Nicholas Watson in Prague -

Moody's Investor Services said in a report released Monday, July 30 that the key to Hungary reversing the ratings downgrade it suffered last year is whether the government can sustain and widen its structural reform programme in the face of an inevitable deterioration of political popularity.

In 2006, Moody’s downgraded Hungary’s sovereign credit rating to 'A2' from 'A1' because of the deterioration in the country’s fiscal and external payments positions. However, in the first half of 2007, bolstered by an austerity programme implemented by the government, Hungary’s economic growth rate has surprised in a positive way, with the better economic performance of Germany helping to drive export growth, contributing significantly to a rate of overall economic growth approaching 3% on an annualized basis.

"The success of Hungarian export performance was due both to cost competitiveness and the character of Hungarian exports. Hungary is integrated into European production chains, supplying intermediate goods to European markets that then bundle these goods into final products destined either for West European or other markets," Moody's said.

So far, Moody's says the government’s austerity package has not yet had negative macroeconomic effects, and is proving effective in reducing fiscal and balance of payments imbalances. For example, higher taxation rates have raised budget revenues and cut household consumption, thus decreasing the rate of growth of imports and narrowing the current account deficit. Cutbacks in public employment have had a similar effect on consumption and the current account. Subdued consumption, in turn, has resulted in subdued investment rates. At the same time, tax increases plus rises in administered fuel prices raised inflation rates year-on-year to a peak of 9% in March from 6% in autumn of 2006.

"The only surprise in all this is that – in spite of higher payroll taxes – the shadow economy has declined and the tax base has widened, thus boosting government revenues. This was accomplished by the simple expedient of insisting that citizens had to pay social security contributions if they wished to receive pensions and health care services. Previously, individuals only had to present a social security card in order to receive these benefits," Moody's said.

It noted that during 2006, 400,000 new registrants paid health insurance and social security contributions.

The ratings agency said that although it was initially felt the government would wait until 2008 to introduce structural reforms that affect the expenditure side of Hungary’s large budget deficit, the government has already initiated a variety of reforms that attack various expenditure-side problems.

For example, during 2007 nominal expenditures on health care will actually be less than they were during 2006. Total sector savings is estimated to be 0.3-0.4% of GDP per annum. The government has also introduced public education reforms. Still on the agenda for 2008-2009 are "difficult" reforms in the areas of pensions and welfare.

"Both the prime minister and his party (the leading coalition member) remain fully committed to carrying out the austerity program in full," said Moody's "It remains to be seen whether or not this commitment can be sustained over the next two years."

Government finance and debt

Although large, Hungary’s consolidated government fiscal deficit for 2006 was 9.2% of GDP as against the original forecast of 11.1%. The improvement was caused by greater-than-expected revenues, due mainly to higher tax rates and a wider tax base. The original government forecast for 2007 was for a deficit of 6.8% of GDP. Faster-than-expected economic growth is now suggesting that the deficit may come in at 6.4% of GDP due again to higher revenues.

"The current forecast of the National Bank of Hungary is for a deficit in the range of 6.0-6.2% of GDP. It is hoped that as the government gradually regains fiscal credibility, the risk premium demanded by non-residents for absorbing Hungarian government paper will decline and, with this, the debt-servicing burden on the budget will lessen," Moody's said.

Even so, several years of rising government expenditures/GDP, large fiscal deficits, and negative primary balances have substantially worsened Hungary’s general government debt/GDP and general government debt/revenues ratios.

"If one assesses various debt indicators, when Hungary is compared to its rating peers and its regional neighbors, the deterioration is even more apparent. At 66% (end-2006), Hungary’s general government debt/GDP ratio is more than three times higher than the 18.2% mean for developing countries in the Aa1-A3 rating range. The country’s 151% general government debt/general government revenue ratio is almost double the 81.4% mean for the same rating peer category. Similarly, Hungary’s general government interest payment/revenue ratio of almost 9% was more than double the 4.2% mean in this peer category. Hungary’s ratios are also the highest in central/eastern Europe, with the Czech Republic (30.4%, 77%, and 3%), Slovakia (30.7%, 92.8%, and 5.1%), and Poland (42.4%, 107.6%, and 6.1%) all posting far better results on these measures," it said.

External vulnerability and liquidity

Moody's notes that for several years Hungary has run a sizeable current account deficit, in spite of good export performance. In the last quarter of 2006, Hungary surprised analysts by running a positive trade balance. The current account deficit in 2007 could fall below 5% of GDP from roughly 6% during 2006, as the austerity programme leads to slower import growth.

Even so, a 5% of GDP current account deficit needs considerable financing and although foreign direct investment is still strong, it has decreased since 2005.

"With low labour force participation rates and a high tax burden, Hungary may well lose foreign investors to neighboring states," it said. "Net FDI turned negative during the fourth quarter due to a large increase in direct investment abroad. It would appear that external financing would depend significantly on debt-creating inflows."

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