Hungary: Loose policy mix helps growth now – may hinder it later

Matthias Reith, Analyst for Austria, Euro area and Central European countries at RBI in Vienna recently held discussions with public sector officials in Budapest. Reith and Zoltán Török, Head of Research at Raiffeisen Bank in Budapest discuss the key issues the Hungarian economy is facing going forward.

 At present the Central European (CE) region enjoys a strong cyclical tailwind. Hungary and its regional peers (Poland, Czech Republic, Slovakia and Slovenia) will post a GDP growth at around 4 per cent in 2017, which would mark the highest growth since a decade (i.e. since 2007). While exports are a key ingredient for the regional upswing, healthy domestic demand plays a vital role as well. In some CE economies strong growth dynamics are already nurturing certain overheating concerns given closed output gaps. With unemployment rates in the CE region falling rapidly labour shortage is increasingly becoming a source of concern for businesses. Labour scarcity is already well reflected in strong wage growth.

Hungarian economy experiences domestically driven recovery

How does Hungary fit into the picture stated above? The Hungarian economy is currently experiencing a domestically driven recovery. Investments are growing rapidly after many years of subdued investment activity. Export is growing fast – in line with the trends over the past several years. Private consumption has been a reliable and increasing source of growth in recent years but managed to reach the pre-crisis level only at the beginning of 2017 given a long-lasting strong downturn and rebalancing. Therefore, on aggregate overheating concerns are less acute in Hungary compared to regional peers. That said, there is a certain rationale behind the idea that monetary policy remained ultra-expansionary up until now, with additional rounds of easing in 2017. Nevertheless, with regards to the monetary policy outlook it is worth mentioning that some regional peers are already switching into a cautious tightening mode.

Unemployment rate at slightly above 4 per cent

With regards to the real economy there is already an increasing labour scarcity visible. The unemployment rate (ILO) currently stands slightly above 4 per cent and thus at a record low level since the regime change, and below what can be considered as structural unemployment, leading to labour shortages and rapidly rising wages. At the same time, the employment rate – while improved quite rapidly over the past few years – is at around EU average (slightly above 70 per cent). This means that there is still a fairly large pool of inactive population – their (re)activation may be one way to overcome the labour scarcity problems. Average wages in Hungary increased by 12.8 per cent yoy in the first three quarters of the year, thereby outpacing other CE countries. This is partly due to tight labour market conditions, but partly also due to the 15 per cent minimum wage increase at the beginning of 2017 – this will be followed by an 8 per cent minimum wage hike in 2018. In order to counterbalance the effect of the minimum wage hike, the Hungarian government lowered employers´ social security contributions (2017: 5 percentage points; 2018: 2.5 percentage points) and cut corporate income tax rate to 9 per cent (effective from January 2017). High wage increases can be a threat to competitiveness if not accompanied by rising productivity. In this regard there is the hope that labour scarcity and wage increases will spur investments and thus productivity. It remains to be seen though if this in fact materializes. In general, we do see difficulties in finding (qualified) employees as a potential bottleneck for growth down the road.

Fairly loose policy mix

Hungary’s strong macro picture is framed by a fairly loose economic policy mix. Monetary policy is ultra-expansionary, using nearly all available conventional and unconventional monetary policy tools. While the key rate remains unchanged at 0.9 per cent over the past one year, the central bank deployed an armada of monetary policy tools those aimed at easing monetary policy conditions, steering the whole yield curve and keeping the national currency at not too strong levels vs. the EUR. As a consequence, the overnight central bank deposit rate is negative, interbank rates got close to zero and the yield curve is very flat. The ambition of the central bank is to support economic growth and to reduce future macro prudential risks as much as possible. Inflation risks are underrated by the central bank in the meantime. So far so good, however we are more concerned about the underlying inflationary trends given the continuing strong wage growth in the economy. Fiscal policy is acting pro-cyclically to a certain degree. While budget deficit was on a declining trend up until 2013, the deficit-to-GDP ratio has not improved further. Moreover, we expect some loosening in the fiscal policy stance given upcoming parliamentary (spring 2018) and municipal elections (autumn 2018), but the headline deficit is expected to remain somewhat below the “hard” 3 per cent Maastricht ceiling. Our view is in line with the expectations of the European Commission (i.e. a sizeable positive fiscal impulse is foreseen – the largest among CE peers). Needless to say that Hungary would be well-advised to run fiscal deficits at 1 per cent to 1.5 per cent at maximum at present (like most regional peers in CE are doing) especially considering the country’s high public debt ratio – even if it would damage economic growth in the short-term to some extent. Although the gross debt ratio reached the peak already back in 2011 (79.9 per cent of GDP), the decline since then has only been moderate (2016: 73.9 per cent of GDP). Thus, a faster reduction of the gross debt ratio (second highest in the CE region) might be warranted.

Going forward the main question will be how long Hungary can preserve its current pro-cyclical monetary and fiscal policy stance in a potentially changing environment that is characterized by a cautious normalization of monetary conditions (incl. the phasing out of unconventional monetary policy tools) inside the euro area and in some key regional peers. To put it differently: we are uncertain whether policy makers would deliver the necessary policy adjustments in due time irrespective of policy or political ambitions or whether they lag behind the curve causing undesired negative side-effects.

Matthias Reith, Analyst at Raiffeisen RESEARCH

 

Zoltán Török, Head of Research at Raiffeisen Bank in Hungary

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