by György Barcza, Economist, K&H Bank
Hungary was a frontrunner in the transition process as the country was among the first to open up for foreign investments and new technologies. Per capita foreign direct investment is high, and foreign companies flooded the country in the 1990s to benefit from a rapidly improving infrastructure and highly-skilled labour at a relatively low cost. Export and investments were the primary drivers of growth and manufacturing; manufacture of car parts and electronic devices became the key drivers of the economy. Exports now account for almost three-quarters of the national income and most of these goods are sold in the EU countries with Germany playing the leading role among export destinations.
The privatisation process started immediately after the fall of the Communist regime in 1989 and most of the financial, energy and telecoms sectors are now owned by foreign companies. Hungary plays a key role in transportation due to its location at the centre of Central and Eastern Europe. The largest companies are often subsidiaries of large Western European manufacturers and recently Daimler, Audi and GM’s Opel announced expansion of production.
Rapid convergence process, but not without problems
Early privatisation and openness to foreign capital allowed for convergence from the start, but this catch-up process was not without problems. Repeated fiscal overspending at election times, low levels of employment and high inflation remained a challenge. Excessive loosening of the budget policy took place basically around all elections in the last 20 years. This first became clear in 1995, when the Socialist government had to carry out a large-scale austerity programme, the so-called Bokros package, which was one of the deepest fiscal consolidation programmes ever in emerging markets. Despite this, the budget deficit rose again to unsustainable levels in the 1998 election and similarly every four years.
The export and investment driven growth was replaced by domestic demand, followed by deteriorating external balance.
The 2002 election was especially problematic as spending occurred not just before, but also after the elections. For example, there was the introduction of a heavily subsidised mortgage loan system, an extra one-month pension and an unprecedented 50% pay rise in the public sector. These measures did not just put the economy on an unsustainable fiscal footing, but also undermined competitiveness. The export and investment driven growth was replaced by domestic demand, followed by a deteriorating external balance. Although the growth rate remained relatively high at around 4%, the economy adopted a growth model that relied more on consumption and less on export, so external imbalances quickly emerged. This fiscal challenge proved to be more difficult than before because the government was not able to use inflation to generate revenues. After a decade of moderate inflation levels between 10% and 35%, the central bank adopted an inflation targeting regime in 2001 and disinflation targets were set. This meant that the disinflation process took place at the time of fiscal loosening.
Financial markets reacted erratically to the situation and there were several periods of market turbulence in 2003. The central bank tried to stabilise markets with sharply higher rates as it was trying to lower inflation to the targeted levels. Although a double-digit base rate level helped to pre-empt attacks against the currency, it also had adverse consequences. Foreign currency based loans became popular among households and the country’s external indebtedness started to grow. Unfortunately, most of these loans were denominated in Swiss francs because of the wide interest rate differential.