Convergence turned into Divergence and Decline The Example of Hungary

1. Convergence turned into Divergence and DeclineThe Example of Hungary Lajos Bokros Professor of economics and public policy Central European University Member of the European Parliament Washington, DC, April 5, 2012

2. Lessons from transition • Development of transition countries is cyclical • Cycles are not synchronized among countries • Primarily explained by domestic factors • Predominantly economic,political,cultural • Institutions are weak, reforms are reversible • Transition is about institution building by • Reforms leading to growth and convergence • Reversing reforms and destroying institutions result in divergence and decline

3. Convergence based on groundbreaking reforms: Hungary 1990-1999 Slovakia 1999-2009 Divergence and decline based on postponement or reversal of reforms Slovakia 1990-1998 Hungary 2000-2012 Hungary & Slovakiadiametrically opposites

4. Reforms in Hungary1990-1994 • Establishment of the State Property Agency to drive privatization in a transparent way • Successful privatization of thousands of SOEs by traditional methods of auction and tender • Huge injection of FDI into the real economy • Groundbreaking legislation in banking, stock markets, bankruptcy, liquidation, accounting • Support to fast organic development of SMEs

5. Reforms in Hungary1994-1998 • Stabilization without recession started in 1995 • Optimal mix of monetary, fiscal and income policies leading to rapid, export-led growth • Social policy reform: shift from entitlements to need-based targeting of financial support • Higher education reform: tuition fee • Pension reform: mandatory private funds • Treasury management for the fiscal sector • Successful privatization of a number of banks

6. Instead of continuing Export-led Investment-driven Fiscally neutral hence financially sustainable growth The only rational policy in a small, open, poor, transition economy Growth was based on Domestic demand Driven by consumption and imports Fuelled by huge fiscal overspending, hence unsustainable, because It was supported by foreign borrowing U-turn in economic policy in 2000

7. Reform reversals 1998-2002 • Reducing considerably the contribution rate to the new mandatory private pension pillar • Opening up the opt-out option (back to PAYG) • 70% salary increase to civil servants, law enforcement officers and military personnel • Subsidies and tax credit to mortgage loans • Eliminating the tuition fee in higher education • Eliminating means testing in family support • Significant increase of the minimum wage

8. Fiscal profligacy with no reforms2002-2006 • 50% salary increase for all government employees (3 times more than civil servants) • 13th month salary to government employees • 13th month pension; increase of survivor pens • 20% increase of family allowances • 30% raise of stipends in higher education • Full tax exemption to minimum wage earners • VAT rate reduction without curbing expenses • Further increase of mortgage loan subsidies

9. Fiscal tightening & reforms blocked2006-2010 • Tax increases (VAT, PIT, excises, witholding) • Reducing price subsidies to energy and drugs • First, wage & hire freeze in civil service • Reducing the number of budgetary institutions • Introduction of tuition fee, co-payment in HC • Elimination of all the above after referendum • Attempts to introduce real estate tax blocked by the Constitutional Court in 2010 • Elimination of the 13th month wage & pension

10. Wholesale reform reversal I.2010-2012 • Nationalization of the mandatory private pension system and confiscation of its assets • Members of the mandatory private pension funds forced to return to PAYG by government blackmail • Regressive changes in tax & benefit systems (OECD) • Minimum wage rise with selective subsidies to firms • Direct government intervention into labor relations • Increasing state shareholding in selected enterprises • Central bank independence severely curtailed

11. Wholesale reform reversal II. 2010-2012 • Fiscal council with no resources but excessive political power (superimposed on parliament) • Tax obligation on severance payments by retroactive legislation (legal uncertainty) • Huge and highly distortionary sectoral taxes in banking, telecom, energy and retail trade • Large number of public providers of education and health care taken from local to central government • Mortgage loan amortization scheme tailored to help only affluent borrowers and destroying bank capital

12. Omnipotent, omniscient statedistorting and replacing markets • Size does matter: general government absorbs and redistributes close to 50% of GDP • Predatory and invasive government behavior not respecting private property and contracts • Competition rules ignored and/or breached • Public procurement rules tailored to favor well connected insiders and special interests • Rise in corruption in all levels of government

13. Negative results:divergence and decline • Maximum vulnerability: twin deficit & debt • Sovereign credit rating declined to junk level • Extremely high bond yields in secondary markets • Protracted stagnation despite marked e/r decline • Unemployment at 11.6%; on the rise again • Credit crunch, negative FDI-flow, capital flight • Divergence from V4 in per capita GDP terms • Destruction of credibility with erratic policies • Irrational “freedom fight” against the IMF & EU

14. General Government Gross Debt

15. Net External Debt

16. Twin Deficit

17. Twin Debt

18. Credit Rating of V4 by Moody’s

19. GDP per capita

20. Crisis and recovery