An Overview of Hungarys Transition Experience

1
An Overview of Hungarys Transition Experience

• By Matt Luby
• March 8, 2005
• Economics 508

Note Background is Hungarian flag, courtesy of
CIA World Factbook
2
Background
Hungary is located in Central Europe (see red box)
Here is an expanded view of Central Europe, with
Hungary highlighted
Courtesy of www.sitesatlas.com
Courtesy of CIA World Factbook
3
Background, continued

• Population 10,375,000 (1990) 10,197,000 (2002)
  9,300,000 (2015, projected).
  
• Negative growth rate as population ages (65 are
  14.8 of country in 2002, 17.4 in 2015 as
  projected by Human Development Reports)
  
• 2003 GDP per capita 14,572, ranked 39th in
  world
  
• Communist governments Bela Kun, Hungarian
  Socialist Republic, 1919 Hungarian Peoples
  Republic, 1949-1989
  
• Important anti-communist uprising in 1956
• Interesting fact Magyar is non-Indo-European

4
MAJOR MACRO INDICATORS
5
MAJOR MACRO INDICATORS, CONTINUED
6
Pre-democratic transition, phase I

• Hungary made extensive reforms under communism.
  
  
• Called the New Economic Mechanism, first
  introduced in 1968.
  
• High growth slowed beginning in 1972
• External shocks (OPEC, etc)
• High rates of investment (30 of GDP) financed
  most growth in mid-1970s
  
• Money came from foreign banks and was used to
  fight external shocks.
  
• Origin of foreign debt problem (World Bank, 1
  Bartlett, 55).

7
Pre-democratic transition, phase II

• Reforms accelerated in 1980s
• Enterprise economic work partnership, 1982
• Work subcontracted after hours
• Higher wages paid, firms more profitable, higher
  productivity
  
• Called hidden privatization by Lavigne (36)
• Debt repayment
• Large foreign debts begin to be repaid with aid
  of IMF, 1982

8
Pre-democratic Transition, cont.

• Price liberalization (Only in Hungary did
  liberalization reach significant proportions
  Lavigne, 39)
  
• Significant decentralization of pricing
• 20 of CPI prices were centrally regulated, 1989
  (Cottarelli et al, 6)
  
• Decentralized labor contracts yield higher
  wages.
  
• No incentive to keep wages low (Bartlett, 57).
• Foreign price levels given a bearing on relevant
  domestic prices
  
• Regulated inflation (5-9 annually, 1976-86,
  Lavigne 62)

9
Pre-democratic transition, cont.

• Bankruptcy legalized, 1986 banking reforms, 1987
  (allow local and small commercial banks) Company
  Law, 1988 Transformation Law, 1989
  
• Thanks to banking reform, National Bank was no
  longer the sole bank. More opportunity for
  investment.
  
• Bankruptcy rarely enforced. State bailed out
  soft budget constraint.

10
PHARE

• PHARE signed in 1989, designed to bring aid from
  EC to Poland and Hungary
  
• Assist with democracy and market
• Stepping stone to association agreements with the
  EC in 1991
  
• Poland, Hungary, Assistance to the Restructuring
  of the Economy
  

11
The Fall

• Communism falls, 1989-1990
• Coalition government was disunited, had trouble
  agreeing on one platform
  
• People felt like transition was already in
  progress
  
• Was already one of the most reformed
  countries-PHARE
  
• Government proclaims shock therapy and massive
  reform
  
• In reality, pursues very gradualist program
• Lavigne associates decision with politics and not
  economics
  

12
Post-fall problems

• Foreign debt was among the highest per capita in
  Eastern Europe
  
• Hungary did not ask for rescheduling or
  cancellation
  
• Chose to repay the debt in full to help
  international credit standing
  
• Continued repayment policy of the communists
• Budget deficit was high
• 1991-estimated between 4-6 of budget, which
  exceeded IMF levels (Szekely and Newbery)
  
• Coalition found it hard to restructure social
  benefits and maintain power

13
Social Expenditures
About 40 of the population aged 15-59 (15-54
for women) is now (1994) dependent on the wages
of others and on social transfers, double
theratio of 1991. (World Bank, 27)
Data courtesy of World Bank, 25
Total implicit pension debt of 263 of GDPmore
than 20-40 times the amount of state assets
pledged to the Pension Fund as reserves. (World
Bank, 36)
Note Data reflect 1993 in Hungary, 1994 in OECD
and 1991 in EU
Note Implicit pension debt-present value of
pension rights already earned by workers and
pensioners in the system (World Bank, 36)
14
A Graphical Interpretation of Hungarian Debt,
circa 1989
Hungarys per capita debt stood at 1,939.
Poland was next closest at a much lower 1,102.
Data courtesy of Szekely and Newbery, 220
15
Describing the stabilization package, as laid out
by Lavigne

• Price liberalization
• Reduce subsidies, stop price fixing
• Already a leader
• Balanced budget
• Raise taxes, cut spending
• Became real problem
• Tight monetary policy
• Raise interest rate to create positive real rate

16
Lavignes stabilization, cont.

• Incomes policy
• Stop inflation in nominal wages
• Taxes on wages
• Credits for eliminating jobs in proportion to
  wage increases
  
• Trade liberalization
• Lower trade barriers, convertability, devaluation
  of domestic currency
  
• EC and CEFTA worked to lower trade barriers
• Currency made convertible, 1990
• Fixed exchange rate with periodic devaluations

17
Suggested structural reforms from Lavigne

• Privatization
• Sell off SOEs, support free competition
• Did not want to give away SOEs
• Foreign companies among biggest investors.
• Foreign investment as percentage of privatization
  proceeds
  
• 1990-92 75, 1995-96 80-90 (Lavigne, 170)
• Sales of large SOEs went slowly
• Smaller SOEs sold well and quickly
• Creation of market
• Reforms to banking, financial, and taxes
• Banking reforms under communism
• State insurance companies privatized very early
  relative to the rest of the bloc
  
• Stock market opens, 1990
• Tax reforms poor, with tax pressure around 55 of
  GDP as late as 1995

18
Structural reforms, cont.

• Social safety net
• Must replace the old social system and provide
  for people in bad times
  
• Failure
• Industrial reform
• Protect and support industry as needed
• EC agreement allowed Hungary to maintain tariffs
  as needed so as to protect domestic industry
  

19
Problems Strike Hungary

• Bad fiscal policy
• May 1994-new government elected
• 1994-1995-economy looked grim
• Real wages were not declining as sharply as
  output
  
• Leads to over consumption by consumers and drop
  in savings
  
• Low savings and high foreign debt combine to put
  current account balance in danger

20
Economic Performance Graphs Gross Industrial
Output (index, 1989100)
Data from Lavigne, Statistical Appendix, Table A2
21
Economic Performance Graphs Real Wages
Data from Lavigne, Statistical Appendix, Table A2
22
Economic stabilization Shock therapy?

• March 1995-economic stabilization package
  adopted
  
• Budgetary spending cut by 15, real
• Currency devalued by 9 and fixed rate replaced
  with crawling peg
  
• Fixed exchange rate hurt trade, as depreciations
  lagged behind inflation, which was near 20
  
• Import surcharge of 8
• Nominal wages targeted for stabilization
• Many authors cite this package as incidence of
  shock therapy in Hungary, albeit 5 years late
  

23
Effects of the Package

• Government deficit/GDP ratio fell from 9.6 in
  1994 to 3.8 in 1996
  
• Current account deficit fell from 9.4 in 1994 to
  3.8 in 1996
  
• 1995-trade balance improves by 1.2 billion
• GDP growth slows

24
The Bankruptcy Law, 1991

• Until amendments in 1993, extremely stringent
• In 1993, significantly reformed
• No longer requires 100 of firm to support
  restructuring
  
• Hungarian firms have met, and adjusted to, hard
  budget constraints. This process is not yet
  complete in most other transition
  countries.Halpern and Wyplosz, 9-10
• Along the same lines, has helped form Hungarian
  corporate structure
  
• Liquidation-sale of assets to repay debt
• Bankruptcy-firm no longer able to service debts,
  assets transferred to creditors or liquidated

25
Effects of bankruptcy law
Data courtesy of Halpern and Wyplosz, 9
26
FDI in Hungary

• Foreign Direct Investment (FDI)
• Foreigners acquire direct capital ownership
  stakes
  
• Has attracted very high share of FDI
• Lavigne cites importance of multinational HQs in
  Hungary
  
• Oddly, Hungary does not have highest growth in
  region
  
• Lavigne believes stability and market orientation
  make it attractive
  
• Halpern and Wyplosz attribute FDI to
  foreign-friendly privatization and corporate
  structure, vis a vis Bankruptcy Law of 1991
  

27
FDI graphs
Data courtesy of Lavigne, 255
28
International Pacts

• Signed PHARE in 1989
• Signed agreement with EC in 1991.
• Establishes limited free trade with EC
  (predecessor to EU)
  
• EC lowers most tariffs on Hungary immediately,
  Hungary given 9-year time frame to reciprocate
  
• Signed Central European Free Trade Area (CEFTA)
  in 1991.
  
• Weak free trade agreement with Central and
  Eastern European nations
  
• Joins NATO, 1999
• Joins EU, 2004
• Membership in EU negates CEFTA membership