Fiscal adjustment is finally moving forward

HUNGARY - Report 22 Jun 2022 by Istvan Racz

Following nearly two months of apparent inaction, the government came forward with an almost complete fiscal adjustment plan in late May. This must have been prepared behind the scenes while PM Orbán was publicly preoccupied with setting up his new cabinet. To enforce the plan, the government is making use of its extraordinary rights secured by the existing emergency order. Revenue measures have been introduced by a government decree, whereas actions on spending have not been publicly announced in any great detail. The government’s budget proposal for 2023 is now in parliament, with the final vote expected around mid-July. There can be little doubt about its easy approval, due to Fidesz’s freshly reinforced super-majority voting power.

The adjustment package is quite large, most likely sufficient for the intended sharp deficit reduction in 2022. Indeed, it is bigger than the adjustment requirement we estimated in our latest quarterly forecast (see the April monthly), and it also covers some extra defense expenditure, to meet NATO requirements. However, meeting this year’s deficit target will also be helped by Eurostat methodology, which allows the government to account for its recent sizable income tax refund as negative revenue for last year. The fiscal deficit ratio is proposed to decrease further in 2023, and the gross debt ratio would also fall materially by the end of next year. Using the positive publicity around this plan, the Treasury quickly launched three new FX bonds, covering nearly half of this year’s deficit target.

Despite all the foregoing, the fiscal story is far from looking entirely positive. Proposed revenue measures will add to inflation as a first-round impact, and it will only be later on that they can contribute to the stabilization of domestic prices and the BOP. Additionally, the feasibility of the 2023 budget will be greatly dependent on access to new EU funds. Should those prove to be unavailable, next year’s fiscal deficit could be much higher than planned or an additional large adjustment would be required. Keeping that risk in mind, we dare to say that relatively high inflation and a weak forint will be important preconditions of fiscal success, as they produce extra revenue for the budget and save the government from the need to recapitalize the MNB.

The worst part of the story is that the eventual unavailability of RRF and other development funds from the EU is quite a realistic scenario. The Commission has been blocking the disbursement of RRF money to Hungary for a full year, and the ongoing rule-of-law procedure has not moved much closer to a positive conclusion. Should no deal be reached on this program by end-2022, the bulk of the RRF funds would be lost definitively. By that time, the rule-of-law procedure is expected to reach a conclusion, deciding if Hungary can get development funds from the EU or not in the future. A bit of good news has been the recent appointment of a minister to specifically deal with this issue, who publicly said that Hungary is ready to make the necessary compromise to get EU funds released. Also positively, the EU Commission has just approved a smaller program of grants for Hungary, to help local SMEs affected by the negative impact of the war in Ukraine.

On the positive side, growth appears to be quite strong for the time being. The GDP growth estimates based on the officially estimated WEAI indicator in the first half of Q2 were only slightly down from the rather strong Q1 actual. Industrial output is still expanding markedly, as the weakness of car manufacturing is more than offset by the robust performance of other branches. Consumer demand is also strong, due to fiscal and income policy measures, although much of the strength of retail sales has originated from fuel tourism, a kind of cross-border fuel-price arbitrage, lately. Despite initial fears, there has not been any serious evidence of tourism suffering from the war impact as yet.

However, the BOP and the inflation picture continue to deteriorate markedly. In the main, CPI-inflation is going through a steep buildup, having entered the double-digit range in May. Massive pressures from global commodity prices, robust domestic demand, an increasingly tight labor market, earlier fiscal and income policy measures, and most recently, the renewed weakening of the forint are all playing a part in this. A special circumstance is the existence of administrative price controls, without which the current inflation rate would be substantially higher. In this regard, the EU’s oil embargo against Russia is a major risk factor for Hungary. Should the country’s temporary exemption cease to exist, it would raise the cost of imported crude oil very substantially and undermine the economic basis for the existing system of fixed fuel prices for households.

Indeed, the oil embargo is just another area where Hungary’s position within the EU appears quite weak. In the main, the exemption from the oil embargo is open-ended, and the political accord is that it will be eliminated as soon as the technological conditions are there. But views on how long it should take to create those conditions are very different. Hungary will likely face a tremendously difficult task in trying to defend its positions regarding the oil embargo against the backdrop of the ongoing rule-of-law procedure and a generally hostile environment within the EU.

At first glance, one might think that the existing imbalances, risks and instabilities would require the central bank to step up its stabilization efforts. However, this is not what the MNB has been doing in recent times. In fact, the MNB appears to have scaled back its efforts lately, expecting a lot from the government in the form of fiscal adjustment and administrative price controls, as a contribution to its own policy actions. It has put more stress than earlier on regular monthly nominal rate increases, apparently reducing focus on real interest rates and the forint’s exchange rate. This has been feeding back into the forint’s market position negatively.

From its most recent policy line, it appears that the MNB has given high priority to the protection of its own balance sheet, which is ultimately an issue of fiscal policy, and to the protection of GDP growth and budget revenues, which is a prime stability issue, of course, and a precondition of success in fiscal stabilization. The downside of this approach, though, is that it does not guarantee the effective tightening of monetary conditions, given rapidly rising inflation.

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