Hungary: IMF staff concluding statement of the 2024 Article IV Mission

Budapest, June 21, 2024

• Hungary is emerging from a period of shocks. The pandemic, Russia’s war in Ukraine, and crisis-related stimulus widened fiscal and external imbalances and triggered double-digit inflation in 2022. Thanks to an effective monetary policy response aided by falling commodity prices and a tighter fiscal stance in 2023, inflation has declined rapidly, while the labor market and financial sector have remained resilient. A large current account deficit in 2022 turned into a surplus, and output is starting to recover.

• Despite these encouraging signs, significant challenges remain. The fiscal deficit and public-debt-to GDP ratio remain well above 2019 levels, and various temporary windfall taxes have created investor uncertainty. Interest rate caps and subsidized lending measures have distorted market rates, and significant state ownership in key sectors impedes competition. Despite some progress, the ongoing negotiations on the super milestones, including the Commission’s assessment of governance conditions, are delaying the disbursement of EU funds that are vital for supporting digitalization, regional integration, and the green transition.

• With the right policies, sustainable and inclusive growth is well within Hungary’s reach. Rebuilding buffers through a credible and growth-friendly fiscal adjustment plan would reduce sovereign risk and support the central bank in its disinflation efforts. Such adjustment should be rooted in a medium-term budget process with a more balanced revenue structure and a growth-friendly spending mix. Stability-oriented macro-financial policies should raise countercyclical capital buffers and allow market forces to drive credit allocation. Coordinated structural reforms are key to addressing Hungary’s lagging productivity relative to the EU average and accelerating progress toward the green transition.

Economic Outlook

A modest recovery is underway, while the disinflationary process remains on track. Following a contraction of 0.9 percent in 2023, IMF staff projects real GDP growth of 2.3 percent in 2024, driven by domestic consumption. Growth is expected to accelerate to 3.3 percent in 2025 as investment gradually picks up, and then converges to its potential of around 3 percent over the medium term. Inflation is projected to increase to 4.2 percent year‑on-year in Q4 2024 before durably converging to the authorities’ 3 percent target in 2026. A modest current account surplus is expected in 2024 with gradual improvement over the medium term in line with the anticipated increase in battery and electric vehicle exports.

The outlook is clouded by uncertainty, with risks tilted to the downside for growth and upside for inflation. The absence of measures to address still sizeable fiscal imbalances and structural policy challenges could weaken investor confidence and deter needed private investment. Lack of progress in governance reforms could result in the prolonged suspension of important EU funds. A resultant increase in risk premia and forint depreciation could prolong tight monetary policy and weaken growth. Inflation could increase again in the event of further disruptions to energy supply caused by an escalation of geopolitical risks, which would also adversely affect the external balance, or if Hungarian wages grow faster than expected. Furthermore, monetary policy miscalibration by major economies could impact Hungary’s macroeconomic and financial stability.

Strengthening Fiscal Sustainability

The recession in 2023, elevated borrowing costs, and spending pressures are weighing on public finances. The government remains committed to reach their 2024 and 2025 fiscal targets of 4.5 percent of GDP and 3.7 percent of GDP, respectively. In the absence of additional measures, staff projects the fiscal deficit to reach 5.3 percent of GDP in 2024 and exceed the Maastricht limit of 3 percent of GDP through 2026, while the public debt ratio will remain above 70 percent of GDP through 2028. The elevated level of debt and financing needs are a source of fiscal risk, as they leave the future evolution of public finances exposed to an unexpected increase in funding costs or a decline in growth.

Additional fiscal consolidation measures would help safeguard fiscal sustainability and reduce sovereign risk. A credible and growth-friendly adjustment plan should aim at bringing the deficit below 3 percent of GDP by 2026—enabling an exit from the EU’s excessive deficit procedure—while bringing the structural deficit to 1.5 percent of GDP by 2029, in line with the preliminary assessment of what the new EU fiscal framework would require. Staff recommends to root measures in a fully-fledged medium-term budget process, as required by the new EU Governance Framework. Such an adjustment is instrumental in rebuilding fiscal buffers to be able to respond to future shocks while bringing down sovereign risk premia and longer-term yields, which would also support activity.

Tax reforms should focus on improving the efficiency and equity of the tax system. Hungary relies on VAT and turnover taxes and has among the lowest statutory personal and corporate income tax rates in the EU. A universal VAT rate with fewer exemptions would enhance efficiency and simplify administration. Staff notes that higher marginal personal income tax rates for high earners would increase revenue and enhance fairness. Staff also recommends that taxation of corporates be made more equitable and efficient by rationalizing tax incentives and increasing the tax rate, while using the additional revenues to eliminate distortive windfall taxes. There is also scope for raising more revenue from property taxes.

Reducing subsidies and rationalizing other current spending will achieve fiscal savings and help disincentivize fossil fuel use. Limiting retail utility subsidies to a basic subsistence amount to protect vulnerable households would yield savings, reduce fossil fuel consumption, and insulate the budget from energy price fluctuations. A rationalization of the public wage bill and goods and services spending, which are above EU averages, would provide further savings. Such measures could also provide room for more productive spending, including on education. Reforms are needed to contain long-term spending pressures, including related to pensions and healthcare, while increased revenue to fund the green transition could be sourced from phasing out fossil fuel subsidies and making greater use of tax

Fiscal risks should be carefully monitored and managed. The assets of SOEs have grown significantly over the past five years while the stock of government guarantees has doubled relative to GDP. Staff recommends developing a comprehensive centralized fiscal risk management framework to improve the monitoring and assessment of contingent liabilities. Guarantees should be prudently managed, centrally monitored and well provisioned, keeping the stock of outstanding guarantees on a downward path.

Bringing Inflation Durably Back to Target

Policy rates will need to remain in restrictive territory into the next year to deliver a sustainable return of inflation to target. The loosening of the monetary policy stance so far has been broadly appropriate and monetary policy remains tight. The simplification of the monetary policy toolkit is a welcome development and will make policy communication easier. There is limited scope for further rate cuts this year as underlying inflation pressures remain elevated, particularly for services. This partly reflects significant wage growth, even though some is projected to be absorbed by a fall in the profit share. The exchange rate is likely to also be a binding constraint on the pace of loosening given its importance for inflation dynamics.

Central bank autonomy is vital for price and financial stability and should be protected by appropriate legal frameworks. The recent amendment to the central bank law no longer mandates recapitalization from the budget within a specific timeframe, thereby allowing the MNB to offset current losses against future income. The MNB’s balance sheet position will improve gradually over time as assets mature and policy rates fall. To ensure that the MNB is well capitalized in the medium term, it is important that—as specified in the law—the MNB does not pay out advanced dividends and that no dividends are distributed until the minimum capital required by the law is reached. As it is unclear how existing rights to create a business or foundation relate to the MNB’s primary objective of price stability, such activities should be scaled down.

The flexible exchange rate regime and reserve adequacy can help Hungary manage external shocks. The authorities remain committed to the flexible exchange rate regime to facilitate adjustment to external and domestic shocks. Staff assesses reserves to be adequate. Further reserve accumulation, especially during risk-on periods, would help bolster external buffers.

Deepening Financial Sector Resilience

The financial sector has remained resilient despite the sharpest monetary policy tightening in decades. Systemic risks appear contained amid strong macroprudential policy frameworks, capital and liquidity buffers well above regulatory thresholds, and a relatively stable non-performing loan (NPL) ratio for banks. Structural changes, such as a substantial increase in the share of fixed-rate mortgages and lower household leverage, have dampened the effects of tightening on the housing market compared to previous cycles.

Continued vigilance is needed to address emerging risks. Current high levels of profitability are likely to be temporary and there are potential lagged effects of the tightening cycle on NPLs, as well as interest rate and maturity risks in the corporate sector and default risks in commercial real estate (CRE). While the housing market has slowed, government housing programs and easing of financial conditions could again fuel housing demand and price increases. Care should be taken to minimize migration of risks to non-bank institutions through continued robust surveillance and supervision.

Now is an opportune time to build resilience, including to lock high bank profits into capital buffers. The scheduled increase of the countercyclical capital buffer (CCyB) and reactivation of the systemic risks buffer for CRE in July 2024 are appropriate. Moving to a higher positive neutral rate than targeted for the CCyB could be an option to further boost resilience, as these buffers can be released in times of stress. While the MNB should play an active role in climate-risk supervision, prudential regulation should remain risk focused, and all climate-related initiatives should be consistent with its price and financial stability mandate. Hungary has strengthened its AML/CFT frameworks and should prioritize implementing the EU’s 2024 AML/CFT legislative package agreed in April 2024 while enhancing national frameworks for non-profit organizations, as recently highlighted by MONEYVAL.

Distortions to market-based credit allocation should be removed, with better targeting of subsidized lending schemes. Interest rate caps, which have artificially lowered lending and deposit rates beyond the stance of monetary policy, are likely regressive, and may encourage credit rationing. While caps on deposits and SME lending rates ended in April 2024, those on mortgages remain, together with various voluntary caps. They should be fully phased out. In this context, scaling back the various fiscal incentives, including for house ownership, would help moderate future house price growth and thus safeguard financial stability. More generally, state-owned banks’ subsidized lending should be carefully monitored and targeted to address market failures.

Reforms for Bolstering Sustainable and Inclusive Growth

Deeper reforms are needed to drive more balanced growth and to accelerate the green transition. Several long-standing, mutually reinforcing challenges are holding back Hungary’s productivity, including a strong presence of state-owned enterprises in some key sectors alongside stringent entry conditions, rigid industry structures, inequalities of opportunities, and lagging digitization. Sustained implementation of a reform program that tackles all these issues will help Hungary to compete in the new digital and low carbon economy.

Strengthening digital competitiveness amid the emergence of AI could improve productivity. Like elsewhere in Europe, the Hungarian economy is highly exposed to the rapid advancement of new AI technologies. To harness the benefits while mitigating the risks posed by AI, the authorities should prioritize and speed up reforms as outlined in the National Digitalization Strategy and implement the new EU AI Act. Further targeted measures, including investment in reskilling the workforce and promoting STEM education, can prepare the Hungarian workforce and economy to adapt and compete in the digital era.

Hungary has made progress on climate mitigation, but large fossil-fuel subsidies complicate the transition to a low-carbon economy. Hungary is committed to the EU Green Deal, aiming to cut its emissions by 50 percent (relative to 1990) by 2030. However, Hungary’s explicit and implicit fossil subsidies are above the EU average, while its share of renewables in the energy mix remains among the lowest in the EU. Phasing out these subsidies would enhance energy efficiency and security and level the playing field for renewable energy investment on top of generating fiscal savings. Investment in low-carbon infrastructure, including renewable-compatible energy grids and electric charging stations, is vital.

Targeted policies can ameliorate regional disparities. Despite some progress, regional income disparities remain high. They may worsen with the digital and green transitions as lagging regions remain less productive amid concentration of activity in carbon-intensive and low-value-added industries and agriculture. Means-tested social transfers for vulnerable household and reskilling of workers for the green and digital transitions can promote social cohesion and inclusion. Policies must be carefully calibrated to support, not hinder, regional economic agility during structural transformations.

Good governance is the foundation for successful structural transformation. Further progress on governance reforms would foster a growth-friendly environment, enhance policy predictability, and unlock EU financing. Industrial policy (IP) is another lever for structural transformation, but the bar is high to get it right. IP measures should be targeted to market failures, time-bound, consistent with EU norms, and avoid negative cross-border spillovers. In this context, the state’s strong presence in some sectors, including through recent telecom and airport acquisitions, should be guided by legal, regulatory and policy frameworks that ensure fair competition.

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

The mission thanks the Hungarian authorities and our other interlocutors in Hungary for the productive collaboration, constructive policy dialogue, and warm hospitality.

Source – IMF