The Rise and Fall of Hungary

The rise and fall of Hungary

By Zlost Darvas Wednesday, 29 October 2008

Hungary came to be regarded as one of the most prosperous emerging European countries after the fall of communism in 1989 ‐ a far cry from its satirical description as the "happiest barrack" in the Soviet bloc.

It attracted a large influx of foreign direct investment and embarked on a rapid and stable growth path. It was barely affected by the Asian and Russian crises in 1997‐1998.

But the current financial crisis has hit Hungary hardest of all among the EU newcomers and forced it to go cap in hand to the International Monetary Fund. Just how did the forerunner become the most vulnerable?

Massive government debt

Part of the problem can be pinned on the large government debt that Hungary inherited from the communists. The situation was exacerbated because Hungary, unlike Poland, did not receive partial debt forgiveness at the time of transition.

But blaming the communists only goes so far since Hungary successfully reduced its debt from a peak of 90% of GDP in 1993 to 52% in 2001 ‐ it has since gone back up to 66%.

Since 2002 the government deficit has ballooned. In 2006, an election year, the deficit would have been 12% of GDP without the fiscal adjustment package launched after the election that brought it down to 9.6%, still an incredibly large number. ©2008 Bruegel– 33, rue de la charité, 1210 Brussels‐ Tel: +32 2 227 4210, Fax: +32 2 227 4219

Since then, Hungary has followed an EU‐approved convergence plan that has cut the budget deficit to an estimated 3.4% in 2008, at the expense of tax hikes, spending cuts, falls in real wages and slowing growth. Despite this action, Hungarian government debt increased to 66% in 2007 and is projected to rise further. Other countries in the region have much smaller debts ‐ the figure is 29% in both the Czech Republic and Slovakia and 45% in Poland.

While high government debt is undoubtedly a problem for Hungary, there are other serious structural weaknesses in the public sector. Government spending is more than 50% of GDP, compared with less than 40% in most other central European countries. In order to finance this high level of expenditure, taxes and other duties are extremely high in Hungary; the employment rate is one of the lowest in Europe and the potential rate of growth has slowed in recent years.

Consumers switched to foreign currency loans

The popularity of foreign currency loans has caused further problems. Since Hungarian inflation was far higher than that in the eurozone, interest rates charged on loans in the Hungarian forint were also much higher.

So, to get lower rates, many consumers and businesses switched to foreign currency loans ‐ 90% of new mortgage loans are now made in foreign currencies. In the Czech Republic and Slovakia, where interest rates were close to the eurozone rate, foreign currency loans only account for less than 2% of households' total.

The Hungarian forint reached its highest level against the euro in July this year, as other countries in central and eastern Europe also peaked.

The financial crisis arrived at high speed

The global financial crisis arrived at high speed in late September this year. Many economists, including this writer, thought that the effects of the crisis on central and eastern European EU countries would not be dramatic. Our banks were not exposed to US sub‐prime losses and were well capitalised.

But it soon became clear that no country can isolate itself from the effects of this global financial crisis. With rising risk aversion and fear of contagion, investors started to sell and pull out of investments in emerging economies.

Hungary was the hardest hit of the central European EU members because so much of its massive government debt Hungary was the hardest hit of the was foreign‐owned. These foreigners wanted to sell their central European EU members because Hungarian forint‐denominated bonds but no new buyers so much of its massive government appeared on the market. Long maturity interest rates debt was foreign‐owned. jumped from the already high 8% to around 12% and the government bond market dried up. Auctions to issue new government bonds were unsuccessful. Hungarian blue‐ chips on the equity market were also heavily sold.

Pressure on the forint intensified and last week the central bank hiked interest rates by three percentage points. The rate rise helped strengthen the forint but the situation remained fragile and the government bond market was still frozen.

Cap in hand to the IMF

It became clear that without outside help the government could face serious problems in financing its spending. It was forced to turn to the IMF and has accepted conditions that, despite a shrinking economy, it must cut expenditure and target a 2.6% deficit for 2009. So, while major economies discuss expensive plans to boost growth, Hungary has to tighten its belt.

Hungary needed the IMF agreement to gain credibility. Since the talks concluded successfully, the forint has gained more than 8% compared to its weakest level last week. Without the agreement the forint would likely fall further, consumers with foreign currency debts would suffer, and the government would not be able to issue new debt securities.

But what Hungary needs more than it needs the IMF are comprehensive structural reforms in its public finances But what Hungary needs more than it that include drastic cuts in spending and tax rates. This is needs the IMF are comprehensive the only way to increase the potential rate of growth and structural reforms in its public finances to avoid the risks of a similar crisis in the future while that include drastic cuts in spending outside the eurozone. My fear, however, is that there and tax rates. could come a time when the impetus for structural reforms will fade. As a side effect of the IMF program Hungary will likely meet the Maastricht criteria much sooner than previously thought. The deficit criterion will be met next year, government debt might start to fall in a few years from now, inflation will likely fall in an amplified economic downturn, and the interest rate will fall as markets would regard the euro strategy of the country credible.

Consequently, Hungary could be in a position to introduce the euro in a few years from now. The euro would offer a shelter against contagion from possible future crises, but the joy of joining the eurozone could diminish incentives to reform. I just hope that the current crisis shakes up Hungarian politicians to think hard about the deeper structural problems of the country's economy.

Zsolt Darvas is visiting research fellow at Bruegel, Brussels