GKI: Forecast for 2010-2011

This year economic trends were basically in line with the forecast of GKI prepared in September 2010. The Hungarian economy is recovering slowly from the recession. In the world economy the Irish crisis that followed the Greek one is intensifying uncertainties and sensitivity to developments that seem to be unsustainable. Hungarian economic policy is not considering these factors. In addition, although the government is committed to meeting formally the deficit targets in 2010 and 2011 that are expected by international organisations and money and capital markets, economic policy triggered rather risky trends by declaring the avoidance of (apparent but not factual) tightening that concern households. The incoherence of this economic policy is indicated by the fact that it does not promote economic growth and job creation significantly even in the short-term. It produces sharp swings in the exchange rate of the forint to the euro and other currencies that raises the burden of debtors including households, the business sector as well as the government. The weakening of the rule of law, the use-up of savings and the general inward looking nature of economic policy constitute the anachronistic Hungarian model that is diverging from European trends. Sooner or later unavoidable painful corrections are be needed that will be much more severe than otherwise would be necessary.

The first half year of the government was the history of battles fought for the extension of the government’s room of manoeuvring that had an adverse impact on financial conditions. This was indicated by the weakening of the forint, the halt of interest rate reductions followed by rate increases as well as by the rise of country risk premiums, by the weakening of Hungary’s attractiveness for foreign capital and that of the economic growth potential, by the erosion of the rule of law and Hungary’s international reputation. Hungary’s CDS spreads have been continuously rising since April 2010, in November they exceeded those of Romania. The real danger exists that international rating agencies may put Hungary into the “junk” category. All these factors have not been reflected in the real economic trends of 2010 yet. The rate of GDP growth equalled to 0.9 per cent in the first three quarters of 2010. Based on this performance the annual growth rate is projected to reach 1.2 per cent rather than 1 per cent projected by GKI earlier. This rate of growth will be significantly lower than the 1.8 per cent average figure of the EU. Although Hungary’s exports exploited favourable external demand in general and that of Germany in particular, the performance of industries selling their goods and services in the domestic market was not particularly impressive in 2010 in general and in the third quarter of 2010 in particular. In 2010 only those industries are performing well that sell their goods and services in external markets. Nonetheless, in the second quarter domestic sales of specific industries, too, have set to grow as well.

The original general government deficit target is likely to be reached. The tax measures of the new government produced a general government surplus amounting to 1 per cent of GDP. The government debt is financed by the market, its larger share (56 per cent) by foreign investors partly in Hungarian forints and partly in foreign exchange. This is the major fundamental base of the external dependency of the Hungarian economy. Hungary may not pursue such a fiscal policy for a long time that does not enjoy the confidence of those financing its government debt.

With the fading of fiscal stimuli global recovery that started in 2010 is set to decelerate somewhat in 2011, the rate of GDP growth is likely to fall from 1.8 per cent in 2010 to 1.7 per cent in 2011. The growth rate of Germany, Poland and some export oriented small member states will exceed the EU average. The combined general government deficit of the EU member states relative to GDP is projected to fall from 6.8 per cent in 2010 to 5.1 per cent in the subsequent year. The Irish sovereign debt crisis is likely to accelerate the development of the institutional system and the tools of crisis management in the EU. Both the EU and the euro is making progress through crises but finally they are likely to stabilise. The euro is projected to weaken somewhat against the US dollar, from USD1.30 in 2010 to USD1.25 in 2011. As a consequence of the global recovery the world market price of crude oil (Brent) per barrel is expected to increase from USD62 in 2009 to USD80 in 2010 and USD85 in 2011.

The economic sentiment index of GKI has not been so high for four and a half year. In the business sphere expectations in each industry improved particularly in those industries that are sensitive to external recovery. Nevertheless, in autumn the expectations of industries oriented on the domestic market in general and trade in particular, too, turned more upbeat. The most downbeat industry is construction. The expectations of households that had been almost continuously on the rise since May 2009 and had improved until early summer also on the impact of the elections reached their zenith in October 2010 and since then they have been stagnating at a rather high level

At the end of 2010 uncertainty concerning the content and the implementation of the new economic policy as well as the behaviour of foreign and domestic economic actors is rather significant. Moral crisis has deepened; very often it is fear that governs. It is uncertain whether general government revenues, among them the quasi nationalisation of private pension funds and the retroactive effect of crisis taxes are in compliance with the provisions of the constitution. It is questionable whether the EU accepts the recording of the Hungarian general government presenting a deficit less than 3 per cent of GDP. Another question is whether the EU considers the general government sustainable, and if not – this is probable – the ongoing excessive deficit procedure governs sanctions and from when (probably after 2011). A confrontational situation like this may have a negative impact on the opinion of credit rating agencies and the international financial community over Hungary. Although the rise in the costs of financing would affect the general government only with a delay, the increase of short-term risks would have an impact on economic policy in 2011. It is a question whether the announcement made in late 2010 by government officials is an indication of some change in economic policy. According to the plans of the government the medium-term economic program with structural changes will be accomplished in February 2011. This program should result in savings in general government expenditures valued at HUF600 billion – HUF800 billion. If the program envisages real changes, they may counterbalance the negative assessment of the Hungarian economy. It is difficult to assess how the softening up of the rule of law and the reorganisation of the tax system would affect the behaviour of economic actors, business investments and the purchasing and saving decisions of households. The fate of the assets of private pension funds (how they will be used by the government) is another question. It is not possible to assess to what extent the members of private pension funds will be loyal to the funds if the present regulation proves to be unconstitutional. The next question is whether the combination of high interest rates prevailing presumably in a longer period and the uncertain legal environment would promote the return of savings kept abroad to Hungary or on the contrary the transfer of a certain part of domestic savings to other countries would be the major trend. In addition, risks favouring the increase of the grey economy exist as well. The direction of the movement of huge sums of money is uncertain.

The general government deficit target in 2011 is 3 per cent of GDP. In order to achieve this, the inflow of revenues from the sale of the assets of private pension funds valued at 1.9 per cent of GDP is envisaged. Excluding these revenues the core general government deficit is estimated to total 4.8 per cent of GDP implying a rather expansive fiscal policy compared with that conducted in 2010. The assets of private pension funds estimated at HUF530 billion as well as the increment of EU funds valued at HUF400-HUF500 billion allow expenditures to increase more sharply than tax revenues in spite of the radical tax cuts. Consequently, according to GKI the general government deficit will be in line with the plans. This means a core deficit corresponding to 4.8 per cent of GDP. Nevertheless, according to the accounting rules of the EU, with the transfer of the assets of private pension funds to the government a general government surplus of 5 per cent of GDP has to be recorded. It is probable that in the excessive deficit procedure and during the so called “spring economic policy semester” the EU will consider the core general government deficit excluding the windfall revenues originating in the transfer of private pension funds’ assets to the government. According to this evaluation, the general government trajectory in 2011 will not be qualified as sustainable, in the convergence program of the Hungarian government to be submitted next spring and in the subsequent consultations the EU is likely to expect expenditure cuts based on profound structural transformations.

In the case of the transfer of private pension funds’ assets to the state, government securities in the amount of HUF1300 billion – HUF1500 billion may be withdrawn leading to the reduction of the government debt relative to GDP by 5 percentage points. The other components of the assets may finance a certain part of the general government of 2011. The rest of the assets together with the unused funds of the EU-IMF credit line in the amount of about HUF900 billion may be a large treasury reserve for a situation when the financing of the general government by the issuance of government securities might become more difficult. This reserve is needed if the government intends to maintain the loose monetary policy of 2011 for a longer period. In contrast to this conformational scenario the other option is “winning only time”. According to this scenario the year 2011 was a one-off derail concerning the general government balance and in 2011 the government elaborates, prepares and introduces structural changes in general government expenditures. This could have a positive impact on money market trends. The financing of the government debt from the market in 2011 and 2012 becomes risky if the banks and a rather large part of their clients react to sustainability concerns by channelling their savings abroad through circumventing the Hungarian financial system. This can be avoided but the “price” of this option could be a rather high interest rate level in certain periods.

The rate of inflation seems to stick at 4 per cent. The government would obviously prefer the inflation target to amount to 3.5 per cent which is higher than the present one. Following the nomination of the new members of the Monetary Council in spring 2011 the formal lift of the inflation target may take place. The rate of inflation is expected to decrease from 4.8 per cent in 2010 to about 3.8 per cent in 2011. Hungary will not join the ERM-2 system until mid-2011, thus the euro will not be introduced in this political cycle. (This issue can be put on the agenda in 2016-2017 the earliest.) The exchange rate of the forint to the euro may average HUF276 in 2011 amid great fluctuations similar to the average of 2010. Nevertheless, both the exchange rate and its volatility may depend on the credibility of economic policy and the sustainability of the trends to a large extent. Independently from the orientation and preferences of its members, the Monetary Council is likely to raise the reference rate of the National Bank of Hungary sharply if the exchange rate of the forint to the euro weakens to more than HUF290, since the stabilisation of the exchange rate at this level would cause grief payment problems among those indebted in foreign exchange with serious repercussions on the banking system. The reference rate of the National Bank of Hungary may increase to about 6 per cent in 2011. At the same time euro and dollar interest rates, too, may set to grow. In the case of serious money market mistrust, the reference rate of the National Bank of Hungary may be higher. If the reform program of the government meets the expectations, the present level of 5.5 per cent may persist. As far as the current account is concerned, following the EUR0.5 billion surplus in 2010 with the slow pick-up of domestic demand, a deficit of EUR1 billion is projected. With the increase of the inflow of EU funds the surplus of external financing is forecast to remain practically unchanged at EUR3 billion.

Favourable external demand supports the dynamic growth of exports, but no acceleration is anticipated. The major part of the tax measures taken by the government (special levies imposed particularly on the banking system, the erosion of the rule of law, the increase of the costs of employment) affects the possibilities of economic growth. This is compensated only partly by the decrease of wage costs of qualified labour and by the reduction of the corporate income tax rate. The relatively weak exchange rate of the forint to the euro affects economic growth mainly by the deterioration of the competitiveness of imports. (At the same time consumer demand and the financing capability of the banks are hit by the increased debt amortisation burdens of households and by the deteriorating loan portfolio, respectively.)

Industry and construction will be the two driving forces of economic growth. Assuming average whether conditions, agricultural production is projected to grow rapidly. Retail trade turnover will be up by about 2 per cent, car sales more than that. Loans provided by banks hardly rise or they will increase only slightly constraining the growth potential of the whole economy in general and that of small and medium sized enterprises in particular. With the levies imposed on banks the profitability of the domestic banking sector will disappear for a rather long period of time, the consequence of which could be the reallocation of financial sources provided by mother banks or financial markets to other countries. In 2011 the number of employees is likely to grow slightly; it will correspond to the rate of decrease recorded in 2010. The rate of unemployment will go down from 11.5 per cent in 2010 to 11 per cent in 2011. Investments will be bolstered by the increase of the inflow of EU funds. As far as business investments are concerned, the favourable effects of the post-recession period (such as huge investments in car manufacturing) will be mitigated in part by crisis taxes with their restrictive effects on investments ass well as the uncertainty weighing on investors over Hungary’s general situation. To sum it up, investments are projected to go up by 4 per cent in 2011. Gross earnings of employees in higher income brackets as well as families with several children will grow. With the rise of the pension contribution and the tightening of tax reclaims, the burden of employees without children and households earning less than HUF290 thousand per months will slightly increase. The real value of their incomes can be ensured only by raising their nominal earnings. The increase of earnings is constrained by the great number of job seekers and the limited cost bearing capacity of companies. To sum up, gross earnings are forecast to increase by 3.5 per cent, net earnings by 6-6.5 per cent, and real earnings by about 2.5 per cent. In 2011 pensions are likely to follow inflation, thus their real value remains unchanged. Family allowances will decrease. Thus, real income may grow by about 1 per cent. The disbursement of the real yields of private pension funds to their members may ad to this rate more than 1 percentage point. In addition, the share of grey incomes, too, is likely to mount. As the combined consequence of these factors, the real income of households may be up by about 2.5 per cent.

Final consumption will increase by 1.5 per cent, purchased one by about 2 per cent. With the increase of households’ financial assets the gross savings rate may go up to 6 per cent. In statistical terms the envisaged restructuring of the private pension fund system reduces household savings by about 1.5 percentage points relative to GDP resulting in a gross savings rate of 4.5 per cent and a net one of 5.5 per cent.

In 2011 the rate of Hungary’s GDP growth will be somewhat higher than the EU average but lower than the Central and Eastern European one. Exports will be the major driving force of economic growth, although investments and household consumption, too, set to recover. The major problem is that the tools of accelerating GDP growth are not present. With unsustainable disequilibria, corrections may be necessary in the medium term that have a negative impact on growth. The confiscation of the savings (and future pensions) of three million members of private pension funds will finance the reduction of taxes of larger companies and employees with higher incomes in a single year (in 2011). In the subsequent years this will not be covered by anything, on the contrary, the specific sectoral taxes will be kept in force permanently that inhibit economic growth, employment and investments.