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Document of The World Bank Public Disclosure Authorized FOR OFFICIAL USE ONLY Report No. 47 194-HU INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT Public Disclosure Authorized FOR A PROPOSED LOAN IN THE AMOUNT OF €1.0 BILLION (US$1.4 BILLION EQUIVALENT) TO THE REPUBLIC OF HUNGARY FOR A Public Disclosure Authorized FINANCIAL SECTOR AND MACRO STABILITY POLICY LOAN August 21,2009 Private and Financial Sector Development Department Central Europe and the Baltics Country Department Public Disclosure Authorized Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Hungary GOVERNMENTFISCAL YEAR January 1 - December 3 1 CURRENCYEQUIVALENTS (Exchange Rate Effective as of June 30,2009) Currency Unit US$l.oo HuF 193.04 Weights and Measures Metric System ABBREVIATIONSAND ACRONYMS CDS Credit Default Swap CEE Central and Eastern Europe CPS Country Partnership Strategy CBEF Capital Base Enhancement Fund DIF Deposit Insurance Fund EC European Commission ECB European Central Bank EU European Union FDI Foreign Direct Investment FRL Fiscal Responsibility Law FSAP Financial Sector Assessment Program FX Foreign Exchange GF Guarantee Fund GP General Practitioner HFSA Hungarian Financial Supervisory Authority HIF Health Insurance Fund HuF Hungarian Forints IBRD International Bank for Reconstruction and Development IF1 International Financial Institution IMF International Monetary Fund LDP Letter of Development Policy LIBOR London Inter-Bank Offered Rate MNB Magyar Nemzeti Bank (Hungarian Central Bank) MOF Ministry of Finance MTEF Medium-Term Expenditure Framework PAYG Pay-as-you-go PER Public Expenditure Review SA0 State Audit Office SME Small and Medium Enterprise Vice President: Philippe Le Houerou Country Director: Theodore Ahlers (Acting) Sector Director Fernando Montes-Negret Operation Manager: Roberto Rocha Task Manager: John Pollner FOR OFFICIAL USE ONLY HUNGARY HUNGARY- FINANCIAL SECTOR AND MACROSTABILITY LOAN TABLE OF CONTENTS LOAN AND PROGRAM SUMMARY .......................................................................................................... ii I. INTRODUCTION ............................................................................................................................. 1 11. COUNTRY CONTEXT.................................................................................................................... 2 HUNGARY'S ECONOMIC PERFORMANCE BEFORE THE 2008 FINANCIAL CRISIS THE IMPACT OF THE INTERNATIONAL FINANCIAL CRISIS RECENT DEVELOPMENTS AND MACROECONOMIC OUTLOOK 111. THE GOVERNMENT REFORM PROGRAM ............................................................................. 11 THE OVERALL REFORM PROGRAM FISCAL REFORMS THE FINANCIAL SECTOR STABILITY PROGRAM PENSION REFORMS THE HEALTH SECTOR IV. BANK SUPPORT TO THE GOVERNMENT'S PROGRAM ...................................................... 30 LINK TO COUNTRY PARTNERSHIP STRATEGY COLLABORATION WITH THE IMF AND OTHER IFIs RELATIONSHIP TO OTHER BANK OPERATIONS ALTERNATIVES CONSIDERED ANALYTICAL UNDERPINNINGS LESSONS LEARNED V. THE PROPOSED LOAN ................................................................................................................. 35 OBJECTIVE AND RATIONALE OPERATION DESCRIPTION AND POLICY AREAS EXPECTED OUTCOMES OF THE OPERATION VI. OPERATION IMPLEMENTATION.............................................................................................. 44 POVERTY AND SOCIAL IMPACTS ENVIRONMENTAL ASPECTS IMPLEMENTATION, MONITORING AND EVALUATION FIDUCIARY ASPECTS DISBURSEMENT ARRANGEMENTS RISKS AND RISK MITIGATION ANNEXES ANNEX 1: LETTER OF DEVELOPMENT POLICY................................................................................. 53 ANNEX 2. POLICY MATRIX.................................................................................................................... 39 ANNEX 3: POLICY MATRIX WITH OUTCOMES ................................................................................. 61 ANNEX 4: HFSA RESOLUTION ADOPTING ASSISTED ON-SITE SUPERVISION PROGRAM .... 64 ANNEX 5. FUND RELATIONS NOTE ....................................................................................................... 65 ANNEX 6. HUNGARY AT A GLANCE ...................................................................................................... 67 This Policy Loan was prepared by a team comprising: Roberto Rocha (Operation Manager, Senior Adviser), John Pollner (Task Manager, Lead Financial Officer), Emilia Skrok (Senior Economist), Andrew Lovegrove (Principal Banking Consultant), Laura Ard (Lead Financial Sector Specialist), Joaquin Gutierrez (Lead Financial Sector Specialist), Heinz Rudolph (Sr. Financial Sector Specialist), Asta Zviniene (Sr. Social Protection Specialist), Pia Schneider (Sr. Economist), Mohamed Ihsan Ajwad (Sr. Economist), Haocong Ren (Financial Analyst), Claudia PardiAas OcaAa (Sr. Counsel, LEGEM), Kenneth Mwenda (Sr. Counsel, LEGEM), and Nicholay Chistyakov (Sr. Finance Officer, CTRFC). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. LOAN AND PROGRAM SUMMARY HUNGARY FINANCIAL SECTOR AND MACRO STABILITY LOAN IBorrower REPUBLIC OF HUNGARY Implementing Ministry of Finance (MoF), Hungarian Financial Supervisory Agencies Authority (HFSA), Magyar Nemzeti Bank (central bank of Hungary, Financing Data IBRD Loan Front end fee: 1.0 Yo Maturity: 8.5 year final maturity Interest rate: LIBOR (Euribor) + 2.0 YO Amount: € 1.O billion (US$ 1.4 billion equivalent) Policy loan (DPL) consisting of two tranches under a single loan. Prepared as part of an international financial support package; financing is also being provided by the International Monetary Fund and the European Commission. The Bank’s assistance is part of a joint IF1 initiative, where the EBRD, the EIB, and the World Bank Group have pledged to support banking sectors in Central and Eastern Europe with up to €24.5 billion over a two year period. I Main Policy The loan supports reforms in four main policy areas: (a) fiscal reforms including further reduction in the fiscal deficit, introduction of legally binding fiscal rules and structural measures; (b) a comprehensive financial sector stability program; (c) pension reforms in the public sector and privately funded pillar, and (d) health sector reforms. Key Outcome - Restoration of investor confidence and increased demand for Indicators government securities evidenced by: lower government borrowing spreads, lower interest swap spreads, and lower credit default swap (CDS) spreads. - Capital adequacy ratios for all banks at required levels after the results of in-depth supervisory examinations and stress tests. - No increase in the average share of FX loans in household loans (at constant exchange rates); reduction in the share of FX denominated loans in currencies other than the Euro. - Reduction in average loaddeposit ratio. - Increase in the effective retirement age. - Reduction in the long term public pension deficit. - Stability of pharmaceutical expenditures in real terms. - Reduction in number of outpatient visits. Program The objectives are fourfold and include: (a) support to fiscal reforms Development designed to ensure long-run fiscal and macroeconomic sustainability Objective( s) and restore investor confidence, improving access ofthe government, banks and the corporate sector to external funding; (b) support to the financial stability program, designed to ensure adequate levels of liquidity and healthy capital cushions, able to absorb the effects ofthe international crisis and the contraction ofeconomic activity, (c) support to pension reforms designed to preserve adequate benefits while tightening eligibility criteria and containing expenditures to improve the sustainability ofthe pension system; and (d) cost containment and deficit prevention in the health sector while ensuring access to care. Risks and Risk Further worsening of the external environment. The financial and Mitigation economic crisis has continued despite the activation and rescue programs implemented in developed countries. There is a risk that money and credit markets will remain clogged and that the downturn in the EU will be more severe and protracted than recently projected. The access to foreign exchange finance will likely remain restricted and the exchange rate uncertain. The contraction ofreal GDP and the increase in unemployment in 2009 could be more pronounced than anticipated. This would strain the banks and the corporate sector, and would also create difficulties for the achievement offiscal targets. Mitigation measures. The multilateral package is geared toward a cautious scenario oflack of external funding. With this program, Hungary’s financing requirements would be met, reducing the risk of further strains on the banks and the corporate sector, and reducing the need for even more drastic fiscal adjustments beyond the new second phase ofcuts recently implemented. The Program also mitigates risks in the banking system through in-depth intensified examinations and the strengthening ofsupervisory powers. Finally, the fiscal program includes a new fiscal responsibility law that should restore investor confidence, by imposing strict indebtedness limits and ensuring a steady decline in