TRANSITION REPORT 2014 Innovation in Transition

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Highlights

  • Growth has markedly revived. Based on current projections Hungary will reclaim its pre-crisis GDP levels by mid-2015. A substantial recovery in private spending and in public investment, owing largely to government programmes, underpins this growth.
  • Public works programmes have played a large role in reducing unemployment and raising labour force participation. However, skills mismatches remain an impediment to sustainable employment growth.
  • State involvement in the economy has further increased. The state continues to acquire assets in a number of sectors, such as energy and banking. The government is planning to turn utility providers into non-profit companies, following a third round of comprehensive household tariff reductions.

Key priorities for 2015

  • Financial intermediation through the private banking sector needs to be restored. When the central bank’s preferential credit scheme expires, private banks should be able to meet the incipient credit demand provided that sector-specific taxes are streamlined and allow reasonable returns on capital invested, and that initiatives to restructure private debt are based on equitable burden-sharing between industry, households and the government.
  • The role of the private sector in public service provision should be enhanced. The acquisition of assets by the state should be narrowly circumscribed and should be on equitable market-based terms. The quality of services in the utility sector will deteriorate unless returns allow investment in the distribution network.
  • Hungary can play a key role in European energy trade. Interconnectors with neighbouring countries and further investment in a diverse range of supply options, including renewables, could underpin this ambition.

GROWTH HAS MARKEDLY REVIVED

PUBLIC WORKS PROGRAMMES HAVE PLAYED A LARGE ROLE IN REDUCING UNEMPLOYMENT AND RAISING LABOUR FORCE PARTICIPATION

STATE INVOLVEMENT IN THE ECONOMY HAS FURTHER INCREASED

2014 sector transition indicators
Corporate Energy Infrastructure FI

Source: EBRD.
Note: FI – Financial institution; ICT – Information and communication technology; Water – Water and wastewater; IAOFS – Insurance and other financial services; PE – Private equity.


Main macroeconomic indicators %

  2010 2011 2012 2013 2014
          proj.
GDP growth 0.8 1.8 -1.5 1.5 2.8
Inflation (average) 4.7 3.9 5.7 1.7 0.4
Government balance/GDP -4.4 4.2 -2.0 -2.4 -2.9
Current account balance/GDP 0.2 0.4 0.9 3.0 2.5
Net FDI/GDP 3.0 1.4 2.3 0.1 0.0
External debt/GDP 143.4 127.5 131.5 120.6 n.a.
Gross reserves/GDP 35.3 35.5 35.9 35.2 n.a.
Credit to private sector/GDP 60.0 57.9 49.6 45.3 n.a.

Macroeconomic performance

Following a second post-crisis recession that extended throughout 2012, Hungary has shown a strong recovery. GDP grew by 1.5 per cent in 2013 (based on a new Eurostat methodology) and by a further 3.8 per cent in annual terms in the first half of 2014. However, real GDP still remains about 4 per cent below its pre-crisis peak of mid-2008. A number of temporary factors have supported growth, notably cuts in utility tariffs, which have boosted household disposable income, and increased public spending as funds under the previous European Union (EU) financial perspective are being fully disbursed.

The export sector continues to support the economy. Export volumes grew strongly up to mid-2014, along with industrial production, as important capacity came on stream in a number of car plants. Since then the downturn in key export markets, such as Germany, has translated into much weaker industrial activity.

Prices have been stagnant since early 2014. This was largely owing to the three successive rounds of utility price cuts. Core inflation still remained at 2.6 per cent in annual terms in July 2014. Given the still elevated household debt, protracted deflation could be a concern for aggregate demand and financial stability. Against this background the National Bank of Hungary persevered with its easing policy until July 2014, with the last cut taking the key policy rate to 2.1 per cent, down from 7 per cent two years ago.

Labour market developments have been positive. Unemployment declined to 7.8 per cent in July 2014, and the employment rate rose to 66.5 per cent in the second quarter of 2014. The expansion of the government’s public works programme has played a major role in these trends. At the end of 2013 slightly over 400,000 individuals, or about 10 per cent of the workforce, were enrolled in this programme. While this programme has had some success in raising employment in the more remote regions in the east of the country, creating sustainable employment in the regular labour market is questionable. Hungary continues to suffer from considerable skills mismatches that explain the relatively high rate of long-term unemployment.

Credit conditions remain difficult. Despite the ongoing disbursement of the central bank’s subsidised facility for on-lending to small and medium-sized enterprises (SMEs), net corporate credit showed a further decline in the first half of 2014. Surveys continue to point towards risk aversion and restrictive conditions in terms of collateral requirements. As banks continue to be plagued by high taxes and recurring initiatives in household debt restructuring, and credit demand remains low, liquidity continues to flow out of the country. In the first quarter of 2014, foreign banks withdrew €2.9 billion in liquidity, equivalent to 2.9 per cent of Hungary’s GDP. Even though the pace of withdrawal has slowed, as in other central European economies, Hungary continues to witness the second worst rate of outflows in the region. Similarly, foreign direct investment (FDI) inflows remain much below pre-crisis levels, with inflows accounting for only about 2.4 per cent of GDP in 2013, and the value of green field investment projects having shrunk drastically.

Growth is expected to lose momentum. Current projections for GDP growth in 2014 are 2.8 per cent, with a deceleration to 2.2 per cent in 2015. Over the medium term the present momentum is likely to wane, as structural fundamentals such as the distortionary tax system, a still-impaired banking sector and growing state involvement reassert themselves. Downside risks could materialise from the export markets in the eurozone.


Major structural reform developments

There remains considerable potential to improve innovation and competitiveness in Hungary. Hungary’s share of high-tech exports remains very high (at over 17.3 per cent of total exports in the latest available data), though the extent of domestic value added is low. The export structure has become more concentrated, with the automotive sector developing strongly, while exports in information technology somewhat contracted in 2013. The Organisation for Economic Co-operation and Development indicators suggest that only about 13 per cent of local SMEs invest in innovation and research and development. Productivity growth remains constrained by the still low investment rate, which declined steadily between 2007 and 2012, and only picked up again in 2013. These indicators underline the competitive nature of Hungary’s FDI sector, as well as the considerable potential to improve innovation in domestic SMEs.

Sector-specific taxes remain burdensome and continue to discourage private investment. Since the introduction of the 2010 levy on financial institutions, new taxes have been introduced on the financial sector and a number of other sectors, such as energy, telecommunications and retail. In June 2014 parliament adopted a tax on advertising revenues of up to 40 per cent.

The government remains committed to its plan to convert utility services into non-profit companies. Only a small profit will be used to cover innovation and upgrades to the distribution network. In March 2014 the Prime Minister announced the establishment of a state utility provider, which will distribute electricity, gas and district heating. To this end, the authorities decreed cuts on municipal utility tariffs. In April 2014 the government announced a third round of utility price cuts, thereby reducing the household price of gas, electricity and district heating by a further 6.5 per cent, 5.7 per cent and 3.3 per cent, respectively. According to the government the previous round of cuts resulted in household savings of HUF 250 billion, about 0.8 per cent of GDP, and the third cut is estimated to save just under 0.5 per cent of GDP. The government also implemented a stricter policy on consumer protection, which includes transparency requirements on pricing.

The state has further expanded its reach into a number of sectors. Since mid-2013 there have been at least 14 acquisitions by the state, which have been completed or announced, totalling over HUF 300 billion (about €1 billion). These were mainly in the energy sector, with the latest notable acquisition being Germany’s RWE minority stake in Budapest gas distributor, Fogaz, which has now become wholly owned by the state asset management company and the municipality. As this acquisition was deemed to be of national significance, the usual scrutiny on competition was suspended. In the banking sector the government bought MKB Bank, the country’s fourth largest lender, for which Germany’s BayernLB had long sought divestment. This has advanced the government’s aim to raise Hungarian ownership in the banking sector to above 50 per cent. More recently, acquisitions also extended into the manufacturing sector, when the government announced the potential takeover of a Canadian-owned train manufacturer.

The government advanced its agenda to reduce vulnerabilities in household foreign exchange debt. In June 2014 the Hungarian Supreme Court ruled on the long-running dispute over bank charges on foreign currency loan contracts. Based on this ruling, unilateral changes by banks to the terms of a contract, such as interest rate hikes, could be considered unfair and hence void unless conditions for such changes had been comprehensively set out upon signing the contract. Meanwhile, the bid/ask spread that was typically applied by banks in disbursements of, and repayment on, such loans was deemed illegal. Consequently, the government prepared new legislation within weeks, which obliges banks to refund borrowers for interest rate hikes and bid/ask spreads charged on foreign exchange loans. The deputy governor of the National Bank of Hungary estimates this may cost the banks up to HUF 900 billion (about 3 per cent of GDP).

The central bank extended the subsidised lending programme in September 2013. This extension was more focused on new lending, as opposed to refinancing, and loosening eligibility criteria. While these funds were almost fully allocated to commercial banks, disbursements to SMEs have been very slow. A fixed margin in the lending rate and a slow and cumbersome process in guaranteeing loans remain key impediments. In addition, other state banks are expanding into the SME market and targeting high-quality clients.