DOCUMENT OF THE EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT STRATEGY FOR HUNGARY As approved by the Board of Directors at its meeting on 22 January 2008 TABLE OF CONTENTS TABLE OF CONTENTS........................................................................................................... 1 ABBREVIATIONS .................................................................................................................... 2 EXECUTIVE SUMMARY........................................................................................................ 3 1. THE BANK’S PORTFOLIO................................................................................................. 5 1.1. OVERVIEW OF ACTIVITIES TO DATE ..............................................................................5 1.2. IMPLEMENTATION OF THE PREVIOUS COUNTRY STRATEGY ...........................................6 1.4. SELECTED LESSONS LEARNT ........................................................................................9 1.5. FINANCIAL PERFORMANCE OF THE EXISTING PORTFOLIO ..............................................9 1.6. MOBILISATION OF CO-FINANCING.................................................................................9 2. OPERATIONAL ENVIRONMENT................................................................................... 10 2.1. THE GENERAL REFORM ENVIRONMENT......................................................................10 2.1.1. Political environment.................................................................................................10 2.1.3. Environmental Issues.................................................................................................11 2.1.4. Legal Reform..............................................................................................................12 2.2. PROGRESS IN TRANSITION AND THE ECONOMY’S RESPONSE........................................12 2.2.1. Macroeconomic conditions for the Bank’s operations...............................................12 2.2.2. Transition successes and challenges.........................................................................14 3. STRATEGIC ORIENTATIONS .................................................................. 19 3.1. BANK’S PRIORITIES FOR THE STRATEGY PERIOD........................................................19 3.1.1. The Bank’s Priorities for the Strategy Period............................................................19 3.2. SECTORAL CHALLENGES AND BANK OBJECTIVES ......................................................19 3.2.1. Enterprise Sector .......................................................................................................19 3.2.2. Financial Sector.........................................................................................................20 3.2.3. Infrastructure and Environmental Sector ..................................................................20 3.3. PORTFOLIO MANAGEMENT CHALLENGES ....................................................................20 4. OTHER IFI’S AND THE EUROPEAN UNION......................................... 21 4.1. EUROPEAN INVESTMENT BANK (EIB) ........................................................................21 4.2. INTERNATIONAL MONETARY FUND (IMF) .................................................................21 4.3. WORLD BANK.............................................................................................................22 4.4. INTERNATIONAL FINANCE CORPORATION (IFC).........................................................22 ANNEX 1: COMMITTED PROJECTS PER YEAR..................................................... 23 ANNEX 2: NET CUMULATIVE BUSINESS BY INDUSTRY .................................... 27 ANNEX 3: PIPELINE STOCK ........................................................................................ 28 ANNEX 4: SELECTED ECONOMIC INDICATORS .................................................. 29 ANNEX 5: RATINGS FROM THE 2005 ASSESSMENT OF TRANSITION CHALLENGES .............................................................................................. 30 ANNEX 6: COMPARATIVE STRUCTURAL CHANGE INDICATORS.................. 32 ANNEX 7: POLITICAL AND SOCIAL ASSESSMENT .............................................. 33 ANNEX 8: OVERVIEW OF THE EBRD TC FUND AND OFFICIAL CO- FINANCING................................................................................................... 39 APPENDIX 1: BREAKDOWN OF TC PROJECTS......................................................................................42 APPENDIX 2: BREAKDOWN OF OFFICIAL CO-FINANCING PROJECTS....................................................45 ANNEX 9: ASSESSMENT OF HUNGARY’S COMMERCIAL LAWS ..................... 47 1 ABBREVIATIONS AAK State Motorway Management Company EIB European Investment Bank EIF European Investment Fund ESCO Energy Savings Company ETS Emissions Trading System EU European Union EUR Euro FIDESZ Alliance of Young Democrats FDI Foreign Direct Investment GDP Gross Domestic Product GM General Motors HUF Hungarian Forint IAIS International Association of Insurance Supervisors IFC International Finance Corporation IFI International Financial Institutions IMF International Monetary Fund IOSCO International organisation of Securities Commissions IPO Initial Public Offering MAV Hungarian State Railways MAVIR Hungarian Electricity System Operator MDF Hungarian Democratic Forum MKB Hungarian Foreign Trade Bank MOL Hungarian Oil and Gas Company MSME Micro, small and medium-size enterprises MSZP Hungarian Socialist Party MT Hungarian Telecom MVM Hungarian Power Companies Ltd NATO North Atlantic Treaty Organisation NHH National Telecommunications Authority OECD Organisation for Economic Co-operation and Development OTP National Savings Bank PAYG Pay As You Go PCA PCA-Budafok Cardboard Factory PPP Public Private Partnership PSZAF Hungarian Financial Supervisory Authority SME Small and medium size enterprises SZDSZ Alliance of Free Democrats TSO Transmission System Operator TVK Tisza Chemical Works WWTP Waste Water Treatment Plant 2 EXECUTIVE SUMMARY Hungary continues to meet the conditions specified in Article 1 of the Agreement Establishing the Bank. Since the beginning of transition Hungary has made considerable progress in reforms with about 80 per cent of economic activity in private hands, an open foreign trade regime and liberal foreign investment conditions. The macroeconomic environment in Hungary is dominated by large fiscal deficit and implementation of a reform package to restore balance in public finances. Economic growth slowed down to an estimated 0.9 per cent year-on-year in the third quarter of 2007, driven largely by a fall in consumer spending caused by higher taxes, tight monetary policy and hikes in utility bills. A collapse of public finances was averted last year by the introduction of fiscal austerity measures. As a result, the full-year fiscal deficit closed at an estimated 9.2 per cent of GDP in 2006 and at around 5.7 per cent in 2007. This has been achieved at the expense of substantial tax hikes which further increased the cost of doing business in Hungary. The current account deficit narrowed to an estimated 6.5 per cent of GDP in 2006, mainly on the basis of a smaller trade deficit. Driven by tax increases, inflation picked at 9 per cent in March 2007 and is expected to gradually decline in 2008. The progress in structural reforms over the last year was driven by the need to reduce fiscal expenditures and decrease the deficit in government finances. The government outlined a number of ambitious medium-term structural reforms. The implemented measures include cuts in subsidies for prescription medicines, tightening of eligibility criteria for disability benefits, co-payment by healthcare patients and a move to reduce the number of hospitals. Further structural reforms awaiting implementation include changes in the healthcare insurance system, modifications of the early retirement and special pension rules, review of the tax system and introduction of a merit-based appraisal scheme in public and higher education. Following the privatisation of Budapest Airport and Malev, the national airline, steps are being taken to complete restructuring of the national railway company and privatise some of its business lines. Pressure on fiscal discipline has also led to increased private-sector involvement in the provision of some public services, including healthcare, which is expected to lead to substantial efficiency gains and improvements. Looking forward, a number of key challenges still require attention: • Structural measures to reduce public expenditures need to be fully implemented to reduce the fiscal deficit and allow for a reduction of the tax burden in the medium term. • Investments in the diversification of energy supply, in energy efficiency and renewable energy need to be promoted to enhance energy security, reduce energy intensity and meet environmental targets. • Transport and environmental infrastructure need to be improved with the assistance of EU structural and cohesion funds, private-sector involvement and commercial co-financing from local sources. The development of municipal projects requires the strengthening of municipal administrative capacity and 3 cooperation, particularly among smaller municipalities, as well as improvements in procurement and project management standards. • Financial institutions would benefit from the introduction of new products, increased efficiency of the pension