Lessons from the Hungarian “Exception”

George Kopits

ICGFM Winter Conference “PFM in the 21st Century” Washington, December 5-7, 2011

Outline• Background

• Broad fiscal trends

• Exception 1.0 (in 2001-09)

• Paradigm change?

• Exception 2.0 (since 2010)

• Implications for sovereign risk

• Conclusion: Lessons

Background

Mixed progress during the transition • Reforms in the tradable sector

– External liberalization– Domestic liberalization (incl. financial system)– Privatization (incl. effective bankruptcy procedures)

• Slow reforms in the non-tradable sector– Public administration: workforce remained bloated– Social security system partially reformed– Tax system partially restructured

• Monetary policy: broadly successful IT regime

• EU membership moral hazard

Background

Economic performance

• Foreign direct investment: first high, then low

• Swings in external performance •

• Near crisis in mid-90s, and late 2008

• Disinflation into single digits, but some persistence

• Marked deceleration in economic growth

BackgroundReal GDP Growth Rate

xxxxxxxxxxxxxxxxxxxxxx

Background

R eal G DP per c apita at ppp(100 = E U27 averag e)

0102030405060708090

100

1995 2010

S l C Z HU S K P L E S L U R O B L L A

Broad fiscal trends

Distinguishing characteristics

– deficit bias

– time inconsistency

– procyclicality

– debt sustainability problem – lack of transparency

Broad fiscal trendsG eneral G overnment B alanc e

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011* 2012* 2013*

Perc

ent o

f GD

P

Deficit forecast of P re-Acces ion and C onvergence programs submitted 2002-11

MNB , NG M

Broad fiscal trends

Broad fiscal trends

Broad fiscal trendsP ublic Debt

40

45

50

55

60

65

70

75

80

85

Per

cent

of G

DP

G ross Debt Maastricht criterionMNB

Broad fiscal trends

Public Debt

0

10

20

30

40

50

60

70

80

2004 2005 2006 2007 2008 2009

% o

f GD

P

B ulgaria C zech R epublic E s tonia Hungary L atvia L ithuania P oland R omania

Broad fiscal trends

Lack of transparency – inconsistent time-series data

– overoptimistic macro-fiscal forecasts

– abusive PPP practices

– distorted accounting for SOEs

– opacity in budgetary procedures

– occasional arrears in expenditures and tax rebates

Exception 1.0 (2001- 09)

Center-left government

Expansionary stance during “Great Moderation”• government wage hikes

• public pension hikes

• VAT rate cuts

Contractionary stance during crisis (IMF-EU standby)

• wage and pension freeze

• VAT rate increase

• some streamlining of social entitlements

• rules-based fiscal framework

Paradigm change?

Rules-based fiscal framework (FRL Nov. 2008)

• policy rules: expenditure limit real debt limit

( limit on discretionary deficit)

• procedural rules: pay-go rule MT budgetary planning

• transparency norms

• independent fiscal institution: Fiscal Council

Paradigm change?

Fiscal Council

• Contribute to goals of fiscal framework– credibility in fiscal policymaking– transparency in public finances– public debt sustainability

• Basic characteristics, functions – independence (incl. election, tenure of members)– arm’s length relation, equal access– decisions by consensus– surveillance (evaluation, compliance)

Paradigm change?

Fiscal Council: surveillance functions

• Evaluation at aggregate level

• Evaluation at disaggregate level

• Compliance with standards and procedures

• Compliance with fiscal rules

• Communication (government, press, etc.)

Paradigm change?

Fiscal Council: performance

– strong technical staff

– early tail winds (during adjustment program)

– favorable press coverage

– positive feedback from civil society

– no interference from government

– first government complied, second did not

– de facto abolition at end-2011

Exception 2.0 (since 2010)Center-right government

Major policy (reform?) measures• flat tax, without exempt threshold

• temporary taxes on selected activities

• record VAT rate (27%)

• nationalization of private pension funds

Institutional changes

• limits on Constitutional Court, on fiscal matters

• political appointment as head of State Audit Office

• attempts at curtailing independence of NBH

• de facto abolition of Fiscal Council

Exception 2.0 (since 2010)

Demise of the Fiscal Council

• Critical assessments by the Council – changes in accounting rules– effects of various changes in tax law, pension reform– forecasts of four-year macro-fiscal outlook

• Reactions by the government– limited access to information – proposal to drastically cut funding– disbandment of FC staff– narrowing remit of FC to opinion on budget bill– appointment of new FC chair (following resignation of former)

Implications for sovereign riskS overeig n default ris k

0

100

200

300

400

500

600

700

800

CD

S o

n 1

0 ye

ar s

ove

reig

n b

on

ds

(bp

s)

Hungary C zech R epublic P oland S lovakia Bulgaria R omania

Implications for sovereign risk

Comparison with the UK

• Common features – fiscal sustainability problem – low policy credibility– contemporaneous election of center-right

governments

• United Kingdom– clear medium-term fiscal target– front-loaded adjustment program– establishment of Office for Budget Responsibility

• Hungary– mixed and opaque policy signals – adoption of distortionary stop-gap measures– abolition of Fiscal Council

Implications: sovereign risk premium

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

yiel

d s

pre

ad o

n 1

0-ye

ar g

ove

rnm

ent b

on

ds

(%)

Hung ary United K ing dom

Implications: sovereign default risk premium

0

50

100

150

200

250

300

350

400

CD

S s

pre

ad

on

10

-ye

ar

go

ve

rnm

en

t b

on

ds

(b

ps

)

Hung ary United K ing dom

Conclusion: Lessons

• “Exception” leads to stagnant activity, long-term sustainability problem, and vulnerability to

crisis (lacking a natural resource base)

• Government should not succumb to populist instincts or to moral hazard

• Government ignores financial markets at its peril

• IMF can provide financial and technical assistance, but policy credibility must be home-

grown

• New government must use opportunity to signal paradigm change and follow up with

action

References

Kopits, G., “Monetary and Fiscal Policy from Transition to EU Integration: A Comparative Assessment” in B.Y. Kim and C. H. Lim, eds., Financial Sector Reform in Transition Economies (Seoul National University, 2009), pp. 29-61.

Kopits, G., “Brussels Can’t Monitor 27 Budgets” The Wall Street Journal (October 11, 2010)

Kopits, G., “Goulash Populism” The Wall Street Journal (February 25, 2011)

Kopits, G., “Independent Fiscal Institutions: Developing Good Practices” OECD Journal on Budgeting (November 2011)