6 December 2004

With an attendant pick-up in economic activity, the pattern of Hungarian economic growth has changed favourably relative to past years: consumption growth has fallen, and gross fixed capital formation and exports have made a larger contribution to GDP growth. A decline in upward risks to price stability has also been a factor positively influencing macroeconomic stability. The inflationary impact of tax increases early in the year has proved transient, as has been reflected in falling inflation expectations.

However, little progress has been made in correcting external imbalance. The Hungarian economy has continued to proceed on a path of indebtedness that is unsustainable over the longer term. Since 2002 the country’s very high external borrowing requirement by international standards, fluctuating around 9 per cent as a proportion of GDP, has been covered mainly by debt issuance. Consequently, Hungary’s indebtedness has increased massively, net external debt as a per cent of GDP nearly doubling in the period since end-2001. However, a positive structural development has been the increase in the share of non-debt inflows of capital within current account deficit financing. The build-up of external debt has nevertheless continued, as evidenced by the over 70 per cent weight of debt creating financing.

Despite the high external deficit and rising outstanding debt, the money and foreign exchange markets have been fairly stable since March 2004. The extremely favourable environment, both globally and regionally, has also contributed to the maintenance of financial stability, in addition to the Bank’s gradualist approach to interest rate setting. Premia on high-risk investments are at historical lows; and investors’ strong appetite for risk in international markets makes it easier for Hungary to finance its high current account deficit. The markets’ attitude to external equilibrium problems has become more benign; consequently, robust economic growth worldwide, stimulating Hungarian exports, has also contributed to the low volatility of the domestic financial markets.

Neither households, nor the corporate sector is expected to perform marked adjustments which could facilitate a reduction in Hungary’s external deficit. For this reason, fiscal policy aimed at bringing down the general government deficit must be given a priority in halting the process of indebtedness and lowering the current account deficit to a sustainable level. Looking ahead, potential delays in reducing the government deficit pose the largest risk to stability.

A worsening in the external economic climate could be an additional source of risk for financial stability. First, an impairment of business conditions and a slowdown in export growth may increase the vulnerability of the Hungarian currency. Second, higher-than-expected rises in international interest rates and yields may affect higher-risk investments adversely and raise risk premia on forint-denominated investments. Either a decline in global economic performance or an increase in developed-country market rates may entail serious stability problems for the Hungarian economy. But the probability of these risks materialising in combination is low.

Closely related to the recent favourable developments in business conditions, the rapid rise in the amount of outstanding bank lending has continued. However, the depth of financial intermediation has increased unevenly, as the expansion of the domestic sources of funding has been unable to keep pace with credit growth. Consequently, the reliance of the banking sector on fund raising abroad has increased.

From a financial stability perspective, the strong pick-up in foreign currency-based lending has been one of the most negative developments of the past period. The further rise in unhedged foreign currency liabilities of the private sector has increased the exposure of the financial system. It is in the fundamental interest of all market participants to reduce the vulnerability of the financial intermediary system to negative shocks by adopting prudent lending and pricing practices. Accordingly, providing their customers with detailed information about the additional risks related to foreign currency-based borrowing is of paramount importance for banks.

Banks’ corporate loan portfolio quality has deteriorated in the course of the year. Higher credit risk can be attributed mainly to reasons related to the business cycle and increased debt service costs. However, higher risk taking, induced by rising competitiveness, has also contributed to the impairment of loan portfolios and resulted in lending to SMEs soaring. Probably, banks will be increasingly less capable of adjusting lending rates in accordance with the rise in credit risks. Consequently, this process is likely to add to financial stability risks over the longer term.

The Hungarian banking system has registered outstanding profitability in the recent period. Banks must prepare themselves for any change in conditions currently ensuring high profitability over the longer term. The sector might only be able to offset the fall in interest income and higher risk taking by significantly improving efficiency, were interest rates to fall and competition to intensify. This is particularly important because of the free movement of financial services within the EU, as Hungarian banks’ efficiency lags behind both regional and EU averages, despite their very high profitability by international standards.