Hungary's budget blues

By bne IntelliNews March 1, 2006

Liz Barrett -

Expensive election promises are a disaster for the already swollen budget deficit

Hungary's budget deficit has gotten so big it is embarrassing. So embarrassing, the government got caught lying to Eurostat, the EU's statistic office, last year rather than fess up to its failure to tackle the problem. Yet, not only have the main political parties running in April's election said little about what they will do to reduce the debt, all have promised to increase spending instead.

The spending plans of the two main parties are particularly alarming given an already swollen budget deficit. The government's official forecast is for a budget deficit of 6.1% of GDP this year (including the costs of pension reforms), but other observers expect it to be higher still. Economists at DZ Bank's Emerging Markets Local Debt division in Budapest forecast a deficit of 7.1%, while the Hungarian National Bank (MNB) expects it to come in as high as 8.8%.

The MNB's figure is particularly high because it expects the costs of motorway construction will have to be included, at least to satisfy Eurostat. The government hopes to exclude this item by financing road building through a private company, as part of a public- private partnership.

AS BAD AS EACH OTHER

The MNB also expects more slippage in the plans of a government that has consistently made mistakes in its forecasting.

However, neither of the major parties can claim much credibility on this issue.

According to Gyorgy Kovacs, macroeconomist at DZ Bank: “In 2001-02, under [the conservative party] FIDESZ, the government typically underestimated revenues, forecasting a sharp decline in inflation and then finding themselves with extra revenues when that didn't occur. Thus they had extra revenues that they could use for discretionary spending.

The Socialists have rather tended to overestimate revenues, forecasting the best revenues scenario possible to match their spending plans.” The Socialists have also faced a loss in revenue from customs duties and VAT on imports since joining the EU.

Observing a growing deficit and a government apparently in denial, the European Commission is becoming increasingly concerned.

It has given Hungary until September to come up with a plan to reduce the deficit, or else face fines. But given the nonchalant attitude of the EU's Economic and Financial Affairs Council, which is composed of the economics and finance ministers of member states, over Germany and France's bad budget behaviour, ultimatums issued by the Commission have their own credibility problems.

A more imminent and real threat is that the markets will panic. So far, investors seem to be hoping the parties will renege on their expensive election promises once in power.

Nevertheless, Hungary has shown much more vulnerability than other European emerging markets to the worsening global liquidity situation of recent weeks. This suggests that even the benefit of the doubt investors are currently bestowing on Hungary is conditional. Certainly, once the elections are over, patience is likely to run out fast.

BROKEN PROMISES

Which party is more likely to break its promises and embark on serious reforms?

Both have left themselves room for manoeuvre.

The Socialists have avoided making rash statements in some notable areas and their pledges relate to the entire four-year term, so there is no need to deliver on them in the first year. FIDESZ, meanwhile, has qualified its promises by stating they are based on current economic figures. Once in power, they might claim the situation is worse than they had expected, hence justifying cuts.

Yet the political pressure on an incoming government of any colour will probably remain high after the elections for two reasons.

First, the new government might have a tiny majority, making it difficult to push through painful measures. Second, local elections are due in the autumn, meaning the new Cabinet will be under immediate pressure to deliver goodies while at the same time avoid making any spending cuts.

Just what signals might the markets look for in the new government's first weeks in office? DZ Bank's Kovacs says the government could achieve some results by increasing taxes, probably VAT, but a successful consolidation strategy must be based primarily on the expenditure side. Here, Hungary has problems on all levels. The incoming government will need to radically cut the size of the state administration, reduce wages and welfare, and make a serious effort to reform healthcare.

But Kovacs warns that politically and socially it won't be easy. “The system is generally bloated and having to do reforms on all fronts is going to be painful,” he says. “You can't do it without some kind of social consensus.”

Another structural problem is the large amount of the workforce that is neither working nor actively seeking work. In the early years of transition, many people took early retirement as a way of dealing with the economic upheaval, leaving Hungary with a participation rate of only 60%. That compares with 65% in Poland and 70% in the Czech Republic, Slovakia and the EU-15. The resulting high tax burden on a small workforce in turn encourages evasion and hence the tax base is low. Neither the Socialists nor FIDESZ seem to have a convincing strategy to deal with this.

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