By Michael Logan
Lies about the economy nearly toppled prime minister Ferenc Gyurcsany last year. But his controversial reforms are bearing fruit, despite deep divisions within the country
When riots broke out on the streets of Budapest last September following Ferenc Gyurcsany’s admission he had lied about the economy, both the prime minister and his flagship austerity package looked destined for ignominy and defeat.
Yet it didn’t quite turn out that way: in just eight months, Gyurcsany has pulled back from the brink, and the once troubled leader now believes Hungary is well on its way towards overcoming its economic woes. “This has been the biggest challenge of my life,” Gyurcsany tells Emerging Markets in an exclusive interview. “The success has only one secret: the government parties have supported both the [economic] programme and me.” The government met the 2006 budget deficit target and is on course to do the same in 2007.
“Most observers did not believe this programme would succeed,” he says. “We know that the budget deficit was lower than we had forecast last summer. We have lowered the target twice this year. This is unprecedented,” he says.
In April last year, Gyurcsany’s Hungarian Socialist Party (MSZP) and its coalition partner the Alliance of Free Democrats (SZDSZ) became the first government to win re-election in the post-communist era. The joy was short-lived, though, and problems began when, in June, Gyurcsany announced the austerity package that raised taxes and energy prices, reformed healthcare and education and cut back on the state.
Hearing is believing
People were aware that Hungary’s economy was struggling after years of missed budget deficit targets, but the scale of the changes provoked anger. The deficit target eventually rose to 10.1% of GDP – around double the pre-election figure, even with the austerity measures. The most serious civil disturbances of post-communist times erupted on the streets of Budapest, after the media revealed a tape recording of Gyurcsany saying that he and other politicians had lied about the economy.
Everyone suspected the government had concealed the truth before the election, but no one expected Gyurcsany to admit it. The prime minister still maintains that he was talking about the lies of all post-communist governments when, in a private speech leaked to the media, he said: “We lied day and night.”
But people took his words at face value. Anti-government riots erupted in September and October, the main right-of-centre opposition party Fidesz organized massive street rallies, and Gyurcsany had to call a confidence vote to bolster his position. Few expected the government to meet its targets amid the chaos, but, now the dust has settled, the prime minister feels he has proved his critics wrong.
Hungary is aiming for a budget deficit of 3.2% of GDP in 2009 and has passed the milestones so far. Eurostat, the EU’s statistical agency, confirmed in April that the 2006 deficit was 9.2%. While this is the largest in the EU, with Italy next on 4.4%, it still smashed the target. The 2007 target has also fallen from 6.8% to 6.6% on the back of high tax revenues and social contributions in the first quarter.
Over the worst?
The negative effects of the austerity package have been apparent – consumer price inflation ballooned to 9% in March, interest rates are running at 8%, and GDP growth is expected to fall to 2.2% this year from 3.9% last year – but most feel the worst is almost over. The Hungarian National Bank (MNB), which is expected to begin cutting rates soon, is predicting 5% inflation by the year end, and 3% the year after. Equally, the government expects GDP growth to pick up next year.
An important goal is euro adoption, and Gyurcsany says that an official target date somewhere between 2010 and 2014 would be set in tandem with the MNB later this year. But he warns that the race for the euro should not blind the country to the real goal: long-term stability. “We must not formulate the macroeconomic circumstances required for that [euro adoption] in an artificial way – we have to be able to sustain it in the long run,” he says.
The final goal is still a long way off, however. The Hungarian economy has previously appeared to be moving in the right direction only to slide back. Lajos Bokros, finance minister in 1995-96, introduced an austerity package, but the deficit soon began to creep up again until Hungary was consistently missing its targets.
Mihaly Varga, finance minister in 2001-02 under the Fidesz government, and now deputy leader of Fidesz’s parliamentary caucus, is unconvinced by the latest results. He believes the “Gyurcsany package” will fare no better than the “Bokros package”. “The government lost a large measure of its credibility with last year’s budget trickery,” he says.
Legal challenge
Gyurcsany says the only task remaining is to “stay disciplined”, adding this would be achieved in part by setting up an independent budgetary office to prevent “political desires” influencing the austerity measures. Most observers agree Hungary has progressed, but they warn of a difficult road ahead. “The task remains a formidable one,” Ashoka Mody, assistant director of the IMF in Europe, said on May 7, after delivering the IMF’s annual report on Hungary’s economy.
While the IMF’s deficit estimates until 2008 were broadly in line with the government’s, Mody warned of upcoming threats, in particular raising concern that the government would fail to freeze public-sector wages in 2008 as promised.
There are other signs of slippage. A wage deal for public workers, and the “expected tax” being ruled illegal by the Constitutional Court, cost the budget around 100 billion forints this year.
While the government has a 200 billion forint reserve this year, the Constitutional Court is also considering the legality of another tax introduced as part of the fiscal consolidation measures – the 4% “solidarity” tax on high-earning businesses and individuals. “If the court strikes down the law, it could cause a 150 billion forint loss,” says David Nemeth, an economist at ING bank.
Gyurcsany acknowledges that a decision against the tax would be the “first major challenge” to his package, and says the government will act if necessary. “If they find the solidarity tax unconstitutional ... we will have to bring in certain measures beyond the reserve,” he says.
Some also see a tendency to overspend in ministries as a threat. A recent poll of 12 analysts by financial website portfolio.hu predicted an overshoot of around 0.3% on the 4.3% deficit target in 2008, citing ministry overspending as one of the reasons. However, Gyurcsany says that the ministries were in hand. “We exercise strict financial control over the ministries,” he says. “Certain parts of their budget are put aside. Only when we have seen that they have stuck to the budget can they spend the reserve.”
Trimming
Another major criticism levelled at the package was that it did not cut spending enough. While some cutbacks have taken place, many feel more could have been made in key areas such as local government: “If they can introduce expenditure cuts in 2008, they can achieve the 2009 budget target,” says Nemeth. “If not, then it may be missed.”
“We have the highest expenditure rate amongst the countries that joined the EU in 2004 and 2007,” Varga says. “Instead of real structural changes, we are witnessing trimming.”
According to the euro convergence programme, general government expenditure will be reduced from 52.9% of GDP in 2006 to 46.6% in 2009. The IMF thinks this is too high, and called for a target of between 40 to 45%. Gyurcsany asserts that no new measures are planned, and says the government aims to cut expenditure to 43.8% by 2009, adding that big savings have already been made in public administration and healthcare expenditure. “Since living history, there has never been a surplus in the healthcare fund, but this happened in March,” he says. The IMF thinks this is too high, and called for a target of between 40 to 45%.
Healthcare reform has caused ructions in the coalition, however. While much of the reform is complete, Lajos Molnar, an appointee of the SZDSZ, recently resigned from the top job at the health ministry amid rumours that the MSZP was stalling on the final reform – a change to a multi-insurer healthcare system.
Agreement has not yet been reached between the coalition parties on this reform, but Gyurcsany believes the disagreement poses no threat. “It is not in the interest of the parties to endanger the coalition, because with the end of the coalition, the reform ends,” he says. “With the failure of the reform, the country would lose. That is why they will agree about the next phase.”
Staff cuts
Despite the cuts in areas such as healthcare, the majority of independent observers feel further reforms are needed, particularly in the bloated state. The government merged several ministries last year and laid off thousands of employees, but local government is still unwieldy, and a bill to cut the number of MPs from 386 to fewer than 300 was blocked last year. “If they can introduce expenditure cuts in 2008, they can achieve the 2009 budget target,” Nemeth says. “If not, then it may be missed.”
Bokros, now working at Budapest’s Central European University, believes that expenditure cuts are needed and has also called for lower taxes. The former minister believes the biggest danger is that Hungary, which has led the region in FDI for many years, could fall behind its neighbours due to high taxation and low growth.
Fidesz feels that increasing the tax burden, which was already one of the highest amongst OECD countries, was a mistake, and feels the government should be trying to grow its way out of the crisis. “Fidesz believes in targeted tax cuts and restructuring,” Varga says. “Companies will become competitive and unemployment will moderate, meaning fewer benefits paid out as well as more income from payroll tax.”
Business cuts
The business community also favours tax cuts. The grey and black economies are estimated at billions of euros annually, and some argue that cutting taxes and increasing penalties for tax evasion would increase revenues and make the system fairer. A recent survey by the German-Hungarian Chamber of Commerce and Industry said its members believed tackling the illegal economy and reforming the tax system were both essential.
Mody, while admitting to concern that Hungary’s low GDP growth means it is in danger of falling behind the region, says that tax cuts are simply not possible in the short term but calls for a simplified and more well-balanced tax system. “It is important to recognize that not only are tax rates high, but the tax code is complicated and creates an incentive to avoid taxes,” he says.
Gyurcsany says that tougher inspections are already reducing the illegal economy, citing increased official employment levels in the traditionally black construction sector to back his case. He says it would be worth looking at restructuring the tax system in 2011, but ruled out decreasing the overall tax burden. “The picture is not as simple as competitiveness equals tax levels,” he says.
Looming beyond the 2009 deficit target are the 2010 general elections. Credit rating agency Standard & Poor’s is just one of many bodies worried the government will have to spend to recover from its current poor ratings, undoing much of its own work. A Szonda Ipsos poll in April [TKTK] suggested only 16% of voters support the MSZP, while 35% support Fidesz. 40% were undecided.
Gyurcsany says that he will not “buy voters”, and will rely on the credibility gained from creating economic balance. “People did not decide on the basis of who promised more in 2006. If they had ... it would not be us who won but our rivals,” he says. “I think Hungary has learned a lesson. You can no longer promise wage increases of 20% or 30%. You can win with credible policies.”
Even should Gyurcsany’s austerity package prove successful, this may not convince many voters. Observers feel that last year’s events only cemented the left-right split that is a legacy of communism. But the prime minister believes 2.5 million swing voters are there for the taking. “They are not party soldiers,” he says. “They are thinking people who speak their minds.”
In any event, says the IMF, Hungary will need a further phase of reform beyond the current “emergency measures” in order to “reorient” fiscal reform. “These will carry Hungary into a longer period of fiscal discipline and promote growth,” says Mody.
Gyurcsany says he is only too aware of this. “In the medium term, we believe we can create balance by 2009,” he says. “The new challenge will be the challenge of growth.”