Executive summary
Inflation is receding and growth has restarted in mid-2023. Fiscal policy should consolidate to curb inflation further and recreate fiscal space.
Economic activity declined amid high inflation. After a strong demand-based recovery following the COVID-19 pandemic, economic activity declined from mid-2022 until mid-2023, with high inflation eroding households’ purchasing power, and high interest rates, uncertainty and low confidence dragging down investment. Despite the contraction in output, the labour market has held up strong, with unemployment rising only marginally and a high number of vacancies.
Inflation rose to the highest level in the European Union (EU) before peaking in early 2023. It was initially due to international factors such as supply-chain bottlenecks following the pandemic, the overheating of the economy, and was then amplified by the surge in global energy and food prices following the outbreak of the war in Ukraine. Domestic agricultural prices also contributed to the exceptionally high food price inflation (Figure 1).
Source: OECD database on Consumer Price Indices.
Growth is projected to pick up in 2024 (Table 1), but the outlook is subject to significant risks. Beyond uncertainty related to inflation and energy prices, rising business failures may cause an increase in non-performing loans, which would further reduce credit distribution and weigh on economic activity. An incomplete or late delivery of EU funds that are currently subject to the implementation of rule-of-law reforms in Hungary is another key risk for investor confidence, the cost of capital and the exchange rate, beyond the direct negative impact on investment and public finances.
Monetary policy is tight. Monetary policy tightening started in mid-2021 and stepped up in the autumn 2022 amid an accelerating depreciation of the currency. As headline inflation peaked in early 2023 and declined throughout the year, monetary policy started to ease in the spring 2023. Uncertainties regarding commodity prices, core inflation, the exchange rate, and the anchoring of inflation expectations call for a gradual and measured continuation of monetary easing.
Fiscal tightening is underway. The pandemic led to a substantial deterioration of Hungary’s fiscal position. Fiscal consolidation started in 2023, but the headline deficit remained higher than in 2022 due to the economic downturn. A strong further consolidation would align fiscal policy with monetary policy efforts to curb inflation, strengthen public debt sustainability, and recreate fiscal space to finance significant ageing-related expenditures and the green transition.
Productivity growth is key to sustain living standards, especially in a context of population ageing. Structural reforms could help raising it.
Productivity growth has slowed since the mid-2000s, even more so in Hungary than in neighbouring countries. Hungary’s labour productivity was catching with G7 economies between the mid-1990s and the mid-2000s, but then started falling behind after the Great Financial Crisis of 2008-09. Productivity growth and income convergence have resumed now, but remain weaker than before the Financial Crisis. (Table 2).
Regulations limit business entry and competition in some key sectors. Competition is limited by stringent regulations in the retail energy, transport, and professional services sectors. This holds back productivity, including in downstream sectors.
Rigid industry structures and in particular the slow exit of weak performers, are related to remaining shortcomings in the insolvency framework. Firms with weak growth prospects immobilise significant amounts of capital that is not available for more productive firms. Further improving the insolvency framework would contribute to a better capital allocation and higher productivity.
Digitalisation is lagging behind, hampering productivity improvements in existing firms. While the pandemic led to an acceleration of digitalisation, Hungary has yet to bridge the gap with other EU countries in the adoption of advanced digital technologies, and the digital divide between small and large firms has widened recently. Accelerating the acquisition of digital skills in the population would facilitate the wider diffusion and use of digital technologies.
Recent reforms to promote public integrity should be fully implemented. These reforms have the potential to significantly improve the anti-corruption and public integrity framework. They can facilitate the release of EU funds and strengthen incentives for private investments.
While transfers keep poverty low, growth could be made more inclusive by reducing inequalities of opportunities between men and women and between income groups.
Social transfers keep income inequalities and poverty low. However, those in the upper income quintile receive a larger share of social transfers than those in the lower income quintile. Better targeting of social transfers would allow achieving the same redistribution in a more cost-effective way.
Inequalities of opportunities are significant. Women face large employment and pay gaps compared to men and intergenerational income mobility is limited. On average, it takes seven generations for children in the lowest income decile to reach an average income level (Figure 2). This low income mobility is related to the education system where students’ achievements are closely linked to their socio-economic background.
Source: OECD (2018), A Broken Social Elevator? How to Promote Social Mobility.
The pandemic revealed weaknesses in workers’ social protection. Hungary’s newly created short-time work scheme had a slow take-up and some workers faced large income cuts during the first pandemic wave. Many workers were also left without unemployment benefits. To avoid this, eligibility conditions could be relaxed and benefit duration extended, at least during recessions.
Stronger price signals and further investment in electricity supply from low-carbon sources are needed to accelerate the green transition.
Hungary’s green transition has made progress but needs to accelerate. For a large part, emission reductions achieved so far have been related to structural shifts induced by the transition to a market economy in the early 1990s. Regulations and standards are currently the main tools used to support the green transition, but they will likely be insufficient to reach the 2030 and 2050 emission targets.
Price signals are key for an efficient decarbonisation. The EU Emission Trading Scheme is the main price-based measure to curb emissions, but only covers a third of emissions. As a result, average carbon prices are low in international comparison, and below what is needed to meet emission targets (Figure 3).
Source: OECD (2022), Pricing Greenhouse Gas Emissions.
Energy price caps and poor dwelling insulation make residential energy use a main source of emissions. Price caps keep residential energy prices at one of the lowest levels in Europe, which is very costly for the government and discourages energy savings and improvements in energy efficiency. Household energy consumption is high and only a small share of dwellings are insulated ( Figure 4).
An ageing vehicle stock, low fuel duties and urban sprawl are pushing up transportation emissions. Over 70% of the car stock is older than 10 years. Low excise duties on motor fuels contribute to long distances travelled by car and high emissions, as do rapid suburbanisation around Budapest and traffic congestion.
The green transition will require a significant increase in electricity supply from low-carbon sources. Current plans to meet the expected increase in electricity demand are focused on solar energy and biomass. Nevertheless, burning additional biomass would increase emissions and reinforce an already acute air pollution problem. The potential for wind and geothermal energy sources is underexploited. Moreover, the development of intermittent energy sources will require massive investments in the electricity grid.
Note: For each country, energy consumption is corrected for changes in meteorological conditions across years.
Source: Odyssee-Mure, https://www.odyssee-mure.eu/
Ensuring a sufficient low-carbon electricity supply will be a challenge. Hungary currently imports 40% of its electricity from neighbouring countries, which are engaged in a similar decarbonisation process. Moreover, the implementation of the planned replacement of Hungary’s single nuclear plant in the coming years is subject to financial, technical and geopolitical risks.