* As the effect of prospective measures cannot be quantified as yet, the projected ESA deficit is shown within the limits suggested by government specialists and analysts. Hence, this is not the National Bank’s projection, all the less so because the Bank’s projection is based on changes in the SNA primary balance, an indicator constructed using a different methodology.
It is also clear from the table that government interest expenses will decrease at the fastest pace in 2003, when they are still largely determined by former arrangements,
2001 2002 2003 2004 2005
preliminary assumptions* hypothetical hypothetical hypothetical
path path path
1. ESA deficit (1=2+3+4) –4.1 –6.5 –5.3 –4.4 –2.7
2. Interest balance –4.2 –4.2 –3.8 –3.6 –3.5
2. ESA central bank contribution 0.0 0.0 0.0 0.0 0.0
4. ESA primary balance 0.1 –2.3 –1.5 –0.8 0.8
5. Net EU funds 0.3 0.3 0.3 0.3 1.1
6. Primary balance excluding –0.2 –2.6 –1.8 –1.1 –0.3
EU funds (6=4-5)
7. Change in primary balance –2.4 0.8 0.8 0.8
excluding EU funds
132 The explanation for the apparently tight ‘reserve’ is that the cyclical sensitivity of the balance currently amounts to merely 15%, and is not expected to exceed 20% within a few years. For more on this, see Chapter III.2.4.
133 The term government sector is used here because current Hungarian terminology does not include the State Privatisation and Holding Company (ÁPV Rt.) and the Hungarian Development Bank (MFB Rt) as constituents of general government.
134As far as contributions are concerned, Hungary is assumed to meet the average EU contribution level from the first year. In respect of agricultural support, we use an estimate for Hungary’s share in the EU’s offer to the ten countries. In respect of structural actions, the calculations use the estimates of the Ministry of Foreign Affairs, which only minimally fall short of the estimates by the European Parliament.
and debts are expected to be gradually re-priced later. Firmness in measures aimed at complying with the fiscal criteria may further speed up interest rate convergence.
As a result of the further reduction in interest expenses, the size of the adjustment required in the primary balance may decrease, while more favourable monetary conditions may contribute to offsetting the negative effect on growth of fiscal adjustment.
In contrast with the interest expenses, access to EU funds134 cannot be expected, even under favourable circumstances, to exert further downward pressure on the size of the required adjustment. This is because only some payments make a predictable effect on the deficit, with the contributions increasing it and the agricultural subsidies decreasing it. By contrast, transfers that can be obtained in the framework of the structural actions depend on our absorption ability, and they do not automatically improve the deficit, as the subsidies are countered by expenditures and there is also need for co-financing. If these combined do not exceed the financing of the previous period for similar purposes (for instance environmental protection), the deficit may lessen, but if they cover additional expenditures, the deficit will remain unchanged. Inasmuch as Hungary’s absorption capacity proves to be significantly better than projected by the Bank on the basis of estimates by the European Parliament and the Ministry of Foreign Affairs, Hungary would gain access to more EU funds, but due to excess expenditures financed by these funds, there would be no reduction in the government sector deficit.
The size of the fiscal adjustment required from Hungary can be viewed as being average relative to earlier euro-area entrants. Of the 11 countries joining the euro area in the first wave, only two countries – Luxembourg and Ireland – complied with the 3%
deficit limit two years prior to the reference period. The first-round joiners were able to reduce the ESA deficit from 5% to 2.6% on average in the course of the two years, 0.4% of which was accounted for by a reduction in the interest burden. Greece implemented even more significant adjustment prior to joining the euro, as its ESA-based financing requirement, in excess of 10% of GDP in 1995, was brought down to
1.6% in 1999. The effect of a drop in the interest burden accounted for 4.5% of this improvement between 1995 and 1999. The adjustment proved to be permanent in most cases, with only Austria and Belgium experiencing some relapse during the two years following the reference period.
V.2.2. Reducing inflation
The inflation criterion requires that domestic inflation should not exceed by more than 1.5% the average rate of the three EU member countries with the lowest inflation in terms of the average rate in the year preceding the preparation of the convergence report. The rate of inflation to be complied with changes constantly, with the lowest rate since 1997 being 1.9% and the highest so far 3.3% in April 2002. In that month, the annual rate of inflation in Hungary amounted to 6.1%, which means that inflation has to be lowered by another 3-4% in order to meet the criterion.
The examination of the convergence criteria will not be confined to checking whether the prescribed values are met, but it will also examine whether the favourable indicators achieved are sustainable. A reduced inflation rate can be regarded as sustainable if market participants also incorporate a permanently lower expected rate of future inflation into their expectations.As the yield curve will reflect domestic inflation expectations less and less reliably as Hungary approaches monetary union, nominal wage growth may become the most significant test of inflation expectations.
A monetary policy issue of crucial significance concerns the date and costs of meeting the disinflation target as required by the Maastricht criterion. The central bank’s current inflation targets are 4.5%±1% at end-2002 and 3.5±1% at end-2003.
Provided that inflation follows its set path, meeting the reference value will require another 1-2% reduction after 2003, which, in view of the speed of disinflation so far, could be met during the reference year between 2004 and 2006. However, the economy may be hit by unforeseen shocks and the inflationary pressure they exerted could only be offset at the price of an excessive growth sacrifice. Therefore, the Monetary Council may temporarily tolerate a rise in inflation. In other words, unforeseen events bearing on the course of the economy may cause a delay in achieving the inflation reference value.
Meeting the inflation criterion may require that the inflation differential relative to the euro area be temporarily reduced below the equilibrium inflation differential (0.8-2.2%, see Chapter II.2). This may be a source of extra costs compared with a strategy aiming for joining the euro at a much later date. This inflation differential will, however, disappear only in the long term as the economy catches up. Indeed, postponing entry into the euro area by four or five years may push up rather than lower the costs. This is because if the disinflation process is reversed or remains flat at a high level for a longer period of time, expectations may become rigid and less susceptible to the announced disinflation programme. This, in turn, may push up the costs of disinflation. From the point of view of disinflation costs, the optimum strategy seems to be based on a steady decline in inflation, leading to a drop in the existing inflation differential within a couple of years.
The extra costs incurred if inflation is brought below the equilibrium level could be offset in the light of the fact that the disinflation process as a whole could probably entail a smaller sacrifice if it is implemented in the context of the preparations for joining the euro. The cost of disinflation in terms of a loss in economic growth depends on several factors, such as:
– the credibility of the announced disinflation programme and its influence on inflation expectations,
– the fiscal and monetary policy mix leading to a lower path for inflation, – the extent to which economic agents view desired monetary stability as
sustainable, and finally
– the cyclical position of the economy.
In view of the above factors it seems expedient for the government and monetary-policy decision-makers to co-operate in implementing the disinflation programme in an effort to meet the requirements for the euro area membership. The credibility of the disinflation programme is greatly enhanced by the fact that euro area membership is not one of many economic policy objectives in the context of an
‘ordinary anti-inflationary programme’. Indeed, it is a matter of national interest with a bearing on the country’s future well-being, with implications going beyond the direct economic effects. Therefore, economic agents are likely to hold it more
probable that economic policy will stick to its intended path. Credibility is also enhanced by the work of the European Commission and the ECB in monitoring and evaluating the implementation of the convergence programme.
Meeting the accession criteria also promotes the creation of an appropriate fiscal and monetary policy mix. In a small open economy, interest rate moves by monetary policy make their impact primarily via the appreciation or depreciation of the exchange rate. Thus, a greater emphasis on fiscal policy usually helps to reduce output costs and has a favourable influence on the sustainability and credibility of the programme through its effect on the balance of payments. From a monetary policy perspective, joining ERM II will enhance the credibility of a disinflation strategy based on the exchange rate. At the same time, if the target is credible, monetary conditions will become increasingly deterministic, and interest rates will converge to euro rates at more and more shorter sections of the yield curve, while exchange rate changes will be significantly influenced by the expected conversion rate.
Therefore, as the date of accession grows nearer, disinflation via fiscal policy must be given increasingly greater emphasis. It is beneficial in this respect if Hungary wants to meet the inflation criterion after the EU accession. This is because complying with the requirements of the Stability and Growth Pact will likely prescribe some fiscal tightening, independent of disinflation.
As shown by the experience of earlier EU entrants, in addition to fiscal and monetary policies, wages policy may also play a key role in disinflation (see Box V–3).
Box V–3
Role of wage agreements in disinflation
In the majority of EU countries, the moderation of wage demands has been of crucial importance in meeting the inflation convergence criterion. During the years preceding the examination of the convergence criteria, most member countries reached wage agreements for a duration of several (two or three) years. This was the case even in countries which had a different tradition. The success of keeping wage inflation within institutional limits was primarily due to a country announcing its intention to join monetary union.
As shown in the table below, even though nominal wage increases in most countries exceeded the extent of the inflation compensation in the pre-convergence-report years, real wage increases remained permanently below the rate of productivity growth. Of the euro area member countries, only Italy and Portugal produced higher real wage growth than productivity growth in the period before joining the euro area as a compensation for the exceptionally low rate of wage increases in both countries in the mid-1990s.