Sources:Eurostat and NBH.
Hungary introduced a more proactive disinflation policy in 2001, with its constituents being the changes made to the monetary and exchange rate policy regimes.
Similarly, there are no material differences in meeting the fiscal criterion. Thanks to a steady reduction in gross debt in recent years, the fiscal indicator for Hungary has been below the 60% reference value for a sustainable period. Hungary is faced with a fiscal adjustment of a magnitude, in terms of general government finances, comparable to that which the reviewed members, except Ireland, faced in the nineties (see Chart II-6).
The high degree of long-term interest rate convergence indicates that market participants judge early membership in monetary union to be a realistic prospect.
II.2. Equilibrium level of Hungarian inflation in the event of entry into monetary union
As discussed in Chapter II.1, although lagging behind the less advanced euro area countries in terms of per-capita GDP, Hungary has reached, and in certain dimensions even surpassed, comparable indicators of those countries in the area of structural similarities and integration. Consequently, based on international comparison, Hungary forms an optimum currency area with the euro area, but, due to the phase of real economic catch-up, Hungarian inflation will likely be higher than in the euro area following the changeover to the common currency.
Although the time that has passed since the introduction of currency union has been too short to allow separation of cyclical from structural shocks, there has been a higher level of inflation observable in the less advanced euro-area countries as well. Excess inflation above the euro area average has been 1.1 percentage points in Spain, Portugal and Greece, and 2.9 percentage points in Ireland, since joining the euro. Below, we will attempt to quantify the size of the expected excess inflation in the case of Hungary.
The size of excess inflation is determined by the equilibrium real appreciationof the forint.11 This means that at any given exchange rate, domestic inflation is derived as the sum of average foreign inflation and equilibrium exchange rate appreciation over
11The remainder of the chapter draws on a study by András Kovács Mihály: Equilibrium Real Exchange Rate in Hungary. See Kovács M. A (2001).
a longer period.12 The equilibrium real exchange rate is usually defined as the relationship between foreign and domestic price levels in the same currency at which the economy is in a state of external and internal equilibrium.13 In other words, at a given exchange rate level the economy grows along with the trend potential output, in a way that the current account balance moves on a sustainable path over the long term.14A general equilibrium model describing the Hungarian economy in detail would be required in order to define the level of equilibrium real exchange rate. However, such a model is currently not available. But, starting from the theoretical framework, it is possible to determine the most important factors underlying the variations in the equilibrium real exchange rate. Below, we attempt to provide estimates for this.
The real exchange rate is the ratio of general domestic and foreign price levels expressed in the same currency. The aggregate real exchange rate can be decomposed into two factors – (i) real exchange rate of tradables,15 i.e. external real exchange rate (the ratio of domestic and foreign tradables prices expressed in the same currency) and (ii) the ratio of services and tradables prices (both for domestic and foreign prices), i.e. the domestic real exchange rate.16According to economic theory, the first component does not reflect a trend over the long term, developing as it does in a stable way.17 In contrast, the second component grows along a long-term trend, according to both theory and the empirical literature.
The consumer price-based real exchange rate appreciated by 28%in Hungary in the period 1990–2000. This implies a 3.2% real appreciation on a yearly average.
However, the evolution of the indicator can be divided into two clearly distinguishable phases. Annual average appreciation amounted to 8.5% in the period up to 1993;
and since then appreciation has only been of the order of 1%. In the first, transition
12 The calculation of the equilibrium real exchange rate uses inflation data on Hungary’s major trading partners according to their weights in trade, which is not identical with the weighting applied in the HICP. The section below does not take account of the bias arising from the composition effect.
13 See Black (1994).
14 Balance of payments current account sustainability can be interpreted in several different ways. In its stronger version it can be viewed as a path for the balance of payments which allows debt accumulation to be covered by future savings. Its weaker version refers to a current account that is consistent with a constant debt rate. Sustainability is also sometimes seen as a deficit that can be financedby capital flows stable over the medium run.
15This study undertakes a separate analysis of two sectors within the economy, with regard to price behaviour. They are the sectors of internationally traded and non-traded goods, hereinafter referred to as tradablesand services, for simplicity.
16 See Kovács and Simon (1998).
17 See, for example, Rogoff (1996).
phase, massive appreciation was required as a consequence of market liberalisation, although available information suggests that the extent of this appreciation was exaggerated, contributing to upsetting external equilibrium in 1993–1994.18 However, the 1% real appreciation observed ever since has been somewhat less than the 1.5%–3% values estimated for the equilibrium real exchange rateso far.19 This is attributable mainly to the fact that, while the domestic real exchange rate has appreciated continuously, the external real exchange rate has depreciateddue in large part to the operation of the crawling-peg exchange rate mechanism (see Table II-4).