The implications of a European slowdown for Hungary


As a result of the US subprime crisis and despite all the efforts by the government and the Fed, the country's economy suffered a serious setback. Since the crisis arose in the world's largest economy, its effect will reverberate all over the world, including the European Union, one of the US's largest trading partners. In 2008 growth in the Union, and in Germany in particular, is expected to decline. This in turn shrinks Hungary's export markets. As a result, in the coming period the Hungarian economy cannot expect a boost from external trends or from the smooth readjustment of world markets. This is clearly demonstrated by the fact that the annual measure of export growth rate already declined in 2007. It fell drastically in December and, while earlier in 2008 it has shown some modest signs of recovery, Political Capital’s structural analysis indicates that the downward trend is unlikely to be reversed.




Table 1. Balance of trade. Percentage, 2000 average price index, same period in the previous year = 100.0 (Source: Hungarian Central Statistical Office)




Table 2. Hungarian exports by destination (Source: NBH)


Snowball effect


However, the adverse global economic climate accounts for only a fraction of the risks being posed to the Hungarian economy. The biggest danger of the current crisis is that due to longer-term, intrinsic and deep-seated weaknesses in the Hungarian economy, the effects of a global crisis may be multiplied. The primary reason for the recent poor performance is that the second Gyurcsány government's stabilisation programme relied too heavily on the revenue side of the budget. While, thanks to significantly higher revenues collected in the past year, the public finance deficit has declined, the spending level has increased as well. In part this explains why, despite the government's success in reducing the deficit beyond expectations, in almost all other segments the economy fell short of projections made by the government and independent experts in 2006. The pessimistic downturn in investors’ and other market players’ outlook poses additional problems: Hungary's investment rate lags far behind the rates in countries that also joined the EU in 2004, and the previous advantage over older member states has decreased as well. According to a recently published survey[1], of all countries in the region Hungary's ability to attract investments declined at the fastest rate in the past year. According to respondents, this is explained by political uncertainty, the periodically announced and then abandoned tax reform, and the shortage of skilled labour.Moreover, the country's competitiveness is constantly eroding, its growth rate is well below that of the regional average, so much so that in 2007 it was the lowest in all of Europe.




Table 3: How attractive are these countries as investment destinations? (1: very attractive, 6: not at all attractive. Source: survey of Deutsh-Ungarische Industrie- und Handelskammer)


Relative disadvantage


One important result of an approaching crisis would be the evaporation of trust on the part of international investors and their loss of appetite for risk. Due to the factors described above the Hungarian economy performs well below its regional rivals, and the escalating domestic political crisis has added a great deal to the uncertainty. The current situation is virtually guaranteed to slow an already less-than-efficient restructuring effort, and raise the chances of fiscal recklessness. Emerging markets are expected to weather the shock caused by the US subprime crisis in a relatively good shape, therefore investors try to ride out the storm in these markets. However, since it is precisely in the competition against its regional rivals that Hungary lost ground in the last year or so, within the group of emerging markets the country may now fall even farther behind. As a result of this relative disadvantage, and due to the simultaneous rise in Hungarian political risk and a reappraisal of risk appetite and strategy by global investors, Hungary may see a relative decline in FDI and reploughed investment in 2008.[2] This in turn can lead to a long-term, institutionally and financially embedded, hard-to-reverse and path-dependent significant relative disadvantage of the Hungarian economy against other countries in the region.




Table 4. Direct capital investment in Hungary, in million euros (Source: NBH)




Table 5. Real GDP growth (Source: Eurostat, Hungarian Ministry of Economy and Transport, Bundesregiereung)


Changing growth paths


In 2006 when the Government set up its convergence program it envisioned a very different economic and political environment. However, in the current situation targets established at that time are unrealistic, the country abandoned the course charted earlier, and this to a great extent undermined the government's credibility in the eyes of investors and the population alike.

Although the macroeconomic figures set in the original convergence program were adjusted last December,there are no guarantees the new targets will be met either. Moreover, the plan submitted to the European Union lists as fait accompli certain reforms (e.g., visiting fee, hospital fee, tuition and railway rationalisation) that now we clearly know will not be realised in the foreseeable future. The leaders of the minority government about to be formed emphasise above all else the importance of the convergence program, although by now the submitted plan is nothing more than a deficit-reduction schedule at best, devoid of a clear and long-term vision for the country’s economy. Moreover, the minority government will have even less elbow room to implement the genuine reforms set out in the original convergence program.



Table 6: Inflation and growth prognoses (Source: NBH, Hungarian Ministry of Finance, Reuters)


The situation is further complicated by the fact that, based on the original plan, prior to the next general election the government would already have had a chance to implement popular measures without abandoning economic rationalism. The prospect of these measures was still based on the 2006 projection of a 4 per cent growth in 2009. A lower-than-expected economic performance means that in a future election campaign the government will not be in a position to make generous social spending gestures and, simultaneously, maintain the deficit level specified in the convergence program. As a result, political and economic considerations may come into sharp conflict, but on the plus side the usual election-year spending spree may for once be avoided.


Mutually contradictory short-term economic and political rationale


In the current situation the country's political leaders can choose between two evils


  • They stick to the plan of reducing the deficit and preserve their credibility in the eyes of the European Union and global investors. In this case few tools will be left to bolster and/or kick-start economic growth, since as public sector investments will stagnate, inflation and a shrinking employment level will have a negative impact on internal consumption and, due to aforementioned factors, the chance for a dynamic expansion of exports will be lost.
  • They increase public sector investments, raise pensions and wages for public employees to ease hardship for this segment of the population, which will boost internal consumption and may accelerate growth. However, since a slowing EU economy will significantly reduce the Hungarian government’s economic room to maneouvre, this could only be done by increasing the deficit. In this case the government could improve its popularity in the short term, although its irresponsible decisions could undermine investor confidence and may even lead to EU sanctions.


Hungarian party system and the current instance of systemic political risk


The traditionally conflict-seeking and consensus-shunning political philosophy of the current opposition, while a perfectly valid philosophy in itself, can only exacerbate the political uncertainty created by the popular referendum and the breakup of the governing coalition. There is no possible scenario in which a conflict-seeking party politics can reduce the economic costs and risk premia arising from the current Hungarian political establishment's increasingly limited ability to respond to a European slowdown and to defend the national economy against the concomitant external shocks. 


Narrowing scope for action


The confluence of internal economic and political difficulties and the spread of global financial crisis may put the country on a course to severely diminished choices. Paradoxically, in a certain sense this would reduce the risk as a potentially new government would also face the same exigencies. In Hungary the administration in office typically pursued irresponsible economic policies when they had some room for manoeuvre, which explains recurring high deficits at the end of each term, followed by austerity measures. However, in the current situation the government has no elbow room as, due to the lax economic policies of the past few years, the country is on “probation” in the eyes of investors and the consequences of further ill-advised decisions would strike with immediate and redoubled effect.

For more details on the possible scenarios of the outcome of the current government crisis, please read “Risk Warning: coalition break-up” on Political Capital’s website, or follow this link:


Contradicting monetary and political interests


The Central Bank, which enjoys high confidence abroad, must be prepared for long-term inflationary pressure (e.g. due to food and oil price hikes). As recently it took firm steps to reach its inflation target, more rate increases are expected in the near future, which, in turn, place additional burdens on the government and may slow down growth. In the short term the government's objectives would best be served by dynamic growth, a low interest rate and high inflation. The potential for conflict may be further escalated by the fact that in the current uncertain situation the Central Bank must further improve its credibility in the eyes of investors (i.e., it will continue to urge the restructuring of social security systems) while the unpopular government will make every effort to regain the confidence of the population.



[2] The fact that the government promised HUF 1400 bn additional investment to the construction sector financed by EU funds in the next 2 years, will have positive impact on the GDP growth, but this remains still well behind the CEE countries’ growth rates.