Hungary's Economy Hinges on Key Reform Questions

Since communism collapsed across Eastern Europe 17 years ago, Hungary has embarked on a remarkable economic reform drive. It has attracted considerable foreign direct investment and leveraged its human capital to best advantage, particularly in the Budapest region. The presumption among many investors is that the country, now a full member of the European Union, will continue steadily along a path of integration, growth and development.

Yet, Hungary still faces tough economic challenges - and risks - that market participants may not fully appreciate. If its government does not successfully address key fiscal and monetary reform questions over the next 12 months, Hungary's outlook may begin to look considerably less rosy.

In a best-case scenario for Hungary's economic health (call it the Irish model), the government undertakes substantial cuts in state spending and the country remains on its present, generally positive course and becomes a fully integrated Western economy over the next several years. It avoids significant disruptions in its financial markets, enters the exchange-rate mechanism in 2009, and adopts the euro in 2011. Its well-educated, highly skilled workforce continues to attract high-value-added foreign investment.

Hungarian companies (such as MOL Hungarian Oil and Gas, OTP Bank and drugmaker Richter Gedeon) become regional leaders in emerging Europe. Fiscal reforms, well-targeted regulation and improvements in Hungary's infrastructure continue to improve the investment climate. Hungary establishes its bona fides as a highly competitive niche investment destination - as Ireland has done over the last 20 years.

In a worst-case scenario (call it the Greek model), fiscal reform stalls and economic growth slows to one or two percent. As a consequence, the government fails to persuade participants in financial and capital markets over the next 12 to 18 months that it can improve Hungary's fiscal outlook. The twin deficits (fiscal and current account) remain alarmingly high.

The resulting crisis in capital markets leads to a sharp slowdown in foreign investment, the cornerstone of Hungary's growth and development. Bond and currency investors take flight. The poor economic climate generates a brain drain as Hungary's homegrown talent migrates to more promising EU markets - Germany, the UK, Ireland and elsewhere. As a consequence, Hungary becomes dependent on EU development aid, and its economic dynamism fades. "Euro-slippage," the process by which some states fall further behind targets set for economic and monetary union, continues.

Which of these scenarios is the more likely to develop? A few key near-term decisions by Hungarian policymakers are likely to answer this question. First, will they follow through on the vitally important fiscal reform agenda and demonstrate positive results? The answer is almost certainly yes. Second, to keep the deficit-reduction agenda on track, will the government take the politically unpalatable step of dramatically cutting spending in the coming year, rather than simply raising taxes and fees? Here the picture is much less clear. Third, will the government reduce and simplify the tax system over the next several years, once administrative reform measures have produced savings? Again, it's very difficult to say.

Hungary is likely to move through 2006 in good shape. But tougher challenges lie ahead. As is usually the case when assessing the likelihood of an outcome between best- and worst-case scenarios, the answer probably lies somewhere between the two extremes.

Likelier than the best- and worst-case scenarios is one in which Hungary enjoys strong growth and development in certain economic sectors and regions while others lag behind. Unemployment remains relatively high. The government dips its toes into the reform process to measure the political temperature without fully diving in.

Hungary's governing Socialist-Liberal coalition won a clear re-election victory earlier this year. But it did so, in large part, thanks to promises of "reform without austerity." Given the state of Hungary's public finances, this formulation has only added to investor skepticism of official commitments to serious reform. Sharp spending cuts are often unpopular, particularly in emerging market countries. The risk is great that if losses in municipal elections in October diminish Prime Minister Ferenc Gyurcsany's standing within his Socialist party, he may step back from precisely the fiscal reforms needed to strengthen Hungary's appeal for foreign investors.

The ruling Socialists are likely to suffer an electoral setback: They will likely lose most of the town and city councils that they control, and several of their incumbent mayors are expected to be defeated. But the impact on the party at the national level will be minimal. The leadership is anticipating these losses. But unless their defeat produces an "earthquake" in which the opposition Fidesz takes most of the local and regional councils and city halls of the largest cities, the government will move ahead with its fiscal reform agenda.

Hungary's fiscal reform efforts matter enormously, because players in the capital markets are watching. They will have little mercy if the twin deficits cannot be tamed in a way that improves the country's investment climate. A recent report by analysts at Goldman Sachs calls Hungary "the most vulnerable of emerging market economies in the region." It warns of Hungary's "low level of international reserves and its high level of state debt." Reserves, according to the report, were the equivalent of less than three months of imports in 2005, lower than the ratios for Poland, the Czech Republic, Romania, Turkey, Russia or South Africa.

In a revised forecast for euro convergence released in late August, the Hungarian government acknowledged that the general government deficit is expected to top 10 percent of GDP this year. For entry into the exchange-rate mechanism, this figure can be no higher than 3 percent. The government report suggests that Hungary's deficit will gradually fall to just under 7 percent next year, to 4.3 percent in 2008, and to 3.2 percent in 2009. These figures do not include the cost of pension reform. Such a sharp deficit reduction program will require both significantly increased revenue and deep spending cuts.

It is not at all clear that Hungary's leaders have the necessary political will to undertake such unpopular reforms. Prime Minister Gyurcsany's socialist credentials are central to his political appeal, and it is unclear whether he accepts the importance of cuts in government spending. Even if he does, he must rally support for them from within his skeptical party and rely on populist opponents in parliament to secure the voting margins he would need for constitutional change. But the government could achieve many of its reform goals without amending the constitution. A series of micro-reforms could have the cumulative effect of meeting many of the deficit targets.

Gyurcsany has already indicated a clear preference for revenue increases over spending cuts as a solution to the deficit problems. This strategy is politically less risky, but it's unlikely to fully persuade investors that the government is on the right track. Cuts in expenditure can be guaranteed. Revenue growth cannot. In addition, if the government relies on tax hikes for the bulk of its revenue increases, it may undermine the country's capacity to grow itself toward satisfying the convergence criteria.

In addition, the Maastricht ceiling for public debt is 60 percent of GDP. Hungary now forecasts that in the next three years, public debt is expected to be above 70 percent (it's been about 68 percent this year). The government's best case for admission to the euro zone may then be that other states have been welcomed with ratios higher than 60 percent - an argument that is not at all certain to find a sympathetic hearing.

Investor skepticism of Hungary's convergence plan is growing. If the European Commission rejects the revised program, there is significant risk that international ratings agencies could downgrade the country's credit rating. Such a move could trigger a full-scale financial crisis as investors run for shelter in other emerging markets. But the commission knows this and is likely to be relatively receptive to the plan.

The twin deficits are the core of the problem. Serious plans to tackle them should rely at least as much on reductions in government spending as on efforts to earn higher revenue. Are Hungary's elected leaders prepared to ask voters to accept the sacrifices necessary for an ambitious austerity program? Only time will tell, but the needed substantial reforms will demand a political courage they have not yet demonstrated.

In the end, the success of the euro convergence plan, and continued economic stability in Hungary, is all in the timing. Hungary is usually considered part of the group of states that includes Poland, the Czech Republic and Slovakia. If Hungary lags significantly behind these others, markets could inflict substantial damage on the Hungarian economy. If, as is more likely, a combination of indulgence from the commission and a willingness by Hungary's government to take the political heat that comes with austerity measures, the country will probably avoid the worst-case scenarios.