Nicholas Watson in Prague -

The news on Wednesday, June 27 that business confidence among Hungary's biggest firms has recovered to a high not seen in several years is further proof of the success of the government's fiscal austerity programme. The fear now is that the government will believe its job is done and fail to follow through on these reforms.

Ecostat, the research arm of Hungary's Central Statistics Office, said its confidence index of the 100 largest firms operating in Hungary rose to 58% in June from 54% in May, surpassing levels of 51% a year ago before the government launched its tough fiscal adjustment plan and the dreadful low of 40% hit last September after it imposed large tax hikes to rein in the budget deficit.

His reforms

This renewed confidence just a year after the programme was launched is, say analysts, a sign that the government has not only fulfilled the great majority of its promises, but it has outperformed most targets and exceeded even the most optimistic expectations. In 2006, Prime Minister Ferenc Gyurcsany introduced the austerity package, including tax rises and expenditure cuts, in order to bring down the highest public deficit in the EU, forecast then to go over 11% of GDP.

The biggest success has been in bringing down the fiscal deficit, which in 2006 came in at 9.2% of GDP, well below the Convergence Programme target of 10.2%. Similarly, the deficit for 2007 is well ahead of projection through April, and is set to end the year closer to 6.0% than to the original target of 6.8% of GDP.

"The good performance is due, in part, to a series of revenue-raising measures, in addition to various successful and stringent expenditure cuts – including the elimination of numerous expensive subsidies, public sector job cuts and various sector restructuring measures," says HSBC. "So far, nearly all planned reform measures have taken place on time, and credibility is rising fast."

Numerous government subsidies have been cut or eliminated altogether such as those related to utilities and drugs, while other public services like transport, health and higher education now incur a cost to the public. Pension reform has made early retirement less attractive and the public sector has been streamlined.

Good growth

The sounder budget also stems from surprisingly strong economic growth. GDP growth was projected to slow to 2.2% in 2007, but has remained stronger than anticipated into the first quarter as the economy expanded at a rate of 2.7%. Ecostat on Monday, June 25 raised its projection for Hungary's economic growth in 2007 to 2.6% in its latest quarterly forecast, up from 2.4% in the previous forecast published at the end of March. Ecostat expects growth to pick up to 3.2% in 2008. The GDP growth forecasts from the think-tank are well above the government's projections of 2.2% in 2007 and 2.6% in 2008.

Analysts say this less painful economic downturn than previously assumed will provide the government with valuable political capital, reducing the risk the government will cave in to fresh street protests – which have plagued the government since PM Gyurcsany was caught on tape telling supporters that his government had continually lied about the country's terrible public finances to win the parliamentary elections in April 2006 – and reverse the reforms.

"There are no guarantees, but the programme’s success may encourage further progress," says HSBC.

However, this being Central Europe, a region renowned for throwing out successful governments, there is always the danger that these reforms will be halted or, even worse, reversed by populist successors.

Analysts say that what is still missing in Hungary is a budget law or comparable measures that would insulate the fiscal process from the political cycle and limit the scope of governments to compromise over the budget ahead of elections. In a positive step, the Finance Ministry has announced plans to establish an independent budget office to produce three-year budgets, which analysts say would be a big step forward.

"While some observers remain sceptical, it seems increasingly likely that reform will continue and that the vast majority of implemented measures are unlikely to be reversed in the future," reckons HSBC.

Perhaps the greatest threat for the economy is inflation, which remains stubbornly high.

The rising price of success

In its business confidence report, Ecostat said that big firms' inflationary expectations rose to 7.1% on annual average in June from 6.7% a month earlier, while their year-end projection also rose to 7.2% from 6.5% expected in May. This compares with Hungary's actual consumer price inflation of 8.5% in May, which was down after peaking at an annual 9% in March.

Even as the CPI starts to fall, one key lingering concern and source of dispute within the central bank's Monetary Council has been the persistent strength of wage growth in recent months. Wage growth has fluctuated, sending mixed signals about labour market dynamics.

"To some extent rising wages are a reflection of a 'whitening' of the labour force as the registered economy grows. But a fall in employment in March, after steady growth in the months prior, suggests rising wage demands, which have inflationary implications, are at least partly responsible," says HSBC.

Despite this, the central bank decided after eight months to cut the base interest rate by 25 basis points to 7.75% on Monday, against most market expectations.

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