annual tax revenue of HUF200 billion in four months this year (about half of the annual profit) seems to be unrealistic and it may have serious consequences on the already strict conditions to access to loans. The expected savings of HUF120 billion (by revising government expenditures) and nearly HUF50 billion (by cutting public sector wages) is unrealistic, since – for instance – decreasing aggregate wages in state-owned companies does not have any positive impact on the budget. As in recent months the 2010 general government deficit was overestimated by the new government, it is not necessarily a problem if some of the unannounced, yet planned austerity measures are not implemented. (It is not by chance that the report of the fact-finding Varga-committee was not published: the new government is not interested in magnifying the problems!). The measures planned do not constitute a unified concept. The impact assessment of the important steps – such as taxing the financial institutions, directing more EU-funds to SMEs, taxing the minimum wage that influences employment and income inequality – is missing. Some plans and concepts are no tin line with the logics of the market economy. They include: the freezing of the fees to be paid for public utilities, introducing the concept of "income outside the tax system", the ban on mortgage loans denominated in foreign currency. Thus far there is no government intention to change the working mechanisms of large public redistribution systems and state-owned companies, although sustained improvement can only be expected if structural changes accompany the cut on spending. The main characteristic of the Action Plan is that a basically austerity programme is combined with populist elements. Thus, economic policy is likely to be two-faced again with double voice, similarly to the 1998-99 period.

In 2010 the general government revenues from taxes and charges will be less than those envisaged by the budgetary law by more than HUF200 billion. However, other revenues of the general government will be higher than the planned ones (especially because the financial consequences of the return of employees from the private pension system to the one run by the state are recorded for this year). In total, about the fallout of revenues valued at HUF150 billion is expected. On the expenditure side, more spending is expected especially because of financing hospitals, labour market schemes and some state-owned companies. Taking into account the savings on interests paid, the fact that the National Bank of Hungary will not make a loss this year, the austerity measures for budgetary institutions and the freezing of most of the reserves, total government expenditures will be by approximately HUF100 billion less than planned. On a cash-flow basis, the general government deficit will be higher than planned by about HUF50 billion (excluding local governments). Thus, the general government deficit (ESA methodology) will be about 4 per cent of GDP. Similarly to 2009, at the end of 2010, gross government debt is expected to equal to about 78.3 per cent of GDP. This will not be an outstanding ratio in Europe at all, however, its continued financing requires maintaining the confidence of investors. Financing the debt can be smooth by using the resources available in the Hungarian financial system and by the further use of the IMF-EU stand-by loan. The external balance will be rather favourable this year as well. In terms of the net position, Hungary will not need foreign financial resources, the current account will be balanced, and the overall external financing will show an EUR2.4 billion surplus (2.4 per cent of GDP), larger than last year. The net foreign debt of Hungary will markedly decrease in 2010, to EUR 48 billion from EUR 52 billion in 2009.

In 2010 the output of industries and firms that sell their goods and services in foreign markets will increase most, including the majority of manufacturing, some segments of road transportation and tourism services in Hungary. The 5 per cent increase of gross industrial production will be the result of exports only. Within construction, which is expected to stagnate, civil engineering will be booming, building construction trends will be determined by a decline in the real estate sector and the reconstruction needs emerging after the flood. In agriculture, the terrible spring weather caused great damage in the vegetable and fruit segment, however, the crop and corn harvest, which determine much of the volume of production will only slightly be lower than last year. In retail trade growth is expected only in the Christmas season. The revenue of telecommunication firms is expected to stay flat, voice communication revenues drop and internet services boom. In summary, for the whole of 2010 a 1 per cent GDP growth is projected. Aggregate domestic demand may increase by 0.5 per cent in 2010. The replenishment of inventories continues. Although the change of government and the related organisational and personnel changes imply the temporary slowdown of government decision making, investments co-financed by the EU – which are mostly infrastructure projects, but some of them promote competitiveness as well – and business investments will increase slightly. However, the number of homes completed will fall to 20 thousand in 2010 from 32 thousand in 2009. In 2010 a 1 per cent expansion of investments is expected. Household consumption will decline further, by 2 per cent. Real earnings will grow by 4 per cent in the business sphere and by 1 per cent in the public sector. Nevertheless, real income will only stagnate. Employment drops further in 2010, the support of unemployed shrinks over time, the benefits of the cafeteria system are declining because they are taxed and family allowances will not increase in nominal terms either. Taking into account the increase based on the inflation rate, the elimination of the 13th month pensions and the pension corrections, the real value of pensions will drop by about 1 per cent. The households' propensity to save will slightly increase in 2010 (it is a somewhat forced increase). The slow increase of credits implies that the net savings ratio grows to 4 per cent of GDP (from 3.2 per cent in 2009). Thereby it finances the expected general government deficit.

Similarly to other countries, but more than the EU average, employment deteriorates further. The number of employees drops by 1 per cent, unemployment goes up to an annual average of 11.5 per cent. Following the 12 per cent peak of unemployment in spring, a seasonal decline is to come, then at the end of the year the seasonal deterioration may partly be offset by the modest growth of employment. In the first half of 2010 the rate of inflation will exceed 5.5 per cent, but it will decline to about 4 per cent by the end of the year. Hence, the annual average rate of inflation will be 4.8 per cent. A higher price index is also likely if oil prices (expressed in forints) increase faster and vegetable and fruit prices climb as a consequence of bad crop. The favourable Hungarian financial market trends were broken by the crisis of the Eurozone and the political campaign about the "emergency situation". Besides, tension prevails between the new government and the leadership of the National Bank of Hungary, partly over the monetary policy to be pursued and partly for personal reasons.

The GKI forecast assumes that the new government keeps the earlier planned general government deficit target for 2010-2011 in order to restore international confidence and thereby access to favourable financing conditions. It assumes that recent, often suicidal ideas will not play a role in economic policy. (So, for instance, it is assumed that there will be no conversion of foreign currency loans to forint ones in large amounts, no rescue belt for those having taken mortgage loans will be offered, the nationalisation of the private pension funds will not accomplished, and no artificially reduced interest rates will be applied). Counting also on the gradual stabilisation of the international investment climate, the demand for Hungarian financial assets will increase again in the second half of 2010. In this case the central bank will be able to reduce its reference rate to about 5 per cent by the end of 2010. Similarly to the first half year, the HUF/EUR exchange rate will average about HUF270 in the second half of the year. When the convergence programme is updated, it will be unavoidable to announce the meeting of the budgetary (deficit and debt) criteria by 2012 and 2013 at the latest. This would make the 2014 adoption of the euro in Hungary possible. In the circumstances outlined, announcing the 2014 adoption of the euro and initiating the accession to ERM-2 by the end of 2010 would be reasonable. It could act as an economic policy anchor, enlarge the room for cutting the reference rate, strengthen the capital absorption capabilities of the country and contribute to accelerating the potential growth in the years to come.