The current situation

1998 was the year in which the Hungarian economy first began to look as it were over the worst of the transformation. The upturn which began at the end of 1996 produced a growth rate of 4.6% in 1997. This positive trend continued and strengthened in 1998. The Horn cabinet expected a 3.5% growth in GDP for that year; preliminary data now suggest that the figure is 5.1%. This 1.6% "surprise" came as a blessing to both the governments that held office in 1998 (an election year), because higher revenues allowed them to counterbalance a weakening budget and increase spending without a rise in the deficit.

It is more than twenty years since the Hungarian economy last showed a 5% growth. On that occasion, in the second half of the seventies, the dynamism in the economy was accompanied by such a fast debt accumulation that in 1979 the brakes had to be slammed on. In the ten years that followed before the change of regime, the economy was necessarily subjected to a "stop-go" policy. Politically-driven booms were accompanied by spiralling external deficits, which in turn necessitated periods of austerity, in order to avoid a rescheduling of loan repayments.

It was only in 1998 that the consolidating economy, now based on private property relations, could at last claim that circumstances had changed. Following the period of stabilization in 1995-6, economic growth did not entail putting the external balance at risk. The foreign trade deficit did increase, but to a smaller extent than expected vis-ŕ-vis GDP growth, and thus did not lead to financing difficulties. What happened in 1998 finally made realistic the contention that the Hungarian economy had indeed broken out of the dilemma of "slow growth and improving external balance versus fast growth and worsening external balance" that had plagued it for decades.

Is this change merely to be put down to the accidental conjuction of favourable factors, or are there durable elements in these improvements? The answer will allow us to draw conclusions for the future prospects of the economy.

There is no doubt that—with the exception of the financial crisis in Russia—external factors affecting the Hungarian economy were favourable over the last year. Today Hungary's leading current trading partners are EU members, the countries still least affected by the world's economic trouble spots, and thus demand for our exports remained keen. There have been times in the past when external conditions were favourable, but Hungary has been unable to exploit the resulting opportunities. This was not the case in 1998, which suggests that in its transition to a market economy, the Hungarian economy has succeeded in creating an export capacity strong enough to be competitive and flexible as conditions change in its markets.

This is the fifth year in a row that Hungary has produced strong export growth figures, of more than 10%. It is an exceptional achievement that, following the 30% surplus of 1997—and despite the significant drop in exports to Russia—the growth in exports in 1998 was more than 20%. Exports were not just a key factor in growth: their actual composition also reflected favourable developments, as the majority of exports was made up of manufactures, largely machinery. The increasing returns on investments made by multinational corporations are behind the success of the export offensive. The success of firms established in customs-free zones is of special note.

Major foreign companies moved into Hungary with enthusiasm, and, judging by their results, successfully. One key to the success of the Hungarian transformation is that it could—like other emerging markets —exploit the positive processes of globalization. The economic stabilization of 1995 would have failed without the potential for surplus offered by foreign capital, or in the lack of supplementary capital injections. The influx of foreign capital also mobilized domestic investment; this also means that Hungarian suppliers establishing themselves around foreign companies are growing in importance.

The same sectors displaying the fastest growth in 1998 appear to be those that in the previous year had undergone major restructuring and development. Above all else, it was the production of machinery that increased, driven by a more than 50% growth in exports for the sector. The construction boom meant that there was strong growth in the production of building materials. (The growth rate in construction was up by more than 3 percentage points over 1997.)

In 1998 exports represented more than half of Hungary's GDP, in itself indicating the openness of the country's economy. These exports are less reliant on imports than they have ever been, which suggests that Hungarian productive capacity is capable of competing with imports. In addition, the development in exports has become independent of changes in the domestic market. Today exports rise not only if restrictive measures are taken to squeeze domestic demand, nor do exports fall if the home market booms. In other words, the major exporting companies do not adjust their strategies to expansion or contraction of the domestic market—as was the case before the change of regime—they target outside markets from the outset, in order to achieve the profit growth their high productivity can bring.

Everything seems to point to the fact that over recent years the Hungarian economy has developed an export potential of great capacity, the success of which depends "only" on the economic conditions of external markets—independent of fluctuations in demand at home. The import content per unit of export is lower than in the past, which, ceteris paribus, should be of lasting benefit to the external balance.

The other major factor in growth proved to be investment, which in 1997 increased by 50% and in 1998 by about 30% a year. Investment in building work grew by about 10%, with the increase in machinery investments more than double that. Investments in capital goods saw exceptional growth in sectors that had previously promised strong returns, that is in the processing industry, the construction industry, in trading, in the stabilizing financial sector, and last but not least, in the state-financed sectors of public administration, health and other social and personal services. (In the case of these sectors, there was also a boom in investments in the previous parliamentary and local government election year of 1994.)

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Changing trends

Behind the mostly favourable trends throughout the year, there were changes which must be mentioned here, for—should the economy become stronger —they may well be decisive in the future. To start with, I will briefly mention those turning points which suggest that the Hungarian economy was following a different path by the end of 1998 than at the beginning of the year.

In the second half of 1998, from about August onwards, a turning point could be felt in economic activity. Industrial and construction output fell, and surveys of corporate activity reported decreasing orders and worsening market prospects. In most industrial sectors both exports and domestic sales weakened. Within the economy, it was in small businesses and the catering and tourist industry that there was dynamic growth in the last months of the year; in these sectors this was a significant change from previous trends of decline or stagnation.

The overall decline was greater than the Russian crisis would have justified, and was present in sectors that were not directly affected by the condition of the Russian market (wood, paper, printing, metallurgy, metal processing). The negative effects of the collapse of the Russian market made themselves felt in the pharmaceutical, food, and public transport vehicle industries.

Also in the second half of last year, there seemed to be a reorganization of the demand-side pull factors on growth. Following the stabilization package (usually called the "Bokros package" after its 1995 initiator) the economy managed to head down a path of balanced growth in such a way that its productive surplus was given not just by its strong export dynamic—which outstripped the rate of growth of imports—but by a boom in investment. In the second half of 1998, however, imports grew at a faster rate than exports. This change was caused by a decline in the growth of exports which was not matched by any fall in the rise in imports. However, a restructuring took place within imports, in which the proportion of inputs for production (raw materials, machinery, transport equipment) fell, while that of finished goods, including consumer goods, grew.

The distinct improvement in retail turnover also goes to show that household consumption in the domestic market had become more significant. In contrast to the trend in production, household consumption grew quarter by quarter; in particular this showed the long-frustrated consumption demands of the middle classes. The years of stabilization had carried with them a significant squeeze on incomes, a decline in real incomes, which only began to relax in 1997. Feeling the improving income conditions, the population began to consume in greater proportions from the last quarter of 1997. During the period of austerity, household investments had fallen back, and any real income surplus was most obviously assigned to clothes and durable consumer goods. (It was the demand for cars that increased the most rapidly.) As imports are the feature common to these sectors, the rise in consumption kept the pace of imports high, making up for the decline in the need for imports for production.

On the one hand, then, household consumption came to play a key role in GDP growth—pushing that of exports to the background—while on the other hand the change in trends contributed to a deterioration in the indicators for the external balance. The surplus of imports induced by stronger consumption can also be a factor in the growing deficits in both the foreign trade account and the current account. As consumption only has a very indirect effect on the growth of the export potential, the financability of future growth becomes more uncertain than when growth in imports was balanced by exports or investments capable of producing components for goods for export.

The changes that have taken place within the demand side of GDP growth have put the economy's growth on a less secure path. This does not mean that it is in danger. We did not even have to face the external financing problem of last year. But we did have to face a slightly less favourable financing of the foreign trade deficit. While after 1994 the deficit in the current account was financed by incoming working capital, in 1998 only two-thirds of the deficit was financed by this advantag-eous, interest-free source. The difference had to be covered by loans, which raised the level of net debt. The debt surplus of a few hundred thousand dollars does not of course represent a threat, but it does suggest that something has changed in comparison with previous years. And that was at a time when unfavourable movements could be felt within the structure of the current account balance itself.

The current account deficit was influenced both by the increased foreign trade deficit, and by the deterioration in the balance of services. It is worth noting that, while in the last few years the tourist industry has grown steadily, in 1998 the sector's capacity to generate foreign currency declined: its output was 133 million dollars less than in the previous year. The industry's foreign currency income declined, with a fall in the number of visitors, who also spent fewer nights in commercial accommodation. At the same time, improving income made it possible for Hungarians to spend more on travel abroad.

In addition to this, the balance for other services deteriorated by 339 million dollars. The repatriation of profits was about double that of the previous year (962 million dollars), a change worth noting. This means that the investments of foreign firms were successful, but it also suggests that foreign owners do not want to keep all of their future investments in Hungary. Outflow of profits jumped most noticeably in May, June and December.

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Short-term expectations

By short term is meant a period of one year. Of course predictions could be made for a longer period, when dealing with an economy whose size makes it less vulnerable to the ups and downs in the world economy. On the one hand, we know that in both a quantitative and qualitative sense the Hungarian economy is a small, open economy. Its development is decisively affected by world events which, at the moment, are highly volatile.

On the other hand, we can infer from the government's statements that during 1999 the cabinet is preparing to make decisions on a number of questions that are crucial to economic transformation. Questions whose resolution could, ceteris paribus, speed up domestic capital development after 2000. Yet in February (at the time of writing), the government had still to publish its economic strategy, despite a promise to have this ready by the autumn of last year. Indeed, it has still not published its evaluation of the situation in which it found the economy when it took it over on 8 July 1998. In an interview published by Népszabadság at Christmas, the Minister of Finance shied away from talking of that inventory.

Only generalizations have filtered out of the strategy being prepared at the Ministry of Trade and Industry—for example, that the goal of economic strategy is to increase family living standards, to modernize the economy, to improve the climate for investment, to prepare the country for accession to the European Union, etc.—but amongst economists there is no knowledge of any more specific proposals.

Knowledge of the inventory and the economic strategy is needed firstly because Fidesz (the Association of Young Democrats) and the other parties in the coalition gave very different evaluations of the country's situation before they were elected from those on which their plans for the 1999 budget were based. It is needed secondly, because the government programme contains objectives for the next twenty years. The priorities mentioned in this document, however, clearly fail to outline what the government actually intends to do during the four years of its mandate. In the absence of the important paperwork already mentioned, we can only rely on predictions which can be inferred from the nature of the economy and what is already known about planned changes for 1999.

In considering foreign trade conditions I will neglect what is called the catastrophe scenario. Neither do serious foreign forecasters deal with this possibility: the collapse of the world economy that would create a crisis whose size, depth and length would be like nothing we have ever experienced, and avoiding this is in the fundamental interest of all the participants.

We can be sure, however, that from the Hungarian economy's point of view this year will bring less favourable conditions. The Russian crisis will not be resolved; the best we can hope for is that the conditions there get no worse. The Hungarian pharmaceutical and food companies can look for solutions to their sales through using a barter system between firms and Gazprom. In the leading export markets, the EU states, growth is slowing. Predictions become more pessimistic the more time goes on, despite the advantages for growth of the introduction of the euro. Meanwhile, there are many who want a slice of the diminishing sales cake. Hungarian exports find themselves in harsh competition with the goods and prices of exporters from Eastern Europe and South-East Asia. As a result, the Hungarian growth rate in exports can be expected to fall further.

At the same time, investors will be more cautious—not that the worsening conditions for economic activity would act as much of a draw for large development projects—and the net inflow of foreign capital will not match the figure achieved in 1998. On the Hungarian part, the supply of items to privatize has more or less run out: the state does not wish to sell land to foreigners, and the remaining assets that could be sold, about 300 billion forints in value, are largely in partial ownership stakes, which will not immediately attract demand.

As conditions for external financing deteriorate, the growth in imports will exceed that in exports, because the obligation to export to Hungary will increase, and also because growing consumption implies a growth in imports. Thanks to the expansive budget, consumption will grow. Thus there will be a continuing deterioration in the demand factors for growth: the disappearance of the pull factor in strong exports will partly be compensated for by household consumption. The rate of growth of investment is also expected to stagnate.

The weakening dynamics of investments is a result of worsening business prospects, of increasing difficulties in finding inputs; it is also a consequence of the higher flow of profit repatriation that began last year, of restrictions placed on state and local government investment, and, last but not least, of the fact that the investment boom created by the need to restructure enterprises in the Hungarian economy is now nearing its end.

All this will lead to slower growth in the construction industry. Weakening exports, the pull factor for industrial production, will lead to a drop in the rate of growth. The agricultural sector, lacking markets and capital, and faced with a restructuring of the key points of agricultural policy, cannot expect an opportunity to climb out of the crisis.

On both the demand side and the supply side—according to the private think tanks—growth in the economy will decline to 3–4%. At the same time, the country's net debt will grow, because direct capital inflow will no longer be able to finance the higher current account deficit. The external deficit will remain financable, but under worse conditions. All the cracks in investment and export-led growth that appeared in the second half of 1998 will expand. Depending on the extent of these changes, some kind of adjustment will have to be made in 1999 or 2000 in order to restore foreign creditor confidence.

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Earlier budgets used the tactic of predicting smaller growth than could realistically be expected, thus underestimating tax returns. Expenditure was tailored to fit this, and if expenditure limits were overstepped, one could expect income to rise in accordance, for faster growth, faster flow of wages, faster consumption would result in higher tax revenue.

This current government has broken with this policy and overturned the logic behind planning the budget. This latest budget was put together on the assumption of 5% GDP growth, including an exceptional reserve of forty billion forints. The latter was envisaged assuming that an extra 1.9% of the given budget of a state institution would be frozen, and only be made available if economic developments in 1999 follow the optimistic scenario expected by the government. However, the forty billion forints, just 0.3% of GDP, are insufficient. Not to mention the fact that a large part of this amount has already been sucked up by the interest resulting from the (240 billion forint) increase in state debt voted for after the budget was passed. (The increased debt came about due to the consolidating of Postabank and the Hungarian Development Bank, and the offsetting of the property of the public gas works; the Ministry of Finance estimates the 1999 interest at 25 billion forints. This sum did not appear in the original legislative proposal.) So the exceptional reserve was illusory; these monies were spent during the preparation of the plans.

The budget forecasts a 5% growth for 1999. (In the Fidesz election manifesto 7% had been promised, a figure quickly and most wisely forgotten once they took office.) The growth of 3–4% suggested by the Minister of Trade and Industry in the autumn the Prime Minister did not regard as acceptable, for it would have forced the government to cut back on many of its promises. Growth of the state budget deficit as a proportion of GDP is ruled out by the obligation to satisfy EU norms, and the present government was among those who criticized the previous cabinet for letting the state budget deficit increase.

The fact that the government determined expected GDP growth at an unrealistically high level meant that receipts by the exchequer were also exaggerated. (In the autumn of 1998, even the research institute drafting the 7% growth programme was predicting GDP growth of below 5%.) This was partly because the rate of inflation fell to a greater degree than expected, partly because of overblown expectations for extending the tax base. The "surprise disinflation" of the second half of 1998 resulted in nominal wages being lower than predicted. Thus the assumed tax base for 1998 turned out to be greater than the real one. It was these figures on which the expected increase in the price index of 11% was based. But in 1999 inflation will be about 1.5–2 percentage points lower than this—assuming there is no explosion of energy or raw material prices. (Though the predicted figure of 11% also makes this assumption.) The lower than expected rise in prices in 1998 will thus continue into 1999; it seems that there has been success in frustrating the desire of the energy producers to raise prices. In fact the government announced as early as January that it would alter its forecasts for 1999, predicting an average increase in the price level of 9.5%, and an 8.5% rise December to December, as opposed to the previous figures of 11% and 10% respectively.

Calculations using a rate of inflation higher than the real one are "blown up", lead to unrealistic projections for tax revenue, which in the light of the inflexibility of expenditure will necessarily lead to a larger deficit than made provision for. The only advantage of lower than expected inflation on the expenditure side is in terms of interest payments on loans. But only in the case of treasury bonds with flexible interest rates (about half of the national debt), and only to the extent that the declining trend in interest rates is stronger than that forecast in the government's original programme. These conditions will only hold if the central bank—taking the maintenance of balance into consideration —thinks the adjustment of interest rates to the faster lowering of inflation is possible.

Over and above this, the 1999 budget assumes certain sources of income which are most probably unrealistic. This is true of expected income from financial institutions, of Russian debt repayments, and of taxes on gambling. The government holds out too much hope for tightening tax collection and inspection, and is overoptimistic with regard to the sale of property belonging to the social security funds, from which it expects income of more than 50 billion forints.

As the income side of the budget seems overstretched, for the reasons given above, and as expenditure will be matched accordingly, it is likely that the budget deficit will be greater than the level set in the budget act of 4% of GDP. This will give a negative signal to credit rating institutions and investment consultants, because it will suggest that the new government has failed to maintain the trend of declining state debt which has been seen since the introduction of the Bokros package. The national debt, which in 1998 was below the level stipulated in the Maastricht criteria of 60% of GDP, may as a result begin to grow again.

As state expenditure is for the most part on consumer goods, this increase in the deficit may further contribute to the revival of consumption, which by increasing imports not covered by exports might worsen the external debt position. Because of the higher deficit, state finances will suck up savings because of its increased credit needs, which in itself will limit the declining trend in interest rates and future cooling of inflation. Thus the 1999 budget, by exaggerating state income, increases rather than decreases the risks to long-term growth.

The global, quantitative effect of an increasing deficit and a rise in the national debt will in the long term be strengthened by the fact that the budget passed by Parliament tends to follow short-term interests, rather than the long-term considerations of economic growth. On the one hand, because the areas where development is concentrated have only a very distant and very loose connection with the economy, and on the other hand, because of ill thought-out priorities, which give off signals unfavourable from the point of view of the development of the economy. The expenditures enjoying the greatest growth in support are the transition to a chancellery type of government, national security institutions, religion and sport (especially football). There are little more than trace elements relating to the financing of the much-stressed economic policy goals (development of backward regions and of small- and medium-sized firms). The public works budget has been cut even in nominal terms, and among agricultural subsidies labour incentive schemes have been axed (together with schemes helping the disadvantaged).

The priorities in the budget seem to indicate unresolved economic management. Abolishing university and college fees, so the opposition argument goes, is incompatible with the principle of marketizing services, which Fidesz supports. Family benefits, which have been made a constitutional right, unjustifiably support the rich, and the fact that they are not indexed to inflation in 1999 hurts the poor, for whom the benefit, relative to their income, would be greater. As to raising pensions, the cabinet seems to have renewed the system of the late Kádár period: to increases based on pension levels, although the basis of pensions is achievement, i.e. the total amount of time spent working. With the thorough changes made to the system of personal taxation, the government is the "creator of values"; it appears to be supporting the better off. By also basing family support on "achievement", it neglected the otherwise necessary social principle. While the Minister of Trade and Industry is pressing for the support of further major investments, the Minister of Agriculture, the president of the coalition partner Smallholders Party, defends small family farms by attacking the large ones.

The above examples show some confusion within the government, the seriousness of which the cabinet tried to minimize by declaring that this was not yet really its own budget. It was repeatedly emphasized that in drawing up this budget the government was forced to remain within the framework established by its predecessor, but that the budget for 2000 would properly be in line with the government's programme.

This suggests that in 1999 the economic leadership will really make itself felt when drafting the budget for the year 2000. According to the principles it has listed, the Fidesz-led cabinet wishes to promulgate a kind of budget that is different from those of the past. Its objective is to reduce the economic role of the state by diminishing state income and income redistribution, and for the distribution of income to be helped by development of the market for capital. To this end they would significantly reduce payroll taxes, strengthen family taxation in the personal taxation system, reduce tax rates, possibly raise corporate tax rates, and unify the taxation of capital wealth, that is introduce a tax on interest.

The reduction of state income must be counterbalanced by a restructuring of state expenditure. The cabinet seeks to achieve this by "illuminating" institutions, as they decide which existing institutions should perform which tasks, with what funds, and with how many staff. On the basis of existing information, they will decide on whether to keep existing budget financing or establish the means of procuring the funds needed for the tasks to be completed.

Through this programme the government clearly wishes to satisfy the much-asserted political requirement that the reform of the state budget should be part of the completion of the economic transformation. The formulation of this as an operative objective is a worthy aim, but its implementation is more doubtful. Such reforms require widespread social support on issues which would mean the curtailment of rights previously acquired by large social groups. So far every government has come a cropper in this area, or has at most been able to claim partial success, as for example the Horn cabinet with its restructuring of the pension system.

Next in line would be the reform of the health system, the social welfare system, higher education, public administration—the most important examples. For the moment, however, the thinking behind the reforms is unknown. Any elaboration of the reforms is made difficult by the fact that the government's fundamental principles seem unsettled. Behind this lurks the fact that while Fidesz, the leading coalition partner, defines itself as a centre-right party, it won the elections on a platform more characteristic of a left-wing party, one in which the role of the state is strong. This is essentially what is described in the government's programme, and Fidesz' coalition partners are quite vocal in their support for this.

There is no question that the restructuring of state finances is a necessary step in furthering economic transformation. 1999 would genuinely be a suitable year for the implementation of such reform, when the hoped advantages of reducing state intervention could be seen against a background of relatively favourable economic conditions. The task cannot drag on until 2000, because then its results would come through the year before the next election, and damage most of all those voters who Fidesz has to thank for its coming to power in the spring of 1998.

In 1999 the government faces a difficult task, whether or not it implements the measures stated in its programme. Yet none of their predecessors inherited as good a macroeconomic background as they have, however much trends may be worsening. Neither would anyone deny that it is the reform of state finances that would put a stop to the increasing budget imbalance, which began in 1998 and became more noticeable in 1999. This would also give a new impulse to growth, for it is only by cutting back expenditure that it is possible to decrease perceptibly taxes in such a way as to give incentives to firms, and thus to strengthen the competitiveness of the Hungarian economy on foreign markets.