Whe investment bank analysts’ community and the Western political commentariat, writing about Hungary, have mostly focused on the twists and turns of the policy disputes/dialogues between the Hungarian authorities and the duo of the International Monetary Fund and the European Union as former as well as potential creditors. Commentators have vehemently debated Hungarian policy measures ever since Viktor Orbán’s election to offi ce in May 2010. Rating agencies have scrutinized the upside and downside risks inherent in these policies. Government officials, naturally, have energetically defended their positions, pointing out that certain key indicators show improvement, and impressive progress has been made in working out the mess that previous Socialist governments left behind.

While policies and political actions have been widely disputed by foreign and domestic commentators, less has been said about the economy itself. In fact, the views on the health of the economy diverge; analysts, in and outside Hungary, are quite divided on how to rate the economy. Many, myself included, feel that the fundamentals of the Hungarian economy are better than are generally recognized. Based on the strength of key macroeconomic data and certain business indicators, one can forcefully argue that the Hungarian economy would deserve a better grade than the present non-investment (“junk”) rating. Others, including the much criticized but still influential risk rating agencies, see it otherwise: government bonds are rated “non-investment grade”.

Principally, when rating agencies pronounce their judgments on sovereign risks, they quantify the probability of the given state’s medium term insolvency but they do not specifically judge the economic health of the country as such. Yet the language of the rating agencies is unclear on that point: they do talk of ”downgrading France” or “upgrading Brazil” as if the sovereign rating implied a judgment on the whole country.

As for Hungary, the sovereign long term rating of BB plus is a rather critical statement about the capacity and willingness of the Hungarian government to honour bonds and treasury bills sold to foreign and domestic investors. But it does not actually say much about the shape of the Hungarian economy. When Fitch, a major rating agency, downgraded the sovereign rating of Hungary in early January 2012, its press release referred to external factors and policy uncertainties: “The downgrade of Hungary’s ratings reflects further deterioration in the country’s fiscal and external financing environment and growth outlook, caused in part by further unorthodox economic policies which are undermining investor confidence and complicating the agreement of a new IMF/EU deal.”

THE FUZZY PICTURE OF THE ECONOMY

It is no accident that the real situation of the Hungarian economy has somehow been neglected amid heated policy debates. Noisy and fast changing politics will always complicate any analysis. But there are other reasons why, as noted, there is no agreement among analysts about the “true state” of the Hungarian economy. Ours is such an open (and, we will see, a bit too open) economy, that Hungary’s own economic strengths and weaknesses are inseparable from those of Europe. Thus, it is hard to form an authoritative judgment about the fundamentals of the Hungarian economy without revealing how you feel about the present health record of the European economy.

Also, some Hungarian economic data seem to have improved recently, but other key variables have not. The European Commission declared in its February 2012 Alert Mechanism Report that the Hungarian economy is in a fi nancially fragile situation (the indicators to support this judgment come from late 2010). Certainly, debt figures do look serious, but if you study carefully other key economic indicators, you will notice that data such as current account balance or unit labour costs have become quite impressive. It is true that at the same time there exist some worrisome social trends, such as the increase of the stock of non-performing bank loans and of late payment for utility bills, while other indicators (increase in geographical mobility among the youth) can be read both as alarming news and as signs of change for the better. The true balance hinges on future results.

And finally, business and economic processes are influenced by perceptions and expectations. Key investors’ attitudes to a given country may be critically shaped by their mental frame; an otherwise healthy economy may lose its appeal to investors should the hardships of its troubled neighbours taint its reputation and status through contagion.

Now, in an open world, a trade dependent country cannot remain immune to bad news and panicky speculations. Hungary is one of the extremely open economies of our time; therefore, the above judgmental factors are more than enough to explain the divergence of views on the fundamentals of the economy. Political noises in and around the country, and the high frequency of legal and regulatory changes in Hungary, help explain why there is no professional agreement on describing the fundamentals of Hungary.

Since sustainability of government debt finance is of paramount interest these days in private and official disputes alike, let us start our tour with public fi nance data. Compared to eurozone benchmarks, certain key indicators look rather reassuring. Let us take public sector balance (“general government overall balance”). Hungary experienced a stubbornly high deficit in the previous decade, particularly in 2002 and 2006, that is well before the onset of the international fi nancial turbulences of 2008, but later the deficit was cut gradually. In 2010, it reached a modest – by European standards – deficit of 4.3 per cent of GDP. What is more, year 2011 ended with a sizable budget surplus.

Still, Hungary remains under the Excess Deficit Procedure of the European Union in 2012. The case is complicated. The relevant European Commission (EC) document establishes that “no effective action has been taken by Hungary to comply with earlier Council recommendations to reduce deficit”. The Commission text reads: “in 2011, the general government balance is expected to turn into surplus, but only thanks to one-off revenues of 9.75 per cent of GDP linked to the transfer of the pension assets from the private pension schemes to the state pillar and of 0.9 per cent of GDP from sectoral levies (on telecom, energy, retail and financial sectors).Without one-off measures the deficit would have reached around 6 per cent of GDP and by far surpassed the 3 per cent of GDP reference value in the Treaty.”

Put simply: the Hungarian government may claim a convincing turnaround in public sector balance (from sizable defi cit to impressive surplus) in 2011, but the same fi scal fi gures can be read to yield a totally different conclusion: if it had not been for a series of one-off measures, the balance would have remained in defi cit. Of the two views, the latter, voiced by the EC, has seemed to carry the day in European capitals.

What complicates the case further is the EC’s view on year 2012. The Hungarian budget targets a deficit of 2.5 per cent of GDP – this is low enough, you may think, to take Hungary off the long list of European countries with defi cits of more that 3 per cent of their GDP. To achieve the deficit target, the Hungarian government will have to apply a tough dose of austerity with fi scal correction exceeding 4 per cent of GDP – tougher than under most former stabilization packages in recent decades. The Commission still determines that Hungary should not be removed from the list of countries with excessive deficit, for the reason that the structural deficit components inherent in the Hungarian fi scal processes would most probably result in a deficit of 3.25 per cent – which is obviously higher, even if only a bit, than the reference value of 3 per cent or of the government plan (2.5 per cent).

Now, for Budapest, this argument sounds like nit-picking, particularly at a time when a high number of member states have and will have much higher defi cit than that. One can sense a degree of irritation in the public statements of the Hungarian authorities: they do their utmost to comply with EU reference values, and although they make it, the first time since Hungary’s accession to the EU, the achievements are not recognized officially. It is a case of double standards, Hungarian office holders claim, given that only a couple of years before, the EU let the then Hungarian governments (Socialist–Liberal by their political colours) off the hook without penalty with much worse figures.

As for other key variables, the state debt ratio stands in line with the European average. At the end of the third quarter of 2011, the government debt to GDP ratio in the euro area (EA17) stood at 87.4 per cent. The largest debt-to-GDP ratio was – unsurprisingly – recorded in Greece (159 per cent), followed by Italy (120 per cent) and Portugal (110 per cent). Hungary’s government debt reached 82.6 per cent of GDP, which is the ninth highest in the whole of the EU. The lowest indices were observed in two new member states (Estonia with 6 per cent and Bulgaria with 15 per cent).

For comparison, let us take the two most important industrial economies of Europe, France and Germany: they have similar levels of public debt, at just over 80 per cent of GDP. Whereas Germany recorded a 4 per cent budget defi cit in 2010, and a little over 1 per cent deficit in 2011, the French deficit stood at 7 per cent in 2010, and close to 6 per cent in 2011 – these figures do not, in themselves, provide them with a platform to lecture Hungary on public fi nance. Having said that, one has to admit that Hungary does not belong to the debtor class of France, and particularly of Germany. Geography and history would destine the Hungarian debt ratio to be somewhere very near to those of Bulgaria or Slovakia, and certainly not higher than that of Poland.

But it is the same history that put Hungary in another box of countries as far as government debt is concerned: “reform-minded” communist governments before the regime change of 1990 turned (the People’s Republic of) Hungary into an indebted economy, and while debt ratio in the first decade of the transition to market economy was successfully massaged down (to 51 per cent of GDP by 2001), the eight year Socialist rule between 2002 and 2010 made Hungary again a high-debt state with over 80 per cent.

ORBÁN’S POLICY IS GROWTH-CENTRED – BUT WHAT HAPPENED TO GROWTH?

The macro-financial picture is thus blurred, mixed at best. Much depends on whose calculations one trusts. But no matter how you look at data, Hungary’s case is far from that of Greece and other heavily indebted nations. Why, then, are rating agencies and certain investors worried about the Hungarian capacity to pay?

One obvious factor is lack of growth. This is certainly a worrisome aspect of the Hungarian reality in 2011 and 2012. The economy was already hardly growing before the “sudden stop” of capital inflows into Central and Eastern Europe – a sign of weakness against the background of phenomenal growth in Slovakia and the Baltic republics. This circumstance shaped heavily Mr Orbán’s election manifesto of 2010, and his initial economic policy platform in 2010: if Hungary’s Socialist governments had killed economic growth through on-and-off austerity and thus let Hungary drift pointlessly during the years of international fi nancial turbulences, the new government should “restart the engines” of economic growth. It is not austerity that helps, Economics Minister Matolcsy kept repeating, but growth.

The puzzling fact is that the growth record of the Hungarian economy has not become bright even after the change of government. The steep reduction of personal income tax in 2010 was meant to serve the acceleration of the growth of the output, and with growing output, creation of new jobs. “One million new jobs in ten years” – it always sounded a politician’s slogan rather than a policy target; but with flat economic activity it is hard even to imagine genuine growth in the number of the employed. But reality is harsh after the second year in office of the new Hungarian government: the unemployment rate stood close to 11 per cent at the end of 2011 – high in itself, also in relations to previous trends, and higher than the average of the EU 27 (about 10 per cent).

However much one would like to see a return of economic dynamism, even a simple analysis of the components of the national output reveals the sad truth: 2012 will not go down in economic history as a year of turnaround in business activity. Let us review the major components of gross domestic product (GDP), starting with consumption.

Private consumption, the largest single item of the aggregate demand of an economy, has been for some time constrained by weak wage growth and high foreign and forint-denominated debt service (see my previous analysis in Vol. II. No. 6: “A Not Too Original Sin: Hungarian Indebtedness in Foreign Currency”). Stagnating household consumption is bad news for domestic businesses, such as construction, retail and tourism, but may also be regarded as a welcome fact given the high level of indebtedness of Hungarian families. The particular government measures chosen to reduce the indebtedness of households through preferential repayment of mortgage loans can be justly criticized for lack of coherence, but even its partial results and the strict prudential regulation applied to foreign exchange denominated lending to households have helped reduce currency mismatches and concomitant exposure to foreign exchange risks. Still, facts are facts: household spending cannot become a growth engine of the Hungarian economy in the short term.

The next component to be reckoned with is investment, private and public. Fixed capital formation has been stagnating for some time in Hungary at a relatively modest level, and one cannot see any basis for improvement in the short to medium term. Automotive investments, including the high profile car project of Mercedes in Kecskemét, have somewhat invigorated the capital formation process in Hungary. But other sectors are just too cautious to increase productive capacities in times of slow growth and poor consumer expectations.

As for public sector investments, the budgetary conditions would not allow even maintaining the previous level of government capital expenditures. Austerity may be a forbidden term in government PR but as far as public sector spending is concerned this is the reality in 2012 and beyond. Rationalization of the civil service and saving measures in government departments all point to less public sector employment and reduced government spending. This is, in general, a welcome tendency since bureaucracy is oversized. But public sector spending will not add to aggregate demand in the years to come.

What remains the only positive component of aggregate demand is net export: the difference of export and import. Certainly, Hungary has had an impressive foreign trade surplus for a couple of years. The surplus of goods and services amounted to EUR 3.5 billion in the first three quarters of 2011 – a very high figure for the size of the economy. The downside of this fact is that the growth of export has been systematically surpassing imports for the unhappy reason that domestic investment activity has been poor for some time, as the economy is close to stagnation. MNB, the National Bank of Hungary, reported that the current account had a surplus of EUR 1,128 million at the end of the fi rst three quarters of 2011 – an improvement of the balance by EUR 240 million compared to the same period of the previous year.

The review of the economic scene must include prices. Given the modest level of economic activity, the rate of increase of consumer prices – 3.9 per cent in 2011 – seems to be relatively high. January 2012, after a further increase in Value Added Tax on most products, produced a pretty high price index (5.5 per cent compared to January of the previous year).
All in all, the macroeconomic picture is mixed but not depressing. Then, why all the fuss about the Hungarian economy? The fi rst ever Alert Mechanism Report pinpoints two areas: “the values of scoreboard indicators for the public debt ratio and the net international investment position are well above the indicative thresholds. The latter is the result of the continuous current account deficits recorded in the years before the crisis. With the crisis, a sharp adjustment has taken place as domestic demand collapsed but the international investment position deficit remains large even if a substantial part is financed by FDI (Foreign Direct Investment).” True, the Hungarian economy has for some time been carrying the debt burdens, public and private, originating in earlier periods. The external net debt of the whole county was EUR 109 billion at the end of September 2011, while the net debt stock amounted to EUR 49 billion – not that high by European standards but signifi cant enough to worry about. But the otherwise unfortunate recent economic slowdown has already helped improve external balances.

The Report also notices that the pre-2008 period saw “very strong credit growth, which in particular for households has been largely financed in foreign currency. The accumulation of external financial exposure in the private sector has taken place in a context of high and increasing public debt levels also financed in foreign currency.” This has been a particularity of the Hungarian economy, but one that will change due to recent policy measures.

However, where the Report does not deal with Hungary, having the average of recent years below the EU threshold is unemployment. For me, this is a most important aspect of the Hungarian economic and social reality: unless jobs are created by tens of thousands already in the short term, there will be no economic foundation for a more stable fiscality and sustainable growth. Low labour market activity is the most serious consequence of the many policy mistakes of previous governments; correction is a must. There are many other important aspects of the socio-economic structure of Hungary, but insufficient labour activity is both a cause and an effect. Mr Orbán’s eventual success or failure very much depends on how he will deliver on his job-creating promises.